Despite Fed, Money Supply Contracting

Deciphering strength among bank stocks ahead of Citigroup (C) Q1 earnings on Friday can be complicated. The sector has increased 45% over the past five weeks inspiring some to call for financials to pull back. Positive earnings news from WFC, GS and JPM have maintained positive sentiment amidst rhetoric from CEOs suggesting further pain ahead on hope that consumers are stronger than expected.

The real issue for the economy isn't the profitability of financial companies themselves, but instead the functionality of banks to provide credit to consumers and firms, renewing the healthy churn of money through the market. It is no mystery that a drastic deleveraging process has begun, spreading from banks, to firms, to consumers and sparking fears of deflation.

Deflation is misunderstood by many, since it has rarely emerged during recessionary periods, but the risks of price decay are very real. The M2 money supply which includes all cash changing hands throughout the economy plus savings deposits, CDs and money market accounts is actually falling at an unexpected rate.

Normally M2 levels are irrelevant to markets because the Federal Funds rate allows the Federal Reserve to dictate the amount of money in circulation. In the current reality, the Federal Funds Rate is at 0.14% (as of April 10) and the Discount Window is open at a rate of .50%, allowing banks and other firms to borrow from the government and each other at extremely low premiums. A flood of liquidity and lending would be the natural result of such policies, yet the weekly M2 data reveals that the 4 week average of money supply peaked in mid march and the rate of decrease is accelerating into April. The data suggests that the effects of most recent Federal Reserve actions are wearing thin ahead of the FOMC meeting in two weeks.

While several phenomena could be stimulating the decline, the real reason for M2 shrinkage is not yet clear. The fall in M2 could be the result of a healthy deleveraging process as banks shore up balance sheets by increasing loan loss provisions and capital rations. A more dismal vantage point may suggest that banks realize they will need to foreclose on more homes as defaults continue to rise and the moratorium on conforming loan foreclosures is expiring. Banks are presently holding many foreclosed properties hoping for better prices and attempting to cash out of these undervalued positions gradually to avoid drowning down the value of performing loans. If banks begin liquidating "legacy" (toxic) assets held on banks balance sheets, they must write down the value of the assets and the loss is recorded as a loss for M2.

Money supply is important to economists as well as traders in this environment, as the pivoting arguments between inflationary and deflationary risks are moving markets. Getting it right could secure the competitive edge to a winning strategy.

Disclosure: Long SKF, Long DXD

Comments

[D. McHattie:]

If I understand correctly, until banks sell the foreclosed homes they can still pretend they are worth the original mortgage amount. So there is a perverse incentive for banks to not do what needs to be done to clear up this crisis.

Meanwhile, productive young people are putting their lives on hold as decent housing remains indecently overpriced.

Once again, government and banks act opposite to the best interests of the electorate.

Apr 17 08:37 AM

[Dirk McCoy:]

The risk of deflation is still high as it can take awhile to wind economic activity down. Significant deflation sounds good to "fixed income" folks, yet it is unrealistic to think that as assets, commodities, and wages fall, there won't be pushback on fixed incomes- look at the tea parties as response to government fixed incomes, unemployment as response to labor fixed incomes, and bankruptcies and defaults as response to debt fixed incomes. Free markets (and peoples) cand send market signals that deflation is required, even if "fixed".

Fortunately, Mr. Bernanke has an understanding of this problem, and is trying to restore expectations of inflation so money velocity increases- which will create some inflation at some point. At that point, the excess supply capacity that has built in this country can start to come on line to mitigate runaway inflation. The dollar probably needs to start weakening again against the yuan on a consistent basis before he succeeds in this strategy- another market signal that has been offset by China manipulations (most recently, huge commodity spending)

Meanwhile, home affordability is at an all time high, and productive young people will be able to get good deals for a long time to come.

Apr 17 10:03 AM

[sr9web:]

Keeping inflated values on the bank books if criminal fraud.


On Apr 17 08:37 AM D. McHattie wrote:

> If I understand correctly, until banks sell the foreclosed homes
> they can still pretend they are worth the original mortgage amount.
> So there is a perverse incentive for banks to not do what needs to
> be done to clear up this crisis.
>
> Meanwhile, productive young people are putting their lives on hold
> as decent housing remains indecently overpriced.
>
> Once again, government and banks act opposite to the best interests
> of the electorate.

Apr 17 10:17 AM

[biodummy:]

"The M2 money supply which includes all cash changing hands throughout the economy plus savings deposits, CDs and money market accounts"

Foreclosures or bank sales would not change any of these; could it be that some cash is moving from the money markets into the corporate/muni bonds or stocks? Since early March (the trough in the market) bond yields dropped quite a bit which indicates demand; also, the stock rally (whether bear market or not) needed some cash to kindle it...

Apr 17 11:39 AM

[MattZN:]

Not actually pretend. Man, doesn't anyone actually read bank filings? What banks do, basically, is to estimate the default rate. It is THAT default rate times the fair-value loss on the home that matters.

For example, if 20% of the principle, on average, in a held mortgage portfolio is underwater, the actual losses on the protfolio is NOT 20%, but instead 20% x the actual default rate. If the default rate were 100% then the banks would write down 20% of the principle of the portfolio. If the actual default rate is 25% then the banks would write down 5% of the principle of the portfolio. If the actual default rate were 10% then the banks would write down 2% of the portfolio. And so forth.

Of course, if a bank has a trillion dollar portfolio then 5% would be a huge amount of money, say around 50 billion. Because of this leverage factor the above two numbers are extremely important, but subjective, measure.

Banks have to estimate the default rate. To do that they categorize the mortgages they hold using risk metrics. It is not an exact science. It is subjective. Banks separate Alt-A, sub-prime, and other types of loans and throw them into categories and then try to estimate the default rate for each category. Some categories will see default rates approaching 60%, but for that category, not for the bank's entire loan portfolio.

If a bank's entire loan-portfolio is sub-prime or alt-a then, yes, that bank is going to be in trouble. The big banks might have exposure, but it is NOT their entire loan portfolio or anything near their entire loan portfolio. You can't just throw out an emotional response based on the term-of-the-day in the media. It's idiotic. Nobody runs a company based on poorly written media reports.

You can sit down and scream all day long that they are lying, and imply you know how the mortgages SHOULD be valued, but it doesn't hold a candle to reality if you can't point to actual categories on the bank financials and state that the bank is making the wrong estimates, and give a reasonable reason for why you think so. Based on NUMBERS, not emotion. If you don't actually read the financials then commenting on whether the numbers are real or not is meaningless because your own emotion-based estimates are even MORE meaningless.

-Matt

Apr 17 01:57 PM

[Moon Kil Woong:]

The Treasury and Fed are precipitating the fall of M2. Why should banks borrow when they can sit around and wait for free government money. Why should they lend when they can just jack up the rates because the government has lowered the rate people get for savings to almost nothing making spreads between loaning and borrowing huge.

How do banks pay for their mess. By paying you 1.5% to nothing for depositing and charging you a 5-20% spread for everything else. If you haven't figured it out look at your credit card interest, mortgage interest, and whay you get at the bank for a CD or money market deposit.

They are laughing at you all the way to the bank.

Apr 17 03:09 PM

[nmelendez:]

So why do you buy them? I'm buying stocks paying 5.9% dividend. I'm putting away 15% of my salary in my 401K. gives me a 33% tax break and lowers my tax bracket. Buying gold and gold mineing stocks. To hell with CD's and banks. I also get 7% dividend from my Credit Union on my shares. Why the heck would any idiot buy CD's at 1.5% when even 30 year treasuries provide 3.75%. At least try savings bonds.


On Apr 17 03:09 PM Moon Kil Woong wrote:

> The Treasury and Fed are precipitating the fall of M2. Why should
> banks borrow when they can sit around and wait for free government
> money. Why should they lend when they can just jack up the rates
> because the government has lowered the rate people get for savings
> to almost nothing making spreads between loaning and borrowing huge.
>
>
> How do banks pay for their mess. By paying you 1.5% to nothing for
> depositing and charging you a 5-20% spread for everything else. If
> you haven't figured it out look at your credit card interest, mortgage
> interest, and whay you get at the bank for a CD or money market deposit.
>
>
> They are laughing at you all the way to the bank.

Apr 17 10:06 PM

[nmelendez:]

People, this is a once in a lifetime opportunity to buy stocks, before the banks can roll in. Go in easy. I am all cash in my 401K. However i am buying good dividend paying stocks and gold/miners. Started buying like i would have 25 years ago. Taking it easy while my cash is safe. Slowly rolling in, especially Argentina and Brazil.

Apr 17 10:16 PM

[H. T. Love:]

On Apr 17 10:03 AM Dirk McCoy wrote:

> <snip>
> Meanwhile, home affordability is at an all time high, and productive
> young people will be able to get good deals for a long time to come.

I agree with all you say. But a caveat about that last item.
"Productuve young people" are seeing flattening or decreasing income for now. So even as prices and interest rates fall, there is the question of whether there is really "affordability".

Further, assuming they learned something in the "crises", they are increasing savings rates and thus may be loathe to enter into a long-term obligation against an income that is seen, at best, as declining (near-term anyway) and, at worst, as possibly non-existent in the not-to-distant future.

For this reason, I believe continued distress in the real estate market will continue longer than some might predict. This does not even consider all the other ills that flow from the mis-guided policies being pursued to "alleviate the short-term pain at the expense of long-term gain".

My Humble Opinion,

HardToLove

Apr 18 12:52 PM

[Gregman2:]

"It is THAT default rate times the fair-value loss on the home that matters." Yet doesn't time (t) factor in when considering M2?

Apr 18 03:00 PM