Friday, December 18, 2009

Bernarke: Moral Hazard Man of the Year

As a financial consultant and blogger who has been closely following the economic crisis since 2007, I nodded my head in agreement when I heard U.S. Chairman of the Federal Reserve was named Time Magazine’s 2009 Person of the Year

Ben Bernarke should be the Time Person of the Year. Not because he saved the United States from a second Great Depression, but because he created a new economic order and enshrined moral hazard for the most powerful financial institutions in the nation.

In the past, only commercial banks enjoyed the backing of the federal government (vis a vis the FDIC) because they were closely regulated and had to put aside capital reserves to cover potential losses.

Under his guidance as chairman, the Federal Reserve actively intervened to decide which industries and companies would live or die. Before the crisis, investment banks and industrial credit companies like GMAC were not backed by the government precisely because they didn’t submit to supervision.

As the credit bubble collapsed and money became harder to come by, the Fed decided to provide liquidity to every financial institution it deemed “too big to fail.” Bernarke directed the Fed to purchase toxic assets from banks. The Fed is now the largest holder of mortgage-backed securities in the nation. In other words, he shifted the burden of selling illiquid assets of unknown value to the taxpayer.

He helped create and enforce the notion that some financial institutions are “too big to fail”. Instead of breaking up the banks, as Paul Volcker suggested, he encouraged them to merge. JP Morgan Chase took over Bear Stearns. Bank of America swallowed Countrywide and Merrill Lynch. Wells Fargo absorbed Wachovia. Their bigness and hence their ability to cause systemic failure has increased exponentially.

The flip side of the coin is that many financial institutions are considered “too small to save.” These are community banks and credit unions that supply much of the lending to small businesses and individuals. They are also the most affected by high unemployment and mortgage foreclosures. As of November 2009, over 120 banks have failed a five-fold increase over 2008. Unlike the “too big to fail” banks, the smaller banks could not trade off the Fed’s explicit guarantee of losses in order to raise funds to replenish their capital.

By keeping interest rates near zero and providing unlimited liquidity rather than insisting on solvency, Ben Bernarke made it easier for companies such as Goldman Sachs to speculate overseas with cheap money. In the meanwhile, credit has tightened for small business and individuals.

But Ben Bernarke’s crowning achievement was that he enforced moral hazard. Moral hazard is when you encourage risky lending because those that take the risk know they will be insulated from their losses. After the Fed’s extensive interventions, there is no doubt that the United States will not allow these “too big to fail” institutions to fail. For them, there is no downside. They take the profits, the taxpayer takes the losses.

It may be conventional wisdom on Wall Street that Zero Ben saved the economy, but on Main Street, which is considered “too small to save”, things are not so upbeat. The economic crisis was not a natural part of a business cycle. It was man-made, the result of a credit bubble collapse stoked by esoteric financial engineering and leverage to the tune of 100 to 1.

The big banks were amply rewarded; first on the upside, and now come January 2010 bonus time, on the downside.

Yesterday in front of Congress Ben Bernarke said there was no evidence of inflation because “the United States economy was operating so far beneath its potential that inflation was unlikely to become a problem.” This is a statement that can only warm the hearts of stockholders. For everyone else, it implies overcapacity and more unemployment.

In any case, his assertion is belied by the Producer Price Index, which registered a surprising spike in prices (excluding food and energy) on Tuesday.

He also said that he saw no sign of a bubble in the stock market. But stock prices have gone up over 60% since February. The stock index in China is up more than 75% this year and the stock in Brazil are up even more. Oil prices have rebounded to over $70 a barrel from the low $40 range in February.

In his 1999 Princeton economics professor days, Ben Bernarke argued that the Fed should get out of the way of bubbles because 1) it wasn't possible to determine when they occurred and 2) if the Fed intervened it would cause more problems. Obviously keeping out of the housing bubble was a serious error. If he is confirmed on Thursday, perhaps the bubble he doesn’t see is the one that will blow up in our faces.


Snowponies said...

Most central bankers only control the money supply to prevent inflation. The Fed actually has two missions controlling the money supply and stimulating growth. (These are sometimes competing objectives.) The Fed is not commissioned to prevent asset bubbles caused as a side effect of policies to stimulate growth. This is a pernicious and persistent problem as the "government never acts without unintended consequences". I agree that this needs to be added to the Fed's mandate.

The Moral Hazard caused by bailing out Investment Banks and other non-banks is an admitted consequence of emergency measures adopted over the past year. It is not in the Fed's power to correct this situation but Congress.

Congress in the thrall of lobbyists lacks the will to enact meaningful reform of our financial system (which is supported by both Bernanke and Geithner).

The windfall profits in the investment banking sector this year are a direct consequence of government policies. Windfall profits taxes as partly enacted in Britain and France (bonus taxes) are in order but not likely in a land where it is not one man/woman one vote but one billion dollars one vote.

whereiscassandra said...

You're right, Snowpony, The Fed and Bernarke can't be blamed for everything. The Treasury bears a lot of responsibility, particularly in the definition of survival oxymoronic "too big to fail" . I'll never forget Paulson's three page TARP contract with Congress, nor his previous promise that all he needed was a "bazooka in his pocket" to deal with Fannie and Freddie.

But what of the opacity of the Fed, and the bankers that sit on its board? It may suggest that it's above politics, but I think bankers on board have their own political agenda that may be at adds with the nation.