Know Unknowns: Bank Balance Sheets & The Federal Reserve

Big Money Printing Press

I consider myself knowledgeable about many things financial: ETFs, stocks, bonds, options, the stock market, for example.  I know the difference between an income statement and a balance sheet, and can read financial statements and prospectuses as a matter of course.

I’ve had little luck deciphering bank balance sheets. Income statements yes, balance sheets no.  They tend to be very opaque, which is one obstacle.  Loans are assets while deposits (other than Federal Reserve deposits) are liabilities.  Accurately determining the quantity, quality, type, and duration of loans can be difficult if not impossible… at least to me.  Perhaps some of this info can be found in the bank’s 10K statements.  Also opaque are details of the bank’s interest rate swaps and other OTC financial contracts.

Historically, the old-style (commercial) bank followed the 3-6-3 rule:   Borrow at 3%, lend at 6%, be on the golf course at 3:00.   Such a bank would take in deposits and lend out with loans (mortgages, car loans, commercial loans).  However, banks could not lend out all the deposits; banks had to keep a fraction of the cash in reserve.  This reserve helps to avoid the “run on the bank” problem, where too many depositors ask for their money — all at the same time.

Keeping all of this spare cash at the bank (about 3-10% of assets) is cumbersome, and also encourages bank robberies.  Banks can transfer much of this physical cash to the Federal Reserve and sometimes even earn a tiny bit of interest (0% to 0.25%, “the Fed Funds Rate”) on it.  Thus the Federal Reserve serves as the bank’s bank.  The Federal Reserve System (or “The Fed”) also helps clear checks (remember those?) and move money between banks simply by moving reserve deposit balances between banks.  No need to shuttle hard currency to and fro.  Deposits are moved with a pencil, or computer transaction in the Fed’s books.

The Fed also lends out money to banks.  Banks can borrow from the Fed at 0.75% (the so-called discount rate).  This system leaves a 0.5% profit for the Fed on the difference between the Fed Funds rate and the discount rate.

Classically the Fed would try to guide the economy by moving the Fed Funds rate and discount rate.  If the Fed thought the economy was overheating (generating excessive inflation) the Fed would raise rates to “cool off the economy”.  The Fed tried to adjust the rates so as to give the economy a “soft landing”.    If the US economy got too sluggish, with high unemployment, the Fed lowered rates.  The interesting thing (no pun intended) about these rates is that they are all short-term rates.  So short-term that the Fed funds rate is sometimes called the overnight rate.

I keep saying “classically” and “historically”, is this is how things used to be done by the Fed.  What’s new, since Fed Chairman Bernanke, has been the manipulation of long-term rates with “quantitative easing” QE, and QE2.  Also new (with the cooperation of US Treasury Sec. Timothy Geithner, Congress, and President Obama) are measures such as the AIG bailout and TARP.

The Fed has shifted into uncharted territory, and in the process neglected one of its two prime mandates: price stability and low inflation.  It also seems to have overlooked the concept of real economic growth (GDP growth adjusted for inflation).  Instead the Fed seems to be fluttering in a course of wide-ranging, unprecedented, knee-jerk reactions.

Today’s Fed is not my father’s Fed, nor are today’s banks.  Today they are increasingly known unknowns.  This path is new and the ticket stub is unclear.  I don’t see a destination nor ETA, but when I look close, very close, I see a dim watermark.  Subtle, like grey on grey, I believe I see in faint yet bold letters INFLATION.

Financial Rant against Washington’s Out-of-Control Debt Machine

“We’re spending $3.7 trillion. We’re taking in $2.2 trillion,” Sen. Jeff Sessions said, “That’s a stunning number, and one of the reasons it’s so out of control is that we don’t have a budget.”

I couldn’t have said it better.  Washington’s overall budgetary condition has gone from ridiculous to shear lunacy.  Without a drastic course correction the loons steering the ship are going to take us and our economy down with them.  (Since most of them have platinum-plated pensions, they will NOT go down with the ship).

By some strange alchemy of mendacity, arrogance, and deliberate ignorance, the United States Government continues to follow the financial lead of Italy, Portugal, Greece, and Spain…. and I might add Japan.  For good examples of fiscal sanity we need only look at countries like Australia, Brazil, China, and South Africa.

US debt trends alarmingly up with no apparent end in sight.   Failure to acknowledge these facts is a failure of leadership.  The lengths the US Government is willing to go to continue this economic farce would likely be criminal if employed by corporations. (Ever heard of fiduciary responsibility?)  Rhetoric like “there’s no problem with Social Security or Medicare… they are solvent”.  Wasn’t the same being said about Freddie Mac and Fanny Mae a short few years ago?  I wish President Obama and the US Congress would read some of the best investing books.

Every good rant deserves to deliver some solutions.  And solutions, I’ve got in spades:

  • Cut Federal spending.  Start the debate at 2008 spending levels, and look for further cuts.  Phase out entire programs.  Freeze federal salaries until unemployment drops below 5%.
  • Acknowledge that Social Security for people currently under the age of 40 will be aggressively means-tested.  Folks under 40 (that includes me) don’t count on much unless you are in poverty during retirement.
  • There are only two kinds of infrastructure with real, lasting economic impact.  Interstate highways and the US power grid.  I’m not talking “Smart Grid”… leave that to local utilities.  I’m talking about new, improved, robust, high-voltage, DC power transmission across the United States.  If Canada and Mexico want to sell their power, let them participate (via treaty).
  • Let US oil and natural gas companies drill.  Charge a 10% profit surcharge on new domestic (and offshore) production if you must, but approve the permits and get out of the way.  [But raise the liability cap for disasters.]
  • Embrace the Canada-to-US oil pipeline.
  • Simplify the C-corp (corporate) tax structure by eliminating ALL “loopholes” and reducing the rate from 35% to 21%.  Exempt the first $250,000 from C-corp taxes, and charge 10% for earnings of $250,000 to $5 million to encourage small business investment.
  • Eliminate the self-employment tax on the first $50,000 of small business earnings.
  • Strike down and reverse most provisions of ObamaCare.
  • Rein in the EPA on faux “pollutants” like CO2 and modest levels of methane.  Instead focus on true pollutants like carcinogens, harmful particulates, and toxins.
  • Get out of the way.  The private sector is a dynamo on steroids and is ready to roll when the regulatory restrictions are lifted and relaxed.  Anti-trust and anti-monopoly rules still serve an important roll.  Workplace safety is important too, but measure results as much as adherence to OSHA procedures.

Believe me, I’m writing with kid gloves.  Tell me where you think I’m wrong.  Please add your suggestions.  I look forward to publishing both.

Millionaire by 40? Inflation says Big Deal!

40 years old is still several years off for me, but I it is very likely I will be a millionaire by the time I reach 40.  In fact, if you count my contributions to Social Security (including my employer’s half), the current value invested in my personal “Social Security Trust Fund” puts me there already.  But I’m certainly not counting on Social Security.

So, I’ll be rich right?  Wrong!   First there’s inflation.   Many economists say US inflation has been about 4% per year over the last century.  There’s a handy rule of 72 that says, for example, 72/4 = 18.  That means 4% inflation means that a million dollars today is only worth $500,000 in 18 years and $250,000 in 36 years.

Second, there’s taxes.  Over $300,000 of my holdings are in tax-deferred accounts such as 401k accounts and IRA accounts.  Sure this money is part of my net worth, but when it comes out at retirement I’ll likely be paying something like 30% tax on it.  That’s about $90,000 to Uncle Sam.  Poof!  Gone!

Back to inflation.  Inflation works like a stealth tax.  According to government CPI figures, US inflation increased just 1.5% in 2010.  That simply doesn’t jive with my experience.  My HOA fees increased 7%, my electric and water bill increased 8%.  Car insurance, home insurance, satellite TV, health-insurance premiums, internet, rooms at my favorite hotel, and meals at my favorite restaurant went up, by 4-10% last year.  Even the local sales tax increased almost 1%, making everything that much more expensive on top of everything else.  In Balhiser World 2010 inflation was about 4-5%, rather than the 1.5% according to the CPI.   Thus I have some new ideas about what CPI stands for…

  • Cagey Price Index  (Price? What price?  Prices are relative.)
  • Calming Price Index  (Nothing to see here. Relax. Inflation is under control.)
  • Clairvoyant Price Index  (Far away someone is substituting chuck steak for Filet Mignon.  Meat is meat.  And prices are low.)
  • Creative Price Index (2+2=3 for sufficiently small values of 2)
  • Cowardly Price Index (Please don’t be mad, prices aren’t that bad… see?)

Of course CPI officially stands for Consumer Price Index.  Let just say that for the next 72 years the official CPI is 4%, but actually inflation is 5%.  That handy rule of 72 says that at 4%, one million dollars today will be worth $62,500 of buying power.  At 5% buying power is cut in half to $31, 250.  Of a long enough time a 1 percent difference in inflation is a big deal.

So what?  Well, the CPI is used for a lot of things such as government cost of living adjustments, tax bracket adjustments, Social Security benefit increases, and money paid on Treasury Inflation-Protected Securities, to name a few.

It’s bed time so I’ll cut to the chase.

  1. One million dollars is not what it used to be, and is certain to be worth much less in the future.
  2. To try to remain solvent (and avoid unpopular austerity measures) the US Government has a powerful incentive to under-report inflation.
  3. Many investors and economists are beginning to believe that the CPI significantly under-reports inflation. Examples: “CPI Controversy”“Bill Gross says so”, “Forbes, pastries, and gold say so too”.

IMF Chief’s Arrest

In brief, I say about Dominique Strauss-Kahn’s arrest, innocent until proven guilty. The markets are under no such obligation of assumption. Speculation and rumor are as viable as fact in bond markets, stock markets, commodities markets, options markets… you name it.

The impact of Kahn’s situation has short-term ramifications on the European debt crisis as most loudly exemplified by the Greek debt crisis. Strauss-Kahn’s personal crisis could slow or alter IMF/World Bank actions.

I am not surprised, but I am disturbed by the general media reaction to the allegations against Kahn.  “Innocent until proven guilty” should trump “presumed guilty upon allegation”.  Recent examples of the Duke Lacrosse Team and Kobe Bryant loom large as examples of premature media reaction.  I hope that cooler heads will prevail; that the facts will come out… either way (possibly somewhere in between)…  in the slow, laborious, and languid way that the law dictates.  Until then I assume innocence.

US Debt Ceiling… Sky’s the Limit?

The current debt ceiling is set at $14.294 trillion, and according to CNN Money we are days away from reaching it.  Treasury Secretary Tim Geithner estimates he and his team can keep the US out of default until early August.

I appreciate the increased attention on the US nation debt.  My concern is the the US is beginning to flirt with danger:  increasing risk of a debt crisis.   US debt is a fair ways removed from the debt crises of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain).  However, the current trend of debt as a percentage of GDP is ominous.

A US debt crisis would look a bit different from that of the PIIGS because the US is not bound to a multi-country currency like the Euro.  Devaluation of the USD is likely to be a component of (or reaction to) a US debt crisis.  So are austerity and tax increases.

The danger is that buyers of US debt will demand higher and higher interests rates to compensate them for taking on three key risks,  inflation, devaluation, and default.   As debt increases so do these risks.  As the US refinances debt for expiring Treasurys it does do at greater and greater costs.  As the government raises taxes to combat debt (and pay higher borrowing costs) the US economy is increasingly depressed and tax raises do not result in nearly as much federal revenue as hoped.  Eventually only austerity and devaluation (via the printing press and increases in money supply).

The way I see it, playing brinksmanship now with the debt ceiling in an effort to but the brakes on the US deficit is a reasonable risk.  The current trajectory of the US debt is unsustainable and reckless.  With US debt 90% of GDP and closing in fast on 100%, we are in jeopardy.  This number puts the US next to the troubled Ireland and not far from Italy as shown in this table.

It is time for Congress to get its fiscal act together.  Time is rather short.  I hope we can start making some sort of progress.

Primary Election Day

Tomorrow is primary election day in Colorado.  The turnout is very high, and I am happy to see that.

There are 3 finance-related issues on my mind this election cycle:

  1. Fiscal discipline.
  2. Treasurer races.  How does Colorado invest for pensions?
  3. Taxes.  How does Colorado structure its tax code?  Especially sales taxes and the internet.

These are the financial investment issues on my mind.   What are yours?

Can we afford national health bureaucracy?

Today the House is voting on the next round of health legislation.   Today I pose a simple question.  Can we afford it?

My belief is that it will be very expensive.  It won’t quite break the bank, but it will result in significantly increased taxes.   This in turn will be another weight dragging on the US economy.  And it will be politically impossible to unload this new burden.

Today, I fear, may be the next step in ensnaring the US economic colossus.  As one person amongst millions who benefits from a powerful but sagging US economy, I am sad to see such a rapid and untested scheme.

Why not a slower more thoughtful path that tests a variety of approaches in a variety of states?

I sigh thinking it is likely too late, perhaps, for such questions.   Pragmatism is a sad casualty of expediency.

So it is with a sad heart that I predict another severe wound will be inflicted on our economy.  Nonetheless I cling onto a faint, faint hope.  I will be watching and hoping as the vote presses on tonight.   Good luck America.

Feeling Stimulated Yet?

Its been roughly a 9 months since the $787+  Billion emergency stimulus bill was enacted.  With unemployment hitting 9.8%, I’m not feeling very stimulated.  When it was enacted unemployment was closer to 7.6%.  I feel vindicated that I was right in my opposition, but disappointed that that is the best Obama and Congress could come up with.