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.

Stimulus 2009 – Tax Relief for Debt Repurchase

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Tax Act of 2009. A portion of the bill allows for tax relief to companies that repurchase their own debt at a discount. The bill will provide significant benefits for private equity funds that repurchase debt on behalf of their portfolio companies. The rationale behind the bill is to incent cash strapped, highly levered companies to repurchase their debt; the reduced burden of the high debt service (interest and amortization payments) would leave the companies more nimble and less likely to layoff employees in the downturn. The tax relief is estimated to cost the Treasury $1.6B over the decade; however, it will be more costly in the near term – $42B reduction in tax receipts over the next three years.

Part IV – Rules Relating to Debt Instruments (starting on page 224), Section 1231 lays out the specifics regarding the repurchase of debt; the law firm Sidley Austin LLP provides a good summary of the new legislation as well.

‘‘(1) IN GENERAL.—At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument shall be includible in gross income ratably over the 5-taxable-year period beginning (in 2014)

Current tax requires a company that repurchases its own debt at a discount to recognize income in the current year in the amount of the discount of the debt. For instance if the company issued $1.0mm of debt, but repurchased the debt for $700,000 to recognize $300,000 ($1,000,000 - $700,000) of cancellation-of-debt (COD) income -> resulting in a ~$100,000 tax bill if taxed at 34% marginal tax rate.

New tax legislation allows companies or related parties (private equity funds) that repurchase debt a discount in 2009 and 2010 to defer the COD income over a five period beginning in 2014. In the above example, the Company would recognize $60,000 ($100,000 / 5) of COD income in each tax year 2014-2018.

The legislation also allows for tax deferral if the debt is restructured via a debt-for-debt exchange, from significant modification of the existing debt instrument, or from complete debt forgiveness – which may the case for ‘debt’ provided by financial sponsors.

The legislation should provide the appropriate incentives for companies to delever and maintain a prudent capital structure. The reduced leverage and cash savings also should reduce the number of bankruptcies and out of court restructurings, hopefully reducing layoffs. Critics point out that companies with enough cash to repurchase debt are not in need of a stimulus, thus the $42B in tax relief could be more effectively placed in other areas of the economy. While these companies may have the cash today, the bill is designed to reduce the likelihood that currently solvent & liquid companies become insolvent and/or illiquid.

You know people are thinking about moral hazard when...

Stuff like this starts making the rounds on the Internet (from Vanity Fair):

Betting Uncle Sam goes bankrupt

Bloomberg is reporting that credit default swaps (CDS) on U.S. Treasury debt are trading at record high prices of 56 basis points. A market participant buying the credit default swap insurance is essentially betting the U.S. Treasury is going bankrupt. That makes no sense.

First of all, U.S. Treasury debt is conveniently denominated in U.S. dollars. It turns out that if the U.S. government needs more dollars, it can simply fire up the printing press and print some more. That would normally be a bad idea (ask Germany), but there is a strong case that printing money would be better than defaulting on debt. Of course, U.S. Treasury CDS could be different than standard CDS. They could be structured to pay out if the U.S. merely monetizes its debt, instead of defaulting. In that case, can anyone recommend a good broker for buying Treasury CDS?

The second reason Treasury CDS contracts are nonsensical: who exactly do you buy them from? If the U.S. Treasury is defaulting on debt, how bad have things gotten? Who is still in business that is willing to pay out on the insurance policy? U.S. banks that are already dependent on the government? U.K. banks that have even higher leverage than U.S. banks? How about me? I would be a great counter-party: I pay my rent on time every month, and the student loans on my personal balance sheet are backed by highly valued (ahem) intangible assets: accumulated knowledge and transformational experiences.

Outside of the People's Bank of China (who holds one trillion dollars or so of U.S. debt), there does not seem to be any credible counterparty. So who exactly is buying these things? And how do they rationalize these two objections?

Show me the money!

The Wall Street Journal is reporting [gated] that Treasury's Troubled Asset Relief Program is being hampered by a lack of staff. Given what Treasury's civil service (i.e., non-political appointee) jobs have to offer potential job seekers, this should surprise no one.

First, consider what type of skills are necessary to help run the TARP. It is not dissimilar from a $700B hedge fund, and it requires similar skills: reading financial statements, creating models, and business judgment. In short, TARP requires the sort of skills obtained on Wall Street and at MBA programs. Treasury competes directly with these alternatives for the best talent, and a Treasury civil service career does not compare well, particularly on salary.

Business Week's top ten MBA programs all claim average starting salary above $100,000, with three programs exceeding the $120K mark, and this is just salary: most jobs include bonuses. A search of Treasury job postings yields five positions that could pay eventually pay $100K, and none where the starting pay exceeds $100K. The pay also tops out lower ($149K, lower than the total compensation of a starting management consultant at Bain, BCG, or McKinsey). This problem is not limited to Treasury; closing the salary differential between judges and private sector alternatives is frequently advocated.

There are other issues as well. Civil service career progression ends when the org chart switches from civil service to political appointee positions. The positions are not breeding grounds for lucrative private sector careers in the future. And, unlike Federal judges, the positions are not regarded as highly prestigious. Finally, the government bureaucracy has a reputation as slow to move, less focused on merit, and discouraging for the entrepreneurial types found in business schools. While the civil service has its benefits - work-life balance, job stability, and, importantly, pride in serving one's country - these benefits do not have top MBAs or Wall Street alumni rushing to Washington.

How to to fix this dilemma? There are examples of government bureaucracies that work. Japan's METI (f/k/a MITI) regularly recruits the nation's top graduates due METI's important role, exclusive hiring practices, and the resulting private sector opportunities. If Treasury's TARP promised similar long-term opportunities, it would have more success in recruiting the needed staff. But more important than that? Show them the money.

Capital Purchase Program

This morning Secretary Hank Paulson made a statement regarding the $250B Capital Purchase Program component of the financial rescue package. Critics of the CPP and TARP question the role of government in the capital markets and believe that the US Government is privatizing profits, while socializing losses.

Although drastic, CPP and TARP are well within the bounds of Treasury’s duties. The following is an excerpt from Department of the Treasury’s mission:

The Treasury Department is the executive agency responsible for promoting economic prosperity and ensuring the financial security of the United States. The Department is responsible for a wide range of activities such as advising the President on economic and financial issues, encouraging sustainable economic growth, and fostering improved governance in financial institutions.

CPP is the direct result of the later two goals. Paulson notes in his statement, “Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital.” The restored confidence should open up the credit markets, prudent deployment of capital will enable sound businesses, aspiring students, and honest homeowners to continue the sustainable growth the United States has exhibited since 1776.

Additionally, the Treasury is utilizing market mechanisms to institute additional regulation. Qualifying Financial Institutions (QFI) will only have access to CPP if the institutions agree to caps on executive compensation, clawback provisions, and bans on golden parachutes. The Government is not ruling with an iron fist, rather the Treasury is providing a carrot for banks and thrifts to exercise increased prudence and to incent greater alignment of interest between all stakeholders.

In the near-term, the Treasury may have socialized losses; however, Paulson highlights the CPP is an investment by the Treasury, not an expenditure of the Treasury. The CPP investments will be in the form of preferred stock (5% dividend yield) with warrants for common stock. Assuming confidence is restored and sustainable economic growth persists, the warrants should provide the Government with substantial upside. As Tier 1 Capital, CPP investments will improve the banks’ capitalization and coupled with an improved balance sheet through other TARP initiatives, bank common equity valuations should improve.

Such investments are not risk free; the Treasury cannot guarantee a return OF capital, never mind a return ON capital. In April TPG appeared to have structured their way into a sound investment of preferred equity in Washington Mutual; however, the investment has turned out to be an expenditure. In reviewing the Interim Final Rule for the TARP CPP, as noted earlier, the qualifications are focused primarily around corporate governance and are not focused on the soundness of the preferred equity investment. A return on capital should yield a return to a prosperous United States.

For more information see the CPP FAQ and Application Guidelines.

Funding the bailout – nation of debtors & foreign creditors

The US is a nation of debtors and once again the US plans to fix its troubles with nothing else but more debt. According to the US Department of the Treasury’s September 20 Fact Sheet, the $700B proposed “bailout” of mortgages and other troubled assets will be funded through the Treasury’s general fund.

Funding. Funding for the program will be provided directly by Treasury from its general fund. Borrowing in support of this program will be subject to the debt limit, which will be increased by $700 billion accordingly. As with other Treasury borrowing, information on any borrowing related to this program will be publicly reported at the end of the following day in the Daily Treasury Statement. (http://www.fms.treas.gov/dts/)

As of the end of July 2008, $2,676 billion of US treasuries were held by foreign governments and institutions. Nations of Savers are leading the way; Japan and China hold $593B and $519B in treasuries respectively. A similar cast of characters will be the likely purchasers of the bailout financing. Multiple concerns arise from the increase in US national debt balance: (1) Our children will pay for our mistakes in the form of interest; (2) The increased debt burden, debt service and interest, will continue to make balancing the budge more difficult; (3) Significant holdings of US treasuries may have negative implications for the US in the form of a strategic bargaining position.

The January 2008 CRS Report for Congress, “China’s Holdings of US Securities: Implications for the US Economy,” highlights the concerns of many economists with the high level of foreign debt held by our, at times less than friendly, neighbors. The report focused on the comments of two Chinese officials regarding China’s ability to tank the US dollar by liquidating large blocks of US Treasuries. This ability could be used as a bargaining chip in strategic trade negotiations, such as the US protection of the steel industry. A flood of US dollars in the market place would create a rapid deterioration of the US Dollar and an increase in interest rates (bond price declines à increase in bond yield). A decline in the US Dollar would increase the price of imports and put substantial pressure on an economy dependent upon foreign imports. A systematic depreciation in the US Dollar (as noted in my previous post) could lead to a reduction / elimination of the trade deficit (positive), but a sudden drop coupled with an increase in interest rates would make the necessary expansion of exports difficult (negative).

China probably would not have a credible threat. The US accounts for 30% of all Chinese exports, if the US Dollar depreciates substantially verse the Yuan, the US will reduce purchase of said exports. The fourth largest foreign holder of US Treasuries is “Oil Exports” (South American and Middle Eastern nations) many of which are unfriendly. Who needs who more? The US has substantial dependence on Middle Eastern oil; however, oil is denominated in US dollars. As long as oil is denominated in US dollars, major oil exports have an incentive NOT to see a precipitous depreciation in the US Dollar verse major foreign currencies.

Budgetary impact – Prior to the proposed bailout, net interest expense is expected grow by more than 8% in 2008 and 2009. Additionally, net interest accounts for nearly 2% of the US GDP. While near term the added interest expense ($700B x ~3% = $20B in annual interest expense) would have a negative impact on the current budget, the total cost is unknown, as it is unlikely for all the troubled assets to go to zero.

I am certain of two things: (1) While I do not know what, something needs to happen to restore confidence in US & Global financial institutions; (2) Americans need to start saving.