Let's summarize where we've been so far this week.
On Monday, we showed how banks and large investors have the capacity to leverage modest amounts of equity into large market positions by taking on debt. We also explained one form of the carry trade that takes advantage of the interest rate difference between short term and long term securities, a trade that has much less risk when interest rates are kept artificially low and stable.
On Tuesday, we pointed out that a normal economy requires savings in order to have money that can be loaned out by banks and that interest rates are the market's mechanism for balancing savings and investment. This equilibrium is manipulated by the Federal Reserve to discourage or encourage savings in an effort to optimize market outcomes. Finally, Mortgage Backed Securities -- a financial product consisting of home mortgages -- provide a higher yielding, shorter term investment than long term treasury notes.
So let's move on to the red flags, as indicated by the Federal Advisory Council, a group that regularly advises the Federal Reserve. Here is how the FAC is described on the Fed's website:
The Federal Advisory Council (FAC), which is composed of twelve representatives of the banking industry, consults with and advises the Board on all matters within the Board's jurisdiction.
The most recent FAC meeting was May 17, the minutes of which can be found here. While the fifteen pages are generally full of statements that support current Fed policies and give endorsement to the notion of a gradual recovery in the economy, the last page has some very revealing insights. The FAC was asked to comment on current Fed policy, which is essentially manipulating the overnight borrowing rate to zero and using quantitative easing to further manipulate downward short term and long term treasuries. Here are some of their statements, which I'll provide some comments on.
The Fed’s securities purchases have reduced mortgage yields and, to a lesser extent, Treasury yields. Current low bond yields are disruptive to management of fixed-income portfolios, retirement funds, consumer savings, and retirement planning. They may encourage unsophisticated investors to take on undue risk to achieve better returns.
The first sentence is essentially what we've been discussing here -- yield is the interest rate and the Fed has been driving down rates. The second and third sentences can be read like this: because your savings account is not paying any interest (or your pension fund, 401(k), etc...), in order to have some earnings, you need to put your money elsewhere. Somewhere more risky.
That's the "undue risk" part, AKA: dumb money.
When your pension fund, for example, is underfunded by 25%, an amount that also assumes an 8% annual return from this point forward, very low interest rates on risk-free securities means that, to avoid falling further behind, the fund needs to invest more and more into higher risk areas. While we may think of the unsophisticated investor as the kid betting on dot.com stocks (been there, done that, circa 1998), we can just as easily think of them as the pension fund manager being sold the comparatively high-yielding Mortgage Backed Security that is very risky yet rated AAA by Moodys.
Unsophisticated is essentially a euphemism for "dumb money," which includes everyone not part of the inside operation (and even some of those that are.) This is not a commentary on intelligence, but access to information and, increasingly, access to bandwidth.
The FAC is indicating that, with interest rates directed by the Fed to remain low for a long time, capital is moving from safe to risky investments. To preview what we're going to talk about tomorrow, junk bonds are now paying around 5%. Understand that junk bonds are the packaged debt of high risk corporate borrowers. Just a few years ago, these funds, which are very risky, paid over 20% interest. So much money is flowing out of zero-interest, safe havens and into high risk places that there is huge competition for even junk.
MBS purchases account for over 70% of gross issuance, causing price distortion and volatility in the MBS market. Fixed-income investors worry that attractive mortgage-backed securities are in very tight supply.
As we discussed Tuesday, mortgage backed securities (MBS) are going to pay a higher rate of interest than a treasury note. With the rates on treasury notes being artificially depressed, investors (think your pension fund) are looking to mortgage backed securities to increase their returns.
Here's the problem: the Fed is actually buying 70% of all mortgage backed securities. Read that again. Seven out of ten home loans being sold onto the secondary market today are being purchased by the Federal Reserve. The remaining -- which are in high, high demand because they have a slightly higher rate of return -- are fought over by investors (fixed income, again think pension fund).
This all drives mortgage rates down, down, down to historic lows. Any mortgage that can make it through the origination process can be purchased, securitized and sold in short order.
Many are concerned about the Fed’s significant presence in the market. They have underweighted MBS in favor of corporate, municipal, and emerging-market bonds.
The term "underweight" here is meant to denote that investors (keep thinking pension funds) are not holding a normal share of MBS and instead are buying other, more risky, bonds. In other words, the Fed is essentially forcing investors not inclined to risk into risky investments. This is why junk bond yields, for example, are so low. If these fixed-income investors could get their yield in a normal mortgage market, they wouldn't be buying junk bonds and the interest rate on junk bonds would rise.
There's also another risk here with the Fed dominating the mortgage market, that being the issue we discussed Monday in the carry trade. If the Fed starts to exit the MBS market, rates will go up. That makes the low rate securities actually drop in value (remember: I'm not going to pay you full face value if I can get a higher rate somewhere else). Since few people are going to refinance when rates rise -- we're essentially mining the refi market right now with these low rates -- MBS holders could be stuck with low yielding, long term notes. Corporate bonds, emerging market bonds and other instruments have a quicker turnover and give a little bit more flexibility in a market where rates are rising, but they are quite a bit riskier.
There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices.
Let's skip the whole conversation of inflation -- a black hole we could get lost in (as one example, note how the size of a basic candy bar has shrunk over the past couple of years -- no price inflation when you shrink the size) -- and focus on the unsustainable bubble in equity and fixed-income markets.
The equities market is the stock market. The FAC is saying that all of this money printing and frantic search for yield could encourage a lot of people to invest in stocks, something that would drive up prices to unjustified -- and thus "unsustainable" -- levels. On the way up, this is actually a self-reinforcing effect; the more stocks rise and the more yields on safe investments are depressed, the more the "dumb money" is lured into the rally. That the "smart money" counts on this reaction from "dumb money" is a tragic reality.
Further, current policy has created systemic financial risks and potential structural problems for banks. Net interest margins are very compressed, making favorable earnings trends difficult and encouraging banks to take on more risk.
Banks can't pay much interest in this environment, just look at your bank statement. With banks competing against the Federal Reserve for places to put money, they are left with the same choices everyone else has: make no money or take uncomfortably high risks. Banks that takes risks face huge problems when the market changes. Banks that don't might not make it that far.
The Fed’s aggressive purchases of 15-year and 30-year MBS have depressed yields for the “bread and butter” investment in most bank portfolios; banks seeking additional yield have had to turn to investment options with longer durations, lower liquidity, and/or higher credit risk.
With the Federal Reserve crowding everyone else out of the mortgage backed securities market -- and thus sucking all the mortgages out of banks (the originators) and into the secondary market -- what's a bank to do? Two things. More transactions, meaning originate more loans and essentially make your money on fees (a dwindling market as the number of homes that could refinance but haven't is shrinking rapidly) and take on more risk.
For at least a portion, that means that carry trade we explained Monday, taking short term money (deposits that can be redeemed at any time) and buying long term notes that fewer people want (which is what is meant by "lower liquidity"). This makes the bank very fragile.
Finally, the regressive nature of the artificially compressed savings yields creates pent-up demand within bank deposit portfolios; these deposits may be at risk once yields begin to rise and competitive pressures increase.
Here's the million dollar statement. Or perhaps the trillion dollar statement. Let's break it down slowly.
Regressive nature: this means the Federal reserve policy of low rates and money printing is hitting ma and pa investor really hard.
Artificially compressed savings yield: this means banks are not paying any interest because the Fed is manipulating the rate downward. This is a distortion of the market price.
Pent-up demand within bank deposit portfolios: Without good options, people are sitting on cash. They wish they could be putting that money someplace productive, yet not overly risky.
Let's put that together: Federal reserve policy is hitting the average saver really hard. Those savers are going to bolt to something that pays a market rate of interest when they get a chance.
So when you read the rest of that statement -- deposits may be at risk once yields begin to rise and competitive pressures increase -- it could be taken one of two ways (or both).
As the Fed stops intervening in the market and things go back to normal, depositors bolt to higher yielding securities, say a normal 90-day Treasury paying 5%. For the bank -- which has been forced to invest in longer term, less liquid instruments (see above) -- they risk losing their depositors very quickly if they don't raise rates to match their competition. No depositors, no money, fire sale, out of business. However, if they do raise rates, now they are struck with the downside of the carry trade (see Monday -- owning a long term note that pays less than the short term debt that finances it) and quickly burn through their equity. That is the same result: no equity, fire sale, out of business.
There's another way to read the FAC statement that builds on this insight on deposit flight, however. I'm not sure if the FAC is going Cyprus on us here, but they could be saying that deposits are at risk, meaning the insolvency of the banks and the sheer scale of the problem could be so great that it would exceed what a depleted FDIC could bail out. If that were the case, then your actual deposit -- the money you have put in the bank -- could be at risk for a partial or complete loss.
Imagine the US government saying, sorry, the FDIC is insolvent and so we're going to take twenty cents of every dollar you have in the bank and put it into the bank itself. We'll give you (non-redeemable) shares in the bank in compensation, so if the bank someday earns a profit you can share in that. That's Cyprus, and probably not what the FAC meant (although some members may have).
Either way, this is not a fun time for the dumb money that is left holding the bag.
Uncertainty exists about how markets will reestablish normal valuations when the Fed withdraws from the market. It will likely be difficult to unwind policy accommodation, and the end of monetary easing may be painful for consumers and businesses.
So the Fed may have things under control today, but it is not clear how they are going to remove the fingers from the dike without the whole thing collapsing. And, by the way, the water is building behind the dike and so this can't go on forever, there needs to eventually be a change in policy back to normal markets.
But look; the entire economy is shifted to either (a) those in cash and desperate for a return to market rates so they can bolt or (b) those who have positioned themselves at great risk with assurances that the Fed will continue to keep rates low. The more people that shift from (a) to (b), theoretically the better the economy will get since there will be less hoarding (saving) and more investing and spending. The problem is, the more people following strategy (b), the more critical it is to suppress rates as rising rates will sink their investment.
And there's the problem. The Fed is stuck in a trap of its own making. If it stops intervening, bank positions go bad, the stock market retreats and mortgage rates climb depressing housing prices, all at once. If it continues to intervene, it is only making these distortions worse, setting itself up for an even more painful unraveling, a reality summed up in the final sentence from the FAC.
Given the Fed’s balance sheet increase of approximately $2.5 trillion since 2008, the Fed may now be perceived as integral to the housing finance system.
What is your house worth? What is a company's stock worth? What is your dollar worth? Nobody really knows because there isn't actually a market for any of those things. Now there's a "market" where things are bought and sold, but not a market where price discovery plays a role in determining what something costs. The very value of the currency is being manipulated, forced into risky and speculative places where it would not naturally go. We're living through the greatest, high stakes, financial experiment in human history.
If it is not already clear, tomorrow I'm going to show how these distortions are manifesting in the housing market and in the stock market. Then Monday (sorry for taking Wednesday off, but something came up) I'm going to lay out two scenarios: the optimistic where the Fed gradually unwinds its positions and the other where things don't quite work out as hoped. You can compare the likelihood of one extreme over the other -- I'll do my best to make them each as realistic as possible.
Footnote: Woke up this morning to do another edit of this post and read this article on global markets. Here's the money quote:
"If you look at it historically, there has never been a period when the Fed has started to take back stimulus that has left the markets untouched," said Hans Peterson, global head of investment strategy at Swedish bank SEB.
"And this time it is a bigger exercise. We have moved markets from 2009 to 2013 on stimulus and now we are trying to take a step into a world which is more driven by natural growth. That transition will not be easy."