classical economics
for analysis,  forecasting
and policy design

Fed Caused Bank Ills
FEDERAL RESERVE CAUSED BANKING ILLS
By Wayne Jett © June 27, 2008
    The Federal Reserve System leaked word of its pending review of regulations governing investment of new capital in its member banks. Many banks urgently need more capital, the Federal Reserve agrees, so existing controls on who owns banks will be relaxed to permit new money to be raised from previously unacceptable sources.
    Who is the principal culprit behind banking needs for re-capitalization? The few who understand classical economic theory will not be surprised that the Federal Reserve itself caused the banking crisis with its unsound monetary policy and counter-productive operating practices. What is worse, even well-meaning parties who do not understand are already calling for the Fed to do more of the same.
Fed Vents Liquidity to Speculators
    Here is how the Fed helped cause banks’ needs for new capital. In early 2004, after achieving stability near the dollar’s equilibrium value at $380 to $400 per ounce of gold, the Fed made known its intent to raise the funds rate “target” above one per cent despite the stability of ten-year Treasury bond yields below four per cent. Between June, 2004, and June, 2006, the Fed raised the funds rate to 5.25 per cent, in the process inverting the yield curve sharply. Doing so, the Fed told banks to charge more for overnight loans of reserves than the market believed reasonable for ten-year Treasury bonds. At the same time, however, the Fed continued adding new liquidity by purchasing Treasury securities in 2004, 2005 and 2006.
    Banks used the unreasonably high funds rates as benchmarks to set their prime rates and offered loans to customers at unreasonably high rates of prime plus two or three points. Unsurprisingly, small and medium-sized businesses which ordinarily obtain working capital from banks found these rates too high and declined to borrow. Economic growth and job creation in those crucially important business sectors stalled and declined. The recovery that followed cuts in marginal tax rates in May, 2003, was slowed and then stopped.
    What were the banks to do for customers without SMB borrowers? Naturally, loan rates too high for normal risk customers are attractive to higher risk borrowers, and banks found plenty of this latter variety. Banks provided high interest loans to high risk borrowers: investment bankers, hedge funds and similar speculators who used the funds to leverage investments in housing mortgage backed securities, commercial mortgage backed securities, credit card debt securities, long and short positions in corporate shares, and commodities futures. Lacking their normal customers, banks treated this higher risk lending as suited to their loans, but the investment risks turned out to be higher than the interest rates charged.
High Risk Chickens Home to Roost
    Losses on such loans and on banks’ own investment operations have eaten into capital, causing concerns over financial soundness and giving rise to calls for replenishing capital. The picture is not entirely that simple, because the level of risk accepted has opened the door to unusual, even remarkable, exposures for the banks.
    To illustrate, a British example is useful because banks in London have experienced similar episodes due to central banking practices mirroring those of the Federal Reserve. In recent months, banks in London have made rights offerings to shareholders, seeking new capital. But those rights offerings have been interdicted by so-called bear attacks of short-side hedge funds driving share prices below the price offered in the rights packages. If successfully completed, the bear attacks would prevent recapitalization and ultimately cause failure of British banks.
    The Financial Services Authority, regulator of all financial service providers in the United Kingdom, acted preemptively to require investors to disclose within 24 hours any short positions in a bank engaged in a rights offering. The London investment community almost came out of its shoes, leaping to protest this precipitous and burdensome reporting requirement as if it simply could not be done. Despite a little slippage, the FSA stuck to its guns, as it must if a financial debacle is to be averted in the UK.
U. S. Regulators MIA
    In the U. S., by contrast, regulators are missing in action where they are most needed, as financial firms here experience bear attacks similar to the London variety. Lehman Bros. appears so far to have averted summary execution of the nature suffered by Bear Stearns. But U. S. bears have chosen to act preemptively themselves, driving down share prices of financial firms even before rights offerings to raise capital can be made.
    Having already expended its capital in buying Bear Stearns for J. P. Morgan Chase Bank, the Federal Reserve is in no position to recapitalize more banks. Though the Securities & Exchange Commission ought to be protecting financial firms from these bear attacks, the SEC has only two of five commissioners and apparently little inclination to take on magnates of Wall Street and in Stamford, who regularly take down companies using tactics that match 1929 and have finally come ‘round to the financial sector.
    The real reason bear attackers in London complained so loudly at the prospect of merely disclosing their short positions is, almost certainly, that they must disclose not only their legal short position but also their illegal “naked” short positions. In naked shorting, they simply fail to borrow or to deliver the shares they sell short – thus increasing their profits by eliminating borrowing fees and driving share prices lower via dilution of the market float. Upon disclosure of their naked short positions, they could be prosecuted for illegal trading to manipulate prices, so they despise disclosure.
    The SEC could protect financial firms by requiring public disclosure of short positions, and simultaneously go a long way towards eliminating naked shorting in U. S. markets. Instead, the SEC accommodates naked shorting by merely listing the names of targeted companies on a “threshold list” that accomplishes no more than requiring the bear attackers to “try harder” to find shares to borrow and deliver. In this malign neglect, the SEC is likely doing the bidding of economic czar and Treasury secretary Henry Paulson, recently of Goldman Sachs and its roles in sub-prime lending and crude oil futures trading.
Advice for Banks and Regulators
    If there are those who wish the banking sector well in its battle to survive “consolidation,” as the Federal Reserve should, they should insist that the SEC protect the securities markets against the illegal trading tactics that threaten financial health of every publicly traded firm. Some financial media seem to be in the opposite camp, ignoring illegal trading as non-existent and calling for the Fed to return to higher interest rate targets to “tighten” monetary policy.
    Those who continue to argue that an overnight interest rate manipulated artificially higher will strengthen the dollar are mistaken. Raising the funds rate will not “tighten” or reduce dollar liquidity flow to the private economy, and neither will it drain liquidity from the economy. If it did, then the artificially high funds rate since 2004 would have denied liquidity to all those bank customers who took the loans and speculated unwisely. Better to allow interest rates to be set by the markets based upon actual liquidity conditions, so SMB borrowers have fair access to credit.
    While raising the funds rate and holding it high since 2004 (and even now), the Fed injected new liquidity during 2004-2006 and then denied new liquidity in 2007 until liquidity withdrawal symptoms hit the unwise borrowers and the credit markets in August, 2007. Since August, the Fed’s large, “temporary” injections of new liquidity have hurt the dollar’s value badly.
    The essential point not to be missed is that “tightening” dollar liquidity does not require raising the overnight funds rate and cannot be accomplished by doing so. In fact, raising the funds rate artificially again without curtailing liquidity flows would repeat mistakes of 2004-2006 that vented excess liquidity away from productive small business and into the speculations of financial firms.
    If the dollar is to be strengthened, interest rates must be floated so the market sets them while liquidity is managed to achieve the desired value for the dollar relative to gold. That liquidity management will require degrees of forbearance to exit the current financial sector crisis, but it must be undertaken soon if additional crises beyond the Fed’s capacity to mask are to be avoided.
    SEC disclosure rules and enforcement actions designed to protect firms from illegal share trading practices ought to be combined with reform of Federal Reserve policy if banks are to have their best prospects for survival. Prospects for those two public policy ingredients to evolve are not good. ~