Thursday, August 26, 2010

The Real Activity Suspension Program

(Think of this as a guest post by the Cynic in me. I’m not sure my Cynic is entirely right on either the facts or the economics, but he has a provocative point. And I apologize for the fact that he misuses the word “recession” to include the period since our inadequate recovery began.)


Americans got angry when the federal government tried to bail out banks by buying assets or taking capital positions. Whatever you may think of those bailout programs, they at least had the advantage that taxpayers were getting something in return for their money. There is another bank bailout program going on now – one that allows the federal government to recapitalize banks with public money, receive nothing at all in return, and somehow escape criticism for doing so. That bailout program is called the Recession.

How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets. So the government pays to recapitalize banks while receiving nothing in return.

Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits.

Another risk, with similar implications, is an increase in the expected inflation rate. That would also lead to capital losses on the banks’ Treasury note holdings and an increase in their cost of funds.

Finally, there is reinvestment risk. Treasury notes mature and need to be rolled over, the coupon payments need to be reinvested, and banks have new inflows of funds that need to be invested. A substantial decline in the yields on Treasury notes (perhaps a continuation of what we are seeing now) would benefit banks in the short run because of the capital gains involved, but ultimately it would effectively terminate the bailout program, since banks would no longer be able to earn a large spread on their safe investments.

So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents – representatives of the banking sector – are the most hawkish voices at the FOMC’s policy meetings?


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

4 comments:

JKH said...

I don't see that the Fed Flow of Funds report bears this story out to a significant degree. I doubt that the addition of Treasuries to bank accrual books is a significant bottom line contributor for the system. Take a $ 100 billion system increase as indicative for example, and run a 3 or 4 per cent net interest margin on it at the best of times, and you only get $ 3 or 4 billion per year for the system. That's small potatoes in the internal recapitalization run rate, as is interest on reserves at 25 basis points.

Ken Houghton said...

"And I apologize for the fact that he misuses the word “recession” to include the period since our inadequate recovery began."

I'll stop calling it a continuing recession when NBER positively identifies six consecutive months of growth not counting December. So far, they know they can't do that, and all the talk that "recovery" began in June or July of 2009 (coincidentally, of course, when a lot of the ARRA spending to the credit-constrained occurred) is backed by less and less data with each revision.

There are 12 months between the end of the Volcker Recession and the beginning of the Reagan Recession; presumably not a double-dip because there are two different proximate causes. Will be interesting to see the duration of the "recovery" this time, but at least there's a benchmark.

(As an aside, 1873-1879 abides, but that may be a data quality issue.)

The Money Demand Blog said...

:)
But what about credit risks? Prolonged recession might cause harm to banks via widening of credit spreads.

Doc at the Radar Station said...

"Americans got angry when the federal government tried to bail out banks by buying assets or taking capital positions. Whatever you may think of those bailout programs, they at least had the advantage that taxpayers were getting something in return for their money. There is another bank bailout program going on now – one that allows the federal government to recapitalize banks with public money, receive nothing at all in return, and somehow escape criticism for doing so. That bailout program is called the Recession."

"How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets. So the government pays to recapitalize banks while receiving nothing in return."

"Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits."

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So, is this, in your opinion, precisely what happened in Japan? If so, this makes a lot of sense!