Christian Debt Recovery

Historic Us Debt To Gdp Ratio

October 21st, 2010 |

Author: Gavin

Is the Fed Adding Stability?

Dow 10,000 has been a target for us at TSR since early April, when the venerable index was 3,000 points lower. The good news is that after a benign FOMC meeting on Wednesday, Mr. Dow’s average rallied strongly and came within 82 points of our intermediate-term target. Pretty good forecasting, eh?

The disappointing news is that the rally suddenly reversed at Dow 9918 and sold off. Thursday brought more of the same cloudy weather. Sure, the 9918 figure is less than 1% from the target, but it still feels like we were all invited to a 5-digit party that got cancelled at the last minute.

But let’s not wallow in self-pity. The major indices have not had to endure a single significant down day since the first day of September. Consequently, individual investors may have grown complacent this month. Day traders certainly had the rug pulled out from under them on Wednesday, as the intraday swing was more than 170 Dow points in less than two hours.

By the way, if you enjoy that type of trading, consider visiting Gregory Spear’s day trading service, Day Trader Hotline (DTH) (www.DayTraderHotline.com), where he takes full advantage of sudden moves in the market using high-octane leveraged ETFs. Money can be made on quiet days as well. DTH posted a one-day 4.25% portfolio gain on Tuesday, which is not paper trading; it’s real money on the line.

The down days this week, occurring so near a psychologically important target, might have stimulated you to take some chips off the table. We certainly would not fault you for selling some inventory after a 55% rally. Timing-wise, however, there may still be some fuel in the market’s tank.

Here’s why we think so.

Mama Fed
There is an adage on Wall Street that goes, “Don’t fight the Fed.”
It arose because the Fed has traditionally used monetary policy as the accelerator and brake pedals to manage inflationary forces in the economy. When the Fed was generously opening the throttle, bullish animal spirits on the Street were supported, but when the Fed was applying the brakes to temper inflation and cool down the economy, rising rates created a headwind for stocks, as well.
Looking back, those were the good ol’ days.

Things are different now. We are in a post-crisis world. The game has changed. Is the Fed fighting Wall Street these days? Hardly. Not only has the policy of secrecy and surprise been lifted, but with Fed fund rate essentially at zero, monetary policy is a non-issue these days, because the Fed is fighting deflation and actually wants to stimulate inflation.

According to the views expressed by the group of Fed governors that make up the FOMC, economic prospects are improving. Nevertheless, the committee voted unanimously to keep interest rates near zero well into 2010. Likening the economy to a hungry baby, the Fed is constantly feeding, burping, rocking, changing diapers, cooing and making nice. No tough love here.

Security Blanket
The key piece of news from the FOMC policy statement is that the Fed will extend its purchases of mortgage-backed securities (MBS) into March of next year. The Fed has now purchased $850 billion of its scheduled $1.25 trillion in MBS and $125 billion of the planned $200 billion in mortgage debt issued directly by Fannie Mae, Freddie Mac and the Federal Home Loan Banks.

What does this mean in plain language? Altogether, the Fed probably owns 80% of the home loans and refi loans made this year by Fannie and Freddie.

Mortgages used to be underwritten and funded by hundreds of companies that then sold them to investors via a process called “securitization.” The underwriting of these derivative mortgage-backed securities was big business for Wall Street brokerages, bond rating companies like Moody’s and for insurance companies like AIG, which formed a special division that insured mortgage-backed derivatives against default. Since premiums were low because risk was presumed to be low, AIG made up for it in volume.

Of course, the securitization industry relied on the rating agencies to price risk in such a manner that everyone felt good about the transactions. Not a problem. (According to one former employee of Moody’s, the company is still making inflated ratings, which is why shares of Moody’s are crashing.) When unsuspecting investors the world over (including banks in Europe and South America) realized that their equity in these high-yield MBS investments had plummeted due to mispriced default risk, the securitization game started to look rather Ponzi-like. The MBS crash happened in the spring of 2007 and by the spring of 2008 the niche was completely dead.

Bonding
And that is why the Fed is now in the mortgage business. The Fed’s underwriting of the mortgage and refi market has provided crucial support for the general economic recovery. As long as the Fed is buying MBS and agency paper, interest rates on Treasuries, mortgages and CDs will remain low. If interest rates are low, you can’t get a decent return on CDs, so maybe you will put your capital to work in a manner that stimulates the economy.

That’s what the Fed is hoping for, anyway and it is making a subtle suggestion on how to do that, namely “buy corporate bonds.”
You see, the Fed’s purchase of MBS, agency and government paper, does not extend to commercial paper, however. In fact, the commercial loan market dried up last year along with the securitization market and is still moribund. Instead, corporations must raise cash via bond offerings. And sure enough, they are.

Corporate bond offerings are expected to reach $800 billion this year, roughly equivalent to the total from the last three years. The climate of low rates underwritten by the Fed allows corporations to issue bonds at a lower cost. This is good news for corporate solvency, but bonds are now competing so successfully for capital, so that inflows to equity funds are seriously lagging historical trends. But heck, even if the stock market is going up on low volume, who cares? It is going up.

Rebalancing Act
But wait. The problem is that the U.S. economy is consumer-based and consumers are retrenching. Household debt is down about $200 billion year over year, which isn’t much, but it is down over $1 trillion from its peak in 2006. This 3-year contraction puts net household debt growth into negative territory for the first time in two generations. Unfortunately, that also means a decline in spending and GDP because spending in the U.S. has been debt-driven.

Meanwhile, the deficit has been generously taken up by the government, whose debt load is up $2 trillion in the last year. To get an accurate read on GDP and the so-called recovery, one should investigate to what degree government borrowing might have impacted the results. There is a limit to how far the government can go in bridging the credit creation gap.

It is different in other parts of the world, however, particularly Asia. When someone wants to buy a car in Vietnam, for example, they plunk down cash or gold on the table. There is no such thing as financing. Companies in Asia are generally debt free because commercial loans are also hard to come by. In our profiles going forward, we will often feature companies that are debt-free or nearly so. Below, however, we ‘un-profile’ a company that has a very high debt to equity ratio and is so widely held that it is virtually synonymous with the stock market itself.