Monday, June 25, 2012

Monetary Ledge

I'm sure Fed Chairman Ben Bernanke keeps a calendar. However, he must have forgotten to look at what is scheduled to happen at the beginning of 2013. On several occasions recently, he himself warned members of Congress about the “Fiscal Cliff” of spending cuts and tax increases that could clobber the economy early next year unless current legislation is changed before the end of this year. Yet he and his colleagues on the FOMC voted last week to extend Operation Twist to the end of this year.

The 6/21 WSJ editorialized: “In addition to the tax cliff facing the economy in January, you can now add a monetary ledge. The Federal Reserve added that extra uncertainty by announcing Wednesday that it will extend its Operation Twist bond swap program by another $267 billion and through the end of the year. Just what the economy needs: Another temporary stimulus that may or may not end when the powers in Washington claim it will.”

So now the US economy is facing three homegrown challenges: The Fiscal Cliff, the Monetary Ledge, and the Credit Divide. The Fed should get lots of the blame for putting us in this predicament. With QE2, the Fed enabled more of Washington’s fiscal recklessness by purchasing $600 billion of US Treasuries at an effective cost of 25bps to the Treasury. QE2 was followed by Operation Twist. The goal was to bring bond yields down at the same time that the FOMC was extending its promise to keep the federal funds rate near zero through 2014.

It worked, as the 10-year bond yield fell sharply this year and the yield curve flattened. However, record low interest rates aren’t working as predicted by the textbooks that Bernanke keeps in his office:

(1) As I discussed last week, the Credit Divide has made it very hard for debt-challenged borrowers with negative home equity to refinance their mortgages. The value of homes plunged 30.0%, by $6.7 trillion from a record high of $22.7 trillion at the end of Q4-2006 to $16.0 trillion at the end of Q4-2011. Over this same period, the value of homeowners’ equity imploded by 51.5% to $6.2 trillion. Americans collectively now own only 40.7% of their homes, down from a recent peak of 61.2% during Q1-2001, according to the Fed’s Flow of Funds data.

(2) Last Wednesday on Bloomberg Radio, Doug Duncan, the chief economist of Fannie Mae, said that his firm will be releasing within the next two weeks a study of the ability of first-time homebuyers saddled with student loans to qualify for a mortgage. He said, “We are worried about that.” 

(3) Exacerbating the Credit Divide is the flattening of the yield curve that has been so successfully engineered by the Fed. Banks have less incentive to lend when the spread is narrow. The squeeze on their net interest margins depresses their net operating income. For all FDIC-insured institutions, that margin has dropped from a recent peak of 3.84% during Q1-2010 to 3.52% during Q1-2012. Over this period, their net interest income has been flat just north of $100 billion per quarter.

Last week, Moody’s downgraded 15 major banks that are the largest players in the global capital markets, including five US-based banks. Some of them reacted by charging that the downgrades were unwarranted and don’t jibe with their improved liquidity and capital adequacy. This weekend, the WSJ editors had fun asking, “Wasn’t [Dodd-Frank] reform supposed to make the financial system stronger?” They suggested that such regulatory excesses might be making banks weaker rather than stronger. I would add that the Fed’s monetary policy excesses aren’t good for banks either.

Today's Morning Briefing. Monetary Ledge. (1) Timing is everything. (2) Operation Twist II ends when Fiscal Cliff starts. (3) Homeowners’ equity has already fallen off a cliff. (4) Flattening yield curve isn’t good for banks and their borrowers. (5) New Greek finance minister is sick to his stomach. (6) The ECB accepts sangria as collateral. (7) Unsettling headlines unsettle US economy. (8) More weak global indicators. (9) Sector-neutral still looks like the best bet for now. (More for subscribers.)

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