One Fed To Rule Them All
May 17th, 2008 by 
reality
The Fed has recently repeatedly announced expansions of the kinds of collateral that it will accept for loans of Treasuries made under the various facilities (TAF, TSAF, TSLF,..whatever). These expansions have included credit card receivabales, student loans and auto loans. The Fed is doing this because the securitization market is still frozen, so that if they didn’t the economy would stop on a dime from lack of new lending. The big banks can’t make new loans until they sell off the ones they’ve already made, they simply don’t have enough capital. So the Fed stepped in because nobody else would. The problem is that the Fed can only do this for so long before its balance sheet is overloaded as well. We heard a few days ago that the Fed has run through half its balance-sheet of Treasuries. Normally the Fed expands it balance sheet by buying Treasuries from the banks, but right now that is kinda defeating the purpose of the whole thing, eh? That’s why Bernanke is asking Ms. Nancy Pelosi for permission to pay interest on reserve deposits. Once he can do that, he can enlarge reserves by increasing the rate he pays, thus making it attractive for the better-heeled of the banks to keep more money in their reserve accounts. That allows the asset side of the balance sheet (Treasuries or loans of Treasuries) to be bigger, because it expands the liability side - currency and reserves. In effect, he wants to facilitate inter-bank lending by acting as an intermediary and guaranteeing the loans. Rather than Bank A lending directly to Bank B, Bank A puts money in their reserve account at the Fed, Mr. B buys Treasuries with it and lends them to Bank B. If that doesn’t work he will literally have to print more physical currency if he wants to buy more Treasuries. Which is what Zimbabwe and the Weimar Republic did. Even Ben can probably see, dimly, that wasn’t a good idea.
The whole idea is to keep the banks’ balance sheets looking better than they really are, so that loans can continue to be made. If the Fed wasn’t doing this, new credit would essentially be frozen. The Fed is the main source of new credit - the lender of last resort.
The Fed has been trying to buy time for the banks to sell off assets and raise capital. If the mortgage mess were “contained”, there might have been a chance. But it isn’t and there never was a chance. So the next stage is what happened in Japan, which was that the BoJ took over the bad assets, created new banks with the garbage and auctioned them off to investors - mostly US hedge and private equity funds - to recover whatever they could. The so-called “good bank, bad bank” strategy. The Fed knows this, and already did this with Bear - created a new SIV to hold the worst garbage and hired Blackrock to manage it, then arranged for JPM to take over the rest. The SIV will be quietly be sold at a huge discount which the taxpayer will eat.
But let’s be clear. Right now the U.S. financial system is being run by the Fed and financed by the taxpayer. This is a command economy. The rest is just smoke and mirrors.
And we pretty well know how well state-controlled economies work, don’t we? There is a track record…
Posted in The Fed | 
May 17th, 2008 at 5:43 pm
Thank you for another very insightful post. The federal government, i.e. the taxpayer is borrowing money collectively to continue the spending binge (via rebate checks, social security, etc) as taxpayers cannot take out loans individually any more. The US consumption at this time is essentially vendor financing as the Chinese and Arabs are giving goods and oil in return for IOUs.
I however remain puzzled by my perception of your position that this will lead to a deflationary collapse. The Fed, through its alphabet soup, is avoiding the destruction of credit (money) or perhaps more accurately, creating more debt to compensate for what has been destroyed already. The burden the fed is taking will eventually be passsed on to the taxpayer, who can only respond by issuing more debt, or printing. This will thus compensate for the deflationary effects that should have been asserted by the destruction of bad debt/credit/money.
Meanwhile the federal government continues to spend like a drunken sailor, issuing treasuries and thus expanding the credit in the economy. This is adding to the overall money in the system. There is no political will in our country to do anything else.
The only realistic progression I can see is that the FCBs at some point stop buying dollars and thus dollar denominated assets, forcing a decline in the dollar and ramping borrowing costs for the US treasury. The likely response of the US treasury will be to print; nothing else will be politically acceptable. Continued dollar decline, lower standard of living, and lack of investment in the US will ensue. This will destroy the economy just the same as a depression (I think its much worse but lets call it the same) but this is politically palatable (inflation always is as the vast majority of people do not understand the cause). The debasement of the dollar will be transmitted back to the US via commodities.
The FCBs meanwhile are central banks too and will print with abandon at the slightest excuse.
So what is a poor investor to do? Acquire something that everyone wants that cannot be created out of thin air in countries where property rights are likely to be secure. Gold? Ummm, no, because nobody needs gold. Energy? Yes! Everyone needs energy, there is a finite supply of fossil fuel, solar power is still expensive. Then let the central banks print all they want. The printed money will simply bid up the price of energy if it results in price inflation. Buy oil/gas or oil/gas producers? I say the producers, because they can make money even if commodity prices decline. I like Canada as they are democratic, have property rights, and are small enough to be kept afloat via their commodity exports.
And what if the central banks grow a brain and don’t print, we wind up with a recession, and energy prices collapse? Eventually the economy will recover and so will energy prices. If we wind up with cheap solar power substituting for fossil fuel, all of us will become enormously wealthy anyway as energy and labor are the two primary ingredients for creating wealth.
I wish I had this figured out last year but I did not. Anyway, I am scaling into oil/gas producers and will slowly move my assets into non-dollar denomitaed assets. I also remain short US financials and small caps. If we get a significant market decline, I will buy some technology as well. Don’t want to short the treasuries as it is impossible to know when the FCBs stupidity will end.
I know the above leaves a lot of loose ends and many things I have glossed over. Plus I am no economist. But this is the best I have been able to reason. Counterpoints would be very welcome.
My apologies for such a long comment.
May 17th, 2008 at 6:04 pm
Very insightful post. I agree, this is exactly what is happening. This is a classic, giant Ponzi scheme which ALWAYS ends badly. There is no other way for it to end; that is a mathematical impossibility. Watching this all transpire is like watching a train wreck in slow motion. There is no other way for it to end except UGLY. The longer this is perpetuated, the worse the final outcome will be.
BTW google auction rate securities and see how many class action lawsuits are already in litigation. Just the beginning.
May 18th, 2008 at 5:43 am
My view is unchanged, yes, this will lead to a deflationary collapse. The Fed’s antics are nothing more or less than re-arranging the deckchairs on the Titanic.
Actually, the Fed isn’t avoiding the destruction of credit. That happens when borrowers default on loans. The Fed is trying to keep the financial system operating in spite of the destruction of credit.
But all that is needed to drive the collapse is for the expansion of debt to slow. Which it has done. As time went by, more and more debt was needed to drive an incremental dollar of GDP. This meant that debt creation had to continue to accelerate. As soon as that acceleration stopped, the downward spiral began. The measures taken by the Fed will, at best, slow the deflationary trend.
Long term, I agree with you that energy is the key resource. If all goes according to plan, that will be a key focus when I go back to investing (rather than speculating).
May 18th, 2008 at 8:04 am
A couple of thoughts. First, I believe that both inflationists and deflationists will be right; I expect that we will have both back to back, or even more likely, simultaneously (inflation of consumables, deflation of assets). Second, I believe that governments are well aware that inflation is politically preferable to deflation as they are less likely to be blamed for inflation. If one accepts that premise, and if one also believes that governments can control whether we have one or the other, then there should never be, nor should there ever have been, a deflation. My view is that deflations occur due to the cyclical nature of social mood (human emotions) and that they are an inevitable consequence of the mathematical certainty that debts cannot be expanded forever.
May 18th, 2008 at 8:09 am
More and more investors are piling into fewer and fewer investments thus driving up prices despite an ongoing collapse. The hot haven last year was gold and silver, food and energy this year, and who knows what next year.
Hence we have deflation in housing and wages while having inflation in commodities (i.e. stagflation).
It annoys me to no end that my investment choices (inflation or deflation) depend entirely on what the Fed does next. As a result I can’t plan beyond next week.
May 18th, 2008 at 9:48 pm
KH,
I believe that you are correct except you should not use the term inflation with commodities in this case (I know what you mean but don’t agree with the use of teh word inflation).
Inflation and deflation are I think, by definition, monetary effects and what we have is commodity price growth (due to bad policy, scarcity, speculation, dollar devaluation, peak oil, etc.) and monetary deflation. We have monetary deflation right now as credit is being destroyed even though credit is not exactly the same as money. I think that it is in this scenario. The actual supply of real money/fiat currency doesn’t change that much. It is the credit that contracts and expands. It makes you wonder what money really is. It is starting to seem like a delusion of modern civilization to me - as long as everyone agrees that fiat currency and credit have some value you are sound as a pound. As soon as they decide they don’t want to take or honor your paper or credit you are in trouble.
I actually don’t believe that there is much true monetary inflation right now, even in commodities. I think that there is more asset and credit deflation offsetting the inflationary FED policies. I believe what we are really seeing is dollar devaluation from the US debt spending policies along with all the other factors I stated above. People don’t want dollars because they already have trillions of them and they are starting to fear that we will not pay back our debts or will be unable to.
I also think that once the asset deflation (home prices, stock market, autos, etc.) bottoms out we will be in for massive real monetary inflation for a period due to FED policies today. However, the stock market is getting the FED put and who knows when houses will bottom.
May 19th, 2008 at 7:05 am
iTod,
I agree with your precise definition of inflation, and I share your view that the contraction of credit in our economy is deflationary. It is possible that commodity prices are inflating due to genuinely inflationary policies elsewhere in the world, countries such as China where there is not massive credit to deflate. Possibly…I don’t know enough about it to be sure.
May 20th, 2008 at 5:22 am
Inflation, deflation, investment and speculation (to my best current understanding).
Monetary inflation is expansion of money base and credit. It seems at present FED isn’t expanding money base, but is acting to protect integrity of financial system and moneyness of US credit - government debt, GSE debt, dollar, and possibly (with some conspiracy) even equities. Moneyness is far more than monetary phenomenon - its political (so inflation too isn’t “allways monetary phenomenon”).
Anyway, oversecuritized overconsumption bubble is contracting now, and “sidelines” money is flowing to “something real” - this time commodity bubble. Concentrated explanation of this process is in recent Minyan Peter post ‘What the ETF?’ http://www.minyanville.com/articles/SKF-commodities-oil-etf-financials-DBC/index/a/17219 .
Process is global. Growing commodity prices oppress consumption and adds to uncertainty (and volatility) in already unstable economical climate. It’s absolutely bad for most of people, but not for all.
Current world financial-political system is based on huge asymmetries of responsibility. There are big differences in consequences of errors made by ordinary investors, investment managers (players with “Other People Money”), and regulators (having privilege to write rules).
Lets give an example. Compare yourself with Angelo Mozillo and, for example, duet of Bernanke-Dimon. Say, you made an unsound investment decision and took mortgage on a house you can not afford. You stupidly thought house prices will always grow. Now you have a real problem, isn’t it? Angelo too mistakable thought real estate prices will always appreciate. And what have Angelo? Angelo have a nice bonus and no head pain at all.
JPM got BSC. James Dimon will get nice bonus for that. And possibly even Ben will have some kind of bonus for his after-hours work and bravely taken responsibility that weekend.
Clearly three different levels - you hold the bag, Angelo sold, leveraged it, got bonuses, but because of crisis will not get more. But if not crisis, JPM wouldn’t got BSC, so wouldn’t be any fun for James and Ben. The responsibility and fun privilege to distribute lifeboats on the Titanic, with personal helicopter on board to fly out after all.
And, you now, helicopters carrying profit from tickets to lifeboats sold, our days often fly to Caymans. Profits concentrates there, and again - are invested in new, this time different titanics, more sophisticated helicopters, and then new tickets are on sale again.
So here are my definitions after all this long story:
Titanic - leveraged asset class
Inflation - cruise at full speed
Deflation - sinking
Investor - passenger
Speculator - reseller of tickets
Helicopter - helicopter
And conclusion - better to refrain from cruises, while captains have personal helicopters. Better speculate in tickets. Or build a ship yourself.
————–
Not to be completely off topic, there is decent article about sentiment analysis: Does “Sentiment Beta” beget “Sentimental Alpha”? http://allaboutalpha.com/blog/2008/05/14/does-sentiment-beta-beget-sentimental-alpha/
May 20th, 2008 at 7:49 am
Some very smart people seem to read this blog, mostly silently :-)Thanks all for some very insightful comments.
Reality,
You are correct that the FED is not avoiding the destruction of credit. My point though was that through the alphabet soup, the FED is creating additional credit to compensate for what is being destroyed.
The zero hour (additional dollar of debt causing no incremental increase in GDP) is interesting. The phenomenon is there, no doubt about it, and zero hour may already be upon us, in which case you are right and we will get a deflationary collapse.
I have never previously thought much about zero hour. What is the underlying reason that increasing debt does not increase GDP proportionately? I can think of the following reasons:
- Imports: We issue IOUs (dollars) to foreigners for goods. The money never really recirculates and the cost of imports is (?) excluded from GDP.
- More and more of the new credit goes towards debt service? But wouldn’t the interest wind up in the hands of the creditor who would then spend/reinvest?
Red Brian,
I have a day job. Greenspan/Ben’s actions have forced me into a second :-( Practically given me a second profession as I am being forced to learn monetary economics.
Vytas,
Part of the problem we are facing is the concentration of wealth in a few hands. The policies of the government(s) have lead to the creation of a super rich class and the rest (as you alluded to). The super rich make money and have no way to spend it all. So they invest. The massive credit/money creation of the past decade made these people even richer, as the money concentrated in their hands. This accounts for the “savings boom” Bernanke/Greenspan are so fond of talking about. The dollar pegs and dollar-recycling of FCBs does the same; you can consider foreign nations as super consumers/savers/investors in the dollar economy and the distortions they are creating are massive.
May 20th, 2008 at 9:36 am
Gigi, the Fed is swapping one kind of debt for another, not creating new.
Yes, I too think it is the increase in debt service. And the debt service will not show up in GDP (consumption) if the recipient doesn’t spend it.