Bernanke Continues to Say Nothing

This speech by Chairman of the Federal Reserve Ben Bernanke was a disappointment. It clearly articulates what happened and some of what was intended, but fails to answer the critical question: What line of reasoning concluded this was the best course of action? Failure to answer this question makes Bernanke look very weak and a bit vacuous.

I thought this sentence was eloquent:

"Great uncertainty about the values of financial assets, particularly more complex and opaque assets, has made investors extremely reluctant to bear credit risk, resulting in further declines in asset prices and a drying up of liquidity in a number of funding markets."

However, this was unsatisfying:

"To avoid unacceptably large dislocations in the mortgage markets, the financial sector, and the economy as a whole, the Federal Housing Finance Agency (FHFA) put Fannie and Freddie into conservatorship and the Treasury, drawing on authorities recently granted by the Congress, made financial support available."

Bernanke says nothing about why the dislocations would be “unacceptably large”.

"In the case of AIG, the Federal Reserve and the Treasury judged that a disorderly failure of AIG would have severely threatened global financial stability and the performance of the U.S. economy. That judgment reflected our assessment of prevailing market conditions, AIG's central role in a number of markets other firms use to manage risks, and the size and composition of AIG's balance sheet."

I’d like to hear more about this judgment. How severe a threat was the failure? Why was an “orderly wind-down” (mentioned earlier in the speech) not pursued for AIG?

Then, there is this statement about the Troubled Asset Relief Program (TARP) established by the Emergency Economic Stabilization Act—the big piece of legislation that passed last week.

"The TARP's purchases of illiquid assets from banks and other financial institutions will create liquidity and promote price discovery in the markets for these assets. This in turn will reduce investor uncertainty about the current value and prospects of financial institutions, enabling banks and other institutions to raise capital and increasing the willingness of counterparties to engage. More generally, increased liquidity and transparency in pricing will help to restore confidence in our financial markets and promote more normal functioning. With time, strengthening our financial institutions and markets will allow credit to begin flowing again, supporting economic growth."

Bringing the government (really, current and future taxpayers) in as a purchaser may promote the “discovery” of prices, but those prices will be inflated. Government intervention will certainly not promote the discovery of intrinsic value. Hence, investor uncertainty about the current value and prospects of financial institutions will be perpetuated, not reduced. The hot potato of losses will merely be passed to the tax payer. On the other hand, fast and “orderly wind-down” of banks would have promoted discovery of prices likely to be at or below intrinsic value.

"Second, the $700 billion allocated by the legislation is not an authorization to spend but rather an authorization to purchase financial assets. The Treasury will be a patient investor and will likely hold these assets for an appreciable period of time. Eventually, however, some assets will mature, and the Treasury will choose to sell others to private investors. Financially, in the long run, the taxpayer may come out either ahead or behind in this process; in light of the many uncertainties, no assurances can be given. But the ultimate cost of the program to the taxpayer will certainly be far less than $700 billion."

It is incredible that Bernanke attempted to pass such statements by a large group of educated economists. Elementary finance, the kind understood even by illiterate street vendors, tells us that profit is only assured if the return rate on an investment exceeds the interest rate paid for borrowing to make it. Many of the assets to be purchased are backed by “underwater” mortgages with negative value. Patience will not turn these radioactive assets into gold. A loss being virtually guaranteed, the question is how big it is, who incurs it, and over what time period it is allowed to drag down the investor. Bernanke states with certainty that the loss will be “far less than $700 billion,” but if there were any truth to this, or evidence to back it, banks would be using it to shore up their balance sheets, not facing liquidation.

Value investors frequently seek what is termed GARP, Growth At a Reasonable Price. The speech suggests that the Federal Reserve seeks growth at any cost. Such naivete in the Chairman of the Federal Reserve is deeply disturbing. I expect the US Federal Reserve to be more sophisticated. I expect it to understand that the economy is a dynamic process subject to cycles. I expect Bernanke to understand that short-term shrinkage (yes, even a recession) may be inevitable but that it can be accelerated, preparing the way for unfettered long-term growth.

This is one of those times when accelerating through the intersection allows you to escape with hardly a scratch, while slowing down only places you smack in the center of a massive pileup. Indeed, you have a moral obligation to speed through, thereby reducing the size of the accident and remaining able to help the victims. And I expect the Chairman of the Federal Reserve to be driving the car, not rubbernecking from the sidelines.

Tags: Economics, Politics

Updated at: 9 October 2008 5:10 AM