Friday, March 05, 2010

The Fed Has Some 'Splainin' To Do
Graph Shows US Financial System Resting on Mortgage-backed Securities

Check out this graph. Look at the far left hand side of the graph. This is the pre-financialmeltdown status of Federal Reserve Assets. Virtually all of it, the green part, consists of t-bills, that is, traditional governmental borrowings, roughly a trillion dollars worth. Then in the fall of 2008 came the meltdown and TARP, and the fed had to loan massive amounts of money to financial institutions to keep the system afloat, total amount over a billion dollars. As President Obama has stated, the financial institutions have gradually paid back most of these loans over the past year or so.

Now here's the part that nobody in the government has been really forthcoming about. Look at the red part of the graph, growing as you go to the right. This part has grown almost in lockstep with the shrinkage of the loans to financial firms. What is the red part? Mortgage-backed securities. The fed is holding over a trillion dollars worth. Supposedly, the program to buy these securities will end at at the end of this month, but because some of this category includes "agency debt" which is nothing but promises to buy more mortgage backed securities what we really have is a situation where the anchor of the US financial system is half-full of whatever junky mortgage securities investors couldn't unload anywhere else.

Let's follow that to another level, to the microeconomic level. Joe Schmo has a mortgage he can't hope to pay. He's upside down 30% on the property. The policy that would be most likely to help Joe stay in his house would be to write the loan down to the value of the property. That would mean that the Fed would take a 30% hit on its balance sheet, and indirectly, the national debt goes up an equal amount. What we have here is a conflict of interest. The government professes an interest in keeping Joe in his home, but the only realistic way to do that is to write down the book value of the loan. In this case, the book values of these loans collectively are the only things that are keeping our currency from going down the toilet.

It doesn't seem to me that the situation here is sustainable. What's going to have to happen sooner or later is the true nature of these assets will be revealed, and this will result in the devaluation of US currency. It may sound heretical, but if it could be kept in control, perhaps a rise in the inflation rate wouldn't be such a bad thing. It would encourage domestic production, and it would allow us (collectively) to pay off old debt with cheaper dollars.

For the whole report from the Federal Reserve Bank of Atlanta, check out this link.

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