Quantitative Easing: Torching the Recovery
By Paul Lamont
October 31st, 2010
Investors Burned by Bernanke’s QE Demonstrations
While Chairman Bernanke has his theory on quantitative easing, we suspect QE will turn out more like this Turkish firefighter demonstrating fire safety (no one was hurt in this video). Instead of limiting losses to those that took risks, Bernanke’s first round of bailouts in 2008-9 spread the fire to all American taxpayers. Ben’s next demonstration of quantitative easing is likely to create uncertainty and chaos by torching the credit markets.
As the Wall Street Journal reports, “Bond investors are buying almost anything the market throws at them.” Wall Street has turned this mania, into refinancing that has sustained subprime companies. “Nearly two-thirds of the junk debt issued this year has gone to refinance existing debt.” October was a record month for issuance “on confidence the Federal Reserve will flood the economy with money.” What the Bloomberg article fails to mention is that when Mr. Bernanke fuels the economy with money, long term rates could erupt. This of course will burn bond investors (and recently that is everybody!). Credit markets will shut down again. Without refinancing, there will be widespread defaults. It is no wonder that Goldman Sachs is getting all it can, for as long as it can.
So why is Bernanke attempting this?
“Banks are literally dying from lack of yield on assets due to the Fed’s ZIRP (Ed Note: Zero Interest Rate Policy).” - Chris Whalen, Institutional Risk Analytics.
He is trying to give them what they want. In this case however, the interests of the banks are diametrically opposed to the borrowing needs of the economy.
Not only is a “lack of yield on assets” a problem for banks, but losses on assets are still a problem as well. The similarities to the early 1930s are still evident:
“Banks had also issued real estate mortgage bonds and sold them with an understanding they would repurchase them if the sellers became dissatisfied, a provision the banks would later regret. By the end of 1930 many of these banks in outlying areas were in ‘dire distress.’ The value of real estate assets plummeted and dissatisfied holders of mortgage bonds attempted to sell them back to the banks from which they were purchased.” - The Banking Panics of the Great Depression, Elmus Wicker 1996.
Currently the “dissatisfied holders of mortgage bonds” are attempting to force Bank of America to repurchase $47B in bonds. Bank of America’s stock price has subsequently fallen 14% this October. J.P. Morgan says this is the “biggest issue facing banks” and estimates losses as high as $120B according to Bloomberg.
In the Spring of 1931, when banks stopped repurchasing mortgage bonds the bank runs started. Credit markets are already marking Bank of America’s debt below investment grade quality. Losses assumed during the Countrywide merger, where the putback issue is concentrated, are very similar to the events surrounding the Creditanstalt failure. This was the tipping point of the Great Depression.
“If we have more stress, if house prices continue to go down, as they've started to do just a little smidgen…if they go down another 5%, that is going to put a lot of stress on financial institutions.” - Robert Shiller, creator of the S&P Case-Shiller Housing Index and author of Irrational Exuberance.
European Troubles Grow
After passing the European stress test in July, the Irish banking system imploded in September. Ireland’s Finance Minister Brian Lenihan (after providing a 50B euro bailout) declared: “The Irish banking system is at rock bottom today.” Investors are now questioning his definition of rock bottom. Allied Irish Bank investors have watched their stock plunge to 2009 lows. Similarly, Anglo Irish Bank bondholders are fighting with the government over what their bonds are now worth. We should expect this to occur in the U.S. as the government’s mood changes (the reason cited for the Irish bond discount).
Besides Ireland, Greece, Portugal and Spain are all still deteriorating. According to Jonathan Tepper, an analyst at Variant Perception; “All the leading indicators for the peripheral economies are negative.” These countries are also increasingly relying on the European Central Bank. But time may be limited, as Germany’s mood, like Ireland, has changed. They are pushing for a state default proposal. According to the AP, Germany is “now pushing to let hopelessly indebted governments do exactly that -- admit they can't pay and hit bond investors with the costs instead of taxpayers.” For bond investors who have been investing on the bailout thesis, things could become more complicated.
Seek Value, Do Not Chase Yield
As investors rushed into the subprime (high yield) bond market this fall, we were reminded of May 2008:
“How Long Do We Sit In Cash? How do we know we are correctly positioned? Because most investors cannot stand being in cash. One advisor describes ‘clients have been ‘kicking and screaming’ about low yields.’ They are eager to ‘pursue riskier investments in search of higher yields.’”
As we now know, investors in mid-2008 were getting rid of their dollars at the precise time they should have been accumulating them. Where is the value now? Who wants to hold cash when everyone knows Bernanke is going to print more? We do. Why? Value is not just a low price; it exists more specifically where few are looking. In June 2008, we observed: “The advertising scheme currently emanating from Wall Street is ‘buying the bottom.’” When most investors are looking for the bottom, you can expect that markets will continue to fall. This answers the Wall Street Journal’s question last week: Bank of America: Has it Hit Bottom?
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