It's no wonder that the Federal Reserve has a watchful eye on commercial real estate. Lending hasn't come back, prices are plummeting and those that poured funds into the sector during real estate boom are getting killed by high vacancy rates and falling rents.

Maguire Properties is one such company. The Wall Street Journal reports the debt-laden REIT is handing over seven buildings to its creditors along with the $1.06 billion of debt that comes along with them. But rather than restructure the debt, the creditors may try to offload them into an extremely soft market, suggesting they'd rather take their lumps now rather than wait for a snapback in the market that may well be years away.

That's not good news for office building prices since such sales could pressure prices even further.

Chief Executive Nelson Rising, who was brought in by the company's board last year to succeed Mr. Maguire, said in an interview that restructuring the debt on six of the buildings, located in Orange County and Los Angeles, is one possibility. But he said the most likely scenario is that the mortgage holders will take over the properties and try to sell them. Maguire already has a deal to turn over one of the buildings, Park Place One, in Irvine, Calif., to LBA Realty, a real-estate company that acquired the debt on the property at a discount in the spring. A telephone call placed to LBA's principal wasn't returned.

Among the office buildings that Maguire will turn over to creditors is Stadium Towers Plaza.

The debt on the other six properties was packaged by Wall Street firms and sold as commercial mortgage backed securities, or CMBS, to dozens of institutional investors. Mr. Rising said that Maguire would work closely with the servicers of that debt to transfer control of the buildings. The seven buildings, with 4.2 million square feet, make up about 20% of Maguire's portfolio.

The CMBS market, though on firmer footing thanks to government programs to revitalize it, still hasn't seen any new issuance since the market closed down last year. That makes refinancing debt difficult if not impossible since banks and insurance companies - the other big lenders - have all but abandoned the sector.

As the FOMC meets this week, CMBS and the broader commercial real estate market is sure to be on policymakers' minds as they consider what stimulative programs should die a natural death and which ones need more time to work their magic. While the Treasury purchases are likely to among the first significant program to wind down, the dismal state of commercial real estate suggests that its lending facilities for CMBS will be with us for a long time to come.

(James Saft is a Reuters columnist. The opinions expressed are his own)

If you thought the U.S. housing crash could be blunted if only lenders would cut delinquent borrowers a break, it is perhaps time to move on to another vain hope.

That’s right, the loan modification movement - pushed by the U.S. administration and others as a means of keeping non-paying borrowers in their houses, keeping those same houses from flooding the market as foreclosures, and even helping beleaguered lenders - is running into a reality-shaped wall.

An exhaustive study of loan modifications by economists at the Boston Federal Reserve, under which delinquent borrowers are given lower rates, more time, or even cuts in the principal amount owed, showed fundamental problems with the way that idea works when put into practice.

Looking at data that covers about 60 percent of U.S. mortgages the authors, Manuel Adelino, Kristopher Gerardi, and Paul S. Willen, came up with two important conclusions.

First, securitization, whatever its other shortcomings, is not an important factor in stopping loan servicers from cutting deals with delinquent borrowers.

Second, and even more importantly, lenders don’t renegotiate for a simple, unanswerable reason: it is not in their best interest financially.

Virtually every rescue plan in the U.S. since the crisis began in 2007 has been in part a loan modification program, the most recent being the Making Home Affordable plan the Obama administration unveiled in February.

The thinking is that, as a foreclosure can cost the lender between 30 and 50 percent of the value of the loan, deals can be struck with borrowers for a lot less than that leave everyone better off.

Sadly, very few loans are being modified - only about 3.0 percent of delinquent loans - with many blaming securitization, which can make a loan modification toxic for one class of lender but beneficial for another.

Seeing as how securitization was part of the way finance spun of control and the bubble was inflated, this was a satisfying narrative, but a false one according to the Fed study. They found no significant differences in the rate of renegotiation among loans that were in private-label securitizations and those actually owned by the servicer doing the negotiating with the borrowers.

NEITHER A BORROWER NOR A MODIFIER…

The real issue is that, in the vast majority of instances, banks are better off not modifying.

For one thing, about 30 percent of borrowers who become delinquent get back on track before foreclosure. Since its very hard to know which borrowers will become payers again, this implies that 30 percent of the money expended in modifying loans is wasted, at least from the lenders point of view.

Secondly, a huge percentage of borrowers who are given new improved terms go and become delinquent all over again. A whopping 40 to 50 percent of borrowers who get modified loans are 60 days delinquent again six months later.

For them, and for their banks, it is just delaying the inevitable, and expensive to boot, as falling property prices make putting off foreclosing and liquidating costly.

The implication is that unless the government wants to pony up much larger amounts of money to entice lenders to modify loans, we are not going to make much of a dent in the wave of foreclosures washing across the economy. This could be done, and possibly support house prices in the process, but at a very high costs.

The real issue is that there are too many houses for the supply of credit worthy borrowers. The re-default rate shows that, as does the low clearing price when banks sell foreclosed houses.

Housing needs to fall in value, less of it needs to be built, and more people should become renters. That is going to continue to eat away at bank capital and act as a drag on growth.

Beyond that, there is a real question about the long-term consequences of mass loan modification. If the incentives are there more borrowers will become selectively delinquent and fewer who become delinquent will in the end catch up with their payments. Why should they?

That means higher loan rates than would otherwise be the case.

The thinking behind loan modification has interesting parallels in the rest of the economy, where policy makers are following similar strategies for banks and corporate borrowers.

Rather than simply cutting back on leverage, probably via default, there seems to be a consensus for stringing struggling borrowers, and lenders, along, hoping that something turns up.

Ultimately, it seems likely that strategy is about as successful in the rest of the economy as it seems to be in housing.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

Reasons people give to explain the quick switch-back movements in stocks and other risky assets are becoming, well, just bizarre.

On Monday, it was the World Bank’s dire outlook for the global economy — no matter that the organization’s president already said output was likely to decline by close to three percent earlier this month.

On Tuesday, it was Moody’s Investors Service reaffirming the Aaa rating of the United States that gave stocks a brief lift, even though few expected any rating agency to make a move on its credit standing any time soon.

Investors should take these kinds of explanation and moves with a grain of salt, especially during the summer months when trading volumes are light and conviction easily undermined.

Those taking the long view shouldn’t let the noise, whether it be a World Bank report on the economic outlook or a perceived change in a data point, distract them from the fact that the financial system is still on life support and therefore susceptible in a very real way to a downturn once governments start to pull the plug.

The Federal Reserve is well on its way to purchasing $1.45 billion of mortgage-related assets in addition to $300 billion of Treasuries, which it could expand if central bankers decide they need more power to drive down interest rates.

This week, in an attempt to drive down rates even further, the European Central Bank is offering funds at a bargain basement rate of one percent for one year. The Bank of England, meanwhile, is keeping rates in that country at a record low while earmarking 125 billion pounds to buy up debt as part of its quantitative easing policy. And the list goes on.

The trillions of dollars injected into the global financial system have helped bolster short-term lending markets to such an extent that few are even talking about such hot-spot gauges as Libor/OIS that flashed beet red last year when banks balked at lending to one another.

By driving down short-term borrowing costs, this money, among other things, encourages banks and investors to invest in higher-yielding, riskier assets that had been beaten down by the crisis.

The return of risk appetite has in turn bred comfort that things are returning to normal. But they’re not, yet.

That’s why the timing of when governments begin to mop up this excess liquidity will be key to where markets go from here. There will be plenty of trading opportunities between now and then, to be sure, but it will be some time before we’ll see anything that we can call normal. Yet, normalcy is what many crave.

Many had hoped that the run-up in stocks and other risky assets since March was the real deal — a sustained rebound, in the manner of 2003.

Real money had been moving into stocks and risky corporate debt not because of isolated headlines but a growing, and I would argue misplaced, belief that the stabilization of financial markets held out the possibility of a rapid rebound, and the opportunity to rebuild 401(k) accounts and other investments pancaked by last year’s crisis.

After taking out $31.5 billion in March, investors rechanneled funds back into equities, adding approximately $36 billion to stock funds since then, according to AMG Data Services, which tracks mutual fund activity.

This isn’t surprising, as it’s hard to turn your nose up at 32 percent gains in the S&P 500 since it hit rock bottom in early March or the even more impressive 36 percent returns seen in the Merrill Lynch Master II high-yield corporate bond index.

But these returns are being juiced by easy money, which means the picture could look much different when cheap funding is harder to find.

– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

Call it a battle for beginnings and endings, and the Federal Reserve is smack in the middle.

As Fed policymakers convene for a two-day meeting starting on Tuesday, the lines are growing more defined between those who want the Fed to do more to stimulate a still fragile economy, and those who are calling for a defined exit strategy to prevent the global economy from going into an inflation-inducing overdrive.

There’s a way to placate both camps, at least in the near-term, and that’s for Ben Bernanke and his colleagues to retire some of the temporary short-term lending facilities put in place at the height of the financial meltdown last year.

It would show good faith that the U.S. is serious about exiting some of those emergency facilities, and it would give the central bank breathing room to keep its ultra-easy monetary policy in place until it’s ready to call the all clear.

Bernanke, as a scholar of the Depression, is all too aware of what can happen should the central bank move too quickly and forcefully in removing stimulus.

One program in particular is a ripe candidate - the Commercial Paper Funding Facility.

Introduced last year, the CPFF made sure that highly-rated companies could get access to short-term funding at a time when traditional commercial paper lenders like money market funds, spooked by losses caused by the Lehman Brothers bankruptcy, shunned such borrowing. By the end of 2008, the Fed’s commercial paper lending added $334.1 billion to its balance sheet.

Since then, the demand for short-term government financing has waned. For one, the program bought companies precious time to cut their dependence on short-term markets as they found financing elsewhere, such as the longer-term corporate bond market. The sharp slowdown in the economy also curbed companies’ need for short-term borrowing, which was often used to cover payrolls, rent or other basic expenditures.

In the latest week, the Fed reported that its facility had shrunk by $6 billion to $132.1 billion in a sign that companies were choosing to pay down their debt before next July when a good portion of the loans begin to mature.

Barclays Capital money-market strategist Joseph Abate expects the commercial paper facility, along with another facility that gives loans to banks so they’ll buy certain types of commercial paper from money market mutual funds, could fall below $50 billion by the time the programs are due to expire in October.

These programs have already been extended once, so they are still in play despite the stated end date.

While practically speaking there would be no harm in keeping facilities like the CPFF open indefinitely just in case financial markets should swoon again, there are pragmatic considerations that should be taken into account.

It’s better to show a commitment to exit strategies with a program that has largely run its course than to start tinkering with interest rates and quantitative easing that can have an outsized impact on the U.S. and global economy, which are still by no means out of the woods.

The World Bank reiterated on Monday its forecast for world economic slump this year, with output contracting by 2.9 percent rather than the 1.7 percent decline predicted in March.

The rise in Treasury yields earlier this month and the quashing effect they had on mortgage lending activity also should be a reminder that the Fed needs to stay flexible when it comes to its unorthodox policies. But it’s time to show the world that it’s also ready to put aside some weapons in its arsenal when the time is right.

– John Kemp is a Reuters columnist. The views expressed are his own –

Intense criticism of the Fed’s role in the financial rescue program and the decision to triple its balance sheet, including monetizing a portion of the Treasury’s debt, has forced the central bank to issue an unusual defense of its actions (http://www.federalreserve.gov/newsevents/press/monetary/20090323b.htm).

It attempts to placate critics by acknowledging the real risk of inflation, and marks the Fed’s first attempt to set out an “exit strategy” for ending quantitative easing and other credit programs once the crisis is safely passed.

The joint statement issued with the U.S. Treasury reflects “the common views of the Treasury and the Federal Reserve on the appropriate roles of the Federal Reserve and the Treasury during the current financial crisis and in future.”

The last time the Fed and Treasury were forced to reach such an agreed statement defining their respective responsibilities was in 1951. Over the previous 15 years, monetary and fiscal policies had largely become fused as a result of the Great Depression (with interest rates kept artificially low to support recovery, then abandoned as a tool of monetary management in favor of reserve requirements) and World War Two (with rates repressed to help finance the government’s massive borrowing program).

Even after the war had finished, the Fed held short-term interest rates at just 1 percent. Rates did not begin to rise until the start of 1948, and they were still at just 2 percent by the end of 1952 (https://customers.reuters.com/d/graphics/WARTIMEFINANCE.pdf).

Crucially, the Fed also enforced a 2.5 percent ceiling on long-term Treasury yields through open market operations to hold rates down and support the federal government’s massive wartime borrowing program and the need to refinance the debt at low cost. Precisely what the Bernanke Fed is now doing through its Treasuries purchase program.

The distortions created in financial markets as a result of a long period of ultra-low rates and massive government borrowing made an “exit” from the program extremely difficult.

One result was the huge bout of post-war inflation in the late 1940s, when the massive amount of liquidity in the system intersected with the removal of price controls, industries geared to wartime rather than consumer production, and the outbreak of the Korean war.

Copper prices, for example, doubled between 1946 and 1948 and there were smaller but sharp increase in the price of most other raw materials (https://customers.reuters.com/d/graphics/METALSPRICES.pdf).

Not until 1951 were the Fed and Treasury able to reach an accord on their respective roles, and was the Fed able to start gradually normalizing interest rates. The Fed gradually loosened its control over long-term rates and allowed them to drift upwards.

The joint statement issued by the Federal Reserve and Treasury on Monday evening reiterates that “Actions that the Federal Reserve takes … such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy.”

It notes that the Treasury has a “special financing mechanism” which helps the Fed manage its balance sheet. The Treasury used this supplementary financing program to sterilize the Fed’s asset purchases during the early stages of the crisis in September and October 2008 by issuing extra cash management bills to soak up the additional liquidity the Fed was pumping into the system and prevent a build up of (potentially inflationary) bank reserves.

The supplementary financing program was subsequently abandoned in favor of a more expansionary policy of unsterilized asset purchases. But it could be reintroduced to issue new Treasury securities and drain excess bank reserves and liquidity from the system if necessary.

STERILISATION

But the most important part of the joint statement notes “the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.”

What this last point means, in plain English, is that the Fed recognizes that the massive increase in bank reserves caused by its purchases of financial assets for cash or easily marketable securities does pose an inflationary risk once the heightened demand for cash is saturated, or starts to fall back to more normal levels.

The Fed wants to head off this risk by being able to sterilize some of the excess bank reserves at the appropriate time in future. In particular, it wants the ability to replace the bank reserves (which are cash-like instruments that banks can tap on demand) with longer-term liabilities (which will tie up bank funds and cannot be accessed immediately).

One option is to have the U.S. Treasury issue debt to the market (draining excess funds from the banking system) and depositing the proceeds with the Fed (where they will be under the control of the government, rather than the banks, so pose less inflationary risk).

The total volume of Fed liabilities would still be the same, but ownership would switch from the private sector (where it might be inflationary) to the government (where it would simply represent an inter-governmental transfer that would allow the Treasury to fund some of its massive borrowing requirement). This is what the Fed means about the Treasury being able to help the Fed manage its balance sheet.

NEW FED DEBT

The other option is for the Fed itself to start issuing debt securities to the banks, which they would buy with cash and excess reserves. The Fed would essentially swap one form of liabilities (excess reserves) for another (Fed debt). If the debt was structured appropriately, it could be much less “money-like” and liquid, absorbing some of the excess liquidity in the system.

What the Fed is hinting at in this statement is that it will ask Congress for the (unprecedented) power to issue its own debt securities. The advantage of these Fed securities would be threefold:

(1) Because they would be issued by the Fed rather than the Treasury, they would not count toward the federal government’s debt ceiling. Since they will in fact be contingent liabilities of the United States government, Congress might choose to impose some restrictions on the amount of debt the Fed can issue, and other oversight requirements. Fed officials are likely to oppose this, however, arguing they must preserve maximum operational “flexibility” to respond to crises and changing conditions.

(2) By design, Fed securities will be less liquid than cash, bank reserves or U.S. Treasuries. Various restrictions could be placed on how they are traded. For example, the Fed might insist that they can only be held by member banks of the Federal Reserve System. This would make them less money-like and reduce the risk that banks would be able to use their holdings as quasi-reserves against which they can safely extend new loans. Or they could simply be made non-tradable like U.S. savings bonds. The key point here is that the Fed securities have to be less liquid and money like than the bank reserves they will be replacing. They will be a very special form of debt.

(3) Banks will probably be compelled to hold some of these new securities as part of regulatory reforms that will oblige them to hold more capital. That would give the Fed a guaranteed market into which it could sell these securities. It would help drain liquidity from the system by replacing excess reserves (which the banks are holding optionally) with special Fed securities (which they would have to hold as a matter of law).

– John Kemp is a Reuters columnist. The views expressed are his own –

Investors have started to balk at absorbing large quantities of U.S. government debt, taking on substantial inflation and devaluation risk in return for little reward. While the government has no trouble placing short-term debt with a maturity of up to 2 years, longer-dated securities are proving much harder to sell.

Increasing resistance from the market explains why the Federal Reserve felt it had no choice but to announce it would start buying back longer-term U.S. Treasury securities last week, in a $300 billion program of direct quantitative easing and monetization.

The attached chart (https://customers.reuters.com/d/graphics/TREASAUCTIONS.pdf) shows the amount of 10-year U.S. Treasury debt placed at each of the auctions since the beginning of 2008, the interest rate which the government offered (coupon yield), and the range of rates (high, low, median) the market actually accepted through the auction process.

The government has been steadily cutting the coupon rate on offer from 4 percent in September 2008 to 3.75 percent in January 2009 and 2.75 percent at the auctions held in both February and March. But the market’s appetite for longer-term debt at such low interest rates has been waning.

The median yield which the market has demanded in the auctions has risen steadily from 2.35 percent in January to 2.71 percent in February and 2.98 percent in March. The high yield is up from 2.42 percent in January to 3.04 percent in March.

The March auction results show the government’s borrowing program was in increasing trouble. The median yield the market accepted (2.98 percent) was 23 basis points above the coupon the government was offering (2.75 percent); the government was forced to place the issue at a substantial discount (the debt was sold for an unusually large discount of 2.49 percent to its face value, or just 97.50 cents on the dollar).

The ratio of bids placed to securities sold (the “bid-to-cover” ratio) was also very low in both February and March (2.2 bids to every 1 sold), confirming that investors were looking for more yield than the government was readily paying.

Moreover, the proportion of securities purchased by primary bond dealers for their own account (60 percent) was down sharply in these auctions compared with last year (when 70-80 percent was normal). Instead, large shares went to indirect bidders (35-37 percent) which include foreign central banks bidding through the Federal Reserve Bank of New York, which may not have strictly commercial motives. The residual went to direct bidders via the primary dealers.

In the absence of the Fed move, the government would almost certainly have needed to raise its coupon from 2.75 percent to 3 percent or even higher at the next auction. It would have reversed the downtrend in place since last autumn and sent a powerful signal to the market that lack of demand was driving long-term interest rates higher.

The buy-back program — targeting 2-10 year Treasury securities — looks like an attempt by the Fed to forestall a rise in coupon payments that would otherwise have been inevitable, triggering a sharp rise in long-term borrowing costs across the economy.

But the program’s likely effectiveness is open to question. Yields on 10-year Treasuries have already risen more than 20 basis points from last week’s lows, and are now just 30 points below the level prior to the Fed’s announcement. Given the size of the government’s borrowing needs — which dwarfs the $300 billion buy back program — the program is unlikely to hold back the rise in yields for long.

– James Saft is a Reuters columnist. The opinions expressed are his own

Treasury Secretary Geithner is all but admitting that U.S. banks are suffering not from market failure but self-inflicted collateral damage.

The U.S. Treasury on Monday detailed an up to $1 trillion plan to buy up assets from banks in partnership with private investors, using financing bankrolled by the government, financing that is only secured by the value of the doubtful assets the fund buys.

One portion will be dedicated to buying complex securities from banks employing capital contributed by private investors and the government topped up with funds borrowed from the Federal Reserve. A second portion will buy older securities that are, or were, rated AAA, using, you guessed it, more non-recourse funding.

But most interesting of all is a plan to buy whole loans, dubbed “legacy loans”, from banks but this time the private-public subsidized vehicle will get its leverage courtesy of Federal Deposit Insurance Corporation-guaranteed debt.

Notice that the ground has shifted subtly and the government is now talking not just about “toxic” assets but “legacy” ones. A legacy asset is, more or less, everything real estate related now on bank balance sheets.

These loans are not marked to market they are held to maturity, so no blaming the market here. They are nothing more than doubtful loans in the process of going bad as the economy implodes and the real estate they are collateralized with drops in value.

There is an almighty bust in the U.S. real estate market and it is blowing holes in bank balance sheets having nothing to do with securitizations.

It rather undercuts the argument that was advanced about earlier subsidy plans, that there was a “market failure” leading to hard-to-value complex securities being priced by the market at too little, below their fair “held-to-maturity” value.

The only uncertainty around a whole loan is whether the debtor will pay back the loan and, if not, what the collateral is worth. So there is no more deception about liquidity, market failure or anything else, only a naked subsidy to the banking industry, using the private sector as a pricing mechanism and cutting them in on the deal in exchange.

DEFINITION OF PRIVILEGE
So, will it work, and if it does how will this step influence the way banking functions down the road? Depends on what you mean by work, but it will doubtless take a tranche of lousy assets off of banks.

But as for creating confidence, I can’t see it. Firstly, investors will twig to the idea that the balance sheet issues are deep, and secondly, now that we are talking whole loans I think it’s clear that the $1 trillion is only a down payment.

That means the administration will need Congress to play along and fund another wodge of subsidy. That may be a tough sell, especially considering that the administration has bent over backward to keep Congress out of the funding loop, using the Federal Reserve and FDIC as funding mechanisms and thereby effectively arrogating the funding powers Congress is supposed to hold.

The plan also hugely encourages moral hazard, as it leaves too big and too failed companies, boards and executives in place while providing them with a chance to climb out of the holes they have dug themselves. Not much of a lesson in accountability.

Writing in the Wall Street Journal, Secretary Geithner said the U.S. must strike a balance between promoting public trust and spending taxpayer cash to get the banking system functioning.

“This requires those in the private sector to remember that government assistance is a privilege, not a right. When financial institutions come to us for direct financial assistance, our government has a responsibility to ensure these funds are deployed to expand the flow of credit to the economy, not to enrich executives or shareholders,” he wrote.

It is just astounding that he even sees the need to remind us that free government money is not a right, and reveals much about the balance of power between him and those seeking handouts. And you simply can’t give a subsidy without enriching executives or shareholders, you can only hope not to do it too obviously.

Finally, don’t even begin to believe that concerns about government interference will leave the U.S. with few well qualified asset managers willing to commit their capital to the plan. New York and Connecticut are stuffed to the gills with asset managers who would crawl naked over hot coals to get access to cheap, non-recourse, long-term funding from the government.

That there are suggestions to the contrary is simply an attempt to try and influence the debate about government control over compensation at firms which accept taxpayer largess. A smokescreen within a smokescreen.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– John Kemp is a Reuters columnist. The opinions expressed are his own –

Yields on long-term U.S. Treasury debt continued to surge higher yesterday as the market braced for a future upturn in inflation and a tidal wave of long-dated issues that will be needed to fund the bank rescues and the emerging stimulus package.

Yields on three-year notes are up by around 47 basis points from their mid-December low. But yields on ten-year paper have soared 82 points and rates on the 30-year long bond have surged 114 points. Long-bond rates have retraced more than half their decline since the autumn (https://customers.reuters.com/d/graphics/USTREAS.pdf).

Back-end yields would probably have risen even further were it not for persistent hints the Federal Reserve is thinking about buying longer-dated issues to cap them. But the market has started to call the Fed’s bluff.

MANIPULATING THE FRONT END

In the press statement accompanying its most recent interest rate decision, the Federal Open Market Committee (FOMC) gave a clear commitment it will keep short-term rates at “exceptionally low levels for some time.” In practice, the Fed will probably hold rates close to zero for the next two to three years until a cyclical recovery is well underway. But thereafter rates will need to rise to more normal levels to contain inflationary pressures.

The steepening yield curve reflects an assumption the Fed’s zero-interest rate policy will dominate the whole yield on debt maturing in 2009-2011, but have a diminishing effect on securities which mature further in the future.

LENGTHENING THE DEBT PROFILE

Federal debt held by the public has surged almost 25 percent in the last nine months, from $4.64 trillion at the end of March 2008 to $5.78 trillion at the end of December. Net debt is scheduled to increase another $1.0-1.5 trillion over the next twelve months as a result of the cyclical downturn and the huge $700-900 billion stimulus package being considered by Congress.

So far, almost all the increase in debt has been funded by issuing short-term instruments. The proportion of debt maturing within one year has climbed from 38 percent at the end of March to 43 percent at the end of December, and will climb over 50 percent within the next twelve months unless the government’s issuing policy changes.

By increasing the volume of debt that needs to be refunded regularly, the shortening profile is creating a dangerous new form of fragility within the system.

In effect, the federal government is now taking on the maturity-transformation role previously provided by commercial banks, corporations issuing commercial paper, and special investment vehicles (SIVs). Like them, it is borrowing short-term from the money markets to make long-term investments secured against tax revenues receivable over decades.

But like the private borrowers, the government will also face a liquidity crisis if at any point the market balks at rolling over the maturing short-term notes.

For the moment, a liquidity crisis is unlikely. The short-term ultra-safe instruments the Treasury is issuing are a good fit for the type of securities which investors want to hold.

But once conditions begin to normalize, investors are likely to want to withdraw some funds from the short-term Treasury market to deploy them more profitably in other assets. And overseas investors will eventually want to reduce their exposure to dollar-denominated assets.

At that point, short rates will have to jump to persuade investors to keep sufficient funds in the market to roll over all the maturity bills and notes.

This risks creating a highly unstable dynamic. Even the slightest sign of stabilization and recovery will trigger a sharp run up in short and medium term government bond yields, cascading across the rest of the bond market into higher borrowing costs on commercial paper and commercial loans.

With so much short-term debt needing constant refunding, the Fed would struggle to control the pace of future monetary tightening. Both the Fed and the Treasury therefore have a strong interest in lengthening the government debt profile.

A much higher proportion of forthcoming debt issues will be placed in the middle and at the back end of the yield curve, which is why debt prices at these maturities have been falling, and their yields rising fastest.

MANIPULATING THE BACK END

The Fed’s open market operations are normally restricted to short-term U.S. Treasury bills. But the central bank has already expanded them to include purchases of commercial paper and mortgage-backed securities issued by Fannie Mae and Freddie Mac. It will soon start funding third parties to buy securities issued by credit card companies, student lenders and motor manufacturers.

The FOMC has stated it is also “prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”

In effect, the Fed has said it is prepared to enter the market as a “buyer of last resort” for longer-dated Treasury securities if their prices fall too much and yields rise too high. Fed officials have talked about buying longer-dated Treasuries for several months. But so far the Fed has hesitated to pull the trigger, because buying long-dated bonds is fraught with danger.

The principal purpose of open market operations is to provide liquidity by making an active two-way market when other banks and institutions fail to do so in sufficient volume. To the extent the volume of open market operations increases, and the total quantity of securities owned by the Fed rises over time, the central bank is also printing money.

When the Fed first started to expand its open market purchases in early autumn, the cost was covered by additional deposits of Treasury money into the central bank. The Treasury issued short term cash management bills, deposited the proceeds with the Fed, and the Fed used them to buy private-sector debts. In effect, the Fed and the Treasury substituted private borrowing from the money markets for public borrowing, so the impact on the total money and credit supply was neutral.

The Fed and Treasury have since run down the supplementary financing program and allowed the cash management bills to mature without replacing them. The increase in the Fed’s balance sheet has started to expand the money supply. But the increase is mostly showing up in a rise in the volume of excess bank reserves, rather than lending, so the impact on business activity and inflation is muted.

There is more inflationary risk in future once conditions normalize and demand for cash liquidity falls. But at that point the Treasury could issue more government debt, or the Fed could sell some of the government and other securities in its portfolio, absorbing excess cash from the banks. In principle, the Fed is still swapping private debt (now) for government debt (later).

But once the Fed begins to purchase long-dated Treasuries it will be unambiguously creating money. It would be turning on the printing press and monetizing the federal government’s deficit.

Since all the Fed’s operations are ultimately backstopped by the U.S. Treasury, the Fed would be using the government’s own money to buy the government’s own debt. The Fed would find itself bracketed with Germany’s interwar Reichsbank and the central bank of Zimbabwe. This is most definitely not a comparison the Fed wants drawn.

The market would almost certainly respond by labeling a long-term Treasury purchase program “deficit financing” and brace for even higher inflation. The market-clearing yield on long-dated Treasuries would rise further. If the Fed wanted to continue holding yields down below this level, it would be forced to buy a substantial proportion — in the limiting case all — of the new issues.

As in the currency market, limited intervention risks backfiring, while large-scale intervention would stoke fears about inflation. So this is a policy the Fed must hope to hold in reserve, and never have to use.

– Mark T. Williams, a professor in the Boston University School of Management’s Finance & Economics Department, was a former Federal Reserve bank examiner in San Francisco and Boston. The views expressed are his own. –

Washington is doling out more than $1 trillion to banks, a hefty capital commitment putting taxpayer money at risk. Meantime, Congress is moving to expand financial sector oversight and the Federal Reserve Bank is likely to take on this additional duty.

As the government’s financial involvement increases, the Fed must be ready for this expanded role. Unfortunately, the current fleet of Fed examiners is in way over their heads. I should know: I used to be one.

The root cause of the financial crisis has been bank driven. Under the Fed’s watch, Wall Street wizards were allowed to concoct, sell and speculate on risky credit-related products. In addition to monetary policy, the Fed has an important duty to maintain a safe and sound banking system. Although this supervisory role is well understood, banks still overdosed on risk — not overnight but over time. This significant risk trend was missed by the Fed and its examination force.

In maintaining safety and soundness, bank examiners are the first line of defense. They are the foot soldiers, the Fed’s eyes and ears. The examination process includes physical sampling, on-site visits, and executive interviews, culminating in a formalized bank rating and written report. These ratings are an important risk measurement and provide a bank’s financial health scorecard. The Fed does not make these ratings public but uses these to assemble lists of the weaker banks that need further attention and oversight.

Data from bank examination reports are also used to evaluate longer-term risk trends on a local, regional, and national basis. As the Fed conducted on-site examinations, it is difficult to imagine how they missed this growing credit storm. The Fed could have quickly put the brakes on risky lending practices, reduced the number of bank failures and better protected the financial strength of this vital industry.

The Fed missed spotting the risk because many of its field examiners lacked the needed sophistication, training and measurement tools. While the bets being placed by regulated banks grew in size and complexity, Fed examiners were ill-equipped to adequately measure, monitor and report on these risks.

This growing gap in examiner knowledge and skills provided greater opportunity for banks, armed with generous bonus plans and sophisticated models, to overindulge in risk.

The banking industry continues to consolidate. In the last 25 years, the number of U.S. commercial banks has declined from over 14,000 to approximately 7,300. This significant trend has caused greater concentration of risk as more assets are being controlled by fewer banks. One botched Fed examination at a major bank can have much more far reaching implications than just 20 years ago. In addition, recent strategic miss-steps by major banks, such as Citigroup and Bank of America, have obliged more day-to-day surveillance and stressed an already wobbly examination force.

The on-going financial crisis has also forced investment banks, such as Goldman Sachs and Morgan Stanley, to adopt commercial banking status. As a result, the Fed now has a new type of “risk-taking” animal to tame and put under regulatory oversight. Unlike commercial banking, investment banks historically have taken more risk and used more leverage in seeking profits. The Fed must quickly and thoughtfully retool its examiner force so it can better carry out the critical role of maintaining a safe and sound banking system.

With significant taxpayer money on the line and more slated to be released, Fed examiners in today’s marketplace must better protect our investment as well as keep banks from inflicting financial harm to themselves and to the broader economy.

To upgrade Fed examiner capabilities, there are four critical areas which needs fixing:

1. The Fed must immediately hire more specialized bank examiners to provide better risk training and establish adequate incentives so the best will be encouraged to stay.

Fed examiners need to show a strong aptitude and understanding of the risk-taking activities which now drive bank earnings. The Fed should hire from the very institutions it regulates. In the last decade, the flow of hiring has been primarily from the Fed to such banks, which has further eroded the strength of the national examination force. In addition, adequate incentive systems need to be put in place to minimize the brain drain and insure that the best examiners have financial incentives to stay.

2. The Fed must tighten regulation and leverage-ratio requirements of investment bank-related activities.

Recent financial losses, including such high profile bankruptcies as Lehman Brothers, the shot-gun marriage of Bear Stearns to J.P. Morgan, and the continued financial harm inflicted by Bank of America’s ill-conceived acquisition of Merrill Lynch division, reinforce the danger of using excessive leverage. The Fed needs to re-examine its position on what is acceptable leverage and provide clear policy.

3. Compensation schemes at commercial and stand-alone investment banks must be re-evaluated with tighter oversight and linkage to overall ratings.

Bank-derived compensation systems can reinforce good as well as destructive behavior. The Fed should take a more active role in better identifying when incentive systems are positively aligned or when they encourage excessive risk taking.

4. The Fed must provide tighter regulation oversight on bank prime-broker operations.

Many commercial banks offer prime-brokerage lending services to unregulated, high-risk hedge funds. Up until recently, this business segment has grown substantially. There are more than 6,500 hedge funds in the U.S. that control more than $1.2 trillion. A bank can only be as strong as its customers. Given that the hedge-fund industry is looking shakier every day, the Fed must strengthen its expertise in regulating and tightening up lending standards in the prime-brokerage areas of its member banks.

By focusing on these four areas, stronger Fed examination staff and oversight will strengthen our banking system and go a long way toward protecting your $1 trillion bet.

– Ram Charan is the author several book, including “Leadership in the Era of Economic Uncertainty: The New Rules for Getting the Right Things Done in Difficult Times.” A noted expert on business strategy, Charan has coached CEOs and helped companies like GE, Bank of America, Verizon, KLM, and Thomson shape and implement their strategic direction. The opinions expressed are his own. –

The first 100 days demand that President Barack Obama sort out his priorities and choose the ones that will help solve many others. With many constituencies and direct reports clamoring for his time and attention, he cannot attend to them all.  He has to decide which of the many complex and urgent issues that have accumulated must be resolved first.

The new president will inevitably be pushed to spend a huge amount of time on foreign policy.  But I suggest that the president’s top priority should be to get the nation out of this economic and psychological funk.  He has selected some very capable people who will help sort out the economic mess. He made a brilliant move to have Paul Volcker in the White House.

But ensuring that various parts of the U.S. economy work together and with the rest of the global economy will take a significant amount of President Obama’s personal time and leadership. I have seen in my work with corporations that the best leaders are hands-on when it comes to making sure their top people coordinate their efforts.  The new president will have to do the same with the secretary of Treasury, Federal Reserve chair, SEC chair, and other relevant government leaders. Each of these experts sees the situation through the lens of his or her expertise.

The president must ensure that their perspectives are integrated.  He must provide the oversight to ensure that they communicate frequently and resolve any conflicts that arise to create cogent, urgent solutions to get the economy going.

The president also needs the common sense perspective of people who spend their lives dealing with the issues of falling demand, global trade, inflation, deflation, and layoffs.  He needs a way to gather “ground-level intelligence” from the business side. He should create a small group of perhaps ten active business leaders to periodically meet with him.

This country has many smart, thoughtful people doing their best to keep their companies going.  Communicating with them frequently will help the president grasp the depth and scope of the shifting economic problems better—and sooner—than hundred-page documents and statistical reports.

This group can help generate new solutions and provide insights into the practicality of solutions being proposed. They can help anticipate the second- and third-order consequences of proposed actions. The leaders must, of course, be carefully chosen so they don’t promote their self-interest; there is no room for PR grandstanding.  I have no doubt that there is an ample supply of business leaders who would donate their time to help get the nation back on track.

The aim should be to find a simple solution to the core problem rather than a comprehensive solution to all the problems created by the domino effect. Solving the problem of toxic assets that have gummed up the flow of money, for example, will have many positive ripple effects.

Here is one possible solution: Announce a program that converts all subprime nonperforming loans as of a particular date (say, February 1) to performing loans by having the Treasury make the mortgage payments for the next five years. As the banks become profitable, they will pay 25 percent of their profits to reimburse the Treasury. External audit firms can provide a check on which loans qualify.

Stemming the tide of foreclosures will turn the psychology of most Americans, who are anxious about their jobs and homes, and open the clogged transactions of CDOs and other derivatives that are based on the original mortgage loans.  Thus multiple problems are resolved by targeting the right one.  My discussions with bankers indicate that this solution is do-able.

Choosing the right priorities is essential.  Addressing them with realism, tempered with optimism, will enhance President Obama’s credibility, and, more importantly, build our future.