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The Fed’s Act of Cowardice

Central Bankers Then and Now, Part VI
Wikimedia Commons, Robert Scoble Lehman Brothers headquarters in New York City on September 15, 2008. Lehman Brothers headquarters in New York City on September 15, 2008.
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We are talking about America’s Monetary Keystone Kops, who have, since 1987 (when Greenspan became chair of the Federal Reserve), been masquerading as central bankers. (Or maybe it’s the other way ‘round, it’s hard to tell.)

The Fed’s finest hour was saving Bear Stearns while wiping out its equity holders and senior management — that is, the folks who caused the problem. As for the Fed’s worst hour, there are so many candidates they are hard to count. I’ve already nominated the Tech Bust and the Global Financial Crisis, but it’s possible that allowing Lehman Brothers to fail tops them all.

As noted last week, when Lehman began to teeter all the Fed could think of was to “do another Bear,” that is, find a merger partner. But Lehman was too big and the crisis was too far advanced for that. Instead of getting creative, the Fed threw up its hands and announced that it lacked the authority to bail Lehman out because there wasn’t sufficient collateral for a Fed loan or other backing.

This claim is either an outright lie or Messrs Bernanke, Geithner and Paulson are the most befuddled public servants since…, well, I don’t know, maybe Vichy. To understand why, let’s take a look at the supposed villain of the piece, FASB 157.

Promulgated by the Financial Accounting Standards Board, FASB 157 has been applied by the SEC to federally regulated banks, which are, under the rule, required to mark to market every security they hold every day. Normally, that makes perfect sense. It allows bank management to understand how much risk a bank is taking on a regular basis.

Indeed, virtually every bank CEO wants to see the VaR (value at risk) his bank is taking at the end of every work day. The “value” part of value at risk is calculated by marking every security to market. The daily VaR number had better be about where it should be, or someone is going to be in a lot of trouble.

But notice that I said, “Normally, that makes perfect sense.” In a crisis, there are no — or only absurdly low — bids for all sorts of securities. That doesn’t mean those securities are worthless, it merely means that there is a crisis going on.

Think about the house you are living in. Is someone making you an offer for that house? No? Then does that mean your house is worthless? The Fed would appear to think so.

And it’s precisely when there is a crisis that we need our central bankers to be calm and thoughtful and to take the long view. Indeed, FASB 157 specifically notes that fair value mark-​to-​market pricing should be “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Instead, Bernanke & Co. panicked. Did they say to themselves, “Well, there are no bids for these securities today, but soon they will be worth a lot of money, so we’re going to go ahead and lend and prevent a gigantic crisis.” No. They looked at a pricing scheme dictated by an obscure accounting rule designed for normal operating environments and said to themselves, “Golly, all these securities that were worth billions last week are now worthless! I guess our hands are tied!”

This decision will go down in economic history as one of the most clueless, most narrowly bureaucratic, most rigidly legalistic decisions ever made by a senior policymaker.

It was also cowardly. Suppose you somehow actually believed that you may not have the legal authority to save Lehman. Guess what, if you also believed that “we won’t have an economy on Monday,” you say “To hell with the lawyers and the second-​guessers, we’re going to save Lehman and, in the process, the U.S. economy.”

But that’s not what the Fed did. Instead, they let Lehman fail, which caused a far bigger problem — the banking system froze up. Banks everywhere suddenly refused to make overnight loans to other banks, loans that were necessary to keep the other banks afloat. This was, in effect, a modern-​day version of a run-​on-​the-​banks.

Why were the banks afraid to make loans? Because the Fed had just told the world that Lehman’s collateral was worthless. If Lehman wasn’t creditworthy, what about every other bank?

It was at this point that the Fed needed, at last, to step up to the plate and tell the world it would “do whatever it takes.” It especially needed to tell the banks it would do whatever it took, including ignoring (okay, suspending) FASB 157.

But the Fed did none of this. Instead, it demanded of Congress vast new powers, powers it would deploy for a decade in a well-​intentioned but mad attempt to destroy the strongest economy in the world.

I’ll bring this Fed-​bashing series to a close next week with a brief lecture on Free Markets 101, since the Fed seems to have skipped that course at MIT.

Next up: Central Bankers Then and Now, Part VII


Greg Curtis

Gregory Curtis is the founder and Chairman of Greycourt & Co., Inc., a wealth management firm. He is the author of three investment books, including his most recent, Family Capital. He can be reached at . Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.

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