The QE3 has been officially launched today by the Federal Reserve, which has promised to buy $40 billion of asset-backed securities from the market each month, on top of $35 billion per month of Treasury securities it is already buying as part of its program to reinvest proceeds from securities which are maturing in its existing portfolio. If this isn’t enough to excite the animal spirits of the economy, the Fed has put no limit or end-date on QE3, and it has pushed out its promise to keep short term interest rates near zero for at least the next 2-1/2 years.
Why is the Fed buying mortgage-backed securities and not Treasuries, which it bought under QE1 and QE2? In the past fiscal year for the US government, the Fed purchased 77% of all the new debt issued by the Treasury, and because the Fed focused its purchases in the 10 year and beyond maturities, the Fed is bumping up against its self-imposed limit of not owning more than 70% of the outstanding paper in any maturity. The Fed is already close to this limit for maturities clustered around the 10 year mark, and the Fed owns on average 50% of all the outstanding paper in the 10 year to 30 year maturities. As Republicans have made clear in this election year, every Treasury purchased by the Fed is viewed as an attempt to influence the election of Obama, so this is a potent political reason to stay out of this market for the time being.
At the same time, the Fed has ceased to be a presence in the 5 year and under element of the maturity spectrum. Traditionally this is where the Fed has parked all of its assets, but could it be that it doesn’t wish to hold paper that earns less than 1% p.a.? The only reason the market has rushed into this section of the yield curve is that the private sector is afraid of default risk in the private market, and is willing to accept virtually no return for the safety of owning US Treasuries. The Fed has no such concern – it is the government. This gives the Fed the advantage of concentrating in long term maturities that yield 2% or more. But by concentrating so heavily in these maturities, and demanding that banks pass these securities on to the Fed before anyone in the private sector has a chance at buying them, the Fed is crowding out the private sector, which is at the same time starved for safe interest income.
If the Fed had decided to devote QE3 to the purchase of Treasuries, and if it kept its purchases in its favored 10 to 30 year maturities, it is estimated that there is only around $600 billion of these securities in private hands that could be sold to the Fed before it reached its limits on maturity holdings. This means QE3 would last about 18 months before the Fed had gobbled up to 70% of all the Treasury bonds.
This would be dangerous on several levels. If the Fed tried to sell such a huge amount of securities back to the market (presumably when the economy is stronger), interest rates would head back up, and perhaps sharply. Even if the Fed stretched out the sales over several years, that would still keep a floor under interest rates, because the market would know there is always a seller at higher prices. Third, if the Fed announced it was holding all these securities to maturity, interest rates would still be subject to greater volatility than we are used to, because the amount of securities left in private hands would be much smaller than, say, five years ago. This would mean that a much smaller transaction in the private market is all it would take to push interest rates sharply higher or lower.
This last risk is already present in the market because the Fed has absorbed so much of the liquidity that used to exist in Treasuries. We are seeing this shortage of liquidity in the derivatives market, in which many transactions are collateralized by Treasuries. This shortage of collateral is becoming so acute that some enterprising large banks are offering to buy other types of financial assets (such as mortgage-backed securities) at a steep discount, and return valuable Treasuries to the seller in exchange.
How convenient, you might say, just as the Fed has announced it is now going to be buying mortgage-backed securities from banks, that these same banks have begun scouring the market to scrounge up such securities. This is more than convenient or coincidental. The fact is, mortgage-backed securities are in even shorter supply than Treasuries. At least with Treasuries, the US government is printing $1 trillion more each year. No one is creating new mortgage-backed securities, and hasn’t been since the housing market crash of 2008.
The two major buyers of home mortgages, and creators of securities backed by these mortgages, were Fannie Mae and Freddie Mac, the two private enterprises that were created just for this purpose by Congress. Fannie and Freddie both collapsed along with the housing market – the losses on their portfolios were overwhelming what equity these firms managed to have (which wasn’t much in the first place). Both institutions were taken over by the Treasury, and there they sit, borrowing billions of dollars each quarter from the Treasury to cover the losses that continue to bedevil their portfolios. Both institutions, being bankrupt, are no longer permitted to buy mortgages and securitize them, and the private sector has no interest in doing so, given the overhang of foreclosures in the housing market, and the depressed prices for property.
Bear in mind also that the large banks have already sold a sizeable portion of their own mortgage-backed securities back in 2009, when the bank bailouts were put in place (TARP in particular). The banks dumped as much of their bad credits on the Fed as they could, and kept the performing securities for themselves. Now they are being forced to give up even these, which is taking away some valuable interest-earning paper from the banks. Even though the banks earn a guaranteed fee for doing these transactions with the Fed, the fee hardly compensates them for the loss of interest income, which hits them directly in their net interest margin.
Zero Interest Rates Destroying Financial Institutions?
People are paying a lot more attention these days to the net interest margins of banks, because this is an indicator of how healthy their bread and butter business really is. The whole benefit of being a bank is to borrow at low rates (usually on the short end of the curve), and lend at high rates, thus earning net interest margin, which in good times can be a 4% spread or higher. These days the banks are watching their net interest margin shrink to half of that, which is not enough any longer to cover their expenses, and at the same time, fee income is shrinking, especially from trading, but also from retail banking since some of the ways banks gouged consumers (on debit cards, for example), have been outlawed.
The Fed is supposed to be in the back pockets of the banks, serving their every need, and for the most part that is the case. But when it comes to monetary policy, the Fed’s actions are now beginning to seriously hamper bank income – not to the point where banks are in danger of failing, but certainly to the point where banks can only dream of earning 15% returns on their capital like in the good old days before 2008. Remember too, banks have been required to increase their capital significantly, making it that much harder to earn rich returns on their capital.
Nor are the banks the only institutions hurt by the Fed’s policies. Anyone dependent on interest income is hurting from the Fed’s zero interest rate policy, which we learn today will be extended at least until the summer of 2015. Everyone has to prepare themselves for less and less interest income, and in some cases none at all, forcing people to liquidate their savings to survive. We see this reflected in the continued poor savings rate in the US; as consumers with jobs try to increase their savings, retired people are forced to liquidate their savings, causing a net wash in the savings rate. This is also reflected in the continued, monthly liquidation of stock holdings by consumers, to the point where the stock market is dominated by Wall Street computer trading, making the market more volatile because computers trade only in the short term, unlike individuals who are long term investors. This lack of trading volume is, paradoxically, yet another blow to the big Wall Street backs.
In the long run, you cannot run an insurance company if interest rates are 0% and the yield curve is deliberately kept flat. Insurance companies expect to earn 5% or more with long term investments to help pay out claims, but where are the safe investments any longer which earn as much as 5%? University endowments, charitable foundations, pension plans, and other institutions which depend on long term fixed income are beginning to panic at the thought that their entire business model is being destroyed by the Fed’s monetary policy. Another institution which is heavily dependent on 5% or more returns in US Treasuries is the Social Security Administration. The Fed’s actions are forcing Social Security to shorten its projected life-span – the point where its savings run out and fresh taxpayer money will be needed to pay claims.
And by the way, if you want a candidate to usher in the next leg down in this depression, it would be among these long term investors. All it would take is some insurance company to admit it hasn't the income to meet its claims, or some large foundation to fold, and the true cost of quantitative easing would be evident for all to see. That would also be the point where the markets would realize the United States is facing a terrifying dilemma: commit suicide over the long term by starving everyone of interest income; or commit suicide quickly by allowing interest rates to rise to their equilibrium level in the market without government interference, and thus push the economy into freefall as it deals with defaults from overindebted borrowers.
Time to Speculate!
The Fed’s answer to complaints from these institutions is crude but probably the only one they can offer: speculate! What they are really hoping for is that savers will put their money in the stock market, and that is happening to a degree – the Dow is near 4 year highs, even though the economy appears to be heading into recession and corporate earnings are shrinking noticeably. The Fed did an interesting study of the stock market reaction on the days the Fed announces the results of its FOMC meeting (such as today, when the Dow is up over 200 points). If you subtract out the performance just on those days, the S&P500 index would not be at 1400 – it would be somewhat over 600. That tells you everything you need to know about the stock market, and how it is totally dependent on the Fed’s liquidity programs and quantitative easing.
The unfortunate side-effect of these QE programs is that the market speculates in more than the stock market. Gold and other precious metals are a favorite target of investors, as is oil and other commodities. The Fed continues to insist that inflation is not a problem, and by the Fed’s narrow measures, which exclude food and energy, that is true. But those two items have been known to increase by double digits after a QE program is announced, and this time may be no different (oil is up substantially since there were hints of QE3).
Critics of the Fed point to these unintended consequences of its monetary “meddling” and ultra-unorthodox actions as reasons why the Fed should desist from such experimentation. Each QE program does indeed produce some unintended consequences, and this one should be no different. One likely result is that the Federal Reserve is rapidly becoming the nation’s leading prop for the housing market. This is a role that used to be played by Fannie and Freddie, but as we’ve discussed, they are defunct. The Fed has taken their place, and will have over a trillion dollars in mortgage backed securities on its balance sheet.
If you were looking at the Fed as a stand-alone institution, it is the last place you would want to put your money. It’s balance sheet is loaded with scary long term assets, and it funds itself very short term at hardly any cost, but that means should short term interest rates ever increase, the Fed is exposed to enormous losses, because it does not hedge its mortgage-backed assets (which also exposes the Fed to considerable prepayment risk, which is hard to hedge in the first place and which got Fannie and Freddie into such trouble). To top it all off, the Fed has a tiny amount of equity on its balance sheet that couldn’t possibly absorb the losses from even a small increase in interest rates.
The good news, of course, is that the Fed is a central bank, and controls short term interest rates. This gives it a rather interesting conflict of interest when it debates whether to raise interest rates (it will be hurting itself as an institution if it decides to do so). The Fed’s governors talk as if the Fed’s balance sheet has no limits on its size or its composition, but even central banks are subject to the laws of finance and economics. The Fed’s balance sheet is now going to exceed 20% of the GDP of the US, and it is clearly impossible for the Fed to reduce its balance sheet significantly without severely damaging the economy.
Many commentators are looking at that unhappy day and wondering what the result will be. I am looking more at the reverse – at the expectation that the Fed will never unload its Treasuries or its mortgage-backed securities. Should the US ever decide it needs a new Fannie Mae or Freddie Mac, the Fed would now be the logical party to play that role. It is already playing that role to some extent; it may not be buying mortgages outright and securitizing them, but it is the main active support for the multi-trillion dollar MBS market that currently exists. As such, I’ve dubbed the central bank “Feddie Mae”, in recognition of the fact it now has three objectives: manage the money supply, promote employment, and support the housing market.
When you think that Feddie Mae is responsible for defending the dollar as the reserve currency of the world, I suppose you could take comfort from the fact that the dollar is now buttressed not only by the good faith and credit of the United States (which is no longer AAA by the way), but by a good chunk of its housing market. Except what sort of comfort is that? If the US ever got into trouble like Spain or Greece, which means if long term interest rates ever spiked up (and remember the prospect for such a move is greater now than ever since the market is so thin and illiquid), then where’s the money going to come from to pay interest on its debt? No nation, not even the US, can print money indefinitely when the market loses confidence in its economic management. The Fed would have to start selling some of its trillion dollars + of mortgage-backed securities, and won’t that have a shocking effect on the housing market.
QE1, QE2, QE3 – unintended consequence piled atop indeterminate outcomes. The only constituency that seems to have any confidence that the Fed knows what it is doing is the stock market, and that means basically a few hundred super computers which could just as easily cause a market panic when just one computer realizes the ramp job being perpetrated by Feddie Mae has come to its logical conclusion. Since each quantitative easing program has had demonstrably less efficacy over shorter periods of time, that day of reckoning is fast approaching.