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The Risks of Monetizing Debt - Part Two |
by John Jagerson
In order to fully understand why debt monetization in its present scale is risky I think it is important to consider some of the specific strategies being used by the Fed. The similarities between those activities and some of the causes of the last asset bubble are interesting. To see part one of this series, click here.
Learn more about what the Fed does through the articles and videos below:
- Understanding Quantitative Easing
- Is the Fed Really Running the Printing Presses?
- What is the Fed's Balance Sheet?
- What is the Fed and Why You Should Care
I would suggest that the Fed has essentially done three things through a variety of new and expanded programs.
1. Through the Primary Dealer Credit Facility (PDCF) and other measures the Fed is now able to loan directly to a larger pool of borrowers.
2. Through the Term Asset-Backed Securities Loan Facility (TALF) and other measures the Fed can accept new forms of collateral (like mortgage backed securities).
3. Through a number of other changes the Fed has extended the time frame on lending facilities.
These extraordinary measures are similar to the kinds of things happening during the housing bubble. Borrowers had to provide fewer and more flexible assets for collateral, terms were extended and requirements for eligible borrowers were relaxed.
These measures were all taken by the Fed to help ease the blocked credit markets. Theoretically they can be reversed (to a certain extent) once the credit markets start operating more "normally," however, things may not go as hoped. Through these measures and the Fed's large Treasuries purchases a debt bubble has been created.
In the case of the housing and mortgage market, these same strategies led to a bubble that popped and resulted in significant asset deflation. In this case, if the current Treasury debt bubble bursts, yields could rise dramatically because Treasury debt prices would fall.
Rising yields and accelerating inflation can be good for commodity investors but it is tough on a variety of other assets like stocks and bonds. Prudent investors should be diversified and thinking about the effect of these risks, should they materialize, on their portfolio.
It is important to understand that no one can tell the future. The Fed's plans may turn out great. No one knows yet what will happen for sure. There is clearly an erosion of confidence in the Fed happening but that alone doesn't guarantee a crash. The key is being prepared for either eventuality.
Next: How to Profit from Falling or Rising Home Prices
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