Where is the
horror?
Magnus Ekervik
June 10, 2004
In recent weeks
I, as many other financial writers, have noticed the extreme
M3 expansion by the FED. The size of expansion is what would
follow after a catastrophic event that could threaten the financial
system like the WTC attacks or the failure of LTCM. What kind
of horror forces the FED to hyper inflate M3? I believe this
is the most important question at the moment.
Some writers
try to explain that the FED is hyper inflating to counteract
the underlying forces of global deflation. I agree that deflationary
forces are like a wet blanket over the global economy. However
we have had deflationary forces in the economy due to overinvestment/overcapacity
since at least 2000. I am not satisfied with such a general explanation
to this last month's sudden super growth in M3. I think there
is a more specific reason for the FED's action!
OK, what kind
of horror has got the FED spooked? They must know something since
they are acting before the event has become public. I think the
FED has told us about the horror they now expect/experience several
times the last two years. Here are some clues for you! Alan Greenspan
touched the issue in Feb 2002 and warned us again in Feb 2004.
William Poole president of the St Louis FED made a publicized
in depth analysis on the "problem" in May 2004.
I will soon
reveal what I think the FED is scared of. But first let's try
to see if we can figure out where all the money is going.
To get the
enormous amount of new M3 money into the banking system the FED
can buy almost any type of debt. Mortgage refinancing has been
in a sharp decline since the bond market took a dive in mid-March.
This money is not likely going to home refinancing.
Has the FED
been buying bonds to halt the rise in long term yields? With
approximately 45 billion dollar in M3 expansion each week the
last month this amount of money would certainly stop a rise in
bond yields at least temporary. But the yield on bonds has been
going up so I don't think they are intervening in the bond market.
Besides the FED is preparing Wall Street for higher short-term
rates so a rise in long-term rates would be normal.
Are US corporations
borrowing new money to increase production capacity thereby boosting
M3? Both new borrowing and investment in production has been
in steady decline in corporate America. So where is the money
going?
OK, here it
is!
I think the
FED directly or indirectly via US banks are liquefying the two
Government Sponsored Enterprises, Fannie Mae and Freddie Mac.
(together FF or GSE from now on).
What on earth would make me think this?
I think FF
is in big trouble and a meltdown of the entire US financial system
is at risk because of the enormous size of these companies. And
the strange/scary thing is Federal Reserve officially shares
my opinion!
I will give
you some scary highlights and personal comments on the article
"GSE's
Borrowing Short and Lending Long" published on http://www.stlouisfed.com/ and written by St Louis FED president
William Poole...
Mr Poole: "Some crises,
such as the one that brought down Enron, are well contained and
do not spread to other firms. Others, such as Long Term Capital
Management, have wider effects. There is no question but that
a crisis affecting either Fannie Mae or Freddie Mac would have
widespread effects because these firms are so large. I want to
emphasize that, on the basis of information I have, no crisis
is at hand in the market for GSE obligations."
ME comment: If there
is no crisis at hand why would FED Chairman Greenspan and St
Louis FED president Poole address this issue twice in the last
4 months. Why cry wolf if there is no wolf around? This could
scare the public and financial markets for no reason. It doesn't
make any sense to address this issue unless the FED is afraid
of getting the blame for a financial system meltdown that these
companies might trigger if faced with a crisis. I think they
are trying to shelter themselves from responsibility. Few other
companies in the US have benefited more from FED easy money policy
than FF. Should the FED be freed from responsibility? Not in
my opinion.
Mr Poole: "In my opinion,
GSE capital positions are undesirably thin and leave these firms
unnecessarily vulnerable to surprise shocks. There is no way
to predict what kind of shock might shake market confidence,
but the reason a shock could have serious adverse effects is
that FF pursue a strategy of borrowing short and lending long,
with a thin capital margin."
ME comment: The
shock Mr Poole is referring to is rising interest rates. Since
mid March the long-term bonds have had a big and swift unexpected
rise in yields. Was this a shock to FF?
Mr Poole: "The main point
about managing a crisis through this mechanism, with FF obtaining
credit from banks and the Federal Reserve providing loans to
the banks, is that the enormous scale of FF obligations would
strain the banking system. This mechanism might not suffice to
handle a major crisis as the banks would insist that FF post
collateral. In a crisis, the mortgage market would be severely
disrupted and mortgages and mortgage-backed securities would
no doubt trade at lower prices, thus impairing the value of the
collateral FF could post. The decline in the value of FF assets
would strain their capital positions, and lead to fears that
either or both Fannie Mae and Freddie Mac might become insolvent."
ME comment: Should a
crisis hit, FF would strain the banking system and might become
insolvent!
Mr Poole: "Under Section
13(3) of the Federal Reserve Act, Federal Reserve Banks have
the authority to discount paper for individuals, partnerships
or corporations. Direct lending to the GSEs would have to come
under provisions of this part of the Federal Reserve Act. Critical
provisions include a finding of unusual and exigent circumstances
and an affirmative vote of not less than five members of the
Board of Governors. The loans would have to be fully collateralised.
There has been no lending under this provision of the Federal
Reserve Act since the 1930s. Such lending, were it to be authorized
by the Board of Governors, would permit GSEs to redeem maturing
obligations and would, therefore, solve part of a crisis problem.
However, such loans might not restore liquidity to GSE debt before
redemption and would not per se restore normal functioning of
the mortgage market. Clearly, Federal Reserve support for the
GSEs would help to prevent a broadening crisis, but most likely
would be incapable of preventing some considerable disruption."
ME comment: The FED could
temporarily milder a crisis but a considerable disruption is
unavoidable.
Mr Poole: "Many financial
institutions seem not to understand the nature of the issues.
It is interesting that GSE obligations trade at much smaller
spreads over Treasuries at the short end of the maturity spectrum
than at the long end. Investors in short-term obligations apparently
believe that they are completely protected from credit risk because
they will have enough warning to permit them to exit these obligations
by letting them mature in a few months. The problem is that should
a crisis occur, it will take hold so quickly that GSE obligations
will in a matter of hours, or days, become illiquid. While any
one holder of GSE debt can exit, not all holders together can
exit at once. The economics of this market are similar to those
of banking markets. A scramble to convert all bank deposits into
cash cannot succeed in the aggregate because not enough cash
exists to effect the conversion. Similarly, a scramble to convert
GSE obligations into cash cannot succeed in the aggregate because
the underlying mortgage assets cannot be quickly converted to
cash."
ME comment: Wow this
is my favourite! Should a crisis occur, GSE debt would become
illiquid within hours or in best case a couple of days. Holding
any GSE debt?
Mr Poole: "I note also
that FF have a powerful incentive to grow. They report returns
on equity in the neighborhood of 30 percent per year. They are
able to achieve these returns by exploiting the implicit federal
guarantee of their obligations, which enables them to borrow
at near Treasury rates despite their thin capital positions and
invest in mortgages at private market rates. Their growth objectives
insure that their scale will increase over time, unless they
become subject to full private market incentives through convincing
federal policies that lead to market recognition that the federal
government will not guarantee GSE obligations in a crisis."
ME comment: Should a
severe crisis occur the FED will/can not bail out FF.
Conclusion:
If
the FED is repeatedly warning us about the possible financial
systemic risk of Fannie Mae and Freddie Mac I think it is wise
to be on full alert for a crisis in these companies. I think
they are experiencing a crisis already and the FED is pumping
billions of M3 to liquefy these companies. Remember that what
you have read above is the official version from the FED.
The official version is scary enough, who knows how they talk
about this issue behind closed doors.
I think a severe shock is about to hit the financial markets
in the form of a GSE collapse. A crash like this will throw the
US and world economies into recession so fast it will make your
head spin. Eventually these events will lead the global economies
into a new depression.
Jun 8, 2004
Magnus Ekervik
Email: me@lac-electronics.se
Copyright ©2004
Magnus Ekervik. All rights reserved.
Magnus Ekervik
offers independent research and analysis of macroeconomics to
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