The Perfect Crime

By Bob Wood, TMO

Bob Wood is a successful financial analyst and recognized investment advisor.  His opinions are his own.

The perfect crime is thought to be one in which the perpetrator had a fool-proof alibi, were nowhere near the scene of the crime, and left no evidence trail behind linking you to it.

Better yet, the crime that went undetected by anyone tops the list. How would one get caught if nobody even knew a crime was committed? Let’s go one further. How about a crime that had many assumed experts cheering the perpetrator along, in some cases, demanding he do it?

In this ideal case, I’m talking about a crime that many believe is actually a virtuous, beneficent act. This might all sound hypothetical or even silly. But it isn’t. The perfect crime is being committed today, right out in the open, with hotly anticipated media coverage of announcements of each step of the act.

The best part of this crime wave is that the perpetrators are making off with trillions in assets and there are some people imploring them to take even larger sums in coming months or years! Best of all, you yourself may be profiting from this amazing crime spree.

What I’m talking about is the Federal Reserve’s high profile programs called QE, for quantitative easing. We’ve all heard about it given the extensive media coverage, notably in the financial media. But how many have actually considered how this series of events really works?

Imagine someone inventing software that could duplicate dollar bills with accuracy so precise that even the wisest bank teller couldn’t tell the difference. The printer of said currency could produce them in unlimited amounts and buy things of real value, like a home, or thousands of them.

He wouldn’t have to stop there. He could go into the financial markets and buy as much stock or bonds as desired, turning worthless paper into a stunningly large portfolio of income and profit producing assets. For what cost him nothing, he could amass billions worth of holdings.

I’ll let you imagine the possibilities. Stepping back into the real world, look at the Federal Reserve’s stimulus programs of the past few years. Implored to do whatever it took to save our economy after our foremost free market, deregulating capitalists blew it up, the Fed embarked on its historic efforts.

They would support the bond market by buying mortgage backed securities, which is basically mortgages on homes from the banks, and Treasuries that helped fund our historic federal budget deficits. If you have a mortgage loan on your home, the Fed may be its ultimate owner.

At the onset of this program, the Fed had on its balance sheet about $800 billion in holdings.

Those holdings have grown today to almost $4.5 trillion. Now, where did all that new money come from?  It’s not exactly counterfeiting as it’s all legal, but it works in much the same way.

We know that by the powers invested in them, the Fed can create money at will when needed to help the banks. Helping the banks is the Fed’s true mandate. If you think the stated ‘’dual mandate’’, or reason for being, of stable prices and full employment is their real focus, you’re just not thinking. That’s just political cover.

Anyway, the Fed printed $85 billion per month during this last round of stimulus. On their balance sheet they sport roughly $1.2 trillion worth of mortgages. That means, they are the ultimate owners of at least that much real estate.

That real estate was bought with money created at no cost whatsoever. Some worry that the Fed has taken too much risk in doing this. The Fed’s balance sheet is leveraged by an enormous 77 to 1. Should the value of its holdings fall only a small amount the Fed would be wiped out faster than Lehman Brothers, done in by leverage less extreme.

A small rise in interest rates would cause the value of those bonds to fall. It would only take a small move in rates to push the Fed into insolvency. But is the Fed really at risk here? Actually, no.

Work it out. Let’s say the value of the Fed’s holdings fell by 10%, highly possible. So the Fed has taken a loss of $400 billion against assets of about $75 billion. If this were a Lehman-type entity, they would surely be bust.

In this case, the Fed owns bonds still worth about $4 trillion. But they essentially paid nothing for them, having created the money at no cost to them using their own magic ATM machine. So what if the bonds’ value have fallen? They really paid nothing for them!

Fed officials including former Chairman Bernanke have argued for more Fed involvement in the markets citing ‘’the wealth effect’’. Higher asset prices, stocks and houses, would encourage consumers to spend, helping the economic recovery.

Some interested observers, myself included, have marveled at the performance of the stock market this past five years amid steadily falling trading volumes, the weakest economic recovery on record, and measures from the Fed and central banks in Europe and Japan that insist they see no organic recovery in sight.

Some are arguing that the Fed has been actively involved in propping up stock prices, not at levels of valuation only seen at past market tops. One conspiracy theorist believes the Fed may own up to one quarter of the total stock market capitalization. Whether this is true or not is speculation only as the Fed hasn’t admitted to doing so.

But would anyone be shocked to learn in coming years that they did? Would anyone object given that stocks have risen so much, seen as helping investors and the wider economy? Well, someone should object!

Japan’s central bank has admitted to buying equities to support prices. In theory, it’s not so far-fetched so think the Fed has been the mysterious buyer supporting share prices in the historic absence of the retail buyer.

If true, the Fed, or the banks owning it, could well own upwards of $10 trillion worth of valuable assets. The best part for them is the income and appreciation on those assets comes from no sacrifice on their part.

Better still, let’s assume the bears will ultimately be proven correct and asset values fall hard from here. What does the Fed lose in this scenario? Nothing!

An asset bought for $100 created at no cost or effort could fall to $50, but since nothing of value was invested, nothing is lost. They still own an asset worth far more than the value they paid for it. The asset could fall to zero, and still nothing would be lost, as zero is the value of what the dollars they paid for them cost them.

Just as a counterfeiter loses nothing if he buys a Ferrari using his fake money and crashes it, the Fed can’t lose if the value of their bonds or stocks falls hard.

Some can argue sensibly that no crime was committed since an investor who sold his shares to the Fed or one of its proxies would have received money that was perfectly legal tender that could be spent on a Ferrari, house or more shares.

The biggest crime here, on top of using an asset that cost nothing to buy things the rest of us must use hard-won dollars to acquire is that stocks have risen to levels that a free market would likely not see. Those who recall the stock market crash in 2001-2002 might remember the Fed’s help in boosting those shares to levels far higher than was warranted.

The Fed also helped greatly in pushing house prices too high leading up to the crash in housing prices in 2008. This time, instead of merely making cheap money available to gamblers, they are actively involved themselves.

What’s mostly wrong in all of this is that the markets offer us the opportunity to profit from risk taking. But the Fed’s holdings carry no risk. They capture all of the upside profits, with no downside risk of loss. Is that a market you feel to be fair?

You may be smiling broadly at the party thrown by the Fed. If so, good for you. Just consider when leaving the party might make sense. Prices sent higher by artificial means tend not to stay there.

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