Sunday, October 27, 2013

Guest Post: 3rd Quarter Economic Review by Dorothy Jaworski

QE3 Taper—Never Mind

If you are a fixed income investor, you are still shell shocked. Throughout the summer, the great bond market selloff of 2013 continued on. Treasuries, Agencies, mortgage backed securities, corporate, municipals- all were battered because the markets believed that the Federal Reserve was about to cut the amount of, or “taper,” its $85 billion of monthly purchases of long term bonds.

The Fed had been telegraphing a taper since April and May, when Bernanke and the Fed governors began giving mixed signals. By the time the September FOMC meeting arrived, 100% of Wall Street believed the taper would be $5 billion to $20 billion per month. What did the Fed actually do? Nothing. Well, never mind!

So why did the Fed decide not to taper QE3? I can see five reasons: 1) the government shutdown and its negative effect on GDP was looming, 2) data releases had become weaker, including housing data, and job growth was weakening, 3) the markets had already tightened long term rates, as unwelcome as that has been, 4) the velocity of money remains at a 50 year low, and 5) a nascent upswing in consumer and business loans this year could be cut off, reverting to deleveraging. The Fed’s own mixed messages caused the extreme selloff. They have no one to blame but themselves.


We landed on the shores of Europe in August. What we experienced was the vacation of a lifetime. What we saw were beautiful old cities, castles on the riverbanks of the Rhine, breathtaking cathedrals, and the wonders of Paris and the friendship of citizens of the small towns near Metz. What we know is that we will go back. What we felt and learned was that the European people are confident that the worst of the recession is over in Euroland.

GDP reflects that, too, as Europe’s economy grew by +0.3% in 2Q13 and is expected to grow by +0.2% in 3Q13. Perhaps part of the reason for our bond market selloff is that the flight to quality due to Europe’s prior problems is abating.

She Devil to Head the Fed

Janet Yellen, affectionately nicknamed “She Devil” by Washington and Wall Street, has finally been nominated by the President as Fed Chairman. Her nomination had been in doubt until Lawrence Summers withdrew from consideration. Wall Street gets the Chairman they want—the one with a decade of Fed experience and the one most likely to continue Bernanke’s policies. She spent time in the Fed with the Maestro, Alan Greenspan. She has hopefully learned to deal with a crisis aggressively and to take actions and make statements that are credible, not like the mixed messages we received for the past six months regarding QE tapering.

I feel bad for Ben Bernanke; he will not get to finish what he started. When “normal” recovery finally arrives, She Devil will get the credit. If all goes well, she will take over as FedChairman at the beginning of February, 2014.

But it will not be all smooth sailing for our favorite dove. She will inevitably face crisis and have to deal with it decisively. Greenspan faced the 1987 stock market crash when he was new and in the late 1990s, faced the Asian currency crisis and the collapse of Long Term Capital Management, and the stock market crash of 2000.

Bernanke, as we all remember well, faced the bursting of the housing market bubble and the 2008 financial market crisis with the Lehman Brothers bankruptcy. We must believe that the toughness implied by her nickname will guide her through trouble.

Government Shutdown and Default Danger

We are in the middle of the 18th government shutdown since 1976. One estimate is that 83% of the federal government is still functioning—something about “essential”—so it is not much of a shutdown. We have great Washington drama with both sides refusing to give ground on their issues. But give they must, negotiate they must, to avoid the unspeakable horror of a default on US debt that would destroy trust in our nation and trust in the dollar.

A drop dead date of October 17th for default was given by Treasury, but this date seems suspect, with expected receipts in October of $200 billion and $25 billion in interest payments due, it is hard to understand why default would occur mid-month. Maturing debt could be rolled over and replaced with new debt without breaking the debt ceiling.

But regardless of when that date arrives- someone, anyone in Washington, are you listening? Debt default is not an option. You must act now. As this newsletter goes to press, only days before the October 17th date, I cannot imagine that a default will occur. I must believe that a midnight deal will happen.

The shutdown is impacting the release of economic data of government data, the timing of which is poor as the data had been weakening prior to the doors of 17% of the government being closed on October 1st. The private data being released has been weak, most notably the ADP private payrolls report, which showed measly job growth of 166,000 in September, after 159,000 in August.

Remember, the government payroll report for August showed measly growth of 169,000 for the month, with the labor force participation rate down to 63.2%, the weakest since the late 1970s. The unemployment rate continues to drop, most recently to 7.3% in August, from hundreds of thousands of workers exiting the labor force. This is not a good trend.

Jamie Dimon

We were hoping that there would be a savior to the great bond market selloff of 2013, a voice of reason able to reassure the markets. We usually look to the Fed, but not this time. We were hoping it would be someone like Jamie Dimon. But, alas, we learned in the 3Q13 J.P. Morgan earnings release why he has been in hiding—he has his hands full of legal issues.

JPM reported the first quarterly loss since Dimon’s tenure as CEO with $9.3 billion in legal charges in the 3Q13. This brings the legal reserve at the Bank to an astounding $23 billion! We know he continues to defend JPM from the ongoing extortion fines (recently $900 million) from the federal regulators, UK regulators, and the SEC over the London Whale’s bad trades. We know he continues to defend Bear Stearns from the ongoing demands of state and federal regulators for more and more money for mortgages that defaulted.

But $23 billion—Wow! Stay tuned.

Thanks for reading. DJ 10/13/13

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

Saturday, October 19, 2013

Sea Story: Anti-Submarine Warfare During Operation Desert Shield

This week somebody asked me for a sea story from my Navy days. Although many colleagues and bankers know I was in the Navy, I can't recall anybody asking me for a story. So I told the one below. They seemed interested, and I thought you might be too. If you were looking for banking insights, you'll have to forgive me for this post.

In September 1990, the guided missile cruiser USS Biddle (CG-34) in-chopped into the Mediterranean Sea with the aircraft carrier USS Saratoga battle group en route the Red Sea. This was after Iraq invaded Kuwait, and tensions were high. I picked up the Biddle (see photo) via a CH-46 Sea Knight helicopter. You know, the big troop/supply carrying helo with two big blades. That harrowing ride and jump to the Biddle is a sea story in itself. But I digress.

The Biddle was tasked with merchant interdiction. If you remember back to Operations Desert Shield and Storm, the "coalition" was intercepting merchant ships, stopping any sort of supplies reaching Iraq via the Red Sea or the Persian Gulf. Biddle stopped the first merchant ship, and the most during the operation.

One evening, I was vigilantly on watch. Which means I was wearing headphones in front of a wall of electronic equipment. Captain Harlow, our CO, came over the 1MC (ship-wide speaker), sheepishly announcing that we were DIW (dead in the water, i.e. not moving), and he wasn't sure why. Next morning divers from the Saratoga were going to check things out.

Turns out, we lost our rudder. That's right, we dropped a rudder into the depths of the Red Sea. My fellow shipmates joked we were doing some anti-submarine warfare and we dropped rudder hoping to hit one.

The closest dry dock to get it fixed was Toulon, France. We were in the Red Sea. Check Google Maps. We're not talking a brief trip, here. And we had to navigate the Suez Canal. If you ever experienced the Suez, and I suspect most readers have not, it is very narrow. It can only accommodate a North Bound convoy, followed by a South Bound convoy. Never the two at the same time. Sometimes you feel as if you can throw a rock from your ship and hit land, it's so narrow.

Captain Harlow was a stubborn man. He did not want to be towed in the North Bound convoy. Instead, he decided to steer by the screws. That means using our propellers to make turning movements to guide us through the canal. We slowed the North Bound convoy down so much, Egyptian authorities made us pull off to the side and wait for a tow. So the remaining North Bound convoy, and the following South Bound convoy passed us in our misery.

The next day, and the next North Bound convoy, a US frigate, I can't remember the name, stopped to give us our tow. A frigate, for the uninitiated, is one of the smallest warships in our fleet. A mighty cruiser, on the other hand, is one of the biggest.

We took our tow, and the North Bound convoy of shame, all the way to Toulon.

But hey, I was able to get off the ship in Toulon and spend Christmas with the family. So there's that!

And that's my sea story. I don't know if there's a lesson here, except check your equipment before leaving port.

~ Jeff 

Saturday, October 12, 2013

What will our depositors do when rates rise?

The subject has been on the minds of bankers for years now. The continued extension of the Fed's easing policy through possibly 2016 has given us a sense of security. But this pro-longed period of low rates, burgeoning core deposits, and uncertainty about what our depositors will do next should keep us restless.

For those that rely on yield for returns, it has been a tough time. Retirees, insurance companies, and bank treasurers have found it difficult to earn money in fixed income. Some have been able to squeeze gains out of bonds as rates fluctuated downward, but the second quarter flip from an unrealized gain to an unrealized loss in bank investment portfolios brought reality home to treasurers.

I'm not certain what depositors will do when rates rise. But I analyzed what they did the last time the Fed raised Fed Funds Rates in mid 2004. On June 30, 2004, the Fed raised the Fed Funds rate from 1% to 1.25%. Over the next two years, the Fed raised rates 16 more times, ending at 5.25% on June 29, 2006 (see chart).

The last Fed action prior to the 2004 rate rise was June 2003, when the Fed Funds Rate stood at 1%. Surprisingly, bank cost of deposits at that time was 1.43%. Note that all deposit and cost of deposit data was for quarterly periods, where Fed Funds rates were on the date they were raised. But once the Fed started moving rates up, bank cost of deposits lagged the movement upward. When the Fed ended its tightening in June 2006 at 5.25%, bank cost of deposits was 2.68%, a significant spread.

What did depositors do during this period? They moved money from core accounts (all deposit accounts less time deposits and brokered deposits) to non-core, as shown in the chart below.

But not to the extent one might think. Yes, non-core deposits as a percent of total deposits grew from 32% in June 2004 to 38% in June 2006. But core deposits did not decline during that period, growing 8.3% during the two year span. But time & brokered deposits grew 48.7% during the same period.

By the time the Fed stopped tightening in the second quarter of 2006, core deposits represented. 61.8% of total deposits. Today, core deposits stand at 77.8%. So, if past is prologue, then we can anticipate that although our overall core deposit base may not decline, time deposits are sure to increase. 

This analysis reviewed what happened to FDIC insured deposits across the U.S. How that money will flow between institutions is a result of efforts made by financial institutions today to win the loyalty of customers once rates begin to rise. Will they stay with you, or go across the street? Is it in your hands, or the hands of fate?

~ Jeff