This is just one more piece of information that the banking system still has major problems.

This is the case even though banks are posting first quarter profits. The latest, Bank of America posted a $4.25 billion net income figure for the quarter. (See http://online.wsj.com/article/SB124021187032334351.html#mod26articleTabs%3Darticle.) But don’t get overjoyed: Apparently, excluding merger costs, Merrill Lynch contributed $3.7 billion to the posted number which included a $2.2 billion gain related to mark-to-market adjustments on certain Merrill Lynch structured notes. The results also included a $1.9 billion pretax gain on the sale of China Construction Bank shares. What does this mean? I don’t know. Who has any trust in the financial reporting of banks anymore!

What information do we have that indicates that the banks still have massive problems? Let me suggest several bits of information that add up to an exceedingly weak banking system.

First, let it be noted, again, that the Monetary Base, the aggregate money figure that is defined as all bank reserves and anything that can become bank reserves (currency in circulation) has doubled in the past year (97.5% increase year-over-year using non-seasonally adjusted data). This measure was increasing at a 2.0% annual rate in August 2008.

The in-bank component of the Monetary Base, Total Reserves in the banking system, in March, was increasing at a 1,722% annual rate (again, year-over-year using non-seasonally adjusted data). We have never seen figures like this before!
In August 2008, the annual rate of increase was -1.0. Yes that is a negative one percent year-over-year rate of increase.

And, what are the banks doing with these funds?

They are holding onto them!

Excess reserves in the banking system (non-seasonally adjusted) were right at $2.0 billion in August 2008. These are funds in the banking system that are just sitting idle on the balance sheets of banks in the banking system—not earning interest or anything. In the banking week ending April 8, 2009, excess reserves totaled $724.6 billion.

Let me put this in perspective. On September 4, 2008, the assets of the Federal Reserve System totaled about $945 billion. So, in the first week of April 2009, the banking system was keeping, in cash, a little less than the total amount of funds that the Federal Reserve had put into the banking system in the first week of September 2008!

If I look at the Federal Reserve Release H.8, I see that commercial banks in the United States, non-seasonally adjusted, had Cash Assets on their balance sheets in March of $915 billion, again quite close to Federal Reserve assets in early September. One year earlier these banks had Cash Assets of only $300 billion, so Cash Assets rose by 205% in the past year.

Now, the total banking system, in aggregate, is lending some. Total bank credit outstanding rose at an annual rate of 3.2% from March 2008 to March 2009. Within this category, Commercial and Industrial loans rose by 4.3% and real estate loans rose by 4.7%. Consumer credit rose by about 9.0%, of which credit card debt rose by 13.0%. So lending in these categories were increasing, but not by major amounts.

The interesting thing to note, security lending—Federal Funds lending and Repurchase Agreements with brokers—dropped by a third, -33.0% and Interbank loans remained basically flat. Banks reduced their lending to other financial institutions, including other banks, during this time period. Talk about risk averse.

The major story that these data tell is that commercial banks are afraid to lend, especially to their own kind. Delinquencies continue to rise, write-offs continue to rise, and banks continue to increase the provision they set aside for future charge-offs. The banks have gone back to lending only to those that don’t need to borrow, the way banking used to be. They are afraid to lend to anyone else and they are still uncertain about the value of the assets that they already have on their books.

This situation is not going to change overnight. There is not much that the Federal Reserve can do if banks won’t even lend to banks!

We see that “U. S. May Convert Banks’ Bailouts to Equity Share.” (See the New York Times article, http://www.nytimes.com/2009/04/20/business/20bailout.html?_r=1&hp.) Still the question remains, “How deep is the hole in bank balance sheets?” We cannot provide the answer to this. Ultimately, the bankers, themselves, will have to provide that answer, and my guess is that bank lending will not start to pick up again until these bankers have that answer.

Good Article? Pull it from here:
The Banking System and Bank Lending

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.

Good Article? Pull it from here:
Be Careful What Bandwagon You Jump Onto

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?

Good Article? Pull it from here:
CIT and Getting Out Of This Mess

Looking at the figure Total Reserves which is defined as bank reserve balances held at Federal Reserve Banks and vault cash at banks used to satisfy reserve requirements. The year-over-year rate of increase in this figure for February 2009 was 1,538 %. Yes, that’s right, one thousand, five hundred and thirty-eight percent, rounded off! But, this rate of growth is down from the December 2008 year-over-year figure which was 1,823%. Yes, one thousand, eight hundred and twenty-three percent!

In August 2008, before the financial tsunami hit, the year-over-year rate of increase in Total Reserves was – 1%. Yes, that is a negative one percent! And the rate of increase throughout 2008 up to August was modest, at best.

Let’s move up to a larger measure, the Monetary Base, defined primarily as Total Reserves and Clearing Balances at Banks plus the currency component of the Money Stock measures. In February 2009, the year-over-year rate of increase in the Monetary Base was 88%, rounded off. That is, the Monetary Base increased by a little less than two times over the twelve month period ending February 2009. In December 2008, the year-over-year rate of increase was 99%, rounded off.

Going back to August 2008, the year-over-year increase in the Monetary Base was about 2%. Again, the rate of increase in this measure throughout 2008 up to this time was around this magnitude, give or take a percentage point or two.

How did this increase in reserve measures get translated into the Money Stock figures? Well, in the case of the narrow measure of the Money Stock, M1, the year-over-year rate of increase for February 2009 was 13.5%, down from 17.2% in December. In August 2008, the year-over-year growth in the M1 Money Stock was a little less that 2%. The rate of growth of this measure for the earlier part of 2008 was slightly negative to slightly positive.

In terms of the components of the M1 Money Stock, what contributed to this increase in growth? First of all, the Demand Deposit component rose by about 35% on a year-over-year basis in February, but this was down from a little over 59% in December. The interesting thing is that the year-over-year rate of growth of the currency component of the M1 Money Stock was relatively constant through the end of 2008 into February of 2009. For example, the currency component grew at around a 7% rate of growth in December 2008 but grew at a 10% rate in February.

The conclusion one can draw from this is that people and businesses are holding more of their wealth in currency and in demand deposits! That is, the funds that the Federal Reserve is pumping into the banking system are staying in the banking system or going into cash or very liquid transactions balance in the banking system.

One could argue that the public is not spending these cash and transactions balance accounts any more than they have to and are keeping them on hand to meet their uncertain needs for living and conducting business. That is, these holdings are for security in treacherous times.

Just one additional note on Demand Deposit growth and Currency growth: in August 2008, the year-over-year rate of growth in Demand Deposits was essentially zero and the year-over-year rate of growth of currency was slightly over 2%. That is, in August 2008 almost all the growth in the M1 Money Stock measure was coming from the growth in the currency component.

Now, what about the rate of increase in the M2 Money Stock measure? In February 2009 the growth over February 2008 was just less than 10%. This growth rate was exactly the same as the growth in this measure in December 2008. In August, the year-over-year growth rate in the M2 Money Stock was approximately 6%.

The conclusion that one can draw from this is that individuals, families, and businesses are keeping funds in very safe and easily accessible form. Growth in deposit measures or credit measures beyond cash and demand deposits is almost non-existent. People and businesses are attempting to protect themselves, they are not borrowing more than necessary, and they are not spending more than necessary. One guesses that this is not going to change much in the near future.

From the non-bank side of the equation, why should people and businesses be borrowing if they can avoid it? Unemployment jumped to 8.5% in March, and this weekend economists were talking that this number would reach at least 10% before this economic downturn is over.

Furthermore, bankruptcies were up, almost 4% in March and up almost 40% over a year earlier. This measure, too, is expected to rise throughout 2009 and into 2010. And then, housing prices continue to fall. One measure used to judge where housing prices are relative to (estimated) rental payments was reported by John Authers in the Financial Times on last Thursday. He wrote that the ratio of housing prices to rents which had risen by 44% from 2002 to its peak through the credit bubble has returned to about its 2002 level. However, Authers argues that even though it returned to the 2002 level this ratio could still fall another 20% to reach levels of a decade or so earlier.

And, why should the banks lend? For one, they still have a ton of questionable assets on their balance sheets. And, if these banks are worried about their solvency, they need to work these assets out and not add more and more new assets to their balance sheet. Their focus needs to be on regaining financial health now, not expanding their balance sheet and reducing capital ratios further.

And, we still have the commercial real estate problems to go through, as well as the problem implied in the credit card area due to the rising delinquencies in that sector. Furthermore, there are two kinds of mortgage loans that are going to reprice over the next 15 months or so. Analysts are afraid of what this might do to foreclosures and bankruptcies given the rise in unemployment and the decline in household incomes. Also, there are the surfacing problems connected with state and local government finance. This has not really gathered much attention to date.

The Federal Reserve has been pushing about as hard as it can. Yet, the monetary stimulus is not working its way through the banking system. This is obviously a problem. But, banks in the condition described above don’t really want to lend, and consumers and businesses are in the process of consolidating and strengthening their balance sheets and have little incentive to re-leverage themselves at this point.

The Keynesian solution to this dilemma is, of course, government spending, the more the better. The intent of this spending is to get the banking system unclogged. Whether or not this government spending can actually accomplish this is still to be determined? So, we still are faced with enormous amounts of uncertainty. And, this uncertainty, in my mind, is not going to go away soon.

Good Article? Pull it from here:
The Clogged Banking System

Second, there is evidence that the regulators are taking a harder line at Bank of America and Citigroup. Each has its own problems, but the Feds seem to believe that they can step up their demands on these two financial institutions concerning boards, managements, business affairs, and so forth. They would not do this if they believed the system to be too fragile.

Third, I sense the Federal Reserve backing off from the more aggressive stance it took with respect to the bond markets one to two months ago. This is just a feeling that I will be following up on in the near future.

These actions provide some preliminary evidence that we are in the “working out” stage of the credit cycle where time is the biggest factor to contend with. Bailouts are needed to prevent “liquidity” problems when markets might crumble under cumulative selling pressures. But, this is a short run problem.

The “work out” phase of a financial crisis is the period when institutions still have severe credit problems but are not under short term pressures to relieve their balance sheets of “toxic” or “underwater” assets.

This does not mean that there will not be more failures of financial institutions and some of them may be relatively large ones. What it does mean is that the problems that still exist within the financial sector can be handled in a relatively orderly fashion. So, the banks and the regulators can operate within an environment that does not seem “desperate.” Severely troubled still, but not in a state of panic.

Within this scenario, the questions that remain about the banking system relate to earnings. We have seen Goldman Sachs and JPMorgan Chase & Co. post strong gains for the second quarter. However, most of the gains were attributed to trading activities, with secondary help from their underwriting business. These are not good, solid “banking” results. And, these organizations are highly diversified and can post returns from these areas, something that most other banks in the United States cannot do.

Still, the banking system seems to be in the stage of recovery where current cash flows can allow the individual banks to write off more and more of their loans and other assets over time and thereby restore the integrity of their balance sheets. With the results it achieved in trading and underwriting, JPMorgan Chase was able to take large write downs of home equity loans, mortgage defaults, and credit card charge offs while also increasing the amount of funds it set aside to increase its loan loss reserve. This is what other banks will be doing to reduce the burden of bad assets they are now carrying.

Overall, Total Assets in the commercial banking system grew by 8.9% from June 2008 to June 2009. The capital residual (Assets less Liabilities) in the system grew by 7.6% so that the capital asset ratio of the banking system dropped from 10.2% to 10.1%.

In terms of how the banks are attempting to protect themselves, the Cash assets of Commercial Banks in the United States were up 186%, year-over-year, in June 2009, although this rate of increase is down from a year-over-year rate of increase of 236% increase in May 2009.

Total Loans and Leases in the banking system rose just about 1.4%, year-over-year, in June while Commercial and Industrial Loans actually decreased by 3.1%. Commercial banks are just not lending to businesses which continues the trend which began last year. Banks are lending to consumers, up 5.5% year-over-year (primarily on credit cards and other revolving credit plans), and on real estate, up 6.4% year-over-year (the largest jump coming in revolving home equity loans).

The cash assets held in the commercial banking system declined regularly throughout June as the peak in cash assets held was reached in May. Thus, it appears that banks are backing off from taking everything the Federal Reserve has put into the banking system and stashing it away in “cash accounts”. This is confirmed by the aggregate banking data put out by the Federal Reserve which indicates that total reserves in the banking system dropped throughout June 2009 and the excess reserves also fell from peak levels reached in late May.

Thus, it appears that things are working out pretty much as the Fed hoped they would. (See my explanation of what the Fed has been trying to do, http://seekingalpha.com/article/145913-is-treasury-s-tarp-debt-already-monetized-part-ii.) Of course, the game is not over yet!

Bottom line: the banking system is working through its problems. The Federal Reserve and the regulators seem to be backing off a little, allowing the system to adjust over time to its dislocations. There is still room for a surprise, but, the more time passes, the less likely a surprise is likely to occur. In other words, the unknown unknowns have been substantially reduced and the known unknowns are what we are working on.

The banks are not lending except on established credit lines (credit cards and home equity loans) and there appears to be plenty of liquidity in the system as a whole. Whereas the lack of lending slows up the possibility for an economic recovery, it is an essential component of getting the banking system healthy again which is needed if there is to be any chance of a robust economic recovery in our future.

Good Article? Pull it from here:
The State of the Banking System

These researchers tell us that this type of behavior is what has helped the human species survive. However, it is not necessarily the kind of behavior that leads to decisions or actions that are in our best interest when investing. “Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.” (This quote comes from David Adler’s new book “Snap Judgment”: see my post that reviews this book, http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) Yet we humans, individually and collectively continue to perform in this way.

Right now, the concern is whether or not the economy is bottoming out and starting to recover. We get “green shoots” here, but then some other indicator of economic activity comes in worse than expected. Alcoa puts up better than expected loss numbers but retail sales come in lower than expected. Sales of existing homes improve yet we get wind of another wave of subprime mortgage problems. (See “Subprime Returns as Housing Woe,” http://online.wsj.com/article/SB124709571378614945.html#mod=todays_us_money_and_investing.) And, what about the problems in commercial real estate, credit cards, and Alt A mortgages?

Then there is the question about whether or not there should be a second round stimulus bill. Paul Krugman has argued for a long time that the first stimulus bill was not enough. Yesterday Laura Tyson indicated that she thought that there needed to be a second round. Now the debate is all over the place. But, wouldn’t another stimulus bill add more to the government budget deficit going forward? And, there are questions about the possibility that the government has already committed to too much debt.

So the Dow Jones average goes up from 6500 and looks very strong approaching 9000 and then goes into a swoon. The price of crude oil was approaching $40 a barrel in February and then shot up to above $70 but now has returned to the $60 range. The yield on the 10-year treasury issue was nearing 2.00% in December 2008, jumped up to around 3.90% in the middle of June and traded at 3.30% yesterday. An index relating the value of the dollar against major currencies was around 70 in July 2008, popped up to the mid-80s in March 2009 and has since declined to about 77.

When the economic indicators seem strong the price of oil goes up as does the stock market and the price of bonds and the value of the dollar decline. When the economy seems weaker we get just the opposite movements. And, my bet is that it is going to continue this way for a while. So, uncertainty, and hence volatility, rule the marketplace.

This is the short run. Recently, however, I have been writing more upon the long run, what deficits do to long term interest rates and to the value of the dollar. Over the longer run, historically, some patterns repeat themselves over and over again. This, of course, brings to mind the statement made by John Maynard Keynes, “In the long run we are all dead!” Still, we need to take the long run into account.

This is where we need to take heed of what the behavioral economists advise. We, as investors, must not rely on intuition or gut reactions. We must not over react to the environment we now find ourselves in. Research has shown that acting in this way is not necessarily in our best interest.

The research also indicates that investing based on fundamental economic reasoning does work. Therefore, it seems as if now is a time for discipline and hard work. And, it is a time for patience.

But, this does not mean that one needs to totally ignore the short run. It is perhaps impossible to expect that most people will just sit out this stage of the economic cycle and invest their funds in safe, low-yielding assets. So, what kind of strategy might work here? My suggestion is that one needs to segment one’s portfolio, allocating some money to playing in the current market volatility, but allocating a larger share of the funds to potential future fundamental investment choices.

The smaller part of the portfolio can be allocated to playing both sides of various markets. Obviously, getting into the market near a “bottom” would be very profitable, but selling short near a “top” would also work. But, by all means consider any investments here as short term in nature because it is highly likely that the “bottom” may not turn out to be a “bottom” at all. Likewise for a “top.” So, one must be very agile in investing this way. Don’t hang onto losses, but let gains ride. Behavioral finance tells us that people tend to operate in the opposite way hanging onto losses hoping for the best and quickly selling gains to have something to show for their efforts. This is where discipline and focus are crucial.

Furthermore, remember that, on average, the expected returns on trading are zero: and there are still fees that need to be paid. But, using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities.

As research has shown, the fundamentals do apply over longer periods of time. Perhaps, however, it is not quite time to commit to some of these “value” propositions. People are worried about the potential inflation that may come about due to the large government budget deficits and the possibility that the Federal Reserve will have to monetize a substantial amount of the debt created. But, there are many people who think that deflation is going to be more of an issue in the near term. Hence, it is perhaps a little premature to put funds into investments that will prosper from a future period of high inflation. This part of the portfolio should be kept safe, but also should be able to be accessed when the time is right to commit to the longer run fundamentals. Research, however, has shown that it is alright to be a little early on these types of investments because the possible returns on such a commitment to fundamentals are substantial enough that being a little early is not harmful.

It is also important that an investor should stay in the areas of the market that they know best. If your skills lend themselves to the technology sector of the stock market then stay there. If your skills are in the government bond market then stay there. If your skills are in the foreign exchange market then stay there. Again, discipline and focus are all important.

Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. The behavioral economists have warned us that this is a dangerous time to act in just an impulsive or instinctive manner. So, if being methodical is not your “cup of tea” then beware for the statistics are not with you. Chasing every “green shoot” or market reaction is not going to produce happy results. Acting in a focused and disciplined way may be very difficult for us to achieve but we need to try. That is what humans have learned they must do in activities like investing in financial or commodity markets.

Good Article? Pull it from here:
Uncertainty: The King of the Market and what to do about it

It seems that every piece of information currently being released carries with it the claim that “this decline was less than expected” or ‘the decline was smaller than the last information released.” These are taken as signs of hope.

Even the results of the Treasury’s “stress tests” on the banks are accompanied by the assessment that the major banks that have just been examined are better off than was thought. Therefore, the banking system is not in as bad a condition as feared, and, stock prices can now continue moving upwards.

Fed Chairman Bernanke is still the leading spokesperson and “cheer-leader” in the administration and he stated this week that the economy will begin to expand later this year. So we must be at or near the bottom if the administration thinks so. Right?

We still have the nay-sayers out there claiming that things remain in terribly bad shape. Nicolas Taleb, of Black Swan fame, is saying that the economic situation is worse than it was in the 1930s because world markets are much more integrated now than it was then. And, Nouriel Roubini continues to sound alarms about how bad things could get. Part of his argument rests on the fact that the worst case scenario used in the Treasury’s “stress test” is out-of-date due to the recently released estimates issued by the International Monetary Fund that financial sector losses have doubled in the last six months. Yet are their claims sounding awfully shrill these days amidst the hope others are seeing?

Where are we?

To me, the uncertainties still outweigh any real sense of which direction the economy might take. I would tend to lean on the side that we have not seen the bottom yet, but what odds would I place on this possibility? Maybe I would give odds of 2-to-1 that the economy still will decline further. Maybe they should be 3-to-1. Maybe they should be 3-to-2. Somewhere in there.

First off, I am not convinced that the banks are coming out-of-the woods yet. Even if they are able to obtain more capital, I don’t see their lending picking up in any major way. Personal and business bankruptcies are still on the rise and there are still several major “black clouds” on the horizon that threaten that the storm that has hit bank balance sheets is not over. There are still large companies that are going out-of-business on a regular basis, in retail, in commercial real estate, in some areas of manufacturing, and we are waiting for the full ramifications of the collapses in the auto industry. Car dealerships are being closed, parts supply companies are on the edge, and the spread of these closures are affecting many other organizations and geographic regions. If unemployment is going to continue to rise, since it is a lagging economic indicator, then there still are houses that are going to need to be sold if not foreclosed upon and some credit card debt and auto loans that will need repayment.

And, speaking of cars. Last time I looked the price of a barrel of oil was approaching $60. Where is the price of oil going? And, the price of other commodities? The Financial Times has had several articles recently about why the price of commodities, including oil, might be going higher if a trough or bottom has been reached. What would higher commodity prices do to any recovery?

Then there is the level of interest rates. The government held an auction today for $14 billion of 30-year Treasury securities. The result? The yield of the new issue came out at 4.288% higher than the expected 4.192%. This caused a decline in bond prices with the 10-year Treasury note trading around 3.30% up from 3.14% late last week which was above the 3.00% level, reached earlier last week a level that had not been crossed since November 24, 2008.

How high are these interest rates going to go and what impact will these higher rates have on mortgage rates and corporate rates? We are already seeing spreads between Treasuries and corporates reach levels since last October and November. And the interest rate spreads on lesser credits have also been increasing. And, there is still much more Treasury debt to come.

Furthermore, the economic structure of the United States (and the world) has changed. The manufacturing base is going to be different in upcoming years and everything is going to be more connected technologically than before. And, what if the personal savings rate in the United States reverts back to 8% or so as it was before 1992? We are not going to be able to force employment, human or otherwise, back into the same industrial and financial structure with the same employment intensity as existed before this economic collapse.

I am not intentionally trying to stay on the “dark side”. It would be great if things were bottoming out and the economy were about to start on an upward path once again. But, there still seem to be too many “unknowns” out there, unknowns that relate to serious problems, for us to get our hopes up too high at this point. Managements must still re-focus their businesses and must deleverage their balance sheets. Boards of Directors still must make sure they have the right executives in the right places, and if the Boards don’t do this then the shareholders must become more aggressive. Many executives that managed in the pre-2007 period, I believe, are not the executives to lead our companies in the post-2009 period.

Are we at a tipping point? Are we at or near the bottom of the downturn?

The most important questions are still going unanswered: even with the results of the Treasury stress tests. Will a major bank fail? How many regional banks might fail? So far there have been 32 bank failures this year, up from 25 last year and 8 the year before. How will a General Motors bankruptcy impact the economy? What other possibilities are out there?

Other company failures? Bloomberg reports today “Moody’s is forecasting the default rate among high-yield companies globally to soar to 14.8 percent by year-end from 8.3percent in April as companies that financed a record amount of high-yield, high-risk debt leading up to the credit crisis struggle to refinance.”

And, I haven’t mentioned the debt overload that exists throughout the country. The list goes on.

It seems to me that what we are seeing a lot of these days is wishful thinking. I really haven’t seen anything yet that one could argue was a “hard” fact pointing to a bottom of the downturn. I really don’t think we are going to see any “hard” facts in the near future, so the stock market and other areas of the economy will just to continue to live off of wishful thinking. This is a situation made for traders. Uncertainty creates volatility and traders feast off of volatility. I guess it is good to know that at least some people profit from this environment.

- John Mason

Disclosure: This article was taken from Mase: Economics and Finance with the permission of the original author.  All disclosure questions should be refferred to the original author.

Remember Simon?

In my recent article on Simon Property Group [SPG: 85.64, +1.46 (+1.73%)] I stated that if GGP were to file for Chapter 11 or simply continue to struggle that SPG would be positioned to snatch up great pieces of real estate at liquidation prices.  Though I don’t think that a fire sale of all the properties is in the mix, it is hard to imagine how they are going to be able to satisfy debt holder demands without raising capital.  Since they are unable to get financing, selling some properties is the next option.  I have gotten a lot of criticism regarding SPG because of it’s recent debt offering and equity raise.  What is so essential to note in economic times like these is that even though it’s debt has a rate of just over 10% they were still able to issue debt!  In normal markets a rate that high would be of concern, but hardly I doubt anyone will argue that these aren’t normal markets.  I would not be writing this article right now if General Growth were able to obtain financing for more than a couple weeks.  They would have loved 10% on it’s debt, and the ability to issue 17.5 million new shares at around $31.  The point here is that there is financing available to those companies who qualify,   such as SPG, and Taubman Centers Inc.  [TCO: 41.94, +0.85 (+2.07%)].  What is very important to note is that the cause of General Growth’s problems did not come from failing properties that they held in it’s portfolios, but from the extreme overleveraging that has been the theme song of the economic crisis.  It’s malls had an average occupancy rate of 92.5% in Q42008 and are rated as above-average.  CEO Adam Metz said that the “core buisness remains sound and is performing with stable cash flows.”  The mountain of debt that GGP must overcome is just daunting.   When CEOs such as David Simon of SPG are quoted as saying “you’re the strong and you want to get stronger,” that is a clear signal that SPG is looking at acquisitions.  I wouldn’t doubt that an underlying reason for it’s two most recent capital raises was a speculative bet on General Growth having serious trouble in the near future.

Going Forward

Two things will be interesting to watch going forward.  One is whether or not General Growth will survive the process (I think it will, they just need the proper environment to restructure).  Second is which competitor will take advantage of the property sales the most and position themselves for long term growth.  As I have stated before, it seems like some property sales are necessary in raising capital to pay down debt.  It is no mistake that Simon is the cream of the crop and that management is focused on growth.  What we are seeing are the markets at work.  General Growth made a mistake that cost them, now they are paying for it.  There is no government bailout or lobbyists trying to tell politicians how unfortunate GGP’s situation is, just pure market forces.  One man’s blunder is another man’s  success.  Therefore, there will be a shakeup and those that were once positioned behind GGP may be able to make moves upward.

Commercial Real Estate Effect

There is a concensus that commercial real estate still has some bad times ahead of it.  The difference of opinions lies in the severity of the bad times.  The Fed is contemplating issuing 5 year loans to investors to buy commercial mortgage backed securities through it’s TALF facility.  This is still in the works.  This will effect GGP’s bankruptcy filing and will have a substantial impact on the amount of properties that they end up selling.  As I stated before, liquidation does not seem probable.  Oversaturating the market with properties will simply depress prices further due to an oversupply.  If the demand is only for a handful of properties then thats all they should sell.  It would also be irresponsible of all parties involved to allow a total liquidation where properties flood the market and cause the problem to get worse rather than help to solve it.  The one glimmer of hope is that the government doesn’t have it’s hands in this so the end result has more promise of being successful.

Check back for on going analysis of GGP’s filing and the residual effects on the market.

-Patrick Dougherty

Disclosures: None

With a market cap of $7.59 billion, SPG is the largest public real estate company in the United States.  As of December 31, 2008, SPG owned or held an interest in 324 income-producing properties in the U.S.  It owns, operates and develops its portfolio of properties with an emphasis on high quality retail real estate. SPG operates from five retail platforms: Regional malls, Premium Outlet Centers, The Mills, community/lifestyle centers, and international properties.  As of December 31, 2008, the breakdown of percentage of owned property was: Regional Malls- 58.3%, Premium Outlet Centers- 10.7%, The Mills- 19.6%, Community/lifestyle centers- 9.2%, and other properties- 2.2%.  SPG reported for the full year 2008 that diluted earnings per share decreased $0.08 or 4.1% to $1.87 from $1.95 in 2007.  However, it also reported that consolidated total revenues increased $132.4 million or 3.6%.  This increase in total revenues was mainly due to the full year effects of its 2007 openings and expansions.

The three main reasons why I think Simon will prevail are its consistently high occupancy rates, the poor conditions of competitors such as General Growth Properties [GGP: 15.826, +0.726 (+4.81%)], and strong growth in Funds From Operations (FFO).

Even in the midst of a tough retail environment, SPG has been able to maintain fairly steady occupancy rates.  As you can see, even though all but The Mills are down year-over-year, they are not down nearly as much as some may have thought given the harsh economic climate for over a year now.  Strong occupancy rates were accompanied in 2008 by stable rental rates which helped SPG to generate growth in operating results even with the pressures of the souring economy.

• Regional Malls: 92.4%, down 1.10%
• Premium Outlet Centers: 98.9%, down 0.80%
• The Mills: 94.5%, up 0.40%
• Mills Regional Malls: 87.4%, down 2.10%
• Community/Lifestyle Centers: 90.7%, down 3.40%
• European Shopping Centers: 98.4%, down 0.03%
• International Premium Outlet Centers: 99.9%, down 0.01%

Lots-O-Cash

SPG has a strong balance sheet with a lot of cash.  As of December 31, 2008, it had approximately $774 million in cash.  Going forward, SPG has specifically said it wants to expand within the US and more importantly, grow its international presence.  In 2008, SPG opened three Premium Outlet centers internationally; one each in China, Japan and Italy. REITs such as General Growth became so highly leveraged that it now cannot afford to make its debt payments and has no cash on hand to do so.  Because of this extreme leveraging, it is unable to get financing for more than a few weeks since the risk of not just default, but bankruptcy, is so large.  If negotiations with bondholders and lenders to alter the terms of their bonds and loans does not work, the next best thing for these companies to do is sell assets. Simon has played it safe over the past forty-eight years and has ample cash to acquire assets at depressed prices from companies in dire need of cash.  In addition to cash, it also has approximately $2.4 billion left on a $3.5 billion credit facility.  (A note on the credit facility: Simon has closed a deal and issued 17.25 million shares at $31.50 and issued $650 million in senior notes due in 2019.  It will use some of the proceeds to pay down part of this credit facility.)  With the highest S&P credit rating among regional mall operators of A-, the company has easy access to capital.

Steady FFO Growth

Funds From Operations, or FFO, is a figure used specifically by REITs to define their cash flows from operations.  It takes Net Income, adds back in Depreciation and Amortization and subtracts Gains or Losses from the Sale of Property.  Since GAAP accounting requires Depreciation and Amortization be subtracted out it may reduce true earnings for REITs because the properties that the REIT owns may actually appreciate over time.  It also subtracts out gains or losses on the sale of properties because these are one time charges that are not recurring and do not contribute to the REIT’s ongoing dividend paying capacity. SPG has averaged 10% growth in FFO since 2005.  Going forward, this growth has the risk of decreasing due to the crisis spreading to commercial real estate.  However, since SPG’s specializes in retail I think that the risk is lower.  This may sound crazy, but if it has been able to weather the past twelve months of poor consumer confidence and spending, I think that the future is a bit brighter.  I don’t necessarily need a ratio or a metric to tell me that maybe the light can be seen at the end of the tunnel. Rather, I need only go to my local mall (coincidentally owned by General Growth) and drive around for ten minutes trying to find a parking spot or visit any Simon owned mall in south Florida and do the same thing.  Now, I realize that not everyone is purchasing items, but it is still traffic in the mall and in the stores.  My high school soccer coach always said, “you can’t score unless you shoot the ball.”  Well, you can’t buy things unless you go to the store.  Consumers are out looking for bargains, and by the looks of the things, stores are giving them what they want.

SPG is looking toward the future and management is focusing on being around for another forty-eight years.  The company’s diversified portfolio along with the several items above will help it continue to be the strongest player in the REIT sector.

-Patrick Dougherty

Disclosures:  None

Creating a Nightmare in the Judicial System

Many years ago, banks held onto loans that they originated.  If they sold a loan to another bank, that bank held onto the loan.  As financiers became more creative, this practice quickly dissipated.  Many banks continue to hold onto loans they originated, but with the creation of Mortgage Backed Securities (MBS), bankers began pooling these loans together into securities and then selling these loans en masse to investors or to other business entities that then did the same thing.

The problem is that under the MHA, the government rewards borrowers by reducing interest rates, writing down principal, and rewarding on-time payments; and rewards servicers for agreeing to make these adjustments.  The MHA does not reward the investors who took on risk by purchasing these MBS.  Many of you will argue that these investors took on risk by purchasing these securities, and should have to deal with the consequences.  If you’re one of those people, and you believe in the MHA, then maybe you should reevaluate your stance.  Lenders and mortgage borrowers also took on risk, but they’re being bailed out.

MBS holders purchased these securities with the expectation of receiving specific principal and interest payments over the course of the security’s maturity.  MBS returns can fluctuate based on prepayment speeds, which adjust based on the length of time people stay in their homes, or refinance.  When rates increase, prepayment speeds decrease, because fewer borrowers refinance.  When rates decrease, prepayment speeds increase because more borrowers refinance at a lower rate.  Most MBS have implied prepayment speeds of between seven and eleven years.

MBS holders are willing to assume the risk that prepayment speeds may change over the course of the investment, based on changes in the market.  But now the government is messing with prepayment speeds by paying servicers to modify loan payments.  The government is pressuring banks to refinance nearly five million mortgages at lower interest rates, and to modify an additional four million loans by lowering the interest rate, extending the maturity, and writing down principal.  This could lead to significant losses for MBS investors.

MBS holders will not stand for such government meddling and recklessness, and in a matter of weeks we will begin to see a surge in lawsuits filed against both the government and mortgage servicers.  The MHA doesn’t protect servicers from lawsuits, so they’re fair game.  Lawsuits could prompt federal judges to force suspension of the program on grounds of unconstitutionality or whatever other reasons they can find.  If this were to occur, those borrowers at “imminent default” would end up defaulting anyway.  If judges forced suspension of mortgage actions entirely, including foreclosure actions, these borrowers would be able to stay in their homes, but banks would suffer immensely as they couldn’t foreclose on non-accruing loans.

On a positive note, if the justice system freezes the plan but allows foreclosures to continue, it may leave room for a market based recovery.  The government’s meddling will cease, and buyers and sellers will help the market to find a true bottom.

Impairing Future Lending

If MBS holders get left out of the MHA, it could spell disaster for the supply of cash in the mortgage business.  The market for MBS provides an amazing amount of liquidity in the mortgage market.  If the US government announces that it favors mortgage borrowers over MBS investors, investors may avoid MBS altogether.  The risk of the government stepping in and destroying the value of these securities would be more than investors could handle.  If this happened, it would strain liquidity and many borrowers would be unable to secure mortgage financing.

If banks and mortgage brokers have high loan demand, they can fulfill that demand when the MBS market is thriving.  Banks and brokers have limited cash for loans, and once that money is gone, they can’t originate anymore loans.  But if the bank can pool those loans, or sell the loan to someone who can, they can make money. This inturn could fund additional loans.  This can only work in a vibrant MBS market.  Without a market for these securities, banks must hold every loan on their books, and when that money runs out, borrowers have nowhere to go.

The subprime market would be hit especially hard.  Individuals with less than perfect credit may be qualified for a loan, but many banks wouldn’t want the risk associated with those loans, regardless of loan-to-value and debt-to-income ratios.  With a vibrant MBS market, the bank may be able to pool those subprime loans and sell MBS to investors who could tolerate a higher level of risk.  Of course this requires rating agencies who can provide accurate risk assessments of these securities.  That’s another issue, for another day.  If subprime borrowers are unable to borrow money for homes, home ownership rates will fall, which will cause further declines in home values.

The best course of action for the government is to leave the housing market alone.  Mortgage products are simply too complex to allow the government to choose one group of investor over the other.  Leaving the market alone may cause more to lose their homes to foreclosure, but it will ultimately strengthen the economy.  If nothing else, those who lose their homes will learn a valuable lesson about living within one’s means, and having an emergency fund in the case of a layoff.  Plus there are many Americans who wouldn’t blink at the chance to invest in a foreclosed property.  I’m one of them.

-Nick Klein

Disclosure: None.