Jubak's Journal Recent articles: • 5 water infrastructure bets, 9/7/2005 • Save your portfolio from Katrina and the Fed, 9/6/2005 • Will Katrina tip the U.S. into recession?, 9/2/2005 More... | Jubak's Journal Do-nothing Fed is dangerously disengaged When it comes to bubbles, Alan Greenspan and his crew are strangely passive. As problems multiply in the financial sector, their lethargy threatens all of us. By Jim Jubak Talk is cheap, Mr. Greenspan. But when it comes to bubbles and potential bubbles, that's all we get from the U.S. Federal Reserve. Greenspan and company can sure talk the talk. But walk the walk? Forget about it. And I think that's going to get us -- and Alan Greenspan's successor as Federal Reserve chairman, come January -- in trouble. Again. In 2006, I'd estimate. Remember the run-up to the popping of the technology stock bubble in March 2000. As easy money, which the Federal Reserve itself provided, drove up stock prices, we got lectures on irrational exuberance. Bad things were bound to happen to investors who forgot about risk, Greenspan warned. (As the bubble continued to inflate, the Federal Reserve chairman changed his tune: Higher productivity justified some portion of these "irrationally" higher stock prices.)
When it came to action, though, the Federal Reserve punted. The central bank ignored all calls -- some from the Wall Street establishment itself -- for higher margin requirements that would have forced investors to borrow less and put up more of their own cash to buy stocks. Would that have helped deflate the bubble more gradually? It might have. But we'll never know. Now, belatedly, the Federal Reserve has decided to warn us that housing prices are getting worryingly high in some markets. Some local housing markets might even be experiencing, dare we say it, a bubble. Some consumers are adding variable-rate mortgage debt without a thought of risk. The Federal Reserve would be much obliged, thank you very much, if all you irresponsible borrowers and real-estate flippers -- you know who you are -- would stop. Related news and commentary on MSN Money All reserve, no resolve But is the Federal Reserve doing anything about the causes of this potential bubble? Not that I can see. When it comes to U.S. banks, the part of the financial system where the Federal Reserve has real, honest-to-goodness clout, Greenspan and his colleagues are curiously passive. And that's truly dangerous. Because the real problems in the financial system, the ones that could blow up at individual institutions and then cascade to affect the entire financial market, are on bank balance sheets. And the Federal Reserve -- like other bank regulators -- seems content to let the problem build. Homeowners and home buyers may indeed be taking on too much debt. Too much of that debt may carry a variable rate that could explode on real-estate borrowers if interest rates rise. Too much of it has undoubtedly been extended to home buyers and home borrowers who can't afford the interest payments that kick in after some initial period of no or below-market interest. But it's easy to understand why borrowers would be tempted to borrow more than they should. Who hasn't felt the allure of a bigger house? Or of that slightly extravagant vacation? Or of borrowing a few hundred now -- and oh, maybe next month, too -- to get through an end-of-the-month rough patch? Lecturing consumers on the need to borrow less, as the Federal Reserve has done, when money is so cheap thanks to its own policies, is like standing in front of an open bar and telling your party guests not to drink more of the free liquor than is good for them. It's great if you like to hear yourself talk and want to be able to say "I told you so" to your hung-over friends. But, please, let's not kid ourselves that it's an effective way to change behavior. A regulator forgets to regulate And besides, the Federal Reserve has an alternative for attacking this bubble: The central bank can go after the banks that are making these loans. For every underqualified investor taking out a loan that is likely to go south, there's a bank making that loan and a banker stretching the rules of sound lending. And the Federal Reserve could do a lot about this deterioration of lending standards if it wanted to. Let's take a look at the Federal Reserve's snapshot of the U.S. banking sector at the end of 2004. On the surface, the banking sector was in good shape. Loans grew by 3.5%, about $170 billion, in the fourth quarter, with the fastest growth in commercial real estate, home equity and credit card loans. But that's only on the surface. Take a slightly deeper look and you'll see some unsettling trends. For example, despite that huge $170 billion increase in loans in the fourth quarter, banks saw their uncommitted capital rise. And despite that increase in loans, net income fell in the quarter. Not by much. Just a 1.4% decline from the third quarter of 2004. But significant, especially given the increase in loans outstanding for the quarter. Why did banks make more loans and yet show less profit? First, because net interest income fell as the yield curve got flatter: Banks make their profit on the spread between long-term interest rates -- what they charge borrowers who take out mortgages, for example -- and short-term rates -- what they pay to raise money in the capital markets and what they pay in interest on savings accounts and other short-term instruments. The Fed's hikes in short-term interest rates have collapsed that spread so that, as of Sept. 6, there was just a 0.6 percentage point difference between the yield on a 10-year Treasury note, the benchmark for many mortgages, and the 3-month Treasury bill, the benchmark for the cost of short-term money. Second, because banking is a competitive industry just like automobiles and steel, banks with lots and lots of money to lend cut the prices of their loans in order to put more of their cash to work. The Federal Reserve first flooded the banks with cheap capital. Then, as the Fed started to tighten, foreign investors made up the difference and more. (Foreign investors have poured money into the U.S. bond markets, a big reason the yield on the U.S. 10-year note has moved constantly lower.) Finding a spare $1.3 billion The Federal Reserve's 2004 data shows that profits at U.S. banks would have been even worse at the end of the year except that 1) banks earned more non-interest income from trading and from servicing mortgages, and 2) they reduced their reserves for loan losses. That second item takes a bit of explaining. In the arcane world of bank accounting, when a bank decides that it only needs to reserve $200 million for losses from future bad loans instead of $300 million, the $100 million difference goes straight to the bottom line, where it is added to earnings. So for example, KeyCorp The trends starting to emerge in the Federal Reserve's comprehensive 2004 report show up even more strongly in recent data. For example, in the first quarter 2005 report from the Federal Deposit Insurance Corp., commercial bank net interest margins declined again to their lowest level in fifteen years. Bank earnings, however, actually climbed as a result of further reductions in loan-loss reserves. According to FIG Partners, the loan-loss reserves at the country's 50 largest banks are now lower as a percentage of loans than at any time since 1990. Banks justify the reductions in loan-loss reserves by looking backward at their own history. KeyCorp, for example, showed the lowest net charge-offs for bad debt in the second quarter of 2005, a minuscule 0.29 percentage points, in the bank's entire history. So why shouldn't the bank reduce loan-loss reserves and book the reduction as an increase in earnings? Because credit cycles turn and the evidence is that we're near a turning point in this cycle. All the things that the Federal Reserve has said about consumer borrowers are true -- and apply to a lot of commercial borrowers, too: They are stretched and too many of their loans are linked to rising short-term interest rates. Because of that link to short-term rates, mortgage interest payments climbed 14% in the first quarter, according to MacroMavens. Greenspan's ugly swan song It's reasonable to conclude that with loan payments going up for some borrowers at least, the rate of loan delinquencies and defaults, now near historic lows, will start to move up, too. It's in the banks' self-interest to look backward at declining loan-default rates and justify releasing more reserves. But the Federal Reserve is supposed to look forward and make sure that the financial system is ready for the turn in the cycle. Besides jawboning borrowers into borrowing less cheap money, the Federal Reserve could be pressuring banks to stop lowering reserves, at worst, and, at best, to start raising them. That would better prepare the banks for the turn in the credit cycle that continued short-term interest rate hikes from the Fed will create. It would also decrease the amount of money banks have to lend and increase their self-interest in improving loan quality -- both measures that would take some of the air out of any potential real-estate bubble. Don't count on it, though. Based on its record, the Greenspan Federal Reserve will continue to talk tough -- and do very little -- until Alan Greenspan walks out the door for the last time. That inaction will let the problems in the banking sector get larger. Morgan Stanley, for example, is projecting that margin pressure on the banks will increase in the second half of 2005 and in 2006 with another 0.06 percentage point drop in margins in 2006. Loan loss provisions will start to creep upward, taking pennies out of earnings instead of putting them in, projects Thomas Brown of Bankstocks.com. The loss of that earnings stream will put even more pressure on bank profit margins. Too much margin pressure could incline some banks to cut back on lending or start charging higher prices for loans. Some banks could decide to put more pressure on any borrower that shows the slightest signs of faltering. All that could cut lending and slow growth in 2006 -- just at a time when the global economy doesn't need another burden to slow its growth. In 2006, of course, Greenspan will be out on the rubber-chicken circuit earning speakers fees doing what he does best: talk. Updates... Buy General Cable I liked General Cable even before Katrina turned the electricity infrastructure of the Gulf Coast into a jungle of twisted cable. Now, news stories that some utilities in the area will not simply rebuild but actually upgrade their transmission networks makes the stock even more attractive. General Cable was one of five infrastructure stocks I recommended on my regular weekly CNBC appearance on July 13, and although the price has climbed about $1 a share since then, I think that momentum just makes the stock more attractive here. Want to send electricity from here to there? General Cable makes the big wires that let utilities do just that. The energy division, which accounted for 36% of revenue in 2004, saw revenue climb 10% in the first quarter on strong demand from utilities upgrading their transmission systems. Want to move electricity around an automobile or some other product? General Cable's flexible power cords do just that. Revenue in the industrial segment, which made up 37% of sales, climbed 3% in the first quarter. Want to move voice and data over copper cables or optical fiber? General Cable makes the cable and the connectors to do just that. The communications segment, 27% of sales, grew revenue by 12% in the first quarter. Overall revenue is projected to grow by 15% this year. With improvements in gross profit margins from closing underused plants, that should lead to a doubling of earnings per share (excluding one-time charges for closing plants) in 2005. I'm adding the shares to Jubak's Picks with a price target of $21 a share by March 2006. Buy Mitsubishi Tokyo Financial Group In my column, "3 picks for the dog days of summer" on Aug. 26, I argued that growth was picking up in Japan and that the Japanese stock market could well outperform the U.S. stock market over the next year. The big risk was the defeat of the ruling Liberal Democratic party government of Junichiro Koizumi that would have dealt a huge setback to efforts to reform the country's financial system. Polls now show the Liberal Democratic party with a strong lead in the run up to Sunday's general election -- with the party standing a good chance of winning an overall majority in the lower house. Nothing is ever certain in Japan's complicated system of proportional representation, but I think Koizumi is likely to get a strong vote of confidence for his policies. That's enough to make me add more exposure to Japan to Jubak's Picks. Mitsubishi Tokyo Financial Group is merging with UFJ Holdings in a deal that will let the bank cut costs and increase its presence in the financial markets. I'm adding the shares to Jubak's Picks with a target price of $13 a share by March 2006. New developments on past columns "Will Katrina tip the U.S. into recession?" Updated post-Katrina price projections from the U.S. Energy Information Administration -- for what they're worth -- show gasoline prices have stabilized following the Labor Day holiday. Regular gasoline was selling at a national average of $3.042 on Sept. 7, according to the AAA. That's up $1.20 a gallon from a year ago. But the Energy Information Agency is projecting that gasoline will average $2.57 in the third quarter and $2.58 in the fourth quarter of 2005. The projections for heating oil and natural gas aren't anywhere near as heartening: the agency is now projecting a 31% increase in the price of heating oil and a 24% increase in the price of natural gas from 2004 levels by the end of 2005. That's up from projections of a 17% increase and 16% increase for the two fuels before Katrina. Adding it all up, the Energy Information Agency now calculates that the United States will spend 18% more on energy in 2005 than it did in 2004 -- a total of $1.03 trillion or 8.3% of our gross domestic product, the highest percentage since 1987. Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday. E-mail Jim Jubak at jjmail@microsoft.com. At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. | |||||||||||||||||
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