Thursday, December 1, 2011

Learning to count

You go girl

It is not enough to simply shout or sign that the system is unfair and thus has to be reformed. It would help if protesters knew how it was unfair and could target their rage appropriately. Protesters must learn to count.

OWS, strikes by British government workers, Greek citizens demanding political reform, are all doomed if the participants don't know how to count. The most recent example of the so-called liberal media getting it wrong and misguiding their readers occurred in today's NYT op-ed by Nicholas Kristof. In his article he recounts the confessions of a former Chase banker who cooked the country. He then goes on to report the findings of the Bloomberg revelation that has minds whirring; "as Bloomberg Markets magazine published a terrific exposé based on lending records it pried out of the Federal Reserve in a lawsuit. It turns out that the Fed provided an astonishing sum to keep banks afloat — $7.8 trillion, equivalent to more than $25,000 per American.
The article estimated that banks earned up to $13 billion in profits by re-lending that money to businesses and consumers at higher rates. The Federal Reserve action isn’t a scandal, and arguably it’s a triumph. The Fed did everything imaginable to avert a financial catastrophe — and succeeded. The money was repaid."
There's the rub, "the money was repaid".

To understand why the money was not repaid you have to know about an important fundamental: This is the definition of the Bond Carry Trade:
For the bond market, this refers to a trade where you borrow and pay interest in order to buy something else that has higher interest. For example, with a positively sloped term structure (short rates lower than long rates), one might borrow at low short term rates and finance the purchase of long-term bonds. The carry return is the coupon on the bonds minus the interest costs of the short-term borrowing. Of course, if long-term interest rates unexpectedly rose (and long-term bond prices fell as a result), the carry trade could become unprofitable.

The second fundamental is to understand that the long tradition of the Fed NOT signaling what moves it was about to make re. interest rates kept the process of a free market capitalism alive and cost players money in that they had to hedge (protect themselves) if the Fed were to change interest rates. Now the fed has spoken and told the players that they will not raise rates for at least two years. The effect of this is to allow the banks (the major players) to borrow Fed money at virtually no interest rate and invest the same money in long term treasuries. That is what they are doing with the majority of the money, not lending it to business or home buyers. They then pocket the difference, firm up their balance sheets, and return the loan when they want to.

What was lost to the Fed was the opportunity costs. Money they might have made in their portfolio had they not given it to the bankers for free.

Opponents of bailouts complain that to help "main street" or home owners, is impossible because of "moral hazard", picking winners and losers, giving one group an unfair advantage. But that is just what the Fed has done.

Imagine the following scenario for example. You own a failing cupcake business. The Fed decides that your business is critical; you employ people, are in the stream of commerce, and anchor a block of retail shops. They decide to bail you out. They lend you let's say 3 mil at no cost which you promptly invest in 30 year government bonds yielding roughly 4%. You pocket the 120k annual cash flow, (money the Fed would have earned) keep your business running, and when all turns bright again, you repay the original 3 mil loan. That opportunity doesn't exist for you. That is what is, has, and continues to be the unfairness that those who are suffering the consequences of Fed policy haven't been able to articulate. Make no mistake. Central Banks all over the world have made up some of the losses (most still remain off the books) of their member banks and allowed the underlying failures on investments wiped out in the crisis to fester. So housing value remains low, which limits tax revenue, which breaks governments ability to function (Teachers are fired, tuitions rise, services are privatized). Pension trusts losses mount and therefore are unable to meet their obligations. Businesses can't get loans, there is no job creation, and the economy craters.

Not to worry. the Fed triumphed and they are being repaid.


  1. The Fed is an entity I struggle to understand, so I have couple of questions. Advance apologies if they are ridiculous.

    Why should the Fed be in the business of bailing anyone out at all (big bank or cupcake store)?

    Also, is there really anything the Fed can do about housing prices? A giant bubble just burst. It seems inevitable that housing values will remain low for a very long time.

  2. 1. Given they are there, and in the business of bail outs, then they are in a position to make choices.
    2.Absolutely! Lets start with funding stabilization programs. One of the drivers of loss is the insecurity of current note holders. If they keep failing then the underlying house price is volatile. House prices will eventually yield to supply and demand needs.