The Trillion Dollar Wash and Rinse

The Housing Bubble party is over.

The bankers and brokers have collected their fees and exercised their stock options, collecting personal fortunes and gone to more favorable climes.

The households in the US are looking with dismay at their shattered balance sheets and rapidly depleting 'savings.' So who is going to clean up this mess, and pick up the tab for the collateral damage?

Surely you must suspect the truth. It will be all holders of the US dollar.


Mortgage market needs $1 trillion, FBR estimates
Without that, prices of securities will fall, raising interest rates on home loans
By Alistair Barr, MarketWatch
Last update: 3:24 p.m. EST March 7, 2008

SAN FRANCISCO (MarketWatch) - Why are interest rates on 30-year fixed-rate mortgages rising even as the Federal Reserve slashes interest rates and yields on Treasury bonds fall?

The answer is that the mortgage market is short of roughly $1 trillion in capital, according to Paul Miller, an analyst at Friedman, Billings, Ramsey.

The modern mortgage market works with lots of leverage, or borrowed money. Investors, including hedge funds and mortgage real estate investment trusts, buy mortgage securities, but finance a lot of their purchases with this leverage.

FBR's Miller estimates that $11 trillion of outstanding U.S. mortgage debt is supported with roughly $587 billion of equity. That's a leverage ratio of 19 to one.

But last year's subprime meltdown has undermined confidence inthe home loans that back these mortgage securities. Now the banks that finance most of these leveraged mortgage investments have started to pull back and impose margin calls, demanding more cash or collateral to back their loans.

This has sparked a de-leveraging cycle in which some highly leveraged mortgage investors have to sell assets to meet margin calls. Forced selling pushes prices lower, sparking more margin calls, which in turn produces more selling and even lower prices. (Especially when you are unwinding an obvious Ponzi scheme - Jesse).

When debt prices fall, yields rise, and that's what's happening to mortgage securities - even those backed by government sponsored entities including Fannie Mae (FNM Fannie MaeFNM) which are considered the safest. (The safest? Compared to a hand written IOU maybe - Jesse)

"The immediate impact is that [interest rates on] 30-year fixed-rate mortgages will have to increase relative to Treasuries," FBR's Miller wrote in a note to clients on Friday. "That is why we are experiencing pressure on mortgage rates despite the downward movement on the 10-year bonds."

Rates on 30-year fixed mortgages usually follow the movement of 10-year Treasury bonds, but this relationship has broken down as de-leveraging in the financial system takes hold.

The difference, or spread, between yields on "agency" mortgage securities backed by Fannie and Freddie and those on Treasuries rose to a 23-year high this week, Miller noted.

"It is the leverage game playing havoc with the system," he wrote. There are two ways to resolve the problem. Either inject $1 trillion of new capital into the mortgage market, or allow prices of mortgage securities to fall (and interest rates on home loans to climb), Miller said. The mortgage market won't be able to raise $1 trillion, so prices have to fall, he warned.

"There is no quick fix here," the analyst said. "It will take about six to 12 months for the pricing pressure to alleviate on these mortgage assets."

"This will be painful, but it must be allowed to play out in an orderly fashion in order for the mortgage market to achieve equilibrium," Miller concluded.

Alistair Barr is a reporter for MarketWatch in San Francisco.

Is the Fed Monetizing Bad Debt?

There is a funny situation going on with the Fed this morning.

As you know the Fed conducts two types of open market operations, permanent and temporary, through their NY office. This is how they manage their monetary policy.

There is a third type of hybrid repo recently created called the Treasury Auction Facility (TAF). Its similar to the Temporary Open Market Operation except its opaque and the terms are lengthier, and the types of collateral they accept appear to be looser than the Treasuries and agencies which are customary. Its a kinder, gentler, more discreet Discount Window. They kicked the amount up to 100+ Billion this morning. We like to think of it as "free money (below the inflation rate) for the banks" in return for shakey collateral.

Here's what we find confusing. The Fed has not conducted a 'Permanent Open Market Operation" since May 2, 2007. That's right, almost a year ago. At least, that is, before this morning when they conducted a 10 billion dollar permanent operation.

NY Federal Reserve Permanent Open Market Operations

What surprised us was that this is not an ADD, which is a purchase on their part and an addition to the money supply, but a sale of Treasuries to the banks by the Fed out of their own account in return for 'cash' which is considered a DRAIN.

Huh? The big tickle has been the liquidity crunch, so the Fed does a DRAIN?

Here's our take. The Fed has been taking all sorts of collateral from the banks at the TAF window. The banks are going to have to mark this debt to market at some point. We don't know how the Fed is actually valuing it for their repo purchases, since it has no liquid market.

In turn, the banks have plenty of short term liquidity. but they need to recapitalize and use that to build their cash flows with a 'multipler effect' which is tough to do with short term monies. The multiplier of a permanent add is 9x based on a 10% reserve requirement.

So the Fed, having just lent the banks 'cash for whatever' turns around and sells US Treasuries to the banks in return for the amount of 10 Billion which the Fed has recently lent to them short term with God knows what for collateral. How was that collateral valued? Who takes the loss?

See the gimmick? The Fed is letting the banks borrow short from the TAF on questionable collateral and get some nice solid long term Treasuries that can be loaned to the Public at 9x the amount or 90 billion. Looks better on the books, gives them some breathing room, and is nice and quiet.

If that was too complex an explanation, we'll offer the one from our friend Sean in Zurich:

They [the Fed] said they were going to neutralize the new TAF/term RP stuff... so banks end up funding their dodgy mtges with Tim at NYFRB and holding bills to compensate.

And there you have it. Selectively placed helicopter money. Our only curiousity is what exactly the Banks will be showing on their books when they start honoring FASB 157 and start marking to market. Are we going to be going through this at the end of each fiscal quarter for the forseeable future with the Fed playing Mr. Market?

Statement Regarding Sale of Treasury Bills from System Open Market Account

March 7, 2008

On Friday, March 7, 2008, the Federal Reserve’s System Open Market Account will sell $10 billion of Treasury bill holdings for settlement on Monday, March 10. This action is being conducted by the Federal Reserve Open Market Trading Desk (the “Desk”) in conjunction with the series of term RP transactions announced earlier today in order to maintain a level of reserves consistent with trading at rates around the operating objective for the overnight federal funds rate.

The Desk will continue to evaluate the need for the use of other tools to add flexibility to its open market operations. These may include further Treasury bill sales, reverse repurchase agreements, Treasury bill redemptions and changes in the sizes of conventional RP transactions.

The Potemkin Economy Just Fell Over

Let there be no mistake, no further debate. With two months of back to back Jobs Report declines the discussion on the US economy must shift from "full recession or mild slowdown" to "how long a recession and how bad."

The internals of the numbers were actually worse than we expected, and worse than the headline number.

We often thought that this would be an interesting economic experiment, with the Fed chairmen, first Greenspan and then Bernanke, getting the chance to replay the onset of the Kondratieff Winter and an economic depression. This time they were allowed to pour the money on in significant amounts, in the absence of that barbaric Gold Standard and honest mainstream economic scrutiny, to try and turn the winter into spring.

Well now we know. It's not working. It raised up a Potemkin economy that looked pretty on the surface from 2003 to 2006, but in reality was as thin as ..... paper.

We're chuckling to ourselves this morning as stocks rally from their lows, ignoring the economic news presumably, perhaps using the increased largesse of the Fed and their Treasury Auction Facility (aka Selective Helicopter Money). But we like to think of it as a fresh coat of paint on the Potemkin facade, to make people doubt their own eyes, and ears, and reason. The first principle of the Big Lie is to never tell the truth, never admit a mistake, while you can shield the people from the consequences of your deceptions.

But the charade can only continue for so long. As von Mises observed:

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved... The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment."

February 2008 Non-Farm Payrolls Report

We are not going to try to forecast tomorrow's Non-Farm Payrolls Report. The work we have done so far with this report has made us believe that it is written in sand, and equally subject to change, and more adjusted in opaque ways than most numbers from official sources.

The consensus of economists is a net addition of 25,000 jobs, against a prior decline of 17,000 jobs in January. We fully expect January to be revised, and probably December as well. It will not surprise us to see this number come in revised to positive, with a potentially lowball number for February. Why? Because that is how the Bureau of Labor Statistics has been rolling their adjustments lately. They give us the 'bad news' but then show its unreliable, and probably not so bad.

We would like to show three graphs in anticipation of this report.

The first compares the seasonal adjustment with the actual numbers. As you can see February is a quite large downward adjustment, although not quite as large as the upward adjustment in January. There is obviously substantial room to play with adjustment in both months, especially when the adjustment method keeps changing and is 'proprietary.' The swings in the non-adjusted number are enormous this time of year, making the 25,000 net adds in the seasonally adjusted headline number almost a statistical rounding error. But Wall Street will react.

The second graph shows what we have been calling the Imaginary Jobs Component, more familiarly known as the BLS Birth-Death Model of small companies that are incognito. The net add in February should be about 100,000 jobs based just on prior history as we have shown here. We have heard that BLS will be issuing some major revisions in their methods, but cannot recall if its in this month or some coming month. This number is added PRE-adjustment, so its tossed in the wash in many months, and is not so big a deal as many have come to believe.

No matter how the number comes out tomorrow, highball or lowball, with a prior month twist, or a total restatement of everything back a couple of years (yes they do that too often we might add), we would like to emphasize that no matter what the stock market does in reaction to the headline numbers, there really is only one type of chart worth looking at for these types of volatile numbers: the moving average trend chart.

We have included the chart below to show how clear the the trend has been. The peak of Jobs Growth occurred in early 2006, and has been in a slow but steady decline since then. During the entire 'recovery' that the stock market was discounting we kept asking, "But where are the Jobs?" Well, they really were not there after the first few bubble years after 9/11 during what we like to call "The Great Reflation." Mask the unemployment as they might by dropping people from the counts as their unemployment runs out, the fact is that we entered a recession at the end of 2007 at the latest, and probably earlier than that if we could obtain a realistic Inflation number with which to deflate our bloated nominal GDP.

Don't be shocked if we do get a positive number tomorrow. Its well within probability given the revisions, and the history of Administrations messing with the numbers going back to LBJ at least. And don't be shocked if the Financial Talking Heads say "What Recession?!!".... or not. The number is capable of coming out any which way, and will be revised next month regardless. We're in the silliest of seasons here, as the proverbial piper comes to be paid, and the entire financial and political structure in the United States seems badly in need of adult supervision.