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Fed president says US banks have “half the equity they need”

In a scathing editorial published in the Wall Street Journal today, the president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, blasted US banks, saying that they still lacked sufficient capital to withstand a major crisis.

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In a scathing editorial published in the Wall Street Journal today, the president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, blasted US banks, saying that they still lacked sufficient capital to withstand a major crisis.

Kashkari makes a great analogy.

When you’re applying for a mortgage or business loan, sensible banks are supposed to demand a 20% down payment from their borrowers.

If you want to buy a $500,000 home, a conservative bank will loan creditworthy borrowers $400,000. The borrower must be able to scratch together a $100,000 down payment.

But when banks make investments and buy assets, they aren’t required to do the same thing.

Remember that when you deposit money at a bank, you’re essentially loaning them your savings.

As a bank depositor, you’re the lender. The bank is the borrower.

Banks pool together their deposits and make various loans and investments.

They buy government bonds, financial commercial trade, and fund real estate purchases.

Some of their investment decisions make sense. Others are completely idiotic, as we saw in the 2008 financial meltdown.

But the larger point is that banks don’t use their own money to make these investments. They use other people’s money. Your money.

A bank’s investment portfolio is almost entirely funded with its customers’ savings. Very little of the bank’s own money is at risk.

You can see the stark contrast here.

If you as an individual want to borrow money to invest in something, you’re obliged to put down 20%, perhaps even much more depending on the asset.

Your down payment provides a substantial cushion for the bank; if you stop paying the loan, the value of the property could decline 20% before the bank loses any money.

But if a bank wants to make an investment, they typically don’t have to put down a single penny.

The bank’s lenders, i.e. its depositors, put up all the money for the investment.

If the investment does well, the bank keeps all the profits.

But if the investment does poorly, the bank hasn’t risked any of its own money.

The bank’s lenders (i.e. the depositors) are taking on all the risk.

This seems pretty one-sided, especially considering that in exchange for assuming all the risk of a bank’s investment decisions, you are rewarded with a miniscule interest rate that fails to keep up with inflation.

(After which the government taxes you on the interest that you receive.)

It hardly seems worth it.

Back in 2008-2009, the entire financial system was on the brink of collapse because banks had been making wild bets without having sufficient capital.

In other words, the banks hadn’t made a sufficient “down payment” on the toxic investments they had purchased.

All those assets and idiotic loans were made almost exclusively with their customers’ savings.

Lehman Brothers, a now-defunct investment bank, infamously had about 3% capital at the time of its collapse, meaning that Lehman used just 3% of its own money to buy toxic assets.

Eventually the values of those toxic assets collapsed.

And not only was the bank wiped out, but investors who had loaned the bank money took a giant loss.

This happened across the entire financial system because banks had made idiotic investment decisions and failed to maintain sufficient capital to absorb the losses.

Nearly a decade later, Kashkari says that banks still aren’t sufficiently capitalized.

(He also points out that banks today are obsessed with pointless documentation and seem “unable to exercise judgment or use common sense.”)

The banks themselves obviously don’t agree.

As Kashkari states, banks feel that they currently have TOO MUCH capital.

Bizarre. They’re basically saying that they want to be LESS safe, like a stunt pilot complaining that his helmet is too sturdy.

I’ve written about this many times– the decision for where to hold your savings matters. It’s important.

In addition to solvency and liquidity concerns, there are a multitude of other issues, like routine violations of the public trust, collusion to fix interest and exchange rates, manipulation of asset prices, and all-out fraud.

(I personally got so fed up with our deceitful financial system that I started my own bank in 2015 to handle my companies’ financial transactions. More on that another time…)

Yet despite these obvious risks, most people simply assume away the safety of their bank.

They’ll spend more time thinking about what to watch on Netflix than which bank is the most responsible custodian of their life’s savings.

There are countless ways to figure this out, but here’s a short-cut: much much “capital” or “equity” does the bank have as a percentage of its total assets?

These are easy numbers to find. Just Google “XYZ bank balance sheet”.

Look at the bottom where it says “capital” or “equity”. That’s your numerator.

Then look above that number to find total assets. That’s your denominator.

Divide the two. The higher the percentage, the safer the bank.

Kashkari thinks the answer should be at least 20%, especially among mega-banks in the US.

Photo: John W. Iwanski The Old Vault Door at the Continental Illinois Bank Building via photopin (license)

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Economy

The $2.4 Trillion Hidden “Fed Tax”

Jerome Powell’s support for the Federal Reserve’s low interest rate regime has long benefited investors, who reacted favorably to news that he would be Donald Trump’s nominee as its new chair.

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Jerome Powell’s support for the Federal Reserve’s low interest rate regime has long benefited investors, who reacted favorably to news that he would be Donald Trump’s nominee as its new chair.

Economists argue that those “unconventional monetary policies” helped the US economy avert a major depression following the 2008 financial crisis and have kept it afloat since then.

However, we couldn’t however find a single estimate of the costs of those policies.



That should come as no surprise. Free market economists have been essentially banned from academia, governments and the banking system, all of whom have a direct interest in masking the costs of public sector involvement in the economy.

So we did a “back of the envelope” calculation on our own, which suggests that ongoing Fed market manipulations equate to a $2.4 trillion annual wealth distribution from savers to borrowers.

The rest of this article is technical, and relates to the calculation of these distortions, which we refer to as the “Fed Tax”, and which the new Fed governor may, or may not address during his mandate.

However, the key takeaway for most readers is that this wealth redistribution (12.9% of GDP, almost as much as the $2.6 trillion Americans will pay in personal income taxes this year) is significantly hiding the scale of the US government’s involvement in the economy.

This in turn is making it impossible for policy-makers, researchers and voters to measure the costs and benefits of these wealth transfers.

*****

First a word of caution. These calculations were made on the back of an envelope, in a Montreal basement, by a non-economist.

As such, although we believe $2.4 trillion to be a useful working estimate of the Fed-managed annual wealth transfer from US savers to borrowers, considerable refinement and nuance is needed to come up with a more precise result.

Readers who have better ideas regarding methodology are invited to contact the writer or to comment below.

To determine the scale of Federal Reserve’s hidden manipulations we start by estimating what interest rates would be in a free market* and then we subtract the level they are at are right now.

We then multiply the difference (which equates to how much interest rates are being suppressed) by all outstanding debt in the US economy. **

*****



As we noted in a recent article, history suggests that the Fed’s and US government’s current interventions, could be depressing interest rates by at least 5.0 percentage points across the yield curve.

To get an idea of where interests rates would be in a free market environment (with a currency backed by gold and little inflation, credit risk or taxes on the interest), we cite the example of British consuls. As Richard Sylla and Sydney Homer note in their magisterial work A History of Interest Rates, consuls were perpetual bonds that yielded between 2.5% and 3%*** during much of the 100+ years that the British Empire was at its peak.

To give an idea of what 30-year US Treasuries (which have similar long-duration characteristics as British Consuls) would trade for in a free market, you’d start with the level their current yields are at (approximately 3%)**** in today’s managed economy.

You would add an inflation compensation premium (say 2%+, which investors would surely demand if there was no Fed money printing to buy up excess debt), a risk premium to account for the US government economy’s current record debt levels (of at least 1%) and compensation because interest payments are currently taxable (at a marginal rate of say 2% percentage points, or 25%), which they were not during the time of the British Consuls.

So, a theoretical minimum US Treasury yield in a free market environment under rough current economic conditions would be 3% + 2% + 1% + 2% = 8%.

This suggests that Fed manipulations are currently depressing yields on US 30-year Treasuries by 5 percentage points (8% – 3%) throughout the yield curve.

If we apply that rate to all $47.9 trillion in US non-financial debt, as per the Fed’s second quarter Z.1 Flow of Funds report, that suggests that government manipulations are transferring $2.4 trillion each year from savers to borrowers.

*****

Footnotes:

* Estimation of a free market rate of interest (which would vary depending in part on how much inflation, credit risk and taxation there is in the system) implies a free US currency market. This would put constraints on the Fed’s ability to tax savers by printing money, because if they did so, savers would abandon the dollar and instead opt for alternate, sounder currencies.

This rate should in no way be confused with Knut Wicksell’s “natural” rate of interest (which refers to an economy with stable prices) or the Federal Reserve’s “neutral” rate of interest (which refers to a rate that neither is neither expansionary or contractionary in an economy with 2% inflation).



** We assume that the interest rate distortions will occur throughout the yield curve.

*** We use gross, rounded approximations in this estimate, to make the calculation easier for the laymen to grasp.

**** We are rounding here. Actual rates on the day of this was written were 2.8%, the
approximate mid-point of the rough 2.5% -3%, range of the British consuls during minimal inflation and sovereign risk periods.

Questions or comments about this article? Leave your thoughts HERE.

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Economy

The Yield Curve Hasn’t Been This Flat In 10 Years. Recession Ahead?

Whenever we see an inverted yield curve, a recession almost always follows, and that is why many analysts are deeply concerned that the yield curve is currently the flattest that it has been in about a decade.

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Whenever we see an inverted yield curve, a recession almost always follows, and that is why many analysts are deeply concerned that the yield curve is currently the flattest that it has been in about a decade. In other words, according to one of the most reliable indicators that we have, we are closer to another recession than we have been at any point since the last financial crisis.

And when you combine this with all of the other indicators that are screaming that a new crisis is on the horizon, a very troubling picture emerges. Hopefully this will turn out to be a false alarm, but it is looking more and more like big economic trouble is coming in 2018.

The professionals on Wall Street take the yield curve very, very seriously, and the fact that it has gotten so flat has many of them extremely concerned. The following comes from Business Insider

In the past, including before the Great Recession of 2007-2009, an inverted yield curve, where long-term interest rates fall below their short-term counterparts, has been a reliable predictor of recessions. The bond market is not there yet, but a sharp recent flattening of the yield curve has many in the markets watchful and concerned.

The US yield curve is now at its flattest in about 10 years — in other words, since around the time a major credit crunch of was gaining steam. The gap between two-year note yields and their 10-year counterparts has shrunk to just 0.63 percentage point, the narrowest since November 2007.

If the yield curve continues to get even flatter, it will spark widespread selling on Wall Street, and if it actually inverts, that will could set off total panic.

And with each passing day, even more “experts” are warning of imminent market trouble. For example, just consider what Art Cashin told CNBC the other day…

Investors may want to take cover soon.

Art Cashin, UBS’ director of floor operations at the New York Stock Exchange, says a “split personality” is manifesting itself in the stock market, and it could hit Wall Street where it hurts at any moment.

“We’ve been setting record new highs, and often the breadth has been negative. We’ve had more declines than advances,” Cashin said Thursday on CNBC’s “Futures Now.”

When the financial markets finally do crash, it won’t exactly be a surprise.

In fact, we are way, way overdue for financial disaster.

Since the last financial crisis, we have been on the greatest debt binge in human history. U.S. government debt has gone from $10 trillion to $20 trillion, corporate debt has doubled, and U.S. consumer debt has now risen to nearly $13 trillion.

Debt brings consumption from the future into the present, and so it increases short-term economic activity at the expense of long-term financial health.

But we simply cannot continue to grow debt much, much faster than the overall economy is growing. I have never talked to anyone that believes that our debt binge is sustainable, and I doubt that I ever will.

The only reason why we have even gotten this far is because interest rates have been pushed to historically low levels. If the average rate of interest on U.S. government debt even returned to the long-term average, we would be paying more than a trillion dollars a year in interest on the national debt and the game would be over. Unprecedented intervention by the Federal Reserve and other global central banks has pushed interest rates way below the real rate of inflation, and that has bought us extra time.

But now the Federal Reserve and other global central banks are reversing course in unison, and global financial markets are already starting to decline.

The only way we can keep putting off the next financial crisis is if we continue our unprecedented debt binge and if global central banks continue to artificially prop up the financial markets.

Of course more debt and more central bank manipulation would just make the eventual financial disaster even worse, but that is what we are faced with at this point.

Most people simply don’t understand the gravity of the situation. Nothing was ever fixed after the last financial crisis. Instead, we went on the greatest debt binge that humanity has ever seen, and central banks started creating trillions of dollars out of thin air and recklessly injected that hot money into the financial system.

So now we are in the terminal phase of the largest financial bubble in human history, and there is no easy way out.

We basically have two choices. We can have a horrific financial crisis now, or we can have one a little bit later.

Usually the choice is “later”, and that is why our leaders have been piling on the debt and global central banks have been recklessly creating money.

But it is inevitable that our bad choices will catch up with us eventually, and when that happens the pain that we are going to experience is going to be absolutely off the charts.

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Economy

Is Financial Argmageddon Bullish For Stocks? One Bank’s Surprising Answer

Everyone knows that after nearly a decade of capital markets central planning by the world’s central banks, “good news is bad news.”

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Everyone knows that after nearly a decade of capital markets central planning by the world’s central banks, “good news is bad news.” But did you also know that financial armageddon has become the most bullish catalyst to buy stocks? That’s the understated take-home message from the year ahead preview by Macquarie’s Viktor Shvets published last week. It is also the conclusion that One River Asset Management’s Eric Peters reached in his latest weekend notes.

While we will have much more to comment on Macquarie’s rather macabre 2018 preview, which is arguably one of the most honest, comprehensive, and objective predictions of what to expect from the “central bank/market confidence boosting nexus”, we will highlight the one argument that has served to promote countless BTFD algo-driven stock rips, summarized in the following blurb, which is a sublime explanation by Viktor Shvets the worst things are, the more you should buy:

If volatilities jump, CBs would need to reset the ‘background picture’. The challenge is that even with the best of intentions, the process is far from automatic, and hence there could be months of extended volatility (a la Dec’15-Feb’16). If one ignores shorter-term aberrations, we maintain that there is no alternative to policies that have been pursued since 1980s of deliberately suppressing and managing business and capital market cycles. [T]his implies that a relatively pleasant ‘Kondratieff autumn’ (characterized by inability to raise cost of capital against a background of constrained but positive growth and inflation rates) is likely to endure. Indeed, two generations of investors grew up knowing nothing else. They have never experienced either scorching summers or freezing winters, as public sector refused to allow debt repudiation, deleveraging or clearance of excesses. Although this cannot last forever, there is no reason to believe that the end of the road would necessarily occur in 2018 or 2019. It is true that policy risks are more heightened but so is policy recognition of dangers.

We therefore remain constructive on financial assets (as we have been for quite some time), not because we believe in a sustainable and private sector-led recovery but rather because we do not believe in one, and thus we do not see any viable alternatives to an ongoing financialization, which needs to be facilitated through excess liquidity, and avoiding proper price and risk discovery, and thus avoiding asset price volatilities.

Translation: central banks remain trapped by the mountain-sized bubble they have blown with years of QE and ZIRP/NIRP, and once volatility returns, and risk assets plunge, CBs will have no choice but to scramble right back and prevent the pyramid from keeling over and undoing a decade of fake “wealth creation” which was pulled from the future to the tune of $15 trillion in central bank asset purchases, which while still rising is about to go into reverse in just over a year’s time. 

If that’s not enough, here is One River’s Eric Peters, with the exact same conclusion:

Anecdote

“The market has an accident, the Fed returns to QE, slashes interest rates, bonds surge, stocks recover,” said the CIO, high atop his prodigious pile, alone. Staring into the distance. Squinting, straining.

“The correlation between bonds and equities remains negative, the risk parity equity/bond portfolios are dented but not destroyed. And we descend to the next lower level in real interest rates. US bond yields turn negative. In essence, we prolong the paradigm that has driven markets for a few decades.”

Far below, economies hummed in harmony, capitalists collecting their expanding share. “A continuation of this paradigm is what everyone believes. And I just doubt that outcome so sincerely.” Hidden within the distant economic whir, labor strived, struggled. Their wage growth anemic, their children indebted, career prospects uncertain.

“It has taken time, but the political context for a regime shift is now established; populism is evident in recent elections. And the academic context for a seismic economic policy shift is in place too.”

The extraordinary response to the global financial crisis prevented depression. But the price of salvation is proving to be as profound as it is impossible to precisely measure — unexpected election outcomes, political paralysis, an isolationist America, de-globalization, fake news, opioid epidemics.

And connecting it all, a corrosive, woven thread; injustice, unfairness, inequality, hypocrisy, distrust, endemic, growing. “We are on the cusp of great change, the old paradigm is set to shift,” he said, at altitude, the air crisp, clear.

“The market has an accident, monetary policy is seen to be bust, the models have been wrong, we have to change what we do, we can’t go down the same route, we need to move to a different policy mix. Fiscal expansion, infrastructure, labor over capital. We’re moving to something that may be great for the economy, but no good for asset markets. New Regime — end of story.”

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