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One for the History Books

December 29, 2011

A couple of weeks ago I promised to share a chart of the Federal Reserve’s balance sheet. Before we quickly glance over this colorful chart, one must understand that we are looking at numbers that are in the trillions of dollars. All the public debate over TARP — the bailout of Wall Street by our federal government (or more accurately, by you the taxpayer), which should not to be confused with the Federal Reserve’s own bailouts — was ‘only’ $750 billion.

Personally I think this is one of the most amazing charts as it shows just how much liquidity has been added, and continues to be added, in various forms. I looked for a chart that would include the FED’s latest “Operation Twist” but was unable to find an easy-to-understand graph. So the first warning is that the FED’s balance sheet has grown worse since last May when this chart was last updated. In fact, in an attempt to not show such astounding growth, the FED has once again reduced their traditional holdings to purchase more mortgages and long-term treasuries when they approved “Operation Twist” this last summer.

(By the way, the Fed “BS” above stands for balance sheet, but the other thing that comes to mind might actually work better)

Here is what we should understand by looking at the Fed’s balance sheet:

1)      The Fed began reducing their traditional holdings (as shown with dark blue on the chart) to accommodate “lending to financial institutions” (shown with green) in early 2008. Remember, it was the U.S. Treasury Secretary, Henry Paulson, Fed Chairman Ben Bernanke and various other economic and political leaders who protested in September 2008 that no one could have known this crisis was coming. However, for six months prior to the need for “bold and immediate action,“ they had been pouring hundreds of billions of dollars into our “Too Big to Fail” financial institutions. And they did it in a way that they purposely hid it by not increasing their total balance sheet. The Fed reduced their traditional short-term treasury holdings to pour liquidity into big banks for the first nine months of 2008.

2)      At the same time that big banks were getting money from TARP they were getting even more from the Federal Reserve (as shown with light blue). Is it any wonder they paid back the TARP money so quickly?

3)      Even though the Fed has reduced their traditional holdings by more than half to bailout Wall Street, they have tripled their balance sheet from under $1 trillion to where they are now approaching $3 trillion.

4)      This is new liquidity and new money and ultimately dilutes your savings, pensions and spending power. It is the biggest liquidity action in the history of our nation.

5)      Remember, all these actions by the federal government and the Federal Reserve were supposed to be temporary, stopgap measures that would be in place only until “the economy got back on its feet.” Think about all the combined action by our government and Central Bank; the lowering of interest rates to zero; TARP; QE 1; QE 2; QE 3; Operation Twist; the purchase of mortgage-backed securities; the exchange of shorter treasuries for long-term treasuries; the change in accounting procedures regarding the value of questionable (crap) assets… and on and on it goes! The more we add to our debt, the more we add to liquidity, the more we add to risk and the more we devalue the dollar only guarantees long-term repercussions.

6)      This is a stunning growth in our central bank’s balance sheet and it seems that no one is willing to question the long-term impact of all these actions (experiments).

7)      The question I have is at what price is the Fed buying these toxic mortgage-backed securities (MBSs)? Remember, even though they own the printing presses, it is still taxpayer debt, and therefore, taxpayer money that will pay for all this. The reason I question the price is that we all know many mortgages carry less than half their original value, but the government, in the midst of all their manipulations in 2008, changed a long-standing accounting procedure of valuing assets based on mark-to-market pricing. In short, mark-to-market means that the value of an asset is priced what you could sell it for today. What are the most devalued assets today? You guessed it, mortgages. Banks have been slow at reducing their balance sheets of foreclosed properties because they would have to realize the losses instead of being able to value their real estate holdings at some future/made-up price. How convenient that the Fed comes along and buys all these toxic assets from the very same institutions that created them!

8)      Here is another question I have: What would our economy look like without this massive, unprecedented infusion of liquidity/debt to stimulate markets and consumers. At some point this huge volume of liquidity has to be extracted from the economy… hmmmm.

9)      The Fed has targeted lowering long term treasury rates, which in turn has lowered mortgage rates, but this is an artificial manipulation and such manipulations have other consequences. While it seems to have little effect on home-buying, it will certainly affect savers, pension plans and other entities reliant on fixed-income returns in very significant ways.

10)   Something else worth contemplating in this action of purchasing long-term treasuries is that we have now entered the stage of our nation buying its own debt. When a government decides to print more money, there comes a point where concerns over devaluing your currencies will result in outside investors not willing to purchase more debt from you. This is part of the checks and balance within our monetary system. It is an astounding fact that the Fed has become the biggest purchaser of our nation’s treasury bills; we are buying our own debt. Certainly the owner of the printing presses can manipulate bubbles, including a bubble in debt issuance. Once again, however, the Fed is acting as an artificial stimulant.   

11)   And what happens if we eventually have to raise interest rates to attract outside investors, because we can no longer be the largest purchaser of our sovereign debt? What will happen is the cost of paying for the overwhelming debt we’ve accumulated under artificial premises becomes too great to even keep up with current payments. The interest on your accumulated debt begins to consume a majority of your revenues.

12)   We are entering into the fourth year of a rapidly increasing Fed balance sheet; this is an unprecedented experiment, but we know for certain that their plans have not worked so far. Just how deep of a hole can we dig ourselves into?

One more topic of copious discussion the Fed balance sheet should generate is the issue of “carry trade.” I don’t have time at this point to get into this topic, but will in the future. The bottom line is that our economic problems were originally identified as a credit crisis and a liquidity problem. This was hugely incorrect and so the prescription/medicine has only worsened our condition. The original problem with our economy was created by too much debt, risk, leverage and greed, and our government and central bank’s response has only increased the very problems that led us into 2008. It is all in the graph… a picture is worth a thousand words, or in this case a couple of trillion dollars.

One Comment
  1. Bob Forrest permalink
    December 31, 2011 2:56 pm

    Hi Jon,

    Over the past few years I have enjoyed reading your views on the economy and investments in another publication. My interests and concerns closely parallel yours going back to the “housing boom.” While a discussion about derivatives, “Operation Twist”, MBS or European debt may induce sleep in many people, I feel an awareness of these and other financial threats are essential to our financial well being.

    You raised many valid points in the “One for the History Books” post. On a related note, I find it troubling that in July 2008 Treasury Secretary Paulson tipped off several hedge funds about a likely Fannie Mae and Freddie Mac rescue:

    I’m wondering when the U.S. bond market “vigilantes” will return. When interest rates start to rise a lot of folks in “safe” bond investments are going to get hurt- especially if they are in funds with longer-duration issues or if they cannot hold individual bonds to maturity.

    With so much public and private debt in the world and a lack of robust economy I’m thinking about how the deleveraging process is going to play out? Are we facing deflation then inflation (hyper-inflation?). Right now there seem to be more questions than answers.

    Congratulations on your blog. I will look for your future posts.

    Take care and have a happy and prosperous new year!

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