The Perfect Storm
Our nation is facing a perfect financial storm that will affect the lives of our citizens for decades to come.
Despite the potential chaos which may ensue, the solutions are very easy to implement.
The federal government and the Federal Reserve would merely need to take decisive steps to demonstrate that they understand that unrestrained fiscal and monetary policies are the causes of the problem rather than acting like the policies are the solution. Easy to implement yet impossible to coordinate. Hence, the perfect storm.
There is a growing body of data which suggests that the recent gains in unemployment, housing prices, and the economy are merely the tip of an unstable iceberg that will eventually lead to a financial meltdown partially because of the very policies the government implemented to "end" the 2008 crisis.
These policies include five years of quantitative easing, unfunded and unmitigated pension obligations at the state and local level, regulatory uncertainty with the Dodd Frank Bill and the Affordable Care Act, and employment statistics that partially mask the problems facing our citizens.
First, Quantitative Easing initiated by the Federal Reserve in 2008 has exceeded $3,000,000,000,000. The extraordinarily low interest rates have now created an entire industry dependent upon maintaining those artificially low interest rates in order to survive.
In the short period of time since the Federal Reserve chairman merely indicated he was going to reduce quantitative easing, the stocks of many real estate investment trusts plummeted. Declines of 20 to 30% were not uncommon for many real estate investment trust assets since May 2013. These are the groups that purchased many of the "sub-normal" interest rate mortgages.
Eliminating quantitative easing after it has been institutionalized will be difficult for banks investment portfolios as well. The fair value losses associated with long-term investments in a rising interest rate environment will wreak havoc on the capital ratios of these banks.
For the first time in over decades, the banks may find that their investment portfolio is more risky than their loan portfolio.
When the fair value asset value reduction is calculated, it is likely that some of our largest banks in the United States will become immediately undercapitalized. This under capitalization will spark the next round of economic quagmire.
The flaw in quantitative easing is that most bank regulatory sensitivity analyses assume the continuity of "duration" of a mortgage or investment. Duration is a term used to describe the expected life term of a particular investment.
In declining interest rate environments, mortgage duration shorten because homeowners are able to refinance mortgages thereby paying off their mortgages "early". The exact opposite happens, however, in an increasing interest rate environment.
It is this increase in the expected duration that will create the fair value quandary. When duration increases, the impact of higher interest rates on fair values of fixed interest rate mortgages may be catastrophic depending upon how much interest rates rise.
This entire scenario is complicated.
It is precisely its complication that causes the concern. Failure to understand the duration risk could spell disaster for the banking industry, the real estate market, state and local budgets, pension fund assets, and the economy.
Second, unfunded pension obligations will likewise feel the effects of the ending of quantitative easing as well. They too will be adversely affected by increasing interest rates and the impact on the fair value of their underlying assets.
Third, the continued regulatory uncertainty of the Dodd Frank Bill and the Affordable Care Act has caused consumers and businesses to delay purchases. This is had an adverse effect on economic growth as well.
Concurrent with regulatory uncertainty, the individual mandate and the significantly higher costs to most wage earners of the Affordable Care Act are just beginning to be felt. The consumer is getting squeezed and the employer is responding with part-time employment opportunities only.
Finally, the causes of part-time employment growing so rapidly in the most recent unemployment statistics are many and varied. It will take years to find out the specific quantitative causes but tangential evidence suggests it is uncertainty, health care costs, and a complex regulatory environment for hiring.
Rather than government spending and monetary policy helping our economy, it is entirely possible that rational theories of fiscal policy and monetary policy may have negative effects when irrationally applied. Temporarily stimulating measures of such policies may have a valuable effect when smoothing economic cycles but when a society becomes dependent upon such stimulating policies the cliff is merely getting higher from which we will inevitably fall.
Our economy has become dependent upon the irrational behavior of the federal government’s spending beyond its means, and a Federal Reserve intent upon manipulating interest rates.
Only by rationally reining in fiscal and monetary policies will our economy avoid the perfect storm.
Col. Frank Ryan, CPA, USMCR (Ret) and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring and lectures on ethics for the state CPA societies. He has served on numerous boards of publicly traded and non-profit organizations. He can be reached at [email protected] and twitter at @fryan1951.