Federal Reserve Board is a powerful entity

By DAVID MOON, Moon Capital Management, LLC
September 23, 2012

On September 13 the Federal Reserve Board made headlines in practically every general publication and newspaper in the country when it announced that it would add $40 billion worth of monthly mortgage-backed securities purchases to its standing program of $45 billion in monthly long-term Treasury bond purchases. This third round of quantitative easing (QE3) pushed the Dow Jones Industrial Average up 206 points for the day as the “risk on” trade was resumed.

The Federal Reserve Board is a powerful entity. Most of us have at least a vague understanding of what role the U.S. President, a bank teller or our spouse plays in our lives.

But do you have a clue about the Federal Reserve or the actual implications of QE3?

The Federal Reserve System is designed as an independent entity, comprised of a presidentially appointed board of seven governors, a 12 member Federal Open Market Committee and twelve regional Federal Reserve banks. Although no one actually owns the Federal Reserve, the regional Federal Reserve banks issue stock to deposit institutions within their geographic regions and pay a six percent annual dividend on those investments.

The Federal Reserve typically creates money by purchasing US Treasury securities in the open market. It pays for these securities with an electronic debit of cash it does not have. It literally creates the money by simply saying “here is some money.” Banks can then lend a multiple of the amount they receive from the Fed, potentially magnifying the effect.

The Fed’s bond purchases over the past several years go at least one step beyond the simple creation of money. An additional stated goal of Chairman Bernanke has been to reduce interest rates in the Treasury and mortgage-backed bond markets.

How active has the Federal Reserve been at purchasing bonds with newly created money?

In 2008, the Federal Reserve purchased almost none of the newly issued Treasury bonds. Since then, its balance sheet has ballooned by almost $2 trillion.

A recent UBS analyst report says that the Fed owns all but $650 billion of all US treasuries with maturities of 10 years or more, or 43.5 percent of the total outstanding. At a net monthly Treasury issuance of $89 billion (the average for the past six months) the Fed purchases about half of all newly issued Treasuries, and almost all of the long maturities.

This is in addition to the Fed’s new plan of $40 billion in monthly mortgage-backed securities purchases – an amount likely equal to 28 to 40 percent of all new issues.

That’s why the yield on the 10-year Treasury bond is less than the practical rate of inflation.

Now that the Fed is moving into the mortgage market, $40 billion in monthly mortgage-backed securities purchases will soon make it the largest single owner of US home mortgage collateral.

These Fed actions and their reciprocal impacts in the bond market are the modern-day equivalent of the dot.com bubble. There is no way it can end but badly.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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