Commercial banks’ balance sheets

We got exactly what I expected, a kind of wishy-washy, “hedging our bets” statement from the Fed. You have to remember that Bernanke was Greenspan’s right hand man for much of the bubble days of the ‘90s and early ‘00s, so the guy is an expert at walking both sides of the line when it comes to policy and public statements.

For instance, the Fed announced it would keep interest rates between 0% and 0.25% for an “extended period.” No surprise there. As I’ve noted previously, 80%+ of the $200+ trillion in derivatives sitting on US commercial banks’ balance sheets are related to interest rates.

For the Fed to hint at raising rates (let alone raise them) would kick off a systemic implosion that would wipe out the very guys the Fed has been bailing out. Suffice to say the Fed won’t be raising interest rates now or anytime too soon (within the next 3-5 years, unless inflation destroys the dollar).

The Fed also announced it would be slowing its purchase of Mortgage-Backed Securities (what I call the Fed’s “cash for trash” program). The Fed has stated previously that it will buy $1.45 trillion in mortgage-backed securities from US banks and that this program will end by the end of 2009. However, last week the Fed said it will be extending the program (but not the amount of money spent) until the first quarter of 2010.

Again, this is not much of a surprise. The Fed performed a similar act with its Quantitative Easing Program (extending but not increasing the amount). However, given the increasing public outcry about the Fed’s balance sheet, this issue of buying toxic debt (and the mortgage backed securities the Fed is buying are nothing if not that) may become a hot topic in the near future. If there is ever a successful audit of the Fed’s balance sheet, kiss the big banks’ equity (and share prices) good-bye.

The Fed did announce that it would let its Quantitative Easing program end in October. If you’re not familiar with this program, it’s basically a fancy way of saying that the Fed has been buying US debt in order to finance Obama et al’s massive deficit.

This particular development is key. A little known fact (and one totally ignored by the mainstream media) is that the Fed accounted for nearly half of all Treasury purchases in the second quarter ($164 billion out of $339 billion). In fact, the Fed bought more Treasuries than the next three largest purchasers combined!!

The Fed’s purchases outnumber foreign holders (foreign governments), US households, and Primary Dealers (mega banks) combined. One should also note that foreign holders reduced their purchases of US debt from $159 billion in 1Q09 to $101 billion in 2Q09 (a 40% decrease).
In simple terms, these numbers indicate that if it were not for the Fed, the US Treasury market would have almost assuredly had numerous failed auctions in the second quarter. It also shows us that foreign holders (China, Japan, etc.) are reducing their purchases of US debt at an incredible rate. This tells us two things:

1) China and pals are putting their money where their mouths are: refusing to service our debt as they did in the past
2) Treasuries will have to become a lot more attractive (higher yields) for foreign investors to start buying again
I’ve often stated that the Fed will have to sacrifice stocks or the US dollar. If the Fed does in fact end Quantitative Easing in October (as it has stated it will in last week’s FOMC), then we’ll see what the market really thinks of US debt as an investment class. It’s clear from the above data that foreign holders want higher rates (yields) in order for them to start buying more heavily. However, as I’ve stated before, the Fed cannot afford higher interest rates without blowing up US banks.

Keep your eyes on the Treasury market going forward. This could very well be the next major crisis brewing. It will certainly be our first taste of how a market operates without life support courtesy of the Fed.

I’m guessing the results won’t be pretty.

When interest rates are held artificially low

A recovery in the economy can only occur via recovery in the private sector. Much of what has been hailed as “green shoots” results from government stimulus. It is not clear what is being stimulated other than reported GDP, because there are few signs of private sector recovery. One area that has received enormous stimulus is the housing market, even though its reported numbers are still dismal.

In the mortgage issuance area, the private sector has disappeared (see previous post by Chris Martenson). Is this because banks are unwilling to lend? Is it because there are no creditworthy borrowers? The answer to both of these questions is a resounding No! Then why is this happening? The government has driven down interest rates so low in a (foolish) attempt to support housing prices that they have made it unattractive for banks to risk money at these rates. In that sense, the government is subsidizing low interest rates with taxpayer money/risk. Private firms make mortgage loans at interest rates commensurate with risk. When interest rates are held artificially low, there are few loans that meet this requirement. Another way to state this is that the government is taking on risks with your money that prudent investors would not take on with their own money. It is precisely that strategy that gave us the Fannie and Freddie debacle. This is not rocket science. The results are predictable and inevitable as evidenced by the following quote:

Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to “buy” houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief in the long run they do not increase overall national production but encourage malinvestment.

The above is a nearly perfect description of what happened in our housing market. Perhaps it could be marginally improved by adding references to “liar” loans and negative amortization loans. But this excerpt was written by Henry Hazlitt in 1948 as a prediction. Its veracity was as true then as it is today. Now it is, as Yogi might say, “deja vu all over again.” We are in the process of repeating the same mistakes. This time the vehicle will be the FHA and the Fed. The results will be just as painful for taxpayers as Fannie and Freddie were (and continue to be).

Effectively confiscating gold

Mish has a take on the Arthur Burns memo to President Ford regarding gold price suppression that is worthwhile. Mish downplays its current significance, suggesting that markets ultimately are stronger than governments. He does provide a valuable caution that all gold investors should heed:

The fear should not be of government to government agreements that can never work in practice, but rather a fear that governments may tax gold sales profits at some phenomenal rate, thereby effectively confiscating gold a second time.

Such a “confiscation” would be relatively easy to impose on ETFs like GLD or SLV. It would be more difficult to impose on physical gold itself.

Future buying power of the dollar

In a post dealing primarily with Bill Ackman’s hedge fund, gold as a holding or non-holding is discussed. Ackman holds none, but his position does not appear to be at odds with others.

One last paragraph we want to focus on is Ackman’s brief mention of the risk to one’s purchasing power. Due to quantitative easing and money printing by the Fed, he acknowledges that there are concerns about future buying power of the dollar. Ackman highlights that many investors have turned to gold to hedge these risks, but not Pershing Square. Instead, they have decided to fight this risk by owning “high quality businesses that have pricing power due to market position and/or business model, and/or that earn their profits globally.”
This is interesting to see his stance on the matter as we can’t really recall him addressing it before. You’ll remember that David Einhorn and Greenlight Capital made a large gold investment and now are storing physical gold. Additionally, John Paulson’s hedge fund Paulson & Co bought gold via GLD (the exchange traded fund) to hedge their share class denominated in gold. It’s interesting to see each fund manager’s individualistic approach and hedging vehicle of choice. However, the main thing to take away from all of this is the fact that they see inflation as a potential threat in the future and are trying to mitigate this risk accordingly.

The entire economy/stock market

“New Normal,” a term coined but not yet copyrighted by the principals at Pimco, is bandied about to describe the prospects for the economy and financial markets. It is  undefined and hence irrefutable. It provides a glib way to state the obvious: the future will differ from the past. Its definitional elasticity ensured its widespread acception.

A more appropriate term might be the  “New Abnormal.” While this term could be criticized in the same manner, it offers one significant advantage. It more strongly implies lack of continuity with the past. This “advantage” is in the eye of the beholder. If you are the common investor, this message is the one that should be absorbed. If you are part of the sell-side hucksters of Wall Street, you prefer the current euphemism, because it is wonderfully clever. It conveys the obvious – things have changed – in a somewhat soothing way.  Optimism (the purpose of the sell-side) is promoted in the sense that “understanding” will be enable you to “manage” the future. It turns lemons into lemonade.  It advances the “Lipstick on a Pig” tactic from boiler rooms to the entire economy/stock market . It is pure Marketing genius.
Despite the “genius”, I am not buying this “used car.”

More modern macroeconomic models

The econometricians and empiricists “explain” the effects of the stimulus

Is the American Recovery and Reinvestment Act of 2009 working? At the time of the act’s passage last February, this question was hotly debated. Administration economists cited Keynesian models that predicted that the $787 billion stimulus package would increase GDP by enough to create 3.6 million jobs. Our own research showed that more modern macroeconomic models predicted only one-sixth of that GDP impact. Estimates by economist Robert Barro of Harvard predicted the impact would not be significantly different from zero.

The natural tendency of government

We are embroiled in a great debate over health care reform. There are two aspects of the debate that are often not identified. The first is whether healthcare is a “right.” The second is the best way to deliver healthcare. When one does not separate the two issues, one biases the solution.

While I do not agree that healthcare is a right (you cannot morally produce a “right” for some by violating the rights of others), let us assume for the moment that it is so deemed. Then the issue becomes how is this “right” best delivered. It seems that the US has answered the first question and now struggles with the answer to the second.
It is the natural tendency of government to want to run things, hence we have the preoccupation with the single payer system or a competing government insurance company. The latter, using the concept of competition and government, is oxymoronic. Is there anyone outside of Washington DC that believes the government at the Federal or local level can run anything efficiently? The empirics regarding this issue are devastating — social security, Amtrak, medicare, medicaid, financial system regulation, the school system, potholes in the streets, the post office, infrastructure maintenance, the court system, garbage collection, department of motor vehicles, etc. etc. ad nauseum. One might reasonably argue that everything government touches deteriorates.
Back in the days of the Cold War, a joke that was popular in Europe went something like this: QUESTION — What would happen if the Soviet Union took control of the Sahara Desert? ANSWER — Initially no changes would be apparent; eventually there would be a shortage of sand.
Doug French has written a timely article that provides real-life context for the joke. His illustration focuses on Venezuela, although thousands of other illustrations could be provided.