Fed Bubble Blowing: A Study Of Denial

Fed Bubble Blowing: A Study Of Denial

Posted by Karl Denninger

Ben Bernanke once again steps into the realm of (intentional?) misdirection with the following missive:

The financial crisis that began in August 2007 has been the most severe of the post-World War II era and, very possibly–once one takes into account the global scope of the crisis, its broad effects on a range of markets and institutions, and the number of systemically critical financial institutions that failed or came close to failure–the worst in modern history. Although forceful responses by policymakers around the world avoided an utter collapse of the global financial system in the fall of 2008, the crisis was nevertheless sufficiently intense to spark a deep global recession from which we are only now beginning to recover.

“Although the firefighters showed up and threw tens of thousands of gallons of water on the fire, thus preventing the ultimate collapse of the structure, the fire was nonetheless intense enough to destroy the contents of the building.”

Even as we continue working to stabilize our financial system and reinvigorate our economy, it is essential that we learn the lessons of the crisis so that we can prevent it from happening again. Because the crisis was so complex, its lessons are many, and they are not always straightforward

“Fire, especially in a structure, is a very complex process.  The usual process of fire beings with the heating of one or more items until they begin to combine with oxygen in the air, releasing energy and producing a self-sustaining series of chemical reactions that we call ‘fire’.  This in turn causes the heating of other items that contain chemical compounds that can both burn and melt.  These chemical processes are extremely complex and so the lessons are not always straightforward in explaining the chemical reactions that take place.”

What Bernanke doesn’t mention is that The Fed ran around playing “Backdraft” setting the damn fires for twenty years and now wants credit as a “hero” for “putting out” their own acts of financial arson!

Surely, both the private sector and financial regulators must improve their ability to monitor and control risk-taking. The crisis revealed not only weaknesses in regulators’ oversight of financial institutions, but also, more fundamentally, important gaps in the architecture of financial regulation around the world. For our part, the Federal Reserve has been working hard to identify problems and to improve and strengthen our supervisory policies and practices, and we have advocated substantial legislative and regulatory reforms to address problems exposed by the crisis.

This sort of nonsense is amazing.  Bernanke then goes on to continue with an “analysis” of the 2000-2005 monetary policy conditions, including his favorite “tool”, the “Taylor Rule.”

The problem with the entire remainder of this “analysis” is that it simply refuses to acknowledge the truth found in the following graphs.  Let’s start with my favorite:

“Something” happened around 1985, didn’t it Ben?  What was “it”?

Simple: The leverage ratio – that is, the amount of debt outstanding in the economy for each dollar of GDP, began to rise precipitously.  This happens to be roughly correlated with the so-called “modern era” of Central Banking by The Fed, just a few short years before Alan Greenspan took office and continuing to this day.

But what caused this expansion?

Simple: A long line of “deregulatory” actions taken beginning with The Depository Institutions Deregulation and Monetary Control Act of 1980, and then the Garn-St. Germain Depository Institutions Act of 1982.  This, along with the ever-present thing called “human greed”, led to rampant real-estate speculation in the 1970s and early 1980s.  It was this unsound real-estate lending that ultimately led to the S&L bust, along with the expansion of brokered deposits and linked financing.

The expansion of leverage led directly to the bust and the “answer” to it in the mid 1980s was even more expansion of leverage!

We then had, in succession, even more booms and busts.  LTCM, Latin America’s debt explosion, the “Asian Tiger” explosion, The Tech Bubble and of course The Housing Bubble.

All of these were caused by one thing – the rapid expansion of leverage – that is, debt – compared to GDP.

It took more than twenty years to go from 150% of GDP to 175% of GDP in total systemic debt outstanding, an increase of about 17%.

Since then – less than thirty more years – we have more than doubled the debt-to-GDP ratio.

This has generated the following distortions in alleged “GDP”:

That is, during the decade of the 1960s, about 10% of the alleged GDP didn’t actually occur (not growth, aggregate output) through growth – it happened due to additions in borrowing beyond that which was paid off.  In the 1970s, 16%.  In the 1980s, 20%, in the 1990s, 16.3% and in the 2000, 21.6%.

Borrowing that produces something – that is, productive investment through the use of financing – will produce a negative percentage contribution.  Simply put, if I borrow $100,000 to buy a CNC machine and it’s aggregate output (ex-costs such as material, employees and the like) over the financed period is $300,000 then it produces a negative aggregate impact on debt-to-GDP ratios, because GDP grows faster than the debt does.

Monetary and regulatory policy is primarily responsible for the above table.  When people are in effect paid to borrow they will do so with wild abandon and use those funds not for productive investment but rather to speculate with.  Further, when those who commit fraud through various schemes are not forced to eat their own cooking, either financially or criminally then they will use leverage as a means to skim off “rents” from various parts of the economy for themselves by making an effective claim that 2 + 2 = 6.

The problem with using things like the so-called “Taylor Rule” is that one must make sure you include in “inflation” the actual price signals of all goods and services.  This, of course, is not done.  The average household spends 30-50% of it’s post-tax income on housing-related items, including the home itself, utilities (which are mostly energy or energy-derived in some form or fashion), food, and of course taxes imposed by governments and insurance costs mandated by the use of leverage to purchase same.  Another 16% of GDP is consumed by health care, making these two general categories of expenses account for the majority of all personal spending.

Yet “CPI”, or what we call “inflation”, does not count actual home price changes – it instead uses what’s called “owner’s equivalent rent“.  The BLS considers purchased housing investment, not shelter – that is, not consumption.  Yet the BLS also considers improvements and repairs to housing part of investment even though those items are clearly consumed!  In other words, they attempt to impute the rental cost of owned property.

This is, however, invalid.  Research has shown that most homeowners retain their house for about seven years on average.  Further it is clear that a home is in fact shelter as it’s prime purpose, not “investment”, and further the expenditure of funds to reverse the inevitable effect of entropy is claimed as investment rather than expense as well!

Health care expenditures are similarly (and deliberately) understated.  Most persons gain the bulk of their health care as part of their compensation – that is, they do not directly spend that money.  This in turn causes the BLS to dramatically understate price inflation in health care expense because most of it does not show up in the consumer price index.  Specifically:

The weights in the CPI do not include employer-paid health insurance premiums or tax-funded health care such as Medicare Part A and Medicaid.

These distortions are critically important because they in turn drive public policy and public perception, and that, in turn, is how we wind up with a series of asset bubbles.

From a mathematical perspective the problem is relatively simple:

As soon as you start refinancing to avoid paying off debt, or writing loans that are not contemplated as amortizing, you have entered The Ponzi Zone.

Identifying these sorts of financing is trivial.  Among them:

  • Balloon, “Option ARM” and other exotic, non-amortizing mortgages.
  • Commercial Real Estate and other forms of corporate loans that are “interest only” and have to be rolled at maturity.
  • Debt issues that include “PIK” sorts of features (so-called “Toggle” bonds, etc.)
  • Credit card “rollover” offers that provide a zero-interest period with no balance transfer cost, effectively permitting the “parking” of debt at a zero rate (for a period of time.)

All of these features tell you that the economic cycle has entered a “Ponzi” phase that will soon inevitably result in a bust.

But when one looks to the “why” rather than the “what” the cause is clear: Negative real interest rates – that is, rates anywhere on the curve that are below the rate of actual price inflation, inevitably lead to excessive speculative borrowing and asset bubbles.

It is here that Bernanke and his predecessor have completely and utterly blown it, and they appear to either not realize it or are desperately hoping they can keep you from figuring it out.

The Federal Government uses things like “owners equivalent rent” and other similar distortions in CPI to prevent having to pay out cost-of-living increases in entitlement programs.  But The Fed is not compelled to use the BLS and BEA numbers in conducting economic policy.  Indeed, The Fed employs a literal army of economists who are quite capable of developing their own independent price measurements – if they wanted to.

Bernanke also alleges that:

What policy implications should we draw? I noted earlier that the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates. Moreover, regulators, supervisors, and the private sector could have more effectively addressed building risk concentrations and inadequate risk-management practices without necessarily having had to make a judgment about the sustainability of house price increases.

What was your first clue Ben?

There was clear evidence of demonstrably unsound financial underwriting by banks you have primary regulatory authority over as early as 2004.  You did nothing.

You claim to have issued “guidance” in 2005 on non-traditional mortgages, yet they were offered by banks such as Wachovia right into the maw of the bust, with them attempting to personally solicit me for one in the spring of 2008, more than three years later!  Instead of taking them up on it I shorted their stock, as that offer was a clear display of idiocy that I was certain would lead to their demise. 

I was right, but you still claim you didn’t “see the problem.”

Clearly you did not regulate – you stood back and watched the bubble inflate.  You even said (just a few months before the bottom fell out of housing) that you believed house prices were supported by “strong fundamentals.”

This claim was either a bald lie or a product of profound blindness.  Either way it does not speak well of your capacity for discernment, say much less judgment.

In addition the peddling of paper with radically inflated claims of “quality” was also evident early in the bubble.  This too is under your domain – fraud is always punishable and the law is supposed to be enforced.  There is no need for more regulation – just enforcement of existing law.  When one takes a package of loans that has a true risk-adjusted return of 300 basis points over Treasuries of the same duration it is impossible to produce a set of securities with a blended return higher than 300 basis points, and it is also impossible for anyone to sell a credit default swap against that package (that they can actually perform on) for less than the true risk-adjusted spread.  Since nobody works for free the true return on a CDS + Debt, where “Debt” has some risk-adjusted return over Treasuries of equivalent duration, must always be less than simply buying the Treasuries!

As a consequence there is never a market for such a “synthetic” bond+protection that is “as safe as government debt” UNLESS someone is intentionally mis-pricing risk BECAUSE AT AN HONEST ASSESSMENT OF RISK AND THUS PRICE THE COMBINATION MUST ALWAYS RETURN LESS THAN AN ACTUAL RISK-FREE GOVERNMENT BOND!

Nobody in their right mind would select such a combination at a blended yield of 3%, for example, if the equivalent-duration US Treasury was yielding 3.5%. 

These products were able to be marketed only because they were laced through and through with fraudulent misrepresentations.  That someone was cheating was obvious to anyone who pulled their head out of their ass and looked at what was being packaged and at what yield it was being sold.  Again, directly or indirectly The Fed had the supervisory authority to put a stop to these practices and refused to do so.

The bottom line is that asset bubbles do not just magically appear – they happen because of negative real interest rates and intentional and pernicious fraud, both of which occur as a consequence of intentional obscurity and outright lies.

Our economy and people deserve better.  It is a fact, whether we like it or not, that we cannot have and sustain the sort of “economic growth” we have been sold over the last 30 years on an indefinite forward basis, as you cannot continually take on debt at a rate that exceeds productive output – eventually you will default.  Instead of facing the truth – a long-term growth rate roughly approximating the growth in population, or about half of what we have allegedly “enjoyed”, we have used debt pyramiding – that is, serial Ponzi schemes, to produce the illusion of dramatically higher economic growth.

There is no evidence that you, or anyone in Congress, has yet had their “Come to Jesus” moment with the blunt mathematical facts.  Attempting to blow another bubble – which is the inherent path you are attempting to take – risks destruction of our nation’s political system and economic future.

There are hard choices to make and economic adjustment to the realities of our debt load and what this portends for economic growth on a forward basis will not be easy.  It is, however, both inevitable and necessary.  The longer we continue to try to deny the math the worse the ultimate outcome.

It was time for the adults to be allowed in the room and the children restrained in August of 2007, as I have previously said.  More than two years of continued banter and bovine excrement from you and others has not changed a thing.   We have solved nothing and you have learned nothing.

In short, it is time for you to step down.