Investors of all stripes have considered it a foregone conclusion that the Federal Reserve will flood the market with a big new dose of liquidity. This "QE2" has been expected since at least Aug. 27 when Federal Reserve Board Chairman Ben Bernanke acknowledged that the economy ain't doing so hot despite the government's massive injections of liquidity into the system.
"The pace of recovery in output and employment has slowed somewhat in recent months, in part because of slower-than-expected growth in consumer spending, as well as continued weakness in residential and nonresidential construction," Bernanke told attendees at a Fed symposium in Jackson Hole, Wyo. He did allow that there might be "some pickup in growth" in 2011 and in subsequent years.
That's not exactly a ringing endorsement of the Fed's policy so far, which has forced short-term interest rates to near zero by keeping the federal funds rate between 0 and 0.25%.
The Fed has also kept long-term rates low by buying trillions of dollars worth of Treasury securities and debt- and mortgage-backed securities from the federal housing agencies.
That the Fed has been poised to implement a second round of massive debt purchases may seem surprising, given that the first round didn't budge unemployment, currently just under 10%, and didn't address a shortage of credit for businesses and individuals.
The stock market likes easing: More easy money promises to boost the price of shares across the board, as well as those of commodities. On Oct. 12, the Fed released notes from the Federal Open Market Committee confirming to investors Bernanke's latest plans, sparking a midweek stock rally. News could come when the committee meets Nov. 2 and 3.
The market's instant reaction aside, many people expect a second round of easing to maintain the economic status quo, but no more. Banks are struggling to work off mountains of bad loans, economic growth remains sluggish, and unemployment is at levels twice that of the past two decades. This assessment is shared by both Bernanke's supporters and his critics.
After all, thanks to the government's liquidity injections, banks are sitting on $1 trillion in excess reserves that they could be lending but are holding instead. No one expects additional infusions to be lent either.
Indeed, the U.S. economy is starting to resemble Japan's, which for well over a decade has suffered from anemic GDP growth, asset deflation and poor returns for investors, all amid super-easy monetary policies.
For Bernanke's critics, that outlook is one that could have been avoided -- and perhaps still could be if Bernanke and Treasury Secretary Timothy Geithner would stop trying to prop up the biggest banks' collapsing balance sheets. "That banks have such big embedded losses is why the Fed has had to consider these extraordinary measures," says Christopher Whalen, an analyst with Institutional Risk Analytics, who has been among the harshest critics of the government's intervention in finance. "The only way to end this misery is to restructure the big banks," he says. "Shareholders and bondholders are going to have to take a big haircut."
Bernanke, however, doesn't appear to be ready to change his strategy. With so much capital -- both monetary and political -- invested in the bailouts of the large institutions, "the fate of large-cap financial firms is now a political issue," Whalen says. Letting them collapse now would be an admission of failure.
The net effect of the government's support for the big banks is to place a huge drag on both consumer demand and job creation, he says. "The Fed is transferring something like three-quarters of a trillion dollars annually from individual and corporate savers to Wall Street." The irony, he says, is that such a vast subsidy won't be enough to stave off restructuring of the most troubled large banks, particularly Bank of America Corp. and Wells Fargo & Co.
"The operational efficiency of banks is deteriorating," he told an audience at the American Enterprise Institute on Oct. 6. "When foreclosing, banks take physical possession of properties and sell them. That's very labor-intensive, and banks are not designed for this. We are turning all of our banks ... into owners and operators of real estate," he says. Indeed, banks are already selling more homes than homebuilders are.
Says Whalen: "The stress is going to overwhelm them."
Trading and other sources of revenue banks might otherwise have relied on to mitigate the costs of handling so much real estate are drying up. Whalen notes that at the 2005-2007 peak of the subprime craze, noninterest revenue at U.S. banks reached a record $80 billion. Since then, noninterest revenue of all U.S. banks has fallen by more than $10 billion and will fall further with the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which restricts commercial banks' and systemically significant investment firms' proprietary trading.
Similar dynamics plague several large institutions, even those with fewer troubles than BofA or Wells Fargo. For instance, J.P. Morgan Chase & Co., which Oct. 13 reported a 23% increase in earnings over third-quarter 2009, faces continuing pressure on the bottom line.
Whalen predicts that those profits cannot be sustained and that J.P. Morgan will lose 10% of current run-rate revenue due to the trading and private equity restrictions imposed by the Dodd-Frank Act.
Industrywide, there are 7.5 million home loans in distress and 4 million that are 90 days or more overdue, according to figures from Lender Processing Services Inc. and CoreLogic Inc. Foreclosures may hit 1.24 million this year.
The numbers get much worse several years out. Thomas Zimmerman, managing director at UBS Investment Bank, estimated that 25% of outstanding mortgages are underwater, meaning they exceed the current value of the loan. "This loan-to-value number we're facing is really a problem," he told the AEI audience. "This is unprecedented."
He predicted that 11.5 million homes could go into default over the next three to five years. "That is a big number."
The U.S. banking industry is less than a quarter of the way through the foreclosure process set in motion by the collapse of the housing bubble. According to figures from Laurie Goodman of Amherst Securities Group LP, one in five U.S. mortgages could go into foreclosure. And now the foreclosure process is being drawn out by state and local pressure for moratoriums and federal mitigation efforts to keep people in their homes.
Nevertheless, the foreclosure wave will continue to play out, causing more big banks to suffer. Eventually, Whalen argues, those failures and the government's need to unload real estate seized during bank takeovers will force it to create liquidation vehicles akin to the Resolution Trust Corp. that helped clean up the savings and loan crisis of the 1980s.
In the meantime, interest rate investors -- from retirees living off nest eggs to corporate treasuries that must fund customer purchases because bank financing isn't available -- is, he argues, "being destroyed."
Whalen thinks interest rates should be raised modestly to balance the banking industry's continuing needs and those of savers. "If we just crawled up to 1% and then slowly up to 2%, people could live with that," he says.
Jerry Flum, CEO of CreditRiskMonitor.com Inc., a service that supplies analysis of public companies to corporate credit professionals, agrees. "Right now we're in the middle of a disaster," he says. "We need to get rid of that debt. Unfortunately, the political and economic community are not letting the American people focus on this."
It will take too long, but eventually the debt overhang will be cleared. "We're going to get out of the mess by writing off this debt," says Flum. "People who lent that money are going to have severe write-offs. But America is going to be below par for many, many years.
"There are citizens out there who would buy a $300,000 house but can't because the government is subsidizing banks to keep that house at $400,000 or $500,000, because the bank would have to write down the existing mortgage on that house," he says. "Instead the government is taking that couple's tax money to keep that house from getting into a range that they can afford. We'll get out of this mess when the government finally gets out of the way and lets home prices drop to a level where they can clear."
Without a change in policy, Flum predicts it will take anywhere from five to 15 years for the banks to work though the bad loans. But even analysts less antagonistic toward Bernanke's monetary policies concede that the financial system will need years to recover and the low-interest rate policies and liquidity measures will not be sufficient to revive economic growth.
Paul Miller, an analyst with FBR Capital Markets, says government liquidity is needed to keep banks and the economy functioning but they are also undermining the foundation for profits. "The medicine may be killing the patient," he says.
Whalen's prediction that more major banks will need to be restructured is plausible, Miller says, but he thinks it's not the most likely scenario. "The most likely outcome is that we have a sluggish economy that takes 10 years to work through. Banks are kept afloat, but the system doesn't die."