Out of Thin Air
[The Registry April 2011 Issue]
An illusionist’s primary tool is distraction: We are made to look left when to the right he is palming the ace of spades. So, too, is the Federal Reserve engaged in creating an illusion. Ben Bernanke and his brethren are doing all they can to direct our attention to the high level of unemployment as the reason for the massive quantitative easing taking place. Yet, the real trick is to reflate property values without awakening the inflation dragon.
According to a small article in the Feb. 1 edition of the Financial Times, the Federal Reserve has surpassed China as the largest holder of U.S. Treasuries with $1.108 trillion on its balance sheet. This milestone (or millstone) seems to have passed with little notice. In the not-too-distant past, there was significant editorial handwringing about the risk of American dependence on China, and fear that the country would lose its appetite for our debt, creating sudden spikes in interest rates. Yet no similar editorials are circulated about our addiction to borrowing and acute craving for low interest rates. We have a knee-jerk reaction against the mere mention of tax increases to reduce our deficit and simultaneously have a blind spot for unsupportable debt.
Yet, increased debt—rather than actually balancing the budget through budget cuts and increased taxes—is obviously the method preferred by U.S. voters to deal with fiscal problems. So politicians and the Fed are merely giving citizens what we want: No new taxes, but more debt. Tomorrow can take care of itself.
This strategy is lethally dependent upon interest rates staying low, which is why the Federal Reserve is willing to play with the fire of hyper-inflation by creating currency out of thin air.
The Financial Times article went on to point out that upon completion of QE2, the Fed will have accumulated $1.6 trillion in Treasuries, surpassing the combined holdings of China and India, and will be shouldering a balance sheet totaling more than $3 trillion.
The Federal Reserve is now the undisputed heavyweight champion of spending money it does not have. The source of funds for the $1.6 trillion buying spree was the creation of a simple, electronic general ledger entry on the books of the Federal Reserve—a private company. Cost for said entry: Zero. Yet the interest paid by U.S. taxpayers will be very real.
If the blended coupon for these Treasuries is 2.5 percent, then the interest payments received by the Fed are approximately $40 billion a year for the next five to 10 years. These are real dollars being paid by the U.S. government to the Federal Reserve and add to the federal deficit. It's a business model that is the envy of Wall Street: cost of goods sold, zero; cost of distribution, negligible; the business model is infinitely scalable, and 100 profits are guaranteed.
Taxpayers can take some solace that these payments may offset the Fed’s losses from the portfolio of assets it acquired in 2008. That included the Maiden Lane III LLC transaction whereby the New York Fed ponied up $24.3 billion to buy the most-toxic collateralized debt obligations on the books of insurer American International Group Inc. And don’t forget the $761 billion dung-pile of mortgage-backed securities purchased from Fannie Mae and Freddie Mac during the liquidity crisis in 2008 when no one else would touch the toxic goo.
More importantly, however, is the ace of spades up the Fed’s right sleeve: its fervent desire to reflate residential and commercial property values, so commercial banks are not crushed under the weight of their fall. It is doubtful that anyone at the Fed truly believes that there is a connection between job creation and pumping massive amounts of liquidity into the financial system at the long end of the yield curve. This is a ruse. The enormous liquidity created by the Fed is chasing returns in stock markets, in currency arbitrage between emerging and developed countries, in commodity prices—anywhere a short-term financial play can turn a quick profit. What it is not doing is inducing investment in the United States that could lead to the creation of much-needed employment.
What the oceans of liquidity are doing is giving hope, not least to real estate markets, that there will be a sustained period of low interest rates, setting the stage for another bull run. Should this happen, potential losses facing banks would be much diminished, which I suppose could save taxpayers a pile of cash—unless Wall Street or the banking oligarchs make massive bets on the resurgence of real property values that don't pan out.
Michael Mackenzie, author of the gem in the Financial Times, noted that 67 percent of this mountain of virtual cash was invested in Treasury notes with maturities ranging from four-and-a-half years to 10 years. Those are precisely the maturities used as pricing indexes for both residential and commercial real estate lending. These maturity horizons match and should smooth the waves of distress heading our way from maturing and underwater commercial loans. If the Fed is successful at creating artificially low interest rates on loans with five-, seven- and 10-year maturities, this will provide great lift for property values and may carry us past 2017 when the last of the bad loans mature.
The chart below is taken from the Congressional Oversight Report published in February 2009 and clearly shows that over the next three years, we will see the highest number of commercial real estate loan maturities in the banking sector. That almost certainly will create the potential for the highest level of defaults and, therefore, the greatest risk of falling prices. The green and red highlights are mine; green represents the three years with the highest commercial loan maturities for banks and the red represents the three years with the most loan maturities for CMBS originations.
Based on this chart, real estate investors should remind themselves that the sun won’t set on default risk until the fat lady sings, and this Rubenesque crooner is the slug of CMBS maturities coming due in 2017.
There has been a lot of ink recently about how the Fed will remove liquidity from the system to ensure that inflation does not run rampant. Yet, clearly the Fed is more worried about the risk of asset devaluation. I believe the Fed will simply allow the Treasury securities to mature and be repaid and therefore this portfolio will self liquidate, which will slowly remove this form of financial subsidy from the real estate markets and may prevent a panic and subsequent rush for the exits.
Because the Federal Reserve laddered its maturities from four-and-a-half to 10 years, repayments of these Treasury notes will begin in 2015, after the crest of the maturity crisis for banks has passed. The remainder of the maturities will roll off the books from 2015 through 2020, hopefully after the CMBS maturity crisis has passed without sinking the fiscal ship.
If interest rates stay low for the next five years as the Fed seems to be hoping, perhaps the benefits of creating an orderly disposition will outweigh the costs. Investors hoping that the rising tide will lift their legacy portfolios of overpriced and over-leveraged real estate to the point of buoyancy should remember that in the last bubble those that left while the party was in full swing kept their net worth intact.
