Where is Banking Headed? Not Up!

The biggest problem in the economy, I believe, is the banking system. The government recognizes this and that is why the various agencies within the government are following such bizarre policies. The Federal Reserve has kept its target interest rate below 20 basis points for over twenty months now and it appears as if it will maintain this target for at least six to twelve more months. The FDIC, as of March 31, 2010, had 775 banks on its list of problem banks and Elizabeth Warren claims that at least 3,000 banks are facing severe problems relative to commercial real estate loans. The United States Treasury Department is tip-toeing around banking issues and especially around the government agencies called Fannie Mae and Freddie Mac.

I sure would NOT want to be a bank regulator now. The workloads must be enormous and the pressure must never ease. And, in my view, this situation is not going to change for another three years or so.

For one, the industry is bifurcating. The big institutions are winning. The smaller institutions are going down the drain. One figure I am fond of quoting is that the largest 25 commercial banks in the United States control two-thirds of the assets in the industry. (This is from Federal Reserve statistics.) On March 31, 2010 there were 6,772 commercial banks in the industry (according to the FDIC) so that about 6,750 banks control only one-third of the assets in the industry.

Note this, however. On December 31, 2002 there were 7,888 commercial banks in the United States and on December 31, 1992 there were 11,463. So the number of banks in the US declined by more than 40% in the past 18 years.

But, commercial banks with more than $1.0 billion in assets increased from 380 at the 1992 date to 405 at the 2002 date to 523 this year.

Banks that had less than $100 million in assets fell dramatically during this time period: in 1992 there were 8,292 banks; in 2002 there were 4,168; and in 2010 there were 2,469.

Banks between $100 million and $1.0 billion in asset size rose from 2,791 in 1992 to 3,315 in 2002 and to 3,780 in 2010.

However, check this out. In terms of full time equivalent employees, banks with less than $100 million in assets averaged 24 employees in 1992, 20 employees in 2002, and 17 employees in 2010. The middle size of banks averaged 121 employees in 1992, 90 employees in 2002, and 72 employees in 2010.

It appears as if the part of the banking system that controls less than one-third of the banking assets in the United States has gotten smaller and smaller in terms of size of institution and employment. Yet, during the last fifty years, the people in these institutions have been asked to do more and more in terms of the environment they are working within and the pressures they feel. Banks, throughout this time period, have not been able to just live off the interest rate spread they earn between loans and deposits.

Furthermore, the thrift industry has also shrunk. The Savings and Loan industry is dead! (http://seekingalpha.com/article/214460-so-long-to-the-savings-and-loan-industry) The numbers support this demise. On December 31, 1992 there were 2,390 savings institutions in the United States. This number dropped to 1,466 at the end of 2002 and fell to 1,160 at the end of March 2010. The Office of Thrift Supervision (which was a part of the Treasury Department) is to merge into the Office of the Comptroller of the Currency (which is a bureau of the Treasury). Thrift institutions will become more and more like commercial banks and the idea of the thrift industry will fade into memory. Most of these are very small institutions, not unlike the smaller commercial banks listed above with very few employees.

I go through this list because many of the problems that now exist within the banking system are concentrated in these smaller institutions, formerly the heart-beat of Main Street America. In the last fifty years the financial environment changed substantially and a large number of these depository institutions were just not able to make the transition. We are going through the final stages of the current restructuring of the banking industry. What we will see in the next five to seven years will be difficult to compare with what existed in the last half of the twentieth century.

What changed? Well, the inflation of the 1960s and 1970s brought about higher and higher short term interest rates. For many institutions, the comfortable interest rate spreads the banks and thrifts worked with disappeared and even went negative in some instances. The government’s response was to open up the balance sheets and allow these institutions to diversify and create more services that could earn fee income. Also, new financial instruments were created to allow these depository institutions to get into more exotic types of investments.

A typical situation was one in which a depository institution had only 15 people or less with most of them being tellers or clerks and only two or possibly three that had executive authority. Most of these employees had been with the institutions for a decade or more. These institutions were flooded with investment bankers and others with all kinds of sophisticated ideas about how a $50 million organization could get into high-yielding assets or buy cheap deposits or do many other very innovative things so as to regain profitability. The late 1970s and 1980s are full of stories about how the managements of small institutions were “educated” in the ways of Wall Street. The thrift crisis resulted.

In the 1990s and 2000s even more sophisticated instruments and opportunities were brought to the smaller institutions that thought they were getting good advice to help them operate in the twenty-first century. Part of what the managements got into was commercial real estate deals. This is what Elizabeth Warren has alerted us to. But, there are many, many other institutions that have securities or other assets on their balance sheets that are not performing or are damaged in one way or another.

What is Ms. Warren talking about when it comes to the magnitude of the problem? Is she talking about a 20% write down of some assets? A 25% write down? Do these “small” banks have sufficient capital to take such a write down? Can these small banks raise sufficient new capital to cover such a write down?

Can the banking industry handle another 40% decline in the number of banks in the system? Can the banking industry absorb this contraction in the next three to five years not in 18 years? This would mean a loss of more than three thousand commercial banks and savings institutions in this time period.

This is the environment that the Fed, the FDIC, and the Treasury Department is currently working within. They have not really let us know how serious the problem is. Elizabeth Warren has perhaps given us more information than others within the government would like us to have. Maybe this straight talking is why many people are reluctant to put her in charge of a government agency. She might tell us what is really going on.

Whatever, it just looks as if the banking system has a long way to go in order to regain its health.

The New Way for the Fed to "Exit"?

Has the Federal Reserve begun its exit strategy? Has the Fed already started the “Great Undoing”? It has, but the new exit movement is not taking place in open market operations…or in repurchase agreements. It is occurring with the help of the Treasury Department. Let’s look at the line item on the Fed’s balance sheet titled “U. S. Treasury, supplementary financing account”.

The Federal Reserve defines the U. S. Treasury, supplementary financing account in this way:

“U.S. Treasury, supplementary financing account: With the dramatic expansion of the Federal Reserve's liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.”

Thus, this account is a deposit facility of the Federal Reserve similar to the U. S. Treasury, general account, the account that the Treasury conducts its general business from. Thus, it is a factor “absorbing reserve funds”, or, in other words, placing funds in this account removes reserves from the banking system. Hence, it contributes to the “exit” of the Fed from its inflated balance sheet.

I posted a note on this account on February 24, 2010 titled “The Treasury’s Latest Maneuver With the Fed”: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed. In that note I described what was going on in the following way: “On September 17, 2008, the Treasury Department announced something called the ‘Supplementary Financing Program.’ Under this program the Treasury was to issue marketable debt and deposit the proceeds in an account that would be separate from the General Account of the Treasury at the Fed.

In September 2008, this account averaged almost $80 billion. In November 2008 it was above $500 billion. The account dropped to just below $200 billion in January 2009 and remained around that level into September 2009. The figure drops precipitously from there as the issue about the debt limit of the Federal Government had to be dealt with. In January and February 2010, the account averaged just $5 billion.

Now that the Congress has raised the debt limit on the government, the plan has been revived.

The original purpose of the Supplemental Financing Account was to get cash into the hands of those that needed funds and not have to go through the market system which would take more time and, perhaps, a greater amount of trading, to meet the peak liquidity demands in the financial crisis. That is, the Treasury had cash to spend out of this account that could go directly to those that needed the stimulus spending. This program allowed the Treasury to issue securities without going directly to the market and perhaps keeping interest rates from falling.

In the present case, the Treasury says that it is going to keep the cash proceeds from the borrowing on deposit at the Federal Reserve. If this is true, then it seems that what the arrangement is providing is more Treasury securities to the Fed to be used as the central bank reduces the amount of excess reserves in the banking system.”

In recent weeks a lot of activity has taken place in this account. As stated in the post on February 24, 2010, there were $5 billion on deposit in this account.

On March 3, this balance was just under $25 billion. The balance rose to about $50 billion on March 10, around $75 billion on March 17, and near $100 billion on March 24. Again it rose to about $125 billion on April 1, $150 billion on April 8, and $175 billion on April 15.

Obviously, the plan is for this account to increase by $25 billion every week until the Treasury reaches its stated goal of $200 billion in this supplemental financing account.

What impact has this had on bank reserves?

Well, on February 24, factors, other than reserve balances, absorbing reserve funds totaled $1.082 trillion. On April 14, this total was $1.320 trillion, an increase of $238 billion. Reserve balances at Federal Reserve banks declined from $1.246 trillion on February 24 to $1.061 trillion on April 14, a fall of $185 billion.

The latest information we have on excess reserves in the banking system indicates that for the two banking weeks ending April 7, excess reserves averaged about $1.094 trillion, a decline of about $100 billion from the average that existed for the two banking weeks ending February 24 of $1.092 trillion.

Thus, this “maneuver” accomplishes two things. First, it is connected with the issuance of Treasury debt to finance the huge budget deficits of the government. Second, the proceeds of the debt issuance do not stay in the banking system, but are withdrawn and put on deposit at the Federal Reserve so that excess reserves are drained from the banking system.

Therefore, the Federal Reserve, with the help of the Treasury Department, has begun to exit!

One could argue that these reserves are coming out of the banking system willingly. That is, the big concern associated with the “Great Undoing” is that the Fed would take reserves out of the banking system that the commercial banks really wanted to “hang onto.” If this were to take place we might get a replay of the 1937 actions of the Federal Reserve when it took excess reserves out of the banking system that the banks wanted to hold onto which resulted in the contraction of bank lending contributing to the 1937-38 depression.

Removing reserves in this way, with the help of the Treasury, might be a benign way to begin the “undoing” which can then be followed up by more traditional central bank operations using repurchase agreements and outright sales of securities. Also, it takes pressure off the Fed in that open market operations could just focus on the Fed’s holdings of U. S. Treasury securities leaving the Fed’s portfolio of mortgage-backed securities and Federal Agency securities free to just decline by attrition. The Fed has only about $777 billion in Treasury securities in its portfolio and, depending upon how much it needs to reduce the excess reserves in the banking system, would probably not want to be forced to use other other parts of its portfolio in removing these reserves.

So, we observe another financial innovation on the part of the government. Niall Ferguson has argued that, historically, governments have been the biggest innovator when it comes to finance. The reason? Governments have been the largest issuers of debt and have had to be very creative in finding new ways to place debt and to manage debt. Certainly in the last fifty years, governments have shown themselves very adept at coming up with new ways to spend money…and to finance this spending.

Federal Reserve Exit Watch: Part 8

Looking at the Federal Reserve statistics these days is rather boring. As has been reported over the past month or two, the Fed has gotten its balance sheet in position for the “great undoing.” And, now it is just waiting.

One can divide the Fed’s balance sheet into three components: the “regular” portion which is roughly equivalent to the asset side of the balance sheet of the Fed in the “good old days”; the portion of the balance sheet that consists of line items related to the “new” facilities created to combat the financial collapse; and the “liability” side of the balance sheet which includes Treasury deposits and reverse repos, the account the Fed has stated it will use in the “undoing” of the excess reserves it has injected into the banking system.

The “regular” portion of the Fed’s statement now represents over 90% of the assets of the central bank. Almost $2.0 trillion of these assets are in the form of securities that the Fed has purchased on the open market and holds outright. The only real movement here is in the Fed’s holding of mortgage-backed securities which, on March 3, 2010, amounted to slightly more than $1.0 trillion. The Fed has stated that this account will reach $1.25 trillion by the end of March.

The Federal Reserve has added, net, $175 billion of the mortgage-backed securities to its portfolio over the last 13-week period, roughly $70 billion in the last four weeks.

In terms of the “new” facilities, the Fed is letting these items run off as the assets run off, are written off, or are sold. Over the last 13 weeks, since December 2, 2009, these accounts have declined by slightly more than $100 billion. Over the past month, since February 4, 2010, they have declined by $30 billion.

Overall, therefore, the Federal Reserve has supplied roughly $76 billion to the building of reserve funds over the last 13 weeks and slightly more than $30 billion over the last 4 weeks. Rather a non-event if you ask me.

In terms of factors absorbing reserve funds, the interesting item here is the Supplementary Financing Account of the United States Treasury. I wrote about this account on February 24, 2010 for it seems to be something that the Fed/Treasury is also planning to use during the “undoing”. For more on this see my blog post: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed.

What has happened in this account is that it has been increasing. It reached a low early this year at $5.0 billion, as the Congress had to approve an increase in the federal debt limit. Since February 4, 2010 this account has increased by $20.0 billion. The Federal Reserve announced that an agreement had been reached with the Treasury Department that the Fed will borrow $200 billion from the Treasury and leave the cash on deposit at the central bank. As explained in my post, this borrowing will be used by the Fed to help it “undo” excess reserves in the banking system. It seems as if the Fed is starting to build up this facility slowly so as not to be disruptive to the banking system.

If we combine all the factors supplying reserve funds to the banking system and factors absorbing funds from the banking system we find that commercial bank’s Reserve Balances with Federal Reserve Banks increased by roughly $70 billion in the last four weeks and over the last 13 weeks: thus, very little changed in the banking system over the last quarter of a year.

If we look at the statistics from the banking system itself, we see that excess reserves in the banking system rose by about $110 billion.

What the Fed did, as it has for an extended period of time now, went directly into the excess reserves of the banking system. Commercial banks, as a whole, are just sitting on their hands and doing nothing. This allows the Fed to do all its repositioning in order to prepare for the “great undoing” without throwing any more uncertainty into financial markets.

The Federal Reserve is still “sitting on the fence”. Its dilemma is that the banking system still remains extremely week…except, of course, for the big banks. For more on this see two of my recent posts: “The Struggles Continue for Commercial Banks”, http://seekingalpha.com/article/190191-the-struggles-continue-for-commercial-banks, and, “The Banking System Continues to Shrink”, http://seekingalpha.com/article/188566-the-banking-system-continues-to-shrink. The Fed cannot move too fast to remove excess reserves from the banking system for fear that this “undoing” may result in many more bank failures among the small- to medium-sized banks.

Of course, the economy remains weak and the Fed has used this excuse for not removing reserves from the banking system and raising short-term interest rates. This may be a cover for their real concern over the systemic weakness of the small- and medium-sized banks in the United States.

On the other side there is the continuing fear over the possibility that sooner or later the excess reserves in the banking system will turn into bank loans which will result in an expansion of the money stock measures which will result in a worsening of inflation. With over $1.1 trillion in excess reserves in a banking system that used to carry less than $100 billion in excess reserves there is substantial doubt that the Fed can smoothly remove all of these reserves thereby preventing possible inflation or even hyperinflation. Nothing like this has ever been experienced in history before.

So, we sit and wait.

The good news is that things within the banking system seem quiet now. The FDIC continues to close banks without major disruptions to banking markets or local economies. The focus of financial markets seems to be on Greece, Spain, Italy, the Euro, and California, New York and other political entities. That is good for the banking system!

Some have pointed to a potential problem arising from the sale of assets recently conducted by the FDIC. The argument is that now that these assets have a price, will other banks have to “mark-to-market” similar assets that they carry on their balance sheet? And, if they have to mark these assets to market, will this speed up the number of banks actually failing or force banks that seem to be doing OK into insolvency?

In the circumstances we now find ourselves, boring is good! Let’s hope it stays boring. Or hope that the situation becomes even more boring.

The Secret No One Wants to Tell

The one thing that seems to provide an explanation for a lot of the things going on today is the continued weakness of the banking sector. It explains the actions of the Federal Reserve System. It explains the actions of the Treasury Department. It explains much of the data that are being released. And, it explains much of the behavior of the banking sector, itself.

The secret: the banking sector is a lot weaker than the government is letting on and the government does not want to publically recognize the fact.

The FDIC recently released numbers on the banking industry for the third quarter. Profit-wise, the industry is very skewed. It is skewed toward the larger banks. The results have been summarized this way:

• Banks with assets less than $1 billion in assets roughly broke even in the third quarter;
  
• Banks with assets between $1 billion and $10 billion, on average, lost $3 million apiece;
  
• Banks with assets in excess of $10 billion recorded an average profit of nearly $42 million each.
  

The big banks, the banks that the regulators were most concerned with, are reaping a bonanza. And, why not? The Fed is keeping short term interest rates down: financial institutions can borrow for three-months in the range of 20-25 basis points in the commercial paper market and the large CD market; they can borrow for six-months in the 30-65 basis points in the CD market or the Eurodollar market. They can buy Treasury bonds that can yield 330 to 400 basis points. This is a nice spread. Plus these banks are traders and there has been plenty of volatility in the bond market in recent months. And, this does not even include the possibilities that exist in the carry trade.

As Eddy, Clarke's brother-in-law, remarked in the movie “A Christmas Vacation”: “This is the gift that just keeps on giving!”

Why?

Because the Fed is going to keep short term interest rates low for an “extended period” of time.

This effort is just another way to “bail out” the big banks!

But, what about the banks that are smaller than $10 billion in asset size?

Here the commercial banking industry has been given a gift of $1 trillion in excess reserves.

And, what is going on in this part of the banking industry? The FDIC released the third quarter information on problem banks. The total of problem banks in the country is 552, up from 416 at the end of the second quarter. Almost all of these banks are of the smaller variety. Given that 50 banks were closed in the third quarter this means that 186 new banks achieved the honor of being placed on the problem list in the third quarter.

It is estimated that at least one-third of the 552 “problem” banks, or 182, will fail in the next 12 to 18 months. If this is true then the United States will experience 2.5 to 3.5 bank closures a week for the next year to a year-and-a-half. This is slightly below the rate of 3.8 bank closures per week that was achieved in the third quarter. The hope is that this situation won’t get worse.

The path ahead for even those banks that are not on the problem list is treacherous. Real Estate Econometrics released information that the US default rate for commercial mortgages hit 3.4% in the third quarter of 2009. This is a 16-year high. The company also released projections indicating that this default rate could rise to more than 5% in 2011. Many of the banks in the middle tier possess millions of dollars of these loans on their balance sheet, relatively more so than do the big banks.

The huge debt of Dubai and Greece and others hang over this market.

In terms of residential mortgages, the picture does not improve. First American CoreLogic, a real-estate information company, recently released data that indicated that roughly one out of four borrowers is underwater in terms of their mortgages. Even 11% of the borrowers who took out mortgages in 2009 owe more than their home’s value.

The Treasury continues to push mortgage firms and others for loan relief. There is an indication that some borrowers are not really helped by the relief measures already promoted and that many who have been helped still face the possibility of re-default going forward.

And, layoffs continue in large numbers, foreclosures continue to take place at a high rate, and large numbers of bankruptcies, both personal and business, continue to occur. Another fact, out this morning, is that delinquencies on auto loans are on the rise.

And, banks are not really lending in any form. The Federal Reserve continues to pump funds into the banking system, yet commercial banks seem to be very content to accept the funds and just hold onto them in the most riskless way possible. If you don’t make a loan, it won’t turn bad on you. Furthermore, commercial banks face the situation in which the longer term liabilities they had accumulated earlier in the decade are going to be maturing. They will need money to pay off these liabilities without replacing them.

Charles Goodhart, Senior Economic Consultant at Morgan Stanley, writes in the Financial Times that central banks should declare victory in the war against financial collapse and cease their policy of quantitative easing. (See “Deflating the Bubble”, http://www.ft.com/cms/s/0/2b7b26de-ddcd-11de-b8e2-00144feabdc0.html.) He writes, “If the authorities go on blowing up financial markets too much, at some point yet another bubble will develop. The last time the financial bubble burst, the taxpayers got soaked...Certainly, we can never get the timing exactly right, but now does seem the moment to declare victory for (Quantitative Easing) and withdraw.”

That is, unless there is something we don’t know and the government is not telling us, like the extent of the weaknesses that exist within the banking sector.

Has the Fed (and other central banks) Made a Mistake?

The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.

I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.

I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.
The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.

If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.

But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.

Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.

The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.

A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.

First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.

And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.

The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.

To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.

Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.

Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?

And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.

To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.

One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!

The Upcoming Banking/Financial Regulation

New financial regulation is on the horizon. As with the health care program, the Obama administration is providing very little unified leadership as to where it really stands and, as a consequence, there is a multitude of plans being tossed out into the air. There is, more or less, a Treasury plan, an FDIC plan, a Barney Frank plan, a Federal Reserve plan and so on and so on.

Where we will end up is anyone’s guess right now. At present, no real leader has emerged. Just like the health care debate.

From what I have seen I am not very comfortable. As is usual, the politicians sense a “popular” issue with the public. “Something must be done!” is the cry. But, as is typical, the politicians, in my mind, are fighting the last war.

There are three topics that seem to be missing in every discussion about new regulation or re-regulation.

First, how does one control and/or penalize “bad” monetary and fiscal policies that can lead to financial stress and a breakdown of the system? How do we overcome the economics of mis-directed presidential administrations? How can we keep the Federal Reserve and the Treasury Department under control when their policies are coming from the likes of Alan Greenspan, Ben Bernanke, Paul O’Neill, Jack Snow, and Henry Paulson?

The actions of the federal government impact the whole country. The actions of the United States government impact the whole world. What the government does changes the incentives in the whole system, how people conduct their lives and their businesses.

Yes, individuals did wrong and took advantage of other people. Yes, corporations and other organizations did not perform prudently. But, they did not create the environment in which such behavior became profitable.

I don’t care what regulations are put into place, when your government, year-after-year, creates trillions of dollars in debt and the monetary authorities keep interest rates at ridiculously low levels for extended periods of time you are going to change incentives and create opportunities for people to take advantage of the system and other people and organizations.

Second, if finance is fundamentally just information, how does one really control and regulate financial innovation? One of the things we have learned about information and the spread of information is that it cannot be controlled. It is easy to take “information” off-shore. It is easy to transform “information” into different forms and into different organizational structures. The world of the future will consist of more and more financial innovation and not less. And, this innovation will happen somewhere because it is easily transported to anywhere in the world, if necessary. And, in real time!

Third, the best regulation is that which emphasizes “processes” and not “outcomes.” We need regulatory systems that produce openness and not secrecy. We need economies that do not contribute to a covering-up of transactions whether it be for tax or flows of funds purposes (see the Financial Times, “Leading Economies Blamed for Fiscal Secrecy”: http://www.ft.com/cms/s/0/ea9f6964-c57a-11de-9b3b-00144feab49a.html) or whether it be for deals (see the Financial Times, “Trading in European ‘Dark Pools’ leaps Fivefold since the start of the year”: http://www.ft.com/cms/s/0/a43d96f0-c74e-11de-bb6f-00144feab49a.html).

Controls, prohibitive restrictions, price limits, artificial scarcities all lead to “black markets” whether the products and services are goods or whether they are just information.

Strict regulations aimed at “outcomes” just tend to drive people and organizations into areas that are less controlled and that are more opaque, less transparent. Is this what we want?

Our rules and regulations should help provide efficiencies and reduce the costs of information to the public. These rules and regulations will not stop individuals and organizations from taking too much risk or from possible financial dislocation. However, the more everyone knows what is going on, in my mind, the better off everyone will be. Also, the economic and financial system will operate better and the swings will be more incremental movements rather than discrete jumps.

Of course, my concerns are not popular with politicians for two reasons. The first is that the voters want to see something tangible done by the government. Developing rules and regulations that are meant to achieve “outcomes” are something that can be bragged about, even if they don’t work very well. Trying to explain that finance is another form of information and that financial innovation cannot really be controlled is difficult to do when the public sees all the perks and benefits that are associated with financial wealth.

The second reason is that politicians have difficulty claiming that government might be the root cause of the problem, especially when they have been a part of that government. Those that govern very seldom support the argument that government might be a cause of difficult times because government is so often looked upon as the solution to the problems we encounter, especially when the problems are of national or international scope.

We are going to get some new regulatory structure and that regulatory structure will, over time, prove to be insufficient to achieve what people hope that it will achieve. The last major change in regulatory structure was enacted in the 1930s. It took until the latter part of the 1990s to eliminate almost all of that structure. Millions and millions of dollars were spent over that 60-70 years to get-around that regulatory structure. Also, much brain-power was devoted to escaping the constraints.

My guess is that it will take a lot less time to get around the regulatory structure that is now under construction. The reasons for this prediction are the three topics that I mention above. In fact, one could argue that the government is doing a pretty good job right now, while you read this post, of conforming to the issue raised in first of the topics.

The Debt Problem Poses a Two-Sided Threat to the Fed

There are two numbers I can’t get out of my head. The numbers are $1.84 trillion and $1.26 trillion. These are estimates of what the deficit of the United States government is going to be for the fiscal year ending in September 30, 2009 and the fiscal year ending in September 30, 2010. (Note that revised estimates for the fiscal year were supposed to be put out in July, but the Obama administration postponed their release until sometime in August.)

It was announced today that the budget deficit in July reached an all time record of $180.7 billion and this brought the year-to-date deficit to $1.27 trillion.

Some simple calculations show that if the estimated number for fiscal year 2009 is to be hit, the budget deficits for August and September will have to average $285 billion per month.

This would mean that the deficits would be $100 billion more a month than the record deficit that was posted in July! This is not a good trend.

Some analysts are predicting that the current year deficit will actually top $2.0 trillion while the 2010 deficit will reach $1.5 trillion. With the deficit for next year at $1.5 trillion, the monthly deficits would only average $125 billion, a figure that would look pretty good given the July, August, and September figures presented above. But, is this realistic given all of the proposals and programs that are in the federal pipeline.

Gross federal debt held by the public increased by more than 28 percent, year-over-year, at the end of the second quarter of this year. That is up from 24 percent at the end of the fourth quarter of 2008 and 15 percent at the end of the third quarter of 2008. With the forecast figures for the deficit, these numbers are going to continue to be at relatively high rates in the near term.

According to the Congressional Budget Office’s alternative fiscal projections, the public debt of the United States could rise from 44 percent of GDP in 2008 to 87 percent of GDP in 2020.
Adding this much debt to the world is going to place a tremendous burden on financial markets!

The Federal Reserve announced today that it was going to continue on its path to purchase the $300 billion in Treasury securities that it had already committed to, but would extend the program through October rather than ending it in September. The Fed will also retain its plan to buy as much as $1.45 trillion of housing debt by the end of the calendar year. By August 5, 2009 the Fed had purchased $543 billion in mortgage-backed securities.

Numbers like these only cloud the picture of what an “exit” strategy might look like for the Fed. In fact, it does not look like an exit strategy at all.

But, this is just one side of the coin. The other side has to do with existing bad assets. Elizabeth Warren, the chair of the Congressional Oversight Panel that is monitoring the bank bailout effort appeared on Joe Scarborough’s “Morning Joe” program today and stated that the “toxic assets” on bank balance sheets that got us into this financial mess are still there. And, they are going to have to be dealt with at some time in the future. For the near term she warned of a looming commercial mortgage crisis, one that will require more federal money, especially for smaller banks.

Oh, and about commercial mortgages, what about the problem the Fed faces with the commercial mortgages that it already has on its balance sheet. This morning in the Wall Street Journal there was an article about how the Fed has to deal with some debt it inherited from the Bear Stearns failure. (See “Fed Grapples with Extended Stay,” http://online.wsj.com/article/SB125003659369724401.html#mod=todays_us_money_and_investing.) On the balance sheet of the Fed there is a line item dealing labeled Maiden Lane related to the Bear Stearns sale to JPMorgan Chase. Included in this line item is a $900 million debt that the Extended Stay Inc. chain of hotels owes to the Federal Reserve among others. Extended Stay is in bankruptcy now and the issue is how the Fed is treated among other debtors and the deals that have been made between Extended Stay and some of the lenders. It is messy. But, this comes with doing the deals that the Fed has been doing.

And, apparently the Maiden Lane fund holds about $4 billion in debt backed by Hilton Hotels. Messy, messy, messy.

But, the Fed has also extended money to AIG, and to money market funds, and to commercial paper dealers, and has $543 billion of assets tied up into mortgage-backed securities. The Financial Times reported this last week that the Federal Reserve Bank of New York is hiring like crazy attempting to add positions to its staff as fast as it can, positions that will deal with all the future issues arising from all the new programs that the Federal Reserve System has gotten into over the last year or so. The administrative headaches of these actions are now being felt. (Question: if the Fed exits all of these programs, does the Federal Reserve Bank of New York need to create an exit plan to have a reduction in staff when these programs go away?)

And, the National Association of Realtors released information today that home price declines accelerated in the second quarter and Realty Trac said that foreclosure filings reached a level at which 1 in every 84 U. S. households had received a filing. ForeclosureRadar warned that California was on the verge of a new wave of foreclosure sales as notices of default, the first step in the foreclosure process, rose 12% in July from one year ago. Prime borrowers that were behind on their mortgage payments rose 13.8% between March and June.

On top of this household debt remains at about 130 percent of disposable income and household net worth continues to decline.

Business defaults are above 11 percent and are heading toward 13 percent according to some experts.

As we have reached a relatively calm period in economic and financial markets, more and more people are demanding that the Fed present them with a picture of how it, the Fed, might get out of the position it is in. With all the debt that currently exists and all the debt that is going to be created, the Fed seems to be at a loss about what an exit strategy might look like. In fact, with the growth of federal debt projected to stay in the double digit range for several more years, the realistic answer to the request for the Fed to devise an exit strategy is that there seems to be nothing to exit from.

If we accept this conclusion then we must argue that the problem is not with the Federal Reserve, the problem is with the federal government. The problem is with the Treasury department and with Mr. Geithner. The problem is that there is too much debt outstanding, and the creation of more and more debt by the federal government is not helping the problem, it is only exacerbating it. And, Mr. Geithner only strains his credibility, and that of the administration, when he argues that there is already a plan to reduce the future deficits.

Explaining the Drop in the Weekly Money Stock Measures

Thursday afternoon the Wall Street Journal came out with a startling headline: “US M1 Fell $16.2 B In June 29 Week; M2 Fell $36.2 B.” (See http://online.wsj.com/article/BT-CO-20090709-714875.html#mod=rss_Bonds.)

Looking at the H.6 release that comes out at 4:30 PM on Thursday afternoon the Journal reported correctly. The H.6 release is titled Money Stock Measures. The seasonally adjusted M1 money stock measure averaged $1,669.1 billion in the week ending June 22, 2009 and averaged $1,652.9 billion in the week ending June 29, 2009, a drop of $16.2 billion. Please note that in the two weeks previous to June 22, the M1 Money Stock measured $1,630.9 billion and $1,656.5 billion, respectively.

Thus, M1 rose by $7.0 billion in the week ending June 15 and by $26.5 billion in the week ending June 22.

In terms of the seasonally adjusted M2 series, the weekly average for the week ending June 22 was $8,385.4 billion and for the week ending June 29 the M2 Money Stock averaged $8,349.2 billion, indicating a $36.2 billion drop. We can note that for the two previous weeks M2 averaged $8370.0 billion and $8,385.2 billion, respectively.

M2 rose by $15.2 billion in the week ending June 15 and by $0.2 billion in the week ending June 22.

Now let’s see what happened to the non-seasonally adjusted data. The M1 money stock rose $29.5 billion in the week ending June 15, by $52.0 billion in the week ending June 22 and rose another $47.9 billion in the week ending June 29. These figures are significantly different than the seasonally adjusted series.

In terms of M2, this series rose by $16.4 billion in the week ending June 15 but it dropped by $74.4 billion in the week ended June 22 and dropped again by $49.0 billion in the week ending June 29. Again there are serious differences.

There are two points to make here. Formerly the Fed did not put out weekly data on the Money Stock Measures because they jumped around so much. Such volatility can be unnerving to people watching the money stock. Obviously, people at the Wall Street Journal reacted very strongly to the weekly release.

Second, trying to seasonally adjust weekly data is only for the foolhardy or for the very brave. The only conclusion I can draw from the behavior of both the seasonally adjusted series and the non-seasonally adjusted series is that a lot of “stuff” is going on and the seasonal adjustment process is doing very little to capture what is going on. That is, what we are seeing here is white noise!

Is there any clue to what might be happening to banking accounts?

The answer to this is yes, there have been things happening that might help to account for some of the swings and because of the uncertainty of exactly when these things happen from year-to-year their movements can “screw up” the seasonal adjustment of the raw series.

To see what might be happening in the banking system, I go to the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances.” This release also comes out at 4:40 PM on Thursdays. The account I am particularly interested in on the Fed statement is the line item called U. S. Treasury General Account. This is the account that the Treasury Department pulls in tax money from the private sector and then pays it out to the private sector. It is the “transaction” account of the Treasury Department, the one in which the Treasury deposits tax money and the one which the Treasury Department writes checks against.

This account is a “Factor that is absorbing reserves.” That is, when the Treasury draws funds in from the private sector it removes reserves from the banking system. When the Treasury writes checks to the private sector and these balances at the Fed decline, reserves are put back into the banking system.

The Fed and the Treasury work hard to coordinate their actions because they don’t want to incur large swings in the bank reserves. So, what happens is that tax payments and such are kept in the banking system until the Treasury is about to write some checks. When it draws funds from the banks, private deposits go down and the Treasury balances at the Fed go up. When the Treasury turns around and sends out checks to the private sector, bank deposits go up and the Treasury balances at the Fed go down. The Fed then manages bank reserves so that there are few if any dislocations caused in the banking system due to these transaction.

What we have here in June is a buildup in balances at the U. S. Treasury General Account and then a draw down as the Treasury writes out checks. What the Wall Street Journal caught was the building up deposits in the Treasury account. This comes out in the releases up to June 29.

However, we have not yet see the affect of the Treasury checks going out because we don’t have more current data on the Money Stock measures. We do have data for the Treasury’s General Account for the banking weeks ending July 1 and July 8.

And what do we see?

In the banking week ending June 10, the Treasury account averaged $31.4 billion. The next week the account averaged on $42.3 billion, but the account AT THE CLOSE OF BUSINESS on June 17 was a whopping $132.8 billion. Most of the money was drawn from the banking system at the end of the banking week so that the average did not move much.

But, for the banking week ending June 24, the Treasury General Account balance averaged $118.7 billion reflecting the growth in deposits, but the account AT THE CLOSE OF BUSINESS on June 24 stood at $78.8 billion. A lot of money passed though this account in a very few days.

The U. S. Treasury General Account then continued its decline. The average balance for the banking week ending July 1 was $72.0 billion and the average balance for the banking week ended July 8 was $34.2. This latter figure was right at the level of the average balances in the account in the first two weeks of June.

So, as the Wall Street Journal reported, we saw a massive decline in both measures of the Money Stock in the week ending June 29. However, the swings were caused by operational transactions within the government and should be reversed out in the data that are released for the weeks ending July 6 and July 13. But we won’t see those data for another two weeks.

Bottom line: the money stock is not collapsing! Whew!

The Future of the Dollar

We live in a global economy. And, unless we destroy the global economy that now exists the way the world destroyed the first global economy starting with the 1914 conflict and proceeding through the next fifty-five years or so, we will continue to face the duties and responsibilities of operating within a world economy. And, those duties and responsibilities begin with the currency of the country.

It is hard to have confidence that the United States accepts this fact.

I know that we are in a recession (depression?). I know that the immediate pressure on the Obama Administration is to “get the economy going again.” I know that the Treasury Department and the Federal Reserve, both dependent partners in the effort to get the financial system functioning, must provide whatever means it takes to avoid further deterioration of financial markets.

Still, there is a need to listen to what markets are saying about what the government is doing. And, the financial markets are saying that the United States dollar is in trouble. And, consequently, the United State government is in trouble.

The value of the Euro relative to the United States dollar climbed to 1.3768 at the close of business yesterday. This represents an 11.7% decline in the value of the dollar since Ben Bernanke became Chairman of the Board of Governors of the Federal Reserve System on January 31, 2006. It represents a 23.0% decline in the value of the dollar since Bush 43 became President on January 20, 2001 when Alan Greenspan was the Chairman of the Board of Governors of the Federal Reserve System.

The numbers are about the same if you look at a trade weighted series. The trade weighted value of the dollar versus major currencies has declined by 23.6% since Bush 43 was inaugurated, and, has declined 5.4% since Ben Bernanke became Chairman.

Of course, the figures look even worse if one focuses upon the lows in the value of the dollar which came about in March, 2008. Using this as the standard we find that the trade weighted value of the dollar declined 33.4% from the beginning of Bush 43 and 17.5% since Bernanke was sworn in. The current numbers look great compared with these, but the current figures benefit from the ‘flight to quality’ that took place following the September 2008 meltdown of the United States financial system.

All during the Bush 43 Administration, both the United States Treasury Secretary, whoever that was, and the Fed Chairmen gave lip service to the importance of the value of the United States dollar, yet no one did anything about it. And, the dollar continued to decline. Certainly someone should have understood that the decline in the value of the currency indicated something was wrong with the way the finances of the United States government were being run.

It is very apparent that the Federal Reserve System is NOT independent of the federal government of the United States. One has to go back to Paul Volcker and then back to William McChesney Martin to find Fed Chairmen that acted independently of the Executive Branch of the government. President Carter knew that Volcker would be independent of his administration if Volcker became the Fed Chairman but believed that he had to appoint him anyway. Certainly Arthur Burns and Bill Miller (remember him?), were not independent of the Presidents they served. And, people are realizing more and more that Alan Greenspan was nothing short of a water-carrier for the Presidents he served.

Not being independent of the Executive Branch means that the Federal Reserve is very subject to the position of the federal budget. Even Paul Volcker was eventually tainted with the huge (at the time) budget deficits run up by the Reagan Administration. Still, during his tenure as Fed Chairman, Volcker saw the trade weighted value of the dollar against major currencies rise by 6.4%.

Overall, during the time that Greenspan was Chairman of the Fed, the trade weighted value of the dollar against major currencies declined by only 16.7%. Greenspan’s grade improved in the 1990s due to the movement of the federal budget from a substantial deficit when the Clinton Administration took over in 1993 to a surplus by the time Bush 43 assumed office. In fact, this measure of the value of the dollar rose 13.9% during the Clinton administration.

The important thing to remember is that in the last half of the twentieth century world financial markets came to realize that substantial government budget deficits often got financed, one way or another, by the central bank of that country. As a consequence of this realization, participants in these world markets moved against the currencies of countries that began running large deficits if they believed that the central bank’s of that country were not fully independent of the government. The result was that governments became much more conservative in controlling budget deficits and central banks became much more independent of their governments.

The United States, in the latter half of the twentieth century, except for the early years that Paul Volcker was the Fed Chairman and during the 1993-2001 period, seemed to feel that they were exempt from this constraint. Yet, international financial markets responded to United States deficits and the possibility that they could be monetized in the same way that they responded to the “loose living” of other governments. They sold the dollar and the value of the dollar, for the most part, declined.

As participants in world financial markets perceive that things are beginning to settle down and that financial institutions are not going to completely self-destruct, they will continue to move out of United States Treasury securities and will continue to move out of the United States dollar. The foundational belief behind this movement is that the United States government is just putting too much debt out into the world. First, there were the huge budget deficits created by Bush 43 and now there are the huge budget deficits being created by the Obama administration. To people in the world financial markets, the lessons of the last fifty years still apply.

The path the economy and the financial markets follow relating to how the deficit problem works out is anyone’s guess right now. Who would have ever written the script for how the 2000s have evolved up until now? The historical evidence points to the fact that huge amounts of debt issued by governments cause dislocations. These dislocations have to work themselves out. How these dislocations work themselves out is different in every case. The general consequence of large budget deficits, however, is that large amounts of government debt are not good for the value of a country’s currency. I believe that this is as true for the United States as it is for any other country. The value of the dollar will continue to decline over the next several years.

My grades for the past three Fed Chairmen? Paul Volcker gets the best grade. I am assigning him a grade of plus 6.4. Ben Bernanke is second highest with a grade of negative 5.4 and Alan Greenspan comes in last with a grade of a minus 16.7. Unfortunately, when the grade is negative, we all have to pay for it!

Should Banks Start Lending Again?

Banks aren’t doing a lot of lending these days.

Why not?

The Federal Reserve System has bent over backwards dumping liquidity into the financial system. The United States Treasury Department has provided the banking industry with a lot of new ‘capital’. Why aren’t the banks’ lending? Why aren’t the banks even lending to themselves…

My question: Why should the banks be lending?

My answer: they shouldn’t…not right now!

A good reason for this is that United States financial institutions still do not have a firm grasp on the value of a large portion of their assets. “The biggest US financial institutions reported a sharp increase to $610 billion in so-called hard-to-value assets during the third quarter…” (“Financial groups’ problem assets hit $610 bn”, http://www.ft.com/cms/s/0/ea576c7c-c729-11dd-97a5-000077b07658.html.) These assets, primarily mortgage-backed securities and collateralized debt obligations, don’t have active markets at the present time and they are difficult to value. I should be noted that the assets so identified “are many times bigger than the market cap of the banks.”

If you were a banker right now, where would you be focusing your resources at the present time? Would you be attempting to put new loans on the books that would pay off over several years’ time…or…would you be trying to get your arms around the value of these ‘level-three’ assets and see how you can minimize the damage they might cause…in the immediate future?

As long as these assets are on-the-books bank managements are going to muddle around, attempting to minimize the information that is released, and ask for the government to protect them from the downside through asset purchase programs that shore up asset price and the like.

This only distracts efforts and prolongs things! Until the banks are forced to write down their assets to realistic (some form of market) values and take their hits…they will be unable to focus on business and get on with their lives.

But there are other things looming on the horizon. Why would you want to put on new loans when you have people talking about the rising level of foreclosures? Elizabeth Warren of Harvard who is leading the oversight of TARP stated on television last night that in the next two years 8 million houses will be in foreclosure, an amount that is about 16% of the housing stock. That is one out of every six houses in the United States will be in foreclosure within the next two years!

And, why would you want to put on new loans when you have people talking about the rising level of charge-offs related to credit cards? (See “Charge-offs Start to Shred Card Issuers”, http://online.wsj.com/article/SB122895752803296651.html?mod=todays_us_money_and_investing.) All the statistics in this area point to a surge in charge-offs that will be faced by credit card issuers in the future.

Furthermore, there is still the unknown number and size of business defaults that are coming down the road. Of course, there are the auto companies…but, the condition of the credit wings of the auto companies reinforce the concern. Ford Motor Credit Co. is teetering on the brink of bankruptcy…as is GMAC. (“GMAC Bondholders Balk at Debt Swap”, http://online.wsj.com/article/SB122891574162094585.html?mod=todays_us_money_and_investing. Also see “Doubts on GMAC bank holding plan”, http://www.ft.com/cms/s/0/3ccf9eb4-c727-11dd-97a5-000077b07658.html.)

Financial institutions cannot make loans when they are so uncertain about the loans that they have already made. Financial institutions cannot make loans when there is so much uncertainty about the length and depth of the recession, the rise in layoffs and the falloff in employment. (Just released: Jobless Claims hit a 26-year high!) Those individuals and businesses that are seeking loans want to refinance or restructure…to gain control over cash flows so that they don’t run out of cash. Borrowing related to expanding business or creating jobs is almost non-existent. (“Executives Are Grim on Economy”, http://online.wsj.com/article/SB122896532391397279.html?mod=todays_us_marketplace.)

Should banks be lending now?

The answer to this is no…they are not social institutions.

Yes, it would be helpful to the economy if all banks opened their doors and started flooding the market with loans. Everyone would benefit…right?

OK, then…who wants to be first?

Did Bernanke Panic?

I have been going over and over the events of the week beginning September 15, 2008 and I continue to come up with one basic conclusion: the reaction of Fed Chairman Ben Bernanke to the existing financial market strains was somewhat precipitous. A good start to understanding the time-line for that week is the article that appeared in the November 10 Wall Street Journal: “Paulson, Bernanke strained for consensus in Bailout” http://online.wsj.com/article/SB122628169939012475.html?mod=todays_us_page_one. The article begins “Federal Reserve Chairman Ben Bernanke reached the end of his rope on Wednesday afternoon, September 17.”

The week before, the week beginning September 8, the government nationalized Fannie Mae and Freddie Mac. Lehman Brothers was next. Secretary of the Treasury Hank Paulson put his foot down on this one…no bailout for Lehman…that’s final! Monday, September 15 Lehman Brothers filed for bankruptcy. The next troubled firm was AIG and frantic efforts were made to find additional cash for AIG. The basic signal being given to the market was…the bailouts are over. Lehman had to find its own way out or declare bankruptcy. AIG also had to find its own solution. The ‘free-market’ leanings of Paulson and others made for a reluctant leadership.

And then Tuesday evening came and the world changed. That evening the AIG $85 billion bailout was announced. When I heard this news around 9:00 PM that night, things just seemed to feel different: this was a different world than it was before. One didn’t know how…but it was different.

The Wall Street Journal article reports that by Wednesday afternoon “Bernanke reached the end of his rope”. He called Paulson and “with an occasional quaver in his voice” he spoke “unusually bluntly” to the Treasury Secretary. Paulson did not move immediately. He had to sleep on it. Thursday morning he committed.

Paulson called the leadership in Congress and asked for them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and “scared the daylights out of everyone.” Bernanke knew his history of the Great Depression and he knew currents events. He was very logical and very articulate. The leaders were told that they had to act and they had to act fast. The plan was to have a bill before Congress on Monday seeking Congressional approval (of both houses) by the following Friday. The Treasury Department had a bill ready (3 pages long) by midnight Saturday evening. The price tag…$700 billion. Why $700 billion? Because it was a big number!

As we know, the bill was rewritten and finally passed on Friday, October 3. What was the bill to do? No one really knew. The important thing, according to Bernanke, was that something was being done and that something was big!

And, the Fed did not stand idle. Helicopter Ben began to flood the financial markets with liquidity. The important thing was to get a lot of liquidity “out there” and worry about cleaning it up later, once the crisis was over. As I have reported elsewhere Reserve Bank Credit has risen from $890 billion in the banking week ending September 10, 2008 to about $2.2 trillion in the banking week ending November 12, 2008. (I have also noted that it took 94 years to get Reserve Bank Credit up to $890 billion and only nine weeks to have it more than double.) The rationale for this increase…the financial markets are in a liquidity trap and we don’t know how much is needed…we just cannot fail to supply enough!

Here we are in the middle of November. The basic conclusion relating to the financial crisis so far is that although we cannot tell whether or not the effort is working, we believe that things are better off than they would have been if the actions of Paulson and Bernanke had not been taken.

However, discontent is now being expressed. Paulson has changed the direction of the $700 billion bailout package and Congress is not particularly happy with this move and expressing its discontent. No one really seems to know what to do. Since events have slowed down and the ‘immediate’ need for the rapid passage of the package seems to have passed away…as might be expected…everyone and his brother and sister have got their hands out to get a piece of the bailout pie. Apparently, lobbyists are over-running the Treasury Department trying to get their share. And, Henry Paulson’s reputation has seemed to tank along with the stock market. (See the article by Rebecca Christie and Matthew Benjamin on Bloomberg.com titled “Paulson Credibility Takes Hit with Rescue-Plan Shift." It seems like no one can be a part of this administration without having their image tarnished.)

And, one question still remains. While Paulson and Bernanke seem to be running this whole show…where is the “decider”? The “decider” has apparently decided to hide out in the White House bunker. This has left Paulson and Bernanke hanging…trying to do something…with no steady hand overseeing their efforts and no vision for a plan.

It seems obvious that the driving force behind all the activity over the last nine weeks has been Ben Bernanke…he is, in a real sense, the initiator, if not the architect, of the hasty and ill-thought out bailout effort. On Wednesday afternoon, September 17 Bernanke reached the end of his rope. The rest, as they say, is history.

It is my personal hope that President-elect Obama will be able to name his own Chairman of the Board of Governors of the Federal Reserve System when he becomes President.