We’ve yet to read a single letter by anyone in the investment industry that favours more quantitative easing, or thinks it will be effective for anything but to inflate a short-term bubble.
John Hussman is no exception, and among other things in his weekly letter, he takes on the idea that it was somehow helpful the first time around.
Instead, he says, what was helpful was suspending mark-to-market accounting.
One of the arguments for quantitative easing is the notion that the Fed’s purchase of $1.5 trillion of Fannie Mae and Freddie Mac debt somehow “pulled the U.S. economy back from the abyss” of a Depression. But a closer examination of the past 19 months suggests that a much more specific mechanism – suspension of truthful disclosure – was actually the key element. Unfortunately, the benefits of this suspension are also impermanent, because the underlying solvency problems have been left unaddressed.
In early 2009, many major U.S. banks were faced with clear capital shortfalls that effectively rendered them insolvent – their liabilities exceeded their assets. Instead of restructuring this debt, or dealing with the problem in a sustainable way, the Financial Accounting Standards Board, responding to Congressional pressure, suspended “mark to market rules” and allowed major U.S. financials to use “substantial discretion” in valuing their assets. Since it was neither possible nor credible for banks to immediately write up those assets overnight, loans from the Troubled Asset Relief Program (TARP) were critical in bridging the immediate shortfall. Over the following quarters, banks substantially wrote up their assets, and they issued a large volume of additional stock. The new issuance created a moderate but legitimate improvement in the financial position of these banks, but the asset writeups appear to be inconsistent with the growing volume of delinquent and unforeclosed homes, and the deteriorating debt-service performance of commercial mortgage-backed securities. Presently, the U.S. financial sector is essentially opacity masquerading as solvency.
As Meredith Whitney has observed, the “recovery” of the U.S. financial sector has been a two stage process – massive writeups of troubled assets on balance sheets, followed by large reductions in loan loss reserves on income statements. This activity has not only driven the improvement in operating earnings reported by banks, but has been one of the primary contributors to the recovery in the aggregate earnings of the S&P 500 Index. It is not a process that should be extrapolated.
As for Fed purchases of U.S. agency securities, there is little doubt that these actions allowed the U.S. housing market to function, albeit at a weak level, over the past 18 months. But this cannot be credited to anything inherent in quantitative easing. Rather, the Fed did something that neither the American public, nor the U.S. Congress were willing to do democratically: it essentially guaranteed Fannie Mae and Freddie Mac debt by taking massive amounts onto its own balance sheet. This was later followed up by more explicit 3-year guarantee by the Treasury (through the end of 2012).
Think of it this way. If Fannie and Freddie had already been explicitly protected by the full faith and credit of the U.S. government, their securities would have been indistinguishable from U.S. Treasury securities, and housing activity through Fannie and Freddie would have proceeded without any action by the Fed. It wasn’t quantitative easing that helped the housing market. It was the Fed’s willingness to put the U.S. public on the line for any losses sustained by these two insolvent financial institutions.
By purchasing $1.5 trillion in Fannie Mae and Freddie Mac obligations, the Federal Reserve has placed U.S. taxpayers in the position of absorbing whatever additional losses will come on two-thirds of the nation’s mortgages. Prior to the Fed’s actions, the bondholders of these institutions had no right to the full faith and credit of the U.S. government, but the Fed’s massive purchases of this debt are now effectively irreversible without such a guarantee. There appears to be no way for the Fed to extricate itself from this position without provoking massive economic dislocations, except through continued Treasury guarantees to make this agency debt whole so that private market participants will buy it back. By making that “monetary policy” decision, the Fed has actually forced an act of fiscal policy.
Of course, in addition to the lack of benefits, he sees major risks associated this time around:
Despite the probable lack of measureable benefits, further QE poses significant risks. It has already triggered a steep decline in the exchange value of the U.S. dollar, and threatens a destabilization of international economic activity, a loss of confidence, and the creation of a “boom-bust” cycle threatening to choke off any economic recovery that does emerge.
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