David Wessel’s book, In Fed We Trust: Ben Bernanke’s War on the Great Panic, is the definitive chronicle of the 2007-2009 financial crisis, but it is much more.  The book gives us an inside view of how policy making took place in response to the striking events. Wessel provides insights into the key players and decision makers, and conveys a very real sense of what they were thinking as those events unfolded.  In doing so, however, his account triggers serious questions about the Treasury/Federal Reserve decision-making process.  Here, we emphasize three serious flaws in the policy-making process that Wessel describes: the consistent lack of a plan and short-time horizon of the decisions, the insularity of the decision makers, and the apparent disregard for FOMC information-security rules governing meetings and associated documents.  We conclude by noting some oversights in Wessel’s account of the Great Depression and the Panic of 1907.

Lack of a Plan

The insider’s view of the policy making is the unabashed strength of this book, and Wessel provides an extensive chronology of how the crisis unfolded.  It is not a pretty picture.  His most telling observation is that the principals seem to have lurched from event to event without a plan, even after it should have been apparent that one was needed.

The discussions among key participants – namely Chairman Bernanke, Secretary Paulson, then-president Geithner, and Governors Kohn and Warsh – seem rushed, from Wessel’s descriptions of them.  The policy discussions tended to focus on short-term problems, pushing off potential longer-run consequences of the policy responses as a matter of expediency.  The sense is that the participants expected each decision to be sufficient to return markets to normalcy; but of course, they were not.  The ad hoc, short-term nature of policy process, as described in the book, carried with it the risk that not all decisions would be good and would carry with them unintended consequences.  For example, the problems of exiting from many of the policies are now significant and have yet to be addressed.

Wessel alleges that the policy makers continually underestimated the crisis and that there was no long-range planning undertaken from the time that the crisis initially erupted.  This should come as no surprise to anyone reading closely the financial press throughout the crisis, and yet it remains disappointing.  It is important to note that not all the decisions had the time constraints that surrounded the issue of the Lehman failure in the fall of 2008.  That event was preceded by almost a year of financial turmoil, serial reports of losses, failures or mortgage related institutions, and market disruptions that should have signaled to policy makers that something serious was at hand and that they weren’t simply facing a short-term liquidity problem.

By now, it is apparent that the crisis was misdiagnosed as a liquidity problem when in fact it was a solvency crisis.  Funds didn’t suddenly dry up and markets did not stop functioning because there were no funds available.  Rather, because of the trail of losses and preceding events, financial markets finally became wary of the solvency of key counterparties, as the Bear Stearns episode clearly demonstrated.  This was long before the problems in Lehman Brothers emerged.  Market participants’ concerns, as subsequent events proved, were well-founded.  It took policy makers too long to recognize the capital deficiencies relative to the risk exposures of major primary dealers, which then left them with insufficient time to design resolution plans.  Most of the largest financial institutions – both domestic and international – proved to have inadequate capital.  Some failed, and many were bailed out by their respective governments.

Wessel’s description of the decision-making process reminds one of a perpetual Chinese fire drill rather than a considered, analytic approach to the problems as they unfolded over time.  The latter implies a systematic plan, and the former implies a sequence of ad hoc responses to unrelated shocks. Even if an initial plan proved inadequate, the experience would have permitted corrections as events evolved.  And lacking a plan, it is harder to see if and when a decision was wrong.

Delegated and Concentrated Decision Making

The second issue that emerges from Wessel’s account is the insular and concentrated nature of the decision-making process, which excluded many members of the Board of Governors and FOMC.  Three governors and the president of the NY Fed apparently took on the decision-making responsibility for the central bank in the midst of the crisis. From the narrative, it seems as if this core group effectively froze out the remaining two members of the Board and FOMC members from both decision making and access to key real-time information.

Why did it happen?  Under what authority did this happen?  One plausible answer is that the core group felt that the existing structure was too cumbersome to effectively coordinate policy among so many principals, and so they simply exploited a loophole in the law governing open and closed meetings of government agencies.  Let us explain.  Normally, there are seven members of the Board of Governors, so that a gathering of four would constitute a majority and could officially make decisions.  According to the 1976 Government in the Sunshine Act, which sets out the rules meetings of  federal governmental agencies, official Federal Reserve Board meetings in which policies are considered must be announced in advance and,  at a minimum, an agenda must be provided,.  For this reason, only three governors can get together in the same room without it constituting a “meeting”  and invoking the provisions of the Sunshine Act.   But during the entire crisis there have only been five governors on the Board, with two vacancies.  (David Kotok has written extensively on this issue in previous commentaries.)  Thus, the gathering of the three governors in the meetings that Wessel describes meant that while not technically meeting the legal requirement for a meeting, the three de facto constituted a majority of the sitting governors and could actually make decisions.  Coordinating policy with the entire FOMC would have been more cumbersome and likely would have also required that a written transcript be prepared.  It could be that the core principals felt that a smaller group would make decisions more quickly, and the sense of such a desire for quick decisions comes across in the narrative.  Nevertheless, one can’t help but feel that it might have been beneficial to have been able to tap the broader experience and expertise of the Federal Reserve Bank presidents, especially since so many of the key principals making the crucial decisions were relatively new to their jobs.

The Sanctity of FOMC Meetings

From the perspective of former senior officials of the Federal Reserve System, the details that Wessel reports about specific material in confidential FOMC documents and discussions that took place during FOMC meetings are especially discomforting.  FOMC security is governed by the FOMC’s Program for Security of FOMC Materials, which is a classified program that defines the security levels and handling of FOMC-classified documents.  The Program also sets out rules for how many people can have access to such documents.  At one time, only 10 people at each reserve bank (with the exception of New York and the Board) could have access to the Bluebooks, which contain the policy options presented by the staff to the FOMC.  The Bluebooks receive the highest level of  security classification.  The procedures also require detailed record keeping and govern storage and delivery of both hard-copy and electronic documents.

Most importantly, it is also clear in the Program to every attendee that what goes on in that board room at the Board of Governors stays in that room until the transcripts are made public five years later.  In the past there have been a few leaks.  When that happened, staff who attended the meetings, as well as bank presidents, and presumably Governors, were interviewed under oath by the FBI in one case and by a representative of the Board’s Inspector General in another case in an attempt to smoke out the source of the leaks.  The penalties for divulging classified information are extremely severe and might even include criminal charges.

Against that background, the kinds of candid conversations that Wessel had and divulged in his book are indeed surprising.  There are at least a dozen revelations of what went on at various FOMC meetings, who said what, and even what was substantively covered, that rise to a level of severity far above that which triggered investigations by the FBI and Inspector General during the Greenspan era.  One might deduce by simply examining historical Bluebook documents released on the Board’s website that the staff typically offers three policy options for FOMC consideration at each meeting.  So in describing that process Wessel is merely drawing on public information. However, Wessel indicates that in one meeting during the crisis there were actually four options presented, and he describes what some of those options were.  Either there have been significant revisions in the Program for Security of FOMC Materials in the past couple of years or there is now blatant disregard, for whatever reason, of the rules and sanctity of the meetings.  One could view this as another example of how the rules are now being bent at the Fed.  In the near term, these revelations may further damage the credibility of both the FOMC and the Federal Reserve.  It certainly weakens the Federal Reserve’s arguments against additional Congressional auditing of Federal Reserve activities.  After all, if FOMC participants can freely talk to the press in violation of their own security rules, surely Congress has a right to know what is going on as well.

Prior Financial Crises: 1907; The Great Depression vs. Depression 2.0

Wessel devotes Chapter 2 to describing what he believes are parallels between financial crises of the past and present.  In the interest of historical accuracy, even if it appears that we are nitpicking,  it appropriate to point out a couple of factual oversights.  In the second chapter of the book Wessel mischaracterizes key events during the Panic of 1907.  Specifically, he notes that the suspension of Knickerbocker Trust on October 22, 1907, after several days of depositor withdrawals, was the catalyst for the onset of that crisis. Wessel refers to the Knickerbocker Trust as the “Bear Stearns” of its day, claiming that Knickerbocker had lent heavily to the copper speculators, who failed in an attempt to corner that market and brought that firm down, just as Bear Stearns’ mortgage activities brought it down.  But in fact, such allegations about Knickerbocker have never been substantiated, and Wessels may have drawn upon a flawed analogy.  Bear Sterns’ problems were of its own making and not due to the actions of its borrowers.  In discussing Knickerbocker’s failure, Wessels also suggests that Benjamin Strong, then a Morgan employee who was asked by Morgan to inspect the books of the trust company, said that Knickerbocker Trust was insolvent.  Rather, Strong said that he was unable to determine whether it was solvent or not, a subtle but important difference.  That uncertainty parallels the uncertainty that market participants apparently felt about counterparties during the current crisis.  Finally, in contrast to Bear Stearns, which was rescued, Knickerbocker Trust suspended operations but eventually reopened as a going concern in March of 1908.  Ironically, the corrected analogy is likely a closer parallel than the one Wessel draws.  It is precisely the lack of clarity about financial-market solvency in 1907 that parallels the opacity that existed in 2007-2008.

Regardless of perspective, we do not really know how close the financial market came to collapse in 2008.  Whether letting Lehman Brothers fail was good policy or not, it is clear that timely resolution is critical when systemic issues are of concern.  If policy makers, present and future, draw their insights from past attempts to alleviate crises, they should distinguish the successes from the failures during those episodes.  Allowing Knickerbocker Trust to fail was likely a mistake, and one that arose from the lack of timely information about its solvency to the existing lender of last resort at the time (Morgan).

In another section, Wessel suggests that the Federal Reserve System’s creation was largely based on an earlier plan written by investment banker Paul Warburg.  The statement overlooks the overarching point that the Federal Reserve Act was not the work of one person, but was in fact the outcome of several years of careful research, discussion, and debate.  In particular, the National Monetary Commission and its proposal for banking reform, named the National Reserve Association, did incorporate many of Warburg’s ideas.  But Wicker (2005) emphasizes that the Federal Reserve Act bore a striking resemblance to the National Reserve Association legislation.  More importantly, the process was completed nearly five years after the Aldrich-Vreeland Act created the commission to study the reform of the monetary system.  The larger point about the time taken to appropriately reform the financial and monetary system is especially relevant today, as the Congress seems to be in a great rush to reform our financial regulatory system in response to the current crisis.

Wessel’s treatment of the Great Depression era is essentially in accord with the standard views regarding that period.  There are two minor points of difference, however.  First, some of the Reserve Bank presidents (governors, as they were then called), most particularly Eugene Robert Black of Atlanta, were consistently supporting the extension of liquidity, rather than policies to enforce the gold standard.  It was this policy that Friedman and Schwartz document and that resulted in a one third contraction in the U.S. money supply, thereby exacerbating the depression.

Bottom Lines

Wessel’s book confirms that the process of saving the financial system was, to no one’s surprise, ad hoc.  Further, the decisions were imperfectly informed by the principals’ perceptions of what was actually occurring.  Clearly, Chairman Bernanke understood the big risk of a financial meltdown and made bold moves to ensure that we didn’t experience another Great Depression.  President Geithner, now Treasury Secretary Geithner, is described as an interventionist whose main concern was the short run and who was willing to deal with the unintended consequences as they arose. Finally, Secretary Paulson seems to have been solely a markets person, long on the bravado associated with a deal maker and short on the analytics required to formulate good policy.

Whether all the actions taken were necessary we will never know, because we can’t observe what might have been had other policies been followed.  But it is clear that the process of dealing with the crisis might have benefited from additional inputs and analysis by people who held responsible positions within the Federal Reserve, but who, for whatever reasons, were not actively involved in the policy-framing process.  Perhaps in the debate that surrounds regulatory reform of the financial markets, the basic management issues of decision-making process design and planning should become a priority.  If not, then we may in the words of Yogi Berra experience déjà vu all over again.

There are two major problems with securitization.

First, in modern securitization markets, nobody is really responsible for the credit risk. Instead of taking loans onto their own balance sheet, and losing money if they default, mortgage companies merely sell the loans they originate to Wall Street, pocketing a fee for doing so. Wall Street, in turn, retains very little of the resultant mortgage packages: It sells them on to investors, who can hardly expect Wall Street to be responsible for each individual mortgage.

Thus, all the parties involved in originating the transaction became salesmen. Since it was no longer necessary to have a balance sheet to originate mortgages, mortgage brokers became pure sales operations.  The sales business being what it is, the more unscrupulous and aggressive the sales operation, the more business it did.

That’s how we ended up with so-called “Liar Loans.”

In newly unveiled draft legislation, the U.S. Treasury Department has proposed to reduce this problem by making securitization originators keep 5% of the resultant credit risk. This seems a sensible move, and should help matters considerably, even if it does reduce the attraction of the more-exotic securitizations.

A second problem with securitization, highlighted by the Massachusetts court decision, is that of documentation.  As I can testify from experience, securitizations are by far the most tiresome of all Street transactions to document, with a non-standard securitization creating incalculable costs while taking 18-24 months to complete.

You can see why the more complex transactions were complicated: Hundreds – or even thousands – of mortgages were being bundled and sold as a bundle to maybe tens of thousands of investors.

Read the full article here

Ludwig von Mises was snubbed by economists world-wide as he warned of a credit crisis in the 1920s. We ignore the great Austrian at our peril today.

Mises’s ideas on business cycles were spelled out in his 1912 tome “Theorie des Geldes und der Umlaufsmittel” (“The Theory of Money and Credit”). Not surprisingly few people noticed, as it was published only in German and wasn’t exactly a beach read at that.

Taking his cue from David Hume and David Ricardo, Mises explained how the banking system was endowed with the singular ability to expand credit and with it the money supply, and how this was magnified by government intervention. Left alone, interest rates would adjust such that only the amount of credit would be used as is voluntarily supplied and demanded. But when credit is force-fed beyond that (call it a credit gavage), grotesque things start to happen.

Read the full article here

This crisis was not the result of deregulation and market failure. In reality, it was born of a highly distorted financial market, in which excessive concentration, excessive leverage, spurious theories of risk management and, above all, moral hazard in the form of implicit state guarantees, combined to create huge ticking time-bombs on both sides of the Atlantic. The greatest danger we currently face is that the emergency measures adopted to remedy the crisis have made matters even worse.

It has often been said since the crisis began that an institution that is “too big to fail” (TBTF) is too big to exist. I agree. The question is how we can best get rid of the TBTFs without increasing the power of government in the economy still further.

Economists have long held that bank failures pose a “systemic” economic risk, because failed banks are associated with monetary contractions for the economy as a whole. There is therefore a presumption that, if big banks are threatened with liquidity or solvency problems, they should be bailed out by the action of the central bank or government. Despite much pious talk of “moral hazard” prior to 2007, little was done to disabuse big financial institutions of this notion. They could and did assume that they enjoyed an implicit government guarantee.

With the exception of Lehman Brothers, they were right. Beginning with the British Government’s takeover of Northern Rock in 2007 and culminating in the US Government’s vast injections of capital into AIG, Citigroup and other institutions, the Western world has witnessed a succession of government interventions in the banking system unprecedented other than in time of war. These measures can be justified on the ground that without them there would have been a banking crisis comparable with that of 1931, which did as much as the 1929 stock market crash to plunge the world into a Great Depression.

But there is a danger that justified emergency measures give rise to unjustifiable permanent conditions.

Read the full article here

(Cassidy’s analysis) asks us to ignore the repercussions of our behaviors. We can rationalize short term gains at the expense of long term losses, because we need to obtain quarterly profits regardless. Apparently, when it bankrupts the company, only then with the benefit of hindsight can we see what went wrong.

I am terribly sorry, but that is precisely the sort of thinking that led to the crisis in the first place. Making loans to people who cannot pay them back is not rational when its profitable — its NEVER rational.

Goldman Sachs avoided most of the credit debacle — were they being irrational when they forewent short term profits for a few years — but avoided the worst of the sub-prime debacle? And what about hedge fund manager John Paulson? His fund bet against all of these other players, netting several billions in profits while others suffered from their “Rational Irrationality.” How irrational was Paulson’s investment posture?

On a risk adjusted basis, the behaviors of Citi, Bear, Lehman, New Century and others was hardly rational. Call it whatever you want, but do not forget this simple fact: It was the sort of narrow, risk-ignoring thinking that is ALWAYS rewarded in the short term, and ALWAYS punished in the long term.

Great stuff from BR! Read the full post here

As Absolute Return Partners wrote in its July newsletter:

The most important investment decision you will have to make this year and possibly for years to come is whether to structure your portfolio for deflation or inflation.

So which is it, inflation or deflation?

This is obviously a hot topic of debate, and experts weigh in on both sides. I’ve analyzed this issue in numerous posts, but every day there are new arguments one way or the other from some very smart people.

Because the arguments for inflation are so obvious and widely-discussed (bailouts, quantitative easing, Fed purchasing treasuries, etc.), I will not discuss them here (other than pointing to an interesting new argument for inflation by Andy Xie).

How Bad Could It Get?

The biggest deflation bears are rather pessimistic:

• David Rosenberg says that deflationary periods can last years before inflation kicks in

• Renowned economist Dr. Lacy Hunt says that we may have 15-20 years of deflation

• PhD economist Steve Keen says that – unless we reduce our debt – we could have a “never-ending depression”

These are the most pessimistic views I have run across.  Most deflationists think that a deflationary period would last for a shorter period of time.

The Best Recent Arguments for Deflation

Following are some of the best arguments for deflation…

Read the full post here

Federal Reserve Chairman Ben S. Bernanke’s efforts to stoke a U.S. economic recovery may be undermined by the central bank’s other goal of restoring the banking system to health.

The Federal Open Market Committee, at the conclusion tomorrow of a two-day meeting, will probably maintain its assessment that “tight” bank credit is impeding growth, said economists including former Fed Governor Lyle Gramley. Lending contracted for five straight weeks through Sept. 9, a drop that in part reflects Fed orders to banks to raise more capital and toughen lending standards, analysts say.

A failure to restore the flow of bank credit carries the risk that the economic recovery will be slower than the Fed anticipates, or even that the U.S. lapses into another recession, economists say. That would make it more likely the Fed will keep its main interest rate close to zero for a longer period.

————

“Even though from a technical perspective the recession is very likely over at this point, it’s still going to feel like a very weak economy for some time,” Bernanke said in response to a question after a speech in Washington. Fed officials in June predicted that GDP will expand 2.1 percent to 3.3 percent next year after shrinking 1.5 percent to 1 percent this year, according to the central tendency of their forecasts.

Banks have plenty of reasons to hold back on lending, analysts say.

Americans fell behind on their mortgage payments at a record pace in the second quarter, with delinquencies rising to 9.24 percent, according to an August report by the Mortgage Bankers Association.

“Consumers aren’t necessarily that creditworthy a proposition right now,” said John Ryding, chief economist and founder of RDQ Economics LLC in New York.

Falling values of commercial real estate are also a problem for banks, with an “uncertain degree of losses” to come, said Ryding, a former Fed researcher. Loans made for commercial property will probably sour and lenders will need to raise more capital to cover credit losses, Mike Mayo, a banking analyst at CLSA Ltd., said today at a conference in Hong Kong.

Read the full article here

“The dollar looks awfully like sterling after the First World War,” said David Bloom, the bank’s currency chief.

“The whole picture of risk-reward for emerging market currencies has changed. It is not so much that they have risen to our standards, it is that we have fallen to theirs. It used to be that sovereign risk was mainly an emerging market issue but the events of the last year have shown that this is no longer the case. Look at the UK – debt is racing up to 100pc of GDP,” he said

Crucially, China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles. Asia’s “mercantilist mindset” of recent decades is about to be broken by the spectre of an inflation spiral.

The policy headache was already becoming clear in the final phase of the global credit boom but the financial crisis temporarily masked the effect. The pressures will return with a vengeance as these countries roar back to life, leaving the US and other laggards of the old world far behind.

Read the full article here

Introduction (Via PBS)

In Breaking the Bank, FRONTLINE producer Michael Kirk (Inside the Meltdown, Bush’s War) draws on a rare combination of high-profile interviews with key players Ken Lewis and former Merrill Lynch CEO John Thain to reveal the story of two banks at the heart of the financial crisis, the rocky merger, and the government’s new role in taking over — some call it “nationalizing” — the American banking system.

“This is more than a story about just one man or one bank,” says producer Michael Kirk. “This is the story of the most important change in the relationship between government and private business in a generation.”

Watch the video below or click here for the PBS FRONTLINE page

Central bankers have no clue. In the first place, the financial crisis was not a black swan. It was perfectly predictable. They ignored the phenomenal buildup in leverage since 1980. They acted like airline pilots who’d never heard of hurricanes.

After finishing The Black Swan, I realized there was a cancer. The cancer was a huge buildup of risk-taking based on the lack of understanding of reality. The second problem is the hidden risk with new financial products. And the third is the interdependence among financial institutions.

…Today we still have the same amount of debt, but it belongs to governments. Normally debt would get destroyed and turn to air. Debt is a mistake between lender and borrower, and both should suffer. But the government is socializing all these losses by transforming them into liabilities for your children and grandchildren and great-grandchildren. What is the effect? The doctor has shown up and relieved the patient’s symptoms – and transformed the tumour into a metastatic tumour. We still have the same disease. We still have too much debt, too many big banks, too much state sponsorship of risk-taking. And now we have six million more Americans who are unemployed – a lot more than that if you count hidden unemployment.

…Ben Bernanke saved nothing! He shouldn’t be allowed in Washington. He’s like a doctor who misses the metastatic tumour and says the patient is doing very well. The first thing I would tell Chinese officials is, how can you buy U.S. bonds as long as Larry Summers is there? He’s a textbook case of overconfidence. Look what happened to Harvard’s finances. They took a lot of risk they didn’t understand, and it was a disaster. That’s the Larry Summers mentality.

Read the full interview here