Thursday, July 29, 2010

Hussman on Bernanke, Fannie and Freddie

Last month I wrote about Bernanke's Guaranteed Box Full of Crap, where he somehow justified the Fed's purchase of a trillion dollars of Fannie and Freddie securities on the grounds that his left hand man at Treasury was guaranteeing the assets.  Today I read John Hussman's weekly piece, where he points to an important exchange last week between Bernanke and NJ Congressman Scott Garrett:

Hussman, first, reiterating the point I made in the blog article linked above:

"Last week, Ben Bernanke appeared before Congress for his regular Humphrey-Hawkins testimony. For most of that testimony, it fascinated me that every time the Bernanke said that the Fed has taken no losses on its operations, there was absolutely no remark that the reason the Fed has not lost money is that the Treasury, directly (Fannie, Freddie) or indirectly (AIG) has made the liabilities held by the Fed whole."

then, the back and forth between Garrett and Bernanke:

"SCOTT GARRETT: You bought over a trillion dollars of GSE debt, and to that point, under normal circumstances, on the Fed's balance sheet what you have on there are Treasuries, or if you had anything else on there, I assume you would have a repurchase agreement for those securities on your balance sheet. Now of course around two-thirds of that are in GSE debt. 


GARRETT: So right now, those are guaranteed - whether they're sovereign debt or not, we don't know - but they're guaranteed by the U.S. government. But they're only guaranteed to when? 2012, right? After that, Congress may in its wisdom make another decision, and at that point in time, you may be holding on your balance sheet - two thirds of your balance sheet - something that is not guaranteed by the Federal government. First of all, you don't have a ... do you have a repurchase agreement on those with anyone? No. 

BERNANKE: I don't know what you mean by a repurchase agreement. We own those securities. 

GARRETT: You own those securities. Right. So there is no repurchase agreement outside to buy them back. You own them. 


GARRETT: So after 2012, if they're no longer guaranteed, is it fair to say that you may at that point in time actually engage in fiscal policy, because you basically are creating money at that time? And I know that you'd agree that it would be an unconstitutional role for the Fed to engage in fiscal policy - so where will you be at 2012 if they had to take a haircut on those because they're no longer guaranteed? 

BERNANKE: Well, first from the government's perspective, I, uh, such an act would, uh, there would, the Federal Reserve would lose money which the Treasury would gain. There would be no overall change to the position of the U.S. government. Secondly, the Federal Reserve act explicitly gives.. 

GARRETT: How would we be gaining? How is the Treasury gaining? 

BERNANKE: Well, if there's a bad mortgage and the Treasury.. it requires $10 to make it good, if the Treasury refuses to do that then the Fed loses $10, so one way or another the government's going to lose $10. But I would just say two things, one is that I think, uh... 

GARRETT: But if you didn't purchase them in the first place, it would just be a total - then what would have occurred? There would not have been the creation of that $10. Now that you've purchased them, and in essence if we don't back them up, then you will have created that additional $10. 

BERNANKE: Well, I hope that doesn't happen, because I think it's very important for financial stability and confidence that we, that we guarantee... 

GARRETT: Let's play out that hypothetical that it does happen. 

BERNANKE: Well, then the Fed would lose money there. But let me just point out that the Federal Reserve Act, that we did not invoke any emergency or unusual powers to buy those agencies. It is explicitly in the Federal Reserve Act that we can buy Treasuries or agency securities and so we did not do anything unusual there. 

GARRETT: In what status were they when you bought them? Were they in conservatorship at that point? 

BERNANKE: Um, yes. 

GARRETT: Is it normal practice for the Fed to buy agency securities when they're in conservatorship? Was that ever done before? 

BERNANKE: It's never been in conservatorship before. 

GARRETT: Well, there you go. So the normal practice is not what was followed here. It just seems to me that we may have gone down a different road than we've ever gone down in U.S. history, where the Federal Reserve has engaged in buying a security, it's not Treasury, it's not guaranteed by the full faith and credit of the United States for its lifetime, nor is there any repurchase agreement from any other entity that you purchased - that you have a trade with an agreement with - and that the Fed in essence could have created money if the government does not guarantee them. At least, that could be the situation we could find ourselves in 2012."

Hussman even explains why it matters:
"It's important to understand that historically, the Fed has never actually "created money" out of thin air. What it has always done is purchase Treasury debt, paying for that debt by creating "Federal Reserve Notes" (see the top of your dollar bill). When it has purchased other types of securities, it has historically done so using "repurchase agreements." These enable the Fed to sell those securities back at a known price, even if the security itself was to default. By restricting the vast majority of its purchases to U.S. Treasury securities, the Fed has always operated under a budget constraint: Congress has always had the sole, Constitutionally enumerated power to authorize the spending that creates government liabilities, and the Fed has merely affected whether those liabilities were held by the public in the form of Treasury debt or in the form of Federal Reserve Notes (money). 

For example, if Congress votes on a billion dollars of spending, and the Treasury issues debt to finance this spending, the Fed might buy that billion dollars of Treasury debt and create a billion dollars of currency to pay for it. But notice that from the standpoint of the public, the end result is still a billion dollars of government liabilities, that was explicitly authorized by Congress. The Fed was never involved in spending decisions, which is fiscal policy. 

Contrast this with what the Fed has done in this instance. It has taken its balance sheet up from about $800 billion two years ago (almost exclusively in Treasury securities) to over $2 trillion today, mostly in Fannie Mae and Freddie Mac liabilities. The government's backing of Fannie and Freddie debt was always implicit - they do not have the full faith and credit of the U.S. for their full maturity. If Congress chooses to restructure that debt after 2012, the Federal Reserve will have created money without an offsetting asset of equal value on its balance sheet. It will have spent money out of thin air to pay off the holders of Fannie and Freddie securities. This would constitute a fiscal policy decision that was not actually voted on by elected representatives in Congress."


babar ganesh said...

> "If Congress chooses to restructure that debt after 2012, the Federal Reserve will have created money without an offsetting asset of equal value on its balance sheet. It will have spent money out of thin air to pay off the holders of Fannie and Freddie securities. This would constitute a fiscal policy decision that was not actually voted on by elected representatives in Congress."

um, contradiction in terms here, an utterly baffling refusal to follow the principles of basic logic. let me summarize this paragraph for you, so you can see how contradictory its line of "reasoning" is:

"if congress decides to restructure the GSE debt then the fed will be printing money withough congressional consent."

try again.

Kid Dynamite said...

interesting point, babar. i don't think it changes the bottom line, which is the core of the Bernanke's Box full of Crap post I wrote - SOMEONE is going to lose money on this stuff - Fed/Treasury - it's all smoke and mirrors.

you have to respect how Bernanke tried to make it look like there was no loss, but Garrett was keen enough to call him out on it.

Kid Dynamite said...

also, babar, it is possible that Garrett mis-spoke, and meant "if Treasury chooses to restructure that debt after 2012," since Treasury is the one offering the guarantee currently?

babar ganesh said...

the only difference between the treasury losing money and the fed losing money is that the treasury has to issue debt to cover its lost money and the fed doesn't.

generally the fed makes money -- it's a bank and does maturity transformation -- and it rebates what it makes to the treasury. i dont have numbers here but that's usually $20B in a normal year. right now with its balance sheet much larger it's making quite a bit more. that's money destroyed. so the fed could lose a little money and just rebate less to the treasury, that wouldn't make much difference.

my sense (i've looked at the GSE quarterly reports) is that the GSEs aren't going to lose nearly as much as projected and that the treasury might come out ahead esp. if you count the 10% they are getting in interest. (as an example right now the GSEs have about 70B in cash against future defaults, and they are paying 10% interest on that cash -- they had to borrow it from the treasury far in advance of needing it) if we double dip or if housing prices crater again soon the story is different.

but anyway you're right that this isn't usually what the fed does -- the fed doesn't usually take credit risk and any loss would end up as a permanent change in the amount of money out there. you could compensate for that by taxing, or eventually you would get inflation.

But What do I Know? said...

Thanks for laying this out, KD. I confess I didn't quite understand what Hussman was getting at when I read him.

I'm still trying to figure out what the Fed's real motivation for buying the MBS was in the first place. Was it simply to keep the buyers of that debt happy? Make them whole? Keep leveraged MBS holders from being liquidated? Or did they really believe that slightly lower mortgage rates would do something for the housing market?

And for the life of me I don't know what the heck they were doing buying long Treasuries--as you note, they were simply exchanging one US debt obligation for another--and if they want to do that, why is the government issuing interest-paying bonds at all?

Transor Z said...

Kid, here's a March 2010 Housing Wire story that might shed some light on this:

Barney Frank:
“Please don’t think this is federally guaranteed. I don’t think it is. I don’t think it should be. I don’t feel any obligation to bail you out,” he told Bloomberg.

By mid-day he issued a statement clarifying that "Fannie and Freddie debt [does] not have the same legal standing as Treasury" debt. He also said he supports the Treasury standing "fully behind the terms" of its unlimited guarantee of agency maturing inside of 2012.

Then, in a CNBC interview, Frank clarified that agency debt purchased prior to conservatorship of the agencies is different from debt purchased during conservatorship.

This view, however, is "inconsistent" with the Treasury Department's unlimited support for senior and subordinated debt outstanding through 2012, according to commentary out from RBS Securities, a wholly owned subsidiary of the Royal Bank of Scotland (RBS).

Swaminathan at Credit Suisse, in a note written over Christmas weekend, similarly saw the risk as small: “The only way GSEs would need to tap more than the $400bn capital line [authorized by Congress under Housing and Economic Recovery Act (HERA) of 2008 - TZ] previously provided is if there is a housing double dip that causes losses on GSE credit books to exceed 8%.”

First of all, thanks for posting on this, KD. It prompted me to take a closer look at the mechanism. Looks like the Treasury guarantee, optimistically cast as a likely "surplus" by Dec. 31, 2012, might be tapped into, as RRE chugs along setting record lows.

But to the discussion with Babar, it appears that he makes a good point: the Treasury temporary guarantee of MBS out of the GSEs runs only through 2012 per HERA. After that, as your buddy Barney notes, all bets are off. That would be a congressional decision.

Curioser and curioser. Good stuff.

Transor Z said...


Anonymous said...

"if congress decides to restructure the GSE debt then the fed will be printing money withough congressional consent."

By moving first the Fed has put the Treasury/Congress in a position where the Feds actions are dictating fiscal policy. By assuming this debt prior to the actions they tie the hands of congress where they cannot restructure without the fed losing money. If you replace the "fed" with "china" you can see how one entity by acting first can force the second's hand.

EconomicDisconnect said...

How does this tie in with word all FNM/FRE mortgages will be refi's to 4.5% all at once?

I wish I were smarter.

Kid Dynamite said...


oc bear said...


Can you render an opinion on this.

There seems to be documentation, but I just can't believe that its true. Even with the changes in accounting rules don't these guys have an obligation to report credit problems or what good is any kind of credit score.

Kid Dynamite said...

OC bear - i've written about that topic before - about how banks are trying to avoid foreclosures because it means they have to take the loss. Bank accounting gurus criticized me, shouting "you idiot - as soon as borrowers become delinquent then banks write down loans."

that's mostly true in theory - reggie middleton's article alleges that it's mostly not true in practice. also, the other problem is that there are tons of people who are way underwater who haven't YET defaulted but will.

i don't know if the banks have no choice but to pretend that the worst is behind us in housing, but i have very little doubt that things cannot get much better in the near future for housing: down is the only way to go

Unknown said...

SO clearly the USG guarantee on agencies is not perpetual, and therefore is an option. That is, there is some probability that the guarantee will terminate, whether 2012 or otherwise. Therefore, it is not a question of whether at that point, the Fed will have engaged in fiscal policy, which they have not been authorized to do. By purchasing the agency securities, they have engaged in fiscal policy, because the securities have an iption compoenet affectign their price.

The Federal Reserve has therefore engaged in ulawful activity.

oc bear said...


I'm wondering if banks have an obligation to report defaults. It would seem that ignoring delinquencies makes credit reporting unreliable and might cause a further contraction of credit. I think Tom Friedman in "The World is flat" concluded that the only advantage the US had was trust.