Bernanke Gets Walloped

Federal Reserve chairman Ben Bernanke faced withering criticism from Republican senators James Bunning and Richard Shelby, as well as Democratic Senator Christopher Dodd, today at his re-confirmation hearing for another four years as head of the U.S. central bank.

But Bernanke will likely get re-confirmed, despite the most serious and threatening attack on the Fed since the U.S. enacted a 1913 law creating the central bank.

Two pieces of legislation afoot in Congress would strip the Fed of its bank regulatory powers and would also subject the Fed's monetary policy to audits by the Government Accountability Office, as the central bank has gone full throttle with various lending programs in addition to keeping rates historically low in order to resuscitate the financial sector.

Sen. Shelby told Bernanke the Fed "failed" and has done a "horrible job" as a bank regulator, given the subprime crisis. Sen. Dodd questioned why the US should give the central bank "exclusive authority" to regulate banks, noting the central bank has too many distractions and that the country needs "a strong, focused central bank." Sen. Bunning said: "I will do everything I can to stop your nomination and drag out this process as long as I can."

Bernanke, in admitting the central bank's mistakes, said the Fed "certainly..had not done a perfect job" at bank regulation, but that the Fed needs to keep its bank regulatory powers since it is best equipped to monitor the financial system.

The Congressional criticism now is that the Fed, as the country's top banking and monetary regulator, did nothing to stop Wall Street's excesses, did nothing to stop the subprime crisis, did nothing to stop bubbles from inflating, and has gotten too close to Wall Street in its rescue plans -- a strikingly similar criticism that was made in the 19th century that stopped two attempts at enacting a U.S. central bank in the first place.

The Fed did stop the economy from enduring a national nervous breakdown, and the banking sector is no longer careening around in a hospital gown. But the credibility and independence of the central bank is now in danger, as the Fed is now entangled more than ever in the economy.

Bernanke also faced criticisms that the Fed let itself be buffaloed by Wall Street in the collapse of AIG, when the central bank handed over tens of billions of dollars to banks with open trades with the insurer.

Why does anyone think the Fed has the fortitude to regulate banks, why is Bernanke fighting to hold onto the Fed's bank regulatory powers when it so easily shot a ton of money out the central bank's back door in the collapse of AIG? Is this the kind of financial regulation taxpayers deserve?

The criticisms, too, are that the Fed is now too close to Wall Street when Main Street is suffering, unemployment is rising, seven million are out of work, and the government is trying to deficit spend its way out of the downturn.

But when it comes to the government's actions, the most pressing question for investors now is this: What is the next Black Swan event, an event no one can foresee or can stop, that will wreck the colossal run up in the Dow Jones Industrial Average and stop the economic recovery cold?

Answer: a crackup in the bond market, meaning, a collapse in bond prices and a massive spike higher in yields that will shove consumer borrowing rates much higher (as loan rates are tied to Treasurys) and potentially create a double dip recession.

The crackup will happen suddenly, with one country igniting a chain reaction around the globe when it sits up and says, “enough is enough, we are not buying any more U.S. Treasurys, America has run amok.”

It won't be China, because China needs to keep buying Treasurys in order to maintain the yuan's peg to the dollar. However, the flood of Treasurys into the global economy is enough to give any other country a transient stroke.

Today, Bernanke himself addressed the next Black Swan event. “If creditors lose confidence in the U.S.,” the Fed “can't control interest rates, there's nothing you can do about it.”

The Fed itself has hit the computer button and created about $1 trillion in reserves in the banking system. It has also bought hundreds of billions of dollars in mortgage-backed securities, putting more cash in the system.

To avoid rampant inflation, the Fed would have to remove that liquidity from the system in an orderly way. Essentially, to do that, the Fed needs to get the Treasury to issue even more bonds to replace that cash.

And that would come as the White House and Congress are borrowing on a scale this country has never seen before. They have enacted a $3.6 trillion budget, a $787 billion stimulus and now may pass a potential $1 trillion health care reform bill.

All of these Treasurys for all of this spending creates a bond glut, which means all of those bonds will have to compete for investors, driving yields higher to lure investors. That's a recipe for a bond crackup.

The Fed's attempts to exit out of its own massive economic stimulus plans will be the equivalent of trying to learn to drink water from a firehose.

Which is why you hear Bernanke now referring to his quantitative easing as “credit easing,” which doesn't carry such negative overtones.

Which is also why you hear Bernanke becoming more vocal about the massive deficit spending the U.S. has embarked upon.

However, an audit of the Fed would involve more political meddling and Congressional interference. It would hurt the Fed's efforts to not only contain inflation as the dollar threatens to buckle and collapse from Congress's massive deficit spending.

And it could also hurt its efforts to cut back its quantitative easing programs supporting the economy, as politicians could hammer the Fed to back off when they face re-election.

Bernanke pointed out in his testimony that former Fed chairman Paul Volcker could not have successfully contained inflation in the early ‘80s by hiking rates if Congress was allowed to audit Volcker's monetary decisions.

“Volcker conquered inflation [in the early ‘80s] for the very reason that Congress stopped the GAO from auditing the Fed's monetary actions when it passed a law in 1978 restricting those audits,” Bernanke testified.

Former Fed chairman Arthur Burns, who ran the central bank during the ‘70s, has noted that even the GAO's circumscribed examinations of the Fed and potential Congressional meddling did hurt his efforts to fight soaring inflation, brought on by a gunning of the printing presses to help Lyndon Johnson finance the Vietnam war.

To date, the Fed's balance sheet has doubled in size, by about $1 trillion, a sum that equates to the economy of Australia, an amount that is enough to buy the Toronto Stock Exchange or to buy every home foreclosed upon in 2007 and 2008.

And its independence is in question, not just because it has purchased sizable amounts of U.S. Treasurys to keep borrowing rates low. But also because the Fed has selectively chosen which companies survive and which don't, as it is now the world's largest junk investor, with an increasingly idiosyncratic balance sheet as it has taken on AIG and Bear Stearns assets to rescue those two companies while letting Lehman Brothers fail, and as it has taken on all sorts of junky mortgage-backed securities and other bonds.

Bunning was most condemning of the Fed. “You are the definition of moral hazard,” he told Bernanke, adding that the Fed's handling of the bailout of AIG is “enough to send you back to Princeton.”

The New York Federal Reserve, then run by Treasury Secretary Timothy Geithner, made 100% whole more than $60 billion in trades that banks had with AIG when it collapsed.

Those banks included Goldman Sachs, Societe Generale, and UBS, even though UBS had asked for a 2% haircut in the trades, even though those trades did not pose any systemic risk whatsoever to the U.S. economy, and even though the Fed could have used its power and asked for a haircut of 60 cents on the dollar (as AIG itself was negotiating with these companies prior to the rescue.)

The TARP inspector general, Neil Barofsky, has since issued a report that says the New York Fed actually put it to the eight banks sitting across from AIG, essentially asking, will you settle your trades for less than 100 cents on the dollar? All of the banks except UBS refused, and Bernanke said at his reconfirmation hearing that UBS actually only wanted a haircut of "2%."

But with its triple-A-rating, why did the U.S. have to settle these trades at all, given that it was backing AIG's balance sheet at the time? Was this another backdoor, silent bailout of Goldman and the rest of the lot?

Why didn't Bernanke and Geithner, who at other times played hardball with the banks, not hang tough when it came to taxpayers' money?

Under fire, Bernanke said a failure of AIG would have posed "enormous systemic risk," but that he had “no power” and “no leverage” to create substantial discounts on these AIG trades, noting that most of the firms trading with AIG "were foreign," meaning, he had no supervisory powers over them.

Sen. Dodd was baffled. “I don't understand that, you are the U.S. central banker,” he said. Bernanke replied that he did not want to abuse his supervisory power, to which Dodd said caustically, “apparently not.”

Next up: A New Take on Whether the Fed Creates Bubbles