What Are They Thinking?

The Fed’s announcement last week that it will purchase $300B on long-dated Treasuries over the next six months sent T-Bill prices soaring and yields plummeting as mortgage rates receded to near historic lows at 4.75%. However, mortgage rates were never the real problem as the housing bubble collapsed in a low interest rate environment. The Fed did not stop there as it expanded its mortgage-backed securities purchase program to the tune of $750B. In effect, Bernanke has decided that the printing press and devaluation of the dollar is the best course of action to combat the dreaded “deflationary” spiral. But this begs another question that the pundits have not really discussed. If there was robust foreign demand for American debt, the Fed would have no need to purchase treasuries. I'll get back to this in a moment.

Not to be outdone, our newly minted Treasury Secretary unveiled a massive bank bailout program on Monday that masquerades as a Public-Private partnership to purchase toxic assets from these "vital" institutions. Mr. Geithner decided that he would commit another $1T in taxpayer money to "unclog" the credit markets by purchasing so called "legacy" assets and troubled loans. I've included a brief summary of the plan below from Sunday's edition of the Washington Post:

"To deal with the troubled loans, the administration would combine resources from the FDIC and the Public Investment Corp. to create several investment funds that could ultimately buy $500 billion to $750 billion worth of loans.

Here's how the program could work: If a lender wants to dispose of about $10 million worth of residential mortgages, it would approach the FDIC, which would run an auction for interested private investors. If the winning bid ended up fetching an $8 million price tag, the FDIC would provide most of the financing and guarantee losses for as much as $6 million. The Treasury would contribute as much as 80 percent of the rest of the cost of the pool of loans. Private investors would contribute only the remaining amount, yet would be in charge of managing the portfolio of loans. Government officials said they would maintain strict oversight on who will run the funds and how the funds will be managed.

To deal with toxic securities, the government has developed two separate initiatives.

One would expand an existing Fed program, known as the Term Asset-Backed Securities Loan Facility, or TALF, that is aimed at reviving non-traditional lending markets. These markets, which some call the "shadow banking system," provide nearly half of all U.S. consumer loans. The program would be expanded to buy some residential and commercial mortgage-backed securities that have high credit ratings using money from the Public Investment Corp. Although details have not been worked out, the plan would require the Fed to offer loans to private investors for a much longer period than the central bank does under TALF, possibly as long as seven years, sources said.

The administration will also launch public-private investment funds to buy toxic assets that back mortgages and other troubled loans. In this case, the Treasury would provide financing that would match, dollar-for-dollar, money from private investors who participate. In addition, the department would provide a loan to increase the newly formed investment funds' purchasing power. "

http://www.washingtonpost.com/wp-dyn/content/article/2009/03/21/AR2009032102246_2.html

So when all is said and done, the private side of this supposed partnership is contributing well less than 10% of the total equity in the transaction with the loans received from the FDIC completely guaranteed against losses. It comes as no surprise that the government selected fund managers like Blackrock and Pimco are really excited about these prospects. They have virtually no risk of loss as it has been transferred to the taxpayer with all these loan guarantees. Financial shares rallied sharply on the news pushing the broader indices up over 6% on Monday. Could the bank share rally be attributable to the generous auction prices that they are sure to receive as a result of all these government guarantees? In other words, the government is employing leverage to artificially inflate these asset prices. Kind of ironic considering that this practice is what got us into this mess in the first place. Please click on the diagram below for a great example of how this program would work.

*Exhibit obtained from zero hedge.

As a result of these dollar killing actions, there is a growing chorus of countries openly questioning the dollar's status as the world's reserve currency. With China taking the lead as the most vocal critic of Washington's latest round of bailouts, its desire to diversify away from its dollar holdings is worth noting. This course of action has sealed the short term fate of the economy. Massive inflation will inhibit any potential rebound that economists have been anticipating for 2010. We have already seen the first signs of a potential commodity explosion as oil and wholesale gasoline prices jumped 10% on the weaker dollar in the past week alone. Gold continues to trade above $900/oz. In addition, the CPI rose .4% last month, resulting in an annualized inflation rate of nearly 5% despite the severe economic contraction.

The Bernanke Boys have not yet developed a mechanism to unwind and reduce the size of Fed's balance sheet when/if the economy does improve. The housing bubble was created by keeping interest rates too low for far too long. So how does creating the same environment that led to the bubble in the first place make any sense for combating the current crisis? The Fed has not been able to provide a logical response to this simple question because it has none.

The Fed’s actions continue to defy free market principles by artificially inflating asset prices while real wages continue to decline. Deflation is the market’s way of bringing prices back down to equilibrium levels. If the economy is not allowed to run its natural course, prices will continually rise while killing the standard of living for most Americans. This is exactly what has taken place over the past three decades with a perpetual growth policy that interferes with the normal market cycles. The government raised taxes on the American people this past week, but few even took notice. How unfortunate…..