Tom’s Blog On Markets & Investments

Well there is no doubt that bank lending is in a pretty severe downward spiral.  The weekly numbers for Total Bank Credit are now declining at a 6% year over year rate.  The growth in bank credit has been negative for the past 6 weeks beginning with the week ending September 23.  In the dual recessions of 1980/1982, the growth rate never went south of 5% positive.  By October of 1983, growth was back in the double digits again.  So that’s pretty bad.

But if we take apart the gross bank credit numbers what do we find.  The two major categories are C&I (Commercial & Industrial) lending and real estate lending.  Some states and types of bank charters have limits on what percent of a bank’s total loan portfolio can be comprised of real estate loans.  There are no percent-of-portfolio limits (comments, please) that I know of on C&I lending.

Let’s take a look at the components.  Here’s a chart of the year over year change in C&I lending. TOTCI (St. Louis Fed data series name) is a very volatile series that is now steeply declining at minus 16-17%, year over year, much more dramatic than overall bank credit.   Real estate lending is doing comparatively much better. Here the year over year rate of change (a monthly series) is still a positive 3%.

Make no mistake, we have a surfeit of houses, hotels, retail and office space in most locales.  And valuations have come down, so banks are wary and eyeing their LTV ratios.  But that is not where the credit crunch is.  And Fortune 500 businesses, even down at the BB/Ba2 level, seem to be able to get funded okay.  But C&I, and I presume small business lending is being hit pretty hard, is on a death spiral down.  My anecdotal information suggests that this is as much demand driven as it is supply (lack of supply) driven.

Obama Administration!  Are you listening?

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That’s CDS (as in Credit Default Swaps), not the computer disks or Certificates of Deposit.  But David Einhorn the well-known chief of Greenlight Capital has come out unequivocally against their existence in a letter to his investors documented in this FT Column.  I never thought I would see this coming from a well-known hedge fund manager.  But I appreciate his candor.  I’ve been thinking all along that all we need to do is get them cleared by a well-capitalized third party clearing house, and, ideally, also get them traded on a listed exchange with publicly available time and price data.  Taken together those two things would go a long way to making these instruments respectable.

Einhorn claims there is no way to properly capitalize such a clearing house, however, and I wonder why this is.  I assume that if you trade and clear and require margin on CDS like futures contracts, why wouldn’t that work?  After all, we believe our futures markets are properly functioning and properly insulated from market shocks.

Part of his reasoning is that a bondholder hedged with CDS may actually want a company to formally enter bankruptcy or liquidation, so they can collect 100 cents on the dollar through the CDS contract, rather than some lesser amount through a distressed debt exchange or some other quasi-defaulting, quasi-bankruptcy process.  I am very sympathetic to this last argument and think he is right on.

Another possible concession for those who feel they absolutely must have CDS available is to make a law that if a creditor hedges some or all of their exposure in a CDS then they give up or lose proportionally their voting rights in a reorganization plan.  Hmmmm.  Hard to predict if that would have the desired effect in real life.  And, trying getting that one passed in Congress.

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The 190,000 job loss number is a tad worse than expectations.  Lots of bearish commentary on CNBC and Bloomberg TV.  The bond market has not rallied like it did last month, though.  Price action in USTs, yields down 6 bps or so, suggests the number is not that much worse than expectations.  Now look at the August and September non-farm payroll revisions.  Remember how much the bond market rallied after the September report of 263,000 jobs lost?  The 10 year ticked at 3.1%.  But that number has been revised to only down 219,000.

August and September job losses were overstated by a combined 91,000 jobs.  That’s almost 50,000 jobs a month.  The August number was revised from a loss of 201,000 to a loss of 154,000 jobs.  If October had come in at a loss of 140,000 jobs, the bond market would be selling off and the stock market futures would be screaming.

Net, net.  The recovery is on track, albeit at a not so blistering pace.  Next up for the markets: lots of worries, and rightly so, about the Christmas selling season and what that means both for corporate profits and for production plans into the first 4-6 months of next year.

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In yesterday’s October ISM survey, the Production Index registered at 63.3, for a 7.6 point move, the largest jump of any of the five components.  September’s reading was 55.7 and the August reading a 61.7.  Couple of notes on this data point.  Clearly more industries than autos are kicking in.  Since 1978 the ISM Production Index has registered 60 or better readings less than 19% of the time.  Two of those 72 readings above 60 are in the last 3 months. As shown below, it must be admitted that the results are due in part to the large number reporting that things are the same and fewer reporting things getting worse.  The percent reporting things are getter better has been flattish over the last 4 months.  Still, this a strong report making a sharp recovery and indicates that higher numbers are ahead.

ISM Production Index Better + Holding Steady

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Bloomberg story today on former hedge fund manager Phil Duff

In 2008, 80 percent of the commercial property in Greenwich was occupied by hedge fund firms, according to real estate broker CB Richard Ellis Group Inc.Thanks to collapses like Duff’s, 460,000 square feet of downtown office space, out of the 2.1 million square feet available, is empty.

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Re: my comments in the previous post about how nervous fund managers are about the Q4 and the strength of the recovery.  The price action in Goodyear Tire, down over 20% as I write, would be a good indicator of that.  Company forecasted a loss for the Q4 and stock just got killed.  After peaking at about $16.50 in early August the stock is now kissing $13.00.

For other signs of this fear, look at some of the retailers get hammered as well, mostly notably, Dillard’s and Macy’s.

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Yesterday afternoon Kansas City Fed President Tom Hoenig spoke to the CFA chapter here in town.  The main message is we have at least, at least a year of very easy monetary policy ahead of us.  My interpretation of the his comments below:  the Fed is still more concerned about deflation risk than inflation risk and will be for a while.  Although well-groomed in Fed speak these are the highlights from the meeting:

• “All recoveries are fragile [until they get stronger]” – Seemed to be a message of don’t despair.  I know the waiting is painful, but the recovery will happen.
• Chief monetary policy tip – (not a direct quote) The Fed won’t be raising the target Fed Funds rate until well into next year because it will be buying MBS in the market for a number of months yet.  Doesn’t make sense to try and increase credit by buying MBS and decrease credit at the same time by allowing Fed Funds to rise.  Encouraging that that seems a little schizophrenic, even for the government.  So don’t look for ANY FOMC action on short term rates before, say, March or April.
• President Hoenig thought it “would take at least a year for the Fed even to get to an accommodative monetary policy.”  Money is loose now and if a “normal”, accommodative rate for Fed Funds is 2% to 2.5%, it is going to take quite a while to get there.  Just shows you how panicked about the economy and the market reaction professional money managers are when they hyperventilate about the prospect of Fed Funds going from 0% to 1%.  There were quite a few related questions and discussions around this point.
• The Tenth Federal Reserve District does have a “significant” banking problem in commercial real estate
• When asked if he thought the national CRE problems were severe enough to trigger deflationary forces, Hoenig said he didn’t think so.  He pointed to the Core CPI number still being positive 1.5% or so.
• Interesting that he choose the Core CPI because back in 2000, Greenspan told Congress that the Fed’s preferred inflation measure was the ”chain-type price index for personal consumption expenditures,” ie, the PCE deflator.  And that year over year rate of change IS (and has been for four months since May) quite negative now, down 0.5% in the August reading.

What does all this mean?  Despite the fact that the dollar is stronger today, look for more USD weakness over the next few months.  The USD is oversold and a snapback could be sharp and sudden, indicating we may well have a equity market (including emerging markets) correction soon, especially as it seems that investors are now worried about Q4 growth and a weak Christmas.  The dollar rallies when risk aversion creeps back into investor psychology, as it is now.  For evidence of that take a look at the A$, Yen (AUDJPY) crossrate.  It has weakened some and will weaken more.

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Former Fed economists that I have heard speak indicate that the Fed, after running lots of simulations and models, has an ongoing, implicit 2% target for inflation. You can see their current thinking in the latest FOMC minutes.  It feels it needs that much inflation to meet its dual mandate. Over the last year its greatest fear is that at inflation rates below 2% it is too easy to tip the economy into deflation. This would have disastrous effects on some critical U.S. asset classes, namely residential and commercial real estate.  Right now we have negative inflation with no clear trend higher.  So the Fed is more worried about deflation than inflation currently.

There are only two ways to create inflation and they are related.  Increase the money supply faster than trend nominal GDP growth and devalue the dollar.  The Fed has already done #1 and short term interest rates are close to zero.  They can’t go any lower.  So it has now moved onto strategy #2, devalue the dollar.  I don’t see any policy makers that are thrilled with the current state of the dollar.  And I hear a lot of commentary that implies the Fed is driving down the dollar just because it is stupid or inept or to help the manufacturing sector or to help autos.  Those are all red herrings.  It is worried about deflation taking hold.

What does all this mean?  The dollar will be under pressure until the Fed can see inflation hitting at least 2%.  Right now 2% is at the high upper range of the most recent set of Fed staff estimates.  Gold, silver, most industrial metals and other currencies will be headed higher.  I expect gold or GLD, SLV to get pretty frothy before the major trend changes.

NOTE: This does NOT mean selling the dollar is a risk free trade.  In fact, it is getting to be quite a crowded trade.  The dollar is quite oversold now.  We could have one or more sharp 10% or so reverses in the dollar that will make people think the dollar is done going down.  But until inflation is a sustainable 2% the dollar will be under pressure and gold will head higher.

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Kansas City must be the capital of the world for best kept secrets.  There is a conference at the Linda Hall Library Friday, Oct 16th.  Some heavy hitters on climate change.  $30, including what will probably be a very nice lunch.  If you haven’t been to the Linda Hall Library, it is a very lovely building in a lovely setting near UMKC.

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Interesting story on NPR this afternoon that relates to the prospects for improved financial market regulatory reform.

What do sardine populations, Wall Street and Antarctica have in common? The answer is, they can all reach a critical moment — a tipping point — and change dramatically and unexpectedly.

Fish populations can crash. Markets can, too. And Antarctic ice shelves can melt with little warning. Those sudden changes can have an enormous impact, so it would be great to know about them before they happened.

The story is about mathematicians that seem to be getting better at creating models that predict tipping points, the point at which a stable system (could be biological, financial, social, whatever) suddenly becomes unstable.  The orign and motivation for much of this work is the study of animal populations and other environmental applications, but those of us that follow markets closely can see where this is headed.

Some quant that only other quants can (initially) understand will create a tipping point model that can be shown to accurately predict tail events, Black Swans in the current lingo.  The quant will go to New York or London, get hired by a hedge fund or bank proprietary trading desk, and make a lot of money.  Other quants will piece together the algorithm, the essentials of which will be published in a leading academic journal, and copy or create their own tipping point model.  At first the new algorithms will be used sensibly, but with the new money making technique spreading like wildfire, it won’t be long before one or more of several things happen.

• Hedge funds and other prop desks take on more risk
• Institutional investors of all kinds are educated on, sold and begin to buy overlay strategies that immunize them from tail risk
• Fixed income and mortgage gurus use the models to create billions of dollars of “immunized” higher credit quality securities
• The new algorithms facilitate unregulated, over-the-counter trading in innovative swaps and new derivatives
• The Basel Committee on Banking Supervision (authors of the Basel I and II bank capital accords) is persuaded that global banks can issue new “immunized” senior unsecured debt securities backed or priced using the algorithm
• It is discovered that the algorithms can not only predict tipping points but drive trading strategies that create tipping points in stocks, bonds, currencies or commodities
• Several rogue traders at different firms around the global gang up to create an unexpected bubble or a collapse in some large liquid market like sovereign bonds, oil, gold or currenices
• There are some big expensive accidents causing a bank or hedge fund to collapse
• The next 9/15/2008?

I could go on.  Point is, the next innovation that re-defines capital issuance, risk and risk taking is always just around the corner.  I’ve heard a lot of ideas but no good ways to re-regulate our banking system and capital markets to maintain the current structure of everybody gets to do everything: from taking deposits and clearing checks to underwriting securities and running proprietary trading desks.  If we want a financial system that serves society instead society and taxpayers creating tons of debt to bail out an errant financial sector then we need to return to the kind of risk taking separation envisioned in the Banking Act of 1933, aka Glass-Steagall.

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