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Almost one and a half years have passed since my last post. Despite repeated claims by the global regulatory community, many parts of the global financial system are not working normally. The only part of the system that is working normally is the bonuses paid by financial institutions have returned to pre-credit crisis levels.

While I have lots of topics to discuss, let me return to my blog by focusing on the latest effort being proposed to get the financial system and the global economy functioning normally again. This is the Fed embarking on Quantitative Easing II (QE II). The simple idea behind QE II is that lowering interest rates stimulates the economy.

Under QE II, the Fed is proposing to buy Treasury securities. In theory, this will drive down the yield on these securities and all of the debt instruments that are priced off these securities. This makes borrowing more attractive and allows borrowers to use money saved from refinancing to buy other goods and services.

However, there might be a fly or two in the ointment.

While true for high interest rate environments , in low interest rate environments, like those that are prevailing today, it is not clear that it will result in a boost to the economy. There are many headwinds to increased economic activity including retirees cutting back on their expenditures rather than spend some of their principal and companies cutting back on investments to fund pension obligations.

It is also not clear that buying Treasury securities will be as effective for stimulating the economy as buying existing structured finance securities.

There would be several advantages to doing this. First, it would immediately drive down the cost of borrowing to consumers and small businesses. Second, it would allow banks to remove from their balance sheet hard to value assets and puts to rest any lingering questions about their solvency. Third, since most of these securities are non-agency residential mortgages, it would allow the government to successfully push mortgage modification over foreclosure. As the owners of the securities, the Fed could instruct the servicers to modify and not foreclose. This in turn would support the current level of house prices.

I can already hear the howls of protest at what on the surface also looks like a bailout of the big banks. It clearly is that. However, it is also the only example I can find of a "free lunch". Since it prints money, by definition the Fed does not have an interest cost that it has to pay to finance the purchase of these securities. The Fed also does not have a balance sheet that needs to be marked-to-market (it can carry the investments at cost).

The howls of protest are getting louder. Let me pose a theoretical question. Does the Fed lose money if the total of the interest and principal payments it receives equals the price at which the Fed purchases the security? I would argue that it and the taxpayer do not lose money.

Why does that work? The free lunch occurs because the Fed, and this would hold true for the Bank of England and the European Central Bank, does not have to pay any interest. For any other government or private investor, there is a cost of financing the position.

But the Fed is likely to overpay for the securities. I agree. As was shown in the Brown Paper Bag Challenge,, valuing these securities without current loan-level performance information is the equivalent of blindly betting. However, as long as the total of interest and principal payments is equal to or greater than the purchase price, the Fed and the taxpayer are not worse off.

What about inflation? Chairman Bernanke has argued that there are many tools in the Fed toolbox for keeping inflation under control.

Isn't this a massive wealth transfer to the bankers? It is a massive wealth transfer to the bankers. I would hope that before engaging in these purchases the Fed would extract a significant amount of concessions for doing this. For example, the Fed might require that large US financial institutions adhere to the same capital requirements as large Swiss financial institutions (namely 10% loss bearing capital and another 5% contingent convertible debt to replace the loss bearing capital).

Disclosure: No positions

Source: QE2: Maybe There Is Such a Thing as Free Lunch