Thursday, May 20, 2010

Review: Meltup

The National Inflation Association has produced a video called "Meltup" that proposes hyperinflation is about to hit America, if it hasn't already. It is making rounds among the economic blogs and has been very successful on YouTube with a third of a million hits within a week of release. The vast majority of viewers who rated it gave favorable ratings.

It uses a lot of fearmongering, half-truths, and misinterpretation of data to arrive at its conclusions. While watching it, I wondered if it is not a straight up advertisement for silver bullion.

Still, I gave it a thumbs up myself, because hyperinflation is a risk in a struggling economy, it does an okay job of explaining that risk, and casts hyperinflation in a bad light (unlike some numbskulls), and also concluded that hyperinflation does not have to happen and it can be stopped with better economic understanding and political activism.

Here is a link to the video.

The NIA website offers a list of charts which I've placed in "Links" to the right. Ironically, most of the graphs look more deflationary than inflationary. The main exception is the 17th graph down showing the St. Louis Adjusted Monetary Base that shows skyrocketing base money production since September 2008. Even this, however, must be weighed against the 37th and 38th graph showing bank reserves, which have always perfectly matched base money production and strongly suggest all newly created Fed money is doing nothing but sitting in bank reserves, and not inflating the general economy.

I believe deflation is the more likely scenario to play out than hyperinflation when government bailouts exhaust themselves. More of this argument will be discussed in upcoming posts. Since my investments are heavily skewed to a deflationary scenario, I've always paid particularly close attention to inflationary arguments. I've signed up for the NIAs mailing list, and if they keep their charts up to date I think it is a good general barometer of the state of prices, money supply, and the overall economy.

Wednesday, May 19, 2010

Fed Holds $1.25T in Mortgage Backed Securities

It is hard to say how many of what assets the Federal Reserve Bank has on its balance sheet, not without a full audit, but I'll post what information there is. MarketWatch is reporting the Fed has accumulated $1.25T in mortgage backed securities [1] through a program which ended last March. Today in an FOMC meeting they announced their hesitation to sell these securities[2], until the economy settles better.

I'd guess this hesitation lies with the fact these mortgage backed securities are toxic and have insubstantial market value, which putting them up for sale would reveal. It is my understanding these purchases are non-recourse, so whatever money is not paid pack on these securities amounts to a gift of free money to whoever gave them to the Fed. This is inflationary, to be sure, but deflationary forces are greater, and keeping asset prices down from their 2007 highs.

The $1.25T comes from a quantitative easing program announced in March 2009 and outlined in June 2009. It was announced then the Fed would buy $1.25T in agency MBS's, and by "agency" they mean the GSEs (Fannie Mae and Freddie Mac), and in addition another $200B in agency debt, and by "debt" I never encountered an adequate definition. Then there was a final $300B in Treasury Bonds the Fed would buy for a total of $1.75T.

Since the Fed hasn't been able to lower interest rates below 0%, which happened on December 16, 2008, quantitative easing is the next step in loose monetary policy. It is a temporary infusion of liquid cash, where the Fed prints money to buy bonds. Any bonds will do, usually it involves Treasury bonds, but in this case Mortgage Backed Securities were also used. The printed money returns to the Fed as the bond is paid off over years. Selling these bonds, as was considered this FOMC meeting, has the opposite effect of draining money out of the economy and back into the vaults of the Fed.

So long as the bond is fully paid off, there is no net infusion of cash over time, but if it isn't, then the Fed has essentially given away the cost of the bond to the seller of the bond. In this case it would be the GSEs so this is a roundabout way for the Fed to hand money to the government. Since GSEs support the banks, banks are the ultimate private beneficiaries in all of this.

As of March, it would appear quantitative easing efforts have ended and I've seen no new ones announced. If some in the Fed are even contemplating removing MBS's from its balance sheet, this might be viewed as a positive sign—amid the sea of pessimism that quantitative easing with mortgage backed securities conjures.

1. Fed won't sell mortgage holdings anytime soon.
2. Fed Majority in no rush to sell assets.

Thursday, May 6, 2010

A Bailout Economy

Following World War II, American manufacturing thrived while many industrialized nations rebuilt themselves in the wake of the war. A nascent technology industry formed and expanded, to be duplicated by the rest of the world, and sometimes improved upon, but what was there mostly originated in America. The technology boom drove new developments in art and culture. In the mid 90's, from local bulletin board services and usenet servers, the Internet would arise, and around it whole new business models formed.

These were all good times for investors in the American economy which enjoyed steady growth and few pitfalls. But most of the new ventures had no clear plan for revenue, and many of those that did still failed. A few thrived—like Google, Amazon, E*Trade, and Ebay—but most would struggle or collapse. Such would lead to the bust of the bubble where the NASDAQ fell from 5000 at the peak in 2001, down to under 2000 less than 2 years later. One might have expected a return to normalcy from the manic highs of the bubble. But that never happened.

The economy was never permitted a deflationary correction. In order to keep the excitement alive the Fed collapsed Interest rates from a general average of 5-10%, down to below 2%. But rather than keep the tech bubble rolling, the easy and cheap credit instead went into the housing market, creating a new bubble right on the heels of the last one. Money that was lost on the Internet could now be recovered as Americans flipped houses from 2003-7.

In a climate of marginal lending standards, in order to encourage the origination of loans, lenders would offer teaser rates, where the homeowner would only pay interest, or even negative amortize, so long as the teaser period lasted.

The first challenge to inflated real estate prices happened in 2007. At that time, subprime loans, which had the shortest teaser rate of 2 or 3 years, were beginning to reset in mass. Defaults began to skyrocket once the very low teaser payments came to an end, and mortgage backed securites built on subprime loans were running into severe problems even in the safer tranches, and came to be seen for the toxic waste they are. At the end of 2007, still early in the wave of subprime resets, credit markets based on private capital froze. The U.S. government and Federal Reserve Bank saw it as their place to intervene.

During this time, the stock market was in a bubble of its own, and similarly would collapse from its peak in the 14000's in Oct. 2007, down to the 6000s by March 2009, before recovering to 11000 today. In the more volatile areas house prices fell by a similar percentage, but generally they have remained down. Any recovery today in the housing market is a tepid one.

In late 2007, the Fed initiated multiple lending relief programs (or facilities) in order to replace losses of private capital. The Federal Funds Rate had recovered to 5% by 2006, but steadly fell to an all-time low of 0% by the end of 2008. For the first time ever, our nation was ZIRP'd. The executive branch pushed through Congress the $700B TARP bailout plan, and later a $787B state stimulus package. Many billions were spent to rescue Fannie Mae, Freddie Mac, and the insurance company AIG (who insured many billions worth of toxic securities for banks).

The scope of the bailouts is unknown, and cannot be determined without a full audit of the Fed. An attempt is underway in Congress, but faces stiff opposition from the banking industry and lobby efforts from the Fed itself.

What is known is that an economy that was once driven by manufacturing and production, and then was later driven by developments in technology and the Internet, and when those came to an end was driven by artificial bubbles in the housing and stock market, then after those crashed the driving force spearheading the economy today is bailouts (from either the U.S. government or the Federal Reserve Bank; this blog will regard the two as economically separate). Wherever one sees elements of recovery, one also sees excessive government spending. Where one sees rising asset prices, one must compare that with exceedingly low rates on bonds, and thus the low yield expectations on riskier assets. While asset prices have risen lately, and risen well in stocks, yields and dividends have been greatly deflationary. Stocks now face little competition from bonds, since the Fed is lending money at zero interest.

In the present bailout economy, this blog asks: how long can this course be sustained? How long can the government keep doing it before it runs out of money? While the Fed never has to run out of money, at the same time it can't give it away—it can only lend it. The U.S. government can give money away, but one day it is going to run out, and that day is when it can no longer sell Treasury Bonds.

This blog will examine the coming of that day.