Posted on Monday, November 8, 2010
Bill Gross will be one of the few to benefit from the Federal Reserve's announcement this afternoon.
The legendary money manager, who oversees more than $1.2 trillion at Pacific Investment Management Co., stands to profit off the plan hatched by the nation's central bank. The Fed announced that it will buy between $850 to $900 billion of U.S. government debt, also known as Treasuries, through June to spur the recovery. Over the coming months, the Fed will then communicate its specific plans well ahead of any such purchases, allowing wealthy investors and firms a chance to buy those assets first so they can sell it back to the Fed at a profit. Folks like Gross will be the biggest beneficiaries.
When it comes to helping Wall Street and corporate America, the Federal Reserve spares no expense.
It expanded its authority and bailed out securities and insurance firms. It tethered the main interest rate to zero. It more than doubled its balance sheet to $2.3 trillion by purchasing mortgage-linked securities and U.S. government debt. To arrest the free-falling economy and jolt it back to life, the nation's central bank has engaged in an unprecedented campaign to ensure banks have cash and corporations access to credit.
That part of the Fed's plan has worked. The economy is progressing through a slow, though not entirely visible, recovery. Employers are gradually adding workers to their payrolls. Industrial production is rising, as is personal consumption. The economy is slowly growing.
The problem is that the Fed's actions have served to help just a small, but powerful, constituency: Wall Street, and the firms that do the most business on it.
The rising tide the Fed ushered in with hopes that it would lift all boats hasn't materialized. Now, on the verge of another round of asset purchases and other steps in order to further bring down the cost of credit, questions are being raised over just who, exactly, the Fed would help.
Asked Thursday how he did "so well in the past 18 months," Gross, who runs PIMCO's $252.2 billion Total Return Fund, told Bloomberg Television that in addition to a variety of other investments he's made money "from mortgages, yes, in terms of buying them in front of the Fed and selling them to the Fed over the six- to 12-month period of time." Translation: the man who runs the world's biggest bond fund is profiting from buying securities he knows the Fed will eventually want, and then selling them to the Fed at a premium.
Meanwhile, families are being devastated by historic unemployment and record home foreclosure rates. Households and small businesses can't get credit. A quarter of homeowners with a mortgage owe more on that debt than the home is worth. Borrowers are declaring bankruptcy in near-record numbers.
"In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places," Richard W. Fisher, president of the Fed bank of Dallas, said last month before a gathering of economists in New York.
As part of its legal mandate, the Fed is required to pursue policies over the long-term that lead to "maximum employment, stable prices, and moderate long-term interest rates." But the extraordinary steps taken to battle the Great Recession's persistently high unemployment rate -- like buying Treasuries, mortgage-backed securities and the debt of mortgage giants Fannie Mae and Freddie Mac -- haven't been enough.
Unemployment has been stuck above 9.5 percent since August 2009, or 14 of the 20 full months Barack Obama has occupied the White House. More than six million unemployed workers, or two of every five, have been out of a job for at least six months, Labor Department data show.
A potentially slow decline in the number of Americans without work "is of central concern to economic policymakers because high rates of unemployment -- especially longer-term unemployment -- impose a very heavy burden on the unemployed and their families," Fed Chairman Ben Bernanke said Oct. 15.
The Fed created numerous programs designed to stimulate the flow of credit. They helped avert a Depression, but their programs have not been enough to reinvigorate the job market. Now, with record unemployment and Washington unable to offer meaningful solutions, the Fed is all we have, commentators say. There's no where else to look for help.
"It's all we got," said Diane C. Swonk, chief economist at Mesirow Financial, during an Oct. 8 appearance on CNBC.
Tinkering with the cost of money, though, can't overcome structural issues. For example, the American consumer gorged on cheap debt because he was unable to maintain his standard of living during a decade with little income growth. So credit afforded consumers the opportunity to live the life they otherwise could not afford. That era has ended.
"The Fed simply does not have the appropriate tools to deal with the myriad of structural hurdles facing the economy, ranging from housing, to debt, to commercial real estate, to state and local government cutbacks and fiscal disarray, to excessive regulation, and the list goes on," David A. Rosenberg, chief economist and strategist at Gluskin Sheff & Associates in Toronto, said in a note to clients Wednesday.
Bernanke told Congress in June and July that the economy needed fiscal stimulus. He warned lawmakers not to cut spending. A newly-resurgent Republican Party, which took control of the House of Representatives and made significant inroads in the Senate, has vowed to cut spending.
So the Fed will continue its activist approach. Yet experts are questioning whether the Fed has pursued policies that push corporate America to invest at home, or whether those policies have had the perverse effect of driving businesses to hoard cash or invest abroad.
Will "another...cut to the general level of interest rates from their current record-low levels...really convince debt-strapped consumers who are focused on balance sheet repair to go out and borrow and spend more?" Rosenberg wrote Wednesday. "Or will it entice capacity-idled companies that are already sitting on a trillion dollars in cash to go on a spending and hiring spree...? Are the banks, who just sat on excess reserves the Fed plowed into the financial system in early 2009, going to unclog the credit channels when nearly one-in-three American households have a sub-620 FICO score and 25 percent of outstanding mortgages are 'upside down'? Hardly likely."
Low Rates Not Leading To Growth
Jeremy Grantham, chief investment strategist at Grantham Mayo Van Otterloo & Co., told clients last month that "lower rates always transfer wealth from retirees (debt owners) to corporations (debt for expansion, theoretically) and the financial industry."
"This time, there are more retirees and the pain is greater, and corporations are notably avoiding capital spending and, therefore, the benefits are reduced," Grantham, whose firm manages more than $104 billion, wrote in his latest quarterly newsletter. "It is likely that there is no net benefit to artificially low rates."
The noted strategist added that the Fed's low-rate policy is a "large net negative to the production of a healthy, stable economy with strong employment."
As Grantham intimated, companies aren't necessarily using the Fed's zero-interest rate policy, or ZIRP, to hire at home.
Walmart, for example, spent $9.1 billion on capital expenditures in the 2008 fiscal year, the company said in an Oct. 13 presentation for investors and analysts. That dropped to $5.8 billion in 2009, and $6.6 billion in 2010.
In 2006, 71 percent of the company's cash went to capital expenditures and acquisitions, while 29 percent went towards share repurchases and dividends, Walmart noted in a separate Oct. 13 presentation. That's now flipped.
Over the last 12 months, 43 percent of the firm's cash has gone towards building the company and hiring more workers. Fifty-seven percent went to shareholders.
In other words, the world's largest retailer isn't using the majority of its free cash to build or hire on a large scale. Rather, it's giving it back to shareholders.
IBM, one of the world's largest technology companies, spent $2.6 billion on long-term improvements in the firm through the first three quarters of last year, and $2.9 billion during the same period this year. But while the firm spent $4.4 billion on share buybacks during that period last year, IBM spent $11.8 this year, according to its recent earnings reports.
Companies with spotty credit aren't using the opportunity afforded by low rates to build, either. Just 21 percent of proceeds from high-yield bond issuance during the three-month period ending in September went to general corporate purposes, leveraged buyouts and acquisitions, according to a Oct. 22 report from Fitch Ratings.
"Firms continue to cut back on their capital expenditures and R&D outlays," analysts at JPMorgan Chase said in a September report. Money spent on long-term investments and research and development represents less than 55 percent of operating cash flow at the non-financial companies that make up the Standard & Poor's 500 index. It's down from a high of more than 85 percent as recently as 2001, the analysts noted.
But money is flowing overseas.
The proportion of capital expenditures spent abroad has risen from 18 percent in 2001 to 27 percent in 2008, the JPMorgan analysts wrote. It's likely higher today "thanks to growth opportunities prevalent in emerging markets."
On Oct. 29, the Treasury Department reported that U.S. portfolios held some $6 trillion of foreign securities at the end of last year. At the end of 2008, U.S. portfolios held $4.3 trillion in foreign securities.
The trend continues this year. There's been a net outflow of money from domestic equities every month since May, according to the Investment Company Institute. Foreign equities, on the other hand, have been growing.
"[F]ar too many of the large corporations I survey that are committing to fixed investment report that the most effective way to deploy cheap money raised in the current bond markets or in the form of loans from banks, beyond buying in stock or expanding dividends, is to invest it abroad where taxes are lower and governments are more eager to please," Dallas Fed president Fisher said Oct. 19. "This would not be of concern if foreign direct investment in the U.S. were offsetting this impulse. This year, however, net direct investment in the U.S. has been running at a pace that would exceed minus $200 billion, meaning outflows of foreign direct investment are exceeding inflows by a healthy margin.
"[I]f it were to prove out that the reduction of long-term rates engendered by Fed policy had been used to unwittingly underwrite investment and job creation abroad, then the potential political costs relative to the benefit of further accommodation will have increased," he added.
In other words, the Fed's next round of asset purchases may not help American families. Rather, it may benefit the citizens of other nations.
Savers Getting Squeezed
Meanwhile, savers, retirees and those living on fixed incomes are getting burned.
In November 2008, a month before the Fed lowered rates to near zero, the average bank-offered checking account in the U.S. was paying consumers 0.34 percent interest, and the average savings account was paying 0.49 percent, according to Market Rates Insight, a data provider. Both have been steadily falling since. In September, checking accounts were yielding 0.16 percent; savings accounts were paying a minuscule 0.24 percent in interest.
In the week ending Dec. 10, 2008, just a few days before the Fed lowered the overnight bank-to-bank lending rate to a record low, six-month certificates of deposit were yielding on average 1.93 percent, according to Bankrate.com. They now yield 0.32 percent.
One-year CDs were paying 2.30 percent back in December 2008, while five-year CDs were yielding 3.13 percent. They're now at 0.53 percent and 1.57 percent, respectively, Bankrate.com data show. CDs are offered by banks and are FDIC-insured.
Taxable money-market funds, sold by brokerage firms and not FDIC-insured, are yielding 0.03 percent on average, according to iMoneyNet, a research firm. In December 2007, when the main interest rate was 4.25 percent, money funds were offering investors 4.08 percent.
These funds typically yield about 50 basis points, or 0.50 percent, below the main interest rate, said Mike Krasner, managing editor of iMoneyNet. The main interest rate is officially called the federal funds rate.
But now, with the fed funds rate tied to zero, the yield offered by money funds can't really go much lower.
Facing a volatile stock market and stung by losses in their retirement accounts and on their homes from the financial crisis, retirees are reluctant to take on too much risk, financial advisers say.
"It's a challenge to get yield because often times people want the safety, but when you insist on safety there's not much yield out there," said Qi Lu, senior portfolio strategist at New York-based Altfest Personal Wealth Management.
Low interest rates are taking their toll.
"It's been a very difficult environment for retirees," said David Certner, legislative policy director at AARP. "We're getting complaints from people who are afraid of the stock market, and about the lack of safe fixed-income investments."
Lu, whose firm oversees about $600 million for clients with between $500,000 and $20 million in assets, said that bonds are "not a very attractive investment when everyone is issuing debt, just like it's not good to invest in equities when everyone is issuing shares."
"My clients always assumed they'd get three to four percent off their CDs, and they cant get that," said Mitchell Dannenberg, president of LTCi Marketplace in Florida. "They were always counting on safety in income."
Certner said that the seniors association has received calls urging it to lobby for higher interest rates.
Wendell B. Fuller, an investment adviser with Bowen|Fuller Wealth Advisors in Midlothian, Virginia, said his clients, too, are worried about the Fed's keep-rates-low agenda.
"My retired clients are the ones who are concerned about the low rates, especially those living on a fixed income," Fuller said. His clients typically have about $500,000 to invest. They include small business owners, doctors, corporate executives, and retired blue-collar workers sitting on healthy savings.
"I have this client, she's 83 years old," Fuller said. "Her mentality is, 'I need income.' But the way my practice is, we're not trying to generate income because with income comes taxes. So my focus is on cash flow so you have cash to pay your bills.
"We've always had our savings and money market accounts, where we could get that little bit of interest. But no longer. We're not getting much, but it is what it is."
Molly Balunek, a senior vice president at Inverness Investment Group who primarily works with women, said she recently spoke with a host of retail investors as part of a call-in event where non-clients could call and ask questions. Low interest rates dominated the discussion.
"I was really surprised by it," Balunek said. "And they weren't all older people. Some were, but many were younger and they were frustrated by the low rates."
One caller told Balunek that she had $50,000 in cash but had earned just $0.10 on it for the whole year.
The callers, and her clients, know there's not much they can do, said the Cleveland, Ohio-area adviser, whose firm oversees about $350 million. If they want the safety of a savings account, they have to give up on interest income. If they want interest income, they have to take on more risk.
"They all seem relieved and resigned" when Balunek tells them that, she recounted in an interview. "It's sad because a savings account is supposed to be a safe place and everyone remembers 2, 2.5 percent interest rates, which are the historical average.
"They know there's no magic elixir. It stinks."
Corporations Sitting Pretty
For corporations, however, life has rarely been better.
Sitting atop a record $1.8 trillion in cash and other liquid assets, non-financial U.S. firms are awash in wealth, Fed data show. Relative to their short-term liabilities, U.S. corporations haven't been this flush since 1956. By that same measure, their balance sheets are twice as strong as they were just 15 years ago.
Thanks to the Fed, which cut the main interest rate -- the rate at which banks lend to each other for overnight funds -- to the 0-0.25 percent range in December 2008, and has kept it there ever since, corporations have been able to borrow at ever cheaper rates.
The combined effect of the central bank's zero-interest rate policy and the massive flood of cash the Fed has poured into the system via asset purchases resulted in a lowering of the interest rate the government pays on its debt.
It's also given banks and investors a ton of free money to play with. But gun-shy financiers have sunk that money right back into low-risk government debt on the assumption that the U.S. Treasury will be among the last enterprises on Earth to default. This increased demand for Treasuries, plus an across-the-board lowering of interest rates based on the aforementioned Fed policy, has allowed the government to offer less generous interest rates on its debt securities.
Two-year notes yielded 0.3435 percent at the close of trading Tuesday, the fifth-lowest yield ever, Bloomberg data show. The yield on 10-year Treasuries stood at 2.59 percent, slightly higher than the incredibly-low 2.38 percent on Oct. 7.
In other words, investors are getting 0.34 percent interest annually to own a piece of two-year government debt, and just 2.59 percent for 10-year debt. On Halloween of 2007, 10-year Treasuries closed the day yielding 4.48 percent; two-year notes yielded 3.94 percent.
Lower yields on Treasures has in turn brought down the interest rate corporations pay investors to buy their obligations. Starved for higher yields, investors are pouring into corporate bonds. The influx of investors, plus strengthened balance sheets thanks to lower labor costs, higher worker productivity, and low interest rates, has enabled corporations to issue debt at some of the lowest rates on record.
Last month, Walmart set new records by offering investors just 0.75 percent interest on its issuance of $750 million of three-year debt and 1.5 percent interest on its $1.25 billion of five-year notes. Both are the lowest yields on record for U.S. corporate debt, Thomson Reuters data show. Investors, desperate for higher yields than Treasuries yet somewhat reluctant to take on too much risk, gobbled it up.
Walmart's record issuance was the third time in as many months that a U.S. corporation broke an all-time low for interest rates, according to records dating back to 1970. In September, Microsoft set the record for all-time lowest yields on three- and five-year debt. In August, IBM set a now-twice broken record by offering what was then a headline-making 1 percent for its three-year notes, while Northern States Power-Minnesota, a subsidiary of Xcel Energy, set the record for its five-year debentures.
In fact, the 10 lowest rates on record for U.S. corporate debt across all maturities -- three-, five-, 10-, and 30-year debt -- have all been issued in 2010, according to Thomson Reuters data.
But it's not just corporations with outstanding credit ratings that are benefiting.
In the U.S., corporations with spotty credit have issued nearly $226 billion in so-called high-yield debt this year, according to research firm Dealogic. Better known as "junk" debt because of the issuer's tarnished credit rating and the high interest rate the corporation needs to pay in order to attract investors, these offerings have already surpassed last year's total of $163.6 billion, and more than quadrupled the total from 2008. This year's total is the highest in at least 15 years, Dealogic data show.
Cliffs Natural Resources Inc., a mining and natural resources concern rated BBB- by Standard & Poor's, the absolute lowest investment grade, could sell about $500 million of 10-year notes at 4.8 percent, according to an Oct. 20 note by analysts at S&P. U.S. government debt of the same maturity was yielding 4.8 percent as recently as August 2007.
Banks Nursed Back to Health
Times are so good that Goldman Sachs, the investment bank targeted by regulators and lawmakers in part became it became a symbol of Wall Street excess, issued $1.3 billion in debt last month that won't mature for another 50 years. Investors are getting 6.125 percent in annual interest on it. Despite the low yield for such a long duration -- debt usually only ranges up to 30 years, for banks typically less -- investors couldn't snap up enough.
Goldman isn't the only bank to benefit, though. Banks across the country are sitting on boatloads of free cash, just like the corporations they serve.
Through September, banks had $981 billion in excess reserves parked at the 12 regional Fed banks across the country, Fed data show. In February it was $1.2 trillion. In August 2008, just weeks before the financial system nearly imploded, banks had just $1.9 billion in excess reserves.
"[R]ight now the economy and banking system are awash in liquidity with trillions of dollars lying idle or searching for places to be deployed," Kansas City Fed President Thomas M. Hoenig said Oct. 12.
Rather than going to households and small businesses that need credit, though, that money instead is going to the biggest borrower of all -- the U.S. Treasury Department.
U.S. banks now own more than $1.5 trillion in Treasuries and taxpayer-backed debt issued by mortgage giants Fannie Mae and Freddie Mac, according to the latest weekly data provided by the Fed. It's a 30 percent increase from the week prior to the Fed's Dec. 16, 2008, announcement that it was lowering the main interest rate to 0-0.25 percent.
Outstanding commercial and industrial loans at U.S. banks have fallen from $1.6 trillion in October 2008 to $1.2 trillion this past September, Fed data show. The $390 billion drop is equivalent to a 24 percent reduction in credit to businesses.
For families, it seems that it's never been harder to get a line of credit. For banks, they book an easy profit by borrowing at near-zero cost and lending it back to Uncle Sam.
In a March interview with The Huffington Post, Hoenig said the Fed didn't "have any business guaranteeing Wall Street spreads," otherwise known as the profit generated from the difference between borrowing at low interest rates and at lending higher.
Thanks to near-zero borrowing rates, the Fed has nursed the nation's banks back to health and shored up their balance sheets.
According to the Federal Deposit Insurance Corporation, in the three-month period ending in June banks enjoyed their lowest cost of funds in the 26 years the FDIC has kept quarterly records. That cost -- the money banks pay to garner deposits and other funds that are then used to lend, invest or trade -- dropped to 0.97 percent, the first time they've paid less than one percent during a quarter since at least 1984, the bank regulator's records show.
Historical records on commercial banks' cost of funds going back to the inception of the agency in the early 1930s show that the last time banks paid less than one percent for the year was 1960.
It may be even lower for the most recent quarter, which ended Sept. 30.
But it's the biggest banks that are benefiting the most from the Fed's generosity.
Banks with more than $10 billion in assets paid just 0.85 percent for their money. The next class of banks, those with assets between $1 billion and $10 billion, paid 1.29 percent, FDIC data show.
The Fed made its Wednesday announcement at the conclusion of a two-day policy-setting meeting. Prior to the meeting, regional Fed chiefs from Minneapolis, Philadelphia, Kansas City, Dallas and Richmond were bristling at the expected announcement that the Fed will do more.
"Dumping another trillion dollars into the system now will most likely mean they will follow the same path into excess reserves, or government securities, or 'safe' asset purchases," Hoenig said Oct. 12.
In June, the Fed's policy makers forecast the unemployment rate next year to be between 8.3 and 8.7 percent. On Wednesday, it said that "progress toward its objectives has been disappointingly slow."
Shahien Nasiripour Huffington Post