Issue 51 - March 25, 2009

The Correct Problem

The Federal Reserve this past week announced massive additions to their most successful mortgage program and took the unprecedented step of announcing that they would begin buying back previously issued US Treasuries. This was immediately met by the largest single day drop in interest rates since 1962. The US 10 year Treasury note moved from 2.95% to 2.52% in a matter of seconds.

Why would the Federal Reserve ever buy back bonds that had just been issued by the guys down the street at Treasury? At first blush it does appear to be a case of borrowing from Peter to pay Paul. But what the Federal Reserve is trying to accomplish by purchasing these particular bonds is two fold: to keep a lid on long term interest rates at a time of major issuance and drive the spread between long term rates and short term rates towards zero. In a flat yield curve where there is little difference between short and long rates, the only way for a bank to make a profit is to actually lend money to individuals and businesses. Alternatively, when the spread between short term and long term rates is substantial (in other words a steep yield curve) banks can make a fair profit simply by buying loans in the form of longer dated US Treasuries and Agency mortgages. They don’t need to make a loan to the private sector to make a profit. This exactly the problem the Federal Reserve is trying to address.

In response to the recessions and banking crisis of 1993, Federal Reserve Chairman, Alan Greenspan, lowered the Federal Funds Rate to a then unheard of low of 3.25%. In the wake of the Savings and Loan collapse, there was simply no more government capacity to deal with the weakening balance sheets of the major US Banks. These institutions were going to have to earn their way back into health and the Federal Reserve in essence lent them their balance sheet to do it. By borrowing funds at 3.25% and then investing in two year US Treasuries and short mortgages earning 4% – the banks made a small spread on huge volume and in a matter of months had substantially rebuilt their capital.

But the problem in 2009 is different. Lower rates would have been just as an effective antidote if higher rates had been at the heart of the problem. But they were not. The problem was a reckless expansion of debt on a global scale. And the treatment for an expansion is a contraction. We are likely to see continued deflation as certain markets like commercial real estate are just entering the refinancing cycle

The Need for Speed

Pundits greeted the news of the latest Federal Reserve actions with a chorus of inflation worries and investment strategies. But we can’t have it both ways. Are we in the midst of a global deflationary spiral which requires one type of treatment or are we are on the precipice of a US led inflationary bonfire which requires something quite the opposite? Clearly, the Federal Reserve is worried about the former and the magnitude of their actions speaks louder than words.

The global losses sustained through this episode are now reported to be in excess of $13 Trillion. Individuals have responded to this assault on their wealth by dramatically increasing their savings. Saving means not spending and not spending means that we have no shot at inflation. Furthermore, spending is only inflationary if the money is spent too quickly and we measure this speed by calculating its velocity. Currently, the velocity of money has fallen back to levels last seen in the early 1990s and is showing no sign of picking back up.

Once we see stabilization and recovery in velocity, it will be a fair exercise to begin the discussion of how to wean the system from the stimulus, but we are far from that point. To treat portfolios for an ailment that has not yet presented itself risks the possibility that we mishandle the risks currently present, namely deflation.

No Good Deed Goes Unpunished

The Federal Reserve and Treasury department have combined to make meaningful progress in the effort to stabilize and reflate the US economy. Specifically, The Federal Reserve and Treasury have offered programs which have provided liquidity and credit support to banks, primary dealers, money market funds, commercial paper issuers, mortgage lending, asset backed securities underwriting, and now an auction mechanism that will become the clearing house for the infamous toxic assets. These programs are all designed to promote credit and encourage private capital to return and partner with the government until such time as the markets can function efficiently on their own. We have already seen this working in real time as cash returned in droves to money market funds and in the commercial paper market where private issuers can now access funds at levels below the federally mandated rates.

However, private capital will not partner with anyone it does not trust. As we noted in our last newsletter, the bulk of consumer finance is achieved through the securitization process. The program targeted to this market; the TALF, was initiated this past week and unfortunately the subscriptions fell far below expectations. Citibank was able to execute its first ABS transaction since May of last year but a program which has $1 Trillion of capacity only managed to lend $4.7BB in total on opening day.

Hopes of attracting private investment capital into a partnership for these most illiquid securities depend upon the trust and good will of both parties. Private investors might well question how profits (if any) will ultimately be treated – would the terms be changed? Of more immediate concern however than investor’s after tax returns is the news that many financial institutions which took Federal money are now looking to quickly return it. The purpose of all of these programs and tax payer dollars was to recapitalize institutions and restore markets such that the system would regain functionality as quickly and efficiently as possible. A capital retrenchment would significantly slow the recovery.

We now have an extraordinary set of programs in place with a great deal of clarity and detail as to the mechanics. But programs unto themselves are no guarantee of an immediate return to liquidity and lending. We should see the most successful programs expand while others will be allowed to wind down. The healing process is well underway but it will require time, patience and trust.

• The Correct Problem
• The Need for Speed
• No Good Deed Goes Unpunished