In Fed We Trust

David Wessel, “In Fed We Trust” (Ben Bernanke’s War On The Great Panic: How The Federal Reserve Became The Fourth Branch Of Government), Crown Publishing, 2009, 275 Pages

Whenever I read about the thought processes and actions of anyone associated with government, I question where the adults are and why these people are permitted outside late at night without supervision. Therefore I was pleasantly surprised by this book: truly a tale of competent adults keeping us out of Depression 2.0. The tale told is called the “Great Panic” to distinguish it from the Great Depression. This is a particularly important book and is an easily understood “guide for Dummies.”

Of course my admiration may be shared by questionable characters: In late spring, 2009, Gao Xiqing, president of the powerful China Investment Corporation, remarked that when China looked at the United States nowadays it saw “socialism with American characteristics”. He was only half-joking.

However I do not admire that none of the main characters of this book saw this coming (Bernanke, Geithner, nor Paulson). This book does not adequately deal with this failure other than to blame it on Greenspan.

In the space of a year, the US government has taken over most of the domestic car industry, pumped hundreds of billions of dollars into its banking system, assumed the operations of huge portions of the formerly private credit markets and entered into a new era of trillion-dollar fiscal deficits. The Chinese must be particularly impressed that this government expansion has been conceived and executed by unelected officials of the Federal Reserve. Yet I find the reasons most of these actions have been taken are convincing and therefore necessary. Congress could never react quickly enough, and in the one instance it did react and have influence, namely the auto industry, it was a huge mistake.

With the exception of the decision to allow Lehman Brothers to go bankrupt, which has since been taken as the unofficial starting date of the meltdown, at every stage the Fed chairman has taken big risks, probably stretching the legal limits, to avoid another Depression.

My Notes:

Pg. 23: ‘Everything fell apart after Lehman,’ Alan Blinder, a Princeton economist and former Fed vice chairman, later wrote. ‘People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear’s rescue, the Lehman decision tossed the presumed rulebook out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not? After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.’

Pg. 25: Two harrowing days after Lehman’s collapse, with markets bruised and panic spreading, the Fed shelled out $85 billion to prevent AIG, the big insurer, from following Lehman to bankruptcy court. (Of course, AIG had really turned in to a Hedge Fund much to everyone’s surprise!).

Pg. 45: In the wake of the Depression, Congress made the only substantial changes to the Federal Reserve Act it has ever made. In 1935, it removed the Treasury secretary and comptroller of the currency from the board in Washington, renamed it the Board of Governors of the Federal Reserve System to emphasize its primacy over the district banks, and changed the title of the heads of the regional banks from ‘governor’ to ‘president.’ Even more significant, Congress diluted the power of the regional Fed banks to set interest rates by creating a Washington-dominated committee, the Federal Open Market Committee. All seven governors in Washington have a vote at all times, but only five of the twelve regional bank presidents vote in any one year, serving in a rotation dictated by statute.

Pg. 86: Some foreign central banks—including the European Central Bank, the Bank of England, and the Bank of Japan—are given one and only one explicit goal: price stability. The Fed, in contrast, was instructed by Congress in 1977 to aim at both ‘maximum employment’ and ‘stable prices. Democrats in Congress warned Bernanke against any unilateral move to alter the Fed’s priorities an admonition that Bernanke, like Greenspan before him, countered by maintain that price stability was the road to maximizing employment and economic growth.

Pg. 88: Cracks in the subprime market began to surface in 2007. In January and February 2007, several subprime mortgage originators filed for bankruptcy court protection. In March, New Century Financial—one of the largest subprime lenders—stopped making loans and said it needed emergency financing; a month later, it, too, was in bankruptcy.

Pg. 98: To lower rates, the Fed (or any other central bank) creates money from nothing, a process called ‘printing money,’ even though it is electronic, and uses that money to buy U.S. Treasury securities from the portfolios of the banks. The banks then have fewer securities but more money to lend. This increased supply of money lowers the federal funds rate, the price of money. When the Fed wants to push up rates, it siphons money out of the market by selling government securities from its vast portfolio; this reduces the credit supply and raises the price of money. The Fed’s balance sheet—its portfolio of government securities and loans on one side (its assets) and the reserves of the banks and currency in circulation on the other (its liabilities)—is part of the magic of central banking. Because the Fed can create money, it can buy as many bonds and make as many loans as it wants. In August 2007, the Fed had a $900 billion portfolio, of which $850 billion was in U.S. Treasury securities of one kind or another.

Pg. 103: The Fed and nearly everyone else had taken false comfort in labeling the behavior of twenty-first-century banks a ‘originate and distribute.’ The notion was that by packaging loans into securities that were sold to investors all over the world, the banks would not get stuck if loans went bad.

Pg. 106: By the summer of 2007, the Fed was stocked with veterans of market crises: the stock market crash of 1987, the savings and loan scandal of the late 1980s and early 1990s, the commercial banking and real estate woes of the early 1990s, the Asian financial crisis of the late 1990s, the bursting of the tech-stock bubble in 2000, and the September 11 terrorist attacks. The conventional wisdom was that crises were unavoidable despite all the best efforts at prevention. The countervailing comfort was that cleverly conceived and targeted responses by the Fed and Treasury—even if flawed in detail—could limit the economic damage from even the most frightening shocks.

Pg. 128: The difficulty in putting a value on loans, securities, and exotic financial instruments banks were carrying on their books became one of the most debilitating features of the Great Panic. With the usual market mechanisms dysfunctional, no one would be sure the assets were properly valued—and that all the losses had been disclosed—so everyone assumed the worst, a problem that would persist into 2009.

Pg. 149: Encouraged by Greenspan, Congress repealed the Glass-Steagall Act in 1999. (Provisions that prohibit a bank holding company owning other financial companies were repealed on November 12, 1999, by the Gramm-Leach-Bliley Act.) Big financial firms grew into banking-insurance-brokerage-trading behemoths like Citigroup. Investment banks, supposedly just outside the Fed’s safety net, became a bigger more vital part of the system. As loans were made by one outfit, packaged into securities by another and sold to investors, and then other outfits bought and sold insurance (called ‘credit default swaps’) on those loans, the shadow banking system’ outside the bran-name, Fed protected commercial banks exploded with a bewildering array of securities, each with its own acronym.