The Insiders Know

Nov. 20 (Bloomberg) -- Federal Reserve officials are stepping up scrutiny of the biggest U.S. banks to ensure the lenders can withstand a reversal of soaring global-asset prices, according to people with knowledge of the matter.

Supervisors are examining whether banks such as JPMorgan Chase & Co., Morgan Stanley and Goldman Sachs Group Inc. have enough capital for the risks they take, how much they know about the strength of their counterparties and whether risk managers have authority to influence bank practices and policies.

Lawmakers led by Senator Christopher Dodd have criticized the Fed for failing to prevent a decline in lending standards that contributed to the credit crisis.

The central bank’s monitoring takes on renewed urgency as Chairman Ben S. Bernanke’s pledge to keep the benchmark interest rate near zero for “an extended period” is helping to fuel a surge in assets. The MSCI AC World stock index is up 70 percent since hitting a recession low on March 9. Gold reached an all- time high of $1,150.60 an ounce today.

The policy is raising the “systemic risk” of new asset bubbles, Bill Gross, who runs the world’s largest bond fund at Pacific Investment Management Co., said in a note posted on the Newport Beach, California-based company’s Web site yesterday. Finance officials in Asia say a bubble fueled by the Fed’s low rates has already arrived.

Fed Powers Debated

More taxpayer-funded bailouts following the rescues of insurer American International Group Inc. and Citigroup Inc., the third-largest U.S. bank by assets, would stoke public anger against the Fed as Congress debates whether to reduce its powers and independence. Andrew Stern, president of the Service Employees International Union, led a protest rally of 150 people outside of Goldman Sachs’ Washington office Nov. 16.

“The Fed staff has to be under a massive amount of pressure,” said Vincent Reinhart, a former director of the Fed’s Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute in Washington. “They must have a sense of zero tolerance for failure.”

Banks might not like “leverage ratios or capital requirements, but they can be effective and protect against the really bad behavior,” he said.

Such controls are critical to economic recovery because they can help ensure that large banks aren’t hurt by swings in the capital markets. Banks are still clamping down on credit to consumers and businesses, even though gross domestic product expanded at a 3.5 percent annual pace in the third quarter after a yearlong contraction.

Withstanding Writedowns

“You want to have as much capital in these firms as you possibly can to withstand asset writedowns,” William Cohan, author of “House of Cards: A Tale of Hubris and Wretched Excess on Wall Street,” about the collapse of Bear Stearns Cos., said in an interview today on Bloomberg Television.

Total loan originations in September at Bank of America Corp., the largest U.S. bank by assets, fell 6 percent to $53.6 billion from a month earlier, according to a Treasury Department report this week. The cause of the decline was “decreased demand for loans in the weak economy as companies and individuals look to reduce debt,” said Scott Silvestri, a spokesman for the Charlotte, North Carolina-based company.

New loans at Wells Fargo & Co., the nation’s fourth-biggest lender by assets, dropped 14 percent to $47.4 billion. “We continued to supply credit to U.S. consumers, small businesses and large corporations with over $547 billion of new credit extended to customers through the third quarter this year,” said Mary Eshet, a spokeswoman for the San Francisco-based bank. “In a slower economic cycle, commercial loan demand is naturally weaker.”

Troubled Asset Program

Taxpayers shored up the financial system with the $700 billion Troubled Asset Relief Program. Another round of bailouts would likely stir up more congressional ire.

My constituents, they’re not just anxious, they are mad,” Representative Michael Burgess, a Republican from Ft. Worth, Texas, told Treasury Secretary Timothy Geithner at a hearing of the Joint Economic Committee yesterday.

Under the TARP’s capital-purchase program, the Treasury injected about $205 billion into more than 600 financial institutions of all sizes as of Nov. 13, according to department figures.

John Mack, chief executive officer of Morgan Stanley, said banks’ behavior justified a Fed crackdown.

We cannot control ourselves,” he said yesterday at a panel discussion hosted by Bloomberg News and Vanity Fair at Bloomberg LP’S headquarters in New York. “You have to step in and control the Street.”

Pressure From Dodd

The Fed is already under pressure from Dodd, chairman of the Senate Banking Committee, who proposed legislation Nov. 10 to strip the central bank of its supervisory authority. The Connecticut Democrat’s move strikes at the core of efforts by Bernanke, 55, and Governor Daniel Tarullo, 57, to overhaul Fed supervision and increase monitoring of risks to the financial system.

Tarullo, President Barack Obama’s first appointee to the central bank, is making greater use of so-called horizontal reviews that compare several banks’ exposures and practices.

He is also drawing more on the Fed’s staff of 220 Ph.D. economists to help identify risks. The Fed is now more likely to pull in the economists to run scenarios on what would happen to bank profits if global markets plunged, especially if the central bank’s exams turn up concentrations of risk throughout the financial system.

The Fed is also studying how well banks match funding with the maturity of their assets and how the lenders’ risk managers interact with their trading and loan operations, according to the people familiar with the program.

Fed spokeswoman Barbara Hagenbaugh declined to comment.

Stress Tests

The close attention to banks’ capital adequacy started in July when the Fed began applying some of the lessons it learned from stress tests conducted in May. Those tests showed how the 19 largest lenders would fare in a slower recovery with higher- than-forecast unemployment. Ten companies including Bank of America, Wells Fargo and Citigroup needed additional capital.

Assuring that institutions are strong enough to weather an abrupt turn in asset prices “is critical,” said Deborah Bailey, deputy director of supervision at the Fed’s Board of Governors until June, when she joined Deloitte & Touche LLP in New York as a director. “The Fed is committed to try and get it right."

Too Reliant

Fed officials are watching to see if financial companies may become too reliant on short-term funding the longer rates remain at record lows, according to the people familiar with the process. The central bank won’t raise its benchmark until August 2010, according to the median estimate of 45 economists surveyed by Bloomberg.

Former Fed Chairman Alan Greenspan telegraphed increases in his 2004-2005 tightening cycle with a phrase in the Fed statement that said “policy accommodation can be removed at a pace that is likely to be measured.” When asked if investors should be prepared for the possibility of more-abrupt action this time, Charles Plosser, president of the Philadelphia Fed said yes.

“There are states of the world and conditions that could arise where we may have to raise rates a lot faster than the last cycle,” he said in an interview. “I am not saying that will be the case. I am just saying we just have to make the markets understand that we will do that if it is required.”

Consider this quote from Bill Bonner recently, "The Dow is now up more than 50% from its March low…and has regained more than 50% of what it lost. Are the insiders taking advantage of this dip to get bigger stakes in their own companies? No… They’re selling 18 times as many shares as they’re buying. Go figure."


The insiders are not fools. They know that revenues have generally not been growing and are likely to stay weak. Yes, profits have grown thanks to cost cutting, but increasing revenue due to demand growth is required for stock prices to continue their climb.

The Fed and insiders are heading for cover. The 220 economists at the Fed are likely sounding the alarm for a reversal in the trend of the US dollar. This is not what the Fed wants. They want a slow "managed" decline of the dollar. The goal is the re-flation of asset prices. The Fed will have its hands full fighting off deflationary forces as long as the economy remains weak and banks are lending less.
We remind our readers that MV = PQ.
That is M is the total money and credit in circulation, V is the frequency of transactions (velocity), P is the price level, and Q is the deflator, that is the real output.
Fundamental to understanding what is presently occuring in the economy is a proper comprehension of M. Yes, the currency in circulation is rising. But, the amount of credit available is declining at an equal or greater rate. We are therefore not seeing a general increase in asset prices at this point. The Fed is desperate to keep interest rates low, as they wish to re-inflate asset prices. Their worry is that an increase in the US dollar will tank the stock market, high government debt will force interest rates up, and kill any recovery that might take place. A wave of mortgage resets and recasts are coming due in 2010 and 2011. An increase in interest rates will push housing prices down further, force the banks to take larger write offs, and defeat their goal of re-flation.
"To big to fail" has raised the risk level for the entire banking system to such high levels, that a relatively minor event may trigger the flight to safety, causing a temporary increase in the US dollar and corresponding drop in bond yields. Then, once Big Ben fires ups the printing press on all 8 cylinders, the volume of currency flooding the market combined with the Fed buying their own debt through monetization will force interest rates up as creditor countries lose confidence and demand higher yields.