Thursday, December 3, 2009

The FED, Asset Bubbles, AIG, & Fraud

For over a year I have questioned why bank executives were not removed, why toxic assets were not ripped out, and why AIG and Citi were allowed to survive in essentially unchanged form.  It has become increasing clear that it was more important to continue the financial system status quo than to establish financially strong but non-systemically dangerous banks and shadow banks.  Financial reforms in Congress have been watered down to the extent that the financial sector is likely to come out ahead in special privileges rather than reformed.  We are constantly told this reform and that reform will deter liquidity when the actual problem is insolvency and a private financial system that gets the profits and pushes the losses off to the the public.

Tom Duy in a post on the Economist's view entitled, "FED Watch: Bubbles and Policy", asks the question are asset bubbles in foreign countries any concern of the Fed and are asset bubbles better contained by monetary policy or regulatory authority.  He now believes that the Fed should be concerned about the US only and that asset bubbles should be controlled by regulation.  In coming to this conclusion, he acknowledges the effect of the weak dollar and US low interest rates on commodity prices as the proper result of monetary policy.

On the other hand, Washington's Blog, had a widely distributed post, "Questions for Bernanke's Senate Confirmation Hearing" in which he made a very detailed argument that the Fed had been repeatedly warned by the Bank for International Settlements (the Central Banks' bank) that a credit bubble was forming as early as 2005.  These excerpts show the BIS concerns:

"The Bank for International Settlements, the world's most prestigious financial body, has warned that years of loose monetary policy has fueled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump than generally understood...
The BIS, the ultimate bank of central bankers, pointed to a confluence a worrying signs, citing mass issuance of new-fangled credit instruments, soaring levels of household debt, extreme appetite for risk shown by investors, and entrenched imbalances in the world currency system."

"Indeed, BIS slammed the Fed and other central banks for blowing the bubble, failing to regulate the shadow banking system, and then using gimmicks which will only make things worse... More dramatically, BIS slammed "the use of gimmicks and palliatives", and said that anything other than (1) letting asset prices fall to their true market value, (2) increasing savings rates, and (3) forcing companies to write off bad debts "will only make things worse"...Instead, they are doing everything they can to (2) prop up asset prices by trying to blow a new bubble by giving banks trillions, (2) re-write accounting and reporting rules to let the big banks and other giants keep bad debts on their books (or in sivs or other "second sets of books") and to hide the fact that they are bad debts, and (3) encourage consumers to spend spend spend!"

"... the central bankers knew exactly what was going on, a full two-and-a-half years before the big bang. All the ingredients of the looming disaster had been neatly laid out on the table in front of them: defective rating agencies, loans repackaged to the point of being unrecognizable, dubious practices of American mortgage lenders, the risks of low-interest policies. But no action was taken. Meanwhile, the Fed continued to raise interest rates in nothing more than tiny increments..."

 The article also cited a 2005 letter from the Mortgage Insurance Companies of America, a trade association of mortgage lender, sent to the Fed: "In the letter, MICA warned that it was "very concerned" about some of the risky lending practices being applied in the US real estate market. The experts even speculated that the Fed might be operating on the basis of incorrect data. Despite a sharp increase in mortgages being approved for low-income borrowers, most banks were reporting to the Fed that they had not lowered their lending standards. According to a study MICA cited entitled "This Powder Keg Is Going to Blow," there was no secondary market for these "nuclear mortgages."..."  The Fed either did not understand what they were told or they ignored it.

Even the new President of the New York Federal Reserve has publicly stated "the causes of the crisis as the excessive use of leverage and maturity mismatches embedded in financial activities carried out off the balance sheets of the traditional banking system...this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.”

Robert Alford in a post on naked capitalist entitled, "The FED, Treasury, and AIG", makes a detailed argument that the bailout of AIG was illegal.  If anything was to be done, it should have been the responsibility of the Treasury and not the Fed.  Janet Tavakoli has gone so far as to say Goldman Sachs was the primary beneficiary of the AIG bailout and it should buy the maiden lane III fund from the Fed and get those toxic assets off its balance sheet and on Goldman Sach's balance sheet.  Alford made some compromise recommendations on how the Fed should be run in the future:

"• The Fed agrees to cease and desist from lending to any capital impaired institution unless specifically authorized by law.
• The Fed agrees to cease and desist from acting in a fiscal role.
• The Fed agrees to never again assume management responsibility for a capital impaired institution unless specifically authorized by Congress
• Treasury assumes all the Fed assets related to AIG and Bear. I believe that there is enough TARP money left.
• The selection process for reserve bank presidents is left unchanged.
• The audit provisions are left unchanged."

In another Washington's Blog post, "Former Managing Director of Goldman Sachs: Accounting Fraud of the Too Big to Fails May be Worse than Enron" asks, as many of us have, how much of banks revenue is real banking vs trading (risk taking).  He cites Nomi Prins' article, "Worse than Enron", details how the banks have used re-classification and opaqueness in doctoring their balance sheets, which is an issue we have discussed on the radio show numerous times.  She waded through over 1000 pages of SEC filings and pretty well lays out how Citi, Bank of America, and Wells Fargo are playing the game.  She asks, given the long time it took to catch Enron, how long is it going to take to catch the banks.  My question is will it take another financial crisis to bring everything into the open.  There are, however, those who are more pessimistic and wonder if we are not seeing the re-institution of Feudalism.

In a Raw Finance post, " Meet the New Crisis, Same As the Old Crisis", Simon Johnson said
"The problem, in the simplest terms, is this:  the government policies that have staved off a depression have driven down the value of the dollar and lowered yields on the safest assets to near zero, while the banking system and those who run it remain largely intact and unchanged; therefore, bankers and investors are encouraged to take on extreme risk once again to achieve acceptable gains and they do this by borrowing dollars generally to buy risky assets, generally in emerging markets that have strong growth potential.  Thus, the asset bubbles that formed in U.S. real estate that caused the 2008 financial crisis appear to be forming again, but rather in non-U.S. assets (see U.S. Current Account Deficit Likely the Cause of Next Financial Crisis)."  He also proposes three best practices: 1) preventing banks from collapsing in an uncontrolled manner, 2) taking over and implementing orderly resolution for banks that are insolvent (this would include firing management and bringing in a new team), and 3) addressing immediately underlying weaknesses in corporate governance which created potential vulnerability to crisis.  Again, we have to ask what is it going to take to make the people who caused this financial crisis responsible for their actions in a way which engenders the public trust?

The Baseline Scenario had a post, "Some Questions for Mr, Bernanke" which intellectually poses three issue crunching questions: 1) what about the doom loop?, 2) how should the bailout mechanism be modified?, and 3) since history has shown that large financial institutions find ways to get around and ahead of regulators, should the large banks be broken up if they are systemically dangerous?

Many commentators are focusing on Bernanke when the actual problem is to what extent do the financial systemically dangerous entities, like Goldman Sachs, influence the Fed and Treasury.  To what extent does the Fed protect the interests of banks as opposed to the public good and to what extent does Treasury under any administration allow itself to be swayed by powerful interests and strategically placed government assistants who used to work for those systemically dangerous private entities?  Who would replace Bernanke?  Larry Summers wants the job but he cannot effectively perform his current job.  If a Fed president, would it be Yellin?  The other Fed presidents have staked ideological turf.  Will they seek another academic economist?  What would happen if they were presented with the choice of a person with a regulatory passion?

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