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.
When the Fed finally unloads it's holdings, boy is that going to be painful. This is like a heroin addict. We now have an unlimited time line for Wall Street crack, we're all supposed to "invest" in this 75% HFT gambling casino now.
Great details Numerian, I don't think the financial press has discussed the actual holdings and their implications in a long time.
Numerian said: "If the US ever got into trouble like Spain or Greece, which means if long term interest rates ever spiked up "
But there is no comparison between the US and Greece. The US issues its own currency and sets its own interest rates. Greece does not issue its own currency and does not set its own interest rates.
Numerian said: "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."
But why would the Fed need to reduce its balance sheet ? Why not let the Fed's holdings mature and then be swept back into the Treasury ? The Fed buys and sells stuff to control interest rates, not to manage its balance sheet for the sake of managing its balance sheet.
Numerian said: "No nation, not even the US, can print money indefinitely."
Actually, the US can pay any bill with only keystrokes, indefinitely, limited only by inflation. The US can continue to roll over its debt indefinitely. Or Congress could repeal the nearly 100 year old law that requires the Treasury to sell debt in the first place, since that law no longer serves any purpose other than to subsidize the financial sector.
Agree with Numerian that the unintended consequences of permanent zero are worrisome.
The best I can say about QE3 is that, if it doesn't work, maybe that'll be monetarism's last breath, and then we turn our attention to fiscal policy like we should have done all along ?
The US is losing control of its destiny
The Fed can control short term rates less than 2 years maturity, and it has more control the closer we get to the Fed Funds rate for overnight reserves. Even the Fed admits it cannot control long term rates. Each QE episode has resulted in rates moving up from where they were when the program started. This one will probably be no exception, and I would not be surprised to see a mini-spike in note and bond rates because of the unlimited nature of the QE3 program.
I agree with you that the Fed does not at this point need to reduce its balance sheet. QE3 will if conducted over the next year bring the balance sheet to $4 trillion. I suspect the Fed can hold on to those assets until maturity, and I believe it already announced that all existing MBS assets will be kept until their maturity. Note however, that the Fed does not hedge the interest rate or prepayment risk on its mortgage portfolio, because it feels it is the central bank and doesn't have to worry about the impact of losses. It also somewhat misleadingly describes the interest income thrown off by this portfolio as "profits" that it is returning every year to the Treasury. Even Fannie and Freddie knew better than to manage their portfolios this way. The Fed, therefore, is not treating its portfolio in the professional away required by a bank in the private sector. It seems to be more concerned about the political implications of its portfolio, without recognizing that the tens of billions of dollars of profit it pays to the Treasury every year is really interest income that used to go to the private sector and has now been siphoned off by the government.
I understand your qualification that the US can pay its bills under all circumstances, inflation permitting. The idea that the US can roll over its debt indefinitely comes from the illusion that the US is exempt from the laws of economics. This illusion exists because of the halo effect that the country enjoys from 100 years of commercial and political power on a global basis, from 100 years of a AAA rating for fiscal and monetary rectitude, and from being the only hyperpower in the world. This halo can last for a very long time since it takes many years to eat the seed corn that the country has built up in the 20th century. But the US is indeed digging increasingly into its wealth for survival, rather than generating new wealth that would permit it to continue in its prosperous lifestyle. This is quite evident in the way the public debt has mushroomed, and in the declining asset holdings of the population at large (losses on equity holdings, loss on housing stock, losses on real income). Most politicians don't recognize this, and if they do they spend a lot of time talking about how the other guy is going to have to cut back on their living standards. No one is looking much at the work that would be necessary to restore productive capacity to the economy, which means in particular getting the trade deficit down. The Fed governors talk openly about how they can ramp up their balance sheet as high as necessary until the economy takes off again. They don't see that the practice of using debt to spur growth, which did buy 100 years of prosperity for the country, got out of control in the 80s and went on a exponential tear until the debt mountain began to collapse under its own weight. Rather than deal with the debt problem - rather than force those actors in the economy who made bad investments and bad choices to accept the pain of bankruptcy (especially the banks), the Fed is trying to restart the debt cycle all over again and push it to yet another new, exponential height. It isn't working because it can't work, and the economy has run out of assets to inflate, so everyone is turning to the Treasury as the last great chunk of equity left to plunder (i.e., the good faith and credit of the country at large). That isn't working either, as we have seen with the loss of the Aaa rating. So I don't agree that the US can roll over its debt indefinitely. The USG has a better shot at it than anybody else, but the private sector is leading the way to debt liquidation through default, since the alternative of debt liquidation through inflation isn't working.
Finally, I think fiscal policy is the answer only in a limited sense - in alleviating or mitigating the pain the average person is going to experience as debt liquidation accelerates. We see this mitigation occuring in the explosion in the use of food stamps - up to 15% of the population. Obviously the risk here is that you create a segment of the population that develops a permanent dependency on the government for the basics in life. Rather than decry this, the US is eventually going to have to accept that 25% or more of the population will be permanently poor and permanently living off welfare in some fashion, while people hustle to find occasional work and odd jobs to supplement their income. This is the nature of every third world society I've ever visited, and we should not be acting so surprised that this is what is occurring in the US as it converts itself into something of a third world country.
Great post and follow up! +10
My first time here, keep up the good work!
Thanks for your vote of confidence
I've been pounding the table about the destruction of savings as a result of the Fed's action since QE1 was launched. There has been hardly any discussion in the press at all about this problem, but it seems people are beginning to notice. Here is an article today that I think was published first in The Independent (UK).
The author talks about QE leading to the destruction of savings. He's right, but that is only one part of the picture. You have to add in ZIRP and NIRP (zero and negative interest rates) to get a complete view of the destructive aspect of Fed policies. Of course, in the broader sense, these policies are in response to deflation and reflect the dreaded liquidity trap that Keynes wrote about. The major global economies have joined or are joining Japan in the liquidity trap, where lowering interest rates has no stimulative effect on economic growth ("pushing on a string", as Keynes said). What this reporter has correct is the anti-stimulative aspect of quantitative easing: with no interest income available, investment grinds to a halt since people park their money where it is safe from credit risk. They need to be wary of credit risk because with no interest income, millions of actors in the economy - businesses and individuals - are exposed to bankruptcy when they start living off their savings and eventually liquidate all they own.
Here is another interesting aspect of deflation and the 1930's Depression that Bernanke ignores. The Great Depression was considered to be as bad as it was because so many banks collapsed from bad debts and bank runs (loss of confidence in the system). Bernanke seems determined to avoid that sort of destruction and loss of confidence in the financial system at all costs, very much as the Japanese avoided this pain too since the 1990s. The result, though, is that the banking sector never gets cleaned up. Big banks linger on, technically insolvent, as problems are kept hidden and the banks are forced to survive off the generosity of the government. Robert Oak has shown us many examples where the US government is funneling profits to the big banks, and even QE3 has now been shown to benefit their bottom line more than that of the consumer.
The paradox is, though, that the economy cannot grow out of a depression until the financial system is cleansed of corruption and bad debts. You also need - sad to say - for the economy to be placed on short rations until this cleansing is completed. That means consumers and businesses need to live with reduced standards, and consumers in particular have to stop spending while they build up their savings. Neither of these two things is happening in the US. Savings in particular are at a low rate, because the only debt liquidation that has occurred is with home mortgages. Corporations are still heavily laden with debt, most of it at high yields. And as we mentioned, savers are trapped because of QE, ZIRP, and NIRP - they have no place to go to earn a safe and fair (market-determined) yield.
Everythone thinks the Great Depression was eventually conquered by huge government spending in the US during WWII. That is only part of the picture, and it is the part Paul Krugman and other Keynsians insist should be happening now. But you need at least three more things. You need to clean up the financial sector (not happening in the least - it is being coddled at the expense of everyone else). You need the private sector to embrace austerity (WWII was successful in part because of the War Bond program, when consumers were urged to invest in government bonds rather than spend money on "luxuries". I remember my parents talking about living under food and gas rationing during the war, and scrounging around for tin foil to sell on the used market). Finally, you need social consensus as to the necessity of this austerity. Being in a war for survival is certainly one way to forge social consensus, but that is hardly an option in a nuclear age. When the US did go to war in the last decade, Bush urged Americans to shop - just the opposite of what is needed during a war. What is a required now is a politician who can build a national consensus on austerity and the need for saving as opposed to consumption, until balance sheets are restored. This same politician will have to put some banks into receivership, and will also have to turn the Fed around too - toward promoting saving and not consumption. Retail spending and global trade will obviously collapse for awhile, making the depression worse, and there are going to be a lot of shuttered stores in most major countries. Governments won't be able to help much here, because their resources are now quite limited having been wasted on propping up the banks and their bondholders/shareholders. Governments will instead have to concentrate on the necessities of life for individuals - access to food, shelter, medicine, school for individuals.
Again, I don't see any of these things happening. Washington seems to be lurching toward austerity, but of the wrong kind - hitting people badly, especially the most vulnerable, and letting certain sectors of the economy off the hook, like the financial and defense sectors. People need to see that government is arbitrating pain-sharing fairly, so that necessities are met, as consumption collapses. This is the failure we see in Europe. Greeks are allowed to watch their economy collapse and consumption fall, but no other European country is willing to help where it matters - a Marshall Plan for basic food supplies, medicines, and energy so that Greek citizens wouldn't have to eat out of dumpsters, or die for lack of basic medicines. Instead all the money is going to the banks.
QE helps banks, not people
Bloomberg I swear read your article. Here is theirs:
yea baby, that trickle upon, indirect stimulation is just so awesome, since it's all not addressing the real reasons our economy is imploding. Works so damn well!