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Szabo - Fed removing US Treas backing on portion FR notes a break of 100 yr tradition

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  • Szabo - Fed removing US Treas backing on portion FR notes a break of 100 yr tradition

    FEBRUARY 22 2008 3:20PM - ...


    Mr. Szabo,

    ... Your article of the 20th of February mentions the "Term Auction Credit". I supposed at the time that this was in some form or another - electronic credit being borrowed on a short term by financial institutions. When you say that this electronic credit is used to substitute for FRN, should I read this as a (vertical) shift in the famous John Exter pyramid?

    Please correct me if I am completely off the ball here. And who is holding the electronic credits in the end? If this is a correct reading, then this means that the John Exter pyramid effectively works and confirms (again) Prof. Fekete's point?

    ************

    Szabo response:

    Before answering your question specifically, some background is in order to make sure we are on the same page. "Term Auction Credit" is the new lending operation instituted by the Fed last December because banks would no longer borrow at the discount window due to the stigma associated with doing that (i.e. confirmation of liquidity problems that necessitate last-resort borrowing from the Fed). Both discount window loans and Term Auction Credits represent short-term advances of Federal Reserve Notes to banks, but there are at least 4 differences: (1) term auction credit rates are competitively determined whereas discount loans are made at the "discount rate" set according to Fed policy, (2) term auction credits cannot be rolled over but rather banks that continue to need funds will have to bid at another auction, (3) the term auction program is presumably temporary, and (4) borrowers are not identifiable. The last difference is key to the banks and is the main reason why the program has "succeeded", while the first 2 are presumably meant to create a more competitive and flexible facility that allows the rate on term auction credit to float unlike the discount rate. Yet it is the third item that may be the most important to gold and silver investors in that the continuation and even expansion of this "temporary" Fed program could provide a useful barometer of the dire status of the financial and banking system in the U.S.

    From my perspective, there are no "electronic credits" involved in either the term auction credit or discount loan programs, nor any other direct interventions by the Fed. In each case, the bank or financial institution provides collateral to the Fed and in exchange the Fed "prints" and credits to the bank a certain amount of money in the form of Federal Reserve Notes (FRNs). While the transaction is initially reflected as a deposit with the Fed (accomplished by a book entry in the Fed's computer system), in all cases the Fed will have the real paper FRNs sitting in its vaults, immediately ready to be sent to the bank's vaults. What the professor means by "electronic credits", I believe, is the ability of banks to lend FRNs on indefinitely through fractional reserve banking. In a severe liquidity crisis, banks will not be willing to lend FRNs as they will need reserves to meet withdrawals and make up shortfalls in loan defaults. As such, the ability of the Fed to flood the system with FRNs and thereby increase the money supply through the multiplicative action of fractional reserve banking could be severely limited. This is because those holding inferior forms of money will want to scramble down to the tip of the upside-down pyramid where gold and silver reside, but they will face an impasse at the FRN level. This devolution process will make anything "above" FRNs (including bank deposits, CDs, money market funds, etc.) essentially worthless while FRNs will be in shorter and shorter available supply even as the Fed desperately dumps them from helicopters, airplanes, hot air balloons, carrier pigeons and everything else capable of flight. In shortest available supply, however, will be gold and silver. That, as I understand it, is the professor's theory of simultaneous hyperinflation and deflation on account of Exter's pyramid.

    Be that as it may, there is also the little issue of the Fed being able to print FRNs at will, which seems to be taken for granted not only by the Fed itself but by both its fans and detractors. The fact is, the Federal Reserve Act, the act of Congress that authorizes and regulates the Fed, proscribes that the Fed must be the (relatively) safest financial institution in the land and therefore it can never hold high-risk or non-performing assets on its books. And so, until last December and since at least the 1990's, the amount of FRNs circulating in the money supply have always been less than the face value of U.S. Treasuries (plus gold pledged from the U.S. Treasury in the form of gold certificates and special drawing rights with the IMF) that are held by the Fed as reserve assets. It helps to think of FRNs as liabilities of the Fed (which they are), because then we can easily see that the above policy resulted in each outstanding FRN being 100% collateralized by securities or direct obligations of the U.S. government (including gold held in Treasury and IMF reserves).

    This was demonstrably by design, as a number of policy papers written in the 1980's and 1990's by the Fed's own staff argued the importance of the Fed employing a "neutral" and "confidence engendering" approach to conduct its activities. Thus, for example, the Fed's open window and system operations have consisted of the Fed buying and selling U.S. Treasury securities as the main direct method to control money supply, both temporarily and on a permanent basis. Consider instead a less restrictive policy in which the Fed would buy corporate, municipal, mortgage or other securities: doing so would artificially influence the interest rate differential between sectors based on the Fed's relative purchases or sales, which would in effect result in the Fed "favoring" some forms of lending over others. In addition, excessive exposure to a troubled sector, which the Fed may be politically pressured to assist, could endanger the Fed's balance sheet. Better to stay out of the fray completely, it was argued, and if any sector should be favored, it would be the federal government (subservient to the interests of banks, of course).

    Okay, enough gnawing on skin, let's get to the meat of the issue at hand. What happened in December is that starting with the December 27 H.4.1 statistical release, the Fed reduced its holdings of U.S. Treasury securities by a whopping $25 billion, which was about the same amount ($20 billion) of the first Term Auction held the prior week. Not only that, but in the following weeks the Fed kept reducing its U.S. Treasury holdings in lock-step with the increase in term auction credits such that as of today it has $60 billion of credits but $65 billion less in U.S. Treasuries. Not surprisingly, the total FRNs in circulation have not changed much between the beginning of December and today despite the much-publicized "liquidity injections" generated by the $60 billion of term auction credits issued so far. In fact, FRNs outstanding have actually fallen in the past two months! Furthermore, FRNs in circulation are no longer entirely collateralized by Treasuries and other federal government obligations. Part of the collateral now includes "Other assets pledged" in an amount of $53 billion. And just what are these "other assets"? Well, there is an "other assets" line on the Fed's balance sheet that appears to include assets denominated in foreign currencies, but this totals only $48 billion. The only "other assets" amounting to tens of billions are the term auction credits.

    Why would the Fed do all of this? Perhaps Mr. Bernanke learned a lesson last August when the Fed's initial reaction to the liquidity crisis was to go out and buy U.S. Treasuries in the marketplace, which combined with flight-to-safety demand from worried investors, overwhelmed the securities market and caused the yield on T-Bills to collapse (more demand means higher prices and higher prices means lower yield). Mr. Bernanke discovered then that the cost of this particular method to drop money from a helicopter was too high; market interest rates were being influenced in ways that may have been contrary to the Fed's interest rate policies. For example, if Fed rate cuts are seen as reactionary by most market participants, they become largely ineffective. It may be so, but at least the holding of U.S. Treasury securities accomplished the goal of keeping the Fed's balance sheet (relatively) safe and risk-free.

    The Fed, however, seems to have competing and often contrary goals, and so interest rate policy seems to have won out over asset preservation when it came time to draft a new program that would supplant the largely ineffective discount window operation. Namely, the acceptance of many forms of bank assets under the term auction facility allows the Fed to stay out of the Treasury markets--even better, the Fed could sell some Treasuries and thus influence the market rate of interest--but at the expense of compromising the safety of the Fed's balance sheet. As an aside, we can study which Treasuries the Fed has been selling and thereby discover the Fed's intended target of manipulation. For example, it turns out that the Fed has primarily reduced its T-Bill holdings since December, which may mean that Mr. Bernanke and friends want short-term rates to be higher and/or long-term rates to be lower. Selling T-Bills will do that by driving down their price and raising their yields, which could help put the Fed back in charge of leading rates down instead of following the market down. After all, the perception of being in charge can be even more important than actually being in charge.

    But what about the stated purpose of the term auction credits, namely to provide liquidity? Well, the Fed action since last December has had the net effect of removing liquidity from the capital markets (the buyers of $65 billion in Treasuries paid the Fed with FRNs) and injecting about the same amount of liquidity into the banking system (via the term auction credits which provided $60 billion in FRNs to the banks). The end result is essentially a loan from the capital markets to the banking sector. Unfortunately, not only is this loan a de facto secret, but it is involuntary as well. Oh, and forget about the Fed not playing favorites, it is clear where its allegiance lies.

    All of this is small potatoes, however, compared to the Fed's apparent abandonment of its long-standing policy of collateralizing the world's reserve currency only with direct obligations of the U.S. government (U.S. Treasury securities and Treasury-held gold). This act of discipline placed some limits on the Fed's ability to print money as it could no longer issue FRNs when no more Treasury securities were available for purchase at a reasonable price in the marketplace. A reasonable price, in this case, would be one where the market price is close to the face value of the security, which is important because bond premiums do not count for collateral purposes. The "problem" of government debt "shortage" could, of course, be readily solved by a government following the Keynesian model of stimulus spending, a perfect example of which is the pending Bush tax rebate. The Fed would simply buy the debt required to fund deficit spending, and thus monetize the stimulus. Without fail, such an approach will devalue the inflated currency and is therefore very friendly to gold. No doubt some of the gold demand in the past few weeks has been driven by this theme.

    Yet there is an important distinction to be drawn. A central bank is expected to monetize a government stimulus by acquiring government debt regardless of how reckless the stimulus might be, because failure to monetize as necessary would be even more reckless. It is an entirely different matter for a central bank to abandon fiscal prudence by changing its reserve policy from one of risk-free collateralization to one where collateral is provided by the very entities (banks) in need of rescue. This is precisely what happened last December when the Fed removed direct U.S. Treasury backing for a portion of the FRNs in circulation and substituted whatever mish-mash of banking assets that have been pledged to secure the term auction credits. These banking assets may be performing today, but they are down the rung in terms of risk compared to U.S. Treasuries, and they expose the Fed to the same spectre of deteriorating balance sheets as faced by the banks that the Fed is supposed to be safeguarding. It may not matter much that the term auction credits are temporary since even 3 months could be a very long time during a fast developing crisis. The complexity and derivative-laden interdependence of today's markets means that AAA credit can turn into junk almost instantaneously.

    You might interject at this point that the U.S. government is the ultimate guarantor of the dollar in every case where the Fed is unable to maintain sufficient collateral to back it fully. Not only that, but U.S. Treasuries represent nothing more than the very same government promise, so why is the type of collateral held by the Fed important when all defaults will presumably be cured by the federal government? To this objection, I would answer that there is a big difference between a promise and the actual need to deliver on that promise. The Fed cannot possibly default BEFORE the U.S. government defaults if it keeps reserve assets predominantly in U.S. Treasuries, but that is not the case if the Fed holds increasing amounts of private sector debt. In the latter case, the Fed would default when it holds too much defaulted private sector debt as reserve assets. This would require a government bailout to rescue not only the Fed but the monetary system as a whole, although it is not clear to me that government intervention would actually work. It would seem to me that evaporating faith in the fiat money issued by a central bank cannot be halted by government dictate. In other words, confidence in the banking system is tantamount to confidence in the government's fiscal and monetary policy.

    The bottom line is this. As the guarantor of liquidity to the banking system, the central bank can arguably survive and alleviate a default crisis in the private sector by holding government debt as its key reserve asset. By contrast, a central bank that holds increasing amounts of private sector debt as its reserve asset is not only incapable of surviving and alleviating a default crisis in the private sector, but may ultimately bring about a crisis of confidence in the government itself that leads to a default on government debt and a wholesale financial collapse. I believe this is the reason why the Fed has survived for almost 100 years, and also why it may not survive a handful more.

    As with many important things in the world of finance, the key is hidden in a little table at the bottom of an obscure statistical report that few seem to know or talk about. Although surely some people MUST know, even if they don't talk about it. They are probably too busy buying gold and silver to talk! Or provocatively, this could be why Manfra, Tordella & Brooks, a coin and bullion dealer located in the heart of Wall Street, has been doing such brisk business lately. If anybody is going to realize the meaning of obscure statistical reports from the Fed, it could very well be the suits on Wall Street. You know, the same guys who ridicule gold on CNBC. Only they might actually be buying it down the street at the same time, getting in before they recommend bullion as the next hot investment to their mainstream clientele.

    Sorry for not relating this more directly to Exter's pyramid but I believe the above is a more important explanation of how these recent Fed developments, not discussed in either the financial media or gold community, may have made a powerful contribution to the present moves in gold and silver, and may have a critical role to play in their future.


    Original article here:

    http://www.silveraxis.com/

  • #2
    Re: Szabo - Fed removing US Treas backing on portion FR notes a break of 100 yr tradi

    Thanks, Lukester! Great piece.

    Originally posted by Lukester View Post
    The "problem" of government debt "shortage" could, of course, be readily solved by a government following the Keynesian model of stimulus spending, a perfect example of which is the pending Bush tax rebate. The Fed would simply buy the debt required to fund deficit spending, and thus monetize the stimulus. Without fail, such an approach will devalue the inflated currency and is therefore very friendly to gold. No doubt some of the gold demand in the past few weeks has been driven by this theme.

    From Bernanke's so-called helicopter speech:
    In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
    Sounds like the choppers are here! IMO the $600 drops are just an introductory sortie. Bigger payloads to come.

    Jimmy

    Comment


    • #3
      Re: Szabo - Fed removing US Treas backing on portion FR notes a break of 100 yr tradi

      Originally posted by jimmygu3 View Post
      Sounds like the choppers are here! IMO the $600 drops are just an introductory sortie. Bigger payloads to come.
      Jimmy
      See also my Stanford post

      Is this a signal to the powers that be?

      Will Education and Univeral Healthcare be a part of the next bubble?

      This is one way of shifting the wealth inequalities -- and a way to helicopter tons of money into the system -- if the credit system gums up

      Any thoughts?

      Comment


      • #4
        Re: Szabo - Fed removing US Treas backing on portion FR notes a break of 100 yr tradi

        There is one very important detail to the TAF which i have mentioned before:

        If the asset defaults, the bank is STILL required to pay back the loan.

        Buy repoing the assets (prevent finding a market price / forced selling), the Fed tries to prevent the default trigger wave in these instruments.

        In essence, this means the Fed changes the risk from goverment debt to banks counterparty risk, which they say to be quote:"virtually" zero.

        So, for the Fed to hold the bag all that has to happen is the default of a TAF counterparty, rsiking the amount of collateral that can not be liquidated. However, IF (big IF) that bank gets a bailout, the Fed gets back 100% of its money and, for example the Government, then holds the assets, which would probably happen in the first place anyways if you allow forced unwinding.

        Its a bit of playing Catch-22, but they try to buy time.

        Dangerous road it seems.

        Comment


        • #5
          Re: Szabo - Fed removing US Treas backing on portion FR notes a break of 100 yr tradi

          Originally posted by Rajiv View Post
          See also my Stanford post
          Some thoughts from Starving Steve, another Joe 6pack in the U.S:

          Production DE-flates paper money. I can buy more now than ever before provided that I shop carefully.

          Some examples: I can buy a wrist-watch that actually keeps time perfectly, and I don't have to wind it either. The cost for such would be about $10 now, or about one-eighth the cost of a good mechanical watch 50 years ago.

          Another example: Tires cost about $40 each, about the same as they used to cost. But to-day's tires last about four times as long because they are made of harder material.

          Another example: My Toyota Echo cost $9200 in 2002, new. And my VW beetle in 1968 cost $1700. But the VW broke-down every month, reliably after it went off of warantee at 24000 miles; where as, the Echo has yet to break-down even once, and it has 90,000 miles on it. Moreover, I have never serviced the Echo, but my old VW required servicing every 6000 miles, major servicing every 24,000 miles, and a motor transplant at 64,000 miles.

          Another example: My new 27 inch colour TV cost $200 new this year, and it has a five-year parts and labour warantee, too. Compare that to the $300 cost of a new black and white TV in 1955, and the black and white 21 inch cabinet TV broke-down every month, EVERY month religiously!

          All of these costs are quotations in NOMINAL dollars.

          And I could go on to discuss groceries, which now cost more than ever but are of much higher quality than ever before. For example: I used to buy a loaf of white bread for 19cents back in 1960. To-day's bread cost $4 or $5 per loaf, but the bread is whole-grain and made without lard, without trans-fats. To-day's loaf is also heavy, like 590grams, give or take; where as, the 19cent bunny bread was all bubbles of air.

          And the foods to-day taste better than ever because they ARE better than ever. I can remember eating spam back in the 1950s. I can also remember eating canned spaghetti, jello, and creamed corn. Ketchup or catsup was as good as life got, at least at the dinner table.

          Although I am a strong believer in gold and the gold standard, there is something to be said for a sound fiat money. And heretofore, the U.S. dollar has been strong, almost as good as gold.

          What has me worried these days are the statements coming from the Republicans (inspired by Arthur Laffer) that deficits don't count and that the economy can grow out of any problem. So, the days of the dollar may, indeed, be numbered.

          Also, the statement above that universal healthcare would be inflationary and might destroy the dollar is pure Republican hogwash. These neo-cons simply do not understand that labour and production create value for the dollar. PRODUCTION DE-FLATES THE FIAT CURRENCY.... It is unemployment and suffering together with a callous neglect from the government that causes inflation.

          I am counting the days until we get a new government in Washington with a new way of thinking. (And may the Republicans go to hell.) The duty of government is to invest in the people because the people give value to the government's fiat money.
          Last edited by Starving Steve; 03-08-08, 11:49 PM.

          Comment


          • #6
            Re: Szabo - Fed removing US Treas backing on portion FR notes a break of 100 yr tradi

            Originally posted by Starving Steve View Post
            Some thoughts from Starving Steve, another Joe 6pack in the U.S:

            Production DE-flates paper money. I can buy more now than ever before provided that I shop carefully.

            Some examples: I can buy a wrist-watch that actually keeps time perfectly, and I don't have to wind it either. The cost for such would be about $10 now, or about one-eighth the cost of a good mechanical watch 50 years ago.

            Another example: Tires cost about $40 each, about the same as they used to cost. But to-day's tires last about four times as long because they are made of harder material.

            Another example: My Toyota Echo cost $9200 in 2002, new. And my VW beetle in 1968 cost $1700. But the VW broke-down every month, reliably after it went off of warantee at 24000 miles; where as, the Echo has yet to break-down even once, and it has 90,000 miles on it. Moreover, I have never serviced the Echo, but my old VW required servicing every 6000 miles, major servicing every 24,000 miles, and a motor transplant at 64,000 miles.

            Another example: My new 27 inch colour TV cost $200 new this year, and it has a five-year parts and labour warantee, too. Compare that to the $300 cost of a new black and white TV in 1955, and the black and white 21 inch cabinet TV broke-down every month, EVERY month religiously!

            All of these costs are quotations in NOMINAL dollars.

            And I could go on to discuss groceries, which now cost more than ever but are of much higher quality than ever before. For example: I used to buy a loaf of white bread for 19cents back in 1960. To-day's bread cost $4 or $5 per loaf, but the bread is whole-grain and made without lard, without trans-fats. To-day's loaf is also heavy, like 590grams, give or take; where as, the 19cent bunny bread was all bubbles of air.

            And the foods to-day taste better than ever because they ARE better than ever. I can remember eating spam back in the 1950s. I can also remember eating canned spaghetti, jello, and creamed corn. Ketchup or catsup was as good as life got, at least at the dinner table.

            Although I am a strong believer in gold and the gold standard, there is something to be said for a sound fiat money. And heretofore, the U.S. dollar has been strong, almost as good as gold.

            What has me worried these days are the statements coming from the Republicans (inspired by Arthur Laffer) that deficits don't count and that the economy can grow out of any problem. So, the days of the dollar may, indeed, be numbered.

            Also, the statement above that universal healthcare would be inflationary and might destroy the dollar is pure Republican hogwash. These neo-cons simply do not understand that labour and production create value for the dollar. PRODUCTION DE-FLATES THE FIAT CURRENCY.... It is unemployment and suffering together with a callous neglect from the government that causes inflation.

            I am counting the days until we get a new government in Washington with a new way of thinking. (And may the Republicans go to hell.) The duty of government is to invest in the people because the people give value to the government's fiat money.
            Excellent post, Steve. In purely economic terms you are giving examples of the benefits of technical and organizational innovation and productivity gains. A rigid system of credit would have stifled these, no doubt about it. Paradoxically, the positive results of this system have financed a level of arrogance that is killing the goose that laid the golden egg.
            Ed.

            Comment


            • #7
              Re: Szabo - Fed removing US Treas backing on portion FR notes a break of 100 yr tradi

              Originally posted by JoeSixpack View Post
              There is one very important detail to the TAF which i have mentioned before:

              If the asset defaults, the bank is STILL required to pay back the loan.

              By repoing the assets (prevent finding a market price / forced selling), the Fed tries to prevent the default trigger wave in these instruments.
              the fed is not necessarily trying to prevent or negate the failure of the paper. it is trying to avoid forced liquidation which will tend to drive the paper's value to zero. first, the paper might actually turn out to be worth something, if only the foreclosed and therefore impaired value of underlying properties. second, and most importantly, by slowing the process the bank which owns the paper has time to repair its balance sheet, earning -if nothing else- the spread between what it pays on the taf and what it may earn on longer dated gov't paper. thus it builds its capital enough - the fed hopes- to absorb the shock of later actually having to write down part of the value of the taf'd paper.

              Comment

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