The Debts of the Spenders: The Bad Bank Idea Ignores the Bond Markets

The noise from commentators and other media pundits about the "Bad Bank" idea has been quite boisterous. However, the silence from this same crowd is deafening when it comes to mentioning the bond markets' influence.

It is simply impossible for any one government - even the US government - to sustain support for both a bad bank and lower interest rates. There is a fallacy among central bankers today. They believe they can set interest rates at all ends of the yield curve spectrum. That is just plain wrong.

Policy makers are slowly realizing that adding a bad bank in its "purest form" would result in the sudden transfer of loss from the private sector banks to the public balance sheet. This would result in a sudden shift from deflation into inflation. Potentially overnight. The reason has to do w/interest rates and the bond markets.

Governments wield immense power over short term lending rates (e.g. the well tracked "interest rate cuts" followed by market traders). However, this capability diminishes the further out the maturity on their notes. At this end of the spectrum, traders - not the government - wield the ability to set rates through their collective actions of buying and selling. Governments TRY to wield influence over the longer end of the curve by buying bonds either directly or through indirect means such as the primary credit dealer facility (see below).

This is all connected to ZIRP or zero interest rate policy. The US and Japan are already at ZIRP. The UK is headed there and so is the EU whether they want to or not (stubborn buggers).

BUT to keep interest rates down, they must issue LESS BONDS...not more. Hmmm. Since we know that's not going to happen, world govts will be buying their own bonds in an effort to keep rates down. (The more they "stimulate" the economy the greater the bond issuance has to be to pay for it).

It's the case of 1 arm buying from another in the same body (fed or equivalent quasi-govt body is buying its own national debt).

This gives the PERCEPTION of higher demand and lower supply. The Fed can get away w/this Ponzi scheme short term b/c it has more firepower than any other single bond buyer and will CRUSH any one bond short in the near term. The Fed is assisted in this activity by the primary credit dealers, or a cabal of chosen banks that get first dibs on cheap treasuries:

http://www.newyorkfed.org/markets/pdcf_faq.html

At strategic junctures, the Fed instructs the primary dealers to withold liquidity through the early return of repos. The earlier return of treasuries artificially lowers the supply and causes the yields to lower.

http://www.fms.treas.gov/tip/repo/repo-flow-chart-8-27-07.pdf

The system worked wonderfully last fall in stimulating a massive rally in treasuries.

Here we have Bernanke, saying one thing before Congress and then doing the exact opposite. He wasn't even trying to hide it at the time - the data is publicly available on the Fed and Treasury's web sites through the FOMC and capital flows data.

But then I realized that the ponzi scheme had to end. And that end would be when Obama came to office and pushed for "change".

Unless there is some actual REAL demand by other non-government bidders, central bankers risk becoming the only buyer left standing at the end of the day. The result? Rising interest rates. Of course, the more of their own debt the central bankers have bought. . . the higher the interest rates will be. Simply put, the chief market manipulator has undone itself through its own short sighted, market actions.

As deflation drags on and the West continues to bailout bad actors, completely innocent 3rd parties like China, Japan, Taiwan, Mid-East arabs, etc. that had nothing to do w/Level 3 accounting and other banking games will decide to save themselves instead of the US and Europe.

Just keep in mind that the more stimulus programs the West enacts, the more it will cost the foreign creditors. And they are getting very tired. Very fast.

So, in the end it really is about the taxpayer.

Or rather the PERCEPTION of the taxpayer being (un)able to repay the mountain of debt that governments have shifted onto their population. Remember, a bond is nothing more than an income stream of future promises to repay. And the West's ability to repay grows more doubtful with every bailout of bad actors and the resulting transfer of risk calls into question their ability to refinance current and future debt loads.