Quantitative Easing – Fed to buy $300 billion Govt Securities

With the target interest rate near zero, the Federal Reserve shifts its main policy tool to quantitative easing. Quantitative easing is a policy tool of central banks to inject liquidity through open market operations or outright printing of money. On March 18, often dissenting Richmond Fed President, Jeff Lacker, finally got his way, the Federal Reserve announced the purchase $300 billion long-term treasury securities. At the January 28 FOMC meeting, Lacker cast the lone dissenting vote, Lacker “preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.” Despite the Federal Reserves best efforts and a target rate near zero, the US monetary base was actually shrinking during the first quarter of 2009. Federal Reserve Bank of St. Louis working paper by R.G. Anderson nicely defines monetary base as follows:

The monetary base in monetary economics is defined and measured as the sum of currency in circulation outside a nation’s central bank and its Treasury, plus deposits held by deposit-taking financial institutions (hereafter referred to generically as “banks”) at the central bank. More generally, the monetary base consists of whatever government liabilities are used by the public to purchase and sell goods and services, plus those assets used by banks to settle inter-bank transactions.

The monetary base exploded starting with the stimulus package in late 2008 at a rate unparalleled in the past 50 years.


However at close examination, the monetary base has been declining of late.


A shrinking monetary base is commonly thought of as a deflationary sign, during Japan’s Lost Decade, the Bank of Japan kept its target rate near zero and allowed the monetary base growth to slow dramatically following substantial growth during the 1980s. This policy action from 1990-1993 added substantially to the destructive deflation of the decade.

Central banks typically have three policy tools, (1) adjusting the discount rate, (2) adjusting the reserve requirement, and (3) purchase securities via open market operations. Open market operations impacts the monetary base (money supply) as follows, the central purchase securities from consumers and institutions there by injection liquidity (cash in the pocket of consumers) leading to an increase in the monetary base (currency), a component of money supply. It is thought that the US is facing a liquidity trap, an economic condition when target rates are near zero (option 1 no longer available) and the central bank attempts to inject liquidity; however, financial institutions are unwilling to lend.

The Fed’s action to purchase $300 billion in long-term government securities should help mitigate the liquidity trap as well as increase the monetary base, reducing the risk of destructive deflation. Most obviously, there will be an increase in currency in circulation through the purchase of treasurys. Additionally, the purchase of long-term government securities dramatically increased the demand for out-of-favor long-term instruments, thereby flatting the yield curve and reducing the rates on credit with similar, longer-term maturities. The key is a reduction in borrowing costs for end-users, mortgages and retail credit; on cue, US mortgage rates fell to 4.85%, the lowest on record. A reduced rate will hopefully increase demand for credit, in turn prudently expanding the balance sheet of financial institutions.

The action does not come without major skepticism from economists focused on inflation, not deflation as the major concern. Interestingly, while a supporter of the policy, Lacker discussed inflation as a potential concern in his speech to business leaders in Charleston. The expansive Fed balance sheet could prove difficult to unwind when the recession end; Lacker noted that skillful central bankers will be required. While inflation, even hyper-inflation could be a concern with the central bank monetizing the debt like a developing nation, the Fed will have far more tools in the tool kit to fight inflation than deflation. The recent announcement should prove timely and coordinated with the Treasury’s initiatives to clean financial institutions balance sheets.

TALF Underway – Help for ‘Main Street’

On March 3, the Federal Reserve announced the revisions to the Term Asset-Backed Securities Loan Facility (TALF). The TALF component of the Consumer and Business Lending Initiative (CBLI) is designed to provide up to $1.0 trillion in lending capacity to consumers and small businesses. Traditional consumer financing, credit card loans, auto loans, student loans, Small Business Association loans rely heavily on the Asset Backed Security (ABS) facilities for funding. The Fed estimates that roughly one-quarter of all non-mortgage consumer loans are financed through ABS SPVs.

Importantly for the March revision, the hair cut and interest rates on the student loans and SBA-guaranteed loans was reduced. Interestingly, the Government’s collateral on the TALF loans are loans which carry and explicit government guarantee. The TALF loans are non-recourse, in the event of default, the Government has the right to seize the collateral (the loans) in order to make good on the TALF loan. Interestingly, as the loan default trickles down the chain, the Government will effectively be paying the left pocket from money in the right pocket. This government guarantee was the rationale for the reduction in rates and haircuts; hopefully we do not see the left-to-right pocket exchange. The potential for a trillion in financing should help expand the economy; as currently drafted, the TALF will provide $200 billion in loans.

Protection for the Tax Payer
As previously mentioned, a few loans carry explicit guarantees, SBA and student loans; loans that do not carry the guarantee must be rated AAA by two approved credit rating agencies. Substantial criticism has been given to the rating agencies handling of the securitized pools of loans; however, absent a better risk assessment system, the AAA rating provides some assurance for tax payers. Second, the “haircut” mentioned above in effect over-collateralizes the TALF loans. For example, a student loan with a 2-3 year ABS life carries a 10% haircut. In order to receive a $90 million dollar loan under TALF, the investor must pledge $100 million in collateral. Lastly, the Government receives an interest rate that corresponds with the risk of the underlying assets. The prime student loan above would be priced at LIBOR plus 50 basis points.

TALF Underway
On March 19, the Fed announced nearly $4.7 billion in loan requests. Requests were linked to $1.9 billion in auto-loan securitization and $2.8 billion in credit card related facilities. Interestingly, no student loans or SBA guaranteed loans were pledged in conjunction with loan requests. As noted, loans need to carry a AAA rating; however, loans downgraded after initial funding remain eligible. Thus, financial institutions accessing TALF funds will likely pledge loans which they perceive to be riskiest, mispriced, or incorrectly rated. Financial institutions are likely most concerned with the state of the over-levered general consumer, pledging credit card and auto loans.

In conjunction with the announcement of initial funding, the Fed announced four additional categories eligible under TALF: (i) ABS backed by mortgage servicing advances; (ii) ABS backed by loans or leases relating to business equipment; (iii) ABS backed by leases of vehicle fleets; (iv) ABS backed by floorplan loans As the pool of eligible loans expands, so does the Feds balance sheet. The exploding balance sheet is a little less daunting when an organization is back stopped by a printing press, not to say the US should or will inflate its way out of the debt problem.

A Scaffolding of Cards for the House of Cards?
Interestingly, the off balance sheet SPVs that appear to have created the credit crisis will be the primary tool for supporting TALF. The Federal Reserve Bank of New York (FRBNY) will create an SPV to hold all ABS collateral received. The SPV will be funded with up to $100 billion on subordinated loans from the Treasury through the TARP and the FRBNY will fund the SPV with a senior loan. In a similar structure to other securitization facilities or CDOs, the investors are ranked and prioritized. The FRBNY holds the most senior position and claims first priority to all cash flows to the SPV, the Treasury holds second priority (mezzanine position), and the residual third priority (equity position) is shared by the Treasury and FRBNY. The scaffolding of cards should hold up, securitization and pooling of assets was not the problem, pricing of the pools was the problem.



On balance TALF should spark consumer and small business lending and is a start down a long, winding road to recovery. Access to credit will enable small businesses to grow and employ Americans. The credit is necessary for capital equipment purchases to create goods and provide services for export and domestic consumption. Purposed slogan: TALF - a $200 billion spark plug for autos.

Unintended consequences, volume 2

Unless you've sworn off TV, newspapers, the Internet, and casual watercooler chats, you have witnessed the enormous backlash against the bonus payments destined for the AIG unit that led to the firm's collapse. Senator Chuck Grassley called for executives to commit suicide. And, if the executives aren't willing to do it themselves, others have written death threats against the bonus-receiving executives. Unions are protesting outside of financial firms' offices. Congress is considering passing a tax that would effectively recapture all of the bonuses. The President is opining on the subject.

This outrage (Mr. Grassley's suggestion and death threats excluded) is understandable and justified. These executives failed, and they are still getting paid. Whoever wrote their employment contract did a horrific job, and policymakers face a monumental challenge in ensuring that executive pay agreements are more appropriately structured in the future. But for all the outrage, the more relevant question is what to do now?

The government is right in asking these executives to voluntarily relinquish bonuses and to plan reforms to ensure that pay structures are better designed in the future. But much more is at stake than $165M dollars:

First, Ameircans should make sure that in their zeal to uphold their principles they do not encourage worst transgressions. There is simply no excuse to call for physical harm to any particpants in this ordeal. Yes, many mistakes were made by AIG executives and employees, but they were mistakes -- not capital crimes.

Second, the government has committed nearly $10 TRILLION dollars to the bailout by some counts. The AIG bonuses are 0.0017% of that total. The bonus issue has hindered Treasury Secretary Timothy Geithner's ability to get things done. Shouldn't we all worry about how he is using the other $9.999 trillion?

Third, consider how this hamstrings the government's ability to restart the economy. The government launched the Term Asset-Backed Lending Facility to help restart consumer lending and get the economy working again. But healthy financial institutions are hesitant to take advantage of the TALF, fearing that they too could get swept up into populist rage against the financial system.

This final point is particularly intresting: it is almost like reverse moral hazard. Companies that don't need taxpayer money might be willing to accept it in order to help get the economy moving again, but only if they won't face fallout or onerous terms in doing so. If they believe that they will catch the backlash even if they don't do anything wrong, they might just decide it isn't worth dealing with -- limiting the government's ability to get the economy moving again. Let's hope that Congress and the Administration can suspend their outrage long enough to realize that the AIG bonus situation makes for great political posturing but isn't getting the economy any closer to health.

Cap and Trade: Path to Glory?

One of the most controversial pieces of the new Obama budget is an emissions trading program which hopes to generate revenue for the government in addition to limiting the amount of greenhouse gases that America releases into the atmosphere every year.

While the details of the program have not yet been fully fleshed out, the proposal itself has created a torrent of criticism, from likely places with an unlikely argument. Regardless of the political controversy, an argument worth having is whether or not this particular system is the most efficient way to curtail greenhouse gas emission.

America's historical experience with emissions trading dates back to the 1990 Clean Air Act, which sought to limit acid rain by curtailing sulfure dioxide emissions. If measured on results, this particular program was incredibly successful. From 1990 to 2002, sulfur dioxide emissions dropped from 16M tons to 10M tons achieving 80% of the goal eight years before the target date. The EPA estimates that the program costs roughly $1 to $2 billion per year, which is relatively inexpensive on a per capita basis. This annual cost is actually only one-fourth of what was predicted when the bill was enacted.

There are several criticisms of the cap and trade borne out of the experience with the sulfur dioxide trading regime, which are highlighted in this particular post by, ironically, Larry Summers.

He lists the following problems:
1. Difficicult to implement.
2. Pollution credits in Europe are very cheap, indicating an ineffective permitting regime.
3. Incentives are created for companies to engage in economic rent-collecting behaviors.
4. Pollution credits are allocated rather than auctioned, creating marketplace inefficiency, and robbing the government of additional revenue.

Picking up on a theme? Most of his difficulties come from his view that any centralized scheme is doomed to failure because of either or both of implementation difficulty or sheer incompetency.

Another perspective comes from the Environmental Defense Fund:
1. Mandatory emissions cap, with a very positive market clearing price for credits.
2. Fixed allowances for each polluting entity.
3. Creation of robust banking and trading of credits.
4. Clear performance criteria.
5. Flexibility for polluters.

Again, the EDF lists many of the design factors in a trading program that need to be optimized, but does not really have any good ideas for how to do it. As such, it would seem that at a cursory level the devil is certainly in the details.

Therefore, it would seem we can only know how effective and efficient the program will be once the EPA actually creates the trading framework. By then, the debate will be over and oversight over the most crucial phase of implementation will be, unfortunately, lax.

A tax by any other name

President Obama has faced little difficulty in selling the biggest component of his tax policy- the expiration of the Bush tax cuts. Given the massive amount of spending we’ve seen in the last two months, the fact that Democrats control the entire federal government, and the not-to-be-underappreciated fact that Obama campaigned on killing the tax cuts, everyone knew this was coming. Republicans are gamely fighting it, but one suspects they secretly welcome a fiscal debate that offers this much clarity. The lapsing of the Bush tax cuts represents a straightforward, old-fashioned tax increase. It is something the public can understand and clearly support/oppose, something they couldn’t do during the expedition into fiscal androgyny known as TARP or the drunken scrum known as the stimulus package.

Given rising concerns over federal debt levels and the redistributive spirit that always seems to accompany economic recessions, the public largely supports phasing out the Bush tax cuts. At the same time, Obama is finding out how hard it is to camouflage tax increases the public doesn’t support. His proposal to decrease tax deductions for charitable contributions was lambasted by non-profits and ridiculed by Congress. His attempt to fast-track carbon taxation through the Senate ran into a brick wall of moderate democrats, and the surprisingly sophisticated public has worked backwards through the math and realized that the home mortgage bailout plan will inevitably push credit costs higher for everyone else, while creating another federal deficit stream that will need to be funded by increased taxation.

In summary: 1) Americans don’t feel they shouldn’t be taxed for money that they give away to others 2) they don’t like being taxed to change their energy consumption behavior when they're in the middle of a recession and viable alternatives don’t exist, and 3) they don’t like paying their neighbor’s mortgage. Go figure.

This week saw the beginning of another new taxation proposal that the public will likely find just as endearing- taxing health care benefits as income. Ironically, during the campaign this idea was floated by the McCain campaign, and quickly became fodder for attack ads from the Obama campaign. The ads failed to note that McCain’s plan called for tax credits to partially offset the new tax, but even if they had it probably wouldn’t have made the proposal any more palatable. The public hated the idea, and if Obama travels down this path he will find that he has indeed become a post-partisan leader. Both the U.S. Chamber of Commerce and the SEIU oppose the idea, which would mark the first time they were on the same side of an issue since, well, I don’t know, WWII.

You can’t blame Obama or his coterie of highly-intelligent-yet-socially-handicapped economic advisers. The proposal makes economic sense. Non-taxation of health care benefits has resulted in an arms race for employers and contributed to skyrocketing health care costs for the entire economy.

For example, let’s say you are a small manufacturing company and you are negotiating a new contract with your line workers. If their base salary level is $40,000, than for every additional $100 you increase it, after backing out a 25% income tax, 7.5% social security tax, medicare, state and local taxes, your employees will only end up taking home about $65 of the $100 you paid out. If instead you offer $65 in health care benefits, your employees would get the same utility, while you as a company would pocket the $35.

Unfortunately you don’t get to keep that $35. The market recognizes your newfound windfall, so your insurance companies and health care providers keep increasing their prices until you find that the marginal cost of providing another cent of health care to your employees is the same as the marginal cost of another cent of salary. At the same time, it has artificially raised the cost of health care by $35 for everyone in the system, which especially impacts those people who have to buy their own insurance.

In a conservative’s ideal world, we wouldn’t have taxes so this imperfection wouldn’t exist. In a Scandinavian’s ideal world, there are no taxes, because the government runs the system and imperfection is a given. Here in real-world America, there is a middle course available to President Obama. Tax health care benefits, but do it at a lower rate than income taxation. A health care benefits tax of 20%, phased in over three years (vis-à-vis tax credits to both individuals and businesses) would be a good target. At this low level, you would get some of the economic benefits and a degree of political solvency for the plan.

One more thing…it should be a flat tax. If we are shooting for a world in which equal access to equal health care is a “universal right” shared by every American, then $100 of health care should have the same economic utility for every American, irrespective of their income level. A household comprised of schoolteachers making $70,000 a year gets the same utility from $100 of birth control and Propecia as does a household comprised of a two investment bankers. OK, that was a bad example. Instead of investment bankers, how about two pawn shop brokers?

Budget Nomenclature

Here's something that's a little fun...Every time a new President submits their budget proposal to Congress, they give it a catchy slogan. You’ve got to hand it to these Presidential wordsmiths, they are nothing if not consistent. See if you can match the official budget slogan with the right administration:

1) “A vision of change for America”
2) “Building a better America”
3) “America’s new beginning”
4) ”A new era of responsibility”
5) “A blueprint for new beginnings”

a) Barack Obama
b) George Bush
c) Bill Clinton
d) George H.W. Bush
e) Ronald Reagan

Very creative.

Comparing the future- a historical look at budgets

Unprecedented, or unremarkable?
Radical, or reasonable?
Foolish, or prudent?

These are just some of the adjectives being used to describe the 2010 budget proposal submitted to Congress by President Obama. The Republican opposition has already begun to refine its red scare messaging, while liberal special interest groups are salivating over the pork that’s coming out of the budgetary oven. The seemingly optimistic economic assumptions underpinning the budget’s spending goals have led some economists to question whether the President can get what he wants without raising taxes, while others are goading him to spend more.

So where does this budget stand in relation to his predecessors’ proposals?

A quick look at previous budget proposals reflects a lack of connection between a president’s initial budget and what ends up happening. President Obama’s proposed increases in receipts might be a bit rosy given the current economic downturn, but they are in line with previous administration’s increases. The same can be said of proposed increases in spending.

Some consistencies emerge….

Receipts forecasted to grow over prior periods, but the actuals usually end up lagging predictions...

Spending is usually forecasted to grow over previous periods, but always increases even more than predicted…


Concordantly, deficits continue to outpace expectations…

The concern held by many is that Obama's spending priorities will further exacerbate deficits, but if the historical data is any indication, anything can happen. The unique combination of Bill Clinton, a conservative congress and a booming economy resulted in a government that took in more than it forecasted, spent less than it expected, and brought the first surplus in decades.

A little help for the FDIC

The FDIC is taking a little breather from bailing out failed banks to... wait for it... be bailed out itself. Turns out that this "no cost to the taxpayer" program that was supposed to be funded by deposit insurance premiums was charging too low of a rate, and is now stock dangerously undercapitalized (thanks to a provision that the FDIC's fund should be capped at 1.25% of deposits). So Senator Chris Dodd (D-CT), Chairman of the Senate Banking Committee, introduced a bill at the behest of FDIC Chairwoman Sheila Bair to raise the FDIC's borrowing maximum from $30B to $500B, a better than 10x increase.

This is a prudent move. The FDIC's deposit insurance fund is running dangerously low, with only $35B in the insurance fund as of Q3 2007, dropping to $19B by year end. The result is a paper-thin base of capital to insure deposits: the FDIC's $19B of capital amounts to 0.4% of U.S. deposits (known as the Deposit Insurance Fund Ratio, or DIF ratio). This is a substantial drop from the usual 1.2%+ range. To raise this ratio, the FDIC has two options: borrow from Treasury, or make the banks pay more. Making the good banks pay for the bad banks' mistakes during a credit contraction has drawn howls of protest (including from this space). Eliminating any doubt of the FDIC's solvency is the right move at this moment in the crisis... let's hope Congress speeds through this policy change.