Alasdair Macleod – 28 October 2010
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.
[i] See Goldman Sachs and the SEC