Wednesday, March 18, 2009

What is the Fed Up 2?

The Fed announced it will buy up to 300 billion of long term Treasury’s. Everybody just glosses over it, not understanding the implications.

First the Treasury sells the bonds to investors to finance debt. The Federal Reserve then buys the bond from the private investor offering a rate or a little above market rate to entice the owner to sell it. It is still a zero sum game. If the Fed prints the dollars and holds the long term bond, the day the bond matures, the Treasury redeems the bond held by the Federal Reserve and this returns the dollars put into the economy. Normally, the Fed might buy and then sell the bond way before it matures. It’s a way of increasing the money supply on a temporary basis.


There is another reason they might want to do the same thing. Suppose that the people owning the 30 year bonds need cash and have to sell in a hurry. Remember the bonds will pay face amount in 30 years at say 3.5% interest. That is a pretty long wait. To sell them fast, they need to discount them. So they might offer a 100K 30 year bond for 90K. That sort of a discount will move it pretty fast usually. When you discount the bond, the effective interest rate increases so in this case, the guaranteed yearly dividend of $3,500 divided by the purchase price figures out to be 3.89% interest for 30 years and a payoff of face amount 100k.

Look at it from a more realistic point of view. Suppose interest rates jump to 7%. In order to sell the 100k 30 year bond paying 3.5, you would have to discount it to 50K or wait 30 years for the full amount back. The interest rate doubled and the price of the bond dropped to 50% of face.

There are two things in play here. The interest rate paid on long term Treasury’s is a cost of doing business for government. The higher the interest rate, the more we the people have to pay on servicing the national debt. The second thing is investors trying to raise money by selling the long term paper. If there are no buyers, they have to discount it even more until it is sold.

What is happening here is that the Federal Reserve has become a market maker for people needing to cash in their long term bonds. If they buy every bond offered, the interest rate doesn’t have to rise, because there is no need to discount the bond. This is what the Federal buy back program is all about.

My interpretation of what is happening, is that the government sees massive redemptions of long term Treasury’s by failed financial institutions and needs to do some damage control. They will try to keep these Treasury’s from hitting the market and prevent interest rates from rising higher. This means they have to buy them all!

There is one slight problem here. The Feds need to sell the bonds back, later on, to contract the money supply. Their buying binge will probably fail. Then when interest rates rise to say 14%, each 100k bond will only be able to repatriate 25k not the 100k they dumped into the market. They can hold the bond for 30 years and collect the face amount, but they cannot contract the money supply by selling the purchased 30 year bonds unless they take a hell of a discount, and why do that? So from there inflation will roar to the finish line. I give this new program three weeks before it falls apart. The Huns (AIG) are looting the Treasury and Congress is helping them cart it away. Go figure! It's probably just my over active imagination running amok as usual.

17 comments:

AIM said...

Hi Jim,
Hey, I'm a published internet author now! (I'll have to give you my address so you can mail me my royalty checks.)

We're dealing with a mix of ignorance, arrogance, fixed ideas, desperation, confusion, hidden and special agendas, and partisan politics.

There is no actual rhyme or reason behind the myriad of actions being taken by the Fed or the government. Look at all of the above factors involved in this mess we are in. How can you know what is going on if they don't? Don't try to understand the incomprehensible.

One thing we do know... having questionable and incompetent people as our leaders, who are knowingly or unknowingly throwing our economic structure out of balance, is a sure recipe for disaster.

Run for the hills! Every man for himself!

Rob in NS said...

Jim

So the stock market seems to like the current statements coming from DC and Wall street. What gives? I can't seem to make any sense of all this as the current state of affairs seems to be devoid of reality. I wonder if I haven't entered an alternate universe where up is down.

rob

AIM said...

Rob asks: "So the stock market seems to like the current statements coming from DC and Wall street. What gives?"

My opinion:
Rob, I think your question is probably rhetorical and you actually know the answer. Yet, here's my two cents...
The stock market and the job market are really the two key statistics in this country. That is what the people react to and what determines whether there is confidence, spending and growth, or a lack of confidence, saving and retreat. The stock market is news driven and based on emotion (fear and greed). The stock market will fluctuate and be volatile on a daily basis due to news (of course you'll go insane following the daily adventures of the stock market, to maintain your nervous system and have a rational approach to investing you just need to be concerned with trends, not the day to day new/emotion).

The herd, the masses, the lumpen citizenry, or whatever you want to call them only care about themselves, meaning: their jobs, their future, their savings, their net worth, their assets and such. They want things to be good, easy and simple. They live in denial whenever times are tough and they are motivated by fear and greed (I don't say this condemningly... it's human nature). Anything (even if it's the government's irrational actions; or moves towards socialism; unethical or destructive actions; something for nothing; etc.) that improves their personal lot or boosts their chances of improving their survival, will be applauded by them.

Rob in NS said...

Aim I have to agree with you but I worry that the unwashed masses are going to wake up soon and see the cows have left the barn, so to speak. Each day, when I get up in morning, I think to myself that this is it and the shenanigans of the power brokers will be exposed. Unfortunately each night, when I head home from work to turn TV on, the same old talking heads are spewing the same old talking points. I swear sometimes I wonder if my real name isn't Winston Smith. I really do think the wheels are going to fall off the bus soon. That said we could still be sitting here two years from now wondering how they keep gaming the system. This announcement I fear is destined for the memory hole like all the rest.

rob

Jim in San Marcos said...

Hi Aim and Rob

The Fed is what boggles my mind. They use to buy some Treasuries here and there to regulate the money supply which didn't bother me. It looks like they are buying all sorts of financial assets with printed dollars. Technically when they sell the asset, they recover the dollars back so its a wash. But when you do 4 trillion dollars worth and they mention that they might go as high as 10 trillion it kind of makes you wonder. The issued amounts are getting absurd.

I guess if they inflate the money supply enough, the houses that Fannie and Freddie hold might in the near future, be worth what they have them on the books for.

Dan Mac said...

Jim,

Good post. Couple of questions:

1) Are they buying both New Issues & Outstanding. Is there a difference? I like your point about the Fed becoming a market maker.

2) Very though provoking last paragraph re: repatriating @ 25. Is your assumption that rates will rise because they will get pounded with supply and the bottom will fall out OR because general inflation expectations are going to percolate and send rates higher?

The either thing I don't get is if they are driving long rates lower, doesn't that hurt bank margins?

Tired tonight - hope I framed my questions ok.

Thanks as usual ~ Dan

Jim in San Marcos said...

Hi Dan Mac

The Fed isn't going to buy new issues from the Treasury. The Treasury holds an auction and sells the new issues to banks or to even you and me. They are fully insured by the government so you don't have to watch bank limits when depositing your AIG bonus check. If the Fed started buying new issues, it would be kind of like a counterfeiter setting up shop in a bank to print money so they didn't have to walk very far to deposit it.

Investors that buy the bonds at times need to sell them before maturity and here is where the Federal Reserve picks them up.

If say China wanted to dump their holdings (and you mise well figure that they are doing just that), they would have to discount the bonds unless there was a buyer at current interest rates. The Fed is going to buy them. China can convert a time based asset into ready cash. From there, you buy something REAL, gold, real estate etc. This conversion is in progress.

As long as the Fed can cover all submissions for redemption, they can maintain the current low interest rate.

The bond market is 10 times bigger than the stock market. If people need to raise cash, they will have to discount the bonds, the Fed can't buy them all. If rates go to 15%, we as a nation cannot pay the interest on the national debt with the taxes collected. At this point, the government is bankrupt.

The interest rate doesn't really affect the banks that are still solvent. They are not paying very much for the use of your funds. Nobody wants to borrow any money. They make good money on servicing loans that they have sold to investors.

If interest rates were to rise drastically, a lot of savings and loans would fail. They loaned long at low rates and would have to pay high rates for new deposits. Which would be a Laural and Hardy rerun of the banking fiasco of the 1990's.

Jim in San Marcos said...

Hi Inquiring Mind

As for being an author, you might just want to start your own blog. It doesn't cost anything and you don't get paid unless you advertise.

Before I started this blog, I wrote two comments on another persons blog that were what I considered top of the line stuff. After the blogger wrote a new article, my comments were history, sealed in a tomb.

When I see something that is good, I publish it to give it some Internet circulation. Otherwise, as a comment, it just goes into the bit bucket and is forgotten.

No problem with giving you a link. As for royalty checks, Congress is the party to contact. I hear that they are spending money in a drunken rage.

Thank you for your comments and take care.

S.A.Fisher said...

We are in for it. This is a bad plan, and folks had better start investing in tangibles, such as food, livestock, land, and other useful goods.
http://preparednessnow.blogspot.com/

Rob in NS said...

Jim

Yourself and Karl Denninger had me convinced that central banking isn't inherently fraudulent. Then I read this post and once again I am having doubts.

I am by nature an optimist but can't help but wonder if I should be packing my bags and heading for the hills.

rob

Anonymous said...

Rob: definitely pack your bags and keep them by the door. Don't head for the hills yet. You may still have a little time left to enjoy your bed and the comforts of home.

Well, the printing presses are really starting up. (In this time period, that means the computer is being booted up. Can you believe it, these guys are so lazy, they won't even go through the action of printing up paper anymore?! They'll just type some digits into a computer.)

Well, this is Bernanke's last chance. This is the last tool in the monetary policy tool box. If printing money doesn't do it, he'll be out of ammo. Then what?

I guess to be right, he'll just continue to print a la Weimar Republic or Argentina or Zimbabwe.

Never thought I'd be using the USD for toilet and wall paper. (Actually the USD will go well with my carpet and sofa which have some green in them.)

Well... I've got my health, my guitar, my golf clubs and a library card. That's all that has ever been important to me anyway. Guess life won't change that much.

Anonymous said...

Wow! The Fed is devaluing the dollar and destroying the bond market. China already expressed their concern earlier about all the US treasuries they are holding. They are worried about those assets. Now what are they they thinking? I know... they are not going to lend to Uncle Sam anymore. Then what will happen... The Fed will keep buying treasuries? Interest rates will rise to attract foreign investor central banks? Taxes will go up? The US will default on its loans?

We want to stop spending, save and pay off our debts. Obama-Bernanke want us to borrow and spend. What is a citizen to do?

I'm going to go into the guillotine business. They'll be in demand very soon.

Anonymous said...

No one in government reads history books or has taken Economics 101. They are so full of fear and confusion they can't even see or think straight.

It's either the above, or...

The globalists have orchestrated this perfect storm and are pushing us into a one world global currency and eventually a one world government. They will scoop up all the assets and the gold as well.

No one can be this stupid. My vote is that it is the latter.

Scared Sh*tless

Gone Soon said...

When the financial industry collapses, the taxpayer is already on the hook. That's because bank deposits are insured, as are bonds backed by government agencies such as Fannie, Freddie, and Sallie.

It's too late to say you didn't want to be on the hook. Now every one of you will have to pay. It's your price for being alive.

The FED is printing trillions of dollars to stave off a catastrophe. These trillions are created out of thin air. They dilute the value of anyone who holds the dollar. This includes savers in the USA, as well as foreigners who have big stashes (like China, Japan, Russia, oil cartel, drug dealers).

There will be higher taxes and higher inflation down the road. We are not there yet. We have to swim across a vast icy river to get to the road. It's not a foregone conclusion that we can accomplish this feat. So set aside your future worries and concentrate on the present struggle.

ca said...

Jim --

The other day you said

"As more and more people find out that Barney Madoff was not a one time event, you are going to see more mattress stuffing which will drain Wall Street."

Talk about prescient:

http://www.nakedcapitalism.com/2009/03/ponzimonium-coming.html

Rob in NS said...

To Anon 8:47

I have everything except the guitar. I strive to be an optimist but I find it hard to be these days. I look at a flat tire as being round on three sides. Lately however it is hard to remain upbeat as the tire has bulletholes in the sidewalls. I'm going to keep the warm bed for now.

rob

Jim in San Marcos said...

Hi Rob

It's kind of like giving a store supervisor control over the petty cash box for purchase of odds and ends for store use.

In the case with Bernaked and the Federal Reserve, I don't see where he has the mandate to increase the petty cash box size to buy the hooker down the street a fur coat.

Admittedly it is a zero sum game in concept. But if something goes wrong, it won't be. There needs to be a way to limit the funds he can create.

The purpose of the Federal Reserve was to preserve and protect the banks. It has gone way past its mandate. It needs to be reined in or destroyed. It has the potential to bankrupt us.