Commentary

Fed Buys U.S. Debt!

I believe that a disproportionate amount of media attention has focused on political squabbles inspired by the latest mega-billion dollar economic stimulus package, the continuing costs of bailing out financial institutions, and the recent show trials of A.I.G. employees. In my opinion, far too little attention is set upon the Federal Reserve, which is embarking on very risky, some would day overtly risky maneuvers designed to restart the flow of credit and stem the tide of asset deflation.

The Federal Reserve rather quietly announced at it’s regularly scheduled Federal Open Market Committee (FOMC) meeting on Wednesday that it would buy an additional $1 trillion of mortgage securities, and more shockingly, longer-term U.S. Treasury bonds in another heroic attempt to revive the desperately ill American economy.

The Federal Reserve explained that it would buy an additional $750 billion of government-guaranteed mortgage-baked securities – it is already in the process of scooping up some $500 billion of these securities. But the shocker came when the Fed added that it would now buy as much as $300 billion in U.S. Treasury bonds the next six months, focusing their spending spree on 10 year notes.

The Federal Reserve reduced the overnight lending rate banks charge one another at a frantic pace during 2008, by December it hovered just above zero. Last fall, as the credit markets seized up, the Fed stepped up the purchase of mortgage securities and started buying commercial paper to prevent the collapse of money markets, which are home to trillions in savings. All of these efforts are designed to improve the flow of credit, which Fed chairman Ben Bernanke believes is the key to reviving the economy. (The Fed’s purchase of mortgage securities did help lower rates on 30-year fixed rate mortgages issued by Fannie Mae and Freddie Mac from approximately 6.5 percent to around 5 percent.)

Just this week, as A.I.G. chairman Edward Liddy was grilled for his company’s alleged crimes by a shocked, yet complicit Congress, the Fed and the U.S. Treasury were launching plans to create the Consumer and Business Lending Initiative in another desperate attempt to increase the flow of credit. This joint venture falls under the new Term Asset-Backed Securities Lending Facility (TALF), which will make its debut offering $200 billion in financing for consumers, small businesses and will be available to corporations for a limited range of purposes. According to the New York Times, the Fed and Treasury hope to include commercial mortgages in TALF, hoping to expand the program’s total financing capacity to $1 trillion.

The Fed’s goal is to reduce mortgage rates in order to aid the distressed housing market (mortgage rates are determined by the yield on the U.S. Treasury’s 10-year note, mass purchases by the Fed will drive up prices of the security, lowering its yield, which will lower the interest rates charged on home mortgages).

The frantic purchase of mortgage securities and Treasury bonds, along with a few hundred billion in consumer and small business financing, will double the Fed’s balance sheet from approximately $2 trillion to over $4 trillion – it stood at $900 billion just over a year ago. The Fed is clearly terrified that asset deflation will worsen, dragging the economy from recession to depression, just as it did in the 1930s. Fed Chairman Ben Bernanke is an expert on the Great Depression, and he studied Japan’s decade and a half of misery caused by inadequate monetary response to the collapse of equity and property markets that developed in the late 1980s – he is determined to avoid what he sees as past mistakes by monetary authorities.

How will the Fed find the money to buy 10-year Treasury notes? Many news outlets say the Federal Reserve will simply print money to buy these securities. This is what happens when a government purchase its debt with it’s own currency. After all, money is not backed by gold, so there really is no limit to how much can be created; it is up to responsible central banks to monitor its creation.

I was in the dark as to how the Fed would actually do this until I came across an article in February’s Institutional Investor. This article spelled out the dangers posed by the possibility – which is now a reality – of the Federal Reserve’s purchase of U.S. Treasuries.

Before I discovered this piece, I didn’t really know how the Fed bought assets, such as mortgage-backed securities. It turns out that it’s really quite simple. The Federal Reserve uses overnight bank borrowings to fund a portion of its asset purchases, which currently costs next to nothing because overnight rates hover around zero these days.

So the Fed uses cheap overnight funding to buy longer-dated securities – sound familiar? This what investment banks, commercial banks and hedge funds did during the credit boom to create massive short-term profits. Many faced collapse and are now receiving billions in bailout funds from the U.S. Treasury because their sources of cheap funding – the global credit markets – dried up. The same thing could happen to the Fed. When the economy recovers, the Federal Reserve could be hit with what Mustafa Chowdhury, head of U.S. interest rate strategy at Duetsche Bank, calls a “funding mismatch”, which sank structured investment products early on in the credit crisis. As the economy recovers, short-term interest rates will rise, raising the Fed’s costs of servicing its debt while reducing the value of the assets (Treasury bonds) it used the borrowed money to purchase.

The article points out that this could force the Fed to seek a bailout from the Treasury after the economy has recovered. This means that the Fed could lose its independence as it is forced to grovel before Congress to receive funding. Poll driven politicians could demand the Fed set lower interest rates in exchange for government funding. (This is a danger that I discussed with regard to government ownership of banks.)

Institutional Investor goes on to say that if the Fed loses it’s ability to fight inflation through raising interest rates when conditions demand it, investors around the world would lose faith in America’s central bank. They would flee U.S. Treasuries, which would cause interest rates to skyrocket, causing the dollar to crash. Hal Scott, a finance professor at Harvard Law School put forth a possible solution to this dilemma. Scott proposed putting troubled assets on the Treasury’s balance sheet, which would increase transparency and funding options (the Treasury could can seek borrowing authority from Congress without compromising the Fed’s ability to act independently in setting appropriate market interest rates.)

The Federal Reserve is a central bank, but a bank nonetheless. It could encounter the same problems that nearly sank some of the largest names in the American banking community. The Fed, by purchasing massive amounts of mortgage debt, and now U.S. Treasury bonds, is amassing huge liabilities that are sitting off the public balance sheet, just as banks did with derivative products. But just as funding mismatches and asset deterioration brought these liabilities back onto banks’ ledgers, so too would a desperate Federal Reserve’s obligations become the responsibility of the U.S. Treasury – and the taxpayer – if interest rate rise. So, just as the economy recovers a few years out (hopefully), the Federal Reserve may need to be bailed out, sending new shockwaves through global financial markets and plunging the world economies back to the brink of disaster.

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