Gold News

Will the Fed Buy Up Mortgage-Backed Bonds?

The US central bank is only one step away from turning bad housing into money. The cost to you is inflation...

WHERE WILL the stock market be one week from now, asks Dan Denning for The Daily Reckoning Australia.

   What about the Gold Price? Will it look back on Tuesday's Federal Reserve action as the turning point in the great credit crisis of 2008...?

   Or will this Tuesday's action be just another failed attempt to halt the rampaging bear market in credit?

   You have to give it to Ben Bernanke. For an academic, he sure has a great sense of theatre. It may not last long, but Tuesday's 416 point rally on the Dow Jones was kind of refreshing...even if it did peter out and reverse for 46-point loss on Wednesday.

   The initial surge – a full 3.5% for the best one-day rally in five years – was like coming up for air after you've been holding your breath under water...for two months running.

   Now you can inhale.

   Did you know that by inhaling and exhaling three times – calmly and fully – you actually reduce the chance you will lose your temper? Fear and anger are physiological as well as psychological. Calm, deep breathing lowers your heart rate and prevents the chain reaction of neurochemical events in your brain that leads to bouts of anger and panic.

   Perhaps oxygen tanks should be made available in the trading pits.

   Then again, traders were quite happy with their Fed-induced high on Tuesday. US investors sent the indexes flying thanks to a new plan of attack by the supreme allied commander in the war against deflation, US Fed governor Ben Bernanke.

   General Bernanke – or perhaps we should call him Air Marshall, in honor of his arsenal of money-dropping helicopters – bombed the markets with an innovative new strategy. It's called a Term Securities Lending Facility (TSFL).

   Starting 27th March, the Fed will loan prime brokers (i.e. big New York banks) up to $200 billion in US Treasury bonds. In exchange for the Treasuries, the banks will deposit with the Fed collateral in the form of AAA-rated residential mortgage backed securities (RMBs), plus agency debt issued by Fannie Mae and Freddie Mac, the government-sponsored US home lenders.

   The prime brokers, you'll recall from the news, are putting the screws to hedge funds. After years of virtually no-questions-asked lending, the prime brokers are now engaged in no-answers-accepted margin calls.

   For example, the hedge fund run by Carlyle Capital is trying to prevent its creditors from selling $16 billion in collateral. The fund pledged the assets as collateral for loans last year. The banks (i.e. the prime brokers) now want their money back, and are antsy to get it.

   The trouble is, in their rush to sell the collateral, the banks risk collapsing prices for all sorts of other assets that have been pledged as collateral. More selling leads to falling prices leads to more selling. You can see where all that goes. Down.

   Into this no-trust zone between borrowers and lenders steps the Fed. The US central bank hopes that by taking the illiquid collateral off the prime broker's hands, it can prevent cascading asset sales.

   But will the prime brokers begin lending again? Let's see now...

   The prime brokers could simply keep the Treasuries on the balance sheet for a month and boost their own capital. This would prevent the big banks from having to borrow more capital from the Gulf States. Or they could lend against the Treasuries. In a fractional reserve banking system, $200 billion worth of new assets can quickly become $2 trillion worth of new lending (lending at 10 times reserves).

   If the banks expand lending on their comfy new Treasury capital base, well then the Fed will have achieved its goal of loosening up the credit markets. But here's a question for you: If the new term securities lending facility leads to an expansion in bank lending, what does it mean for the Gold Price? Hasn't the Fed indirectly increased the money supply?

   For starters, the Fed's action might make it less likely to cut rates by 50 or 75 basis points on March 13th. That's one reason Gold didn't move more on the day. But the bigger reason is that we have to wait and see if the Fed's action has the intended reaction, namely restoring liquidity to the financial system.

   The initial rush wore off inside 24 hours for the Dow. The Gold Market, on the other hand, has since made another attempt on $1,000 Gold.

   As for the money markets – the source of the trouble, at least until you track this Banking Crisis back to the base problem of bad loans made to people who can't repay – it's too early to tell if banks will actually change their lending behavior because of the new lending program. We walk past a magic shop on St. Kilda Road every day. But that doesn't mean we have a closet full of wands and white rabbits.

   Maybe banks will use the Term Securities Lending Facility. Maybe they won't. The banks know a third new wave of mortgage debt is already facing higher delinquency rates. They may not be in any hurry to loan more money at all, knowing that a lot more collateral is about to go bad.

   What do we know? Not much. But it does seem safe to say the Fed has solvency in mind as much as liquidity.

   The Term Securities Lending Facility is supposed to allow prime brokers to exchange illiquid assets for liquid ones for 28 days. But that 28 days could just as well be 56...or 84...or three years. That is, the Fed has shown it's willing to take de facto ownership of bad mortgage debt in order to restore order to the system and guarantee that banks don't become insolvent due to inadequate capital.

   Of course the Fed can't come right out and say it's willing to own bad debt. If it did, the US Dollar would tank even faster! But the bond market isn't stupid. And "the risk of losses on US Treasury notes exceeded German bunds for the first time ever amid investor concern the subprime mortgage crisis is sapping government reserves, credit-default swaps prices show," reports Abigail Moss at Bloomberg.

   The bond market realizes that with its new Term Securities Lending Facility, the Fed has wandered down a path that may lead to the nationalization of a huge amount of bad American mortgage debt.

   At the very least, this means inflation – and most likely higher Gold Prices. And there may be bigger plans in the offing.

   Ask yourself: What does a thirty year US Treasury bond have in common with a thirty year, fixed-interest rate mortgage?

   They both, quite obviously, have the same duration (30 years). So is it inconceivable that the Fed would buy up (at some discount) a large portion of Fannie and Freddie's mortgage portfolios, and then, as the new lender, allow Americans to refinance into 30-year fixed mortgages?

   The Fed could then either hold onto the new mortgage portfolio, or foist it off on some new government agency.

   It's not inconceivable, because we just conceived it. In any event, this drama isn't over yet. Monetary intrigue aside, the world's central banks are fighting debt deflation with all the tools of inflation. As a result, you're getting inflation in your cost of living.

   In China, inflation is growing at its fastest pace in 11 years. Chinese consumer prices were up 8.7% in February. Food costs were up a staggering 23%.

   US vice-president Dick Cheney has now been dispatched to the Middle East to try and talk down oil prices from $110 per barrel. Good luck with that Mr. Cheney. Gulf States are importing inflation through their Dollar-pegged currencies. Keeping oil prices high by refusing to increase supply may be the Saudi's way of getting back at Bernanke for gutting the Dollar.

   So an eventful few days, all in all. We reckon stocks the world over had better enjoy the fresh air while they can.

   Inflation sucks all the oxygen out of a room like a greedy fire.

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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