Wednesday, September 21, 2011

"The Twist:" Ben Bernanke channels his inner Vincent Vega

I ain't saying it's right. But you're saying a the twist don't mean nothing, and I'm saying it does. Now look, I'm giving 400 billion bonds 400 billion  duration shifts, and they all mean something. We act like they don't, but they do, and that's what's so fucking cool about them. There's a sensuous thing going on where you don't talk about it, but you know it, the Christine Lagarde knows it, fucking BofA shareholders know it, and Rick Perry should have fucking better known better. I mean, that's the  fucking term structure, man. I can't be expected to have a sense of humor about that shit. You know what I'm saying? -Ben Bernanke in the todays Fed announcement.

Quite an action packed day today was. Today we got a large stock market move lower, down about 3%. This was driven by three news items.

First of all this morning existing home sales were released and the numbers were better than economists expected: 5.03 million vs. an expectation of 4.75 million. Most of the data out of the housing market has been pretty abysmal lately so the markets took this with a grain of salt.

The second most important thing to happen today was that Wells Fargo and Bank of America both had their ratings cut by Moodys to below AA. Though something along these lines was expected it was still a big deal. The reason that its a big deal is that BofA and Wells Fargo are two of the four largest banks in the country. With the other large banks they have been struggling to recover from the near death experience that the financial system underwent in 2008. Yes they have paid back their TARP funds and have more or less returned to profitability but there remains a huge overhang of sketchy real estate loans on their balance sheets. There has been a lot of speculation as to what these balance sheets are worth and generally the markets have their doubts which is why the financial sector has taken a beating all summer.

There are only two ways for the balance sheet problem to be fixed, one is for the assets in question (US residential real estate) to recover significantly enough to remove the cloud of doubt as to what the true value of the balance sheets are. Today's ray of sunshine notwithstanding the markets are not too optimistic about this scenario. The other is to earn their way out, that is, if they earn enough money so that they can fill whatever balance sheet hole there is with their profits then they'll be fine. The problem with the downgrade is that it will seriously impair their ability to make money.

Remember all a bank does is borrow money from savers and lend it to borrowers. What money they don't borrow from depositors they borrow from other institutions at what is usually called LIBOR (The London Interbank Offered Rate. Believe it or not this was invented by the Soviet Union when they refused to hold their Marshall Plan Aid in US banks and so deposited it in London and the London banks had to figure out a generic interest rate to pay the Russians. Thus the offshore interest rate for US dollars was born and has been called LIBOR ever since.) This is the rate at which banks generally lend to each other and the credit rating for LIBOR is generally assumed the credit rating is AA. Now BofA can't borrow at LIBOR any more, it has to pay more. So therefore in the interbank lending market BofA's costs of funds are higher. Interest costs are the most important factor in bank profitability so losing their AA rating instantly means that they'll be less profitable and therefore it will take them longer to close the balance sheet hole.

Interestingly one of the reasons that Moodys lowered the rating was that they felt that the US government is less likely to bail out a troubled financial institution than it was in 2008 because there is less risk of contagion. Since these banks were, formerly, considered too big to fail they're correspondingly riskier. This is interesting considering the high adventure going on in the European banking system right now. If there is a Eurozone sovereign default then there will almost instantly be a MAJOR European banking crisis. This crisis will spread far and wide at high speed. I actually think that Moodys is correct that government assistance will not be forthcoming but not because there is less systemic risk. There is a large and powerful faction within the Congress that was willing to let the US sovereign default. Do you think they're willing to let Bank of America default? Sure are you're born.

Of course the most important news of the day was the Federal Reserve Statement. The Federal Reserve announced, after a two day meeting, that they would move $400 billion of their Treasury portfolio from short dated securities to longer dated ones (an operation called “the twist”) and they would reinvest their maturing mortgage securities into new mortgage securities rather than Treasuries as they had been doing. They also said that the economic outlook was increasingly gloomy and that downside risks were increasing.

So what does this all mean? First the easy part, during the financial crisis when there was a massive collapse in the mortgage market the Federal reserve stepped in and began buying mortgage backed securities. This was a controversial move because the Fed usually government securities, it was a departure from standard practice for the Fed to intervene in the private sector borrowing markets. Since the crisis, as the securities that the Fed bought have matured the Fed has bought treasuries with the proceeds, slowly getting out of the private sector mortgage markets and returning to its natural habitat of US government securities.

Their announcement today means that, going forward, they're going to be reinvesting back into mortgages. This will lower mortgage rates generally, or at least dampen any increases. The Fed is probably hoping that this gives a bump to the real estate markets and thereby help the banks with problems they have with all the residential real estate on their books. The real estate markets are indeed in serious trouble so any little bit helps but I doubt that this will have a significant impact.

The main event of course was “The Twist.” The repositioning of the government securities on the Fed's balance sheet from near term to long term. The nominal objective is to lower long term rates without affecting short term rates very much. They'll succeed in this because $400 billion isn't that much in the very deep and very liquid short term US government securities markets, but its really big in the long term markets. Thus they can have a lot of impact on long rates by buying but not too much impact on near term rates by selling. Keep in mind that because the transactions will be offsetting this is not Quantitative Easing, so Rick Perry can leave his shotgun on the gun-rack in his F-150.

What's behind this? Well, basically for the past few years banks have had a free ride. The Fed has crushed near term rates to zero which, if you have a bank account of any kind, means that banks can borrow money from their depositors at near zero interest rates. They could then buy ten year Treasuries at 3% or so and make that a risk free 3% per year and this is what they have been doing. Sure there has been some loan growth but why lend money into the real economy if you can make this nice juicy 3% risk free? Well, sheriff Bernanke has come to town and is calling that game over. What he's trying to do is force longer term interest rates so low that the banks are forced to move up the risk curve and start lending more money into the real economy.

Will it work? That is a really tough question. There are a lot of really good reasons to have your capital close to the vest right now if the banks hold back and stay where they are on the risk curve all the Fed has done is reduce the profitability of the banking sector. You could look at today as a one two punch for the banking system, the downgrades lower increase their costs and lower long term interest rates lower their revenues. On the other hand if they are forced out on the risk curve and at lower rates that might be helpful for the real economy. This of course assumes that the reason that loan demand has been so low is that businesses think that long term rates, already the lowest in over a decade, are still too high. This is not likely. Far more likely is that economic conditions are very uncertain and taxes on investment are scheduled to almost double by 2014.

In any case the markets were not a fan. The S&P, which opened the day lower, dropped like a stone into the close closing down 3% on the day. I think this is for three reasons. One, I think that though most market analysts correctly called the Fed action many market participants thought that Bernanke might do something more aggressive. There are serious problems in Europe and the US data is getting pretty bad. Bernanke has been very innovative and I think the markets thought he might have something else up his sleeve perhaps even QE3. The fact that gold also dropped like a stone and the dollar rallied seems to indicate that the markets had baked a bit more loosening into the market cake. Alas, no joy. The second reason I think is that the Fed remarks were very grim. At the same time, the relatively limited action of the Fed this time despite that grim data, and the relatively high number of dissenters is a further indication that the tools the Fed has at its disposal are limited. Finally, I think that the speculative attack in Europe may have been on hold until the Fed made its announcement. Now that the Eurozone bond vigilantes know where Bernanke stands, they're free to renew their assault on Fortress Europa. It should be interesting.  

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