Issue 64- August 18, 2010


A Tricky Diagnosis

The old adage “1⁄2 full or 1⁄2 empty” certainly seems an appropriate way to sum up the market action in 2010. Strong first quarter results were more than offset by a weak second quarter, only to see another rebound in the third quarter to date. It all depends if you are pouring or drinking as they say. All kidding aside, this axiom does a fair job of encapsulating the current state of economic affairs. Where exactly are we?

We noted earlier this year the unusually confusing nature of this episode. People have argued incessantly as to when the recession actually began and when it actually ended – if - as the NBER (the national bureau of economic research) has wondered, it ever really ended at all. We have endured months of articles on the perils of the inflationary implications of quantitative easing only to find ourselves now being bombarded by odds makers on the chances of deflation taking hold. Most importantly, there remains confusion on the most important metric of all: the cause.

If this recession were simply a deeper than average, garden variety, inventory induced slowdown, then the variety of stimulus programs should have yielded substantially more results. But they have not. Perhaps, we now can say with more conviction that this recession was the result of the massive, deflationary shock resulting from the collapse of the credit complex in the fall of 2008. Cheap credit fire hosed towards a responsible, deleveraging economy is an old fashioned case of “Coals to Newcastle”. Symptoms can look similar, but understanding and accepting the correct diagnosis is the critical step to implementing the appropriate policy decisions and the corresponding investment allocations. However, even perfect knowledge of the true causes will not make treating the problem any less painless or protracted.

Traditional Treatment

We have now had a zero Federal Funds rate since December of 2008. Consensus thinking stated that this in combination with major increases in the money supply and government sponsored programs would be the overwhelming force required to stem the downturn and jumpstart the domestic economy. Post World War II history would suggest that it was well more than enough. However, circumstances have intervened. The credit collapse set off a cascade of falling dominoes and after 6 plus decades of credit expansion, the entire system went into reverse.

In September of 2008, credit briefly came to a stop. Liquidity collapsed. The Federal Reserve, Treasury, and Congress responded will a multitude of highly successful programs which restored many of the basic lending functions such as commercial paper and the money market fund complex. However, there remain problems that could not be quickly fixed.

Credit contracted for consumers primarily in the form of home mortgages. Momentum swung rapidly from buyers to sellers. Inventory flooded the market and prices plunged. Low rate mortgages would typically be an appropriate counter to housing weakness, but by the fall of 2008, everyone who was going to buy a home already had one (if not more). Thus began the long and painful process of moving the excess housing inventory from the weak hands of speculators and poorly qualified buyers to the strong hands of those with traditional qualifications and occupancy interests. This has predictably put consistent downward pressure on prices and depending on the survey; we now have over 1/3 of homeowners underwater on their homes. Without sufficient home equity, low rates are simply of passing interest. Homeowners who are current on their loans but who are without additional financial resources can neither opportunistically refinance nor easily sell to move on. Government programs to date have focused on either first time buyers pulling demand forward or on loan modifications which have focused on those who are no longer able to make their payments.

Banks have reluctantly become the hub of the housing catharsis. Rather than their traditional role as a provider of credit, they now own too much of the market. Their REO (real estate owned) portfolios have swelled just as the coincident melt down in commercial real estate has expanded that part of their balance sheet. Any remaining available credit for small business has completely evaporated. Real estate tipped over the next domino in line – small business credit. The last data point we had on the number of banks on the FDIC’s trouble list was 775, but they have since shuttered another 30+, so lets call it 740. That still leaves several years worth of work to repair the banking system.

Let us again be clear about where small businesses borrow for start up and working capital. They borrow from their home equity and personal lines of credit – now gone or substantially reduced or they borrow from their local banks – now chewing their way through their real estate portfolios.

The prophetic words of Meredith Whitney at year end now ring ever more true.

“Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting. Access to credit is being denied at an accelerating pace. Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan…."

Housing, which has been an engine of growth and a source of capital in the post war period, will remain in intensive care until such time as the inventory overhang is worked off and the troubled bank list is whittled down.
This impact of the housing weakness leading to the small business credit contraction has been a major contributor to unemployment. As it has been said repeatedly, small business has been responsible for some 60+% of job growth in the modern era. Chairman Ben Bernanke of the Federal Reserve said in 7/13/2010:

"Making credit accessible to sound small businesses is crucial to our economic recovery, and so should be front and center among our current policy challenges,"

Traditional treatments will proceed, but it could be some time before the negative feedback cycle running through housing and small business can be reversed.

Bad Medicine

While much of the current economic malaise is a function of unwinding decades of compounded leverage, we are doing ourselves no great favors by manufacturing additional uncertainty and headwinds. These come in the form of uncertain tax and regulatory policies. Not every small business is in trouble or has been denied access to credit. Far from it.

Healthy, small businesses when asked publicly will politely cite a lack of demand for their unwillingness to expand or borrow. Businesses of all sizes have seen a renaissance in their productivity that will not be reversed even as the economy ultimately picks up and this, no doubt has negatively impacted the employment picture in the short term. However, the uncertainty surrounding regulatory policies and looming tax hikes when combined with sluggish demand is simply too much to overcome. The NFIB’s (national federation of independent business) Chief Economist, William Dunkelberg, said

"The U.S. economy faces hurricane force headwinds and the government is at the center of the storm, making an economic recovery very difficult."

Consumer demand is a function of employment and growing employment is a function of growing demand. They are hand and glove. Ever increasing amounts of leverage had perhaps for some time masked genuine levels of demand. If we are to grow real demand in this brave new world of decreasing leverage, policy makers are going to have to go out of their way to establish an environment that nurtures certainty.

New Age Medicine - Pegging Rates

In April of 1942 after the US entered World War II, The Federal Reserve committed itself to maintaining a rate of 0.375% on Treasury Bills and 2.50% for longer term debt. This policy remained in effect until March of 1951 when the Federal Reserve was freed to run policy once again.

Fast forward to 2002, then Fed Governor Ben Bernanke made a speech on November 21st:

“Sustained deflation can be highly destructive to a modern economy and should be strongly resisted…For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well

Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.”

From Gluskin Sheff - 8/12/10

This is a profound statement and the implications; both positive and negative are enormous.

First, consider that as recently as April, the US Treasury 10 year note was sneaking up on 4% and the prevailing wisdom was that the next stop would be 5%. Last week we saw the Federal Reserve trim its forecasts for US Growth for the second time in just 6 weeks. The landscape is changing before our eyes and this chairman who went to school on the dos and don’ts of fiscal policy in the 1930s will not be shy in his use of non traditional approaches.

What can lower long term rates accomplish that lower short term rates could not? We have already noted that in a deleveraging economy, lower rates are not the powerful antidote that they had historically been. We have also noted that lower rates will not translate immediately into increased equity to help those underwater homeowners. It will not magically heal 700+ impaired banks and it will not immediately hand credit back into the hands of small businesses. However, we are not dealing with a short term problem. We are dealing with the aftermath of decades of credit overexpansion. If we can begin to get our heads around the time that it will take to work our way through this deleveraging process, then we can use that perspective to address and solve the most intransigent issues over that longer horizon. Predictable, ultra low, long term rates could potentially help to rebuild equity in a number of markets and stem the negative feedback cycle that appears to be picking up steam.


Not every homeowner is underwater. If there were a generic 4% mortgage available, we would see a tsunami wave of refinancing take place. This would address a couple of pressing needs in the economy. It would put real, after tax money back into the hands of responsible consumers and it would allow for these same homeowners to rebuild equity far faster. Consider an example – a homeowner who borrowed $500,000 at 6% on a traditional 30 year mortgage in 2007. Their monthly payment was $2997/month. In the three years since that loan was taken out – they have paid down just $20,000. If this borrower had sufficient home equity to refinance at say 4%, they could enjoy a lower monthly payment or they could keep the same monthly payment and have this loan paid off in 19 years. Importantly in this second approach, they would begin to build their equity much, much faster. In three more years they would have paid down an additional $54,000. US consumers do not need more leverage – they desperately need more equity. Equity in their homes will provide flexibility to trade up or down or to move for a better opportunity.

Fixed long rates could also provide a catalyst to the moribund jumbo mortgage market. Those loans in excess of $417k currently have no deep secondary market as compared to those “conforming” loans under this limit. If a significant number of loans could be issued with uniform terms and documentation for this segment of the market, liquidity would return. As of now – jumbos are being done in “one off” fashion and typically the underwriter will need to retain this loan thus making it more expensive than an off the shelf type of offering.

It is also interesting to consider just how many mortgages would be potentially refinance-able at say 4%. Setting aside the reality of how many homeowners are underwater, it is probably fair to say that virtually every fixed rate borrower would benefit. That has some potentially very positive implications for the teetering behemoths; Freddie Mac and Fannie Mae. There are also a number of interesting ideas in the very early stages being kicked around as to how to apply an ultra low rate approach to those responsible borrowers who find themselves underwater. Bill Gross and others will be speaking on the merits of such a plan over the coming months.

The Banks

We have commented before that the steep yield curve has allowed banks to earn their way back into health by paying virtually nothing for deposits and then reinvesting those funds into US Treasuries for a profit that requires little in the way of capital requirements. A flatter yield curve, however would force the healthy banks to get back into the old fashioned lending business. This is not an unwelcome prospect.


A flatter curve would disproportionately hurt those banks which have not yet fully healed. But the steep yield curve solution is typically medicine best applied to large and midsized institutions rather than small, local lenders. It was never intended to be a long term business strategy replacement for traditional lending practices. One unintended consequence of this remedy has been to see the banking system become highly concentrated within the 4 largest firms (Bank of America, JP Morgan, Citibank, & Wells Fargo) which now possess total assets greater than the next 46 combined! This in itself may not pose any particular problems as evidenced by the Canadian banking system which is highly concentrated yet had no particular trouble with this latest banking episode.

Pension Plans

One potential serious loser would be the pension plan complex whose liabilities are theoretically discounted by prevailing interest rates. Ultra low long term rates could balloon their liabilities to apocalyptic proportions. For those underfunded plans that have been using rates of 8% or more to mask their truly impaired nature, persistently low long term rates would be an unwelcome development and would force a serious restructuring dilemma.

Bull Flattening

For some time now, we have argued the merits and positioned our portfolios for the possibility of low rates for an extended period. You could say we took the Federal Reserve at their word. Weakness in housing and employment were the symptoms not the cause of the recession. Credit will continue to contract for many years. Household debt has fallen from its high of 131% of income now down to 122%, but that is a far cry from the historical norm of 70%. Rather than debate the timeline, it is safe to say and prudent to invest with the firm belief that we are still closer to the beginning than the end of this process.

The better understanding of the root causes of our current economic situation that has come with the passage of time should provide for better treatments and a more realistic set of expectations for its outcome both ultimately and intermittently. Long term rates may continue to fall with or without the assistance of the Federal Reserve. Baby Boomers have long been underweighted fixed income and many endowments and foundations have found themselves in a similar situation. The Bank Credit Analyst argued back in 2009 that much of the growing US deficit could be self financed by these underweighted constituents. Long term interest rates have seen a spectacular rally since early April. However, if the Federal Reserve perceives further substantial weakening in the coming months, no one should be surprised to see these rates come down further. This type of action in the US Treasury curve is known classically as a “Bull Flattening” move reflecting the gains that will be made by those who own long bonds. More than just a trading strategy, a Bull Flattening might be one of the best modern day prescriptions for combating long term deflationary forces.

Best Wishes,

Patsy and Jen


In this Edition

  • A Tricky Diagnosis
  • Traditional Treatment
  • Bad Medicine
  • New Age Medicine -Pegging Rates
  • Homeowners
  • The Banks
  • Pension Plans
  • Bull Flattening

Huntington Steele

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Seattle, WA 98104



Past Issues

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward

58 - 12.29.09
2009-The Year in Review/ 2010 - The Year of "The Exit"/ Deflation or Inflation?/ 4 Cylinder Economy/ Rates and Returns

57 - 11.04.09
Banks-Back to the Future/ Navigating the Tsunami/ TARP 3.0/ Implications

56 - 09.15.09
Are We There Yet?/ The Beginning? The Present/ The Journey is the Destination

55 - 08.04.09
A Transformation is not a Recovery/Not All Economic Data is Created Equal/
Smallest, Lowest, "Shortest"

54 - 06.24.09
Aftershocks/ Fragility/
Inflation and the Fed

53 - 05.29.09
A Brave New Road to Recovery/ Vehicle Choice/ Speed Limits

52 - 04.07.09
The Things We Know/The Things We Don't Know/Savings and Sensibility

51 - 03.25.09
The Correct Problem/ The Need for Speed/ No Good Deed Goes Unpunished

50 - 03.05.09
Rebuilding Credit/ Under Repair/Problems Persist/Big Chore

49 - 01.12.09
The Year in Review/ The Path Forward/ 2009

48 - 12.15.08
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47 - 12.05.08
Unwinding/ The Past/ The Present/ The Future.

46 - 10.07.08
History/ Changing Hands/ Dominos/ The Road Block.

45 - 07.02.08
Black Gold/ The Federal Reserve, The Banks, & The Earnings/ Moving Forward/ The Recovery

44 - 06.03.08
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43 - 04.09.08
Q1 2008/ The Call/ The Response/
Investing Opportunities

42 - 02.27.08
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Risk vs Reward

41 - 01.02.08
2007-Year in Review
2008 - Outlook



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Market Highlights



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