FDIC Problems
Today, Bloomberg is reporting that the FDIC Proposes Banks Prepay Fees Through 2012, Raise $45 Billion
Sept. 29 (Bloomberg) -- The Federal Deposit Insurance Corp., seeking to replenish deposit reserves as banks fail at the fastest pace in 17 years, today voted unanimously to have lenders prepay fees through 2012, raising about $45 billion.
Lenders would prepay FDIC premiums for the fourth quarter and next three years on Dec. 30, to replenish the deposit insurance funds that staff estimated will have a negative balance at the end of this quarter, the agency said.
One just has to ask, what happens in 2010, 2011, and 2012 when the FDIC needs money, but banks have already pre-paid through these years? What will the FDIC do then? Charge banks fees through 2020?
I, for one, don't think that the worst is yet behind us. Even if it is, I am expecting that the deleveraging process may last a decade or more, just as it has in Japan. Unemployment will remain high as we go through a "jobless recovery," and spending (and thus company earnings) will remain lower than the during the peak that we reached in late 2007. This will not be good for banks (at least banks that took on too much risk…which seems to be most of them), and it will no doubt lead to more bank failures.
But Will They Need More?
Even if this does happen, and the FDIC gets their $45 billion, is that enough? From the following table on the FDIC's website, we can see that as of 6/30/2009, all FDIC-insured institutions in the States have about 13.3 Trillion in assets, about 11.8 Trillion in liabilities, and just over 9 Trillion in deposits.
Looking at these numbers, it is easy to see that the FDIC is walking on eggshells. 45 Billion won't even cover 1 percent of the insured assets, and that doesn't leave much wiggle room. Credit default risk has soared during this crisis, though recently the bond markets are making it seem as if risk has receded. I do not think that risk has receded, and I am expecting corporate bond rates to rise again as the economy takes another dip. If the credit risk does rise again, it is not even remotely hard to imagine the FDIC being on the hook for much more than $45 billion.
Do We Need the FDIC?
This may lead some to pose the question "Do we really need the FDIC?" Of course my answer to this question is "absolutely not." The FDIC is one of the facilitators of the current mess we are in. FDIC insurance gives depositors confidence in all banks equally (as long as they are FDIC insured, of course). But in reality, some banks are more stable than others--some banks make wiser investments than others. All of these things would normally be taken into account when a depositor decides which bank his or her money should reside in.
If a depositor picks a bad bank, they run the risk of losing their money. This puts a lot of responsibility on the banks to prove that they are worthy of people's deposits, and it also puts responsibility on the depositor to research banks, and know what banks are really up to. Neither of these is a bad thing. It would lead to a depositor base that is more educated about what is going on at banks, and it would also mean that banks taking lots of obvious risk would not get as much capital to play with (assuming people are paying attention).
Essentially, under the current FDIC system, a bank taking ridiculous risks with depositors money will get just as many depositors (if not more), than a bank that is being careful and diligent with depositor's money--they may even offer higher interest rates on deposits to entice people, which brings about more risk to the bank! This amounts to taxpayer subsidization of deposits at these risky institutions because eventually the ball has to drop; it always does. When this happens, taxpayers, as well as other banks who may have done nothing wrong, help foot the bill.
The FDIC is trying to raise money as they go, flying by the seat of their pants. I suspect they are aware of the very high likelihood that they will need to raise even more money again. In fact, this is not the first time during this crisis that they've had to find ways to get more money from taxpayers and banks. I hope those in congress will start spending time figuring out how to slowly get rid of the FDIC rather than contemplating how to sell off our future to fund them now.
Fed to Slow Mortgage Purchases
The Federal Reserve today announced that they would slow their purchases of mortgages gradually over time. When the announcement was made, the market proceeded to fall for the remainder of the trading day, as can be seen below:
As most of you know, the stock markets, and the corporate bond markets as well, have been soaring for the past several months. During this time, the Fed has been buying about 80% of the entire U.S. mortgage-backed securities market (around $850 billion worth!). What happens when the Fed's purchasing of these securities slows? The Wall Street Journal has an article looking at just that question: When the Fed's Buying Ends
What happens after that program expires? The Fed has tentatively extended it by three months, to the end of March 2010.
Mortgage rates will likely move up, as private-market buyers will charge more than the Fed for bearing the risks of holding government-backed mortgage securities. As the Fed pulls back, Credit Suisse expects mortgage securities will yield about 1.15 percentage points more than 10-year Treasurys, compared with 0.9 percentage point now. Granted, that isn't a big increase, but there is huge uncertainty given how much of the market is dominated by the Fed. Any sustained upward move in mortgage yields could delay a housing recovery, given its shaky state.
Meanwhile, the Fed hasn't been buying corporate bonds, but its purchases of mortgages and Treasurys likely helped a blistering recovery in that market. Private investors were more likely to buy corporate debt than mortgages and Treasurys once Fed buying had made yields on those unattractively low. On a net basis, U.S. investment-grade companies will issue an estimated $820 billion of bonds this year, almost as much as in the previous three years combined, according to Barclays Capital.
A risk is that investors will be less attracted to corporate debt if mortgage yields go up as the Fed pulls back. Of course, the Fed could simply extend its asset purchases if private investors get the jitters again -- something it hinted at Wednesday, saying it will "evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets."
That is, if markets play along. Investors are already balking at the heavy use of printing presses. Just look at the sliding dollar.
As this article points out, investors may start to see more risk (I believe the risk has always been there, people may just start to see/realize it now) in the corporate bond market once the Fed is not pushing so much money into the mortgage-backed-securities market. I mentioned in my recent article, Market Sentiment Peaking?, that I would be watching the corporate bond market as a potential indicator that the market might turn around.
I will be keeping my eyes on the corporate bond markets to see when financing may start getting more difficult, and this may be a key sign of when the markets may have a turn towards the downside.
Corporate bonds generally rose today, but as the Fed begins to exit the markets, we may see more risk priced into corporate debt, which is something I will be watching for.
Disrupting the Housing Market
Bloomberg also reported today on the Fed's announcement in Fed Slows Mortgage Purchases, Sees Stronger Economy.
Sept. 23 (Bloomberg) -- The Federal Reserve will slow its purchases of mortgage securities, seeking to avoid disrupting the housing market as an economic recovery takes hold.
If the Fed is seeking to "avoid disrupting the housing market," then one might ask why were they so heavily involved in the housing market for this entire year? How is being 80% of the mortgage market not disruptive to the housing market? Does this even make any sense?
The central bank’s purchases and the Obama administration’s homebuyers’ tax credit helped stabilize housing and push the Standard and Poor’s Supercomposite Homebuilding Index up more than 30 percent this year.
Fed officials signaled a stronger commitment to support housing markets, saying they would buy “a total of” $1.25 trillion in mortgage-backed securities. Last month, they said they could buy “up to” that total.
This all seems "disruptive" to the housing market to me. Without these actions, mortgage rates would likely be higher (as the Wall Street Journal article mentions will probably be a result of the Fed's exit from the market), corporate bonds would likely have higher yields, and the U.S. Government would have less debt and less of a deficit.
All of these things would be good things. Mortgage rates need to be higher because the risk of default is higher. Default rates are soaring, and mortgage risk has definitely increased, why should rates go down in that environment? Corporate default risk is very high as well, and premiums for these corporations to borrow money should reflect that.
Of course, these things will come anyway. Mortgage rates will go higher, and I believe corporate bonds will also fall lower than their current levels. What the Fed is doing is delaying these inevitables, and this is a disruption of the market. There is no other way to look at it. As much as the Fed talks about avoiding "disruption," the very nature of everything they do is, in fact, disruption.
Sentiment
The Fed announcement today may have begun wearing away at the recent euphoria surrounding the markets, and articles such as the Wall Street Journal one above may help people realize what is going on. When sentiment does change, I think a significant pullback in corporate bonds as well as the stock market will be likely. This may cause another flight to safety, which could cause Treasuries to rise as well. It will be interesting to see how it plays out, but in the mean time let's see how long we can keep the party going.
Market Sentiment Peaking?
I'm not trying to call a top here, and I'll be the first to admit that this current market rally has lasted much longer than I thought it would. That being said, I see more and more signs every day that market sentiment may be getting closer and closer to peaking. Today, Bloomberg reports Stocks Likely to ‘Catch Up’ With Corporate Bonds: Chart of Day.
Sept. 22 (Bloomberg) -- Stocks offer greater value than bonds and are poised to “catch up” with a rally in corporate debt, according to Rod Smyth, chief investment strategist at Riverfront Investment Group LLC.
The CHART OF THE DAY shows that the difference in yield between corporates and 10-year Treasury notes has narrowed more quickly than the Standard & Poor’s 500 Index has risen since March. The yield comparison is based on a Moody’s Investors Service index of Baa-rated debt. Smyth and colleagues Bill Ryder and Ken Liu had a similar chart in a report yesterday.
Since December, the yield gap has fallen to 2.9 percentage points from a peak of 6.2 points, according to data compiled by Bloomberg. This spread is near its lowest level since January 2008, when the S&P 500 was about 22 percent higher.
“‘Animal spirits’ are returning to Wall Street even if they are still suppressed on Main Street,” the report said. Spreads have narrowed so much that stocks have more room to rise than bonds, especially as earnings increase, it added.
To say that stocks offer greater value than corporate bonds does not necessarily say much at today's levels. Both have had a meteoric rise for the last several months, and I think both come with a lot of risk.
Underlying economic data has continued to deteriorate while the risk implied in corporate bond prices has plummeted. This doesn't add up and can only last for so long in my view. There may be some value in a few corporate bonds, but in general, I feel that the risk has been vastly understated, and these bonds are set to go lower.
I think it is obvious that stocks have been overbought as well, rising 50% since early march! Of course, stocks and bonds could both continue their rises for many more months, but at some point this steam has to run out, and putting new money into either of these right now seems crazy to me.
I will be keeping my eyes on the corporate bond markets to see when financing may start getting more difficult, and this may be a key sign of when the markets may have a turn towards the downside.
In the mean time, "Animal Sprits" can continue to pour more money into the stock market, and we will see when the pool of greater fools runs out. I feel it will be sooner rather than later, but I also did not imagine this rally lasting for as long as it has. Let's keep an eye on things and wait for signs of changing sentiment.