They are the three elements in most magic tricks: a diversion, then a lightness of fingers and, finally, the astonishing result. The first is called the “pledge”, the second the “turn” and the third the “prestige”, the last meant to be accompanied by the magician’s “hey presto” call ringing over the heads of the spectators. On March 15th 2009 US Fed Chairman Ben Bernanke had his hey presto moment when he talked about the green shoots of recovery.
If his predecessor was known as the Maestro then Bernanke should be bestowed the title of Grand Sorcerer. What we were watching was a magic trick performed on a phenomenal scale by the US Federal Reserve and the US Treasury, the Penn and Teller of the American economy. They together decided on the trick, set it up and then pulled off what looked like a miraculous economic recovery. The banking system was the volunteer, but there was nothing voluntary about its actions; if it didn’t go on stage it would die and the audience would probably die as well.
But then the central bank kept telling us – those of us who have spent a professional lifetime tracking its every move – that it was all for real. Yet now when the time has come for the levitating banks to stand upright and leave the auditorium along with the somewhat incredulous spectators, the magician suddenly seems nervous and is showing a marked reluctance to end the performance. The suspicion has returned: it must really have been an illusion.
Let’s unpack the magic. The central bank and Treasury planned a stealth takeover not of our banks but of the function of banking. The banks for now are just shells, large trading desks that have been given a license to make money by “playing the carry” of a steep yield curve, using cheap funds from depositors, and sometimes directly from the Federal Reserve itself, to invest in higher yielding longer-term US Treasuries and certain other fixed-income securities and produce profits from the difference in the returns. The Fed and Treasury are doing the rest.
It helps to remind ourselves of what banks used to do and how the financial system got itself into this mess. In the last twenty or so years banks came to rely on securitizing and trading all forms of household debt and commercial real estate loans to replace the fast diminishing income from their corporate finance business. These assets by the end of 2008 accounted for just under $6 trillion of the $7.4 trillion of the banking system’s claims on the domestic private sector. The securities were meant to be originated and distributed but a large share were retained in the banks’ murky investment portfolios. When one class of assets – subprime mortgages – turned bad and appeared in shockingly large quantities on their balance sheets (with questionable insurance against default) and the banks’ capital buffers to absorb these losses turned out to be insufficient the crisis came to a boil. They first stopped lending to each other, then to the rest of the economy, and the great unraveling began.
So what did the US central bank do? The tongue-curling torrent of liquidity support programs to banks and those few primary dealers who had not rushed to become banks – the TSLF, TAF, PDCF, MMMF, the swap lines to foreign central banks for lending onwards to others with US dollar liabilities – were just borrowing facilities; that is, they were temporary swaps of securities for cash or Treasuries. No one was impressed. The majority of these were introduced in late 2007 and through the first half of 2008 and they made no difference to confidence in the financial system. The all-important money markets – the offshore London inter-bank market and the onshore repurchase markets – remained severely impaired.
But then something happened around mid-September 2008. In the midst of all the turmoil that engulfed the markets the US Federal Reserve discovered the power of magic. In a bland and technical announcement about paying interest on bank reserves it gave itself the power to expand its balance sheet without limit. It then also proceeded to cut rates to close to zero per cent so that within weeks it was giving itself unlimited and costless funds. We were told that the money was needed to increase the size of the liquidity support measures. But this was only a diversion — the “pledge” in the magic trick — to distract us from what was really being planned.
By late November, three weeks after the US presidential elections elections, it was using its balance sheet to buy and hold government and agency debt as well as mortgages. It had gone from being lender of large resort to banks and primary dealers to being the investor of first and last resort in the obligations of the federal government and the agencies that were guaranteeing mortgage borrowing. The purchase of other securities backed by credit card debt, auto and student loans under the TALF program would follow.
The incoming Obama Administration was happy to play its part. It became the other end of the double-handed saw, creating immense quantities of Treasury and agency-guaranteed debt which the Fed, aided by a banking system that was too scared to lend to anyone else, would buy. For all the public talk of retaining the confidence of international investors as Treasury and other contingent liabilities soared no one in Washington was losing any sleep over it. The Fed stood ready to replace foreign buying several times over if necessary with its infinite and costless overdraft facility. It has come through on that assurance. Within months of that announcement it increased its balance sheet by $1.7 trillion, greater than all the US securities holdings in China’s fabled foreign exchange reserves. This was the “turn” – the second part of the magic trick.
Why does this matter? Because by doing this the US central bank has extended its remit to control interest rates along the full length of US Treasury yield curve. Much of the term lending and borrowing that happens in the US economy and in fact in many other parts of the world are based on these rates. The Fed has exercised iron-clad control of these longer yields so that they are kept just high enough for the banks to make money, but not so high that they would crimp the demand for mortgages and other kinds of credit (of which, once securitized, the Fed is the main buyer in any case).
Vast swathes of the most important financial market in the world have therefore ceased to be a market in all but name. It is little exaggeration to say that what we’re seeing is a simulacrum of the American economy and not the real thing. Here the US government is the support for much of the domestic demand, the banking system intermediates the borrowing and the US Fed is the dominant and in many cases the sole buyer of those investments. The Fed and the US Treasury have gamed the system and from that has emerged something like weak growth. This is the “prestige”, the third part of the trick, but on the grandest scale.
And so that is the recovery we have been given – worthy of a centrally-planned economy, while the Fed’s self-serving supporters like Warren Buffett (not to mention the reprobate bankers) pay lavish lip service to the ideology of free markets and American capitalism and are rewarded handsomely for it. Bernanke’s “noble” lies that the economy is returning to health and that we are at the start of a self-sustaining recovery had as much truth as anything that came out of Dick Cheney’s mouth on Iraq. His – and the Fed’s – prestige (in both senses) will stand or fall on how things turn out when the magician exits the stage, which is why he is suddenly looking for an excuse to stay.
Arun Motianey was a managing director and head of Macro Research & Strategy at Citi Global Wealth Management till March 2009. He is the author of the forthcoming book SuperCycles: The New Economic Force Transforming Global Markets and Investment Strategy, published by McGraw-Hill. The book’s release date is February 1, 2010.