1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up. Bank profits have become very reliant on low short term funding. I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

Good government never depends upon laws, but upon the personal qualities of those who govern. The machinery of government is always subordinate to the will of those who administer that machinery. The most important element of government, therefore, is the method of choosing leaders.

In other words, we depend – to an extent we probably do not appreciate – upon honor. On aspects of individual character and the tendency of empowered agents to possess an internal motivation to act consistently with a certain set of values. We depend on the existence of leaders who will make clear commitments and then fulfill those obligations when the time comes, even at the cost of personal sacrifice.

Insofar as financial regulation is concerned, is our “method of choosing leaders” serving us well? Is it redeemable with reform?

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov’t would could happen – seeing that result all but solidified the ‘too big to fail’ mantra.

2. Second, they will be forced to raise rates – that’s right folks, 0% – 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road – perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed’s paid interest on excess reserves – the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.

Thoughts????

…and have a safe and enjoyable trip.