Tuesday, April 10, 2012

The Professor Who Did NOT Save the World

"The Fed's efforts prevented a 'total meltdown' of the financial system at a time when fears of a second Great Depression were 'very real,' Mr. Bernanke said Tuesday at the third of his four lectures at George Washington University in Washington."

Wall Street Journal, "'Fed Prevented Total Meltdown,' Bernanke Said," March 28, 2012.

This is not true.

Each of Federal Reserve Chairman Ben S. Bernanke's four lectures at George Washington University was unfortunate in its own way. In his third assault on history, logic, and common sense, "The Federal Reserve's Response to the Financial Crisis," Simple Ben made it clear he still cannot think his way through the 2008 financial crisis.

The sequence of events follows: On September 15, 2008, Lehman Brothers, an investment bank, failed. This triggered claims on credit default swaps. These derivatives pay the holder a specified amount of money when a company defaults. American International Group (AIG), an insurance company, had sold credit default swaps to protect the buyer if Lehman Brothers failed. (Credit default swaps are often labeled "insurance." As an analogy to insurance, this description is helpful; but they lack a key feature of insurance (insurable risk), one reason they should be banned.) It was time to pay, but AIG did not have the resources to do so. In the mythology of the moment, Ben's World introduced a waterfall of Old Testament proportions: AIG would fail, and the entire financial system would follow, without a government bailout.

On September 16, 2008, the U.S. government "seized control of AIG" (quoting from the September 17, 2008, Wall Street Journal). The Federal Reserve lent AIG $85 billion which allowed AIG to honor its credit default swaps.

On Sunday, September 21, 2008, "Morgan Stanley and Goldman Sachs applied to the Fed to become bank holding companies." The applications were "approved with extraordinary speed." (Financial Crisis Inquiry Commission Report) This was "in tandem with the Department of Justice," a caper that has been insufficiently explored.

The mythology is just that. I thank David A. Stockman, former director of the Office of Management and Budget under President Reagan, for the analytical assistance and for the pleasure of reading an early draft of his book: The Great Deformation: How Crony Capitalism Corrupts Free Markets and Democracy.

Those who held insurance policies with AIG or its subsidiaries never bore risk of non-payment. The policies were backed by nearly $900 billion of high-quality assets. Most of AIG's capital sat in AIG's insurance subsidiaries, sequestered from bankruptcy claims.

It might be possible that Ben Bernanke, Treasury Secretary Hank Paulson, and New York Federal Reserve President Timothy Geithner - the trio who robbed the taxpayers - did not understand insurance regulation. It is implausible that staff lawyers and regulators did not understand the insured were whole. It is simply impossible, four years later, for Simple Ben to think "we prevented the total meltdown" (as he stated at George Washington University). Lacking this myth, the $700 billion Troubled Asset Relief Program (TARP) is understood as unnecessary. It was a lifeline to crony capitalists.

Those who bought a credit default swap from AIG purchased a contract with the holding company, where there was practically no capital. The credit default swap contracts held by Goldman Sachs (for instance) were, from a practical view, worthless. Goldman might salvage itself from the residue apportioned in bankruptcy court (if AIG's holding company went under, which it surely would have), but Goldman's failure would not have been a loss to the economy. Investment banks do not hold customer deposits. The only capital they were raising was to securitize dubious mortgages which were, by now, the problem of pension and hedge funds. Their other playgrounds are self-serving.

In any case, Goldman Sachs CEO Lloyd Blankfein told the FCIC (Financial Crisis Inquiry Commission) his firm would not have failed: "We had tremendous liquidity throughout the period. But there were systemic events going on, and we were very nervous. If you are asking me what would have happened but for the considerable government intervention, I would say we were in - it was more a nervous position than we wanted [to be] in. We never anticipated the government help. We weren't relying on those mechanisms...."

The FCIC Report states that Goldman's liquidity pool "had fallen from about $120 billion on the previous Friday [September 13] to $57 billion on Thursday [September 18.]" Even at the depressed market prices of mid-September 2008, Goldman Sachs held $220 billion of long-term debt and preferred stock as well as $60 billion of common stock. Morgan Stanley held $190 billion and $25 billion of the same. These last two investment banks held one-half a trillion dollars of long-term capital at the moment Bernanke and Paulson performed their Chicken Little routine on Capital Hill - and Hank Paulson rose to the top of Goldman Sachs for his exploits as an investment banker.

If the capital was overvalued (and, it was), the investment banks could have raised more debt and equity from investors. If this proved impossible, the banks could have liquidated their assets at fire-sale prices. If Goldman's $1.1 trillion of assets were so mispriced that the bank could not survive, then it should have been liquidated. The assets would have been bought by better managed firms that had not resorted to the death-defying - but extremely profitable - wholesale funding markets and that leveraged their balance sheets at 40:1 or 80:1. The "Big Five" investment banks deserved to go out of business and it would have helped the economy. They destroy capital.

We will never know what might have happened. Bernanke and Paulson terrorized the American people who terrorized their congressmen into authorizing the $700 billion TARP. This stopped the short-term funding panic.

Bernanke has never gotten around to explaining just how the commercial banking system would collapse. Some large banks were worthless (Washington Mutual), some were and still are questionable enterprises (Citigroup), but most are viable. The FDIC increased its deposit insurance from $100,000 to $250,000 on October 3, 2008. If the chain of CDS defaults felled a depository institution such as Citigroup, the federal government would make depositors whole up to the $250,000 limit.

Yet, four years later, the chairman of the Federal Reserve misled GWU's finest: "[N]ow, the failure of AIG in our estimation would have been basically the end. It was interacting with so many different firms. It was so interconnected with both the U.S. and the European financial systems, global banks."

From the beginning, Bernanke has justified his interference with such vagaries. Thus, Ben's waterfall of tears: just as it is impossible to follow a pint of water over a cataract, Bernanke has yet to describe the sequence of failures after Goldman Sachs and Morgan Stanley (e.g.: would it have been commercial banks, asset-backed commercial paper? - neither argument would pass muster).

He was questioned at length on these very points before the Financial Crisis Inquiry Commission (FCIC) on November 17, 2009. The Fed fought the release of this transcript to the public. One can understand why. The Top Secret document exposes the Federal Reserve chairman to Double-Secret Probation. His ignorance of markets, banking, and insurance regulation is obvious; his inability to explain the chasm is manifest; though, the evidence gathers dust.

On page 28 and 29 of the FCIC transcript, our dedicated interest-rate suppressor told the Committee: "The reason AIG was set up the way it was originally, the financial products division ["Financial products division" was the profit center that sold CDS - FJS], which did the CDS, attached itself precisely because it was a large, highly-rated insurance company with lots of assets. Therefore it could sell CDS without what would otherwise be sufficient capitalization and protections because the counterparties would know that this was a highly rated firm with lots and lots of assets. It was precisely because of that reason when [AIG] financial products [division] had to sell - had to come up with the collateral - and was facing a run on its positions, that the Fed - that there existed the collateral, the assets that the Fed could lend against." [My italics - FJS]

This is not true. (It is also difficult to read. The editorial board here decided multiple [sic] entries would distract. If you don't get it the first time, try, try again.)

First, the financial products division, which sold the CDS (Bernanke was correct about this), was in AIG's holding company. If the holding company declared bankruptcy, the insurance subsidiaries would have remained unscathed.

The distinction between the holding company and the subsidiaries seems to thwart his claim that "[t]herefore it [AIG financial products] could sell CDS without what would otherwise be sufficient capitalization and protections because the counterparties would know that this was a highly rated firm with lots and lots of assets." Bernanke words this clumsily. Still, it looks as though he thinks buyers of AIG's credit-default swaps were looking to the collateral that rested in the insurance subsidiaries. He should be placed back in the witness stand to explain what he is trying to say.

Lacking subpoena powers, it is the opinion here that "lots and lots of assets" was not: "precisely... [the] reason" AIG so successfully sold worthless credit-default swaps. It is probable, knowing the tenor of the times, that investment banks and other purchasers did so precisely because they could. The premium that Goldman (and the others) paid AIG for the CDS looked extremely cheap. In fact, the CDS were sold to Goldman at market-clearing prices precisely because there was (for all intents and purposes) nothing to back the contracts.

The November 17, 2011, FCIC transcript, as well as his four lectures at George Washington University, demonstrate that his economics are assertions. It is not long into Essays on the Great Depression that his lackadaisical approach becomes apparent. It really is not economics at all, more accurately he parrots the Politics of Assertion. He does not explain the "total meltdown" beyond AIG, Goldman Sachs, and a jumble of financial instruments that every cab driver heard on the radio in September of 2008.

In the 89-page FCIC transcript, Chairman Bernanke consistently avoided the tributaries by substituting a life raft of "et ceteras." Just what was the sequence that would have shut the Bailey Savings & Loan, caged the payment system, sealed insurance policy payments? As the list of 29 "et ceteras" attest, his mind can only comprehend the problems of AIG - a wholly imaginary understanding, at that - and the difficulties of overnight funding suffered by highly leveraged hedge funds (veiled behind the white-shoe anachronism of "investment bank").

Please judge the Princeton professor's mental limits yourself:

P. 8 "...my own view is that if the system had been adequately stable, had strong enough supervision, et cetera, et cetera..."

P. 9 "...a striking aspect of these securitizations is that these vehicles, these special purpose

vehicles, et cetera..."

P. 9 "...financed by very short-term paper, overnight type money, commercial paper, et cetera..."

P.12 "...the investment banks, which were a huge problem, of course, Bear and Lehman and Merrill, et cetera..."

P. 14 "...the ad hoc responses to Lehman and AIG, et cetera..."

P. 16 "...would have exposure to a SIV which held subprime mortgages, et cetera, et cetera..."

P. 16 "...the Fed should be looking at non-bank subs, et cetera..."

P. 26-27 "...the financial impact of the collapse of AIG on so many financial institutions in this period of intense crisis already, plus the impact on insurance markets, et cetera, et cetera..."

P. 28 "...our ingenuity of finding merger partners, et cetera..."

P. 33 "...for each one of these firms and had asked for reports on what are the principal risks, you know, within these firms, et cetera..."

P. 34 "...strengthening the infrastructure, central counterparties, et cetera..."

P. 38 "...critical parts of the company to continue functioning, is able to override existing collateral or employment agreements, et cetera, et cetera..."

P. 45 "...to operate as counterparties to international firms, et cetera, et cetera..."

P.49 "...evolution in the types of businesses, and their risk management, et cetera."

P.50 "...was it a function of regulatory change, et cetera?"

P.61 "...were assigning contracts to others without telling the original - et cetera, et cetera."

P. 64 "...you don't have to know who you're trading with because the central counterparty will, through use of margins of capital, et cetera..."

P.64 "...so long as those counterparties themselves are well managed and have enough capital, et cetera..."

P.74 "...system set up in a crazy way, which was we were supposed to make rules for mortgage brokers, et cetera..."

P.80 "...I would prefer having a systematic risk council [!!!!! - FJS] which is responsible for the overall system [!!!!! - FJS] and looks for emerging risks and coordinates and information, et cetera, et cetera..."

P.86 "...I should have mentioned a lot of the other things we did to protect the asset-backed securities market, the commercial paper market, money market mutual funds, et cetera, et cetera..."

The 29 et ceteras might be a habit of speech, though they consistently appear at the moment Bernanke has identified a river pouring into the waterfall. Each time, the curious student is left untutored: et cetera, et cetera. The suspicion that there was no waterfall - and therefore, not the potential for a "total meltdown" (to remain consistent, these were icy waters) - is supplemented by Simple Ben's 27 "and so ons."

For example:

P.3 "...the macroeconomic background that led to the risk-taking and so on..."

P.11 "...forced the banks to take them back on their balance sheets or to support them and so on..."

P.11 "...did not take into account the appropriate correlation between - across the categories of mortgages and so on."

That leaves 75 pages and 24 "and so ons" for the dedicated phenomenologist.

Of course, Bernanke is a hero. From the same Wall Street Journal article quoted earlier:

"The failure of AIG, in our estimation, would've been basically the end," Mr. Bernanke said. "We were quite concerned that if AIG went bankrupt, that we would not be able to control the crisis any further."

Americas still shivers at the thought.

America will panic when it becomes obvious that Et Cetera, who has increased the Federal Reserve's balance sheet from around $800 billion in 2008 to about $2.8 trillion of assets today, has not thought through how it is going to withdraw the dollars it created to buy those assets. And-So-on's explanations of how he will do so, before inflation runs wild, are off-the-cuff Et Ceteras.

Gold, silver, and other hard assets are the obvious precaution.

Bernanke is not alone. The "1980s trained economists... a very complacent group" (see: Samuelson Flunked Bernanke) hold a monopoly on policy. The Politics of Assertion triumphed. Bernanke, Mankiw, Steiglitz, Hubbard, the Romers (husband and wife) - it goes on and on and was described in a 1944 novel by Evelyn Waugh:

"The trouble with modern education is you never know how ignorant people are. With anyone over fifty you can be fairly confident what's been taught and what's been left out. But these young people have such an intelligent, knowledgeable surface, and then the crust breaks and you look down into the depths of confusion you didn't know existed."