Most Popular ArticlesIs the Fed's Zero Interest Rate Policy Driving Global Deflation?
Institutional Risk Analytics
Christopher Whalen
February 16, 2010
"The last duty of a central banker is to tell the public the truth." Alan Blinder Former Vice Chairman of the Federal Reserve System
One of the more intriguing aspects of the financial crisis has been the inability or refusal of the Federal Reserve Board to take aggressive policy steps to help the real economy and, in particular, break the asset deflation which is dragging down incomes and employment across the country - and the world. The same balance sheet deflation that is costing jobs in Detroit is also driving economic contraction in Shenzhen. While the Fed's staff in Washington and most other residents of the Capital City believe that asset deflation and the resulting financial crisis is nearing an end, we beg to differ. Adam Smith believed and most economists who work at the Fed today seemingly believe that deflation of balance sheets do not affect real wealth or economic activity. But when so much of a nation's apparent wealth and income is a function of credit and paper assets, that assumption seems suspect. The Fed also believes that maintaining the "flow" of credit through the financial sector is sufficient to avoid prolonged asset deflation and economic dislocation. Again, we differ. The corollary to the view that financial "flow" is what really matters to modern economies is that the use of low or zero interest rate policy (ZIRP) is sufficient to recapitalize banks and eventually restore the availability of credit to private borrowers. But again, the falloff in employment, trade, bank lending and other indicators of real economic activity around the world seems to refute these modern day assumptions made by US policy makers. While the largest Wall Street banks continue to enjoy subsidies c/o the Fed's policy of quantitative easing (QE), the real economy is contracting and, in some parts of the US, is dying altogether. Based on our daily observation of the banking, securitization and real estate sectors, what we see evolving is a situation where the underlying weakness in the real economy in the US is becoming more and more apparent, this even as the Fed's narrowly focused intervention in financial markets is being withdrawn. Looking at the preliminary results for the IRA Bank Stress Index for Q4 2009, we do not see any indication that the crisis affecting commercial banks is at an end. Loan loss rates among US banks continue to rise for the twelfth straight quarter in a row. Cash flows from bank loan and securities portfolios alike are still shrinking, forcing further contraction in balance sheets, loan portfolios, cash balances and new loan allocations for bank managers. This is what you call deflation. And keep in mind that these observations about credit losses apply both to on-balance sheet profiles of FDIC-insured banks and off-balance sheet (OBS) vehicles created by banks and GSEs. With the changes in accounting rules regarding OBS securitization vehicles made by the FASB at the start of the year, loss rates in general are going to rise even more at US banks, this as the GSEs and private insurers of mortgages and other assets attempt to mitigate losses from these OBS exposures. For example, if you examine the announced repurchase by Fannie Mae and Freddie Mac of some $200 billion in defaulted loans inside securitization vehicles, the accelerating pace implies a dramatic increase in losses for banks that have been active in mortgage securitizations. Whereas under the old accounting rules the GSEs could allow defaulted loans to sit inside the securitization vehicles for up to 24 months, now the situation is reversed. Each GSE as well as private insurers have a strong incentive to immediately take back these bad loans and then make claims against the financial institution which originated the underlying loan or other asset. Whether or not the MBS holding the defaulted loan is owned by the Fed, the GSE itself, or a private investor matters not. Indeed, the deflationary effect of the mounting backlog of defaulted mortgage loans is not effected at all by the Fed's policy of QE. Thus while the bond markets are starting to react to the immediate prospect of an end to Fed purchases of new MBS issuance from the GSEs, the more profound problem of rising credit losses for banks, the GSEs and even the Fed on existing collateral is ignored by policy makers. To date the entire focus of Fed policy efforts has been to temporarily spare the largest dealer banks from losses on securities and not helping the real economy. This fact is illustrated by the $2 trillion in Fed asset purchases to date. While Fed Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee claim that these MBS and Treasury purchases have helped to keep domestic mortgage interest rates low, there little indication that these operations are supporting actual credit availability for consumers and businesses at these yield levels. The only "winners" from QE are the financial institutions and foreign governments in Europe and Asia which forced the Fed to repurchase these assets at above-market prices. Looking at the loss data from the FDIC on bank balance sheets and the still non-existent flow of new lending and securitizations documented by various agencies, it appears that all the Fed accomplished with QE is to temporarily spare the major Sell Side dealers and foreign governments further negative marks on securities while bank lending is increasingly curtailed. In addition, the Fed's policy of maintaining another $1 trillion in bank reserves is neither helping the banks lend nor solving the embedded credit loss problem inside banks and OBS vehicles. Someone at the Fed thinks that paying banks 0.25% per year on bank reserves is helping the solvency of depository institutions, but we think that forcing bank reserves back into private assets would be more productive for banks and the global economy. Members of the banking industry with whom we speak know there is a problem lying in wait in the form of rising interest rates, but they are largely powerless to manage the massive duration risk created by the Fed's QE program. All of this happy news brings us back to ZIRP, GSE loan repurchase and the Fed's strategy to recapitalize banks via low interest rates and wide net interest margins (NIM) for banks. Net-interest margins in the banking industry were around 3.5% at the end of 2009, the highest quarterly average since 2005 and a level of NIM that implies no hedge. Remember this is an asset-weighted average and many banks are operating well below this level of NIM, while larger banks such as Well Fargo have NIMs above 4%. But it is no surprise that as the assets of the banking industry shrink and bank loan books run off due to redemptions and charge-offs, the gross yield from the banking industry's loan book is also falling. This is why the search for earning assets has become one of the most pressing priorities for the banking industry. Nor will it come as any surprise that with the Fed deliberately holding interest rates down, the yield on the investment side of the banking book is also falling. And remember that by purchasing $2 trillion worth of securities through QE, the Fed also has taken tens of billions of dollars per year of interest income from these assets out of private sector banks and transferred it to the Treasury. Which brings us finally to the accounting change by the FASB for off-balance sheet assets. Prior to the change, the GSEs were for years subsidizing MBS investors by trying to avoid the capital hit in buyouts. This meant that the GSE were paying interest on the notional principal amount of the bonds, not the true principal amount remaining net of defaulted loans. Now, however, with the FASB rule change the GSEs have an incentive to buy-back the bad loans and this results in prepayments to banks and other MBS investors, including the GSEs and the Fed. Prepayment speeds on some GSE collateral are running at 50% per year or higher. When banks receive these prepayments on higher coupon MBS, they are forced to reinvest the proceeds at the artificially lower interest rates engineered by the Fed. Remember that Bernanke & Co have decided that ZIRP is the road to economic recovery. And the best part is that since the Fed has done such a good job manipulating the MBS market, many of these securities are trading above par. Thus the prepayments will result in a capital loss for banks, other MBS investors, the GSEs and the Fed! Pretty cool, eh? So what would we do? One of the great acts of idiocy seen in recent days was the Fed, Treasury and the Obama Administration congratulating themselves for making money on TARP and QE while the real economy continues to shrink. Had our policy makers really understood the nature of the problem facing the US economy, namely huge credit losses still embedded inside banks and OBS securitization vehicles, they would have compelled banks to write-off their TARP capital by charging-off an equal amount of bad assets. And we may still need to revisit the issue of restructuring large banks later this year. Second, the Fed must discard the notion that holding large balances of bank reserves is helpful to the real economy. For those not familiar, $1 trillion in bank reserves deposited by private banks at the Fed represents almost 10% of the net assets of the US banking system. As with the market-maker role described above, the Fed should be actively discouraging banks from placing reserves with the central bank and instead encourage them to repurchase private MBS and other liquid assets. Third, we'd like to see President Barack Obama make restoration of the market for private securitizations a national priority. President Obama, Fed Chairman Ben Bernanke, Treasury Secretary Tim Geithner and FDIC Chairman Sheila Bair need to sit down at the same table and devise a plan to redefine the legal and financial template for bank securitizations. In concert with having the Fed making markets in MBS and reducing the level of bank reserves held at the central bank, a national accord regarding a new model for bank securitization is a necessary condition for the recovery of the US economy. Finally, the three points above obviously imply a gradual increase in interest rates. While such a policy move may result in a massive loss for the Fed on its securities portfolio, that is not an issue. As noted above, if the Fed does not soon allow interest rates to rise so that banks and other investors may earn a positive return on assets, the natural process of re-pricing of assets will soon wipe-out any subsidy from the Fed's ZIRP approach. In a fiat money system, ZIRP implies that paper assets have no value. If the Fed wants to break the deflationary cycle that now threatens the global economy and truly restore investor confidence, then it is time to let interest rates start to rise. Questions? Comments? info@institutionalriskanalytics.com About IRA Products and Services
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