The Money View

Privatizing QE3

Pity the plight of the central banker.   The halcyon days of inflation targeting recede ever farther into the past, along with the glorious simplicity of agonizing whether 25 bp is enough.  Instead, the fate of the world seems to hang in the balance, even while the Fed Funds rate remains stuck at zero.

All over the world, central banks are stepping in to catch the falling knife dropped by their ostensible political masters, the issuers of sovereign debt.   Most notably, the ECB has extended its bond-buying to Spain and Italy, and the Fed has guaranteed another two years of ZIRP.

But central bank balance sheets are still swollen from the private sector rescue of 2008.  And central bankers are under much closer scrutiny than in 2008—no chance this time that the Fed will be able to double its balance sheet before Congress notices.

That’s why QE3 is happening off the Fed’s balance sheet, rather than on it. 

To see this, it is helpful to recall QE1 and QE2.  QE1 was about buying mortgage-backed securities, and QE2 was about buying long-dated Treasury securities.  In both cases, the purchase was made using the Fed’s own liabilities; that’s what the $1.6 trillion of excess bank reserves are funding.

This time around the Fed is not buying anything, so why do I say it is doing QE3?

Basically, the ZIRP provides strong incentive for carry trades of all kinds.  If you can borrow at zero, and can roll your borrowing for two years, then anything with a positive yield looks good.  If a hedge fund borrows at zero and buys MBS, that is QE1 private-style.  If a hedge fund borrows at zero and buys long-dated Treasuries, that is QE2 private-style.

The difference is that, since the Fed is not doing the trade on its own balance sheet, it has no control over which trades get made.  Private speculators can also buy yen or Swiss francs, and central banks intent on preventing currency appreciation are forced to take the other side of the speculation, so doing their own QE.  And speculators can also buy gold, or indeed any other asset, so long as expected capital gains exceed storage costs.

Another difference is that private-style QE gets financed with private money expansion (private debt secured by the asset purchased) rather than public money expansion (Fed debt which is bank reserves).  

From this perspective, private-style QE3 looks like a repurposed shadow banking system.

As everyone now knows, the collateral that stood behind the original shadow banking system turned out not to be the AAA credit it was claimed to be.   But, at the time, demand for private money backed by that dodgy collateral was sufficiently strong that there were strong incentives not to look too closely.

Today, even as the Fed’s ZIRP creates incentives to rebuild the shadow system, there is no question that the demand is still there.  (Zoltan Pozsar’s recent paper, glossed by Gillian Tett, establishes this point convincingly.  Read it now.)  The question is where to find the collateral needed to back the corresponding supply.  The search is on.

After the collapse of the original shadow banking system, we met demand for a while with an extraordinary expansion of public money.   Not this time.

This time it will be private money, and that means that the profit motive is key.   As we were building the original shadow banking system, that profit motive led to all kinds of weird and wonderful engineering, all directed to creating AAA collateral.  This time, end investors are likely to be looking more closely at the underlying credit.

Nevertheless, just like last time, collateral transformation is the name of the game.  Anyone who can figure out how to create AAA collateral from existing non-AAA assets can, in effect, coin money.

The search is on.