Tag Archives: Banks

When the fed funds rate starts rising: how high? what does this do to stocks?

April 1, 2010 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Recent Market Action, Shaping a portfolio for 2010, Strategy Tags: , , , , , , , , , , , , 5 Comments

The economy is healing

We know the US economy has turned the corner.  At some point, activity will be strong enough that the Fed will begin to raise short-term interest rates from their intensive-care-unit level of today.  (Yes, the Fed has already begun to raise the discount rate, but this has been to force the major banks back into the commercial paper market instead of dealing solely with the government.)

what happens when the fed funds rate rises?

Even though the initial move may be months off, when is less important than how high the rate is likely to go and the effect the move will have on stocks and bonds.  It’s not too soon to begin thinking about any of this.

two parts to this post

–The first will be what financial theory, such as it is, says about what should happen.

–The second will be an examination of the historical record of fed funds rate increases over the past twenty-five years.

Theory

fed funds rate behavior

One of the Fed’s jobs is to help carry out our highest-level national economic objective:  maximum sustainable growth with low and stable inflation.  “low and stable” means nothing much higher than 2%.

This gives us our first benchmark.  Under normal conditions the fed funds rate, the price of overnight interbank deposits, will be slightly positive in real terms–about .5%-1.0% higher than the target inflation rate.

If the economy is running too hot, the Fed temporarily raises the rate, both to telegraph its concern and to raise the cost of borrowing, thus slowing the economy back down.  When the economy is down in the dumps, on the other hand, the Fed drops the rate below inflation to try to pep activity back up.

Today, the rate is at about .25%, meaning the economy has been in a train wreck and is barely breathing.

Where is normal, then?  Assuming inflation is under control, that is, 2% or less (and I think it is), the fed funds rate should be somewhere around 2.5%-3.0%.  That means that one the Fed starts upping the rate, it won’t stop until it has tacked on 200 basis points, and possibly as many as 250.

Long rates won’t rise by as much, since this isn’t bond investors’ first rodeo and thus to some degree have already priced in some of the short-term interest rise.  The extent of the yield curve flattening (meaning a smaller rise in long rates than in short) remains to be seen, but the ten- and thirty-year bond yields could easily rise by 100 bp.

the effect on stocks

Strictly speaking, there is no independent demand either for stocks or for bonds.  This is because, to a great extent, the two asset classes are substitutes for one another.  There is demand for the more  general class of long-lived investment securities, which includes both stocks and bonds.

Why is this distinction important?  If stocks and bonds are more or less substitutes, then anything that changes the price of bonds also tends to change, in the same direction, the price of stocks, and vice versa.

As interest rates go up, the price of bonds goes down.  So rising interest rates should exert downward pressure on stocks as well.

For government bonds, that’s the end of the story.  Not so for stocks, however.

The Fed only  raises interest rates when economic activity–and thus corporate profits–are expanding as well.  Rising profits tend to put upward pressure on stock prices, offsetting part or all of the negative force of rising interest rates.  One can at least imagine circumstances where interest rates are rising slowly enough, or profits are growing fast enough, that stock prices are either stable or have a rising bias.

bond-stock equilibrium

One can also look at what the equilibrium relationship between stocks and bonds should be.  This is usually done by comparing the interest yield on government bonds with the earnings yield on stocks.  The earnings yield is typically calculated as the annual earnings per share of an index like the S&P 500 divided by the price of the index.  It’s the inverse of the PE ratio.

If we assume that the 2010 earnings per share for the S&P 500 will be 85 and the index level is a bit below 1200, then the earnings yield is about 7.0%, which equates to a price earnings ratio of 1/.07, or 14.

Let’s say that as a result of the rise in fed funds to 2.75%, the ten-year bond yield increases to 5.0%.

The “right” proportion between a unit of yield in the bond market and in the stock market is a function of investor preferences and changes as they do.

If investors were indifferent to whether the earnings came from stocks or bonds (a big if, but more or less the relationship that has prevailed over the past twenty years), equilibrium would occur when the interest yield and the earnings yield were equal.   A 5% long bond would imply a 20 times price earnings ratio (a 5% earnings yield) on the stock market.

Whatever the exact right number for today’s world may be, one can observe that a unit of earnings is available today much more cheaply than has historically been the case in the stock market vs. the bond market.

To sum up:  increasing earnings give stocks some defensive power against rising fed funds and long-bond interest rates.  Also, relative to one another, stocks are priced much more cheaply than government bonds–again arguably giving them some protection against rising rates/lower bond prices.

History Continue reading →

Mike Mayo vs. Citigroup: score it yourself

March 29, 2010 By in Accounting, Banks, deferred taxes, Industry Analysis Tags: , , , , , Leave a comment

The Mayo prediction

Mike Mayo, the heralded bank analyst of Calyon Securities, predicted late last year that Citigroup would write down its deferred tax asset account, on the books at a net value of $44.6 billion, by $10 billion at yearend.

The 10-k is out

Reporting time has come and gone.  C filed its 10-k, all 272 pages of it, with the SEC about a month ago.  No writedown.  In fact, deferred taxes are up $1.5 billion on a net basis, at $46.1 billion.  This despite three consecutive years of substantial pre-tax losses.  Further, C’s auditor, KPMG, has given C an unqualified audit opinion–meaning KPMG agrees that the accounts give a fair and accurate picture of the company’s finances.

C’s reasoning

in not writing down its deferred tax assets:

1.  Foreign operations aren’t a problem.  The company’s domestic–federal, state and NYC–deferred taxes expire in twenty years.  Over that time the company needs to generate $86 billion in pretax income to use them up fully.  That would be an average of $4.3 billion in pretax a year. (What isn’t said is that if we look back a decade ago, well before the current financial mess, C was earning $10 billion+ annually.)

2.  C has $27.3 billion in profits from foreign operations that are “indefinitely invested” abroad.  Were that money repatriated to the US, $7.4 billion in US income taxes–after allowance for (lower) foreign taxes already paid–would be due.  A reasonable guess (read: my very rough calculation) is that doing so, which would arguably give C greater flexibility in using this capital, would use up about $14 billion of the deferred taxes.

3.  If all else fails, C could sell assets.  Presumably, there are some where C still has a profit.  They might be businesses or physical assets that have been on the books for ages.  Or they could be the money-making side of hedged investment positions.

What to make of this?

Not a lot.

As far as I can tell, Mr. Mayo is keeping a low profile, which is what brokerage analysts do when they make a dramatic, headline-grabbing prediction that doesn’t come true.

C is also leaving well enough alone.  It would be unseemly for a big company to gloat–especially prematurely–over an unfavorable analyst comment.  It will doubtless hope that Mr. Mayo’s future comments about it will be more tempered.  Good luck with that.

KPMG isn’t making a strong statement, either.  Yes, its “unqualified” opinion means it doesn’t see the situation at C as being as dire as Mr. Mayo has been contending.  As far as deferred taxes are concerned, KPMG sees no convincing evidence to say C is crippled enough to be unable to start earning profits at half the rate it did a decade ago.

What makes this news?

Nothing, really.  I just thought I should follow up on the Mayo prediction, since I wrote about it in the first place.  And also, this illustrates a bit about how Wall Street works.

another SEC problem: first Madoff, now the Lehman case

March 21, 2010 By in Banks, Industry Analysis Tags: , , , , , , , , Leave a comment

Madoff vs. Lehman

Madoff

By now, everyone is at least somewhat familiar with the extent of the SEC’s failure in not detecting the Bernie Madoff ponzi scheme, even after being handed damning evidence on a silver platter by whistleblower Harry Markopolos.

Probably just like any other present or past Wall Streeter, I find two aspects of the Madoff case particularly striking:

–Markopolos’ account of how little the SEC knows  (basically, nothing, in his view) about how the finance industry works, and how disinterested it was in either learning about the industry it is mandated to regulate or in doing its job of enforcing the rules

–Madoff’s comments on how easy it was to fool the SEC.  Auditors came in, asked a few questions and left without bothering to actually audit–that is, to verify the truth of Madoff’s answers.

From hearing Markopolos on Bloomberg radio during his book (No One Would Listen) tour, I came away with the impression that Markopolos is a very obsessive, prickly man with a more-than-healthy respect for his own intelligence.  Whether he was that way before his pursuit of Madoff, or because of it, is an open question.  But, if you wanted to be extra-generous to the SEC, you might think that he gave off a weirdness vibe when he (repeatedly) visited them, that worked against the case he was making.

Lehman

Now comes Lehman, which is shaping up to be a carbon copy of the Madoff case.

I’ve already written about the bare bones of the Lehman case a few days ago.  Basically, SEC examiners were sent into the offices of the major investment banks, including Lehman, as the financial crisis was unfolding.  Their job was to monitor trading activities and identify liquidity or leverage problems.  According the the just-released report of the Lehman bankruptcy court, however, Lehman was, in effect, falsifying its financial accounts right under the SEC’s noses.

See my earlier post for more details, but in the simplest terms what Lehman did during the last year of its existence was to:

— borrow tens of billions of dollars right before its quarter ended,

–use the money to repay other debt,

—but not show the new borrowings anywhere in its financials.

The result was that the company substantially understated its financial leverage in its reporting to shareholders and the SEC.

New information

1.  Initial reports indicated this accounting sleight of hand was being accomplished by shunting highly questionable transactions through Lehman’s London office.  This activity, and the associated “funny” accounting, was presumed to have the blessing of the British Financial Services Authority, the UK equivalent of the SEC.

To me at least, this seemed like another bad consequence of the UK’s “regulation lite” policies, which were aimed at building up the country’s financial services industry by  supervising companies’ activities less rigorously than was customary elsewhere.

It turns out, however, that this isn’t right.  The Financial Times reports that Lehman rendered a full and accurate account of these transactions to the FSA, using conventional accounting standards.  It reported both the cash received and the new borrowings.  It was only when Lehman gave its worldwide financials to shareholders and the SEC that it eliminated the new debt.

This sounds just like the Madoff ponzi scheme, where Madoff told the SEC one thing and foreign regulators another, in the hope no one would make a simple phone call to compare notes.  And, of course, no one did.

2.  It also turns out that Lehman used its dubious financials to bad-mouth other brokers, including Merrill Lynch, to the commercial banks who were lenders to both.  Merrill believed itself at a disadvantage.  It briefly considered mimicking the Lehman accounting technique but rejected the idea.  So Merrill called up the SEC–and the Federal Reserve–and reported what Lehman was doing. Apparently, both the Fed and the SEC–again, a lá Madoff–ignored what Merrill was saying.

3.  In what appears to me to be twisting the knife a little bit, JP Morgan Chase announced that it had at one time used an accounting treatment similar to Lehman’s for a small number of low-dollar-value transactions.

Morgan makes two points, in an implicit criticism of Lehman, the SEC and the auditors, Ernst & Young:

(1) it stopped doing so when Jamie Dimon, one of the few heroes of the financial meltdown, took over (read:  this was at best a dubious way to do business); and

(2) it disclosed the new borrowings in footnotes, as it believed accounting rules required it to do (read:  JPM thinks Lehman should have disclosed the new borrowings someplace, even with the accounting dodge it was using).

Where is the SEC?  When did it stop regulating the markets?

The SEC response

The SEC response to the newspaper accounts is reportedly that all the senior people assigned to Lehman have since left the agency–and, I guess, by implication they have nothing that they can investigate.

I don’t think this is a good enough answer.  Although the investigatory wheels are grinding extremely slowly, they do seem to be moving.  The Lehman bankruptcy report could easily, I imagine, lead to prosecution of Lehman’s top management.  This is something that I think the American public wants, given the enormity of the damage to the economy the financial crisis has done.

Given instances like Madoff and Lehman, investigation of the regulators can’t be far behind.  If the press depiction of the SEC inaction turns out to be substantially accurate–and the evidence seems very strong that it is–the most benign finding I can imagine is one of incompetence and negligence on a level that defies belief.

Of course, logically speaking, it may turn out that the situation with the SEC is not so benign–and is in fact far worse than that.  There’s no evidence of a darker side to the SEC as yet, however.  And in any event, the strength of Wall Street lies less in the SEC than in the basic honesty of the very large majority of market participants.

Beijing reins in local governments

March 9, 2010 By in Asian economic development, Banks, China, economics, Industry Analysis Tags: , , , , , Leave a comment

…the emperor is far away

One of the first things I heard from old China hands when I began looking at the country twenty some odd years ago was, “The mountains are high and the emperor is far away.”  Whether this is a good translation of the old saying, the point remains the same.  It means: a traditionally weak central government in Beijing will be unable to control the actions of provincial authorities.

The local authority head may at times find himself facing decisions among conflicting interests.

On the one hand, as a state employee and a Communist party member he is evaluated and gets promoted based on his ability to create economic growth.  He also maintains his reputation among his constituents by providing jobs.  And, in some cases, he may receive “gifts” from real estate developers or construction companies if he provides them work.

On the other, he is a state employee and a party member.  So he’s supposed to do what Beijing tells him.  That’s ok during expansionary periods, but at times like this when fiscal stimulus is supposed to stop, it’s not so easy.  Historically, local areas have simply ignored, or partially ignored, Beijing’s mandates to slow things down.

the cat-and-mouse game

In the cat-and-mouse game of making rules (Beijing) and finding loopholes (the locals), several rounds have already been played, including a prohibition by Beijing of local governments’ guaranteeing the borrowings of private industry projects–like apartment blocks or factories.  This is more important than it sounds.  Since the bank managers are also state employees and possibly party members, if the mayor or governor–much higher-ranking in both organizations–come to the bank to plead the cause of a given firm, it’s very hard to say no.

Always creative, local Chinese governments have taken a page from the playbook of commercial banks across the world.  Facing lending actions barred to banks, those institutions have simply created non-bank subsidiaries to perform the outlawed lending.  Local Chinese governments have done the same.  They’ve created investment companies which either borrow directly to finance building or issue loan guarantees that are implicitly backed by the government.  This is also similar to the actions of the US federal government in fostering the over-leveraged and now effectively bankrupt mortgage-lending entities, Fannie Mae and Freddie Mac.

Beijing’s latest move Continue reading →

The Fed just raised the discount rate–what does it mean?

February 19, 2010 By in Current Market Thoughts, discount rate; Fed Funds rate, economics, Recent Market Action, Vocabulary Tags: , , , , , , , , Leave a comment

The discount rate is going up to .75%

After the close of stock market trading yesterday, the Federal Reserve announced that it was going to raise the discount rate from .5% (annual rate) to .75%, effective today.  It will also limit the maturity of “discount window” loans to overnight, effective March 18th.  Previous policy allowed loans of up to 90 days.

What does this mean?

Some background

the Fed Funds rate

Federal banking laws require that each bank keep deposits, called reserves, with the central bank equal to a specified proportion of the loans it makes.  The proportion varies with the kind of loan.

Banks don’t always have the exact amount of money they need to have on deposit with the Fed.  Some have more than they need, some less.  Under normal circumstances they borrow and lend with each other in the market for overnight bank deposits, called the Federal Funds market.

The Fed uses this market as its principal tool for setting money policy.  It announces its desired level for the fed funds rate.  The Fed also trades in this market as necessary to keep the rate at the designated level.  The current fed funds policy, which is to keep that rate under .25%/year, remains unchanged by the rise in the discount rate.

the discount rate

The Fed has another tool for controlling short-term rates, the rate for borrowing funds directly from the Fed rather than from other banks.  This rate, which was a prominent Fed tool a generation ago but is no longer particularly relevant, it called the discount rate. Banks who use this rate are said to be going to the Fed’s “discount window.”

Under normal circumstances, the discount rate is higher than the fed funds rate.  Just before the financial crisis, the discount rate was 1% more.  Banks have no absolute right to borrow from the discount window, but must ask the Fed for permission to do so.  Discount window borrowing normally carries a stigma with it, since it implies that the bank in question has either hugely messed up its planning of reserve deposits, or that other banks are unwilling to lend to it.  Serial discount window borrowers may face Fed disciplinary action.

The situation up until today

With the onset of the financial crisis in 2007, interbank lending, even overnight lending, started to dry up.  At the height of the crisis, no one would buy bank commercial paper.  No one would lend in the fed funds market.  Therefore, banks couldn’t raise money to make loans to customers.  Even worse, banks that were borrowing to have money to meet minimum reserve requirements on outstanding loans were faced with the prospect of having to call in loans to satisfy the reserve rules with the cash they had on hand.

The Fed dealt with this mess by becoming an active lender to any and all member banks at the discount window, by lowering the premium over the fed funds rate, in stages, from 1% to .25% and ultimately extending the maturity of discount window loans from overnight to 90 days.

At the height of the financial crisis discount borrowing was extremely important, reaching well over $100 billion.  Today it has shrunk to less than $15 billion.

Why the changes?

Two reasons:

–the short-term lending market has pretty much returned to normal.  The only reason for a bank to borrow from the discount window today is that the rate is better than a weak bank could get in the open market.  By ending this subsidy, the Fed is sending a message to these institutions to get their houses in order.

–it’s a signal to the financial markets that the Fed intends to act responsibly and return money policy to normal when conditions are right.  Remember, in its announcement, the Fed stressed that for now the Fed Funds rate, the key policy rate, will remain unchanged.  The Fed has already withdrawn a couple of its support programs, but an increase in the discount rate is a much more visible step.  So it has much greater psychological value.

Market reaction

So far, reaction has been muted but slightly negative for stocks and positive for the dollar.  Treasury bonds are up, but that’s because of favorable inflation data announced this morning.

The rise in the discount rate will have no practical effect on world economies.  As a statement, I think it should be read as a mild positive, that the US economy is healthy enough that it no longer needs this support (which wasn’t doing that much any longer, anyway).  I think stock markets should be up on the news.