Hike in Fed Funds Rate Would Cause Damage to Collateral on Books of America’s Banks

Reddit

Free beer. It’s even better than free money. Beer you can drink right away. Money has to be exchanged.

Your editor is thinking about beer because he’s going to win some of it from Kris Sayce at Money Morning. The Sayceninator was one of several colleagues last week who expressed the view, if we understand them correctly, that the Fed’s decision to raise the discount rate last week was a sign of monetary tightening.

This triggered a flurry of speculation what the net effect would be. Sell equities? Sell bonds? Buy bonds? Sell gold? Buy gold? What what what?!!

Our response: don’t believe the hype.

So we made a bet with Sayce: if the Fed raises the Fed Funds rate at any time in the next three months, or even fixes short term rates at 0.25% instead of today’s free-floating range, we’ll buy him three barley pops. If the Fed Funds rate goes nowhere, that’s more beer for us.

The market seems to agree with us, so far. After an initial fainting spell on Thursday, it remembered itself and gathered its composure. Granted the S&P and Dow didn’t do much on Friday. But they didn’t crash, either. And today Aussie stocks have held their nerve as well and sprinted higher.

The simple, unarguable, world-conquering, completely undeniable, not-to-be-disputed truth is that the Fed cannot raise the Fed Funds rate without doing serious damage to an American real estate market that’s already in intensive care. We would bet a keg of Heineken on it. Why?

A hike in the Fed Funds rate would do more damage to the collateral on the books of America’s banks. It would wipe out more (already thin) capital cushions. And it would undo the work the Fed has done in other markets (securitisation) to get credit flowing. The Fed can’t risk all that.

It’s not the big money-centre banks in Wall Street you have to worry about. It’s the smaller regional and community banks. The Federal Deposit Insurance Corporation shut four more of them over the weekend. That’s 20 for this year, which is a lot less than the 140 last year. But if you wanted to see a spike in U.S. bank failures, you’d definitely raise interest rates.

Besides, why bother? The Euro is in slow-motion imploding as a currency experiment. The dollar, as the not-euro, is getting a bid. At the very least, the dollar bears are closing their shorts for now. The U.S. dollar index is still testing resistance at around 80. As Murray said last week, if it can hold 80, the next stop is 84. That’s consistent with a much weaker euro.

All of this happened without a puny 25 basis point rise in the discount rate. If the Fed really wants to get tight, it can shrink its balance sheet and quite directly supporting lending and asset prices in any number of markets. Until you say a shrinking balance sheet, don’t think Ben Bernanke has suddenly turned in Paul Volcker.

Long-only stock fund managers can sigh a breath of relief then. The easy-money conditions that have led stocks up since March of last year are not disappearing any time soon, as far as we can see. Not that you have an all clear to buy Aussie stocks. But where does that leave us?

It leaves us pretty much in the same position we were to start the month: having no idea what the future holds. We know what SHOULD happen. More global deleveraging ought to lead to lower prices for stocks and real estate and even commodities. We’d expect a bear market in paper money that would have a corresponding bull market in precious metals and precious metals equities.

This is how we resolve having a fundamentally bearish position on the economy but still recommending you own some stocks. Yes, it’s risky. But it is a strategy nonetheless.

Still, we can’t help but think that official policy makers here still underestimate how vulnerable Australia might be to another credit shock. No one is worried about Australia’s sovereign debts because, by comparison, they are a smaller as a percentage of GDP than many other nations. The country’s debt burden is lighter, and thus, easier to service.

But if there is another credit crunch in America due to falling commercial and residential real estate values – how eager are American and European lenders going to be to to lend money to Australian banks? Won’t they want to conserve capital instead? And then where will the money come from?

This leads us back briefly to a few more facts about Australia’s net foreign debt. And here we mean the debt owed by households and corporations too, not just sovereign debt. Based on the maturity schedule of the debt and composition of lender countries, we’d say Australia could have a massive debt shock rather easily.

That would put the Federal government in the position of lender or debt guarantor of last resort. And THAT could quickly lead to rising government debt-to-GDP ratios-exactly the same kind that blew out in America and Europe in the last two years due to similar circumstances. But where’s the proof?

First, have a look at the chart below. It shows that the UK, the US, and Japan make up combined make up 49% of Australia’s foreign debt country. To the extent the banking resources of these countries will be dedicated to saving their own hides in a second credit crisis, you can assume they might not have as much money to lend here. That leaves a huge burden on the remaining lenders, including the 32% classified as unallocated (whoever that is).

Composition of Foreign Debt by Country

But the problem is more serious when you read about the maturity schedule of Australia’s foreign debt. According to 2008 data, over $400.1 billion dollars of Aussie foreign debt – or 35.4% of the total – matures in 90-days or less. Nearly half the debt total – $514 billion – matures in one year or less. What does that mean?

We think it means two things. First, that’s a lot of debt to roll over in a short period of time. It gets even harder to do when your lenders have bigger fish to fry. Second, it makes your borrowing a lot more interest rate sensitive. You may indeed be able to borrow. But it will cost you a lot more to do so. And you can be sure that if the Big Four Aussie banks have to pay higher rates internationally, they’re going to pass on those rates domestically. We’ll see what happens to housing finance commitments then.

One guess is that the government will have to pony up more money in the residential mortgage backed securities market (RMBS). The government has pumped more than $8 billion into the market since 2008, according to Danny John in today’s Age. This means the housing boom is being propped up by government borrowing to support lending.

There are more than few outrageous aspects to all of this. For one, it looks to use like many of the non-traditional lenders who are financed via the AOFM are loosely affiliated with Big banks anyway. It’s a way for the Big Banks to practice high-risk lending and sell the loans to the AOFM, all in the name of making housing “affordable” to people whom the Big Banks won’t lend to on their own balance sheet. That’s pretty shady.

The issue for Australia is whether the back-door rigging of Aussie house prices by the AOFM will eventually endangers Australia’s ability to pay its sovereign debts. Granted, $8 billion here or there hardly seems like the sort of thing to break the national bank these days. But it’s the trend that concerns us.

That trend is that in markets where traditional financiers and lenders won’t participate, the government is forced to come in and put the public balance sheet on the line. There are few markets more politically important than housing. You can see why the government is committed to supporting prices even if it means supporting friendly affiliated non-bank lenders with billions in the securitisation market when few others will.

But our question this week is what happens to that $500 billion in foreign debt with a maturity date of less than one year? What happens in another credit crunch if Australia’s main borrowers – and let’s be clear it’s the big banks and financial companies we’re speaking off – have to pay more to borrow (assuming they can get it?)

One obvious answer is that the federal government will have to step in. This could lead to transfer of private liabilities on to the public balance sheet here in Australia in just the same fashion it happened in the U.K. and the U.S. And for a nation already carrying a large foreign debt burden, it might not take much for such a crisis to put the federal finances on incredibly unsteady ground.

But maybe we’re just grumpy because it’s Monday.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
Reddit

Leave a Reply

41 Comments on "Hike in Fed Funds Rate Would Cause Damage to Collateral on Books of America’s Banks"

Notify of
avatar
Sort by:   newest | oldest | most voted
geo
Guest
It’s interesting that after the emperor has been walking around with no clothes on for long enough people stop looking, or even noticing. Here is my 4 step plan for western nations to get back in the black with no pain whatsoever: 1. Nationalize the illegal drug industry. ( Yes i know we hate nationalizing things, but hey..). Conservative estimates put that at about $100 billion per year in the US…..I would estimate it to be more like $200 billion. Everybody likes getting high. Always have. Always will. In fact historically the only things we seem to like better are… Read more »
Mark Lahiff
Guest

Your most insightful discussion yet of the mechanisms that will probably lead to the total devastation of the Australian Housing Market following in the footsteps of the U.S. Our only hope is if our currency remains in demand as a hard commodity currency.

Biker Pete
Guest

Mark: “…the total devastation of the Australian Housing Market…”

Attempting to generalise the US and Japanese situations to that of Australia is precisely the mistake made by Steven Keen, whose hunches about Australian property, interest rates and unemployment rates were all _hopelessly_ wrong.

“Following in the footsteps (hoofprints?) of the US”(?) Good luck with that hope, Mark. You’re relying on us following those cowboys down the yellow brick road? Happy trails, pardner! ;)

Rob of Currumbin
Guest
Hmmm. Let’s put this into a scenario your average punter can understand. You have to re-finance the residual on your car loan (the foreign debt)in a couple of days and you’ve kept it in reasonably good nick (the economy) and might still have some equity against the re-sale value (the Howard surplus),not like your Greek neighbour with the ’91 Nissan Pulsar, however the finance company (Wall Street) wants some projections and they’re worried about your biggest client (China)getting the wobbles and reducing your cashflow; your missus recently blowing out the credit card (Rudd Government deficits; the kids squabbling for more… Read more »
Luke Of Stafford
Guest

My theory for Dans quick trip back to the states…he has found a property in the beautiful Colorado wilderness for pennys on the dollar, where he can set up his “Mogambo Guru” style bunker complete with harem and stocked with loads of weapons and baked beans to see out the financial catastrophy that awaits us all! Hopefully whilst still publishing the DR Aus. Hope everything is well Dan, have a safe trip, Cheers Luke.

Stillgotshoeson
Guest
Biker.. Steve Keens was not WRONG per se.. His timing is out is all and unprecedented responses to the GFC post his comment altered that timing. The multi billion dollar FHOG stimulus can not be denied on having an impact on suring up property prices. Unemployment, downturns in the past were catalysts for major redundancies in the workforce this time around we had reduced hours… from todays The Age.. “in September 2007, there were 518,400 classed as underemployed. A year later there were 655,000….but there are no such doubts over the rise over the following year, when underemployment jumped to… Read more »
Biker Pete
Guest
Shoe-son, yes, I’m well aware that Keen complains that Rory Robertson ‘ambushed’ him; ie., that the crash is _still_ going to happen, given 10 – 15 more years. But Keen’s failure to consider that governments would protect the third largest Australian industry, construction; and, in so doing, protect employment and our tax base, means that Keen wasn’t really aware of the ‘big/ger picture’. Economists should include such likely factors, particularly if they crave media attention. Keen saw a domino effect… US, Japan, UK… us next… and then found data to support his thesis. There will be plateaus and corrections in… Read more »
Ned S
Guest
Steve Keen tried to time the market – And was wrong. As to “ifs” – Well, “if” me aunt had dangly bits she’d be me uncle eh? :) Let’s face it, “if” one particular blogger here hadn’t believed the government would stimulate housing, he would’ve been wrong like the rest of us! Been working on that plan Biker – It’s not perfect. But I DON’T care – As it’s shaping up to quite possibly mean I’m gunna be debt free in my own humble little dunger with $45k pa coming in after tax for the next 4 years (’till I’m… Read more »
Biker Pete
Guest
Sounds like a good move to me, Ned. We’ve had a string of requests for rentals today, including numerous long-term _government_ contracts, which we’ve never had before. With our one-year-lease policy, we’ve declined; but we’ve only one vacant, anyway; waiting to be painted and carpeted. Have a feeling the 1% vacancy rate may have fallen.. . I responded to Shoe-son, but have been hit by the WWW Cops… so I’m waiting, waiting, waiting to see if/when my response gets aired. Starting to see a possible pattern here; if one posts a link or two, the filter puts the post ‘on… Read more »
Ned S
Guest

They like to review links to Wikipedia. And to at least some of their own old DRA stuff is about the best I’ve been able to make of it Biker.

As to the plan – Yep, I’ve had a look at the stock trading thing and reckon it’s not my bag. And figure if things should go real crook then neither cash nor bullion are where I want to be. So figure I’ll keep on keepin’ on – Or somesuch? :) :) :)

Stllgotshoeson
Guest
_Biker-Pete_ $350000 Unit $300000 Mortgage 30 year term 9% Interest Repay $555 per week @6.99% Repay $459 per week My wage after tax $1127 per week Rent $260 perweek $200+ Extra per week to invest with Real Estate Bulls are right and Capital Gain is 7% a year for next few years… just keeps up with interest bill at 6.99% @9% I will actually be falling behind. More likely to get better than 7% return on investments in shares so I am in front. Rent goes up 10% a year (average $286pw for 3 years) I just signed of on… Read more »
Dan
Guest

Nah Pete, it’s WordPress’s spam filter which looks for positioning of links and all kinds of other fuzzy criteria and it rarely misses a real spam message – but it means they have to manually scan for genuine stuff fairly often.

Biker Pete
Guest

Thanks for that, Dan. Sorry to have to sink the ‘wages containment’ ship… .

Don
Guest
I think I might have mentioned the Cairns situation here before – high unemployment, 14% or thereabouts and a depressed tourism market and we are in the middle of the wet season. Anyway we started looking for a 2br apartment to rent about 12-16 months ago and I distinctly remember at the time that there was hardly anything available under $250 and what was there was pretty rubbish. Did a search on realestate.com today and for 2 br (not looking just interested) – there is nothing above $230 in the 2br range now. New apartments, the paint barely dry for… Read more »
Biker Pete
Guest

Pretty amazing, Don. My kids are paying twice and three times that amount for their apartments.

What’s Cairns like, from a lifestyle point-of-view? Wouldn’t mind owning an apartment right on coastal QLD… . We should both be retired (whatever that means) by mid-2011.

nv
Guest

LOL! what a bunch of penny pinchers.
ROFLMFAO!!

Don
Guest
Lifestyle isn’t too bad during the dry season – usual rules apply though, always have an air conditioned bedroom otherwise you go nuts :) We used to live in the Northern Beaches – Palm Cove – which is a beautiful spot and the mozzies are quite sparse. Of course you have to be careful in the water during the dry season – Box Jellies and the Irukandji (little tackers – very painful sting, end up in ICU for a week or so on painkillers – look on youtube for some footage of that!) We moved to a 2br house in… Read more »
Don
Guest
I know there are people who are sure of the coming housing crash and fine with that but god I feel for these people up here. I used to be one of them 10 years ago :( To be stuck with a dud unit/house (house rents are only slight higher!!! aiiiyeee), knowing that you are competing with so many others just trying to land a half decent tennant whilst the big body corporate and council fees just keep rolling on in. In 1997! – we used to get about $200 per week from our 3 bedroom unit in Westcourt! That… Read more »
Biker Pete
Guest

The scenario you’ve described is hard to imagine, Don. Meanwhile at almost the same latitude, Broome is booming, property-wise. As Greg Atkinson states, there’s a diversity of markets across Australia.

NV doing a Cobain on us? Heard a loud bang and there he was writhing on the floor, abdomen totally disconnected !~

Dan
Guest
Don, if rents are low and prices are high, maybe it’s a good time to test the market by perhaps cashing in and taking profits? Otherwise, if the place has no debt on it, then it’s just a reflection of the general ability to pay IMO, and it’s likely all investments will perform similarly poorly in the coming years – no miracles there. As you say if wages aren’t rising, then something else has to adjust. A place has to have a reason worth living in, after all, be it a mining boom (Broome) or as a tourist Mecca (Cairns)… Read more »
Dan
Guest

Incidentally, I was referring to Cairns in particular. Ability to pay is obviously going to be changing globally, but seriously who, except for a few, is likely to take on the complexities of travelling internationally to buy and sell investment properties?

Don
Guest
I agree Dan, unless you fall in love with the place you would give investing here a miss. Cairns does have a reasonable number of people living there who FIFO to places like PNG and the like which does offer some support and has prospects for growth in the future. However the impression I get is that tourism is definitely no longer growing up here and that is the problem. The official population of Cairns is about 150k. I see what you mean with Broome Biker – the rent there starts at $230 and looks like an average of $580-600… Read more »
Lachlan
Guest

Interesting posts Don :)

Don
Guest

Maybe Steve Keene should walk to Cairns intead :)

Biker Pete
Guest
Broome is hardly a mining town, Dan… . More one of WA’s tourist meccas. Pearling probably contributes in a minor way, but the premiere business is definitely tourism. Dan: “…who, except for a few, is likely to take on the complexities of travelling internationally to buy and sell investment properties?” Not sure it’s about ‘buying and _selling’_. Our hope has been to locate one of those fabled bargains in the NH we keep hearing about, as a holiday home. The problem is that if there were such amazing opportunities, the locals would have snapped them up. The only great buys… Read more »
Biker Pete
Guest

Don: “I see what you mean with Broome Biker – the rent there starts at $230 and looks like an average of $580-600 per week. Mind you that $230 looks shall we say…. a little basic, and there is only one.”

It will be very, very basic, Don. And there will probably be major issues not readily visible on the internet! Average of $590 pw seems about right.

Don
Guest
I have been giving it some thought overnight about where you would look at in FNQ for a holiday/retirement place. Cairns: If money was not tight I would look at buying a elevated place (ie on a hill looking out towards the sea or Cairns way). Edge Hill has some nice spots (hence the name) and I have seen a few nice ones at Yorkey’s Knob (pity about the name but oh well). There are others dotted around the place as well. Be aware of what floods regularly if you want to buy on the flats (old cane fields are… Read more »
Dan
Guest

It seems at FNQ that whatever shortcomings there may be living there are easily filled with alcoholic beverages (the builder’s-bog of lifestyle).

Biker Pete
Guest

Terry Ryder (Hotspotting… I’d post the link, but they don’t get through…) has just named his best picks for 2010. Last year, one of our locations was picked in the top three.

Only one WA location this year… . Merredin (wheatbelt) $160K – $220 K.
Rental demand high… .

Ryder’s Top 10 “cheapies with prospects” in Australia

Merredin, WA

Ceduna, SA

Gawler, SA

Glen Innes, NSW

Hunter Valley, NSW

Kingaroy, QLD

Launceston, TAS

North West NSW

Port Lincoln, SA

Portland, VIC

Sambo
Guest

It would seem that ‘hotspotters’ are also community destroyers. I read an article that mentioned on town being overrun by speculators after it was mentioned in a top 10. Locals got priced out of their own town. Social responsibility does not pay these people’s salaries though.

Biker Pete
Guest
That’s one perception, Sambo. Another might be that Ryder is doing FHBs a service by alerting them to locations they can afford. I sent the same list to a younger couple who can’t afford to buy in Perth at $500K, but could easily afford to service a debt of $160K in Merredin. Many wheatbelt towns, having lost the next generation to regional centres, Perth, or the northwest mines, actually promote and market their community’s benefits to the rest of WA, very keen to have an influx of new families, in order to retain medical services, secondary schools, police services, etc.… Read more »
Edward
Guest
All When are you guys going to relaize that the DR guys are full of shit! Look closely they are hypocrites, in one breath they tell you all of the stock markets are goign to collaspe , China is going to implode etcetra. Then in the next breath in their paid news letters they have the next best resource investment directly linked to China since sliced bread! Ok the world may implode and there are some serious issues happening at the moment. What we dont need is to pay these guys for contradicting advice.So guys which is it? If there… Read more »
Sambo
Guest

I’m sorry but you are wrong Biker Pete. It is not FHBs that flock to these towns, because there is not enough work to compensate. It is speculators. Also, there is no point encouraging property or population growth in a town if there is not enough work to support it.

Dan
Guest

The list Biker Pete provides is not devoid of employment opportunities. They are generally good places to live and for people with the right kinds of jobs (tradies, retail, health, farming related etc) would have no trouble in those areas. I don’t think any of the places on that list (to my knowledge) is doing particularly poorly economically either.

Biker Pete
Guest
The particular family to whom I referred has a breadwinner whose online business is a fledgling enterprise which earns him a reasonable _starting_ income. His partner is a teacher, who would be happy to pick up relief teaching work in a wheatbelt town. I realise that a ‘let-small-towns-die’ perspective may be consistent with a ‘let-the-economy-die’ ethic, but I support neither. I’d have thought that by encouraging young families to take up rural opportunities, reducing severe pressure on the cities, an oft-stated goal of reducing competition for homes in the city might be achieved. Having lived over a decade in some… Read more »
Sambo
Guest

You are a strange man Biker Pete. Violence and name calling never solved anything.

Don
Guest

Gawler eh? We used to travel out there from Adelaide pretty well every weekend for two decades to visit grandma. What was noticable over that time was the way what was market gardens and farmland were slowly turning into housing estates. I therefore have a soft spot for the place and my aunty and cousins live there and are doing quite well thank you :) Nice little town all up, slowly becoming a suburb of Adelaide.

Ross
Guest
Biker, I know a little of wheat belt towns but not of WA. The wheat belt is still dealing with the relentless drive for efficiency on farm. From bagged wheat to bulk handling, and from gatmrts that formerly had owned machinery now moving to contractors both hit hard at townie employment. Then there were “benefits” income migrants. What these towns all need however is supplementary income. One of my interests is up country containerisation of commodities as a holistic logistics enterprise. That means not just container logistics but getting around the bulk import distribution infrastructure in the end destination country… Read more »
Biker Pete
Guest

Can’t argue with that, Ross. One of the chief complaints we hear in WA is in regard to the imminent removal of essential services used by rural people for generations. As you say, agriculture is one of our critical industries.
I feel for small communities which lose these services. And, as you say, why should these communities suffer any inequality of service?

The container concept is interesting. Unfortunately we’re only just starting to realise the value of rail again. Did I read recently that Warren Buffett is actively buying rail services?

Biker Pete
Guest

Sambo: “It is speculators.”
Ah, name calling. You are a very forgetful man, Sambo.
Sambo: “Violence and name calling never solved anything.”
Perhaps not, but I’ve always found it particularly satisfying in dealing with horseflies. Bad this time of year… .

wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au