Friday, October 30, 2015

How Bernanke's Encouragment of Bue Sky Thinking Shaped the Fed's Responses in the Financial Crisis

At Bernanke's behest, in response to early tremors foreshadowing the financial crisis, Federal Reserve board members and staff engaged in a process of idea generation and brainstorming. The effort was aimed at finding creative ways to provide emergency short-term lending and guarantee programs to extinguish the potential fires of financial panic and restore collapsed financial markets. 

This blue sky thinking was well underway by September 2007 and prepared the Fed for what Bernanke calls "the dark abyss" at the height of the panic and pushed the limits of the Fed's authority in the bailouts of Bear Stearns and AIG. 

By Robert Stowe England
October 30, 2015

Before former Federal Reserve Chairman Ben Bernanke came up with an array of lending facilities to put out the fires of financial panic that broke out in 2007, he laid the groundwork inside the Fed with a brainstorming effort he called blue sky thinking. “We had ongoing conversations that were like a doctors diagnostic discussion, where you throw out ideas and then try to think about what could go wrong and the advantage and disadvantage of each approach,” says Bernanke at his office at Brookings Institution, where he is a distinguished fellow in residence with the Economic Studies Program.

By summer’s end 2007, after the first tremors of the financial crisis rattled the financial world, creative thinking inside the Fed had already generated a blue sky list of options to fight financial panic, according to Bernanke’s new book The Courage to Act: A Memoir of a Crisis and Its Aftermath, published by W.W. Norton October 5.

Compiling a playbook of short-term emergency lending options to fight panic was an important development at the Fed, according to David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at Brookings Institution. “It is kind of amazing Bernanke got the job at the time he did” because he brought important insights from his study of the role of monetary policy in the Great Depression, Wessel says. One key lesson: “The arteries of the economy were clogged with the carcasses of dead banks. And, the Fed’s inability to deal with that stopped the economy from recovering,” he says.

Bernanke reports in his book that he laid out his case in support of the policy options on the blue sky list in a September 2, 2007, email to Fed Vice Chairman Don Kohn, New York Fed President Timothy Geithner, and Fed board member Kevin Warsh.

Top of the blue sky list was a proposal to offer foreign currency liquidity swap lines with other central banks to provide dollars to overseas markets with repayment collateralized by the borrowing central bank’s home currency. This idea was soon implemented in December 2007 when the Fed extended swap lines to the European Central Bank and the Swiss National Bank. A proposal to auction interest rates for short-term loans to depository institutions to take away much of the stigma attached to borrowing from the Fed’s discount window became a reality in December 2007 with the creation of the Term Auction Facility.

A third blue sky proposal was to invoke the little-known Section 13(3) of the Federal Reserve Act, which would allow the Fed in “unusual and exigent circumstances” to lend short-term to any creditworthy person or entity, not just depositories, provided there was good collateral to back the loan. When board members who received Bernanke’s email pushed back on this idea, Bernanke resisted and said he would keep it, but as a gesture to those who criticized it, he offered to list it under the “Hail Mary section.”

By March 2008, with fresh crises erupting almost daily, Bernanke decided it was time “to break out the Hail Mary section of the playbook.” With Bear Stearns cash reserves down to $2 billion on Thursday, March 13 from $18 billion only three days earlier, the firm was facing bankruptcy the next day, Friday, March 14, a prospect the promised a wider panic. In response to what was seen as a systemic threat, the Fed’s board agreed to allow the New York Fed to provide a $12.9 billion emergency non-recourse loan to JPMorgan Chase, which was then to be lent to Bear Stearns. The loan was given to keep Bear Stearns afloat over the weekend so that a deal could be hammered out with JPMorgan to acquire the firm.

Two days later on Sunday, March 16, the Fed’s board also approved a second non-recourse loan of $29 billion to facilitate the acquisition. This loan, combined with a $1 billion loan from JPMorgan Chase, allowed the New York Fed to acquire $30 billion in toxic assets and place them in Maiden Lane, a limited liability corporation. The name of the special purpose vehicle came is also the name of the lower Manhattan street that runs along side the back of the New York Fed building. Tom Baxter, general counsel for the New York Fed, has said that the reserve bank wanted to call the special purpose vehicle “Liberty Street,” which is street on the front side of the New York Fed building and also its street address but found that name had already been taken by another entity. So they switched the name to Maiden Lane.

In the case of the $12.9 billion emergency loan to JPMorgan to bolster Bear Stearns, the Fed invoked Section 13(3) for the first time since the Great Depression. “We felt the uncontrolled collapse of Bear Stearns would be very damaging to the broad financial system and the economy,” Bernanke says. Section 13(3) was invoked again for the second $29 billion loan to acquire Bear Stearns’s assets. Blue sky thinking have paved the way as the Fed had already had internal discussions more than half a year earlier about when it should be used. After the two loans were made, former Fed Chairman Paul Volcker slammed the Fed for intervention and accused the central bank of acting on “the very edge of its lawful and implied power.” Bernanke takes some comfort in noting that at least Volcker did not say the Fed had gone over the edge of its authority.

The New York Fed has been made whole for its loans to rescue Bear Stearns and facilitate its sale to JPMorgan Chase. By June 2012 Maiden Lane LLC had fully repaid with interest its $29 billion loan from the New York Fed from the net proceeds of some of its assets. In September 2014 Maiden Lane repaid with interest the $1 billion loan from JPMorgan Chase with the proceeds from sales. The New York Fed receives 100 percent of cash flows from the remaining assets at Maiden Lane.

Within six months of the Bear Stearns rescue, the Fed would face yet another test of the limits to which it could go to extinguish the raging flames of financial panic. During the week of September 15, 2008, Bernanke recalls, the Fed “stared into the abyss of financial collapse in the darkest says of the crisis.” Lehman went bankrupt and American International Group (AIG) was poised to follow closely behind. In a much-derided decision, the Fed decided not to provide emergency short-term funding to Lehman to provide it liquidity until a buyer, possibly the United Kingdom’s Barclays Bank, could be found for its good assets while possibly a consortium of banks would acquire the bad assets and place them in a special purpose vehicle. “Barclays ultimately bought the broker dealer, a small part of the overall firm. They did not make an offer on the overall firm because their regulator told them they couldn’t,” Bernanke says.

As for AIG, the former Fed chairman describes how he  and Treasury Secretary Hank Paulson engaged in agonizing deliberation and consultation with President Bush and Congress over whether to bail out the company out with an $85 billion emergency line of credit. For the Fed, the decision was fraught with risks, according to Bernanke. The company lacked sufficient financial assets to serve as collateral for so large a loan. However, there was sufficient collateral if you included all of AIG assets, including its many insurance subsidiaries and other financial services companies. The risk, however, was that the underlying value of the subsidiaries would plummet if the holding company failed. This amounted to lending against equity and not lending against assets, which would ultimately raise questions about its legality. Despite those concerns, the Fed “saw no alternative” but to go ahead, Bernanke says.

After Paulson and Bernanke consulted with congressional leaders to explain what they thought they had do to, they got a blunt response from Senate Majority Leader Harry Reid, Nevada Democrat. “Mr. Chairman. Mr. Secretary. I thank you for coming here tonight to tell us about this and to answer our questions. It was helpful. You have heard some comments and reactions. But don’t mistake anything anyone has said here as constituting congressional approval of this action. I want to be completely clear. This is your decision and your responsibility,” Reid said, according to Bernanke.

The New York Fed, the regional reserve bank that extended the AIG loan, required AIG to cede control of 79.9 percent the company, a move seen by some critics as a step beyond the edge of the Fed’s authority. While the rescue was helpful, AIG continued to limp along. Ultimately, the Fed had to continue to advance funding to AIG until its lending totaled $182 billion, the largest bailout for a single company during the crisis. Fannie Mae and Freddie Mac together required $187 billion in advances to stabilize them. The New York Fed eventually expanded its ownership stake in AIG to 92 percent of its common shares. When share prices recovered a few years later, the U.S. government gradually sold off its stake, completing the last sale in December 2012. At the end, the full amount of all the cash advances made to AIG was paid back and the government pocketed a $22.7 billion gain.

Even though the Fed’s loans to AIG were repaid, fresh doubts about the AIG bailout surfaced in June 2015, when Judge Thomas Wheeler of the U.S. Court of Federal Claims ruled that the New York Fed had no right to control and run a company that had taken a sizable loan from it. The ruling came in a shareholder lawsuit brought by former AIG chairman Maurice Greenberg, who owned a sizable stake in the company. The Fed in an official statement stated its actions with AIG “legal, proper and effective.”

Mark Calabria, director of financial regulation studies at the Cato Institute, Washington, D.C., takes issue with the Fed’s response to the Judge Wheeler’s finding the Fed had broken the law and had taken actions beyond its authority. “For the Fed to show such little respect for the judicial system I think is troubling,” Calabria says. “Can you imagine Jamie Dimon saying stuff like that? Well I know we’ve been found guilty of this, but whatever.” The judge also ruled that shareholders could not be compensated for their losses because the government’s action was unauthorized.

The Fed’s blue sky thinking would yet serve up more ideas that the Fed successfully used to calm financial markets. In October 2008, the Fed began purchasing commercial paper and, in the process, stabilized the money market fund industry. In November the Fed set up its Term Asset-Backed Securities Loan facility that provide non-recourse loans to help finance new issues of asset-backed securities that are collateralized by student loans, auto loans, credit card loans, and small business loans. This action revived the ABS market, which had collapsed a year earlier.

According to a Fed spokesman, ongoing research about how to respond to potential systemic risk has been institutionalized at the Fed within the Office of Financial Stability Policy and research, which houses 27 economists. Wessel thinks that Fed probably continue to engage in creative thinking, especially about “how do we begin the tighten monetary policy so that it is something approaching normal without freaking out everyone.”

Blue sky thinking could be a beneficial way to go about finding solutions to the fiscal challenges that have divided and gridlocked Washington along party lines, according to Wessel. This is an important challenge that needs to be addressed. He points out that while the deficit has been brought down, the U.S. still has a very high debt-to-GDP level and the nation faces a big debt problem ahead based on aging populations and health care costs. At the same time the economic recovery remains lackluster and subpar and could benefit from fiscal stimulus. “What is the right fiscal policy to do that makes the present better without making the future worse? That’s a really hard question to answer,” says Wessel. It is also a question that could be posed to a group policy experts and policy makers for an intensive exercise in blue sky thinking.

Bernanke agrees with Wessel about the need to think creatively about fiscal policy and contends that for too long the Fed has done all the heavy lifting on policy matters. It is time, he says, for other policy makers in Washington in the Executive Branch and in Congress to work together on fiscal and regulatory ideas that could energize an economy growing too slowly in part because of slow productivity growth that began before the crisis. That would seem to be an extraordinarily daunting challenge. Bernanke agrees. “It’s obviously not an easy proposition.”


Monday, October 5, 2015

Bernanke: We Rely Too Much on the Fed

Former Fed Chairman Ben Bernanke Interviewed on CNBC's Squawk Box
October 5, 2016

Bernanke's book, Courage to Act, published today.


Second Segment: Bernanke Responds to Stanley Druckenmiller's Claim the Fed Should Have Started Raising Rates A Year and Half Ago

Tuesday, September 29, 2015

Carl Icahn's Video: Danger Ahead

Video Released September 29, 2015

Tyler Durden at Zero Hedge summarizes Icahn's comments as follows:

Low rates and asset bubbles: Fed policy in the wake of the dot com collapse helped fuel the housing bubble and given what we know about how monetary policy is affecting the financial cycle (i.e. creating larger and larger booms and busts) we might fairly say that the Fed has become the bubble blower extraordinaire. See the price tag attached to Picasso’s Women of Algiers (Version O) for proof of this.

Herding behavior: The quest for yield is pushing investors into risk in a frantic hunt for yield in an environment where risk free assets yield at best an inflation adjusted zero and at worst have a negative carrying cost.

Financial engineering: Icahn is supposedly concerned about the myopia displayed by corporate management teams who are of course issuing massive amounts of debt to fund EPS-inflating buybacks as well as M&A. We have of course been warning about debt fueled buybacks all year and make no mistake, there’s something a bit ironic about Carl Icahn criticizing companies for short-term thinking and buybacks as he hasn’t exactly been quiet about his opinion with regard to Apple’s buyback program (he does add that healthy companies with lots of cash should repurchases shares).

Fake earnings: Companies are being deceptive about their bottom lines.

Ineffective leadership: Congress has demonstrated a remarkable inability to do what it was elected to do (i.e. legislate). To fix this we need someone in The White House who can help break intractable legislative stalemates.

Corporate taxes are too high: Inversions are costing the US jobs.

Read more here.

Friday, September 18, 2015

Marc Faber: "I believe we are going to see QE4"

Bloomberg Interview with Marc Faber:
September 17, 2015

“I know exactly what they [the Fed] will do today. They will either leave rates where they are, or increase a quarter of a percent. I think they will probably do nothing… Number two, I think the damage has already happened. People simply don’t remember that Greenspan deliberately created the Nasdaq bubble. Then the bubble burst, then deliberately – and this is written in statements – created the housing bubble in the US, built on credit. The credit bubble in the US burst and produced essentially the greatest recession crisis since the Great Depression of the ‘30s. But people say, ‘Mr. Bernanke saved the system in 2008, 2009.’ And yes, indeed. They cut interest rates to zero in December 2008, so in three months time we will have the anniversary of almost seven years of almost zero interest rates. What I’m saying is that this has created a lot of distortions in the system, and I believe we’re going to pay for it…

“One of the problems with these artificial low interest rates is the following. We all know that one of the problems is the size of governments in the Western world. They have become larger and larger within the economic system. This was enabled essentially by very low interest rates, because the governments could borrow more and more money. In the US, for the last 10-15 years, the interest payments on the government debt have not gone up, although the government debt is up three times. Because the government pays less and less on its outstanding bonds and paper, treasuries, they essentially didn’t suffer from it…

“I think precious metals are relatively attractive. I believe we are going to see QE4. I like gold, I like platinum, I like silver. I think even if they increase rates a little bit here, it’s not going to be a trend. What would really be surprising for investors if the Fed said, ‘We are going to go from one quarter of a percent to 1.5% in, say, 12-18 months time. And we’re going to stick to this policy.’ But that they will not do. They will say, ‘We will increase a quarter of a point or nothing. We are data dependent.’ Based on the US, there is an argument where rates could go somewhat higher. Based on international economic developments… there’s no way to increase rates at the present time…”

Sunday, July 12, 2015

With or Without a New Bailout, Greek Banks "Insolvent," Need Capital Injections

Rising loan delinquencies and declining public confidence will require banks to recapitalize. Based on their Texas ratios, they are already bankrupt, according to U.S. economist Steve Hanke.

By Robert Stowe England
July 11, 2015

With or without a new bailout package for Greece, it will take more than a green light by the European Central Bank to raise the Bank of Greece’s ceiling for Emergency Liquidity Assistance to undo the damage done from the capital controls imposed Greek banks on June 29. Indeed, their financial condition was already deteriorating over the course of the last six months, as customers withdrew more than €40 billion in deposits. When the banks re-open, there’s worry the exodus of deposits could resume.

With hope rising for a new bailout package for Greece, it will take more than a fres flow of funds from the European Central Bank to the Bank of Greece and out to the Greek economy to undo the damage done by shutting down the banking system for two weeks except for small daily withdrawals for 60 euros. Greece’s banks have been weakened by the shutdown and public confidence on the banking system, already declining, has fallen sharply lower.

Buffeted by a rising tide of bad loans on a thin capital base, Greece’s largest banks are sailing toward bankruptcy, according to Steve Hanke, professor of applied economics at Johns Hopkins University in Baltimore and director of the Troubled Currencies Project at the Washington, D.C.-based Cato Institute, which monitors currencies that are in trouble. “The banks are on tenterhooks. They have almost no good collateral to even go the European Central Bank to get more liquidity and they are probably insolvent,” Hanke says.

Non-performing loans on Greece’s banking system reached €78 billion at the end of the first quarter of 2015, representing 35 percent of bank portfolios, according to the Bank of Greece, up from 34 percent at the end of 2014. Nearly half of all consumer credit was in arrears, while 35 percent of business loans and 30 percent of mortgages were delinquent. Banks have reserved €50 billion to cover losses on the troubled loans.

The four largest Greek banks – the National Bank of Greece, Piraeus Bank, Eurobank Ergasias, and Alpha Bank – hold €346.4 billion or 87 percent of €397.8 billion assets in the Greece’s banking system. “They have huge dominance,” says Hanke. Given their central role to the economy, Hanke argues, the Big Four will have to be recapitalized to salvage the Greek economy, which declined 0.4 percent in the first quarter is expect to decline the rest of the year.

Hanke’s gloomy analysis is based in part on the fact the Texas Ratio scores for Greek banks have risen to a level that in the past has predicted bank failure. The Texas Ratio was devised during the U.S. savings and loan crisis of the 1980s by RBS Capital bank analyst Gerard Cassidy to identify banks and thrifts likely to fail and helped identify which bank and thrifts were like to fail in New England during the 1990s.

At year-end 2014, the Texas ratio for Greece’s four largest banks was at or above 100 percent. Any measure above 100 means that the book value of all bad loans and foreclosed real estate is greater than the bank’s entire tangible equity plus loan loss reserves. “If you have a ratio over 100 percent, there is a high probability the bank will end up being insolvent if those nonperforming loans ultimately have to be written off,” explains Hanke. The National Bank of Greece has the best Texas ratio at 98.7 percent. The other three are higher: Eurobank Ergasias, 124.7 percent; Alpha Bank, 129.4 percent; and Piraeus, 195.1 percent.

The Texas ratio, while very useful, can still mask weaknesses, according to Hanke. For example, a dominant share of Greek bank equity is made of up a tax deferred assets. Hanke calls such deferred tax assets “phantom capital” because they are only useful to offset future earnings and offer no real capital buffer in a time of crisis when banks are unprofitable. At the Big Four banks tax deferred assets range from a low of 38 percent of tangible equity capital at the National Bank of Greece to high of 61 percent at Eurobank Ergasias. Taking out tax deferred assets from the capital, adjusted Texas ratios give a grimmer but more accurate snapshot of the Big Four, according to Hanke. For example, the adjusted Texas ratio rises to 122 percent for National Bank of Greece. It rises to 265.5 percent at Piraeus Bank.

Hanke points to the steady decline in money supply as a key culprit in the deteriorating outlook for Greek banks. According to the Bank of Greece, the nation’s central bank, the M3 measure of money supply fell 16 percent year-over-year in May, falling from €193.6 billion in May 2014 to €161.9 billion in May 2015. Worries about the Greek banks are also draining away deposits. Even thought depositors added funds to the banking system most of last year, since last fall deposits at Greek banks have plunged 22 percent or €39.9 billion, falling from €178.5 billion in October 2014 to $138.6 billion by the end of May, according to the Bank of Greece.

To boost falling capital ratios, banks are also scaling back the size of their loan portfolios by not making new loans and refusing to roll over some loans when they come due. As a result, loan portfolios at Greek banks shrank from €235.5 billion in January 2015, a recent peak, to €229.6 billion in May. “There is no money and credit being produced in the banking system,” Hanke says. “That means the depression they are going to have in Greece is going to be massive when compared to what it’s been in the past.”

With deposits falling, Greek banks are growing more vulnerable to restrictions on how much emergency liquidity assistance the European Central Bank will allow the Bank of Greece to provide to Greek banks to compensate for loss of deposits at banks. “Greek banks are now almost as reliant on funds from the Eurosystem . . . as they are on the customer deposits,” Moody’s Investors Service stated in a comment by analysts Alpona Banerji, Nondas Nicolaides and Colin Ellis on June 22.

Greece’s banks were shut down June 29 for six days to prevent their collapse a day ahead of Greece’s default on a €1.6 billion debt payment to the International Monetary Fund with withdrawals limited to €60 a day. On July 6 the capital controls on the bank were extended through July 9. Also on July 6, the day after Greek voters soundly defeated the European Union’s austerity proposals in a referendum, the Governing Council of the ECB held steady its €89 billion cap on emergency liquidity assistance but also tightened the screws by requiring the Bank of Greece to apply haircuts to the collateral from banks for the funds the central bank advances under the emergency program.

Resolving the Greek crisis will necessarily also mean finding a way to bolster confidence in the banks by boosting their capital levels. The banks last year raised €8.3 billion in private capital but now need additional capital injections to bolster their balance sheets. Without the capital, the banks will continue to shrink their balance sheet to compensate for rising levels of non-performing loans and falling deposits, starving the Greek economy of money, its economic lifeblood, according to Hanke.

While in the past the banks could have gone to the financial markets to raise real equity capital, the window of opportunity may be closing. “That’s just not going to happen because the price of shares in the banks is way below book value,” Hanke says. More shares would just completely dilute the value of existing shares, he argues. A second option, going to the Greek government for capital injections, is “improbable,” says Hanke, because the government has no money to do the recapitalization. A third option would be to have the European Union recapitalize the bank and, in effect, take ownership of the Greek banks – but that may be politically impossible, he adds.

One viable option, say Hanke, would be for the Greek government to privatize some of its considerable holdings of land and buildings to raise the cash to capitalize and nationalize the banks, a more politically palatable resolution. “That should be their top priority because without the banks functioning you have an engine shut down that normally supplies 87 percent of the money in the system,” says Hanke.

Friday, July 10, 2015

Greek Prime Minister Alexis Tsipras Capitulates

There's no way to interpret the proposal of terms from Greece to obtain yet another bailout other than to say Greek Prime Minister Alexis Tsipras has caved to European Union demands, mostly the terms of Germany's finance minister Wolfgang Schaeuble.

July 10, 2015

Here is the Greek proposal.

Also, see scathing analysis from naked capitalism here.

Also, see analysis from The Business Insider here.

Friday, June 26, 2015

Dennis Gartman: Own European stocks, sell euro

Dennis Gartman of The Gartman Letter talks about how to  trade Europe amid Greek tensions on CNBC, June 25, 2015. He thinks that the euro would be better off without Greece in it and would prefer to see a Grexit than to see Greece stay in the monetary union.

Wednesday, June 17, 2015

Ron Baron: "I love Tesla," "a huge opportunity"

Ron Baron, Baron Capital Chairman & CEO, explains why he loves investing in Tesla. He was interviewed on CNBC's Squawk Box, June 17, 2015.

Tuesday, March 31, 2015

Kevin Warsh: The Fed is spoiling 'exhausted markets'

Kevin Warsh speaking on CNBC's Squawk Box
March 31, 2015, 7:15 am