Wednesday, December 2, 2009 14 comments ++[ CLICK TO COMMENT ]++

Opinion: The US govt should re-appoint Ben Bernanke

Resistance is mounting for the re-appointment of Ben Bernanke to the Federal Reserve chairperson position. Those in favour of re-appointment heavily outweigh the dissenters but I sense a shift in the mood. MarketWatch reports that a senator is attempting to block the re-appointment:

Sen. Bernie Sanders placed a hold Wednesday on the nomination of Ben Bernanke for a second four-year term as chairman of the Federal Reserve, saying it's time for a change in economic policies.

Sanders' hold could delay the vote on Bernanke's confirmation, but likely won't derail it. The hold means the Democratic leadership would need at least 60 senators to agree to bring the nomination to a vote, instead of the 50 needed without the hold.

As I have said many times before, Ben Bernanke is not perfect but he is the right person for the job right now. If USA is indeed undergoing a deflationary bust as I suspect, Bernanke is one of the most qualified people out there. This doesn't mean that he will make all the right decisions but I am not too fond of other candidates that have been floated around.

Americans have a right to be wondering about all the central bank policies—a lot of amounting to transferring huge quantity of wealth from taxpayers to bondholders of financial institutions—but blocking the appointment is not going to accomplish much.

I also don't like the fact that the US government is attempting to strip the Federal Reserve of some powers and shift it towards the government. I am not too knowledgeable about government agencies and American laws but I do think some changes can be made. Clearly the FedRes didn't regulate the banks properly! However, some of the wide-ranging proposals being floated around would significantly strengthen various government agencies at the expense of the central bank—I don't like these plans at all.

The fact that the Federal Reserve is largely independent and is partly owned by private owners* (essentially private banks) causes problems and damages society at times. However, this is also what makes monetary policy in America much better than most other countries. The Federal Reserve has acted independently and largely gone against the government (the most recent example was in the 80's when the FedRes tightened monetary policy substancially against the wishes of most politicians.)


* I'm not an expert on banking but my impression is that the Federal Reserve is very unusual. Unlike other central banks, such as Bank of Canada or Bank of England, the Federal Reserve's shareholders are private banks such as Citigroup. This creates an interesting (largely theoretical) situation whereby foreigners can have sizeable impact on the monetary policy of USA. For instance, the biggest shareholder of certain leading private banks have been foreigners at times, and hence they, indirectly, influence the FedRes. However, as far as I know, the private banks only hold shares in one branch bank (USA is divided into regions and have branches representing regions) so the influence is quite limited.

In any case, the power of the private banks are limited. The US government has powerful oversight, such as deciding who to appoint as FedRes chairperson, and controls the currency and banking laws. And, of course, the government controls the military and hence, the FedRes, even if privately owned, is a subordinate of the government, which in turn is a servant of the voting population... or at least that's how I think a democracy is supposed to work.


14 Response to Opinion: The US govt should re-appoint Ben Bernanke

December 5, 2009 at 9:36 AM

1) The illusion that we will be in a deflationary bust for a long time is incorrect. This is similar to Bernanke's opinion that the huge liquidity in 2004-2006 is because of the savings glut. If you read Keynes, this is inherent human nature called animal spirits. Read Kyle Bass' Oct 09 letter  to shareholders where he presents data to show how excess reserves at banks have gone from 2.5 billion to 800 billion all within one year. Remember, each dollar of reserve when the banks loan out has a multiplier effect. All this money currently sitting on the sidelines for no reason other than animal spirits called fear.

December 5, 2009 at 9:36 AM

2) 'The federal reserve did not regulate the banks properly' - this is open for debate. Again, your unfamiliarity with the regulations causes you to being biased. Banks are regulated by rules called Basel I and now Basel II. Basically, banks are required to have capital reserve based on their risk-weighted assets. So, for instance,
- if the bank makes commercial loans, it requires to have 8% of those loans as capital reserves.
- If the bank has mortgages on its books, it requires to have 4% of those loans as capital reserves.
- If the bank has investments in GSE securities or AAA securities as rated by any of the NRSRO (Moodys, S&P, Fitch) then it only requires 1.6% of those investments as capital reserves.
- If the bank creates a SIV and sells its assets to the SIV and provides a LOC (line of credit) to the SIV for less than a year and no other backstop, then no capital reserves are required !

The AAA requirement was added in Basel II.  So, why only 1.6% for GSE (Fannie Mae, Freddie Mac, Ginnie Mae). This goes back to the reason for the origination of the GSE - to create a secondary market for mortgages and thus make housing affordable. The GSE would be the buyer of all the mortgages from the banks, banks would have incentive to sell the loans to them because it reduces their capital reserves, GSE would package them and sell to investors. In turn, the banks would hold the securities issued by the GSE, but only need to hold 1.6% capital. So, my conclusion is that banks were only playing by the rules, obviously to their benefit. The NRSRO's recognized that with the Basel rules basically created a high demand for AAA securities. They rationalized using sophisticated models that the certain tranches of subprime securities are safe since they take the last losses and started churning out lots of AAA securities. Why did this happen? In David Einhorn's opinion (read his value investing congress speech), this is because this is govt blessed oligopoly. Open the market place for NRSRO's and there will be competing rating agencies that will challenge this rating. Again, the banks only played by the rules set by the regulators. I recommend that you stop drinking the kool-aid, and start reading literature that gives you both sides of the coin. Currently, the new administration has perpetuated that wall street has been greedy and that is what has caused the crisis. To some extent,  it is true. However, there is another player. It is the unintented consequences of decades of regulations in a complex world. The current administration - including Bernanke and Geithner are blinded  and behaving as if regulations have no unintented consequences.

Sivaram Velauthapillai
December 6, 2009 at 2:49 PM

You know a lot more about the regulations than me; I'm just an outsider observing things. However, unlike you, who is perhaps an employee of the institutions in question, I have more of a neutral view and don't have incentives. I don't agree with a number of David Einhorn's views so I'm not going to go there but let me address your core argument.

Your view seems to be that the banks were playing by the rules. I actually agree with that. But that should be obvious. If they were not following rules, they may end up breaking laws and the FBI would be breaking down their doors, not the FDIC or the Federal Reserve. So, I agree with you that they were following rules.

However, like any industry, rules are guidelines that are supposed to guide the industry. Industry always tries to get around the regulations while not breaking them (an example is the car industry overcoming the fuel efficiency standards introduced many years ago but shifting heavily into trucks and SUV, many of whom weren't part of the regulation.) The bankers have done the same thing here. So I see two problems.

First problem is that the banks, especially their senior executives and shareholders who profit from them, ran around the regulations. The regulations may say AAA securities are to be held but there is a huge difference between holding a AAA US Treasury bond and a AAA-rated auto loan. The rating agencies are a problem but it still comes down to the "investors" of the securities--in this case, the risk officers at the banks. Regulation really needs to be tightened up in this area.

Secondly, the central banks and other regulatory agencies did not enforce or provide proper oversight. They clearly did not regulate the banks. They kept loosening regulations, some of which I disagree with (such as merging commercial banking and investment banking), and didn't do much.

Sivaram Velauthapillai
December 6, 2009 at 2:55 PM

Overall, I think you are downplaying the culpability of the banks. No one forces a bank to do anything they don't want to. Like I said, a bank could easily buy a AAA-rated US govt bond rather than a AAA-rated synthetic security of some sort. They were reaching for yield and this clearly is their fault.

I also think you are mistaken if you think unintended consequences of regulation was the culprit. As a profit-seeking private business, it is up to the banks to decide what to do (within the law.) If regulation was the problem, every single bank in America would be in the same state. Yet that's not the case. On the investment banking side, you'll see that Goldman Sachs came out alive (although it needed some support with short-term financing); on the commercial banking side, it appears JP Morgan came out alive (but it's hard to say right now given their very-large derivatives book.)

Sivaram Velauthapillai
December 6, 2009 at 3:09 PM

I'm not familiar with Kyle Bass but I'll take a look (thanks for the suggestion.)

I read the situation completely differently. I actually expect very large excess reserves during deflationary busts. I have to confirm this but I believe this happened during the Great Depression as well. There are several reasons you would expect increasing reserves during deflationary busts:

(i) Banks/citizens/businesses save more to handle possible defaults or other adverse scenarios. Currently, there is a potential for massive losses on Alt-A loans, starting next year, and it wouldn't surprise me if banks are keeping reserves for that. As for citizens, they are losing their jobs and may be building up reserves--bank reserves also represent citizen savings so that's why I'm bringing this into the discussion.

(ii) Deflationary bust essentially means more and more people and businesses go bankrupt (they can't service their debt.) This should result in creditworthiness worsening. So it doesn't surprise me that reserves are building because banks have no one worthy enough to lend to. Similarly, borrowers don't want to borrow because they are over-leveraged and don't need to increase debt.

As for animal spirits, you are right in saying that it is probably due to fear. But step back for a minute and think about what animal spirits even mean. I haven't read Keynes but my opinion is that it reflects the psychology of the participants. The question, then, is, whether the animal spirits are rational or irrational in this case. If you believe debt defaults are still possible then the fear is valid. If you think de-leveraging will continute then the fear makes sense. And so on.

I agree with you that, if the reserves are loaned out, it will be highly inflationary, with huge multiplicative effect. But I lean towards debt deflation and hence don't think the banks will loan them out like they have over the last 30 years.

To sum up, the question is not whether fear permeates the banking world. Instead, it is whether the fear is rational or not. Should banks be loaning out more money? Should businesses and individuals starting borrowing heavily? It remains to be seen... I say credit growth is going to be weak, especially once governments curb their stimulus programs...

December 6, 2009 at 11:41 PM

I am not downplaying the culpability of banks. If you read Fools Gold, it says the same thing that you are saying. In the end, this is still free enterprise. Banks can still choose to be prudent. JP Morgan did that. However, if you were reading JP's annual reports during 03-07 they really were swimming upstream compared to the other commercial banks specifically Citi. How many banks have CEOs that put their career at risk and are willing to years of being a contrarian? Citi had 7 SIVs setup to offload its assets via these shadow banks. Regulators loved it since they were 'shipping the risks'  in theory via the SIVs to far and wide places whereas JP decided to keep these assets on the books and thus had to have more capital reserves for these assets. JP had 0 SIVs. (remember that no capital reserves are required for assets offloaded to an SIV). Now that Citi had more capital freed up, they could grow their balance sheets even further. This is how Citi become the biggest commercial bank. Then, there was the panic of 2007 (read Gary Gorton's paper) where the ABCP market frooze up. The financing for the SIVs dryed up and then Citi had to extend the line of credit to the SIVs to maintain its reputation. Then, Citi had a series of writedowns in Q4 07 and Q1 08. Citi was not trying to work around any regulations. They were playing by the rules.

My question is how come when the regulators designed this specific regulation they did not think about the consequence that the particular regulation will give rise to off-balance sheet conduits and add to systemic risk? In theory if we could design a more thorough set of regulations, then we can get around the issue. Therein lies the problem.

December 6, 2009 at 11:46 PM

'there is a huge difference between holding a AAA US Treasury bond and a AAA-rated auto loan'

If there is a difference why are securitized auto-loans marked as AAA? The point of the ratings is that each person investing in the security does not have to be a credit analyst. Either open the market place to other rating agencies that can challenge the AAA ratings (of auto-loans) like David Einhorn says or go back to olden times where the risk manager of a bank or financial institution has a mandate to invest prudently and thus has to have inhouse credit analysis expertise like Prem Watsa says (in his latest interview - read on Gurufocus).

December 6, 2009 at 11:47 PM

'However, unlike you, who is perhaps an employee of the institutions in question, I have more of a neutral view and don't have incentives'

I am also an outside observer. Not employed in any kind of financial institution.

December 7, 2009 at 12:12 AM

'Secondly, the central banks and other regulatory agencies did not enforce or provide proper oversight. They clearly did not regulate the banks.'

The problem did not originate in the commercial banks that were regulated by the Fed. It was in the shadow banks (read '<span>The Shadow Banking System:
Implications for Financial Regulation' on ny fed's website). Specifically, the SIVs sponsored by commercial banks and the investment banks (Bear, Lehman, Goldman). The shadow banks relied on short-term funding - ABCP and repos. The collateral used in either case were mortgage-backed CDO. When markets lost faith in the value of the collateral, the market froze. The shadow banks were not regulated by the FED since they do not take deposits from depositors. Also, since they are not regulated, they do not have access to Fed's discount window. So, when the market froze, and there were no buyers for the assets held by the shadow banks, they could not go to the Fed and raise short-term financing (commercial banks can do that). In case of the SIVS, the sponsoring banks took the assets back on their balance sheet. In case of the Bear, Fed gave access to its discount window via JP morgan. Thus, Bear could post collateral to the Fed through JP and raise financing to run their operations. In case of Lehman, they decided to let it fail.</span>
<span>So, it is not a question of improper regulation of commercial banks. There was nothing improper. It is that the shadow banks grew under the nose of the Fed which was totally unregulated. Why did the shadow banks grow? One reason is capital regulation relief. (SIVs for commercial banks).</span>
<span>The Fed should have let all the shadow banks fail since they were not being regulated. They took the risks, they ought to fail. However, this goes against the popular opinion that the failure of Lehman is what made the crisis go from bad to severe. John Taylor, an economist at Stanford, has done emperical studies to challenge this point-of-view. You can read his new book called 'Getting off Track' to understand this. </span>

December 7, 2009 at 12:15 AM

'such as merging commercial banking and investment banking'

This had nothing to do with the crisis that happened. The crisis started in the shadow banks.

December 7, 2009 at 12:20 AM

'Yet that's not the case. On the investment banking side, you'll see that Goldman Sachs came out alive'

When AIG got bailed out, the Fed bought out the underlying securities that AIGFP had sold CDS for. What price did the Fed pay for the underlying securities when they bought them from AIG's counterparties. They bought the securities at par ! This was at a time when there was no secondary market for these securities. Which means that these counterparties could not have sold these securities in the market place for any price. So, instead of buying them with some kind of haircut, the NY Fed led by Timothy Geithner, decided to bail out the counterparties by buying these securities at full price. Who was one of the biggest counterparty? Goldman. Read Neil Borofsky's audit report on the AIG bailout for details at

December 7, 2009 at 12:29 AM

'I agree with you that, if the reserves are loaned out, it will be highly inflationary, with huge multiplicative effect. But I lean towards debt deflation and hence don't think the banks will loan them out like they have over the last 30 years'

I will stop by suggesting that you read 'Monetary Regimes and Inflation' by Peter Bernholz.

December 7, 2009 at 3:08 AM

Furthermore, the orderly restructuring of distressed investment banks would not have been possible without the repeal of Glass-Steagall - acquisition of Bear by JP and Merill by Bank of America. Claims that the merging of commercial and investment banks causing the crisis are without merit.

Sivaram Velauthapillai
December 7, 2009 at 2:49 PM

Thanks for the responses... I'll respond when I get a chance...

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