Interest Rates Will Stay Low In The Midst Of Bad Bank Behavior And Paul Ryan's Mistake

Will Rogers was the most popular man in America in the Great Depression. He said:
"Borrowing money on what's called 'easy terms,' is a one-way ticket to the Poor House. If you think it ain't a Sucker Game, why is your Banker the richest man in your Town? Why is your Bank the biggest and finest building in your Town? Instead of passing Bills to make borrowing easy, if Congress had passed a Bill that no Person could borrow a cent of Money from any other person, they would have gone down in History as committing the greatest bit of Legislation in the World." WA #14, March 18, 1923
and:
"I have been trying my best to help (the President) and Wall Street "Restore Confidence." Confidence, is one of the hardest things in the World to get restored once it gets out of bounds..." WA #362 Dec. 1, 1929
*****
A lying financial system is certain to scare away investors and could create a credit crisis. Bank contagion is about banks lying to one another. Collateral not being where it is supposed to be is just a lie, and we have had a few of those recently.

It had been reported last September that Steel pledged as collateral in China came up missing.

It has been reported that Germany has given the Fed 7 years in order to retrieve her gold. Either the gold is not there or it has been pledged as collateral and is tied up.

It has been said that the GLD is not made up of gold, but rather of promises to supply gold. Gold bugs can comment.

Turns out gold has been made into a tier one asset effective Jan 1, 2013, although some stocks are tier one so gold is not considered a pristine asset.

And all this relates to what was supposed to be good collateral.

The bigger lie has to do with the posting of bad collateral. There is no shortage of bad collateral. There is so much bad collateral that interbank trading has slowed. The velocity of money has plunged proving that interbank lending and MainStreet lending has slowed.

The effort to change bad collateral into good takes the form of transformation of assets, and securitization of same. Transformation gives hedge funds and traders cash for bad collateral with a haircut. This can build in a lot of risk to the banks. It has not yet gotten to be a large process but could.

The bigger and more important process is that of changing bad collateral into collateral good enough to use in securitization. Investors want good MBS. They demand good MBS after the housing crisis.

Bad collateral was deposited in the money markets. That was part of the shadow banking system that generated the bad collateral, bogus CDOs in the first place. Getting from there to a revitalized securitization market is a major goal of the Fed. If the banks lend to households, they don't want to keep the loans once the lending standards are lowered.

So, the solution will be to have government guarantees of all mortgage loans as the banks want. The NY Times reported on this awhile back. The banks have threatened to do away with the 30 year mortgage if they don't get this guarantee. If you have noticed, most big banks with the exception of Wells Fargo have fled the mortgage business!

So, there will likely be a guarantee of most mortgages at some point. I have said that Bernanke could force this to happen.

Yet, as we see the GSE's getting ready to enter the securitization business again, we see that business being spun off to a private entity. The plan, according to regulator Edward DeMarco, is to keep securitization separate from the government.

Yet we know that is a lie. We know that regardless of GSE involvement, the big banks want a guarantee of all mortgages or the securitization market will not work on a large scale. It is called the Bernanke Backstop because Ben Bernanke testified that in the event of a wind down of the GSE's a government guarantee would be necessary going forward.

So, why do the banks and investors want a guarantee of most or all mortgages going forward? It is easy if you look at the housing market.

The housing market is very unstable. Even Mr. DeMarco said we are nowhere near normalcy. I would venture to say that we won't be near normal for years to come, if ever. The housing market is based upon cash purchases and some 3.5 percent down payments through FHA, which is having trouble. Dr Housing Bubble Blog has said that the FHA 3.5% down is leverage of 30 percent. That percentage is what brought banks down in the credit crisis, and what brings many households down.

The skin-in-the-game mortgage, 20 percent down or at least close to that, was what made the housing market stable in the last century. That stability is gone, vanished. It has been estimated that well over 40 percent of houses are owned by folks over 55 years old.

I should also add that besides real estate derivatives, there is a derivative that makes up the bulk of all derivatives, north of 400 trillion dollars. Those are interest rate swaps, where counterparties swap fixed rate securities for short term adjustable rate securities.

We know that in the housing crisis, the inability of people to swap teaser rates for long term fixed rates brought the housing market down. That is small bananas compared to the massive interest rate swap market. Can you imagine the margin call effect of having to cover the rise in short term bonds you have as a hedge?

Joe Weisenthal has said the Fed has this all under control and interest rates will be low for a long, long time. And it seems true that the Fed has slow growth as part of the plan, watching what the Fed does, rather than what it says, and inflation is curbed.

And Ben Bernanke has said he does not owe savers a living.

Inflation is an illusion, in this economic system. Is the Fed lying about the function of interest rate swaps? It is said that the interest rate swap market is actually the driver of demand for the US treasury bonds, insuring low rates. Inflation must be controlled by tight money on MainStreet, because the Fed can no longer jack up interest rates to stop inflation.

So, in summary:
1. We have gold as tier one but not pristine.
2.We have lies about collateral even existing or it has been rehypothecated.
3. We have a shortage of pristine collateral. As the government pays off bonds, and fewer countries have good credit, this becomes a larger problem going forward.
4. We have the big banks wanting MBS to be that pristine, AAA collateral, made possible by a government guarantee.
5. We have collateral transformation which is risky.
6. We have a massive interest rate swap market that is dependent on low interest rates and may force low interest rates.
7. We have an unstable housing market that relies on loans difficult to pay back, hence the need for securitization.*
8. We have a Fed that no longer needs to raise interest rates to stop inflation. It just walls off the money printed from MainStreet.

It doesn't all fit. As a business model it has to be close to a racket. We see that in number 6 we see that big companies, pension funds, insurance companies, etc, all buy protection from the Fed through the purchase of interest rate swaps. This has the effect of driving interest rates down.

By hedging against inflation, the big companies actually maintain our bonds for collateral in great demand, driving interest rates down. Obviously these companies have faith that the Fed can control inflation! They get low interest rates in return for this protection.

But the alternative of anarchism to stop this mafia-like system is chaos. I have a prediction below as to how this will work out.

*Securitization is theoretically ok if it is based upon sound lending and the need for cash to make more sound loans. But the banking system knows that not enough people can afford sound loans. Yet this process moves toward its goal of more risk in real estate, while attempting to make the banking system safer.

Yet we have Joe Weisenthal of Business Insider saying that the credit crisis is over and we are in a bull market. We have a constant mantra in the media that all is well. Dick Bove is bullish on the banks.

Joe must be the new Will Rogers, helping to restore confidence. Only difference? Will Rogers was frank about it. He said:
Now I am not unpatriotic, and I want to do my bit, so I hereby offer my services to my President, my country and my friends to do anything, outside of serving on a commission, that I can in this great movement. But you will have to give me some idea of where "confidence" is. And just who you want it restored to." DT #1035, Nov. 19, 1929
Bernie Madoff proved that a racket can last a long time if you lie enough. The question is how much and how damaging is the lying that is going on today in the larger financial system? Oh, and how long this can be sustained without another loss of confidence? However, confidence in treasury bonds seems unshakeable.

Don't forget, in the Great Depression, speculation was curtailed, and Glass-Steagall was passed and rehypothecation was limited. But now we have Mary Fricker saying that the Repo Market, central to Fed bank control and shadow bank lending is inherently unstable.

The Repo Market allows the Fed to directly manipulate shadow banking so that the Fed is not in the ivory tower being a force for good while the shadow banks are rebels. No, the Fed is directly involved in the ongoing mortgage instability.

Based upon this knowledge, we know the Fed can run this Ponzi housing scheme under its control for quite a long time. We can watch all short term debt schemes as a way to raise cash for the next shadow bank housing bubble.


So, investing in real estate and even in banking, while not for the faint of heart, could bring rewards, until this short term shadow bank lending gets red hot, or it becomes a millstone around the neck of counterparties. Then watch out. But will the interest rate swap market trump the mistakes?

Watch the Millenials. If the young are shunning mortgages and credit, this could actually limit the bubble and the damage. Watch wages, and if they are growing, housing has a chance to appreciate long term. Otherwise, it is just a momentum play. It could be a long duration momentum play. But invest with caution if loans become too easy and the populace bites.

Can banks continue to make money with low interest rates? They won't lend much, as repo markets don't take consumer loans, unless the Bernanke Backstop is applied. So they will be zombie like and we will behave like Japan, if the theory of interest rate swaps holding down bond rates is true.

However, banks could, if interest rates remain low, lend at no money down, but would likely not have teaser rates available unless interest rates rise. So, this is my prediction:

If the banks trust this model of low interest rates for as long as interest rate swaps do their job, they will jump into the residential loan business and start lending with gusto.

Watch for the Bernanke Backstop being applied to the new private securitization companies, and once that happens, bankers will be able to feel free to lend to anyone with easy terms, knowing that they won't get killed in the future, like the S & L's did, with rising interest rates.

The Fed cannot really raise interest rates too high in order to contain inflation. Of course, the Fed will have to come up with other mechanisms to stop any potential inflation besides raising those interest rates. I have shown how this is within the realm of the Fed now. The Fed can do as Japan can does, control interest rates by maintaining slow growth, higher bank capital requirements, even in times of contagion and uncertainty about stocks and the economy.

And interest rates are controlled by strong demand for treasury bonds, as companies buy inflation protection. Buying inflation protection in the form of interest rate swaps actually serves to control interest rates, because pristine collateral is required to back these swaps.

Paul Ryan has said that the only reason Treasury Bonds have low interest rates is because the Fed buys the bonds. That is patently false. The reason it is false is because the Treasuries would be in great demand for interest rate swaps anyway.

The Fed buys them in order to take bad, or less good collateral off the balance sheets of the banks in exchange for the treasuries it has. The demand would be there even if the Fed did not do this bailout.

Even if the system is dirty and rotten regarding the housing market and stocks as mentioned at the beginning of the article, and there is massive volatility possible, it appears that the bond market is as solid as a rock.

Maybe Ryan wants some other collateral being used in place of treasuries to fund this interest rate swapping. However, there is not enough gold mined in the entire history of the world to supply this demand. So, people like Ryan need to explain how this necessary component of lower interest rates will be backed in the future.

It is my view that Paul Ryan cannot trust the Fed to keep inflation under control, and others have come to the same conclusion about him. Investing with the assumption that the Fed cannot keep inflation in check could be an expensive mistake, based on the solid history of the Fed in this age of massive derivatives. Inflation is under control.

Ryan wants inflation to be controlled by rising interest rates. But, while that would be great for savers, it is not necessary to control inflation. It would make many items even more expensive.

And raising interest rates, as Paul Volcker did in the last century, could bust the banks, and make the Savings and Loan Crisis look like a stroll in the park as all the banks with low interest loans on the books would be immediately insolvent.

As far as investment decisions go, this is a difficult time for the small investor. He gets little value investing in bonds, as yield is low. They are so low that the little inflation there is exceeds the yield.

The big companies buying inflation protection benefit by interest rate swaps. They benefit from this swap as their costs of borrowing for business growth and maintenance stay low. The act of buying the swaps actually allows the Fed to keep interest rates low!

The average investor does not borrow that much. So it is not such a benefit for him unless he takes out a mortgage to buy a house. If gold is a no win investment as many have said, then corporate bonds and REITS look like the most sound low-interest-rate-environment investments.

I posted this at an article on SA regarding other ways the Fed has to control inflation:

 I maintain they don't have the first of the following three options since they can't raise interest rates much: the discount rate, reserve requirements and open market operations
Entitlement programs are a control over inflation because they allow for very slow growth without rebellion. 
Update: I come down on the side of those who want rates to rise even though large raises in rates are unlikely. I emailed this to Ellen Brown on the subject:

We face two problems with low interest rates. First, savings are decimated. Second, banks won't lend for houses when interest rates are low because they will be destroyed once interest rates rise. So, there should be rates that are reasonable, not too low or high. When Janet Yellen says she hates the gap between rich and poor increasing, she has increased that gap because the middle class cannot get loans for houses and cannot get a return on their savings. I realize that raising rates would destroy the US budget, but defense spending is out of control and the rich don't pay nearly enough in taxes. So that could be fixed. The low rate regime insures the gap between rich and poor will increase.






Disclaimer: This article does not offer professional investment advice. I am not a financial advisor nor am I an attorney. Seek those out before making any investment decisions. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 

Comments

  1. Gary A...an excellent piece I have read thrice. Thank you for continuing to improve my understanding of the activities within this sector of the capital markets.
    RHD.

    ReplyDelete
    Replies
    1. Thanks for your encouragement. No one has a crystal ball, but fighting the Fed could prove to be a fools errand.

      Delete
  2. "8. We have a Fed that no longer needs to raise interest rates to stop inflation. It just walls off the money printed from MainStreet."

    Yes, well said. No velocity, at least for the average schmuck.

    ReplyDelete

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