Merkel on Banking Sector
A: A few new blogs that I want to share with UrbanDigs readers, especially for those more interested in the bigger picture, than on one specific real estate market. The Aleph Blog, by David Merkel, and Across the Curve, by 30-year bond veteran John Jansen. Both are very good reads on the macro economy and the bond markets. For today, I want to discuss David Merkel's piece on why he is concerned about the state of the banking system bringing him to the ultimate conclusion that the fed's next move will be to loosen; I agree.
First off, I publicly stated my dovish stance in regards to future fed policy actions on AUG 5th, after the fed kept rates steady. To me, the fed is talking tough on inflation for a number of reasons, mainly to support the dollar, correct commodities & inflation expectations, and allow them more room to cut rates in the face of an event; such as a rescue of the GSE's or a failure of a large financial institution. Both of these risks are very high right now.
David Merkel looks at Barry Ritholtz's post on US Banks notional derivatives exposure risk, and gets a bit nervous. Some of his conclusions from his piece titled, "Banking on Continued Risk in Lending Markets", include:
ON BANKS DERIVATIVES EXPOSURE
"I know things are bad, and I can’t vouch for Institutional Risk Analytics’ risk based capital model for banks, but the level of notional derivatives exposure at many of the major banks to their tier 1 surplus made me pause. There are two claims on surplus — losses from direct lending, and losses in the derivative books.
Those who have read me for a long while know that I think the derivative books at the investment banks are mismarked and possibly mishedged. When accounting rules are not well-defined, and instruments are illiquid, even well-meaning managements tend to err in their favor in the short run."
ON LINK OF BOND MARKETS, SPREADS & BANK LENDING
"The bank loan and and bond markets are closely connected. Troubles in one tend to spill over to the other. Loans have a higher priority claim, so the yields are lower than for bonds. As it is, investment grade corporate bonds, particularly financials, are facing higher yields. The high yield market has slowed considerably.
So, what does this imply? The banks are hunkering down. They are scrutinizing all risk exposures. They aren’t expanding lending, which is showing up in MZM, M2, and my M3 proxy. Credit is getting tough/sluggish. And the degree of leverage that banks are willing to use versus the Fed’s monetary base is dropping, and hard (the graph covers 28 years)."
As I discuss often, credit deflation & deleveraging. Read Mish's site daily as he covers the debate between inflation & deflation often, and is consistently in the deflation camp. Folks, this is all very important stuff. Think outside the box, if banks are 'hunkering down', minimizing risk, deleveraging toxic assets, taking losses, forced to re-capitalize, etc., how will this:
a) affect near term economic growth AND
b) set the stage for a sustainable recovery in the housing market
ON FUTURE FED POLICY
"So, I’m not optimistic here. I believe in the value of “long only” money management as having better chances of risk control than hedged strategies, but this is making me queasy. What it makes me think, is that the FOMC’s next move is a loosen. It hurt to say that, particularly given my dislike of inflation, but the solvency of the financial system comes ahead of inflation in the Fed’s calculus, even though loosening won’t help much."
Exactly. The fed can't tighten with so much trouble still out there and they can't ease when the dollar is at its low against other major currencies, oil is near $150, and gold is near $1,000; the commodity inflation and inflation expectations are just too strong. The ideal environment for the fed to use their limited remaining bullets, is on a correction of the dollar & commodities priced in dollars. I think this setup is happening right now and I think the fed's next move will be a rate cut, likely inter-meeting in response to some sort of event. We still have to deal with the economic after-effects of credit deflation and an economy that has gone through sharp tightening of lending; and this is likely a late 2008 and early 2009 story. Good stuff.
RELATED:
Mish's TOO BIG TO BAIL List of Troubled Financial Institutions
