Is Ben Bernanke driving the QEII or the Titanic?

December 6, 2010

Our colleagues in the media have been diligently pouring over the latest disclosure by the Federal Reserve on rescue loans made to banks and corporations around the world in the hope of uncovering a pearl. For one thing, the details of the extensive rescue operation by the Fed following the collapse of Lehman Brothers in 2008 confirms the role of the U.S. central bank as the global lender of last resort, a job description as yet unauthorized by Congress. But there are some rather subtle revelations which do deserve investigation.

A number of writers have noticed that the fact that the Fed did not reveal these operations until now doubtless effected how the Congress finally legislated in the case of the Dodd-Frank law. “The Fed’s current set of powers and the shape of the Dodd-Frank bill over all might have looked quite different if this information had been made public during the debate on the bill,” American Institute for Economic Research fellow Walker Todd told Gretchen Morgenson in the Sunday New York Times. “Had these tables been out there, I think Congress would have either said no to emergency lending authority or if you get it, it’s going to be a much lower number — half a trillion dollars in the aggregate.”

Perhaps more important is the fact that there is now confirmation that the Fed took in equities as collateral during the market liquidity operations in 2008 and 2009. As one of our favorite equity market observers wrote last week, the fact of the Fed financing equity positions was known in September of 2008, but as my colleague noted at the time, “you had to read between the lines.”

As it turns out, the Fed’s primary dealer credit facility or “PDCF” was essentially able to take any paper, debt or equity, proving once and for all that the Fed had abandoned any pretense at market discipline. For 25 pips over Fed funds, you could finance any equity security: “Eligible collateral will include all collateral eligible in tri-party repurchase arrangements with the major clearing banks as of September12, 2008,” said the Fed in a press release.

Previously I had heard from a number of large bulge bracket firms that there was no problem financing anything with the Fed during the crisis: office furniture, equities, whatever. So now this latest data dump from Chairman Bernanke seems to confirm that eye-opening fact and more, namely that during the crisis dealers were using the Fed to finance equity positions as well as Treasury bonds and mortgage-backed securities.

Thus the question becomes: Will the U.S. central bank continue to backstop equities when (not if) falling economic growth, rising employment and rising interest rates push equity valuations lower? There are a number of reasons to be concerned that a sustained increase in interest rates will not only make bonds and other interest rate instruments more competitive with stocks, but that an overly optimistic consensus behind the prospects for growth is about to be brought down to earth.

For one thing, the Fed’s zero interest rate policy has made the equity markets seem relatively attractive. Putting cash into blue-chip equities makes more sense, at least for some investors, than buying bonds at what may be the lowest yields that will be seen for a generation. Given the Fed’s purchases of Treasury debt via QE II, volatility is understated and thus the duration risk on bonds is likewise being understated in the markets. As one trader asked me recently: “Is Fed Chairman Ben Bernanke steering the QE II or the Titanic?”

The other issue that has made equities relatively attractive is liquidity. When investors are buying large-cap stocks, even financial names such as Citigroup, JPMorgan and Wells Fargo, they are buying size, not quality. Whereas most of the largest US banks have single digit or event negative risk-adjusted returns, smaller regional exemplars such as Cullen Frost, BB&T or US Bancorp have consistently out-performed the larger players when it comes to growing fundamental value at reasonable levels of risk.

When the Fed uses QEII to subsidize the largest players on Wall Street, it is disadvantaging the smaller, better run banks, and it is also playing with politics. Priyank Gandhi and Hanno Lustig, in a National Bureau of Economic Research working paper issued in November (No. 16553), suggest that the implicit collective guarantee extended to large U.S. financial institutions reflects an annual subsidy to the largest commercial banks of $4.71 billion per bank, measured in 2005 dollars. But, even more important, the paper notes that subsidies for the “too big to fail” banks shows the Fed’s willingness to support the equity markets, an extraordinary and ultimately political act that requires further hearings by the Congress.

Like it or not, indices such as the dollar, the Dow Jones Industrials and S&P 500 are a litmus test not only for the markets, but for the credibility of American political leaders. When the Fed deliberately bails out some banks but not others, and also relieves Congress and the White House from doing their collective jobs in terms of fiscal policy, Chairman Bernanke provides short-run stability via endless liquidity, but ultimately hurts the American people by short circuiting the political process.

It is time for Fed Chairman Bernanke and the other members of the FOMC to step back from crisis mode and demand that Congress and President Obama pick up the ball. Specifically, Washington needs to take an example from our friends in the United Kingdom and begin the process of economic and fiscal restructuring now, before the next phase of the economic crisis crests next year. That may require letting equity markets sag when the full truth of the remaining economic adjustment is accepted by the public.

As I wrote in Zero Hedge last week, “Loss Given Default: From Madrid to Los Angeles Foreclosures Set to Crest in 2011-2012”), next year, IMHO, we are going to see a further sharp decline in residential home prices as the tide of foreclosures begun in the past year starts to clear the courts and move to market via involuntary sales. The same thing is happening in Spain, by coincidence, “Foreclosed Homes May Flood Spanish Market as Banks Offload Unwanted Assets”. When this next deflationary leg in the “revenue side” of the economic equation ripples through the economy, both restructuring and aggressive action by the Fed to provide liquidity will be required.


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Thank you Mr. Whalen for going to the heart of the matter. I would suggest that you understate the significance of what the Fed is doing, apropos the political process. By “short circuiting the political process”, what Bernanke is really doing is dislodging the anvil of democratic due-process, and leaving a tiny cabal of financial moguls and their elected cronies to wield the hammer of government as they please.

What is lost in the talking points and posturing by various high-priests of economic doublespeak, is that the perceived legitimacy of the world’s reserve currency has been, up to this point, grounded in the general perception that the United States Constitution and it’s vaunted “checks and balances”, contain and correct the corrupt impulses of the individual human beings who exercise it’s authorities.

The most fundamental canard which is repeated countless times when discussing the fiscal policies of the US government is that these are ‘tax-payer dollars’ being spent, and it’s equally fraudulent companion, ‘generational theft’, ie: the notion that the consequences of more debt will be borne by “our children and our grandchildren” decades in the future, as opposed to us in the here and now.

In fact, if tax-payer dollars were actually being collected and spent, the fiscal policies of the US government would be far different from what they are, and the US economy far different from what it is now. As for our children and our grandchildren dutifully organizing their lives and their careers so that they can pay off the debts we have created for them, it’s hard to imagine a more insolent use of sophistry to distract voters from the looting of their current assets which is taking place each day.

Posted by tbfh1955 | Report as abusive

“It is time for Fed Chairman Bernanke and the other members of the FOMC to step back from crisis mode and demand that Congress and President Obama pick up the ball.”

Au contrare! It is time that the commercial bank, the Fed Reserve, step down as a voice, driving force, or shister terrorist to America and its economy, and force the U.S. Treasury to retake the full measure of its authority. If you want to create government jobs, I think every conservative in the nation will support the massive growth of the Treasury to take over the full tasks currently held, managed and secreted away by the Fed.

Kill the Fed, and reassume the duties under the entity of government that should have it: The U.S. Treasury. If the Treasury holds the banking functions of the U.S., then Congress, and hence the citizens, control the nation’s fiscal and fiduciary duties, not a global commercial bank conducting ‘under the covers’ banking and loaning funds, our backed-dollars, to potential enemies, poorly run businesses, or other entities – and then turning to bite the hand that feeds it, and say that ‘no one has the right to audit the Fed’…who’s money do they think they are playing with, anyhow?

Posted by Muerte | Report as abusive


The only thing that surprises me is that people are surprised by the fact that the Fed backstops stock prices. Bernanke even announced that a key goal of QE2 was to push stock prices higher in his Washington Post Oped the night of the QE2 announcement. Furthermore in my work tracking the Fed over the past 8 years, the correlation between TOMO and POMO and the direction of stock prices was very strong.

In Fedpoints on the NY Fed website nt/fed32.html , the Fed describes how “The Fed’s traders discuss with the primary dealers how the day might unfold in the securities market and how the dealers’ task of financing their securities positions is progressing.” It doesn’t say “not including equities”. They are very clear that they meet daily with the Primary Dealers to rig the game. There it is in black and white. The smoking gun.

In instituting PDCF, they conducted those operations even more directly, however PDCF was a brutal failure, because at the same time the Fed was pulling hundreds of billions out of SOMA, and shifting it into direct lending programs with the banks and every other supplicant who showed up at Ben’s doorstep. That forced the PDs to sell everything in sight. $200 billion a month in SFP Treasury paper didn’t help. The correlations show clearly, that far from mitigating the September-October 2008 crash, the Fed and Treasury caused it.

As someone else recently said so eloquently, the Fed people are lying liars who lyingly lie all the time, but propping stock prices was never something that they overtly lied about. They may not have crowed on the street corners about it, but they didn’t run away from the fact either. The amazing thing is how incompetent the Fed is when it comes to these things. They are a bunch of delusional stumblebums flailing around in the dark taking us into the black hole with their insane policy actions.

Lee Adler
The Wall Street Examiner

Posted by LeeAdler | Report as abusive

I think Jim Rickards’ proposal that the U.S. permit gold and silver to be revalued to a market price would go a long way as a market clearing mechanism. However, you are right, at some point the second point of the clearance, that of writing off debt, must occur. It is the millstone preventing recovery. I would go so far as to say a partial default on Treasuries is the answer. The debt market and derivatives market are far too large in relation to the world economy to make any rational sense. Price is the word.

Posted by Fazsha | Report as abusive