Monday, October 18, 2010

“QE 2” or “Ben’s Titanic”?

Federal Reserve Chairman Ben Bernanke seems to want desperately to prove Warren Buffett wrong.

He is, in fact, betting the U.S. economy on it.

Bernanke, as all the financial world knows, is pushing the Fed into a multi-billion dollar buying spree of Treasury securities at a time when Treasury securities are at all-time record high prices.

Here’s how he justified it this past Friday:

Oct. 15 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said additional monetary stimulus may be warranted because inflation is too low and unemployment is too high.
“There would appear -- all else being equal -- to be a case for further action,” Bernanke said today…. Bernanke and his central bank colleagues are considering ways they can stimulate the economy as the unemployment rate holds near 10 percent and inflation falls short of their goals.
After lowering interest rates almost to zero and purchasing $1.7 trillion of securities, policy makers are discussing expanding the Fed’s balance sheet by purchasing Treasuries…

—“Bernanke Sees Case for ‘Further Action’ on Inflation,” by Caroline Salas and Joshua Zumbrun.

Ben’s theory is that the Fed can drive the price of Treasury securities even higher than the market has, on its own, priced them; that this, in turn, will cause the interest rate on those securities to drop (even further than interest rates have already dropped); and that this, in turn, will somehow prompt companies to start hiring again.

It is called “quantitative easing,” and since this is the second round of the Fed’s monetary efforts to restart the economy, it is known, cutely, as “QE2.”

We hear at NotMakingThisUp, however, think a far better—and more accurate—model of Ben’s recipe for success is The Titanic, not the venerable QE2.

After all, in the real world (as we described in “Memo to Bernanke: Listen to a Conference Call Once in a While”) companies hire new employees when they are confident enough in their future prospects to believe that adding a full timer will pay off—not when the cost of borrowing drops a few more basis points.

And you would think Ben would have figured this out, since interest rates have dropped a whole lot this past year, and yet unemployment remains, in the current shopworn phrase, “stubbornly high.”

The real problem, as most business people know, is not that interest rates weren’t already low enough. The problem, at least initially, was that taxes were set to rise next year, which made businesspeople leery about hiring new full time employees, despite rising order books.

Then along came so-called healthcare reform, which opened another big can of uncertainty on American business at exactly the wrong time.

And that’s when you could kiss the “V-shaped” recovery good-bye.

(People get touchy about this stuff, and we’ll no doubt get comments from thin-skinned political types about all manner of irrelevant why-this-isn’t-Obama’s-fault rationalizations, which is not the issue: in investing you deal with the world as it is. And if you want to learn about the world as it is, go ask a business owner—any size, big business or small—about how they’re feeling these days. You’ll get an earful.)

But Bernanke isn’t letting the facts confuse him. He’s going ahead with his “QE2,” which, as we already noted, involves buying hundreds of billions of dollars of Treasury securities at all-time, record-high prices.

Now, Warren Buffett has a different opinion on the value of such fixed income securities—i.e. bonds—than Ben Bernanke. In fact, Buffett recently told his friend, ace Fortune Magazine editor Carol Loomis, the following:

“It's quite clear that stocks are cheaper than bonds. I can’t imagine anybody having bonds in their portfolio when they can own equities, a diversified group of equities.”

And when Warren Buffett—who never gives stock tips and rarely comments directly on the merits of buying or selling asset classes such as stocks or bonds—speaks this directly about the lousy prospects for what Ben Bernanke wants to buy, well, attention must be paid.

After all, Buffett is no One-Way-Johnny when it comes to the merits of bonds versus stocks: indeed, for his personal account, Buffett owned only low-risk Treasury securities in the pre-crisis, bull market mania bubble years, even while self-promoting Buffett-followers such as Bill Miller were stuffed to the gills with financial stocks such as Bear Stearns and Fannie Mae in their funds.

And when the stock market began to collapse in 2008, Buffett famously began selling his Treasuries in order to buy stocks—a few months too early, as it turned out, but not as early as the poor shlubs who owned Bear Stearns and Fannie Mae and watched them evaporate.

So it has come to this: Warren Buffett says he “can’t imagine anybody having bonds in their portfolio,” while Ben Bernanke is determined to buy government bonds until the cows come home, or the unemployment rate starts to decline.

Who would you rather have making investment decisions for the Fed?

Now, readers might well be thinking, “Okay, wise-guy, what would Warren Buffett be doing if he was in Ben Bernanke’s shoes?”

And while we haven’t asked Buffett this question—if we did he’d very likely give a disarmingly amusing and self-deprecating response, along with a verbal pat-on-the-back for Mr. Bernanke (Buffett adheres to the Dale Carnegie school of making friends and influencing people)—we do have a thought about what Buffett might well think would make more sense.

Before we explain, we wish to reprint excerpts from a highly topical news story which appeared on our Bloomberg at the very same moment Ben Bernanke was reiterating his vow to pay top-dollar for U.S. Treasury securities:

Oct. 15 (Bloomberg) -- Washington policy makers, who moved swiftly to calm markets during the subprime mortgage crisis in 2008, have resisted calls for similarly broad steps in response to concern that banks may have acted illegally to seize homes.
President Barack Obama and the federal agencies that share responsibility for housing finance are opposing calls for a nationwide foreclosure freeze, fearing further damage to the housing market. Even as bank stocks tumbled yesterday on concern that the mishandled loans will increase costs for lenders, the White House and federal regulators avoided any grand gestures designed to reassure investors.
Obama this week endorsed a coordinated investigation by attorneys general from all 50 states into whether lenders used false documents to justify foreclosures….
“There are 2.3 million loans that are out there in foreclosure,” said John Courson, chief executive officer for the Mortgage Bankers Association. “The administration has in fact made the right decision by not pressing for an overall moratorium. They see the debilitating effects that could have from the standpoint of the entire economy.”

—“Washington Resists Calls for Big Fix in Foreclosure Crisis,” by Lorraine Woellert and Phil Mattingly

How encouraging 50 state attorneys general to investigate the banking system will help un-freeze the housing market is beyond us.

Rather, we wonder, why doesn’t the Fed use its purchasing power to buy houses in foreclosure?

If 2.3 million loans are in foreclosure, and if the average house in that pool could be bought for $100,000 (a number we are making up for lack of specific data), that amounts to a quarter trillion dollars the Fed could “put to work,” as money managers like to say, in a market that—quite unlike the Treasury market—is suffering from a lack of buyers and an overload of sellers.

A Resolution Trust Corp-type entity could then mass-market the properties to entrepreneurs and capitalist pigs who would maintain them and resell them at reasonable prices.

By thus providing a highly liquid market beneath a seemingly bottomless housing foreclosure pit, the Fed could kill many birds with one stone: a) re-liquify the banks, b) re-liquify underwater homeowners, c) stop the slow-bleeding in housing, and d) start the healing process.

It wouldn’t necessarily make businesses feel better about impending tax increases and healthcare cost increases, but it might make homeowners feel a whole lot better than another reduction in the interest income on their savings account.

Of course, the Fed wouldn’t exactly be the right vehicle for this: it’s a job for the FDIC with some strict legislation behind it from Congress.

Still, instead of buying treasuries at record-high prices in a futile attempt to get companies to hire people, we think Ben ought to consider the merits of buying foreclosed housing at record-low prices.

After all, Warren Buffett’s been buying low for, oh, 60 years now, and it seems to work okay for him.

Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Kid Dynamite said...

But Jeff - I'm no fan of Bernanke and his policies, but this is PRECISELY his goal with QE2 - make it impossible for people to own bonds --> stocks look cheap "relative" to bonds --> people are forced into stocks --> everyone feels richer because their retirement account value increases --> people spend money.

Now, what the end game is for this hot-potato passing, I can't imagine...

side note: you won't believe this, but my word verification for this comment is FEDGVRUB

Jeff Matthews said...

Kid D: Understood, and I agree, but by so paying record-high prices for Treasuries he is promoting a bubble in less safe securities ("the risk trade") with the hope that, indirectly, it leads to stronger real-world economic activity and thus higher employment levels. That's a lot riskier bet than buying cheap assets that directly benefit the most frozen part of the economic engine.

And you know Google is so powerful now they are probably matching word verifications to meaningful acronyms!


PJ said...

The goal of QE2 is to print more money so that inflation expectations get back up to 2%. The market's expectation of inflation has been falling since January - a clear sign that the market wants more liquidity. The Fed can fix this is by printing more money (buying bonds).

Much of that money will end up in the hands of "entrepreneurs and capitalist pigs" who will use it to buy, among other things, under priced homes.

Kieran McCarthy said...

Loved this line from Hussman's missive today.

"To assess whether QE is likely to achieve its intended objectives, it would be helpful for the Fed's governors to remember the first rule of constrained optimization - relaxing a constraint only improves an outcome if the constraint is binding. In other words, removing a barrier allows you to move forward only if that particular barrier is the one that is holding you back."

Are long-dated treasury yields holding this country back? Hmmm...

Anonymous said...

i bet that ben would consider something like that, but taking credit risk is outside his charter except in an emergency.

congress on the other hand could set up that resolution authority. phone your republican representative and tell him to allocate $200 billion dollars to such a resolution authority. i am sure you'll get a good response.

CurmudgeonlyTroll said...

Clearly, the financial crisis did not insert any uncertainty into the economy; but the actions taken to avert greater crisis gave CEOs the vapors and caused them to swoon, rendering them incapable of all the hiring that would otherwise have taken place.

Michael M said...

How about this idea:
China buys 3-5 mill foreclosed homes. China/US allows 3-5 mill Chinese skilled families to immigrate to the US on special permanent visas that don’t allow any receipt of benefits, take over a foreclosed home, live first two years rent free with the option to buy later and get a small interest free loan to start a business. The Chinese are used to giving loans that are never repaid and moving millions of people. And China has a long history of export of excess labour.

This will benefit the US economy, diversify China’s US dollar assets, make China’s US treasury bond investments safer, improve Chinese exports, improve US-China relations short and longer term and create a Trojan horse for future Chinese exports (more Chinese speakers in the US).

But What do I Know? said...

Apparently the studied of economics does not require any connection with the actual facts. After the Fed announced QE 1, long Treasuries increased dramatically in yield over the next six-nine months, and since they announced QE2 at the end of August, the 30-year has done nothing but increase in yield. So how exactly does QE reduce interest rates--other than in the world of ceteris paribus?

Frozen in the North said...


While the Bush tax ending and health care costs are certainly a major cost issue for American companies, in the end, it is demand that will dictate the decision to hire more workers (or raise price to increase margins), operating below optimal capacity means that there is no need for expansion... Yes costs are a key factor, but demand has to exist, the reality of rising inventories across the supply chain would seem to suggest that the market is constrained by demand.

McKenzieG1 said...

This post seems a little obtuse - or is it disingenuous?

The point of QE is not to prop up treasury bond prices, but rather to increase bank reserves and lending and generate inflation by printing money. Once the Fed has created the new money, they have to hand it out to the banks, which they do by buying treasury securities from them.

Goosing treasury prices is just a side effect. Whether or not it is a desirable one is up for debate.

Anonymous said...

Would'nt taking the houses off the banks'hands for 100000$ lead them to take massive losses? What would their capital position look like following those transactions?

Anonymous said...


You said the magic word, "bubble," for it's bubbles that get politicians re-elected, fed officials reappointed and called maestros and most importantly consumers made to feel "the wealth effect."

Unfortunately creating a really good bubble like Ben's predecessor, Alan, devised is a delicate fine art. Creating a housing bubble actually can create jobs, albeit temporary, but it can. Again unfortunately, creating a stock market bubble doesn't do much in job creation and it doesn't make a lousy < $ 10K 401K holder feel wealthier.

Anonymous said...

Unfortunately, Jeff, I think you've got it exactly backwards. Uncertainty isn't preventing businesses from hiring, certainty is -- the certainty that they can demand uncompensated overtime and other productivity-enhancers from the existing workforce while cutting benefits, perks and pay. That's accounted for the bulk of the recent surge in corporate profits -- why mess with a winning formula?

BTW, the idea that hiring an employee represents some sort of "commitment" on the part of a business is so cute -- what part of Europe did you say you were writing from?

Jeff Matthews said...

"Anonymous" writes straight from either the union picket line or tenured college professor's office.

He or she clearly has never talked to an actual businessperson about what is causing them not to hire.


Anonymous said...

Professor Jeff:

There are so many things I want to say in response to your post, but I think the quote I'll share below sums up the responses other posters shared:

"If the governments devalue the currency in order to betray all creditors, you politely call this procedure 'inflation.'"

George Bernard Shaw

Rich said...


I listen to a ton of calls, including a lot of banks. On the Citigroup debt call on Friday, they mentioned that their Citi Holdings asset book declined from $705 BILLION to $421 Billion from 3Q08 to 3Q10(slide 8). That is hugely deflationary.
from slide 2 -
Citi Holdings: Assets of $421B; down $44B from 2Q’10 and 49% lower than 1Q’08 peak. Expect to be below $400B by year-end, or less than 20% of Citigroup’s assets

Virtually every loan book of banks are flat to down. The mortgage market is a pale shadow of what it was a few years ago.

GDP = Money supply X Velocity - It's a flow concept, and things ain't flowing! If bank loan portfolios are declining the way they have, do you really want Ben to sit on his hands and ignore the stagnant money pool?

I'd suggest re-reading the Bernanke speech from 2002, at-

He isn't likely to buy 30 year paper, and if 2-5 year US paper is swapped for currency, why is that irresponsible? It's simply swapping a non-earning asset for an earning one. He's jawboning the market to do the reflation ahead of him, so the effect is more that of a put.

We all have to hope that it works!

Jeff Matthews said...

Rich makes excellent points in a well thought out comment. His observations on the lending markets are accurate. The Citigroup call was indeed grim, as have been those of most banks, regionals not excepted.

Our beef is this: the heart of the problem is the housing market, and the blood is not flowing to the rest of the patient because the foreclosure valve is blocking it.

Lower rates won't cure this, in my view--they haven't done a thing so far anyway--but what would cure this is a final, market-clearing foreclosure buyout on a scale of the type Bernanke is contemplating for his Treasury buys.

The RTC accomplished this in the early 1990s with commercial real estate. A new RTC could do the same, it seems to me.

I still don't understand how lower short-term rates moves the needle.


Rich said...

The lack of an obvious transmission mechanism is where the hope comes in.
My hope is
- that the excess money flows into stocks, and that Joe Average starts feeling better about his portfolio and starts spending

-that businesses take the higher stock price as a cue to spend money on that new project, which hopefully expands employment

-that the higher stock prices have a salutary effect on pension funding levels, thus reducing the risk of a hare-brained reallocation from equities to bonds being discussed by pension funds.

It's all about confidence. It would also help if the incessant barrage of negative campaigning by the Rove party didn't give the corporation-funded impression that the sky is falling.