Active Shooter Capitalism: U.S. Goes Postal on it Biggest Creditor
WHILE YOUR ATTENTION WAS DIRECTED ELSEWHERE: The U.S. is fast choking off two of China's major oil suppliers, Iran and Venezuela, and last Thursday, a Treasury and Commerce Department order effectively closed the American market to Huawei, the biggest Chinese cell phone manufacturer. That follows an announcement on May 14 by the US Trade Representative of a 25% tariff on a $300 billion basket of Chinese-made goods. Not surprisingly, China has started to dump $1.2 trillion in U.S. Treasuries it purchased in 2009-2013 that refloated the Federal Reserve emergency fund following the Wall Street meltdown. It is unlikely that China will be buying new U.S. debt securities to replace the hundreds of billions in 10-year Treasury Bills it owns that are now maturing and coming due.
The Fed now says that it will resume buying back Treasuries again, and will dump its portfolio of mortgage-backed securities to pay for it - but, where's the real money to reinflate a bankrupted U.S. banking system coming from this time?
During the third quarter of 2008, the American banking system and its credit markets had a near-death experience. While most of us remember the yellow mortgage foreclosure signs that followed, few Americans know that the crisis was set off by a run on U.S. Treasuries by panicked investment bankers.
In October, 2008, trading volume in the then four trillion dollar a day U.S. Treasuries Repo Market -- the primary short-term lending source for big New York investment banks -- dropped 60 percent from levels a month earlier. One academic journal later described the fear and pandamonium by bonds traders this way(1):
[The] Financial Crisis of 2007-2008 was a repo run in two directions. Lenders holding privately-produced collateral in the repo market, e.g., mortgage-backed securities, ran to get their money back while borrowers who had supplied Treasuries as collateral wanted their Treasury collateral back.
After several large investment banks went belly-up during the waning days of the Bush Administration, tens of billions of dollars in Repo trades failed, as other banks were either unwilling or unable to produce "zero risk" U.S. Treasury Bills promised as collateral. The NYT tells the story a few years ago this way:(3)
"Let’s recall. The collapse of investment banks Bear Stearns and Lehman Brothers in 2008 Before it failed, Bear Stearns depended on $50 billion in overnight repo loans that it used to finance the majority of its mortgage-linked securities. A week before it collapsed, Lehman had $200 billion in overnight repo loans. Rescuing Bear through the JPMorgan purchase involved an unprecedented Fed commitment to absorb up to $29 billion in losses. And the Lehman bankruptcy kicked off a $300 billion-single-week run on money market funds and widespread panic."
According to a report yesterday in Bloomberg: (2)
As soon as next year, analysts say the Fed will resume large-scale buying of debt securities -- this time just U.S. Treasuries -- in amounts that may ultimately exceed its crisis-era purchases. According to an estimate by Wells Fargo & Co., the central bank’s balance sheet will rise past its historic peak as it adds over $2 trillion to its Treasury debt holdings in the next decade.
What this Bloomberg article doesn't mention is that since January 2017, the Fed has already gone through half its reserve fund, which it politely refers to as "unwinding" its position in mortgage-backed securities. While the Repo Market was quiet and orderly for years, the bonds traders are going nuts again swapping assets, seeking "haircuts" (the margin between market value and the rate of return available in repo deals) while banks are again hunting the relative safety of Treasuries in the Repo market. It's happening again, only this time, China seems unlikely to bail out the Federal Reserve.
Few Americans seem to be aware that when the U.S. banking system flat-lined during the Third Quarter of 2009, the primary reason it recovered was an infusion of more than a trillion dollars into the Federal Reserve's rainy day fund. During the years of "recovery" that followed money was lent out at negative real interest rates to major American banks. The program was called Quantitative Easing, or "Q.E.", on the street. The source of that injection that literally saved the U.S. economy from collapse a decade ago was a $1.2 trillion purchase of U.S. debt by the Chinese central bank and large state-owned enterprises.
Now, much of that debt to China is coming due, much of it in the form of a colossal stack of 10-year denomination Treasury Bills that are presently coming to maturity. The primary purchaser was China. At the same time, we are placing a gun to the head of Venezuela and Iran, along with a global oil embargo, countries that supply 10 percent of China's crude oil needs. Russia, also the target of U.S. sanctions regime, provides another 16%.
What the Administration has done to prepare for the next financial crisis is essentially this: Financing costs on the mortgage on the house are now due, and the response of the homeowner is to drive downtown to threaten the lender with a loaded shotgun. On his way to the bank, he holds up the Citgo Gas Station on the corner. Welcome to the age of Active Shooter Capitalism.
(1) The Run on Repo and the Fed's Response - NBER (2017) www.nber.org/papers/w24866
(2) Bloomberg.com, "QE May be Over But the Fed's Debt Hoard is Set to Double", May 21, 2019, https://www.bloomberg.com/news/articles/2019-05-21/qe-may-be-over-but-th...
(3) NYT, "Time to Reduce Repo Run Risk", April 4, 2014, https://dealbook.nytimes.com/2014/04/04/time-to-reduce-repo-run-risk/