Wednesday, March 18, 2009

Bernanke Pulls Back His Curtain

Well, I don't even know where to begin.

The world was shocked today by the Fed's announcements.

Let's back up a step, however, and take a pulse of where we've come from. Moving into the month of September last year the Fed's balance sheet was just under $900 billion. This was the total accumulation over the entire 95 years of their existence.

Wait, let's back up one more step. What do I mean by their balance sheet? Up until September of last year the Fed had one tool to increase the size of their balance sheet. They would print money, then exchange that money with the government for treasury bonds. This allowed the government to allow new money to enter into the economy. So up until September of last year they had just under $900 billion in treasury bonds comprising their balance sheet.

**Side note**: (They started exchanging a portion of these bonds for mortgage securities earlier in the year, but this had very little effect on the money supply because banks could not lend new money on those treasury bonds)

Then, as you know, things changed. The Fed took swift action to try and ease the pain of the credit crisis. They started printing money and exchanging it with banks for toxic assets. It started with mortgage securities and has recently blossomed into essentially everything: auto loans, credit card loans, student loans, money market debt, and corporate debt.

Their balance sheet exploded in size from $900 billion to $2 trillion in about six weeks. The past few weeks there were rumors that the Fed's balance sheet was shrinking in size and it would continue to do so after their new programs were unwound.

Today the world realized what was happening was exactly the opposite. Bernanke announced he plans on:

-Purchasing an additional $750 billion in mortgage securities, bringing the new total up to $1.25 trillion
-Purchasing another $100 billion in Fannie and Freddie debt, bringing the total to $200 billion
-Purchasing $300 billion in long term treasuries

The treasuries were the news that rocked the market. As I have been saying over and over for the past few months this is their next target and $300 billion is only the beginning. Their new balance sheet total after these purchases have been made?

$3.8 Trillion

Remember, this is only the start. As the market continues to crumble, and the Obama administration increases the deficit spending by the hour, their balance sheet is going to mushroom in size.

This balance sheet growth is essentially a direct cash injection into the economy. However, that is only one side of the equation. You need to remember the magic of fractional reserve banking.

If the Fed takes $1.25 trillion of mortgage securities from the banks and replaces it with cash, the banks can then lend out 10 times the amount of cash they have on hand. If the banks choose to lend the money out for new loans, that $1.25 trillion will magically turn into $10.25 trillion.

Right now the banks are not lending because the losses continue to pour in, but as the Fed continues to give them cash for their assets it is like a fire hydrant waiting to explode.

The third and final part of the equation is the continuous cash that is building and building on the foreign countries balance sheets. If they become net sellers of dollars instead of massive buyers (and they will) then all that cash that is building is going to come flooding back onto our shores.

As all this pent up cash begins to emerge it will start to lose value, and it is going to look for a home. It is going to look for an asset class to store value. The four major asset classes this cash will look toward will be:

1. Stocks
2. Bonds
3. Real Estate
4. Commodities

Which asset class do you think the ocean of money will flow toward? The ultra rich around the world are making their bets today, waiting patiently for the money to flow toward the asset class they believe it will end up. Fortunes will be made for those that choose correctly, and it will be the greatest transfer of wealth in human history.

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