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Reader Questions Answered

What about all the toxic debt?

I am reading an outlook for the US Economy from a well known forecaster, and he claims that one of the reasons for the ongoing contraction in private sector bank lending (and therefore M2 growth) is that “there are $176 billion of commercial real estate loans of questionable value on banks’ books”. Thus, the banks fear they might not be adequately capitalized should they need to write these loans off down the road, and as a result they are reluctant to extend credit.

While I agree completely with this analysis, it comes as a surprise to me that he only cites the extent of the CRE problem. So the question is: Did this author forget to mention all the other toxic stuff that was supposedly on the banks’ books (“securities held to maturity” to avoid the write-offs) or was it all erased by one of the many bailouts we’ve had in the last couple of years (and which institution is left holding the bag in that case) ?

“All the other toxic stuff” is things like:

  • Non-performing/Delinquent Residential RE Mortgades
  • Agency RMBS
  • CDOs
  • CDS

This came in by email overnight from reader Rodrigo. I’m no specialist where banks and bank balance sheets are concerned, so I can’t address what banks are holding or not holding at this point. I can, however, address things from a couple of perspectives.

First, from the headlines and stories I’ve read, the folks at the Fed seem to be more concerned with what the commercial real estate sector could do to put pressure on the banks than much else, so the newsletter author in question isn’t the only one with that concern. That is no doubt a factor in the rapid decline in Commercial and Industrial loans.

As for the “other toxic stuff”, keep one very big thing in mind. Both the Fed and Freddie and Fannie have been very active in the mortgage market. The agencies have bought up a lot of loans, many of them troublesome, while the Fed now owns about $1.2 trillion worth of MBS paper. Those activities have done a considerable amount to stablize the market, both in terms of the underlying mortgages and the securities. Obviously, we still have a fair amount of foreclosure activity, but it seems like the banks have that at least mostly factored in to things.

Here’s a look at what money supply has been doing of late courtesy of shadowstats.com. Notice how the M3 growth rate (light blue line) went negative in the latter part of 2009. That’s an indication of contracting credit and lending in the economy.

Note, M3 is no longer published by the Fed. Shadow Stats has carried on the calculation using their own methods, which is what you see above.

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Taxes, Budget Deficits and Inflation

A couple of things have come out from different politicians the last couple days which have me shaking my head. File this under big picture macro fundamental anlysis, I suppose. I don’t normally offer up market analysis here, but it’s worth indicating the way one can approach market analysis.

Tax Hikes Leading to Inflation
The first is a statement yesterday by the governor of the Mexican central bank. In talking about forecasts for the year to come he expressed the view that tax hikes instituted in the latest budget could add 50bps (0.50%) to the annual inflation rate in 2010. I can only pressume that he means said tax cuts will somehow filter through into higher consumer prices as a pass on effect.

Now I don’t know the specifics of the tax hikes in question, so I can’t speak directly to the type of pass-along effect there might be and from what directions. I seriously doubt it would ever be a 100% pass through from producers to consumers, and some of the hikes may directly hit comsumers, which wouldn’t be involved in price levels at all. In other words, I have lots of questions about how much pass-along there is likely to be.

On top of that, there are two other elements to the inflation equation. To the extend that pass-along taxes increase prices and/or taxes directly impact consumer it will lower demand. That would tend to put downside pressure on prices. Furthermore, when the government increases taxes it pulls more money out of the system, reducing money supply. If inflation is at least partly a function of money supply, then taxes tend to be a depressive factor rather than an expansionary one.

Government Budget Deficitis of 3%
US Treasury Secretary Geithner was on CNBC this morning talking about the plan to get the US budget deficit down to 3% of GDP with the work on getting it down there starting in 2011. The EU finance ministers set similar targets for several members to reach by 2012-2015. So in other words, the world’s major economies will still be running budget deficits for quite a few more years to come.

Why is this important? Because one of two things have to happen. Either more sovereign debt (Treasuries, Gilts, Bunds, JGBs, etc) have to be issued or the monetary base will expand by the amount of those unborrowed deficits. In the latter case you get inflationary pressures. In the former you get lots more supply of debt instruments. Both tend to equate to higher interest rates over time.

Now if all countries are running deficits and not issuing debt to offset then everyone will see inflationary pressure, but it will tend to be cancelled out in the forex exchange rates. Things like commodities (think gold and oil), however, would tend to see price appreciation.