Financial topics

[Higgenbotham]

When the Fed got these MBS two years ago they created more dollars then. They should have "marked to market" then and never paid more than they were worth.

Now if they bought the MBS I don't see how they can today make the banks take a haircut.

If the MBS were collateral for a loan, and the banks pay back the loan and get their MBS back, maybe. But I don't think it was done that way.

The other option is to go after the fraud the banks did when they were doing "liers loans" and passing them on as good.

I don't think the Fed will try to say that the electronic dollars that particular banks have are not worth a full paper dollar. This probably breaks legal contracts the Fed has with the banks to treat the electronic dollars the same as paper dollars. Also, it is such arbitrary power that could be used to abuse Chinese or anyone else that doing this would cause a loss of faith in the Fed and the dollar.

Another part of the "real bills" theory of central banks issuing paper money is that they should only ever accept short term debt as collateral, like 3 month or less. The reason is that long term debt can go up and down in value, so might not be worth as much as they paid for it when they needed to use it. Imagine that the Fed buys a 30 year bond when interest rates are 4% and then rates go up to 9%, the bond will be worth only about 48% of what they paid for it. If they then try to buy back the FRNs they issued they can only buy back 48%. The central bank has lost control of the other 52% of the FRNs. So when the Fed bought MBS they broke this "only high quality short term debt" rule big time.

Anyway, I really doubt the Fed can restore their balance sheet given the full situation.

It's true that extra electronic dollar reserves were very likely created 2 years ago.

Remember when I said the NY Fed is part of a lawsuit against Bank of America? I think this is the key to how this may resolve. The courts may have to resolve it. It's going to be a real mess.

There's a larger issue, I think, as to why the Fed won't post MBS as collateral for Federal Reserve notes. They don't want to touch the issue that all the MBS in the banking system have phony marks. The first time MBS are marked to market for any reason will establish what Fed officials think they are really worth and give indications that all MBS may soon be marked to market. That would likely set off a panic. If they post MBS as collateral and give them phony marks, Ron Paul and Congress will go ballistic. That would likely set off a panic. In both cases, the Fed would be blamed for setting off the panic.

[Higgenbotham]

I've been looking around for any new information regarding what the Fed might post for collateral for Federal Reserve notes at present in accordance with Section 16 of the Federal Reserve Act. This issue doesn't seem to be on anybody's radar except the Fed's itself and not lately. I can't help but think that in previous Fourth Turning eras the citizens would be debating an issue like this.

On another note, I bought some puts on the stock indices yesterday and today. Stocks haven't made much progress since last week's close and early Monday, which the cycles indicated might be the end of this rally, but they haven't gone down either.

[Higgenbotham]

This doesn't all format correctly, but it's formatted on the bottom of the Fed's balance sheet at the link. As can be seen, mortgage-backed securities have been stated to be pledged against Federal Reserve notes.

The Fed has more Treasuries on its balance sheet than Federal Reserve notes required to be collateralized. I will be watching these numbers to see if the Federal Reserve notes to be collateralized begin to exceed the total value of the Treasuries on the Fed's balance sheet.

11. Collateral Held against Federal Reserve Notes: Federal Reserve Agents' Accounts
Millions of dollars
Wednesday
Federal Reserve notes and collateral Dec 15, 2010

Federal Reserve notes outstanding 1,125,187
Less: Notes held by F.R. Banks not subject to collateralization 186,751
Federal Reserve notes to be collateralized 938,436
Collateral held against Federal Reserve notes 938,436
Gold certificate account 11,037
Special drawing rights certificate account 5,200
U.S. Treasury, agency debt, and mortgage-backed securities pledged (1,2) 922,199
Other assets pledged 0
Memo:
Total U.S. Treasury, agency debt, and mortgage-backed securities (1,2) 2,124,282
Less: Face value of securities under reverse repurchase agreements 45,385
U.S. Treasury, agency debt, and mortgage-backed securities eligible to be pledged 2,078,897

Note: Components may not sum to totals because of rounding.

1. Includes face value of U.S. Treasury, agency debt, and mortgage-backed securities held outright,
compensation to adjust for the effect of inflation on the original face value of inflation-indexed
securities, and cash value of repurchase agreements.
2. Includes securities lent to dealers under the overnight securities lending facility; refer to table
1A.

http://www.federalreserve.gov/releases/h41/current/

[vincecate]

It's true that extra electronic dollar reserves were very likely created 2 years ago.

Remember when I said the NY Fed is part of a lawsuit against Bank of America? I think this is the key to how this may resolve. The courts may have to resolve it. It's going to be a real mess.

For sure it will be a real mess. People are mad enough at taxpayers bailing out banks who then paid themselves billions in bonuses that the banks may be in trouble one way or another.

The only way the Fed could buy $1.2 trillion in MBS 2 years ago was by making new money. And there are charts showing the Fed's balance sheet jump up back then. Like this one:

http://www.clevelandfed.org/research/da ... /index.cfm

Also 2 years ago Bernanke admitted he was essentially printing money (though crediting reserve accounts so it was electronic dollars):

http://howfiatdies.blogspot.com/2010/12/blog-post.html

[Higgenbotham]

It's true that extra electronic dollar reserves were very likely created 2 years ago.

Remember when I said the NY Fed is part of a lawsuit against Bank of America? I think this is the key to how this may resolve. The courts may have to resolve it. It's going to be a real mess.

For sure it will be a real mess. People are mad enough at taxpayers bailing out banks who then paid themselves billions in bonuses that the banks may be in trouble one way or another.

The only way the Fed could buy $1.2 trillion in MBS 2 years ago was by making new money. And there are charts showing the Fed's balance sheet jump up back then. Like this one:

http://www.clevelandfed.org/research/da ... /index.cfm

Also 2 years ago Bernanke admitted he was essentially printing money (though crediting reserve accounts so it was electronic dollars):

http://howfiatdies.blogspot.com/2010/12/blog-post.html

Let's say this is near the top of a rebound and not enough GDP growth is forthcoming. The first difference between now and the top of the bubble is, as we've stated, the Fed has $1.2 trillion in deteriorating MBS on its balance sheet versus having none at the top of the bubble. Perhaps those assets are government guaranteed agencies. Forgot to mention that before. Frankly, I don't think any goverment guarantee on MBS makes any difference at this point. The second difference is, as we've noted, that some of the treasuries are almost surely going to deteriorate even as people seek safe havens. Treasuries will not be considered safe across the curve as they were during the first collapse. From what I can see of the Fed balance sheet, the Fed is stating in so many words that they are going to collateralize Federal Reserve notes with deteriorating assets. I don't see any evidence that is being recognized or challenged. Next question is whether, as those assets deteriorate, that additional assets will be posted to back the Federal Reserve notes or whether the asssets will be posted at face value. If additional assets are posted, then there's less to offset the electronic reserve dollars. If not, then there's not enough backing for the paper dollars. If the Fed spreads their assets out between the electronic dollars and the paper dollars then there will be, all things equal, devaluation of the entire monetary base. If the Fed crams their assets into the backing of Federal Reserve notes by posting additional collateral then there will probably be stratification of the monetary base. Something else I should mention. I now recall going through all this in my mind about 2 years ago. My conclusion was that it might be possible if the Fed turns the entire monetary base into junk that the short term t-bill rate could go highly negative and that any good short term paper of any type would be more valuable than Federal Reserve notes. Another thing I would add is the only possible claim Bernanke has left to back his statement that he is not printing money would be to preserve the integrity of the Federal Reserve notes. If he does not do that, then he has for all intents and purposes printed both electronic and paper dollars because their value will be indistinguishable.

[vincecate]

If the Fed spreads their assets out between the electronic dollars and the paper dollars then there will be, all things equal, devaluation of the entire monetary base.

If the Fed were to admit it can only defend the value of just electronic dollars or just paper dollars the market would immediately tank both electronic and paper dollars.

My conclusion was that it might be possible if the Fed turns the entire monetary base into junk that the short term t-bill rate could go highly negative and that any good short term paper of any type would be more valuable than Federal Reserve notes.

I think if they don't keep the 1:1 peg between electronic dollars and paper dollars that both will crash. As long as paper dollars and electronic dollars are pegged, money months in the future will not be more valuable than money now.

Another thing I would add is the only possible claim Bernanke has left to back his statement that he is not printing money would be to preserve the integrity of the Federal Reserve notes. If he does not do that, then he has for all intents and purposes printed both electronic and paper dollars because their value will be indistinguishable.

He has tried to deceive people with his comments. He thinks if people knew the truth they would panic, so he lies. He has to keep the peg, so when he makes one it is the same as if he had made the other.

[Higgenbotham]

If the Fed were to admit it can only defend the value of just electronic dollars or just paper dollars the market would immediately tank both electronic and paper dollars.

The Fed will never admit anything, but if they were to move in the direction of defending Federal Reserve notes over electronic dollars, my prediction would be that the payments system would lock up, which would explain why they will give no appearance they will move in that direction. Going back to past history, I seem to remember now that sometime in 2009 the Fed did not have enough treasuries on its balance sheet to back the Federal Reserve notes, so they have a past history of doing exactly as you suggested. At the time, I wondered why people weren't dumping their Federal Reserve notes. That was a different environment but, having recalled this, my view is that the Fed will do exactly as they did in the past, contrary to what I posted. All of the old Fed balance sheets are still online, so this can be easily verified.

Thinking about it more, it's easy to see why the Fed is doing this. If the payments system locks up, then people will fear the banks might close and there will be a run on the banks, so any move to defend paper dollars over electronic dollars becomes a self fulfilling prophecy. The Fed has no choice but to pledge their crap collateral for Federal Reserve notes and ignore the letter of the law. Will Ron Paul and the Congress demand that the law be enforced?

As long as paper dollars and electronic dollars are pegged, money months in the future will not be more valuable than money now.

In making this comment, I'm categorizing both forms of money (dollars and t-bills) as short term money (one resides inside the Federal Reserve/banking system and one resides outside). If the Fed makes both paper dollars and electronic dollars equivalent in terms of backing (and thus directly interchangeable in any quantity minus time constraints, etc.), paper dollars may not have ultimate safe haven status should a panic unfold and people are quickly dumping assets. I watched a similar situation in 2008. As some money funds broke the buck or threatened to before the Fed quickly rescued them with electronic money guarantees, t-bill rates went negative (money funds lost value while t-bills gained value).

I can't recall where this fits in, but to the extent that the Fed has compromised its own balance sheet, it becomes susceptible to questions about solvency just like any other bank. Hence, a reason for a preference for t-bills over Federal Reserve notes.

Overall, I would say these conditions point to a system that is very crisis prone and highly unpredictable, much more so than in the leadup to the 2008 debacle. That one was easy to predict and respond to; this one will not be.

On another note, check out the ISEE Index of "Equities Only" for the full span of dates available. As of yesterday, we now have record sentiment levels on the index as well as record moving averages of sentiment! We will now see if sentiment that far exceeds levels seen at the 2007 all time high means anything or whether Fed money pumping carries stocks even higher. According to the NY Fed there was about $24 billion in Fed treasury purchases this week alone.

[vincecate]

I can't recall where this fits in, but to the extent that the Fed has compromised its own balance sheet, it becomes susceptible to questions about solvency just like any other bank. Hence, a reason for a preference for t-bills over Federal Reserve notes.

Insolvency for a central bank means that their assets are not enough to buy back all the currency they issued at the current price. So what happens is the value of the currency goes down. The "notes" that a central bank issues are their "debt" (used to be a promise to pay gold). So when they are insolvent they can not withdraw all the currency they issued. It means they can not control inflation.

Overall, I would say these conditions point to a system that is very crisis prone and highly unpredictable, much more so than in the leadup to the 2008 debacle. That one was easy to predict and respond to; this one will not be.

I too think conditions now are even worse than 2 years ago. But, going on the book "this time is different", I am very confident that "sovereign debt crisis" and "currency crisis" are what is coming. I even think that "hyperinflation" is getting very clear.

On another note, check out the ISEE Index of "Equities Only" for the full span of dates available. As of yesterday, we now have record sentiment levels on the index as well as record moving averages of sentiment! We will now see if sentiment that far exceeds levels seen at the 2007 all time high means anything or whether Fed money pumping carries stocks even higher. According to the NY Fed there was about $24 billion in Fed treasury purchases this week alone.

The Fed is planning like $900 billion over 9 months, so $100 billion per month or about $25 billion per week. The Fed is planning on monetizing debt at about the rate that the government's deficit spending is making debt. In other countries with large deficits and full monetization of the deficit, the currency has not done well.

The theory of "contrarian investing" makes sense to me. If everyone thinks the market is going to go up then they will have already invested and there are no new buyers, so it will go down. Seems very logical. Will soon see if it works again.

[Higgenbotham]

Insolvency for a central bank means that their assets are not enough to buy back all the currency they issued at the current price. So what happens is the value of the currency goes down. The "notes" that a central bank issues are their "debt" (used to be a promise to pay gold). So when they are insolvent they can not withdraw all the currency they issued. It means they can not control inflation.

Overall, I would say these conditions point to a system that is very crisis prone and highly unpredictable, much more so than in the leadup to the 2008 debacle. That one was easy to predict and respond to; this one will not be.

I too think conditions now are even worse than 2 years ago. But, going on the book "this time is different", I am very confident that "sovereign debt crisis" and "currency crisis" are what is coming. I even think that "hyperinflation" is getting very clear.

It becomes more difficult to predict because the panic state becomes more difficult to predict. As I said before, Bernanke has narrowed the door. As people panic, they will need to make decisions on where to move their capital. Some of this can be instantaneous and some can not be. Some can be by choice and some can not be depending on what the routes of settlement are. For example, in stock accounts, settlement is into money markets. People can pre choose treasury only or something else, but they must settle into US dollar accounts. As the panic occurs, pre existing fundamentals can morph into new fundamentals. Established above is the fact that Federal Reserve notes are junk dollars. The Fed balance sheet states so. The only way that will change is if the politicians act. That could occur, and there is some reason to think it might, but there isn't anything concrete on the immediate horizon that I know of. The tendency is for the politicians not to act until emergency conditions prevail. Federal Reserve notes are still legal tender though. The US government can maintain its short term obligations for the time being. Therefore, under panic conditions (say a stock or bond market panic), the panic state is very likely to be that settlement dollars will be moved into short term obligations of the US government and strong corporations at any almost any price because that is only open door to safety. To do that, since Federal Reserve notes pay zero interest, the market adjustment will be made through the interest rate, which will go highly negative. This will then become a fundamental that did not exist in the pre panic state. It's a deflationary phenomenon because a preference has been established for good dollars over junk dollars. At the same time, it is a rejection of the currency and is a currency crisis in that the exchange between strong short term obligations and Fed junk dollars is no longer 1 for 1. At that point, the politicans will need to take emergency action and that will further alter the fundamental conditions. Other conditions will be very chaotic.

I should add that this does not take into account international money flows that will occur if the panic is set off outside the US. This is a general scenario I see for US conditions as they exist now. The immediate problem is in Europe and that can buoy the US paper and electronic dollars.

[vincecate]

Therefore, under panic conditions (say a stock or bond market panic), the panic state is very likely to be that settlement dollars will be moved into short term obligations of the US government and strong corporations at any almost any price because that is only open door to safety. To do that, since Federal Reserve notes pay zero interest, the market adjustment will be made through the interest rate, which will go highly negative.

As people get worried about the future of the dollar they will sell (or don't buy) the longer term bonds/bills/notes and move toward short term and cash. This has been going on for years. Very little money is going into 30 year bonds.

When things turn to panic the longer term debt will be crashing in value and the yields will be shooting up higher. We might be seeing the very first stages of this move now as prices are going down and yields are going up. If this move picks up speed then the end is near.

You will not get "highly negative interest rates". Won't happen. You will get very high interest rates as people fear for the future value of dollars and don't want to hold long term debt.

You seem to be thinking that the treasury bills denominated in dollars could in a panic be safer than dollars. This is an impossibility, as long as paper and electronic dollars are pegged 1:1. In the best case the treasury pays you back with dollars. In the worst case they don't increase the debt ceiling and can not pay you anything. If you have cash you have cash already, which is the best case outcome of the treasury debt. I think there is a far higher chance that the treasury defaults than that the Fed breaks the 1:1 peg between electronic and paper dollars. Since the Fed can make either paper or electronic money they can always keep the peg (maybe a delay on printed dollars while they print some more, but with 1,000 and 10,000 notes there will never be a long delay).