Wednesday, March 23, 2011

After $82 billion profit, Is It Still Time to End the Fed?

During the financial crisis, America’s rage against rescuing the collapsed banking system loomed large. That’s understandable since we had a chance to witness first-hand the return on Wall Street’s $5 billion investment in Washington politicians and lobbyists during the decade preceding that collapse. When Wall Street’s highly leveraged bets on bogus mortgages wiped out its capital, the free market was repealed.

Instead, we witnessed reverse-Robin-Hood at its best -- $23.8 trillion in government cash and guarantees – including billions in taxpayer funds funneled to pay Wall Street bonuses.

But it’s turning out that all those bailouts are paying off. When you take into account the Fed’s $82 billion in profit from those bailout deals, it’s beginning to look like the taxpayer will actually make a profit after bailing out history’s worst financial crisis. How did the Fed make that profit? And does this mean that Ron Paul is right that it’s time to end the Fed?

Beginning in March 2008, when it facilitated the merger of Bear Stearns with JPMorgan Chase, the Fed's balance sheet nearly tripled from around $900 billion to nearly $2.6 trillion. The Fed became the garbage dump for Wall Street's toxic waste along with some other debt that was created to stimulate the economy in the wake of the financial crisis.

The Fed donated its $82 billion in 2010 profit to the Treasury Department. And according to the New York Times, that profit came from interest earned on its investments financed through free money. Here are the biggest sources: 
  • $45 billion came from its $1 trillion in mortgage-backed securities that it took on in order to keep mortgage cash available -- the MBS yielded about 4.5%
  • $26 billion in interest on its $1.1 trillion in government debt -- to which it will add $600 billion in 2011 as part of its so-called Quantitative Easing 2 (QE2) plan to stimulate growth -- the debt yields 2.4%
  • $3.5 billion from the $30 billion Maiden Lane subsidiary it created to buy assets from Bear Stearns and American International Group -- it yielded a whopping 11.7%.
It is beginning to look like history will judge the coordinated efforts of the Treasury Department and the Fed during the financial crisis as the most brilliant piece of government bailing out in history. As I posted, the bailout has cost the FDIC only $8.89 billion and the Troubled Asset Recovery Program (TARP) is expected to cost only about $25 billion by the latest count. If you added in a portion of the Fed's profit, the U.S. might end up breaking even or even earning a profit on its bailout. This pales in comparison to the $220 billion price tag for cleaning up after the deregulation of the S&L industry in the early 1990s -- a far less perilous crisis. 

The Fed was originally set up to fight the financial fires created by our unique system of finance that inevitably creates excesses of exuberance and terror. Although it was late to recognize the problem -- noting until the fall of 2007 that the damage from subprime mortgages was contained -- in retrospect, it's clear that the Fed performed quite well during the 2008 crisis.

But Ron Paul (R-Texas), who heads a congressional committee that oversees it, wants to end the Fed. According to Reuters, his latest effort to accomplish this goal is based on his claim that the Fed weakens the dollar and causes inflation. His remedy is to replace the Fed with a gold standard.

I firmly believe that Ron Paul is wrong about this and I am comforted that he lacks the political support to put his ideas into effect. Why? As I've posted, inflation remains low -- despite spiking food and energy prices -- because of downward pressure on wages. And while gold is a popular religious totem, actually using it to control money supply would result in massive economic contraction as the world adjusts to the imbalance between the low supply of gold and demand for the shiny metal.

While it was far from certain that any of the government's intervention would work in 2008, the simple fact is that it has done so. I would be delighted to see a change in our economic system that would minimize the need for the Fed's role as bailer-out-of-last-resort. Doing that would require eliminating the ability of banks to take government-guaranteed deposits and lend them out to risk-taking traders and real estate developers.

Since that little change is not imminent, the Fed has again proved itself to be doing its job well. I am all for political entertainment -- and Ron Paul provides plenty of it. But I just wish the American taxpayer did not need to foot the bill for his circus sideshow.

Monday, March 14, 2011

Japan Disaster: Two Interest Rate and Oil Price Scenarios

Japan’s 8.9 earthquake and tsunami have produced a staggering toll in lives lost and disrupted. The value of the property in the area affected is about $300 billion, an estimated 14% of which is covered by earthquake insurance. Since our economies and markets are tightly bound together, Japan's economic response will affect U.S. interest rates and oil prices -- likely in a way that helps the U.S.

Japan’s central bank responded by pumping $183.8 billion into its economy to make up for the lost production and to pay for rebuilding the country. But this big addition to Japan’s debt, which before the quake had reached 200% of its $5 trillion GDP, is not resulting in a weakening of the Yen.

Rather, Japan is taking its capital out of its global investments, and bringing it home. Considering that $882 billion of that capital had been in U.S. government securities, representing 22% of the total $4.4 trillion worth of foreign holdings of those securities, according to the U.S. Treasury, that sell-off could lead to higher U.S. interest rates unless other investors step in to take Japan’s place.

Meanwhile, the decline in Japan’s more than four million barrel per day oil consumption, about a million of which evaporated in the quake's wake, could take pressure off of rising oil and gasoline prices. This could slow down U.S. economic growth. The answer depends on which of four possible scenarios on interest rates (higher or the same) and oil prices (higher or lower) unfolds in the coming months.

While theoretically, there are four possible scenarios, I'd guess these two are most likely and they're listed below in order of my guess as to their chances:
  • 1. U.S. interest rates unchanged, oil prices lower. Under this scenario, interest rates remain unchanged because the effect of Japanese investors translating their Dollars to Yen is offset by investors who pile into U.S. government securities as a flight to quality. Meanwhile, oil prices drop because 29% of Japan's oil refining capacity has been shuttered in response to the earthquake, thus reducing its daily consumption of oil by 1.3 million barrels a day, 29% of its 4.5 million daily consumption before the quake.
  • 2. U.S. interest rates unchanged, oil prices rise. Under this scenario, interest rates remain unchanged for the reasons mentioned above but oil prices rise as investors anticipate that Japan ends up consuming more oil to make up for its loss of nuclear power capacity. This scenario seems less likely because many analysts expect Japan to use natural gas and coal as the primary substitutes for nuclear power, that accounted for 30% of its energy supply.
Japan is the world's third largest economy. It could be months or years before it is rebuilt to the point that it can return to its pre-quake levels of consumption and production. This should take pressure off of rising prices that might boost inflation and cause the Fed to decide it needs to act by raising interest rates.

It's possible that Japan will shift some of its production of automobiles to U.S. plants since production has been disrupted in Japan. Similar disruptions in Japan's semiconductor industry --  it makes 40% of smartphone data storage chips and leads in making liquid crystal displays for tablets -- could create opportunities for U.S. competitors to pick up some of the slack. But the rebuilding will help some Japanese companies -- stock in Kajima, a major Japanese construction company, rose 22.1% today.

When combined with the removal of the braking effect of higher oil prices -- a $10 a barrel increase in oil prices reduces GDP growth by 0.5% -- Japan's economic pain could boost U.S. growth. But as images of last Thursday's disaster keep pouring in, I hope the rest of the world does all it can to help Japan rebuild.

Sunday, March 13, 2011

Japan Quake, Tsunami, Nuclear Meltdown to Exact $100 Billion Economic Toll

The 8.9 earthquake that struck off the coast of Japan near Sendai Thursday is a human tragedy of enormous proportions. The number of people who have lost their lives in the ensuing Tsunami could exceed 10,000. And for those who live in Tokyo, which did not receive the full brunt of the damage, the shut-down of some of its trains left many to walk home after the quake -- one colleague spent over 10 hours walking 40 miles to get home.

Beyond this human cost, insurance companies and the nuclear power industry are likely to pay an economic toll of at least $100 billion, according to a risk modeler, Equecat interviewed by Reuters. That $100 billion represents about a third of the value of the property in the insured regions. Reuters reports that American International Group (AIG), ACE Ltd (ACE), Munich Re (MUVGn) and Swiss Re (RUKN) are likely to be exposed to some of that damage. However, only about 14% of Japanese property owners have earthquake insurance, so it's likely that the Japanese government will pay much of the rebuilding costs.

The expected economic damage is far higher than many recent quakes. For comparison, here are a few of the larger quakes in the last 20 years and their economic costs:
  • Kobe's January 1995 7.1 quake generated damage that cost over $100 billion, according to the BBC.
  • Northridge's January 2004 6.7 quake took $45 billion to repair the wreckage it left in its wake, according to
  • Chile's February, 2010 8.8 quake was estimated to cost between $15 billion and $30 billion, according to the Economist.
  • San Francisco's October 1989 7.1 quake cost between $6 billion and $8 billion to fix, according to vibrationdata. 
Moreover, the nuclear power industry is likely to pay a significant price as a result of the Japanese catastrophe. Two Japanese nuclear plants were partially melting down on March 13 and others were also at risk -- threatening to release radioactive material into the atmosphere. 

These reactors' inability to withstand the earthquake and tsunami calls into question the safety of the industry and is likely to raise questions about the safety of nuclear plants in the U.S., such as California's Diablo Canyon (near San Luis Obisbo) and San Onofre (in San Clemente), that lie on earthquake faults, according to the Washington Post. Nuclear power accounts for 30% of Japan's energy supply and 20% of the U.S.'s.

What happens next is unclear, however, the economic damage from this tragedy is likely to rise. In its wake, the demand for energy is likely to shift away from nuclear and towards more sustainable sources. And the insurers that pay for the cleanup are likely to raise their rates as they seek to rebuild their depleted capital.