In Fed We Trust (?): Part 2

The internet ran out of Bernanke pictures
this was the best I could find, sorry
in many ways it is just as bizarre
as the tale you're about to read


"You Will Never Trust the Fed Again" is a tad more intense than my assessment.

David Wessel says the Fed was bad when it didn't act or warn despite knowing calamity was at hand. He says their money-aggressiveness saved the financial sector, its leaders and preserved the bonus system. Salaries at the Fed are extraordinary, and the Fed is on a major hiring spree right now. This is the story of how power players quickly used trillions of public dollars to pay both winners and losers of the Great Derivatives Game.

According to Wessel, the raison d'être of the Fed is to regulate credit, to oversee fiat money - that if money were only Gold and Silver coin, we wouldn't have a central bank. The Fed uses Federal Reserve Notes as a substitute and that is the first key to understanding its power. That's how central banks got started, beginning in 17th century Britain.

We get historical background - the significance of the Panic of 1907 as well as The Great Depression in creating the Federal Reserve as it used to be. Then the book gets interesting starting when Alan Greenspan became the celebrity chairman and marched the country to The Great Panic with additional actors joining.

The book leads to the conclusion that the Fed set itself up as the major beneficiary of the crisis, using its powers to pour liquidity on the fire with self-interested selectivity. Wessel calls the Fed the Fourth Branch of Government and warns it's not directly accountable to voters. The question naturally arises whether it will be possible for a candidate to become president without its imprimatur.

Wessel enumerates the people who created and benefited from what he calls "The Great Panic." He cites the Fed for its 3-pronged contribution: keeping interest rates too low for too long; not using its regulatory powers; and Alan Greenspan successfully advocating the view that markets self-regulate. He contends Greenspan actually believed the rich and powerful would keep the financial game going because they held such a strong interest in it. Greenspan later said in a weak admission that his world view was wrong.

The book gives the chronological order of the Fed's response to The Great Panic: it rescued Bear, not Lehman for lack of a Plan B when there was no buyer, the AIG fiasco and everything else. Wessel says the Fed, with its huge staff of PhD economists and insider connections, didn't understand AIG. Perhaps it is too disturbing to the author to acknowledge the Fed understood AIG quite well.

AIG had been doing unregulated derivative deals with the major investment firms. In the very early part of the previous administration, Congress drove through a law that forbade government to regulate derivatives. Before then, regulatory agencies weren't regulating derivatives, but the Fed and the financial industry feared the possibility of regulation. Then the derivatives game exploded, going from some billions to hundreds of trillions - an absurd situation that made some people very rich, very quickly. Warren Buffett famously called derivatives "weapons of mass destruction." Everybody knew this would someday blow up, but public funds were not meant to backstop those that couldn't pay up.

AIG derivatives traders appear to have deliberately wrote and sold losing derivatives. These derivatives methodically took the wrong side of the bet but matured years later, so they wouldn't be exercised for some years. In return for taking the wrong side of the bet, they received cash up-front. Goldman Sachs and many investment banks from around the world bought into the scheme, which promised enormous returns that one could never get in a normal investment, but they had to pay AIG a fee for each contract.

AIG immediately took the windfall cash receipts and paid them out as huge multi-million dollar bonuses. At the same time, the ratings agencies gave AIG two thumbs up. We are told the Fed failed to understand that when the derivatives matured, AIG would not have the money and that it would be of a magnitude beyond anything any corporation on earth could pay. Wessel seems overly diplomatic, thus I cannot award the full five stars.

Due to the size of the matter and the possibility that government would not be able to contain the panic unless it took the position that it would not enforce unregulated derivative contracts, the Fed provided trillions quickly and without transparency. Taxpayer money immediately got routed through AIG and paid out to Goldman Sachs and others.

Much information about money movements was withheld from Congress and much continues to be withheld. The central fact is that the Fed has unlimited power when circumstances are unusual and exigent. Thus the Fed strategically placed almost $2 trillion in the financial sector in addition to other financial commitments.

That kind of money could have funded grand infrastructure projects that would have created good jobs for the real economy and incomes for mortgage payments. But time was of the essence and political leadership was lacking. The Fed moved decisively when the country was most exposed and at its weakest with a disengaged President at the end of his second term.

The book explains the political position of the Fed and Ben Bernanke, and the near inevitability of increased power residing in the Fed (Obama's plan) or conversely increasing transparency (Ron Paul's bill). The Fed does not want to disclose what happened to the entire $2 trillion. Instead it has used a public relations campaign, and in a display of raw power has even hired a former Enron employee as its lobbyist to Congress. Whatever the price, the Fed has "crossed the Rubicon."

In Fed We Trust provides this lesson on how the Fed should respond to deflationary crises (panics): To save the country, you must save the existing financial system. To save the financial system, you can't help but bailout those sharing responsibility for the problem and you even utilize them to help fix the problem. It's unfair but Wessel warns against populist sentiments. Then you put better regulation in place. Further, you maintain foreign confidence in the Fed with special attention to China. This points to reappointing Ben Bernanke to show continuity in both the Fed and the White House.

Surely Wessel has a point about not going overboard with populist sentiments despite the incredible unfairness with which liquidity was distributed. And we can't argue with the fact that without the Fed's supernumerary powers, our collapse could have become an immediate Depression unless the government had chosen not to enforce unregulated derivative contracts.

Quite apparently, something is terribly wrong. Wessel is only a diplomatic messenger, albeit a well-connected one. But to end up debating how much power the Fed should have in the face of the favoritism it has shown demonstrates how far the nation has been knocked off course. Citizens need only visit a bank for a mortgage or business loan to verify that we are no beneficiaries of Fed largess. Soon there will be additional taxes to pay.

The following is a selection of high-profile people that clearly predicted the collapse if not the Fed's Machiavellian response: Nouriel Roubini, David Walker, Nassim Nicholas Taleb, Joseph Stiglitz, Stephen Roach, Stephanie Pomboy, Naomi Klein, Ron Paul, Robert D. Manning, Danny Schechter, Juliet Schor, Alf Field, Peter G. Peterson, John Rubino, Daniel A. Arnold, John R. Talbott, Park Dae-sung, Bill Gross, Jim Sinclair, John Mauldin, Fred Hickey, Robert J. Shiller, Barry Ritholtz, Marc Faber, Richard Rainwater, George Soros, Peter Schiff, Bob Bixby, Martin Weiss, Robert Prechter, David Tice, James D. Scurlock, Elizabeth Warren and Paul Krugman.

This is why we let Amazon stick around (well, also for gems like this). If anyone finishes the book before I do, please let me know.

It has been pointed out to me that Michael Panzner is suspiciously missing from the above list. No list of those who foresaw the financial crisis is complete without him! (thanks, RS)

Jr Deputy Accountant

Some say he’s half man half fish, others say he’s more of a seventy/thirty split. Either way he’s a fishy bastard.