Christopher Whalen

The page proofs of my upcoming book, “Inflated: How Money and Debt Built the American Dream,” just went back to the editors. One of the benefits of writing a book about U.S. financial history is that it forces you to take a long view of both economics and the political narrative used to describe it. It is the issue of language and labels, in my view, that is making it so difficult for Americans to understand the current state of the economy.

The National Bureau of Economic Research just declared that the “recession” that began in 2007 ended in the middle of 2009, making it the longest downturn since WWII. The only problem is that none of the people who work at NBER today, which is one of my favorite research organizations, are old enough to remember what the U.S. economy was like before WWII; before the age of Keynesian socialism and the use of debt to stimulate growth and employment became standard policy in Washington.

Let’s start with the term “recession,” which itself reflects the assumption that economic growth is always positive and the trend line is always upward sloping. While many economists in the U.S. remain convinced that this is an accurate descriptor, what Americans and many other people of the world need to consider is whether the assumption that the economy will grow endlessly is reasonable.

In the period following the Crisis of 1907 and before the start of WWI, Americans faced a grim economic outlook. Jobs were scarce, product and commodity prices were flat, and the value of farm products and land had been falling for years. The American economy was entirely dependent upon Europe for financing and to buy U.S. products, mostly agricultural and other commodities. The dismal economic scene fed the rise of the Progressive movement in U.S. politics.

WWI provided a sharp relief from this picture of economic stagnation. Employment rebounded, American agricultural prices soared and the value of real estate around the U.S. also rose sharply. With renewed growth came inflation, however, so that by the time that WWI ended, prices for many consumer staples had doubled, but wages did not keep pace. Economic activity gradually slowed as the U.S. made its way through the Roaring Twenties, but many Americans never saw any benefit from this period of speculation and financial excess.

Following the Crash of 1929, the pretense observed by both political parties that all was well in the U.S. economy evaporated into almost twenty years of economic stagnation. While the massive mobilization  for WWII provided the appearance of a recovery, and the period of the Cold War extended this mirage on a sea of public debt and paper dollars, the basic issue of overcapacity remained.

From the 1970s, when the U.S. shifted from defense to housing as the chief driver of American economic growth, the illusion became ever more attractive and, seemingly at least, permanent. But the sad fact is that much of what Americans think was real growth supported by real income and real work was, in fact, the result of deficit spending and reckless monetary expansion by the Fed, first under Alan Greenspan and now Ben Bernake.

In an interview for my book former Fed Chairman Paul Volcker noted:

We live in an amazing world. Everybody has big budget deficits and big easy money, but somehow the world as a whole cannot fully employ itself. It is a serious question. We are no longer just talking about a single country having a big depression but the entire world. If the world as a whole cannot employ everyone who is ready and able to work, it raises some big questions.

Earlier this week in a research note for the IRA Advisory Service, we reported that some of the leading experts in the housing sector believe that the U.S. is less than 25% through the restructuring of defaulted loans on commercial and residential real estate, and that the backlog is growing.  Last week at the AmeriCatalyst conference held in Austin, TX, Laurie Goodman from Amherst Securities predicted that one in five U.S. households remains at risk of foreclosure. If this prediction turns out to be correct, the optimistic view of the U.S. economy and banking sector must be radically revised — and soon.

Just as the housing sector and the related debt was the driver of the U.S. economy over the past several decades, I believe that the deflation of the housing market could spell an equally drastic period of shrinkage in economic activity in the U.S. and around the world.  In order to meet this challenge, both the political and economic communities need to put aside preconceived notions of how the economy should look and begin to develop new language to describe what is really happening to consumers and businesses. Only then can we truly begin the process of working through what is the most serious economic contraction in the U.S. since WWI.

This week I lovingly disparaged those members of the media who spent much time covering the new and improved bank regulatory scheme known as “Basel III.” As someone who was quizzed by my father about the original 1988 Basel accord, I don’t give a toasted sausage about Basel III and said so recently:

Basel III is entirely irrelevant to the economic situation and even to the banks. Through things like minimum capital levels, the Basel II rules provided the illusion of intelligent design in the regulation of banking and finance. In fact, Basel II made the subprime crisis possible and the subsequent bailout inevitable [by enabling off-balance sheet finance and OTC derivatives].

Part of the reason for my undisguised contempt for the Basel III process comes from caution regarding the benefits of regulating markets. In the 1930s, the U.S. government took responsibility for the soundness of banks and markets.  Since then we’ve had nothing but an accumulation of public sector debt and growing market volatility, begging the question as to whether the Treasury’s legal monopoly on regulating a market filled with fiat paper dollars is really a public good.

But a large portion of my criticism for Basel III and the entire Basel framework is even more basic, namely the notion that any form of a priori regulation, public or private, can prevent people from doing stupid things. Neither the failure of Lehman Brothers nor Bear Stearns were caused by a lack of capital. “When a bank goes bad, it doesn’t make much difference how much capital it has,” former Fed Chairman Paul Volcker said recently.

To me, the even more offensive thing about Basel II/III is the financial and economic assumptions which underlie the framework. This week in The Institutional Risk Analyst, we republished the written Testimony of David Colander as submitted to the Congress of the United States, House Science and Technology Committee on July 20, 2010. His views on what is right and wrong with economists and the world of economic research are very much at the heart of the problems with Basel III, at least as sold by regulators to their respective voters in the G-20 nations.

The key premise of Basel III is that the use of minimum capital guidelines and other strictures will somehow enable regulators to prevent a crises before it occurs. The only trouble is that regulators have no objective measures for compliance with Basel II/III, much less predicting market breaks. There is also the larger issue of the conflict between the Fed’s monetary policy role and its job as regulator.

Fed Chairman Ben Bernanke told Congress recently that the Fed and other regulators must rely on the disparate internal systems of the banks to monitor compliance with regulations. But this assumes that bank managers themselves understand the risks they face. Do you think JPMorgan CEO Jamie Dimon knew last week that his bank had a serious problem with its website? Risk is no more predictable than life and no more amenable to statistical forecasts than the weather.

As in past decades and crises right through to 2008, the regulators will be the last to know about a problem. The fact that the Fed and other agencies have no objective means of measuring compliance with Basel III and other regulatory norms is but your first hint of trouble. Add to that basic problem the use of suspect methodologies to measure risk and thus prescribe minimum capital levels. This is the next indication of serious issues with the regulatory status quo which is now reaffirmed in Basel III.  Then add to that the lack of a unified set of accounting rules and the de facto regime of “national treatment” that prevails within the G-20 nations, and it seems reasonable to ask whether Basel III is really worth all of the trouble and bother.

What is more important than Basel III for customers and creditors of and investors in banks? The accounting rules changes on off-balance sheet (OBS) vehicles and the fair-value crusade being led by the Financial Accounting Standards Board are top of the list for our clients.

The EU and SEC/FDIC rules processes on securitization are #2 on the important list. While everyone focuses on Basel III, the key to the future of finance is emerging now with the implementation by the EU of something called “Article 122a” regarding asset backed securities (ABS).

Article 122a is an amendment to the European Capital Requirements Directive. Specifically, it requires European credit institutions that invest in structured finance securities to know what they own. It lays out explicit penalties if a European credit institution does not obtain sufficient data regarding an ABS to satisfy regulators that the buyer fully understands the security.

Would that American regulators dared to propose anything remotely like Article 122a to bring order to the U.S. market for structured notes and derivative securities. Indeed, the divergence in goals and objectives between the EU and the U.S. over bank regulation could grow after the November election, when the Republicans are expected to win big. My prediction is that if the Republicans prevail at the polls, the U.S. may go its own way on Basel III. Stay tuned.

In the wake of Institutional Risk Analytics’ comment last week about the lack of ideas inside the Obama Administration for resolving the economic mess, President Obama suggested new tax credit and infrastructure spending. Neither of these ideas is likely to become real, however, since the Republicans are expecting to take control of at least one house of the Congress in two month’s time.

Over at the Federal Reserve Board, a different kind of policy gridlock persists. The Federal Open Market Committee thinks low interest rates are helping the economy, but the opposite is the case. The monetary policy mechanism that provided liquidity to households when the Fed lowered the cost of credit is broken. Both the central bank and the White House need to recognize this fact and act to address it with effective policy.

Offit Capital Advisors noted in an August 1, 2010 commentary entitled “The Invisible Tax” that the zero rate policies by the Fed are draining hundreds of billions of dollars in income each year from the U.S. economy. Offit estimates that $350 billion per year is being foregone by investors in state and federal obligations and transferred to the government due to Fed low rate policy. The income foregone by individual and corporate savers and transferred to the banks is something closer to $600 billion annually or nearly $1 trillion in total.

When theses subsidies from low interest rates are added to the huge mortgage banking profits being taken by the top four banks from Fannie Mae and Freddie Mac, the largest U.S. banks are literally draining a large portion of the income from the American economy. The fact that these large banks and GSEs are refusing to refinance many residential mortgages in order to preserve their profit margins only adds insult to injury, a political fact that will be made clear at the polls in November.

The chart below, which is inspired by a chart used by David Zervos at Jeffries & Co in a research note on this same topic, illustrates the problem. MTGEFNCL is the yield of the par 30-year FNMA mortgage backed security. USMIRATE is the effective rate for all outstanding mortgages in the US from the Bureau of Economic Analysis. In days gone by, you could add 50 bp to the FNMA yield to get the zero point mortgage rate to homeowners, but not today with banks adding points to the effective cost of mortgages. The Fed target rate is the federal funds rate.

Note how the progression of Fed interest rate cuts from the 1980s to today resulted in a significant reduction in average mortgage borrowing costs for households. This is the case until 2008, when mortgage rates implied by the bond market fell significantly but households were not able to refinance.

What is preventing a refinancing wave today? Fees charged by Fannie Mae and Freddie Mac (Loan Level Pricing Adjustments and Adverse Market Development Fees) and a mortgage origination industry that is highly concentrated in the big four banks, who are working for 4-5 points on new origination loans. Those frictions, which can add up to 7 to 10% of the face value of the loan, raise mortgage rates to borrowers by hundreds of basis points. Banks and the housing GSEs, however, saw significant benefits in declines in funding costs thanks to low Fed rates.

The banks, of course, do not exist in a vacuum. As JPM and the other money center’s desperately fight to survive, they are actually making conditions worse in the real economy, for consumers and business alike. As this reality comes more sharply into focus and the forward growth prospects for the U.S. economy are revised lower, the final blow to consumer confidence will come in the form of higher interest rates by the Fed.

Now into year three of the Fed’s quantitative easing, with visible duration on all first mortgages is already 2x 2005-2006 levels, the party is over for the largest zombie banks. And federal regulators cannot claim that they were not warned. The table below is from a presentation by Alan Boyce, CEO of Absalon, given at an FDIC-sponsored mortgage conference organized by Professional Risk Managers International Association in 2009 and shows the changes in the duration of the US mortgage system:

Source: Absalon

Notice in the table that the option-adjusted duration (OAD) of the mortgage sectors has roughly doubled during the period of Fed zero rate policy – this due to the steepness of the yield curve, a flight from adjustable rate mortgages to fixed rate loans, and high interest rate volatility. As the central bank is slowly forced to allow rates to rise in order to restore income to savers (or perhaps defend the dollar), the OAD for all manner of U.S. securities will explode. This interest rate trap illustrates the key policy error made by the Fed under Alan Greenspan and with the complicity of Ben Bernanke.

“From September 2003 to September 2006, the Federal Reserve Board (“FRB”) directly reduced the total mortgage market OAD by doing three things: they flattened the yield curve, they talked down options volatility and they encouraged homeowners to take out ARMs,” notes Boyce. “This sucked out a huge amount of OAD from the mortgage system despite increasing the outstanding amount of mortgages by $3 trillion. If the FRB had not driven down the OAD, we would never have made all those loans. The change in OAD was $3.6 trillion dollar duration years. To put it in perspective, the Chinese bought $600 billion of Treasuries and Agencies during that time period, with an aggregate duration of $1.2 trillion. The latter is 1/3 the “weight” of the former but is well understood and is the commonly accepted explanation of the Greenspan Conundrum.”

There are many things that need to be done in order to correct the immediate and structural problems in the U.S. economy. But one of the top priorities for President Obama and Chairman Bernanke is to press the banks and the GSEs to immediately accelerate efforts to refinance performing loans in their portfolios to lower rate mortgages now, before interest rates begin to move.

We cannot undo the decisions made by the Fed in past years, but we can recognize at long last that there is no free lunch. The low rates policies of 2002-2006 created a distortion in the financial markets, a shift we are still struggling to deal with a decade later. The first step to fixing the problem is to lighten the load on households now so that today’s homeowner is not tomorrow’s loan default event.

There are growing signs of unease bordering on desperation inside the Obama White House. Most of the O Team now understands that the real, private economy never got out of Dip Number One. The prospect of a permanent downward shift in “trend growth” to a lower track, and continued double digit unemployment, are driving a search for alternative measures that has even touched conservatives in the worlds of finance and economics.

The Obama Administration and the Fed have taken the position that the crisis affecting the U.S. economy and the financial sector is slowly ending. In fact, the largest banks remain profoundly troubled by bad assets on their books as well as claims against these same banks for assets sold to investors. By allowing banks to “muddle along” and heal these wounds using low interest rates provided by the Fed, the Obama Administration is embracing a policy of deflation that has horrible consequences for U.S. workers and households.

In a post over the weekend on ZeroHedge –  “Bernanke Fed Drives Deflation With Zero Rate Policy” — I described the negative effects of the Fed’s low interest rate policy on bank earnings, as well as consumer and corporate spending and saving. When interest rates are low, savers move their preference for liquidity to infinity, especially after the past several years of market breakdown. Retirees spend less because the interest earned on bonds and savings has plummeted.  Here’s an excerpt:

When the Fed buys securities through QE, it is removing duration from the markets, pushing down yields and volatility. For a while this boosts the net interest margin (NIM) of leveraged investors such as banks, who are able to borrow at lower rates to fund current assets. As assets re-price to the low rates maintained by the Fed, however, NIM begins to disappear. Over the medium to longer term, think of duration and NIM as being linked, so obviously a sustained period of QE is bad for NIM. This is why NIM in the U.S. banking sector is starting to fall.

Just as the earnings of leveraged investors like banks are starting to suffer due to zero rate policy, so too the spending by all manner of savers, from retirees to companies and not-for-profits to municipalities, is falling too. Fed Chairman Bernanke and the other members of the FOMC are killing the real economy to save the banks — but none of the benefit flowing to the banks is reaching U.S. households. In fact, the Obama Administration has been providing political cover for the Fed to conduct a massive, reverse Robin Hood scheme, moving trillions of dollars in resources from savers and consumers to the big banks and their share and bond holders.

The first priority is to make clear to the largest banks, especially the top four institutions — JPMorganChase (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C), that the party is over when it comes to providing credit to the real economy. Until President Obama and Fed Chairman Bernanke recognize that six institutions — FNM, FRE, BAC, C, JPM and Wells Fargo — have broken the mechanism which makes interest rate easing work, we will make little progress fixing the economy.

“In every Fed easing event during my career in finance (1986, 1992, 1998, 2002), it was the wave of refinancing of debt after the Fed eased interest rates that put permanent disposable income into the hands of households,” notes a former Fed official who worked in the banking industry for decades. “In this last easing, however, FNM, FRE and the TBTF banks have conspired to break the transmission mechanism for monetary policy and are now strangling the U.S. economy to save themselves from past errors.”

Rules changes made by FNM and FRE since the Treasury’s conservatorship began in 2008 have prevented millions of American consumers and business from refinancing their mortgage debts. The Bernanke Fed will attempt to compensate for this de facto freeze on refinancing with QE II, but this will fail.

So what should President Obama do?

First, the Obama Administration should use the power provided in the Dodd-Frank legislation to force an accelerated cleanup of bad assets and to mandate refinancing and principal reductions for performing loans with viable borrowers. If any banks resist, the Treasury should use the power under current federal law to remove recalcitrant officers and directors of these same banks.

Second, President Obama also needs to focus on the growing competitive problem in the U.S. mortgage sector. The mortgage banking industry suffered significant consolidation since 2007. In particular, the competitive, third part origination players went out of business via bankruptcy or by being taken over. The industry is now dominated by a cozy oligopoly of Too Big To Fail banks (TBTF).

The top three banks control 55% of all mortgage originations. The top 10 banks control 95%. The top five run the only surviving channels to sell loans to Fannie Mae (FNM) and Freddie Mac (FRE), and force their pricing upon the entire banking industry. Small banks give up half the economics of a typical loan to sell a loan to FNM or FRE indirectly, through WFC or JPM. Why is there no antitrust investigation of the top banks by the Department of Justice?

The Obama Administration should move to restructure FNM and FRE now, not in 2011. The Treasury should use its existing authority under the conservatorship to force FNM and FRE to make rules changes to allow for the refinancing of all existing residential mortgages, if only to reduce the current cost of the debt and increase disposable income for households.

By moving on reforming FNM and FRE, the Obama Administration can provide relief to home owners and also send a strong message to Wall Street and global investors that the practice of “too big to fail” is at an end. We should always remember that the model of the government sponsored enterprises (GSEs) goes back to fascist Italy and Germany of the 1920s. The very public demise of these GSEs is an important part of ending TBTF for the large banks — but only part of the story.

President Obama should make some political hay over the fact that loan origination margins for the top four banks have gone from ½ point to over 4 points in the last two years. This is the subsidy for Wall Street above and beyond the zero interest rate policy of the Fed. The Obama Administrations needs to require changes in the way in which FNM and FRE do business with the banking sector and with mortgage holders, and use these changes to reform the mortgage market in preparation for legislation from the Congress.

By reducing barriers to refinancing by FNM and FRE, and aggressively forcing private banks to mark mortgages to market and accept principal write-downs or short sales to clear the backlog of bad debt, the Obama Administration can restore balance to the economy and create a healthy basis for new growth.

The official version of reality in use this week at the White House says that the U.S. economy is recovering, slowly but surely, and unemployment is falling.  The same perspective says that residential real estate markets are stabilizing and banks are starting to lend more aggressively.  None of these statements are true, but there are quite a few people in the White House who believe them nonetheless.

My view is a bit different, namely that unemployment is likely to remain at current levels during the balance of 2010.  The sharp reduction in credit available to the real economy and the overhang in the mortgage markets are not likely to improve anytime soon.  I spoke about the economic outlook with Larry Kudlow and James Glassman on CNBC last Friday: “Double Dip Fears Mount.”

While the public sector of the U.S. economy received a great deal of assistance due to various forms of stimulus, the private sector never recovered from the first “dip” during 2008 and much of 2009.  Virtually all of the Fed’s assistance from zero interest rate policy has gone to the banks or the U.S. Treasury, with no help for American households and workers.  This means higher unemployment and lower economic activity in coming months or even years.

“When the FOMC tries to boost the economy and credit creation, none of the benefit is working its way to investors or consumers,” we wrote last week in The Institutional Risk Analyst (“Zombie Love: Do Fannie and Freddie Provide Any Benefit to the U.S. Economy?”). “Because the Fed and the White House are allowing the banking sector to heal its collective wounds via zero interest rate policy from the Fed, the banking system is not passing along any of the benefit of Fed easy money.  Thus while the banks absorb all of the subsidies from the Fed and Treasury, U.S. households, businesses and private investors are slowly destroyed.”

“Policy makers in Washington know all of this, of course,” we continued. “Nobody in the Obama White House or the Fed dares to admit in public that the ‘quantitative easing’ by the FOMC is pretty much useless in terms of helping the real, private economy.”

No surprise, then, that Wall Street economists are gradually pushing down their “growth” estimates for the U.S. economy for the balance of 2010 and beyond.  This grudging admission of the truth is mirrored in shrinking analyst estimates for revenue for sectors from banking to retailing to autos.  With growth receding, there is no surprise in reports that investors are fleeing equities, as the New York Times reported on Sunday.

The financial crisis of 2008 and the aftermath raise fundamental questions about money, debt and value in a way that Americans have not seen in over a century.  The response to the crisis by the Fed, focused entirely on Wall Street, begs the question of whether Main Street can survive.  The falling expectations for the economy are translating into truly horrible poll numbers for Democrats and the Obama Administration, but also for all incumbents.  The rate of turnover in the Congress this year could be one of the highest in the post-WWII era.

If the Democrats in Congress take a trouncing as is widely expected, then President Obama may decide not to run for another term.  While that possibility may seem far-fetched, my sources in Washington say that President Obama may seek to become the first American Secretary General of the United Nations.

According to this admittedly speculative scenario, President Obama will choose not to run again so he can take a shot at the UN post.  Obama knows that he never could win the position after two terms.

The other interesting twist that some see emerging after the November election due to the poor economic outlook involves the newly created Consumer Financial Protection Bureau, or CFPB.  The chair of the Congressional Oversight Panel, Harvard Law Professor and bankruptcy expert Elizabeth Warren, is one of the leading candidates for the job, but the banking industry naturally is opposed.

It is becoming clear that the Obama Administration may not pick a candidate for the CFPB job until after the November election in order to dodge this very political issue.  By holding the voting on the new agency head until after the election, members of both parties will be able to extract maximum contributions from the banking lobby.  But I hear that the choice may have already been made.

It may surprise some observers that House Financial Services Committee Chairman Barney Frank may want the CFPB job for himself.  Frank reportedly has already expressed interest to the White House.  Sad to say, Chairman Frank probably has seniority over Chairman Warren.

“Barney did some heavy lifting,” says a source on the committee who is close to Frank.  “He might want a different gig, especially if he loses the chairman’s seat in November.  Frank would not want to hang around in Congress as part of the minority.  Being the first CFPB emperor, however, could be a more interesting gig than, say, eventually being made head of HUD of the FHA.”

You heard it here first.