Subprime Insight

Here is the last post I wrote before taking the two month break from the Blog. I did not post it, but as a way of getting back into the fray, here it is.

I have previously claimed that it was me who brought Non Borrowed Reserves to the attention of Wall Street with my Monterroza Research blog. I will admit that I had help from Mish’s Global Economic Trend Analysis who introduced me to Net Free of Borrowed Reserves, but I was pointing out how much non-borrowed cash banks had in their accounts. So I looked for the number and found that the trend was was literally off the charts. Immediately after my first blog post Wall Street began it’s offensive to dismiss the number as irrelevant and as the writer as a conspiracy theorist. Unfortunately for them, the number is neither irrelevant and the writer was an accounting major, economics minor and investor. Shortly after, there was an announcement that the Bush administration was shutting down a website that aggregates major sources of economic indicators from many federal websites. I thought nothing of it at the time but I thought that the reason for shutting down the website was ridiculously idiotic: the website was shut down due to budgetary constraints. However, when I went back to check my favorite data series, Non Borrowed Reserves, I was startled at what I found: the series was altered.

If you check the Fed of St. Louis website right now what you will see is a series entitled Total Non Borrowed Reserves and Term Auction Funds. What is amazing is that the two phrases, “Non Borrowed Reserves” and “Term Auction Funds” are a conundrum when put together. Non Borrowed Reserves are just that non borrowed, while the TAF loans are temporary loans that were invented three months ago. Non Borrowed Reserves have since the 1960s never included any type of borrowing, not even discount window borrowings. If someone does not call the government out on this small data manipulation who knows what they will be inventing next and what crap we’ll be accepting next.

I analyzed the difference between total reserves and non borrowed reserves since the 1960s in excel last month but I did not bother to post the charts since I thought people would get the point. Since people have not, I will release the data and excel soon. It is important to note that I made this during the beginning of February.

I have not blogged about many things that I have followed in the market simply due to time restraints. The truth is I read and analyze a lot more than one post a day of market news. The market is way too complex to accurately analyze properly with minimal analysis, but just simple enough to meaningfully predict profitable trends. With that said, there has been a sad trend that I have followed but not really talked about because I thought it was unimportant to the market. However, this past week I was proved wrong.

Although Ron Paul is running for President very few people actually know of him. His policies are about as free market as free market can get. Support from Wall Street is raining in from those who understand the perilous position that we are in. These are two videos that every informed American should watch. However, for those that understand economics: his stance is too little too late (I’ll explain that later).

Ron Paul on the Inflationary “Depression” that is coming:
Ron Paul video on his stance for a strong dollar:

Yesterday, I pointed out the dwindling power of the Fed to stop recessions and deflation. The day before, I pointed out the financial industries inability to capture the upside of the Fed cuts in the short term since they have a severe funding crises. Today we’ll take a closer look at the unintended consequences of the Fed’s rate cuts for the past decade. Disclaimer: This is more of an opinion based on research, that won’t be discussed here, than a true analysis.

 

Here is the chart of the federal funds rate again:

First, a look at the 1990s. After the S&L Crisis (Savings and Loans Crisis) interest rates went up, but not to previous historical levels. We can thank Greenspan for that. Throughout the 90s we saw sustained low interest rates that failed to curb unproductive economic development. By not doing so he created what is known as an “asset bubble.” This bubble was concentrated around the Technology Industry. Here is what an asset bubble looks like and the subsequent collapse, or “bubble burst:”

 

I am not claiming that the Dow or S&P 500 will lose that much value. This is just for illustrative purposes.

 

Instead of letting the financial system weed out inefficient firms by lifting interest rates after the dot-com bubble burst, the Fed instead chose more inflation. This time it came in the form of Real Estate. During the period of 1.00% interest rates, the Real Estate industry began to push all forms of exotic mortgages to unknowing borrowers that could not pay back their debt. Add the “Income Effect,” where home owners view their income increasing due to rising home prices, and you get a perfect excuse to spend more money than what you are making. In fact, for the past decade real GDP has grown by 2.9% annualized while consumer spending has grown at 3.6%. The extra spending started around a little before 2001 and has since then added an extra $3 trillion to the economy that was never earned. So every time you hear Wall Street mention this being a “consumer led” recession, don’t believe it. In truth, Wall Street has been prospering on the backs of the American consumer. The collapse of the “income effect” is due to Wall Streets massive speculation on Mortgage Backed Securities. The coming crisis is what happens when years, I repeat: years ,of growth in the financial sector are lost.

 

And now we have the outcome of two massive bubbles, created in part by the Fed, coming down at once with a multitude of other problems. To hear Jim Cramer’s take on this, refer to my previous post and listen to his 45 minute speech, touching partly on the defunct fed, the failures of capitalism, and the two asset bubbles.

 

 

The question shouldn’t be whether or not we are going into a recession, but rather: How much of that 3 trillion are we going to lose? For generations, Americans spent more for a couple of years then paid back their debt. In recent history the cycle has broken. I’m betting on the cycle returning in the recent future.

Last month, we saw the Federal Reserve cut the Fed Funds Rate a full 125 basis points (1.25%) to 300. What does that mean historically? In the following article we will take a look at just how dramatic the Fed’s 125 basis cut in 8 days means.

 

 

 

The Fed started issuing “Target Rates” in 1982. Before then, the free market set the prevailing rates. Now, the Fed through the open market works to get the rate to its target. Here is the graph of the Target rates since 1982:

 

 

As is plainly visible, the Fed has been slowly lowering Fed funds rate since it started controlling it back in 1982. What does this mean? Basic economics says that the power of a central bank depends largely on how they control interest rates. Generally the higher the interest rates are before coming recessions, the more power the Fed has to flush the economy with money and increase liquidity. Following this logic, we can see that the Fed has been slowly loosing its power to provide liquidity relative to previous recessions.

 

 

If you were to actually look at the rate the Fed has cut its Fed Funds rate, there has been no precedence for cutting 125 basis points in 8 days. The closest we have come is a 100 basis point cut in the time span of a month. What does this mean? Although, many can argue that differences in styles of Chairmen of the Federal Reserve would bar extrapolating long term trends, this could mean a couple of things that are not mutually exclusive of one another.

 

 

One: We can be seeing a new type of Fed. A Fed willing to forgo the typical steady prolonged cuts of the past. This could simply be a change in style from Greenspan to Bernanke. Possibly an “experiment” of a new way to set target rates.

 

 

Two: The Fed is acknowledging that it was late in beginning to cut rates. There have been critics of the last fed funds rate rises and the slow reaction time of the Fed to begin cutting rates. This could simply signal that the Fed is trying to “catch up” with the economy.

 

 

Three: the economic downturn we are headed for is unprecedented and the Fed is ready to take drastic actions against the coming recession. After all, desperate times call for “drastic” measures.

 

 

However, the most important question is: How much can the Fed Cuts help in this coming downturn?

 

 

Let me reiterate this: They obviously help. But how much?

 

 

Basic economics tell us that with Fed cuts comes easy money. In theory, banks can more easily lend to other banks or from the Fed to solve liquidity crises. But is that the case during this cycle? Although, some would say this is a “consumer led” downturn, I would argue otherwise. This cycle has been created by the willingness of banks to lend money frivolously, headless of risk. The problem today is that banks don’t have cash reserves to lend out to other banks. Look at my previous post, “One Reason Last Week’s Market Rally was a Bear Rally,” to see just how hurt banks are with cash. The level of borrowing from the Fed is, again, unprecedented. This along side the fact interest rates have been historically trended downward, limits the immediate help the Fed can give to banks in the short term.

 

 

 

Here is a chart of what the Federal Reserve has had to deal with since the 1960s:

 

 

Generally, until 1982, the Fed had to actively fight inflation, or “Stagflation.” Since then, after every recession, or threat of deflation, interest rates have not risen to the levels before economic downturns. In other words, the Fed’s power to stop deflation has been curved. This, along with liquidity problems in the financial industry, leave the Fed with one hand to save the economy.

 

 

Question to ponder: If we have not had interests rise above their previous peek after every recession since 1982, what makes this recession different? If anything, we should expect a longer period of low interest rates due to the limited power that the Fed has to stop us from going into a serious recession, or curving deflation.

After the Market plummeted to begin the year, it staged a magical 4.9% week to finish January. Don’t believe the magic. In the following analysis I take a look at why last week should be described as the market’s emotional attempt at a bear market rally. To get a closer look at the financial sector, I took a lead from Mish at the Global Economic Blog but took it further. Here’s the scoop:

 

At the heart of all this and most evident at the time is sub prime. However, no one can really understand how bad it is until they see the crisis in charts. To quickly recap the damage it has wrought just take a look at the following year long stock charts: Moody’s, Countrywide, Citigroup and almost every other commercial bank… and the list goes on. This has been happening for some time now so people are predicting a bottoming out around now, hence the rally last week.

 

Mish pointed out this interesting chart a few weeks ago:



 

As can be seen on the chart something is not right. Moving back in time lets look at history:

 

The sharp decline of borrowed money from Depository Institutions, aka “the US banks”, is the result of massive sub prime write downs. A quick look can show you that this todays levels are unprecedented. No crisis has tested the reserve requirements of banks to such a massive extent.

 

The next closest circle, for comparison purposes, is the recession of 1991, aka the Savings and Loans crisis. The only time in history that financials have been sold off this much was during the Savings and Loans crisis of 1991, aka financial stocks are currently valued at the cheapest level in a long time. Notice how the reserves never went negative but in fact went up during this period. On simply a reserve basis, we can see that the financial stocks are overvalued, if they are selling at 1991 levels, assuming the magnitude of the subprime crisis is much bigger.

 

 

Then we have the recessions of the 1970s. In those times we saw an even bigger run up in housing prices and a bigger decline than what we have today. Here we see that although banks became net borrowers, it never and as rapidly amassed to such huge levels of borrowing from the Fed.

 

 

Finding this interesting, I decided to take a further look at the total non-borrowed reserves of depositary institutions.

http://research.stlouisfed.org/fred2/series/BOGNONBR?rid=19



 

Surprisingly, the huge drop off of reserves happened back in December, not January. Meaning the huge drop in reserves seen here does not take into account the massive borrowing from the Fed in January. Notice how no crisis has ever depleted reserves like this since before the 1960s.

 

From their latest, non graphed records we can go to:

 

http://www.federalreserve.gov/releases/h3/Current/
Here we find that the preliminary results for Jan 30th is -$8,751 billion. To make it more clear: The American financial system as a whole has non of the reserve requirements necessary, aka they have all been lost due to subprime losses and banks are now borrowing to meet demand withdrawals. To make it clearer: The money you withdraw from your bank next time is actually borrowed from the Federal Reserve. Also, the Fed is charging banks interest on that money. If this was graphed on the above chart the value would be negative for the first time since before the 1960s. Again, the blue line would actually cross the x-axis.

 

This shows that banks need to sell more than $40 billion in assets to meet the reserve requirement without borrowing. Taking into account that they managed to raise $84 billion in cash from sovereign funds and that $72 billion of losses will be triggered in the downgrading of a bond insurer alone and the picture does not look good for the financial industry.

 

However, it is important to note that generally the market prices in recessions well before they actually happen and stock markets generally go up during recessions. For the reason explained above and many others that will soon be discussed here, I have a feeling we are far from over this sub prime mess.

After deciding to cut the Fed Funds Rate to 3.0% on Wednesday, the Federal Reserve bank has slashed the discount rate to 3.5%. While the Fed Funds Rate determines the rate that banks can charge one another for borrowing money, the discount rate controls what the banks get charged after directly borrowing from the Fed.