Fed to bolster the economy with $1 trillion purchase - a.k.a. the road to hyperinflation
I wrote a post about 3 weeks ago about the alarming news that I had heard from a bond trader friend of mine on how the Fed was trying to control the yield curve by buying at the long end and selling at the short end and how that gets us to hyperinflation. They did just that but in a massive scale - today comes the news that they are going to buy $1.2 trillion of long term government bonds.
Typically, the Fed buys and sells short term bonds to control the money supply. This is an unusual action in its size that significantly increases the money supply in the market - a lot of U.S. dollars all of a sudden appear out of nowhere.
This new infusion of cash in theory should lower the interest rate spread of treasuries and lending rates (i.e. banks will make loans at lower interest rates) and stimulate economic activity (i.e. people would start borrowing again to buy stuff).
On the other hand, increasing the money supply devalues the dollar. DJI went up 1.23% today but the JPY gained 2.47% against the dollar, the Euro went up 3.54% so actually today net net was a down day in the market for all of us.
The Fed is taking a big risk that could dilute the value of the dollar further and set the stage for future inflation. We still have to borrow and that is a lot harder to do with a weaker dollar.
AIG Discloses Recipients of $75B in Bailout Payments
new information from AIG on where teh bailout money went. So I was not too far off base in my previous post after all. I look forward to seeing the full list and finding all the middle eastern banks among the recepients.
AIG Discloses Recipients of $75B in Bailout Payments
By Brady Dennis
Washington Post Staff Writer
Sunday, March 15, 2009; 8:13 PM
In the six months since the government’s bailout of insurance giant American International Group, a rescue that has become increasingly costly and contentious, one question has loomed above all others: Where did the money go?
The answer became a little clearer today when AIG unexpectedly released the names of dozens of trading partners it has paid using billions in taxpayer dollars. The disclosure, which the company said was made after consulting the Federal Reserve, revealed that AIG paid more than $75 billion in the final months of 2008 to numerous domestic and foreign banks, as well as to various U.S. municipalities.
The funds were paid from the government’s initial $85 billion emergency loan in September and included major firms such as Goldman Sachs, Societe Generale, Deutsche Bank, Merrill Lynch, Morgan Stanley, Bank of America and Barclays.
The payments were made between Sept. 16 — the date that government assistance began — and Dec. 31.
More than $34 billion of the money went to trading partners of AIG Financial Products, the small subsidiary whose exotic derivatives brought AIG to the edge of collapse. In recent years, the firm had written massive numbers of credit-default swaps, insurance-like contracts that other companies bought as protection against the default of mortgage-backed securities. When the housing boom began to go bust, banks that had purchased the swaps demanded collateral from AIG, burying the company under a tidal wave of debt. Federal officials, wanting to keep the company from failing because they feared it was too intertwined with the global economy, stepped in to help.
In the last months of 2008, AIG Financial Products paid $22 billion in taxpayer money to satisfy debts caused by its swap contracts. Another $12 billion went to pay off municipalities in dozens of states for whom the firm had created complex investment agreements.
Nearly $44 billion went to debts that AIG incurred under its “securities lending” program, according to the company. In those instances, various companies borrowed securities from AIG in exchange for cash. In turn, AIG invested much of the money in mortgage-backed assets that plummeted in value, leaving the insurer on the hook for billions.
Today’s disclosure marked an about-face for both AIG and the Fed. In recent weeks, public outrage and pressure from lawmakers demanding to know who benefited from the AIG bailout has reached a crescendo. But until today, AIG executives and federal officials had repeatedly refused to release such details, arguing that trading partners had a right to privacy and that any disclosure could harm their business.
“These are extraordinary times,” AIG spokeswoman Christina Pretto said today in explaining the company’s decision. “And we and our partners at the Fed thought this was right thing to do.”
Fed spokeswoman Michelle Smith agreed, saying, “We commend the company for finding a balance between its concerns with confidentiality and the concerns of the public interest.”
AIG’s disclosure came on the same day that President Obama’s top economic adviser berated the company for its plans to dole out hundreds of millions of dollars in employee bonuses and retention pay, despite posting a record $62 billion loss in the fourth quarter of 2008.
“There are a lot of terrible things that have happened in the last 18 months, but what’s happened at AIG is the most outrageous,” Lawrence H. Summers, chairman of the White House National Economic Council, said today during an appearance on ABC’s “This Week.” “What that company did, the way it was not regulated, the way no one was watching, what’s proved necessary, it is outrageous.”
Summers was but one in a chorus of administration officials and lawmakers who took to the airwaves today to excoriate AIG, whose total rescue package from the federal government stands at an estimated $170 billion.
“This is an example of people at the commanding heights of the economy misbehaving, abusing the system,” said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee.
Their anger stemmed in large part from the company’s decision to move forward with retention bonuses for executives at the troubled Financial Products unit. In early 2008, before the government rescue, the firm’s employees had been promised more than $400 million in retention pay this year and next. Lawyers for the government and AIG have agreed that most of those payments, however unsavory, are legally binding.
“We are a country of laws. There are contracts,” Summers said today. “The government cannot just abrogate contracts. Every legal step possible to limit those bonuses is being taken by Secretary Geithner and by the Federal Reserve system.”
In addition, AIG is in the process of paying out $121 million in previously scheduled corporate bonuses and hundreds of millions more in retention payments to more than 6,000 employees throughout the company’s global insurance units.
The bonuses and other payments have infuriated the public and government officials. After a contentious call on Wednesday between Treasury Secretary Timothy F. Geithner and AIG chairman Edward M. Liddy, first reported by The Washington Post, Liddy agreed to alter the terms of some executive bonuses and make future payments contingent on the company’s progress with restructuring and paying back taxpayers.
But in a letter that followed, Liddy said he had “grave concerns” about the impact on the firm’s ability to retain talented staff “if employees believe that their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury.”
Speaking on CBS’s “60 Minutes” tonight, Fed Chairman Ben S. Bernanke once again expressed frustration with the bad will that AIG has wrought.
“I understand why the American people are angry,” he said. “It’s absolutely unfair that taxpayer dollars are going to prop up a company that made these terrible bets, that was operating out of the sight of regulators, but which we have no choice but to stabilize, or else risk enormous impact, not just in the financial system, but on the whole U.S. economy.”
Staff writer Neil Irwin contributed to this report.
Where did the AIG Bailout money go (what they don't tell us)?
I recently got an e-mail from my nephew who is a EE PhD Student at Brown. In his e-mail he was asking for an explanation - if I had any - to the AIG bailout money. Where did it go? I think the answer is pretty obvious but not too many people are talking about it and it is not hard to guess why.
We already know of AIG’s role as the insurance counter party to many interbank transactions. We also know that AIG was counter party to many derivative instruments that went bad (reached maturity) and possibly many more to come (when they also reach maturity - and the need for all the additional bailout that is yet to come).
As far as I understand it, some of the money they got went to shore up AIG’s credit rating with the agencies by adding more cash to their balance sheet but most of the money went to settle those very derivative transactions that they ended up owing money. The fed and treasury don’t want to disclose the names as they claim the transaction are too complex, difficult to unravel and there are too many counterparties.
We know some of the counter parties to those derivative transactions like Goldman Sachs, Morgan Stanley and Deutsche Bank. It is not hard to imagine that a big chunk of the counter parties to AIG are banks in the US and all over the world (just like Goldman, Morgan and DB) and they probably are receiving a big chunk of the money. So the bailout of AIG is an indirect bailout of all those banks. Instead of declaring the derivative instruments illegal, or allowing AIG to go bankrupt and helping the banks directly, the Fed and treasury decided to do this indirectly.
There are 2 benefits to this:
- Regulated banks are required to maintain certain leverage ratios - how much of the deposits they can invest relative to their capital paid in cash reserves. If AIG defaulted on their obligations, all these banks would have to come up with more capital to offset the investment losses and prop up their balance sheets or reduce their investment exposure. Either way, the markets would tank further or more likely many these banks would go bankrupt - not just in the US but all over the world.
- The second benefit (more of a conjecture) is that US tax payers don’t want to hear that the money is going to fat cat wall street bankers like GS and MS or BofA, or to foreign banks and foreign financial institutions in the Middle East, China, South America, Europe, you name it; so doing this indirectly spares us all the reality.
This is a much kinder gentler way for the fed and treasury to shield us from the truth - if they don’t prop AIG or if they were to let it fail the banks behind it that it owes money to, the whole financial system will collapse irreparably. I guess no one needs too much imagination as to what might happen if a lot of banks were to fail like dominos.
This is a “…you can’t handle the truth!” thing if you will.
There are also undoubtedly non-bank beneficiaries to this bailout - and we’ll find out who they are eventually when they get named to the Forbes’ wealthiest people list (if the magazine is still in print) and their fortunes shadow Bill Gates and Warren Buffet combined but for the sake of maintaining this chaotic but survivable world we live in I would be indifferent to their success.
Comments to my Blockbuster (BBI) article
I received a bunch of email responses to my previous post (disqus anyone?). Here is an interesting commentary from someone who worked for John Malone. It is exciting to hear that at some point they saw us as a strategic threat! Here is the email, I removed the name and email address.
…………………..
Hello Mr. Politi,
Just read your post on Blockbuster and the move into cable and I remember this series of events quite vividly… but from the competing side. You see, at the time I was working with John Malone at Liberty as his GS point of contact and we were concerned that this deal would become reality. We actually tried to stop this deal by talking directly to Verizon and telling them to sell the property to Liberty instead. We even set off lobbyists to start massaging the agencies (FTC/FCC/etc) so that they approve of the sale. I wasn’t the lead guy in any of the talks but was kept in the loop at all times. We all had a collective sigh of the relief when the merger thing happened… I ended up working with Malone for 6-8 months after that and then went into commodities. It’s great to hear how the thing went down from the other side… thanks for posting it!
Xxxx
PS Found your post here: http://www.newmogul.com/ a bunch of us biz/HF/VC/banker guys read it daily.
Blockbuster and how I almost became the kingpin of cable
There was an article about Blockbuster (BBI) on Venture Beat yesterday. The trading of the stock was halted after it dropped 77% because apparently the company is seeking to file Chapter 11 bankruptcy.
I worked for Blockbuster for a brief period of time after Bankers Trust (another defunct company - now part of Deutsche Bank) and before CRV. I was the President of BBI responsible for new media. I got there right before their second IPO as it spun out of Viacom and left right before the now infamous Enron deal.
It was an excellent career move for me and despite my short time there I learned a lot, got to do a lot and almost became the kingpin of cable!
Here is the story of what almost happened:
After months of much trial and tribulation, I finally convinced the management team that our future was in becoming a cable company. Our option was either to (a) buy a cable operator and consolidate the market (the market was still fragmented at that time) or (b) partner with a Telco and launch a Blockbuster branded Video over DSL service competitive to cable much like US West and GTE were doing at the time.
I got us talking to Bell Atlantic as it was merging with GTE to form Verizon. Our pitch was our brand and our ability to sign up customers for service at Blockbuster stores. We got lucky, they bit. And to top it all, Verizon – the new entity - had to shed all its cable assets, mostly GTE systems in CA, because of anti-trust and we had the chance to buy it all.
It would have been an instant family. We would have ended up with a few million subs, excellent cash flow and an agreement to aggressively roll-out a video over DSL service on top of the new Verizon network in major metropolitan areas. Verizon and BBI would split the cost of the roll out.
I started lining up all the pieces: Bear Stearns to raise the debt component, venture investors for the equity portion (that’s when I first met my Spark co-founder Todd Dagres) , a small acquisition that would have given us all the middleware we needed – the works.
I even went office shopping in Silicon Valley with my partner in crime at the time – Steve Pantelick who is now the CFO of Aggregate Knowledge. We were going to spin this baby out and then consolidate the cable market as fast as we could. We would remake the company. If we could pull it off, we would use all the free cash flow from the store business - $500M/year at the time - lever up and buy a lot of cable subs - at the then going price of $2,000 per sub.
Then CBS happened – Viacom merged with CBS and shelved the plans to spin out 100% of Blockbuster as they needed our free cash flow to pay for the acquisition. As a subsidiary of a Media Company, the word came down that we could no longer compete with the hand then fed them and that was the end of it.
Soon after, I left. I think I cried when I met the CEO to resign.
So you believe my Hyperinflation theory - what do you do with your money? (Option 2 - REITs and Real Estate)
The key thing about hyperinflation is the rapid incineration of value - or as my partner @toddDowl would say – your money is now like “an ice cube in the sun”. What would you do if you knew the $100 in your pocket is going to be worth less than $50 in effective purchasing power in a year (and you did not like my first option:buying TIPS)?
Option 2. REIT’s and Real Estate (or aka - “oh my, do I the right mortgage”)
I’d say go buy something physical that would maintain its value even in adverse conditions. Many would tell you that’s gold, hence the more recent herd mentality on ADRs and gold denominated funds. Gold is a practical material with many commercial uses and it is probably the only physical asset that can be converted to a currency in an easy transaction like presenting it at a bank.
Unfortunately, I cannot get myself to buy gold because (a) I think it is tacky (it is a personal thing) and (b) right or wrong, I believe the value of gold is arbitrary - more an indication of supply and demand (of irrational investors like me looking for protection) and nothing to do with the real value of the commodity itself.
So instead, it might just as good to focus on your own real estate portfolio. You can (a) re-examine your mortgage and make sure you are setup properly against hyperinflation; (b) buy your first home if you can get the loan or (c) If you have cash sitting on a money market account in a bank (that just got yet another bailout loan) you can make a real estate investment or (d) if you don’t want to deal with all the hassle of ownership you can buy into a REIT.
This is all about practical advice so let’s look at REITs first:
REITs have gone through mega share price adjustments – and rightly so. At the same time, because of the steep decline in share prices, the spread between equity REIT yields and the 10-year treasury are at a historical high. Lodging REIT yields are at 19%, industrial at 16%, apartments 12%, retail 10%. Most are already cutting dividends as their cash flows decline bt the spread will continue.
I would stay away from lodging, and retail for obvious reasons but if you stick with well capitalized REITs that use operating cash flow to pay dividends (ex. Boston Properties - BXP), in the long term my bet is that this strategy (a) would beat treasuries by a healthy margin and (b) gain equity value from the recovery.
Now let’s talk about mortgages and buying real estate:
If you have something like a 5/1 ARM or 10/1 ARM that has less than 3 years left in the fixed portion, it is time to get into something longer term (10 years fixed at least) now! I would go back and read the mortgage documents carefully, figure out the max interest rate you’d pay in case LIBOR starts to fluctuate; how often the rate gets adjusted etc. The last thing you want is to get caught with your pants down - an adjustable rate mortgage as the interest rates start climbing up rapidly. That’s how people get bankrupt.
Alternatively, if a bank is willing to give you a long term loan with a great fixed rate take it – if hyperinflation hits, the interest payments would cost you less than a Starbucks cup of coffee.
It’s pretty hard to time markets in general – especially in real estate. In the last 10 years any time was a good time to buy and sell until we all hit the wall. The prices have gone down dramatically already and still have a ways to go. The realities of unemployment are slowly starting to hit major metropolitan areas like NYC, Boston or San Francisco where real estate prices were bid up to a ridiculous levels . The picture is even worse in the secondary homes market and not so different in commercial real estate either – I drove through Rt. 20 in the greater Boston area last weekend. It was striking how many homes and commercial properties are for sale in this coveted stretch of land.
If it is bad today, it is going to get worse in 6 months, prices will go down even further and may not recover for years (one good thing about hyperinflation is that at least on paper your home would gain value even if it loses value in real dollars). There are already a number of ready and willing sellers out there and not too many buyers.
Buying real estate is a very tricky proposition and comes with a lot of headaches but if you buy well - something you like at a price you can afford even if it gets really bad and don’t have to sell it prematurely and enjoy it while you own it - live in it, vacation in it, rent it to a friend - it can be a great long term investment for value protection.
So you believe my Hyperinfaltion theory - what do you do with your money? (Option 1)
I had a bunch of people e-mail me after my hyperinflation post titled “AIG expected to report a $60B loss. What does that mean to you?” to tell me that they have the same fear and asked if I had any suggestions where to invest in that kind of an evironment.
First, I asked them why they e-mailed me instead of adding comments to my blog (which is exactly what I was hoping for) and then I reminded them that I have neither the expertise nor the qualifications to give them any kind of financial advice.
Then again, lack of expertise or qualifications has never stopped me from giving advice before so here is the first of a series of new posts which will be aptly titled: “So you bought into my hyperinflation theory - what to do with your money”.
The advice that follows is exactly as intended - it is unqualified at best.
Option 1. TIPS
TIPS are “Treasury Inflation-Protected Securities”, sold by the government to provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation. The principal is pegged to CPI - the consumer price index. The instrument also pays interest twice a year, your principal gets adjusted based on the CPI and you get paid a fixed interest rate over the adjusted principal so the interest dollars also go up with inflation and down with deflation. At maturity you get paid either adjusted principal or original principal, whichever is greater.
So this is actually a pretty good instrument to buy if you are worried about your money loosing value - if you beleive CPI correctly reflects inflation, in real terms you don’t loose any value. I personally think CPI is 1bps to 2bps lower than reality (I follow the McDonalds Index which I think now is more relevant than ever) but it comes very close.
You can buy TIPS directly from the government (TreasuryDirect) or you can buy a TIPS fund from any of the mega mutual fund companies out there - Blackrock has a pretty good TIPS fund, so does Fidelity.
TreasuryDirect is the cheapest option, since you don’t pay a fee but redemption is a bit difficult I think. It seems you have to hold the instrument to maturity.
The TIPS mutual funds got hit a lot the latter part of 2008 although they are up anywhere from 8% to 11% since the beginning of the year and have caught up. I looked into why, it looks like most fund are almost 75% in TIPS from the Treasury, 5% in cash and 20% in equities to goose up returns which worked very much against them with the sharp drop in the market.
The surprise in all this for me is how large these mutual funds are and they seem to be growing rapidly so I am not alone.
In the spirit of taking my own medicine, I pledge to move whatever little money I have to TIPS in the next few days and report back on the experience.
Shipwrecks visible on Google Earth
Google Earth is just amazing. I am also impressed that people take the time to find things - like Atlantis! I wonder how they do it. I am sure there is a bunch of image processing going on there but if you don’t know what you are looking for, it is all about patience.
The latest thing are shipwrecks,take a look.
Breaking News: G.D.P. Shrank at 6.2% in Q4
This is awful and yet another sign of the things to come. The original estimate was 3.8% decline and usually what happens in Q4 bleeds into Q1. The Obama budget assumes a blended 1.9% decline for the whole year. If Q1 is anywhere near Q4, then we only can shrink on average 0.45% the rest of the 3 quarters, not going to happen!
Here is a more detailed article from the NYT;
In Revision, G.D.P. Shrank 6.2% at End of 2008 - NYTimes.com
Signs of wear and tear for Treasuries
The article from the Financial Times below is talking to some of the issues I outlined in my last 2 posts. It sounds like Treasuries are starting to show signs of wear and tear.
Treasuries caught in the crossfire of ‘two realities’
By Michael Mackenzie
Published: February 26 2009 02:00 | Last updated: February 26 2009 02:00
US bond investors are caught between two competing forces. Pulling one way is an economy that is still deteriorating amid a falling housing market, hefty job losses and low consumer confidence. Pulling the other way are record new debt sales - needed to finance the country’s bank rescue and fiscal stimulus packages.
The stalemate between these two forces helps to explain why Treasury yields remain anchored in a well-defined range, unable to make a decisive break higher, or return to their recent historic lows.
This week, this dynamic has been aptly illustrated: the US Treasury has embarked on selling $94bn in new two-, five- and seven-year notes just as the S&P 500 has dropped to its lowest level since 1997 amid a new raft of dire economic data, notably for housing.
Late yesterday, the yield on the benchmark 10-year note was at 2.95 per cent, up from below 2.80 per cent on Monday.
“The economy continues to worsen, keeping rates from rising unduly, as the tsunami of Treasury issuance constrains the market’s ability to rally a lot,” says David Ader, strategist at RBS Greenwich Capital. “Effectively, rates seem bookended by these two realities.”
In general, bond dealers expect the two-year note to trade between 0.75 per cent and 1.1 per cent, a ceiling which held yesterday, while the 10-year note trades between 2.60 per cent and 3 per cent.
At the start of the year, the 10-year was yielding just above 2 per cent and early in February it briefly went above 3 per cent, amid concerns about supply and whether foreign investors would keep buying Treasuries.
Yesterday, the second leg of this week’s Treasury debt sales sparked solid demand for a record $32bn in five-year notes. That came after $40bn in two-year notes was sold on Tuesday and attracted reasonable demand.
Today the seven-year note returns for the first time since being suspended in 1993. The $22bn offering is also a record amount for this issue as the Treasury remains on course to sell some $2,200bn in new debt for the current financial year.
This month, the Treasury sold $67bn in three-, 10- and 30-year debt. In effect, bond dealers and investors are now facing two hefty slugs of issuance each month.
For now, the lack of any positive signs for the economy is keeping a lid on bond yields as worries over supply are neutered.
Economists increasingly believe an anaemic recovery will only emerge next year, whereas a few months ago, there was hope of a rebound in the second half of this year.
“Given the economic news, I don’t see a better investment opportunity than Treasuries over the next six to nine months,” says Tom di Galoma, head of treasury trading at Jefferies & Co.
The prospect of a further fall in equities, as the economy struggles to find a footing, means Treasuries will attract buyers and cap yields, argue dealers.
“People have been worried about supply but those fears ease when stocks show no sign of a bottom,” says Rick Klingman, managing director at BNP Paribas.
“Until stocks steady, parking your money in a 1 per cent two-year note doesn’t sound too bad. At the moment, preservation of capital is the priority.”
Once the latest Treasury debt sales are completed, attention will focus on data due in the first week of March, crowned by the monthly employment report for February.
John Ryding, chief economist at RDQ Economics, says the economy remains in deep trouble and that job losses for February could reach 700,000. Meanwhile, the tone of recent data suggests a first-quarter contraction in activity of some 5 per cent, he adds.
That said, there are signs that supply is weighing on the bond market and could become a much heavier burden in the coming months.
Mr Ader highlights this week’s moves in Treasury prices and yields against a backdrop of bad economic news and fears over the financial sector.
“If yields can’t fall further on the steady litany of bad economic news and disconcerting stocks, the bond market has a problem,” warns Mr Ader.
At some point, the sheer scale of debt issuance is expected to weigh on the appetite of Treasury investors.
There is also a fear that foreign investors, facing bleak domestic economic prospects, could sell their current Treasury holdings.
Mr Ryding expects the yield on the 10-year note to rise to 4 per cent by the end of the year. “The problem for the US is that more than 50 per cent of our debt is held by foreign investors.”
Ultimately, Mr Klingman says the long-term trade looks bearish for Treasuries and investors who stay in the market are staring at losses.
