Nov202013

Quantitative easing and mortgage interest rate stimulus bail out Wall Street, not Main Street

The populace was sold on quantitative easing and mortgage interest rate stimulus as a measure to save “Main Street.” It was said this money pumped into the economy would create jobs, and the combination of jobs, increased incomes, and low mortgage rates would cause a boom in housing which would elevate loanowners above water. What was sold as a big benefit to Main Street has instead devolved into another massive bailout of the banking industry with few tangible benefits to the people the programs were ostensibly designed to help out.

Proponents of these policies can point to the rapid increase in house prices over the last 18 months as a sign of success. While it’s true that many loanowners have emerged from beneath their debts, this policy wasn’t designed to keep them in their homes. The interest rate stimulus has merely elevated prices so when the terms of loan modifications increase borrower costs and push them out, the lender losses less money. (See: 2014 will see the “Rise of the Short Sale”)

The policy of mortgage interest rate stimulus can only be characterized as a success from the perspective of a banker. Higher house prices are helping them recover more money from their bad bubble-era loans. Wouldn’t the real measure of success from the perspective of Main Street have people remain in their homes rather than simply improve the bank’s bad debt recovery?

And what about future buyers? They are being forced to pay bubble-era peak prices and endure a much higher cost of ownership. Is that a success for Main Street? It looks much more like a success for lenders. Not just do they recover more on their bad loans, they also get more interest income because they are making large loans to today’s homebuyers. It’s a win-win for the banks.

However, the biggest back-door bailout of them all is the quantitative easing policies of the federal reserve. Basically, the central bank is printing money, some of it has flowed into mortgage bonds to drive down mortgage rates, but much of it has made it’s way onto bank balance sheets and into deposits at the federal reserve who pays those banks interest on the money the federal reserve prints. Not a bad deal — for the banks.

Andrew Huszar: Confessions of a Quantitative Easer

We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street.

By Andrew Huszar — Nov. 11, 2013 7:00 p.m. ET

I can only say: I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I’ve come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.

Five years ago this month, on Black Friday, the Fed launched an unprecedented shopping spree. By that point in the financial crisis, Congress had already passed legislation, the Troubled Asset Relief Program, to halt the U.S. banking system’s free fall. Beyond Wall Street, though, the economic pain was still soaring. In the last three months of 2008 alone, almost two million Americans would lose their jobs.

The Fed said it wanted to help—through a new program of massive bond purchases. There were secondary goals, but Chairman Ben Bernanke made clear that the Fed’s central motivation was to “affect credit conditions for households and businesses”: to drive down the cost of credit so that more Americans hurting from the tanking economy could use it to weather the downturn. For this reason, he originally called the initiative “credit easing.”

The federal reserve can only create money by loaning money. It can’t merely print dollars and put them into circulation. It generally buys US Treasury notes (Government debt) to print money, but it now also buys mortgage-backed securities (private debt).

How much of this money has made it’s way to Main Street? Does the average American feel the benefits at this point?

In its almost 100-year history, the Fed had never bought one mortgage bond.

Many people forget this program had no precedent. We take it for granted today as a permanent part of the financial landscape, unfortunately. It was not always that way.

Now my program was buying so many each day through active, unscripted trading that we constantly risked driving bond prices too high and crashing global confidence in key financial markets. We were working feverishly to preserve the impression that the Fed knew what it was doing.

It wasn’t long before my old doubts resurfaced. Despite the Fed’s rhetoric, my program wasn’t helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans.

I can’t hold the banks at fault for this one. Availability of money to lend wasn’t their problem — which is unfortunate since that’s the only problem the federal reserve can do anything about. The real problem for banks was the lack of good prospects for loans to give the money to.

The idea of a federal reserve and counter-cyclical interest rate policy emerged from observations on 19th century economic busts where the availability of capital to lend made the downturn much worse than it would have been if more capital were available.

In purely economic terms, mortgage interest rates should have skyrocketed in 2007 and 2008 when lenders realized risk was mis-priced. For as equity-crushing as the collapse in house prices was, can you imagine how bad it would have become if mortgage rates had risen to 12%? So much capital would have been removed from the system that no money would have been available to loan to anyone. Those savers with capital would have loved it as interest rates went sky high, but the economy would have suffered for a very long time. That’s the scenario the federal reserve is created to prevent.

The problem with a bust like the last one is that liquidity was not the problem. There was no shortage of money to lend.

The problem was insolvency. Nobody had the income to support the debts they already had. Insolvency is a much more serious problem than liquidity, and the federal reserve has only one tool to deal with it — ultra-low interest rates. They can make the marginally insolvent borrower solvent again by lowering their cost of debt, but that’s about it. Adding liquidity does nothing to improve the problem of insolvency. Potential borrowers need stable and expanding incomes, and they need to pay down the debts they already have. That takes time — a long time. We’re at five years and still counting.

More insidiously, whatever credit they were extending wasn’t getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.

Wall Street needed to make more money to make up for the massive loan write-downs they were making. The above chart showing declining loan balances didn’t happen because people took money out of their savings and paid down debt. Those reductions were caused by bank write downs, mostly on mortgage debt.

Trading for the first round of QE ended on March 31, 2010. The final results confirmed that, while there had been only trivial relief for Main Street, the U.S. central bank’s bond purchases had been an absolute coup for Wall Street. The banks hadn’t just benefited from the lower cost of making loans. They’d also enjoyed huge capital gains on the rising values of their securities holdings and fat commissions from brokering most of the Fed’s QE transactions. Wall Street had experienced its most profitable year ever in 2009, and 2010 was starting off in much the same way.

I want to make sure you understand how this part of the bailout worked.

Mortgage bond prices are inversely related to interest rates. Interest rates go down when bond prices go up. Since the federal reserve was buying a lot of bonds to drive down rates, the prices of bonds rose a great deal. The banks knew this was coming, so they loaded up on 10-year Treasuries and other bonds, held them while the federal reserve bid up prices, then sold these bonds to the federal reserve at nosebleed prices. In that way, banks made billions in capital gains by taking the money given to them by the federal reserve, buying bonds, then selling them back to the federal reserve. It was free money given to the banks by manipulating bond prices — and they made transaction fees on these deals to boot.

That’s a pretty good deal for the banks, wouldn’t you say?

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2.

The banks weren’t healthy yet, so we will have QE3, QE4, and QE infinity if necessary. Until house prices reach peak bubble values everywhere — not just in Irvine — the federal reserve will keep printing money. They may taper at some point, but they will keep printing until the banks are no longer exposed.

Chart of non-preforming real estate loan exposure

Where are we today? The Fed keeps buying roughly $85 billion in bonds a month, chronically delaying so much as a minor QE taper. Over five years, its bond purchases have come to more than $4 trillion.

Amazingly, in a supposedly free-market nation, QE has become the largest financial-markets intervention by any government in world history.

Free-market capitalism was a casualty of the Great Recession. We now live in a world of centralized financial planning not dissimilar to the old Soviet Union.

And the impact? Even by the Fed’s sunniest calculations, aggressive QE over five years has generated only a few percentage points of U.S. growth. By contrast, experts outside the Fed, such as Mohammed El Erian at the Pimco investment firm, suggest that the Fed may have created and spent over $4 trillion for a total return of as little as 0.25% of GDP (i.e., a mere $40 billion bump in U.S. economic output). Both of those estimates indicate that QE isn’t really working.

Unless you’re Wall Street. Having racked up hundreds of billions of dollars in opaque Fed subsidies, U.S. banks have seen their collective stock price triple since March 2009. The biggest ones have only become more of a cartel: 0.2% of them now control more than 70% of the U.S. bank assets.

I have made the argument for months that the housing market bottomed due to decisions made in the boardrooms of the major banks. It’s a cartel arrangement. Those 0.2% of institutions that control 70% of the assets made a conscious decision not to foreclose on delinquent mortgage squatters, deny short sale approval to those who do want out, and cut deals with the rest until house prices get back to the peak.

It’s been argued that these banks are just doing what they’re told by the government. Well, the government told them to modify instead of foreclose from 2008-2011, and it didn’t dry up the MLS inventory of foreclosures. I’ve even explored the possibility that loanowner bailout, HARP 2.0, bottomed the housing market, but I remain unconvinced.

Something changed in mid to late 2011 that caused the number of foreclosures processed to decline significantly — and it wasn’t that they ran out of people to foreclose on. Was it a secret meeting in a smoky room? That’s how JP Morgan did it in 1907. We may never know, but what we can see from the evidence is that policies changed, and the distressed inventory was removed from the MLS causing house prices to bottom.

As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy. Yes, those financial markets have rallied spectacularly, breathing much-needed life back into 401(k)s, but for how long? Experts like Larry Fink at the BlackRock investment firm are suggesting that conditions are again “bubble-like.” Meanwhile, the country remains overly dependent on Wall Street to drive economic growth.

Even when acknowledging QE’s shortcomings, Chairman Bernanke argues that some action by the Fed is better than none (a position that his likely successor, Fed Vice Chairwoman Janet Yellen, also embraces).

(See: Yellen Signals Continued QE Undeterred by Bubble Risk)

The implication is that the Fed is dutifully compensating for the rest of Washington’s dysfunction. But the Fed is at the center of that dysfunction. Case in point: It has allowed QE to become Wall Street’s new “too big to fail” policy.

Do you still believe quantitative easing and mortgage interest rate stimulus was designed to help you? I think it was designed to help the banks, and the evidence supports that view.