It's become popular in this community to bash the Fed's QE– and most recently, the story championed by some is that the Fed is "giving away taxpayer money" to the primary dealers with the mechanics of its open market purchases. This hysteria reached an embarrassing climax when the Chair chose to post a Daily Spec Website link to Zero Hedge's entirely wrong article on the subject entitled "Is QE2 a Stealthy $90 Billion Gifting Scheme to The Primary Dealers?"

I am not a fan of QE, however, the facts are quite different from the conspiracy theorists' allegation regarding the costs and mechanics.

Here is a link to today's open market operations.

An objective observer notes that the largest purchases were in securities that were between 2 and 5 basis points CHEAP on the curve. An objective observer further notes that there were no purchases in quite a few securities — and on balance, those securities were rich spots on the yield curve. Furthermore, anyone with a Cantor-Fitz broker screen can see that all of these securities trade with a 1 to 2/32 bid-ask spread.

My conclusion is that the open market desk today did a fairly good job at buying securities that represented relative value on the yield curve. And even if the NY Fed pays the offer side on its entire 600 Billion QE, that bid/ask spread totals about $187 million. That isn't chump change, but it is materially smaller than the savings which they can achieve by picking "cheap" points on the yield curve.

If the community wants to debate the philosophical and economic issues at stake, that seems productive. But I hope these facts will put to rest the baloney that the NY Fed has handed a $90 Billion gift to the dealer community — as Zero Hedge wrote — and which Mr. Rogan and the Chair gullibly accepted.

George Zachar writes:

It's been known all along that Goldman's branch at Liberty Street tends to buy the "cheap" parts of the targeted curve segment. It's childsplay for dealers knowing in advance the outlines of the NY Fed buyback program to accumulate the "right" securities, certain they'll face a forced buyer in the near future. The size of this "edge" is only known by the P/L clerks around the street.

Even if it's "only" a few hundred million dollars, it's becoming increasingly hard to view the current matrix of finance/govt interlocks as anything but a brazen conspiracy to loot a defenseless public.

Tim Melvin writes:

Of course there is NO chance the dealers bought those securities a couple of days ago and sold them "cheap on the curve" today. Such a thing would be unheard of on Wall Street. 

Rocky Humbert replies:

In the event that some members of the community have never run a treasury arbitrage book, I'll let you all in on the dirty little secret of how it works: (1) buy the stuff that's CHEAP. (2) short the stuff that's EXPENSIVE. (3) Pray that the repo-clerk doesn't screw you on the financing. (4) Wait for a real money (i.e. Pimco, Fidelity, OR THE NY FED) account to close the arbitrage. It's always nice as a broker dealer to avoid paying the bid/ask spread, however, if even LTCM (a non-broker-dealer) had stuck to this strategy, they'd still be in business.

Mr. Zachar seems "shocked - just shocked" that Goldman might buy the cheap part of the yield curve in the course of its market operations. But that is the job of a treasury trader — QE or no-QE. I'd also remind him that primary dealers are REQUIRED to provide a bid and offer to the NY Fed — whether or not they have inventory. I feel some sympathy for the hapless mid-curve trader who had to make an offer on $2 Billion of the 9%'s of 11/18 — since that issue is probably held by a bunch of widows and orphans, and the dealer would have been stuck paying a reverse rate for god-knows-how-long.

I am skeptic about the efficacy of QE — for a variety of macro-economic and feedback-loop reasons, but I refuse to stoop to unconvincing hyperbole such as "looting a defenseless public." Whatever happened to the ballyhoo deflation and the scientific method?

George Zachar recovers:

I traded on-the-run mortgage-backed securities at primary dealers for a decade…"shocked" is not exactly how I feel.

The "dirty little secret" of primary dealer flow trading is that front-running inflexible counter-parties is a central strategy. Not news.

One problem with QE2 is that the primary dealers have sympathetic decision-makers on the other side of the trade who are not trading their own capital, or even client capital that is accountable. The dealers are blissfully front-running the taxpayers of the US, with their own pals facilitating the trade.

As someone who owns high-end real estate in NYC, it is very much in my interest for the local swells to fleece the broad public, keeping a bid under my assets.

That doesn't alter the nature of what's happening to the nation's taxpayers. One man's clever arbitrage P/L is another's "looting the tax payer".

Vince Fulco writes:

On the eve of the GM deal and near the holiday season, a fine American like Rattner reminds us of all WE have to be thankful for w.r.t. the actions taken by the Bush and Obama admins. Reminds me of the recurring historical magazine cover which keeps popping into my head…anyone remember the line from National Lampoon in the 1970s, "Buy the magazine or we'll shoot this dog!"






Speak your mind

3 Comments so far

  1. Lazlo Minks on November 17, 2010 5:05 pm

    Perhaps I am gullible myself, but the argument for QE2 as I understand it is as follows:

    1) In the past 2 years we have fallen off the ~2% inflation trend of the past few decades
    2) The main point of QE is to get inflation back up to its 2% trend so as to lower real labor costs at the margin.
    3) What we have now is a phenomenon similar to a very high minimum wage because it is universally difficult to cut people’s salaries to match the drop in the inflation trend.

    Not everybody buys the sticky wage theory, not everybody buys that we have experienced disinflation, but it sounds sensible to me.

  2. Adam Kretschmann on November 17, 2010 10:30 pm

    I want to thank all of the recent contributors for the extended posts. In my view the “new” format is a welcome improvement. Perhaps you could bring back the book list as well? Regards, Adam

  3. Matthew on November 18, 2010 1:41 pm

    Outstanding thread (again) here on DS.

    Just the facts….from Mr. Joshua Rosner of E21


    “It has been three years since the crisis began, and Washington, from White House to Congress, has done everything possible to prevent recognition of losses from troubled assets being held at inflated values on bank balance sheets. The Fed, whose independence is necessary to its authority, has increasingly become a policy tool in bidding for many of these bad assets. Rather than supporting effectively functioning market pricing of assets, as a lender of last resort, the Fed has crowded out the market’s pricing mechanism by becoming a lender of first resort. This has resulted in losses to those private market participants who were most conservative in their risk management and gains to those who were least conservative. Even today, the Fed’s actions interfere with prudential risk pricing. Market participants would buy conforming conventional mortgage backed bonds at around a 6% yield, but the Fed’s actions, which have stimulated little new mortgage demand, create a subsidy to that rate.

    The kabuki theatre has all been intended to create confidence in a few large banks that are too saddled with bad assets to lend and too connected to campaign financing of Washington to be forced to restructure or allowed to fail. But what good is confidence if banks know they continue to hold troubled assets at inflated values? So, instead of investing in the real economy, as banks have historically been expected to do, they use each incremental dollar the Fed manufactures not for long term lending but for short term trading of the yield curve or ever inflating commodity, emerging market and equity bubbles. After, all, they have no way of knowing when they might need to apply those dollars against unrecognized losses.”



Resources & Links