Monday, June 29, 2009

Is Madoff Worse Than Bernanke?

A reader emailed me a question the other day. I decided to post the answer I sent to him.

Why bond price go up when Fed buys bonds?

There are two things going on here. The Treasury issues and sells bonds and the Federal Reserve is in charge of the currency. The Treasury borrows money and the Federal Reserve exchanges like for like.

At a Treasury auction, the buyer is a person or institution with savings to purchase the bond. The purchase removes money from circulation (the government is going to spend it) The selling process is an auction. If there are more buyers than bonds, the price for the bond increases and in lock step, the interest rate decreases.

The other thing happening is when the Federal Reserve buys a bond. The Treasury prints the paper and the Federal Reserve pays for it with printed dollars. In this simplified form, it is a zero sum game and makes no real sense. Why would you create it and then sell it back to yourself?

These two things seem unrelated but carry it forward one step. If China decided that it wanted to sell the bonds it holds back to the US and there were no buyers, the bonds would drop in price until they found a buyer. If say, a previously issued bond was at par and paying 4% interest was offered for sale, and buyers demanded 8%, the bond would drop in value by 50%. This would be very observable to the buyers at present Treasury auctions and they too would want 8%. So the Federal Reserve is buying these bonds at par as they hit the market. The net result is an increase in the money supply. This action guarantees the value of all previously sold Treasury issues. Note, the investor pays in real dollars and gets back printed ones. Since all dollars are alike, we have more dollars chasing the same amount of goods.
[End of email]

I think what we need to look at here is values. Madoff got 150 years in prison and he is 71 years old. So he will be 221 years old when he gets out(I'll only be 212). I think that a 30 year sentence would have kept the judge from looking like an incompetent idiot. You do have to ask yourself, if Bernanke buys enough US Treasury's from China, does he get the same treatment? Of course if Madoff's sentence were to be adjusted for inflation, he just might be free in 10 years.

We are next in line to lose our savings by inflation and no one will go to jail, go figure!


mark said...

I agree - inflation here we come.

What I don't understand is how the treasury market continues to be seen as a "flight to safety".

Perhaps for very short terms but how can buying 10 and 30 year notes at more or less historic low rates at a time when the Fed is inflating the money supply as fast as it can be considered safe?

If the Fed stops printing demand drops and you lose as the price drops, and if they keep printing your stuffed due to inflation. A large chunk of the world's money is relying on the Fed steering a perfect course. There will be no 'goldilocks recovery'.

Jim in San Marcos said...

Hi Mark

I don't see the T-bills a a flight to safety, I see that as the Fed buying to keep prices in line.

My question is why would you want to buy a T-Bill that is paying negative interest?

It's not rocket science to figure out that the people managing your 401k have no idea what they are doing. Why not try your own hand in the game, at least if you lose, you don't have to blame them.

Once everyone realizes that the money managers in charge of the funds have no skin in the game, the game plan changes. At that point it may be too late.

Anonymous said...

Maybe a little off topic, but...

I read recently that BofA will cash 3 billion in California's IOUs. Since BofA is receiving billions in aid from the Fed, is this not just a backdoor way for California to receive cash from the Bernake and Geithner? And when California can't pay up, does not this just turn into free grant money for the state?


Jim in San Marcos said...

Hi Angry Tax Payer

I agree, this California funny money has a very bad smell to it.

I'm not sure how it will work out, but you can bet your bottom dollar, we get to pay for it --sooner or later.

In doing the math, California wrote 53 million in registered warrants on July 2. So every 10 working days that would be about a half billion. It doesn't look like B of A's 3 billion will travel very far, 6 to 12 weeks at the most.

frakrak said...

Jim I think I understand what you are saying with regard to U.S. government backed bonds.

When Obama took office the Chinese premier gave an uncharacteristic press conference angry at the U.S. "economic credibility," it presented itself as a thinly veiled threat to the U.S. Is this why the Fed is buying these bonds back at par value?

Can this be regarded as a complicit act in the destruction of the value of the American dollar, and your economy? Why give the Chinese an advantage to what is now "beyond the event horrizon?"

They are busy stockpiling precious metals, metals, mining resources world wide and financing a huge military buildup for the looming instability!

Forget them .. what's your expression ... mark to market?

I am a little insecure with this post, (not a giant of intellect when it comes to international finance),

Jim in San Marcos said...

Hi Frakrak

I think that the Chinese made a big mistake when they decided to loan us money. If they had loaned us their currency, they wouldn't be in this mess now.

Iceland and some other countries that got into trouble borrowed Euros and when their own currency went South, the Euro went North (from their point of view).

With us, if the dollar goes South so does the Chinese holdings of dollars. That doesn't make them happy campers.

Our problem is redemptions on the open market by anyone. I am of the opinion that the Federal Reserve is buying them up to keep interest rates from rising. If interest rates were to jump to 16% the government could not meet the interest on the national debt.

I don't think that the government is facing the long term consequences of their actions, each of their fixes gives them just another day of grace.

Living one day at a time just doesn't cut it for me. I want to buy green bananas and watch them ripen (outlive them). Our politicians have lost all vision of the future, go figure!

I think that you are right to feel insecure, I share the same feeling and it is quite unsettling.