I hope that these people are right and that we are coming out of the recession. There are fears of a “W” (not Bush) or a “double-dip” recession and these should not be discounted. But, we don’t really want the recession to carry on in any form; we really don’t want the risks associated with the down-side.

Even though we may be at or near the bottom of the recession there are still plenty of concerns to deal with. My continued concern is that the collapse in the economy was primarily due to a supply side shift and was not initiated by a fall in aggregate demand. This I have tried to capture in posts like my June 22 effort: http://seekingalpha.com/article/144508-structural-shift-in-the-u-s-economy-is-really-in-supply. If the recession was, in fact, initiated by supply shifts then there are structural dislocations in the economy that need taking care of that cannot be satisfied by just increasing aggregate demand to put people back in the jobs in which they were formerly occupied. We cannot just return to factories that are only being partially used or have been cvacated. Trying to push things back to where they were just postpones the restructuring of the economy that needs to take place.

In the past twenty years or so, we, in the United States, have experienced two credit bubbles or credit inflations. These bubbles have created excess growth first in information technology in the 1990s and then in the housing sector of the economy in the 2000s. But, these credit bubbles were not just restricted to the United States.

There was a credit inflation throughout the whole world. Evidence of this has just been released in a report by Close Brothers Corporate Finance in the UK. (See “UK is Europe’s capital of distress” in the Financial Times: http://www.ft.com/cms/s/0/aba06ea2-758e-11de-9ed5-00144feabdc0.html.) The report claims that “The UK has western Europe’s highest percentage of financially distressed companies after being the leveraged buy-out capital over the past decade.” But, the report goes on to show that the credit bubble resulted in the serious collapse of the European manufacturing sector, as well as in the retail and leisure sectors. And, of course, there is the case of Japan in the 1990s and 2000s.

The problem created by credit bubbles or credit inflations (in addition to the excessive amounts of debt created) is that too much capacity is created in areas of the economy that cease to be needed any more once the bubble has burst. The normal response of the economy is to restructure so as to eliminate the excess capacity that exists and re-deploy resources into areas that are experiencing growth and development. A Keynesian effort to “pump up” aggregate demand is just an effort to re-employ resources in the same areas that formerly prospered but that now need to be “down-sized.” This does nothing to get rid of the excess capacity and postpones the restructuring of the economy. Furthermore it retains the misallocation of financial capital that evolved during the period of the credit inflation or credit inflations.

The drop in capacity utilization in the United States since the start of the recession has been extremely dramatic. Firms have gone from using about 81% of their capacity to using only 68%, a drop of 16%. This is the steepest drop for the longest period of time in the data series. But, even more important in my mind is that capacity utilization has been dropping steadily since 1967. Obviously, capacity utilization drops in periods of economic recession. Yet, in the United States, capacity utilization, after a recession, has never returned to the peak level it reached in the previous period of economic expansion.

Capacity utilization in the United States has been falling since the 1960s. This can be seen in the accompanying chart.

Although the United States has grown around 3% compounded annually over the last forty years and employment, through most of the period, has been at relatively high rates, there are still two pieces of information that are rather unsettling. The first is the continuing decline in capacity utilization just mentioned. The second is the decline in the civilian participation rate. For the United States, this rate peaked in the 1990s a little above 67.0% and has declined through the late 2000s remaining below 66.2% since 2004. This may not seem like much of a fall but it indicates that a lot of people have left the labor force!

The latter problem can be confirmed by figures from the Bureau of Labor Statistics. There are major sectors of employment in the United States that have experienced significant reductions in jobs and employment. These are in industries that one could seriously argue were in substantial need of restructuring. (I will return to this topic soon in another post.) The question is, should people to be pushed right back into these jobs again by a government stimulus program of increasing aggregate demand? Instead, it seems as if there needs to be a significant education of a large portion of the civilian population that would like to participate in the labor force again.

If there are structural problems in the United States and in the world that result from the existence of excess capacity in industries that are declining or less technologically relevant, shouldn’t we let these industries decline or try to become technologically relevant rather than stagnant? Should we try and keep people producing buggy whips when there are means of transportation evolving other than buggies?

So, to reclaim full economic health there is a need to reduce the excess capacity that has been built up in industries that are not so relevant any more and a need to deleverage financial structures. Unfortunately, a large portion of the needed financial deleverging is connected with firms that have excess capacity. Furthermore, there is a need to restructure U. S. manufacturing and business, and train more of the workforce to fit into twenty-first century jobs so as to get the labor participation rate up.

In my study of the Great Depression, this is one of the reasons why it took so long for the United States economy, and the world economy, to recover through the 1930s. The structural change in the United States taking the country from an agricultural society to an industrial society did not really take place until the beginning of the Second World War My concern is that the needed current economic restructuring will be delayed if Washington continues to focus on companies with redundant capacity by stimulating the re-employment of the same workers that used to work in them. The economic statistics (the leading economic indicators) may continue to improve in such cases, but the economic recovery will continue to languish.

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What Kind of Economic Recovery?

The company provides services to a broad range of commercial, industrial, utility and institutional customers. They report operations in six market segments: (a) electrical construction and facility services within the U.S.; (b) mechanical construction and facilities services with the U.S.; (c) U.S. facilities services; (d) Canada construction services; (e) United Kingdom construction and facilities services; and, (f) Other international services. The electrical construction and facilities segment involves systems for electrical power transmission; premises electrical and lighting systems; low-voltage systems, such as alarm, security and process control; voice and data communication; roadway and transit lighting; and fiber optic lines. Mechanical construction and facilities services include systems for heating, ventilation, air conditioning, refrigeration and clean-room process ventilation, fire protection; plumbing, process and high purity piping; water and waste-water treatment and central plan heating and cooling.

Consensus estimates for sales ending 12/09 are projected to be $7,246.88 million. Consensus EPS estimates for the same period range from $2.28 to $2.65.

Sales growth is 24.8% YOY and EPS growth is 45.1% YOY. The historical five year growth rate for sales is 8.4% and for EPS it is 13.2%. The company reported positive earnings surprises for the quarters ending 10/08 and 07/08.

At its recent price of $20.72, EME is selling at 7.9X next year’s estimated earnings. Operating margins have steadily expanded from 0.9% in 2004 to 4.2% currently. Similarly, net margins have grown to 2.5% from 0.7% in 2004. The company does not pay a dividend.

Our estimate of fair value is $29.97 to $48.96 with a mean value of $41.97. Using consensus EPS of $2.58, EME is valued at 11.6X to 18.9X earnings; the average fair value multiple is 16.27X earnings. The low end of our estimate provides a PRG ratio of 0.88, based on historical growth rate.

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EMCOR GROUP, INC. The Rebuilding Of America

For over a year I have been arguing that more attention needs to be given to the supply side of the equation. Yes, the growth rate of real GDP has been going down and the rate of employment has been going up. But, the rate of inflation, as measured by the rate of increase of the GDP price deflator has not declined since the fourth quarter of 2007. If it were just a demand side problem, this would not be the case.

I focus on the rate of increase in the GDP implicit deflator because of some of the measurement problems associated with the Consumer Price Index, such as the treatment of housing expenses and energy. Certainly, the CPI should be watched, but in dealing with economic aggregates, I prefer the former.

My point has been that if the problems in the economy were all tied to a substantial fall in aggregate demand, then there should have been a more substantial lessening in the rate of price increases. Consequently, my argument has been that something has happened on the supply side of the economy for the numbers to have been reported as they have been.

I would like to point to two areas of the United States economy that indicates that the problems of recovery may be more difficult to overcome than if the dislocation in the economy were just one of inadequate aggregate demand. The first area is that of industrial output; the second area is the labor market.

In terms of the industrial base of the economy I would like to focus upon industrial production and the industrial utilization of capacity. Industrial production has been declining steadily since the start of the recession in December 2007. At that time, industrial production was growing at about a 2.0% year-over-year rate of growth. By April 2008 the year-over-year rate of growth had become negative. The figures for 2009 are
January -10.8
February -11.3
March -12.6
April -12.7
May -13.4

This certainly shows a continuing weakening in the economy. However, taken by itself I don’t think that it carries more meaning than does the decline in the rate of growth of real GDP which has been declining as well.

Combine this performance with the figures on capacity utilization and one gets a different picture. As expected, total industry capacity utilization has dropped substantially in this recession. In December 2007, the figure stood at a little over 80.0%. In May 2009, capacity utilization had fallen to about 68.0%. This is the largest 18 month decline in the post-World War II period.

But, this is not all. The peak in capacity utilization in the past ten years was only slightly more than the December 2007 figure. But, this peak of the last ten years was substantially below the level of capacity utilization for most of the 1990s which was below the peak utilization in the 1970s which was below the peak utilization in the 1960s. That is, it appears as if we have been using less and less of our capacity on a regular basis since the 1960s.

The structure of our industrial base is changing. We can see that in autos, in steel, and in many other parts of our manufacturing base. It appears as if the weakness in our economy is composed of two things: first the cyclical swing in business; but this weakness is on top of a secular decline in our productive ability. The economy is in the process of restructuring!

This shift is also showing up in labor markets. The civilian participation rate in the labor force for the United States rose from the late 1960s into the 1990s when it peaked a little above 67.0%. The civilian participation rate has declined since late 2000 and has remained below 66.2% since 2004. In terms of the number of people who are not participating in the labor market any more, this represents a large number. People have left the labor force in the last five or six years and this trend has, of course, been exacerbated by the recession. Over the past forty years the rise in the participation rate has slowed down or stopped during recessions, but at no time did it decline as it did in the in the past six years.

Of further interest, the Labor Department reported that separations from jobs in April remained relatively constant as they have for the past two years, but the rate of hiring continued to be quite low. In early 2008 the percentage of the labor force that were separated from their jobs was about equal to the percentage that were being hired. Since then separations have exceeded hirings, as might be expected, causing the unemployment rate to rise.

In terms of those that were separated from their jobs, there was a dramatic shift between those that quit their jobs and those that were laid off or discharged from their jobs. The percentage of layoffs and discharges rose dramatically from April 2008 to April 2009 whereas quit levels dropped substantially. That is, although separation rates did not change much at all during this time, the composition of those being separated from their positions experienced a tremendous shift. This is an indication that there is a structural shift in what is happening in the labor markets.

This information leads me to believe that there is a substantial restructuring taking place in the United States economy. And, a structural shift is a supply side issue and not a demand side issue. In fact, demand side responses can just make a bad situation worse by trying to force people back into positions that companies and industries are attempting to eliminate because the world has changed.

The figures on industrial production and capacity utilization seem to indicate that industry is changing and the numbers from the labor market reinforce that conclusion. Pumping up aggregate demand is an attempt to stop this restructuring or, at least, slow it down.

The problem that policymakers’ face is that they, or we, do not know what the new industrial structure is going to look like. It is impossible for anyone to know. People can make guesses, but that is all they are—guesses. And, in situations like this, it is more likely that the guesses will be wrong rather than being right. It’s just that the future is unknown. The need for the United States economy to restructure just adds another “unknown, unknown” to our list of “known unknowns” and “unknown, unknowns.” My guess is that this restructuring is going to take some time and could be sidetracked by huge government deficits and a supportive monetary policy.

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A Walk on the Supply Side

The high volatility in the financial markets has resulted from the high degree of uncertainty that plagues the market with regards to what is going to happen to the economy, the financial system and whether or not the programs initiated by the Obama administration will work. The stocks that have been moving the most have been those that have gotten a lot of publicity over the last six months or so and in which there is a lot of uncertainty connected with the unknown future of the companies they are associated with.

Niederauer goes on to say “large institutions and other long-term investors” have basically sat on the sidelines during this little run-up. The short-term traders do not need to take an extended view of prospects and therefore attempt to make money on the ups and downs of the market. Thus, it is hard to use the recent uptick in the stock market as a longer-term indicator of the economy with a lot of confidence at this point. He adds that when the large institutions and other long-term investors come back into the market the trading volumes will become larger and will be more consistently there.

And, why should the longer-term investors come back into the market at the present time. A piece of evidence against jumping in right now is the bankruptcy of mall owner General Growth Properties, Inc., which is recorded as one of the largest real-estate failures in the history of the United States. The cloud over the commercial real estate sector of the economy has been approaching for some time now and this news seems to be just the first of many that will follow.

Also, Capital One Financial, one of the largest issuers of credit cards in the United States, just announced writedowns that have exceeded the unemployment rate, an interesting relationship if you ask me. It seems like this is an indicator of how bad things are when credit card charge offs exceed the unemployment rate but I don’t see any necessary correlation between the two. Anyhow, the expectation is for credit charge write offs to continue to rise as home foreclosures and personal bankruptcies continue to rise indicating more pain in the future. Personal bankruptcies have risen almost to the pre-2005 level, the time when the bankruptcy laws changed.

In addition, although people keep contending that the housing market is getting firmer, housing starts continue to show a substantial weakness. Housing construction in March fell to an annual rate of 510,000 units, the second lowest level on record. This total was almost 50% below the level of starts attained in the same month last year.

Building permits also fell 9 percent from February to an annual rate of 513,000, which is down from 932,000 last year. This number provides some indication of the amount of future construction that will take place.

And, the amount of foreclosures on personal property continues to rise. It has been reported that foreclosure filings increased 9 percent in the first quarter of the year with filings rising 17 percent from February to March. The area of personal finance continues to be unsettled. And, this is not even considering the rising level of small business foreclosures that seem to be rising monthly.

There is little good news to encourage the large or longer-term investor coming from other areas in the financial sector. We still have to see the results of the “stress test” on the banking system. It seems that Secretary of the Treasury Tim Geithner has messed up another public relations opportunity, this time over the announcement of the results of the stress test or the fact that there will be no announcement of the results or that there will be a limited release of information. For an administration that supposedly was going to see to it that the government operated with more transparency and openness, the Treasury Department and its leader have certainly not contributed to the confidence that it is on top of the situation.

Then there is the concern that the banks have not reported accurately the value of their assets in order to obtain TARP funds. (See my post http://seekingalpha.com/article/130712-are-the-banks-telling-us-the-truth.) There is seemingly no reason why we, or anybody, should take seriously the financial reports coming out of the banking system, including the quarterly reports being released this week by major financial institutions!

We further read that “Fitch Ratings is warning investors in complex loan investment funds about the practice by their managers of accounting for loans at par, regardless of market value of the loan.” (See “Fitch alert on accounting for CLOs”, http://www.ft.com/cms/s/0/cb8f70ac-29e7-11de-9e56-00144feabdc0.html.) Fitch is concerned that managers are attempting to get around rules on how they account for collateralized loan obligations (CLOs) by encouraging investors to consent on having certain restrictions removed so that they can mark assets up to par. In early March, Moody’s warned the market that there would be a review of ratings in response to changes in its rating assumption, including an increase in expectations of the default rate among leveraged loans. In February, Standard & Poor’s warned investors that the debt issued by CLOs could be at greater risk of losses than they realize if only a few companies default.

And, there is more!

The problem is that there is too much debt around. Debt loads have to be worked off and in some way reduced. Of course, one way to reduce debt loads is to inflate away the real value of the debt which is what Bernanke and the Obama administration are trying to do. Otherwise, debt has to either be paid down or written down as Capital One is doing.

A helpful suggestion for government action is to provide money to write down the principal of mortgage loans rather than help troubled mortgagees to get interest rates on the loans reduced. This would have a more stunning effect on home owner performance than would trying to put people to work or to reduce interest rates or to inflate away the debt. It would also probably be cheaper. Pouring money into the banks has not worked! Why not try something else to reduce the debt problem?

Whatever is done, time is going to have to pass. Large investors and longer-term investors will not come back into the stock market until they see that the debt issue is passing and that people, consumers, have their balance sheets more in control. Until then, the stock market will just be a traders’ market. So don’t trust market swings one way or another. Focus on what the real problem is.

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Be Careful What Bandwagon You Jump Onto

These growth measures are high historically, but only modestly higher than the rates of growth that were being achieved before the Federal Reserve began pumping up its balance sheet in September and October of 2008. The important thing is the changes that have taken place within this broad measure of the money stock. The movement has been from time and savings accounts to transaction accounts as people have moved their funds from accounts that are interest-earning to those that are basically used to make payments.

The first look at a smaller component of the M2 money stock is to examine the performance of the M1 money stock. For the first half of 2008, the M1 money stock hardly grew at all on a year-over-year basis. But, in the third quarter this measure began to increase as the financial meltdown occurred. For the third quarter the M1 money stock grew at a 3.1% year-over-year pace, but this jumped up to 11.4% in the fourth quarter, followed by a 13.4% growth rate in the first quarter of 2009 and a 16.3% rate of increase in the second quarter.

The monthly year-over-year growth rates for April, May, and June of 2009 were 15.1%, 15.3% and 18.4%, respectively. Something is happening within the M1 measure of the money stock that is not happening to the non-M1 component of the M2 money stock which remained relatively flat during these three months.

What is growing?

Well, demand deposits at commercial banks grew by 44.3% year-over-year, in June 2009, up from 33.1% and 34.5% in April and May, respectively. This is also up from slightly under 30.0% for the first quarter of the year. People and businesses are moving their money into transactions accounts in order to have funds available to meet their day-to-day spending needs.

We see a similar jump in “Other Checkable Deposits” at commercial banks and thrift institutions as these accounts were growing by more that 12.0% in June 2009, up from 6.5% and 7.2% in April and May, respectively. In the first quarter of the year these accounts were only increasing at around a 2.5% to 3.0% rate of growth.

Another component of the M1 money stock is also increasing quite rapidly. Coin and currency held outside of commercial banks has been steadily rising by more than 11.0% year-over-year every month in 2009. A year ago the pace of growth in coin and currency was about one-half of what it is now. Again, one can only draw the conclusion that people are buying more and more things with cash now than they were a year ago. This is another indication of the fact that so many people are unemployed or are going bankrupt.

Where are the funds going into transaction accounts coming from?

The sources of these shifts seem to have been from primarily two areas, Small-denomination time deposits and retail money funds. There has been a drop of about $90 billion in deposits in retail money funds over the past twelve months. The decline in these accounts, year-over-year, is now about 8.5%. The rate of increase in small-denomination time deposits has dropped by 50% in the last six months and there has been an outflow of about $110 billion from these accounts since December 2008.

The conclusions one can draw from these data, I believe, are very clear. People and businesses have become much more conscious of their need to have cash and deposits available for meeting their daily living needs. People and families are moving funds from their small, low interest-earning accounts where they have not been earning much at all. These same people and families seem to be leaving funds in bigger accounts that earn higher rates of interest. It will be interesting to see what happens to these accounts in upcoming months if unemployment continues to rise and bankruptcies remain at high levels. In addition, businesses have found that other short term sources of funds are not available and so have had to become more liquid in order to satisfy their cash demands.

One could argue that the actions of the Federal Reserve have had little stimulative impact through the banking system since the rate of growth of the M2 measure of the money stock has only increased slightly so that the rapidly increasing rate of increase in the M1 measure of the money stock has resulted from individuals and businesses redeploying their short term assets.

This conclusion is reinforced by the information repeated in my July 16, 2009 post on “The State of the Banking System.” (See http://seekingalpha.com/article/149272-the-state-of-the-banking-system.) Commercial banks are not lending except in to consumers and just to consumers that have pre-arranged lines of credit like equity lines on homes and credit cards. This just supports the argument that people are doing what they can to make day-to-day ends meet. And, commercial and industrial loans have actually declined on a year-over-year basis. The argument can be made that no one is going to do anything that would lead one to conclude that economic units are going to increase their spending in a way that will stimulate the economy.

We need to continually watch what is going on in the banking sector. We are going to watch for further changes in behavior that might indicate the changing decisions of families and businesses. Of course, things could get worse and we need to watch for that. But, if things are going to get better, one place to look for changes in behavior is to watch where people are allocating their short term funds and whether or not banks are beginning to lend again. However, it doesn’t seem as if this change for the better will appear soon.

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What Do The Money Stock Figures Tell Us?

The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”

Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.

The potential—fraudsters would be receiving indictments!

Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.

The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.

The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.

Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!

But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.

Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.

It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.

Is this fraud? That is what Mr. Barofsky is going to have to find out.

Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.

In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”

My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!

And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!

Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.

We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.

And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See http://www.ft.com/cms/s/0/cb2ddafc-278c-11de-9b77-00144feabdc0.html.) “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!

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Are Banks Telling the Truth?

“The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!”

On this issue, let me point out the post by Jonathan Weil on Bloomberg this morning, “Crisis Won’t End Until Balance Sheets Get Real” (http://www.bloomberg.com/apps/news?pid=20601039&sid=azsX7o.atu7U). After presenting interesting data on the state of commercial bank balance sheets he argues the following:

“Banks and insurers got Congress to browbeat the Financial Accounting Standards Board into making rule changes that will let them plump earnings and regulatory capital. There also was Fed Chairman Ben Bernanke’s line in March about “green shoots,” which sparked a media epidemic of alleged sightings.

For all this, we still have hundreds of financial companies trading as though the worst of their losses are still to come. Just imagine what their prognosis might be if the government hadn’t pulled out all the stops.”

And, then Weil closes:

“Truth is, there’s no way to know if the economy has turned the corner, or if last quarter’s market rally will prove sustainable. Yet when this many banks still have balance sheets that defy belief, it means the industry probably hasn’t re- established trust with the investing public.

Trust, you may recall, is the financial system’s most precious asset. On that score, we still have a long way to go before we can say this banking crisis is over.”

This is the short run problem and it is the one that is going to determine whether or not the Federal Reserve is going to be able to shrink its balance sheet. This has been the point of my last two posts. And why are we facing such uncertainty at this point? Because the Mark-to-Market rule was pulled and because there is not enough openness and transparency in the public financial reporting of financial institutions. If there are going to be regulatory changes in the future, a lot is going to have to be changed as far as the reporting requirements for financial institutions is concerned.

But, this is just the short run problem.

The longer run problem is the projected budget deficits of the Federal government. Even if things work out as the Federal Reserve has planned as far as bank reserves are concerned and Federal Reserve credit retreats back to where it was in August 2008, there is the massive problem facing the country about how prospective government deficits are going to be financed. The bet is that the Fed will finance a substantial portion of the deficits to come. Let the printing presses roll!

The fear? Inflation.

But many say, we are in a severe economic contraction now. The fear should be deflation and not inflation.

The only response to this counter argument is that in the latter half of the 20th century, any nation that has run substantial deficits has, sooner or later, run into problems related to inflation. Monetary authorities are never so independent of their central governments that imprudent fiscal policies are not in one way or another underwritten through some form of monetization. And, since this happens time after time, how can the international investing community sit on the sidelines and do nothing? Yes, the United States is in a severe recession right now, but what are your odds for the monetization of a lot of the Federal debt over the next three years? Over the next five years? Over the next ten years?

Where do you look for such for an indication of market sentiment on this? Look at the value of the United States dollar. The dollar fell by about 15% against major currencies in the latter part of the 1970s as the Carter budget deficits seemed to get out-of-hand. As we know, Paul Volker played the savior there by conducting a very restrictive monetary policy to bring the value of the dollar back in line. However, the Reagan budgets became so severe by 1985 that the value of the dollar began to plummet. In the face of continuing deficits and the realization that this would continue to result in a weak dollar, Volker gave up the reins of the Federal Reserve in August 1987. The dollar did not pick up strength again until fiscal restraint was returned to Washington with the Clinton administration as the value of the dollar rose over 25% from April 1995 until the end of 2000. The massive budget deficits of Bush 43 were translated into another precipitous decline in the value of the dollar which fell by almost 40% between the middle of 2002 to March 2008.

The fiscal policy of a nation does matter to the international investment community!

But, you say, look at all the other major countries having economic problems and their budgets are out of balance as well. Look at England, Germany, Italy, France, and others.

The response to this? This is not the case for many of the major emerging countries of the world, specifically the BRIC countries. Perhaps one leaves Russia out of this, but China, India, and Brazil are going to emerge from this period much stronger relative to the United States than could have been thought even a year ago or so. So is Canada and several other important countries. This world crisis is going to shift world economic power in a way that has not been seen since the shifts in world power that took place in the 1920s and 1930s. And, international investors are realizing this!

Yes, the dollar will still be used as the reserve currency of the world…for a while longer. The Chinese, and the Russians, and the Brazilians, and the Indians all realize this. And, even though they keep talking about establishing a new reserve currency, they seem to back off and say that the dollar cannot be replaced right now. Yet, the Chinese have called for the Group of 8 to talk about a new reserve currency at its upcoming meeting. The issue IS on the table and my guess is that it is not going to go away.

Which brings me back to the deficits. In my mind, the budget deficits of the United States government are out-of-control right now and there is great concern that this administration will not be able to regain control of them in the near future. There is no “reversal” mechanism that is built into these budgets as the Fed has attempted to build in a “reversal” mechanism in its efforts. As a consequence, great pressure will be put on the monetary authorities over the next several years to monetize a substantial portion of the debt that will be created. The history of the past fifty years or so is that the Fed will not be able to avoid the pressure. This is perception that the international investing community will be bringing to the market when it place its bets. This can be translated into higher long term interest rates in the United States and a continuation in the decline in the value of the United States dollar.

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Is Treasury’s TARP Debt Already Monetized? Part III

Debt is the problem and it currently continues to haunt most businesses, governments, and individuals in the economy. It is a problem because this debt load has to work itself out. But, in working out the debt problem, the economy suffers and will continue to suffer.

The current debt crisis is so severe because of the credit inflation created by the U. S. Government over the last eight years of so. During expansions, credit inflations take place. This is what happens as the economy is stimulated and confidence in the private sector builds and things appear to be good and getting better. Credit inflations don’t have to directly result in general price inflation, although they can end up with this result.

In the 1990s as well as the 2000s we have had credit inflations where price increases have been relatively mild. In the 1990s we saw the stock market bubble and the credit inflation with respect to new ventures. However, during that decade we saw the federal government turn a deficit budget into a surplus budget by the end of the century. In the 2000s, we saw the housing bubble and the general credit inflation, but we also experienced a huge increase in government debt on top of everything else. Debt was good and most partook of it!

If the credit inflation during a period of economic expansion is not too excessive then the following correction that must take place can be relatively mild and reasonable and the government can come in and re-flate the economy so that the financial dislocation can be righted in a reasonable amount of time without too much “hurt” in the economy in general. Moral hazard is created, but what’s the problem with a little moral hazard? Right?

This is what happens in most minor recessions.

An exception occurred in the credit inflation of the 1970s. President Nixon was so paranoid about getting re-elected that he set about inflating the economy and connected this with taking the United States off the gold standard, floating the dollar, and freezing wages and prices. This philosophy was not abandoned by President Ford. Jimmy Carter just inflated, period. And, by the end of the decade, serious work had to be done to bring general inflation under control.

What happened in the decade of the 2000s was of a totally different nature. The debt structure that was created through this decade’s credit inflation could not be sustained. Debt was growing way more rapidly than the economy could support and the resulting imbalance was greater than at any time since the Second World War. Almost everyone was excessively over leveraged. The headlines focused first upon the subprime market and then upon Structured Investment Vehicles (SIVs) and the Collateralized Debt Obligations (CDOs). And, then it became apparent that this excessive leveraging had been going on everywhere in the economy. And, the federal government was right up there with everyone else.

There is too much debt out there! Yes, there is deficient aggregate demand, but that is not going to be corrected until the debt situation is corrected…no matter how much Paul Krugman and the Keynesian wing of the world cry out! People and businesses are going to have to get their balance sheets in order before private spending will really pick up. Unless, of course, the government is able to get a hyper inflation going again which is the classic solution for an economy with too much debt.

There are three ways for economic units to reduce debt. The first is to sell assets and pay off the debt. However, if people are uncertain about asset values this solution to the debt problem is not going to work. Second, economic units can save out of income and revenues and pay down their debt. This, of course, is the soundest way to de-leverage, but it is also the slowest way to reduce the debt on a balance sheet. The third way to reduce debt is to renounce the debt: that is, declare bankruptcy. This solution does have repercussions, however, on the value of the assets of other people and other businesses.

A firm with too much debt can face another problem. Debt matures and sometimes has to be refinanced. The problem here is that a company may not be able to refinance the debt that is coming due. In such cases, these firms will either be forced into the first way of reducing debt, selling assets and perhaps taking a loss on the sale of the assets, or it will have to renounce the debt by declaring bankruptcy.

One sees CIT examining its resources to decide what is its best option. The second option does not seem to be a viable option because CIT doesn’t have sufficient time to generate enough revenues so that it can pay down its debt. So, it is looking at a situation where it has a substantial amount of debt maturing in the next six months or so. Refinancing is an option, but with its bond ratings reduced to the ‘junk’ category, this could be quite expensive and could produce negative cash flows so that earnings could not provide revenues to pay down debt. Thus, CIT could reduce sell off assets to generate cash to pay off the maturing debt. But, how much does CIT stand to lose if it sells off assets?

If these are the scenarios, then it is good that CIT is getting advice on declaring bankruptcy. This still presents a problem. As people see this possibility facing the company, why should short term lenders continue to help finance the company and why should borrowers continue to borrow from CIT, a company that may not be there tomorrow. Also, on Monday morning investors dumped the company’s stock.

The fact of the matter is that there are many companies, governments, and individuals (and their families) that face this situation right now. And it is very, very scary.

The question is, given these problems, why should these economic units spend? They have a debt problem. And, with rising unemployment and more and more debt coming due in various sectors of the economy, like commercial real estate, why should we expect people to pick up their spending in the near term. There are other, more pressing issues to deal with. This is why the economy is not going to start to pick up much speed soon.

Almost every week there is a new “CIT” that we read about. These companies are too big to ignore. And, that is what is so worrisome. How many more of them are there?

Something else that is worrisome as well. When banks are closed by the FDIC, the general operating procedure is to place the deposits and good assets of the closed bank with a healthy bank. Word is that there are not that many healthy banks around. Thus, the deposits and good assets of banks that are closed are not being placed with healthy banks (See “FDIC’s Challenge with Busted Banks,” http://online.wsj.com/article/SB124744606526030587.html#mod=todays_us_money_and_investing.) So, we now have more banks that have been focused on their own problems taking on the problem of integrating the deposits and good assets of closed banks which can’t help but divert their attention from their own problems. As of last Friday, 53 banks have been closed this year and the expected total of bank closings for the year is over 100. If we don’t have a lot of healthy banks around now to take care of the current crop of banks that are closing, what are we going to do for the rest of the year?

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CIT and Getting Out Of This Mess

‘The global semiconductor industry is going through one of the steepest corrections in its history,’ said SIA President George Scalise. ‘While it would be premature to conclude that the sales have hit bottom, there are some indications that the rate of decline has moderated from the final quarter of 2008.’

‘Demand for semiconductors is likely to continue well below 2008 levels for the next few quarters with a gradual recovery to follow as the global economy recovers,’ Scalise concluded.’

There are similar problems within the semiconductor materials market. The materials market was flat in 2008 as compared to 2007. Semiconductor materials market sales reached $42.7 billion globally in 2008. The industry group for the semiconductor materials market, SEMI, reports that “the wafer fabrication materials and packaging materials $24.1 billion and $18.8 billion, respectively.” These sales figures represent a decline from 2007.

“The global wafer processing equipment market segment decreased 31%; the assembly and packaging segment decreased 28%; the total test equipment sales decreased 32 percent. Other front end equipment sales declined by 32 percent”

We believe the market is discounting the recovery somewhat ahead of itself. It remains to be seen if the global economy will pick-up before 2010. Even if it does, the semiconductor market may lag the recovery. The companies we have on our watch list, Altera Corporation (ALTR), Analog Devices (ADI), Intel (INTC), QLogic Corporation (QLGC), Taiwan Semiconductor (TSM), Texas Instruments (TXN), and Xilinx (XLNX), are priced as though the recovery is already here. Sales and earnings will continue to decline through 2010. We would wait until there are signs of recovery before being buyers of semiconductor stocks.

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This is not time to own semiconductor stocks

There is no doubt in my mind that the Federal Reserve has “printed” a lot of money since early September 2008, most of it before January 2009. The Monetary Base (Non-seasonally adjusted, NSA) rose from $847 billion in August 2008 to $1,712 billion in January 2009, an increase of $865 billion. Between January and May 2009, the Monetary Base only rose $63 billion.

Total Reserves (NSA) in the banking system increased by $817 billion from September 2008 to January 2009, but only increased by $42 billion since January. The most interesting thing is that Excess Reserves (NSA) in the banking system rose by almost $800 billion in the earlier period and increased by $46 billion in the January to May period.

The Federal Reserve put a lot on money into the banking system over the last nine months and the VAST MAJORITY of the funds went into Excess Reserves. The Fed “printed” a lot of money (or, created a lot of deposits at the Fed) but these monies did not find their way into the economy!

These two periods need to be separated in order to get a better picture of what the Fed has done and for some implications about what might occur in the future. My basic argument is that the Fed has put a tremendous amount of money into the world banking system and has ultimately underwritten the Treasury’s TARP program and provided much more money to the banking system than Congress authorized.

The underlying effort has two goals: first, to keep financial markets liquid; and second, to protect against the insolvency of the banking system. The first goal has basically been accomplished. The second is still playing itself out. The crucial thing to understand is that the way the Fed has acted has given the system a chance to get healthy and yet provide a net to catch insolvent banks so as to avoid a precipitous collapse of the banking system.

In the September 2008 to January 2009, the crisis period, the Fed basically ceased using the normal tools of monetary policy: open market operations consisting of outright purchases of government securities and repurchase agreements. In the fall, the Federal Reserve basically picked and choose what parts of the financial markets needed liquidity and created facilities to support these ill-liquid sub-markets. The major ways that it supplied funds or saw funds withdrawn in the September 2008 through January 2009 period and in the January 2009 through May 2009 period.

Change (billions) from Sept/08 to Jan/09: Term Auction Credit $257; Other Loans $166; Commercial Paper LLC $334; Other Fed Reserve Assets $506; for a total of $1,263. The change (billions) from Jan/09 through May 2009: Term Auction Credit (-$124); Other Loans (-$62); Commercial Paper LLC (-$206); Other Fed Reserve Assets (-$411); for a total of minus $803.

The Term Auction Credit Facility (TAF) helped to get reserves to the commercial banks that needed reserves, an effort the Fed believed was more efficient than open market operations. TAF peaked at $300 billion increase on 12/31/08. Other loans include increased borrowings from the Fed’s discount window, a facility for asset-backed commercial paper (which reached a peak increase of $152 billion on 10/8/08), a facility for primary government security dealers (which reached a peak increase of $147 billion on 10/1/08), and a facility for AIG. The commercial paper LLC was a limited liability facility that bought 3-month paper from eligible issuers (which reached its peak of $334 billion on 12/31/08). The increase in Other Fed Reserve assets was primarily Central Bank Liquidity swaps (which reached a peak of $682 billion on 12/17/08).

However, the Fed’s efforts reported here resulted in almost a $1.3 trillion increase in its assets and an $865 billion increase in the Monetary Base. Thus, almost the entire monetization ended up as excess reserves held at Federal Reserve Banks. Bank reserves at Federal Reserve Banks increased steadily throughout the fall, peaking at $856 million on December 31, 2008. Whew! The Federal Reserve had made it through this period of financial market illiquidity which accompanied the entire Thanksgiving/Christmas seasonal need for cash.

What happened in 2009? As mentioned above, the needs of specific market makers retreated, but now the solvency of the banking system came to the fore. In terms of the special facilities, as can be seen from the figures given above, a total of $803 billion was removed during the first five months of the year. Then the Fed began to conduct open market operations again. Throughout this time, securities bought outright by the Fed increased by $712 bullion. This included a program to buy government securities on a regular basis which contributed $177 billion to the Fed’s portfolio. It also added $70 billion of Federal Agency issues. Furthermore, the Fed initiated a very important program in 2009 and bought $465 billion of Mortgage-backed securities.

In essence, Total Federal Reserve Bank credit declined by about $200 billion during the first five months of the year but, as was reported earlier, the monetary base increased by $63 billion and total reserves and excess reserves in the banking system increase by more than $40 billion. In essence, the Fed operated in 2009 to keep the banking system very liquid and replaced the reserves that had been supplied to different parts of the financial markets in 2008 by interjecting funds directly into the banking system. The new twist? Directly helping banks sell their mortgage-backed securities, thereby reducing pressure on the banks to clean up their balance sheets. This was the original purpose of the Treasury’s TARP program.

The banking system faces three problems going forward: existing bad assets; bad assets that will appear over the next 18 months or so; and refinancing needs as the banks may not always be able to roll over existing liabilities.(See my post of June 15, “What Banks Aren’t Telling Us”, http://seekingalpha.com/article/143276-what-aren-t-banks-telling-us, for more on these factors.) The huge amount of excess reserves will help the banks face these problems. In terms of financing needs, the banks have the cash to pay off maturing liabilities without needing to roll the debt over. In terms of bad debts, this is where the TARP program comes in because the Treasury has provided preferred stock to banks with warrants attached. Charge offs can go against existing capital and the preferred stock and warrants can be transformed into new capital owned by the government to keep these banks afloat until something can be done with them.

Some banks have repaid the TARP funds that they had received. Several well-known large banks returned $68.25 billion this month to reduce Federal Government oversight. Still there have been 633 banks that have directly received about $200 billion in TARP funds and a total of 32 banks have now repaid about $70 billion. (On this see “Small Banks Not Shying From TARP” in June 27 Wall Street Journal, http://online.wsj.com/article/SB124606040026463617.html.) So, of the roughly $800 billion that banks are now holding in excess reserves, one could argue that approximately $130 billion of them have been supplied through the Treasury program and are held, mostly, by smaller banks and $670 billion of them has been supplied by the Federal Reserve, the total of the two being the money “printed “ to get us out of the current financial crisis.

The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!

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Is Treasury’s TARP Debt Already Monetized?–Part Two