by Gary North
by Gary North
In this report, I introduce you to an amazing chart. It is getting zero attention from the mainstream financial media. The information it conveys is at the heart of Bernanke's looming problem. I have decided to post a link to this chart on a permanent basis in the "Free Materials" section of my website.
But, first, here is some background information. The Federal Reserve System on December 17 began a unique experiment: debt swaps with large commercial banks. The FED is now swapping at face value highly marketable U.S. Treasury securities in exchange for discounted mortgages. Nothing like this has ever been attempted before. It represents an innovation in central bank policy. It is called the Term Auction Facility (TAF). The initial offer was for $20 billion in swaps.
Since that time, the 28-day swaps have risen in volume to $75 billion.
As of May 5, according to the FED, $150 billion in TAF swaps have taken place.
The rate charged is about 2%. This is why the FED has cut the FedFunds rate to 2% — not to stimulate the economy directly but to make available TAF loans at low rates.
Here is how the game is played. The borrowing banks can place the borrowed Treasury debt on their books at close to face value. This looks as though the banks are meeting their capital requirements.
What is really going on? Deception on a massive scale — a fully legal deception that the U.S. government's bank auditors understand and go along with.
Let me make a comparison. When a person who wants a mortgage signs the loan application, he is asked if any of his down payment is borrowed. The lender does this because he wants the equity to belong to the home buyer. He doesn't want any other lender, such as a relative of the home buyer, to be able to claim first dibs on the money if the home buyer walks away. On the other hand, when it comes time for a large bank that loaned money to a defaulting borrower to cover itself by borrowing high-rated assets, the bank's auditors do not ask the same question of the banks: "Is any of this capital borrowed?"
The FED's decision-makers were able to convince four other central banks to adopt a similar swap policy with the government-issued debt of their nations.
The FED is making it worthwhile for the other central banks to cooperate. It is providing these banks with the money to make the swaps. The FED's May 2 announcement describes what is going on.
In conjunction with the increase in the size of the TAF, the Federal Open Market Committee has authorized further increases in its existing temporary reciprocal currency arrangements with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts of up to $50 billion and $12 billion to the ECB and the SNB, respectively, representing increases of $20 billion and $6 billion. The FOMC extended the term of these reciprocal currency arrangements through January 30, 2009.
The fact that the other central banks are going along with this plan indicates that the subprime mortgage crisis has spread far beyond the borders of the United States. Commercial bankers in other nations made the same mistake that America's commercial bankers made. They assumed that a package of mortgages with different degrees of risk would create sufficient risk diversification that the market value of these packaged pools of debt would not fall from book value. Beginning in August 2007, this assumption was revealed to be breathtakingly naive.
Bankers loaned money to hedge funds to buy these packaged mortgages. Now the hedge funds that invested heavily in these mortgages are unable to pay interest to the banks. The liquidity for these assets has fallen. The market has discounted these assets to 80% or less of face value. So, the collateral for the bank loans to the hedge funds is trouble. If the banks mark these assets at market value, as new accounting rules in the United States require, then the banks will have to cut their estimates of their capital, which will require that they cut their lending. All this is happening as a recession in the United States has begun, despite the financial media headlines. This has been argued persuasively by economist Stefan Karlsson.
WOULD YOU FUND A USED CAR PORTFOLIO FOR THIS BANK?
Back in 1960, a Democrat drew a cartoon of Richard Nixon. Under the Nixon's face was this question: "Would you buy a used car from this man?" Because the election was so close, we can blame Nixon's defeat on almost anything, including the ballots cast in Cook County, Illinois, where, in the words at the time of black comedian Dick Gregory, "your vote really counts, and counts, and counts." But I prefer to blame that cartoon, which was reproduced everywhere.
With this as background, let us consider the words of the Federal Reserve System as of May 2.
In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve's Schedule 2 Term Securities Lending Facility (TSLF) auctions. Primary dealers may now pledge AAA/Aaa-rated asset-backed securities, in addition to already eligible residential- and commercial-mortgage-backed securities and agency collateralized mortgage obligations, beginning with the Schedule 2 TSLF auction to be announced on May 7, 2008, and to settle on May 9, 2008. The wider pool of collateral should promote improved financing conditions in a broader range of financial markets.Deciphering the FedSpeak, we learn that the FED is swapping U.S. Treasury securities for packages of loans on just about anything. I suppose this could include cars, if the FOMC decides the asset meets its wider standards.
I can't help it. I have this mental image of Ben Bernanke on some late-night television commercial for used cars. He's out on the lot, walking down a row of used cars. "Friends, you've got to get down here tomorrow morning. No matter how long and hard you look around town, you won't find a beauty like this 2005 Hummer." He whacks the hood. The bumper falls off.
All over the banking world, the bumper has fallen off. As for the AAA-rating, let me quote the late Senator Everett Dirkson. "Ho, ho, ho — and, I might ad, ha, ha ha." If the AAA rating meant anything significant, the paper would not be trading at discounts from face value.
Consider these words: "The wider pool of collateral should promote improved financing conditions in a broader range of financial markets." Let me translate.
The wider pool of eligible capital for swaps will allow banks to convince government auditors — wink, wink — that the assets on the banks' books need not be marked to market with a discount. Therefore, the banks will not have to call in loans in order to bring their loan-to-capital ratios back into line with regulations.
HOW LONG CAN THE GAME GO ON?
It can go on for as long as the Federal Reserve System has U.S. Treasury debt to swap. As Hamlet said, "There's the rub."
In November, 2007, two weeks before the first TAF auction was held, the Federal Reserve System held about $800 billion in Treasury debt. As of May 1, it held $539 billion. "May day! May day!"
The Federal Reserve's "creative financing" to bail out banks that have invested in creatively financed mortgages has a limit. The limit is its portfolio of Treasury debt.
This brings us to the chart. It is published by Cumberland Associates. It lets us see the decline in the FED's holdings of Treasury debt. The important section of the chart is labeled "Securities." The color is deep purple.
It took from 1914 until November 2007 for the Federal Reserve to accumulate $800 billion worth of Treasury debt. It has take from December 17 to the end of April for the FED to divest itself of $260 billion of this portfolio, a decrease of one-third. In its place, it has placed AAA- rated mortgages.
At the current swap rate, the Federal Reserve System will be out of Treasury debt in December of 2008. But by adding car loans to the list of eligible paper, the FED has guaranteed that this rate will accelerate.
During this period, the financial media have remained characteristically mute. Half a century ago, in "Damn Yankees," the musical treated us with this lyric: "Whatever Lola wants, Lola gets, and little man, little Lola wants you." The FED wants a docile press to match the docile Congress. It gets what it wants. "There's no exception to the rule. It's irresistible, you fool. Give in."
The chart is Bernanke's nightmare. It reveals the reality of the limits of the FED's program to make the banking system solvent without creating fiat money by purchasing assets. The FED has not created new money since early last August. In fact, it has deflated. We can see this in the chart. Its ending date in May 1.
Several decades ago, Ben Stein's father Herbert, who had been the head of Nixon's Council of Economic Advisors, uttered one of the profound observations of our era: "When things can't go on, they have a tendency to stop."
The FED's swap programs are going to stop. I think they will stop this year. If I am correct, then the FED will have to come up with a fall-back program.
INFLATION IS ONE ANSWER
If the FED buys more Treasury debt to swap for AAA- rated paper held by banks and financial institutions, then it will have to abandon its anti-inflation policy.
Then again, the FED could keep the game going a while longer. It could sell its other major asset: gold. This of course assumes that the FED still is sitting on physical gold. If it is, it can sell it. For accounting purposes, it is held at $42.22 per ounce.
If it hikes the price by 20 to one before selling, this will increase the monetary base, just as surely as the purchase of a comparable quantity of T-bonds would. The FED officially holds 262 million troy ounces of gold. That's over $200 billion in gold at $800 per ounce. To sell gold at $42.22 an ounce would transfer enormous windfall profits to the buyers. Congress might take a close look at such an arrangement. Technically, the U.S. government owns the gold. So, I don't think the FED will sell off its gold.
The FED is hoping that the market for AAA-rated mortgage packages and car loan packages will recover before the end of the year. If it doesn't, then the banks will no longer have a cooperating buyer of these packages at face value for 2%.
The clock is ticking for Dr. Bernanke and his fellow Board members and Federal Open Market Committee members. They have adopted the most creative "creative financing" program in central bank history. They have invited other central banks to adopt the program, which they have.
The problem is, there is an economic law here: "At a below-market price, there is greater demand than supply." There is a rush by commercial banks and financial institutions to swap AAA-rated paper for Treasury debt. I can understand their enthusiasm.
The game cannot go on indefinitely. Remember Herb Stein's law: "When things cannot go on, they have a tendency to stop."
The FED is not inflating today. My opinion is that it will not maintain this policy through 2009.
May 7, 2008
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