15 April 2009

This Is Your Economy on Credit Crack - and Heading for a Crack-Up

Here is a clear and simple explanation of why we may have already passed the point at which the Fed and Treasury will have no choice but to substantially devalue the bonds and reissue a 'new US dollar' as part of a managed default on our sovereign debt.

Ben's Un-shrinkable Balance Sheet
Delta Global Advisors
April 14, 2009

As he stated again clearly today, the Chairman of the Federal Reserve has deluded himself into thinking that when the time comes, he will be able to shrink the size of the Fed's balance sheet and reduce the monetary base with both ease and impunity. He also has deluded himself into thinking inflation will be easily contained.

It is very important that he does not fool you as well.

The Fed believes low interest rates should not be the result of a high savings rate, but instead can exist by decree, a conviction which has directly led consumers to believe their spending can outstrip disposable income.

The result of such thinking has been a rise in household debt from 47% of GDP in 1980 to 97% of total output in Q4 2008. As a result of this ever increasing burden, the Fed has been forced into a series of lower lows and lower highs on its benchmark lending rate. Keeping rates low is an attempt to make debt service levels manageable and keep the consumer afloat. Problem is, this endless pursuit of unnaturally low rates has so altered the Fed's balance sheet that Mr. Bernanke will be hard-pressed to substantially raise rates to combat inflation once consumer and wholesale prices begin to significantly increase.

Banana Ben Bernanke has grown the monetary base from just $842 billion in August 2008 to a record high of $1,723 billion as of April 2009. But it's not only the size of the balance sheet that is so daunting; it's the makeup that's becoming truly scary.

Historically speaking, the composition of the Fed's balance sheet has been mostly Treasuries. And the Federal Open Market Committee would typically raise rates by selling Treasuries from its balance sheet into the market to soak up excess liquidity. However, because of the Fed's decision to purchase up to $1 trillion in Mortgage Backed Securities (and other unorthodox holdings), it will not be selling highly-liquid US debt to drain reserves from banks. Rather, it will be unwinding highly distressed MBS and packaged loans to AIG. Not to mention the fact the Fed would have to break its promise of being a "hold-to-maturity investor" of such assets.

Moreover, not only are the new assets on the Fed's balance sheet less liquid but the durations of the loans are being extended. According to Bloomberg, the Fed is contemplating extending TALF loans to buy mortgaged backed securities to five years from three after pressure it received from lobbyists and a failed second monthly round of auctions. That means when it finally decides it's time to fight inflation, the Fed will find it much more difficult to reverse course.

But because of the extraordinary and unprecedented (some would say illegal) measures Mr. Bernanke has implemented, only $505 billion of the $2 trillion balance sheet is composed of U.S. Treasury debt. Today, most Fed assets are derived from the alphabet soup of lending programs including $250 billion in commercial paper, $312 billion of Central Bank liquidity swaps and $236 billion in mortgage-backed securities.

Thus, our economy has become more addicted than ever to low interest rates. But because bank assets will now be collecting income at record low rates, when and if the Fed tries to raise rates it will only be able to do so on the margin. If Bernanke raises rates substantially to fight inflation, banks will be paying out more on deposits than they collect on their income streams. Couple that with their already distressed balances sheets and look out!

Additionally, not only do the consumers need low rates to keep their Financial Obligation Ratio low, but the Federal government also needs low rates to ensure interest rates on the skyrocketing national debt can be serviced. Our projected $1.8 trillion annual deficit stems from the belief that the government must expand its balance sheet as the consumer begins to deleverage. In fact, both the consumer and government need to deleverage for total debt relief to occur, else we're just shuffling debts around and avoiding a healthy deleveraging entirely.

In order to have viable and sustainable growth total debt levels must decrease, savings must increase and interest rates must rise. But that would require an extended period of negative GDP growth-a completely untenable position for politicians of all stripes. Ben Bernanke would like you to believe inflation will be quiescent and he can vanquish it if it ever becomes a problem. Just make sure you don't invest as though you believe him.