The $1 Trillion Solution
03/15/08
Last week ended just like the week before and the week before that. Monday morning the markets digest the amount of depressing news from overseas, pull themselves up by the bootstraps and start another hopeful attempt of stabilizing, building a base and generally trying to go on with their lives like every other drug addict who is trying to go cold turkey. By the time Friday afternoon rolls around, this attempt, like the others, has been totally shattered and all that is left to do is to fall back into exhausted depression once again. The bulls put up a valiant fight day in day out all week long, only to end up on their hind legs by the time the last trading hour of the week is over. Each of the preceding three Fridays has seen the market close at the low of the week. Each of the past three weeks ended with the prospect that another weekend full of bad news and dire warnings was lying ahead. Is it any wonder that our reflexes make us reach for the old drug that makes one forget? Only the drug in our case is debt, not alcohol and Dr Ben Bernanke administers its use for medicinal purposes only, pretty much like methadone instead of heroin is being used for rehabilitation. The U.S. financial system needs the capacity to lend (credit greases the wheels of commerce) and the only way this can be achieved is by giving the banks and brokers enough capital so that they can keep loans on their balance sheets rather than being forced to sell them in an unforgiving market place. Money supply growth will eventually provide the banks with enough capital to hold loans and issue new loans. In the meantime, all Bernanke can do is ameliorate the junkie�s withdrawal symptoms.
The money supply expressed as M2 has risen over the past 2 months by $200 billion or 22% annualized. M 2 consists of all physical currency, checking accounts plus savings accounts, CDs and (non-institutional) money market funds. Thus M 2 constitutes the more liquid portion of the financial system. A similar measure with emphasis more on the institutional side is also growing by leaps and bounds. MZM (money zero maturity) consists of M2 (minus small CDs) plus institutional money market funds. The general rise in liquidity was led by (of all things) an $80 billion increase in savings deposits. As savings deposits grow, capacity in the banking system increases and the ability to absorb losses and/or lend funds to borrowers increases. For each dollar received your bank has to keep 10% on deposit and can lend 90 cents to somebody else. If the Federal Reserve wants to win this race of inflation (reliquification through increases in money supply) versus deflation (bad debt being reduced, sold or written off), then they have to continue what they are doing. They need to lower interest rates and pump liquidity into the system. Our situation reminds me more and more of the deflationary spiral in Japan that developed after the bubble popped in 1989. Bernanke�s 2002 speech in this context becomes more and more prescient (eerie, ironic) or insert your own adjective. The outcome is by no means certain. Japan is still reeling from the fallout of the real estate bubble 20 years ago. If I had to choose between a falling dollar and rising inflation on one hand and deflation as we have seen in Japan on the other hand, I�d rather deal with inflation. If Bernanke continues to flood the system with cheap liquidity we stand a decent chance of working through this difficult period without loosing our shirts. However, time is of the essence. Inflation numbers were published on Friday showing the CPI declining from annualized 4.4% to 4.1%. The core CPI index (ex food & energy) also fell from 2.47% to 2.28%. Both measures were scoffed at as unreliable (rigged, manipulated) but the fact remains that recent inflation data provide much needed cover for the Fed to continue flooding the system with liquidity. Right now, the building is on fire and they do not have the luxury to worry about water damage (inflation), because without water, there will be no building left to worry about. We therefore may lament the cure being worse than the illness but at this point in time, there is no real alternative. We will have to grin and bear it and hope that the light at the end of the tunnel will be for real. Perhaps the following charts will show you the way this might come about.
The first chart shows all assets of the American banking system. Remember that assets on the books of a bank consist of loans. The amount of all loans currently on the books of our banks (not the off balance sheet loans, which are still hard to quantify) amount to $9.369 trillion. The increase in the amount of those loans (as measure by the 3 months rate of change, annualized) has collapsed since the beginning of November, even though it recovered more recently. The reason for this collapse in loans to the commercial sector is clear. Banks overextended themselves and need to horde the customer�s deposits to be able to withstand the write downs of bad loans from the past. The faster money supply measures such as M2 increase (see above) the faster the banks can reliquify and start lending again, which in turn will get the economy and the labor market out of the funk they are currently in. If we can grow bank credit by about a trillion dollars over the next 12 months, it seems possible for the banking system to overcome those $400 billion - $600 billion in bad loans. This of course would mean that all bad loans end up on the balance sheets and have to be absorbed 100% by the banks. This scenario appears to be the worst case but it nevertheless could mean that over the coming twelve months, the amounts of liquidity provided by the Federal Reserve will be soaked up 100% by the banking system and will not lead to further lending. The selling on of loans to investors has already become virtually impossible so that we have to assume that future loans will be very rarely securitized, which further means that most future lending will be done by banks with the intent to hold on to the loan. This in turn means that banks will have to raise their lending standards drastically, since they can not simply sell the loan for a fee.
The Federal Reserve Board measures the stringency of lending standards in its quarterly "Senior Loan Officer Opinion Survey". When you read the survey and look at the chart it becomes immediately obvious that the bottom in lending standards coincided exactly with the peak in the residential real estate market. Let me summarize: The reliquification of the banking system is well underway. At the current rate we should see some definite positive impact in the 4th quarter of this year. If the economic numbers should show measurable progress in the fourth quarter, then stocks should discount this improvement RIGHT NOW. Perhaps we have seen a bottom or perhaps we have seen THE bottom. In either event the bulls have all but disappeared, which in itself is bullish and gives me courage to buy.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.