The Real LIBOR Scandal

Frederick J. 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) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

            Whatever can be said for and against Barclays and Bob Diamond, the story is in danger of exhausting itself at the wrong link in the chain. It has sidelined BubbleTV's around-the-clock coverage of Facebook. Mark Zuckerberg's dog walker has been waiting in a studio sound booth for a week now.

            The populace has been so successfully coached and beaten to a pulp that the source of interest-rate price fixing is not mentioned. That source is the Federal Reserve.

            Upon its invention, the Fed had no such authority. In 1923, New York Federal Reserve President Benjamin Strong wrote a letter to friend, which says about all that needs to be said about the Federal Reserve's open market operations: "What I can't understand is the willingness of thoughtful, studious men who presumably have been brought up in the spirit of American institutions and should be imbued with their principles, proposing a scheme to Congress which in effect delegates avowedly and consciously this vast power for price fixing to a small group of men who, in an economic sense, might come to be regarded as nothing short of a super-government. It is undemocratic, absolutely contrary to the spirit of America institutions, and so dangerous in its possible ultimate developments that I cannot see the slightest merits for its proposal." [My underlining - FJS]

            It should be noted that Strong was a Morgan man (Bankers Trust). He headed the New York Fed upon its birth in 1914. It is also of note that "Fed policy" was run by Strong, not by the Chairman of the Federal Reserve System in Washington. Power moved to Washington in the 1930s.

(Today, this appearance of power in the capital may be more form than substance. The current chairman of the board of the New York Fed is a Morgan man, in fact, he is the Morgan man: J.P. Morgan Chairman and CEO Jamie Dimon. The board of directors of the Federal Reserve Bank of New York chooses its own president: currently William C. Dudley, formerly, chief economist of Goldman Sachs. Dudley was hired by then-New York Fed president Timothy Geithner in 2007 to run the Federal Reserve's open market operations (buying and selling Treasury securities through his primary dealer network), which still operate from 33 Liberty Street in Lower Manhattan. The neo-Florentine palazzo has been home to the New York Fed since its construction was completed in 1924. As president of the New York Fed, Dudley's top responsibility is to find buyers of Treasury securities to plug Treasury Secretary Timothy Geithner's $1-trillion-plus annual gap between revenues and spending.)  

Despite his Morgan interests, and his power, Benjamin Strong saw no good in the Federal Reserve setting market interest rates. This was soon to change. The New York Fed contorted interest rates in 1922, 1924, and in 1927. (The 1922 operation was benign. In the words of Lester Chandler, author of Benjamin Strong: Central Banker: The "prime motivation was to assure themselves [the Federal Reserve district banks] of enough earnings to cover expenses and dividend requirements.")

Strong's change of heart might be chalked up to "absolute power corrupts absolutely." Strong was human. Senator Elihu Root of New York attempted to kill the 1913 Federal Reserve Act. He understood its inevitable folly: "[W]ith the exhaustless reservoir of the government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community. Bankers are not free of it. They are human...when credit exceeds the legitimate demands of the currency and the currency becomes suspected and gold leaves the country...it is the United States that is discredited by the inflation of its demand obligations which it cannot pay."

The Morgan man at Banker's Trust helped Senator Root prepare that speech.

Strong's decision to drive down interest rates in 1927 had the greatest consequence. Adolph Miller, a member of the Federal Reserve Board at the time, testified before the Senate in 1931. He described the explosive nature of the Fed's open market operations: "In the year 1927, you will note the pronounced increases in these [Federal Reserve holdings of Government securities] in the second half of the year. Coupled with the purchases of acceptances, it was the greatest and boldest operation ever undertaken by the Federal Reserve System, and, in my judgment, resulted in one of the most costly errors committed by it or any other banking system in the last 75 years.... [T]he Federal Reserve [put] money into the markets, not because member banks asked for it by offering paper for rediscount, but in pursuance of a policy of our own which in effect said, 'We shall not wait to be asked to provide increased money through rediscounts; we will operate upon our own responsibility....'"

Miller, unlike the fashionable economists of the 1920s, including Irving Fisher and John Maynard Keynes, did not fall for the New Era: "That was a time of business recession. Business could not use and was not asking for increased money at that time. But the banks do not want to and in fact do not carry uninvited moneys or idle reserves. Here then, in 1927, came an accession to their reserves for which they had to find a use."

Barclays and Bob Diamond, not free of the spirit of optimism, acted as described in the speech written by Senator Elihu Root and soon-to-be head of the New York Fed, Benjamin Strong.

"One of the most costly errors committed by it or any other banking system in the last 75 years" led to the Great Depression, during which, even third-rate pupils of the period learned that over production of money through open market operations can in fact lead banks to "carry uninvited moneys or idle reserves."

It would be better if Mark Zuckerberg's dog walker were Federal Reserve chairman today.

Since Libor is the purported subject here, the nagging question shall be raised: Why is an interest rate set in London fundamental to the structure of mortgage rates on the North American continent? Recidivist homage to the United States' former sovereign? This seems to be one more practice that has gone on for so long that its dissonance is forgotten.

Having raised one, another nagging question: Should it be LIBOR or Libor?

How Long Will This Go On?

Frederick J. 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) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

            The Tisch family's shipping venture (A Buyer's Market) jogged the memory. The August 26, 1985, issue of Grant's Interest Rate Observer, in which Jim Tisch discussed buying ships for less than 10% of the new construction price, included a mix of leveraged developments that appeared doomed. Some were. Some go on and on.

            The story under a page one headline: "Mortgages: A Federal Risk" suggested "it might be helpful to know the extent of the Treasury's exposure to mortgage values (and thus to the great postwar bull market in houses, which seems to be getting tired). Helpful, or not, the numbers are staggering." In 1984, the federal government guaranteed $386.7 billion of loans in 1984. The biggest component by far is mortgages. "The heart of the mortgage numbers [were] real estate loans that the federal government itself was on the hook for...." [For comparison: the coarse measurement for the size of the national economy - the GDP - rose from $4.2 trillion in 1985 to $15.1 trillion in 2011. - FJS]

            According to usgovernmentrevenue.com, the federal government spent $851 billion in 1984. During this final year of the first term of the Reagan Administration, the government received $666 billion in revenues, thus spending $185 billion beyond its receipts. It was in the same year the government added $386 billion in (mostly) real estate guarantees. There may be a mismatch of calendar and fiscal years here, but Moody's and S&P still had cause to downgrade the U.S. government's AAA-rating. How long could this go on?

            In the same issue, a recent circular from Kohlberg Kravis Roberts & Co. was discussed. The founding partners had participated in 13 buyouts between 1965 and 1976 that produced an estimated 63% annual return. KKR was formed in 1976, after which (to the time of this circular, announcing its fifth equity investment buyout fund) the annual rate-of-return had been 46.8%.

KKR goes on, with some successes and some failures. RJR Nabisco and TXU were among the firm's ill-chosen ventures. Even if investors should have looked elsewhere after 1985, the principals have prospered. Henry Kravis continues to accumulate assets (that is, his personal fortune) by not veering much from the same leveraged strategy described to potential investors in the 1985 memorandum. Of the targeted companies: "There should be a low debt-to-equity ratio, thereby permitting significant additional leverage in the new capital structure."

            One consequence of this strategy has been the leveraging of corporate balance sheets across industries, no matter the inclinations of corporate management. A company that preferred to manage its balance sheet conservatively (mostly equity with little debt) stood as much chance of escape as a slow-moving target in a schoolyard, dodge-ball game. If it did not wise up (a little equity and mostly debt), KKR and its brethren would be sure to notice.

Companies in cyclical and capital-intensive industries that had traditionally eschewed debt were now showered with investment banking offers (along with the investment banks' well-compensated, Nobel-winning academics) to layer their balance sheets with faddish debt offerings. The result is an international corporate structure that is not poised to weather a decline in asset values. It is often claimed that U.S. corporations are "cash rich." This is highly misleading, as any reporter would discover with ten minutes of investigation, yet the claim is good for averting the S&P 500 and for deflecting closer inspection of companies that are buying back their own shares. The latter is another officially sanctioned though little mentioned contrivance to skew asset prices upwards.

Fannie Mae was the topic of another article. The credit-worthiness of Fannie was compared to its relatively unknown sister, Sallie Mae. (The latter won by a landslide.) As for Fannie, its chairman's second quarter letter to shareholders was discussed. Quoting part of what was quoted: "charge offs...for loan losses increased from $19.4 million to $27.6 million in the second quarter. During the second quarter, charge-offs exceeded the rate at which we provided for losses. The primary cause of this significant increase is the growing number of properties that Fannie Mae is acquiring through foreclosure. The problem is concentrated in depressed housing markets like Houston and Southern Florida, though is not limited to these."

-David O. Maxwell CEO, FNMA - second quarter [1985, believe it or not - FJS] report to shareholders.

            Grant's commented: "To the investing world, the stocks and bonds of Fannie Mae might just as well be candy. Never mind the company's enormous leverage, its chronic losses or...its mounting credit problems."

            Well, then, why was Fannie so attractive? The editor of Grant's had an answer: "Almost nobody could believe that 'they' (the Treasury, the Fed, the Department of Housing and Urban Development) would ever allow the Federal National Mortgage Association to go the way...." The way it in fact did go - twenty-three years later.

For many, this is painful to read. Not the comeuppance in 2008, but Fannie's pretense over the previous decades. There were short sellers who knew, without any doubt, that Fannie was insolvent in 1998, in 2000, in 2002. They kept shorting Fannie. Post-modern accounting conventions and congressionally muzzled regulators impoverished portfolios at the same time Jim Johnston, Franklin Raines, and Angelo Mozilo got rich.

Whether or not Maxwell, Johnston, Raines, Mozilo, or Henry Kravis understood it, they, and much of the so-called one percent, were on the winning side of the restructuring of the American economy. Woe betide the college graduate of 1980 who pursued a career at a manufacturer or oil producer. For decades, an incremental $1.40 of debt produced $1.00 of additional GDP. By 1985, it took $4.00 of additional debt to produce $1.00 of economic growth. This defied the natural boundaries of a functioning economy. Surely, the game was up.

The investor who understood nature, history, and fundamental analytics did not foresee how far an economy could push the limits when it could print its own currency, painlessly. The U.S. dollar has, subsequently, had its up and downs, but foreign central banks willingly (or, maybe not so willingly) have absorbed trillions of dollar emanations by releasing trillions of their own currencies. How long can this go on?

Reading the August 26, 1985, issue of Grant's (and forbearing a synopsis of Professor James C. Van Horne's July 1985 paper in The Journal of Finance about the financial "promoter [who] wishes to make a profit regardless of whether an idea has substance"), we are reviewing an important moment in history; 1984 to 1986 was a time when finance and business broke from the past.

For instance, banking was now a growth industry. The loan officer at a money-center bank was no longer so concerned that a borrower could extinguish a loan as long as the interest could be paid. Rolling over the loan at maturity was enough. Lending had become a volume business. As long as the loan book rose at a faster rate than defaults, profits and dividends could meet growth targets.

Fifteen years after the Bretton Woods gold standard ended, redemption of loans was no longer necessary, since the volume of dollar growth was no longer restricted by redemption into gold.

Fast money has made more money since. Capital-intensive, slow assets lost. They went the way of disco. Dollars were growing at a faster pace than aluminum. It's easier and more fun to hand out money than run a factory. The latter pays off too slowly for the portfolio manager judged by quarterly or annual performance. So, the rust belt moved to China.

The question before the house: Can the Powers Who Want It to Remain So support asset prices of largely under producing and redundant assets, around the world, with more, and necessarily much larger, emissions of currency for another 27 years? (The investment strategy, no matter the answer to that question, is to buy gold and silver. Central bankers can only imagine, as a response to weaker asset prices, the production of trillions upon trillions of dollars, euros, yen, pounds, and yuan.)

A clue might be gleaned from the answer to the following question, aimed at (though we know in advance he would claim immunity) European Central Bank President Mario Draghi: "We know that most European banks no longer deal with each other. We know, for instance, the lending market among European banks contracted by $637 billion in the fourth quarter of 2011. To settle overnight balances, commercial banks now use the European Central Bank as its counterparty. That is, commercial banks trust that the ECB will not go bust before tomorrow morning. Yet, the ECB seems intent on diluting the credit worthiness of its own balance sheet. The ECB gave 75% haircuts (discounts) to some of the loans that banks used as collateral in LTRO2. Since then, you have added categories of collateral that were previously verboten. What will happen on the day banks decide your balance sheet is in worse shape than the counterparties they already rejected?"

ECB President Draghi might offer a similar response to that proffered by the host of a conference put on by Data Resources Inc. on August 12, 1985:

QUESTION: "It seems to me that the U.S. has turned into a three-tier economy. We've got the farm sector - it is on its ass - and the manufacturing sector - it is on its ass - and the services sector which in reality is the financial services sector, which in a great measure is the business of distributing and trading around government debt. Where does all this lead?"

ANSWER: "Let's move on to the next topic."

            As a gander, the spoil sport at the Data Resources soiree underperformed over the next twenty-seven years. Those who moved onto the next topic - that is, many who do not recognize, even today, the insubstantial nature of the world's economy - have made a mint. The latter defines 99% of what goes by the label of Wall Street, since those who did not go with the flow found a new job. Do investment advisers and consultants have another 27 years before their investment strategies come a cropper? It would be improvident to dismiss the possibility, but it seems more likely that in a flash of recognition, sooner rather than later, legions of experts will, along with Mario Draghi, ask: "Where did all the money go?"

A Buyer's Market

Frederick J. 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) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

"China should delay its bid to pass South Korea as the world's biggest shipbuilder to prevent a flood of new vessels extending industry-wide losses, said Clarkson Plc's Managing Director Martin Stopford. 'This sort of target really should be put aside for the time being,' he said in an interview Wednesday at a conference in Shanghai. China has asked state banks to boost financing for new ships to prevent order cancellations, safeguard jobs and support a plan to pass South Korea in ship production by 2015. At the same time, the global container-ship fleet has as much as 20 percent excess capacity...."

--"China Shipyards Should Delay Bid to Pass Korea, Business Asia, December 4, 2009

"Jiangsu, the dominant province in Chinese ship manufacturing, received 61.7 percent fewer orders for ships in the first five months than in the same period of 2011, due to a slump in the global shipping market, new official figures have indicated....The sluggish world market and excess of transportation capacity contributed to the drop in orders, according to the commission."

--"Chinese Ship Orders Drop Drastically," Xinhua, July 2, 2012

The unwinding of the commercial shipbuilding market will appeal to a small group of investors. It can be viewed more broadly as representative of value investments to come. The characteristics apply to assets that were ordered and built with projections of ever-increasing demand. Or, as described in the objective of Chinese shipbuilding above, to achieve national greatness, buyers or no buyers.

Demand for new ships is notoriously unpredictable. Shipping companies and commodity producers order when the economy is blooming: trade percolates, more ships are needed. Deliveries are often made after the business cycle has peaked and trade is wilting. Freight rates are falling at the same time cargo capacity (new and usually larger ships) is delivered.

The world economy is slowing fast. Trouble in shipping is being exacerbated by mendicant banks. A most neglected problem (in public discussion) is the deceleration of collateral, the consequence of which is forcing banks to shed assets. Europe is the center of balance sheet downsizing, but hardly alone. The base of assets that U.S. banks are permitted to pledge as collateral has shrunk by around $5 trillion since 2008. European banks lent generously to Asian companies, but are now retreating.

The indefatigable Andy Lees (AML Macro Limited) wrote in his July 2, 2012, Morning Headlines: "The contraction in European banks' balance sheets took another turn as Commerzbank announced it was to pull out of ship finance. It had been the world's 3^rd largest maritime lender. Danish shipping association BIMCO said 'Ship owners stuck in a financial moment they cannot get out of are likely to get closer to a bankruptcy as yet another option in the traditional ship finance banking market is lost.' Lloyds and Soc Gen [Societe Generale] have already pulled out. About USD249bn is needed in new debt and equity in the coming 3 years to cover orders for new ships."

Commerzbank, Lloyds, and Societe Generale are in a fix. First, is the general encumbrance of European banks, not necessarily the three under discussion. National greatness in the Old World opens with government demands for banks to buy their nation's debt. This has been a losing proposition since the dawn of the Renaissance. Second, the quality of their pledged collateral is falling. Most European banks need to borrow from the ECB (European Central Bank), but can only do so by pledging eligible collateral. They are selling assets that would require additional collateral, or, simply selling assets to reduce exposures.

Dominoes fall: As Danish shipping association BIMCO warns, this pushes the ship owners closer to bankruptcy. The value of those assets declines. The ECB then demands more collateral to supplement current pledges. We will stop here. (The ECB is turning the quality of the collateral into a farce, but that should be addressed separately.)

It is not difficult to look at this dynamic and foresee falling prices around the world. Given the tentacles of central banks across asset classes, it is to Bernanke, King and Draghi investors look to forestall an avalanche. The central bankers are doing what they can to suspend the repricing of assets in a deleveraging world. The ECB collateral farce is one attempt. The Bank of England's announcement on July 5, 2012, that it will dump £50 billion into the British economy is another. Given the volume of assets in the world, this is pocket change, as is Bernanke's latest Twist. The Fed chairman must be chomping at the bit. He has a textbook opportunity (his textbook) to really test his acumen: $5 trillion at a minimum.

Redundant ships brought the Tisch family to mind (Loews Corp: L on the NYSE). Searching the archives, it was Jim Tisch who was interviewed in the August 26, 1985, issue of Grant's Interest Rate Observer. Ships were the Old Maid. "Sunk" was the headline in Forbes. "Used Ship Prices Set to Fall," claimed the Financial Times. A ship owner was quoted: "You'll probably [make] some money, but there'll be a hell of a bloodbath in the meantime."

Jim Tisch was buying ships for $5.5 million each. They had cost $60 million to build and would cost the same to construct in 1985. These assets (so to speak) were idling in Norway and Scotland (after having been renamed after Loews' movie theatres: Orpheum and Paradise, for instance).

The thinking was probably not much different than investing in movie theatres: how much do we need to fill them to make money? (They made plenty.) Today, the coincident problems of falling asset prices and depleted lending will empty ships, commercial real estate, and other structures of investors, renters, and the good word of Forbes.

When Zero Rates Don't Work

Frederick J. 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) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

Jon Hilsenrath, the Wall Street Journal's ferret at the Fed, reports what the Federal Reserve wants the public to know while retaining anonymity. He found the professors in a stew. In the June 19, 2012, edition, Hilsenrath disclosed: "Fed officials have been frustrated in the past year that low interest rate policies haven't reached enough Americans to spur stronger growth, the way economics textbooks say low rates should. By reducing interest rates-the cost of credit-the Fed encourages household spending, business investment and hiring, in addition to reducing the burden of past debts. But the economy hasn't been working according to script."

Since the professors wrote the textbooks, Fed headquarters is not a source of economic inspiration. Textbooks in the U.S. are the monopoly of Bernanke, Romer, Mishkin and a few other cross-pollinated primates.

Notable in Federal Reserve Chairman Ben Bernanke's Essays on the Great Depression is its inbreeding. The professor is unsparing in his praise of such contemporaries as Romer, Mishkin, and of course, devoted to Friedman and Schwartz. He neglects earlier economists who might have modified the certainty of his negative real interest rate policy.

There were many prominent economists - two, three, and four generations ago - who warned that low- and lower- and zero-percent interest rates may fail to waken an economy. Bank reserves may sit in the bank. That's that.

This happened in the Great One. It was obvious by the mid-1930s there was little appetite for lending or borrowing, even with interest rates below one percent. If ever the phrase "it takes two to tango" fits, here we are. A loan includes two parties: a lender and a borrower. Reading Hilsenrath's article, the stalagmites in the Eccles Building only think about the lack of lending. The possibility that credit-worthy customers do not want to borrow is apparently negligible.

By 1934-1935 the domestic banking system had become saturated with idle cash. So notes David Stockman, former director of the Office of Management and Budget under President Reagan, in the draft of his future book: The Great Deformation: How Crony Capitalism Corrupted Free Markets and Democracy. Stockman writes that excess bank reserves at the Fed rose from $2.7 billion in 1933 to $11.7 billion by 1939. These fallow dollars remained sterile, like Grandpa Joad's farm. They accounted for 75% of the Fed's balance-sheet growth during the period.

            Bernanke has entirely ignored earlier scholarship, but it may be of interest to readers:

In 1910, William Beveridge (of the 1942 Beveridge Report) wrote:

"Clearly a mere offer of cheap money does not suffice; banks at times of depression may go on offering cheap money for months or even years together before any recovery happens."

-- William Beveridge, Unemployment: A Problem of Industry, Longman, Green and Co. (1910)

In 1926, Dennis Robertson:

            "...while there is always some rate of interest which will check an eager borrower, there may be no rate of money interest in excess of zero which will stimulate an unwilling one."

Robertson also wrote:

"...those theorists are right who have found cause of 'crises' in a 'deficiency of capital.' But what is deficient is not money, otherwise the situation could be cured, as all experience shows it cannot, by continued inflation."

            -- Dennis Robertson, Banking Policy and the Price Level, King, 1926

In 1936, Wilhelm Ropke:

"The American experiences have amply verified the surmise that even an interest rate which approaches zero may be insufficient...to induce entrepreneurs to enter upon new investment."

            --Wilhelm Ropke, Crises and Cycles, William Hodge & Company, Limited, 1936

In 1937, C.A. Phillips, T.F. McManus and R.W. Nelson:

"[W]e have witnessed for four years and more a policy of deficit borrowing which has forced Government bonds on the banks and has created new credits to such an extent that the demand deposits of the Federal Reserve System are now higher than they were in 1929 ($16,324 million on June 29, 1929, $19,161 million on March 1936); and for almost five years we have experienced excessively low rates of interest for short-term capital coincidentally with unprecedented excess reserves in the banking system; both conditions indicate that the basic immediate need is not for more credit, but rather that conditions in the investment market are still such that extensive long-term investment is not being made."

Also from the trio:

"What is to be desired is a greater use of bank credit now in existence rather than a greater absolute volume of credit....The total volume of bank deposits now in existence is in excess of the 1920 total ($51,335 millions of deposits [exclusive of interbank deposits] on June 30, 1936, as against $37,721 million in June, 1920), yet the price level and the cost of living are both below the levels prevailing in 1920-1921. Between December 30, 1933, and December 31, 1935, total deposits [exclusive of interbank deposits] increased by $10,459 million, or at a rate of $100 million a week."

--Banking and the Business Cycle, 1937

            The reader may note a common theme in the titles to these books, "banking" and "cycles" recurring. This suggests why Bernanke & Co. may remain detached from such tomes. They do not believe in cycles. If bad things happen, the intruders are thwarted by good policy. That the policy is "good" is assumed. (I am not making this up.)

  

In 1937 (probably: this is from the 1946 edition), Gottfried Haberler:

"During a depression, loans are liquidated and gradually money flows back from circulation into the reserves of banks....Interest is by this time fallen to an abnormally low level; but, with prices sagging and with a prevalence of pessimism, it may be that even an exceedingly low level of interest rates will not stimulate people to borrow."

            -- Gottfried Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements, United Nations, 1946.

            Haberler discussed Ralph Hawtrey, who changed his mind. Hawtrey's shift is mentioned since there is an inverse relationship between one's status (regardless of whether we are discussing economists, biologists, or motor mechanics) and the willingness to admit one's error. Hats off to Hawtrey:

"Mr. R.W. Hawtrey is confident that eventually, if only the purchases of securities are carried far enough [and, by implication, interest rates are low enough - FJS] the new money will find an outlet into circulation, consumers' income and outlay will begin to rise, and a self-reinforcing process of expansion will be started."

Haberler wrote of Hawtrey's maturation: "In more recent publications, under the impression of the slump of the nineteen-thirties, Mr. Hawtrey has modified his views to some extent. He still believes that 'a failure of cheap money to stimulate revival' is 'a rare occurrence' but he admits that since 1930, it has come to plague the world and has confronted us with problems which have threatened the fabric of civilization with destruction."

As Bernanke would say: "et cetera, et cetera." (See: The Professor Who Did Not Save the World)

Dr. Kevorkian Holds a Press Conference

Frederick J. 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) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

"We have taken today a step, which is a substantive step, which will provide additional accommodation for the economy and moreover we have stated that we are prepared to take further steps if necessary to promote sustainable growth and recovery in the labor market, so we are prepared to do what is necessary. We are prepared to provide support for the economy."

                                                   -Ben S. Bernanke, Press Conference, June 20, 2012

            Felix Somary, banker, economist, and diplomat, did not adapt to modernity. Viennese born (1881), he had the foresight to convert his clients' Austrian and Belgian bank deposits to gold (in Switzerland and Norway) in July 1914. ("I was uncertain how much insight the King [Edward V - first cousin to Kaiser Wilhelm II] could have into the situation. I had seen six years before how little informed more capable rulers had been; the information available to insiders, and precisely the most highly placed among them, is all too often misleading.") He became a Swiss citizen in 1933 and later served in diplomatic missions to Washington. He died in 1956.

In Democracy at Bay (1952), Somary looked at the financial immolation of the West from an earlier perspective: "But that invested capital should in an equal period of time not only not increase but shrink to nothing, or almost nothing, would be considered an impossibility in the eighteenth or the nineteenth century. Despite all the technological advances the West was set back economically by several generations, and the doctrine of the various political parties became meaningless."

Somary published a table of capital increase between 1884 and 1914 in Germany (+150%), Austria (+150%), Italy (+150%), and France (+110%). Another table follows with the capital decrease between 1914 and 1948 in Germany (-100%), Austria (-100%), Italy (-98.5%), and France (-97%).

Somary commented that in the ruin of the savings banks and of the insurance companies, the middle class lost its financial backbone. The depreciation of government bonds wiped out the reserves of workers' old age insurance funds.

Bringing this up to date, the middle class and workers are left perplexed, uprooted, disoriented, and can not distill the truth, since, for so long, it has been turned inside-out (or upside-down) by clever and shoddy academics, power-mad bureaucrats, and political opportunists.

Benjamin Anderson, otherwise known as "The Good Ben," wrote an excellent book with an awful title: Economics and the Public Welfare, A Financial and Economic History of the United States, 1914-1946, published in 1949. It is an economics unfamiliar to this generation's central bankers; among other reasons, Anderson understood integrity was the backbone of finance. There is probably not a mainstream college textbook today that addresses this nexus, since the combination is foreign to celebrity, economics professor.

Let us compare accounts by Good Ben and Bad Ben of the destruction wrought by Britain when it abandoned the gold-exchange standard in 1931. Anderson wrote (skipping ellipses, as is true below): "The collapse of the gold standard in England was absolutely unnecessary. But Britain did not fight. To a British banker in 1913, this would have been an incredible thing. There was a great shock as it developed that the Bank of France had lost seven times its capital through its holdings of sterling, through trusting the Bank of England, and perhaps the even more shocking discovery that the Netherlands [central] Bank, trusting the word of the Bank of England, had lost all its capital in the decline in sterling. Governments could no longer trust governments in financial matters, and the confidence in central banks by one another was gravely shaken. An immense world asset was destroyed when the Bank of England and the British government broke faith with the world."

In his lecture series at George Washington University in March 2012, Federal Reserve Chairman Ben S. Bernanke, The World's Leading Authority on How to Create a Great Depression, told the unfortunate students (watch the video - they are taking notes!): "[T]he reason the Bank of England could maintain the gold standard was that everybody knew that they were going to - their first, second, third, and fourth priority was staying on gold and that they had no interest in any other policy objective. But once there was concern that [sic] Bank of England might - you know, might not be fully committed, then there was a speculative attack that drove him [sic] off gold."

The gilded professor taught the students that at the moment a rock-solid solemn vow is attacked, the thing to do is abandon resolution and to panic: courage to the rear of the class. This, obviously, is a neon sign for investors to expect in the future what we have seen in the past: in a pinch, Bernanke's course will be to steer the Fed and his banking buddies out of harm's way. Taking a longer view, it is leadership of this persuasion that fleeces the middle class and peasants, steering the 99% into stocks and mortgages when the 1% need protection.

It is not true in the least that once there was a speculative attack, Britain needed to abandon gold. At the simplest level, it makes no sense. If it did, anyone at anytime could have launched a speculative attack against a currency - including all currencies with less prestige than the pound - and won big. Anderson wrote: "On August 28, [1931], an additional credit of $400 million was given to London by a consortium of commercial [French and U.S] banks and private banks. The expectation was this would surely be enough if Britain made the necessary adjustments. But Britain did not fight. On Friday, September 18, Doctor Vissering, head of the Netherlands Bank, phoned Governor Montagu Norman of the Bank of England to inquire if it were safe for him to continue to hold sterling, and received unqualified assurance that England would remain on the gold standard. England went off the gold standard with [the] bank rate at 4.5 percent. [In the past], in a much less grave crisis, [the] bank rate would have gone to ten percent long before anything like so much gold had left the country."

Bernanke's other comments during his lecture about the Bank of England in 1931 mirror the above, in the professor's strange Val-Girl-Does-the-Ivy-League patois: "In 1931, for a lot of good reasons, speculators lost confidence that the British pound would stand gold [sic], so just like a run on the bank, they all [sic!] brought their pounds to the Bank of England and said, "Give me gold." And it didn't take long before the Bank of England was out of gold cause they didn't have all the gold they needed to support the money supply and then, there was essentially, they've essentially had to leave the gold standard....They had no choice because there was a speculative attack on the pound."

Of the United States abandonment of the gold-exchange standard in 1933, Anderson wrote: "The government had written the word gold not only on the Federal Reserve notes, but also on its bonds and on every interest coupon attached to them. The government was bound by its solemn promises, and the President was personally bound by his campaign utterances and by the platform of his party. It was dishonor."

The Good Ben penned the most important lesson to be learned from Britain's abdication of duty, one that Bernanke never learned or was taught, and it may not be possible to teach. At least, that is the real lesson taught by Ivy League economists. Bernanke is representative of the amorality that leads from the top today. Anderson wrote: [T]here is no need in human life so great as that men should trust one another and trust their government, should believe in promises, and should keep promises in order that future promises may be believed in and in order that confident cooperation may be possible. Good faith - personal, national, and international - is the first prerequisite of decent living, of the steady going on of industry, of government financial strength, and of international peace."

The United States abandoned the gold standard, for an incomprehensible reason dreamt up by Franklin Roosevelt and a farm economist whose earlier scholarship included Alfalfa, An Apple Orchard Survey of Orleans, and Some Suggestions for City Persons Who desire to Farm.

In Once in Golconda, John Brooks described this amateur prank: "As to government policy, nations had before 1933, and often have since then, intervened in the markets to defend the values of their currencies; conversely, over the years they have often deliberately lowered the relative value of their currencies, but no nation had ever mounted a systematic and concerted attack on the currency, in a time when its gold stock was ample, for the sole purpose of creating domestic inflation and thus helping debtors. They had not done so because the idea was so outlandish it never occurred to them. If it had, it would have appeared to their economic ministers about as sensible as repeatedly hitting oneself in the head with a hammer so it would feel good when one stopped."

In short, whatever else FDR and his hayseed economist concocted while eating scrambled eggs in the President's bedroom, it was not a product of economic thinking. FDR excluded economists of any weight from this lark. Bernanke's generation has no trouble justifying the action. A tribute to their scholarship is the fine description of Bernanke's to George Washington U's eager attendees: FDR "abandoned the gold standard. And by abandoning the gold standard, he allowed monetary policy to be released and allowed expansion of the money supply which ended the deflation and led to a powerful short term rebound in '33 and '34."

To address the Bad Ben's causes-to-effects ad seriatim (or, discuss any phrase other than he "abandoned the gold standard"), would be such a task, that only a budding economics Ph.D acolyte should take it on.

A Scandanavian central banker later told Anderson: "I have lost money in sterling. I have lost money in dollars. I have never lost money in gold."

Anderson supplanted Somary's historical review of the fleeting, insubstantial nature of savings, investment, and capital by 1949. Compared to the world of yesteryear, one could not know where in the world money was safe: "We knew nothing of 'hot money' on a large scale in the decades that preceded World War I, when great governments protected the gold standing of their currency as a matter of course because it was the honorable and expected thing to do. But since the bad faith of the two greatest governments in the world, Great Britain in 1931 and the United States in 1933, we have had a world of hot money jumping about nervously from place to place, seeing no safety anywhere, but going from places that seemed unsafe to places that seemed less unsafe. We have had a world in which men have been afraid to make long-run plans. We have had a world in which conscientious and scrupulous trustees have been turning from "gilt-edged bonds" toward common stocks, not because they are safe, but because they were less unsafe than the government obligations, and we have had them doing this with the approval of scrupulous and upright judges who have taken cognizance of the bad faith of government." [My italics - FJS]

Somary wrote in 1952: "[F]or the first time in four centuries European free enterprise was deprived of investments and credits. The "capitalist' had vanished overnight." Somary added a footnote: "The temporary mushroom of inflationary and wartime speculation is a secondary phenomenon not related to this development."

"Temporary mushroom," indeed. Somary's foresight throughout his life was extraordinary. But here, towards the end, it was impossible for him to believe the inflationary speculation would not only continue for another 60 years, but grow by - how much? - A thousand fold? Ten thousand fold? A million fold? Whatever the case, the middle class and peasantry do not know which way is up.

Dr. Kevorkian created a money-making brand name with his assisted-suicide gimmick. A generation earlier, he would have remained a strange specimen, studied by curious students, akin to radiation-resistant bacteria in a lab. His medical research explorations would have been ignored, at large. Like so much else these days that fills the news, his arguments were too preposterous to debate.

And so it was with FDR's rationale for going off gold in 1933. He accomplished this feat at a time - as is true today - when the people were perplexed, uprooted, disoriented, and can not distill the truth. Today's clever and shoddy academics, power-mad bureaucrats, and political opportunists control the categories. The destruction wrought by illegal money is, as Somary explained, the cracked foundation of social dishevelment.

Even with plain evidence of Bernanke's failure at every step of his chairmanship, he could tell the press on March 20, 2012: "There are additional steps that can be taken and we have demonstrated through both communications techniques, guidance about future policy, which is something the Japanese have done as well, by the way - and through asset purchases, also something ... Japan has done [he's using Japan as an example of success! - FJS] - that central banks do have some ability to provide financial accommodations to support the recovery even when the short-term interest rates are close to zero. That being said ... these nonstandard policies are less well understood and they do have some costs and risks but I do think at the same time that they can be effective in helping the economy."

Chairman Bernanke is an unqualified failure. He is delighted at the prospect of experimenting with his Ad Lib Economics. Less than two years ago, the former head of the Princeton economics department returned to campus. After he was awakened from his favorite barcalounger in the faculty lounge, he spoke at the Bendheim Center for Finance: "The episode [the 2008 financial free-for-all - FJS] as a whole has not been kind to the reputation of economics and economists, and understandably so. Almost universally, economists failed to predict the nature, timing, or severity of the crisis; and those few who issued early warnings generally identified only isolated weaknesses in the system, not anything approaching the full set of complex linkages and mechanisms that amplified the initial shocks and ultimately resulted in a devastating global crisis and recession."

And not one person threw an egg.

Donning our Parachutes

Frederick J. 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) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

We know the drill. The Federal Reserve Open Market Committee (FOMC) will meet on June 19 and June 20, 2012. On June 30, the Fed is scheduled to retire "Operation Twist" (selling shorter-term U.S. government bonds and buying longer-term U.S. Treasuries). The talk is whether the Fed will extend Twist, replace it with Operation Boom, or do nothing.

The "pro" positions will make the most noise since rooting for bubbles is Wall Street's job. The media observes its customary reverence for ensconced strategists and economists, who will parody the interests of Bubble TV's advertisers. The "cons" include: (1) a reluctant FOMC (word has it that Bernanke wants full-throated, or voted, support from the FOMC), (2) a meandering economy (not popularly thought to be in a recession), and (3) "He's run out of bullets."

Before addressing numbers (1), (2), and (3), the Fed chairman's footnote (or, so it was regarded) to his testimony before the Joint Economic Committee on June 7, 2012, should be considered his preferred excuse for Operation Boom: "The situation in Europe poses significant risks to the U.S. financial system and economy and must be monitored closely...". The Old World is approaching negative equity; recognition of such delays a multi-trillion dollar (and euro) response. Brussels and Strasburg are distant cities, but the New World is getting dragged, once again, over there. Most important is to understand the collateral, there and here. At the tipping point, Europe may close stock and bond markets.

Assuming Andalusia and Athens retain more decorum than Damascus, the FOMC will operate within more limited considerations.

If number (1) is true, the FOMC will probably have to wait before revving up the helicopter again. Number (2) should be modified. Federal Reserve Chairman Ben Bernanke does not care about the economy. He reacts to falling stock and bond prices. (Recall that when interest rates rise, bond prices fall.) Yet, the Fed chairman is compelled to link his Monopoly® money games to the common folk. If markets are breaking down, there are plenty of economic indicators to justify Operation Boom. The media will simply relay what it is told by the Fed's P.R. specialists. His indifference to the economy is the flip side of his inflating of markets, until the markets decide: "enough." See "Uncle Ben Wants You! - To Buy Stocks", "Economics 101: Long Material, Short Certified Idiots,", "An Absolute Zero."

There is overwhelming evidence the Fed's three monetary easing operations have indeed inflated asset markets. Simple Ben brags about his contribution to the tax base of Greenwich. The Federal Reserve chairman confirmed his affaire de coeur with hedge-fund managers when he vamped CNN on January 13, 2011: "'I do think that our policies [He was referring to QE2 - FJS] have contributed to a stronger stock market, just as they did in March of 2009,' [Bernanke] said, referring to the Fed's initial round of quantitative easing." His reference to "March of 2009" was a claim that QE1 had succeeded.

Returning to CNN's commentary of Bernanke's January 13, 2011, interview: "He pointed out that since he signaled the Fed would likely unveil QE2 during a speech in Jackson Hole, Wyoming [August 27, 2010 - FJS], that the Russell 2000 of small cap stocks is up 30%, even more than the 15% to 20% rise in blue chip indexes. 'A stronger economy helps smaller businesses,' he said." His weird reverence for the Russell 2000 Small-Cap Index and negligent association to small businesses was a distraction. Admittedly, it was a successful distraction. That is expected. Little is said of how Bernankeism has produced piecemeal employment, shredded savings, and confiscated pension plans by stealing our interest rates.

Another distraction that identifies Bernanke with common folk is houses. When the chairman next indulges his fantasy, he will claim Operation Boom will lift house prices.  If the Fed's interference in other markets was intended to lift house prices, it has failed. According to Federal Reserve legend, lower long-term rates boost house prices.

Operation Twist succeeded in pushing down long-term rates. Freddie Mac 30-year fixed mortgage rates have fallen from 4.22% to 3.75% since the beginning of September 2011, when Twist began. The benchmark one-year ARM rate has likewise dropped, from 2.89% to 2.75%. Alas, the Case-Shiller Home Price Index for 20 metropolitan areas fell 6.2% from the end of August 2011 through March 2012 (the latest month published). The Index has dropped by 35% since its peak in 2006.

The answer to why lower rates have failed to lift prices is obvious: the bursting of the housing (really, mortgage) boom has burdened the mortgagee with unserviceable debt. Debt does not interest Bernanke or his generation of economists, so the Fed will persist in claiming long-term rates boost house prices. Thus, Simple Ben is not constrained by (2).

In fact, he is doing is job. Bernanke (and most of his associates) made it to the top by convincing his academic colleagues and department heads that he was reliable. He will never let the establishment down. He has not veered from his position that additional doses of money can prevent any depression. Never mind that, by any measure other than government transfer payments, the real economy is in worse condition than when Bernanke first opened the money spigot. It is in Depression.

That addresses (3). The FOMC will keep smothering us under its crank theories. Whether or not June 20 is the time: one warning. If markets do not respond, or the response is tepid, clear out. Since all prices are rigged, diminished prestige of Fed interference will clock markets.

The Bond Boom

Frederick J. 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) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

            The indexes below were discussed at a recent investment committee presentation:

 

            Upon turning to this page, the speaker noted the 5-year returns show "an absolute flooding of the market and system with capital by central banks [QE, ESFS, LTRO...]. This has been an incredibly distortionary period." (The quotation is from notes, so is not exact.)

            It is noteworthy that the speaker did not explain how these index returns are incredibly distortionary. The 5-year returns stand on their own as testament to how central banks have mangled markets.

            Pursuing this point beyond what the speaker may have said, all prices are now phony. These preternatural mispricings have turned humans into laboratory specimens. Driving interest rates to zero has inflated stock markets. Commodity and house prices have been addled by feverish interference. Employment and wage markets have been   and flogged and pilloried.

Even though stock markets have been inflated, that is not the same as aiding the economy. Such low rates have resuscitated businesses that should have failed. This has hurt better businesses that would have acquired the assets and customers of the failures. Continuing this train-of-thought across supply chains, borders, and currencies reveals many pricing distortions.

            The central planners' decision to pull profits into the present will correspond to lower profits in the future. The certified experts surely believe their infallible model will prevent a profit recession. Their model will once again prove central bankers have the most inflated reputation since the ginsu knife.

            Such a stark contrast between bond and stock returns over a five-year period is arresting. The investor may decide asset returns will regress to the mean. So, buy stocks. But, there is no hurry.

Before embarking on such an allocation, consider the artificial means by which bonds produced such sparkling returns. This cannot last, even though the stock market is still obviously priced for immaculate faith in central banks.

This is obvious since the central banks control the yield curve. At some auctions, they are the only buyer of government bonds. If investors in toto thought the issuers of sovereign debt and the central banks might fail to keep rates below 2.0% (for example: if the bid at a future U.S or German 10-year auction shoots up to 6.0%), stock markets would be 30% to 50% lower today.

The denouement of stock and bond markets may not be so sharp and so obvious as an instant 4.0% jump, but it will come. This future trauma is sometimes referred to as "The Great Reset." When the 10-year Treasury resets from 2.0% to 6.0% (the prediction is only directional) the betting here is the losses will be greater in the stock market than in bonds.

The major media generally restricts its investment advice to stocks vs. bonds. When the Great Reset hits, an investor holding cash will be well-positioned. The difficulty, real or psychological, is the price inflation (principal erosion) between now and the Great Reset. Gold, silver, and gold and silver stocks may be the best protection for principal, but that will be (as it currently is) a wild ride too, and (obviously) such investments are still considered eccentric, at best.