Kabuki Theater: Analyzing Bernanke's Senate Testimony

Includes: TLT
by: Colin Lokey

As many readers are no doubt aware, Fed Chairman Ben Bernanke appeared before the Senate banking committee on Tuesday to testify and to deliver his semiannual report on monetary policy (the full text of the prepared remarks is here and the full video of the testimony is here). To those who have kept track of Bernanke's relationship with Congress, it was easy to predict when the fireworks (and hilarity) would ensue: as soon as Tennessee Senator Bob Corker got the mic. A bit of background information is necessary here for those who might be unfamiliar with the history between Corker and Bernanke. Here's a quick recap excerpted from a piece I wrote on ZeroHedge:

...on August 28 of last year, Tennessee Senator Bob Corker wrote a scathing op-ed in the Financial Times in which he dared to question the omnipotence of economic central planner in chief Ben Bernanke. Corker called the Chairman a "distraction" and urged the abolition of the dual mandate. On [February 4], Corker took his criticism a step further and, along with Senator David Vitter, introduced the Federal Reserve Single Mandate Act. Corker said the Act [would] "provide the Fed with a clear and explicit focus on keeping inflation low [which] will serve America better than the broad, bipolar mandate it has today." Corker also noted that "the dual mandate blurs the line between fiscal and monetary policy and allows Congress to shirk its responsibility to enact sound budgets and policies that produce economic growth."

Readers interested in reading more about the dual mandate issue are encouraged to follow the links provided above and to review my previous piece on Corker's op-ed but for now, suffice it to say that Corker is not a fan of the Chairman nor of the FOMC's policies.

Corker wasted no time Tuesday cutting straight to one of the thorniest issues in the debate about Fed policy. Once given the floor, Corker's first question was:

I don't think there's any question that you are the biggest dove since World War 2, I think that's something you're quite proud of, and we have a federal government that's spending more than any government since World War 2, so I think those are working well together, as the Fed is actually purchasing large amounts of the new debt issuance as we live beyond our means, just wondering if you ever talk about in your meetings how this policy is punishing those who have done the right thing like savers, do 'yall ever talk about the longer term degrading policies as we try to live for today? (emphasis mine)

There are two important parts to that question. The second part references the well worn (and entirely legitimate) notion that savers and retirees are being crushed by the virtual disappearance of interest income and, besides noting Bernanke's remarks on the matter below, I won't revisit that point here.

The first, and far less appreciated, part of Corker's question references the fact that the Fed is actively engaged in deficit funding. Importantly, this goes beyond petty notions of political expediency -- that is, Corker isn't necessarily trying to make a statement about excessive government spending. His point, which is one that I and many others have made repeatedly, is that there is so little separation between the Fed's purchases of U.S. Treasury bonds and the Treasury Department's issuance of those bonds that the Fed might as well just buy directly from the Treasury. For instance, the Treasury will auction 7-year notes at 1 p.m. on Wednesday, a mere 46 hours after the Fed bought $3.3 billion of the same notes:

Source: NYFed

Corker's point is that this becomes absolutely absurd at a certain point. The government is aggressively issuing debt in one department and just as aggressively printing money to buy it in another department. It is a ridiculous merry go round that has ultimately resulted in the Fed owning nearly 30% of outstanding 10-year equivalents. In fact, for some Cusips, the Fed now owns nearly 70% of the issuance as the following graphic shows:

Source: Stone & McCarthy

In his response to Corker's question, Bernanke primarily addresses the issue of savers. Here is his response:

In regards to savers, if we tried to raise rates…our economy isn't strong enough to sustain that…we would throw our economy back into recession… the only way to get interest rates up is to provide for a strong recovery and the only way to get a strong recovery is to provide support for the recovery. (emphasis mine)

Note that this is essentially the same ridiculous logic applied by Business Insider's Joe Weisenthal back in October. The reasoning here is so flawed that it is difficult to take seriously and it boils down to this: If we want higher interest rates, it is obvious that the only way to achieve that is to keep interest rates low.

Next, Corker addresses the issue of what happens when the Fed begins to unwind its portfolio:

...we've had this easy money policy which really allowed big institutions on Wall Street to really… reap tremendous benefits at least in the early stages without really doing anything and then you're getting ready, at least in a few years, to basically have to print money to sell securities at losses and then to pay interest on excess reserves to these big institutions… do your concern yourself at all with the Fed not being as independent as it used to be?

Apparently, the cat is out of the bag regarding the fact that when the Fed begins to tighten, it will, in all likelihood, become technically insolvent. It is important to note here that Bernanke would likely say there has been no attempt to obscure the issue of a possible negative income future for the Fed. Indeed the Chairman referenced the idea in his prepared remarks. I think it is entirely fair to say however, that the overwhelming majority of the population (and perhaps even the majority of the investing public) has no idea that the entity which prints money is on the verge of literally going broke.

I have explained how this is possible in a previous piece but allow me to go through it once more here for clarification purposes. Up until now, the coupon payments on the securities held in the Fed's SOMA portfolio (i.e. the bonds it has been buying) have exceeded the interest it must pay out on excess reserves (IOER). When rates begin to rise however, the interest payments on excess reserves will likely rise as well whereas the income from the SOMA portfolio will not -- those coupons are fixed. Put simply, the Fed will not make enough income to pay its bills.

The Fed of course, will not simply shut its doors. Rather, it will use the central bank equivalent of a deferred tax carryforward and record a claim against future Treasury remittances (income) which will be reduced in the future when the Fed once again swings to a profit. This is not speculation and it is not a myth. The following graph (from the Fed itself) shows when this will take place and how deep the capital losses will be under different scenarios:

Source: Fed

This is what Corker means when he refers to the fact that the Fed will soon be forced to print money to operate at a loss and to pay interest on excess reserves to the largest banks. Let me reiterate: the Fed, which will be operating at a loss, will be printing money (devaluing the dollar) in order to pay billions in interest to the largest banks, both domestic and foreign.

In his response, Bernanke assumed (rightly) that the Senators probably had very little idea about the carry trade between repo funding and the IOER. Referring to what happens when the interest rate paid to banks on overnight reserves rises, Bernanke said:

We'll be paying exactly what they could be getting in the repo market….there's no subsidy involved. (emphasis)

That's an interesting statement to make considering that the Treasury GCF repo rate has been below the IOER rate almost perpetually since the Fed began paying interest on excess reserves:

Source: IMF

This means that, at least over the past several years, banks have not been able get the same rate in the repo market as they can parking money at the Fed. In fact, it is entirely the other way around. That is, banks simply fund their collateral in repo and park the proceeds at the Fed. Because the repo rate (i.e. the rate the banks pay for cash loans secured by general collateral) is lower than the IOER rate, the banks are able to pocket the difference in a foolproof carry trade. As the chart above shows, the GCF repo rate actually fell as low as 1 basis point in mid 2011, meaning banks could pocket 24 basis points on the carry trade.

Interestingly, Bernanke suggested that one option for unwinding the Fed's portfolio without wreaking havoc on the Treasury market is to keep the balance sheet the same size, but tighten by raising the IOER rate. The question then becomes, if the Fed does not alleviate the collateral scarcity by releasing supply onto the market and simultaneously raises the IOER, will the collateral scarcity keep the repo rate low just as the IOER rises thus further incentivizing banks to park their cash? Relatedly, if rates begin to rise, but the Fed does not sell, will core short positions in the Treasury market rise, thus driving up the demand for still scarce collateral and pressuring the repo rate further?

The bottom line is that the IOER certainly appears to be a Fed-engineered bank subsidy. The Fed has engineered a scarcity of repo-able collateral driving down repo rates and at the same time agreed to pay a rate at least twice as high on parked reserves creating a wonderfully simple arb for the participating banks (the FDIC assessment spolier notwithstanding).

In sum, it is critical that investors understand the reality of the Fed's policies. The best way to view this is to think about what needed to happen in the wake of the crisis: the government needed to spend more money and the nation's largest financial institutions needed to be propped up, recapitalized, subsidized, and given access to unlimited liquidity (think daily SOMA borrowings). The Fed's policies have accomplished all of these goals (as outlined above) and have done very little for the average American.

Perhaps the ultimate slap in the face for the public is that these policies are now being justified by the pursuit of a specific unemployment rate. Ultimately then, policies which disproportionately benefit government and big banks are now operating under the auspices of providing jobs for main street. Perhaps those of us concerned with the injustice of it all can take our revenge by betting against Treasury bonds (NYSEARCA:TLT) and profiting from the unwind of these egregious policies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.