The Financial Minority Report
by Christopher Rupe
Austerity in the U.S.?
In: Finance
17 Jun 2010It’s been about 2 months since the Federal Reserve has released its minutes from the March 16 FOMC meeting. Most of the content within the minutes was pretty mundane however, there was one section dealing with various “exit strategies” typically referred to as “reserve draining tools” that really made me sit up and take notice:
The staff also briefed the Committee on potential approaches for managing the Treasury securities held by the Federal Reserve. To date, the Desk had been reinvesting all maturing Treasury securities by exchanging those holdings for newly issued Treasury securities, but an alternative strategy would be to allow some or all of those Treasury securities to mature without reinvestment [emphasis mine]. Redeeming all of its maturing Treasury holdings would significantly reduce the size of the Federal Reserve’s balance sheet over coming years and hence could be helpful in limiting the need to use other reserve draining tools such as reverse repurchase agreements and term deposits. Redemptions would also lower the interest rate sensitivity of the Federal Reserve’s portfolio over time. Nevertheless, the initiation of a redemption strategy might generate upward pressure on market rates, especially if that measure led investors to move up their expected timing of policy firming. Participants agreed that the Committee would give further consideration to these matters and that in the interim the Desk should continue its current practice of reinvesting all maturing Treasury securities.
The staff appears to recognize that they cannot rely on the ability to sell the mortgage backed securities nor rely on the repo market to drain cash from the system. Duh. So, the Treasury portfolio is again on the chopping block. Again?
This is akin to the December 2007 through May 2008 period when the Fed rolled off its short dated Treasuries in order to get the cash to fund the various liquidity facilities as a cover for masking the insolvency of the banking system. 
At the time, they had no other sizable category of assets on their balance sheet to liquidate. Selling the Treasuries was the only way to get the necessary cash. When the crisis hit full bore in September 2008, the Fed was desperate and asked the US Treasury to sell $500 billion in extra debt and put the resulting cash on deposit at the Fed to use at the Fed’s discretion. This was the Supplementary Financing Program (SPF).
As the markets began to rebound in March of 2009 with the announcement of the Fed’s purchase of $300 billion in Treasuries, many market participants took this to mean that the Fed was printing. In fact, Bernanke tried to convey exactly that during his 60 Minutes interview that month. I have always taken a contrary view that the Fed was merely replenishing the Treasuries that it had previously sold to deal with the credit crisis. To wit, the Fed H.4.1 from 11/29/2007 lists $779 billion in Treasury securities and the most recent H.4.1, 06/3/2010 lists $777 billion.
Today, the Fed has $200 billion in SPF funds at the ready for any immediate liquidity needs. And now the Fed staff is discussing the possibility of selling the Treasury portfolio again. When I first read those minutes above, I wondered if perhaps the staff recognized that we are not suffering from an ongoing liquidity crisis but rather a solvency crisis. That perhaps they now know that economic decline is inevitable and job No. 1 is to “manage the decline”.
The recent experience of the Europeans and their attempts to paper over insolvency with more debt rebuffed by the markets, have caused policy makers in Europe to do an about face and promote policies to manage their inevitable economic declines through austerity. Although the Obama administration seems loathe to reign in deficits here, the political climate in Congress is shifting. US austerity is in the offing. And the Fed looks to have only about $1 trillion in potential cash to manage a decline of potentially $25 trillion (everything from the internet and housing bubbles) in credit deflation. “Mr. Scylla, meet my friend, Mr. Charybdis.”
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- Tags: austerity, debt, Federal Reserve, insolvency, liquidity crisis, solvency, solvency crisis, Supplementary Financing Program
Debt Rollover to Become an Issue for the Treasury
In: Finance
5 Apr 2010This image is from the NYTimes:
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As the image indicates, higher long term interest rates are indicated by this need to roll over some of this short term debt. The Treasury must also issue an additional 1.5Trillion dollars in NEW borrowing this year. This massive demand of government borrowing will also push interest rates up. Indeed, they already have. Compare the following two charts:
Today 12/10/2009
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Notice anything? The entire curve has shifted up and the 10-Year Treasury is yielding 4% vs. 3.5% 4 months ago.
This is incrementally bad for other rates referenced off Treasuries in the economy, notably mortgage rates. It also means that interest cost for the taxpayer is going to increase which exacerbates an already huge fiscal deficit.
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- Tags: debt, deficit, yield curve
The Federal Reserve’s Predicament
In: Finance
3 Apr 2010Recently, the Federal Reserve gave everyone a peek inside the bag. Specifically, they disclosed the contents of much of the Maiden Lane off-balance sheet entities they created to absorb some of the toxic debt and provide financing (read bailout) for propping of AIG and also JPMorganChase’s buyout of Bear Stearns among other things.
The following Bloomberg article reveals:
In a 4:30 p.m. announcement in a week of congressional recess and religious holidays, the central bank released details of securities bought to aid Bear Stearns’s takeover by JPMorgan Chase & Co. Bloomberg News sued the Fed for that information.
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“The Fed absorbed that risk on its balance sheet and is now seen to be holding problematic, legacy assets,” said Vincent Reinhart, a resident scholar at the American Enterprise Institute in Washington who was the central bank’s monetary- affairs director from 2001 to 2007. “There is both an impairment to its balance sheet and its reputation.”The Bear Stearns deal marked a turning point in the financial crisis for the Fed. By putting taxpayers at risk in financing the rescue, the central bank was engaging in fiscal policy, normally the domain of Congress and the U.S. Treasury, said Marvin Goodfriend, a former Richmond Fed policy adviser who is now an economist at Carnegie Mellon University in Pittsburgh.
‘Panic’ Cause
“Lack of clarity on the boundary between responsibilities of the Fed and of the Congress as much as anything else created panic in the fall of 2008,” Goodfriend said. “That created a situation in which what had been a serious recession became something near a Great Depression.”
Central bankers also created moral hazard, or a perception for investors that any financial firm bigger than Bear Stearns wouldn’t be allowed to fail, said David Kotok, chief investment officer at Cumberland Advisors Inc. in Vineland, New Jersey.
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Assets in Maiden Lane II totaled $34.8 billion, according to the Fed, which set their current market value in its weekly balance sheet at $15.3 billion. That means Maiden Lane II assets are worth 44 cents on the dollar, or 44 percent of their face value, according to the Fed.Maiden Lane III, which has $56 billion of assets at face value, is worth $22.1 billion, or 39 cents on the dollar, according to the Fed’s weekly balance sheet. A similar calculation for the Bear Stearns portfolio couldn’t be made because of outstanding derivatives trades.
Bloomberg had sued the Fed under FOIA request to get a look at what was in these entities. After losing at least two court rulings, the Fed finally gave disclosure.
It’s not pretty.
The controversy at the time of creating these entities is indicated by the bolded part above. Namely, that the Fed was directly engaged in fiscal policy, exposing taxpayers to bailouts without the consent of Congress as clearly defined in Article 1 Section 8 of the US Constitution. This is commonly spoken as “All government spending must begin as a bill in the House of Representatives”. A pretty clear violation of law.
Indeed, Paul Volcker, the former Chairman of the Federal Reserve criticized the Bear Stearns deal as being at “the very edge of legality”. A pretty strong characterization coming from an insider.
There are rumors now that the Fed itself is in trouble with its balance sheet now that it holds these toxic securities and is disclosing how badly they are performing. There is talk of actively targeting the Fed to take advantage of its seemingly precarious position.
Last year there we discussions of forming a ‘Bad Bank’ to pile all the toxic debt into. It now appears that perhaps the Federal Reserve is the ‘Bad Bank’.
Does this presage the Fed’s demise? My visceral reaction is that although the potential asset deterioration in its portfolio is enough to impair the capital of the Fed, the central bank is not without considerable resources at its disposal to strengthen its capital position.
- You must remember that the Fed is privy to considerable amounts of non-public (i.e. insider) information and it routinely trades on this information to its advantage. Legally, by the way. The Federal Reserve has an exemption that permits it to do this.
- There was talk during the September – November 2008 credit crisis period of the Fed selling its own bonds to provide itself financing. This talk could come back.
- The Fed has a large portfolio of Mortgage Backed securities it is holding to offset the excess reserves on deposit at the Fed. If things get dicey for them because they come under speculative attack, they can fire back at the speculators by dumping these securities back on the market and pulling a trillion or more dollars of liquidity out of the system. This action would drive the dollar higher, Treasury yields lower, and consequently its own portfolio of Treasuries would rise in value.
There could of course be other actions they could take. I’d have to think on that a bit.
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- Tags: debt, excess reserves, Federal Reserve, liquidity crisis, solvency crisis
My Thoughts on the Diminishing Productivity of Debt
In: Finance
29 Mar 2010Recently, I shared this graph with Nathan Martin and he has since made it famous. It has been showing up on dozens of other blogs (here, here, here, here, here, here, here, here for example) and there are continuing questions as to the source of the data as well as the methodology used to calculate it.
The data sources are the Federal Reserve Z.1 Report, specifically, the Total Credit Market Debt figure and the annualized quarterly Nominal GDP number from the Bureau of Economic Analysis. I was sort of the progenitor of resuscitating this graph according to the original Legg Mason format and methodology.
Total Credit Market Debt includes all public debt (federal, state, local) and private debt (mortgages, auto loans, credit cards, etc.). It does NOT include the unfunded public liabilities such as Social Security, Medicare, etc.
Since I have the dataset, and have been compiling and thinking about it for a year and a half, I feel compelled to give my opinion on what I think it means.
The chart is not hard to reproduce, although a bit tedious.
The specific methodology is simply a 4 quarter moving average of (GDP(t) – GDP(t-4))/(Debt(t)-Debt(t-4)), where ‘t’ is in reference to the quarter in question.
That in and of itself isn’t so tedious, however, quarterly data disappears once you go back a few years and all you have left is annual data. So, you have to do a linear interpolation between each of the annual datapoints in order to generate the quarterly data. Incidentally, if you want to get rid of the simple moving average, you of course get a noisier chart with a deeper plunge:
The plunge goes to -0.91.
So, that’s really all there is to the method, although there are a number of other ways you can calculate and plot a chart to get the gist of what is occurring here.
For example, Karl Denninger has also done a version of this chart on his own with his “Ponzi Finance Indicator Chart”:
Karl’s chart has some advantages over the other presentation. For example, I believe Karl’s chart uses a year over year % change format for his data rather than a year minus year format. Thus, his chart is not as susceptible to the problem of dividing by very small (close to zero) numbers that the other chart is. Indeed, if you go back in time far enough (I have this data back to 1916) this problem occurs more than once.
If you plot the Legg Mason method over a similar (postwar) time scale it has a look somewhat similar to Karl’s chart:
Now, there has been some debate as to the significance of this chart. Some think it is not very significant since it is recognized that if either the numerator OR the denominator goes negative, then the chart goes negative. If both are negative, then the chart yields a positive number. Others think that correlation is not causation w/r/t the impact of debt on GDP. Obviously, some think it is very significant. Nathan Martin referred to it as the ‘Chart of the Century’.
I agree with the detractors insofar as this is not a perfect metric of our predicament. GDP, for example, is kind of a fuzzy number. Not just because of tabulation games the government plays along with the constant revisions, but because GDP doesn’t even have a universal definition. Different countries calculate GDP in different ways.
I flatly disagree that debt and GDP are not correlated. Indeed, I view this chart as a measure of the Marginal Velocity of Debt in the economy. I have referred to it as such before. In this view, Total Credit Market Debt is synonymous with the Total Money Supply. All money is debt, and this debt has value and has varying degrees of liquidity. To the extent that debt loses it’s value or becomes totally illiquid (Home Equity Loans anyone?) it ceases to be money. To the extent that debt is paid back or is defaulted on, money supply shrinks!
This is an unconventional view of money. There would be howls of protest against this view ranging from mainstream (keynesian/monetarist) economists to the austrian economists. Gary North might disclaim me.
However, I have never liked any of the monetary statistics as compiled and named, M0, M1, M2, MZM, etc. I find them too narrowly focused on the liability side of U.S. bank balance sheets. A lot of money is missing in that view. Much of it is obscured by multiplier effects due to the advent of off-balance sheet entities. Some is not counted. Cash held by foreign central banks for example.
The way I see it, all loans must be originated by U.S. banks whether or not they are held on or off balance sheet. This is a distinctly asset side of bank balance sheet view of money. And ALL of this money is accounted for in the Federal Reserve Z.1 as Total Credit Market Debt. So, I have sometimes referred to this statistic as ‘Mtotal’.
This velocity measure thus follows the familiar equation of exchange: Velocity = GDP/(Money Supply) and Marginal Velocity = Delta(GDP)/Delta(Money Supply). Not just correlated, but plain old related as can be seen.
My own view overall is that the chart indicates (however imperfectly) that something significant has occurred. Indeed, nothing like it in 65 years. Anyone can check the Z.1 history and see that Total Credit Market Debt has never had a year over year decline in the postwar era.
Until now.
I view it as confirmatory (in our unique circumstances) that we have ‘hit The Wall’ with the amount of debt that the economy can carry (debt saturation). Politicians and policy makers have been able to keep the game going by continually and incrementally debauching lending standards.
Think about it this way. A large reason why we have emerged from every postwar recession and renewed the credit cycle to grow to ever greater heights is because the policy response has been to allow, nay, promote the decay of lending standards.
- In the ’60s you had to have a 20% downpayment. PMI applied to tiny fraction of mortgage loans. Credit cards required either a security deposit or were secured by a savings account. The point is, they had some kind of collateral.
- In the ’70s, PMI grew, especially encouraged by policies like the CRA
- After the early ’80s recession, Usury laws began to go away so credit cards eliminated their collateral requirements now that they could charge very high interest rates. Also, the law was changed to take Social Security surpluses and use them to buy government debt. This effectively lowered the lending standards to the government since they now had a guaranteed buyer. Incidentally, this change plus the continued growth in credit set up a feedback loop to artificially lower rates on Treasury securities.
- After the ‘91 recession, reserve requirements on most bank accounts were eliminated and Adjustable Rate Mortgages began to really grow as a % of home loans. FICO scores were developed in lieu of having any actual collateral for loans. Credit cards were now given away freely to any college kid with no job. Banks begin to financially innovate ways to originate loans but package them into off-balance sheet trusts which are sold, not counting against their capital requirements.
- After the 2001 recession, the gloves come off and anyone can get a loan for anything, no downpayments, bad FICO score, no job. Sometimes the bank will even loan more than the asset is priced at.
In this way, the policy makers took down the artificial barriers (read safety net) of prudence in lending because no politician wants to deal with a nasty recession or perhaps fewer campaign contributions from Wall Street. So, we eventually reached the point where there were simply no safety nets left and all that remained was ‘The Wall’. You just can’t stuff anymore credit into the system.
We have crashed into the wall.
Marginal Velocity has collapsed.
Hank Paulson, the former CEO of Goldman Sachs and Treasury Secretary for the Bush administration gives some interesting information about his experience during last years financial collapse here.
Henry Paulson, the former U.S. Treasury Department secretary, just said in a CNBC interview that in the midst of the Lehman Brothers collapse he had no idea what to do and was so afraid he excused himself from an emergency meeting on the matter and called his wife.
“I’m scared,” he said he told his wife on a cell phone, while appearing to the others in the meeting that he was making a business telephone call. “I didn’t know what to do.”
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More shocking, is Paulson’s contention that prior to the collapse, neither he nor other administration officials had any idea how housing debt was structured in various Wall Street creations. Paulson has said that he discovered all of this in the midst of the crisis. Prior to the collapse, his department had done a study of housing and concluded there was no problem. The study left out the esoteric financial structures that turned out to be a disaster.
Now, if we are to take Hank at his word, that he was unaware, when many others not connected to Wall Street could see the rampant fraud embedded in the housing market and the securitization industry, then he is grossly incompetent. Why should anyone believe anything he has to say about solutions.
On the other hand, if he did know what was going on, then he is lying now and was lying then. In which case, why should anyone believe anything he has to say about solutions. It’s just not logical. Hank Paulson also told Americans during the Lehman collapse that “the Banking system is safe and sound”. Hank Paulson is irrelevant and is not to be trusted.
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