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Where is the Horror?

In recent weeks I as many other financial writers have noticed the extreme M3 expansion by the FED. The size of expansion is what would follow after a catastrophic event that could threaten the financial system like the WTC attacks or the failure of LTCM. What kind of horror forces the FED to hyper inflate M3? I believe this is the most important question at the moment.

Some writers try to explain that the FED is hyper inflating to counteract the underlying forces of global deflation. I agree that deflationary forces are like a wet blanket over the global economy. However we have had deflationary forces in the economy due to overinvestment/overcapacity since at least 2000. I am not satisfied with such a general explanation to this last month sudden super growth in M3. I think there is a more specific reason for the FED's action!

OK, what kind of horror has got the FED spooked? They must know something since they are acting before the event has become public. I think the FED has told us about the horror they now expect/experience several times the last two years. Here are some clues for you! Alan Greenspan touched the issue in Feb 2002 and warned us again in Feb 2004. William Poole president of the St Louis FED made a publicized in depth analysis on the "problem" in May 2004.

I will soon reveal what I think the FED is scared of. But first lets try to see if we can figure out where all the money is going.

To get the enormous amount of new M3 money into the banking system the FED can buy almost any type of debt. Mortgage refinancing has been in a sharp decline since the bond market took a dive in mid March. This money is not likely going to home refinancing.

Has the FED been buying bonds to halt the rise in long term yields? With approximately 45 billion dollar in M3 expansion each week the last month this amount of money would certainly stop a rise in bond yields at least temporary. But the yield on bonds has been going up so I don't think they are intervening in the bond market. Besides the FED is preparing Wall Street for higher short-term rates so a rise in long-term rates would be normal.

Are US corporations borrowing new money to increase production capacity thereby boosting M3? Both new borrowing and investment in production has been in steady decline in corporate America. So where is the money going?

OK, here it is!

I think the FED directly or indirectly via US banks are liquefying the two Government Sponsored Enterprises, Fannie Mae and Freddie Mac. (together FF or GSE from now on)

What on earth would make me think this?

I think FF is in big trouble and a meltdown of the entire US financial system is at risk because of the enormous size of these companies. And the strange/scary thing is Federal Reserve officially shares my opinion!

I will give you some scary highlights and personal comments on the article "GSE's Borrowing Short and Lending Long" published on http://www.stlouisfed.com/ and written by St Louis FED president William Poole.

Mr Poole: "Some crises, such as the one that brought down Enron, are well contained and do not spread to other firms. Others, such as Long Term Capital Management, have wider effects. There is no question but that a crisis affecting either Fannie Mae or Freddie Mac would have widespread effects because these firms are so large. I want to emphasize that, on the basis of information I have, no crisis is at hand in the market for GSE obligations."

ME comment: If there is no crisis at hand why would FED Chairman Greenspan and St Louis FED president Poole address this issue twice in the last 4 months. Why cry wolf if there is no wolf around? This could scare the public and financial markets for no reason. It doesn't make any sense to address this issue unless the FED is afraid of getting the blame for a financial system meltdown that these companies might trigger if faced with a crisis. I think they are trying to shelter themselves from responsibility. Few other companies in the US have benefited more from FED easy money policy than FF. Should the FED be freed from responsibility? Not in my opinion.

Mr Poole: "In my opinion, GSE capital positions are undesirably thin and leave these firms unnecessarily vulnerable to surprise shocks. There is no way to predict what kind of shock might shake market confidence, but the reason a shock could have serious adverse effects is that FF pursue a strategy of borrowing short and lending long, with a thin capital margin."

ME comment: The shock Mr Poole is referring to is rising interest rates. Since mid March the long-term bonds have had a big and swift unexpected rise in yields. Was this a shock to FF?

Mr Poole: "The main point about managing a crisis through this mechanism, with FF obtaining credit from banks and the Federal Reserve providing loans to the banks, is that the enormous scale of FF obligations would strain the banking system. This mechanism might not suffice to handle a major crisis as the banks would insist that FF post collateral. In a crisis, the mortgage market would be severely disrupted and mortgages and mortgage-backed securities would no doubt trade at lower prices, thus impairing the value of the collateral FF could post. The decline in the value of FF assets would strain their capital positions, and lead to fears that either or both Fannie Mae and Freddie Mac might become insolvent."

ME comment: Should a crisis hit, FF would strain the banking system and might become insolvent!

Mr Poole: "Under Section 13(3) of the Federal Reserve Act, Federal Reserve Banks have the authority to discount paper for individuals, partnerships or corporations. Direct lending to the GSEs would have to come under provisions of this part of the Federal Reserve Act. Critical provisions include a finding of unusual and exigent circumstances and an affirmative vote of not less than five members of the Board of Governors. The loans would have to be fully collateralised. There has been no lending under this provision of the Federal Reserve Act since the 1930s. Such lending, were it to be authorized by the Board of Governors, would permit GSEs to redeem maturing obligations and would, therefore, solve part of a crisis problem. However, such loans might not restore liquidity to GSE debt before redemption and would not per se restore normal functioning of the mortgage market. Clearly, Federal Reserve support for the GSEs would help to prevent a broadening crisis, but most likely would be incapable of preventing some considerable disruption."

ME comment: The FED could temporarily milder a crisis but a considerable disruption is unavoidable.

Mr Poole: "Many financial institutions seem not to understand the nature of the issues. It is interesting that GSE obligations trade at much smaller spreads over Treasuries at the short end of the maturity spectrum than at the long end. Investors in short-term obligations apparently believe that they are completely protected from credit risk because they will have enough warning to permit them to exit these obligations by letting them mature in a few months. The problem is that should a crisis occur, it will take hold so quickly that GSE obligations will in a matter of hours, or days, become illiquid. While any one holder of GSE debt can exit, not all holders together can exit at once. The economics of this market are similar to those of banking markets. A scramble to convert all bank deposits into cash cannot succeed in the aggregate because not enough cash exists to effect the conversion. Similarly, a scramble to convert GSE obligations into cash cannot succeed in the aggregate because the underlying mortgage assets cannot be quickly converted to cash."

ME comment: Wow this is my favourite! Should a crisis occur, GSE debt would become illiquid within hours or in best case a couple of days. Holding any GSE debt?

Mr Poole: "I note also that FF have a powerful incentive to grow. They report returns on equity in the neighborhood of 30 percent per year. They are able to achieve these returns by exploiting the implicit federal guarantee of their obligations, which enables them to borrow at near Treasury rates despite their thin capital positions and invest in mortgages at private market rates. Their growth objectives insure that their scale will increase over time, unless they become subject to full private market incentives through convincing federal policies that lead to market recognition that the federal government will not guarantee GSE obligations in a crisis."

ME comment: Should a severe crisis occur the FED will/can not bail out FF.

Conclusion: If the FED is repeatedly warning us about the possible financial systemic risk of Fannie Mae and Freddie Mac I think it is wise to be on full alert for a crisis in these companies. I think they are experiencing a crisis already and the FED is pumping billions of M3 to liquefy these companies. Remember that what you have read above is the official version from the FED. The official version is scary enough, who knows how they talk about this issue behind closed doors. I think a severe shock is about to hit the financial markets in the form of a GSE collapse. A crash like this will throw the US and world economies into recession so fast it will make your head spin. Eventually these events will lead the global economies into a new depression...

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