Money For Nothing?


…there is now a nagging fear that credibility in central bankers is being lost. Investors, it seems, are losing confidence in the Fed.

You think? I believe the definition of insanity is to keep doing the same thing over and over and expecting a different result. It seems to me the Fed has sidelined itself and the future path of the economy will be determined by markets, and it won’t all be good. As Stockman says (see second article below), the global economy in many respects is at peak debt, thus the global private and public sectors are both struggling to de-leverage. The only borrowers are national governments and those speculating in asset markets.

Thus, the Fed’s efforts to boost inflation to 2% have been for naught and merely goosed asset markets and resource misallocation. For the global economy to re-balance from peak debt requires debts to be written down, something that occurs with bankruptcy accompanied by price deflation. Forestalling instead of managing these corrections only means a larger correction at some point in the future.

On another note, our experience is confirming the weakness of Friedman’s monetarism. Inflation is not purely a monetary phenomenon – more important, it is a behavioral one based on demographics and the perceived level of uncertainty and risk regarding the future of the economy and policy distortions.

Markets reflect the collective intelligence of humans; they’re not all stupid.

Why Wall Street’s Stimulus Junkies Weren’t Thrilled by the Fed’s Rate Decision

By Anthony Mirhaydari
It wasn’t supposed to be like this.

In a massively hyped Federal Reserve policy announcement Thursday — one that threatened to end the nearly seven-year experiment with interest rates near 0 percent and usher in the first rate hike since 2006 — Chair Janet Yellen and her cohorts gave Wall Street exactly what they wanted: No change, in line with futures market odds.

And yet stocks drifted lower, even as the action in the currency and commodities market was as expected, with the dollar falling hard and gold up 0.8 percent. Why?

Cutting to the quick: Investors, it seems, are losing confidence in the Fed.

While the Wall Street stimulus junkies should’ve been happy with the continuation of the status quo, there is now a nagging fear that credibility in central bankers is being lost — something that RBS’ Head of Macro Credit Research Alberto Gallo took to Twitter this afternoon to reiterate.

Moreover, the Summary of Economic Projections by Fed officials revealed that, at the median, policymakers now only expect a single rate hike by the end of 2015. The futures market is now pricing in a 49 percent chance of a hike at the December meeting (although Yellen noted that the October meeting was “live” and could result in a hike should markets and economic data improve).

But the kicker — the one that pushed large-cap stocks lower into the closing bell — was the appearance of a negative interest rate projection by a Fed policymaker on the newly released “dot plot.” Someone, it seems, expects federal funds policy rate to be in negative territory at the end of 2016. Four officials don’t expect any hikes this year at all.

Not only does this undermine confidence in the state of the economy, but it calls into question the efficacy of the Fed’s ultra-easy monetary policy stance that has been in place, to varying degrees, since 2008. Moving forward, it will be critical for the bulls to recover from Thursday’s intra-day selloff. The day’s action resulted in a very negative “shooting star” technical pattern that signals buying exhaustion and often precedes pullbacks.

In their statement, Federal Open Market Committee members fingered recent global economic weakness and financial market turbulence as giving reason to believe that inflation would take longer to return to their 2 percent target. So the new dot plot shows the median rate projection for the end of 2015 falling to 0.375 percent from 0.625 percent as of June; to 1.375 percent for 2016 vs. 1.625 percent before; and 2.625 percent for 2017 from 2.875 percent. The long-term neutral rate declined to 3.5 percent from 3.75 percent, signifying ongoing structural problems in the economy holding down its potential growth rate.

But a tree should be judged by the fruit it produces. In this case, median household incomes are stagnating despite all the Fed has already done, including three bond-buying programs and the “Operation Twist” maturity extension program. With corporate profits rolling over and global growth stagnating, people are wondering: Is this all the Fed and its central banking counterparts can do? Fresh threats, such as another possible debt ceiling showdown on Capitol Hill this autumn and an election in Greece, are approaching.

As for what comes next, Societe Generale Chief U.S. Economist Aneta Markowska suggests a replay of the late 2013 experience surrounding the beginning of the end of the QE3 bond-buying program: “Our scenario is reminiscent of 2013 when the ‘taper tantrum’ spooked the Fed in September, a government shutdown spooked the Committee in October, and the fog finally lifted by December when the taper was finally announced.”

If the Fed left rates unchanged, there were some new wrinkles in its statement. In explaining their decision, Fed officials elevated issues like global economic growth and the dollar’s valuation seemingly above its traditional mandate regarding labor market health. J.P. Morgan Chief U.S. Economist Michael Feroli believes investors shouldn’t read too much into the new factors being cited. In a paraphrase of the infamous rant by former Arizona Cardinals coach Dennis Green: Yellen is a dove. She is who we thought she was. And until higher inflation becomes a clear and present problem, this continual moving of the goalposts for Fed rate hikes — deferring until more data comes in — looks set to continue.

But that may no longer be enough to keep stocks happy.



David Stockman is not a fan of the Fed. In fact he claims that the Fed is on a “jihad” against retirees and savers.

The former Reagan budget director and author of “The Great Deformation: The Corruption of Capitalism in America” visited Yahoo Finance ahead of the Fed announcement to discuss his predictions and the potential impact of today’s interest rate decision. “80 months of zero interest rates is downright crazy and it hasn’t helped the Main Street economy because we’re at peak debt,” he says.

Businesses in the U.S. are $12 trillion in debt. That’s $2 trillion more than before the crisis, but “all of it has gone into financial engineering—stock buybacks, mergers and acquisitions and so forth,” according to Stockman. “The jig is up; [the Fed] needs to get on with the business of allowing interest rates to find some normalized level.”

While Stockman believes that the Fed should absolutely raise rates today, he isn’t so sure that they will (Note: they did not). But even if they do, he says they’ll muddle the effect by saying “‘one and done’ or ‘we’re going to sit back and watch this thing unfold for the next two or three months.’”

This all fuels an inflationary bubble on Wall Street, according to Stockman. “This massive money printing we’ve had has never gotten out of the canyons of Wall Street. It’s sitting there as excess reserves.”

According to Stockman, the weakness of the U.S. economy has been due to a lack of investment over the past 15 years and inflated labor costs in America that can’t compete on a global scale. “Simply printing more money and keeping interest rates at zero do not help that problem.”

Zero interest policies, says Stockman, are leading to the global economic turmoil we are currently experiencing. “In the last 15 years China took its debt from $2 trillion to $28 trillion… it’s a house of cards with an enormous overcapacity and enormous speculation and gambling that is beginning to roll over,” he says. “It’s just the leading edge of a global deflation that I think is underway as a consequence of all this excess credit growth that we’ve had.”

If the Fed raises rates and doesn’t mince words there’s going to be a long-running market correction, says Stockman. If the Fed doesn’t raise rates there will be a short-term relief rally but eventually the markets will lose confidence in the central bank bubble and we’ll be in store for a “huge correction.”

The Warren Buffett Economy


This is an interesting series of posts from David Stockman’s blog. This is Part 4 of 6 – the others can be found here. Stockman gives a concise overview of recent history to explain how we arrived at the point we are today. The old saying that “the road to ruin is paved with good intentions” seems appropriate here.

The Warren Buffett Economy——Why Its Days Are Numbered (Part 4)

By David Stockman documented in Parts 1-3 (Part 1, Part 2, Part 3), the Fed has generated a $50 trillion financial bubble since Alan Greenspan took the helm in August 1987. After 27 years, honest price discovery has been destroyed, thereby reducing the nerve centers of capitalism—-the money and capital markets—-to little more than gambling casinos.

Accordingly, speculative rent-seeking in the financial arena has replaced enterprenurial innovation and supply side investment and productivity as the modus operandi of the US economy. This has resulted in a severe diminution of main street growth and a massive redistribution of windfall wealth to the tiny share of households which own most of the financial assets. Warren Buffett’s $73 billion net worth is the poster boy for this untoward state of affairs.

The massive and systematic falsification of asset prices which lies at the heart of this deformation of capitalism is a direct and unavoidable consequence of monetary central planning. That is, the pursuit of Keynesian business cycle management and stimulus through central bank interest rate pegging and massive monetization of existing public debt and other securities—-especially since the latter has no purpose other than to artificially goose the price of bonds and lower their yields; and also via other indirect  methods of financial asset levitation such as the Greenspan/Bernanke/Yellen doctrine of wealth effects and the implicit central bank “put” which underpins the economics of buy-the-dip speculators.

As previously indicated, the Keynesian bathtub model of a closed, volumetrically driven economy is a throwback to specious theories about the inherent business cycle instabilities of market capitalism that originated during the Great Depression. These theories were wrong then, but utterly irrelevant in today’s globally open and technologically dynamic post-industrial economy.

As reviewed in Part 3, the very idea that 12 people sitting on the FOMC can adroitly manipulate an economic ether called “aggregate demand” by means of falsifying market interest rates is a bad joke when in it comes to that part of “potential GDP” comprised of goods production capacity. In today’s world of open trade and massive excess industrial capacity, the Fed can do exactly nothing to cause the domestic steel industry’s capacity utilization rate to be 90% or 65%.

It all depends upon the marginal cost of labor, capital and materials in the vastly oversized global steel market. Indeed, the only thing that the denizens of the monetary politburo can do about capacity utilization in any domestic industry is to re-read Keynes’s 1930 essay in favor of homespun goods and weep!

As I detailed in the Great Deformation, the Great Thinker actually came out for stringent protectionism and economic autarky six years before he published the General  Theory and for good and logical reasons that his contemporary followers choose to completely ignore. Namely, protectionism and autarky are an absolutely necessary correlate to state management of the business cycle and related efforts to improve upon the unguided results generated by business, labor and investors on the free market.  Indeed, Keynes took special care to make sure that his works were always translated into German, and averred that Nazi Germany was the ideal test bed for his economic remedies.

Eighty years on from Keynes’ incomprehensible ode to statist economics and thorough-going protectionism, the idea of state management of the business cycle in one country is even more preposterous. Potential labor supply is a function of the global labor cost curve and now comes in atomized form as hours, gigs, and temp agency contractual bits, not census bureau headcounts.

In fact, the Census Bureau survey takers and the BLS numbers crunchers have not the foggiest idea as to what the real world’s potential labor force computes to, and how much of it is deployed on any given day, month or quarter. Accordingly, printing money and pegging interest rates in pursuit of “full employment”, which is the essence of the Yellen version of monetary central planning, is completely nonsensical.

Likewise, the Fed’s current “soft” target of 5.2% on the U-3 unemployment rate is downright ridiculous. When in the year 2015 you have 93 million adults not in the labor force—-of which only half are retired and receiving social security benefits(OASI)—-and a U-3 computational method that counts as “employed” anyone who works only a few hour per week—-then what you have in the resulting fraction is noise, pure and simple. The U-3 unemployment rate as a proxy for full employment does not even make it as primitive grade school economics.

At the present time, there are 210 million adult Americans between the ages of 16 and 68—to take a plausible measure of the potential work force. That amounts to 420 billion potential labor hours, if we accept the convention that all adults are at least theoretically capable of holding a full-time job (2,000 hours/year) and pulling their share of society’s need for production and work effort.

By contrast, during 2014 only 240 billion hours were actually supplied to the US economy, according to the BLS estimates. Technically, therefore, there were 180 billion unemployed labor hours, meaning that the real unemployment rate was 42.9%, not 5.5%!

Yes, we have to allow for non-working wives, students, the disabled, early retirees and coupon clippers. We also have drifters, grifters, welfare cheats, bums and people between jobs, enrolled in training programs, on sabbaticals and much else.

But here’s the thing. There are dozens of reasons for 180 billion unemployed labor hours, but whether the Fed is monetizing $80 billion of public debt per month or not, and whether the money market interest rate is 10 bps or 35 bps doesn’t even make the top 25 reasons for unutilized adult labor. What actually drives our current 43% unemployment rate is global economic forces of cheap labor and new productive capacity throughout the EM and dozens of domestic policy and cultural factors that influence the decision to work or not.

To be sure, for a brief historical interval—-from roughly the New Economics of the Kennedy Administration to the 2007 eve of the housing crash and financial crisis—- the Fed did levitate the GDP and meaningfully impact the labor utilization rate. That was owing to the one-time trick of levering up the household and business sector through the inducements of cheap debt.

Household Leverage Ratio - Click to enlarge

But that monetary parlor trick is over and done. Household’s are still de-levering relative to income, and the Fed’s bubble economics have channeled incremental business borrowing almost entirely into the secondary market of financial engineering. That is, borrowings which are applied to stock buybacks, M&A deals and LBOs result in a re-pricing of existing equity claims and more gambling stakes in the casino, but do not add to demand for new plant, equipment and other tangible assets.

So the transmission channels through which monetary central planning could historically impact the labor utilization rate are now broken and done. The Fed’s default business, therefore, is inflating the financial bubble and subsidizing carry trade speculators. That’s all there is to monetary policy at the limits of peak debt.

In that context, consider the complete foolishness of school marm Yellen’s campaign to fill up the bathtub of potential GDP by causing labor utilization to reach full employment. And start with the case of non-monetized labor.

Back in the 1970s during one of those periodic debates about full-employment, legendary humorist Art Buchwald proposed a sure fire way to double the GDP and do it instantly. That was in the time that most women had not yet entered the labor force and politically incorrect discussion was still permitted on the august pages of the Washington Post.

Said Buchwald, “Pass a law requiring all men to hire their neighbor’s wife!” That is, monetize all of the cleaning, cooking, washing and scrubbing done every day in American households and get the monetary value computed in the GDP; and, in the process get homemakers factored into the labor force and their contribution to the economy’s real output in the labor utilization rate.

As a statistical matter—-even though four decades of women entering the labor force have passed since Buchwald’s tongue-in-cheek proposal—- there are still approximately 75 billion un-monetized household labor hours in the US economy. Were they to be counted in both sides of the equation, our 43% unemployment rate would drop to 25% for that reason alone.

Needless to say, whether household labor is monetized or not has no impact whatsoever on the real wealth and living standards of America, even if it does involve important social policy implications. The point is, as an economic matter Janet Yellen can’t do a damn thing about it, even as she dithers about asking Wall Street speculators to pay 35 bps for their overnight borrowings.

And the same thing is true for almost every single factor that drives the true hours based unemployment rate. Front and center is the massive explosion of student debt—now clocking in at $1.3 trillion compared to less than $300 billion only a decade ago. The point is not simply that this debt bomb is going to explode in the years ahead; the larger point is that for better or worse, Washington has made a policy choice to keep upwards of 20 million workers out of the labor force and to subsidize them as students.

Whether millions of these debt serfs will get any real earnings enhancing benefits out of this “education” is an open question—–one that leans heavily toward not likely in either this lifetime or the next. But these 40 billion potential labor hours are far greater in relative terms than under the stingy student subsidy programs which existed in 1970 when Janet Yellen was learning bathtub economics from James Tobin at Yale.

Likewise, there are currently about 17 billion annual potential labor hours accounted for by social security disability recipients. Again, that is a much larger relative number than a few decades back, and it is owing to the deliberate liberalization of social policy by Congressional legislators and administrative law judges. The FOMC has nothing to do with this form of unemployment, either.

Then there is the billions of potential labor hours in the un-monetized “underground” economy. While the work of drug runners and street level dealers is debatable as a social policy matter, it is self-evident that state policy—–in the form of the so-called “war on drugs” and the DEA and law enforcement dragnet—–account for this portion of unutilized labor, not the central bank.

The same is true of all the other state interventions that keep potential labor hours out of the monetized economy and the BLS surveys—-most especially the minimum wage laws and petty licensing of trades like beauticians, barbers, electricians and taxi-drivers, among countless others.

Finally, there is the giant question of the price of labor as opposed to the quantity. And here it needs be noted that “off-shoring” is not just about shoe factories and sheet and towel mills that went to China because American labor was too expensive. Owing to the rapid progress of communications technology, an increasing share of what used to be considered service work, such as call centers and financial back office activities, have already been off-shored on account of price. And that process of wage suppression has ricocheted into adjacent activities owing to the willingness of off-shored workers to accept lower wages in purely domestic sectors when push comes to shove.

Indeed, the cascade of the China “labor price” through the warp and woof of the entire economy is so pervasive and subtle that it cannot possibly be measured by the crude instruments deployed by the Census Bureau and BLS.

In short, Janet Yellen doesn’t have a clue as to whether we are at 30% or 20% unemployment of the potential adult labor hours in the US economy.  But three things are quite certain.

First, the real unemployment rate is not 5.5%—–the U-3 number is an absolute and utterly obsolete joke.

Secondly, the actual deployment rate of America’s 420 billion potential labor hours is overwhelmingly a function of domestic social policy and global labor markets, not the rate of money market interest.

And finally, the Fed is powerless to do anything about the real labor utilization rate, anyway. The only tub its lunatic money printing policies are filling is that of the Wall Street speculators.

And that’s what the Warren Buffett economy is actually all about.

In Part 5, the possibility that the free market in finance could function just fine without activist monetary policy intervention and bubble finance fortunes like Warren Buffett’s $73 billion will be further explored.

The Making of Financial Policy


The following is excerpted from an article by Jay Cost:

How about Wall Street reform? Obama likes to pose as a people-versus-the-powerful crusader, but he staffed his administration with friends of the big banks. Unsurprisingly, that has enormously influenced policy.

David Skeel, a professor at the University of Pennsylvania Law School, writes about the framework “that would eventually become the Dodd-Frank legislation,” in particular the resolution rules that enables Treasury to intervene when too-big-to-fail institutions fall into distress.  He explains:

Both the resolution rules and the overall framework read as if they had been written by Timothy Geithner in consultation with the large banks he had worked with as head of the New York Fed. Geithner would get all of the powers that he and former Treasury Secretary Henry Paulson wished they had when they intervened with Bear Stearns, Lehman Brothers, and AIG. But the framework also did not overly ruffle the feathers of the largest financial institutions. There was no call to break them up…While systemically important status might subject the biggest institutions to greater oversight, it also would bring benefits in the marketplace. They could borrow money more cheaply than could smaller competitors, because lenders would assume they would be protected in the event of a collapse, as the creditors of Bear Stearns and AIG were.

The suspicion that the legislation might be a little too accommodating to the largest banks was further aroused by the discovery that David, Polk & Wardell, “a law firm that represents many banks and the financial industry’s lobbying group,” as the New York Times put it…had been deeply involved in the early drafting of the legislation. Treasury had worked from a draft first written by Davis Polk, and the legislation literally had the law firm’s name on it when Treasury submitted it to Congress, thanks to a computer watermark that Treasury had neglected to delete.

That’s not all. In Confidence Men, Ron Suskind reports that Obama instructed Geithner to develop a plan to break up Citi — as a warning to the other banks and a signal to the broader marketplace that the government was in charge, not the banks. But, per Suskind, Geithner disobeyed Obama, and never put together the plan. He suffered no consequences.

The best that can be said about this president and Wall Street is that, when it mattered most, he was a passive observer in his own administration. He allowed shills to write a bill enormously favorable to the biggest interests.

Not Too Big to Fail


We need a means of imposing financial discipline and restructuring banks in a system where some are deemed Too Big To Fail. This is one proposal from Nobel economist Vernon Smith (from the WSJ):

Bonds, Not Bailouts, for Too Big to Fail Banks


Call the bonds Class R, for reorganization. Owners might take a haircut, but they’d also become owners of the bank.

On Aug. 3 the Portuguese government announced a €4.9 billion ($6.55 billion) bailout for Banco Espírito Santo, another reminder that the “too big to fail” doctrine still prevails six years after the financial crisis. At least in this case junior bondholders—those who invested less than a year ago—and shareholders were forced to take a haircut. That’s progress for those who argue that economic recovery is impeded when monetary and fiscal authorities rescue private institutions from the consequences of their decisions.Too big to fail remains unresolved in the U.S. Last week the Federal Reserve and the Federal Deposit Insurance Corp. said that not one of the nation’s 11 largest banks could fail without threatening the broader financial system. The news came after regulators reviewed the banks’ “living wills,” the emergency plans required under the 2010 Dodd-Frank law.Living wills, according to resolution plans from the FDIC and the Fed, should “not rely on the provision of extraordinary support by the United States” and should “prevent or mitigate any adverse effects of such failure or discontinuation on the financial stability of the United States.” Most of the living wills, including those for the four largest banks— J.P. Morgan Chase, Bank of America, Citigroup and Wells Fargo —are based on a combination of Chapter 11 bankruptcy of the parent firm and sales of subsidiaries.

But selling business units in a liquidity or solvency crisis is hardly a viable plan. When Lehman Brothers filed for Chapter 11 in September 2008, the U.S. financial system spiraled into disarray, which led to public intervention. And Lehman was small compared with Bank of America and Citigroup, both of which have roughly three times the assets that Lehman had when it went under.

Instead of living wills or government bailouts, we propose that banks issue a class of bonds to privately secure the financial system against a cascade of failures. Let’s call them Class R or “Reorganization” bonds. Class R bonds would function like any other corporate-debt instrument in normal times, meaning that bondholders would have no control over the corporation.

In the event of the firm’s imminent failure, Class R bondholders would form a committee to develop contingency plans to appoint a new board of directors and reorganize senior management.

In bankruptcy, the existing board of directors would be dismissed, the equity of the firm would be eliminated and the Class R bonds would immediately be converted to equity. The Class R bondholders might take a haircut, but they would also become the owners of the bank, free of claims from prior management or shareholders. This bondholder capital avoids the involvement of the federal government, allows the firm to shed a substantial portion of its liabilities, but compensates Class R bondholders with control of a firm with a healthier balance sheet.

Bear Stearns is an example of how Class R bonds would work. Bear had about $350 billion in assets before its collapse, so if the firm had issued Class R bonds for 8% of its assets, the face value of the bond issue would have been roughly $28 billion. The firm was sold to J.P. Morgan Chase for $1.2 billion packaged with $29 billion in asset guarantees by the Federal Reserve. If the buyer needed guarantees of 24 times the sale price, the firm was worthless at the point of sale. Hence, Class R bondholders would have taken a substantial haircut when they came into possession of the firm.

Reorganization through bondholder committees has a long tradition in corporate bankruptcy, but it has not been used with banks. In finance, the Fed and other regulatory agencies have been charged with guarding against systemic risk. But that approach did not prevent the 2008 crisis.

For depository institutions, our proposal would work well with policies in place at the FDIC. Since 2008 the FDIC has handled 489 small- to medium-size bank failures using procedures that transfer ownership of most assets, and responsibilities for most liabilities, to new owners.

This approach has been successful in avoiding serious bank runs during reorganization, but the Class R approach could improve the process. The FDIC could continue to insure deposits, but it would no longer need to assume loss-share agreements with a bank that is taking over a failed institution. The Class R bondholders would assume the losses.

For a well-managed institution, the risk in these bonds should be minimal. If the viability of the institution comes into doubt, it should be signaled in lower Class R bond prices, but their owners would have the potential upside of coming into control of the firm.

We estimate that banks would need to issue Class R bonds for up to 8% of their institution’s balance-sheet liability, which includes demand and time deposits, loans from other banks and corporate bonds.

In the event of a failure, the firm’s liabilities will be reduced by 8%. In every case except AIG, this was well in excess of the amount of support that the government provided to maintain firms in the 2008 crash; and in most cases the firm’s loss approximated only about half of their outstanding corporate bonds. Crucially, to maximize a bank’s ability to finance new growth after a failure, its losses need to be absorbed by incumbent investors to enable a fresh start.

The living wills discussion is part of the process of finding a better institution for dealing with bank failures. Our proposal seeks to promote systemic stability by securing each of its private elements.

Legalized Theft

Credit: William Waitzman for Barron's

Credit: William Waitzman for Barron’s

Do average Americans understand how their pockets have been picked clean by the big banks under the Federal Reserve actions of recent years? Here is the relevant point from this rather long and esoteric article:

The government’s motive, as the judge summarized Starr’s argument, was to use AIG and its assets to provide a “backdoor bailout” of such other financial institutions as Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P. Morgan and UBS. …In other words, did the Fed … achieve a public-policy goal of making the Fed’s constituents, the banks, whole?

Let’s translate: Bernanke (together with NY Fed’s Geithner and Treasury Sec. Paulson ) led the charge to save the megabanks who had enormous losses from their trades with AIG. These banks received full payment for their reckless gambles on AIG swaps. Where did the money come from? Why, the shareholders of AIG and ultimately the good old U.S. taxpayer. So, our federal agencies are using their power to reward those same entities largely instrumental to the financial crisis. The “too big to fail” casino players made out like bandits and are now more powerful than ever. Good job fellas. I doubt this will go too far in the courts, but a little sunlight on these backroom deals will hopefully be eye-opening.

From the WSJ:

Ben Bernanke’s Anger and the AIG Case

The Federal Reserve took over the company and wiped out the shareholders. Was this legal? Or even constitutional?


Sometime in the next few weeks—if Judge Thomas Wheeler of the U.S. Court of Federal Claims gets his way—Federal Reserve Chairman Ben Bernanke will be forced to testify under oath about the Fed’s 2008 bailout of the insurance giant American International Group, better known as AIG.

The U.S. government has been fighting this deposition tooth and nail, warning of financial calamity if Mr. Bernanke is distracted from his duties at the central bank. But Judge Wheeler ruled last month that Mr. Bernanke could not duck his responsibility in a case involving enormous claims for damages. “The court cannot fathom having to decide this multibillion-dollar claim without the testimony of such a key government decision-maker,” the judge wrote.

The deposition could still be halted by an appeals court. If it does take place it would be unprecedented for a sitting Fed chairman. Such a deposition would be unlikely to be open to the public. But it could lead eventually to the public gaining a glimpse of what might be called Mr. Bernanke’s own moral hazard.

A moral hazard arises when someone takes a risk because the costs will be felt by someone else. It is exactly the kind of hazard Mr. Bernanke faced when, in a fit of anger that he acknowledged publicly only later, he engineered the AIG bailout—and takeover of the company—in September 2008.

Now Starr International is in court, on behalf of itself and other owners of AIG stock, with a $55 billion claim against the United States. Starr was the largest shareholder in AIG when the insurer ran into a liquidity crisis that triggered the bailout. Starr is headed by Maurice “Hank” Greenberg, who built AIG before he came under attack by the then-New York state attorney general, Eliot Spitzer, for accounting irregularities, and stepped aside. The new management took most of the gambles at the heart of AIG’s collapse.

Starr contends that the bailout wiped out shareholder equity in a way that amounted to a government “taking” that is unconstitutional absent the due process and just compensation guaranteed by the Fifth Amendment. Starr filed suit in 2011. As the case was later summarized by Judge Wheeler, Starr alleged that rather than providing liquidity support like the government did to “comparable financial institutions” such as Citigroup and the Hartford Financial Services Group, the government “exploited AIG’s vulnerable financial position by becoming a controlling lender and controlling shareholder of AIG.”

The government’s motive, as the judge summarized Starr’s argument, was to use AIG and its assets to provide a “backdoor bailout” of such other financial institutions as Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P. Morgan and UBS. In pursuit of that end, Starr alleges, the government seized AIG’s property, including 562,868,096 shares of its common stock.

Starr alleges that when the Fed made its loan to AIG in 2008, it took 79.9% of its stock and put it in what Starr characterizes as a “sham Trust”—a sham because it existed solely as a vehicle to get around the Fed’s lack of authority under the law to own stock in private companies.

Starr also makes an issue of the Fed’s denial of a shareholder vote on the dilution of AIG shareholders in 2009. The company initiated a reverse stock split to accommodate the government’s demand for 80% of the company’s stock. In other words, did the Fed use a forbidden ownership in a private corporation to achieve a public-policy goal of making the Fed’s constituents, the banks, whole?

“The basic terms of these transactions amounted to an attempt to ‘steal the business,’ ” Starr claims, quoting what it says a banker hired to represent the interests of the New York Federal Reserve Bank remarked at the time of the bailout.

The government disputes this, arguing in a court filing that to the extent AIG “exchanged any property” with the New York Fed, “it agreed to do so for consideration” and was rescued from the consequences of its own actions. “That exchange was not a taking.”

Government officials, though, were plenty nervous about what they were doing. The Treasury secretary at the time, Henry Paulson, has written of a meeting with Mr. Bernanke and a group of congressional leaders in September 2008. Mr. Paulson reports that then-Sen. Christopher Dodd (D., Conn.) twice asked “how the Fed had the authority to lend to an insurance company and seize control of it.”

According to Mr. Paulson, Mr. Bernanke explained that the Federal Reserve Act “allowed the central bank to take such actions under ‘unusual and exigent circumstances.'” Eventually, in Mr. Paulson’s account, Sen. Harry Reid (D., Nev.) announced: “You’ve heard what people have to say. I want to be absolutely clear that Congress has not given you formal approval to take action. This is your responsibility and your decision.”

The meeting was so tense, according to Mr. Paulson’s account, that the Treasury secretary at one point ducked behind a pillar in the Capitol and went into dry heaves. The following year, when Mr. Bernanke was being questioned by the Senate, he confessed in reference to AIG’s behavior and the need for a bailout, “If there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one, than AIG.”

Could it have been an anger management issue that explains the Fed running past redlines in the statute and the Constitution? Mr. Greenberg, in his own book, “The AIG Story,” insists that the statute did not authorize the Fed to seize control of private property. He argues that the constitutionality of any such provision would be doubtful.

On top of which, Starr argues, the seizure of AIG’s equity was part of punitive measures imposed on no other recipient of a government bailout. Mr. Bernanke himself has said that the Fed imposed significant costs and constraints on AIG’s owners in order to mitigate concerns that the bailout of AIG would “exacerbate moral hazard” and “encourage inappropriate risk taking.”

No wonder Judge Wheeler seems bound and determined that Mr. Bernanke becomes the first Fed governor to sit for a deposition. The only question is why do it in private?

There’s a lot the public deserves to know, starting with the question of whether Mr. Bernanke, who normally seems unflappable, got so angry at AIG that he lost his own sense of the very moral hazard he was claiming to be acting to prevent.

The Legacy of Timothy Geithner

I had to reprint this article as I was completely taken by surprise that the NY Times could actually be objective enough to publish such an expose.

The Legacy of Timothy Geithner

As the problems escalated, Mr. Geithner came to stand for providing large amounts of unconditional support for very big banks – including Citigroup, where Robert Rubin, his mentor, had overseen the dubious hiring of a chief executive and more general mismanagement of risk.


“Too big to fail is too big to continue. The megabanks have too much power in Washington and too much weight within the financial system.” Who said this and when?

The answer is Peggy Noonan, the prominent conservative commentator, writing recently in The Wall Street Journal.

As Timothy F. Geithner prepares to leave the Treasury Department, most assessments focus on how his policies affected the economy. But his lasting legacy may be more political, contributing to the creation of an issue that can now be seized either by the right or the left. What should be done about the too-big-to-fail category of financial institutions?

Mr. Geithner came to Treasury in the middle of a severe financial crisis, a set of problems that he helped to create and then worked hard to prevent from worsening. As president of the Federal Reserve Bank of New York, starting in 2003, he watched over – and failed to defuse – the buildup of systemic risk. In fact, the New York Fed was relatively on the side of allowing large, seemingly sophisticated financial institutions to fund themselves with more debt relative to their thin levels of equity.

This was a major conceptual mistake for which there still has not been a full accounting. In fact, blank denial continues to be the reaction from the relevant officials.

Mr. Geithner was also in the hot seat as more explicit government support for large financial institutions began in earnest in early 2008. The New York Fed brokered the sale of failing Bear Stearns to relatively healthy JPMorgan Chase, with the Fed providing substantial downside insurance to JPMorgan, against potential losses from assets they were acquiring.

Mr. Geithner also acquiesced to Jamie Dimon, the chief executive of JPMorgan Chase, allowing him to remain on the board of the New York Fed even as his bank was suddenly the recipient of very large additional subsidies (the insurance for his acquisition of Bear Stearns). This was the beginning of a deeper public realization that there had come to be too little distance between some parts of the Federal Reserve and the big banks.

For some senior officials within the Federal Reserve System, the appearance of this potential conflict of interest was a cause for grave concern. Unfortunately, their concerns were ignored by the New York Fed and by leadership at the Board of Governors in Washington. The result has been damage to the Fed’s reputation and an unnecessary slip toward undermining its political independence.

From March 2008, when Bear Stearns almost failed, through September 2008, very little was done to reduce the level of risk in the financial system. Again, Mr. Geithner must bear some responsibility.

In fall 2008, Mr. Geithner worked closely with Henry Paulson – Treasury secretary at the time – in an attempt to prevent the problems at Lehman Brothers from spreading. They were unsuccessful, in fairly spectacular fashion. The failure to anticipate the difficulties at American International Group must stand out as one of the biggest lapses ever of financial intelligence – again, a responsibility in part of the New York Fed (although surely other government officials share some blame).

As the problems escalated, Mr. Geithner came to stand for providing large amounts of unconditional support for very big banks – including Citigroup, where Robert Rubin, his mentor, had overseen the dubious hiring of a chief executive and more general mismanagement of risk. (While a director of Citigroup, Mr. Rubin denied responsibility for what went wrong.)

Rather than moving to change management, directors or anything about the big banks’ practices, Mr. Geithner favored more financial assistance – both from the budget (through various versions of the Troubled Asset Relief Program), from the Federal Reserve (through various kinds of cheap loans) and from all other available means, including insurance for private debt issues provided by the Federal Deposit Insurance Corporation.

In official discussions, Mr. Geithner consistently stood for more support with weaker (or no) conditions. (See “Bull by the Horns,” by Sheila Bair, former chairwoman of the F.D.I.C., for the most credible account of what happened.)

Mr. Geithner’s appointment as Treasury secretary in January 2009 allowed him to continue to scale up these efforts.

In retrospect, what helped stem the panic was the joint statement of Feb. 23, 2009, issued by the Treasury, the F.D.I.C., the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Reserve, that included this statement of principle:

The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses. The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth. Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.

Mr. Geithner is often given credit for pushing bank stress tests in spring 2009 as a way to back up this statement, so officials could assess the extent to which particular financial institutions needed more loss-absorbing equity. But such stress tests are standard practice in any financial crisis.

Much less standard is unconditional government support for troubled banks. Usually such banks are “cleaned up” as a condition of official assistance, either by being forced to make management changes or being forced to deal with their bad assets. (This was the approach favored by Ms. Bair when she was at the F.D.I.C.; her book lays out realistic alternatives that were on the table at critical moments. The idea that there was no alternative to Mr. Geithner’s approach simply does not hold water.)

Any fiscally solvent government can stand behind its banks, but providing such guarantees is a recipe for repeated trouble. When Mr. Geithner was at Treasury in the 1990s and Mr. Rubin was Treasury secretary, the advice conveyed to troubled Asian countries – both directly and through American influence at the International Monetary Fund – was quite different: clean up the banks and rein in the powerful people who overborrowed and brought the corporate sector to the brink of financial meltdown.

In Mr. Geithner’s view of the world, the 2010 Dodd-Frank financial reform legislation fixed the problem of too-big-to-fail banks. Outside of Treasury, it’s hard to find informed observers who share this position. Both Daniel Tarullo (the lead Fed governor for financial regulation) and William Dudley (the current president of the New York Fed) said in recent speeches that the problems of distorted incentives associated with too big to fail were unfortunately alive and well.

Ironically, despite the fact that the Obama administration failed to rein in the megabanks and allowed them to become larger and arguably more powerful, this has not helped the Republicans in electoral terms.

As Ms. Noonan puts it bluntly: “People think the G.O.P. is for the bankers. The G.O.P. should upend this assumption.”

This is a significant opportunity for anyone with clear thinking on the right – someone looking for a Teddy Roosevelt trustbusting or Nixon-goes-to-China moment. Again, Ms. Noonan gets it right: “In this case good policy is good politics. If you are a conservative you’re supposed to be for just treatment of the individual over the demands of concentrated elites.”

Recall that some grass roots conservatives are already there: House Republicans initially voted down TARP, the former presidential candidate Jon Huntsman’s plan to end too big to fail received widespread applause from many Republicans and a number of influential commentators, including George Will and Ms. Noonan, have advocated ending too big to fail.

This would play well in the Republican presidential primaries – and even better in the general election. Watch PBS “Frontline” on Jan. 22 for an articulate presentation of why serious potential financial crimes were not prosecuted during the first Obama administration, and think about how to turn these facts into political messages.

A smart candidate could even mobilize plenty of financial-sector support in favor of breaking up or otherwise restricting the too-big-to-fail financial entities. The megabanks have very few genuine friends.

The lasting legacy of Timothy Geithner is to create the perfect electoral issue for Republicans. Will they seize it?

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