There's an intriguing conspiracy theory being spread around the financial blogosphere. It purports that the Federal Reserve has been taking unprecedented measures to ensure that U.S. Treasury security prices remain high. This action would go far beyond its well-publicized quantitative easing efforts of simply purchasing Treasuries. The theory is little more than that -- just a theory accepted by few in financial markets. But it's interesting to think about: is the Fed using puts as a monetary policy tool?

The Financial Times Alphaville blog has a few posts about the "literal Bernanke put" today. It would entail the Fed selling Treasury puts to investors. Tracy Alloway does a good job of explaining:

The basic idea here is that the Fed, by selling those puts, comforts a US Treasury market increasingly nervous about rising interest rates, the end of QE2, US debt dynamics or whatever. These are American-style put options conferring the right, but not the obligation, to sell a given quantity of the underlying asset at a certain price. So they act almost like portfolio insurance in this particular case.

A little more clarification may be helpful here for readers who still don't understand what a put does. It's a derivative that provides the buyer the ability to sell a specified security back to the put's seller at a specified price. For example, if I you sell me a put on Stock X with a $30 strike price for $5, and its price declines to $20, I can buy a share of Stock X for $20 and you must purchase it from me for $30 -- yielding me a $5 profit ($30-$20-$5). In the case we're concerned with here, an investor would buy a Treasury put from the Fed so that if the Treasury security's price declines, it can sell ("put") the security to the Fed at the higher strike price.

Why would the Fed want to do this? It sell puts would act as another way to keep interest rates low and Treasury prices high. This would work in a few ways. First, it would create a supply of (presumably cheap) puts for investors who have large Treasury portfolios, but worry about prices declining, due to the Fed exit or for other reasons. It's like insurance. Second, the derivatives market plays a role in signaling the prices for securities. If you could buy a put on a stock for very cheap, for example, then the market interprets that to mean that there's little chance that the stock price will decline to the put's strike price.

Could this really be happening? It doesn't appear to be impossible. Alphaville points out that put options for Treasuries are priced very low right now, which could just be a coincidence. There also appears to be some international precedent for central banks using options to conduct monetary policy. Finally, the Fed appears to have even suggested the possibility of doing this several years ago.

While sell puts might seem like a slick way for the Fed to keep investors from shying away from buying Treasuries, it has a pretty big downside. Let's say that, despite the Fed's best efforts, Treasury prices plummet. It would be left with a huge put exposure, which it would require the central bank to purchase a huge chunk of Treasuries at a price well above market value.

Such a scenario could cause massive losses for the Fed. Tyler Durden at ZeroHedge compares this tactic by the Fed to what AIG was doing with credit-default swaps prior to the financial crisis and its collapse, and sees a similar disaster looming:

Stunningly, today we learn that to keep long rates low, the Fed may have resorted to nothing short of the same suicidal trade that destroyed AIG FP and brought the entire system to its knees. Namely, Ben Bernanke is now quite possibly the second coming of Joe Cassano, since in order to keep rates low, Bernanke is forced to a last resort action of selling billions upon billions of Treasury puts to "pin" rates low contrary to natural supply-demand mechanics. If so, the Fed is now basically AIG Financial Products, although instead of being synthetically long mortgages (and thus betting on a rate decline) and selling hundreds of billions in CDS to amplify its bet, Bernanke has done the same thing, only this time with Treasurys. Of course, Ben has the printing press on his side apologists will claim. Alas, that will have no impact whatsoever, if indeed the Fed has been reduced to finding ever fewer counterparties to a synthetic bet to keep long-term rates low, as very soon, with inflation ticking up, all hell may break loose in an identical replay of what happened to AIG once the Fed's put is called against it. Only this time there will be nobody to bail out the ultimate backstopper, resulting in the long overdue end of the current failed monetary system experiment. (his emphasis)

Whether or not this possibility should scare you depends on what sort of an outcome you find frightening. As Durden points out, as long as the Fed can print as much money as it likes, it can never really lose money -- it will just print more. So the Fed can't really fail, like AIG failed. The Fed pretty much defines too big to fail.

But as he also points out, if the Fed does lose the bet, it will become impotent in its attempts to keep long-term interest rates low and inflation tame. If the Treasuries hit the fan, the Fed would be forced to print more and more money to cover its losses and would not be able to execute its exit strategy effectively, as no one would buy Treasuries except at a very low price. Very high inflation would likely result. Of course, without the tool of effective monetary stimulus, the U.S. recovery would also face a new headwind.

Again, it's important to keep in mind that this is little more than a semi-plausible conspiracy theory at this time. There's no firm evidence that the Fed has taken this action. This would make for a great question for a journalist to ask Chairman Bernanke next week at the press conference following the monetary policy committee's monthly meeting. If the Treasury is selling put options on Treasuries, then asking Bernanke directly will make it tough for him to wiggle out of answering -- without providing an effective confirmation through a failure to categorically deny the theory.

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