January 4, 2010
Timothy Geithner Meets Vladimir Lenin
“The best way to destroy the capitalist system is to debauch the currency.”
Vladimir Lenin, leader of the 1917 Russian Revolution
Last week, while Congress and the nation were preoccupied with the holidays, the Treasury made a Christmas eve announcement that it would be providing Fannie Mae and Freddie Mac unlimited financial support for the next three years. The Treasury's press release notes:
“At the time the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship in September 2008, Treasury established Preferred Stock Purchase Agreements (PSPAs) to ensure that each firm maintained a positive net worth. Treasury is now amending the PSPAs to allow the cap on Treasury's funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years.”
Put simply, in a single, coordinated stroke, the Treasury and the Federal Reserve have encroached on spending powers that are enumerated for the Congress alone. Under the Housing and Economic Recovery Act of 2008 (HERA), the Treasury has no such open-ended authority. Indeed, the applicable portion of the Act explicitly limits the total amount of mortgage principal (not losses, but total principal) as follows:
"LIMITATION ON AGGREGATE INSURANCE AUTHORITY.—The aggregate original principal obligation of all mortgages insured under this section may not exceed $300,000,000,000."
That's $300 billion of original principal. If there is some loophole by which the Treasury's action is legal, it's clear that it was no part of Congressional intent, and certainly not broad public support. Taxpayers are now being obligated by the Treasury and the Fed to make good on a potentially much larger volume of bad mortgage loans, made by reckless lenders, guaranteed by Fannie Mae and Freddie Mac in return for a pittance (called a “G-fee”), and packaged into securities which are now largely owned by the Federal Reserve, which has acquired them through outright purchases (not traditional repurchase agreements).
As I wrote several weeks ago, “The Federal Reserve has expanded the U.S. monetary base by more than 150% since the beginning of the recession. That is not a typo. The monetary base has soared from $800 billion to over $2 trillion. Much of this has been accomplished through outright purchases of mortgage-backed securities (not repurchases) and an equivalent creation of base money. Unless these securities can be sold back out into private hands for the same value that was paid to acquire them, the Fed will have effectively forced the U.S. government to make its implicit guarantee of these agency securities explicit, without the authorization of Congress. To the extent that the underlying mortgages default, the U.S. government will be forced to issue additional Treasuries to retire the mortgage backed securities now held by the Fed. Alternatively, if the U.S. does not explicitly bail out Fannie Mae and Freddie Mac to the full extent, the Fed will have created money, with no recourse, and without the equivalent backing of assets or securities on its books. In short, the Fed is now engaging in unlegislated, back-door fiscal policy.”
The Treasury's action last week completes this circle. It provides a surprise pledge of public resources to make these mortgage loans whole, and an unlegislated commitment to make the “implicit” backing of Fannie Mae and Freddie Mac explicit. All without debate, and without the force of public will. Even as the homeowners underlying these mortgages lose their property to foreclosure.
Or worse, perhaps homeowners who have been diligently making their payments will keep their homes, and homeowners who took out mortgages they couldn't afford will keep their homes as well with no adverse consequence to the lenders – since the underlying loans are now owned largely by the Fed, and the Treasury has pledged its unlimited support. Why pay one's debts if it becomes optional, and the Treasury stands to absorb unlimited losses at public expense?
This policy is likely to lead to far more delinquencies. Whether it will lead to far more foreclosures depends on the nations' capacity and willingness to shoulder multiple insolvencies in order to protect bondholders, mortgage our national wealth to China and other large purchasers of U.S. Treasuries, or alternatively, massively inflate away the dollar value of the underlying loans. The much-vaunted TARP money that has “profitably” come back to the Treasury is a tiny sliver of what has been committed to defend the private bondholders of financial institutions from losses. Either the debt we create to save these bondholders will stand as a claim on our future national production and a diversion of our ability to spend public resources for the benefit of the public, or we must inflate it away. There is no third option. This does not deserve legislative discussion?
What is likely, in my view, is that we will observe far greater issuance of government liabilities, which will predictably create a near doubling of the consumer price index in the coming decade (though probably not for a few years due to credit concerns, which dampen monetary velocity). It is notable that the massive expansion of government liabilities beginning in the late-1960's eventually exploded into uncontrollable inflation by the late 1970's. There are lags between the creation of government liabilities and their inflationary effects. But to expand these liabilities as recklessly as the Fed and Treasury are now doing is to undermine the long-term foundations of the economy.
It is commonly argued that we cannot observe inflation with unemployment so high. In my view, this is a misinterpretation of A.W. Phillips (1958) analysis. While the famed “Phillips Curve” was described as a relationship between (nominal) “money” wages and unemployment, the British data Phillips used was from a period when Britain was on the gold standard, and the general price level was extremely stable. Thus, any wage inflation observed by Phillips was actually real wage inflation. The Phillips Curve is simply a standard economic argument about relative scarcity. It says that when the labor markets are tight, nominal wages rise faster than the rate of general inflation (i.e. real wages rise), and when unemployment is high, nominal wages rise slower than the rate of general inflation (i.e. real wages fall). As we observed in the 1970's, high unemployment can exist in concert with high rates of inflation. All that happens, in that case, is that wages tend to rise slower than prices. Assuming labor productivity is growing as well, real wages don't keep pace with productivity growth. In any event, unemployment emphatically does not prevent the inflationary consequences of reckless creation of government liabilities.
Is the Treasury's policy a game-changer? No – it simply establishes the government bailout of bad mortgage debt more formally. As I wrote five years ago in Freight Trains and Steep Curves, when the foundations of the recent credit crisis were being laid: “the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. The borrowers don't actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government . These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam. On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This mountain of debt in the U.S. financial system - tied to short-term interest rates - is ultimately and perhaps somewhat inadvertently backed by the U.S. government.”
What will be a game-changer is if Congress fails to recognize that the Treasury's action is at minimum an evasion, and possibly a usurpation of powers that are enumerated to Congress alone. If Congress does not forcefully defend that prerogative – even if it ultimately ends up voting for exactly the same policy – it will have relinquished the power of fiscal policymaking into the hands of unelected bureaucrats. This is real public money that is being spent to make bad mortgage loans whole. It may not appear to be costly at present, since risk-averse individuals conscious of credit risks, and foreign countries running massive trade surpluses, are still willing to accumulate the Treasury securities being issued, with no apparent impact. But ultimately, those securities will either stand as claims on our future national production, or they will be inflated away. Either the Treasury securities will retain value, so that holders such as China get to use them to acquire our productive assets in the future, while we ultimately tax ourselves in order to pay off that debt, or we must dilute the ability of those Treasuries to claim real goods and services, which is another way of saying we inflate away the debt.
Understand the Fed's balance sheet here. In the past, the asset side of that balance sheet would represent Treasury securities that were purchased, and the liability side would be the U.S. monetary base (currency - the little pieces of paper in your wallet with “Federal Reserve Note” across the top - and bank reserves). Now, whether the Fed bought those Treasury bonds directly from the Treasury, or from the open market, the Treasuries purchased by the Fed have always been accompanied directly or indirectly by revenue to the government that could be spent on behalf of its citizens for government programs that had the vote of Congress. Prior to 2008, the total amount of monetary base created in the history of the United States was about $800 billion.
Monetary policy was largely limited to the following. At any point in time, the Federal Reserve could decide to sell Treasury securities out into the open market, and reduce the monetary base by an equivalent amount (an “open market purchase”) or vice versa. Importantly, these transactions never changed the amount of government liabilities held by the public – the Fed's only power was to determine how much of those government liabilities would take the form of base money versus Treasuries. Fiscal policy was always the domain of Congress alone.
What has happened over the past two years is that the Federal Reserve has purchased about $1.25 trillion dollars in mortgage-backed securities issued by Fannie Mae and Freddie Mac – securities that the Treasury has now made an unlegislated (or at minimum, unintentionally legislated), bureaucratic decision to fully back. Now, as the underlying mortgages fail to produce adequate cash flows, but Fannie Mae and Freddie Mac are called on to pay them off anyway, the Treasury has committed to “allow the cap on Treasury's funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth.”
In a sharp break from the past, the issuance of these Treasury securities will not be accompanied by any revenue to the government for Congressionally approved programs. The Treasuries will be issued, the money will be handed over the Fannie Mae and Freddie Mac, and those funds will go largely to the Federal Reserve and other holders of existing mortgage debt simply to replace the bad, but bailed-out agency securities with cash as they mature. The public gets nothing for something - the issuance of the Treasuries is in itself their expenditure.
None of this changes if the Fed is somehow successful in “unwinding” its $1.25 trillion in agency holdings by selling them out to the public and re-absorbing the similar amount of monetary base that now sits largely in the form of bank reserves. Such a transaction does nothing to change the overall quantity of government backed liabilities that must be held by the public in some form. Unwinding the Fed's position simply means that the global economy will be forced to absorb not only the mortgage securities themselves, but also the newly issued Treasuries that will be required to make those mortgage securities whole.
Every dollar of bad mortgage debt that should have been written off is now enshrined as two dollars of government-backed debt. One dollar as the original debt, which will now be made whole, and one dollar of new Treasury securities, which must be issued to make that original debt whole. Accordingly, the holders of both securities will have claims against our national assets and future wealth. A similar two-for-one obligation holds true for bailed-out bank losses.
“Too Big to Fail” - The Bear Stearns crisis revisited
In March 2008, the Federal Reserve and the Treaury provided a $30 billion non-recourse loan to J.P. Morgan in return for toxic securities of Bear Stearns. I strongly argued for regulatory authority to expedite the receivership of non-bank financial institutions, so that the losses of these institutions would be properly borne by the bondholders, without the need for a disorderly unwinding of the operating companies (as we ended up having in the case of Lehman). I emphasized that the “failure” of financial institutions need not result in customer losses or disorderly unwinding. All it requires is that the bondholders of the institution properly absorb the losses. In the case of Bear Stearns, for example, the liabilities of Bear to its own bondholders were far more than sufficient to absorb any loss without any public funds at all. The following reiterates what I wrote at the time, which may be worth revisiting from the perspective of what has occurred since:
“Alarmingly, immediately after the pixels dried on last week's comment (noting ‘the Fed is emphatically not taking the default risk of the mortgage market onto itself' with these term facilities), details emerged that the Fed had agreed to a very different deal in its attempt to rescue Bear Stearns. This is a major and ominous departure from historical Fed policy, and from legality.
“In effect, the Federal Reserve decided last week to overstep its legal boundaries – going beyond providing liquidity to the banking system and attempting to ensure the solvency of a non-bank entity. Specifically, the Fed agreed to provide a $30 billion “non-recourse loan” to J.P. Morgan, secured only by the worst tranche of Bear Stearns' mortgage debt. But the bank – J.P. Morgan – was in no financial trouble. Instead, it was effectively offered a subsidy by the Fed at public expense. Rick Santelli of CNBC is exactly right. If this is how the U.S. government is going to operate in a democratic, free-market society, ‘we might as well put a hammer and sickle on the flag.'
“The Fed did not act to save a bank, but to enrich one. Congress has the power to appropriate resources for such a deal by the representative will of the people – the Fed does not, even under Depression era banking laws. The ‘loan' falls outside of Section 13-3 of the Federal Reserve Act, because it is not in fact a loan to either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a business entity under this agreement. And if the fiction that this is a ‘loan' to J.P. Morgan was true, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of the ‘collateral' would become an issue would be in the event that J.P. Morgan itself was to fail. No, this is not a loan. It is a put option granted by the Fed to J.P. Morgan on a basket of toxic securities. And it is not legal.
“The deal was made under duress, to the benefit of a private company, on the basis of financial assurances that the bureaucrats involved had no business making. The Federal Reserve is going to put up public assets and accept default risk so that Bear Stearns' own bondholders are effectively immunized?! That's not sound monetary policy – it's a picnic for insiders, bought and paid for through the abuse of public funds by government officials too unprincipled even to recognize the abuse.
“As of November's 10K report, Bear Stearns had $9 billion in unsecured short-term debt, and $66 billion in long-term debt. The $12 billion in shareholder equity, of course, is gone. Any portion of the debt that is unsecured should be the first to fall. If Bear Stearns is worth $2 a share to somebody (provided $30 billion of “non-recourse loans” from the Fed), and yet Bear's bondholders and even the unsecured lenders can still expect to be paid off on over $75 billion of debt (J.P. Morgan assumes that obligation as part of the buyout), then the public guarantees aren't required in the first place. What is required is that Bear's bondholders take a loss, as they should, rather than the public doing so.
“In the unlikely event the value of Bear Stearns is negative after entirely zeroing out both shareholder equity and bondholder claims – then and only then is there a problem for Bear's customers and counterparties. But in fact, J.P. Morgan is already willing to take on all of Bear's assets and liabilities, including over $75 billion in debt to Bear's bondholders, for $2 a share. This is an indication that bondholder's claims would not even be wiped out in a full liquidation. Surely, whatever loss is required to transfer the ownership of the company should be taken by the bondholders, not by the public.
“At what point will investors stop begging the government to save private companies and recognize that the losses should be taken by the stock and bondholders of the offending financial institutions? If the Fed and the Treasury are smart, they will act quickly to figure out how to respond to multiple events like we've seen in recent days, to expedite turnover in ownership and quickly settle the residual claims of bondholders, without the kind of malfeasance reflected in the Bear Stearns rescue.
“As for the future of the free markets, Dylan Thomas comes to mind:
Do not go gentle into that good night
“The Fed overstepped and the Treasury overstepped. At the point where unelected bureaucrats pick and choose who to subsidize – who prospers and who perishes – in a free capital market, and use public funds to do it, more is at risk than just $30 billion. Instead, we cross a line, and stumble off a very clear edge down an interminably slippery slope. We speak up now, or forever hold our peace.”
Implications for financial markets
If the foregoing qualifies as a “rant,” it is a rant motivated by a historical understanding of the ultimate damage that comes to economies from fiscal recklessness and from surrendering the rights of a democracy into the hands of bureaucrats.
From the standpoint of the financial markets, we can anticipate an increase in mortgage delinquencies in the coming months if only from the combination of high unemployment, high loan-to-value ratios, and a gradual movement into the heaviest portion of reset schedule on Alt-A and Option-Arm mortgages written at the peak of the housing bubble. That this will result in true credit losses is virtually certain. Whether or not this leads to fresh reported credit losses depends on how much latitude regulators allow in maintaining current (substantially written-up) values for securities that are not delivering the underlying cash flows.
What we do know is that stocks are overvalued even on the basis of normalized earnings, to an extent that exceeds nearly every pre-1995 level except 1929. Intermediate term conditions are strenuously overbought, investors (with advisory sentiment now down to 15.6% bearishness) are clearly overbullish, and interest rate trends are pushing higher. This situation does not always resolve itself into market declines, and indeed, given that market internals remain reasonably firm, we may continue to observe marginal new highs for some amount of time. But the statistical regularity from overvalued, overbought, overbullish, rising yield environments is one of steep, abrupt market losses generally within a period of about 10-12 weeks.
This time window coincides with a period over which we would expect to acquire some amount of additional clarity about the true state of the credit markets, as FASB rules now require off-balance sheet entities to come onto balance sheets (undoubtedly one of the reasons for the Treasury's pre-emptive commitment), and we discover the extent to which the “shadow inventory” of delinquent but not foreclosed homes will be modified or finally put into foreclosure.
As I've noted before, what we need most in order to establish a more constructive investment stance are valuation and clarity. Some amount of market weakness, coupled with greater clarity regarding credit conditions, would go a long way toward increasing our willingness to accept market exposure. As I've said before, we don't need to solve all of our economic problems, but without clarity on the full scope of those problems – particularly clarity that we expect in the next few months – risk taking is vulnerable to sharp hits from that blind spot. My impression is that investors underestimate the risk of assuming that those problems are solved because we are riding a wave of deceptively “costless” government bailouts.
What we also know is that we can expect far greater issuance of government liabilities due to the coupled effects of bailouts and shortfalls in tax revenues, which will ultimately erode the value of those liabilities. The extent to which it erodes the value of the U.S. dollar relative to other currencies depends on the extent to which other governments match our own in terms of debt issuance and money creation.
What is clearer is that the value of those liabilities is likely to sharply decay over the next decade or so in terms of real goods and services. I continue to view a near doubling of the consumer price index over the coming decade as a reasonable expectation, though again, much of that pressure is likely to occur beginning several years out, due to the continued concern about credit defaults, which tends to mute monetary velocity. Emphatically, slack resources (such as labor and manufacturing capacity) are not a good argument for lack of inflation. It is only an argument that the prices claimed by those slack resources will rise slower than the general price level. I expect that we will tend to be buyers of commodities and hard, non-slack real assets on weakness, but this represents a longer-term view, not a near term forecast.
In any event, our most important time horizon is the present moment. At present, stocks are characterized by an overvalued, overbought, overbullish, rising yield profile that is generally coupled with poor average returns. Though the tendency is for the market to actually make marginal new highs for some amount of time following the emergence of these conditions, very steep and abrupt subsequent breaks are also the norm. Defensive positions in that sort of environment promise to be frustrating, because of that tendency for the market to creep to new highs, retreat a bit, and then press to marginally higher levels. Still, despite this tendency toward further marginal progress, the fog tends to be thick, and the cliff tends to be steep.
As for bonds, we have a certain amount of ambivalence. Treasury yields have risen substantially in recent weeks, and we certainly do not believe that Treasury securities are priced to deliver positive real returns after inflation over the coming decade. However, I also expect that we are at the threshold of fresh credit concerns, which will tend to put temporary upward pressure on the dollar and downward pressure on default-free Treasury yields. Based on the higher level of yields, there is some amount of speculative merit in modestly increasing Treasury holdings on price weakness, but this is clearly a short- to intermediate-term view rather than a view about the merit of holding to maturity.
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