Will the Fed Bail Us Out? (Make Money Anyway.)

Posted under Economics, Inflation, Investing Strategies, Recession by Darren Hom

Will the Federal Reserve bail us out of this mortgage mess? Jim Bradley doesn’t think so. He says they cannot do this without destroying the dollar. The only alternative to hyperinflation is to allow a recession to occur.

Fallacy 5 - The Fed can (or will or must) “bail us out”.

Not true. The Fed has diminished their ability to “inflate” because they operate on a base of roughly 900 billion in base money - and that’s after nearly 100 years in operation (and 95% drop in the value of the dollar despite major growth). There is no practical way to monetize a trillion-dollar mortgage-banking accident into cash without completely destroying the currency, ruining the market for U.S. treasuries, and effectively shutting down the Federal Reserve. The only option is to “borrow” our way out. Under current circumstances, to do so without price inflation will require extinguishing a multiple of that purchasing power in the private market to offset the public debt.

If investors sense hyperinflation, they will front-run the Fed even if the Fed isn’t yet inflating - which appears to be happening to some degree now. The Fed might need to go far into deflationary territory before a scared market is satisfied with the soundness of the dollar. Rather than analysts arguing for a persistent policy of excess monetary expansion, it is far more likely the Fed will oscillate policy from fast to slow, as then they have a more sustainable market for treasuries by pushing participants to extremes on in the market, effectively forcing a “bust” and creating demand for currency.

As I wrote before, I agree with Jim that the Fed is not inflating. Jim goes so far as to say that this stable-money policy is effectively deflationary: it was cause prices to go down. We’re already seeing price deflation in the housing market, which is most immediately tied to the credit crunch.

Is the Fed deflating now?

Most likely. Total credit is and will continue (without intervention) to fall strongly while the Fed holds base money expansion nearly flat. If those circumstances hold, policy is deflationary no matter what certain classes of prices do.

Ironically, if the Fed reverses soon enough, price deflation may not be evident across broad groups of goods that are now rising and the inflationists would appear right even though they are currently incorrect.

For now, the current credit contraction may be the worst since the great depression. The near collapse of U.S. housing is an effect that far outweighs the rise in oil prices (the banking system will probably register between 1 and 2 trillion in final losses, and probably 2-3 trillion in credit contraction over the next 3-5 years as old loans fail, cannot be refinanced, and only a fraction succeed). Already, defaulted loans are near 650 billion. Price deflation - should it occur - will be baked in when average goods (those that are not busted like housing or going up fast like oil) register price declines.

Only in the case where the losses are not taken (a bailout leaving a large part of the spending power in existence) AND the Fed complies by running looser money will that solidify the past monetary expansion and lead to future (very high) price inflation.

Jim’s post is detailed and worth reading in its entirety.

How to Make Money from the Mortgage Mess

Because our investment group’s background is in real estate and real estate backed loans, we’re not planning to buy put options on stocks or short commodities. Those markets are incredibly efficient, and predicting the future makes or breaks that kind of business.

We’ll make our profit when we buy, not when we sell. Bad loans have already begun to flood the market, and the price of the notes is declining more quickly than the price of the real estate securing the notes. This provides an opportunity for us to catch a spread by buying the notes, obtaining the properties, and selling the properties.

The keys for us will be to buy the loans at the right prices and to add value by selling the notes and properties at higher prices than banks normally can.

It’s the same reason that short sales are profitable. Investors pay banks more than the banks could recover by foreclosing themselves, and the investors utilize efficient systems to prepare and market the properties for quick sale.

Stay tuned as we continue to post updates on our investment strategies.