A Story in Pictures

It is rather remarkable to note that every time we visit the Fed’s statistical database we increasingly encounter a “SERIES DISCONTINUED” notice in connection with the data that we have come to rely on to analyze the activities of the US Central Bank and the health of the economy (Our friend, Marvin the Paranoid Android, asks:”What are they trying to hide?”). The disappering data notwithstanding, some inferences are possible using the information they still deign to release. We are therefore pleased to be able to offer the following narrative based on recent information found on the Fed’s website .

In March we informed our clients and service providers about the unprecedented developments on the Fed’s Balance Sheet. Back then we were surprised to find that the level of Reserve Borrowing had risen to USD 100 BN, a level of borrowing suggestive of the “backdoor nationalization” of the US Banking System. We argued that the re-entry issues associated with this state of affairs may prove extremely problematic.This is because over the entire history of the Federal Reserve System, Discount Window borrowings were usually maintained at extremely low, frictional, levels – certainly never much more than USD 1-2 Billion from week to week, whether the economy was weakening or not (see Chart 1). Since our March report the level of net borrowing has skyrocketed further, into the area of 170 BN, indicating that the pace of increase in the markets’ reliance on the Fed displays no sign of slackening.

Chart 1

Clearly, banks are finding it increasingly difficult to find funding in the open market for vast chunks of their asset exposures. This however does not tell the entire picture. The borrowings reported on the Chart above only include discount window loans to depository institutions and not the dollops of financing that have been extended to broker/dealers and other zombie institutions unable to otherwise source liabilities for themselves.

The recent buybacks of Auction Rate Securities (aptly named ARS’s) by the dealers have likely also been underwritten through the backdoor by the Fed. On our estimates, the Fed has now encumbered more that 75-80% of its balance sheet with illiquid, and otherwise unfundable, loss-making paper. There is presently no exit in sight.

Loan Losses Popping

While this has been going on, other statistics published by the Fed show that loan losses have started to accumulate in the Banking System. Chart 2 below shows that net charge offs have doubled in the year to end March 2008. 

Based on recent projections of system wide losses of USD 1.5 to 2.0 TRN that have been made by the IMF, Goldman Sachs and other market analysts, we can expect reported  loan losses to climb sharply in coming quarters and to vastly exceed the previous peaks shown on Chart 2 by a factor of 2 to 4. This means we can expect aggregate charge offs to reach some 4 to 6 percent of system assets if the loss projections announced by various analysts as described above come to pass.

This level of loan losses will be unprecedented. At a minimum it suggest that Ken Rogoff’s recent comments about a small number of high profile financial players going to ground is a conservative view. It will likely be much worse, and many, many financial institution failures will occur.

Chart 2

Don’t Count on the Curve to Bail Anyone Out

In past crises the Fed lowered rates, the yield curve steepened and the financial sector re-liquified their balance sheets as the spreads between their asset yields and liability costs widened. This is clearly shown on Chart 3, particularly in the spread expansion shown in the periods immediately subsequent to the previous downturns in the early 1990’s and 2000’s. The income statement response was fast and predictable.

Chart 3

Unfortunately this is not happening this time around. Net spreads have continued plummeting amidst one of the most significant Fed easings in recent memory. In fact net spreads are at an all-time low and still falling, despite the easing. Due to the fact that median asset quality is declining, significant optimism is required to support a view that even a small recovery from these levels is possible within a reasonable timeframe.

We’re not in Kansas any more Toto!

Thus, it appears that the tonics and potions that the Fed has used in past crises, and the new elixirs brewed up earlier this year are not doing the trick. This means that the Fed is rapidly running out of bullets, and they have to be now betting that things are going to get a LOT better before they get ANY worse.

Our conclusion is that the Fed is in a hole and digging itself deeper.

Since the Fed’s rescue program appears not to be working, expect more jawboning from the US Policymakers. However, if their comments continue to be as ill-advised as Paulson’s varied mumblings as regards the viability of the GSE’s and Bernanke’s recent inflation outlook commentaries, then the markets may punish them by sharply lowering the credibility they attach to such guidance (When I was trading rates we called this the “BS Coeffiicient”; or otherwise, the inverse of credibility) .

Other things to watch for include:

• Banks are going to tighten lending conditions significantly. Expect credit rationing as opposed to price-driven activity.
• There will be a significant spike in corporate bankruptcies both as a result of the credit squeeze but also intimately related to the vast volumes of sub-investment grade debt issuance in the last 5 years.
• Stock Markets will remain weak and IPO activity will continue at a low ebb. M&A, Private Equity Investment and other speculative activities dependant on friendly markets and gullible investors with deep pockets will decline markedly.
• Growing financial stresses will cause numerous banks to go under. Expect consolidation and a further strain on Fed and US Government Agency resources. In this connection, it is worth noting that the recent Indy Mac bankruptcy alone consumed 10% of the reserves of the FDIC.
• Spreading Contagion. A crisis of confidence might break out leading to a chain reaction in global financial markets and an ultimate break in confidence in the US dollar. This confidence is not being helped by recent Russian military adventurism, other festering problems in Central Asia and North Korea, commodity price volatility, poor relative inflation performance and the seemingly insatiable requirement for foreign capital inflows needed by the US to keep its game afloat.

Returning to our initial premise, if we can draw these conclusions on the basis of what the US Government is still allowing the markets to see in the way of statistical information, then, we wonder, how much worse is the situation relative to what we have been told and are able to deduce; how much more problematic is it going to get; and are US Policymakers truly able to adequately cope with what is turning into a rapidly deteriorating mess of gargantuan proportions?

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