Expect the Treasury Bubble to Continue to Inflate

The Federal Open Market Committee announced yesterday that it would keep target rates unchanged at 0-0.25bp, yet made no mention of additional quantitative easing:

Release Date: April 29, 2009

For immediate release

Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower. Household spending has shown signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing. Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time. Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

This is a very interesting policy direction, especially when taken in context of recent Fed monetary policy statements, Congressional spending initatives, and the current state of the American economy.

On March 18, the Fed announced it would be printing $1.15 trillion to buy agency debt/securities and Treasuries. The Congressional Budget Office announced a $953 billion deficit for the first half of FY2009 and estimates a $1.7 trillion deficit for FY2009 ($1.8 trillion if Obama's proposals for budget reform and accounting shenanigans banishment are enacted). The CBO also estimates that the total budget deficit for Obama's first term to be $3.8 trillion. These are all based off of CBO baseline budget statistics and don't take into account Congressional spending plans yet to pass, which surely we will see a lot of in coming months and years.

I mention these budget figures because they represent baseline figures that need to eventually be paid. These don't count any of the future spending programs, which will surely be massive, such as the commercial real estate, insurer, airliner, and newspaper bailouts that will be most likely be coming in the next 1-2 years.

The commercial real estate and insurer bailouts in specific are significant because they are both worthy of "systemic risk" characterization if AIG and Citi (C) were deserving of the label and also because of their magnitude. Commercial real estate loan maturities by 2013 total $1.4 trillion, according to this insightful article and Bloomberg reports that the Fed is already considering expanding TALF to include CRE loans and CMBS.

As for insurers, they have over $200 billion in their own exposure to CRE maturities by 2018. Life insurers have billions in guaranteed variable annuities that are eating away at equity as the equity and debt markets pummel. They also have troubling exposure to Eastern Europe, the next region to face cataclysmic default. In essence, as AIG taught us, insurers have used policyholder capital as investment in overleveraged insurers-turned-hedge funds exposed to toxic assets. Principal (PFG), Hartford (HIG), Lincoln (LNC), and Prudential (PRU) all have tangible common equity/tangible asset leverage ratios of 35x or higher. These are absurdly high leverage ratios that will eat away at insurer equity as their assets depreciate and they write down losses. Using these numbers, a 1.04% depreciation written down in Hartford's assets would wipe out the entirety of its common shareholder equity. This is why Hartford, Genworth, and Lincoln have already bought commercial banks so they qualify for TARP bailout funds.

Sure enough, the Treasury extended the TARP lifeline to life insurers and many applied for the funds, including insurers without commercial bank acquisitions yet. The immediacy of bailing out insurers is especially important because of the credit rating downgrade risks they face. For example, Moody's recently cut Prudential's senior debt to two notches above junk. Two more notches lower and Prudential would no longer qualify for the Commercial Paper Funding Facility (CPFF), which is instrumental for these failing insurers to roll over debt. Also, as credit rating agencies cut the ratings on some of the debt held as assets by these insurers, that also eats away at equity because of capital requirements and increased risk. Moody's cut credit ratings on CMBS in February, causing tension in insurers with massive exposure to CRE and CMBS. Moody's also recently downgraded its outlook on property-casualty commercial insurers.

With commercial real estate and insurers representing tens (if not hundreds) of billions of bailout spending, one can start to imagine the type of deficits the United States government will be running in coming years. And if AIG provides any precedent, the bailouts won't exactly be the most efficient or ethical use of funds. Bailouts are supposed to be necessary uses of taxpayer money to prevent systemic collapse. For example, in AIG's case, its bankruptcy would mean its counterparties would be screwed on their CDS transactions, overexposing their own risk to toxic assets and also losing them money on their CDS profits not being settled. The AIG bailout was meant to provide capital to AIG to give to its counterparties in the form of CDS trade settlements at haircut prices-- high enough to prevent systemic collapse, but no higher than that. On the contrary, banks received full face-value trade unwinds at past prices, as AIG took two more waves of bailout cash. This type of moral hazard is inherently present in bailouts with no conditional liquidity and will continue to be prevalent as more sectors receive bailouts.

The FDIC needs a bailout of its own, as four more banks and another credit union went under this past weekend. According to its Quarterly Banking Profile, its Depositor Insurance Fund (DIF) reserve ratio declined to 0.40% at the end of Q4 2008. This means for each dollar held on reserve by the FDIC, it insured $240. Since then, 29 more banks have failed, and most likely DIF reserves are all but gone. FDIC Chairman Sheila Bair in fact admitted the FDIC will go broke without a bailout: "Without additional revenue beyond the regular assessments, current projections indicate that the fund balance will approach zero." Clearly the government cannot allow the entity preventing the depositor confidence crises that lead to bank runs to go under. In September 2008 when Lehman's bankruptcy caused money market funds to break the buck and ignited a widespread liquidity crisis, money market funds witnessed an "electronic" bank run and the Treasury had to step in and guarantee money market funds' assets in the event NAV drops below $1.

General Electric (GE) is another bailout target and has the "AIG syndrome" of having a sturdy main business being crippled by a much smaller but highly-levered financial division. GE's finance arm GE Capital Corp (GECC) has massive exposure to domestic residential and commercial real estate loans and securities, as well as UK and Eastern European real estate loans. According to its most recent earnings release, parent company GE has a tangible common equity/tangible asset leverage ratio of over 200x, mostly due to GECC. GECC's exposure to Europe alone is estimated to yield losses over $35-40 billion, which would immediately wipe out GE's entire $4 billion of TCE and even GECC's $33 billion in total tangible equity. And according to a Fortune report, a credit rating downgrade to AA- would cost GE an immediate $4 billion in GIC payments, which would also wipe out GE's shareholder equity. And because of its massive exposure to Europe, whose distressed loans the Fed cannot merely force the ECB and BOE to purchase with printed Euros and Pounds, the Treasury and Fed are very likely to have to infuse cash directly into GE rather than letting their bailouts of the toxic asset industries themselves help GE indirectly.

This could amount to trillions of dollars of more spending on top of what is already committed. Thus far, $10.5 trillion has been committed by the United States government. And adding trillions to that figure is not at all beyond reason.

But how will this deficit spending be financed? The Federal Reserve has made it clear it will be monetized. On March 18, the FOMC released its scheduled statement with an unexpected addition to the status quo.

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

The additional $750B of agency securities, $100B of agency debt, and $300B of Treasuries scheduled for purchase amounted to a $1.15 trillion quantitative ease.

As if printing $1.15T to buy toxic debt wasn't enough, according to the Financial Times, the Fed put the ideal interest rate for the United States economy at -5%. The monetary stimulus required for this target would be titanic and statements like these this early on in the deflationary deleveraging wave are clear indications on the monetary goals of the Fed-- it is going to print its way out of the mess.

This comes as no surprise to anyone, as Fed Chairman Ben Bernanke has been widely quoted in his "helicopter" speech from 2001 entitled Deflation: Making Sure "It" Doesn't Happen Here. Below are some goodies from the speech:

By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

People know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation.

With the QE already started, why then did the Fed not expand its balance sheet further this week? The massive spending and now printing has been using up a lot of the Federal Reserve's and Treasury's political capital with the public. Tax Day Tea Parties sprung up across the United States on the 15th of April as common-era allusions to the Founding Fathers' revolts in Boston on the British government's tea tax. Gold surged and the USD tanked on the QE news and inflationary risk started to creep back into public discourse.

With the necessity to start talking about the "green shoots" of economic recovery in order to lend credence to the recent bank record earnings (financed by illegal AIG trade settlements and blatant accounting shenanigans) so banks could offer equity at inflated prices. To print more money just as the stock market rallies over 30% and economic recovery shows its first signs would not be met with a very accepting public, nor would it allow the Fed to continue monetizing the deficit without a watchful public eye.

Why is Bernanke doing all of this? The most important step in understanding his policies is to understand the nature of inflation itself.

Inflation is essentially a regressive consumption tax, regressive because the income elasticity of the most inflation-sensitive goods is naturally less than 1. This is because inflation is a price rise not met by a corresponding expansion in goods. It is a monetary phenomenon caused by an increase in liquid money supply not met by an increase in goods represented by that money. This causes malinvestment as inefficient businesses "work" due to the artificially higher prices of inflation. The malinvestment often ignites more investment as prices keep rising to the point where speculators start entering the market, at which point the malinvestment is a bubble. Eventually, there isn't enough of the bubble asset to chase with more investment and the Ponzi scheme of sorts collapses. This is how the housing bubble happened -- through the easy credit policies of former Fed chairman Alan Greenspan incentivizing the misallocation of capital into houses and consequently mortgages and mortgage-backed securities.

In the context of Bernanke, however, he aims for inflation because it allows the financial sector to share its burden of depreciating asset values with the taxpayer. When the Fed prints $100, it is taking $100 worth of wealth away from the aggreagate and spends it where it wants to. That is why inflation is a tax. Printing $1.15 trillion amounts to about an $8200 tax increase on average on each taxpayer, and this ignores inflation's regressive taxation nature. The assets purchased with the "inflation tax" are depreciating agency securities and debt and long-term Treasuries, which the Fed itself said is aiming for negative real rates in. This is theft but is to be expected with the conflict of interests prevalent in the unchecked, unaudiated Federal Reserve.

The Public-Private Investment Program (PPIP) is a prime example of passing off toxic asset depreciation onto the taxpayer. The FDIC provides PPIP's 7x leverage through non-recourse loans and the Treasury provides 2x leverage to purchase toxic securities and play hot potato with them until default. The PPIFs would of course buy massive CMBX exposure for their leveraged toxic asset exposure, so when the CMBS starts depreciating, the default swap derivatives rake in tons of cash for the PPIP while the CMBS depreciation is mostly passed off to the FDIC because of the loan's non-recourse nature. As we have already concluded, the FDIC-- the government entity created to protect the solvency of the American banking structure-- is insolvent and will need essentially a government bailout. The Treasury is financed by bond purchasers, which include the public and now the Federal Reserve (with printed money, so really just taxpayers). Which means the taxpayer pays for all of this (well, almost all-- don't forget the poor foreign holders of US government debt that will face partial default through QE debt inflation).

Why is taxpayer wealth being used by the government as 14x leverage financing for hedge funds to purchase toxic assets? Because the government wants to pass off the bank's problems to you, the taxpayer. What's even more ridiculous is TARP-capitalized banks are even considering applying to the PPIP. The logic of being bailed out for legacy security exposure and then using the bailout money to take leveraged positions into those toxic assets seems to be shaky at best. But the banks win, they free up equity in their balance sheet. The PPIFs win, they collect profits from their default insurance exposure while facing only 7% of asset depreciation losses because of non-recourse financing. The government wins, it makes everything look great. So who loses? Anyone who holds Dollars or Treasuries. That's right -- you.

The AIG counterparty fiasco and the ludicrous Q1 bank earnings were other blatant examples of passing off toxic asset depreciation onto the taxpayer. Quantitative easing is an extension of all of this, as it essentially forces the public into buying these toxic securities and bearing the burden of their depreciation. Printing money amounts to a tax on holders of dollars and a partial default on holders of Treasuries.

With rates right back to where they were pre-QE and rising, I expect the Fed to resume its QE in its next announcement on June 24. This should cap rates once again and direct more of America's wealth into Treasuries. As equities again start to decline and the economy's green shoots dull to a yellowish hue, risk-aversion will be the name of the game and anyone who didn't already deleverage their worth out of their 401k's and home equity will do so, into the safety of the United States Treasury. Unfortunately, it is these types of crowded trades caused by incentive crises due to too much government influence that causes black swan events.

I expect a Treasury bubble to inflate in the next several months as the Fed prints money to buy American government debt and when it finally collapses, rates will rise and the Dollar will begin its drastic decline as gold begins its surge up. Unfortunately for foreign creditor nations, the threat of economic mutually assured destruction will force them to have to face the effects of the inflation-default on their Treasury holdings. Not to mention trying to liquidate Treasury holdings would be tantamount to asking for a nuclear war with the United States. The USD won't see hyperinflation, like the GBP and EUR possibly could (and MXN almost certainly will), but it will face sharp devaluation once the Treasury bubble -- the final episode of the Greenspan-Bernanke trifecta of asset bubbles -- comes crashing down.

Disclaimer: Short PFG, HIG, LNC, PRU, GE.

Comments

[bluesmoke:]

Good article. It's hard to run against the tide, but I suspect you are right. Thanks.

May 01 10:17 AM

[gabe borens...:]

Nonsense.There will be no bubble .The U.S economy was recued from a massive economic implosion which would have made the Great Depression look like a desirable economic outcome .For myself ,I have heard enough of the econonomic/quant back seat drivers.The time to express quantitative concern was between 2005 and 2007 (I did ).We are fine ,The FED did a great job although it should not contemplate measures that would allow a large financial entity go under.The Lehman experience should a lesson to all.

May 01 10:26 AM

[Big Bubbette:]

We are not hearing much from Geithner. I suspect that the delay in the announcement of the stress test is to allow the banks and holders of the toxic assets to use mark to market and figure out which loans have value and which are worthless now. They will keep the assets with any value (for example any loan that has PMI insurance that was issued with some degree of underwriting standards). Separate assets with value so the banks can pass the truly worthless on to the People. I am sure Geithner and Obama will be suitably shocked when this turns into trillions of worthless debt passed on to the backs of the People.

Until we end the Federal Reserve and bring the Treasury back under the Congress we will continue to be at the mercy of bankers. Thomas Jefferson was right.

Support Ron Paul and HR 1207 and demand an audit of the Federal Reserve. It is a start.

May 01 01:35 PM

[Jasper M:]

A good article, but I suspect the execution will be a bit different than the author predicts.

Certainly yields on longer Treasury securities have seen their lows, for the foreseeable future. In that respect, the bubble is already done.

Credit is a state of mind, and so debt pyramids can collapse way, way faster than the central banks can inflate (as fast as people can change their mind). Once the mood turns (best measured by the financial markets, especially now), all the Fed's efforts will be more than matched by credit destruction by market forces.

And that means that various debtors will not be able to find credit to roll over their debts, any more than they will be able to earn their way out in a depressed economy.
The hunger to raise dollars to pay these debts will induce sales of all asset classes (including, I suspect, gold), driving down prices, and driving up the dollar.

May 01 09:18 PM

[sethmcs:]

With the trillions lost the feds actions although scary and almost desparate will not be enough to counteract deflation in the short run. However, the tricky part will be unwinding this "intervention" once the economy starts growing. There maybe some interesting scandels that result in regulation of the regulators "fed" "treasury" et al. These are indeed interesting times.

May 02 12:18 AM

[MGA_1:]

Good article. Basically, the US economy is deep sixed and the govt is trying to rescue the whole thing and is pissing people off in the process. If the fed *hadn't* intervened at all I think we were in for a collapse that would surpassed the 1930's downturn, but now I think think the intervention is simply slowing the decline. The only way to clear out all the bad debt is going to be either deflation or inflation. It looks to me like the fed is picking the latter which should be good for gold. People loosing faith in T Bills will be an awful event and in truth may be the beginning of an inflationary spiral. I wouldn't rule out the possibility of hyperinflation in the US although it's not inevitable. IMO we are in a lull in the downturn which I think will pick up again in summer and fall.

May 02 11:44 AM

[carey_jim:]

Good research effort.

However, the financial future is never certain, there are only probabilities. Even the weatherman gets it wrong sometimes.

Watch out for black swans.

May 02 12:52 PM

[secmaven:]

The increased savings rate by the still employed US consumers will provide the funds for the Treasury to rescue the economy. The financial symbiotic relationship between China and the Treasury will be replaced by US investors buying government bonds. The Fed will have to buy a smaller amount than we thought.

May 02 02:06 PM

[Tony Daltorio:]

Great article! In my more than 20 years experience in the investment business, the current bubble in Treasuries is the biggest by far.

May 02 03:50 PM

[The Geoffster:]

I'm up 20% this year shorting the long bond. I'm fascinated by this wealth/credit destruction argument. Dollar bulls think the dollar stays strong because all this credit is denominated in dollars and assets must be liquidated in dollars to pay it off. The dollar is simply another credit used to pay off a credit. M1,M 2, and the retired M3 have shot through the roof. These dollar denominated credits are being repaid with inflated dollars. The only reason the Fed has gotten away with debasing the currency so far is people think it's a safe haven. It's paper people!

May 02 09:28 PM

[Dave Wrixon:]

I fail to see how you can justify the final statement:

"The USD won't see hyperinflation, like the GBP and EUR possibly could (and MXN almost certainly will), but it will face sharp devaluation once the Treasury bubble -- the final episode of the Greenspan-Bernanke trifecta of asset bubbles -- comes crashing down."

Otherwise a very good article.

May 03 03:36 AM

[Brent Forsland:]

GE..a bailout target. You are way off base. GE capital does have considerable exposure mtges and other loans that are in default. It was particularly hurt this past quarter by its mortgage lending business, which suffered a $173 million loss. However to even consider the parent of this conglomerate as a bailout is nuts. Even its losses GE Capital still earned $1.1 billion in the quarter. Even though this was down 58% from a year ago GE projects that its finance arm willcarve out a profit of between $2 billion and $2.5 billion this year. GE never took on the exposure in the credit default swaps market that put AIG at such risks and in is a completely diffrent boat.Tough year? Yes Bailout target? Not even close

May 03 09:00 PM

[Bluemanowar...:]

".....Until we end the Federal Reserve and bring the Treasury back under the Congress we will continue to be at the mercy of bankers. Thomas Jefferson was right."

You must be out of your mind, exactly where do you think we would be right now had we not had Bernake and the Fed outside of Congresses unintelliglbe, incompetent hands...seriously. They would still be arguing about the first step at this point and we would be in the middle of THE Great Depression. Lunacy!

Jul 26 05:13 PM