Bernanke Under Fire: Grayson / Paul

In a letter to The Senate Banking Committee today Representatives Grayson and Paul demanded of Senator Dodd that Bernanke's reconfirmation hearing be suspended until The Fed provides answers to several questions, specifically:

1. Information that Bloomberg reporter Mark Pittman has requested via a Freedom of Information Act Request on the Bear Stearns rescue and that the Federal Reserve is contesting in the courts and which Manhattan Chief U.S. District Judge Loretta Preska has ordered by turned over by the Federal Reserve.
   
   
2. Information that Rep. Grayson requested in February at a hearing and by follow-up letter on which institutions received the $1.2 trillion added to the Federal Reserve’s balance sheet, how much each institution received, and what was promised in return.
   
   
3. All Federal Reserve documents that went to Attorney General Andrew Cuomo’s office relating to the Bank of America/Merrill Lynch merger in which potentially illegal and coercive activity might have occurred, as well all Federal Reserve documents relating to the lawsuit pursued by Merrill Lynch shareholders in the US District court for the Southern District of New York.
   
   
4. Transcripts of all Open Market Meeting Minutes up to and including that of June, 2009, transcripts which are normally withheld from the public for five years.
   
   
5. Full disclosure of all terms and conditions of all off-balance sheet Fed transactions in the past three years.

I have been sharply critical of Representative Paul over the previous two years in The Ticker, mostly due to the fact that he has refused to display evidence that he "gets it", including questioning directed to Fed Chair Bernanke in multiple hearings since this crisis began.  "Hard money", his "all the time, every time" issue will no more solve the problems our nation faces than will wishing for The Easter Bunny or believing in Santa Claus.

But today I am forced to change my beliefs, at least in part.  I don't know if Representative Grayson turned a light on or if Representative Paul simply woke up over the last couple of months, but what I see here before me is a substantive and welcome change.

Now I want to challenge both Representatives Paul and Grayson, as well as the rest of the House and Senate, to consider the following points:

1. This is not a Recession.  It is a Depression.  All credit-led economic downturns are.  If you doubt that this is a Depression have a look at the article in The Detroit News today, chronicling a scene every bit as forlorn as was seen in the 1930s, every bit as poignant, and every bit as unnecessary.  It was asked:
   
   "This morning, I seen the curtain pulled back on the misery," he said. "People fighting over a line. People threatening to shoot each other. Is this what we've come to?"
   
   It is what we will come to nationally if we do not stop the stupidity here and now.
   
   Government created this Depression just as Government created the Depression of the 1930s by refusing to do its job of regulation.  75% of the people in the 1930s had jobs.  75% of people have jobs now.  If you truly believe that unemployment is 9.something percent, you're delusional.  If you believe it is the 16.x percent that is recorded in "U-6" you are likewise delusional as neither counts those who have given up trying to find work.  Take a trip to Detroit, Michigan.  It is not that different from any other major city today.  If your perspective is limited to the Beltway of Washington DC or the sheltered parts of America where it all appears ok you need to get out more often.  I have, I lived in the Detroit area in the 1970s and 1980s, and I have never - ever - seen anything like what happened at Cobo Hall as described in that article before today in America.  Anywhere.
   
   
2. This Depression was caused by the same thing all others in modern times have been: banks lending unsecured beyond excess reserves.  That is, banks lending in a speculative rather than secured manner. That is the primary sin. It is that simple. It has always been the primary sin that has led to this result, and it is the primary sin this time as well. This must end, now and forever, if we are to both stop this lunacy and prevent it from ever happening again.  Our regulators, our Congress, and so-called "economists" have spent more than two years waving their arms claiming that this or that "tweak" to the regulatory structure will prevent systemic risk and set things right.  They're either wrong or lying and the proof lies in mathematics, not political or philosophical dicta.  If you need an explanation, read "Sound Banking: A Capitalist Imperative."  Reality is that if you provide a business with a means to speculate with someone else's money (in this case, yours and mine through the credit of the sovereign) they will do so recklessly since the losses are not theirs.  You can only prevent this outcome by barring the practice.
   
   
3. We have compounded that sin by refusing to force banks to admit to their insolvencies, and there are in fact many, even a majority, that are insolvent.  They are not "mildly" or "slightly" insolvent either.  Just last week Warren Bank failed and was seized by the FDIC.  The loss to the deposit fund is estimated at $275 million out of an asset base of $538 million - that is, the bank was underwater by 51%.  But it is, in fact, much worse than that since "well-capitalized" according to the government requires a Tier 1 Leverage capital ratio of at least 5%.  To fail "adequately capitalized" you must have Tier 1 Leverage capital under 4%.  To put this in perspective this bank failed 12.75 times before being seized.  This is not an accident, it is willful, deliberate regulatory malfeasance or fraud on the part of examiners and institutions.  There is no other possible explanation.  This is also not an isolated incident; Colonial Bank was seized recently, a huge bank, and the assets were written down 39% - a nearly ten-fold failure before being seized.
   
   
4. The government cannot make up for the contraction in private credit.  All the government is doing is risking its own insolvency.  We cannot run trillion dollar+ deficits - Depression or no Depression.  We cannot continue to take bad debt onto the balance sheet of Treasury or The Fed and we cannot make unsound FHA (and now USDA!) real estate loans.  WE CANNOT LIE OUR WAY OUT OF THIS.  Despite the fact that Washington DC politicians are known for lying whenever their lips are moving, mathematics never lies and always catches up with you - without exception.
   
   
5. The Government's continued mendacity in this matter is leading to the destruction of the Dollar and, potentially, our economy and government funding mechanisms.  We now have an active "carry trade" going on using dollars as the funding currency - an unthinkable situation just a few months ago.  The credit system is functioning only in places where tens or even hundreds of billions in printed money are being used to "purchase" worthless (or nearly-so) loans.  Fannie, Freddie and now the FHA have become embroiled in a futile attempt to prop up residential property markets, which in turn has led banks to withhold foreclosure actions as a means of hiding losses.  This in turn has trapped millions of homeowners in underwater property, preventing them from moving to seek better employment opportunities and creating artificial shortages of housing in some MSAs as inventory is "locked up" by banks as a means to avoid recognition of losses that have already occurred.
   
   
6. We cannot restore our economy to health until we force the bad debt out of the system.  We must stop trying to layer on more debt to pay interest on existing debt, and we must stop playing shell games with the bad debt that exists.  It is mathematically impossible for credit creation to continue at a rate exceeding growth in output on a continual basis.  The fraudulent granting of credit with no assets or capital behind it (#2 and #3) is why we are here.  The only path to a durable economic recovery is to stop doing that which led us into the mess in the first place.

Given these facts we have choices to make as a nation.

We can choose to continue that which has failed, or we can choose to reform the banking and financial system.  We can insist that the banking and financial system face the following regulatory changes:

• Mark all assets to the market, now and forevermore, on a nightly basis.  If this results in firms becoming insolvent, then so be it.  We need a banking system - we do not need the specific banks we have operating today.
  
  
• Pass a federal law mandating that receiving deposits or transacting business while insolvent is a felony, as is the case in several states.  Then enforce it.  Strictly.
  
  
• Define insolvency as the inability to pay all depositors at any point in time through ordinary business transactions.  This implements the requirement that banks lend unsecured only to the limit of their excess capital and never beyond.  Banks can lend to any degree they'd like provided they have capital or assets of at least the outstanding balance behind each loan.  If a bank wishes to lend to you on a credit card, it must hold one dollar of capital for each dollar you have outstanding on your charge plate.  If a bank wishes to write a 100% LTV home mortgage it may, but it must hold one dollar of capital for each dollar of loan balance beyond your home's recovery value - including resale expenses.  It is a bank's decision how close it wishes to operate to the line of insolvency and forced closure and it is also a bank's decision as to how much capital it wishes to raise; the less "cushion" it wishes to maintain the greater the risk that its shareholders and unsecured bondholders will lose everything through an unexpected drop in the market value of the assets behind their loans.  This removes all the nonsense and games about "leverage" and reduces it to one simple reality: you may not impugn the credit of the sovereign (The Federal Government) as a private enterprise.  Period.
  
  
• Force The Federal Reserve to disgorge all of its non-government-guaranteed paper.  The Federal Reserve Act (Section 14) clearly does not permit the purchase of any such obligation.  This is a monstrous problem as there could be hundreds of billions of dollars in losses embedded in that paper and it was acquired illegally.  Such a loss, if and when it detonates on their balance sheet, will have severe and perhaps catastrophic consequences for our government, our banking system and the dollar.  The entire essence of Mr. Paul's and Mr. Grayson's (very valid) complaint is that The Fed is preventing trash debt resolution by taking it onto its own balance sheet and refusing to disclose that it has done so and how it has valued those so-called "assets."  Disclosure is laudable but requiring The Federal Reserve to actually live within the strictures of The Federal Reserve Act should be the standard we demand.
  
  

These four steps end the credit crunch tomorrow and prevent it from ever returning.  They also end a number of large financial institutions tomorrow.  That's ok - there are literally 330 million capitalists in this nation, some of whom will want to start new banks, and there are also thousands of community banks and credit unions that can operate within these rules.

No, these steps will not bring back the "free credit" world of the 2000s.  That is gone forever whether we like it or not.  Credit will be available to worthy borrowers at a risk-adjusted interest rate that reasonably reflects the probability of default and inflation, plus a fair, demanded profit.  This is how credit should have been for the past 230 years of this nation's history, and how it can be going forward.

In addition The Federal Government must adjust its policies and operations, specifically:

• The government cannot spend more than it makes.  With the possible exception of a declared war, deficit spending is indefensible, especially when the deficit reaches 30, 40 or even 50% of the entire Federal operating budget.  If government wishes to increase spending then it must increase tax revenues.  This in turn requires that The Government take a long, cold, hard look at how we can couple tax revenues to growth.  I am a personal advocate of The Fair Tax because it aligns Federal Revenue with GDP and thus provides a powerful incentive for the government to act in a manner that promotes economic prosperity, but there are undoubtedly other means of accomplishing this central goal.
  
  
• The government must not bail people out.  The essence of capitalism is that when you screw up you fail - and go bankrupt.  Only the hand of the market provides disincentives to bad decisions - either prospectively or, if not heeded, retrospectively by clearing the playing field for new entrants in the place of failed enterprises.  The US car companies are prime examples; "Cash for Clunkers" and the US Auto Bailouts have been dismal failures; the collapse in sales in September has made clear that Chrysler, for example, is almost certain to fail to survive more than another year, even when the billions given to Cerberus to "restructure."  That was pure money down the drain that accomplished nothing other than suspending Chrysler's death sentence for a few months to a year, yet it has blocked the acquisition of those facilities by a potential competitor as-yet unknown.  The economic damage done via these interventions is severe and irreversible.
  
  
• Government must enforce laws against fraud in all areas of the market evenly and swiftly.  Banks, as just one example, cannot be permitted to "re-order" transactions so as to generate the maximum in overdraft and other "junk" fees - a clearly unfair business practice.  The practice of pretending that loans are performing when they are not by shuffling paper around between subsidiaries must bring prosecutions, not forbearance.   When someone is cheated (for example by bogus "ratings" on securities or unlawful front-running in the markets) they need to be able to look to the government for help, rather than the bad actors taking cover behind willful regulatory blindness.

The rest of the world is passing judgment on our nation's willingness and even ability to rein in the rampant financial fraud and outrageous acts that led us to this precipice.  These nations are, quite realistically, looking to diversify away from the dollar for international transactions and as a reserve currency as they perceive that our government and business environment has become nothing more than a giant looting machine operated for the benefit of a handful of firms and people on Wall Street who have been and will be allowed to siphon off whatever they desire at everyone else's expense.

Firms and individuals worldwide were sold well over a trillion dollars of worthless securities by these bad actors.  Some of them, such as the Chinese and large foreign banks, appear to have received a "back door" bailout via unannounced and likely unlawful actions of The Fed, while others have been left to twist in the wind.

Lehman was permitted to co-mingle customer margin funds with their own operating capital, resulting in billions of dollars of customer wealth that should not have been at risk being tied up in the bankruptcy courts, possibly for years, with a very real risk that it will never be returned to its rightful owners.  At the same time The NY Fed may have have received their funds back immediately after the filing in violation of bankruptcy preference laws.

Our banking system is currently hiding hundreds of billions in defaulted mortgage loans "off book" via exotic and undisclosed financial shenanigans.  In the instances where these properties are being disposed of huge losses, often in excess of 50%, are being realized - yet this is not being recognized as the "mark" on similar securities held by other institutions as it should be.  This is presenting a false view of financial institution health, but more importantly it is severely constraining credit as consumers trapped in these homes where banks are refusing to proceed to foreclosure are unable to proceed to rebuild their credit while the banks are stuck with an "asset" they are refusing to sell at its market price, clogging up their credit origination capacity.  Worse, those institutions that are disposing of these "assets" have first put in place "loss-share" arrangements where the FDIC or Treasury is in fact "eating" 90 or 95% of the losses - meaning that the loss of value in these assets (houses) is being distributed as a tax to all Americans!  The banks that distributed these "profits" to shareholders and executives on the way up have managed to set up a "heads we win and keep it, tails you lose and eat it" circumstance - but only for them.  For the homeowner he's bankrupted by these shenanigans and those who refused to participate in the fraud get the tax bill.

We can choose to address these problems now or we can continue to march toward the abyss.  The loss of confidence in our government, in our regulatory agencies and indeed in our currency is on the brink of becoming disorderly.  Should that point be reached it will be too late to take remedial action and our nation will be forced to suffer the (well-deserved) consequences of our willful blindness to these outrageous acts of looting, all of which will come raining down on American consumer's heads.

We the people must insist on better and hold our lawmakers feet to the fire.  If the Washington DC politicians will not do their jobs then we must in turn insist that our state lawmakers do so - including, if necessary, by enforcement of our State 10th Amendment rights.