The ALM First Quarterly Economic Outlook provides financial institution management concise and relevant economic data that has both a direct and indirect impact on the institution’s financial well-being. Clients often find the information useful in planning balance-sheet strategic action plans for the upcoming quarter.
Fourth Quarter Review
Good Riddance to 2008!
After a catastrophic year for global markets, the question most asked by down-trodden investors is if 2009 will be any better. The last four months of 2008 were particularly awful as bank lending all but halted, and financial markets went into a tailspin that abated only when governments agreed to spend trillions of dollars bailing out the global financial system. U.S. GDP is estimated to have dropped at a five percent annual pace in the fourth quarter and is expected to contract another three percent in the first quarter of 2009. Moreover the U.S. economy lost 2.6 million jobs last year, the most since 1945, and the unemployment rate rose to 7.2 percent.
To review just a few of the catastrophic event in 2008, Lehman Brothers went bankrupt and the conventional investment-banking business model crumbled; the Federal Reserve cut interest rates effectively to zero and the government took over mortgage giants Fannie Mae and Freddie Mac. Meanwhile the Reserve Primary Fund became the first money-market fund in 14 years to break the buck, meaning the value of each of its shares fell below $1. What is even more amazing is that all this happened after Labor Day. By year end, J.P. Morgan Chase’s March takeover of Bear Stearns and the collapse of the auction-rate securities market seemed like the dim and distant past.
We discovered that the U.S. is 12 months into a recession at this point according to the National Bureau of Economic Research, who officially designated December of 2007 as the peak of the prior expansion. The longest two recessions since World War II were 1973-75 and 1981-82, both of which lasted 16 months. Therefore, if the current recession does not end by May of 2009 it will surpass them – which is at this point a very real possibility.
Financial Markets
Stocks lost 42 percent of their value in 2008, according to the MSCI world index, erasing more than $29 trillion in value and all gains made since 2003. The Dow Jones Industrial Average fell 33.8 percent, its worst year since 1931, while the Standard & Poor’s 500 stock index fell 38.5 percent. The only assets to prosper were government bonds and gold.
The credit markets led stocks and the U.S. economy down in 2008, setting records along the way as prices of corporate and mortgage bonds sank to new lows and yields soared to sky-high levels. Last year's turmoil caught many investors off
guard and sent them running to U.S. Treasury securities in the ultimate flight to quality. As prices of Treasuries rose, yields tumbled to record lows; in fact, some investors bought short-term T-bills at a zero percent yield, just for the assurance they will get their money back when the debt matures.
As investors flocked to Treasuries, prices skyrocketed, making these securities by far the best-performing asset class with a return of about 14 percent for the year, according to a Merrill Lynch index. The yield on the two-year Treasury note declined to 0.77 percent from 4.81 percent a year ago, while the yield on the 10-year Treasury dropped to 2.25 percent from 4.03 percent.
The past year was marked by unprecedented moves by both the Federal Reserve and Treasury, which committed billions of dollars in attempts to restore order in the credit markets. The government acted as a backstop for parts of the short-term markets, increased its lending to financial institutions, provided guarantees on bank and finance-company debt, took steps to bring down home mortgage rates and tried to ensure that consumers and lenders have access to capital.
The full impact of many of these actions remains to be seen, but it seems that some of the measures have finally begun to have the desired effect. For example, investors embraced bonds issued recently by banks and finance companies that are guaranteed by the Federal Deposit Insurance Corporation (FDIC) for the next few years. Financial institutions including Goldman Sachs, Morgan Stanley, and the finance arms of farm equipment maker Deere & Co. and industrial conglomerate General Electric Co. have sold a total of more than $100 billion of these securities, whose yields have been as low as two to three percent.
Meanwhile, the Fed's programs to provide guarantees to money-market funds and to purchase short-term commercial paper directly from companies helped thaw short-term lending markets somewhat. However, many finance companies still don't have sufficient access to the asset-backed debt markets, where they sell securities backed by loans they make to individuals or other borrowers.
Monetary Policy
The Federal Reserve cut its key interest rate a total of seven times in 2008, from 4.25 percent at the beginning of the year, with the last cut in December setting the target rate at zero to 0.25 percent, a historic low. While important as a historic milestone, the move to a target interest rate of zero from one percent was largely symbolic. The effective funds rate, which affects what banks charge for lending their reserves to each other, had already fallen to nearly zero because banks have been so reluctant to do business.
The Federal Reserve has stated it will “employ all available tools to promote the resumption of sustainable economic growth.” Those tools may include buying mortgage-related bonds, longer-term Treasury bonds, corporate debt and even consumer loans. Of greater practical importance, the Fed bluntly announced that it would print as much money as necessary to revive the frozen credit markets and fight what is shaping up as the nation’s worst economic downturn since World War II.
With its rate ammunition spent, the Fed has now turned to an approach called “quantitative easing,” which involves injecting money into the economy rather than aiming at an interest rate target. In effect, the Fed is stepping in as a substitute for banks and other lenders and acting more like a bank itself. Quantitative easing was the name given to a three-part monetary policy program implemented by the Bank of Japan from March 2001 to March 2006.
The Fed’s quantitative easing efforts differ significantly from the Japanese variety. Prior to the expansion of its balance sheet, the Fed focused on providing targeted support to distressed parts of the capital markets by lending against illiquid collateral. Now it has expanded the scope of that intervention by purchasing agency debt in the open market, and in some cases, such as the Commercial Paper Funding Facility, providing a source of demand for new borrowing. These actions have been financed with an increase in excess bank reserves, but the focus is on the interventions rather than the reserves themselves. In contrast, for the Bank of Japan, increasing reserves was the objective of policy – the emphasis was on the liabilities side of its balance sheet rather than the asset side.
While its policy objective is still the Fed funds rate, the Fed’s balance sheet has more than doubled over the past few months to over $2 trillion as it has expanded its emergency lending programs, foreign currency swap lines, and open market purchases. When the Fed began creating new lending facilities last year, it financed them by selling Treasuries, thereby keeping its balance sheet from expanding. A few months ago, the Fed ran low on Treasuries it could sell and began to expand its balance sheet; however, it sought to soak up or “sterilize” this expansion through the use of a special Treasury bill program. The Treasury sold bills and deposited the proceeds in its account with the Fed, and the Fed used the proceeds to extend loans to banks based on illiquid collateral. While the Fed’s balance sheet was being grossed up, the Treasury was soaking up cash through bill issuance and system-wide liquidity was unchanged.
The Treasury program is being wound down however and the expansion of Fed programs is now being financed through increases in excess bank reserves. In this case, the Fed is extending the same collateralized loans, generating excess reserves, and grossing up its balance sheet without sterilizing the transaction through the Treasury facility. Thus, the Fed is currently “printing money” and the over-provision of reserves to the banking system is far beyond what would be required to meet the FOMC’s target funds rate
Outlook for 2009
So if 2009 is supposed to be better, where will the first signs of growth emerge? Some analysts predict that the United States economy, which fell into recession in December 2007 and is poised to receive a stimulus package from Washington of as much as $1 trillion over the next two years, may actually start to lead the world out of the downturn in the second half of the year. However the continuing deterioration in the U.S. housing market, the struggles of the auto industry and layoffs almost everywhere serve to dampen this optimistic view. Analysts say the current recession, which officially began a year ago, is all but certain to break the postwar record for duration, 16 months. The economy has already lost two million jobs this year. Analysts predict that unemployment, now at 7.2 percent, could rise to 9 percent by the end of next year.
The International Monetary Fund forecasts that developed economies will contract slightly in 2009, while overall world output will grow only 2.2 percent. The fund defines a global recession as growth below 3 percent, because that is far too weak to keep up with the demands of a growing population in emerging markets for jobs.
While 2008 was dominated by a financial crisis, 2009 is likely to be the year when the bad news comes from the economy and from the non-financial corporate sector. All the forward-looking surveys, such as the purchasing managers’ indices, have been gloomy for months. Also the driving forces that have lifted the U.S. economy out of every recession since World War II will be of little help this time around. Inventory rebuilding, household spending, home construction and payroll growth - the forces that powered, to a greater or lesser extent, each recovery since 1945 – are likely to remain missing for much of 2009. A glut of unsold properties could keep the housing market depressed, while diminished or non-existent savings will discourage consumer spending.
In response to this predicament, the measures that have been thrown at the economy are almost unprecedented. Banks have been rescued, the money markets flooded with liquidity, taxes have been cut and, very shortly, interest rates in much of the developed world will be at, or close to, historic lows. In addition the incoming Obama administration is working on a two-year stimulus package worth as much as $850 billion in increased government spending and lower taxes.
The financial crisis began in the credit markets, and eventually it will end there. But as the financial industry rounds out possibly the most wrenching year in its history, bankers and policy makers alike are struggling to find a way out of this mess. The primary problem in the credit markets is one of trust, or rather, the lack of it. Even after receiving millions, in some cases billions, of dollars from the government, banks are still reluctant to lend money. Crucial parts of the financial system have stopped functioning. The pendulum has swung from the exuberance of the boom, which led bankers to make loans to people who could not repay them, to an intractable fear of making any loans at all. This fear is so pervasive that it has brought the credit sector to a virtual shutdown, even to borrowers with good credit.
Another big worry is the future of securitization, a key mechanism of modern banking that enables banks to bundle loans and bonds into securities for sale to investors. This crucial market is practically shut down now that many of its creations have plunged in value. Mortgage-backed issuance fell a whopping 80 percent last year. Some question when, or if, certain areas of securitization will revive. Securitization, radically changed banking and the credit markets over the past several years. Three decades ago, banks supplied $3 out of every $4 of credit worldwide. Today, because of securitization, that share has dropped to about $1 in $3. Unless financial companies can securitize debt - which, in turn, depends on investors’ willingness to buy the bundled loans - credit will remain tight even if banks resume lending.
One view is that a recovery, whenever it comes, may be anemic and heavily dependent on continued low-cost lending by the Federal Reserve and stepped-up spending by the new administration. Short-term interest rates will likely remain at current levels for most of the year, while the federal budget deficit stays at or near record highs into 2010. Economists surveyed by The Wall Street Journal believe, on average, that the economy will continue to contract through June and that, once it does start growing again in the second half of 2009, the growth rate will be slower than normal.
But with central banks cutting interest rates to spur growth and governments pumping money into the system, some investors see more positive signs for 2009. World governments have pumped more than $1 trillion into their economies, and more aid is expected in 2009 as leaders battle to stave off an even deeper recession.
On top of all that is the sharp fall in oil prices, which acts as a tax cut for western consumers. None of this is having much of an impact yet because the economy is still suffering from the delayed effect of the credit crunch and the earlier surge in commodity prices. There is also the lag time between changes in monetary policy and their effect (usually between 12 and 18 months).
For those looking ahead for signs of life, there are a few key indicators to watch out for. First and foremost is housing - and in particular home prices. Spring is the biggest home-sales period and will prove crucial this year. The 2007 spring season could be characterized as moderate, while the 2008 season was a disaster. But the 2009 season is being ushered in with record low mortgage rates of about five percent or less for 30-year fixed-rate loans. If the 2009 spring season is a disappointment however, home prices will likely continue their headlong descent. That would further pressure the economy, banks and markets, thereby undermining any chances of recovery in the second half of the year.
Equally important will be any signs that liquidity is returning to frozen debt markets. There are some glimmers of hope. Money markets have calmed since the Federal Reserve created a facility to ease strains in commercial-paper markets. Banks are becoming less leery of lending to one another as shown by a reduction in the spread between the London interbank offered rate (LIBOR) and government borrowing costs. Debt issuance is also picking up, if only slightly.
Key factors will include how aggressively the Federal Reserve pursues plans to manage long-term rates through the purchase of securities, and how the government spends the remaining TARP bailout money. Also, there is the shape and effectiveness of any fiscal stimulus package. While President-elect Barack Obama is pushing lawmakers to enact an $850 billion (at last count) stimulus package next month, plans can always change on Capitol Hill.
For now, any predictions are little more than guesses. Eventually, the Fed's moves are likely to fuel a rebound in economic activity, but at this point who can say when that will take place? Another consideration is that nobody yet has any idea how much permanent damage may have been done to the structural underpinnings of U.S. and global capitalism."
