How much QE? - As much as it takes
The Fed
is expected to announce the size and terms of QE2 next
week, and commentators have produced a wide range of
estimates. There is little point in speculating, and it
is better to understand the true purposes of QE2, one of
which is to ensure government deficits can be financed
at the lowest possible cost. But the Fed also has to
take other matters into account as part of its forward
planning, and there are three problems looming which
have the potential to derail the American banking
system: the housing market, a European banking crisis
and derivatives. The first is an immediate problem,
which is very much in the news today.
By now
there must be few homeowners in America who are unaware
of the problems lenders are having with paperwork, which
has predictably been dubbed by the media “foreclosuregate”.
It is a spanner in the works that has the potential to
lead to a complete seizure of the residential property
market. Whatever the rights and wrongs, the courts are
going to be clogged up with homeowners challenging
documentation, investors in mortgage-backed securities
will be suing banks for compensation, mortgages will
become unavailable, and the few cash buyers looking for
bargains cannot get title indemnity insurance. These
are the ingredients of another collapse in house prices,
with disastrous consequences for the banks.
The
banking system will have to be rescued for a second time
from this housing mess; covertly, because there is now
strong public antipathy for bank rescues. Any credible
rescue plan must include open-ended purchases by the Fed
of securitised mortgages to maintain asset values, so
they do not have to be written down in bank balance
sheets. The Fed and its regional network will therefore
either buy mortgages from the banks, or take them in as
collateral for low-cost loans. This operation is simply
an extension of QE1.
The
scale of the foreclosure problem on its own suggests
that QE2, for this is what we are talking about, will be
prolonged and substantial. The “shock and awe” tactics
that were appropriate for QE1 and the first banking
rescue are not appropriate today; instead the Fed is
likely to announce “ a flexible regime”, “we will review
monetary policy as events unfold” and they will “remain
vigilant at all times”. Unlike the first banking
crisis, the Fed is fully aware it faces systemic
difficulties, so it has a strategy. This will require an
open-ended facility to print money to handle
foreclosuregate and fallout from the looming
European banking crisis, and likely problems in
derivative markets.
There
is a general awareness in financial circles of the
problems facing the weaker member states of Euroland.
These problems are intensifying and sooner or later can
be expected to escalate into a full-blown crisis. This
will create problems for the American banks, whose
exposure is on two levels: through loans to the region
and through derivatives where there is also counterparty
risk.
The
exposure of US banks through derivatives to Euroland is
far larger than loan exposure, and it is worth getting a
sense of this by looking at the market statistics.
According to the FDIC, outstanding derivatives held by
US banks increased from $155 trillion to $225 trillion
between mid-2007 and mid-2010. In other words, since the
credit-crunch the derivative bubble in the US has grown
a further 45% and is now fifteen times total US GDP,
literally dwarfing the banks’ total equity, which is
only $1.35 trillion. Consider this fact: derivative
exposure is 189 times total bank equity.
The
largest player is JP Morgan and at JPM’s last year end,
its total derivative exposure was $78.7 trillion, about
35% of the total held by all US banks. 96% of derivative
exposure in the US is with just six banks, the other
five being Bank of America, Goldman Sachs, Citi, Wells
Fargo and HSBC North America. Only part of this exposure
is with Euroland, but even on the conservative basis
that Euroland accounts for ten per cent of these
derivatives, Euroland’s troubles have to potential to
wipe out total US banking capital many times over. The
position is worse considered from a counterparty basis,
since Euroland banks are also counterparty to derivative
contracts outside Euroland. And we already know that
local authorities in Europe are reneging on derivative
contracts they did not fully understand.[i]
There
is also the consideration that derivative teams in these
banks are institutionalised, broadly sharing the same
institutionalised backgrounds, education and opinions.
Therefore these six banks are likely to have adopted
similar derivative positions against third parties in
non-US banks and in the non-banking world. This
inevitably means that when an important market or
economic event signals a change of derivative strategy
they will be unable to cover their positions. We have
seen the potential for such a squeeze in silver futures,
where JP Morgan has a short position that is impossible
to cover: the point is that these imbalances also exist
in many OTC derivatives on a far larger scale.
The
likelihood of problems in derivatives as the US and
global economies worsen increases, but the timing is
difficult to predict. The best the Fed can do is to
ensure the financial system is supplied with enough
money so that a market event, such as a large fall in
Treasuries or stocks, does not derail derivatives. It
is why interest rates have to remain at or close to zero
for the foreseeable future.
Taken
together with the need to print money to finance the US
budget deficit, the continuing solvency of the banking
system is so important that there is now no option but
to accelerate the money printing machinery as and when
required. Inflation is not today’s problem and there
are more pressing matters, so QE2 will have to be
infinite.
28
October 2010
