If you look at the most recent reports of the Federal Reserve, you will see that loans and investments in the US banking system are contracting. Northern Trust’s Paul Kasriel notes that this is the “sharpest 13-week contraction” in the history of this data series. The Fed’s measure started in 1973. Contracting credit is an indicator of the deleveraging of the US banking system.
Contracting credit is also a force for deflation, not inflation. Money expands through the use of credit. Monetary policy works because of this credit multiplier, which is why a rise in the price level (the true definition of inflation) is achieved through credit expansion. The reverse is true when credit is contracting.
In the most recent Term Auction Facility (TAF) auction, the Federal Reserve rolled $75 billion in direct-reserve 28-day lending to US banks at an interest rate of 2.34%. That rate is higher than the Discount Window borrowing rate by 9 basis points (bps). It is also 33 bps higher than the expected Fed Funds rate over the same period (overnight indexed swap rate, OIX).
Why did 77 American banks participate in an auction and pay 33 bps above the rate they could pay by borrowing from each other? Or why did they pay 9 bps above the rate they would pay if they borrowed from the Discount Window (which uses the same collateral as the TAF)? Answer: the “stigma” of borrowing is still infecting the banking system.
One must conclude that the US banking system is still wounded and the US credit markets are still dysfunctional. They may be less dysfunctional than in previous months when the bid-to-cover ratio of the TAF was higher but they are still not functioning rationally. What about this relative measure of dysfunction over the last few weeks? Here the news is not good. In May there was a TAF auction below the Discount rate. Now it is above the Discount rate.
For us to conclude that the US banking system is really mending, we must see repeated auctions of the TAF below the Discount rate. We are not yet there.
In Europe things appear to be worse when we examine the US dollar-denominated credit sector. We conclude this by comparing the bidding for the TAF conducted through the European Central Bank (ECB). Remember, this is a parallel process to our American TAF auctions.
In the US there were 77 banks bidding, submitting $91 billion in bids for $75 billion of available TAF funding. In Europe the ECB country member banks collectively submitted bids for $85 billion even though that TAF-type facility had only $25 billion of available funding. Remember that in Europe the banks post collateral with their local national banks. That collateral is denominated in euros even though the money is actually loaned to them in dollars which are sourced in our Fed.
In other words the demand for TAF-type dollar liquidity in Europe (outside the US jurisdiction) was about the same as the demand inside the US. We infer that the banking problems in Europe are worsening in terms of US dollar lending and investing. The ECB bidding was a new record high. This may also explain why the London Interbank Rate (LIBOR) has been stubbornly above the normal spreads that existed before the credit crisis of the last year commenced.
More support for these inferences is seen in the substantial deterioration in the market prices of banks stocks in the US and in Europe. In the US we now see the collective market value of the banks in the bank stock index trading below the collective book value. This is a rare occurrence and usually coincides with a very attractive entry point in the banking sector. In the present case it seems that the market does not believe the book value and suspects that there are billions of additional losses to unfold in the banking sector.
At Cumberland, we believe that caution is warranted toward banks at this time. We think this is true of the financial sector generally. Our portfolios are now below market weight for this sector, even as the market weight is dramatically lower than when the credit crisis began. We have avoided the capital market sector specialty ETFs and exited the insurance sector ETF. We stopped scaling into the banking sector ETFs. Our original start of scaling was too early.
We want to see the second-quarter reports of banks, and we want to see more information about the deterioration of the home equity lending balances on banks’ books before we resume positioning in this sector. We also believe that the capital markets and brokerage firms face additional difficulties. And we expect more revelations about liabilities of those firms involved with Auction Rate Securities (ARS) and other sectors of the financial markets which are nonfunctional.
We look for the Fed to extend the various special tools they have introduced as temporary measures before their September expiration. The sooner the Fed announces that extension, the better the markets will be able to rely on the Fed, and that will serve to lessen an uncertainty risk premium that currently is priced into credit. We also expect the Fed to move to liberalize the ownership rules for banks so that additional capital can be attracted into the system.
Not all banking in all places is impaired. There are several regions and countries where the toxic poison paper is diminished. Singapore is one of them. The Singapore index ETF is about 50% financials. The city state is a regional banking and financial center. The currency is strong and corporate governance is seen to be of a high standard. We are maintaining our over-weight position in Singapore in our international ETF portfolios.
We will celebrate the 4th of July on a plane to Singapore. Three days of meetings next week include bankers and investors in Singapore. This is my first visit; colleagues Bill Witherell and Bob Eisenbeis have been there several times. For those with access, CNBC Squawk Box Asia has scheduled me to guest host from 7 to 9 A.M. Singapore time on Tuesday, July 8th.
Readers are wished a festive celebratory birthday of America.
We close with a special thanks to Barclays Capital’s Julian Callow and Julia Coronado for the auction details on the ECB’s TAF-type liquidity facility auction.