A Round Trip

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 dedicated resuscitators of the Federal Reserve are doomed to lose their battle with sanity, akin to Alexander Scriabin's fate in search of the lost chord. Chairman Ben S. Bernanke has not a clue where this will end. Our doleful fate is leading staunch establishmentarians to sink the Fed.

A group of worthies tacked a manifesto to the September 17, 2012, Wall Street Journal editorial page. The five authors are insiders; insiders being those who created and benefited from the false economic structure compounded over the past four decades. "J'accuse" should have been the title under which they charged the Federal Reserve with committing every crime under the sun.

            Before reviewing the convolutions and unaccountable chaos created by the Bernanke Fed, it is worth looking at the simplicity of the original Federal Reserve System. An above average tenth-grade student of 1913 could have understood how the Federal Reserve functioned. That being so, if the newly formed central banking system had stuck to the founders' intentions, we would not be suffering a pusillanimous satrap such as Ben Bernanke hurtling the Fed, and more importantly, the rest of us, off a cliff.

The principles upon which the central bank was founded have been jettisoned. Few know this. Students who attended Chairman Bernanke's "Origins and Mission of the Federal Reserve" lecture at George Washington University in March 2012 are still in the dark. Rereading the Chairman's lecture, he pings, pongs, and drifts in such a haphazard fashion that his knowledge of Origins and Missions remains a mystery. Once again, it is striking how little he knows - about anything.

H. Parker Willis was more than a scribe and less than the author of the Federal Reserve Act. Carter Glass, Senator from Virginia, had the vision. Willis understood the nuts-and-bolts of central banking.

            Willis was a professor of economics (Washington & Lee, Columbia University) fully versed in the English banking school, including the "real bills" monetary doctrine. The Federal Reserve Act (signed by President Wilson on December 23, 1913) authorized the Federal Reserve System to accept "real bills" from banks. Government securities were not acceptable.

The original process by which the Fed operated with banks worked as follows: An industrial or commercial concern asked its local bank for a loan. The loan was backed by short-term, fixed-maturity payments to be received by the Company (the aforementioned "industrial or commercial concern"). We will assume the payment is due in 30 days. At that point, the Company pays off the commercial loan - "commercial paper" - to its local bank. The Company is able to do so from the payments for goods it received from its customers: Real Bills for Real Goods.

On day five (of the 30-day period), the local bank needs cash. Perhaps there is a bank run, or more probably, some incident or whim of less interest to us. A guiding light before the formation of the Federal Reserve System was to provide cash to banks in such instances as a bank run.

The local bank - a commercial bank - presents the commercial paper to the Federal Reserve. (This would have been one of the 12 district banks, which operated quite independently at the beginning.) The Fed "rediscounts" the commercial paper and lends money to the local bank. The Fed holds the paper (and can demand payment from the Company's customers should the company fail.) The loan from the Fed will be repaid by the local bank when the commercial paper matures.

The commercial bank's nervous customers (during a bank run) see that the Federal Reserve is meeting the demands of any and all bank customers (depositors). The fearful customers dismiss concerns of their money being housed in a fractional-reserve operation, and depart the recently mutinous bank lobby without withdrawing their accounts. Again, it was the intention of the Federal Reserve founders to offer bank customers this assurance. The assurance was fortified knowing the Federal Reserve's balance sheet was limited to such short-term, self-liquidating loans that were backed by Real Goods.

The Federal Reserve was to be a non-inflationary central bank. In fact, all central banks were non-inflationary (over periods of time) in 1913. "Price stability" did not need to be defined. Our ancestors of 1913 would not have been able to comprehend a banker, an economist, a public servant: that is, serving the public, who would announce "price stability" means 2% inflation. (Nor comprehend that when 2% is no help "we'll-make it-4%-then-8%-then-12%." Adam Posen at the Bank of England has rolled out the 12% possibility.)

It was non-inflationary because the credit extended by the commercial bank matched the level of business in the economy. This was a fairly simple business.

In the December 1915 Political Science Quarterly, Willis published "The First Year of the New Banking System." Being a professor, he could not abstain from instructing his readers: "Under the provisions of the Federal Reserve Act it is required that loans be made upon paper protected by warehouse receipts, and such provisions have been made by the Board in the circular relating to commodity paper (Circular No. 17, Series of 1915)." Government bonds need not apply.

World War I disrupted this arrangement. The Great War also deranged the world's financial system when it was found necessary to decapitate the International Gold Standard. As mentioned above, in 1913, none of the world's central banks were inflation-producing operations. Since 1914, not a single central bank has accomplished much else.

The fledgling Federal Reserve did what it was told to support the doughboys. The Fed's Annual Report of 1918 noted the institution's "duty to cooperate unreservedly with the government [i.e., the Treasury] to provide funds needed for the war." Duty bound, the Fed was a full-fledged participant in the U.S. Treasury war-bond market.

In the June 1920 issue of Proceedings of the Academy of Political Science in the City of New York, Willis discussed "The Federal Reserve and Inflation." The professor admitted the Federal Reserve System had diverged from its original purpose "as a system for the accommodation of business and for the discounting of paper of fixed maturity growing out of industrial, commercial, and agricultural operations." At that moment the Federal Reserve "was carrying in its portfolios about $1,500,000,000 of so-called war paper."

The only question to Willis, in his 1920 paper, was when and how the Fed would divest itself of war paper, otherwise known as government securities. He hardly needed to say why, but, being a professor, mentioned "in so far as the Federal Reserve banks continue to retain this volume of paper in their portfolios, they would be contributing to the maintenance of inflation and would be aiding to sustain the existing level [of inflated - FJS] prices." Another problem was holding "loans on non-liquid security [that is loans not backed by the liquidation of industrial, commercial, or agricultural inventory: the security of which beat war paper any day - FJS], including Government bonds and other obligations." Note that government bonds were not liquid. Their composition and properties are far inferior to the short-term, self-liquidating commercial paper.

Professor Willis attempted to resurrect the old religion when he wrote The Theory and Practice of Central Banking in 1936. This was the same year John Maynard Keynes's General Theory of Employment, Interest, and Money was published. Professor Willis (a native of Weymouth, Massachusetts and son of suffragist Olympia Brown) dropped dead in 1937. This may have been caused by a broken heart after Keynes's tome won the beauty contest, but confirmation requires further research.

The world has changed. Economics professors have concocted a theory that hinges on government bonds being "risk-free." The risk-free professors handed each other medals and entered astonishingly lucrative consulting and publishing arrangements. The gist of their so-called theory has anchored every pension plan, endowment, and financial adviser's risk-return selection model. The consequences continue to unfold. (See: "It's Over" and "Scarlett O'hara's Risk-Free Rate.")

Even today, with European sovereigns beyond hope of borrowing in an unrigged market, the academic grip remains. As for the United States risk-free premise, it will turn to "risk-fraught" when the Federal Reserve is no longer permitted to own U.S. Treasury securities. That day will come. H. Parker Willis will be vindicated.

The September 17, 2012, edition of the Wall Street Journal, unleashed "The Magnitude of the Mess We're In," by authors George P. Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer and John B. Taylor.
 

The rebels opened: "Sometimes a few facts tell important stories. The American economy now is full of facts that tell stories that you really don't want, but need, to hear."
 

Among the ugly truths (and I'm only addressing a small number within their lengthy list), Schultz & Co. ask: "Did you know that the Federal Reserve is now giving money to banks, effectively circumventing the appropriations process?" In other words, if money is to be given by the government to an industry, this is a decision of Congress, not the Executive, not the Supreme Court, and certainly not a panel of bureaucrats. Of course, it is Congress's duty to retain control of its own responsibilities. Congress is negligent in not taking administrative or legal action to prevent the Federal Reserve from acting outside the law.
 

Another unwanted, but important story: "The Consumer Financial Protection Bureau is also being financed by the Federal Reserve rather than by appropriations, severing the checks and balances needed for good government." This only hints at the much larger intrusion by the Fed. It has no budget. It can buy whatever and whomever it wants. The Schutzstaffel never had such latitude.

On we go: "And the Fed's Operation Twist, buying long-term and selling short-term debt, is substituting for the Treasury's traditional debt management." U.S. Treasury Secretary Timothy Geithner holds responsibility for managing the nation's debt. It is his duty to midwife the structure of U.S. debt securities. A few years ago, a Treasury Secretary stopped issuing 30-year bonds. After a bit, a different Treasury Secretary decided to issue 30-year bonds again. Whether either decision was good or bad is not the point. The Treasury Department, within the United States' government's Executive Branch, controls the structure of U.S. Treasury securities. The Federal Reserve has no business treating the size of the two- and ten-year Treasury market like an accordion for testing failed theories.

The conflict of using the Federal Reserve balance sheet as custodian of U.S. Treasury securities is apparent: "Did you know that annual spending by the federal government now exceeds the 2007 level by about $1 trillion? [R]evenues are little changed. The result is an unprecedented string of federal budget deficits, $1.4 trillion in 2009, $1.3 trillion in 2010, $1.3 trillion in 2011, and another $1.2 trillion on the way this year."

            The latest Monthly Treasury Statement shows $179 billion of Receipts in August 2012 and $369 billion of Outlays: inflows of 48 cents for every $1.00 spent. August either signals a disintegrating trend or was an off month. Over the first 11 months of this fiscal year (October 2011 through August 2012), the Treasury Department received 65 cents for every one dollar spent. Really now, how can the credit agencies still call the United States a AAA or even AA credit?

           

The Federal Reserve's forays into fiscal policy destroy its "apolitical" claims. On August 31, 2012, Chairman Bernanke told legislators how to construct budgets: "It is critical that fiscal policymakers put in place a credible plan that sets the federal budget on a sustainable trajectory in the medium and longer runs. However, policymakers should take care to avoid a sharp near-term fiscal contraction that could endanger the recovery." Again, these escapades are not only Bernanke's fault; it is Congress's job to shove a rag in his mouth.

In a practical sense, the Fed now plays a critical role in the nation's fiscal incontinence. If not for the Federal Reserve's day-in and day-out purchases of Treasury securities, the Federal government would be firing every other worker (using the simplifying projection of 48 cents of receipts for every dollar spent). It is not the Fed's job to finance salaries and departments. Schultz et.al., remind us: "Did you know that, during the last fiscal year, around three-quarters of the deficit was financed by the Federal Reserve? Foreign governments accounted for most of the rest, as American citizens' and institutions' purchases and sales netted to about zero. The Fed now owns one in six dollars of the national debt, the largest percentage of GDP in history, larger than even at the end of World War II."

            No one pretends the federal government will ever pay down its current debt, of which the Fed may soon be the sole net purchaser. The accounts of Japan and China are turning over (see  "Peak Imbalances Are Falling") and will probably soon be consistently (rather than occasionally) net sellers of Treasury securities.

Simple Ben has announced open-ended buying of any-and-all securities, forever. He is bidding for mortgages. Next week, it could be pawn-shop loans. He, and the Fed, will be retired at some unknown date. Copies of the The Theory and Practice of Central Banking will be in every school child's hands and the General Theory will broil on the bonfire of insanity. 

No Limits

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 European Central Bank's latest maneuvers jettison limits to the expansion of its balance sheet. The ECB's manner of improvisation is reminiscent of Federal Reserve Chairman Ben S. Bernanke's dismissal of legal restrictions in 2008, when Bernanke talked his way around the law before pliant, ignorant, and frightened politicians.

European Central Bank President Mario Draghi's abandonment of monetary restrictions would be, in due time, an incitement to unlimited price inflation. This is also true for the United States. However, practical matters (discussed below) will restrict this central bankers' nirvana. After watching how swiftly opposition to the ECB's latest decrees melted away, Ben Bernanke may feel reassurance of his freedom to roam. However, he too can only go so far. Maybe he'll be stoned to death.
  

So, buy gold, silver, and gold and silver stocks.

It was not just Alan Greenspan. Now, central bankers the world round draw greater devotion than Britney Spears (who, according to Forbes magazine's 2012 rating, is the world's sixth most powerful celebrity, demonstrating once again that no matter how egregiously these mystical abstractions behave, they can do no wrong). On September 6, 2012, "Mario Draghi's press conference was covered as if it were a soccer match. We are told that all across Europe shop stalls and bistros had TVs showing his presentation," reported Art Cashin at UBS. (Cashin's Comments, September 7, 2012). Comparisons with the waning of the middle ages are apt.

            The European Central Bank president, wearing an "immaculately tailored dark suit," delivered an address that left no doubt he will do whatever it takes to preserve the euro. "I am what I am," Draghi warned his Frankfurt audience, which was sitting (and possibly shaking) within a stone's throw of the Bundesbank.

            Draghi's announced a new acronym OMT, (Outright Monetary Transactions). Henceforth, the ECB will buy unlimited quantities of "sovereign bonds in the euro area." In the not-too-distant future, the betting line here is an expansion beyond sovereign bonds, to suit an unknown (as this is written) but a greater crisis. Draghi's declarations on September 6 addressed the current meltdown of falling European sovereign bond prices - particularly those issued by Spain and Italy. Yields are rising and buyers at auctions are disappearing, so the ECB will buy and hold yields below an unstated ceiling.

            This objective is clearly outside the ECB's sole mandate to maintain price stability. Draghi's description of how his actions are consistent with the ECB's function is a monument to bureaucratic malfeasance. His rationale of the compatibility between unlimited money printing and price stability was explained in a three-step syllogism: [Step 1:] "We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance." [Step 2:] "OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro." [Step 3:] "Hence, under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area." [My italics. - FJS] If the Greeks were in a surplus position, they might tutor Draghi on his misconstruction of logic.

           

Draghi let his audience know there will be no expansion of the money supply. If this is so, inflationary tendencies from his newest initiatives will be second-order consequences. The press release from the ECB that accompanied Draghi's speech states: "STERILIZATION: The liquidity created through Outright Monetary Transactions will be sterilized." That is the full statement. The ECB established an airtight condition: For every sovereign bond the ECB takes in-house, it will sell a bond of equal price.
 

This being true, the ECB's buying operations are not unlimited. But hark! Draghi squirmed out. The September 7, 2012, Grant's Interest Rate Observer reports Draghi told euro zone officials if the debt matures within three years, it does not "constitute the act of monetarily financing a government."

The importance here is not so much the specific ukase, but that by Draghi stating such, it is so. Flipping through October 2008 archives is a reminder of expedient decrees in the United States. In the here and now, the ECB can do what it wants on the fly: so watch out. For instance, no private bondholder - pension fund, insurance company, hedge fund - should accept Draghi's word that it holds equal footing with the ECB in a sovereign workout.

Back to the specific "three-year rule," it is a short step for the ECB to declare (since the purchase of these particular sovereign bonds does not constitute the purchase of a sovereign bond) the requirement to sterilize Outright Monetary Transactions of three-and-under bonds does not apply. And, even if the ECB attempts to live by its promise of sterilization, the poor quality of its balance sheet will restrict such operations. There will be no buyers for the unspeakable trash it is hiding.

At the press conference, Draghi once again loosened the ECB's requirements of what constitutes acceptable collateral. At this stage, it would be more helpful to produce a summary of what is not acceptable: a very short or non-existent list. Here lies the greatest problem of all, that of trust. European banks already restrict their overnight lending to the ECB. If they decide the solvency of the European Central Bank is untrustworthy, the ECB, Fed, Bank of England, and Swiss National Bank may fall like toy ducks in a shooting gallery.

In any event, Mario Draghi has put the ECB in a position of no return. He must now "do whatever it takes," meaning engage in "unlimited" purchases, or he, and the euro, will lose all credibility. In 1957, Federal Reserve Chairman William McChesney Martin found himself in the same position. The U.S. Senate lobbied the Federal Reserve to cap interest rates. Should it accept the mission, Martin's Fed would buy U.S. Treasury bonds with newly created Federal Reserve notes and institute a ceiling on rates. Martin knew better. He told the U.S. Senate Committee on Finance, on August 13, 1957:

"It has been suggested, from time to time, that the Federal Reserve System could relieve current pressures in money and capital markets without, at the same time, contributing to inflationary pressures. These suggestions usually involve Federal Reserve support of the Unites States Government securities market through one form or another of pegging operations. There is no way for the Federal Reserve System to peg the price of Government bonds at any given level unless it stands ready to buy all of the bonds offered to it at that price. This process inevitably provides additional funds for the banking system, permits the expansion of loans and investments and a comparable increase in the money supply - a process sometimes referred to as monetization of the public debt. This amount of inflationary force generated by such a policy depends to some extent upon the demand pressures in the market at the time. It would be dangerously inflationary under conditions that prevail today. In the present circumstances the Reserve System could not peg the government securities without, at the same time, igniting explosive inflationary fuel."  

Martin was unschooled in economics. He made it through life with only a baccalaureate degree, in English and Latin. 

Over and Out

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)

           A collapsing order will do what it takes to retain power, no matter its abuse of law or decency. Writing in Die Zeit on August 29, 2012, European Central Bank president Mario Draghi wrote (in German): "[I]t should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole."

            Dropping the dead fish on Berlin, Draghi reminded Germans he is not a man to be messed with. That is why he was awarded the presidency of the ECB at such a desperate moment. On July 26, 2012, Draghi pledged: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

            "Within our mandate" is defined by Draghi. He lifts restrictions on ECB legal authority at a moment's notice. This is exactly as the bureaucrats prefer. The sinecures in Brussels will be selling dead fish rather than dining on prawns and apricot soufflé at Comme Chez Soi if Draghi fails. Europeans and foreigners with securities invested in European markets should consider the possibility of confiscation or lengthy sequestration.

            European leaders, on the whole, will not object to shutting markets. Some obvious difficulties will arise, but the alternative - a trip to the guillotine - is more unattractive. The leaders are ignorant of the functioning of markets so it is a small matter to shut them. They regard markets solely as instruments of their policies: raise or lower taxes, save or shelve the national airline, raise or lower stock markets. Federal Reserve Chairman Ben Bernanke employs this mode of thinking. He reminded his guests of his fatuous pretensions at Jackson Hole, Wyoming, on August 31, 2012. Praising himself for the Fed's buying of market assets, Bernanke preened: "[Asset purchases] have boosted stock prices.... [I]t is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC's decision to greatly expand securities purchases. This effect is potentially important because stock values affect both consumption and investment decisions." There is no evidence to support his boost-the-economy contention, yet, Simple Ben contended: "Econometric....[m]odel simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy." He really believes these models, which produce the results he predetermined. Similarities to the final, paranoid proclamations of superiority by the Kremlin are obvious.

            Whether one prefers Mario Draghi's brass knuckles or Ben Bernanke's harebrained approach to playing puppeteer of the masses (both received economics Ph.D's at M.I.T.; both theses under the tutelage of Nobel prize winner Robert Sobel), it should not be forgotten those in charge fully support such expedients. Sarkozy, now Hollande, Merkel, and Obama have aggressively pursued criminals who engage in markets. No, not Jon Corzine, but the widows and orphans who find it difficult to eat on zero-percent interest rates.

Aside from Draghi's warning that he will crush anyone in his path, Germany's position, as backstop to the euro is important and it is clear Germany will not protect property rights. On May 19, 2010, "German Chancellor Angela Merkel laid out proposals to gain control over 'destructive' financial markets, after she imposed a unilateral ban on naked short-selling that sent stocks sliding.... 'The lack of rules and limits can make behavior in financial markets driven purely by the profit motive destructive and lead to an existential threat to financial stability in Europe and even the world,' Merkel told lawmakers in Berlin today. 'The market alone won't correct these mistakes.'" (Bloomberg)

Merkel's attack on naked short-selling deserves a sympathetic ear or two (though, the actions taken, and others threatened, were designed to crush a larger carrier battle group), but the Chancellor is prone to think closing markets will solve the euro's troubles. The Happy Dreadnaught's public statements betray no reservations about shutting markets. On January 16, 2012, S&P downgraded the EFSF from AAA to AA+. On the same day, the Financial Times reported: "Ms Merkel said she would consider calls from her party colleagues for legislation to bar institutional clients such as insurance companies from selling bonds when ratings were downgraded, or fell below investment grade." Presumably, the cohort in question were European, including German, insurance companies. When the time comes, protestations by Fidelity or Goldman Sachs are unlikely to open markets.

Merkel was thwarted in this effort, which would have caused untold havoc. In their corner of the world, insurance companies prevented from selling bonds when their price was falling would have seen prices of insurance-company stocks, bonds, credit-default swaps, and insurance policies sinking to previously unplumbed depths.

January, 2012, turned out not to be the proverbial Armageddon that looked so dire on January 16. The reckoning has been delayed but not solved by eurocrats who have done so by preventing market discovery of real prices. Such repugnant acts as proclaiming the European Central Bank senior creditor (above private bond holders) betrays a willingness to substitute vocabulary for legal rights.

Other subterfuges to deceive the public fall under the heading of manipulating markets to jam their failed policy down Europeans' throats. In August, PriceWaterhouseCoopers reported non-performing loans at European banks have doubled since 2008, to over $1 trillion worth. Very little of that amount has been written down. Capital as well as collateral at European banks is a joke. That includes commercial banks, national central banks, and the European Central bank. The latter's portfolio is quite weak since it bought assets that even the eurocrats would not permit to be pledged as collateral. Interbank overnight lending operates through the ECB since the banks no longer trust each other. Why they hold the ECB in high regard is only by the latent trust in central banks, since the ECB balance sheet has so deteriorated. (Adding to the perplexity of today's financial discussion is the angst about Libor when its existence as the interbank rate is extinct.)

The blatant dishonesty in European finance may be even worse than the Paulson-Geithner-Bernanke model across the ocean. European banks did not recapitalize to the same degree as U.S. banks after 2008. Yet, their practices and leverage were as aggressive. In the boom, larger European banks met capital adequacy requirements by purchasing credit-default swaps (CDS) on collateralized-debt obligations (CDO) sold by AIG. That was reported in the fall of 2008. Like so much else that went awry, the consequences seem to have evaporated in the mist.

Only to reappear. A parallel to the CDS-CDO-AIG nonsense is the current minefield of a Greek default. To pretend they are still solvent institutions, European banks have written (that is: the bank is the insurer) of credit-default swaps on Greek sovereign debt. (Not to be forgotten is the North American banks - yes, Canadian banks are none too sturdy - that have written CDS on European sovereign debt. American banks have shredded this risk, but what remains? CDS can be traded, bundled - oh, you know the hopelessness of bank balance sheets today.)

The deceptions run wide and deep - more evidence of the dysfunctional European financial system. Europe seems to have bettered Americans at cumulative weirdness. A personal favorite, from Bloomberg, August 30, 2007: "Landesbank Sachsen Girozentrale, the German state-owned bank ravaged by investments in U.S. subprime mortgages, had 'secret' investments of up to 46 billion euros ($63 billion), Sueddeutsche Zeitung said, citing Saxony's government finance committee. In addition to off-balance sheet investments in Dublin, SachsenLB also created so-called conduits in Leipzig in 2003 under the code name 'Dublin II,' the newspaper said...." Secret Squirrel never had this much fun.

In fact, the Landesbanken stench floated to Ireland via Hypo Real Estate where its Irish subsidiary, Depfa Bank, is hiding (the following is a conglomeration of estimates) between $1 to $3 trillion (with a 't') of trade receivables that are over 270 days past due. These dead loans (over-270-days-past-due are not repaid) were somehow plucked from European banks. This is one more layer in the dissolving European Project that will receive its day of reckoning.

Those who hold European securities (U.S. money-market funds were large investors) own (to what degree is it "ownership"?) paper floating in a sea of chaos. As the financial institutional framework cracks, the informal - and, non-taxpaying - economy replaces it. The Mafia is now Italy's biggest 'bank,' according to James Mackenzie at Reuters. Mackenzie reported this non-bank bank is "squeezing the life out of thousands of small firms.....Organized crime now generated annual turnover of about 140 billion euros ($178.89 billion) and profits of more than 100 billion euros," which equals 7 percent of Italy's national output. Here we see the legitimacy of the eurocrats as well as local government authority flickering before the final gale.
 

The Troika (European Union, or, more particularly, European Commission, ECB and IMF) has thus far forestalled panic in the markets by changing rules, a process that has degenerated as the preventive measures grow more desperate. We are closing on a day when non-government investors, as well as the masses, say: "Enough." With any luck, that will be ahead of a general sequestering of their assets.

Tracing the deterioration of collateral is an avenue to clarity. From Bloomberg on June 25, 2012: "Residential mortgage backed-securities and loans to small and medium-sized enterprises rated at least BBB- by Standard & Poor's will now be accepted with a valuation haircut of 26 percent.... In the case that the ECB Governing Council [approves] this, 'it would reduce the widely criticized influence of Standard and Poor's, Moody's and Fitch,' one euro zone central bank source who spoke on condition of anonymity said. 'On the other hand, this could also expand the shrinking pool of collateral which banks in troubled countries have available.' The ECB declined to comment." This story is a prime instance of institutional confusion. First, "the ECB declined to comment," yet a "euro zone central bank source" was extensively quoted. Where does he work? In the ECB's pâtisserie? Second, as much as the rating agencies are widely criticized, the obvious ploy to include dead-fish securities as proper collateral makes a sham of the ECB.

The trustworthiness of collateral can only be manipulated so far. It is a point of observation in human inertia that trust has not already been extinguished, but, it required a trigger with Bear Stearns and Lehman Brothers.

A few more changes to acceptable collateral that were publicly announced and duly reported:

(Bloomberg, June 28, 2012): "ECB to accept certain mortgage-backed securities, car loans... leasing, consumer finance-backed securities, as collateral. Measure to come into effect when adopted in legal act June 28."

Andy Lees (AML Macro Ltd.), July 31, 2012: The ECB is considering unsecured bank debt as collateral.

Bill King (The King Report) wrote on June 20, 2012: "The EU put on its clown shoes and stated that it would no longer use rating services and would issue its own ratings."

June 22, 2012: Not to be outdone, IMF synchronized swimming champion Christine Lagarde put on her clown shoes, whinnying "for the ECB to be more inventive" in aiding the eurozone to beat the debt crisis. The currency union needs a "creative and inventive" monetary policy." This criticism was uncalled for. The Draghi ECB may lack many attributes, but creativeness and inventiveness are its forte.

There is a limit. However much investors are willing to accept the EU clown court, after the solvency of a financial institution is past slavation, heroes are not rewarded for tossing a lifeline. Recent examples of vaporizing trust were Bear Stearns and Lehman Brothers. A clearinghouse survives by retaining trust. LCH.Clearnet, the largest clearinghouse in Europe, served notice on June 4, 2012, that it might require additional collateral on Spanish government debt held by banks. On June 20, the clearinghouse raised the margin requirements for Spanish sovereign debt used in short-term funding (repos) from 13.6% to 14.7% on certain maturities (it varies). This looks like a compromise. Clearnet raised the percentage, but not enough to upset the distribution of Spanish bonds. To retain confidence, the clearinghouse may be forced to act decisively, in the not too distant future.

In the not too distant past, LCH.Clearnet announced it would accept unallocated gold as collateral for margin cover purposes (starting on August 28, 2012). The CME announced that it, too, would start accepting gold as collateral for margin requirements on August 28, 2012. Markets are racing back to the nineteenth century faster than central bankers can destroy their credibility in the twenty-first.

Another limit was noted in June by the Bank for International Settlements (the central banker's central bank). The BIS warned of "asset encumbrance," that is, the current need for European banks to pledge so large a portion of assets for collateral is weakening banks' liquidity needs.

These limits are a reason ECB President Mario Draghi has served notice the ECB will decide whether "irrational fears.... require exceptional measures." The world awaits the German Constitutional Court's decision, scheduled for September 12, 2012, of whether Germany can participate in the ESM's (European Stability Mechanism) bailout of countries.

Since Germany is already the "transfer union" of funds to the rest of Europe (TARGET2 - not discussed here), its participation will be fundamental. Draghi muscles opponents into Jimmy Hoffa's locker so may not wait for, or possibly ignore, the court's decision. In any case, the €500 billion ESM (which does not exist) is not large enough to hold Spanish and Italian sovereign bond premiums to a ceiling of 200 basis points above German government bonds. That is only one of the current mandates shouted from the balcony of the Palazzo Venezia and Draghi knows this. Merkel, Monti, and Hollande know it, too. Thus, the hope the ECB will call the non-existent ESM a "bank" to leverage the €500 billion into bank loans. Bank lending to companies in the eurozone has fallen 43% this year, so the wonders of fractional-reserve lending would not seem to apply.

Market participants are heading to the exits. As alluded to above, U.S. money market funds have sold European securities. How much, and how the funds would post a daily price if assets are frozen, are question that lead to a slew of other questions.

Europeans, too, are transferring money. On July 31, 2012, Reuters reported outflows from Spanish banks at €41.3 billion ($50.6 billion) in June and €163 billion from January through May: an accelerating pace. To fill the void, Spain's banks borrowed €50 billion euros from the ECB (that is: Germany) in June, and a total of €204 billion between February and June.

Shell "is cutting back its exposure to European credit risk in the worst-hit economies and putting a higher price on doing business with the region's peripheral nations...[T]he Anglo-Dutch oil major would rather deposit $15bn of cash in non-European assets, such as US Treasuries and US bank accounts." (Daily Telegraph, August 6, 2012) U.S. banks "are telling counterparties and borrowers to restructure contracts or find another bank as they prepare for the potential exit...from the eurozone. Using hedges, such as credit-default swaps [Yikes! - FJS], U.S. banks have reduced their net exposure to troubled eurozone countries. But they are also engaged in more work behind the scenes to ensure that if a country leaves the eurozone they will not have to receive payment in a devalued drachma or peseta." (Financial Times, August 6, 2012) Some companies are "sweep[ing] cash out of euros nightly to reduce foreign-exchange exposure, while others are looking at alternative payments in case customers flee the euro or run out of cash." One company "has been preparing a version of the company's pricing list in pounds...." (Wall Street Journal, August 14, 2012)

The counterattack is mounting. In fact, nationalization of assets has recent precedent. When its banking system collapsed in 2008, the Icelandic government "ring-fenced domestic accounts and shut out international creditors. Iceland's central bank prevented the sell off of krona through capital controls, and new banks were created that were controlled by the state. Then the government and the state-controlled banks agreed that amounts in excess of 110% of home values would be forgiven on mortgages." Iceland is not a euro participant, has a population of 300,000, so did not endure complications that European renegades will face.

A boatload of restrictions on money flows have washed across Europe over the past three years. Many are petty and simply an excuse for bureaucrats to collect a paycheck, but the mandarins in Madrid locked Spaniards in chains in late June (recall the acceleration of money fleeing, above) by instituting a minimum fine of €10,000 for taxpayers who don't report their foreign accounts and the prohibition of cash transactions greater than €2,500 for individuals and firms. Looking at flow data in Spain, this does not seem to have accomplished its goal, but simply reading numbers, without context, can be misleading.

All in all, LCH.Clearnet and the CME are ahead of a mad rush. 

Greenspan's Silver Anniversary

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)

"Tomorrow is the 25^th anniversary of one Sir Alan Greenspan's confirmation vote. Fred, you doing anything special to celebrate?" wrote Scott Frew, General Partner of Rockingham Capital Partners L.P. hedge fund.

            Well, no, but we have an obligation to remember. What follows is a draft of was later refined in Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession and in other publications. This includes comments of other senators that may not have been published elsewhere. Reading through this early version, it is notable how many senators were concerned the imbalances - federal budget deficit, trade deficit, the leveraging of corporate balance sheets - were about to crush the country. And here we are 25 years later.

            Since I'm dragging out reruns, a frequently repeated warning:

"The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent."

                                                -George Eliot, Silas Marner

Now, to the hearing that preceded the Senate confirmation vote on August 11, 1987:

Greenspan's nomination hearing before the Committee on Banking, Housing and Urban Development took place on July 21, 1987. It was chaired by Senator William Proxmire of Wisconsin. In Proxmire's opening remarks, he churned out the requisite nonsense. He ticked off a pantheon of chairmen - Martin, Burns and Volcker - then extolled their backbone: "If there is one distinguishing hallmark of their service as chairman of the Fed it was their consistent independence. They were independent of the President and were independent of Congress." He then confirmed the legislators' support for such independence by asking the question: "From the time you take over this office you will be entreated to expand the nation's money supply.... Are you the man who can say no to the Administration and to Congress?" (This was in the early stages of Proxmire's remarks and no answer was expected, but we can be sure, what was expected would have been pronounced, with neither the candidate nor the interrogators believing a word of it. During the hearing, Greenspan would quote from the textbook: "It is absolutely essential" that the Fed's "central focus be on restraining inflation because, if that fails, then we have very little opportunity for sustained, long-term growth.")

Proxmire's exploration then grew more interesting. The senator told Greenspan he had voted against the CEA chairman's nomination in 1974. Greenspan had proved himself to be a "get along, go along, comfortable and increasingly popular chairman." (It is not clear if Proxmire considered this good or bad.) The Banking Committee chairman chided the candidate for a "dismal forecasting record" when he was chairman of the CEA. Proxmire reviewed the forecasts made by the Council of Economic Advisers between 1976 and 1986. The Senator was most interested in the CEA's projections made during Greenspan's term looking forward to the years 1976, 1977 and 1978. In Proxmire's words, the forecasts made by the candidate were "way off." Of the interest rate forecasts made by the Council of Economic Advisers (for the years 1976 through 1978), Greenspan's were wrong by the biggest margin of any of the 11 years..." Proxmire went on: "There you broke all records for the entire period in error." The man whose opinions President Ford weighed more heavily than "those of any other economist" had prophesized the Treasury bill rate would be 4.4% in 1978. It was 9.8%.

Of inflation: "There again, you broke all records." The only CEA chairman to adorn the front cover of Newsweek estimated the Consumer Price Index would rise 4.5% in 1978. It soared 9.2%.

In later years, Greenspan would control such quibbles; not this day. He replied to Proxmire: "That is not my recollection of the way the forecasts went." Proxmire, forecasts in his hand, read the date to Greenspan. The candidate admitted: "Well, if they're written down, those are the numbers."

The transcript follows:

PROXMIRE: "Yes."

GREENSPAN: "There is a very substantial difference, Senator, between forecasting in the Administration and forecasting outside."

PROXMIRE: "I sure hope so!"

Greenspan then embarked on the gobbledygook so familiar in later years. Proxmire waited patiently and then responded:

PROXMIRE "Every one of the chairmen of the Council of Economic Advisers had the same problem, and they didn't miss by as much as you did, not nearly as much..."

GREENSPAN: "I feel sorry for me and happy for them."

Proxmire, perhaps having anticipated Greenspan's public sector-private sector line of defense, had done his homework. The firm of "Greenspan & O'Neil" in the following discussion refers to a joint venture between Greenspan and Rory O'Neil that provided money management services to pension funds.

[Note: Rory O'Neil recently died, on July 31, 2012. Reading the obituaries, he was an accomplished investor and was a hard-working philanthropist, spending over 30 years restoring the dilapidated waterfront of Hartford, Connecticut. Of course, the obituaries had to fall under such headlines as: "Former Greenspan partner..." They spent less than one year together. Such are vagaries of history. - FJS]  

"You had the opportunity to be forecaster with Greenspan & O'Neil. As you know, you put your forecasting to a direct test in the private sector." Proxmire then quoted a recent issue of Forbes Magazine. "'Greenspan & O'Neil turned in one of the least impressive records of all pension fund advisers.' "

Greenspan did not throw out an illusory defense this time: "All I can say is, I acknowledge that did not work out very well, and I take my share of the responsibility."

PROXMIRE: "...I hope... when you get to the Federal Reserve Board everything will come up roses. You can't always be wrong.

GREENSPAN: "All I can suggest to you, Senator, is that the rest of my career has been somewhat more successful."

As a taste of what was to come, this was an introduction to Greenspan's ever-present qualifiers: "suggest" and "somewhat" giving the candidate room to maneuver, should Proxmire pursue this course of interrogation. The Senator did.

Proxmire quoted a forecast Greenspan sent to clients on March 20, 1987. "The recession we had not expected until 1990 now appears more likely to emerge in the last quarter of 1989.... A stock-market led expansion of capital equipment in late-1987 is projected to lead to a final surge for the business credit cycle. This surge is expected to precipitate a recession shortly thereafter... [And the] recession is also expected to be somewhat more severe than we had projected in October [1986]."

Proxmire asked Greenspan if he still stood by that forecast:

GREENSPAN: "May I ask you what the date on that is?"

PROXMIRE: "The date is March 20, 1987. Four months ago.

GREENSPAN: "I don't know how to answer that..."

Since Proxmire prefaced his statement by stating the date, Greenspan's question is strange. After not knowing how to answer that, he then launched into an answer that was not an answer, but a response full of qualifications that went on to qualify the qualifiers. Proxmire waited patiently before responding: "You were so specific in the dates of this forecast." To this, Greenspan went on to qualify more qualifications. Proxmire, his time up, responded "yes".

The other senators had their own concerns, more general in nature. Given the evolution of finance during Greenspan's term, his opinion in 1987 is worth knowing. Senator Sasser from Tennessee was concerned with debt accumulation. He thought rising corporate debt associated with mergers and acquisitions was troubling, particularly the capacity of business to operate in the next downturn. Greenspan agreed. The U.S. would be more vulnerable in the event of a significant downturn. The fixed charges, "specifically, debt service, which obviously does not decline when gross operating incomes fall, and the so-called "coverage" of the interest becomes insufficient.... We are increasing debt at levels which should make us all uncomfortable. It certainly makes me uncomfortable."

Greenspan spent his early tenure at the Fed shoveling out the debris caused by companies that had taken on more debt than they could bear. Greenspan's answer was qualified in the case of a "significant" recession, which is more in line with 1975 than the early-1990s. Nevertheless, companies were crippled. Knowing his worries in 1987, and what he lived through, his later comfort with consumer fixed debt, particularly home mortgages, is a repudiation of his own insight and experience.

Senator Riegle from Michigan was also concerned about spiraling debt: "We are adding $1 billion of new debt every 2-1/2 days." Riegle lamented that the U.S. had been a creditor nation since 1914 but was now adding $170 billion a year to the trade deficit. There had been a "breathtaking change" in dollar claims outstanding between 1982 and 1986.

Greenspan sounded equally distraught: "The greater the external liability is denominated in dollars of the United States, the greater the number of problems that occur when holders these dollars decide to switch..." out of the dollar.

Senator Shelby from Alabama had the same concerns. He asked Greenspan if he was troubled that, as a nation, "the U.S. had added $1.5 trillion to the national debt over the previous five years when it took the first 195 years to accumulate $1 trillion.

Greenspan responded: "It bothers me a great deal." He then attempted to pacify the senator by stating: "We're starting to deal with it." Shelby was having none of this: "We haven't even started to deal with it." The nominee thought he might sooth Shelby by claiming he did not think "it would be necessary to actually reduce the national debt." Greenspan then launched into some equivocations, that, if read five or ten times (not a luxury available to the senators), essentially meant: "We can't reduce it because we won't reduce it." This, of course, was true.

In an Abbot-and-Costello, "Who's-On-First?" routine so common in later years, Shelby worried about America's status as the largest debtor nation in the world. Greenspan replied, it "isn't clear" if the U.S. is the largest debtor nation in the world.

SHELBY: "If we are not first, who is?"

GREENSPAN: "Oh, there are a lot of others."

End of discussion. Shelby did not have time to clarify answers-and-questions for Jeopardy. The senators were allotted a given amount of time to quiz the nominee. There may be a good reason for this (filibustering politicians comes to mind), but, Greenspan knew - if not on this day, soon enough - he could run out the clock with his own form of filibustering. This often took the form of the Shelby discussion. Like a caterpillar that huddles into a ball when its back is touched, Greenspan would change a specific point of topic into a vague assertion that would leave his questioner unable to pry him open.

Shelby warned the national debt was "a ticking time bomb." He worried that the U.S. was vulnerable to foreign influence on the dollar. He asked the nominee: since the Germans, French and several others held an abundance of dollar claims, could they, in unison, decide to peg the U.S. dollar at a specific rate convenient to their own policies?

The senators agreed some of their questions were too involved for the candidate to answer on the spot. He was sent a list of questions after the hearing to which he responded in writing.

One written question asked Greenspan if the Federal Reserve could intervene in the foreign currency markets to set the price of the dollar. He responded that the Federal Reserve should not intervene in currency markets. It could, however, set the currency rate, but only for a short period of time.

In another written response, Greenspan disavowed his former advocacy of the gold standard. His reasoning was specious: "Considering the huge amount of dollar claims in world markets, fixing the price of gold [by central bank intervention] seems out of reach." It is safe to assume he pulled this response out of a hat. He wanted to be Federal Reserve chairman. The Committee wanted an assurance Greenspan was not one of those dreaded gold bugs. Each side got what it wanted.

Proxmire closed the hearing, resigned to the result. The senator had greater concerns than wayward forecasts. It is only conjecture, but the transcript leaves the impression that Proxmire's real concern was the integrity of the banking system. From his statements and questions, Proxmire obviously thought the growing concentration of financial power and solvency of the financial system was heading down a dark road. Given this, the purpose of his interrogation of Greenspan may have been to prevent the fox from entering the henhouse. Proxmire's concern might be summed up in this closing comment: "It seems to me that banking in this country and finance in this country is moving very sharply... in a direction of concentration and in a direction, which, I think, most senators, if they thought about it very long, might very concerned about." This leaves the sense of a man with a clear view of the future, but who was frustrated with his myopic, fellow senators.

Given that Proxmire was correct, it is worth reviewing his specific concerns, all of which bore fruit (or weeds). He was concerned about non-banks encroachment on the banking industry. He thought Greenspan was not the man to halt this tide. The candidate had been an "advocate" for Sears. The consulting economist "wrote articles in support of and allowing commercial and industrial firms to own banks." Proxmire expected no resistance to whatever Greenspan proposed to the Federal Reserve Governors or FOMC. ("[Y]ou will move in with a board of clones - not clowns - clones.") The committee chairman regretted they had not discussed Greenspan's position on direct investments by savings and loans associations, "but many of us feel that direct investment can mean the downfall of an industry..." This shows a surprising gap in the senator's preparation as we shall soon see.

Proxmire resigned himself to the inevitable: "[T]his nomination should result in a slam-bang debate in committee and the floor. It won't, and it is startling, given what you have told us."

The senator's investigative reporting prodded the New York Times to look past its archive of Greenspan superlatives and study his forecasting record - for one day. The Times decided the Committee's challenge to the Greenspan image was "only partly justified." It found justification in a study by the Federal Reserve Bank of Boston in which Townsend-Greenspan' and Wharton Economics' inflation predictions tied for last place." (Wharton was the firm headed by Larry Klein, Nobel Prize winner in 1980 and inspiration for the Lawrence R. Klein Award for Blue Chip Forecast Accuracy.)

In a reminder that the inflation of words was rising at a rapid clip, the Times opened the article by reminding its readers: "For more than 20 years, Alan Greenspan has figured prominently on all the lists of famous American economic forecasters." Other than the occasional prediction quoted by the Times', Greenspan was an unknown figure before his CEA tour. His fame as a forecaster, if that is the right word, principally rose because the status was asserted. (For example: in 1981, the Times explained Murray Weidenbaum was at a disadvantage, since the new CEA chairman lacked Greenspan's "expertise as a forecaster.")

Aspects of Greenspan's willowy character bloomed during the summer of '87. In early June, he told a Chicago audience that "over the long run" the value of the dollar would go "significantly lower." A week later, at the press conference announcing his nomination, he discussed "evidence" that the dollar's fall had bottomed out." Before the Banking Committee, he announced the dollar had entered a "period of stability."Given the approaching stock market crash, which was inseparable from a plunging dollar, this last prediction would seem to rival his 1973 advice to buy stocks. But this was not his prediction at all; his own position was expressed to the Chicago audience the month before. Proxmire was on his tail, but pursuing Greenspan's currency conversion would be a useless exercise. Greenspan knew this; the senator knew this. The candidate also knew the Federal Reserve chairman could survey the political winds each morning and make the opportune forecast.

            Townsend-Greenspan died quietly on July 31. The White House asked Greenspan to remove his name from the firm. He complied. The furniture and computers were sold at the beginning of August. Greenspan was required to place his $2.9 million of assets in trust.The White House request was fortuitous. Pierre Rinfret, a New York consulting economist (who served with Greenspan on Nixon's 1968 economic advisory panel), refuted the common perception: "Everyone thinks that Greenspan gave up a lucrative consulting business to work in the public sector. In actuality, his business had been losing clients steadily to the point where he hardly had any left by the middle of the nineteen eighties."[Note: for more recent comments, see: "Color Commentary."] The new Fed chairman had spent the past few years lobbying at 1600 Pennsylvania Avenue in lieu of studying livestock and mobile home sales at 120 Wall Street (the firm's address). Townsend-Greenspan had been hollowed out.

Prior to the hearing, Greenspan submitted a statement to the White House and Congress, a full disclosure of relationships that might cause conflicts of interest. The nominee listed his board membership at J.P. Morgan and Company as well as its banking subsidiary Morgan Guaranty Trust Company, his associations with Capital Cities/ABC Inc., General Foods Corporation, Mobil Corporation, Pittston Company, Aluminum Company of America and Automatic Data Processing Inc. Senator Proxmire questioned Greenspan on two relationships Greenspan had not listed: Sears, Roebuck & Company and Lincoln Savings & Loan of Irvine, California. Greenspan's distinguished the two by slipping them in the side pocket of "advocacy projects." Cutting through the euphemism, he was paid by each to lobby for banking de-regulation. As Fed chairman, he would become the nation's banking regulator.

Greenspan's "advocacy" distinction was furtive. At the time, he was lobbying for non-financial companies such as automakers and retail chains to operate limited-service banks. His advocacy for such was anathema to Proxmire, who was no fan of de-regulation. Greenspan also wished to [eliminate] the Glass-Steagall Act. This 1933 bill prohibited commercial banks from underwriting securities. The Glass-Steagall Act was disappearing by slow erosion. (It was repealed in 1999.) An early victor was J.P. Morgan & Company, the first commercial bank allowed to underwrite corporate debt (in 1989) and common stock (in 1991). Greenspan's influence should not be exaggerated. J.P. Morgan still possessed the aura of its namesake. It was considered by many as an appendage to the U.S. Treasury. [Note: It still is. - FJS, 2012] Its first past-the-post victory was a natural step in the evolution of banking.

Greenspan was fortunate his nomination preceded the unwinding of Lincoln Savings & Loan. The "Keating Five" scandal was hatched at Lincoln. Five senators lost credibility in its wake (specifically: Cranston, Riegle, De Concini, Glenn, and McCain).

Savings and loans had suffered whiplash from the rise and fall of interest rates. Many were in danger of extinction. Alan Greenspan had warned of their vulnerability. In 1981, he told U.S. News & World Report that high interest rates were suffocating S&Ls: They "can only exist in a non-inflationary environment." He told the Times "[t]here are now a bunch of moribund cases out there." The consulting economist was not sure if "any" of the savings and loans had equity, but that was not the real problem: "The problem is cash flow...There are a number of institutions that are barely able ... to pay their liability side [of the balance sheet]."

His sweeping claim of insolvency was an exaggeration, but there was much truth in what he said. Notably, his concerns did not apply to Lincoln. It was run by the Crocker family, which owned 40% of the shares. Like most S&Ls, it lost money in 1981 and 1982, but, as with many of these institutions, returned to profitability in 1983 (with the decline of interest rates). Donald Crocker, son of the founder, had dropped his law practice to nurse Lincoln back to health. Having succeeded, he wanted to do something else. Charles Keating offered to pay $51 million - two and a half times its over-the-counter market price. Michael Milken helped broker Keating's acquisition.

An economic consultant who would write a bill of good health on the part of Lincoln should have looked upon Keating with some curiosity. Since Alan Greenspan devoted his greatest energy to knowing everyone who wielded the levers of power, it would have been a strange lapse if he was singularly uninterested in his client. Keating had been executive vice president of Carl Lindner's American Finance Corporation. Lindner's reputation rose from the conglomerate boom of the 1960s. Lindner was an early and smart investor in Milken's junk bond offerings. In 1979, the SEC charged Keating with making improper loans to insiders and friends (of Lindner's Provident Bank of Cincinnati). Keating had also arranged a pattern of loans to purchasers of assets which Lindner wished to sell. Keating consented to a permanent injunction with the SEC, which should have barred him from ownership of an insured depository. Somehow, his Lincoln Savings application to the FHLB slipped down the drain hole.

William Seidman, who headed the Resolution Trust Corporation, the body that cleaned up the savings and loan mess, wrote later that Michael Milken had "rigged the market by operating a sort of daisy chain among the S&Ls to trade the bonds back and forth across his famous X-shaped trading desk in Los Angeles. By manipulating the market, he maintained the façade that the bonds were trading at genuine market prices... [W]hen.... [Milken] was brought down, and his trading operation with him, so were the S&Ls that depended on the value of his bonds to stay afloat."

In 1984, Alan Greenspan was hired by Charles Keating, who needed a respected figure to write a letter to his regulator, the Federal Home Loan Bank of San Francisco, stating that Lincoln Savings and Loan's investments were sound.

On February 13, 1985, Alan Greenspan wrote a letter to Thomas F. Sharkey, the Principal Supervisory Agent at the Federal Home Loan Bank in San Francisco. Most of the letter addressed the direct investments of Lincoln. (In the wake of hyper-activity, the Federal Home Loan Bank Board had recently passed a new direct investment rule in an effort to corral overzealous S&Ls.) He informed Sharkey that Lincoln had "adequate capitalization, sound business plans, managerial expertise and proper diversification." Greenspan stated that Lincoln's management "is seasoned and expert in selecting and making direct investments." The seasoned, J.P. Morgan board member revealed Lincoln "has developed a series of carefully planned, highly promising, and widely diversified projects" and "that denial of the permission Lincoln seeks would work a serious and unfair hardship on an association that has, through its skill and expertise, transformed itself into a financially strong institution that presents no foreseeable risk to the Federal Savings and Loan Corporation."

By that time, Lincoln was not only loaded up with deals through Milken, it was swapping them at a profit with its holding company, American Continental Corporation.

American Continental Corporation - and Charles Keating - had been spun out of Carl Lindner's American Financial Corporation.

In William Seidman's words: "The Greenspan report failed to note that Keating's savings and loan had simply exchanged interest rate risks for the much greater asset quality risks - that is, the old-fashioned, hair-curling risk of speculative real estate investments." While under Keating's employ, Greenspan also suffered a lapse when writing a letter to Ed Gray. The man who would become the nation's leading bank regulator in 1987 notified the FHLB chairman that deregulation was working as planned. Greenspan cited 17 thrifts that had reported record profits and were prospering under the new rules. By 1989, 15 of the 17 thrifts would be out of business and cost the Federal Savings and Loan Insurance Corporation several billion dollars."

Barrie Wigmore, then at Goldman, Sachs, wrote an excellent book, Securities Markets in the 1980s. Wigmore discussed how Meshulam Riklis, Carl Lindner, and Saul Steinberg used their conglomerate platforms to swap paper.

Wigmore wrote, of Riklis, Lindner and Steinberg: "[I]t is tempting to conclude they... represented a cabal.... [They] cooperated and invested with each other extensively and were old hands in the market aspect of "Chinese paper" from the merger wave of the 1960s." Their "activities illustrate the combination of native cunning and access to leverage that made them effective."

Wigmore wrote they (Riklis, Lindner and Steinberg) had a common involvement with Michael Milken's group at Drexel Burnham that probably helped to create enough liquidity for their junk bond securities..."

Greenspan surely knew who he was dealing with. He had been on Wall Street in the 1960s. He trafficked in knowing who he should be smoozing. In the 1980s, he must have known Lincoln was part of the Riklis, Steinberg, Lindner, Milken crowd.

This was just the man to inherit the Federal Reserve chairmanship in 1987. Four years before, in 1983, a poll of Wall Street executives found that 31% of them had a special confidence in Alan Greenspan, should he be named chairman. He was second in that poll, behind Paul Volcker. What was it that Wall Street saw in this fourth-rate economic consultant?

            Charles Keating was convicted of looting $3.4 billion. Alan Greenspan was not held to account for his endorsement because the political establishment was in no position to cross-examine him. When Keating was asked whether the money he contributed to the Keating Five had influenced them, his response was refreshingly honest: "I certainly hope so." In 1988, when the hemorrhaging S&Ls had already cost several politicians their credibility, 333 Congressmen and 61 senators listed "significant donations from the industry." Donald Regan, who was President Reagan's chief-of-staff from 1985 to 1987, had been trying to oust Ed Gray from his position since 1984, (when Regan was Treasury Secretary). Many of the S&Ls Gray shut (including San Marino S&L) were large contributors to President Reagan's 1984 re-election campaign; Donald Regan "believed in helping contributors to the party." Gossip on Capital Hill had it that the former chairman of Merrill, Lynch wanted to "destroy the S&Ls as privileged providers of housing finance." True or not, the contributions of Merrill and like firms to the housing mania two decades later were impressive.

The other body that might have investigated Greenspan's involvement was the media. It made little ado about much. When it did make ado, Greenspan turned the question on its head. This was to be the mistletoe that hung over his 18-year affair with Congress. A quintessential example of his enduring magic act was anteceded by a 1989 Times' article with the title "Greenspan's Lincoln Savings Regret." The article was poorly titled; the chairman expressed no regret. If Greenspan received the same assignment in 1989 with the same evidence he had in 1984, "his conclusions about Lincoln... would be very much the same."

Alan Greenspan cannot admit to a mistake. Like a mother hen defending her offspring, Greenspan developed highly successful defenses. Here, he takes a defiant stand; it puts an end to the interrogation. He seemed to reserve this for instances when his actions were indefensible. (We will see it again when Greenspan came under attack for a speech in 2004 that urged the innumerate to buy adjustable-rate mortgages.) Note that when Senator Proxmire pinned Greenspan to the mat, he could not make the simple admission: "I was wrong." The Greeks developed this plot 2,500 years ago. Greenspan will, as chairman, imitate art - his mistakes will compound and inflate, inducing the most tortured logic, mutating the economy and financial structure in ever greater distortions.

He told the Times reporter the issue was whether the ownership by savings and loans associations in real estate projects and other commercial ventures "posed excessive risks." This was not the issue at all. The consulting economist had been hired by a man with a dubious past and a regrettable present whose financial statements were filled with fraudulent loans and junk bonds. Lincoln had more than doubled in size over the past year when Greenspan reviewed its "application [for direct investments] and its audited financial statements" (according to his letter to Thomas F. Sharkey.) The financial statements showed depositors' money had been invested in raw land in the Arizona desert and betrayed an insatiable appetite for junk bonds. The erstwhile S&L had abandoned the home mortgage market, Southern California or otherwise, despite its superb mortgage record among large thrifts. Recall that Keating had agreed with the Federal Home Loan Bank to concentrate his portfolio on Southern California home mortgages. Surely, this thumbing-of-the-nose at the FHLB would have crossed Greenspan's inspection if he more than glanced at Lincoln's books.

Again, by 1989, Greenspan was the country's top bank regulator. And again, he had been a director of J.P. Morgan. He had been on the board of directors of Trans-World Financial, a savings-and-loan holding company from 1962 to 1974. At a 1998 FOMC meeting he would reminisce: "When I was in the private sector, I remember looking at the details of particular loans that were shown to bank directors. I was on the loan committee of [J.P. Morgan], and we actually went through the loan portfolio major client by major client. The banks' senior loan officers would provide a basic review. They would take the loan portfolio and point to the vulnerabilities and strengths of the borrowers and give their evaluations of the risks that were involved. The review was quite thorough..." The audited, junk-bond portfolio placed before the consulting economist may have been priced at par. But chances are, they were Drexel Burnham issues. The 1984 annual report of Tom Spiegle's Columbia Savings & Loan - one of the "big three" that held $3.5 billion of junk at the end of the same year - shows that every issue was sold my Milken's group. By 1985, everyone had their suspicions about Drexel and Milken.

The Times reporter told his readers that "no one in Washington is saying that" the author of the essay "Integrity" has "compromised his integrity or his office."

Now, the man who attempted to assure Senator Proxmire that "the rest of my career has been somewhat more successful," was the new Federal Reserve chairman. Was there anything, was there a single trait, a feature, a mark of - not distinction, but simply an acceptable level of mediocrity - Alan Greenspan possessed, a requisite in the composition of a Federal Reserve chairman?