Picking Up Nickels…
By Chris Richey
October 25, 2012
Those who pursue puny returns in the face of enormous risks to their principal are said to be “picking up nickels in front of a steamroller”. You would think such behavior is limited to drunkards and fools, but you will be shocked to hear that our very own Federal Reserve has undertaken just such a strategy in their well-intentioned, but, by their own admission, futile pursuit of improved U.S. employment numbers.
In September, Ben Bernanke and the Fed announced their intention to spend $40 billion a month purchasing long-term mortgage backed securities from banks until they see the labor market “improve substantially”. Some have suggested that this third installment of “quantitative easing” or “QE3”, should be called “QE∞” or “QE Infinity” because the program lacks both an end date and a dollar cap. Others have called it “Desperation Bazooka Tactics.” Whatever it is called, it comes on top of two other Fed policies, “ZIRP”, or “zero interest rate policy” (now in its fifth year) and Operation Twist/Keep Twisting, in which the Fed sells its short term holdings and buys long term bonds to the tune of $45 billion per month until the end of this year.
All this adds up to roughly $75 billion on long-term bond purchases through year-end and $480 billion annually thereafter. QE3 bond purchases are “unsterilized”, meaning that the Fed does not sell other assets to make these purchases from its constituent banks, instead it issues electronic IOU’s, just like with QE1 and QE2. This is also called “printing money”. With further fiscal stimulus stymied by gridlock in Congress and between the Executive and Legislative branches of the Federal Government, some say the Fed had no choice but to buy more bonds.
So, in addition to the combined $1 trillion spent in the Federal fiscal stimulus packages of 2008 and 2009, you can add the $2 trillion to date of Fed monetary stimulus with a further $0.5 trillion per year hereafter. Fed monetary stimulus, unlike fiscal stimulus is off-balance sheet financing, i.e. it does not show up (yet) in the $14 trillion of U.S. national debt so widely reported. Off balance sheet financing has a bad reputation because it has a nasty habit of finding its way onto the balance sheet.
Looking forward 14 months to the end of 2013, the upshot of QE3 is that the Fed’s balance sheet will be 25% the size of the entire output of the U.S. economy, having grown from just 8% in 2008. Based on its stated intentions, and according the BoA Merrill Lynch, by 2014 the Fed will own more than 33% of the entire U.S. mortgage market and 65% of all U.S. Treasury Bonds in 6-year to 30-year range. These estimates will likely end up being too low, given that QE3 and ZIRP are scheduled to run through 2015.
If “too big to fail” was a problem in the private financial sector, what happens when you have a Fed that is “too big to hedge”? There is simply no other entity or even group of entities (central banks, the IMF, the World Bank, bulge bracket investment banks, or global insurance companies) large enough to insure a meaningful portion of Fed’s super-sized balance sheet.
On top of that, Operation Twist has skewed the Fed’s balance sheet to bonds with maturities of 10 years or more, taking its bond portfolio duration from 2.5 years in 2007 to 8 years today and headed to 10 years at the end of 2013. The higher the duration, the greater the drop in bond prices as interest rates increase.
Key Metrics of the Federal Reserve Balance Sheet
Bottom line: the Fed now has a $3 trillion balance sheet loaded with long term bonds and undercapitalized to the extent that its current leverage ratio is 53:1 and headed to 61:1, levels far in excess of the leverage ratios of Lehman Brothers (30:1), Bear Stearns (35:1), Fannie Mae (35:1), and Merrill Lynch (44:1) at the times of their respective demises. If you are a “glass is half full” person, then you can take heart from Freddie Mac’s 109:1 leverage ratio… just before being rescued by the Federal Government.
In return for taking on this extremely dangerous level of leverage, the Fed’s expanded portfolio of Treasuries and mortgages earned it 3.2% in 2011: about $80 billion of interest income on $2.5 trillion of portfolio assets. Actually less than nickels on the dollar, so perhaps our “nickels” analogy should be “pennies.”
There are three policy justifications for QE3 cited by the Fed. First, and foremost at this time, the Fed believes the most pressing problem in the U.S. economy is high unemployment and that low interest rates and ample liquidity can lower unemployment. Second, through low interest rates they want to encourage cash-strapped homeowners to refinance their mortgages. And, third, the Fed wants savers/investors to put their cash hoards to work in risky assets, thus driving up the prices of those assets and creating a “wealth effect”.
Critics of the Fed argue, one, that low interest rates are not effective at bringing down unemployment, a point Bernanke readily concedes, though the Fed must pursue “maximum employment” given that it is one-half of its dual mandate (the other half is “moderate interest rates”), two, those homeowners who could meet the re-imposed standards of creditworthiness have already refinanced their mortgages, and, third, temporarily “goosing” risky asset prices with borrowed money makes a mess of free market price discovery and adds to investor uncertainty, i.e. risk on/risk off investing.
Casting aside the merits and deficiencies of the Fed’s justifications for purposes of this commentary, thoughtful investors also need to grasp the personal/professional motivations of Bernanke, since that understanding helps explain why such a seemingly well-trained and experienced economist as Bernanke would put his agency in what we believe is grave financial peril.
Bernanke’s training and career have been largely devoted to the Great Depression, as well as Milton Friedman’s monetary theory and the proper response to deflation. According to Friedman in A Monetary History of the United States: 1867-1960, the Fed turned the Great Crash of 1929 into the Great Depression of the 1930’s by tightening money supply and raising rates between 1930 and 1933. In 2002 in one of his first speeches as a member of the Fed’s Board, and with Friedman and his co-author wife, Anna Schwartz, sitting front row, Bernanke closed his speech with the following spontaneous remark: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna, regarding the Great Depression: you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
In his 1999 paper, Japanese Monetary Policy: A Case of Self-Induced Paralysis, Bernanke expressed his admiration of FDR’s “Rooseveltian Resolve,” stating that “[his] specific policy actions were, I think, less important than his willingness to be aggressive and to experiment—in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done”.
In light of these twin beliefs, Bernanke has more than proven his devotion to loose money and unrestrained experimentation to the tune of several trillion dollars. By his own admission, this “non-traditional” monetary policy is largely an exercise in “learning by doing”. But we have to ask exactly how groundbreaking and bold is “quantitative easing” if we simply call it “printing money”, which is what it is. Perhaps less time in the “lab” and more time in the library will help remind Bernanke that two thousand years of monetary history are littered with the bones of regimes that fatally debased their currency.
The decisive moment will arrive when ZIRP becomes “NIRP” (“normal interest rate policy”) and the Fed begins its promised exit from its “accommodative monetary policy”. Unless Bernanke intends to follow the Japanese down the rabbit hole of decades of interest rate repression, which he has vehemently denied he will do, at some point interest rates will go up, with or without the blessing of the Fed. Richard Fisher, President of the Dallas Federal Reserve, raised this issue on the eve of QE2 in 2010:
Then there is the issue of exit policy. The more we engage in a policy of asset purchases that moves us further out the yield curve—and the more we laden our balance sheet with price-sensitive assets—the greater the likelihood of realizing a loss on our holdings… I shudder at the prospect of the Chairman or any other members of the FOMC appearing before the House Banking Committee in 2012 to report that the central bank of the United States has generated a loss of X billion dollars.
Though the loss of “X billion dollars” that Fisher anticipated have been forestalled by ongoing zero-bound interest rates, the size of the probable crisis has grown by another trillion dollars in the interim and will continue to balloon now that QE3 is in progress. And as we will set forth below, “X billion” looks more likely to be “XXX billion” when all is said and done.
Nonetheless, unwind its balance sheet the Fed must, if Bernanke is true to his word: “I’m confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way.” From the Fed’s June 21, 2011 FOMC minutes we learn that the fourth step of the Fed’s exit strategy is “Sell agency securities over a period of three to five years.”
Whether he follows through is another question because, unlike private sector institutions, the Fed is not required to mark its bonds to market and run the gain or loss through its income statement quarterly. Only if the Fed actually sells its bonds, does the loss flow through to its capital account. There is an extremely compelling argument that the Fed will never sell these bonds and, instead, will hold them all to maturity: to do otherwise is financial self-mutilation. Why sell at all if you can simply hold to maturity and avoid the loss altogether?
Regardless of whether the losses are realized by the sale of the bonds before maturity, the Fed does calculate and footnote the change in value of its bond portfolio on a marked to market basis in its H.4.1 quarterly release, so bond vigilantes and other interested observers will have a very clear idea of the losses embedded in the Fed’s portfolio. Even assuming an absence of “unreasonable scenarios” per Fisher’s quote, the pending losses caused by holding long bonds in a rising interest rate environment will hang there, like the Sword of Damocles, over the neck of the Fed’s capital account.
If we assume the Fed Funds Rate rises to its 10-year average of 1.9% from today’s 0.3% target with longer rates shifting upwards proportionately, then that “sword” is a $500 billion embedded loss. If we assume the Fed increases its Fed Funds Rate back to its 20-year average of 3.25%, this becomes a $1 trillion embedded loss on the Fed balance sheet. In its current undercapitalized position, the Fed will zero out its capital account when it has sold less than 20% of its bond portfolio.
Then what? The Fed must be recapitalized and, preferably, sooner rather than later. The loss of confidence in both the Fed and the U.S. Federal Government would cause a catastrophic fall in global financial market, certainly on the scale of 2008/9, perhaps worse because it was only the intervention of the Fed and the Federal Government that stopped the free-fall 4 years ago.
On the eve of the announcement of QE3, Harvard professor and Former Reagan Administration economist Martin Feldstein, who prophetically warned in the late 1990’s of the fatal flaws in the structure of the then-pending advent of the Euro, raised concerns about the impact these bond losses and the subsequent recapitalization would have on Fed independence:
If they're sitting there, holding long-term bonds, the Fed is at risk of a capital loss. In a sense, that doesn't matter. It's a paper loss, they haven't sold it, they're just holding it -- so I guess in that sense, there is no loss. But their opponents in Congress will say the Fed just lost $200 billion and in an accounting sense, that will be true. It's an extra risk that the Fed takes about its own long-term authority.
Based on the numbers we set forth above, we estimate that the cost of such a rescue might be in the range of $500 billion to a $1 trillion. Given the magnitude of these losses and the certainty that both the Left and the Right will use this catastrophe to attack the Fed, we believe an even less independent Fed is the likely outcome. Such is the outcome when the “lender of last resort” finds itself flattened like a pancake with only a few nickels to show for its good intentions.
(c) Neosho Capital