The Housing Market in China is Crashing

Jim Chanos Was Right: The Housing Market in China is Crashing

Whatever goes up must come down."

That is the general law of gravity, but it is surprisingly true for
the real estate market too.

It happened in the United States, it happened in several European
countries, it happened in Dubai, and now it seems that the reality is
being witnessed in China. After going up steeply for the last few
years, now the housing prices in Beijing, Shanghai and in the other
cities have started to come crashing down. In March, the real estate
prices fell by a staggering 26.7% from February. But this is not just
a one-off month. The housing prices have actually come down by 50.9%
over the last 12 months.

Jim Chanos was one of the first to sound the alarm. At the time,
people thought he was a fear monger, and was dead wrong. The argument
went that China is different because down payments are so high, and
the economy is booming, etc. The "this time is different syndrome" was
rampant both in China and abroad. Now, almost everyone agrees that
things are getting out of control in China; the question is, "Will the
Government be able to stop it? And how bad will the crash be?" Let us
take a look at the housing market in China to get a clearer answer.

Housing is still scarce in many populated cities of China. In fact,
Shanghai, Beijing, Guangdong and most of the other major Eastern areas
are overpopulated, and they are bursting at the seams.

There are many reasons why the Chinese real estate market has been
booming for the last few years. First, the financial sector here is
quite limited — the investment options here are quite limited. Because
of this, many people believe in buying property to maintain the value
of money. Also, there are hardly any social security benefits and
state pensions in China too. So, investing in property in anticipation
of price rise is a way of saving for the future.

Interestingly, those with money in China believe in purchasing
multiple properties. Typically, a person would buy one in the city
center, and another one outside. And there are those who are always
open to upgrading by selling off an older property and purchasing a
new housing unit. So, a lot of apartment complexes and condos have
been coming up, and most of them were being sold off even before the
construction was complete.

The booming housing market has been driving China's economy too. In
fact, residential property investments accounted for 6.1% of the
country's GDP in 2010. Interestingly, housing accounted for a large
percentage of U.S. GDP in 2005 when the housing industry was booming
here, before it all started to crash down.

So, the warning bells have been ringing for some time now. Citigroup's
(C) research head in China, Shen Minggao, had warned investors that
the property market was about to enter the bubble stage, and that the
bubble was bound to burst. This level of growth was just
unsustainable, he said. Some people believe that based on things like
rent to income, and other statistics, the Chinese housing market is in
a worse position than America's was pre-bubble.

One reason for this is because of the fact that, unlike the U.S.
market, China's housing industry is not very regulated (although,
regulation in the United States was extremely lax during the boom in
the United States) and is quite inexperienced as well. According to
estimates, there are about 25,000 real estate broking companies that
employ more than 200,000 agents in China. There are also 20,000
property management businesses that employ about 2 million people.
Many of these companies do not have a license and the necessary
qualifications. In a recent survey, it was found that out of 4,000
real estate businesses in Beijing, just 700 had the license to carry
out business.

The global economy has definitely gained because of the growth in
China's housing market, but if the bubble bursts, which it now seems
might be happening already, then it could be bad news not just for the
country, but for the economies of other countries as well.

With clear signs that the bubble is already bursting, the authorities
in China have started to take steps.

As a law, state data cannot be released to the public if it is not
from the government. So when the data in March was published on the
Internet, that the real estate prices have fallen by 26.7%, it was
severely condemned by Shen Laiyun, who is the spokesman of the
National Bureau of Statistics in China. He warned of legal steps. He
mentioned that the official data will be published soon. But experts
say that this data of a 26.7% fall in March, and the 50.9% fall over
the last 12 months is indeed correct.

Honestly, the government has been taking note of the spiraling prices
and has been taking steps for some time now. In 2010, steps were taken
to halt the buying of second properties. The minimum down payment to
be made was increased. New taxes have also been imposed on buying
properties in Chongqing and Shanghai. Third mortgages have been
banned. Interest rates have been hiked two times in the last four
months alone. Local governments have been told to establish price
targets on new properties that are coming up. Some other restrictions
have also been imposed on bank loans.

So, the government is definitely sitting up and taking notice. But is
all this too little, too late? Only time can tell us. But one thing is
certain, and this is that the bubble in China's housing market has
definitely been getting bigger for some time now, and it has already
started to burst.

Nouriel Roubini

Nouriel Roubini is an American professor of economics at New York
University's Stern School of Business and chairman of Roubini Global
Economics, an economic consultancy firm.

Roubini may now be best known for his frequent commentary on global
markets, often with a pessimistic view point.

After receiving a BA in political economics at Bocconi University,
Milan, Italy and a doctorate in international economics at Harvard
University, Cambridge, Massachusetts, he began academic research and
policy making by teaching at Yale while also spending time at the
International Monetary Fund (IMF), the Federal Reserve, World Bank,
and Bank of Israel. Much of his early studies focused on emerging
markets. During the administration of President Bill Clinton, he was a
senior economist for the Council of Economic Advisers, later moving to
the United States Treasury Department as a senior adviser to Timothy
Geithner, who is now Treasury Secretary.

In 2008, Fortune magazine wrote, "In 2005 Roubini said home prices
were riding a speculative wave that would soon sink the economy. Back
then the professor was called a Cassandra. Now he's a sage". The New
York Times notes that he foresaw "homeowners defaulting on mortgages,
trillions of dollars of mortgage-backed securities unraveling
worldwide and the global financial system shuddering to a halt". In
September 2006, he warned a skeptical IMF that "the United States was
likely to face a once-in-a-lifetime housing bust, an oil shock,
sharply declining consumer confidence, and, ultimately, a deep
recession". Nobel laureate Paul Krugman adds that his once "seemingly
outlandish" predictions have been matched "or even exceeded by
reality."

As Roubini's descriptions of the current economic crisis have proven
to be accurate, he is today a major figure in the U.S. and
international debate about the economy, and spends much of his time
shuttling between meetings with central bank governors and finance
ministers in Europe and Asia. Although he is ranked only 512th in
terms of lifetime academic citations, he was #4 on Foreign Policy
magazine's list of the "top 100 global thinkers." He has appeared
before Congress, the Council on Foreign Relations, and the World
Economic Forum at Davos.

Early Life and Education

Nouriel Roubini was born in Istanbul, Turkey, to Iranian Jewish
parents. When he was age two, his family moved to Tehran, Iran, and
later he lived in Israel. From 1962 to 1983 he resided in Italy where
he attended Bocconi University in Milan, and then he moved to the
United States to pursue his business doctorate in international
economics at Harvard University. He is currently a U.S. citizen and
speaks English, Persian, Italian, and Hebrew. He lives in Manhattan,
has never married, and is "well-known on the New York club circuit".

Roubini spent one year at the Hebrew University of Jerusalem before
moving to Milan, Italy, where he received his B.A., summa cum laude,
in economics from the Bocconi University in 1982. He received his
Ph.D. in international economics from Harvard University in 1988.
According to his academic adviser, Jeffrey Sachs, he was unusual in
his talent with both mathematics and intuitive understanding of
economic institutions. In an interview in June 2009, when asked about
his best investment in life, he replied, "I think investing in a good
education has been key for me, although the investment was more in
time than money."

Career

For much of the 1990s, Roubini combined academic research and policy
making by teaching at Yale and then in New York, while also spending
time at the International Monetary Fund, the Federal Reserve, World
Bank and Bank of Israel. Currently, he is a professor at the Stern
School of Business at New York University. He spent much of his time
working on emerging market blowouts in Asia and Latin America which
helped him spot the looming disaster in the U.S. "I've been studying
emerging markets for 20 years, and saw the same signs in the U.S. that
I saw in them, which was that we were in a massive credit bubble," he
said.

By 1998, he joined the Clinton administration first as a senior
economist in the White House Council of Economic Advisers and then
moved to the Treasury department as a senior adviser to Timothy
Geithner, then the undersecretary for international affairs and now
Treasury secretary in the Obama administration.

Roubini returned to the IMF in 2001 as a visiting scholar while it
battled a financial meltdown in Argentina. He co-wrote a book on
saving bankrupt economies entitled Bailouts or Bail-ins? and opened
his own consulting firm.

Role Models

He credits a number of economists for his understanding of economics.
He said, "One person who has had a great impact on me intellectually
was my adviser at Harvard, Jeffrey Sachs. For me he's the model of a
great intellectual. He is both a rigorous academic and very human,
involved in big picture issues such as poverty, AIDS, and Africa. He's
someone with a great mind that is also very engaged with the world.
Another intellectual hero is Larry Summers, the former President of
Harvard, an amazing intellectual and academic, who is very deeply
involved with the policy world. I worked for him for many years in the
US Treasury during the Clinton Administration".

Global Nomad

He likes to refer to himself as a "global nomad", and says, "You can
be sitting still surfing the Internet, and experience other worlds,
ideas and societies. But I've found that there is nothing better than
visiting a different country, even if for three days. ... you can't
only be a virtual Global Nomad, with goggles on, in a virtual reality.
You have to be there. You have to see it, smell it and live it. You
have to see people, travel, and interact."

Partly to fulfill this need, he became chairman of RGE, an economic
consultancy for financial analysis. In describing the purpose of RGE
Monitor, he said, "the world is my home, so everything about society
and culture — no matter how miniscule — is worth knowing. I am an
information junkie and created RGE Monitor to collect information
about what's happening around the world."

Speaking of his early influences, Roubini said, "I was born into a
relatively orthodox Jewish family in Iran, lived in Israel and Turkey,
and then moved to Italy as a child. By the age of six, instead of
going to a yeshiva, I went to a secular Jewish school where I
interacted with kids from all sorts of different backgrounds. Had I
gone to an orthodox Jewish school, I would perhaps be orthodox now and
may have never become a Global Nomad."

Personal Investments

During an interview in June 2009, he was asked about his personal
lifestyle expenses and other investments. He said, "I regularly save
about 30% of my income. Apart from my mortgage, I don't have any other
debts. The credit crunch hasn't affected me much. . . . I've always
lived within my means and, luckily, have never been out of work. I
would say I'm a frugal person — I don't have very expensive tastes. .
. . You don't need to spend a lot to enjoy things."

Asked whether he invests in stocks, he replied, "Not as much these
days. I used to have a lot in equities — about 75% — but over the past
three years, I've had about 95% in cash and 5% in equities. You're not
getting much from savings these days but earning 0% is better than
losing 50%. . . . I don't believe in picking individual stocks or
assets. . . . Never invest your money as though you are gambling at
the casino. Buying and selling individual stocks is a waste of time."

Economic Forecast

U.S. Economy

In the 1990s, Roubini studied the collapse of emerging economies. He
used an intuitive, historical approach backed up by an understanding
of theoretical models to analyze these countries and came to the
conclusion that a common denominator was the large current account
deficits financed by loans from abroad. Roubini theorized that the
United States might be the next to suffer, and as early as 2004 began
writing about a possible future collapse. Business Week magazine
writer Michael Mandel, however, noted in 2006 that Roubini and other
economists often make general predictions which could happen over
multi-year periods.

In September 2006, he saw the end of the real estate bubble: "When
supply increases, prices fall: That's been the trend for 110 years,
since 1890. But since 1997, real home prices have increased by about
90 percent. There is no economic fundamental—real income, migration,
interest rates, demographics—that can explain this. It means there was
a speculative bubble. And now that bubble is bursting." In the Spring
2006 issue of International Finance, he wrote an article titled "Why
Central Banks Should Burst Bubbles" in which he argued that central
banks should take action against asset bubbles. When asked whether the
real estate ride was over, he said, "Not only is it over, it's going
to be a nasty fall."

By May 2009, he felt that analysts expecting the U.S. economy to
rebound in the third and fourth quarter were "too optimistic." He
stated, "Certainly the rate of economic contraction is slowing down
from the freefall of the last two quarters." He expects negative
growth to the end of 2009, and feels that during 2010 the recovery is
still going to be weak," with the full recession lasting 24 or 36
months, and a possibility of an "L-shaped" slow recovery that Japan
went through in The Lost Decade. But in fact, the US economy started
to grow in mid 2009 just like the optimistic analysts forecasted.

In his opinion, much of the current recession's cause is due to
"boom-and-bust cycles," and feels the U.S. economy needs to find a
different growth path in the future. "We've been growing through a
period of time of repeated big bubbles," he said. "We've had a model
of 'growth' based on overconsumption and lack of savings. And now that
model has broken down because we borrowed too much." He feels that too
much human capital went into financing the "most unproductive form of
capital, meaning housing" and would like to see America create a model
of growth in more-productive activities. He feels that "sustainable
growth may mean investing slowly in infrastructures for the future,
and rebuilding our human capital," by investing in renewable
resources. "We don't know what it's going to be," he says, "but it's
going to be a challenge to find a new growth model. It's not going to
be simple."

Recovery From Recession

In August 2009 Roubini predicted that the global economy will begin
recovering near the end of 2009, but the U.S. economy is likely to
grow only about 1 percent annually during the next two years, which is
less than the 3 percent normal "trend." He notes that the Fed is "now
embarked on a policy in which they are in effect directly monetizing
about half of the budget deficit," but that as of now "monetization is
not inflationary," as banks are holding much of the money themselves
and not relending it. At some point, however, probably by 2011, he
sees the recession ending, and "banks will want to lend the money;
people and businesses will want to borrow and spend it." Then it will
be time for an "exit strategy, of mopping up that liquidity" and
taking some of the money back out of circulation, "so it doesn't just
bid up house prices and stock values in a new bubble. And that will be
'very, very tricky indeed,'" he states. However this prediction proved
to be wrong when the US economy grew 2.2% in the third quarter of
2009, and contracted only 0.7% in the second quarter of 2009, showing
that the economy is recovering earlier and much more robustly than
Roubini expected.

Also, in late July he warned that if no clear exit strategy is
outlined and implemented, there was the potential of a perfect storm:
fiscal deficits, rising bond yields, higher oil prices, weak profits,
and a stagnant labor market, which combined could "blow the recovering
world economy back into a double-dip recession."

Global Economy

2009

As of January 2009, he remained pessimistic about the U.S. and global
economy. He said in September, 2008, "we have a subprime financial
system, not a subprime mortgage market". "As the U.S. economy shrinks,
the entire global economy will go into recession. In Europe, Canada,
Japan, and the other advanced economies, it will be severe. Nor will
emerging market economies—linked to the developed world by trade in
goods, finance, and currency—escape real pain." He was quoted in South
Africa's 2009 budget speech for his role in predicting the current
financial crisis in the developed markets.

Roubini notes that the subprime issues are a global, and not just a
U.S. problem. In an interview with author James Fallows in late spring
of 2009, he stated, "People talk about the American subprime problem,
but there were housing bubbles in the U.K., in Spain, in Ireland, in
Iceland, in a large part of emerging Europe, like the Baltics all the
way to Hungary and the Balkans. It was not just the U.S., and not just
'subprime.' It was excesses that led to the risk of a tipping point in
many different economies."

His pessimism is focused on the short-run rather than the medium or
long-run. In Foreign Policy (Jan/Feb 2009), he writes, "Last year's
worst-case scenarios came true. The global financial pandemic that I
and others had warned about is now upon us. But we are still only in
the early stages of this crisis. My predictions for the coming year,
unfortunately, are even more dire: The bubbles, and there were many,
have only begun to burst".

At a conference in Dubai in January, 2009, he said, the U.S. banking
system was "effectively insolvent." He added that the "systemic
banking crisis.... The problems of Citi, Bank of America and others
suggest the system is bankrupt. In Europe, it's the same thing." To
deal with this problem, he recommends that the U.S. government "do
triage between banks that are illiquid and undercapitalized but
solvent, and those that are insolvent. The insolvent ones you have to
shut down." He adds, "We're in a war economy. You need command-economy
allocation of credit to the real economy. Not enough is being done,"
he felt at the time.

2010

In 2010 he again warned that despite an improved economy with rising
stock markets, the crisis was not over and new bubbles were on the
horizon:

We are just at the next stage. This is where we move from a private to
a public debt problem . . . We socialised part of the private losses
by bailing out financial institutions and providing fiscal stimulus to
avoid the great recession from turning into a depression. But rising
public debt is never a free lunch, eventually you have to pay for it.

In late May 2010, markets around the world began dropping due partly
to problems in Greece and the Eurozone. "Roubini believes Greece will
prove to be just the first of a series of countries standing on the
brink," writes the Telegraph. Roubini explains the new issues
governments must deal with:

We have to start to worry about the solvency of governments. What is
happening today in Greece is the tip of the iceberg of rising
sovereign debt problems in the eurozone, in the UK, in Japan and in
the US. This... is going to be the next issue in the global financial
crisis.

China

Roubini met officials in China during spring 2009, and points out that
many Chinese commentators blame American "overborrowing and excess"
for dragging them into a recession. However, he states that "even they
realize that the very excess of American demand has created a market
for Chinese exports." He adds that although Chinese leaders "would
love to be less dependent on American customers and hate having so
many of their nation's foreign assets tied up in U.S. dollars,"
they're now "more worried about keeping Chinese exporters in business.
. . . I don't think even the Chinese authorities have fully
internalized the contradictions of their position."

Jim Chanos

James S. Chanos is an American hedge fund manager, and is president
and founder of Kynikos Associates, a New York City investment company
that is focused on short selling.

Chanos is famous for his short sale of Enron and more recently his
pessimistic view on China.

Born in 1958 in Milwaukee, of Greek origins, he was schooled at Wylie
E. Groves High School and Yale, where he graduated in 1980. In
business, he developed an investment strategy based on intensive
research into stocks searching for fundamental and large market
failures in valuation: typically under-estimated or previously
un-reported failings in the business or market of a stock. Followed by
committing to a (usually large) short-position which he is willing to
hold for long period of time - almost the mirror image of Warren
Buffett's reputed "fundamentals+long stay" investment strategy.
Because of this model, his investments function more like those of a
whistle-blower than most typical investments. Examples of this include
short-selling companies such as Baldwin-United, and more recently, the
notorious Enron Corporation.

He rose to fame in the 1980s as a short seller who had a knack of
spotting stocks that he thought to be overvalued. After working as an
analyst in several firms, he founded Kynikos (Greek for "cynic") in
1985 as a firm specializing in short selling. A critical position
taken at Kynikos was his shorting of Enron.

In October 2000, Chanos started research into the valuation of Enron
Corporation. He examined their use of mark to model (opposed to
mark-to-market) accounting, which, in Chanos' experience, results in
management overstating earnings, as well as what appeared to be a
worryingly low (6-7%) return on capital investment. Enron stock
declined from $90 in August 2000 to a low of $1 near the end of 2001.
Over this period, Chanos was a short seller of Enron during 2001,
increasing his short position as more information surfaced. Kynikos
profited greatly and Chanos himself became somewhat of a celebrity as
a consequence of his early awareness of Enron's problems.

More recently, James Chanos has warned that China's hyperstimulated
economy is headed for a crash, rather than the sustained boom that
some economists predict. He reiterated his concerns about the
stability of Chinese economy, stating that historically analogous
evidence points especially to a housing bubble, having mentioned
commercial real estate in particular.

Jim Rogers: The China Shorts Have Had It All Wrong

Jim Rogers: The China Shorts Have Had It All Wrong, But At Least Hugh
Hendry Admits It

The China shorts have got is all wrong thus far, and while the economy
will continue to experience problems, it will make it through, says
Jim Rogers in an interview with Index Universe.

Rogers says that while hedge funder Hugh Hendry has admitted his China
short is hurting him, Chanos has not thus far. He believes both, in
the long-run, will be proven wrong.

Jim Rogers, from Index Universe:

Well, I feel sorry for them. They've been dead wrong for two years.
Hugh Hendry has at least acknowledged that being short China is
hurting him. I don't know about Chanos—Jim said he was short, and if
so, he's hurting too. China has not gone down. It's been two years now
and, sure, there are going to be setbacks in China along the way, but
China has not collapsed. We, in the U.S., had many depressions—with a
"small d;" we had a horrible Civil War; we had very little rule of
law; we had periodic massacres in the streets; we had virtually no
human rights; you could buy and sell congressmen—well, you can still
buy and sell congressmen in America, but they were cheap in those
days. As recently as 1907, the whole system was broke in the U.S., and
yet we were on the verge of becoming the most successful country in
the 20thcentury.

Maybe real estate speculators in Shanghai will go bankrupt. I expect
that, I hope it happens; it would be good for China and it would be
good for the world. But in the meantime, these guys shorting China
have been dead wrong. But I want to repeat this: There will be massive
setbacks in China, along the way. It's the way the world works. If I
see serious problems in China, I'm not going to stop teaching my
children Mandarin.

CHANOS: China's Property Bubble Is Hitting The Wall Right Now

Fund manager Jim Chanos spoke to Bloomberg TV's Carol Massar about
China's economy, debt and real estate market.

Chanos said that growth in China may be zero and that China has
"European kind of numbers" when it comes to debt.

"I think that will be the surprise going into this year, and into 2012
- that it is not so strong. The property market is hitting the wall
right now and things are decelerating. The CEO of Komatsu said last
week that he is having trouble getting paid for his excavator sales in
China. Developers are being squeezed. They're turning to the black
market for lending, this shadow banking system that is growing by
leaps and bounds like everything in China.

"Regulators over there are really trying to get their hands around the
problem. In the meantime, local governments have every incentive to
just keep the game going. So they will continue with these projects,
continuing to borrow as the central government tries to rein it in."

Chanos on his long and short positions:

"We are short Chinese banks, the property developers, commodity
companies that sell into China, anything related to property there is
still a short."

"We are long the Macau casinos. It's our long corruption, short
property play. We feel that there's American management and American
accounting. They are growing at a faster rate even than the property
developers."

On the IMF lowering growth estimates for China:

"A lot of people are assuming that half of all new loans in China are
going to go bad. In fact, the Chinese government even said that last
year relating to the local governments. If we assume that China will
grow total credit this year between 30% to 40% of GDP, and half of
that debt will go bad, that is 15% to 20%. Say the recoveries on that
are 50%. That means that China, on an after write off basis, may not
be growing at all. It may be having to simply write off some of this
stuff in the future so its 9% growth may be zero."

Misleading Indicators

Please consider China Stocks Advance Most in Four Weeks as Leading
Indicator Shows Growth

China's stocks rose, sending the benchmark index to its biggest gain
in four weeks, after a gauge of economic indicators signaled growth is
withstanding Europe's debt crisis and faltering expansion in the U.S.

"Valuations have reached a bottom, leaving limited room for further
declines," said Mei Luwu, a fund manager at Lion Fund Management Co.,
which oversees more than $7.8 billion. "Volatility will rise in the
market as investors bet on the timing of a rebound."

The index "signals a continuation of economic expansion through the
end of this year," Jing Sima, the board's New York- based economist,
said in a statement. "The rate of economic growth will be slower in
2011 than last year."

The IMF estimates the Chinese economy will grow 9.5 percent this year,
down from a forecast of 9.6 percent in June, and 9 percent in 2012.
The fund lowered its estimate for world growth this year to 4 percent
from the previous 4.3 percent forecast.

Expect Huge China Slowdown

Developers not getting paid, coupled with excessive and unsustainable
credit growth, trumps alleged leading indicators.

For another view on the coming slowdown in China, please consider
Michael Pettis: Long-Term Outlook for China, Europe, and the World; 12
Global Predictions.

Pettis, unlike Chanos does not foresee a China "crash" but at a
minimum, those expecting huge growth certainly will not get it.

Here are 12 predictions by Pettis (Please see article for detailed
explanations regarding China).

To summarize, my predictions are:

BRICs and other developing countries have not decoupled in any
meaningful sense, and once the current liquidity-driven investment
boom subsides the developing world will be hit hard by the global
crisis.
Over the next two years Chinese household consumption will
continue declining as a share of GDP.
Chinese debt levels will continue to rise quickly over the
rest of this year and next.
Chinese growth will begin to slow sharply by 2013-14 and will
hit an average of 3% well before the end of the decade.
Any decline in GDP growth will disproportionately affect
investment and so the demand for non-food commodities.
If the PBoC resists interest rate cuts as inflation declines,
China may even begin slowing in 2012.
Much slower growth in China will not lead to social unrest if
China meaningfully rebalances.
Within three years Beijing will be seriously examining
large-scale privatization as part of its adjustment policy.
European politics will continue to deteriorate rapidly and the
major political parties will either become increasingly radicalized or
marginalized.
Spain and several countries, perhaps even Italy (but probably
not France) will be forced to leave the euro and restructure their
debt with significant debt forgiveness.
Germany will stubbornly (and foolishly) refuse to bear its
share of the burden of the European adjustment, and the subsequent
retaliation by the deficit countries will cause German growth to drop
to zero or negative for many years.
Trade protection sentiment in the US will rise inexorably and
unemployment stays high for a few more years.

Valuations Not at Bottom

In the face of coming writedowns, alleged "cheap" valuations will
likely get much cheaper.

As Minyanville's Peter Atwater is fond of saying "At the top of every
credit cycle, the Income Statement is the Past, the Balance Sheet is
the Future"

Atwater's statement applied to "financial institutions", but Ponzi
financing is everywhere you look in China and the ripple effect will
hit every company just as happened in the US credit bust (soon to be
resumed).

Income only counts if you get it. Developers not getting paid is a
huge warning sign.

A Twisted QE3

The Federal Reserve announced last week that it will engage in a
policy called "the twist" - meaning it will sell some of the
short-term U.S. treasury holdings in exchange for long-term U.S.
treasuries. This is said to be neutral to the money supply and
therefore not inflationary, but let's take a closer look at the
consequences of this action.

Suppose the Fed did not announce this program and the treasuries held
by the Fed, with maturities ranging from a matter of months to three
years, stayed on its balance sheet. What would happen? Well, when they
matured and the U.S. Treasury had to come up with the cash to pay back
the principal, this would most likely just get refinanced at the
current rates. No new Federal Reserve notes are created in this
process. The date of repayment is simply pushed further into the
future and a new interest rate is imputed on the debt. The Fed
literally creates money and therefore can never experience a liquidity
crisis and so would never have any pressing need for cash.

Now let's look at what happens under the current scenario where the
short term debt is now being held by dozens or hundreds of private
investors. Many of the recipients of the short term treasuries are
going to be banks, which are facing a huge liquidity crisis. They need
cash and they need it now in order to remain solvent. So it's unlikely
that this debt is going to be refinanced. When these treasuries
mature, the principal is going to have to be repaid. But with a $1.6
trillion annual budget deficit, the government hasn't exactly planned
for the repayment of this money. They will have to find other lenders
and this will most likely come in the form of increased Treasury bond
purchases by the Fed, which is inflationary.

The Fed has also announced that it will start purchasing more
mortgage-backed securities at the expense of U.S. treasury purchases.
This can only be a symbolic gesture toward the failing housing market.
Interest rates are still at historic lows but no recovery is in sight.
Bernanke is firing every gun in his arsenal, in every direction, but
is still not hitting the target. It must be a tough time to be the
head of the world's most influential central bank. Day after day, the
god-like powers central bankers assumed they had are giving way to the
reality that they're just money-printers, completely impotent at
effecting any real improvement to economic conditions.

An article in the Wall Street Journal yesterday says it all:

"The Fed announced that through June 2012 it will buy $400 billion
in Treasury bonds at the long end of the market - with six- to 30-year
maturities - and sell an equal amount of securities of three years'
duration or less. The point, said the FOMC statement, is to put
further "downward pressure on longer-term interest rates and help make
broader financial conditions more accommodative."

It's hard to see how this will make much difference to economic
growth. Long rates are already at historic lows, and even a move of 10
or 20 basis points isn't likely to affect many investment decisions at
the margin. The Fed isn't acting in a vacuum, and any move in bond
prices could well be swamped by other economic news. Europe's woes are
accelerating, and every CEO in America these days is worried more
about what the National Labor Relations Board is doing to Boeing than
he is about the 30-year bond rate.

The Fed will also reinvest the principal payments it receives on
its asset holdings into mortgage-backed securities rather than in U.S.
Treasuries. The goal here is to further reduce mortgage costs and thus
help the housing market. But home borrowing costs are also at historic
lows, and the housing market suffers far more from the foreclosure
overhang and uncertainty encouraged by government policy than it does
from the price of money.

The Fed's announcement thus had the feel of an attempt to show it
is doing something to help the economy, even if it can't do much. The
current 10-member FOMC also reported three dissenting votes from
regional bank presidents, who also dissented from its August decision
to declare that short-term interest rates will stay near-zero through
mid-2013."

With the economy ailing, the Fed is trying everything it can to keep
the stock, housing and U.S. debt markets afloat. As the sovereign debt
crisis continues to spread throughout Europe it will reach epidemic
proportions. Already we're hearing demands for inflation in order to
make repayments easier. With these demands, the desperation of these
monetary and economic engineers is becoming more and more overt.
Resorting to inflation in order to repay huge debts has been the final
act of every empire, state and banana republic the world has ever
known. From Weimar to Zimbabwe, even "just a little inflation" has
turned in to a lot when the public realizes that the money system is
being gamed for the benefit of big government and big banks. Inflation
begets more inflation, as the price-level indexed government pension
and benefit liabilities grow with every successive injection of money.

Former Fed Chairman Paul Volker, who actually managed to avert an
inflationary catastrophe by doing the exact opposite of what Bernanke
is doing, couldn't have said it any better in a recent New York Times
article:

So now we are beginning to hear murmurings about the possible
invigorating effects of "just a little inflation." Perhaps 4% or 5% a
year would be just the thing to deal with the overhang of debt and
encourage the "animal spirits" of business, or so the argument goes.

It's not yet a full-throated chorus. But remarkably, at least one
member of the Fed's policy making committee recently departed from the
price-stability script.

The siren song is both alluring and predictable. Economic
circumstances and the limitations on orthodox policies are indeed
frustrating. After all, if 1% or 2% inflation is OK and has not raised
inflationary expectations - as the Fed and most central banks believe
- why not 3 or 4 or even more? Let's try to get business to jump the
gun and invest now in the expectation of higher prices later, and
raise housing prices (presumably commodities and gold, too) and maybe
wages will follow. If the dollar is weakened, that's a good thing; it
might even help close the trade deficit. And of course, as soon as the
economy expands sufficiently, we will promptly return to price
stability.

Well, good luck.

Good luck indeed, Mr. Bernanke. As for me, I'll be taking advantage of
the lower gold and silver prices to expand my position and profit from
the monetary lunacy that's crippling the global economy.

Effects of operation twist

The Federal Reserve announced on Wednesday that it will sell some of
its shorter-term assets in order to buy more longer-term assets. Here
I assess some of the possible consequences of this move.

The maneuver is being referred to by some as "operation twist", an
expression that was originally used to describe a plan implemented by
the Kennedy administration and the Federal Reserve in 1961, and given
its moniker after a dance popular at the time. The idea then was that
the Treasury would replace some of its longer-term debt with
shorter-term obligations, and the Federal Reserve would simultaneously
sell some of its shorter-term securities and buy longer-term
Treasuries. Some of the early research (e.g., Modigliani and Sutch,
1966) concluded that the original Operation Twist was not terribly
successful. However, Federal Reserve Bank of San Francisco economist
Eric Swanson has a new paper recently presented at the Brookings
Institution that makes a convincing case that Operation Twist did
succeed in its goal of modestly lowering long-term interest rates.

The Fed announced on Wednesday that it is going to try something
similar, intending over the course of the next 9 months to sell about
$400B worth of its Treasuries that have maturity between 3 months and
3 years in order to buy securities with maturities of 6 years or
longer. According to the latest H41 statement, the Fed currently only
has $129B in Treasuries between 3 months and 1 year, meaning that much
of what they plan to sell has to be in the 1-3 year range. The details
of the plan released by the Federal Reserve Bank of New York indicate
that about 2/3 of the securities purchased will be in the 6 year to 10
year range, and most of the rest will be over 20 years.

The idea behind this plan is that, in the current setting, dumping an
increased supply of shorter-term Treasuries on the market should have
little or no effect on the short-term interest rate. But by buying
more of the existing supply of longer-term Treasuries, the intention
is to nudge the price of those securities a little higher, or in other
words, try to move the long-term interest rate a little lower. The
hope is by lowering interest rates, there would be slightly more
opportunity for households and firms to borrow or refinance and
perhaps increase spending a bit. The new measure thus represents
something the Fed could try, over and above what it already did in
QE2, that might further stimulate the economy without expanding the
overall size of its balance sheet any bigger than it already is.

In a research paper, we came up with a framework for evaluating the
effects that policies like this might have. Our estimates are based on
how changes in the relative supplies of publicly-held Treasury debt of
different maturities correlated historically with changes in the basic
factors determining interest rates on different securities, which
factors we summarized by the level, slope, and curvature of the term
structure of interest rates. We also built a simple model of how
latent level, slope, and curvature factors have been influencing the
evolution of interest rates in an environment like the current one in
which the overnight interest rate is stuck near zero.

We decided to redo some of our earlier analysis in order to evaluate
the potential effects of a policy like that just announced by the Fed.
We conducted the following counterfactual experiment. Suppose that at
some historical date t, the Federal Reserve were to have sold off its
entire holdings of securities between 3 months and 3 years duration,
and used the proceeds to buy an equiproportional amount of all
outstanding Treasury securities between 6 years and 30 years duration.
For example, if implemented in December 2006, this would have been an
operation involving about $343 billion in securities. We calculated
what this would have done to the level, slope and curvature factors,
and what that would mean for interest rates of different maturities in
the present setting where the overnight rate is stuck near zero. The
result is plotted in the graph below. The horizontal axis reports the
maturity of a given security (measured in weeks), and the vertical
axis reports how the yield on that security (measured in annual
percentage points) might change in response to operation twist.

Horizontal axis: maturity of security (in weeks). Vertical axis:
predicted change in yield on that security (in annual percentage
points) as a result of "operation twist". Calculated using same
methodology as dashed line in Figure 11 in Hamilton and Wu (2010). The
figure plots 5200bn*'φΔ3 for Δ3 = (0.014313,0.012336,-0.0047943)'
corresponding to the average impact on q of the Fed historically
selling all its 3m-3y and buying 6y and up.

We don't claim to have very precise estimates for the outcome of this
new counterfactual experiment-- the values in the figure above are not
statistically distinguishable from zero, according to our analysis.
Nevertheless, they represent the best estimates I can give for the
effects of operation twist. Our estimates suggests that a policy such
as the newly announced operation twist might increase 1-3 year yields
by 2 basis points and lower the yield on the longest term securities
by a little less than 10 basis points.

In addition to the statistical accuracy, there's another big caveat
for these estimates, which is that we are analyzing the effects of Fed
policy alone, assuming that there are no changes over the next 9
months coming from the Treasury. However, this assumption proved
definitely not to be the case with QE2. There, while the Fed was
trying to buy more long-term securities, the Treasury was
preferentially issuing new long-term securities at an even faster
rate, with the net result that the Treasury basically undid any
stimulative effects of QE2. Thus, in contrast to the original Kennedy
Operation Twist, in which the Treasury and Fed were working together,
it's quite possible that in the current environment, they will
continue to be pulling the economy in opposite directions. So I expect
the effects of the Fed's latest measure could turn out to be
significantly less than 10 basis points.

How then do I explain the fact that the 30-year Treasury yield fell 17
basis points on Wednesday? My answer is, this wasn't just the Fed.
News of a weakening European economy may have been more important.
There also may have been some signaling effect with investors
concluding, "Gee, if the Fed thinks they have to do this, the economy
must be in even worse shape than I thought!" As evidence in support of
such an interpretation, commodities and equities also fell
significantly, moving in the opposite direction from what you would
have expected if you believed new stimulus from the Fed was the key
development driving markets.

The modest effects that one could reasonably anticipate for a measure
like operation twist are easily swamped by other developments, and
even a sizable effect on 30-year Treasury yields would not in my mind
provide a major stimulus. I think the correct interpretation is that
the Fed would like to bring some more stimulus, this was something
they could do in that direction, so they did it.

But if you were about to drown, I wouldn't want to count on operation
twist as your lifeline to safety.

Analysis: QE3 may do more harm than good

There may be a point at which global investors get indigestion from
U.S. money printing.

A fresh round of U.S. monetary easing may even do more harm than good
for long-term investors as another flood of easy money into
fast-growing emerging economies risks refueling oil and commodity
price inflation, sapping consumption and growth.

Prospects for a third round of the Federal Reserve's quantitative
easing program (QE3) grew this month after Chairman Ben Bernanke said
the central bank was prepared to ease further if economic growth and
inflation falter again.

Nearly in one in two fund managers surveyed by Bank of America Merrill
Lynch this month said QE3 was likely.

The temptation for risk-loving investors is to rub their hands with
glee. Traditionally risky or high-yielding assets such as global
equities, energy and commodities and emerging markets surged in the
months after the Fed gave the green light for Round Two of QE -- which
involved $600 billion in new money in the form of Treasury debt
purchases and which ended last month.

But the impact on the U.S. economy and the labor market has been less
obvious, given that growth has slowed significantly into 2011 -- at
least partly because higher energy costs have undermined consumer
spending everywhere. Asset prices, as a result, have retreated sharply
again since April's peaks.

This has given rise to a debate about whether QE3 works. If it doesn't
give a sustained boost to financial markets and is ambiguous for the
real economy, is there any point?

"We have a negative opinion of QE2, and believe QE3 could very well
turn out to be ineffective at best, and counter-productive at worst,"
said Stephen Jen, managing partner of London-based hedge fund SLJ
Partners.

"If we are right, QE will be self-defeating in that the more the Fed
eases, the more commodity prices rise, which erodes the capacity of
consumers to spend on non-energy products and services."

Since Bernanke unveiled the Fed's QE2 bond buying program in a speech
in Jackson Hole in August last year, Brent crude oil have risen 58
percent, while the benchmark CRB commodities index has gained nearly
30 percent.

Developed and emerging stock indexes are both up around 20 percent
since that speech but they are coming off their April highs. On the
year both of them are largely flat.

"My best guess is that there will be a few weeks of positive reaction,
followed by a sell-off, as investors realize the circular and
pointless logic of (the argument that) QE2 could lead to permanent
increases in economic activities," Jen said.

UNINTENDED CONSEQUENCES

Some advocates say quantitative easing works best by revaluing
financial assets so that there will be a positive wealth effect for
U.S. consumers, encouraging them to start spending again. The Fed
argues that it boosts credit in a similar way to an orthodox easing by
directly lowering long-term benchmark borrowing costs.

But the effect of ample dollar liquidity spreads beyond the United
States, largely because emerging economies either are pegged to the
dollar or have inflexible exchange rate policies. Even economies that
do allow their currencies to appreciate are at risk of asset bubbles
as cheap money seeks higher yields.

This means these fast-growing emerging economies effectively import
the Fed's monetary easing and lift their demand for oil and
commodities, whose prices also tend to rise on a weaker dollar.

The other problem is that easy money chasing high-yielding assets
drives hot money into the emerging world, fans inflation and triggers
monetary tightening which in turn slows growth -- creating a vicious
circle.

"If QE3 is simply a repeat of QE2, I don't think it has a positive
impact that has sustainability," said Bob Janjuah, head of tactical
asset allocation at Nomura.

"(It) will make a commodity problem even worse. It won't help the
economy but create a much bigger inflationary pressure.

QE3 will force one globally positive growth area, emerging markets, to
slow down because of inflation ... We could end up with a negative
effect."

Janjuah's preconditions for QE3 are a rise in the U.S. unemployment
rate above 10 percent and a 20-25 percent fall in the S&P 500 index.

As benefits wane, many fear the cost of repeated QE operations could
be self-defeating in that more money printing fuels inflation, debases
the currency and ultimately raises the government's borrowing costs.

According to Jen, the Fed's balance sheet has grown by 10 points to 18
percent of GDP in two years - a similar scale to Japan's in the five
years to 2006.

"The marginal impact of QE is decreasing progressively... The weight
of debt on Fed balance sheet is increasing indeed," said Didier
Saint-Georges, member of the investment committee at private asset
manager Carmignac Gestion in Paris.

Why QE3? Fed Right to Focus on Other Things

Jackson Hole and Federal Reserve Chairman Ben Bernanke's speech there,
attention has shifted to this month's Federal Open Market Committee
and the debate over QE3 -- a third round of so-called quantitative
easing.

Given the weakness of the recovery, volatile financial markets and the
headwinds from fiscal austerity, why wouldn't the Fed engage in
another round of easing? After all, QE2 was initiated last year when
the recovery and global financial markets were less fragile.
The Federal Reserve is considering a third round of quantitative easing.

QE3 is not a done deal and could prove to be ineffective despite the
current economic weakness. More and more, monetary policy (especially
quantitative easing) appears ill-equipped to provide support for the
fragile recovery.

Consider these factors:

QE2 remains controversial, and its timing was better: It is always
difficult to isolate cause and effect in an environment as tumultuous
as this global economy, so QE2 remains controversial. Unlike the first
set of actions the Fed took in 2007 and 2008 to stabilize the global
financial system, the impact of QE2 is more muddled. Clearly, the
dollar depreciated, equity markets improved and inflationary
expectations (and retail price movements) increased. It is also clear
that economic activity did not accelerate, commodity prices increased
further and overseas central banks had to respond to the Fed's
actions. In today's environment, retail price pressures are more
prevalent (and not deflation), the dollar is already weak and interest
rates are at modern lows. From the standpoint of interest rates, Fed
statements over the past few weeks have accomplished what QE3 would
do, namely bring down rates. So what else QE3 would accomplish
(besides a temporary bump in equity prices) is something that is not
clear at this juncture.
The Fed still has options, but ... : The Fed's actions since the
beginning of the crisis have been unprecedented, including aggressive
rate cuts, asset purchases totaling almost $3 trillion and a
willingness to provide liquidity to financial and nonfinancial
institutions. Yet there comes a point where monetary policy is pushing
on a string, and the Fed is probably past that point. Liquidity is no
longer an issue. Financial institutional balance sheets have improved
considerably and households have begun the long journey of rebuilding
balance sheets. In addition, remaining committed to its current
accommodative stance through 2013 is a bold action in support of the
recovery. Maybe the time has come to stay on the sidelines for a time
and let other policy solutions support the recovery?

Fiscal policy in the U.S. and Europe matters more than the Fed:
Support for the recovery is not a monetary policy issue. The focus
should be on fiscal policy and the need to provide support in the
short term and a credible plan to address debt levels over the
intermediate to long term. One concern with the Fed repeatedly
intervening is to shift the focus away from where the policy issue
sits -- namely in Washington and European capitals. Enhanced
confidence levels stemming from stronger fiscal policy would have a
more substantial impact on the recovery than QE3 or any other measures
the Fed can bring forward.

QE3 may not be a done deal at this point, and if it does not come to
pass, it will certainly not be the end of the world.

And perhaps the focus will shift to where it should be: the next round
of fiscal negotiations

What are the differences between QE1, QE2 and QE3?

20 June 2011 10:00 

Because the Federal Reserve has become a political target, it is in no hurry to have monetary policy displace fiscal policy in underpinning the economy, but it may be forced to do so given its dual mandate and the likelihood of fiscal contraction. Last week, when discussing what QE3 could look like I indicated that were the Federal Reserve to start expanding its balance sheet, QE3 will see interest rate caps after a pause and period of reflection. Let me address the differences between the various QEs here to illustrate why interest rate caps are being contemplated.

QE1

The LSAPs were not aimed at supplying liquidity to financial institutions or at reducing systemic risk. Instead, they were intended to support economic activity by keeping longer-term private interest rates lower than they would otherwise be.

A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.

-The Fed's Expanded Balance Sheet, Brian P. Sack, Executive Vice President, Federal Reserve Bank of New York, Dec 2009

I am not sure why Brian Sack stressed the Fed's intention to support economic activity as the chief aim of QE1 in December 2009. While I won't dispute a Fed official's interpretation of the Fed's intentions, it is abundantly clear that QE1 was a different animal than QE2. In QE1, the Fed purchased agency securities and mortgage-backed securities rather than Treasury securities as it did in QE2. This is significant as Fed Chairman Ben Bernanke was at pains to stress that QE1 was "credit easing", focused on the asset side of the balance sheet, and therefore distinct to what the Japanese had done. See the Bernanke speech at the LSE from January 2009. When he says "in addition to easing monetary policy, the Federal Reserve has worked to support the functioning of credit markets by providing liquidity to the private sector" at the 7-minute mark, it is clear to me that he means that credit easing has provided liquidity that the purchase of mere Treasury securities could not. Whether these asset purchases were "aimed at" providing liquidity is largely semantic.

In my view, the difference between Sack's commentary in December 2009 and Bernanke's in January 2009 owes to the political backdrop because bailouts of the financial sector had become extremely unpopular. During QE1, the Fed purchased $175 billion of agency debt securities and $1.25 trillion of mortgage-backed securities in addition to purchases of Treasuries. In effect, the Federal Reserve became the market as the shadow bank sector imploded. The mortgage-backed securities market had ground to a halt and the Fed took the entire market onto its balance sheet to prevent a second Great Depression.

So, if I had to characterize QE1 I would say: the first round of large scale asset purchases by the Federal Reserve was intended to support economic activity. However, because the Fed focused on the asset side in increasing its balance sheet by buying assets it had not previously purchased in large quantities, the Federal Reserve worked to support the functioning of credit markets by providing liquidity to the private sector. Without this easing, the US and the global economy would have had a depression of indescribable severity with unknown attendant geopolitical and military consequences.

Was QE1 a bailout? Yes. But QE1 was also a legitimate lender of last resort operation. We should question the terms of QE1 i.e. "The Fed lent freely, but at a low rate, on dodgy collateral" not the operation per se.

QE2

The second round of quantitative easing was distinct from the first – and more akin to what the Japanese had done. The aim was to support economic activity in the US domestic economy. Starting in August 2010, the Federal Reserve started reinvesting principal payments from agency debt and agency mortgage-backed securities that it had acquired in QE1 in longer-term Treasury securities. By November 2010, after the 2010 mid-term elections, the FOMC decided to expand its balance sheet by $600 billion through the purchase of Treasury securities.

But, as we have detailed many times here at Credit Writedowns, quantitative easing doesn't actually have an impact on the real economy. It is an asset swap. The Federal Reserve buys Treasury bonds and sells dollars it has created expressly for that transaction. After the asset swap, the balance sheet of the primary dealer which sold the Treasuries to the Fed has not increased; it now has cash instead of Treasuries. So there are more reserve deposits and fewer Treasuries in the private sector. The Federal Reserve has Treasuries instead of the money it created in expanding its balance sheet. While the reserves can ostensibly be lent out, the reality is that this money will sit in a bank vault idle unless the demand for loans warrants otherwise. It is a misunderstanding of how the banking system works to assume the mere creation of reserves has any significance regarding lending. I would argue the swap drains the economy of higher interest-bearing assets that add to income, replacing them with essentially non-interest bearing assets. Why would we want the Fed to conduct QE then if we know this will just create excess reserves as it did when the Fed began credit easing in QE1?

In particular, central bank purchases of longer-term securities work through a portfolio balance channel to depress term premiums and longer-term interest rates. The theoretical rationale for the view that longer-term yields should be directly linked to the outstanding quantity of longer-term assets in the hands of the public dates back at least to the 1950s.

-Unconventional Monetary Policy and Central Bank Communications, Janet Yellen

This is problematic because the Fed had intended to lower interest rates via the lowered risk premia. That was their stated purpose when they started QE. I know they talk only about having boosted asset prices now to prove QE2 was a success. But, initially, the Fed wanted to lower interest rates too. So while the Fed lowered risk premia, It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage". Moreover, the Fed's QE2 raised inflation expectations, causing interest rates to actually rise and working at cross-purposes with the lowered risk premia. Thus, QE2 was only successful insofar as it has increased business credit and raised asset prices. As we now see, the economy has actually cooled during QE2. So soon after I told you the QE2 trade was effectively over in late March, asset prices and bond yields started to come down as inflation expectations plummeted.

QE2 has been a bust.

"desperate measures for desperate times seems like the best characterization." I think we all agree here:  It's totally ineffectual.  It makes the Fed look like a bunch of amateurs.

-Let's talk about QE, inflation, and consumer demand, Marshall Auerback, Nov 2010

QE3

The FOMC has already considered offering unlimited quantitative easing to target specific interest rates and buying municipal bonds has been broached by well-connected Fed watcher David Blanchflower. I want to focus on the interest rate caps here because I believe this is politically more feasible, and therefore more likely.

When it comes to quantitative easing, we have to look both at the quantitative and the easing. Going back to the Fed's failure to reduce longer-term interest rates during QE2, it has more to do with the quantitative than the easing. Ultimately, one can influence the price or the quantity of something, but not both. And with QE2, the Fed decided to influence the quantity (of bank reserves), when its stated aim was to influence price (of money reflected by interest rates).

It is unlikely that the Fed will go back to the well for the same policy since QE2 has proved ineffective. So now that the economy is weak again, it will up the ante and target rates instead of specific easing quantities. This has the potential political benefit of the Fed's not having to expand its balance sheet. The Fed would essentially guarantee a rate and let the markets move interest rates to that level. Of course, the Fed would promise to defend the rate(s) if and when necessary. The Fed may be tested initially, but punters would lose their shirts fighting a market player with a potentially unlimited supply of liquidity. So I would expect the balance sheet effects for the Fed to be muted. And clearly, if QE3 reduced rates in addition to having largely the same impact as QE2 as well, it would be a more powerful tool.

There could be internal dissent to such an aggressive policy. I do not expect QE3 now nor do I expect it unless the economy deteriorates further. So the Fed could start off by signalling to the market that it will conduct what I have been calling 'permanent zero'. Look for how the Fed reinforces its commitment to "exceptional low levels for the federal funds rate for an extended period". If Bernanke is forceful about this commitment in this week's FOMC press conference, people will be forced to accept the likelihood of permanent zero and the term structure will flatten further and further out the curve.

I hope this post spells out the differences between the various QEs. QE3 is qualitatively different than credit easing (QE1) or quantitative easing (QE2). Let's call QE3 rate easing. And while we can hope the economy strengthens so that rate easing is unnecessary, the push for it is already well-advanced.

Three Lessons From QE1 & Thoughts On The End Of QE2

As we get closer and closer to the end of QE2 it's wise to begin game planning for the potential impacts.  The following are some goods thoughts from Glenview Capital regarding QE2 and lessons from QE1:

The first lesson we should take from 2010 is to respect the end of quantitative easing, either as an actual or psychological calendar event that could trigger a change in liquidity and economic activity. There are three reasons we should be concerned about the end of QE2 and the unlikelihood of QE3:

1) QE2 is set to expire in June, and it took seven months last time before a new round of quantitative easing was enacted. Thus, it seems reasonable to expect QE2 to lapse, particularly as the economy has rebounded and deflation seems contained as a risk (see #2).

2) US Fed Chairman Bernanke said in his most recent congressional testimony on March 1 that the "risk of deflation has become negligible." If that is the case, it would be odd for the Fed to come forward four months later with further extraordinary monetary stimulus.

3) Two days later, the ECB President Trichet said that an increase in rates at the next meeting (April) is possible. Again, this doesn't seem consistent with an extension of QE2 globally.

As such, we will be closely watching liquidity and economic conditions as the first elements of the unprecedented level of global monetary stimulus are withdrawn.

Second, we believe that the markets are next going to deal with the economic ball bouncing off the "right gutter" of inflationary pressures in early 2011. We already have seen extreme spikes in food and textile commodities, and since late August, the price of oil has risen 50% as a result of global demand and Middle East turmoil. Interest rates on the US 10-year Treasury bond rose over 100bps from the early October lows and, as described above, the tone and tenor of Central Bank commentary are now more weighted towards the risks of inflation.

Finally, it appears that the practical implications of a rising federal deficit ($1.3 trillion) in the US and a renewed emphasis on deficit reduction in Congress (not only the "Tea Party" but across both major parties) will likely slow the growth of both Federal and State/Local spending that has played such a key role in reinforcing the economy to prevent a double-dip recession. This is playing out in state legislatures in Wisconsin and New Jersey, in the President's budget that calls for reductions in discretionary spending, and in the debates this month about extending the debt ceiling to accommodate additional federal deficits.

Taken together, these factors pose a complex scenario for our relatively simple and straightforward gutter guard scenario: just as the ball seems to be bouncing off the inflation gutter guard, both Congress and the Fed seem to be removing the left gutter guard. This is of course logical – if we want to fight inflation, we should first stop fueling it. However, it does beg the question – if the contemporaneous removal of extraordinary monetary and fiscal stimulus through the expiration of QE2 and a move to a more balanced budget does in fact slow the economy, will there be sufficient time, will and resources to re-establish a left gutter? Such is the danger of a zero interest rate policy, as it gives you little incremental room to provide incremental stimulus.

QE2 Is Likely to More Successful than QE1

On November 3, the FOMC announced that it would increase the quantity of its outright holdings of securities by a net $600 billion by the end of the second quarter of 2011. Thus, the Fed has re-embarked on a policy of quantitative easing. Its first real "voyage" of quantitative easing, QE1, started at the end of November 2008 and ended in March 2010. The expected (hoped for?) outcome of a quantitative -easing policy is increased nominal demand for goods and services. Under normal circumstances when the commercial banking system is not constrained by actual or expected capital inadequacy, the Fed is able to stimulate the nominal demand for goods and services by lowering its key policy interest rate, the federal funds rate.

The federal funds rate is the one-day cost of immediately available funds in the financial system and, therefore, represents the marginal cost at which banks can fund themselves. As banks' cost of funds goes down, due to competition, banks pass on their lower cost of funds to their loan customers. The decline in loan rates leads to an increase in the quantity demanded of bank credit. The increase in bank credit supplied leads to increased nominal spending on goods, services and assets. When the banking system is constrained by actual or expected capital inadequacy, banks collectively are unable to increase their supply of credit even though their marginal cost of funds has fallen. This actual or expected banking- system capital inadequacy has been hampering the effectiveness of the Fed's low interest-rate policy in stimulating the nominal demand for goods, services and assets. Thus, the Fed is now turning to a second round of quantitative easing.

There has been much misinterpretation in the media of how quantitative easing "works." Indeed, we are not sure that even the Federal Reserve fully understands how quantitative easing works. The typical explanation of how quantitative easing works is that the Fed's purchases of longer-maturity securities will bring down the interest rates on these securities. The lower interest rates on longer-maturity securities will then induce the nonbank private sector to borrow and spend more. Also, the lower interest rates on longer-maturity securities will make equities more attractive investments at the margin, thereby causing a really in equity prices, which, in turn, will induce the private sector to increase its current spending on goods and services via a wealth effect.

Lastly, the lower interest rates on longer-maturity securities and the expectation that the Fed will hold short-term interest rates at a very low level for a extended period of time will weaken the foreign -exchange value of the dollar, thereby making U.S. exports more price competitive in global markets. All else the same, we do not dispute that interest rates on longer-maturity securities would fall, that equities would become more attractive and that the foreign-exchange value of the dollar would decline with the implementation of quantitative easing on the part of the Fed. What we do dispute is that these are the main channels through which quantitative easing operates to stimulate the nominal demand for goods, services and assets.

Have you noticed by now that whenever we mention quantitative easing, we italicize quantitative? We have done this to emphasize that the main channel through which quantitative easing stimulates the nominal demand for goods, services and assets is through the quantity of credit created by the combined Federal Reserve System and commercial banking system, not the price of credit (the interest rate), not the price of equities and not the price of foreign exchange. If one were to review Econ 101 text books, one would discover that central banks are able to create credit figuratively "out of thin air." The important implication of this is that the recipients of central bank-created credit are able to purchase goods, services and assets without any other entity in the economy having to cut back on its current purchases of goods, services and assets.

The Federal Reserve, of course, is the U.S. central bank. If one were to read a little further in the Econ 101 text, one would discover that the commercial banking system, not an individual bank, also is able to create credit figuratively "out of thin air,"providing that the central bank supplies the "seed money" for this to the commercial banking system. The important implication of the creation of credit by the commercial banking system, is the same as that of the creation of credit by the central bank: the recipients of this credit created by the commercial banking system are able to purchase goods, services and assets without any other entity in the economy having to cut back on its current spending on goods, services and assets. Thus, if combined central bank and commercial banking system credit increases, there is a presumption that current nominal aggregate spending on goods, services and assets will increase. That same presumption with regard to an increase in nominal aggregate spending cannot be made when credit is granted by the nonbank sector. In this case, the presumption is that the grantors of credit will decrease their current nominal spending, transferring purchasing power to the recipients of the credit. Thus, when the nonbank sector extends credit, the presumption is that nominal aggregate spending does not increase. The exception to this presumption would occur if the quantity of currency and bank liabilities desired to be held by the nonbank public were to fall by an amount equal to or greater than the amount of nonbank credit extended.

To reiterate, the logic or theory of quantitative (we have stopped italicizing it now) easing is that an increase in the quantity of combined central bank and commercial banking system credit will lead to an increase in nominal aggregate spending on goods, services and assets. Chart 1 shows that the correlation coefficient between percentage changes in the annual average of combined Federal Reserve and commercial banking system credit and the percentage changes in nominal U.S. GDP from 1960 through 2006 is relatively high at 0.62. (A perfect correlation between the two series would be represented by a correlation coefficient of 1.00). Chart 2 demonstrates that this correlation coefficient is reduced to 0.49 when the period is extended through 2009. In 2008, there was a large percentage increase in combined Federal Reserve and commercial banking system credit but a reduction in the percentage change in nominal GDP. We believe that a significant amount of this increased Fed-commercial bank credit was acquired to build up "cash" holdings for precautionary reasons due to the turmoil in the financial markets.

Now, let us examine what happened to combined Federal Reserve and commercial banking system during the Fed's first round of quantitative easing that covered the 16 months ended March 2010. Chart 3 shows the net change in total Federal Reserve credit, Federal Reserve outright holdings of securities and Federal Reserve credit excluding outright holdings of securities in the 16 months ended March 2010 (the shaded area in the chart). Notice that although Federal Reserve outright holdings of securities increased a net $1.5 trillion during the first round of Fed quantitative easing, total Federal Reserve credit increased by only a net $200 billion during this period because other elements of Federal Reserve credit contracted by a net $1.3 trillion. Chart 4 shows that commercial banking system credit contracted by a net $875 billion in the 16 months of the Fed's first round of quantitative easing. Thus, when we sum the net change in Federal Reserve credit and commercial banking system credit in the 16 months ended March 2010, the period encompassing the Fed's first round of quantitative easing, we find that the net change in credit was minus $675 billion. Is it any wonder, then, why the response of nominal GDP growth was so restrained to QE1? We would argue that QE1 was a misnomer in that there was no quantitative easing, but rather a quantitative contraction.

What is the prospect that the Fed's second round of quantitative easing will not be a misnomer, that is, it will result in a net increase in combined Federal Reserve and commercial banking system credit? Chart 5 shows that in the seven months since the end of QE1, the rate of contraction in other elements of Federal Reserve credit besides outright securities holdings has slowed significantly. In the seven months ended October 2010, these other elements of Federal Reserve credit have contracted by only a net $36 billion. If these other elements of Fed credit continue to contract by only a small amount or stabilize, then the Fed's planned $600 billion net increase in its outright securities holdings will make almost a dollar-for-dollar increase in total Federal Reserve credit. Chart 6 shows the behavior of commercial banking system credit since the end of QE1 through September 2010, the latest full monthly data available. In the six months ended September 2010, commercial banking system credit contracted by only $47 billion. In each of three months ended September 2010, commercial banking system credit increased.

The latest Federal Reserve survey of bank lending practices, which covered the three months ended July 2010, showed a significant increase in the percentage of respondent banks easing their lending standards. The actual recent behavior of commercial banking system credit and the results of the recent Federal Reserve survey of bank lending practices suggest that commercial banking system credit will be a considerably smaller drag on combined Federal Reserve and commercial banking system credit creation or perhaps make a small positive contribution during the second round of Federal Reserve quantitative easing.

For the sake of argument, let us assume that in the next seven months combined Federal Reserve and commercial banking system credit increase a net $600 billion, the amount of the Fed's planned securities purchases over this period. This would represent a 5.2% increase in the September level of combined Federal Reserve and commercial banking system credit. Chart 7 shows that there has not been a seven-month increase in this credit aggregate of 5.2% or greater since March 2009. Now, a 5.2% increase in combined Federal Reserve and commercial banking system credit is unlikely to result in a boom in nominal aggregate demand, but it will help prevent the economy from slipping back into a recession within the next 12 months in the face of substantial economic headwinds emanating from the housing and state/local government sectors of the U.S. economy.

There appears to be some concern by foreign monetary authorities that QE2 will result in the Federal Reserve "exporting"some U.S. inflation to their economies. This could occur if foreign central banks peg their currencies to the U.S. dollar. If QE2 puts downward pressure on the foreign-exchange value of the dollar and foreign central banks purchase dollars in the open market in order to prevent an appreciation in their home-country currencies, paying for these dollars by issuing their own currencies, then, indeed, foreign central banks could be "importing" increased inflation. But foreign central banks are not obligated to do this. They could accept an appreciation in their currencies vs. the dollar. Would this have an adverse effect on exports to the U.S. of economies whose currencies are appreciating? At the margin it would. But overall exports to the U.S. from these economies might remain the same or even increase as the negative foreign-exchange effect, or price effect, might be more than offset by the "income"effect in the U.S. emanating from QE2. That is, QE2 would be expected to increase the nominal demand for goods and services, some of which would be imported goods and services.

We have not published an economic/interest rate forecast update since August due to no meaningful change in our outlook and due to an extremely heavy travel schedule. We apologize for this "silence"to any clients and partners who missed our updates. Since our August publication, we have reduced marginally our 2011 real GDP growth forecast from 3.2% on a Q4/Q4 basis to 3.0%. The reduction is primarily due to a reduction in our 2011 growth forecasts in the categories of residential investment expenditures and state/local government spending. Despite the downward adjustments to these categories, we believe that stronger real GDP growth can be achieved in 2011 compared with 2010 and some modest reduction in the unemployment rate can occur in 2011 with the small but positive growth in commercial bank credit that we anticipate and the increase in Federal Reserve credit as a result of QE2. We also have pushed back into early 2012 our forecast of the first Federal Reserve interest rate increase. Even if QE2 were to end in the second quarter of 2011, and there is no guarantee that it will end at this time, the FOMC is unlikely to begin raising its policy interest rates - the federal funds rate and the interest rate it pays on banks' excess reserves - immediately after the end of QE2.

Paul L. Kasriel
Asha G. Bangalore

A QE1 Timeline

November 25, 2008: $100 Billion GSE direct obligations, $500 billion in MBS

S&P 500: 851.81

The Federal Reserve announced

the purchase of the direct obligations of housing-related government-sponsored enterprises (GSEs)--Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae.
...
Purchases of up to $100 billion in GSE direct obligations under the program will be conducted with the Federal Reserve's primary dealers through a series of competitive auctions and will begin next week. Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end. Purchases of both direct obligations and MBS are expected to take place over several quarters.

December 16, 2008 FOMC Statement: Evaluating benefits of purchasing longer-term Treasury Securities

S&P 500: 913.18

As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.

January 28, 2009: FOMC Statement: FOMC Stands Ready to expand program.

S&P 500: 874.09

The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

March 18, 2009: FOMC Statement: Expand MBS program to $1.25 trillion, buy up to $300 billion of longer-term Treasury securities

S&P 500: 794.35

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

QE1 purchases were completed at the end of Q1 2010, although it took a little time for the securities to settle on the balance sheet.

 

August 27, 2010: Fed Chairman Ben Bernanke hints at QE2: Analysis: Bernanke paves the way for QE2

S&P 500: 1064.79

End of QE2: financial crisis timeline

End of QE2: June 30, 2011

What the Fed did

• As previously announced, the Fed concluded its $600 billion bond purchasing program.
• QE2 was conducted at an even pace, and the end date was telegraphed from the start of the program.

What was expected

When the program was about to end, some mortgage experts feared rates would rise.

What happened

Mortgage rates have tumbled since QE2 ended and have recently reached record lows.

QE2: financial crisis timeline

QE2: Nov. 3, 2010 - June 30, 2011

What the Fed did

• The Fed continued to reinvest payments on securities purchased during the QE1 program.
• In addition, it began the purchase of $600 billion of longer-term Treasury securities.

What was expected

The Fed said QE2 would help promote a stronger pace of economic recovery. Industry observers expected QE2 to keep mortgage rates low or push the rates lower.

What happened

Contrary to what was expected, mortgage rates spiked more than half a percentage point in a little more than a month after QE2 started. When the program ended, the 30-year fixed-rate mortgage was about 30 basis points higher than it was when QE2 started.

End of QE1: financial crisis timeline

Mortgage rates and the Fed

End of QE1: financial crisis timeline

End of QE1: March 31, 2010

What the Fed did

• After completing the purchase of $1.25 trillion in mortgage-backed securities, $300 billion in Treasury bonds and $175 billion in federal agency debt, the Fed ended QE1.
• QE1 was initially open-ended. The Fed did not set an end date for the program until about six months out, as it slowed the buying pace.

What was expected

Many industry experts expected mortgage rates to rise after QE1 ended.

What happened

Contrary to analysts' expectations, mortgage rates tumbled after the program ended.

QE1: financial crisis timeline

QE1: Nov. 25, 2008 - March 31, 2010

What the Fed did

• The Fed initiated purchases of $500 billion in mortgage-backed securities.
• It announced purchases of up to $100 billion in debt obligations of mortgage giants Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks.
• The Fed cut the key interest rate to near zero, Dec. 16, 2008.
• In March 2009, the Fed expanded the mortgage buying program and said it would purchase $750 billion more in mortgage-backed securities.
• The Fed also announced it would invest another $100 billion in Fannie and Freddie debt and purchase up to $300 billion of longer-term Treasury securities over a period of six months.
• The quantitative easing program, or QE1, concluded in the first quarter of 2010, with a total of $1.25 trillion in purchases of mortgage-backed securities and $175 billion of agency debt purchases.

What was expected

The Fed wanted to lower mortgage interest rates and increase the availability of credit for homebuyers to help support the housing market and improve financial market conditions.

What happened

Mortgage rates dropped significantly, to as low as 5 percent, about a year after QE1 started.