I don’t often write about government policies that I like. It’s not that I’m crabby; it’s because they are so scarce. But today I will make an exception. Today, the Fed and the Treasury, along with several other financial regulators, correctly identified the cause of the small business lending problem–themselves–and took steps to fix it. It’s about time.

Today the financial regulators passed the grown man test by “manning up” to what we have known all along; banks have been effectively redlining loans to small businesses due to fears of regulatory reprisal. You can read the statement by clicking here.

They have made a start at addressing the problem by instructing banks to look at the health of the borrower, rather than computer models, when assessing loans. And they have gone on record that banks who do their homework and make loans to healthy small businesses will not be subject to criticism from the regulators.

The purpose of the directive is “to ensure that supervisory policies and actions do not inadvertently curtail the availability of credit to sound small business borrowers.”

Banks have loaned U.S. small businesses minus $300B over the past 12 months

As you can see from the chart above showing bank lending to business borrowers. it would have been helpful if they had started ensuring that this wouldn’t happen 15 months ago when banks slammed their doors shut for business borrowers. But let’s not quibble. I’m happy they are taking action now.

Longtime readers will know that I believe non-price credit rationing to be the principal trigger for downturns in employment. It happens when regulators get over-zealous and lay their heavy hands on lending standards. I called it a credit crunch in a series of articles I wrote for the Wall Street Journal in the early 1990′s and again in 2001, which prompted a vicious response from the then Comptroller of the Currency, who denied it ever happens. The fact is, business customers don’t decide how much money to borrow based upon the interest rate; it’s the availability of credit that matters.

This time around, non-price credit rationing has fallen especially hard on small businesses–the source of almost all new jobs. In the dotcom bust, only 15% of the drop in loans hit small businesses. This time it is almost half.

The facts are simple. Employment can’t increase until small businesses can borrow the money to meet payroll. Today’s step just might be a nudge to make that happen.

Bravo to the regulators for taking steps to fix the problem they created in the first place. Now it’s time for banks, large and small, to respond to this statement by giving small business owners the loans they need to do what they always do best–make more jobs for people who want to work.

JR

The credit crisis is all you hear about from officials in Washington and from talking heads on TV. Indeed, the credit shortage is still alive and well. Employment is still falling and small business owners–the only real source of new jobs–have an even tougher time getting working capital loans from banks than they did 2 months ago before bankers fell in love with the new government bailout plans. But it’s time for investors to move on to the next story.

Bank Reserves

The credit crisis is ending. The wall of money created by the Federal Reserve to extinguish the credit crunch and deflation that they, themselves, had created has rigged the deck so banks will make money. The banking system today is being run as a de facto monopoly bank by the Fed. The Fed is paying them interest on reserves, which at $990 billion are roughly ten times the level they were just eight months ago. Over the same period, bank depositors withdrew roughly $90 billion from their bank accounts to keep at home just in case their bank failed. As I pointed out in a post yesterday, there are signs people are beginning to exhale–currency holdings are no longer rising. When they once again feel safe they will put that $90 billion bank into their accounts, which will swell bank reserves by the same amount from 10x to 11x times last August levels.

This tsunami of reserves since last September translates into bank profits at no risk. The Fed pays the same 0.25% interest on bank reserves whether the bank lends the money to customers or not. How much? One quarter percent of the $1 trillion reserve increase equals $2.75 billion per year in incremental bank earnings. The spread between deposit rates–effectively zero–and lending rates, including fees is huge. And the FASB accounting rule change at the end of the first quarter that allowed boards of directors the leeway to value assets based upon their expected cash flow rather than firm quotes from dealers was a huge boost to bank balance sheets. That’s why bank stocks have knocked the lights out since then. And those reasons are why bank stocks have been the biggest bet in my portfolio this quarter with returns 17% over the market so far this year.

Now it’s time to change the bet gain. I still have big bets on bank and financial stocks but have been increasing my exposure to two other bets, China and inflation. Both bets have been working nicely.

My visits with Chinese leaders and Asian CEOs at the BOAO Forum in April convinced me that we were going to see a long string of positive growth surprises from China and its main suppliers around the Pacific Rim–Singapore, Hong Kong, Australia and Indonesia.

The inflation bet is still early. But the recent run of commodity prices and weakness of the dollar suggest it is not too early. Once the credit crunch and recession are off the front page people are going to focus more and more on two factors. First, the Fed tsunami of bank reserves will sooner or later translate into rising price levels. If the Fed allowed the reserves it has already created to remain in the market after the crisis is over the U.S. price level would rise to about 9x its current level over a small number of years, i.e., the $3 vanilla latte you bought at Starbucks today is going to cost you $30–you better start saving your money. Of course, the U.S. political system will not allow a nine-fold increase in the price level so sooner or later the Fed is going to have to take steps to reduce bank reserves. Hint: the same guys who brought you the current disaster are going to be the ones who will be in charge of shrinking reserves. This is not going to be elegant.

The other reason, of course, is that government spending is completely out of control. Ever since last fall when Treas. Secretary Paulson convinced Congress to give him $700 billion to spend however the hell he wanted with no controls or oversight the barn door has been open. Obama’s team has pushed trillions of dollars of new spending through that door in the space of a few months. The result is the $3.5 trillion budget Obama proudly presented to Congress. That budget projects budget shortfalls of roughly $1 trillion per year for the next decade. And that does not even include the added cost of his new national healthcare system.

Those huge spending numbers, of course, mean that Congress will soon increase every tax rate in the book including taxes on ordinary income, dividend income and capital gains as well as higher corporate taxes. We can also expect increased excise taxes on tobacco, liquor, and energy of a forms. Last week the White House also floated the idea of adding a national sales tax–they call it a value added tax–that would be a huge increase on working families. The problem is these tax rate increases are not going to generate much revenue–they never do–because people can easily avoid them by either using tax shelters or by simply deferring or avoiding the realization of income. Over the past 6 decades tax rates have varied all over the map but tax revenues, the amount people actually pay, has been 19% of GDP +/= one percent.

If spending is out of control and the government can’t raise more tax revenue we are going to have massive budget , or budget deficits, shortfalls every year. The Treasury is going to have to sell truckloads of new Tbills and bonds into the market every year as well as roll over the ones already out there. That is the scenario that is now beginning to spook the bond and currency markets. Big bank reserve growth, big spending increases and big budget deficits mean the market is being floods with dollar assets, which has to drive down the value of all assets denominated in dollars. That’s why the long Treasury bond yield has increased by more than 100 basis points, or one full percentage point, in recent weeks. And the dollar is posting new lows against both the Euro and the pound. And that’s why the vice Premier of China asked me last month if there was a way China could protect its $2 trillion Tbill portfolio against inflation and a falling dollar.

Faster growth in China and higher inflation point you in the same direction–commodity stocks. I have been increasing my exposure to oil (STO), coal (BHP) and copper and metals (FCX). I expect to add more to these positions next week.

It has been a long time since we needed to worry about the impact of budget deficits on interest rates. But now we do. The best analysis I have done on the topic is Chapter 4 of my book Lessons from a Road Warrior. Over the next few days I will write a series of blogs to help readers think through the issue.

JR

California’s budget mess is front page news. Some are trying to figure out whether they can (or will) cut spending enough to live within their means. Others are looking for new revenue enhancers–we don’t call them taxes anymore or people will vote them down in elections. Both are missing the point. It’s not only the budget, but the balance sheet that needs attention.

California does not only have a tax and spend problem; it has a balance sheet problem. There are too many promises of future cash flow to pay for pensions and the like. California needs a balance sheet solution. Not the one that failed in last week’s election—borrowing more money and accounting with mirrors. California needs to sell assets and shrink liabilities in order to regain financial health. When a person or a company declares bankruptcy the judge takes your house, your car, your toys and your other ‘stuff.’ Although state governments cannot, formally, declare bankruptcy, the same medicine will work for them as well. Easier said than done.

Yesterday I wrote about the strange accounting practices for government entities used by the Federal Reserve Board in preparing their quarterly Z1: Flow of Funds of the United States reports. They provide detailed information about cash receipts and cash disbursements for federal, state and local governments, consolidated on p. 110 for all levels of government. They include the information on current receipts (tax collections) and current expenditures as well as information on government purchases and sales of all sorts of assets including spending to buy fixed assets (buildings etc., $513.1 billion annual rate in Q4/08). But in the consolidated balance sheet, which I have reproduced above, they conveniently forget to mention that governments own real assets.

According to the table, All levels of government owned $3280.4 billion in financial assets and had total liabilities of $10,171.3 billion on 12/31/08, which seems to imply that governments had a negative net worth position of nearly 7 trillion dollars (-$6,890.9 billion). But where are the $513.1 billion in fixed assets they reported governments buying in the flow of funds table? Indeed, where are all the other tangible assets–the land, the buildings, the machines, the trucks and buses) the governments purchased in all the previous periods? If they had included government holdings of tangible assets the statements would look much different. Indeed, they would reveal the immense stockpile of real assets on government balance sheets that are available for sale to meet the government obligations everyone is writing about. The federal government, for example, owns more than 700 million acres of land (not reported on their balance sheet either). These assets can be sold outright or they can be sold and leased-back. Either way the cash is available to pay obligations. Either way we would have more honest financial statements.

JR

Yesterday I posted a piece about inflation and interest rates arguing that although recent inflation numbers have been very tame, the tsunami of bank reserves (=800%) released by the Fed is beginning to show up in inflation expectations, which is why long Treasury yields are rising. I ended with a warning that long-term bonds, not stocks, are the riskiest assets in our portfolios today.

A good friend asked me to review some of the logic in more detail. I will do so below:

1) The link between rising interest rates is not just a theory that might or might not be true. It is the definition of an interest rate, or yield. 

For example, In the chart below, if you pay pay $95.24 to buy a bond (really just an IOU) that promises to pay you $100 in one year then we would calculate its yield as r = ($100-$95.24)/$95.24 = $4.76/$95.24 = 5.0%.

If something changes in the marketplace and people lose interest in owning bonds so that their price falls to $90.91 then we would calculate their yield to be r = ($100-$90.91)/$90.91 = $9.09/$90.91 = 10.0%.

SO, SAYING THAT INTEREST RATES GO UP FROM 5% TO 10% IS THE SAME EXACT STATEMENT AS SAYING THAT BOND PRICES ARE FALLING.

2) the interest rate, or yield, (which is just a calculation we make by dividing a contractual interest payment by the price we pay for the security) on all sorts of securities rises and falls with inflation (actually expected inflation. Bet way to understand this is to think of the inflation rate as the “interest” you receive from owning a tangible asset like a house or a bar of gold. If you buy it for $100 this year and its prices goes up to $110 in one year (10% inflation) then the “yield” on the asset is $10/$100 = 10% (the increase in value divided by what you paid.) 

The logic is; inflation goes up => “yield” on real goods goes up => that makes the yield on real goods high compared with the yield on bonds and other securities => that makes people sell bonds to buy more houses and other hard assets => that pushes hard asset prices up and bond prices down => Falling bond prices increases the yield. => SO YOU DON’T WANT TO OWN BONDS WHEN THEIR PRICES ARE FALLING.

3) Over long periods the price level will be roughly proportional to the money supply. The money supply is roughly proportional to bank reserves. The Fed has increased bank reserves by +800% since last September. Together these mean that there is a big increase in the price level, hence inflation, baked into the recent Fed policy. When the economy starts to look a little more normal again (it is starting to do this already) people are going to worry about inflation unless the Fed does something to reverse their actions over the past 6 months.

Moral of the story–you don’t want to own bonds when people start worrying that inflation, hence interest rates, will go up.

JR

Last week we had reports on both producer prices (PPI) and consumer prices (CPI) for April. The headlines were about flat and falling prices. So why are interest rates going up?

April PPI showed finished goods up 0.3%, 0.1% ex food and energy and -3.7% from 12 months ago. Intermediate goods ex food and energy were -0.9% for the month of April and -10.5% over the last 12 months. Crude goods were -0.6% in April and a stunning -40% from a year earlier.

Consumer goods in April were flat (0.0%), and -0.7% from 12 months earlier. Energy costs were -8.5% over the past 3 months, and -25.2% from year earlier. 

So then why are interest rates going up? Not at the short end where the Fed is keeping fed funds and T-bill rates low, but at the long end as shown in the above chart of the 10 year Treasury yield. Rates have popped up by roughly one percentage point in recent weeks.

You can see the same bump in the 30 year Treasury yield above. Looking at the 30 year yield has fallen out of fashion due to the interruption in supply and thinness of the market compared with the ten year. But I think it is especially important because its duration is much closer to the duration of the stock market, roughly 25-30 years at today’s rate levels. In rough terms that means a one percentage point increase in the long Treasury yield (currently 3.17% for the 10 year and 4.18% for the 30 year) will reduce the intrinsic value (the expected value of free cash flow) of the S&P 500 by 25-30%.

So why are rates rising? Because bond market investors can see the end of the financial crisis that still dominates the headlines and the talk in Washington. They are looking beyond the credit crunch at the inflation implications of the Fed’s unprecedented tsunami increase in bank reserves (roughly +800%) since last September. They are right to do so.

I don’t think many economists would argue with the statement that an 800% increase in bank reserves, if allowed to remain in the market permanently, would increase the price level by about 800% over a few years. To clarify, that means the price of a quart of milk would go from $2 to $16! I don’t think that is going to happen because I believe the Fed and the political system would not allow it to happen. But it does mean that the Fed is going to have to start taking steps very soon to clean up their mess before it hits prices in a big way.

Here is the catch. The guys who are going to be in charge of cleaning up the mess by vacuuming up the 800% bank reserve increase (and an additional $90 billion that will come back onto reserves when consumers finally unclench their buttocks and re-deposit the $90 billion worth of $20 and $100 bills they have taken out of their bank accounts over the last year) are the same guys (the Federal Open Market Committee) that created the mess in the first place by first under-printing reserves in the year before last September, then over-printing reserves since then. The odds that they will handle this mopping up exercise with grace and agility are approximately equal to zero.

I’m not smart enough at this point to write the story of what happens when they try to do so. But I do believe we will see further increases in long rates as we approach the Fed hoover exercise, which could start to take place as early as the end of the year.

This has two implications to me: First, long-term bonds are the riskiest component of people’s portfolios in spite of what all the textbooks say. Second, the strong gains in the stock market caused by the Fed tsunami are real but temporary. There is no surer way to kill a long-term stock market that to increase bond yields.

JR

The chart below shows the amount of currency held by the public through last Friday. Can you detect a pattern? When people get scared, as they are now, they pull money out of the bank, out of money funds, and out of their brokerage accounts and stick it under the mattress.

 
When this happens, the initial impact is to shrink bank reserves by draining off increases in the monetary base outside the banking system. This is important because (at least until 2 weeks ago)the monetary base was growing quite slowly. During the period 9/27/07 to 8/27/08 the monetary base increased at a 2.6% annual rate, while bank reserves increased by just 0.9%. Both are too low to allow banks to provide working capital to their growing business customers, let alone to solve a credit freeze. That’s why I have been complaining about the Fed’s sterilization policy and that’s why I have been advising the administration, in a series of White House conference calls, that the rescue plan cannot succeed unless it has the proper Fed policy to support it.

Over the past 2 weeks, of course, all this has changed. The Fed has nearly doubled reserves, from $98.3B on Sept. 10 to $166.3B on Sept. 24. It is too soon to tell if this is a new policy (i.e., if they have abandoned sterilization), or if it is a one-time hail Mary pass. It would help if the Fed would clarify this in writing.

The increase in currency holdings also highlights one more thing. I think it is dereliction of duty for policy makers and political leaders to use fear as a weapon. Can you imagine Winston Churchill, or FDR, or President Reagan intentionally scaring people? In my book, a real leader helps people remain calm in difficult situations and helps them marshall their energies to fix whatever issues need to be addressed. At least since 9/11, we have used fear as a tactic for mobilizing public support for various policies and for manipulating people’s behavior. But fear, over long periods of time, is physically and psychologically debilitating. And fear tactics undermine the public’s willingness to respond when there is a genuine problem. I can’t help wondering how much of today’s fear is a reaction to that history.
JR