Feds to Buy Government Debt

It's the waterslide into Hell! Whee!

What a day. Under cover of the AIG scandal, the Fed did something foolhardy yesterday.

"Fed plan stuns investors," says the headline in the Financial Times this morning.

It should stun us all. But we're getting used to expensive bamboozles.

In response to the Fed's latest move, the yield on 10-year Treasuries fell more than any time since they started keeping records in 1962. From 3.01% it had fallen to 2.48% when last we looked.

Yields fell because the Fed said it would buy $300 billion worth of government debt. Stocks rose - with the Dow up 90 points. And the dollar fell heavily against the euro...down to less than $1.31/euro.

Of course, most people have no idea what this means. But here at The Daily Reckoning we weren't born yesterday. And we've been following this story for the last 38 years.

Yes, dear reader, when Richard Nixon cut the link between the dollar and gold, the world has been using a money system that is, to put it in its best light, experimental. The last experiments of this sort - on anything like this scale - were conducted in the 18th century. The Banque Generale was set up by that rogue, John Law, to buy up the debt of France - of which there was plenty. And a similar plan was underway in England soon after - later known as the South Sea bubble. It was similar in that the bank substituted pieces of paper - stock in the South Sea Company - for government debt.

In the U.S. version, circa 2009, the Fed uses pieces of green paper called 'dollars' to buy up the government debt.

Wait a minute...where do the dollars come from? Oh, silly reader, they come from the same place that shares in the South Sea Company...or shares in the Mississippi Company (the French version) came from - they just printed them up!

And now, they don't even have to print them up. When the Fed buys U.S. debt, it merely makes an electronic notation...like an IOU that disappears as soon as the power goes out.

When those 18th century debt buy-up schemes were put in place, at first their stock rose. John Law's shares were such a hit that ladies would stop him in the street...it was rumored that they offered their most cherished favors in exchange for an opportunity to buy. Shares in the South Sea Company, meanwhile, went up 10 times in a single year.

U.S. bonds rose strongly yesterday too; of course, the richest investor in the world just entered the marketplace - announcing he would buy $300 billion.

And if that doesn't work...he'll buy more.

"Fed to buy $1 trillion in securities to aid economy," reports the New York Times.

"The Fed is engaging in massive quantitative easing," said William Poole, former head of the St. Louis Fed.

And why not? The central banks of England, Japan and Switzerland are all buying their government bonds. The IMF too.

Besides, all the bailouts and stimulus plans so far haven't worked. And at least this latest plan makes a little more sense. The problem is debt, not liquidity. Buying up the securities of Fannie and Freddie, the Fed will lower the cost of mortgage debt. This will give homeowners an opportunity - probably the last one of their lifetimes - to refinance their houses at low interest rates. The target range...we've heard...is between 3% and 4%.

In the short run, if the homeowner is able to refinance at such low rates, he reduces his monthly cash-flow burden and frees up cash for other things (such as paying down his credit card debt). In the long run, if he's able to lock-in those low rates, he will almost certainly see the debt burden itself significantly eased - thanks to rising inflation rates.

Lenders beware! U.S. Treasury bonds are attractive because they are safe. But they could turn out to be the riskiest safeguard in financial history. This is a moment when it is probably better to be a borrower than a lender. Refinance your house at 5% fixed rate. For the first few years, paying that mortgage may be as painful as marriage counseling. But then, when the marriage finally breaks up...and inflation heads to 10%... think how free and easy you'll feel. In a few years, your mortgage will practically disappear.

This is so attractive; we're tempted to do it ourselves. But we haven't had a mortgage in 20 years...we don't want one now.

Better to follow the smart money. John Paulson is one of the few hedge fund managers to understand the financial crisis and to make money in it. He made a fortune betting against subprime in 2007. In 2008, his fund was up 37% - while the rest of the world lost trillions.

What's he doing now? He was in the news this week, because he bought a big stake in a gold miner - AngloGold Ashanti - for $1.28 billion.

Gold went down yesterday...and then bounced back over $930.

"The dollar took a major hit after the Fed announced that it will be buying more government bonds and mortgage backed securities - that's another 1.2 trillion in 'new' currency hitting the money supply," writes our intrepid correspondent, Byron King. "The announcement created a frenzy in the gold market. The price of gold shot up $50 per ounce less than 2 hours after the feds meeting."

"Precious metals are like fire insurance. You don't wait until you smell smoke to call your agent and buy coverage."

Given yesterday's announcement, it's surprising that it is not already over $1,000 an ounce. Perhaps it soon will be...in which case, we urge you to get in now, while the price is still relatively low. We think we're going to see the yellow metal much, much higher.

Now over to Addison, reporting from Charm City...

"In a single breath the Fed committed another $1.15 trillion to the credit quagmire," writes Addison in today's issue of The 5 Min. Forecast.

"The dirty details:

"* $750 billion for purchasing mortgage backed securities from Fannie Mae and Freddie Mac (on top of the $500 billion the Fed has already promised).

"* Another $100 billion directly toward Fannie and Freddie's debt. That's also atop a pre-existing, $100 billion program.

"* The knockout blow... the Fed will officially begin buying 'longer term' U.S. treasury notes. The FOMC said they'd spend at least $300 billion over the next six months.

"Yesterday's announcement could easily balloon the Fed balance sheet to over $3 trillion," continues Addison. "We expect that to go even higher by the end of 2009. These are 'up to' numbers, mind you. So it may never happen. But the Fed did choose them for dramatic effect. Likewise, we thought we'd show you a chart of the Fed's balance sheet, if it ballooned as dramatically as last fall:

"The Feds statement reads 'the Committee expects that inflation will remain subdued.' Phew."

Addison writes every day for The 5 Min Forecast, an executive series e- letter that provides a quick and dirty analysis of daily economic and financial developments - in five minutes or less.

And back to Bill, reporting from Paris, France...

Those poor English. If any people were dumber at finance than Americans, it was the English. While debt in the United States rose to an unprecedented 350% of GDP, in England it went to 500% of GDP. And now joblessness in Britain has risen above 2 million for the first time since 1997.

House prices were outrageous in the United Kingdom - but they're becoming less outrageous by the day. One expert says he expects them to fall another 55% before hitting bottom.

Meanwhile, here in France, the chiselers and whiners have taken to the streets. Today, there's a big strike going on - supposedly. We didn't see any signs of it on our way to work. But the French are said to be up in arms because of the financial crisis.

France is an importer of tourists and an exporter of luxury items...and high technology. The Russians are broke, so they're not spending billions on French champagne and fashions. Americans are broke, so they're not filling the restaurants the way they did last year. The English are broke, so they're not buying little houses in the south of France. The airlines are losing money, so they're not buying French planes. And so forth...

"Class war," the Financial Times calls it. Factories are closing. Layoffs are increasing. The unions have organized to protect jobs. And the government is doing a bad job of lying. It has bailed out the banks...but failed to pretend to bail out the little guys too.

We'll let you know how this develops...

But today's headline story is still the AIG scandal.

"Give us back our money," yelled a protestor at Edward Liddy, AIG CEO, yesterday.

The taxpayers are upset. The politicians are pretending to be upset. And the media thinks it has a hot story.

But what is remarkable is that the public has an opinion about how much insurance executives should be paid. Whenever the public has an opinion on something that should be a private matter, you can be sure there's a bamboozle in it somewhere.

"Street of Shame," writes an editorialist in the FT. AIG bonuses are a "humiliation for Wall Street and a travesty for the taxpayers."

What they really are is a huge distraction. The insiders are making off with billions, while the watchdogs are yapping at a handful of over- paid insurance hacks.

David Leonhardt, writing in the New York Times:

"I looked into every large company that had changed chief executives over the previous six months. Not a single boss at any of them had left for another job. Such departures are so rare that Booz & Company's annual study of executive turnover doesn't even include a category for them. The benefits of the job - the pay, the perks, the gratification that comes from running a company well - are too good to leave, even for a similar job.

"The situation is a little different for jobs below the top level, particularly on Wall Street. Surely, if the employees of AIG's notorious financial products division were to be denied their bonuses - a big chunk of their annual compensation - many might leave.

"The nub of Mr. Liddy's argument is that these departures would be a terrible thing. But there are several weaknesses with this argument.

"The first is that the original explanation for these bonuses was rather different. When they were devised in early 2008, months before the first bailout, as Mr. Liddy's letter to the government on Saturday explained, 'AIG Financial Products was expected to have a significant, ongoing role at AIG.' The idea, he said, was to guarantee 'a minimum level of pay for both 2008 and 2009.' So the rationale for AIG's retention bonuses is as malleable as the rationale for chief executives' bonuses.

"Most amazingly, the AIG bonuses haven't even accomplished their stated goal. Andrew Cuomo, New York's attorney general, said Tuesday that 52 employees who received bonuses had since left AIG.

"The second problem with Mr. Liddy's argument has to do with Mr. Liddy himself. His defenders have noted that the government brought him out of retirement to fix AIG and that he presumably puts a higher priority on doing a good job than pleasing AIG's employees.

"And he probably does. But he is also a product of the current, broken executive pay system. As the chairman of Allstate from 1999 to 2007, when the company's stock underperformed those of its rivals, he made $137 million. Almost $14 million of that, according to the Corporate Library, came in the form of stock that the company called a 'a tool for retaining executive talent.' Which means Mr. Liddy may not be entirely objective about retention bonuses.

"Finally, there is the question of how hard replacing those AIG employees would be. Certainly, some of them must have particular insight into unwinding the toxic portfolio they built. But I doubt that anywhere near all 418 financial products employees - who have received bonuses worth $395,000 on average - are indispensable. "

Mr. Leonhardt is right. But he is missing the point. Companies should be able to pay their employees however much they please. They should be able to go broke too.

That's how capitalism is supposed to work.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

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