In our last article we promised to take a periodic look at different markets, and our perspectives on just what is happening. We are no more intelligent than our readers and this is not financial advice, merely observations. In our other articles we have taken three looks at the markets by decade starting in 2000. Each generation has a distinct perspective of where and when to invest, but since we are in the Baby Boomer generation, we plan to focus on that era in this article.
Many things are going on in the markets and listening to the morning financial news is about as confusing as it gets. Half of the pundits believe that the markets still need to go way down to get to the end of our troubles. Half believe inflation is coming down and the FED needs to stop raising rates. They are just about evenly split on every relevant or irrelevant financial topic. But everyone has a viewpoint based on their profession, position, or personal investments. Staying informed and figuring out what you believe is the key.
The Long View
The long view is for those of us that hit our peak earnings years in the early 2000’s. This is the view that has the most relevance in our world of investing, and at the same time covers the other two time periods.
For the long view from 2000 until today, gold continues to be the only asset that outperformed all the markets and the growth in the national debt. Despite what we hear on talk shows, there seem to be a lot of headwinds for the next few years. But markets move much faster today and only after all these events play out will we know whose view is right. We see little that would cause gold to drop below $1,900 or go higher than $2,000, but a lot that can cause the various stock markets to faulter.
Only to the Senate, the President and Janet Yellen does our National Debt seem to be an irrelevant or “down the road” concern. But in an election year the importance of the debt is always downplayed by those in power and discussed by the opposition. Nothing will happen to the trajectory of the debt unless the Republicans win the Presidency and both houses of Congress, and even then, true spending behavior modification is unlikely.
The downgrade in our public debt by the rating agency Fitch last week was significant and should have been a wakeup call to Congress and the Washington bureaucrats. But when you are drunk on giveaways little will change your habits.
While the downgrade in our debt will not resonate with most politicians, what will resonate is the more rapid growth in our borrowing to pay a higher rate for our bonds. Eventually this translates into either higher tax, higher inflation, or both. Our debt is already unstainable, and this just adds fuel to the fire. Believing that our Congressmen and Congresswomen have some special economic insight or training is a fool’s errand.
Because the public and markets are focused elsewhere and the incentive for those on Wall Street is to keep the current little rally going, the growing debt and increasing risk are being ignored. But Stimulus Money has run out and consumers are still spending. Credit card debt has now eclipsed the $1 trillion mark and will only grow until something happens to slam the brakes on the economy.
Often acknowledged on television is the looming refinancing of office space in major cities. Some former owners are just walking away from their obligations and leaving the mess to their banks. The mess is staged over a three-year period so this will be a slow-motion train wreck. This cycle has been repeated several times over the past three decades and it cannot be avoided as markets slow. All we can hope for is that the banks are prepared.
We believe the biggest issue is total consumer debt. According to information from the Federal Reserve Bank of Saint Louis, total consumer debt of all types is now over $17 trillion. The largest part of this is home mortgage debt, but credit cards, auto loans, and second mortgage (HELOC) debt is significant. Any floating rate debt in these figures is even riskier to borrowers, but also to the health of the economy.
The FED signaled last week that they do not think the banks are prepared, and after ignoring bank reserves for the past year they are now at the point where they must deal with it. They must raise rates further to stop inflation. This will further degrade the value of bank bond portfolios and will probably hasten problems in the housing market and short-term consumer debt.
Another big issue for banks is the looming adoption of the international accounting standards known as the Basel Accord IV. Basel IV is aimed at international standards for supervision and weighing risks in banks using consistent risk calculations. The Basel Accords are not mandatory, but the FED has hinted at adoption which has our largest banks pushing back. It is likely that implementation of Basel IV would bring into the risk calculations unrecognized bond losses, requiring more capital for our largest banks.
U. S. banks are arguing that they have passed the FED’s stress test and that is enough, but the FED is now signaling that it has concerns for all banks with $100 billion in assets or more. The FED has openly said that it wants banks to account for their unrecognized losses on bonds. This would put a great deal of stress on Bank of America and Wells Fargo. Unrealized bond losses for the two of them are at 48% and 25% of capital, respectively. The Basel IV requirements for risk assessment would require that they recognize these, and the FED wants another 16% to 19% on top of that. In the case of Bank of America, they would need approximately $150 billion in added capital. Wells Fargo would need to raise approximately $1o0 billion. (See our articles on Gold versus Stocks 1 and Gold versus Stocks 2)
Other large banks would feel a little strained, but not like Bank of America and Wells Fargo. The FED must raise rates further and this will cause the bond losses to escalate more, so recognizing the losses and raising capital seems prudent.
While uncomfortable and not what they want these banks can meet added capital requirements through profits, curtailing stock buybacks, temporarily capping bonuses, freezing dividend levels, and issuing stock. The comfort level issue for banks is that it will temporarily hurt their stock prices. But it will not hurt nearly as much as a major bank failure, and if they are given three years to meet the higher standards, we believe they can do it.
There is another issue the banks do not discuss, and it is lending volume. Greater capital requirements will slow lending and indirectly slow the economy. It is one more tool in the belt of the FED and one they have not discussed deploying until now. This is a way to slow things down in the economy without raising rates further and avoiding more of a federal debt crisis.
Why Does It Matter?
Nothing matters more to the markets and overall health of our economy than the strength of our banking system, particularly the top ten to twenty banks. Size does not always mean success as we have seen in recent failures. The FED is fighting inflation and at the same time trying to protect the banking system, consumers, and markets. Something must suffer to get inflation under control, and in election years getting Congress to either curb spending or raise taxes, or both, never happens.
With the latest inflation numbers, we are probably in for another rate hike or two before the FED pauses again. They, the FED, and banks, must hope this halts inflation because the FED does not have many arrows left in its quiver. When we stop and ask about the risks in the markets, we can see the FED’s concerns.
- Unrecognized losses in bank bond portfolios
- Loans on commercial real estate tied to office rentals
- Rising labor costs
- Rising oil prices
- Rising house prices even with rising rates
- Housing shortages
- Record high credit card debt
- Record Federal operating deficits
- Record high interest payments on the Federal Deficit
The question is not should the FED act, but why has it taken so long? Not acting would make the FED Board of Governors look like Alfred E. Newman reciting “What me worry?”
The last arrow in the Fed’s quiver is raising reserve requirements on bank deposits, and if they get there it will assure a hard landing not a soft one. Raising the reserve requirements on deposits slows the multiplication effect on the velocity of money in the economy, and this would deleverage it all, instantly.
Currently the reserve requirement on deposits is zero (0%), madness! This places banks in a position where all reserves are in their capital accounts and assumes all banks will be responsible and self-regulate, also madness. This allows banks to leverage deposits infinitely into loans and bonds, and the ill effect of that decision is just coming to light.
Our thanks to freeman for his help looking over our shoulder on this article. More than one set of eyes looking at all of this always helps.
There is a growing overlap in the two series “Gold versus Stocks” and “Banking Time Bomb” and we encourage everyone to read both for a more complete view of current banking and financial concerns.
Resources Used in This Article
Average American Household Debt in 2023: Facts and Figures, by Jack Caporal, The Ascent, fool.com, July 14, 2023.
Banks with at least $100 billion in assets could face higher capital limits, by Elisabeth Buchwald, CNNbusiness, cnn.com, July 10, 2023.
Fed plans to boost US banks’ reserve requirements; industry gripes, by Peter Schroeder, Reuters, reuters.com, July 10, 2023.
Punishing Banks for Regulatory Failure: Regulators want to saddle midsize banks with new capital rules, by The Editorial Board, The Wall Street Journal, August 9, 2023.
What Basel IV Means for U.S. Banks, by Greg Daughtery, Investopedia.com, March 17, 2023.
Why Fitch’s Downgrade Matters: U.S. debt is in much riskier territory than when S&P lowered its rating in 2011, by Greg Ip, The Wall Street Journal, August 9, 2023.