Monday, September 17, 2012 - Maybe We Need to Eliminate the Middlemen

Maybe We Need to Eliminate the Middlemen

-by Sinclair Noe

DOW – 40 = 13,553
SPX – 4 = 1461
NAS – 5 = 3178
10 YR YLD -.03 = 1.84%
OIL -.04 = 96.58
GOLD  - 8.00 = 1763.50
SILV - .43 = 34.35
PLAT – 42.00 = 1673.00

After the enthusiasm last week for QE3 to infinity and beyond, the markets paused today. It is easy for Wall Street traders to get jacked up like little kiddies on a sugar buzz at the prospect of the Federal Reserve passing out Free Money. Then there is the consolidation phase, where we ask: What Have we done? Where is this leading?

From the New York Times:

“The Federal Reserve’s experimental effort to spur a recovery by purchasing vast quantities of federal debt has pumped up the stock market, reduced the cost of American exports and allowed companies to borrow money at lower interest rates.

“But most Americans are not feeling the difference, in part because those benefits have been surprisingly small. The latest estimates from economists, in fact, suggest that the pace of recovery from the global financial crisis has flagged since November, when the Fed started buying $600 billion in Treasury securities to push private dollars into investments that create jobs….

“A study published in February found that interest rates decreased, but only for companies with top credit ratings, “Rates that are highly relevant for households and many corporations — mortgage rates and rates on lower-grade corporate bonds — were largely unaffected by the policy.””

The first round of QE was actually much larger than the just announced versionand by some estimates QE1 only lowered long bond yield by only 17 basis points. The Fed used to buy bonds as a matter of course and they didn't call it QE anything. And even when they supposedly ended QE1 and QE2, they were still buying. Further, the idea of a fixed dollar amount of purchases was bizarre. There was no way of knowing what if anything it would accomplish. Did the purchase of X number of bonds make a difference in rates or the economy? Don't know, don't care; they reached their number and that was that. It would have made more sense for the central bank to set a rate target (say for whatever longer-dated maturity it chose to target) and buy whatever it took to keep that level.

Now, the Fed has a plan to use QE until unemployment gets better. So, now we should learn if monetary policy is an effective tool for creating jobs. I’m guessing not.

The problem is the banks have stepped in as middlemen between the Fed and the Main Street economy.

The federal funds effective rate, which is the short-term rate that banks use to lend to each other, is at 0.14%. That is down from 3.62% in September 2005. So the banks are enjoying the benefit of low interest rates when they borrow.  Interest rates in general are down on savings vehicles such as CD’s, or even a 10-year Treasury note yields less than 2%, down from 4.2% in 2005. Yet, the interest paid on a credit card loan has hardly budged. The Federal Reserve’s own data shows the average credit card interest rate is 12.06% compared to 12.45% in 2005. Who makes the difference? The middlemen bankers. Of course, you might consider credit card lending to be risky. What about nearly risk free loans?

The federal government guarantees the cost of defaults in nearly every mortgage made today. The banks have almost no risk at all. Banks make mortgages to borrowers and then take those loans and attach the government guarantee of repayment of those mortgages , and then the banks package the mortgage loans into bonds, which they sell to investors.  The Fed has been a big buyer of mortgage backed securities and that has pushed yields down to 2.2%, which pushes the prices of those mortgage backed securities higher and higher, but the cost of mortgages to borrowers has not dropped correspondingly.

No one should be surprised that mortgage rates are very low and refinancing is attractive (few bank executives should be surprised by QE3, plus they’ve all been banging on the table for it for the last few months).  Yet, for some reason, banks say they don’t have the staffing to originate loans faster, as if they were somehow unprepared for this environment. It’s preposterous.

The only explanation: lenders don’t want to originate any faster. Nonetheless, QE3 to infinity and beyond will be a huge opportunity for bankers to make a lot more trading. The Fed basically confirmed low rates and continuous MBS purchases through 2015; call it the Bernanke Put, and that provides a lot of opportunity to make money. Lending, however, is an afterthought.

Now, the Federal Reserve also has broad regulatory powers and they have a bully pulpit. The Fed could force the banks to lend to Main Street, but we haven’t heard a word about that. Maybe the Fed thinks it is more important for the bakers to make big profits than for John Q. public to get a job; it is clearly more important for the banks to strengthen their balance sheets even though they are more likely to pass out executive bonuses than build equity levels.

There have been some who argue that the Fed’s policy has been good at rebuilding the economy and they cite the profitability of corporate America, but let’s look at that accomplishment. After reducing spending and eliminating jobs during the recession, American companies reaped huge gains by keeping expenses down and putting off aggressively hiring new workers as growth slowly returned. Strong profits have also propelled the stock market higher.  On Friday, the S&P 500 Index hit its highest levels in 5 years. Like I said, Wall Street loves it when the Fed passes out Free Money, but ultimately we have to look at fundamentals. A lot of the profit gain you had in the last few years was a bounce from the recession and a result of very aggressive cost-cutting, and there are limits to cost cutting. The expected decline in profits has yet to set off big layoffs. But it is another factor that is inhibiting hiring and keeping unemployment above the politically important level of 8 percent.

On Friday, the Federal Reserve announced its boldest effort yet to kick-start growth and confront persistently high unemployment. The next day, the government reported that industrial production in August fell 1.2 percent, the biggest monthly contraction since March 2009. Many business executives are now expressing concern over just how much impact the Fed’s actions will have. The slowdown overseas is beginning to cut into profits at both large and small companies, many of which had benefited in the last few years from heightened demand abroad even as growth in the United States slowed.

Just over half of managers at North American companies now expect production levels to increase in the next 12 months, down from 64 percent in the second quarter, according to a survey by CEB, a member-based advisory firm. In the same survey, the percentage of executives who expect to hire more workers fell to 34 percent from 41 percent last quarter. The problem is that there is no natural big growth that would require hiring. If there were willing buyers, companies would hire workers to meet the demand.

Earnings for the typical company in the S&P 500 are now expected to decline 2.2 percent in the third quarter from the same period a year ago, the first such drop since the third quarter of 2009. Earnings are expected slide 3 percent from the second quarter of 2012. What is more, 88 companies have already said that results will come in below expectations; 21 that have signaled a positive outlook. That’s much more pessimistic than normal.

All is not doom and gloom. In addition to the stock market rally this month, corporate earnings are still expected to finish 2012 up 6.1 percent from 2011, largely because gains in the first half of the year will offset any decline in the third quarter. And earnings results in the fourth quarter could benefit from a slowdown late last year, making make year-over-year comparisons look better. However, if corporate profits enter a sustained decline, big companies are likely to face increased pressure to cut jobs, since there is much less room left to cut costs elsewhere. After rising steadily in the wake of the recession, profit margins for S&P 500 companies peaked at 8.9 percent in late 2011. Margins are expected to fall to 8.7 percent in 2012. Margins are eroding at some companies as revenue dips. While profit margins have plateaued in corporate America, productivity gains in the overall economy have ebbed as well. After rising at an annual rate of 2.9 percent in 2009, and a 3.1 percent pace in 2010, productivity inched up 0.7 percent in 2011. There’s only so much you can cut.

Occupy Wall Street celebrated its one year birthday. Yes, it's still a mere infant. The crowds started gathering near Zuccotti Park this morning and they grew throughout the day but they weren't pulling in the really big numbers like they did a year ago. Still, there were more than 100 arrests because free speech has apparently gone the way of super-sized sodas in the Big Apple. I think it is safe to say the Occupy movement has been somewhat effective. We've seen increased awareness of the problems of inequality. We now realize that the overwhelming majority of us are indeed part of the 99 percent; we have seen the effects of sluggish wage growth; we've seen net worth take a hit. At some point, the issues raised by the Occupy movement will need to be addressed by the political and media mainstream.

It seems the story of the day is how the Occupy Movement has been an abysmal failure. That's how it goes for populist movements; the powers that be try to ignore them, they denigrate them, they laugh at them, they try to act like everything is okay; if that fails, they try to buy them off, but this group of Occupiers doesn’t seem to be willing to sell, and so the reality is that populism scares the beejeebers out of the elite. I was recently reminded of other populist movements in our history. In the 1890's a Populist Party sprang up to express the hostility to banks, railroads, and other elites. William Jennings Bryant tried to challenge the gold cartel. L. Frank Baum created a children's book, “The Wizard of Oz”, which was really an allegory for the times. The Yellow brick road was actually a reference to gold. Dorothy wore silver slippers, the ruby slippers were just for the movie. Think of the Scarecrow as representing farmers, the Tin Man was a stand in for the industrial workers. The Wicked Witch of the West represented the Railroad Barons. The Wicked Witch of the East represented the banksters. Oz? Think of the abbreviation for an ounce of gold. And part of the message is that the elites are not as powerful as they would pretend. Who would have thought we would learn so little from our history? Who could imagine that a simple children's book would be so enduring? Inspiration comes from unexpected sources. Significance can be difficult to identify in the moment.