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Feds In A Box - Unwinding May Not Be So Easy

Thursday, September 10, 2009, 4:19 PM

One of the key questions is, "Can the Fed ever unwind all of the positions it has taken on from failed banks and Wall Street firms?"

This is an important question, because if the answer is "No, at least not precisely when they wish to do it," then it raises the risk that all that hot money will prove immune to efforts to recall it and it will whiz around creating all sorts of monetary trouble.

Now that the Fed has declared that the recession has ended and green shoots are everywhere, the next obvious part of this journey will have to be the unwinding of the massive amounts of stimulus and thin-air money that has been injected into the system.

Certainly after watching the risk-money out-chasing junker stocks well up off their lows, we can surmise that the speculative animal juices are flowing again and that the Fed might want to consider taking away the punchbowl.

Instead, today the Fed bought another $18.8 billion net ($32.4 billion gross) in agency mortgage-backed securities, which represents the exchange of thin-air money for GSE MBS paper.

So far, all that we know about is that the Fed is talking about how to take the punchbowl away but that bankers are warning the Fed to "go slow."

Fed Tries to Prepare Markets for End of Securities Purchases

Sept. 3 (Bloomberg) -- The Federal Reserve is trying to prepare investors for an end to its housing-debt purchases, while keeping interest rates near zero, reflecting an economy pulling out of a recession with little momentum.

Federal Open Market Committee members discussed extending the end date of the agency and mortgage-backed bond programs, minutes of the group’s Aug. 11-12 meeting showed yesterday. The move would be aimed at avoiding disruptions in housing credit at a time when recovery prospects are clouded by rising unemployment and slowing wage gains, analysts said.

While the economy is projected to expand this quarter, central bankers had “particular” concern about the job market, signaling that the FOMC may need to see a peak in the unemployment rate before it begins withdrawing monetary stimulus. Some policy makers saw dangers of “substantial” declines in the inflation rate, yesterday’s report showed.

“They need to see labor markets improve and inflation stabilize, and not fall, before they even have a serious discussion about increasing interest rates,” said Michael Feroli, an economist at JPMorgan Chase & Co. in New York and former member of the Fed’s research staff.

Central bankers extended their $300 billion U.S. Treasury securities purchase program by a month in August and continue buying up to $1.25 trillion in agency mortgage-backed securities and $200 billion in the debt of agencies including Fannie Mae and Freddie Mac.

A number of policy makers judged that a “tapering of agency debt and MBS purchases could be helpful,” the Fed minutes said. Officials postponed a decision on extending the initiative, which is scheduled to end in December.

An extension would be “an attempt to make quantitative easing potentially less disruptive when it ends,” Feroli said.

Central bank officials have indicated differences on when to begin withdrawing the monetary stimulus.

What all the above means is that we are still quite a ways away from seeing the end of the Fed "thin-air" rescue programs. 

And I have a prediction:  It's going to be a lot harder than anybody thinks.  Every effort to withdraw the money will be met with dire warnings from bankers that the "stability of the financial system is at stake," and other such nonsense, meant to disguise the bankers loss of access to risk-free money.

Okay, this is not really a prediction anymore, because we already have our first example of just how rapidly government officials will cave in response to banker demands.

The example comes to us from efforts to end a relatively modest program of debt guarantees where, for a minor fee, the FDIC guaranteed bank debt up to 125% of its face value.  (Try getting that sort of guaranteed insurance for your business debt).

Given that banks are allegedly on their way to health and some are reporting tidy profits, one would think this program could easily sunset on time.  Not so fast, says the American Bankers Association:

FDIC Proposes Six-Month Extension for Debt Guarantees

Sept. 9 (Bloomberg) -- The Federal Deposit Insurance Corp. proposed a six-month, emergency-only extension to its debt guarantee program as regulators move to wean companies from federal aid approved at the height of last year’s credit crisis.

Bankers have pressed the FDIC to spell out how it will end the program, which Federal Reserve Chairman Ben S. Bernanke has said was instrumental in keeping markets stable during the worst of the 2008 financial crisis. The program is part of the Temporary Liquidity Guarantee Program; a portion for business checking accounts was extended in August for six months.

“The point here is to allow for an orderly transition out of a government-backed system,” said Robert Strand, a senior economist at the American Bankers Association in Washington, in a telephone interview yesterday. The ABA had asked the FDIC to “worry about the cutoff points and the suddenness” of ending the guarantees, to make sure closing down the program doesn’t roil markets, he said.

The lessons here are clear:

  • At every step of the way, bankers are going to resist the loss of their free money.
  • The banker's tactics will be to toss out dire warnings of "roiled markets" and "destabilizing the system" and other such veiled threats that translate into, "When our industry is unhappy, you're unhappy."
  • The removal of stimulus, when it does begin, will be exceedingly gradual and delicate.

For my part, I have serious doubts that all of the "assets" purchased by the Fed can ever be completely unwound.  Either the counterparties no longer exist, or if they do, some will decline (read: refuse) to buy the assets back, because doing so would bankrupt them (due to the fact that the assets are worth a lot less than the price the Fed bought them for).

Adding to this story are the immense borrowing needs of the federal government over the next year.  How can the government possibly find enough cash to borrow if the Fed is busy withdrawing cash from the markets?

No, it would seem that the Fed's thin-air money program (called "quantitative easing" in fancy parlance) is going to be with us for a while.

Unwinding is not going to be easy.

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10 Comments

Davos's picture
Davos
Status: Diamond Member (Offline)
Joined: Sep 17 2008
Posts: 3620
Re: Feds in a Box - Unwinding May Not Be So easy

Hello Chris:

Good read!

Can't wait to see them wind back up right after they try to unwind when CRE and the Alt-A's and Option arms pop. Take care

jdownie's picture
jdownie
Status: Bronze Member (Offline)
Joined: Apr 7 2008
Posts: 58
Re: Feds in a Box - Unwinding May Not Be So easy

Chris, sounds like the Fed may be 'jawboning', all talk but no action.

The situation is the same here in Australia, a couple of weeks ago it was all "rates somewhere north of 3%", then surprise, surprise, they left the cash rate (equivalent of your Fed Funds rate) at 3%. Like the Fed, the RBA has increasingly been buying up bank 'assets' of dubious quality, at increasingly distant maturities. I don't see how this will be unwound.

The AUD took a hit when the RBA left rates at 3% but has since continued to strengthen against the USD. I'll go out on a limb and predict that the RBA will announce an 'emergency' rate cut if the situation continues.

SkylightMT's picture
SkylightMT
Status: Silver Member (Offline)
Joined: Sep 30 2008
Posts: 125
Re: Feds in a Box - Unwinding May Not Be So easy

I'm confused, really.

They can't unwind now because the recession isn't really over. In fact, its still on its way down. I can understand that they are talking about unwinding but that's because they think the financial system is stabilized. But its nowhere near stablized. It just appears stabilized because of FASB.

So it doesn't matter what excuses the banks have for continuing to need to the money. They really do continue to need the money. Its way too soon to be talking about unwinding. Its time to be talking about the next round, in which no more bailouts are available and the banks need to be allowed to collapse in a controlled manner that doesn't result in another Lehman.

What am I missing here?

Raydelaware's picture
Raydelaware
Status: Member (Offline)
Joined: Jul 31 2009
Posts: 2
Re: Feds in a Box - Unwinding May Not Be So easy

It seems that the key issue is when and if this free hot money ends then the markets crash. If they continue then investments in oil , gold should continue up, if it ends then these will drop as banks pull back funds from the markets. We , I am playing the game of 1/2 in cash and half on the casino table looking for an end to the free chips. Any ideas on how to see when to run for the door or confidence to gamble some more chips.

thanks

Ray

Woodman's picture
Woodman
Status: Diamond Member (Offline)
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Posts: 1028
Re: Feds In A Box - Unwinding May Not Be So Easy

At every step of the way, bankers are going to resist the loss of their free money.

Some banks have returned TARP money  right, when it no longer suited them to have constrictions on compensation etc.?  And some bailout money has just been guarantees that may or may not have actually been exercised.

I still agree though many assets that the Fed bought will be difficult to return and recoup the original value. 

Is there a good summary of all the bailouts actually spent to date, and what is recoverable vs what is not?

Tom

okubow's picture
okubow
Status: Bronze Member (Offline)
Joined: Aug 16 2009
Posts: 67
Re: Feds In A Box - Unwinding May Not Be So Easy
Woodman wrote:

Is there a good summary of all the bailouts actually spent to date, and what is recoverable vs what is not?

Not sure about what's recoverable and what's not, but here's a list of all the bailouts. It will at least give you some idea of who's been bailed out and for what amount.

http://money.cnn.com/news/storysupplement/economy/bailouttracker/

Orion

cmartenson's picture
cmartenson
Status: Diamond Member (Offline)
Joined: Jun 7 2007
Posts: 5570
Re: Feds In A Box - Unwinding May Not Be So Easy

TARP money wasn't free.  It usually came with some sort of preferred stock equity stake for the government, as well as other restrictions.   Badly underpriced thought the preferred stock was, it was still not free.

Contrast that with the Fed stepping in and buying a ruined portfolio of CMBS paper for 85 cents on the dollar.   Or the fact that through such actions the Fed gave banks massive amounts of "excess reserves" which were then deposited at the Fed and had interest paid on them. 

Ruined assets turned into an interest bearing stream of cash. 

The TARP money is a smaller pile compared to the combined FedRes and GSE activities. 

Woodman's picture
Woodman
Status: Diamond Member (Offline)
Joined: Sep 26 2008
Posts: 1028
Re: Feds In A Box - Unwinding May Not Be So Easy

 I was just hearing on the mainstream media this morning about how the economy is turning around and banks are returning bailout money.   Thanks for the clarification of how the Fed is really injecting money to prop things up.

One of Robert Pretcher's arguments in support of deflation in the recent Financial Sense podcast was that this money can be pulled back, but I've heard no one yet explain how that can be feasibly done.

DJT's picture
DJT
Status: Member (Offline)
Joined: Feb 18 2009
Posts: 7
Re: Feds In A Box - Unwinding May Not Be So Easy

I have a somewhat related question that maybe someone here can help me with. I am aware the Fed creates money in the form of debt in order to finance the Government and when the debt is repaid a portion of the interest goes back to the US Treasury.

Where does the principal go?

Along this line of thinking, since the inception of the Federal Reserve what is the total amount of money created and repaid and where did it go?

memorrison's picture
memorrison
Status: Bronze Member (Offline)
Joined: Apr 16 2008
Posts: 90
Re: Feds In A Box - Unwinding May Not Be So Easy

Chris-

Last year you posted an article on the Texas Ratio or something like that, it ranked banks.  Have you pulled that out lately and updated if the current bank failures from the past year are on the list?  I have not taken the time to look it all up and was wondering if you have kept the form up to date?

Thanks

 

 

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