The normalized TED, which is the 3 month LIBOR minus the 3-month Treasury divided by the 3-month Treasury, has reached a level not seen since the fall of 2008. The TED, i.e. the numerator or the LIBOR minus the Treasury, is normally interpreted as a wholesale banking spread. When this rises, there is greater perceived risk to the banking sector. The normalized TED can also rise if the 3-month Treasury falls, which can happen in “flight to quality” situations, as is also the case now. This spread appears to be indicating a rising probability of a change to the European Union. We at CERF now believe that it is not if the European Union will break up, but when. However, this spread is just one of many indicators that we have watched to form this opinion.

The second chart shows the ten-year Treasury, TB10Yr, and the triple-A corporate bond rate (ten-year) and the normalized spread between these two measures. The normalized spread has almost reached levels that occurred in late 2008. This measure is also indicating a “flight to quality” in financial markets because the ten-year Treasury rate is falling faster than the triple-A corporate bond rate.

I have argued in this blog-space that these indicators helped us see the regime shift to a serious recession that occurred in late 2008. The current levels are uncomfortably close to indicating another regime shift.

If you are looking for a summary statistic on the United States economy, I recommend you consider bank charge-offs. These are the loans that banks have written off their books, because the probability of collecting them is so low. It doesn’t mean that the borrowers are off the hook, or that the bank will stop trying to collect the loan. It only means that a bank can’t consider a charged-off loan an asset.

Most people use GDP growth as a summary statistic for the economy, which leads to the current situation where policy makers and talking heads have declared a recovery while millions who have been unemployed for months or years continue to be unemployed. Indeed there were two recessions, based on GDP, in the 1960s where all of the job losses occurred after the recession was declared officially over.

OK, so why not use jobs as an indicator of prosperity? Actually, I’m sympathetic to that. It is certainly a better indicator of well being than is GDP. However, I think that charge-offs, particularly now, give us a little more information. Jobs tell us what businesses are doing. Charge-off data tell, at least in some sense, what business can do. That’s because banks don’t lend much when charge-offs are high, and without loans, businesses can’t grow.
So, what are bank charge-off data telling us?

They are telling us that a robust recovery is a ways off. Below is a history of real, inflation adjusted, bank charge-offs:

Prior to 2007, quarterly bank charge-offs had never exceeded $15 billion a quarter in today’s dollars. Then, they skyrocketed to almost $60 billion a quarter. Since then, bank charge-offs have fallen, but they remain well above $40 billion a quarter. You have to conclude that our banking system is still crippled.
This impacts small business much more than it impacts big business. Big businesses have direct access to capital markets and don’t need financial intermediation.

There are more reasons to be bearish on American small business growth. People who own small business own real estate, much more than the typical American. About 98 percent of all small business owners own their own home, but only about 66.5 percent of all American households own their own home. This means that small business was disproportionally hurt by the collapse in real estate values. Their balance sheet was suddenly over-leveraged, impairing their willingness and ability to borrow.

The inability of small business to use real estate equity to finance growth has impacts that are exacerbated by a banking sector that has forgotten how to lend to small business without the use of real estate as a secondary repayment source.

It used to be that small business had access to lines of credit secured by inventories or receivables. These were expensive loans, but they did not require real estate equity for the firm to grow, and in cyclical businesses they were self-liquidating, something that bankers just loved.

As real estate values climbed, banks lowered costs by moving away from these loans. Consequently, while some inventory and receivable financing remains, it is less important than it used to be. Perhaps worse, many bankers don’t know how to make and supervise inventory and receivable lines of credit. It was always a specialty. Today, asset-based lending, as this type of lending is referred to, is an almost forgotten specialty.

Still, those banks that are well enough capitalized to be aggressively seeking lending opportunities would be well advised to consider setting up asset-based lending units. It may be the only way for them to significantly increase loan volume in the near term. It would also be a service to small business and the economic well being of all of us.
The other alternative for small business expansion would be for real estate values to suddenly increase. That is not going to happen in this or next year. I go into the reasons more in the Real Estate Essay, but I have another summary statistic for you, Home Ownership Rates.

Home ownership in the United States is generally about 64 percent. That is about 64 percent of households own the home they live in. When the homeownership rate gets much above 64 percent, we have problems in our financial sector. Remember the Savings and Loan Crisis?

The United States homeownership rate climbed during the second half of the 1990s and the first half of the 2000s, until they peaked at over 69 percent. Since then, it has fallen, but not by enough. Until the United States home ownership ratio drops to below 65 percent, there will be no generalized upward pressure for home prices.

I think we have to conclude that this recovery is weak, because the normal drivers of a robust recovery, small business and real estate, can’t contribute.

Seeing a problem and knowing how to solve it are two different things.  So, we’re going to see lots of silly ideas proposed.  We’ll see demands for more government spending.  We’ll see demands for less government spending.  We’ll see demands for higher taxes.  We’ll see demands for lower taxes.  We’ll see demands for more consumer spending.  We’ll see demands for more consumer saving.

All of these recommendations can’t be correct.  In fact, they are all beside the point.  I’m not saying the proposals won’t have any impact.  They will, but the impacts will either be marginal or they will be some time in the future.  Our problem is immediate and very serious.  Here’s what we need to do to avoid a lost decade:

• Fix the financial sector
• Stop paying interest on deposits at the Fed
• Lower effective borrowing costs with an investment tax credit
• Reduce regulatory uncertainty and big-business bias
• Increase immigration

Any vigorous recovery needs a vigorous financial sector, and ours is not.  Fed policy has been ineffective, because the money multiplier has tanked, even as the monetary base soared.  There are two reasons for this: The Fed is paying banks to deposit at the Fed, and the banks–burdened with over-leveraged balance sheets, huge charge-offs, and bad assets–are in no shape to lend.  Fix the banks, and stop encouraging them to park money in Washington, and we’ll have a start on real recovery.

We have an investment problem; there isn’t any.  That’s because, even at zero, borrowing costs exceed expected returns on investments, and the future regulatory environment is extremely uncertain.  We can’t lower interest rates below zero, but an investment tax credit would effectively lower borrowing costs.  Do that and remove regulatory uncertainty, and our businesses will invest.  While we’re at it, let’s reduce big business’ regulatory advantage.

Finally, we don’t have any problems that couldn’t be fixed by a few million new immigrants.  We’d see an immediate increase in housing demand and construction.  Our inner cities would be renewed.  Our economy would see a burst of creativity, energy, and new business formation.

“The U.S. financial system remains fragile and banks subjected to additional economic stress might need as much as $76 billion in capital, according to the results of International Monetary Fund stress tests.”

We at CERF have been long concerned about the strength of our financial sector.  In fact I suspect that the IMF study may be understating the severity of the situation.  That would be a problem.  Ask the Japanese what a weak banking sector can do to an economy.  The weakness of their financial sector, and their failure to correct those weaknesses, were a significant contributor to their 20 years of economic malaise.

Failure to promptly deal with our weak financial sector can have similar consequences for us.  You may think the new financial regulation fixes our banks.  It doesn’t.  It creates a new regulatory environment but it does nothing to address the problems that are keeping our banks from fully participating in our economy, inadequate capital and bad assets on their books.

• Keep it simple. Simple regulation is cost-effective regulation. Simple regulation minimizes both regulatory costs to the government and compliance costs to the regulated firms, costs eventually borne by consumers or taxpayers. Complicated regulation invites lawsuits and encourages efforts to avoid the regulation.

• Regulate the smallest possible number of firms. Regulation is a market distortion and tends to limit innovation. Because of the September 2008 collapse, some people are not convinced of the benefits of financial innovation. This is unfortunate. Financial innovation is, on net, positive. Consider the Farmer who hedges against bad weather by using futures or the airlines that hedge against higher gasoline costs. We need to encourage financial innovation.

• Preserve incentives. We’ve all encountered either government monopolies or government regulated monopolies. The DMV, the Post Office, and utilities come to mind. We’ve also seen the innovation that followed the elimination of the phone monopoly. Bad regulation provides perverse incentives. Good regulation maintains incentives for quality, service, and innovation.

• Maximize market feedback. Markets have built in incentives that are beneficial to society. Where possible, we should allow that feedback to do its magic. It is the cost-effective way to preserve incentives.

• Minimize moral-hazard problems. Moral-hazard issues result from free or under-priced insurance. It is currently pervasive, and it is our single largest source of unnecessary systematic risk. The too-big-too-fail concept in particular has resulted in excessive risk taking, with disastrous results. Similarly, FDIC insurance was under-priced, as evidenced by the FDIC accelerating the collection of future premiums, and the results are self-evident.

• Minimize political influence. Political influence in economic matters is counterproductive. It is clear to me that the vast majority of political types are trying to optimize something other than economic activity or efficiency. Whether the political objective is maximizing the likelihood of reelection, rewarding supporters, or simply greedy corruption, we need to avoid the results.

• Regulation is not protection. Regulators often become partners with the regulated. Sometimes this is because the regulator expects to be eventually employed by the regulated. The regulator may have been employed by the regulated, or may become friends with the regulated, or may be corrupt and accept bribes. In all cases, we are ill served when the regulator is protecting the regulated.

• Regulation should not be adversarial. The purpose of regulation is not to punish the regulated. We have a legal system to provide punishment when it is needed. Adversarial regulation will encourage evasion. The best approach is arms-length, fair, and firm.

The problem with regulating capital ratios is that the capital ratio is not a sufficient measure of the firm’s risk. The firm’s risk is a function of both the capital ratio and the riskiness of the assets it holds, and that poses serious regulatory challenges.

A firm has a preferred risk profile. If you limit the capital ratio, the firm can achieve its target risk profile by increasing the riskiness of its assets. This means that if you want to regulate the riskiness of a firm using a capital ratio, you must also control the riskiness of its assets. No problem there.

Well, actually, there is a problem. Controlling the riskiness of a firm’s assets is impossible.

If regulation is to have any impact, the firm has a big financial interest in having riskier assets than the regulators would prefer—an interest that is only made larger by free (too-big-to-fail) or under-priced (FDIC) insurance—and the regulators have only a limited interest. Therefore, the firm will succeed in working around any constraints, and they will always be at least a step ahead of the regulators. The regulators are just no match for a determined firm with a big financial incentive.

Even if regulators could control the risk of firms’ assets, they still could not control the risk of the firm, because risk is dynamic, changing over time. In my banking days, we had a saying: In good times you don’t need capital; in bad times you will not have enough capital.

The problem is that in bad times, everything goes bad. We say the covariance goes to one. It may seem farfetched that a New York grocer, a Los Angeles realtor, and a Chicago lawyer would have economic prospects that were related, and that is true in most states of the world. This is the argument for geographic diversification. However, in a big event like we saw in September 2008 the grocer, the realtor, and the lawyer were all in the same boat. The probability of each of them failing to meet obligations has gone up, but more importantly, the probability of all of them defaulting has gone way up.

There must be a better way to regulate financial companies.

• Keep it simple
• Preserve correct incentives
• Minimize political influence
• Maximize market feedback
• Minimize moral hazard issues
• Regulation is not protection

Our friends at KERN Economics have come up with a plan that meets all of my criteria. It also has the desirable characteristic of having successful working examples, examples that were unfazed by 2008’s meltdown. Good original thinking. Read it here.

How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. Over the past one and a half years, the Fed has piled on securities with long maturities and exposed itself to credit risk. If it sold those assets, it would post considerable losses, deadly to the institution’s already fragile reputation in the current political climate. Instead, the Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.) This matters because two slots on the board are currently open, giving the White House an important opportunity to shape monetary policy through future nominations. Indeed, given natural turnover among governors, President Obama will probably be able to appoint a majority of the board in a single term of office.

In the first paragraph, Vince highlights the flipside of quantitative easing. The Fed bought a bunch of long-term financial assets, the value of which will go down when interest rates go up. Now, owning these assets is a constraint on Fed actions. There is already plenty of pressure to reduce the already-compromised “Fed independence.” Selling those assets at a loss will further increase pressure for more congressional oversight.

This means the Fed will control inflationary pressure by increasing the rate they pay on excess bank deposits at the Fed. That will work, but it will likely have a more negative impact on economic activity than traditional methods. With high risk-free yields at the Fed, banks, already under regulatory pressure, undercapitalized, and risk averse after the 2008 meltdown, will have no incentive to lend. Small business, which traditionally funded growth with bank loans, will have difficulty obtaining capital. Big business, with direct access to debt and equity markets, will have easier access.

Economic growth, therefore, will probably be slower than under traditional Fed tightening, and it will be biased toward big business. Small business, handicapped by an uneven playing field, will almost surely decline as a percentage of business activity.

The second paragraph is important, because it implies that Fed policy will become more political. Given current and projected United States debts levels, political pressure to monetarize the debt will be strong. As debt levels and interest rates increase, interest costs will soar, as will the pressure to inflate. Will a more politicized Fed resist that pressure? I wouldn’t bet on it.

Jeff isn’t buying any of this. He says:

It seems peculiar to me that the Fed would conduct its monetary policy with a major constraint being the effect on its own profitability. While it might be embarrassing to sell some securities at a loss, it would be even more embarrassing to have a portfolio like the thrifts in the 1980s: long-term fixed rate assets funded with short-term liabilities in a rising rate environment. That would look really stupid.

Good point. We’ll see.

New unemployment claims also rose to 444,000, again exceeding “consensus expectations.”

There was also a report that will receive much less attention, but it is important. Inventories increased in November, the most recent month for which data are available. If inventories were increasing over the Christmas shopping season, and sales were declining, retailers ended the year with excessive inventory. That means reduced production in the first and second quarters of 2010.

2009’s third quarter output (GDP) growth was positive, and many expect a very impressive positive number for the fourth quarter, some as high as five percent. If the fourth quarter does come in with a strong GDP growth rate, it will be hailed as the harbinger of a soon-to-be-realized vigorous recovery.

Don’t buy that, and you won’t be disappointed.

That vigorous recovery may eventually come, but it is unlikely to come in 2010. Whatever growth generated in second-half of 2009 was government-supported consumption, ephemeral, not a solid foundation for economic growth, certainly not the basis for sustained vigorous job growth.

A vigorous recovery will be a result of investment, technological growth, and improved productivity. Recent productivity numbers have been encouraging, but in large part, they are probably the result of firms downsizing. Technological growth and solid job growth require investment, and that is the problem.

Our banks are in no condition to fund any vigorous expansion. Indeed, bank loans have been declining since October 2008. Businesses and consumers remain over-leveraged, unable to increase spending on consumption, unable to invest, desperately trying to reduce debt.

We won’t see a vigorous recovery until balance sheets are improved and banks can lend.

Government programs haven’t helped. Most of the spending programs have been consumption based instead of investment based. Some have been outright counterproductive, programs such as foreclosure-delay, paying interest on bank deposits at the Fed, and cash for clunkers. Even worse, the banking problem has been ignored, and now new taxes on banks are being discussed. That is as bad an idea as I’ve heard in a long time.

Scheer doesn’t give his reasons for supporting a new Glass Steagall, but he quotes McCain extensively. McCain’s comments are essentially a populist rant against “fat cat bankers on Wall Street.”

That’s a problem. I’m all for a new Glass Steagall, but let’s get the reasons right. Populist rants only confuse things.

The Glass-Steagall Act, passed in 1933, was part of the response to the Great Depression. The component relevant to today’s debate was the restrictions on the breadth of financial institutions’ operations. Investment banks were restricted from commercial banking, and commercial banks were similarly restricted from investment banking. An investment bank engages in transactions involving capital, securities, mergers and the like. Commercial banks take deposits and make loans.

The repeal of Glass-Steagall, in November 1999, was supported by both political parties. The arguments for repeal were that it would reduce risk by diversification and that advances in financial technology meant that risk was low.

Right.

The diversification argument sounds reasonable: Banks could diversify, and if one business was in trouble, the other probably won’t be in trouble. But, there is a problem with that argument. Financial theory and experience is clear. Stockholders can diversify for themselves. Businesses should concentrate on their core competency, the one where they maintain a comparative advantage.

The diversification argument also implicitly assumes a relatively low correlation between the returns from the various businesses. Financial panics throughout history have demonstrated that when things go bad, the correlation goes to one. When things go wrong, they go wrong everywhere.

The argument that financial technology has improved, and we now know how to do things with low risk is an old one. I refer readers to Reinhart and Rogoff’s book This Time is Different: Eight Centuries of Financial Foll. In it, these respected economists document the plethora of financial panics this type of thinking has created.

We do need to reinstate the separation of bank business. Let’s do it for sound reasons. While we’re at it, let’s limit the maximum size of any corporation. We also need to get rid of the Too Big To Fail concept.