Great Leap Forward


I’m directing a research project on the Fed’s bail-out of Wall Street and am periodically posting updates on the findings. Previously I’ve blogged the preliminary findings of two of my grad students, James Felkerson and Nicola Matthews and the first paper was finished a few weeks ago  (my summary here; full paper here

As expected we got a lot of push-back. The Fed funds a huge stable of economists whose research funding relies on maintaining good relations at the Fed.

(I saw many of them presenting research studies “proving” there was no housing bubble as late as 2008 even as the whole damned US real estate sector was crashing. Many of you have no doubt seen former Governor Rick Mishkin’s performance when he explained away his glowing reports of Iceland’s banks—research funded by the Chamber of Commerce. It should be no surprise to read his remarks at an FOMC meeting when he described his efforts at income generation through textbook writing, required to “afford” his wife (he also refers to “Ben” Bernanke, but it is not clear that Ben agrees he writes textbooks to “afford” his spouse): “In the inflation reports, they’ve moved to using the best textbook writing techniques—nice colors, boxes. Ben and I have been involved in this process. It’s the reason that I can afford my spouse.” P. 144

However, let me say that there are also a lot of objections from serious independent scholars with no love lost on the Fed. The typical objection is that in a financial crisis the central bank has no choice but to provide “liquidity” to stop runs—and if it took tens of trillions of dollars to do that, so be it. They also object that a lender of last resort intervention to “provide liquidity” should not be called a “bail-out”.  And finally, some (erroneously) claim we could not tell the difference between a stock and a flow—the total outstanding Fed commitments peaked at some $1.5 trillion so the cumulative measure we reported–$29 trillion—was double and triple and quadruple counting.

OK I have dealt with the last complaint in several previous posts, and no careful reader of Felkerson’s paper linked above can possibly believe that we confuse stocks and flows. We provide three measures of the size of the bail-out, including two measures of the peak outstanding Fed commitments plus the cumulative measure. The latter was $29 trillion at the time, but because the Fed has recently ramped up its lending to the European Central Bank, that is now well over $30 trillion. It is our argument that if you want a measure of the total Fed effort at rescuing the US financial system, it makes sense to add up the Fed’s lending and spending (to purchase toxic assets, for example) over time. $29 Trillion and counting.

And to be more precise, that is what it is taking to rescue Crony Capitalism—an America of, by, and for Wall Street. It will take more. Much more. The $29 trillion was only a down-payment. This will not stop—so long as we have Crony Capitalism, the Fed and Treasury will need to keep shoveling dollars into the bottomless pit.

(As an aside, the Fed’s current lending to massively insolvent and sure-to-bust Euroland is a backdoor attempt to protect US Money Market Mutual Funds. Why backdoor? Because Dodd-Frank prohibits the Fed and Treasury from bailing-out US MMMFs. So the Fed is pumping dollars to the ECB to try to forestall the inevitable failure of massively insolvent Euro banks, whose toxic waste liabilities are held by US MMMFs! Rest assured, this will not work—the MMMFs will break the buck and collapse. The Fed will shovel another $3 trillion to try to rescue them.)

Now, the question is this. Does the Fed have any mandate to rescue Crony Capitalism? Those who make the liquidity argument rely on Walter Bagehot’s 19th century recommendation: lend freely, at high interest rates, against good collateral. This is the way to stop a run on banks. Lend freely: to all financial institutions. At high interest rates: to penalize them. Against good collateral: to minimize central bank losses and to ensure that you do not lend to crooks who have only trashy junk.

Ok what did the Fed do? Lend freely? No. At high interest rates? No. Against good collateral? No.

Instead the Fed bumbled around with incompetence, creating an alphabet soup of lending facilities. Why? Because it did not want any behemoth institution to be embarrassed by coming hat-in-hand to borrow at the Fed. It would be unbecoming to an institution of the status of a JPMorgan-Chase or a Bank of America to borrow at the discount window. So instead the Fed created special purpose facilities open to behemoths but also open to Real Housewives on Wall Street—a one-stop shop for all manner of deadbeats.

High interest rates? No—these institutions were mostly insolvent, with earnings far below costs of servicing liabilities. So the Fed chose to be the low-cost funder of positions in junk assets with no return. Unfortunately, the Fed could not directly fund the positions taken by investment banks like Goldman and Morgan Stanley—so it handed them bank charters. Not only could they get cheap Fed funding, but they could also issue FDIC-insured deposits at low interest rates. The “subsidy” amounts to tens of billions of dollars annually—which allowed the biggest banks to quickly return to paying huge bonuses to top crooks managing the banks. But they are still massively insolvent, since all revenues and hand-outs were sucked away to feed the crooks.

Look, all fraudsters eventually face liquidity runs. Their assets are junk, their liabilities cannot be serviced. They call it a “liquidity crisis”. If they can find a sucker to lend, they can continue the scam. Think Bernie Madoff. If the Fed had decided to lend billions of dollars to him, he’d still be in business bilking his customers out of millions more dollars. That is exactly what the Fed has done for the other control frauds—like BofA, Citi, Morgan, and Goldman. So long as they have access to “liquidity” they can stay in business and pay bonuses. All insolvent institutions view their problems as “liquidity” problems—it is the other side of the coin of a control fraud that has been exposed. Bernie’s only mistake was that he was not a subsidiary of Goldman. If he had been, he would have got Fed loans and he’d still be in the money.

Against good collateral? No. Indeed, the Fed decided that rather than lend, it would be better for the banksters if it started buying their toxic waste—not only would banks get the cash but their balance sheets would be relieved of junk assets.

The Fed’s bail-outs of Wall Street violated both the law as established in the Federal Reserve Act (and its amendments) and also well-established procedure. There is a long tradition in the Fed that there is a distinction between continuous versus exigent borrowing at the Fed. Briefly, the Fed is permitted to lend (freely as Bagehot recommended) to resolve a liquidity crisis. That is the exigent part. But it has long refused to provide “continuous” lending. Here the idea is that the Fed should stop a liquidity crisis but then solvent financial institutions should quickly return to market funding of their positions in assets. The crisis started in 2008. Four years later the Fed is still lending “freely” to anyone who has a heartbeat and an address on Wall Street. I will document that claim in coming posts. The “subsidy” (I will admit I do not like the term) is tens of billions of dollars. And against long-established Fed policy.

Second. The Fed is generally prohibited from lending to “nonbank” financial institutions—what we now call shadow banks that are not members of the Federal Reserve System and that do not issue FDIC insured deposits. However, there is an exception granted in the Fed’s  “13(3)” provisions. These allow the Fed to lend in “unusual and exigent” conditions. Certainly the crisis in 2008 qualifies as unusual and exigent. However, the 13(3) restrictions are tight: the lending must be at a discount, to a troubled individual, partnership or corporation that is unable to secure adequate credit from other banks, and on the basis of indorsed or secured debt.

Now, what did the Fed actually do? Taking a tip from Wall Street, it created Special Purpose Vehicles (SPVs) to buy toxic assets from the likes of JPMorgan-Chase and AIG. What is wrong with that? The 13(3) provisions specify loans, not asset purchases, to troubled financial institutions at a discount. The NYFed actually made the loans to its SPVs (not to troubled financial institutions), to buy waste, and with no discount. The Fed created other SPVs to buy Asset-Backed Commercial Paper, with the NYFed lending to the SPV to buy the waste. Again, the loans were not to troubled institutions (the loans were to the SPV to permit it to buy troubled assets). Essentially the Fed undertook the same actions with the bail-out of AIG: loans to Maiden Lane to buy trash. And the purpose of that was to pass-through funds to banksters like Goldman. None of this is permitted by 13(3)—the lending must be directly to the troubled institution, at a discount, against collateral.

OK, you might ask, “so what”. A bit of questionable, possibly illegal activity by our nation’s central bank. Who cares? Only $30 trillion and counting.

Because the result—even if not intended—was to prop up the crooks on Wall Street, those running the “control frauds” in the terminology of my colleague, Bill Black.

By agreement of all researchers who’ve looked into it, the effect of the bail-out has been to massively increase the distribution of income and wealth flowing to the top one-tenth of one percent. It has kept the same management in control of the worst serial abusers—the Goldmans, the Bank of Americas, the Citis, the JPMorgans. They have continued their frauds—securities frauds, foreclosure frauds, accounting frauds—as they paid record bonuses to the top crooks in America. You cannot read a newspaper in America any day without coming across yet another account of the on-going frauds.

And Washington has been completely paralyzed—Eric Holder, our Attorney General in chief, has not begun a single investigation of criminal behavior by a top bankster. Yes, I know there have been some recent investigations of low-level traders as President Obama finally began to realize that he is going to lose the next election. But so long as Holder remains as AG, this will never go to the top of the control frauds.

The reason is simple: Obama needs the campaign contributions of the top fraudsters. A cynic might believe that the current investigations are merely a “shake-down” to fill the reelection coffers by the Crony Capitalists. And, no matter who wins the next election—be it an Obama or a Romney—many believe we will have a representative of the Crony Capitalist Class in charge.  Just ask David Stockman, President Reagan’s right-hand Supply Sider: Full Show: Crony Capitalism Moyers & Company Air Date: January 20, 2012

Now, what should have been done? Bagehot’s recommendations are sound but must be amended. Any of the “too big to fail” (which is really “systemically dangerous institutions”) that needed funding should have been required to submit to Fed oversight. Top management should have been required to submit resignations as a condition of lending. The Attorney General’s office should have been called in to investigate all top management, to prosecute them, and to pursue real jail time for all convictions. Short-term lending against the best collateral should have been provided, at penalty rates. A comprehensive “cease and desist” order should have been enforced to stop all trading, all lending, all asset sales, and all salary and bonus payments to anyone above the pay-grade of a secretary. The FDIC should have been called-in (in the case of institutions with insured deposits), but in any case the institutions should have been dissolved according to existing law: at least cost to Treasury and to avoid increasing concentration in the financial sector.

Consider this blog a down-payment. I will provide more argument and evidence for claims made in coming weeks.

10 Responses to “$30 TRILLION TO PROMOTE CRONY CAPITALISM: The Fed’s Bail-Out of Wall Street”

JoeFirestoneFebruary 4th, 2012 at 3:04 am

Well, you're certainly closing in on a compelling narrative. But how does it do any good when we only have a choice between Mr. 1% and Mr. "just ignore those DFH retards." They have nowhere else to go anyway. Somehow we've got to make the electoral system work for us and not for the 99%. I don't know how to do that in time for the 2012 election, and right now it still looks like the feedback is the direction of accelerating progress toward plutocratic fascism.

Cam Brotherton-JenningsFebruary 7th, 2012 at 8:13 am

There is nothing wrong with the idea of a free marketplace with regulations governing financial institutions and the private sector. In an ideal world there are regulative authorities who are vigilant in upholding the law and carrying out justice.

Creative Capitalism is what we now have seen implemented not only on Wall Street but also in Congress. The Fed Reserve must also be included here as the problem is greed and corruption and is systematic.

It is a not merely an economic problem for it is also a social problem and one that is now deeply entrenched into America. When a society is so deeply imbued with making money and never admitting liability for mistakes, then the dysfunctional government is merely a reflection of it’s people. If there is a thinking society then there’s a responsible government.

God save America because he is over blessing them due to creative capitalism. The world now prepares to welcome the replacement to America within the next decades.

It’s merely the last decades of what was once a mighty and powerful nation. Five hundred years ago it was the Spanish, then Dutch, then English and then America as the dominant economic leaders.

Forget about the USA they’re just old news and soon to be history as this is the Asian Century. By the time America wakes up from the party it’ll be far too late and the hangover will last for generations.

If I still lived in NY (2005-2009) I’d be learning a Chinese language, forget Spanish & English.

Smoke and mirrors combined with bravado and bull can only work so long.
America finished in or around 1970 and has been on the slide downhill since then.

sierra7February 7th, 2012 at 7:36 pm

"America finished in or around 1970 and has been on the slide downhill since then. "
I was beginning to believe I was the only one that saw that one coming…..truly, since the '70's, we have witnessed the ongoing of stagnant wages and globalization brought the monster of, "….the ongoing crushing of American labor to a world level playing field" that gave way for the "forceable" expansion of credit to "save the system" from collapse.
We are and will be paying this bill for generations.

SchofieldFebruary 8th, 2012 at 9:48 pm

If only all this deficit spending to bail out Crony Capitalism was a conspiracy by MMT'ers to establish the validity of Modern Monetary Theory ! Hang on maybe….. !

learn moreFebruary 9th, 2012 at 7:46 pm

M. C. Escher: “By keenly confronting the enigmas that surround us, and by considering and analysing the observations that I have made, I ended up in the domain of mathematics, Although I am absolutely without training in the exact sciences, I often seem to have more in common with mathematicians than with my fellow artists.”

Euro2012February 10th, 2012 at 9:34 pm

Joe Orton: “I’d the upbringing a nun would envy and that’s the truth. Until I was fifteen I was more familiar with Africa than my own body.”