NY Fed's Brian Sack: Paint The Tape, Close Green, And Get Away Clean
Submitted by EconomicPolicyJournal.com
We would like to pay tribute to a soon-to-be departing VP of the New York Fed--one who was not only an architect of Ben Bernanke's quantitative easing programs, but who ended up its chief implementer over the last three years. When he came back to the New York Fed on June 2, 2009, after taking a break in the private sector, the prior Fed analyst would be charged with the eventual winding down of the largest expansion of the Fed's balance sheet in history (QE1 already being partly underway at the time). Another QE(2) and one Operation Twist later, we know how that worked out (hint: an extra $trillion on the left hand ledger since arrival).
Just why is he throwing in the towel now, scheduled to leave on the last transaction date of Operation Twist at the end of June, 2012? Is he conceding that, in fact, the Fed will never be able to extract itself from balance sheet hyperplasia? We cannot know for sure, but we can offer the following tribute to perhaps the second most influential person in the maddest of monetary experiments in Western central bank history.
His name was Brian Sack.
Over the years, we've written much about Mr. Sack, one of the myriad M.I.T. graduates that run the global central banking cartel. For in 2004, he, along with future Fed Chairman Ben Bernanke and then-Fed economist Vincent Reinhart, wrote the watershed white paper that would become the guide for the Fed's massive monetary experiments--the putative "solution" to what would become the financial crisis of 2008: "Monetary Policy Alternatives at the Zero Bound."
Described by his undergrad alum paper at the University of Vermont (UV), "[Sack] was a math whiz who just happened to take enough economics classes by his senior year to earn a math/economics double major." These math skills would be critical to determining just exactly how many billions in Treasury and MBS securities the Fed would have to buy each day (vis a vis Permanent Open Market Operations "POMOs") to keep the too-big-to-fail banks afloat without causing rampant price inflation for those lucky few who don't eat food or drive.
The Fall 2009 UV profile continues:
Given that Sack started his current job after much of this buying by the Fed had already taken place, his biggest task over the coming few years will be to figure out how to best manage or even sell off big chunks of this $2 trillion portfolio of Fed assets without disrupting economic growth. As the Fed never really wanted all this stuff–buying it, essentially, to kick-start the economy–selling it all off may prove more complicated.
Complicated indeed, which speaks to the potential end game for the Fed (and which we will get to in a bit). But far from overseeing a reduction in size of the Fed's balance sheet, Mr. Sack has been an advocate of its expansion vis a vis serial QEn campaigns. As we predicted in October, 2010 (see "Preparing for QE Ad Infinitum"), just ahead of the Fed's QE2 announcement, Mr. Sack would be instrumental in guiding future Fed balance sheet policy.
Source: The Market Oracle
The Fed would conduct an unscheduled meeting before its November 3, 2010 meeting, in which it would formerly announce QE2. At discussion were the very issues Mr. Sack had brought up in a recent speech, such as whether to bring a bazooka or a machine gun to fight the markets. QE2 would be a mix of both, for the initial announcement size of $600 million was intended to be the bazooka, and the now daily purchases (as opposed to twice weekly) were to be the machine gun. Supposedly, this would result in less market disruption and prevent front running by the Fed's primary dealer purchase partners, a select and highly insider group of the largest banks and brokers (and, at one time, Jon Corzine's MF Global).
Who does the Fed work for?
Yet, as Zero Hedge detailed time and time again, the Fed, under Mr. Sack's supervision, consistently purchased the richest spline in its QE2 operations--meaning it bought the most expensive bonds on a relative basis from its favorite dealers. This amounted to a de facto subsidy to them (see here, here, here, here, here, and here).
Another egregious example occurred on one morning in Spring, 2011, shortly after the Japanese Fukishima nuclear disaster had disrupted the global markets. After an errant comment by a European energy commissioner spiked bond markets just as one of the Fed's daily POMO auctions was closing (meaning the offers by the primary dealers were already in and they were about to face massive losses because of the comments that spooked the markets), Mr. Sack terminated the auction, cancelled the dealer offers and restarted the auction thirty minutes later.
We demonstrated this amounted to a $15.7 million gift to Wall Street that morning. Perhaps not a lot by comparison to the billions in outright purchases by the Fed, but maybe it demonstrates the mentality that pervades the New York Fed's trading room. Yes, the very trading room that has no Bloomberg terminals, but does have a black box algorithm supervised by an NYU intern that spits out the non-market prices at which the largest marginal buyer of Treasury securities in the world should use to pay [subsidize] its primary dealers.
A candid Mr. Sack.
Not that Mr. Sack is not forthcoming at times. For it was he, in a paper he co-authored entitled "Large-Scale Asset Purchases by the Federal Reserve / Did They Work?" that we learned that the Fed's $1.25 trillion in MBS purchases as part of QE1 were not conducted competitively (emphasis ours, as reported originally here, in December 2010):
Because the MBS purchases were arranged with primary dealer counterparties directly, there was no auction mechanism to provide a measure of market supply. Instead, the pace of purchases of each class of MBS was adjusted in response to measures of whether that class appeared relatively cheap or expensive. To avoid buying at excessively high prices and to support market functioning, purchases were increased when market liquidity was good and were reduced when liquidity was poor.
This corrects the apparent falsehood on the New York Fed's MBS purchase page FAQ that says, "Outright [MBS] purchases were conducted via competitive bidding to ensure that trades were executed at market rates." Presumably, "market rates" is rounded to the nearest million, which is about the precision that the Fed reported its MBS purchase prices after its arm was twisted by the US Supreme Court in response to Bloomberg's FOIA request.
Mr. Sack was again candid when he spoke at the 2010 CFA Institute Fixed Income Management Conference:
To be sure, I think it is fair to say that [Fed balance sheet manipulation] is an imperfect policy tool. Even under the estimates noted earlier, the Federal Reserve had to increase its securities holdings considerably to induce the estimated 50 basis point response of longer-term rates. In addition, there is a large degree of uncertainty surrounding the estimates of these effects, given our limited experience with this instrument. Lastly, it is reasonable to assume that the effects of balance sheet expansion would diminish at some point, especially if yields were to move to extremely low levels. Nevertheless, the tool appears to be working, and it is not clear that we have yet reached a point of diminishing effects.
This latter statement begs the question of whether the departing Mr. Sack now sees a point of diminishing effects, a year and a half later. Indeed, to our knowledge, Mr. Sack is the only Fed official to publicly acknowledge the trip wire for what we perceive as the potential end game for the Fed: namely, when (not if) it goes carry negative (though Mr. Sack sees this as a temporary state of affairs).
End game for the Fed?
Speaking at the Global Interdependence Center Central Banking Series Event in February, 2011, Mr. Sack explained (and bear with us through this extended quote, which gets to the crux of the matter):
The risks to the [Fed] portfolio arise because the characteristics of the assets that have been purchased differ from those of the liabilities that have been created by those purchases. The assets held in the SOMA portfolio have fixed coupon rates that reflect longer-term interest rates. However, the purchases of those assets create reserves in the banking system, and the Federal Reserve pays interest on those reserves at a short-term interest rate that it controls. The interest paid on reserves can be thought of as the "funding cost" of the portfolio.
Today, because short-term interest rates are low relative to longer-term interest rates, this mismatch produces a very elevated stream of net income. In particular, the SOMA portfolio has a weighted average coupon yield of about 3.5 percent, which, if applied to a $2.6 trillion portfolio, produces about $90 billion of income at an annualized rate.14 In contrast, the annualized funding cost of the portfolio at this time is only around $4 billion. This cost is relatively low because of the near-zero level of the interest rate paid on reserves. In addition, the private sector holds nearly $1 trillion of currency, which are liabilities of the Federal Reserve that bear no interest.15 Thus, the SOMA portfolio should produce a considerable amount of net income over the near term.16
Beyond the near term, though, the income that will be produced by the SOMA portfolio is uncertain. If short-term interest rates were to rise, the funding cost of the portfolio would increase relative to the fairly steady yield earned on the assets held, reducing the amount of net income from the portfolio. In addition, if longer-term yields were to shift higher, the Federal Reserve could realize capital losses if it were to begin selling assets.
However, even if interest rates did move up abruptly and the SOMA portfolio experienced realized losses, it would have no meaningful operational consequences for the Federal Reserve's ability to implement monetary policy. These losses would not impair the FOMC's ability to control short-term interest rates by paying interest on reserves or by draining reserves as needed. Accordingly, the Federal Reserve would continue to operate in the same manner that it otherwise would have in pursuing its economic mandate.
What would be affected by unexpectedly large realized losses on the SOMA portfolio would be our remittances to the Treasury. All Federal Reserve earnings in excess of those needed to cover operating costs, pay dividends and maintain necessary capital levels are remitted to the U.S. Treasury on a weekly basis. Accordingly, any change to the income on the SOMA portfolio directly affects the amount of funds that the Federal Reserve remits to the Treasury. The unusually large amount of portfolio income realized of late has boosted those remittances considerably. If portfolio income were to decline going forward, whether toward more normal levels or toward unusually low levels, the amount of those remittances would adjust lower.17
17 In the most extreme case, the Federal Reserve would have to cease remittances to the Treasury for a time. Of course, one might also want to take into consideration the additional tax revenue to the government that could be generated by the more robust economic recovery supported by the asset purchase programs.
What Mr. Sack is saying is that when interest rates inevitably rise, the Fed could experience operational losses that would cease the payment of billions in annual remittances to the US Treasury. What Mr. Sack alludes to when he says, "These losses would not impair the FOMC's ability to control short-term interest rates by paying interest on reserves or by draining reserves as needed"--but fails to outright disclose, is that the Fed has devised a fraudulent accounting scheme that will let the banks keep the money that should rightly be repatriated to the Treasury and, hence, taxpayers.
We outlined the dynamics of this in December, 2011 in "Dear Congress, Bernanke Just Lied to You" (emphasis original):
After the Fed massively expanded its balance sheet through the creation of reserves (printing digital money), it has attempted to mitigate price inflation by encouraging banks to keep such reserves parked at the Fed. This program, accelerated by you, Congress, in October, 2008, approved the payment of interest on reserves. As long as short term rates are exceptionally low (and Mr. Bernanke said they would be through mid-), this is a minor expense. Meanwhile, the Fed is earning higher interest rates on the $2 trillion+ in securities it bought as part of its so-called QE programs. It is the spread between what it earns and what it must pay that allows the Fed to remit funds to the Treasury, and by extension the taxpayers.
When (and not if) short term interest rates rise (and the markets might force this in a violent fashion long before Mr. Bernanke would prefer), the Fed could easily go cash flow (or carry) negative. That is when the cost of paying banks interest on reserves (to reign in price inflation) exceeds the Fed's interest income it receives on the securities it holds. Consider that just under three decades ago, short term rates quickly reached nearly 20%.
In response, the Fed could outright sell assets that it holds, but I urge you to consider what happens when the world's largest holder of Treasury securities switches from being a net buyer to a net seller of Treasurys and what it would do to the United States' long term borrowing rates. Mr. Bernanke [and (by extension) Mr. Sack believe] that [they] can blissfully guide the Fed to a graceful exit from its $2 trillion+ balance sheet expansion. You might not wish to give [them] the benefit of the doubt.
This scenario is not lost on the Fed, which is why in March, 2009, its Board of Governors concocted a fraudulent accounting scheme (implemented retroactively to include the year 2008), which allows it to operate with negative income. It also prevents its member banks from having to pony up the difference, which was the case prior to the accounting change. Instead, in this scenario, the interest that the Treasury pays on securities held by the Fed will go to the banks, instead of back to the Treasury.
It's beyond the scope of this response to discuss all the details. However, in brief, the Fed allows a line item on the liability side of its balance sheet (specifically, the one that covers remittances to the US Treasury) to go negative. It creates a deferred asset from a hypothetical amount it will be remitting to the Treasury at some non-specified time in the future.
The heads of anyone with accounting knowledge ought to be spinning right now. For everyone else, it's as though you or I could log into our bank account and increase our balance in any given month in which expenses exceed income, with the promise that we will correspondingly lower our balance the next time we have a surplus.Only, there is no guarantee that you or I would ever again generate a surplus--meaning, we would have printed ourselves money not to be repaid. Similarly, there is not any reason to believe that once the Fed goes cash flow negative that it will ever again generate a surplus.
This creates the absurd scenario that the Fed could end up printing money as a tightening measure to reign in price inflation. Welcome to the grave that Mr. Bernanke [and Mr. Sack continue] to dig deeper for us. [They assure] us there will be nothing but an orderly withdrawal from this unprecedented activity. However, markets have a way of punishing central banker hubris.
A curious resignation announcement by the New York Fed.
The actual press release regarding Mr. Sack's resignation reveals a curious exit structure:
Mr. Sack will step down as head of the Markets Group and SOMA Manager on June 29, 2012. He will then be placed on leave until September 14, 2012, during which he will have limited contact with the Bank and no access to Bank information, including FOMC and supervisory materials.
As mentioned at the top, June 29, 2012 is the last day of the Fed's latest balance sheet experiment, so-called Operation Twist. It would be only natural he would see it out to the end. A friend from the banking industry also pointed out to us:
If that is a year-anniversary, it may satisfy his third complete year, possibly completing the checkbox for comps to give him the summer off paid. I've never met a public employee who did not know, to two decimals, the exact countdown to some comp deadline. The FED's benefits list runs to three pages. He's a relatively young man. No one ever went broke over-estimating the self interest of publicly paid servants.
Indeed, but why then the two and a half month leave period wherein he is operationally and informationally shut out of the Fed, yet presumably still on the payroll (or at least on the official registrar)? Based on our research of the New York Fed's website, this leave period appears unusual for the end of someone's career at the Fed. On the other hand, the September 14 exit date (a Friday) is two days after a September 12 FOMC meeting.
A spokesman for the New York Fed said, "[Mr. Sack] will continue in his current role 'until June 29, 2012, to help ensure a smooth transition'. He is being placed on leave to establish a reasonable time period between his cessation of work and any potential future outside commitment."
It appears our friend, Mr. Brian Sack, likely has something else big lined up--perhaps, a job of import that might be influenced by future FOMC meetings, including the two during his leave period? Will it be the World Bank, the IMF, or something more lucrative with BlackRock or Citi? We'll have to wait to see, but in the meantime, here's to the [relatively] unsung soldier who helped design and deliver quantitative easing and all its yet-to-be-experienced [side] effects to the US [and, by extension, World].
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Special thanks to Ellis Wyatt for carrying the torch.