The Fed cannot
create a bid in bidless markets that lasts beyond its own
buying.
We all know the
Federal Reserve (and every other central bank) has one last Doomsday
weapon to stop a meltdown in the global financial markets: creating
trillions of dollars out of thin air and using the cash to buy assets that
are in free-fall.This
is known as “the nuclear option”–the direct monetizing of stocks, Treasury
bonds, commercial real estate mortgages, student loans, corporate bonds,
non-U.S. sovereign bonds, subprime auto loans, defaulted bat guano
securities, offshore loans denominated in quatloos–you name it: The Fed
could print money and buy, buy, buy to create and maintain a bid in
bidless markets.
The idea is to
stop a cascade of panic by buying assets in quantities large enough to
staunch the avalanche of selling. The
strategy is based on one key assumption: that no more than a small
percentage of the asset class will change hands in any day or
week.
Thus a low-volume
sell-off in the $20 trillion U.S. equity markets can be stopped with large
index buy orders in the neighborhood of $10 – $100 million–a tiny sliver
of the total market value.
But in a real
meltdown, popguns will no longer conjure a bid in suddenly bidless
markets, and the Fed will have to become the bidder of last resort on a
massive scale in multiple markets. We
need to differentiate between loans, backstops and guarantees issued by
the Fed and actual purchase of impaired assets.
After poring over
all the data, the Levy
Institute came up with a total of $29 trillion in Fed and Federal
bailout-the-financial-sector loans and programs. The GAO found the Fed
alone issued $16 trillion in loans and backstops:
The Fed’s purchases
of impaired mortgages has also made its balance sheet “the place where
mortgages go to die:” the Fed can hold impaired mortgages until maturity,
effectively masking their illiquidity and impaired market value. We can
see these two major purchase programs in this chart from Market Daily
Briefing:
The Nuclear
Option rests on another questionable assumption: markets only go bidless
in brief panics, not because the assets have lost all
value. The basic model of Fed
emergency loan programs and asset-buying is 1907–a financial panic that
erupts out of a liquidity crisis.
In a liquidity
crisis, the underlying assets supporting loans retain their market value;
the problem is a shortage of credit needed to roll over short-term loans
on those still-valuable assets.But what the world is finally starting to experience is not a liquidity crisis: it is a valuation crisis in which assets and collateral are finally recognized as phantom. I explained the difference between liquidity and valuation crises in In a Typhoon, Even Pigs Can Fly (for a while) (January 30, 2014).
Let me illustrate
why the Fed’s Nuclear Option is a one-way street to
oblivion.
What is the market
value of a defaulted student loan that has no hope of ever being repaid by
an unemployed ex-student debtor? The answer is zero: the “asset”
has a value of zero and will always have a value of zero. It is not
“coming back.”What is the market value of a commercial mortgage on a dead mall that has no hope of ever being repaid by an insolvent mall owner? The answer is zero: the “asset” has a value of zero and will always have a value of zero. It is not “coming back.”
The New York
Times recently published an article that nails the core issue in
the entire U.S. economy: the top 10% is the only segment able to support
additional consumption:The Middle Class Is Steadily Eroding. Just Ask the
Business World (Yahoo news version)
“The Biggest Redistribution Of Wealth From The Middle
Class And Poor To The Rich Ever” Explained
This raises an
obvious question: can the excess consumption of the top 10% support every
mall, strip mall, premium outlet and retail center in the U.S.? Equally
obvious answer: no. Most
dead malls cannot be repurposed; the buildings are cheap shells, and while
the land might retain some value for future residential housing, the
coming implosion of the latest housing bubble nixes that hope: WARPED, DISTORTED, MANIPULATED, FLIPPED HOUSING
MARKET (The Burning Platform).
What is the value
of a company’s shares if that company has lost any means of earning a
profit? Answer: the book value of the company’s assets minus
debt. Given the staggering
debt load of the corporate sector, the real value of many companies once
their ability to reap a real (as opposed to accounting trickery) net
profit vanishes is near-zero.
How about the
value of Greek sovereign debt? Zero. The value of mortgages on empty
decaying flats in Spain? Zero. And so on, all around the
world.This leads to a sobering conclusion: Should the Fed attempt to create and maintain a bid in bidless markets, it will end up owning trillions of dollars in worthless assets–and the market for those assets will still be bidless when the Fed stops being the bidder of last resort.
Let’s assume the
Fed’s leadership will feel a desperate need to stop the next global
financial meltdown in valuations. Offering trillions of dollars in
liquidity will not stop sellers from selling nor magically create value in
worthless assets. The Fed can only stop the selling by becoming the entire
market for those assets.
The list of
phantom assets the Fed will have to buy outright with freshly conjured
cash is long. Let’s start with
hundreds of billions of dollars in defaulting/impaired student loans. Once
the debtors realize the system is swamped with defaults and can no longer
hound them, the flood of defaults will swell.
The Fed can buy
as many defaulted student loans as it wants, but it will never raise the
value of those loans above zero. The
market for worthless student loans will remain bidless the second the Fed
stops buying.The same is true of all the defaulted, worthless commercial real estate (CRE) mortgages on dead malls, decaying strip malls and abandoned retail centers: no amount of Fed buying will create a market for these worthless assets.
Dead Mall Syndrome: The Self-Reinforcing Death Spiral of Retail (January 22, 2014)
The
First Domino to Fall: Retail-CRE (Commercial Real
Estate) (January 21, 2014)
There is no
technical reason the Fed cannot create $10 trillion and buy up $10
trillion of worthless or severely impaired assets; the Fed can become the
owner of every dead mall and every defaulted auto loan in America should
it wish to.
That would of course
render the Fed massively insolvent, as its assets would be worth a
fraction of its liabilities. But so what? The Fed can simply assign a
phantom value to all its worthless assets and let them rot until maturity,
at which point they vanish down the wormhole.
The point isn’t
that “the Fed can’t do that;” the point is that the Fed cannot create a
bid in bidless markets that lasts beyond its own buying. The Fed can buy half
the U.S. stock market, all the student loans, all the subprime auto loans,
all the defaulted CRE and residential mortgages, and every other worthless
asset in America. But that won’t create a real bid for any of those
assets, once they are revealed as worthless.
The nuclear
option won’t fix anything, because it is fundamentally the wrong tool for
the wrong job. Holders
of disintegrating assets will be delighted to sell the assets to the Fed,
of course, but that won’t fix what’s fundamentally broken in the American
and global economies; it will simply allow the transfer of impaired assets
from the financial sector and speculators to the
Fed.
Anyone who thinks
that is the “solution” should read QE For the People: What Else Could We Buy With $29
Trillion? (September 24, 2012).
The Retail
Commercial Real Estate Domino with
Gordon T. Long and CHS:
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