Thursday, May 29, 2008

The Bernanke Put: What Next?

The Fed has so far used up almost half of its balance sheet in its bailout efforts (see chart below, click to enlarge). It has accepted all manner of securities backed by mortgages, credit card receivables and auto loans in exchange for its own US Treasurys. The Fed's holdings of Treasurys have declined from 92% of assets last May, to 57% this year*.

In essence, the Fed provided - gratis, I might add - a put option which was immediately exercised by commercial and investment banks in dire straights. What will undoubtedly become known as the Bernanke put, is currently turning schlock into lucre by the bucketful. Who said the philosopher's stone doesn't exist, eh?

Data: FRB

The Fed's unprecedented actions arrested what was shaping up as a major shake-out of the shadow banking system - but at what cost?

The immediate result is that Federal Reserve Notes (i.e. US Dollars) are now backed to a very large extent by entirely price- and quality- opaque assets, issued by private banks, brokers and special purpose securitization entities. This is certainly no small matter, but not my main concern right now.

More serious, in my opinion, is the possible effect on market psychology if there is another incident similar to Bear Stearns. This is becoming increasingly likely because the real estate market continues to weaken and consumer sentiment and behaviour remain negative. (For example, Nouriel Roubini thinks that Bank of America is now unlikely to take over Countrywide.)

In such an event, market participants will immediately think as follows:
  1. Damn! Whatever the Fed did, didn't really work. Here we go again.
  2. Look! They have much less wiggle room in their balance sheet.
  3. So! What are they going to do now? What can they do?
At that point every investor, trader and speculator will have to make up his/her own mind how to act. Given the reduced means of the Fed's balance sheet, the chances of "shoot first, ask later" are high and this means a whole lot of pain for markets.

In other words, the extensive exercise of the Bernanke put has increased the likely damage from a second round of financial turbulence.
* Gold, SDRs and other incidental assets have been omitted for clarity - they amount to less than $20 billion, anyway.


  1. Mishkin resigned from Fed yesterday to spend more time with his family and students.

    What do they say about rats and sinking ship?

  2. There have been several who have absconded from the Fed in the past few months - three, I believe. And I think Greenspan left because he saw what was coming, in the first place.

  3. Fed officials now hinting they will hike rates soon.

    Does this crew finally realize they have gone too far down the road of dollar debasement?

  4. I was reading that the Fed has already worked out its 'next move' when they run out of assets to swap: pay interest on current deposits. Apparantly in order for this to happen however, it requires congress speed up a 'reform' that would otherwise not have started for several years.

    I have a couple of questions about this:
    1. Do you know if Japan tried this?
    2. What would this do to the federal deficit?
    3. Would this be highly inflationary?

  5. Paying interest on reserves will do nothing to turn "bad" assets that no one wants, into Treasurys (or other high quality) securities.

    Like I have been saying for ages, it's not a traditional "liquidity" crisis: it's not that there is a ton of money hiding someplace, not wanting to move from place A to place B.

    The problem is that assets are simply no longer worth their sticker price, and thus in reality there is less money to go around.

    If a bond is no longer worth 100 but 30, there is 70 less "money" to go around. As simple as that...

    The Fed's actions so far is hiding the drop in asset prices by taking the schlock onto their own books and pricing them at par (or near there).

  6. Hell, I think the Fed will continue to hint they will take more bold actions when warranted. Ultimately, I think they are as committed to "taking action" as they are committed to "fixing the problem". Notably, they are not promising they will fix the problem, but Paulson & Bernanke have indicated they do not want to go down in the history books as the new Herbert Hoovers of the 21st Century who simply sat by and watched the banks fail and GDP shrink 30%+. So ‘taking action’ it is.

  7. Hell thanks-- forgive my confusion: would you be willing to point out my logic error below:

    If The Fed pretends Asset A is worth $100 (even though everyone really knows it is worth $30) and then pays 5 % interest on asset A as if it were worth $100 (or $5 instead of $1.5), then won't the company that owns Asset A still now have an income stream of $5 (albeit an artificially high one instead of the true $1.5 they should be getting) to shore up their books, etc...? In the end, wouldn't this be similar to The Fed just running the printing presses to subsidize private investors (albeit doing so by creating a much larger Federal deficit liabililty than would have otherwise existed and pushing the US governement into insolvency that much sooner). Isn't this just a way for The Fed to leverage their ability to privatize profits and nationalize debt over and above their $1 trillion dollar sheet maximum limit they currently have?

    Again, sorry for the confusion.

  8. Hellasious: "More serious, in my opinion, is the possible effect on market psychology if there is another incident similar to Bear Stearns."

    Not a problem, send the bill to the taxpayer--"deficits don't matter." Congress will pass whatever laws are necessary to bail out their masters--corporations and the executive branch.

  9. Thai,

    What the Fed is doing right now is accepting Asset A (say a CDO with a par price of 100) as collateral for repo or in exchange for Treasury securities. It doesn't pay interest, it gets PAID interest for the loans.

    The trick is in the "haircut", i.e. what value the Fed assigns to said CDO. And here's the rub: when no one is willing to buy this CDO AT ANY PRICE, i.e. there is no market price whatsoever, should the Fed be accepting it as good collateral, just because it has a nameplate AAA rating?

    Bernanke says yes. I beg to differ.

  10. Thanks-- by the way, I would be amazed if there were any readers of your blog that disagreed with you on this... I guess I have a bunch of reading to do.

    I think I am confusing 2 different pools of money at the Fed:
    1. Their balance sheet (where did it originally come from by the way?)


    2. I thought banks had to keep a certain % their assets with the Fed as part of the whole fractional reserve lending system. I thought the Fed was the final depositor in the whole chain.

    I guess it was concerneing pool number 2 I am talking about. I did read that none of these reserves currently earn interest (one of the reasons banks don't like to keep money with the Fed in the first place). The plan was for the Fed to start paying interest on these assets. I am guess they are probably good assets however.

    But paying interest on these assets to banks tomorrow where the Fed is not doing it today must still 'push' money into the whole system.

    I think I am just confused (I am sure yoyomo and Marcus would agree :-)). If you ever want to write a 'banking for dummies' post, it will be greatly appreciated.

  11. For info on the Fed you can look up Federal Reserve on wiki. Pretty good explanation.

    Fractional reserves deposited at the Fed by commercial banks are very different from its own balance sheet.

    Such reserves are in the form of cash (i.e. a portion of their deposits), not assets subject to valuation fluctuation. The reason Bernanke wants to pay interest on them is actually quite technical and has to do with maintaining Fed Funds rates at the target rate more easily.

  12. Gretchen Morgenstern wrote about this at the NYT recently. My response: got gold? Get more. The dollar is going to be turned into wastepaper.

  13. When a group of bankers get together to make changes to the existing rules or expedite any proposed change, you can be sure that your best interest is the foremost thing on their mind :) :)

  14. More than banking for dummies, you need a copy of central banking for dummies. Here are my two cents.

    Fed is just a bank like any other bank. Any bank has two components - depositor and borrower.

    Who is the primary depositor of Fed? US treasury - it saves our tax dollars there.

    Who are the borrowers? Commercial banks.

    Just like you have to show an asset to borrow big money from a bank (car, house), commercial banks also need to deposit assets.

    Just like people borrowed money from the banks with overinflated assessments of their houses, commercial banks are borrowing with AAA-rated junks. Irrespective of that, they are borrowing money.

    Only if the borrowing bank defaults on its loans, Fed loses money. Who cares, if a bank loses money? The owners of the bank. Fed is a profitable bank and all its profits go directly to treasury. So, now you know how the taxpayers are going to get affected.

  15. Independant accountant-- If I have read this blog faithfully and accurately, Hell is not a fan of gold. He seems to suggest we are headed for deflation where gold would do terribly.

    While it is true our elected leaders keep spending money like there is no tomorrow-- he still thinks deflation more likely and gold will not do well becasue the US ultimately will not print its debt away, rather IF we spend to the point of bankruptcy- the US would be more likely to default on its debt than it would actually print money. And if I understand this correctly, default would also be very deflationary.

    Is this how you have been reading him over these months?

    Hell, if I am reading this accurately, I guess my only question to you is as follow: 'to the extent readers of your blog take your advice to heart and make actual personal financial decisions based on them, are you sure you are giving the most responisble adivce you can on the precious metals issue? Remember, your readers are like me, non-finance types trying to do the best they can for themselves by going to people they can trust? knew I'd eventually have to throw the trust and integrity issue in there somewhere

    Greenie-- thanks. Would you answer another question? Why are newspaper articles then saying Bernanke intends to use 'paying interest on cash deposits' as his next tool to combat this liquidity crisis? Hell implies the fed is doing this simply to make controlling the fed funds rate easier (is it hard to control the rate in the current environment?). Why the rush to have congress accelerate the law's implimentation?

    Could the tool be used to continue life support to banks? Supposing they paid artifically high interest rates? Who would pay for this?

  16. Thai -

    I have been confused about the whole inflation vs. deflation vs. gold question as well.

    My take on this is that (one of) Hell's objections to gold is that energy is a more universal store of value -- ultimately we need energy more than we need gold.

    As for whether a fed default is inflationary or deflationary for the dollar, I don't see what meaning the dollar would have in a default. It would be deflationary in the sense of value destruction, but it's not clear to me what impact that would have on currencies vs. gold.

    In either case I would not want my wealth stored in dollars; and it seems likely that other currencies might be forced to inflate in the process of limiting damage to their economies.


  17. If the CDOs become stranded on the Fed's balance sheet because the banks can't take them back w/o failing or have already failed, how does the Fed balance its assets and liabilities if these CDOs default? Can the Fed carry a negative balance in its equity account or would it be forced to buy enough Treasuries with new money to balance out its debits/credits? Anyone have any ideas?

    Hi Thai,
    Required bank reserves are not that large ($40-45B) and so the interest income to the banks would not be a major source of cash but it would allow the Fed to add liquidity (by purchasing T-Bonds) without driving rates too low. The floor rate would be the rate the Fed paid on reserves and the ceiling would be the discount rate the Fed charged. This would allow the Fed to divorce rate setting from its open market operations.

    The cost of the interest payments would come out of the Treasury's account if the Fed doesn't want to create new money.

    WRT default vs. printing, I think the point that Hel and Mish miss is that if there was widespread fear of default, the demand to hold dollars could go down faster than the shrinking supply of dollars and produce price inflation in the face of monetary contraction as $-holders tried to unload $ for anything of value.

  18. You are almost there.

    The dollar is not backed by the Fed, it is backed by treasury debt which in turn is backed by taxes.

    The reason to abandon Ts and dollars is because the US governments ability to convert Ts and dollars into collected taxes has reached its limits. The economy as a productive engine is broken down. Currently there is no domestic nor export production to finance taxes. The only means of taxation rests on collecting from money movers on Wall Street. RE is gone, and Insurance is gone, so we are left with Finance from the FIRE economy and government employees.

    How long will taxing government employees suffice to finance the government debt? Perhaps if we socialized everything and all became government employees we could sustain the economy as suggested by Maxine Waters.

    Talk about being under water.

  19. "Hell's objections to gold is that energy is a more universal store of value -- ultimately we need energy more than we need gold."

    Hell does not know what he is talking about. A currency needs to be something useless - otherwise it creates distortion in economic activities.

    Go to google and search 'alan greenspan gold'. You will find an article by Maestro's Mr Hyde that explains who gold is better than other materials as currency.

  20. "I think the point that Hel and Mish miss is that if there was widespread fear of default, the demand to hold dollars could go down faster"

    US government never defaults. That is what we deflationists base our arguments. Default of government was never seen in the long Anglo-Saxon history of capitalism, and also is not in the best interest of the government. Federal reserve can be sacrificed and there were precedents.

  21. Tai, Others answered your questions well. So, I am not attempting to.

  22. The Fed's fumes are turning toxic.

    But isn't the ECB also rubbing the philosopher's stone? Lashings of liquidity, but more resolute on interest rate targetting. Is Trichet engaged in the same experiment?

  23. Thanks everyone.

    Sometimes some of these back and forths remind me of the scene in Monty Python's The Life of Brian. (I couldn't find a video feed of that particular scene, but I did find the scene just after it.) I doubt Hell would ever be so mischievous as to just watch a melee?

    And @Greenie who said "Default of government was never seen in the long Anglo-Saxon history of capitalism". I beg to differ and think you might want to check your historical facts.

  24. Not state government default - I am talking about the federal government. Britain never defaulted on its sovereign debt, and neither was/will US of A. On the other hand, I fully expect California to go bankrupt before the end of this cycle.

  25. Yo Folks, I got myself in a financial bind the other day. Real bad situation. Home Boy was all mad at me 'cos I'd fallen behind on my payments. He said if he wouldn't get the money asap his sister couldn't pay the probation officer. If sis' goes to jail and leave the young'ens behind that in turn would get child protective services involved which is really bad news. If y'all ever had to deal with them folk you know what I'm talking 'bout. So there was a lot of systematic risk ya see. What's a guy gonna do? Right! Uncle Ben's pawn shop. A few gold teeth I'd inherited from grandma, my priced shot gun and a few power tools I'd stolen of a job site. Voila, all the funding I needed.
    Debt's paid, systematic risk averted...till next time. Just wonder what uncle Ben is going to do with all that garbage I dragged to his store. Good thing that's his worry not mine 'cos I ain't gonna bail that crap out.
    Thanks uncle Ben!

  26. To all:

    This blog is a collection of observations, opinions and preferences.

    IT IS NOT PERSONAL ADVICE, investment or other.


  27. Hell,

    Would you be kind enough to comment on the following article:

  28. Re: article

    Yes, I will comment.

    The writer is sadly ignorant of thermodynamics.

    From Malthus onward all the doomsters were thankfully proven wrong because man was able to extract sequentially denser forms of energy (and more of them). From wood to coal, to crude oil and natural gas and then on to nuclear.

    Unless we now manage to find something even denser and more plentiful, Cassandra will be proven right - in some way or another.

    I have said it many times: ALL economists and politicians should be required to take and pass Thermo 101. There is no better way to turn the dismal science into something resembling a proper one.



  29. Hell, your point is taken, although it is also the journalistic equivalent of banks offering no document loans... I shudder to think what would happen if physicians said the same thing to people who were asking them medical questions 'and were not their patients'.

  30. Thai,
    I want to correct an error that Greenie made; the Fed has no depositors, its liabilities consist of FRN (i.e. paper currency) which it uses to purchase Treasuries (by law, not directly from the Treasury) thus spending those FRNs into circulation. As old notes are taken out of circulation they can be replaced without the need to purchase more Treasuries.

    So the Treasury is not a depositor at the Fed, it is in debt to the Fed by the amount of Treasuries which the Fed holds and the Fed collects the interest on those Treasuries and at the end of each year transfers a percentage of its profits back to the Treasury.

    Now that the Fed is accepting other than Treasuries and agency debt, a portion of each dollar is now backed by CDOs if the Fed can't foist these junk bonds back on the banks. Hel has yet to comment on what would happen if these CDOs were to default while they are stranded on the Fed's balance sheet and the borrowing bank was insolvent and unable to pay the Fed back.

    As for tax receipts, they don't stay at the Fed; as soon as they are collected they are distributed to designated private banks around the country awaiting disbursement so as not to drain reserves from the banking system.

    WRT investment decisions, at this point no one knows which way the wind will blow. Something major bad is going to happen but the trick is to figure out if it will be inflationary or deflationary. IMO the safest strategy is to play both sides of the fence 50/50. If we get major inflation, the gains on PMs and commodities will offset your currency losses and vice versa if we get deflation. You can diversify your currency holdings with the Merk Hard Currency fund.

  31. Crimson Ghost wrote:

    "Fed officials now hinting they will hike rates soon."

    -Don't bank on it.

    Marcus wrote:

    "Not a problem, send the bill to the taxpayer--"deficits don't matter." Congress will pass whatever laws are necessary to bail out their masters--corporations and the executive branch."

    First of all the executive branch aren't the masters of the legislative branch, but even if they were, should the PTB do what you suggest, you will then have what I will call a Karl Marx moment because the taxpayer is tapped out.

    Hell wrote:

    The trick is in the "haircut", i.e. what value the Fed assigns to said CDO. And here's the rub: when no one is willing to buy this CDO AT ANY PRICE, i.e. there is no market price whatsoever, should the Fed be accepting it as good collateral, just because it has a nameplate AAA rating?

    Amen. The Fed is doing nothing more than playing hide the toxic hot dog, but as Joe Louis said about Billy Conn before Loius knocked him out (in a closely contested) bout, "He can run, but he can't hide."

    Regarding "thermodynamics/oil" here is a hopeful

    Also, gold's record in deflationary environments such as in The Great Depression is to maintain its value.

  32. Thanks Yoyomo. Actually, I don't do any investing myself, I have someone do that for me so I don't lose sleep. And if I understand their strategy correctly, they are doing just what you suggest: hold BOTH cash and gold (at least a small % in gold via an ETF symbol GLD... I think they also have a bunch of foreign cash in ETF's as well like symbol JEM)... I am one of those odd birds that just finds this stuff interesting.
    But I imagine many readers of this blog do make their own decisions based on Hell's thoughs.

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