Stressed Out: Geithner’s Stress Test

Stress-Test-BookThis is a review of former US Treasury Secretary and Chair of the New York Federal Reserve Bank Timothy Geithner’s explanation of the financial crisis and its subsequent management (also posted at Amazon).

Though full of interesting perspectives, Geithner’s exposition seems more of a desire to preempt the writing of history with a rationalization of his policy choices than provide any insight into the reality of the crisis or how it has reconfigured the financial landscape for the worse. Not surprisingly, fellow liberal Paul Krugman’s critical review is not cited by the publishers.

Geithner’s view of the economy and the role of finance is colored by the myopic banker’s view of the credit system, but I guess we should have expected this from a Treasury Secretary whose only preparation for the job was as head of the NY Federal Reserve Bank.

Geithner believes the financial crisis was a liquidity crisis akin to a bank run. Geithner’s solution was calibrated to the Federal Reserve stepping in as the lender of last resort, a role which it performed admirably. But the payments breakdown was merely the symptom of the problem, not the cause. The cause was (and still is) insolvent balance sheets across the financial sector. And this insolvency can be traced back to bad policies: easy credit by Greenspan, Bernanke and Co. and the lack of banking oversight, by, well, guess who? Timothy Geithner at the head of the NY Fed.

A housing bubble fueled by easy credit and securitized mortgages led to balance sheets with mispriced assets for financial intermediaries the world over. In other words, the AAA-rated MBSs they were holding as capital reserves were only as good as the value of the underlying collateral: all those ridiculously priced houses leveraged on cheap credit. When people began to realize this, the run was on and the repo market froze, cascading across all the credit markets. This was an insolvency crisis reflected in a payments freeze. The Fed needed to stand in as lender of last resort and did so, with Geithner’s full support.

But then Geithner’s solution to the post-liquidity financial de-leveraging has been to make bankers whole and push the mispricing costs onto taxpayers, savers, homeowners, and lenders. AIG went into receivership, but all the counter parties from Goldman Sachs to European banks were paid back at par on their credit default swaps. This not only enriched, but sheltered bad actors like Goldman from accountability. This served Geithner’s Wall Street constituency rather well (not exactly the constituency of the US Treasury Secretary, which is a bit broader). This was “heads we win, tails you lose,” on a grand scale. Now the banking system is more concentrated than ever with systemic risk of another shock even more threatening. Meanwhile, Main Street business struggles to obtain credit to grow the real economy. Hence anemic job creation. I doubt the Stress Test assures an all-clear, except for certain favored banking actors who now have a virtual government guarantee as TooBigToFail.

Instead, the Fed and Treasury should have managed the deleveraging of the historical credit bubble until asset prices again reflected fundamental values rather than false confidence in monetary engineering. Like AIG, failed banks should have been restructured by the government and then sold off to profitable buyers.


Despite the self-congratulatory tone of the author, we are nowhere near writing the end of this story. The Fed has expanded its balance sheet by $3.5 trillion and is holding much of that in overvalued MBSs that it has purchased through Quantitative Easing. The policies have tried to inflate housing values in order to return these mortgages back to nominal face value, but the prices of houses are artificially being pumped up by Fed credits while housing fundamentals (median incomes) remain in the doldrums. The bubbles in financial markets are also a direct manifestation of Fed policy. The Fed knows that it can cover its bad assets by merely creating more credit liabilities. The final reckoning will likely be the depreciation of the US$ and the loss of real value to savers, lenders, and working people.

Krugman is right, Geithner and the Fed saved the world from a Great Depression (of their own making – thank you very much), but have invited even greater economic disaster in lost opportunity for the middle class.

Back to the Races


Terrific. I guess it’s high time to roll the dice again on an overpriced home market. (That’s overpriced relative to median incomes and rent multiples.) People can’t afford homes because of a stagnant labor market, but that’s okay – let’s give everyone cheap loans and easy credit standards, since that worked so well last time. The real problem is that monetary policy has encouraged banks to build reserves and hold those reserves in asset markets instead of taking the risks of lending to home owners for overpriced housing assets. Relaxing lending standards doesn’t change this and only encourages the riskiest lending by marginal players in the mortgage lending business.

U.S. Backs Off Tight Mortgage Rules

In Reversal, Administration and Fannie, Freddie Regulator Push to Make More Credit Available to Boost Housing Recovery

By Nick Timiraos and Deborah Solomon

WASHINGTON—The Obama administration and federal regulators are reversing course on some of the biggest postcrisis efforts to tighten mortgage-lending standards amid concern they could snuff out the fledgling housing rebound and dent the economic recovery.

On Tuesday, Mel Watt, the newly installed overseer of Fannie Mae and Freddie Mac, said the mortgage giants should direct their focus toward making more credit available to homeowners, a U-turn from previous directives to pull back from the mortgage market.

In coming weeks, six agencies, including Mr. Watt’s, are expected to finalize new rules for mortgages that are packaged into securities by private investors. Those rules largely abandon earlier proposals requiring larger down payments on mortgages in certain types of mortgage-backed securities.

The steps mark a sharp shift from just a few years ago, when Washington, scarred by the 2008 crisis, pushed to restrict the flow of easy money that fueled the housing bubble and its subsequent bust. Critics of the move to loosen the reins now, including some economists and lenders, worry that regulators could be opening the way for another boom and bust.

For the past year, top policy makers at the White House and at the Federal Reserve have expressed worries that the housing sector, traditionally a key engine of an economic recovery, is struggling to shift into higher gear as mortgage-dependent borrowers remain on the sidelines.

Both Treasury Secretary Jacob Lew and Federal Reserve Chairwoman Janet Yellen last week noted the housing market as a factor holding back the economic recovery.

Mr. Watt, the former North Carolina congressman who took over as the director of the Federal Housing Finance Agency in January, used his first public speech on Tuesday to lay out the shift in course for Fannie and Freddie, and pegged executive compensation at the companies to meeting the new goals.

Fannie and Freddie, which remain under U.S. conservatorship, and federal agencies continue to backstop the vast majority of new mortgages being issued.

The FHFA has recently attempted to lure private investors back into the housing-finance market—and reduce the Fannie and Freddie footprint—by raising the cost of government-backed lending.

With few signs that private investors are returning on a large scale, Mr. Watt signaled a clear break with his predecessor, Edward DeMarco, who left the FHFA last month after nearly five years as its acting director.

“I don’t think it’s FHFA’s role to contract the footprint of Fannie and Freddie,” Mr. Watt said during a discussion at the Brookings Institution in Washington. Winding down the companies without clear proof that private investors are willing to step back in “would be irresponsible.”

His comments signal a move away from treating Fannie and Freddie as “institutions in intentional decline” towards “institutions that should be better prepared to form the core of our system for years to come,” said Jim Parrott, a former housing adviser in the Obama White House.

Mr. Watt’s remarks are significant, given legislation to overhaul the mortgage-finance giants and replace them with a new system that reduces the government’s role in housing appears headed for a dead end in the current session of Congress.

Mr. DeMarco in a separate speech at a banking conference in Charlotte, N.C., on Tuesday, urged restraint: “Do not confuse weakening underwriting standards and underpricing risk with helping people or promoting market efficiency.”

The new steps are the fruit of three years of strenuous pushback by those opposed to tighter lending standards.

In the wake of the 2010 Dodd-Frank law, regulators proposed a spate of new rules intended to eliminate questionable mortgage products and remove any incentive banks had to make loans unlikely to be repaid.

Among the biggest changes that were proposed: Borrowers would either have to put 20% down, or the bank would have to retain 5% of the loan’s risk once it was sliced, packaged and sold to investors.

The March 2011 proposal triggered a huge outcry from lawmakers, affordable-housing groups and the real-estate industry, all of whom said it would put the brakes on homeownership for millions of credit-worthy borrowers, particularly first-time buyers and minorities. [Note: Instead we’ve pushed the prices out of their reach and now want to enable them to borrow more debt! Is this insane?]

The potential for a high down payment also raised alarm bells at the Department of Housing and Urban Development, one of six writing the rule, according to government officials.

HUD officials agitated for a gentler approach, telling counterparts that a high down payment wasn’t the only way to prevent defaults, but would likely destroy any chance for a housing-market recovery.

At a meeting before the rule was proposed, a HUD official warned fellow regulators away from a 20% down payment, saying that “the impact is between uncertain and bad,” according to a person familiar with the discussions.

When the five other agencies were not swayed, HUD took another approach and refused to sign off on the proposal unless a 10% down payment was included as an alternative. Regulators agreed.

By August 2013, more than 10,000 comment letters had poured in to the agencies, and the response was almost universal: Regulators should avoid a high down-payment level.

The groundswell caught the attention of U.S. policy makers, who began to worry about the collective impact of so much new regulation.

Regulators announced a series of steps Tuesday that they said could help ease standards—abruptly raised by lenders during the financial panic—and make it easier for first-time and other entry-level buyers.

Mr. Watt said that he would direct Fannie and Freddie to provide more clarity to banks about what triggers “put-backs,” in which lenders have been forced to spend billions of dollars buying defective loans sold during the housing boom. To guard against future put-back demands, lenders say they have enacted standards that go beyond what Fannie, Freddie and other federal loan-insurance agencies require.

Mr. Watt said that he hoped that the changes would “substantially reduce” credit barriers, “and that lenders will start operating more inside the credit box that Fannie and Freddie” provide.

Shaun Donovan, the HUD secretary, announced on Tuesday similar changes designed to encourage lenders to reduce similar restrictions on loans insured by the Federal Housing Administration, which is part of his department.

Federal Reserve Gone Wild


From a report by First Trust Advisors, Brian Wesbury, Chief Economist:

The Fed has massively increased the size of its balance sheet, from roughly $850 billion in 2008 to its current $3.96 trillion. Quantitative Easing was accomplished by having the Fed buy bonds and pay for them by “creating” excess bank reserves – reserves above and beyond those that are required.

Now it looks like the Fed will finish tapering and then raise interest rates without shrinking its balance sheet. In this way, the Fed is behaving like any other government agency, not wanting to shrink again after growing during a crisis. But, in order to make this work, the Fed will eventually have to pay banks a high enough interest rate to incentivize them to keep excess reserves from turning into inflationary money growth.

However, not just banks hold reserves. Fannie Mae, Freddie Mac and some Federal Home Loan Banks hold reserves, too. But the “Financial Services Regulatory Relief Act of 2006,” only gave the Fed the legal right to pay interest on balances “maintained at a Federal Reserve Bank by or on behalf of a depository institution.” In other words…by law, the Fed can’t pay Fannie Mae or the others interest on reserves.

As a result, the money the Fed has injected into these institutions is a potential source of inflation if they lend their reserves to banks. So the Fed has dreamed up a new program of “reverse repos,” where it temporarily lends GSEs (and some money market funds) Treasury bonds with a promise to buy them back at a higher price in the future.

The price difference is an implied interest rate and by doing this the Fed is paying a higher rate today than these institutions can earn by buying 1, 3, or 6-month T-bills. The Fed is trying to mop up excess liquidity in the system so the money supply doesn’t inflate.

But this flouts the law written by Congress. In effect, by coloring outside the legal lines, the Fed is paying interest on reserves to “non-banks.” The Fed hopes this operation lets it have its cake (a large balance sheet) and eat it too (no rapid money growth).

In addition to undermining the rule of law, the practice is fraught with danger. If profitable lending opportunities accelerate, then, as the Fed tries to mop up excess reserves, it will be forced to raise interest rates higher and higher as an incentive for banks not to lend. Otherwise, if banks feel they can lend money to the private sector more profitably than they can lend to the Fed, they will not participate in the repo market.

This can cause the equivalent of an “arms race” in the financial system, where interest rates must be raised faster and further than the markets want in order to keep the lid on inflation and bank lending.

Rather than flout the law, the Fed should be looking for ways to unwind QE. It’s time has come and gone. The Fed is too big – much bigger than Congress (The Law of The Land) ever wanted.

We should see that the only choices available to the Fed are 1) to raise interest rates high enough to mop up excess reserves and risk economic stagnation, or 2) to lose their grip on inflation. Mostly likely we will get a combination of both, which we know as stagflation. A sharp correction is the only remedy, and the longer it is avoided, the larger and steeper it will eventually be.


Fed Gambles

images …with your future.  From the WSJ:

In Going Long, the Fed Is Short-Sighted

The Fed is clearly doing everything it can, at the expense of small savers, to provide the U.S. Treasury with minimal borrowing costs to help it finance a profligate administration and Congress.

Stock and bond traders spent most of last year in a state of high anxiety over what would happen when the Federal Reserve began “tapering” its monthly $85 billion purchases of Treasurys and mortgage-backed securities. But when the tapering was actually announced in December, the Dow Jones Industrial Average rose sharply, apparently out of relief from all the suspense. Today, after various fluctuations including last week’s swoon, the Dow is pretty much where it was back then.

The taper this month will take the purchases down to $55 billion, $30 billion in Treasurys and $25 billion in the tainted mortgage-backed securities that were the product of Uncle Sam’s “affordable housing” fiasco of the 2000s. So far, the worst fears of the markets haven’t happened.

Why not? One reason may be that the Fed isn’t tapering as much as the numbers might indicate.

While the Fed is buying fewer securities, those it is buying have longer maturities. So the Fed’s purchases, though shrinking, are relieving banks and the Treasury from a higher proportion of their risks.

Numbers compiled by the Federal Reserve bank of St. Louis record the lengthening of Treasury maturities in the Fed’s ballooning portfolio. The face value of that portfolio now stands at something over $2.3 trillion, of which bonds with maturities of more than 10 years account for 26%, compared with 18% only four years ago. Maturities between five and 10 years now account for 37%, versus 26% in 2010. But maturities from one to five years have dropped to 37% from 42%. Short-term notes, 91 days to a year, ran around 23% of holdings in the pre-2008 years. Today, they are zero.

This might all sound rather arcane, but longer maturities mean that the Fed is buying more risk. That mitigates whatever tightening effect tapering might have on the markets.

John Butler, a fund manager for Amphora Commodities in London, has commented that by buying a greater proportion of longer-dated securities from the banking system and thus relieving bankers of risk means that monetary policy may be no more tighter than it was before tapering. That would be debatable considering the substantial $10 billion increments the Fed is removing from the “buy” side of the Treasury and MBS side of the market each month. But it certainly can be said that by relieving banks and the Treasury of some of their long-term risk, the Fed is softening the market impact of tapering.

Long bonds normally return greater yields than shorter-term securities because in a fiat money system subject to bouts of inflation, they carry greater risk. Thanks in part to the Fed’s purchases, the 10-year Treasury is currently yielding less than 3%, which doesn’t offer much protection against a future inflation loss.

At the Fed’s target of 2% annual inflation (which the CPI is currently undershooting if you believe those numbers), a 10-year Treasury with a 2.75% coupon would net less than 1% at maturity. If inflation rises above 3% it becomes a loser and from 5% inflation on up it becomes a big loser. Even a one-year spike of 10% in a decade of otherwise modest inflation could produce a loss at maturity for bonds with the remarkably low coupons Treasurys carry today.

The Fed has made no secret of its plans to go long, but the whole concept of “quantitative easing,” including the term itself, is shrouded in obfuscation. While the Fed says its policies are a form of economic stimulus, any such effect is far less obvious than what is plainly visible. The Fed is clearly doing everything it can, at the expense of small savers, to provide the U.S. Treasury with minimal borrowing costs to help it finance a profligate administration and Congress.

Banks, especially the big ones, aren’t doing so badly either. According to the Federal Deposit Insurance Corp., the banking industry had record earnings of $154.7 billion in 2013. The largest, “systemically important” giants have an added fillip in that their too-big-to-fail designation and close connections with the Fed reduce their borrowing costs versus their less-favored brethren. The Fed pays a quarter of a percentage point to borrow from the banks the money it uses for supporting the Treasury and the mortgage market under “quantitative easing.” That pads bank earnings as well.

So everyone wins, right? Well, except maybe for the Fed itself, and of course savers.

The Fed has put itself in a position that offers no easy way out. If credit demand rises and that huge holding of excess bank reserves finds its way into the global economy, it could trigger inflation in excess of the Fed’s strange 2% target, and it could happen fast. The Fed could find itself sitting on a lot of devalued Treasury and mortgage-backed debt that would lose money even if held to maturity.

Who knows what the world will look like 10 years from now, or even next week? At least the Fed has an incentive to try to contain inflation. But given the size of the bank reserves already exploded by the Fed, maybe it already has failed in that task.

A Self-Destructive Housing Policy

home castleA poorly conceived housing policy is one of the driving forces in our economy’s over dependence on debt that has impeded the politics of financial policy reform. Federal Reserve policy has managed this by accommodating the same wrong-headed policies. The costs are exacted from the very taxpayers who have acted prudently.

Michael Milken quoted in the WSJ (article):

As someone who helped finance several of the nation’s leading residential builders, I understand the important role the industry plays in the economy. Homebuilders didn’t create the problems. Policies made in Washington distorted the banking system and discouraged personal responsibility by subsidizing loans that borrowers couldn’t otherwise afford. This encouraged housing speculation supported by financial leverage. Ultimately, taxpayers got the bill.

Housing’s 2008 collapse led to the U.S. Treasury takeover of Fannie’s and Freddie’s obligations even as the Federal Housing Administration increased its guarantees to more than $1 trillion and the Federal Reserve stepped up purchases of mortgage-backed securities. Federal debt surged.

Americans will eventually have to pay for that through some combination of inflation, higher taxes, higher interest rates or reduced benefits and services. For now, the Fed is doing what the savings and loan industry did in the 1980s: borrowing short term while lending long term. When interest rates rise, the value of the government’s mortgage holdings will decline.

True Confessions

pigs2Now we get the truth from the horse’s mouth. This is what’s been happening all along and the costs increase with each passing month of this failed policy. From the WSJ:

Confessions of a Quantitative Easer

We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street.

By Andrew Huszar
I can only say: I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I’ve come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.Five years ago this month, on Black Friday, the Fed launched an unprecedented shopping spree. By that point in the financial crisis, Congress had already passed legislation, the Troubled Asset Relief Program, to halt the U.S. banking system’s free fall. Beyond Wall Street, though, the economic pain was still soaring. In the last three months of 2008 alone, almost two million Americans would lose their jobs.

The Fed said it wanted to help—through a new program of massive bond purchases. There were secondary goals, but Chairman Ben Bernanke made clear that the Fed’s central motivation was to “affect credit conditions for households and businesses”: to drive down the cost of credit so that more Americans hurting from the tanking economy could use it to weather the downturn. For this reason, he originally called the initiative “credit easing.”

My part of the story began a few months later. Having been at the Fed for seven years, until early 2008, I was working on Wall Street in spring 2009 when I got an unexpected phone call. Would I come back to work on the Fed’s trading floor? The job: managing what was at the heart of QE’s bond-buying spree—a wild attempt to buy $1.25 trillion in mortgage bonds in 12 months. Incredibly, the Fed was calling to ask if I wanted to quarterback the largest economic stimulus in U.S. history.

This was a dream job, but I hesitated. And it wasn’t just nervousness about taking on such responsibility. I had left the Fed out of frustration, having witnessed the institution deferring more and more to Wall Street. Independence is at the heart of any central bank’s credibility, and I had come to believe that the Fed’s independence was eroding. Senior Fed officials, though, were publicly acknowledging mistakes and several of those officials emphasized to me how committed they were to a major Wall Street revamp. I could also see that they desperately needed reinforcements. I took a leap of faith.

In its almost 100-year history, the Fed had never bought one mortgage bond. Now my program was buying so many each day through active, unscripted trading that we constantly risked driving bond prices too high and crashing global confidence in key financial markets. We were working feverishly to preserve the impression that the Fed knew what it was doing.

It wasn’t long before my old doubts resurfaced. Despite the Fed’s rhetoric, my program wasn’t helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were extending wasn’t getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.

From the trenches, several other Fed managers also began voicing the concern that QE wasn’t working as planned. Our warnings fell on deaf ears. In the past, Fed leaders—even if they ultimately erred—would have worried obsessively about the costs versus the benefits of any major initiative. Now the only obsession seemed to be with the newest survey of financial-market expectations or the latest in-person feedback from Wall Street’s leading bankers and hedge-fund managers. Sorry, U.S. taxpayer.

Trading for the first round of QE ended on March 31, 2010. The final results confirmed that, while there had been only trivial relief for Main Street, the U.S. central bank’s bond purchases had been an absolute coup for Wall Street. The banks hadn’t just benefited from the lower cost of making loans. They’d also enjoyed huge capital gains on the rising values of their securities holdings and fat commissions from brokering most of the Fed’s QE transactions. Wall Street had experienced its most profitable year ever in 2009, and 2010 was starting off in much the same way.

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2. Germany’s finance minister, Wolfgang Schäuble, immediately called the decision “clueless.”

That was when I realized the Fed had lost any remaining ability to think independently from Wall Street. Demoralized, I returned to the private sector.

Where are we today? The Fed keeps buying roughly $85 billion in bonds a month, chronically delaying so much as a minor QE taper. Over five years, its bond purchases have come to more than $4 trillion. Amazingly, in a supposedly free-market nation, QE has become the largest financial-markets intervention by any government in world history.

And the impact? Even by the Fed’s sunniest calculations, aggressive QE over five years has generated only a few percentage points of U.S. growth. By contrast, experts outside the Fed, such as Mohammed El Erian at the Pimco investment firm, suggest that the Fed may have created and spent over $4 trillion for a total return of as little as 0.25% of GDP (i.e., a mere $40 billion bump in U.S. economic output). Both of those estimates indicate that QE isn’t really working.

Unless you’re Wall Street. Having racked up hundreds of billions of dollars in opaque Fed subsidies, U.S. banks have seen their collective stock price triple since March 2009. The biggest ones have only become more of a cartel: 0.2% of them now control more than 70% of the U.S. bank assets.

As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy. Yes, those financial markets have rallied spectacularly, breathing much-needed life back into 401(k)s, but for how long? Experts like Larry Fink at the BlackRock investment firm are suggesting that conditions are again “bubble-like.” Meanwhile, the country remains overly dependent on Wall Street to drive economic growth.

Even when acknowledging QE’s shortcomings, Chairman Bernanke argues that some action by the Fed is better than none (a position that his likely successor, Fed Vice Chairwoman Janet Yellen, also embraces). The implication is that the Fed is dutifully compensating for the rest of Washington’s dysfunction. But the Fed is at the center of that dysfunction. Case in point: It has allowed QE to become Wall Street’s new “too big to fail” policy.

The Aftermath


Good summary of the financial crisis and its aftermath. From Barrons:

Five Years on Fire


The disastrous events of September 2008 live on.

Five years ago last week, the U.S. Treasury yelled “Fire!” in a crowded theater by letting Lehman Brothers go bankrupt. The world of finance took up the chorus as it ran for the exit. The panicked crowd trampled the guilty and the innocent alike: banks, quasi-banks, nonbanks, money-market funds, bonds and stocks, and their investors.

There was no exit for any of them. The world financial system had become globalized, which is another way of saying we are all in a room with no door, called Earth.

As Jean-Paul Sartre warned in No Exit, his 1944 play portraying the eternal punishment of three souls by putting them in a locked room, “Hell is other people.”

When financial institutions heard the cry of “Fire!” they smelled smoke in their own attics, where they had stashed their dubious mortgages and their mortgage-backed securities. Financial engineering supposedly had made such paper safe as houses; in fact, it was all subject to spontaneous combustion.

What Could Be Worse?

Faced with the possibility that the Treasury (or the Federal Reserve or the tooth fairy) might not honor the implicit government guarantee of the financial system, the system swooned. Troubled institutions needed credit like addicts need dope, but nobody would lend to a credit junkie, least of all another credit junkie. It takes one to know one, and even without the help of credit-ratings agencies, they all knew one another very well, like scorpions in a bottle.

The government swooned next. Lehman Brothers was the only major financial institution allowed to go into bankruptcy, and officials quickly declared that it was all a mistake that would never be repeated—proving it almost immediately by propping up AIG with an $85 billion injection. We were on the brink of the Great Depression, according to then-Treasury Secretary Henry Paulson in the dark days of September 2008. He believed, and still believes, according to anniversary interviews, that nothing could be worse.

So far, there has been no repeat of Lehman’s debacle. “Too big to fail” is the reigning dogma of financial regulators and lawmakers, who pretend to tighten up the rules to reduce leverage and risk but shrink from forcing financial firms to take the consequences of their risky behavior.

For five years, the Treasury, the Fed, the Congress, and the White House have agreed on little, but they do agree that no more sparrows like Lehman shall fall—not by accident and certainly not on purpose. The eagles of Wall Street, of course, will soar. And even the gnats have an implicit government guarantee, as Fed Chairman Ben Bernanke demonstrated last week.

Since May, Bernanke & Co. had been publicly warning everybody within smelling distance that it was getting to be time to dial back or taper the Fed’s adventure in monetary stimulus. Suddenly, he reversed course.

Numbers Rule the Game

For those who have lost their way in the fog of euphemisms, the Fed’s policy has been known as quantitative easing, parts 1, 2, and 3, with Operation Twist tacked on for bad measure. In operational terms, the Fed and financial experts generally talk about the Fed’s buying $85 billion worth of bonds—Treasuries and mortgage-backed securities—every month, but that too is a euphemism. The Fed now works like a pawn shop, taking in unwanted assets and lending money in return. There are nine billion names and phrases for it, but only three are honest: monetization, money-printing and inflation.

The practical results, however, have been surprisingly small. Most prices have remained fairly stable—except gold, commodities, and stocks, which have been volatile with a bias to the upside. Economic growth has been lame. And without much growth, consumer income has been dull.

This was not supposed to happen. Whether a government stimulus is Keynesian, using spending increases and borrowing, or Friedmanesque, using money creation, it’s supposed to get the economy moving again. That it has never done so without a major war hasn’t stopped American economists from expecting better results from each successive replay.

That’s why the inflation policy won’t be tapered off just yet, even though the Fed’s optimistic forecasters had projected a growing economy that would let it be done without pain. Bernanke said this week the sluggish economic data convinced nine out of 10 members of the Federal Open Market Committee that the economy is too weak to fly on its own power without further monetary support from the Fed. He also claimed that Congress and the White House have been insufficiently stimulative on the Keynesian front. A few trillion here and there are apparently not enough.

Stock-market reaction to this turn of events was curious to anyone not a credit junkie: The Dow and the Standard & Poor’s 500 set new highs. A new shot was more vital than a new attempt to make the economy get straight.

Meanwhile the political parties are daring each other to shut down the government, or to stick to the debt ceiling they legislated earlier this year, or both. Bernanke rightly said that was an item of concern. It would be embarrassing if the Fed tapered and then felt forced to untaper.

Big Brave Words

Traders hang on every word from any Fed chairman, hoping for clues to what he really thinks. Even Bernanke’s stated policy of transparency hasn’t satisfied them. The chairman may say he eschews obfuscation, but sensible traders know that all central bankers prevaricate.

During No Exit, one of the characters tries over and over again to escape from the locked room. Near the end of the play, he tries one more time and the door opens. But then he won’t leave. Though he manufactures excuses about needing “absolution” from one of the others in the room, it’s clear that his real problem is fear.

Who knows what might be outside of the room? It might be worse than his current version of hell.

Bernanke and the rest of the American financial leaders surely know the feeling. They seek absolution while denying their guilt. Their fear is natural and pathetic.

Gambling with Debt and Leverage


This article explains the simple problem with the modern world of banking and finance: too much debt leverage promoted by misguided tax and regulatory policies. The root cause of every financial crisis is excessive leverage funded by cheap credit. The solution is more equity on the part of shareholder owners through higher capital ratios. The essence here is RISK and the proper pricing of that risk. This means more skin in the game for those who control the financial risks. Then they can absorb the rewards or the failures of risk-taking, not the taxpayers. Of course, less leverage also means less bang for the buck, which implies banking should become the boring business it was meant to be.

From the NY Times:

We’re All Still Hostages to the Big Banks


NEARLY five years after the bankruptcy of Lehman Brothers touched off a global financial crisis, we are no safer. Huge, complex and opaque banks continue to take enormous risks that endanger the economy. From Washington to Berlin, banking lobbyists have blocked essential reforms at every turn. Their efforts at obfuscation and influence-buying are no surprise. What’s shameful is how easily our leaders have caved in, and how quickly the lessons of the crisis have been forgotten.

We will never have a safe and healthy global financial system until banks are forced to rely much more on money from their owners and shareholders to finance their loans and investments. Forget all the jargon, and just focus on this simple rule.

Mindful, perhaps, of the coming five-year anniversary, regulators have recently taken some actions along these lines. In June, a committee of global banking regulators based in Basel, Switzerland, proposed changes to how banks calculate their leverage ratios, a measure of how much borrowed money they can use to conduct their business.

Last month, federal regulators proposed going somewhat beyond the internationally agreed minimum known as Basel III, which is being phased in. Last Monday, President Obama scolded regulators for dragging their feet on implementing Dodd-Frank, the gargantuan 2010 law that was supposed to prevent another crisis but in fact punted on most of the tough decisions.

Don’t let the flurry of activity confuse you. The regulations being proposed offer little to celebrate.

From Wall Street to the City of London comes the same wailing: requiring banks to rely less on borrowing will hurt their ability to lend to companies and individuals. These bankers falsely imply that capital (unborrowed money) is idle cash set aside in a vault. In fact, they want to keep placing new bets at the poker table — while putting taxpayers at risk.

When we deposit money in a bank, we are making a loan. JPMorgan Chase, America’s largest bank, had $2.4 trillion in assets as of June 30, and debts of $2.2 trillion: $1.2 trillion in deposits and $1 trillion in other debt (owed to money market funds, other banks, bondholders and the like). It was notable for surviving the crisis, but no bank that is so heavily indebted can be considered truly safe.

The six largest American banks — the others are Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley — collectively owe about $8.7 trillion. Only a fraction of this is used to make loans. JPMorgan Chase used some excess deposits to trade complex derivatives in London — losing more than $6 billion last year in a notoriously bad bet.

Risk, taken properly, is essential for innovation and growth. But outside of banking, healthy corporations rarely carry debts totaling more than 70 percent of their assets. Many thriving corporations borrow very little.

Banks, by contrast, routinely have liabilities in excess of 90 percent of their assets. JPMorgan Chase’s $2.2 trillion in debt represented some 91 percent of its $2.4 trillion in assets. (Under accounting conventions used in Europe, the figure would be around 94 percent.)

Basel III would permit banks to borrow up to 97 percent of their assets. The proposed regulations in the United States — which Wall Street is fighting — would still allow even the largest bank holding companies to borrow up to 95 percent (though how to measure bank assets is often a matter of debate).

If equity (the bank’s own money) is only 5 percent of assets, even a tiny loss of 2 percent of its assets could prompt, in essence, a run on the bank. Creditors may refuse to renew their loans, causing the bank to stop lending or to sell assets in a hurry. If too many banks are distressed at once, a systemic crisis results.

Prudent banks would not lend to borrowers like themselves unless the risks were borne by someone else. But insured depositors, and creditors who expect to be paid by authorities if not by the bank, agree to lend to banks at attractive terms, allowing them to enjoy the upside of risks while others — you, the taxpayer — share the downside. [Heads we win, tails you lose.]

Implicit guarantees of government support perversely encouraged banks to borrow, take risk and become “too big to fail.” Recent scandals — JPMorgan’s $6 billion London trading loss, an HSBC money laundering scandal that resulted in a $1.9 billion settlement, and inappropriate sales of credit-card protection insurance that resulted, on Thursday, in a $2 billion settlement by British banks — suggest that the largest banks are also too big to manage, control and regulate.

NOTHING suggests that banks couldn’t do what they do if they financed, for example, 30 percent of their assets with equity (unborrowed funds) — a level considered perfectly normal, or even low, for healthy corporations. Yet this simple idea is considered radical, even heretical, in the hermetic bubble of banking.

Bankers and regulators want us to believe that the banks’ high levels of borrowing are acceptable because banks are good at managing their risks and regulators know how to measure them. The failures of both were manifest in 2008, and yet regulators have ignored the lessons.

If banks could absorb much more of their losses, regulators would need to worry less about risk measurements, because banks would have better incentives to manage their risks and make appropriate investment decisions. That’s why raising equity requirements substantially is the single best step for making banking safer and healthier.

The transition to a better system could be managed quickly. Companies commonly rely on their profits to grow and invest, without needing to borrow. Banks should do the same.

Banks can also sell more shares to become stronger. If a bank cannot persuade investors to buy its shares at any price because its assets are too opaque, unsteady or overvalued, it fails a basic “stress test,” suggesting it may be too weak without subsidies.

Ben S. Bernanke, chairman of the Federal Reserve, has acknowledged that the “too big to fail” problem has not been solved, but the Fed counterproductively allows most large banks to make payouts to their shareholders, repeating some of the Fed’s most obvious mistakes in the run-up to the crisis. Its stress tests fail to consider the collateral damage of banks’ distress. They are a charade.

Dodd-Frank was supposed to spell the end to all bailouts. It gave the Federal Deposit Insurance Corporation “resolution authority” to seize and “wind down” banks, a kind of orderly liquidation — no more panics. Don’t count on it. The F.D.I.C. does not have authority in the scores of nations where global banks operate, and even the mere possibility that banks would go into this untested “resolution authority” would be disruptive to the markets.

The state of financial reform is grim in most other nations. Europe is in a particularly dire situation. Many of its banks have not recovered from the crisis. But if other countries foolishly allow their banks to be reckless, it does not follow that we must do the same.

Some warn that tight regulation would push activities into the “shadow banking system” of money market funds and other short-term lending vehicles. But past failures to make sure that banks could not hide risks using various tricks in opaque markets is hardly reason to give up on essential new regulations. We must face the challenge of drawing up appropriate rules and enforcing them, or pay dearly for failing to do so. The first rule is to make banks rely much more on equity, and much less on borrowing.

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.