What Is The Fed Doing? I Love Ben Bernanke

Includes: DIA, QQQ, SPY
by: Russ Fischer

A long, long time ago, on a planet far, far... er, no that's a different thing. A long time ago, after being confused one more time again about what the Fed actually did and how it did it, I sat down and read The Secrets of the Temple. This seems to be the definitive "The Fed for Idiots" book. Let me tell you, I wore out some coffee cups getting through that baby.

So today, the Fed is buying mortgage backed securities hand over fist - $40 billion worth each and every month with no ending date until unemployment reaches some level much lower than today. What happens when it does this?

Let's examine this on a micro basis: Let's say Joe Blow with the average mortgage ($200,000) decides he wants to refinance his loan. He is not upside down on his current loan, so he goes out and finds that he can refinance his 6% mortgage for 3.5% with no closing costs, thus saving 2.5% on $200,000 each year. That is $5,000 per year additional money in Joe Blow's pocket. So, Joe arranges to pay off his mortgage faster, right? Wrong, Joe goes out and buys a new iPhone and new car, and takes his wife out to dinner.

Because the Fed will wind up buying and thus providing the funds for the re-finance, it is providing stimulus of the most immediate kind that is most relevant to Mr. Blow. In the process, of course, the Fed now owns Mr. Blow's new mortgage. As the holder of that mortgage, as any owner of a debt instrument, the Fed is entitled to the interest that Mr. Blow pays each month on his mortgage.

What does the Fed do with this money? Does Ben Bernanke have a big party? No. Once a year, the Fed transfers its profits to the US Treasury. As you can see, this is no small deal and with the unlimited nature of QE3, these transfers to the US Treasury will grow substantially.

These MBS are self liquidating as the mortgages are paid off. If the economy turns up, the Fed simply stops buying the MBS. Interest rates will increase when it does that, but that is what the Fed is supposed to do in a strong economy.

The money thus generated by the Fed through these MBS goes to the Treasury where it augments tax revenue in the funding of operations of the government. This money is indistinguishable from your tax money. Of course, the wizards in Congress will use this money wisely and pay down the public debt and balance the federal budget, right? Well, only if they have a gun pointed to their head in the form of guaranteed election loss for excessive spending.

Who loses on this QE3 thing? Probably the big banks. Who cares, they have screwed up the mortgage business at least twice in my lifetime. Seriously, banks might just not be able to handle loans with 30-year terms. Of course, the Fed can, the Fed can hold its breath through boom and bust with no threat of "runs on the bank" and other manifestations of human ignorance.

The holder of Mr. Blow's old mortgage, Ahmed, in Saudi Arabia, will be surprised to get a payoff check, instead of a monthly payment. Now he has the problem of what to do with that cash that he didn't want in the first place. He looks at treasuries at low or no yield. He looks at Intel (NASDAQ:INTC) with a 4%-plus yield or any of hundreds of other American equities that yield more than debt instruments and decides that maybe some risk exposure isn't so bad.

Who wins on this QE3 thing? Well, Joe Blow scores like a tall dog in short grass. The Treasury gets some much needed help. To some extent, we all benefit by all the Joes paying their interest to the Fed rather than to Ahmed. Multiplied by millions, we are actually taking about some real money here.

There are $30 trillion worth of open mortgages in the US economy, about equally split between residential mortgages and commercial mortgages. Figure about 4.5% on average (commercial rates are higher than residential) and QE3 taken to its illogical maximum, the Treasury could collect $1.35 trillion per year! Instant balanced budget. Obviously, that is not going to happen, but higher revenue and lower spending and this new source of revenue will contribute to reducing or eliminating the deficit.

The US equity markets should be the big winner on QE3 once we get past the election. The "fiscal cliff" will certainly get solved, so being in the market just after the election should capture that rather large event.

Some suggestions to play QE3:

SPDR S&P 500 (NYSEARCA:SPY), with a 2% yield, should be a good investment until QE3 ends.

Power shares QQQ (NASDAQ:QQQ), with a 1% yield, should provide growth and a tiny yield.

The Dow index (NYSEARCA:DIA), with a 2.4% yield, might be the safest way to play QE3.

To puff up the return even more, write covered calls on the above.

Disclosure: I am long INTC, DIA. 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.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Problem with this article? Please tell us. Disagree with this article? .