Asset Inflation as a Policy Tool

The Addiction of the Fed to Cheap Money & Asset Inflation

 

“Faster Horses, Older Whisky, Younger Women & More Money”

Tom T. Hall, 1975

 

 

Mortgage Shortfalls & Bank Capital, an Ugly Equation

My Aunt Nancy was a daughter of the American South, and an occasional fan of country music. She delighted in the above lyrics of Tom T. Hall, as it was such a wonderful descriptor of a purely self indulgent fantasy from a self absorbed voluptuary. Our Federal Reserve and the Obama Administration are living the monetary equivalent of this ditty, as they desperately try to re-inflate housing values rather than let the market equilibrate. The following equation clearly indicates the fundamental problem facing the Administration and the Fed.

Northern Rock Depositors Considering Capital Adequacy Ratios

Total Bank Capital US Banks – Amount US Home Mortgages are Underwater – Amount of Estimated Losses on Second Mortgages = Adjusted Capital of US Banks

Substituting actual values as most recently published by the Fed and other sources including WSJ as of 2/25, 2011, “Banks Bristle at Mortgage-Loan Plan” produces the following results.

$1.2 T. (Bank Capital) – $744B. (Mortgage Shortfall) – 1.0T. (Second Loan Losses) = ($.544) T. (Adjusted Bank Capital)

The long and short of it is that if housing prices in the US are allowed to stabilize at current levels, our entire banking system is underwater by around $2.0 trillion dollars, the amount of unrecognized housing loss on bank’s balance sheets ($.5 T), plus the amount required to bring the banks up to the required capital levels of the Basel Accords ($1.5T). After stuffing over $2 trillion into the Fed’s Balance Sheet over the last two years “re-liquefying” the Banks the first time, and sucking up over $600 Billion in below market debt in the last 6 months to fund the QE2 initiative, even the Fed is out of gas.

Clearly, there is no political capability for another QEX-1 plan from the Fed., and short-term interest rates cannot be dropped to rates lower than zero, their current levels. The solution proposed by the Treasury Department of millions of individual mortgage modifications is a transparent attempt to buy time, as it is totally impractical to enforce.

My bet on what comes next – watch out for a major effort to revitalize the Zombie Banks, Fannie and Freddie. These “Economic Verduns” will be wheeled back out next to try to keep the housing market afloat. These same GSE’s that lie at the core of the rot in the housing market will be touted next as the solution to what lies ahead. The Fed and the Administration will do everything in their power to promote asset inflation in all asset classes, particularly housing – by any means possible. In the meantime, steer clear of all fixed rate bonds, particularly those of municipalities dependent on real estate values to generate property taxes.

We are still a long way from “normal”, and the Fed’s policy of asset inflation is the only alternative it has to making some tough monetary and policy choices – choices that neither it nor the Administration want to make.

Resources:
Federal Reserve: Assets and Liabilities of Commercial Banks in the United States (Weekly)
Federal Reserve Bank of St. Louis Economic Research: Condition of Banks

Wes Chapman
Written by Wes Chapman