Ben’s Bluffing

Soleil: Perspective
Vince Farrell
Soleil Securities Corporation
Chief Investment Officer
Phone: 212.380.4909
vfarrell-at-soleilgroup.com
www.soleilgroup.com

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You all know the feeling. You get back from vacation mellow and full of good cheer for your fellow man, and then reality rushes in. It sometimes takes until Monday lunch, but rarely longer. Catching up on stuff I read summaries of the Fed’s statement last week. Uncle Ben said he’s ready to unleash Quantitative Easing II – QE II – and buy a bunch more stuff and that will set the economy right. The feeling is he will spend $1 trillion buying longer dated Treasuries to force interest rates down and revive bank lending. The stock market seemed to like it and rallied. The rally was also credited to a hedge fund manager that has been unusually good. But if the mountains of cash that drift around the world are funneled to a market because one guy touts the advantages of said market, we are grasping at thin straws indeed.

And why bother with another round of Fed spending? We spent, or the Fed did, over $1.5 trillion buying mortgage securities, agency paper, and some Treasuries and we have over a trillion of that still on deposit at the Fed. And we still have the fear of deflation, although that seems to have eased the last week or so. I suppose another trillion can’t hurt, but I don’t see how it helps. Large scale asset purchases would lower rates but that’s not the problem. The problem is the consumer is way overleveraged and lacking in confidence. For banks to start lending you need loan demand. The small businesses that need the money don’t qualify and the big guys the government wants to borrow have lots of cash.

A round of QE II will not work. If you gave a party and no one came your social standing would be trashed (not that I know from first hand experience or anything like that). If we tried QE II and it flopped, the market might be badly rattled. Better to threaten you’re going to launch. But then Hank Paulson hoped that the threat of his TARP bazooka would straighten the market up so it would march properly to the tune of money, and it didn’t. Ben, back off. Don’t play the bluff. QE II would be a huge mistake. QE-I didn’t rejuvenate bank lending or stop deflation fears and QE-II won’t either.

When consumers are as indebted – still – as they are, flooding the system with more money won’t do it. Thanks to Capital Economics in Toronto, a research house I subscribe to and wouldn’t do without, we have an up to date picture of the American household balance sheet. The total debt (and here we mean all debt, public and private) to GDP ratio fell in the second quarter but only because GDP grew. Debt in total grew $154 billion to over $50 trillion. That’s over 340% of GDP. Ouch!

Household debt fell $77 billion in the quarter and is now down $473 billion from its peak. But household debt to income is still at 123% and while there is no magic number, my guess is it should fall to less than 110%. And, there is always an ‘and’ or a ‘but’, roughly half the decline in consumer debt is due to defaults, and not pay downs. The Federal Deposit Insurance Corporation says in the second quarter total bank charge offs of residential mortgages, credit cards, and other consumer loans was $37 billion, or almost half of the $77 billion decline mentioned above. Since the beginning of 2008, bank charge offs on consumer loans have totaled $263 billion, or 56% of the reduction in household debt.

Maybe it doesn’t matter how the debt is paid down, but I suspect banks that take the loss care. Also, individuals that default will be denied credit for years which has to feed back into consumer expenditures. Savings are up, but Capital Economics figures if savings stayed at 6% of income where it has recently been, and if the savings were used to pay down debt, the debt to income ratio would take until almost 2012 to fall to 110%. 100% debt to income would not be reached until the end of 2012. Either way, the consumer is not likely to be a growth engine.