Two Historic Retreats: 1812 and 1218

How Do 1812 and 12-18 Compare?

Age of Wisdom, Age of Foolishness (8)

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The historic significance of the number sequences “18/12” and “12/18” depend on which side of the Atlantic one lives on. Europeans will equate “18/12” with Napoleon’s disastrous retreat from a classic example of policy overreach. Americans will look at “12/18” as the day the Fed decided to retreat, from the monetary policy overreach known as Quantitative Easing, in the form of the “Taper”. Looking more closely however, the “Taper” is no retreat at all; but rather a slower advance. Monetary policy overreach therefore continues but at a slower pace.

Chairman Bernanke’s careful scripting of his legacy continued with his epigrammatic speech, about the Fed’s “finest hour”, fighting back political encroachment whilst saving the global economy[i]. This speech was in fact Bernanke’s “finest hour” in defending the Fed from the growing criticism, with some justification, that the Fed saved “Wall Street” rather than “Main Street”. The Fed is currently in the process of saving itself from financial and political capital losses on its balance sheet; as it continues to grow in size in a period during which the Fed has lost control of interest rates. QE no longer suppresses interest rates. In fact QE causes interest rates to rise; because the capital markets now charge the Fed a risk premium for its actions. This heroic line in his epitaph was then swiftly followed with the FOMC’s “surprise” announcement to begin “Tapering” in January. Careful scrutiny of the capital market fundamentals will show that this decision should not come as a surprise. The “dysfunctional” Congress has defaulted to the “Sequester” as the process for reducing the nation’s debt. As a consequence, the supply of US Treasury Bonds is falling. The Banks are also scaling back their creation of private credit. This scaling back of credit has two drivers. The regulatory driver comes from Basel III and Volcker II; which force the Banks to carry more capital. The second driver comes from the commercial decision making process in the Banks. The Banks are reluctant to extend credit directly. They thus securitize debt and then swiftly pass it on to the Fed’s balance sheet. So far, the Banks have transferred the risk associated with Mortgage Backed Securities (MBS) to the Fed. The Banks are now in the second stage of risk avoidance; which involves them foreclosing on mortgages and passing these assets to private investors.

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The problem with the second leg is that the investors understand that they are being set up; and so they have stopped being aggressive buyers and are holding out for a correction lower in prices. The Banks are also not replacing foreclosed housing debt with new housing debt. The supply of MBS is therefore diminishing. The Fed is thus running out of Treasuries and MBS to purchase, ergo the pace of QE must slow, ergo the “Taper”.

As the Fed’s balance sheet expands, admittedly more slowly, so does the level of systemic risk that the Fed is creating. The Banks underwrite this risk by lending to the Fed and receiving interest on these Reserves that they are lending to the Fed. The Banks have decided that the risk premium that they charge the Fed should now go up, as the Fed’s balance sheet expands to create the credit that the Banks should be creating. The combination of falling supply of assets to purchase plus the higher risk premium charged by the Banks is therefore what has driven the “Taper” decision. The dissenting voices of Charles Plosser and Richard Fisher, never disagree with the fact that economic growth is weak or that inflation is low. They dissent because they see that the Fed’s purchases are way in excess of the supply of balance sheet eligible assets; so that a bubble has been created. Chairman Bernanke’s epigrams about the Fed’s “finest hour” and its solidarity with “Wall Street” were therefore noble lies. The biggest noble lie however was told on “12/18” by the FOMC.

The truth being spoken last week was far more humble. Freddie Mac’s Senior Vice President Tracy Mooney humbly promoted HARP to borrowers who are not distressed; and therefore are not strictly-speaking those who the Federal Government had in mind when the “Acronym” HARP was born[ii]. The inconvenient truth seems to be that HARP is no longer working to drive refinancing, which keeps people in homes and keeps homes off the market so that home prices are supported.

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The FHA confirmed this inconvenient truth in its latest report on delinquencies. HARP refinancing has fallen in line with normal refinancing which has been curtailed by the rise in interest rates[iii].

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The FHA lamented that loans eligible for HARP but not being refinanced were showing an accelerating delinquency profile compared to those that were refinanced in the programme. As usual it is the loans taken on later into the recovery which show the best delinquency characteristics. These profiles show why Freddie Mac’s Tracy Mooney was so keen to spread the word about the benefits of HARP to borrowers. The real inconvenient truth is that both HARP and Non-HARP delinquencies are rising though. The application of HARP just slows down the rate of delinquency; however it does not reverse the trend in delinquency. HARP is therefore fundamentally flawed. This flaw occurs because those with the loans still can’t afford to repay them, even after going through the HARP process. HARP just kicks the can a little further forward in time.

In recognition of the flaw in HARP, Freddie Mac has therefore taken the unilateral pro-active step of directly pushing HARP to borrowers with loan-to-value ratios below 80%[iv]. As of April Fools’ Day 2014, borrowers with market-to-market loan-to-value (LTV) ratios of less than 80 percent are now eligible for a 480-month or 360-month modification with lower principal and interest payments than their current loans. Basically HARP becomes HAMP and vice versa, as both interest and principal get modified i.e. reduced. Freddie hopes to boost the pipeline of mortgages so that the Fed has more assets to buy. Since these assets are in the non-distressed category, the Fed should not incur extra risk in paying up for them; even if it has left money on the table for the borrowers in terms of lower income and principal. These non-distressed borrowers, who have just refinanced through HARP, should now find themselves with more money to spend. The Federal Housing Stimulus thus drives on with the support of the FHA, Freddie and the Fed.

Even the BIS appears to be in on the game. In its latest edict, the BIS opined that Basel III will reduce the risk weighting on asset backed securities (ABS)[v]. Banks have a financial incentive to make and warehouse non-housing related loans. This will also make these loans ABS eligible for the Fed to buy; so that when it has run out of MBS to buy there will be a new supply of ABS to monetize. Suddenly Bernanke’s retreat is starting to look like Yellen’s advance.

With Bernanke’s passing, the significance of the reporting by his chosen trusted source John Hilsenrath is now in question. As the horizon was scanned, for new trusted sources, a new developing picture was observed at Bloomberg. Bloomberg has opened up a new editorial theme in relation to demographics[vi]. Aging demographics is explained as being the secular trend which is the greatest economic headwind of our times. Central banks are now being framed as the agencies through which this headwind must be confronted. Unconventional monetary policy, involving the monetization of specific asset classes associated with the un-financeable debts of this aging demographic, is allegedly already being crafted. One immediately hears the helicopter blades of Michael Woodford and Adair Turner making the characteristic sounds, of wealth confiscation through inflation, beating closer.


  1. Bernanke Says Fed in ‘Finest Hours’ Stood Up to Pressure
  2. HARP Myths Debunked by Freddie Mac Exec
  3. Declining HARP Volume Matches Broader Refinance Trends
  4. Freddie Mac Releases Updates to Foreclosure Alternative Processes
  5. Asset-Backed Finance Wins Capital Reprieve From Basel Group
  6. Boomers as Retail Clerks Shows Why Greenspan Saw Low Growth Era

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