United States Federal Reserve chairman Ben Bernanke is visibly frustrated that
many in Congress do not give the Fed what he believes is enough credit for what
it has accomplished in responding to the economic crisis, even as Wall Street
heaps praise on his bold actions and steady hand in pulling the financial
system out of an impending meltdown.
Bernanke, whom President Barack Obama this month appointed for a second term as
Fed chairman, faces a far from smooth passage through calmer seas over his next
four years in the post. All the structural weaknesses that caused the economy
to implode two years ago are still in the financial system, albeit
swept under the rug into the Fed's balance sheet and masked by massive amount
of new money and public debt not backed by any new wealth creation.
Even if all goes according to the seemingly chaotic plan, the prognosis is that
recovery will be anemic and stretch out in several years if not decades. Eroded
by events, Bernanke's falling popular approval and low credibility could in
themselves add to further loss of confidence in the market at a time when the
Fed is trying its utmost to restore confidence.
On the employment front, the Fed's dogmatic monetarism renders it operationally
impotent in reducing unemployment except through trickling down from corporate
profit, which cannot recovery without consumer demand, which in turn cannot
recover without full employment.
On the financial front, the Fed faces a dilemma of deciding when to implement
an exit strategy. Fed exit strategy is dependent on an economic recovery, but
recovery will be aborted by a Fed exit. Yet the future of the dollar requires
the Fed to implement an exit at the earlier possible time. The Fed has a
Hobson's choice between a robust recovery, low interest rate, low inflation, or
a strong dollar, but not all. Unfortunately, Bernanke, by trying to balance on
a high wire, may end up losing all and fall flat on his caution.
On the political front, Bernanke is trying to protect the Fed's regulatory
power and independence as the White House and Congress debate plans to overhaul
the financial regulatory regime. Critics of the Fed assert that making the Fed
or any other unit of government a super regulator will lead to bank
consolidation and monopoly that will increase systemic risk.
Democrats such as Senate Banking Committee chairman Christopher Dodd of
Connecticut and House Financial Services Committee chairman Barney Frank of
Massachusetts contend that the Fed's incestuous relationship with big banks and
Wall Street firms was a systemic cause of the mortgage crisis, and that the Fed
already has too much power to merit getting more.
Bernanke and his predecessor, Alan Greenspan, now concede that the Fed failed
to anticipate the full danger posed by the explosion of subprime mortgage
lending made possible by their loose monetary policy. As recently as the spring
of 2007, Bernanke still insisted that the problems of the housing market were
largely "contained" to subprime mortgages. Even when panic over mortgage-backed
securities began spreading through the broader credit markets in late July
2007, the Bernanke Fed still refused to cut interest rates to ward off an
impending systemic collapse.
Even as late as the end of 2007, five months after the credit crunch first
began, the Fed was still unable to reach a consensus internally on a decisive
policy response and decided to leave interest rates unchanged. Bernanke as
captain of the monetary ship, was ordering steady as she goes directly into a
perfect financial storm.
Only in the January 21, 2008, FMOC meeting did the Fed belatedly slashed the
benchmark federal funds rate by 75 basis points to 3.5%, the biggest one-time
reduction in decades. Nine days later, The Fed cut the rate again down to 3%.
By then the panic was spreading full speed to all markets.
As the credit crisis paralyzed the financial markets, Bernanke led the Fed to
devise unprecedented but controversial bailout measures without fully
understanding or at least show concern for long-range implications. Underneath
all the complex technicality of financial ballistics, Bernanke's gunpower was
an old-fashion creation of massive amounts of money by expanding the Fed's
balance sheet to $2 trillion from $900 billion a year ago.
The hard half of the game
But that was only half the game. The other half, the end game, is how to
withdraw all the public money from the financial system without throwing the
economy into a protracted depression.
The Fed's "exit strategy" as outlined by Bernanke is based on a groundless hope
that financial recovery will bail the Fed out of its oversized balance sheet,
reversing the logic that the Fed is supposed to bail out the economy out with
an engineered sustainable financial recovery. The Fed has bailed out the
debt-infested financial system by transferring its toxic debt to the Fed
balance sheet and the Fed's exit strategy is to unload the same toxic debt back
on the financial system as it recovers without causing its collapse again.
The game is for the Fed to give more money to the banks to buy back the toxic
debt from the Fed's balance sheet and call it a recovery. Throughout this
circular exercise, the economy is left to rot with rising unemployment and a
damaged dollar.
The Treasury Department's $700 billion Troubled Asset Relief Program (TARP)
bailout has stabilized a handful of banks deemed too big to fail, but it has
not saved the critically impaired banking system as a whole. Small banks
continue to fail, burdening the Federal Deposit Insurance Corporation with
having to ask the Treasury for more money, for which the Treasury in turn has
to ask the Fed to provide by buying more Treasury bills to add to its balance
sheet. That critical observation is the essence of the Congressional Oversight
Panel (COP) report in August. (See
A lost decade ahead, Asia Times Online, September 14, 2009).
TARP was initially designed to buy troubled and illiquid mortgage-backed
securities from banks. But by accepting the public recommendation of Nobel
economics prizewinner Paul Krugman via the New York Times, the Treasury never
actually used the appropriated funds to buy troubled assets, in part because it
was simpler to invest money directly into the nation's banks and in part
because banks were reluctant to sell their toxic loans at a loss.
"The nation's banks continue to hold on their books billions of dollars in
assets about whose proper valuation there is a dispute and that are very
difficult to sell," the COP report said. As a result, the COP report warned,
many banks could find themselves short of capital if the economy suffered
another market downturn and their losses on troubled loans soared. What the
report did not say was that the prospect of further bank crisis itself will
bring about another market meltdown.
While recommending further stress tests for the too-big-to-fail banks, the COP
report warned that thousands of small and medium-size banks, which it defines
as those with assets of $600 million to $100 billion, might find themselves
short a total of $21 billion in capital if the conditions match its worst-case
assumptions.
The report noted that other institutions had already estimated the amount of
troubled assets on bank balance sheets that had yet to be written down. The
Federal Reserve estimated in May that banks in the United States still had
about $599 billion in assets to write down. Goldman Sachs and the International
Monetary Fund (IMF) estimated the total at about $1 trillion. And RGE
Economics, headed by doom guru Nouriel Roubini, has estimated the total at
$1.27 trillion.
The COP report urged the Treasury to either expand its Public Private
Investment Program (PPIP) to soak up troubled assets "or consider a different
strategy", without identifying one.
Seizing on a report of existing home sales rising 7.2% in July, the biggest
jump this decade, albeit from very low base, Bernanke declared what may become
another set of famous last words: "The prospects for a return to growth in the
near term appear good." He did not mention at what distressed prices the sales
were make.
Meanwhile, Meredith Whitney, who commands more credibility in the market than
Bernanke based on her accurate analyses of the precarious position of Citigroup
as the credit crisis was building up, observed: "There will be over 300 bank
closures." European Central Bank (ECB) president Jean-Claude Trichet cautioned
against assuming that the world was back to normal.
Some critics think the August 2009 COP report makes the false assumption that
when a bank is insolvent that it automatically ceases operations, which of
course is not necessarily what happens. Receivership is the way that a bank's
liabilities are restructured when that institution is insolvent. The
restructured bank's debts are reduced but depositors can still access 100% of
their deposits without interruption up to the $250,000 limit insured by the
FDIC.
In most cases, the failed bank's management will be replaced, some liabilities
to creditors are reduced, and one of the healthy competitors of the failed bank
takes over the branches of the failed bank to continue operations. Much of the
time, receivership means that bank shareholder equity is wiped out, but the
branches remain open for business, making loans the very next business day.
It is not clear that the Fed buying toxic assets from small banks would be a
good idea. In two papers: "The Put Problem with Toxic Assets" and "A Binomial
Model of [Treasury Secretary Timothy] Geithner's Toxic Asset Plan", University
of Louisiana Professor Linus Wilson shows that the government must overpay for
toxic assets to get banks that have not entered receivership to part with these
trash loans and securities.
Wilson's research shows that troubled banks that are not yet in receivership
will be most reluctant to part with their toxic loans. That is because most of
their stock price is derived from the volatility of the market value of toxic
assets. FDIC receivership allows the FDIC to write down bank debts so that
failed banks can emerge from restructuring healthier than they entered. But
another of Wilson's papers: "Debt Overhang and Bank Bailouts", shows that toxic
assets are the biggest problem when banks are poorly capitalized.
There are over 8,000 FDIC insured banks in the United States, serving
communities of all sizes. Most of them are not large enough to pose systemic
risk to the financial system. Wilson's research shows that Geithner's plan to
sell toxic assets through the PPIP is most likely to be effective if it is used
on banks that are in receivership, rather than to keep banks out of
receivership. It would be a misguided subsidy, which would hurt the deposit
insurance fund, if the Legacy Loans Program, part of the PPIP, is used on
undercapitalized small banks to keep them out of receivership to preserve
shareholder value.
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