With Fed's Current Efforts, Our Financial System Is Contracting

Includes: IYF, KBE, KRE
by: Kimball Corson
Beginning toward the end of 2009, money has begun tightening, despite the Fed earlier pushing interest rates to almost zero percent, making loans readily available to key players and purchasing more than $1.7 trillion in mortgage loans and Treasuries. The banks of course remain busy trading on their own accounts instead of lending, even though many small businesses need loans but have grown tired of asking.
The conclusion that money is tightening comes from a new study or collaborative effort of chief economists from Goldman Sachs (NYSE:GS), Deutsche Bank (NYSE:DB), Princeton University, Columbia, and New York University to come up with an index that better measures over-all financial conditions. While there are several such measures about, the new effort seems to be a major step forward, according to many.
What the new collaborative effort shows is that money is tightening. This is a form of deflationary pressure. It arises because banks are not lending, the issuance of asset backed securities is sharply down (autos and credit card debt), and commercial paper outstanding has contracted from $1.3 trillion in September to $1.1 trillion at the end of January.
Combining the new group's financial index with previous and similar efforts by others in a report presented recently to top Fed officials, the findings are that after good improvement in the first half of 2009, thanks to the Fed’s good efforts, financial conditions are again tightening as the Fed’s efforts are starting to contract. For example, loans of various types packaged into CDO’s dropped in value from an excessive peak of $700 billion in 2006 to a paltry $168 billion in 2009, largely for the reasons I have indicated plus the fact that sales are slowing because investors no longer really trust the credit rating agencies’ assessments of these CDO’s. Having once been burned badly, they are now twice shy.
While money is cheap, the fact is it is not accessible. That is the rub and much of the problem rests at the doorstep of the banking system which is simply not lending or seriously trying to. This is notwithstanding the Fed’s TALF program, a non-recourse funding source for term asset backed securities launched last March. Too, according to Fed sources, the broader measures of the money supply are soft. M2, the total of deposits and money market funds, has contracted at an annual rate of 0.9% in the last three months through January. Partly this is due, I suspect, to a fair amount of money being parked in the stock market which is largely crabbing sideways with relatively limited exposure in both directions. But still, this drop is of concern.
These data and this report have serious implications that I have suspected for several weeks now. The Fed may be backing away from its countercyclical monetary policies too quickly and too precipitously. The economy surrounding housing and its related sectors is not sufficiently out of the woods yet and could well falter seriously again without continuing Fed support, a point being overlooked.
The truth is we are not deleveraging the financial sector very quickly at all. Instead, many lending sources are not lending and are hiding their insolvency behind abandonment of the mark to market rule as they trade the market for profits instead. TARP I and II did not deleverage the financial system and nothing else much has. We are in a stall mode here and if the Fed backs out, I see a double dip recession waiting for us in the wings. The Fed should be hyper careful here and proceed very slowly at doing almost anything to exit. I think the Fed is backing out too quickly or, at a minimum, is signaling too fast a back out.
We also need something like FDIC insolvency proceedings to seriously deleverage our banking system and we need to get on with it or this canopy of bad mortgage loans is going to hang over us for decades and destroy future bank lending as well. Our economy is threatened because of the problem. Too few seem to realize this and of course the bankers oppose any such effort, fearing they will be scraped off with the bad debt in any such proceedings. We have got to get a handle on deleveraging and we need to do it soon.
Regrettably, the bankers have the political muscle to protect themselves, their positions and their salaries and bonuses. We seem therefore stuck in this regard, unless we give them a pass, as we deleverage, but our economy is being place in jeopardy because of the problem.

Disclosure: None