Excess Reserves

As good news appears to be bad news for now and the hopes of imminent dovish QE3-gasms gets pushed off a week or two, we thought it useful to dig into the mysterious central bank go-to play in a little more detail. Morgan Stanley's European Economics Team asks and answers five of the most frequently discussed questions with regard quantitative easing. From whether QE has worked to inflation fears and concerns over policy normalization and what happens if the public lose confidence in central bank liabilities, we suspect these questions, rather dovishly answered by the MS team, will reappear sooner rather than later, and as they interestingly note, the deployment of central bank balance sheets is, in essence, a confidence trick.

Today, Rand’s fictional world has seemingly become a reality – endless bailouts and economic stimulus for the unproductive at the expense of the most productive, and calls for additional taxation on capital investment. The shrug of Rand’s heroic entrepreneurs is to be found today within the tangled ciphers of corporate and government balance sheets. The US Federal Reserve has added more than $2 trillion to the base money supply since 2008 – an incredible and unprecedented number that is basically a gift to banks intended to cover their deep losses and spur lending and investment. Instead, as banks continue their enormous deleveraging, almost all of their new money remains at the Fed in the form of excess reserves. Corporations, moreover, are holding the largest amounts of cash, relative to assets and net worth, ever recorded. And yet, despite what pundits claim about strong balance sheets, firms’ debt levels, relative to assets and net worth, also remain near record-high levels. Hoarded cash is king. The velocity of money (the frequency at which money is spent, or GDP relative to base money) continues to plunge to historic lows. No wonder monetary policy has had so little impact. Capital, the engine of economic growth, sits idle – shrugging everywhere.

Are we really in an economic recovery or is it a figment of the Fed's quantitative easing? This will be the biggest factor in the 2012 elections.

Remember robosigning and the whole fraudclosure scandal? In a few days you can forget it. Because in America, the cost of contractual rights was just announced, and it is $25 billion: this is the amount of money that banks will pay to settle the fact that for years mortgages were issued and re-issued without proper title and liens on the underlying paper, courtesy of Linda Green et al. Why is this happening? Because staunch hold outs for equitable justice (at least until this point), the AGs of NY and California folded like cheap lawn chairs (we can't wait to find what corner office of Bank of America they end up in), but not before the one and only intervened. From the WSJ: "The Obama administration made a full-court press over the past four days to secure the support of key state attorneys general, including those from Florida, California and New York." Nothing like a little presidential persuasion to help one with overcoming one's conscience. Because in America the push to abrogate the very foundation of contractual agreements comes from the very top. But wait, there's more - just to wash its hands of the guilt associated with this settlement which shows once and for all that the Democratic administration panders as much if not more to the banking syndicate as any republican administration, as it announces one settlement with one hand, with the other the US will sue banks over the mortgage reps and warranties issue covered extensively here, in the most glaringly obtuse way to distract that it is gifting trillions worth of contingent liabilities right back to the banks, not to mention discarding the whole concept of justice. From the WSJ: "Federal securities regulators plan to warn several major banks that they intend to sue them over mortgage-related actions linked to the financial crisis, according to people familiar with the matter. The move would mark a stepped-up regulatory effort to hold Wall Street accountable for its sale of bonds linked to subprime mortgages in 2007 and 2008. At issue is whether the banks misrepresented the poor quality of loan pools they bundled and sold to investors, the people said." Wait, let us guess -that particular lawsuit will end up in a... settlement? Ding ding ding. We have a winner. All today's news succeed in doing is finally wrapping up any and all legal loose ends, so that banks can finally wrap all outstanding litigation overhangs at pennies on the dollar. And if at the end of the day, they find themselves cash strapped, why the US will simply loan them more cash of course.

As some may remember those long ago days of January, when the market was not still lost in the latest bout of QE-hopium induced euphoria, December sales missed expectations, following even more disappointing November sales, despite propaganda channel promises that the 2011 shopping season was the "strongest ever"... and yet, many were wondering where did the already cash-strapped US consumer procure the cash to shop as much as they did, even if it was well below a record level. Now we know: it was on credit. As the chart below shows, Non Seasonally Adjusted Credit in December 2011 exploded by $33 billion sequentially In December compared to November: the third highest in the past 18 years, and only second to August 2007, which just so happens was both the peak of the market, and the peak of the credit bubble. The SA chart shows pretty much the same: a surge in consumer credit in December, even if the bulk of it was non-revolving, or used for such purchases as offloading some of that GM channel stuffing, and paying for one's college education. What does this mean? Well, with at least 2 more years of ZIRP, the credit bubble is already back, and it is only uphill from here. US consumers will get increasingly more and more in debt as they use more debt to pay of credit card interest, leading to ever further cash injections to keep asset prices higher to give US consumers the illusion that they are wealthy, so they spend even more, and so on. Just as Bernanke is talking about QE, the US consumer is actually saying it is time to tightening. Needless to say, good luck with that. Congratulations Ben - by exterminating US savers, you have managed to reflate the consumer credit bubble as for the 4th month in a row, nobody is deleveraging, even as the US government continues to add about $140 billion in debt each month. The most epic credit bubble collapse ever is coming fast, and this one will be at ZIRP, which means that even the smallest rise in interest rates will finally and mercifully end it all. Yet an even more epic surge in prices may precede it as banks slowly but surely are forced to push excess reserves into circulation. All $1.6 trillion of them... compared to the $1 trillion of currency in circulation.

Back in January 2010, when in complete disgust of the farce that the market has become, and where fundamentals were completely trumped by central bank intervention, we said, that "Zero Hedge long ago gave up discussing corporate fundamentals due to our long-held tenet that currently the only relevant pieces of financial information are contained in the Fed's H.4.1, H.3 statements." This capitulation in light of the advent of the Central Planner of Last Resort juggernaut was predicated by our belief that ever since 2008, the only thing that would keep the world from keeling over and succumbing to the $20+ trillion in excess debt (excess to a global debt/GDP ratio of 180%, not like even that is sustainable!) would be relentless central bank dilution of monetary intermediaries, read, legacy currencies, all to the benefit of hard currencies such as gold. Needless to say gold back then was just over $1000. Slowly but surely, following several additional central bank intervention attempts, the world is once again starting to realize that everything else is noise, and the only thing that matters is what the Fed, the ECB, the BOE, the SNB, the PBOC and the BOJ will do. Which brings us to today's George Glynos, head of research at Tradition, who basically comes to the same conclusion that we reached 2 years ago, and which the market is slowly understand is the only way out today (not the relentless bid under financial names). The note's title? "If 2011 was the year of the eurozone crisis, 2012 will be the year of the central banks." George is spot on. And it is this why we are virtually certain that by the end of the year, gold will once again be if not the best performing assets, then certainly well north of $2000 as the 2009-2011 playbook is refreshed. Cutting to the chase, here are Glynos' conclusions.

Back on December 30, we noted that a little known name in the US, but very well known in Europe, PetroPlus is having significant solvency issues as banks froze a $1 billion revolver. Less than a month later the situation has proceeded to the next evolutionary step, as Europe's largest refiner by capacity has announced it will file for bankruptcy protection. And while operations should not be impacted, the fact that this comes just as Europe imposes an oil embargo on Iran, virtually guarantees that the continent's gasoline prices, already among the highest in the world are likely to set off even higher, paradoxically even as end-market demand is at lows. The bankruptcy will also guarantee that European initial jobless claims will plunge, especially if the BLS opens a Brussels office and applies its own very unique brand of "logic" to Europe.

There are consequences to this policy.

Nowhere in S&P’s statement about “global economic and financial crisis”, did it clarify that sovereigns were hit due to backing their largest national banks (and international, US ones) which engaged in half a decade of leveraged speculation. But here’s how it worked: 1) Big banks funneled speculative capital, and their own, into local areas, using real estate and other collateral as fodder for securitized deals with derivative touches. 2) They lost money on these bets, and on the borrowing incurred to leverage them. 3) The losses ate their capital. 4) The capital markets soured against them in mutual bank distrust so they couldn’t raise more money to cover their bets as before. 5) So, their borrowing costs rose which made it more difficult for them to back their bets or purchase their own government’s debt. 6) This decreased demand for government debt, which drove up the cost of that debt, which transformed into additional country expenses. 7) Countries had to turn to bailouts to keep banks happy and plush with enough capital. 8) In return for bailouts and cheap lending, governments sacrificed citizens. 9) As citizens lost jobs and countries lost assets to subsidize the international speculation wave, their economies weakened further. 10) S&P (and every political leader) downplayed this chain of events.... The die has been cast. Central entities like the Fed, ECB, and IMF perpetuate strategies that further undermine economies, through emergency loan facilities and  bailouts, with rating agency downgrades spurring them on. Governments attempt to raise money at harsher terms PLUS repay the bailouts that caused those terms to be higher. Banks hoard cheap money which doesn’t help populations, exacerbating the damaging economic effects. Unfortunately, this won't end any time soon.

Lately, Bain founder and GOP presidential candidate Mitt Romney has found himself in a spirited defense of the private equity industry, doing all he can to spin decades of data which confirm, without failure, that PE Leveraged Buy Outs are nothing but "efficiency maximizing" transactions whose only goal is the "maximization" of EBITDA in the pursuit of dividend recap deals, IPOs or outright sales, while loading up the company with untenable amounts of leverage. All this with a 3-5 year investment horizon, which ignores the long-term viability of a company and seeks to streamline (read fire as many as possible) operations as quickly as possible in the goal of maximizing short-term returns. We wish him luck in his endeavor. As for the other side of the equation, we recreate a post we penned back in November 2009 which analyzes just how effective the mega-LBOs have been for the economy, and the workers involved. In other words - the facts. In a nutshell, here they are: "The Disastrous Performance Of Private Equity: Of The Top 10 LBOs, 6 Are In Distress, 4 Have Defaulted." Read on for the full details.

For anyone who still hasn't grasped the magnitude of the central planning intervention over the past four years, the following two charts should explain it all rather effectively. As the bottom chart shows, currently the central banks of the top three developed world entities: the Eurozone, the US and Japan have balance sheets that amount to roughly $8 trillion. This is more than double the combined total notional in 2007. More importantly, these banks assets (and by implication liabilities, as virtually none of them have any notable capital or equity) combined represent a whopping 25% of their host GDP, which just so happen are virtually all the countries that form the Developed world (with the exception of the UK). Which allows us to conclude several things. First, the rapid expansion in balance sheets was conducted primarily to monetize various assets, in the process lifting stock markets, but just as importantly, to find a natural buyer of sovereign paper (in the case of the Fed) and/or guarantee and backstop the existence of banks which could then in turn purchase sovereign debt on their own balance sheet (monetization once removed coupled with outright sterilized asset purchases as is the case of the ECB). And in this day and age of failed economic experiments when a dollar of debt buys just less than a dollar of GDP (there is a reason why the 100% debt/GDP barrier is so informative), it also means that central banks now implicitly account for up to 25% of developed world GDP!

For those confused why gold just hit a new all time high of $1,480, it may have something to with this. In the week ended April 13, the Fed's balance sheet hit a new all time record of $2.65 trillion, primarily due to an increase of $15 billion in Treasury holdings by the Fed (chart 1). Not surprising to those who have read our previous post on the matter, prepayments to the Fed have all but dried out, and for the third time in a row there were no MBS prepayments, which at $937.2 billion have declined by just $12 billion since the beginning of March: so much for magnetization demand arising from QE Lite (chart 2). Excess reserves continue to surge increasing by $29 billion in the last week. The increase at this point is more than just one accounting for the $195 billion SFP program unwind (which finished last month): should the economy really improve and banks start lending, all hell may well break loose. At this point the surge in excess reserves (liabilities) is rapidly overtaking the increase in Fed assets since the beginning of QE2 (chart 4). "Other Fed Assets" hit a fresh new ridiculous total: $125 billion, an increase of $2.5 billion over the prior week (chart 5). If this number is indeed a form of capitalized POMO commission to the PDs, then America likely has a right to know. Lastly for those still curious, the Fed's asset maturing within 1 year are $143 billion (chart 6). Putting this all together, presents the following picture: in a period during which the Fed's assets increased by $203 billion, GDP increased by about 1.5%, once all revisions are in the books. QE2 ends when Q2 ends. And so far, the economic in this quarter is without doubt starting to turn down. What will happen when there is no incremental monetization once Q3 kicks off, and GDP is about to go negative?

There are two key datapoints to present in this week's Fed balance sheet update: the surge in excess reserves, and the comparative Treasury holdings between the Fed and other foreign countries. But first the basics: the total Fed balance sheet hit a new all time record of $2.5 trillion. The increase was primarily driven by a $23 billion increase in Treasury holdings as of the week ended February 23 (so add another $5 billion for yesterday's POMO) to $1.214 trillion. With rates surging, QE Lite has been put on hibernation and there were no mortgage buybacks by the Fed in the past week: total MBS were $958 billion and Agency debt was also unchanged at $144 billion. The higher rates go, the less the QE Lite mandate of monetization meaning that the Fed will be continuously behind schedule in its combined QE2 expectation to buy up to $900 billion by the end of June. Yet most notably, as we touched upon yesterday, the Fed's reserves with banks surged by $73 billion in the past week, as more capital was reallocated from the unwinding SFP program. As noted previously, we expect the total bank reserves held with the Fed to jump from the current record $1.29 trillion to at least $1.7 trillion by June.

As Zero Hedge accurately predicted, on Thursday there will be no $25 billion 56 Day Cash Management Bill auction, as part of the just announced roll down of the Fed's SFP (or SFB as it is known elsewhere) program, which will bring down holdings of associated debt at the Treasury from $250 billion to just $5 billion in 8 weeks. Previously we predicted that the impact of this activity will be nothing short of a doubling of POMO but did not discuss the impact on bank excess reserves. Over the weekend, Barclay's Joseph Abate analyzed the impact of the termination of SFP as well as the ongoing QE2, and came to the conclusion that excess reserves, which at last check had been just about $1 trillion (well below where they should be based on recent asset purchases, another topic we have discussed) are about to surge by a massive $700 billion over the next 5 months! What this means is the market will simply factor in even a greater impossibility for the Fed to tighten liquidity when the moment comes (which we believe will be pretty much never) forcing those evil speculators to push all commodities to even greater record highs (yes, rice included), forcing us to get even more bullish on the continuation of the recent round of global food-price hike driven revolutions.

At this point the weekly updates of the Fed's balance sheet are becoming more or less an autopilot issue: each week the Fed will add between $25 and $30 billion of Treasuries, with the only real question becoming how much mortgages are being prepaid, and what is the incremental liquidity boost due to the weekly change in excess reserves. But before getting into those, here is a broad look at how the Fed's balance sheet looked as of close today (including today's $6.8 billion POMO).