Thursday, May 13, 2010

The 2004 Fed Transcripts: A Methodical, Diabolical Destruction of America's "Wealth"

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

The Federal Reserve releases transcripts of the Federal Open Market Committee (FOMC) meetings with a five-year lag (as required by law, the Fed would like to burn them). Transcripts for 2004 meetings were released on April 30, 2010. The Dow Jones Industrial Average fell 998 points on May 6, 2010. The 2004 transcripts help explain why the Dow could have disappeared last week.

The Setting

To refresh memories, the Fed had cut the fed funds rate to 1.00% in June 2003. America leveraged up on free money ("free," since inflation was higher). The mortgage boom etched itself on the national conscience. The 2004 FOMC meetings were filled with discussions of whether and when the Fed should tighten. ("Tighten," meaning, raise the funds rate from 1.00%. Raising the rate should tighten, or restrict, access to credit.) The result of FOMC talk was to increase the funds rate after each of the FOMC meetings, starting in June through the end of the year. Each time it was raised by 0.25%. In practice, this is the Fed's minimum rate change. The FOMC raised the funds rate to 1.25% in June 2004, to 1.50% in August, to 1.75% in September, to 2.00% in November, and to 2.25% in December. It would continue with a total of 17 consecutive 0.25% boosts, until the funds rate reached 5.25% in June 2006. This gave the impression the FOMC was walking on eggshells.

FOMC transcripts in 2004 confirm the Fed was afraid of markets. Its concerns about the economy were only a derivative function of how market volatility could disrupt consumer spending. (Over 100% of economic growth after the post-2001 recession had been consumer spending.) The Fed understood rising asset prices boosted consumer spending. As I discuss below, the FOMC was not simply fixing short-term interest rates. It was now interfering with long-term interest rates, the stock market, and the housing market. This distorted the entire structure of prices through the economy and we know how it ended - no better than the Politburo's central planning.

In 2004, the FOMC knew that when it raised the funds rate, financial markets might exhibit any number of unintended consequences. In June, Chairman Greenspan stated a policy change to avoid such turmoil: "By committee desire, we have been changing the funds rate only at meetings. That was not the case in the past." He wanted the markets to know it could rely on the Fed's constancy.

The FOMC seemed most concerned that higher rates might interfere with the carry trade. In the sad tale of The Financialization of the United States, the carry trade deserves a chapter. It received one in [Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession.] Chapter 10: "Restoring the Economy: Greenspan Underwrites the Carry Trade, 1990-1994," discusses the unique recovery from the 1990-1991 recession. Never before had the U.S. economy resurrected itself through finance rather than industry. To accomplish this amazing feat, finance flooded the banking system and hedge funds.

The Federal Reserve had cut the funds rate from 9.75% in 1989 to 3.0% in 1992. Quoting from Panderer to Power: "Speculators borrowed at a cheap rate - such as a Treasury bill, yielding 3%. They bought higher yielding securities, such as Japanese government bonds that yielded around 6%. They expected (or hoped) the borrowed asset would not rise in price. They leveraged the 3% spread at 10:1 or 100:1. Up to the present, the carry trade has funded fortunes in New York, London, Tokyo, and Shanghai."

By 2004, the carry trade was a mammoth enterprise of hedge funds and banks. The too-big-to-fail banks were, by now, leveraging their own internally managed hedge funds, managing their own proprietary trading desks, and also lending to highly leveraged hedge funds. Leverage, and, the belief that access to rising levels of credit would never end, pushed up asset values on bank balance sheets - whether real estate, bonds, stocks, or private-equity. This increased the banks' lending capacity which encouraged banks to lend more. Hedge funds and private-equity funds (that were leveraging their acquisitions into bankruptcy) could not, or would not, refuse free money. Rising asset prices boosted mortgage origination, refinancing, home-equity withdrawal, prices of mortgage securities and lines-of-credit from commercial and investment banks to unscrupulous mortgage lenders. Markets believed asset prices would only go up for many silly reasons. Belief in the Greenspan Put may have been the silliest but also the most influential. (The Bernanke Put today is even sillier.)

The FOMC's Manipulation of Asset Prices

Federal Reserve Governor Donald Kohn stated the FOMC's mission at the March, 2004 meeting: "Policy accommodation - and the expectation that it will persist - is distorting asset prices. Most of the distortion is deliberate and a desirable effect of the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices...."

It is worth pausing here. Kohn told his confreres that Federal Reserve policy was to distort asset prices. He also said this was deliberate and desirable. In other words, distorted asset prices were not an unfortunate consequence of such-and-such Fed policy. The Fed's goal was to distort asset prices.

Kohn went on: "It's hard to escape the suspicion that at least around the margin some prices and price relationships have gone beyond an economically justified response to easy policy. House prices fall into this category [note: the Fed was deliberately overpricing houses], as do risk spreads in some markets and perhaps even the level of long-term rates themselves, which many in the market perceive as particularly depressed by the carry trade...." Summarizing, Kohn believed the Fed had deliberately set a policy that raised house and long-term bond prices beyond a "justifiable response" to the 1.00% fed funds rate. (One justifiable response to free money is a price of infinity, but Kohn was not of that persuasion.) Second, Kohn thought the carry trade was reducing yields on long-term Treasury bonds. (As follows: when a trader borrows $1 billion at 1% and buys $1 billion of 10-year Treasury bonds that yield 4%, prices of the 10-year bond go up as the yield goes down.)

At the January 27-28, 2004, FOMC meeting, Fed Governor Roger Ferguson voiced his own fears, about the state of financial markets: "During the intermeeting period [the prior meeting was on December 9, 2003], we saw quite a run-up in the prices of equities.... During the same period, interest rates dropped quite significantly. Risk spreads have come down.... This may indicate an underappreciation of the risks that may be imbedded. Frankly, to put it mildly, I think that the dollar carry trade has become extremely well entrenched and that the markets are looking to us perhaps more than they should be.... Perhaps we are anchoring the yield curve more than we'd like....I'm afraid the fixed income markets in particular are not in fact doing the appropriate job of pricing risks. We need in some sense to remove the anchor that we have placed on those markets."

Greenspan did not agree. At the same January meeting, Governor Kohn said he did not think the FOMC should "second-guess asset price levels." Kohn continued: "It's something we didn't do in the stock market run-up in the '90s and I was pretty comfortable with how we handled that. So I'd be a little cautious about using monetary policy to try to damp asset price movements." Greenspan replied to Kohn: "I certainly agree with that." It is not clear if the chairman was agreeing to this obsequious compliment of Greenspan's successful demolition of the stock market, but the chairman was affirming he wanted asset prices to move up and up and up.

As a more trivial matter, these conversations contradict Alan Greenspan's recent attempts to rehabilitate himself at the Brookings Institute in March 2010, and before the Financial Crisis Inquiry Commission (FCIC), on April 7, 2010. According to the old humbug, the Greenspan Fed does not bear an iota of blame for "by far the greatest financial crisis globally ever" (Greenspan's words). He claimed under oath before the FCIC that the Fed was blameless because the "house bubble, the most prominent global bubble in generations, was engendered by... long term mortgage rates" which "by 2002 and 2003... delinked from their historical tie to central bank overnight rates." The italics were Greenspan's. There are many pages in the 2004 FOMC transcripts where tactics to move or fix the 10-year Treasury yield are discussed. (For those who remember Greenspan's "conundrum" - his inability to understand why long-term rates weren't rising - this answers what most suspected. His protestations of bewilderment were a ruse.)

In 2004, the then-Fed chairman stated there was a direct link between Fed policy and long-term interest rates. At the September 2004 FOMC meeting, Greenspan said an issue on the table was "whether we should encourage lower ten-year interest rates...." He stated this would happen "if we do decide to pause later in the year, we will end up with lower long-term rates, higher bond prices, and presumably higher asset prices on the balance sheets of a number of financial institutions." (A "pause," in this case, would be to break from the established pattern of raising the funds rate at every meeting.) There was no question about it: "we will end up." Yet, he told the FCIC this linkage no longer existed after 2003.

Dino Kos, Manager of the Fed's System Open Market Account (at the New York Fed, which fixes the fed funds rate by trading with dealers), made an interesting observation at the March meeting: "If we talk to people who are active in, say, Treasuries, we hear a lot about the carry trade and about an expansion of risk and leverage." It is not clear from reading the transcript, if Kos, or others, considered this to be good or bad. Speculative risk and leverage in the banking system would not normally be welcomed by the nation's leading bank regulator (Greenspan), but neither was it desirable to slow down the mortgage carry trade. Such developments as Interest-Only and Negative-Amortization mortgages may have remained a niche market if not for speculators who were asking for more assets to buy with the money they had borrowed. (Dino Kos at the June 29-30, 2004 FOMC meeting: "Banks and hedge funds are still holding on to large positions in mortgage-backed securities.") By 2004, Wall Street was funding and even buying subprime mortgage lenders to accelerate the flow of mortgage securities they sold, such as CDOs. In 2004, Lehman Brothers was the 11th largest subprime lender in the U.S. and the top issuer of subprime mortgage securities.

Greenspan: "We Created the Carry Trade"

At the September FOMC meeting, Federal Reserve Governor Susan Bies commented: "The whole process of reserve management has changed. This is a profit center in a bank...."
The Fed worked closely with the banks to help maximize these profits. According to Bies, this has "gotten a lot of credibility in the market and we need to be careful what we do..." Chairman Greenspan chimed in, drawing an analogy to another cooperative effort in which the Fed maximized profits of commercial banks: "For the same reasons we've created the carry trade, because if you lock in with some permanence one leg of it, that reduces the risk."

There was never doubt that the Fed was aware, and possibly complicit, in the restructuring of America into a financial economy. It is noteworthy to discover that the Fed is so much more; such entrepreneurial spirit is unusual within government bureaucracies. Who guessed the pivotal role Alan Greenspan played in turning investment banks into proprietary trading desks; that the Fed created the carry trade? Certainly not the author of Panderer to Power. No wonder the man still commands six-figure fees for speaking engagements sponsored by banks and attended by hedge fund managers.

It is also interesting to read that this Public-Private Partnership "lock[s] in with some permanence one leg of [the carry trade], that reduces the risk." This evolution of the Federal Reserve's responsibility has escaped legislative approval. It does not seem sporting to eliminate risk to speculators who can make $100 million a year when the trade works. (Long-Term Capital Management is an example of 100-to-1 leverage that failed.) Rather than an investment, this looks more like a racket.

Greenspan's motives are always a quagmire of probabilities. It is better to operate from certainties and, in this case, it is certain he was caught in a trap with no good way out. He entered a pact with the devil when he created the carry trade in the early 1990s. By not allowing nature to take its course, the "real" economy could not heal. Finance drove steel piles into the ground and established a new foundation for the financial economy. The real economy slowly rusted while finance rose to the sky. Greenspan perverted the nation's economic discussion during the second half of the 1990s with his productivity fantasy. Wall Street spread the Greenspan gospel and made fortunes from the Internet bubble.

The stock market collapsed in 2000 and 2001, which is the inevitable conclusion of such hallucinations. The girders of the real economy were wobbly by then - manufacturing jobs were disappearing at the fastest rate since the Great Depression. From March 2001, the official starting date of the recession, through the end of 2004, employment in the private economy fell by 1,200,000. Greenspan looked for a financial solution - the housing bubble. It was, in the larger sense, a credit splurge. This Godzilla had to be much bigger than the stock market fiasco, and it was. (The farther the economy deviated from its traditional foundation, the more credit needed to be created to forestall a collapse.)

At the 2004 meetings Greenspan - and the FOMC - were setting Federal Reserve policy not only by fixing short-term interest rates, but also by calibrating the carry trade. Conversations show the Committee understood the danger of expanding the trade: if it grew too large, a financial earthquake would crash the rising skyscraper to the ground. At the January 2004 meeting, Dino Kos talked about "the already rather steep yield curve [nirvana to the carry trade], the 3 percent differential between the funds rate and the yield on the ten-year bond is historically wide, and further steepening probably would bring in new investors to take advantage of the carry." The tone of Kos' comment (measured by the direction of the meeting and questions being asked) seems to be that the 3% spread was about right. Less, and credit arteries might harden. More, and the Fed might not be able to contain the carry trade. The FOMC, interpreting Kos' statement, should work towards holding the spread at 3%.

This was the same meeting at which Governor Ferguson had worried that "we are anchoring the yield curve more than we'd like." The anchor was the short-term borrowing rate, the 3% spread to the long-term rate was the profit, after it was leveraged.

The FOMC was also tugging on long-term interest rates for reasons Chairman Greenspan discussed at the September meeting. He asked the question: "[Should] we should encourage lower ten-year interest rates, given how close they are to levels that would prompt a lot of mortgage financings and a significant drop in duration in the mortgage market...?" His interest in mortgage refinacings was to boost consumer spending.

Consumer spending exceeded consumer income. This had to continue. Greenspan described the importance of rising asset prices in fooling the consumer at the November FOMC meeting: "We have a very significant problem with private saving. The household saving rate has come down dramatically and now is close to zero....The idea of having a negative savings rate is not out of line with the way the world works. Remember...the average household looks at the market value ...of its equity holdings.... We can have a negative saving rate with a significant part of the population believing that they are saving at a fairly pronounced rate."

This strategy of fixing asset prices at an artificially high rate to fool the American people into spending money they did not have was diabolical. It was even more so, given what Greenspan told the public. Before Congress on July 15, 2003, he claimed: "The prospects for a resumption of strong economic growth have been enhanced by steps taken in the private sector over the past couple of years to restructure and strengthen balance sheets....Nowhere has this process of balance sheet adjustment been more evident than in the household sector." The man will say anything.


Greenspan is gone and his successor is also a man not to be trusted filling your gas tank. In 2004, when then-Federal Reserve Governor Ben S. Bernanke was still an underling to Greenspan, he demonstrated the lack of truth, common sense, and intelligence needed to be selected Fed chairman: "Increases in home values, together with a stock-market recovery that began in 2003, have [aided]...the expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancings and home-equity lines of credit." This is not "wealth," but it was a sales pitch that may have convinced a perplexed audience to buy houses. That was in public. At the December 2004 FOMC meeting, Simple Ben showed an appreciation for why he was bamboozling the public: "As a result of rising stock and house prices, over the past year U.S. net wealth... has increased about $3.3 trillion, or around 30% of GDP. That's a number which, incidentally, goes some way to explaining the continued strength of consumer spending."

He consistently misunderstands the current situation. On November 16, 2009, he told an audience: "It's not obvious to me in any case that there's any large misalignments currently in the U.S. financial system." How on earth can anyone think an economy run on a zero-percent interest rate - a fantastical plan never before attempted in recorded history - is A-Okay?

The manipulation of markets and of the American people has grown worse under Bernanke's chairmanship. In the fall of 2009, Governor Kohn spoke at a Federal Reserve conference. He made it clear that the Fed still wants to fool the people into a state of poverty: "Recently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.... Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years."

On March 27, 2010, former Federal Reserve Chairman Alan Greenspan told Bloomberg TV if not for the stock market recovery, the economy would be shrinking faster than Zimbabwe's. That is an exaggeration, but he was drifting in that direction. From the horse's mouth: "Ordinarily, we think of the economy affecting stock prices. I think we miss a very crucial connection here in that this whole economic recovery, as best as I can judge, is to a very large extent, the consequence of the market's bottoming last March, and coming all the way back-up. It is affecting the whole structure of the economy, as well as creating the usual wealth effect impact."

The 998 point drop in the Dow on May 6 was a warning to those who still invest in and trust markets. The government has permitted sophisticated strategies among a handful of operations to run the stock market. Program trading, high-frequency trading, and investment bank proprietary trading have replaced the buy-low, sell-high investor. At the August, 2004 meeting, Dino Kos reported: "In the past several months, quite a few traders have bemoaned the low level of volatility across a range of asset markets and the absence of perceived trading opportunities." It would take a strong imagination to not believe the FOMC is just as solicitous and equally willing to anchor the risk of institutional traders today.

The Financial Times reported in January 2010 that only 3% of trading is retail. The traditional relationships by which common stocks are measured such as price-to-earnings ratios are not that relevant anymore. IBM's price is more likely a reflection of a computer programmed to trade the stock because of a phrase spoken on CNBC. It is difficult to retain the pretense of markets reflecting the distilled knowledge of a company's value. Caveat Emptor.

More importantly to those with money invested in public markets is the possibility of a 5,000 point drop in the Dow that does not recover, but converges on zero. Traditional diversification strategies such as separating stocks among small, large, domestic and foreign companies neglect protection. The Bernanke Put will fail and with it the greatest bubble of all will crash. This is the reason investors need to devise a personal put strategy.