The Fed Could Have Also Helped Main Street Instead of Just Wall Street

In this post I am going to perform a little magic trick.  At the end, I will reveal how I did it.

The Federal Reserve Bank (FED) bailed out the banks with a program it called Quantitative Easing(QE). The QE progam bought toxic assets from the big banks to rescue them from insolvency.  These toxic assets were Collateralized Debt Obligations (CDOs).

A CDO is a financial intrument that Banks sold to the public.  It pays high rates of interest, which is why buyers wanted them so badly.  The flow of interest payments to the investors was funded by the mortgage payments of the package of mortgages that comprised the CDO.  They became toxic assets when enough of the mortgagees could no longer afford to make their payments.

The FED bought CDOs so that the Banks no longer had the obligation to pay the interest.

The Fed just created the money to buy these assets.

What if the FED had bought actual mortgages directly instead of buying packages of mortgages in the form of CDOs?  They could have told the mortgagees that they wouldn’t hold them responsible for payments if they couldn’t make them.  After all, some  of the mortgagees aren’t paying anyway.  The difference is that we wouldn’t have so many homeless people who were foreclosed upon, and we wouldn’t have vacant houses that are deteriorating before our very eyes as weather and vandalism take their toll.

As I tried to dig up references to justify what I wrote above, I came across a few surprises.

Forbes has the article Bernanke Admits To Congress: We Are Printing Money, Just ‘Not Literally’

“Where does the Fed get the money to buy [assets],” Congressman Keith Rothfus asked the Chairman.  “Do you create the reserves,” he queried in a follow up, receiving a simple “yes” from Bernanke.  And finally, the money shot: are you printing money? “Not literally,” the Fed Chairman surprisingly responded.

YouTube video of explanation of Bernanke’s Financing of the Asset Purchase

These securities purchases were financed by adding to the reserves held by the banks at the Fed; they did not significantly affect the amount of money in circulation.  The Fed has multiple ways to unwind the large-scale asset purchaes (LSAPs) including selling the securities back into the market.

If I left it there, I can use that as proof that the Fed just created the money to buy the toxic assets.  If you view the video, you will see some sleight of hand to prove that it did and it didn’t do what you think you just saw.

Then there is the New Economic Perspectives article Where Did the Federal Reserve Get All that Money?

John Carney just wrote a very nice piece, showing that not only was the Fed able to find buyers for its assets but that markets actually bought them back at a premium. Bernanke addresses the second objection in his remarks below – idle balances don’t chase any goods – but it’s the financing of the asset purchases that I want readers to understand, because this is fundamental to understanding Modern Monetary Theory (MMT).

This article refers to the Bernanke video above.  The above link is to the relevant 5 minute excerpt of a lecture.  The Board of Governors of the Federal Reserve System has links to the full lecture The Aftermath of the Crisis.

When I saw the 5 minute snippet of the lecture, I saw some amazing sleight of hand.  As I was mulling that over, I came across the New Economic Perspectives article mentioned above, it looked like even experts whom I respect got taken in.  I was pleased to see that in the comment thread that followed that article, there were a few who caught the trick that I saw.

Here is only a part of the conversation that gives you an insight to the sleight of hand.

Right. But those were risky assets, and I’m saying that this is not a full accounting.

Do we know what kind of losses the Fed has yet to realize?

Say you paid $2 trillion in risky assets with a face value of $2.5 trillion, which may pay 10% interest or may pay nothing and lose 50% of its value. Say it’s 50-50, but you’re levered 20:1– owing $1.9 trillion in debt. You’re either going to make $200 billion or lose $200 billion… on your $100 billion gamble.

Now the Fed buys the stuff off you for $2 trillion and you pay off your debt. You realize no gain, but you weren’t expecting to, anyway. You’re more liquid than before, with far less risk.

The Fed, however, realizes $125 billion in interest on $1 trillion in assets, which it dutifully turns over to Treasury. What’s not mentioned is the $125 billion loss on the rest. Sure, the $125 billion would have gone to the you, and is now at Treasury. But there’s a $125 billion loss at the Fed that also would have gone to you.

And that assumes the Fed pays you fair value for those assets, which is pretty unlikely. Suppose the market price for your assets was falling– maybe you would have only realized $1.8 trillion if you sold to anyone else. That doesn’t matter to the private sector, but that’s still another $200 billion subsidy to the private sector.

And so on.

That drew another possibly more interesting response, but I can’t go on forever quoting everything I have read.

The trick I played is using some of Bernanke’s words that I believe to be true to prove a point, while asking you to ignore Bernanke’s words that at best are trying to avoid revealing the truth.  The meta-trick is that what I did is exactly what Ron Paul and Rand Paul do all the time.  They do it to make a false point, but I do it to reveal the truth, if you believe me.

Maybe I will write another blog post trying to explain where are all the mirrors in this house of mirrors.

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