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A Repo Implosion

by MIKE WHITNEY

President Barack Obama is determined to prevail in his battle with GOP congressional leaders on the debt ceiling issue, but not for the reasons stated in the media.  Obama is less concerned with the prospect of higher interest rates and frustrated bondholders than he is with the big Wall Street banks who would be thrust back into crisis if there is no resolution before October 17.  Absent a debt ceiling deal, the repurchase market–known as repo–would undergo another deep-freeze as it did in 2008 when Lehman Brothers defaulted triggering a run on the Reserve Primary Fundrepurchase market which had been exposed to Lehman’s short-term debt. The frenzied selloff sparked a widespread panic across global financial markets pushing the system to the brink of collapse and forcing the Federal Reserve to backstop regulated and unregulated financial institutions with more than $11 trillion in loans and other obligations. The same tragedy will play out again, if congress fails lift the ceiling and reinforce the present value of US debt.

Repo is at the heart of the shadow banking system, that opaque off-balance sheet underworld where maturity transformation and other risky banking activities take place beyond the watchful eye of government regulators.  It is where banks exchange collateralized securities for short-term loans from investors, mainly large financial institutions. The banks use these loans to fund their other investments boosting their leverage many times over to maximize their profits. The so called congressional reforms, like Dodd Frank, which were ratified after the crisis, have done nothing to change the  basic structure of the market or to reign in excessive risk-taking by undercapitalized speculators. The system is as wobbly and crisis-prone ever, as the debt ceiling fiasco suggests. The situation speaks to the impressive power of the bank cartel and their army of lawyers and lobbyists. They own Capital Hill, the White House, and most of the judges in the country.  The system remains the same, because that’s the way the like it.

US Treasuries provide the bulk of collateral the banks use in acquiring their short-term funding. If the US defaults on its debt, the value that collateral would fall precipitously leaving much of the banking system either underwater or dangerously undercapitalized. The wholesale funding market would grind to a halt, and interbank lending would slow to a crawl. The financial system would suffer its second major heart attack in less than a decade. This is from American Banker:

As banking policy analyst Karen Shaw Petrou describes it, Treasury obligations are the “water” in the financial system’s plumbing.

“They’re the global reserve currency and they are perceived to be the most secure thing you can own,” said Petrou, managing partner of Federal Financial Analytics. “That is why it is pledged as collateral. … The very biggest banks fear that a debt ceiling breach breaks the pipes.”….

Rob Toomey, managing director and associate general counsel at the Securities Industry and Financial Markets Association, said institutions are concerned about whether Treasury bonds that default are no longer transferable between market participants.

“Essentially, whatever the size is of the obligation that Treasury is unable to pay, that kind of liquidity would just disappear from the market for whatever time the payment is not made,” Toomey said.”

By some estimates, the amount of liquidity that would be drained from the system immediately following a default would be roughly $600 billion, enough to require emergency action by either the Fed or the US Treasury. Despite post-crisis legislation that forbids future bailouts, the government would surely ride to rescue committing taxpayer revenues once again to save Wall Street.

Keep in mind, the US government does not have to default on its debt to trigger a panic in the credit markets.  Changing expectations can easily produce the same result. If the holders of US Treasuries (USTs) begin to doubt that the debt ceiling issue will  be resolved, then they’ll sell their bonds prematurely to avoid greater losses.  That, in turn, will push up interest rates which will strangle the recovery, slow growth, and throw a wrench in the repo market credit engine. We saw an example of how this works in late May when the Fed announced its  decision to scale-back its asset purchase. The fact that the Fed continued to buy the same amount of USTs and mortgage-backed securities (MBS) didn’t stem the selloff. Long-term rates went up anyway. Why? Because expectations changed and the market reset prices. That same phenom could happen now, in fact, it is happening now. The Financial Times reported on Wednesday that “Fidelity Investments, the largest manager of money market funds…  had sold all of its holdings of US Treasury bills due to mature towards the end of October as a “precautionary measure.”

This is what happens when people start to doubt that US Treasuries will be liquid cash equivalents in the future. They ditch them. And when they ditch them, rates go up and the economy slips into low gear.  (Note: “China and Japan together hold more than $2.4 trillion in U.S. Treasuries” Bloomberg)

Now the media has been trying to soft-peddle the implications of the debt ceiling standoff by saying, “No one thinks that holders of USTs won’t get repaid.”

While this is true, it’s also irrelevant. The reason that USTs are the gold standard of financial assets, is because they are considered risk-free and liquid. That’s it. If you have to wait to get your money, then the asset you purchased is not completely liquid, right?

And if there is some doubt, however small, that you will not be repaid in full, then the asset is not really risk free, right?

This is what the Fidelity flap is all about. It’s about the erosion of confidence in US debt. It’s about that sliver of doubt that has entered the minds of investors and changed their behavior. This is a significant development because it means that people in positions of power are now questioning the stewardship of the present system. And  that trend is going to intensify when the Fed begins to reduce its asset purchases later in the year, because winding down QE will precipitate  more capital flight, more currency volatility and more emerging market runaway inflation. That’s going to lead to more chin scratching, more grousing and more resistance to US stewardship of the system. None of this bodes well for Washington’s imperial aspirations or for the world’s reserve currency, both of which appear to be living on borrowed time.

The media has done a poor job of explaining what’s really at stake. While, it’s true that higher interest rates would make consumer loans more expensive and put the kibosh on the housing recovery, that’s not what the media cares about. Not really. What they care about is the looming massacre in shadow banking where USTs are used as collateral to secure short-term loans by the banks so they can increase their leverage by many orders of magnitude. In other words, the banks are using USTs to borrow gobs of money from money markets and financial institutions so they can finance their other dodgy investments, derivatives contracts and ancillary casino-type operations. If there’s a default, the banks will have to come up with more capital for their scams that are leveraged at 40 or 50 to 1. This systemwide margin call would trigger a deflationary spiral that would domino through the entire system unless the Fed stepped in and, once again,  provided a giant backstop in the form of blank check support.   Here’s how Tim Fernholz sums it up over at Daily Finance:

“…Many informed people are worried” (about) “A freeze in the tri-party repo market, akin to the cascade of troubles that followed the Lehman Brothers bankruptcy in 2008.”….

In 2008, more than a third of that collateral was mortgage-backed securities. When Lehman went bankrupt, its lenders began a “fire sale” of the securities it used as collateral, which drove down the value of other mortgage-backed securities, which led to more fire sales. This dynamic would eventually lead to a freeze in the repo markets, which, at the time, provided $2.6 trillion in funding to the banks each day…..

Today, most of the collateral in use is U.S. Treasuries and “agency securities” — mortgage-backed securities guaranteed by the U.S. government:

… if the ugly day of a default comes, lenders may simply stop accepting U.S. debt as collateral. That will have the effect of sucking some $600 billion in liquidity out of the banking system. Unable to get funding for Treasurys, securities dealers would be pressured to sell them-or other assets-to find new funding, creating a fire sale dynamic…..

And, of course, this scenario is only about how the Treasurys work in the repo markets. U.S. debt is used as collateral for derivatives swaps and numerous other transactions; if they are suddenly worth less than expected, lenders can be expected to demand more collateral up front, putting even more pressure on the financial system. That’s why pressure is building to raise the ceiling before the world’s largest economy enters a scenario with so much uncertainty.”

Repeat: “That’s why pressure is building to raise the ceiling before the world’s largest economy enters a scenario with so much uncertainty”.

So the Obama team isn’t worried that Joe Homeowner won’t be able to refi his mortgage or that the economy might slip back into recession. They just don’t want to see Wall Street take it in the shorts again. That’s what this is all about, the banks. Because the banks are still up-to-their-eyeballs in red ink.  Because they still don’t have enough capital to stay solvent if the wind shifts. Because all the Dodd Frank reforms are pure, unalloyed  bullsh** that haven’t fixed a bloody thing. Because the risks of another panic are as great as ever because the system is the same teetering, unregulated cesspit it was before. Because the banks are still financing their sketchy Ponzi operations with OPM (other people’s money), only now, the Fed’s over-bloated balance sheet  is being used to prop up this broken, crooked system instead of the trillions of dollars that was extracted from credulous investors on subprime mortgages, liars loans and other, equally-fraudulent debt instruments.

Can you see that?

This is why the media is pushing so hard to end the debt ceiling standoff; to preserve this mountainous stinkpile of larceny, greed and corruption run by a criminal bank Mafia and their political lackeys on Capital Hill. That’s what this is all about.

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The President’s Legal Authority at the Debt Limit

By Andrew Kloster

Some time between the middle and the end of October, the federal government will reach a hard limit on the amount of debt it can issue, and its ability to finance governmental operations will be affected. Confusion about the debt limit abounds, and this Issue Brief will address some common questions.

What Is the Debt Limit?

The United States debt limit, or debt ceiling, is the statutorily defined amount of debt the U.S. Treasury can issue, either by borrowing from the public or issuing an intragovernmental receipt to special accounts, such as the Social Security or Medicare trust funds.[1]

The Treasury Department has to have liquidity, or cash on hand, to disburse the funds necessary to meet its contractual obligations. The federal government maintains this liquidity by managing governmental receipts (such as income tax payments) and selling debt (such as Treasury bonds).

Will a Government Shutdown Occur If the Debt Limit Is Not Raised?

The debt limit is often confused with the expiration of appropriations bills. Reaching the debt limit is distinct from a government shutdown. A government shutdown occurs when appropriations authorization expires: Unless there is a law saying that money may be spent on a project, money may not be spent on that project.[2] A debate over an appropriations bill is a debate over whether to fund a specific government function. When the government shutdown began, only certain statutorily defined “essential” government functions have continued to operate.[3]

The debate over the debt limit, however, is a debate over how to finance governmental operations—reaching the debt limit would not force a government shutdown. Currently, the debt limit is $16.699 trillion.[4] The federal government reached this limit on May 19, 2013, and Treasury has since used statutorily allowed “extraordinary measures” to avoid issuing additional debt and still have the cash on hand to finance day-to-day operations. When the Treasury exhausts these extraordinary measures, the federal government will continue operating. However, the President might decide that federal employees, for example, will not necessarily be issued checks available to cash immediately.

Even without the ability to issue additional debt, the government will continue to accrue legal obligations; it will simply not be able to immediately liquidate (pay cash for) those obligations.[5]

What Happens to the U.S. Debt If We Reach the Debt Limit?

It is impossible to tell what would happen if the debt limit is not raised.[6] If Congress and the President are unable to reach an agreement on raising the debt ceiling, markets and credit rating agencies might interpret this negatively as unwillingness of the U.S. government to honor its obligation. If the President chooses to default on all obligations rather than a few (discussed below), this could exacerbate the problem. Market perception of U.S. sovereign debt directly affects bond yields (interest rate paid) on U.S. debt, so decisions the President makes can actually save or cost the government money in the long term.

The Prompt Payment Act[7] provides that the “temporary unavailability of funds to make a timely payment” does not excuse delayed payment and that the government is responsible for paying interest charges on such delayed payments. Over time, these interest penalties capitalize, so the federal government ends up paying compound interest. Depending on how the President manages payments, statutory interest payments may be greater or smaller.

What Would the President Prioritize?

While there have been proposals to cabin the authority of the executive to prioritize payments,[8] as it stands there is no statute governing how to manage government finances past the debt limit. Since governmental obligations would exceed receipts, exceeding the debt limit logically implies that at least some obligations would be delayed. These obligations would thus, by definition, be in default. There is no general “governmental default” past the debt limit; default would occur with respect to specific obligations that the President chooses not to prioritize.

There are constitutional backstops on the President’s otherwise plenary authority to prioritize payments.[9] Of these, the most important is that the President may not prioritize payment in violation of the Due Process Clause of the Fifteenth Amendment. He may not, for example, choose to pay the salaries of federal employees of one race before paying the salaries of federal employees of another race. Subject to this limitation, the President’s prioritization choices are essentially unbounded.

The President could, of course, play a game of political brinksmanship and fail to pay any obligations until the debt ceiling is raised. He could argue that all obligations are on an equal footing and that prioritizing payments violates some principle of fairness. Former Treasury Secretary Timothy Geithner made statements about the political unworkability of prioritization in the past,[10] but to date, Treasury has not disavowed its legal authority in this area. Failing to prioritize debt obligations would have far-reaching consequences, however, including potentially increasing the cost of servicing the debt long after the debt limit crisis ends.

Further, to the extent that this situation would involve having cash on hand and failing to pay some receipts, this option implicates the Congressional Budget and Impoundment Act of 1974, which prevents the President from deferring any “budget authority.” This phrase is defined to include “borrowing authority, which means authority granted to a federal entity to borrow and obligate and expend the borrowed funds.”[11] Holding cash until such time that the Treasury can meet all of its payments necessarily includes deferring expenditures of borrowed funds until such time as the debt ceiling is raised, which would implicate these statutory limitations.[12]

The President could also choose to continue payments for “essential” services analogous to those defined in the appropriations context.[13] There is no statutory requirement for this decision, but the idea that there are “core” functions of the federal government that ought to remain liquid is easily understandable. Meeting debt obligations and paying military personnel might be prioritized at the expense of other obligations, such as issuing certain grants and loans to private-sector firms and to state and local governments, for example. So-called mandatory spending, such as Social Security payments, do continue during a government shutdown, but they need not be prioritized at the debt limit.[14]

The President could also pick and choose among programs he likes and those he does not like. He might direct Treasury to pay Department of Defense employees before Department of Education employees, or vice versa. Whatever decision he makes would be essentially unchallengable in court.

Ultimately, however the President chooses to manage payments, delays will accumulate and worsen until either spending is cut or the debt ceiling is raised.

Broad Authority

In brief, the President has broad authority to manage government payments to avoid defaulting on federal obligations. He can choose which payments to make and in which order, and these choices will impact the effects on the average U.S. taxpayer and the economy.

—Andrew Kloster is a Legal Fellow in the Edwin Meese III Center for Legal and Judicial Studies at The Heritage Foundation.

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Fed Up: Bernanke Declares War On The Poor

September 14, 2012

This week, we saw both the European Central Bank and the Federal Reserve deliver massive amounts of stimulus to the markets.

The ECB is now backed by the 500 billion euro European Stability Mechanism facility, which has been ratified by the German parliament. This is a game-changer for Europe, as now it is finally moving toward a federalist system, similar to the one in the United States. This measure has been successful in bringing down the bond yields for Spain, Italy and Ireland to a very manageable level. And it is likely that those central banks might not even need to tap the ESM.

The big surprise this week, however, came from the Federal Reserve.

The Fed has decided to go all-out in fueling the next massive asset bubbles through its QE3 bazooka. The Fed announced plans to buy $40 billion worth of mortgage securities per month on an open-ended basis, while continuing to reinvest its income from the securities purchased during QE1 and QE2.

The following statement from the Fed shows its clear intent to support its mandate of full employment. But I fail to see how it will manage to do that “in the context of price stability” while creating asset price inflation through unabashed QE programs.

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

This new move by the Fed is unleashing massive amounts of money into the risk assets. Markets will now believe that, between the ECB and the Fed, all tail risks to the markets have gone.

In other words, this could mean that all the money that was hiding in the safety of U.S. Treasuries will now leave the Treasury markets and flow into equities and commodities.

If so, I would not be surprised to see a parabolic move into year-end in both gold and equities that could take the S&P 500 to 1,650 and gold to $2,000 per troy ounce by year-end.

Now here is the dangerous side to this equation. This rally will also lead oil and grains to new highs, which will results in higher gas prices at the pump and food prices at the grocery store. While employment and wages are still low, this will hurt the working class.

This massive and irresponsible Fed stimulus package by Ben Bernanke & Co. will make the rich richer by fueling their asset portfolios and bringing loads of misery to the poor, who will find it harder to make ends meet.

Besides the poor, this latest move also declares war on the retirees or those who subsist on fixed income returns from bonds. With the Fed’s monetary policy stuck at zero for another three years at least and more Federal money creating artificial demand for fixed income assets, yields will not rise for quite a while. This means that the coupons on newly issued government and agency bonds will be stuck at below inflation rates.

Another debilitating aspect of the latest round of QE is that by removing coupon generating bonds from the monetary system, it reduces the amount of money in the economy, thus reducing aggregate demand.

In summary, QE will reduce net savings of U.S. dollar holders and increase paper wealth in terms of higher equity market valuations.

While the initial reaction of the markets has been to sell the U.S. dollar, fewer U.S. dollars as a result of QE will result in the dollar eventually rallying hard, especially against the EUR. My target will be around 1.3500 before EUR/USD starts heading back down towards parity.

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Quantitative Easing Forever?

https://i0.wp.com/c9211642.r42.cf2.rackcdn.com/wp-content/uploads/2011/08/printing-press.jpg

Central bankers don’t see their mistakes.

Posted August 10, 2011
Guatemala City, Guatemala

Despite assertions that it has ended its policy of quantitative easing (QE), the Fed is unlikely to be able to do so until it also ends its zero-interest-rate policy (ZIRP). This deadly policy duo has had terrible consequences for the American economy and every country using U.S. dollars, which continue to depreciate.

It is as though the Fed were riding on the back of a double-headed monster. It cannot hang on forever, but it cannot dismount the beast without being devoured. As it is, the U.S. Treasury depends on ZIRP to fund America’s ballooning debt. As investors flee an enfeebled dollar and ponder S&P’s downgrade, the Fed is likely to be the “buyer of first resort” so that the price of Treasuries does not fall, pushing up interest rates. So with the Fed insisting that short-term interest rates will remain near zero “for an extended period,” a phrase used for the past two years, a new round of QE is almost inevitable.

Excess Liquidity

For its part, QE involves flooding financial institutions with excess liquidity to try to flatten out the yield curve and depress long-term interest rates in hopes of sparking a recovery. But QE has created a massive overhang of excess reserves in the banking system that constitute repressed price inflation. And the sums involved are truly staggering with the Fed having injected at least $2.3 trillion into the financial system since Lehman Brothers collapsed in September 2008.

From late 2008 through March 2010, the Fed bought longer-term securities worth $1.7 trillion (QE1). This included purchases of $500 billion of mortgage securities and $100 billion of agency debentures with a target of $1.25 trillion for mortgage debt. purchasing mortgage-backed securities and bailing out AIG and Bear Stearns, as well as buying other securities, led to an increase in the monetary base of 140 percent.

In November 2010 the Fed began QE2 by buying an additional $600 billion in longer-term Treasury securities, a program that officially expired at the end of June. Yet the Fed has indicated it will continue buying Treasuries using proceeds from maturing debt it already owns, allowing it to engage in continuing quantitative easing by another name.

With over $112 billion of the Fed’s government bond holdings maturing over the coming 12 months, replacement alone would involve purchases of Treasurys of over $9 billion each month. It also has more than $914 billion of mortgage-backed debt and $118 billion of debentures issued by government-sponsored enterprises (Fannie Mae and Freddie Mac). As such, this is a “stealth” continuation of QE with only a limited, if any, decrease in the money-creation process.

Last Gasp

For all the fanfare about QE, it must be said that it constitutes a last-gasp step and admission of failure of other monetary policy tools. Consider the case of Japan. Its central bank, the Bank of Japan (BoJ), began asset purchases under QE to offset deflation and stimulate its ailing economy in early 2001.

After nearly a decade of setting interest rates near zero, the BoJ realized it had been unable to conjure up an economic recovery. Then after five years of gradually expanding its bond purchases, the BOJ exercised an exit strategy from QE in 2006, only to begin again.

Last March the BoJ increased its QE program from ¥5 trillion to ¥10 trillion (about $130 billion) scheduled until the end of 2012. Recently, it announced another expansion to ¥15 trillion ($183 billion).

A child untutored in economics might think it makes no sense to continue massive increases of liquidity into the economy that have been ineffective for so long. But most central bankers and many economists demur that previous amounts were too little and more is needed.

No Growth

But the incentives that QE and ZIRP create for commercial banks make it easy to see why these policies cannot promote economic growth. On the one hand, low interest rates reduce the cost of borrowing, which should encourage more investment spending. But on the other, commercial banks pay almost nothing to borrow yet receive interest payments from the Fed to hold excess reserves, making them unlikely to extend new loans.

A sufficiently high interest rate paid on bank reserves will induce banks to choose a risk-free, interest-bearing asset rather than lending to private-sector borrowers. And so it is that commercial banks are earning record profits while making very few new loans.

The question of whether the Fed or the BoJ have an effective “exit strategy” from their policies of monetary expansion using near-zero interest rates and quantitative easing remains open. One possibility for the Fed is to engage in repurchase agreements (reverse repos) to remove some of the excess liquidity that it pumped into the financial system.

These reverse repos involve selling securities to commercial banks with the Fed agreeing to buy them back at a higher price at a later date. But once again, commercial banks will find the choice between holding risk-free, interest-bearing assets a much better bet than issuing new commercial loans.

Repressed Inflation

In the end both QE and ZIRP have been ineffective in restoring economic vitality while also creating a massive overhang of repressed inflation. Most economists view business startups, especially small- and medium-sized enterprises, as the key to economic recovery and growth. Yet QE and associated central-bank policies are diverting credit away from newly forming firms.

The Fed has now announced it will continue the “exceptionally” low short-term interest rates until the middle of 2013! This indicates that U.S. central bankers are unconvinced of the errors of their ways in their policy choices. That they are unwilling and unable to change course means that the U.S. and Japanese economies are doomed to painfully slow economic growth for the foreseeable future.

Christopher Lingle is visiting professor of economics at Universidad Francisco Marroquin in Guatemala and research fellow at the Centre for Civil Society in New Delhi.See All Posts by This Author

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