Is Ben Bernanke driving the QEII or the Titanic?

Dec 6, 2010 22:26 UTC

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.


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.

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In a new period of instability, Obama becomes Hoover

Oct 7, 2010 14:50 UTC

Yesterday I participated in a “Living in the post-bubble world: What’s next?” event with Nouriel Roubini. The key take-away from the discussion is that the U.S. and global economies are headed into a new period of instability and competitive currency devaluations.

The primary driver of this breakdown in the international consensus around free trade and global markets is the overt policy by the Fed to use quantitative easing or “QE” to devalue the dollar. The final comments by John Makin illustrate this point very nicely.

Now the Fed claims that further QE, which will include the purchase of hundreds of billions in debt issued by the Treasury, will help stimulate the U.S. economy and reverse the secular deflation that is depressing real estate valuations, employment and business investment. But the trouble is that QE is having little positive impact on American households. Without refinancing, there is no reflation of balance sheets or consumer spending.

As I noted in an earlier comment, “Bernanke conundrum is Obama’s problem,” the Fed’s attempts to help American households is being blocked by the largest banks. We wrote about the issue again this week in The Institutional Risk Analyst, “Refinancing, Not Foreclosures, is the Issue.”

While the Fed has been attempting to refloat these same banks — and their bond holders — on a sea of cheap money, the central bank is ignoring the larger, structural problems in the real estate sector. Forget mere valuations losses on ABS and derivatives on same. The real surprise heading for Washington and Wall Street is when everyone realizes that the big risk facing the U.S. economy is not from the foreclosure crisis, but from the actions of the “Big Five” financial monopolies — Fannie Mae, Freddie Mac, Bank of America, Wells Fargo and JP MorganChase – to prevent tens of millions of American homeowners from refinancing performing mortgages.

In public, the Fed is keeping a brave face on its policy moves, but in private current and former Fed officials acknowledge that there is little that the central bank can do to reverse the deflation that seems to be accelerating. There is a 40% probability of a double-dip recession, Nouriel Roubini said during the discussion.

I would argue that such metaphors miss the many differences in the present economic collapse compared with previous “recessions.” Indeed, as Tom Zimmerman of UBS noted very astutely, by easing interest rates in 2001-2002, the Fed avoided a recession then, so now we are going through double the adjustment process.

What is to be done? For starters, American policy makers need to acknowledge that the real intent of the Fed’s resumption of QE is not to stimulate directly domestic economic activity, but instead to drive down the value of the dollar — an adjustment that is long overdue. The monetary ease already injected into the U.S. economy justifies a significant drop in the value of the greenback, an adjustment that America’s creditors and trading partners have long resisted. A cheaper dollar means less export revenue for China and the other mercantilist nations of Asia and a de facto default for America’s foreign creditors.

Second, in concert with QE, the Fed needs to dust off the bully pulpit and start to publicly discuss why the largest U.S. banks are unable or unwilling to refinance the more than 30 million households which have relatively high-cost mortgages. As I have noted previously, the large banks and the housing GSEs, Fannie Mae and Freddie Mac, are using fees and other subterfuges to block refinancing for millions of Americans. This renders Fed interest rate policy largely ineffective.

It also is time for Chairman Bernanke and other Fed governors to publicly own up to the surreptitious transfer of hundreds of billions of dollars per year from American savers to the largest banks, a cowardly strategy that is allowing the Obama Administration and Congress to avoid making tough decisions about restructuring the U.S. financial system. The spectacle of Treasury Secretary Tim Geithner publicly accounting for repayment of TARP while the largest U.S. banks sink into insolvency is a national scandal.

As the Fed starts to get ahead of the curve in terms of the continuing crisis in the banking sector, the economists inside the central bank should start to ponder a new policy approach: QE to devalue the dollar and modestly higher interest rates to restore balance between the continuing needs of the banking industry and American savers.

Retired Americans, working families and corporate treasurers are all being taxed via QE and zero interest rates to subsidize the largest banks. It is time for Fed Chairman Bernanke to reassert the independence of the U.S. central bank and demand that Congress and the Treasury start to do their jobs. If we need to restructure the largest banks, then we should make the cost explicit and conduct the process publicly for all Americans to see.

As I told the AEI audience, the avalanche of mortgage defaults now hitting Bank of America, Wells Fargo and other large lenders could force these banks to seek new government bailouts in 2011, an outcome that will expose the Obama Administration’s incompetence for all to see.

For the economy, the slow process of muddling along championed by Secretary Geithner will ensure that Barack Obama becomes the Herbert Hoover of the Democratic Party. From the Crash of 1929 until the end of his term in 1932, President Hoover repeatedly predicted the end of the crisis. The rest is history.


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Double dip or global deflation?

Sep 20, 2010 20:03 UTC


The page proofs of my upcoming book, “Inflated: How Money and Debt Built the American Dream,” just went back to the editors. One of the benefits of writing a book about U.S. financial history is that it forces you to take a long view of both economics and the political narrative used to describe it. It is the issue of language and labels, in my view, that is making it so difficult for Americans to understand the current state of the economy.

The National Bureau of Economic Research just declared that the “recession” that began in 2007 ended in the middle of 2009, making it the longest downturn since WWII. The only problem is that none of the people who work at NBER today, which is one of my favorite research organizations, are old enough to remember what the U.S. economy was like before WWII; before the age of Keynesian socialism and the use of debt to stimulate growth and employment became standard policy in Washington.

Let’s start with the term “recession,” which itself reflects the assumption that economic growth is always positive and the trend line is always upward sloping. While many economists in the U.S. remain convinced that this is an accurate descriptor, what Americans and many other people of the world need to consider is whether the assumption that the economy will grow endlessly is reasonable.

In the period following the Crisis of 1907 and before the start of WWI, Americans faced a grim economic outlook. Jobs were scarce, product and commodity prices were flat, and the value of farm products and land had been falling for years. The American economy was entirely dependent upon Europe for financing and to buy U.S. products, mostly agricultural and other commodities. The dismal economic scene fed the rise of the Progressive movement in U.S. politics.

WWI provided a sharp relief from this picture of economic stagnation. Employment rebounded, American agricultural prices soared and the value of real estate around the U.S. also rose sharply. With renewed growth came inflation, however, so that by the time that WWI ended, prices for many consumer staples had doubled, but wages did not keep pace. Economic activity gradually slowed as the U.S. made its way through the Roaring Twenties, but many Americans never saw any benefit from this period of speculation and financial excess.

Following the Crash of 1929, the pretense observed by both political parties that all was well in the U.S. economy evaporated into almost twenty years of economic stagnation. While the massive mobilization  for WWII provided the appearance of a recovery, and the period of the Cold War extended this mirage on a sea of public debt and paper dollars, the basic issue of overcapacity remained.

From the 1970s, when the U.S. shifted from defense to housing as the chief driver of American economic growth, the illusion became ever more attractive and, seemingly at least, permanent. But the sad fact is that much of what Americans think was real growth supported by real income and real work was, in fact, the result of deficit spending and reckless monetary expansion by the Fed, first under Alan Greenspan and now Ben Bernake.

In an interview for my book former Fed Chairman Paul Volcker noted:

We live in an amazing world. Everybody has big budget deficits and big easy money, but somehow the world as a whole cannot fully employ itself. It is a serious question. We are no longer just talking about a single country having a big depression but the entire world. If the world as a whole cannot employ everyone who is ready and able to work, it raises some big questions.

Earlier this week in a research note for the IRA Advisory Service, we reported that some of the leading experts in the housing sector believe that the U.S. is less than 25% through the restructuring of defaulted loans on commercial and residential real estate, and that the backlog is growing.  Last week at the AmeriCatalyst conference held in Austin, TX, Laurie Goodman from Amherst Securities predicted that one in five U.S. households remains at risk of foreclosure. If this prediction turns out to be correct, the optimistic view of the U.S. economy and banking sector must be radically revised — and soon.

Just as the housing sector and the related debt was the driver of the U.S. economy over the past several decades, I believe that the deflation of the housing market could spell an equally drastic period of shrinkage in economic activity in the U.S. and around the world.  In order to meet this challenge, both the political and economic communities need to put aside preconceived notions of how the economy should look and begin to develop new language to describe what is really happening to consumers and businesses. Only then can we truly begin the process of working through what is the most serious economic contraction in the U.S. since WWI.


During the economic doldrums of the 30′s the national government was able to accomplish the major hydroelectric projects, established the TVA and was able to do a lot of conservation work in national parks. They were able to do it for relatively cheap wages too. There was also a major campaign of constructing public buildings. Town Halls, Courthouses, and public schools were built all over the country. Most of the Art deco or “art moderne” public buildings that still stand date from that period.

Years ago I met an old coal miner from PA who said he was getting $5 per day during the depths of the depression. He was making a very good income for the time and for his trade. It was a surprise to hear that because I thought those guys were worked to death. That they were the most exploited laborers.

This country can’t do anything cheaply apparently. That would be a disaster in its own right.

The stimulus money was spent keeping the cost structure up and paving a few roads. Billions just don’t seem to deliver much of a punch.

But if growth is not to be expected here – what do the inmates do – especially the unemployed inmates? One can’t even be innovative or adaptable if one lacks the means. A one-year at home online computer graphics course can cost from $14,000 to $17,000. For what?

The wealthy aren’t holding lavish balls or giving big and expensive parties as they did during the depression, with the very self conscious idea that they had to spread the wealth somehow – Noblesse oblige – and the bargains they must have got. But they stopped doing that under Roosevelt or thereabouts. It looked bad in the papers and was ridiculed.

WR Hearst at San Simeon had a workman build a fireplace and chimney for one of his guest houses, and then ordered it torn down and rebuilt in another wall and than changed his mind and ordered it torn down again and moved back where it was to begin with. The fireplace was three stories of modern and antique masonry and reinforced concrete. One of the masons was so upset he quit at the time when Hearst’s castle was one of the few active construction projects in the state of California. I know a great many construction workers who would dearly love to meet a modern Hearst.

To heck with re-labeling the current recession or incipient depression or global big sleep! A much clearer idea of what the real course of action should be is needed. It isn’t encouraging that the few economic bright spots the author describes were during the major blood baths of WWI and WWII. But not even war expenditures are delivering the economic adrenaline rush they used to. It also suggests that perhaps the only time the economy is really kicking is when cannibalism is being practiced. That humanity had to eat itself to feed itself?

Maybe the country is just dying. It is getting old and needs to rest? God help the young. It isn’t fair to them to be pulled into the grave with those more than ready, and maybe more than deserving, to hang it up.

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Memo to Obama: time to break the refinance strike by the big banks

Aug 31, 2010 16:56 UTC

There are growing signs of unease bordering on desperation inside the Obama White House. Most of the O Team now understands that the real, private economy never got out of Dip Number One. The prospect of a permanent downward shift in “trend growth” to a lower track, and continued double digit unemployment, are driving a search for alternative measures that has even touched conservatives in the worlds of finance and economics.

The Obama Administration and the Fed have taken the position that the crisis affecting the U.S. economy and the financial sector is slowly ending. In fact, the largest banks remain profoundly troubled by bad assets on their books as well as claims against these same banks for assets sold to investors. By allowing banks to “muddle along” and heal these wounds using low interest rates provided by the Fed, the Obama Administration is embracing a policy of deflation that has horrible consequences for U.S. workers and households.

In a post over the weekend on ZeroHedge –  “Bernanke Fed Drives Deflation With Zero Rate Policy” — I described the negative effects of the Fed’s low interest rate policy on bank earnings, as well as consumer and corporate spending and saving. When interest rates are low, savers move their preference for liquidity to infinity, especially after the past several years of market breakdown. Retirees spend less because the interest earned on bonds and savings has plummeted.  Here’s an excerpt:

When the Fed buys securities through QE, it is removing duration from the markets, pushing down yields and volatility. For a while this boosts the net interest margin (NIM) of leveraged investors such as banks, who are able to borrow at lower rates to fund current assets. As assets re-price to the low rates maintained by the Fed, however, NIM begins to disappear. Over the medium to longer term, think of duration and NIM as being linked, so obviously a sustained period of QE is bad for NIM. This is why NIM in the U.S. banking sector is starting to fall.

Just as the earnings of leveraged investors like banks are starting to suffer due to zero rate policy, so too the spending by all manner of savers, from retirees to companies and not-for-profits to municipalities, is falling too. Fed Chairman Bernanke and the other members of the FOMC are killing the real economy to save the banks — but none of the benefit flowing to the banks is reaching U.S. households. In fact, the Obama Administration has been providing political cover for the Fed to conduct a massive, reverse Robin Hood scheme, moving trillions of dollars in resources from savers and consumers to the big banks and their share and bond holders.

The first priority is to make clear to the largest banks, especially the top four institutions — JPMorganChase (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C), that the party is over when it comes to providing credit to the real economy. Until President Obama and Fed Chairman Bernanke recognize that six institutions — FNM, FRE, BAC, C, JPM and Wells Fargo — have broken the mechanism which makes interest rate easing work, we will make little progress fixing the economy.

“In every Fed easing event during my career in finance (1986, 1992, 1998, 2002), it was the wave of refinancing of debt after the Fed eased interest rates that put permanent disposable income into the hands of households,” notes a former Fed official who worked in the banking industry for decades. “In this last easing, however, FNM, FRE and the TBTF banks have conspired to break the transmission mechanism for monetary policy and are now strangling the U.S. economy to save themselves from past errors.”

Rules changes made by FNM and FRE since the Treasury’s conservatorship began in 2008 have prevented millions of American consumers and business from refinancing their mortgage debts. The Bernanke Fed will attempt to compensate for this de facto freeze on refinancing with QE II, but this will fail.

So what should President Obama do?

First, the Obama Administration should use the power provided in the Dodd-Frank legislation to force an accelerated cleanup of bad assets and to mandate refinancing and principal reductions for performing loans with viable borrowers. If any banks resist, the Treasury should use the power under current federal law to remove recalcitrant officers and directors of these same banks.

Second, President Obama also needs to focus on the growing competitive problem in the U.S. mortgage sector. The mortgage banking industry suffered significant consolidation since 2007. In particular, the competitive, third part origination players went out of business via bankruptcy or by being taken over. The industry is now dominated by a cozy oligopoly of Too Big To Fail banks (TBTF).

The top three banks control 55% of all mortgage originations. The top 10 banks control 95%. The top five run the only surviving channels to sell loans to Fannie Mae (FNM) and Freddie Mac (FRE), and force their pricing upon the entire banking industry. Small banks give up half the economics of a typical loan to sell a loan to FNM or FRE indirectly, through WFC or JPM. Why is there no antitrust investigation of the top banks by the Department of Justice?

The Obama Administration should move to restructure FNM and FRE now, not in 2011. The Treasury should use its existing authority under the conservatorship to force FNM and FRE to make rules changes to allow for the refinancing of all existing residential mortgages, if only to reduce the current cost of the debt and increase disposable income for households.

By moving on reforming FNM and FRE, the Obama Administration can provide relief to home owners and also send a strong message to Wall Street and global investors that the practice of “too big to fail” is at an end. We should always remember that the model of the government sponsored enterprises (GSEs) goes back to fascist Italy and Germany of the 1920s. The very public demise of these GSEs is an important part of ending TBTF for the large banks — but only part of the story.

President Obama should make some political hay over the fact that loan origination margins for the top four banks have gone from ½ point to over 4 points in the last two years. This is the subsidy for Wall Street above and beyond the zero interest rate policy of the Fed. The Obama Administrations needs to require changes in the way in which FNM and FRE do business with the banking sector and with mortgage holders, and use these changes to reform the mortgage market in preparation for legislation from the Congress.

By reducing barriers to refinancing by FNM and FRE, and aggressively forcing private banks to mark mortgages to market and accept principal write-downs or short sales to clear the backlog of bad debt, the Obama Administration can restore balance to the economy and create a healthy basis for new growth.


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