Final Thoughts on the Bernanke Nomination and AIG

We posted a new item today that contains our final thoughts on the nomination of Ben Bernanke for another terms as Fed governor. We also feature an interview with Mike Krimminger of the FDIC on that agency’s impending draft rule regarding bank securitizations. The text of the Fed rant is below and you can read the Krimminger interview on our web site: http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

The Institutional Risk Analyst
Final Thoughts on the Bernanke Nomination and AIG
December 14, 2009

Last week after we published his comment on auditing the Fed, our friend Martin Mayer reminded us of a couple of more reasons for the Senate to oppose the Bernanke confirmation. Top among them, according to Mayer, is Bernanke’s appointment of Patrick Parkinson to be head of the Fed’s division of supervision & regulation, a post Parkinson comes to by way of the central bank’s division of research & statistics. Says Mayer:

“An even bigger reason to resist the reappointment of Bernanke is his appointment of Pat Parkinson to be the new head of supervision. Parkinson was Greenspan’s guru on derivatives. Of course, the great benefit of customization of derivatives is the elimination of margin, which is safe enough as long as the Fed will contribute taxpayer money whenever anything goes wrong. The Fed does not protect customers, or the safety and soundness of the institutions, or the taxpayer. Nothing MUST be protected except permission for the institutions the Fed allegedly supervises to keep their freedom to avoid the standardization that might make possible the creation of an honest market from the ruins of what Parkinson defends.”

Suffice to say that many of Parkison’s views on OTC derivatives, which you may see for youself on the Fed’s web site, are seemingly identical to the views of the lobbyists for the large OTC dealer banks. Perhaps we are missing something, but to us Parkinson seems to typify the term “regulatory capture” and specifically the tendency of the Fed’s Washington staff to serve as advocates for the large NY dealer banks, rather than serving the broad public interest. For this reason alone, we think Bernanke deserves to go back to Princeton.

Of note, on Saturday the Wall Street Journal’s Serena Ng and Carrick Mollenkamp published an important contribution to the bailout knowledge base, reporting how Goldman Sachs (GS) used OTC credit default swaps to cause the failure of American International Group (AIG). Entitled “Goldman Fueled AIG Gambles.” the article confirms our long held view that AIG could not have come up with the trading strategies that caused its failure without a little help from GS and several other dealers. Customers just don’t come up with stupid ideas like this on their own. And interesting that the Murdoch-owned WSJ published the revealing piece on a Saturday…

Phill Swagel contacted us last week and said that we were wrong in our characterization of how Fed personnel viewed his Brookings Institution paper, wherein he described the events at Treasury around the time of the AIG bailout. “I can assure you that folks at FRB are not mad about what I wrote. After all, my paper is 50+ pages of defending Fed and Treasury,” says Swagel. True enough, but we stand by our comment.

We think Swagel is too modest. His paper suggests to us at least that Treasury repeatedly abdicated its responsibility to the financial system and the country as it sought to avoid or postpone difficult political battles with the Congress. Swagel concludes that the Treasury and authorities were always behind market developments and were “reactive.” This admission of the Treasury being behind the curve is ironic when juxtaposed with Swagel’s opening revelation that a year before the crisis in the Summer of 2006 Paulson told Treasury staff that it was time to prepare for a financial system challenge.

Did the former GS CEO Hank Paulson already perceive the political issues involving a rescue of a non-bank firm before the failure of Bear, Lehman and AIG? Swagel notes in his paper the narrow role the Paulson Treasury envisioned for itself prior to Bear:

“Treasury had urged institutions to raise capital to provide a buffer against possible losses, but had not contemplated fiscal actions aimed directly at the financial sector. Instead, the main policy levers were seen as being the purview of the Fed, which had cut rates and developed new lending facilities in the face of events.”

We think all observers of the crumbling US financial system owe Phill Swagel a debt of gratitude for describing the events which occurred during his tenure at the Treasury. Too much of the history of Washington is unwritten, just as agencies like the Fed do not seem to be able to follow the law even when it is written down for them. We think every member of the Senate should read Phill Swagel’s paper before voting on the Bernanke nomination.

To us, the Swagel paper illustrates just how badly the Fed mishandled its legal responsibilities during the crisis, a key oversight issue for Congress. The bone of contention we have with Chairman Bernanke, former FRBNY President Tim Geithner, members of the FRBNY board and the Board of Governors in Washington, is governance. When the markets started to come undone in 2008, officials at the Fed did not know their place, legally or politically, and the central bank as well as American democracy suffered as a result. Like we said last week, so much for central bank independence.

Using Bernanke’s own version of events, when the decision was made by Treasury Secretary Paulson to rescue AIG (and his former colleagues and clients at Goldman Sachs and other large bank derivatives dealers), Bernanke and Geithner should have expressed their support – but then only to offer to lend Treasury the cash to accomplish the AIG rescue by the Treasury. Of note, we are working with several media organizations to get a hold of the minutes of the Federal Financing Bank (FFB) for this period. The FFB is the Treasury’s vehicle in all fiscal operations involving private counterparties.

From the perspective of Fed independence, the first failure of Bernanke, Geithner et al in dealing with Treasury Secretary Paulson was not forcing the Secretary to take political responsibility for the bailouts of AIG and even Bear, Stearns. As Martin Mayer reminded us last week, the Fed is subservient to the Congress, not the Executive Branch. The Chairman of the Fed is not supposed to be a “team player,” in the parlance of the political economists who populate the Obama Administration. Saying no to the White House is what central bank independence is really about.

The proper thing for the Fed to have done in the circumstances was to offer financial support to the Treasury to rescue AIG, even without Paulson seeking enabling legislation by the Congress, but force Paulson and President George Bush to take political responsibility for this extraordinary fiscal operation. The Fed, by stepping in front of the Treasury, committed an act of political intervention as well as intervening in the financial markets. Bernanke neatly allowed President Bush and Secretary Paulson to escape political responsibility for the AIG takeover — and left the problem for President Obama. Senate Democrats should think about that when they vote on Bernanke.

Since the rescue of AIG, the Fed under Bernanke has compounded the problem, using the central bank’s balance sheet to absorb $2 trillion in MBS, Treasuries and other toxic detritus that Wall Street cannot finance. Bernake even suggested last week that the Fed does not intend to sell its hoard, meaning that he is now using Open Market operations to directly subsidize the banks and the public markets generally. Who cares about executive bonuses when such sums of money are involved in direct corporate subsidies? As we noted in the IRA Advisory Service last week:

“First, zero interest rate policy and Fed purchases of all sorts of collateral have essentially taken the risk and duration out of the fixed income markets, forcing investors into equities of all stripes. Not only have Fed purchases so far of $1.8 trillion in Treasury, agency and MBS obligations taken duration out of the markets, according to several colleagues in the Herbert Gold Society, but by not sterilizing this duration in the options markets (as the GSEs do routinely with their purchases of collateral and MBS), the central bank has greatly reduced visible market volatility.”

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