QE3, Deflation And The Money Illusion

Update1/Chart — The announcement last week by the Federal Open Market Committee that the central bank would initiate additional, open-ended purchases of residential mortgage backed securities (RMBS) was more than a little sad. Let us count the ways.

The first reason for sadness was the idea that people here in New York and elsewhere in the global financial community were actually surprised by the Fed’s move. The FOMC is fighting deflation. Credit continues to contract globally as much of the western world goes on a pure cash budget. So while I would like to see the Fed raise short term rates, the fact is that the central bank has little choice but to support the markets. But buying RMBS will neither help housing nor reverse the current deflationary spiral on which we all ride.

The second reason to be circumspect is the fact that the Fed’s leaders continue to pretend that driving down yields in the RMBS markets will have any impact on the housing sector or the economy. The two thirds of the mortgage market that cannot refinance their homes will be unaffected by QE3. In fact, the latest Fed purchases are a gift to Fannie Mae and Freddie Mac, the TBTF banks and the hedge fund community. A fund on the floor of our offices in New York actually started dancing around like little children shouting “QE3” after the Bernanke press conference.

The link below shows a great chart from Credit Suisse of par RMBS vs 10 year constant maturity swap or “CMS.” Just how much lower does the Fed expect RMBS yields to go?

http://www.rcwhalen.com/pdf/qe3.pdf

“The entire move in MBS prices will go into profit margins,” one mortgage market veteran told the Berlin-New York-Los Angeles mortgage study group last week. “FHFA has made sure that the mortgage market has oligopoly pricing and zero competition for the existing servicers. QE3 is risk free profits for the unworthy. And we wasted 40 years and Trillions of dollars fighting the USSR over the need for a free enterprise system?”

Unfortunately, since two thirds of the mortgage market cannot be refinanced, the effect of the Fed’s largesse will indeed go straight to the GSEs and Wall Street zombie banks. This is the key, historical error being committed by Bernanke and the rest of the FOMC. Instead of looking for ways to stoke consumer demand by restoring income and consumer demand, the Fed is simply feeding subsidies to Wall Street. Since the Fed does not think that savers like grandparents and corporations spend money, the error is magnified several orders of magnitude.

The basic problem with the people on the FOMC today is that they are all Obama appointees who are by and large neo-Keynesian socialists in terms of economic outlook. By spending all of their time trying to prevent the 50% drop in GDP which occurred in the 1930s, the Fed forgets or never knew that this catastrophe was the result of the disappearance of private sector capital – not a lack of government spending. And why did this happen? One word: Fraud. Bill Black has been talking about fraud for years, So does Fred Feldkamp, the father of the good sale in RMBS. And so have we at IRA and many others.

The third sadness is that people still don’t understand that fraud is the core problem in the market economies. Until you deal with fraud and start to restructure the trillions of dollars in bad assets now choking the US economy, no amount of Fed ease will reverse the contraction in credit. This is not so much a monetary problem as much as a political issue.

Just as during the 1920s and 1930s it took years for our leaders to understand that securities fraud was the core issue menacing the US economy, today the same process of discovery and revelation grinds slowly forward. Fear causes investors to withdraw from markets and save cash. But because Chairman Bernanke and the Fed refuse to attack the source of the fraud – namely Bank of America and the other zombie banks – the US economy is destined for years of stagnation and eventual hyperinflation.

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