Bernanke Tries to Play Politics, Loses

Dec.10.10 | About: PowerShares Build (BAB)

The BABs story has gone political. And now the Fed is tossing information into the hopper that just does not pass the smell test. The question is: Why is the Fed doing this?

The real story on BABs is that Republicans want to nix the program, as it provides a very clear benefit to the three biggest blue states: California, New York, and Illinois.The opposition does not want to really show its hand as being purely political, so it's attacking the extension on the merits. The strongest reason to oppose the extension is that it is a federal subsidy that costs the taxpayers money and adds to the deficit. But the problem all along is that no one in D.C. really has a clue how much this is actually costing.

BABs was first sold as being revenue-neutral at the federal level. The talk was that the 35% interest subsidy paid by D.C. would be offset by tax dollars created when the bondholders paid federal income on their interest income. It never worked like that at all. The BABs bonds went to tax-exempt holders. 401k/501c accounts, foreign banks and other tax-exempts bought the BABs bonds. In my opinion, the treasury is lucky if it gets back 15% of the 35% that it is paying out as a result of the tax arbitrage that has been created.

I have consistently heard that some big takers of the BABs were foreign banks. That makes perfect sense. Prior to BABs, they had no ability to build up state assets as they had no tax base to offset. But with BABs that issue went away, and an attractive asset class with a desirable fixed coupon and long duration was created. The New York Times had this to say about foreign bank participation in BABs:

"The reason I know foreign holdings are going up is that I am selling more and more muni bonds to foreigner investors," said one municipal bond banker in New York.

So what does the Fed do? It muddies up the waters with a new report. The timing of the release is curious. But even worse, the numbers put out by the Fed are very suspect. Previously it had reported that foreign bank ownership of Muni bonds was rising quickly. Yesterday it threw out all the old numbers and revised the estimates to show (surprise, surprise) that foreign ownership was in fact steady.

A spokeswoman for the Federal Reserve said the explanation for the drastic revision is that the Fed “reviewed and revised the methodology it had been using to estimate those numbers,” and applied the new methodology retroactively to mid-2009.

Unbelievable. The Fed has skewed the data to make a case that the tax subsidy for BABs is not leaking out of the country. You can bet that the Democratic supporters pushing for a BABs extension will be waving this “timely” Fed report to make their case.

The Fed wants BABs because it facilitates debt creation by munis. The Fed wants as much new debt as possible, as we all know that "Debt = Growth," and the Fed is desperate for some growth. So it spins a report to support its objectives. What a way to run a country.

There is still uncertainty on BABs. Possibly the new Fed report will shift some votes. But one outcome is certain. The Republican leaders are not blind. They will see that the Fed attempted to manipulate the outcome. I doubt that those folks want the Fed playing in their sandbox. I would imagine they are a bit miffed at the timing of the report. So look for some payback on this.

Ben is going to get raked over some Congressional coals as a result of his meddling. I can’t wait.