Thursday, June 18, 2009

End the Fed Now! or give it more Power

Letting the Fed have more power over regulating the banking industry is like letting foxes guard the henhouse. Please see Historical CPI since 1800 and Money Supply, CPI, and Real S&P to really understand what the Fed has done to our currency.

Credit is a drag on future production, especially when the underlying asset the credit purchased is not cash flow producing. Lets say you have a rental house. You bought it with 10% down for $100,000 and it was cash flowing with a cash on cash return of 10%. $10,000 down means you cash flow about $1,000 per year. Along comes the credit crisis and suddenly the house has dropped 30% leaving you upside down with negative 20% in equity. Houses down the street have gone into foreclosure for $70,000 and landlords are demanding a 15% cash return on the new underwriting standards of 25% down. Rents have fallen from $800 per month to $650 per month because these new land lords have bought at a lower basis and they can compete for better tenants at a lower rent. Suddenly you are losing $30 per month. This is a net drain on your purchasing power. You were making $80 per month for a net swing to the negative of $110. You can't go out and buy that electronic gizmo this month or have that nice meal. Multiply this across several million homes and much larger dollar amounts and you have a net drain of billions of dollars of consumption.

But the fun doesn't stop there. The best business decision is to try to get out of the property. But remember you are upside down to the tune of $20,000. That either has to come out of your pocket at closing, the bank has to allow you to short sell it and destroy your credit, or you default and walk away. Either the short sale or the default are very undesirable for banks. They are going to take a hit to capital of at least $20K since you had negative equity. Then add closing costs, any taxes and fees, attorneys, etc. and you're quickly to $30K. The bank is not happy because now their capital base has fallen by $30K on what was originally a $9,000 commitment since when the loan was made, the bank essentially electronically created a loan asset of $90,000 against $9,000 of capital and advanced that money at closing. This is fractional reserve lending at its finest.

ROI of -300% does not make the Bank CEO happy. Let's say the default rate rises, as it currently is, to 3% from a more typical 1-2%. Every loss costs the bank 2-300% of its original commitment. Suddenly the bank with $10 million in capital and $100 million in reserves has lost $9 million and the capital ratio has fallen to 1% of assets. Now this bank is effectively insolvent and must be shut down by the FDIC.

But wait! The FDIC has been busy shutting banks down and its Deposit Insurance Fund is nearly depleted since it did not price risk effectively. It can't shut down banks and return depositors money so it takes a loan out from the Treasury to replenish the fund.

But wait! The Treasury is running huge deficits financing a stimulus package designed to invest capital into institutions that they will force into bankruptcy later anyways and then forgive those loans while providing debtor in possession financing. So the Treasury calls the investment banks that are insolvent to find buyers of Treasury debt at the lowest possible interest rate. The investment bankers say they can't fill the supply at the rate that the Treasury wants because the Treasury is simply issuing too much debt. So the Treasury calls the Federal Reserve chairman and asks him to buy Treasury debt. The Federal Reserve chairman obliges because he thinks its the right thing to do to save the financial system. But the Fed has already purchased/repo'd $2 trillion in assets on $40 billion of capital which represents a 50:1 leverage ratio (Lehman and Bear Stearns failed with about 30:1). What are they going to do? They will simply "create" money to purchase the debt or monetize the debt. The newly printed treasury bond is purchased and put into the electronic ledger of the Federal Reserve balance sheet. Everything is fine now right?

Except now the bond market sees that the Fed is buying Treasuries and devaluing their holdings through monetization. These Treasuries are falling in value because the bond market is selling them to the highest bidder, which happens to be the Fed. Now the Fed is faced with a choice - save the Treasury or save the member banks whose CEOs are on the board of directors of the Fed. The member banks will be saved and the Treasury will be screwed.

This game goes on until the ponzi scheme can't be run any longer. The transfer of private debt to public debt is reaching escape velocity with the result being the eventual sovereign default of the country's treasury, whether it be through a hyperinflationary currency collapse or deflationary debt paydown and a secular shift towards less debt and control by bankers.

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