John Hussman: The Federal Reserve's Exit Strategy: Unlegislated Bailout of Fannie and Freddie
John Hussman of www.hussmanfunds.com puts out a Weekly Market Comment (which I highly encourage you to read every week). Per usual, this is another good article. The actions of the Fed during the last round of the crisis (Quantitative Easing and the massive purchase of MBS's) and the current round of the crisis (see below, more MBS purchases) show that the course of action was always going to be debt monentization on a massive and unprecedented scale.
Please read the full article, it is very good.
This is directly inflationary. But does monetary inflation (which leads to price inflation eventually) always mean that all assets (in this case I am referring to equities as a general asset class) go up in nominal price? NO -- The Long View - Q&A - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=314893 (Description of the stagflationary scenario and a risk assesment for the bullish / neutral / bearish case for equities)
The Federal Reserve's Exit Strategy: Unlegislated Bailout of Fannie and Freddie
John P. Hussman, Ph.D.
February 16, 2010
How to spend (up to) $1.5 trillion without Congressional approval (updated)
Step 1: Federal Reserve purchases $1.5 trillion in Fannie Mae and Freddie Mac securities, creating $1.5 trillion of monetary base to pay for these purchases.
Step 2: U.S. Treasury quietly announces unlimited 3-year support for Fannie Mae and Freddie Mac on December 24, 2009, indicating that it is acting under the authority of a 2008 law (HERA) that was originally written to insure a maximum of $300 billion in total mortgage principal (not losses, but principal).
Step 3: Fed Chairman Ben Bernanke testifies to the House Financial Services Committee on February 10, 2010 that "I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term. However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities." During the interim, the Federal Reserve indicates that it expects to limit the extent to which banks lend out the base money created in Step 1, through a policy of paying interest on bank reserve balances.
Step 4: On February 11, 2010, with Treasury backing in place, Fannie Mae and Freddie Mac (whose delinquency rates have more than doubled over the past year) announce the purchase of $200 billion in delinquent mortgages that they had previously guaranteed. The entire remaining principal balance will be paid to investors at face value. This action provides a glimpse into the future: Fannie and Freddie take bad mortgages onto their balance sheets, extinguish the MBS securities at face value, and rely on Treasury funding to fill the gap.
Step 5: In the next few years, the U.S. Treasury can be expected to issue up to $1.5 trillion in new Treasury debt to the public, taking in much of the $1.5 trillion in base money created by the Fed in Step 1.
Step 6: Proceeds (base money) received from new Treasury debt issuance are periodically transferred to Fannie Mae and Freddie Mac in order to cover cumulative balance sheet losses.
Step 7: Over a period of years, Fannie Mae and Freddie Mac use the proceeds to redeem mortgage securities held by the Fed, thus reversing the Fed's transactions in Step 1, without the need for liquidation or any other "unwinding" transactions. If the MBS securities extinguished in Step 4 are not directly held by the Fed, the Fed can be expected to simultaneously sell an equivalent amount of its own holdings out to the public, so that the publicly held stock of MBS remains constant. In any event, the base money created by the Fed ultimately comes back to the Fed, and the mortgage securities purchased by the Fed disappear, by burdening the American public with a new, equivalent obligation in the form of U.S. government debt.
Outcome: The Federal Reserve closes its positions in Fannie Mae and Freddie Mac securities, the quantity of outstanding Fannie Mae and Freddie Mac liabilities declines by as much as $1.5 trillion, thus allowing their remaining assets repay the remaining liabilities despite insolvency, and the outstanding quantity of U.S. Treasury debt expands by as much as $1.5 trillion in order to protect the lenders, while ordinary Americans continue to lose their homes and jobs.
This would all be really clever if it weren't so insidious.
On Bloomberg television last week, James B. Lockhart III, the former head of the Federal Housing Finance Agency (Fannie and Freddie's regulator) commented on the bailout funds already provided to Fannie and Freddie, saying "Most of that money will never be seen again. They were just allowed to leverage themselves so dramatically."
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