Bernanke: Deflation violates the spirit of contract law

I'm sure RW will have a full blow by blow of Bernanke's remarks at EPJ Central. Time limits my own analysis today, but I just wanted to share this gem, as Gentle Ben reveals a new "tool" that may soon be added to his bloated belt:

"A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC [EB: but, just wait a few months until unemployment is back above 10%]. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began."

Got that? Deflation demands compensation because contracts were signed with the presupposition that the Fed was hell-bent on inflation. Maybe the SCOTUS could discover a constitutional "right" to inflation. That's really how these f*!kers think. And, by "people" do you mean your crony elite bankster friends, who thrive, and indeed depend on, the persistent inflation subsidy? Or, the poor widow who won't get to pay back her mortgage with worthless dollars? Just who is the signer of the most long term debt contracts? Oh, right. These guys.

Time to Lock in Those 100 Year Rates

It's taken several months and a drop of several hundred basis points, but the inflation hysteria from those myopic economists focused only on the monetary base has finally given way, as even Morgan Stanley's chief bond bear, Jim Caron, capitulated over the weekend and is now on the 10s-30s flattener bandwagon. It's worth reviewing what he said about the 30 Year on (or about) June 29, 2010:

A Counter Point to the Deflationistas

If true deflation fears were at work in the market then one should expect the longest duration points on the curve to rally most and we would see a significant flattening of the yield curve, especially the UST 10s30s segment of the curve. We use this as a check against deflation fears. Instead, we see the opposite with the UST 10s30s curve right up against its 20-year highs. If deflation is truly at work in the market, then someone ought to tell the UST 10s30s curve. And for that matter, all curve segments should be much flatter. Yet the curve flattening has been slow and grudging. Thus the yield curve is more representing an overall shift to lower yields as the Fed is expected to be on hold for a long time, not that deflation is truly at work. Don't confuse the two. It's too early to conclude that deflation is truly at work in the marketplace.

At the time, we had a different opinion (and it's also worth noting that the spread between the 10 Year T-Note and 30 Year T-Bond was still within its 2009 trading range):

[Caron's] observations on the 10s30s spread are leading to an erroneous conclusion. That segment will be the last to contract because (a) there is a real and rising risk of US default as evidenced by credit default swaps (30 years is 3 times as long as 10 years, after all), (b) the 30 year is not used as a primary hedge instrument against duration, nor is it materially a necessary embedded component in the half quadrillion in interest rate swaps (IRS) (whereas the 2, 5 & 7 tenors--and to a lesser degree the 10--are), and (c) the greatest demand for the 30 year will be the Fed itself when it restarts Treasury QE.

Since that post, the 10s-30s opened from 98 bps to an all-time, eye watering record of 125 bps, reaching its peak on August 10, 2010 which, not coincidentally is the exact date the Fed formally announced its next round of QE. Now that the spread has contracted to 106, it remains to be seen how much juice can be squeezed out of the trade, but we're sure Caron will capitulate when it's obvious post-facto the trend has once again reversed.

In a volatile economic environment, the worst strategy is long term trend following because there are, in fact, only short term trends punctuated with inflection points that are difficult for most to identify. As RW pointed out at EPJ Central over the weekend, retail investors have been burned once, and they will be as quick to jump out of bonds as they were out of stocks after the flash crash. Yet, we learn that pension funds--required to reduce risk by regulatory fiat--are salivating over a new 100 year bond issue from Norfolk Southern.

Norfolk Southern Corp .'s (NSC) reopening of its 100-year bond, first issued in March 2005, has launched at 5.95%, inside price talk of 6%, according to a person familiar with the sale. The sale has also been upsized to $250 million from original guidance of around $100 million.

The Norfolk, Va.-based railroad's new senior fixed-rate bonds, which come on top of the existing $300 million sold in 2005 and also maturing in 2105, are expected to be rated Baa1 by Moody's Investors Service and BBB+ by both Standard & Poor's and Fitch Ratings.

Bankers have estimated the issuer will need to pay a premium of roughly 0.75 percentage points more than what it would cost them to sell 30-year debt. The original deal from 2005 sold at par with an interest rate of 6%, and with a spread over Treasurys of 1.37 percentage points. Another 100-year bond the company sold in 1997 for $350 million, which was part of a $4.3 billion deal, had a spread of 0.97 percentage point over Treasurys.

Goldman Sachs is lead bookrunner on Monday's sale, proceeds from which will be used for general corporate purposes, according to the person familiar with the sale.

A spokesman for the issuer said its "decision to reopen the 100-year bonds was based on the current low [interest] rates, coupled with the strong appetite among buyers for them."

Bankers have been pitching century bonds selectively in recent weeks because Treasury rates are so low that issuers can lock in 100-year financing at reasonably attractive rates. At the same time, investors are sitting on piles of cash and looking to put it to work in corporate bonds, where where they are seeking longer-dated assets that give them higher yields.

Investors say that 100-year bonds aren't much more sensitive to interest rate moves than are 30-year bonds.

Century bonds were very popular earlier this decade and in the mid-1990s, but they aren't very liquid in secondary trading, meaning that they only make sense for certain types of investors. Life insurers and pension funds are the likely buyers and market chatter last week suggested there was around $100 million of capacity among these buyers for a 100-year bond. Investors prefer bond issues to be at least $250 million in size so they are eligible for inclusion in the Barclays Capital Aggregate Bond Index, like the Norfolk Southern 2105 bonds are.

Driving more pension fund interest will be the Pension Protection Act of 2006, which Michael Collins, senior investment officer for Prudential Fixed Income, said over time will encourage pension fund managers to minimize risk between their assets and liabilities even more than they do now.

Not to mention the unknown ramifications from the Frank-Dodd bill, which will keep DC bean counters busy for years tinkering with what's left of the economy. One might think that 100 years would be the ultimate duration, but it is not. Since (officially) 1751, the British government has been paying perpetual interest on consolidated annuities, or Consols. Andy Kessler wrote of them ten years ago:

In April of 1721, a plan was agreed on to fix the South Sea problem. Remember, the members of Parliament were complicit in the scheme; it was their debt that was being swapped for South Sea Company equity. The plan was called a consolidation. The government would swap shares of the South Sea Company for a piece of paper that would pay 3% interest forever. That’s right, forever, a perpetual annuity that paid out interest year in and year out. In 1726 came the Three Per Cent Bank Annuity, and in 1751, the Consolidating Act gave Parliament the power to issue these instruments, or consols, short for consolidation. England was relieved of the burden of paying back big money in 1721, in exchange for an agreement to pay interest every year. They still pay interest on these consols, the interest rate fluctuating with the market.

The odd effect was that English investors became very risk averse. Burned by equity and now guaranteed interest payments forever, the store of wealth became the guarantee of interest, which put a dagger through the heart of risk capital. In the 1870’s, the British were wealthy and America was poor. Undersea telegraphs opened America to British capital markets, and tons of money flowed to the U.S. to finance the build out of the U.S. railroads. But rather than owning equity in these railroads, the British mainly lent money, still more comfortable with getting paid interest and their eventual money back, rather than take the risk in equity, 250 years after the South Sea Bubble burst. Even today, you find a much less developed venture capital business in England and all of Europe vs. the risk junkies of Silicon Valley.

So, we had an investment bubble that was created by the government, which then exchanged worthless investment paper it helped create for government guaranteed debt--debt it is still paying for 250 years later. Mark Twain seems more prescient every day. Yet, one thing is assuredly different this time, which is the global nature of the present serial bubble economy. With all asset classes approaching plus or minus one correlation and nearly all central banks in the competitive devaluation business, we're in danger of killing off risk appetite for generations worldwide. That is, unless we can correct the basic economic fallacies that are leading the most productive economy in the history of civilization off a cliff.

BlackRock's Madoff-like Valuations Push Maiden Lane to New Highs on Her 2nd Anniversary

On June 30, 2010, Maiden Lane celebrated her second anniversary, though her composition was mark-to-markedly different than the $30 billion toxic brew of Bear Stearns assets with which she was originally stuffed. We first revealed the curious trading performed by BlackRock Financial Management on June 1, 2010, which demonstrated a significant portfolio churn in Agency mortgage backed securities (MBS) over just a two month window based on detailed holdings released by the New York Fed. Today, it has released the June 30, 2010 portfolio details, and while a follow up forensic analysis will be forthcoming, readers can be assured that the record low volatility ascent in valuation has continued, whereby she's only $1.297 billion short of a 100% payout of principal and interest to JP Morgan and the NY Fed (sic taxpayer).

Click image to enlarge.

Incidentally, the current shortfall is very close to the principal and interest owed to JP Morgan of $1.280 billion. Why not liquidate the portfolio immediately, now that the taxpayer's contribution can be recovered (that is, unless the valuations are suspect)?

In the earlier post, we pointed out a loophole that would have allowed JP Morgan to collect early ahead of the taxpayer's $28+ billion. While we congratulate the Fed on avoiding the temptation to indulge Obama's favorite banker (Jamie Dimon) on this particular front, we must continue to point out that the fair Maiden was sold to the public as a wind down facility. Yet, since March 31, 2010, BlackRock has stuffed it with brand new 5, 10 and 30 Year interest rate futures for September 2010 expiration.

9,179 short contracts is nothing to sneeze at (not to mention the $3.374 billion in outstanding swaps), which also begs the question raised by ZeroHedge in months prior: why would the Fed bother to hedge interest rate risk in a measly $30 billion portfolio while the Fed's $1.1 trillion in MBS holdings remain completely unhedged? As we have recently been told by the FOMC, it is content to let the New York Fed replace all its MBS securities with Treasurys, as the former are gradually paid down. So, we'll probably never know the hit the Fed took to support the entire MBS market in 2009. However, at some future date to great fanfare, it can point to its poster child, Maiden Lane, as an example of how it recovered 100 cents on the dollar for us.

The Failure of Exponential Systems - Grasshoppers, Gorilla Harems and Debt Supercycles

I once witnessed first-hand a grasshopper plague in the mid-West. For 15 or 20 years, their numbers had been increasing, often doubling from one year to the next. The last year, by definition, was the worst because that was when demand for food vastly outstripped supply. What was merely a manageable nuisance the prior year became an obliterating crop-destroying machine the next. When the little green guys ran out of crops, they ate the paint off the barns, and most of them starved to death (great for the fishing season, though).

I sometimes think about our current economic situation from an anthropological standpoint, one from which I am wholly unqualified to speak. The last 80 years or so created the illusion that we were freed from the shackles of supply and demand, basic economics, etc.--that there is an unlimited supply of security, food, shelter and easy riches. It's like the last silverback that wanders into a banana plantation with his harem. No threat from other males, unlimited food and unlimited sex. There's a reason they call it "going ape shit".

Such is the nature of exponential systems. That's why I think Ray Kurzweil and the California techno-libertarians are way off base when they say the technological singularity is coming as soon as the 2030's. Assuming it's possible--and that's a big assumption--I'd say the 2070's to 2080's, at least. We've got the Fourth Turning, the end of a debt supercycle and increasing institutionalized suffocation of creativity. Just as people will be shocked when longevity of the elderly decreases, they'll be shocked when Moore's Law breaks this decade. The worst models are those that are used to justify infinite geometric expansion; however, those seem to be the most prevalent models in economics.

And, as long as we're on the subject of predictions, I agree with Jeffrey Tucker that the gentleman's hat is going to make a big comeback. Get yours now.

On Druckenmiller, Paul Tudor Jones and Bob Murphy

Taylor Conant links here to a Seeking Alpha article on Stan the Man Druckenmiller.

He was also one of the best and quickest chart readers. I knew someone who conducted due diligence on him in his Pittsburgh days--don't know if it was while he was at PNB. The details are a bit fuzzy, but it went something like this. A group of people sat around him at a conference table, and one set a stack of charts in front of him. Spending just a few seconds on each chart, he flipped through and made that week's buy and sell decisions in a matter of minutes.

The article also mentions Paul Tudor Jones, who apparently Tony Robbins is now channeling. Robbins recently issued a major video warning against holding stocks based on the investment advice of a "secret" client. Given the description, it's most certainly Jones, as he made a fortune in the '87 crash. Robbins is an interesting guy, and skimming the 20+ minute video, he has the finance terminology mostly down--probably as a result of working with many top financiers and traders over the years. He gets it all wrong, though, when he starts talking about spending as the only key to the economy. I'm guessing he never coached Bob Murphy?

Here's the video:

Source: Tony Robbins blog

ht Trader's Narrative

How Much New QE? Perhaps a bit less than Rosenberg estimates.

Update: First month's purchases will be $18 billion and start next Tuesday, wherein it looks like the Fed will concentrate on buying 5's and 7's.

http://www.newyorkfed.org/markets/tot_operation_schedule.html

Bank of America's Jeffrey Rosenberg estimates that $340 billion of the Fed's $2 trillion portfolio will roll off over the next twelve months, including $62.4 billion in Treasury debt and $46.9 billion in Agency (Freddie/Fannie) debt. However, the Fed is already authorized by the Federal Reserve Act to replace maturing issues by purchasing directly from the issuer. The Fed stated yesterday:

On August 10, 2010, the Federal Open Market Committee directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities (agency MBS) in longer-term Treasury securities.

Accordingly, for purposes of calculating future open market activity, maturing Treasurys and Agencies should not be included in the total. Principal payments on Agency debt of $159.4 billion with an average weighted coupon of 3.80% equals $6.0 billion over the next year. Cash flows from MBS must be estimated, however, as they vary with interest rates.

An analysis of an admittedly small sample size of MBS factors of the Fed's actual holdings suggests that payments will be 15.3% over the next year. If interest rates were to stay constant (which of course they won't), this would equate to $170.9 billion. If interest rates continue to go down, the amount increases, if they rise, the amount decreases. Also, if Freddie and Fannie started realizing losses and paid off defaulted securities, this number could explode. However, ceteris paribus, the Fed's new Treasury purchases will be $176.9 over the next year, or $14.7 billion per month--about half of Rosenberg's estimate.

As RW points out on EPJ Central, Treasury QE has a different effect than MBS QE, and we verified this in 2009 by observing a very high correlation between stock market ramps and Treasury purchase days in Q2 and Q3 2009. Most likely, the primary dealers will funnel this into proprietary trade positions. Will $14.7 billion a month have the same effect as last year? All we know is that it will find a home somewhere--perhaps where we least expect it.

Update 9:30 am Aug 11 2010: Revised discussion to exclude maturing Agencies and only consider Agency principal payments. Initially, we accepted Rosenberg's number of $46.9 for Agencies.

If you thought the ratings agencies were bad...wait until the DC bean counters take control

The latest fallout from the Frank-Dodd miscarriage of economic prudence was released today in the form of a joint statement by the top bank cops, including my beloved Fed. Frodd requires a retooling of existing bank supervisory regulations to eliminate any reliance on ratings agencies. After all, weren't they the bad guys? Not that shoveling nearly unlimited amounts of free money to banks courtesy the Fed had anything to do with it.

What will be the effects of this latest Frodd finger of [in]stability? More appropriately phrased, what will it not affect? Every security or money market instrument on a bank's balance sheet will be subject to the bureaucratic modeling whims du jour. He who defines risk by fiat controls where investment money flows. A bean counter in a cubicle will give the ol' Caesar thumbs up or thumbs down to entire asset classes, directing money to those that are most likely to squander it [god forbid we don't help the children and the earth some more].

Apparently outsourcing regulatory capture was too inefficient and it will now be done in-house. What used to be decided by a government-licensed (but at least putatively private sector) analyst who got paid by the issuer/rate-ee will now be performed by an army of unbiased, tax subsidized public servants exercising all the dispassionate analytical rigor demanded by their post.

Never mind that a functional private ratings agency model exists, as anyone familiar with Egan Jones can attest--one in which those seeking the best opinions on the buy side are the ones picking up the tab. Never mind, it was the captured bank cops in the first place that approved and promoted the S&P/Moody model to provide flimsy cover for moral hazard and a license to securitize anything and everything down to discarded offtrack betting receipts.

The saddest part: this is but one of dozens, if not hundreds, of similar economy-wrecking changes coming down the pike. The progressives' ultimate dream is finally coming true, and all it took was a bamboozled public whose 401K's halved in four months to get bought off with two years of unemployment insurance and various promises of debt forgiveness. The Jubilee this ain't.

Full text of the release follows, with a link to the full Notice at the bottom.

Joint Press Release

Board of Governors of the Federal Reserve System

Federal Deposit Insurance Corporation

Office of the Comptroller of the Currency

Office of Thrift Supervision

For immediate release August 10, 2010

Agencies Issue Advance Notice of Proposed Rulemaking Regarding Alternatives to the Use of Credit Ratings

The federal banking agencies (agencies) today have agreed to publish an advance notice of proposed rulemaking (advance notice) regarding alternatives to the use of credit ratings in their risk-based capital rules (capital rules) for banking organizations. The advance notice is issued in response to section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Act), enacted on July 21, 2010, which requires the agencies to review regulations that (1) require an assessment of the credit-worthiness of a security or money market instrument and (2) contain references to or requirements regarding credit ratings. In addition, the agencies are required to remove such references and requirements and substitute in their place uniform standards of credit-worthiness, where feasible.

Through this advance notice, the agencies are seeking to gather information as they begin to develop alternatives to the use of credit ratings in their capital rules. This advance notice describes the areas in these capital rules where the agencies rely on credit ratings, as well as the Basel Committee on Banking Supervision's recent amendments to the Basel Accord. The advance notice solicits comment on alternative standards of creditworthiness that could be used in lieu of credit ratings. It requests comment on a set of criteria the agencies believe are important in evaluating creditworthiness standards, including risk sensitivity, transparency, consistency, and simplicity. It asks for comment on a range of potential approaches, including basing capital requirements on more granular [read: up everyone's arse] supervisory risk weights or on market-based metrics, as well as on how these approaches might apply to different exposure categories. It also seeks comment on the feasibility of and burden associated with alternative methods of measuring creditworthiness for banking organizations of varying size and complexity.

The advance notice addresses only the references to credit ratings in the agencies' capital rules. It is expected that proposals for removing references to credit ratings in other parts of their regulations will follow separately.

The advance notice, issued by the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation, solicits comment for 60 days after publication in the Federal Register, which is expected shortly. The Office of Thrift Supervision plans to join the other federal banking agencies in issuing this advance notice pending clearance by the Office of Management and Budget.

Media Contacts:

Federal Reserve Board Barbara Hagenbaugh 202-452-2955

FDIC David Barr 202-898-6992

OCC Dean DeBuck 202-874-5770

OTS William Ruberry 202-906-6677

Attachment (73 KB PDF)

Fed Blinks; Will Resume Money Printing - Follow up

This is posted pursuant to the comment thread at EPJ Central, for Fed Blinks; Will Resume Money Printing. Robert Wenzel commented to me as follows:

@BobEnglish

It's true that the amount of money the Fed will pump in via this method is likely not terribly sizable, but the actual amount is unknowable. It depends on how many of those 30 year and 15 year mortgages experience pre-pays. Plus, although they are identified as 30 year and 15 year product that would be the maturity at issue, not currently.

It is likely they mostly contain mortgages between 2000 and, say, 2007, so there is probaly some time (but not 15 or 30 years) before big waves hit, but given the current low level in rates, you would think any good paper is being refinanced, if terms allow that to be done.

August 9, 2010 10:33 AM

@RW:

Well, I did some digging and found that the talk is focusing on prepayments and redemptions--not the scheduled coupon payments that I was talking about. It's possible the Fed will reinvest all three, but now it's becoming clear what's going on.

Look at the below (click through for larger image):

This was created by parsing the Detail worksheet of the Fed's MBS Excel file. It's evident that the bulk of maturities are between 2039 and mid-2040--meaning the bulk of the mortgages the Fed bought were issued from 2009 through mid-2010--not a terribly prosperous period in the last decade.

Those borrowers in the pools the Fed bought who qualify at the currently lower rates will very likely refinance, but my guess is the Fed bought some pretty bad paper. Prepayments won't be as big a factor as actual redemptions when Freddie/Fannie pay the Fed for defaulted securities (through its now unlimited line of credit to the Treasury). This may also include any shortfalls created through loan-mods that are rumored to be coming.

Got that? Homeowners default on mortgages that the Fed bought through MBS securities. Fannie/Feddie pay the Fed for the defaulted MBS securities by borrowing from the Treasury. Fed uses proceeds to buy more Treasurys in an amount to offset the Fannie/Feddie borrowings. Reserve neutral--the FedWire circle (jerk) is complete.

Is the Fed sharpening its tightening tools in case it massively over-eases?

Just a thought, as the Fed announced two more tests of the tri-party reverse repo system this morning that sucked up $225 million in Agency MBS and $180 million in Treasurys. The amounts are peanuts, but the timing is interesting as tomorrow is FOMC day.

http://www.newyorkfed.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE

Now Goldman Sachs Clueless as to Effects of Fed Policy

As discussed recently here and on EPJ Central, mainstream economists--even those anointed by the heavens--just don't have a handle on the enormous implications of Fed policy. Goldman Sachs' Jan Hatzius writes as follows:

Chairman Bernanke also outlined three possible tools for further easing: (1) to strengthen the commitment to keep short-term rates "exceptionally low for an extended period;" (2) to cut the interest rate on excess reserves (IOER) from its current 25-basis-point level; and (3) to resume asset purchases. He also said that the FOMC would review all of its options, including the possibility of reinvesting MBS prepayments and redemptions. Currently, these proceeds are not being reinvested, with the result that the Fed's balance sheet is set to shrink slowly over time. This amounts to a slight tightening bias in the current policy stance, albeit one that may not have much effect given the enormous volume of excess reserves in the system. With the IOER already close to zero, we see little to be gained from cutting it further, other than to signal a switch in policy orientation. The incentive for banks to make new loans would increase only marginally, while money market funds would have a tougher time eking out positive returns as yields on other short-term assets moved even closer to zero. Besides, the FOMC could send the same signal by taking up the MBS reinvestment option. Although it is a close call, we now expect this to occur at next week's meeting.

To his credit, we are in agreement with many of Hatzius' assessments, including the fact that MBS cash flows into the Fed have a slight policy-tightening bias, as we discussed the other day. However, there are several hidden and incorrect assumptions in the statement, "IOER is already close to zero". "Zero" is largely unimportant as both an absolute level and from the perspective of what is relevant to measure IOER against. As interest rates are manipulated by the Fed, we do not know what real interest rates are (that is, interest rates absent government intervention that reflect actual time preference and inflation expectations). Similar to temperature (on a non-Kelvin scale), the zero level is more important as a psychological boundary, and not the all-important inflection point it is made out to be. [And, there is really no reason why IOER could not be negative--thus no downside limit. In the topsy turvy world of quantitative easing, we have already surpassed the level once considered undoable.]

What is relevant is the spread of IOER to other short term rates on the lower end of the yield curve--namely, (1) the Federal Funds rate paid on uncollateralized overnight loans between banks and other large financial institutions and (2) short term Treasury Bill rates. As of Friday, August 5, the Fed Funds rate was 0.19%, and the 1, 3 and 6 month T-Bills were yielding between 0.15% and 0.19%. Even 1 to 2 month investment grade commercial paper has been yielding less than the IOER.

This means that banks can leave their excess money at the Fed and get paid 0.25% every night, as opposed to lending to another bank at the lower rate of 0.19% or locking the money up in Bills or commercial paper for a month or more. [It's also important to know that the reason the Fed Funds rate, which is uncollateralized, is less than the IOER is largely because the biggest lenders are Fannie and Freddie, both ineligible to park their money at the Fed because they are not banks.]

Accordingly, were the Fed to lower the IOER to say 0.10%, several investment options would immediately become more attractive to banks and a material amount would likely leave the custody of the Fed. How much and in which directions cannot be known, but the implications should not be ignored simply because the spread is seemingly small. We're talking over $1 trillion of leveragable cash held by banks. They might not loan it to businesses and consumers, as Hatzius concurs, but never underestimate the influence of vast amounts of digital zeroes suddenly searching for a new home.

The danger is that, because a change in Fed policy with respect to the interest on excess reserves is incorrectly being discounted as relatively innocuous, it has tremendous power to inflict unforeseen effects on the economy. Leave it to Ben and his sandbox of tools? No thanks.

Via ZeroHedge

Can the Fed Inflate the Money Supply at Will? My 2 Cents....

See here for the Mish/Ciovacco "debate" and RW's comments. The following is to explain the actual mechanics of what will likely happen in the near future.

James Bullard of the St. Louis Fed recently proposed via a research paper that the Fed resume quantitative easing. However, the FOMC is expected to announce next Tuesday that the Fed will merely reinvest its MBS cash flows in Treasurys. This is considered reserve-neutral (though most certainly not impact neutral).

The NY Fed's System Open Market Account, or the world's largest hedge fund as I like to call it, has $1.1 trillion in MBS outstanding. For simplicity, we'll ignore prepayments and say the average coupon is 5%. Therefore, $55 billion per year is being transferred out of the economy (and into the Fed) from people paying down their mortgages. M2 money supply as of July 26 is 8.556 trillion, so M2 is being deflated by 0.65% annually just as a result of this phenomenon, which is material when M2 growth has been anemic at under 2.5% for all of 2010.

The Federal Reserve Act allows the Fed to exchange maturing securities (Treasurys/Agencies/MBS) with the issuer (Treasury/Fannie/Freddie). However, it would be a violation to simply use MBS cash flows to purchase directly from the Treasury. Accordingly, the NY Fed will buy already issued T-Bills, Notes and Bonds from the 18 primary dealers through what are called permanent open market operations (POMO). This is where the NY Fed intentionally buys above market prices for securities to entice dealers to sell (or vice versa for POMO sales that soak up reserves).

While a dealer might acquire inventory from other institutions or the public for the specific purpose of selling to the Fed, most of the securities the Fed buys will be from the dealers' unhedged portfolios they acquired directly from the Treasury at auction. This means most of the $55 billion that was transferred by the public to the Fed will be transferred by the Fed to the dealers, who may then deploy it as they wish. This money may or may not enter the economy, as it could simply lay fallow as excess reserves at the Fed. Or, it could be funneled into proprietary trade positions, such as equities (as we saw in the second and third quarters of 2009), derivatives, precious metals, or more Treasurys.

Seldom is either deflation or inflation omnipresent in an economy. Despite the ongoing consumer and bank deleveraging, large amounts of free money will always look for a market in which to bid up prices. Will $55 billion a year be enough to inflate a particular market or sector of the economy? Maybe, maybe not. However, it is inevitable that at some point in the future we will return to crisis mode to an extent that will goad policymakers into demanding a much larger amount of printing. As there is no end in sight to mammoth deficit spending, that time will not be the last either. Accordingly, the risk of money printing overshoot with resulting across-the-board inflation is real and should not be ignored.

Did Top Bank Officials Just Admit the Fed Will Backstop All Munis?

Each quarter, representatives from the banking elite primary dealers meet with top Treasury officials to advise an optimal debt issuance strategy. The Minutes of these Treasury Borrowing Advisory Committee meetings and formal Report to the Treasury are a window into their perceptions and insider knowledge, yet they seldom receive notice--even outside the mainstream financial news outlets. Surprising, because there are often a few hidden gems, and today's release is no exception as we learn that it is now the PDs' foregone conclusion that the Fed will backstop the entire municipal bond market. Indeed, the Report offers a statement not covered in the more lengthy Minutes:

Implicit in this analysis is the Federal government's willingness to intervene in the event the municipal market ceases to function.

Also present is the typical cluelessness regarding the Fed's "accomodative" stance, covered at length here at EPJ:

The Fed has limited tools to employ should growth disappoint or inflation expectations fall precipitously.

At least they can recognize a wounded duck economy when they see it, unlike Bernanke:

[Deputy Assistant Secretary] Rutherford also suggested that the risks to the recovery have risen since the committee last met in May.

Below are the full Minutes followed by the Report. Highlights and bracketed comments were added by the author, who apologizes for the sparse annotations, which are all time allows.

http://www.treas.gov/press/releases/tg801.htm

To view or print the PDF content on this page, download the free Adobe® Acrobat® Reader®.

August 4, 2010
tg801

Minutes of the Meeting of the Treasury Borrowing Advisory Committee

Minutes of the Meeting of the Treasury Borrowing Advisory Committee

Of the Securities Industry and Financial Markets Association

August 3, 2010

The Committee convened in closed session at the Sofitel Hotel at 10:03 a.m. All Committee members were present. Assistant Secretary for Financial Markets Mary Miller, Deputy Assistant Secretary (DAS) for Federal Finance Matthew Rutherford and Director of the Office of Debt Management Colin Kim welcomed the Committee. Other members of Treasury staff included Fred Pietrangeli, Nathan Struemph, Alfred Johnson, and Veena Ramaswamy. Federal Reserve Bank of New York members Richard Dzina and Fabiola Ravazzolo were also present. The Chairman of the Committee introduced one new member, Ruth Porat.

DAS Rutherford opened the discussion with a presentation to the Committee that highlighted current fiscal conditions and financing needs. The presentation began with a review of the near term budget outlook and projections for the upcoming year. DAS Rutherford noted that the economy continues to grow at a moderate pace, with economic activity expanding at a 2.4 percent annualized pace in the second quarter.

He also stated that tax receipts continued to gradually improve, led by robust increases in the corporate figures. There was a brief discussion about the evolution of tax receipts following recessions. DAS Rutherford indicated that the recovery of the receipt base following the trough in GDP in the current recession was similar to previous downturns. However, he underscored that the economy contracted much more sharply in the current recession, leading to a lower base level of receipts. He noted that the Administration is expecting receipts to total 14.7 percent of GDP in FY 2010, below the 50-year average of approximately 18 percent.

DAS Rutherford explained that the Administration had recently released the mid-session review of the President's budget. The budget deficit for FY 2010 was revised down to $1.471 trillion, although the FY 2011 deficit was revised up to $1.416 trillion. Rutherford noted that primary dealer economists anticipate a smaller budget deficit for FY 2010 than the figures given by the Administration in July. The average deficit forecast from the primary dealers for FY 2010 is $1.351 trillion, $120 billion below OMB's forecast.

DAS Rutherford also suggested that the risks to the recovery have risen since the committee last met in May. As a result, Rutherford indicated that debt managers must remain extremely flexible to respond to changes in borrowing needs. He noted that there was still scope to continue to reduce auction sizes further, but that the reductions would likely occur at a more gradual pace. DAS Rutherford indicated that once these cuts are complete, Treasury will likely hold auction sizes constant for a period of time to assess the fiscal outlook.

Rutherford then discussed auction dynamics. Coverage ratios remain extremely high for bill, note, bond, and TIPS auctions. DAS Rutherford also highlighted that domestic funds have increasingly become more active in the Treasury market. There was a brief discussion on bank purchases of Treasuries. It was noted that banks have more than doubled their holdings of Treasuries in the past 2 years. This was largely attributed to weak loan demand, as well as potential changes surrounding liquidity requirements in upcoming bank regulation. Rutherford also noted that increased demand for duration has lead to an increase in STRIPS outstanding.

Director Kim then turned to the current state of the Treasury portfolio. Overall, the bills as a share of the total outstanding portfolio continue to fall. He noted that bills (including SFP) currently make up 22 percent of the portfolio, compared to the pre-crisis average of around 24 percent. The decline reflects the transition to coupon financing, as nominal coupons' share has risen to 71 percent. Treasury inflation-linked securities (TIPS) currently comprise 7 percent of the portfolio and issuance in this program will continue to steadily increase over the next year. For calendar year 2010, Treasury expects to issue between $80 and $85 billion in TIPS. Issuance will gradually increase again in 2011 as Treasury expects to increase the frequency of auctions.

Kim noted that the average maturity of the portfolio continues to lengthen. The average maturity of the debt currently stands at 58 months, directly in line with the average observed since 1980. Going forward, Kim indicated that the average maturity of the debt will gradually extend further, largely due to the fact that Treasury continues to hold monthly coupon auctions across the entire yield curve. However, he noted that any further extension will likely occur at a slower pace than what has been observed over the past year. Ultimately, he underscored that Treasury must retain its flexibility in order to respond to a range of financing scenarios.

Rutherford then briefly concluded with a few comments on the longer-term fiscal challenges facing Treasury. There was a discussion about the changes made to the President's 2011 budget in the mid-session review. One member asked about the macro growth assumptions underlying the Administration's forecast. Rutherford indicated that the real GDP growth assumption was approximately 4 percent over the next several years. Another member asked about assumptions regarding the extension of the 2001 tax cuts. Rutherford explained that the Administration used an assumption of eliminating tax cuts for those earners with income over $250,000, and that such an assumption added $37 billion per year to revenue. Additionally, he indicated that the bipartisan fiscal commission is currently working to identify policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run. Rutherford noted that the Administration and Congress await their recommendations, which are due at the end of the year.

The committee then discussed projected auction sizes for nominal coupon securities going forward. It was noted that given constant levels of coupon issuance, Treasury has cut a cumulative $232 billion of annualized borrowing capacity when compared to April levels.

One member began by noting that given projected financing needs and uncertainty around the economy, the Treasury would probably need to stabilize coupon issuance by January 2011. The member noted that nominal coupon issue sizes peaked in early 2010 and held steady from February through April 2010. Further marginal issue-size reductions in nominal coupons could probably continue for the remainder of the calendar year, according to this member. Such a plan would still provide Treasury with capacity and flexibility to address unexpected financing needs, and also extend the average maturity of outstanding debt further.

A lively debate followed. [LOL]

A member stated that given the fiscal and economic uncertainty going forward, it may be prudent to pause after some further gradual issuance-size reductions. The member stated that Treasury should consider making small reductions in 10-year notes and 30-year bonds. Other members agreed with the idea that 10-year notes and 30-year bonds should be cut slightly, with one member stating that the 10-to 30-year spread has widened [Yes--to record levels (113bps)] and that there is a perception by some market participants that Treasury wants to extend its duration even though term premia appears to be elevated by some metrics.

Other members challenged this notion, suggesting that small marginal cuts in 10-year notes and 30-year bonds might not be considered to have a substantive purpose and that there was nothing to be gained from doing such cuts at this point. One member stated that given the long-run fiscal forecast, uncertainty about extension of the 2001 tax cuts, and absent any sort of credible fiscal plan for reducing government borrowing, cutting 10-year notes and 30-year bonds would be imprudent.

Ultimately, the Committee thought it was important for Treasury to maintain the flexibility to cut across the curve in the future. There was general consensus around the idea of pausing issue size reductions at some point in the future until more clarity forms around the economic and fiscal outlook.

A brief discussion followed regarding the optimal size of the T-bill market. One member stated that once bills as a percentage of the overall portfolio drops below 20 percent, dislocations and poor liquidity become more problematic in the bill market. Another member stated that if the Fed starts to reinvest cash flows from their MBS portfolio in the front end of the curve, shortages in the bill markets may be further exacerbated. Another member commented that bill issuance should be skewed more toward the short end of the bill curve to accommodate the demand from 2a-7 money market funds which are under new WAM constraints; many investment vehicles that money funds used to invest in are in shorter supply, including ABS paper and SIVs.

The committee next turned to the question in the charge concerning state and municipal debt markets and the ability of municipal issuers to access the capital markets. The committee focused its response on current market dynamics, including overall financing costs and strategies, as well as implications for the Treasury market and fixed income markets more broadly.

The presenting member began by describing general municipal market conditions, noting that the municipal bond market has grown dramatically over the past few decades, totaling $2.8 trillion at the end of 2009. The member noted that the municipal bond market has a higher average credit rating than the corporate bond market, which can be attributed to municipal taxing authority, low historical default rates and conservative debt profiles. Seventy percent of municipal bond holders are retail or retail equivalent buyers, including households, mutual funds, ETFs and money market mutual funds. Life insurers are large purchasers of taxable Build America Bonds (BABs), owning over 50 percent of many BABs deals.

The presenting member then went into a discussion on the municipal credit default swap (CDS) market, noting that the market is small and relatively illiquid. The market has only a handful of actively traded issuers, including the States of California, Illinois, New Jersey, Florida and Texas. As of the end of July, only 6 out of the top 1,000 CDS reference entities were state or local governments, and only $105 million of single-name municipal CDS was traded during the last week of July. In comparison, $144 billion of CDS was traded for the top 1,000 reference entities.

The member then discussed the MCDX index, which is an index containing 50 equally weighted state and local government and revenue issuers. The MCDX has approximately $3.8 billion of net notional outstanding, significantly below the $300 billion for the investment grade corporate index. The member noted that the MCDX is a poor indicator of perceived risk in the municipal market given that the index is subject to inconsistent market making and unpredictable investor participation.

The presenting member then went into a discussion of current cash market conditions and concerns going forward. It was noted that the largest municipal issuers have had continuous access to the market. This is evidenced by municipal issuance, which is at $232 billion year-to-date, a 13 percent increase from 2009. In absolute terms, municipal rates are at multi-decade lows. However, municipal bond yields remain elevated relative to Treasury yields. The yield on the Bond Buyer 11 index is currently 110 percent of Treasuries compared to a long-term average of 86 percent.

The member then discussed overall municipal market structure changes, highlighting the BABs program, which was introduced in 2009. Under the BABs program there has been $120 billion of taxable bond new issuance. The dramatic decline in municipal bond insurance was also highlighted. Five years ago, 50 percent of issuance was insured, compared to below 10 percent today. The member noted that the use of bond insurance is unlikely to return to previous highs given increased investor focus on the underlying credit quality of issuers as well as the health of the bond insurers.

The importance of the short-term market was also highlighted. Short-term offerings are generally used by issuers to smooth cash flow timing mismatches. They are used more frequently during recessionary times when budget deficits increase.

The presenting member then went into a discussion of current municipal market investor concerns. State budget imbalances are among the top concerns for investors. Although most states have balanced budget requirements, budget solutions are often one-time in nature and credible revenue and expense solutions are not evident for the largest general-obligation issuers. In addition, liquidity access and management was highlighted as a concern given roll-over risk for letters of credit for the variable rate market. Approximately $200 billion of letters of credit are maturating in 2010 and 2011, of which $30 billion may be difficult to renew. The result will likely be more restrictive terms, higher costs and less availability for lower-rated issuers.

The member then discussed the major risks to municipal issuers, which fall into two categories: market access and new issue pricing. In terms of market access, the member noted while a state GO default seems unlikely, if it were to occur, it would result in significant dislocation in the new issuance market. However, this risk is mitigated by a number of factors, including: state taxing authority, low debt/GDP ratios, low debt servicing costs, high debt payment priority, expense reductions, alternate sources of funding (asset sales, revenue stream securitizations), as well as rainy day reserve funds.

With respect to new issue pricing, the member suggested that municipal issuers would likely face higher financing costs if the BABs program is not extended. Other concerns included worsening credit quality of issuers and regulatory reform, which could affect banks providing letters of credit for variable rate issues.

The member concluded that in the near term the likelihood of a major default is low. However, a long-term deterioration in credit fundamentals is possible and funding costs are likely to increase.

The members then discussed the dramatic increase in municipal bond issuance over the last few decades. One member wondered how GDP growth over this time period had been affected [lower, you think?] by the sharp increase in municipal debt, where proceeds are typically used to finance state and local infrastructure projects.

The committee then turned to the third question in the charge concerning the drivers of demand for long duration fixed-income assets and the corresponding implications it may have on the gradual extension of the average maturity of Treasury's debt portfolio.

The presenting member began by noting that in contrast to the recent strong price performance in many financial assets, economic fundamentals have continued to weaken. Real GDP for Q2 came in lower than expected at 2.4 percent annualized pace. Both market consensus and the FOMC's Central Tendency Forecast for real GDP and inflation have declined. The subdued economic outlook and decline in inflation expectations have pushed out expectations for policy rate increases and driven yields lower across the curve.

The presenting member next discussed how changes in the mortgage market were affecting fixed income markets more broadly. The member underscored that the Federal Reserve holds 27 percent of 30-year agency MBS, which has altered the traditional hedging activity observed by mortgage investors. [Big effect on Treas mkt] He also noted that capacity constraints are continuing to weigh on refinancing activities. It was concluded that agency MBS supply is likely to remain low for some period of time.

The member noted that one sector where supply is picking up is agency callable debt. At current rate levels, there is the potential that over $50 billion of outstanding agency debt will be called over the next two months [based on which obsolete duration model?], which would boost gross issuance and agency supply.

However, it was reiterated that Treasury still remains the dominant issuer in fixed income markets. Even if budget deficits decline in the next few years, Treasury will remain the major source of net supply in fixed-income markets.

The presenting member then discussed sources of demand in fixed income markets. It was noted that banks have been a strong source of demand for Treasuries over the past year. Corporate pensions continue to be a net buyer of fixed income despite low yield levels. Mutual Funds and ETFs have also seen significant inflows into fixed-income products throughout the crisis. It was noted that initially this was supportive of government issuance, but more recently, the low absolute level of yields has led some investors to pursue higher-yielding strategies.

The presenting member finished by noting that long-end demand continues to exceed supply. Treasury auctions continue to exhibit strong coverage ratios, and as a result, the member recommended that Treasury continue to lengthen the average maturity of outstanding debt.

The meeting adjourned at 11:45 AM.

The Committee reconvened at the Department of the Treasury at 5:35 p.m. All of the Committee members were present. The Chairman presented the Committee report to Secretary Geithner.

A brief discussion followed the Chairman's presentation but did not raise significant questions regarding the report's content.

The Committee then reviewed the financing for the remainder of the July through September quarter and the October through December quarter (see attached).

The meeting adjourned at 6:15 p.m.

_________________________________

Matthew Rutherford

Deputy Assistant Secretary for Federal Finance

United States Department of the Treasury

August 3, 2010

Certified by:

___________________________________

Matthew E. Zames, Chairman

Treasury Borrowing Advisory Committee

Of The Securities Industry and Financial Markets Association

August 3, 2010

___________________________________

Ashok Varadhan, Vice Chairman

Treasury Borrowing Advisory Committee

Of The Securities Industry and Financial Markets Association

August 3, 2010

Treasury Borrowing Advisory Committee Quarterly Meeting

Committee Charge – August 3, 2010

Fiscal Outlook

Taking into consideration Treasury's short, intermediate, and long-term financing requirements, as well as uncertainties about the economy and revenue outlook for the next few quarters, what changes to Treasury's coupon auctions do you recommend at this time, if any?

Municipal Bond Market

We would like the Committee to provide an update on state and municipal debt markets and the ability of municipal issuers to access the capital markets. Please provide detail on current market dynamics, and whether overall financing costs and strategies have changed. How have these dynamics affected the Treasury market, and fixed income markets more broadly?

Demand for Long-Duration Assets

What are the forces that are underpinning demand for long-duration fixed-income assets? What factors should Treasury consider as the average maturity of outstanding debt continues to gradually extend?

Financing this Quarter

We would like the Committee's advice on the following:

• The composition of Treasury notes and bonds to refund approximately $33 billion of privately held notes maturing on August 15, 2010.
• The composition of Treasury marketable financing for the remainder of the July - September quarter, including cash management bills.
• The composition of Treasury marketable financing for the October - December quarter, including cash management bills.

TBAC Recommended Financing Tables: Q4

TBAC Recommended Financing Tables: Q1

______________________________________________________

http://www.treas.gov/press/releases/tg800.htm

August 4, 2010
tg800

Report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee of the Securities Industry and Financial Markets Association

August 3, 2010

Dear Mr. Secretary:

When the Committee met in early May, the economy was firmly transitioning to a self-sustaining expansion. Economic releases since then suggest that this progress has slowed. Business spending and private employment rose at a solid pace last quarter but momentum appears to have slowed into midyear. Similarly, the robust gains in retail spending recorded early this year has been tempered by recent weakness. Rising uncertainty about growth prospects and the direction of policy has also weighed on consumer confidence. In all, the expansion continues to move forward but at a more modest pace than had been anticipated three months ago. This loss of momentum heightens lingering concerns about the expansion's resiliency in the face of a significant fiscal tightening planned for the quarters ahead.

The US economy has just completed a year of economic expansion in which realGDP rose 3.2%. Importantly, all components of private demand – consumption, fixed investment and inventory accumulation – contributed to growth in the first two quarters of the year. However, their relative magnitudes remain imbalanced. The latest figures show strong gains in business spending and inventory accumulation this year. In addition, exports are rising at a double-digit pace. Consumer spending, by contrast, is sluggish. Despite solid income growth, consumption rose at a 1.8% annualized rate in the first half as the household saving rate moved up to 6.2%. This mix of strong business spending and sluggish personal outlays has concentrated much of the gain in output to goods producing industries. Services GDP has increased at a meager 0.5% pace during the first year of economic expansion.

The US manufacturing sector has benefited from the lift in domestic and foreign goods demand with output rising 8.3% over the past year. This year of boom has realigned depressed levels of manufacturing activity to final demand. With inventories now rising, output growth is poised to slow. The slide in the ISM manufacturing survey to 55.5 in July suggests moderation is underway. A downshift in manufacturing following a bounce is a regular feature of the early stages of US expansions. Generally, service sector activity tends to improve as the expansion matures and the manufacturing lift fades. With the downshift in production indicators providing less of a directional signal, demand and labor market indicators will shoulder the burden of highlighting the progress of this rotation and the underlying health of the expansion.

The continued shift by cash-rich firms away from a defensive posture is likely to provide further fuel for growth in the coming quarters. Adjusted corporate profits are estimated to have increased more than 35% over the past year, the most rapid rise in more than a quarter century. Although the lift to growth from a shift away from paring inventories management is largely spent, a recovery in capital spending and hours worked from depressed levels remains in its early stages. The tentative expansion now underway should receive additional support in the coming quarters as credit availability improves and global demand continues to rise. It is encouraging that last quarter produced the expansion's first material rise in private payrolls (1.6%, saar) although momentum on hiring appears to have slowed as the quarter came to an end.

Households are expected to remain cautious in the coming quarters as they continue to adjust their balance sheets to an environment of weak labor and housing markets. With saving rates drifting higher, rising labor income will be the key for bolstering confidence and sustaining modest consumption gains. The first half of this year provided encouraging news as labor compensation rose at a 2.7% pace. More disappointing has been the sharp drop in home sales with the end of tax incentives. Household credit quality appears to be improving but an overhang of existing homes in the foreclosure process looks likely to limit any lift in home prices.

In spite of a year of growth, resource utilization remains depressed and disinflationary pressures persist. Over the past year, the core CPI rose at less than 1%, the slowest pace since the early 1960s. With trends in hourly labor costs still moving lower, inflation will likely stay low for some time to come. Faced with high unemployment and very low inflation, the recent loss of growth momentum has raised concerns that the economy could slip into deflation. The Federal Reserve has responded by balancing its discussion of exit strategies with rhetoric that signals it would consider additional monetary stimulus if needed. The Federal Reserve looks likely to remain on hold for some time to come and asset sales will wait until levels of employment and inflation are consistent with a tightening in policy.

US monetary policy will need to maintain an extremely accommodative stance in part because fiscal policy is turning restrictive. The ARRA federal stimulus is already fading and state and local spending is likely to continue to contract at its current 1.5% pace. As the economy turns towards next year, ARRA federal transfers to states will end and a number of tax cuts will expire. Although accommodative monetary policy is expected to provide an important offset to this drag, policy rates are already close to zero. The Fed has limited tools to employ should growth disappoint or inflation expectations fall precipitously. [Is this a joke?]

Against this economic backdrop, the Committee's first charge was to examine what adjustments to debt issuance, if any, Treasury should make in consideration of its financing needs. In the near term, the Committee felt a continued reduction in nominal coupon issuance was appropriate. However, coupon issuance sizes will likely stabilize at or about the end of calendar year 2010. Given the uncertain economic and fiscal backdrop, the Committee felt that maintaining maximum flexibility was necessary.

The bulk of the reduction in coupon issuance should continue to be in the two-year, three-year, five-year and seven-year maturities. Although this is broadly consistent with the Committee's desire to increase the average maturity of the outstanding debt, some felt that given the meaningful progress thus far, reductions in ten-year notes and thirty-year bonds could be justified.

The Committee discussed both the relative and absolute size of the Treasury bill market. One member commented that bills should not drop below twenty percent of marketable Treasury debt outstanding. However, the Committee concluded that more work needed to be done to better understand the evolution of Treasury bill demand dynamics. Finally, the Committee felt that growing TIPS from roughly $80 billion gross issuance in fiscal year 2010, to over $100 billion in fiscal year 2011, was still appropriate.

The second charge was an examination of the current state of the municipal bond market. The member looked at municipal market dynamics, the ability of issuers to access the markets, risk factors, and the impact of municipals on fixed income markets more broadly.

The presentation (see attached) highlights that municipal bonds outstanding rose over the last decade by $1 trillion to $2.8 trillion. Despite some of the recent headline risks and the challenging economic outlook, the member concluded the municipal market appears to be in reasonably good condition. Broadly, municipalities still have a low probability of default, historically high recoveries, low absolute cost of funds, access to a broader investor base via the Build America Bonds program, and a largely unlevered existing retail investor base. Implicit in this analysis is the Federal government's willingness to intervene in the event the municipal market ceases to function. [No discussion of this in the Minutes--where did this come from? Got that--it is presumed that the Feds will backstop the entire muni market]

The third charge was to examine the demand for long duration fixed income assets amidst the backdrop of a gradual increase in the average maturity of debt outstanding. The member focused on the impact of the Federal Reserve's asset purchase program. In particular, the presentation (see attached) highlights the absence of mortgage hedging needs as a stabilizing force underpinning long term yields. In addition, the member referenced the secular increase in demand for long duration assets from asset managers, insurance companies, and pension funds. Furthermore, cyclically, the member showed that investor confidence in the path of central bank policy rates tends to anchor long term yields.

In the final charge, the Committee considered the composition of marketable financing for the remainder of the July-September quarter and the October-December quarter. The Committee's recommendations are attached.

Respectfully,

Matthew E. Zames

Chairman

Ashok Varadhan

Vice Chairman