Friday, October 31, 2008

Bank of Japan

The Japanese central bank lowered their benchmark interest rate (overnight call rate) to 0.30% today. Obviously, inflation is not their major concern. In fact, prices are finally rising in Japan. Their mishandling of the 1980s banking crisis lead to a significant deflationary period: for almost 4 years, annualized CPI was negative. Therefore, real interest rates were higher than nominal interest rates. This has a crippling effect on industry. The Bank of Japan responded by lowering rates to essentially zero for a considerable length of time. Also, please take notice of how the stock market reacted and the timing of the moves.

The "Real" Interest rate calculation is not robust, just a rough estimate:

Call Rate - CPI = "Real" Rate

All Hallows Eve

Halloween is an amalgam of pagan and Catholic traditions. The Celtic festival Samhain acknowledged October 31 as the day that the boundary between the living and the dead dissolved. This coincides with the harvest and the change of seasons. Celts would dress in ghoulish regalia to placate the spirits so the harvest would be successful and the dead would not remain with the living.

All Hallows Eve, All Saints Day and All Souls Day (10/31, 11/1, 11/2) commemorate those who have been anointed and those awaiting purification. The original date of All Saints Day was May 13, Pope Gregory III and Pope Gregory IV shifted the celebration to November around the 700s.

I hope everyone finds more Mary Janes and 3 Musketeers in their candy bags than apples and raisins.

Thursday, October 30, 2008

Casino Federale

From the Federal Reserve statistical release H.4.1 (10/30/08):

-- The Federal Reserve System holds $48.76 in assets for each dollar of capital

-- Their holdings of U.S. Treasury securities have decreased by $303 billion in 1 year

-- Other loans (this includes broker/dealer loans, the asset backed commercial paper liquidity program and the initial AIG loan) total $370 billion

-- Commercial Paper Funding Facility has provided $144.8 billion in liquidity

-- The U.S. Treasury has now supplied the Fed with $559 billion via the Supplementary Financing Program (unchanged versus last week). Please check the 10/8/08 post "Some Bullet Points" for Program details.

Those Rich Wall Streeters....

I can't stand it any longer. Wall Street, Main Street. Wall Street bad, make money by crush Main Street.

Well, let's take a look at Citigroup for example:

2007: 275,000 total employees

2007: $34.435 billion in compensation and benefit expenses

2007 average compensation per employee: $125,218.18

Now, that includes:

Chuck Prince (no longer with Citi): $41 million

Win Bischoff: $6.99 million

Vikram Pandit: $3.16 million (slated to make over $100 million in 2008)

Gary Crittenden: $12.79 million

Michael Klein (no longer with Citi): $19.3 million

Sallie Krawcheck (no longer with Citi): $12 million

Lewis Kaden: $8.3 million

Stephen Volk: $10.25 million

My point is that there are thousands upon thousands of moderately paid employees at these firms. They did not participate in the windfall of profits from the real estate/mortgage/CDO/SPV debacle. And I just listed the executive suite, there were several others that made millions. How many Citigroup employees would not see tax increases if Obama were to be elected???????

One More Program....

Forgot to mention the FDIC's Temporary Liquidity Guarantee Program (TLGP). This is the one that provides the increased bank deposit insurance limit and bank debt subsidies.

A Little More on Inflation

It may seem a little passe to look at inflation while deflation is all the rage, but I took a peek at CPI for the first nine months of 2008. Averaging the quarterly rates, inflation according to the CPI was running at 5.42% for this year. Some critics state that CPI understates actual inflation, so these critics would be very curious about the GDP Deflator.

Plan Summaries

Click below for additional programs.

First Leg of a Recession?

According to the National Bureau of Economic Research, a recession is "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."

Generally, two consecutive quarters of negative growth in GDP is accepted as a recession. Today, the Bureau of Economic Analysis announced their advance estimate of 3rd quarter GDP growth: -0.3%. The bulk of this decline was due to falling personal consumption expenditures.

This comes on the heels of 2.8% growth in the 2nd quarter. Since 2006:

- 4th occurrence of growth less than 1%

- 2nd occurrence of negative growth

GDP is interpreted as a trailing indicator, so let's see if there any components that will tell us if there any bumps down the road instead of in the past:

- Gross private domestic investment totaled $1.694 trillion, down from $1.839 trillion in the 3rd quarter of 2007

- Quarterly Government expenditures have increased by $49 billion over the last 2 quarters

I would also like to point out the GDP Deflator. According to the last 3 reports, prices are increasing at an annualized rate of 2.66%. Not including the recent drop in gasoline prices, does it really seem that prices are only up 2.66% this year?

If the Deflator underestimates the actual level of price increases, it serves to inflate GDP.

Note: Today's report is the first of three reports that the BEA releases on quarterly GDP. Each report is revised and fine tuned. The next report is the preliminary release, followed by the final release.

Wednesday, October 29, 2008


Press Release

Release Date: October 29, 2008

For immediate release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

317 to 221......Just One Guy's Guess

Tuesday, October 28, 2008

Equity Market Finally Rebounds

Seems like the right time for a little perspective:

The above graph takes a look at the S & P 500 over the last 22 years. The right axis looks a bit odd because I wanted to capture the prices swings in relative terms (natural log values). That way, percentage changes appear equal rather than point moves.

Volatility was calculated on a quarterly basis, based on weekly closes. The percentage number on the left axis equals the annualized standard deviation of the index, based on the quarterly move. In other words, if the realized volatility in the most recent quarter were to repeat for a whole year, you would expect that the index would trade between 487.45 and 1,209.71 for 62.87% of the time.

This NOT the same as the VIX that has been mentioned in previous posts. The VIX measures implied volatility for near term, close to the money options on the index. It is the volatility input used in option pricing formulas to arrive at a dollar price for the option.

What is used in the graph is historical or realized volatility. This measure is useful in creating an estimate for implied volatility, but as we know, the past does not fully predict the future.

Shipping Rates

A good friend of mine pointed this out to me several years ago: Baltic Dry Index

It is a measure of shipping costs for raw materials, like coal, commodities, etc. It does not measure shipping costs for finished goods. The Index is considered to be an excellent predictor of inflationary forces.

Rates vary depending on ship size, delivery site and delivery date. The Capesize component of the index (largest ship class: 100,000 dead weight tons) commanded a rate of $172,000 a year ago, up from roughly $20,000 in 2005. Yesterday, it would have cost $8,000. Stunning.

Fuel costs, ship shortage and commodity demand all contributed to the price run-up. Now, all of those components have eased dramatically.

Case / Shiller Home Price Indicies

Price declines show little sign of abating. In addition, the geographic areas that have been hit the hardest continue to underperform.

The 10 city index recorded a 1 month decline of 1.1% and a 12 month decline of 17.7% and the 20 city index recorded declines of 1% and 16.6%. Both measures represent an acceleration of price declines.

The indices are benchmarked to 100 for January, 2000.


% Change





NY-New York



CA-Los Angeles















CA-San Diego






CA-San Francisco



NV-Las Vegas






























I would guess that declines in Florida will be the most likely to continue, based on relative supply compared to the price appreciation experienced since 2000.

Monday, October 27, 2008

The Grand Chessboard

This is truly one of the most illuminating books I've ever read. It was written by Zbigniew Brzezinski, occasionally referred to as the Democrat's Henry Kissinger. The first link is to a bio, the second link is to an online pdf of the book. Please note, the pdf is a big file: 10 mg

Real Interest Rates & Behavioral Finance

There is a topic in behavioral finance that addresses the economic memory of a population. Much like any other life instruction, the leaders of the family unit pass own their knowledge and experience to the younger generation. It seems that economic lessons in particular are etched deeply into the minds of the young and take precedence over the the economic scenario that the younger generation is met with.

For example, some raised by the generation that lived through the Great Depression misplayed the 1970s. Saving during a time of high inflation is a mistake. Debt is actually a good idea because inflation decreases the real interest rate that a borrower pays over time. Their utility was maximized by spending earlier than they were taught, despite high nominal interest rates.

We may be in the midst of a reversal. If we do wander into a deflationary period, borrowing would not be the preferred behavior. A borrower would be paying interest to buy goods in the present period when the same goods will be selling at a lower price in a subsequent period. High real interest rates benefit lenders.

This is a complex and difficult problem to resolve since business owners are discouraged from borrowing as well. Why would they borrow money to produce a good when, by the time production is completed, the sales price of the good decreases. Japan has been battling this problem for almost 20 years.

...and I Thought We Were Bad


Debt - external

Date of Information

GDP (purchasing power parity)

Date of Information


United States




2007 est.


United Kingdom




2007 est.






2007 est.






2007 est.






2007 est.






2007 est.






2007 est.






2007 est.






2007 est.




30 June 2007 est.


2007 est.


This is straight from the CIA World Factbook. External debt is "the total public and private debt owed to nonresidents repayable in foreign currency, goods, or services. These figures are calculated on an exchange rate basis, i.e., not in purchasing power parity (PPP) terms."

So much for the U.S. being the source of all problems, it seems as though several countries levered up all on their own. I am not defending our profligate ways. We do not have a monopoly on greed.

Bank Capital Infusions

I have mentioned in previous posts that there was no guarantee that banks would use the proceeds from the U.S. Treasury for extending new loans. Well, last week PNC announced that they would acquire National City with the new funds. Summaries below:

JP Morgan Chase


Citigroup, Inc.


Wells Fargo, Inc


Bank of America


Morgan Stanley


Goldman Sachs


Merrill Lynch


PNC Financial


Capital One Financial




Regions Financial


Bank of NY Mellon




Huntington Bancshares


State Street Corp.


Northern Trust Corp.


First Horizon Nat'l


City National Corp.


Valley National


Washington Federal


Provident Bankshares




In exchange for the cash, the banks will deliver preferred stock and warrants to the Treasury. The funds are part of the $700 billion that was authorized by the Emergency Economic Stabilization Act. The Treasury decided to allocate $250 billion to such infusions. The above list may not be complete because the banks have the discretion to announce the infusions or not.

Friday, October 24, 2008

Some Notes: How NOT to Improve the Savings Rate

From the Federal Reserve statistical release H.4.1 (10/23/08):

-- The Federal Reserve System holds $45.26 in assets for each dollar of capital

-- Their holdings of U.S. Treasury securities have decreased by $303 billion

-- Other loans (this includes broker/dealer loans, the commercial paper liquidity program and the initial AIG loan) total $408 billion

-- The U.S. Treasury has now supplied the Fed with $559 billion via the Supplementary Financing Program. Please check the 10/8/08 post "Some Bullet Points" for Program details.

From the Federal Reserve statistical release Z.1 Flow of Funds (9/18/08):

-- Household real estate holdings: $19.429 trillion

-- Household mortgage debt: $10.632 trillion

-- Household real estate equity: 45.3% (please see the 10/15/08 post for details)

-- My best guess, this ratio will hit 43.4% at year end. This is like a margin call for real estate, defaults will only slow when this ratio gets back to 50%.

Finally, The Discussion Sessions Begin

The above chart (click to expand) tracks the rolling 10 year total return of the S & P 500 Index. The graph starts on 12/31/45, so the first data point represents the total return you would have earned if you bought the index (and reinvested the dividends) 10 years earlier.

The most recent data point is a guess for 12/31/08. I used S & P's dividend estimate for 2008 ($28.05) and a year end value for the index of 1,040.18:

-- I chose this level because it would generate a 0.0% total return for the latest 10 year period.

-- This level is 161.41 points higher than it is right now, so I am building in an 18% rally into year end. Obviously, if this not not occur the latest 10 year total return would be negative.

-- A 10 year total return of 0.0% or lower has never happened. This is part of the reason why investors are nervous. It is a difficult decision to increase a bet that has not paid off after 10 years.

-- Okay, now what? Do the levels present the buy of a lifetime? The next post will start to address this, beginning with an examination of the Federal Government's finances.

Please Note: The total returns referenced above are in nominal terms, no adjustment for inflation.

Look Out Below

U.S. equity futures are limit down in the overnight session as international stock markets are hammered.  S & P 500 down 60, DJI down 550.

Thursday, October 23, 2008

Atomic Number 79

Gold is currently trading at about $708 per troy ounce. Back in 2001, it was $300 and peaked earlier this year at $1,002.

The recent pullback (traded @ $918 on 10/9/08) has been attributed to:

- Hedge fund selling. This is the time of year when hedge funds typically allow their fund holders to redeem shares. Since they need to raise cash, the preference is to sell the investments they have realized gains in.

- Dollar rebound. The US dollar has moved higher over the last few weeks. As a result, gold (like any other dollar denominated asset) becomes more expensive in local currency terms if overseas accounts want to buy. Therefore, the price will fall to keep buyers interested.

- Decreasing inflation fears. The US economy is slowing and the global economy is not far behind in experiencing slowing growth. Shipping prices are down, fuel prices are down unemployment is higher: not the breeding ground for higher prices.

So, why am I not convinced that gold should be sold? Aside from its use as an inflation hedge (which, depending on your inflation measure, gold has done a poor job of tracking), gold is purchased as a store of value. In this sense, gold is acquired because it has more scarcity value than fiat currency.

Efficacy aside, the Federal Reserve and US Treasury will be pumping vast amounts of funds into the financial system. They will try to prevent a purging of the system, a deep recession that will decrease the amount of debt and a reversal of the savings rate. Not that it tells you everything, but the stock market is not convinced it will work. The interbank market is not convinced.

Since our currency is not backed by anything, the only value it has is based on relative supply. Our dollar only has value based on how many of them exist and who wants them. With trillions in supply coming, with defaults escalating (which decreases foreign demand), I think the death of gold is exaggerated.

Wednesday, October 22, 2008

Pushing on a String

I wanted to plant the seed on this one, it really deserves much more conversation: the money multiplier may work on the way in, BUT ALWAYS works on the way out.

Our financial markets are based on a fractional reserve banking system. Simply put, a lending institution is allowed by regulators to lend out more money than it has accepted in deposits. If a bank secures $100 in deposits, it is possible for the bank to create roughly $1,000 in loans. Let's take a look....

A bank is required to hold on reserve only a fraction of the deposits it garners. Only a fraction is held because it is postulated that depositors don't redeem their deposits at one time. The required reserve ratio is set by the Federal Reserve. The current ratio is tiered, based on bank size and deposit type.

Reserve Requirements

Type of liability


(Percentage of liabilities)

Net transaction accounts

$0 to $10.3 million


More than $10.3 million to $44.4 million


More than $44.4 million


Nonpersonal time deposits


Eurocurrency liabilities


Let's use 10% for sample calculations: a customer deposits $1,000 in a bank. The bank is required to hold $100 in reserve with the Fed and can lend $900 out. The customer who borrows that $900 buys a TV. The store owner takes the $900 check and deposits it in his bank (possibly the same bank as the borrower secured his loan from, but the net effect on the banking system are the same even it is a different bank). The process continues: the bank holds $90 in reserves and can lend $810. The end result is that the initial $1,000 deposit can create $10,000 in money supply: $1,000 * (1/0.10) = $10,000.

The caveat: banks do not have to make the maximum amount of loans. All we know is that there is somewhere in between $1,000 and $10,000 introduced into the system.

However, when the customer withdraws that $1,000, the net impact on the system IS a drop of $10,000. In an earlier post, I mentioned that the Fed was in a race to put money into the system at a faster rate than it was being removed. This is compounded by the fact that the Fed can't control how many loans are made with the additional liquidity (pushing on a string). If banks choose to be conservative, the Fed must over-supply the market with funds relative to the anticipated amount of money creation implied by the reserve ratio.

Loan defaults deplete the system, just like withdrawals. So each time you here about a $1 billion of loans written off and not recovered, $10 billion have just been removed from the system.

Dow Drops


Closing Value

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Closing Value

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