Monday, May 03, 2010

The trillion-dollar fraud
...I believe the reason Paulson didn’t pursue his original toxic-asset purchasing plan is because such a purchase would have created a market price for these assets, and then all of the banks would have had to mark their poor-quality assets to this low market price. This would have resulted in the bankruptcy of almost all the major commercial and investment banks, because their leverage was so high that they couldn't withstand such a hit to their equity.

When Paulson couldn't achieve one of his objectives during the crisis, he typically called on Ben Bernanke to see if the Fed could be of assistance. Paulson was in a difficult position and needed Bernanke's help. He had, just two weeks earlier, told Congress that if they didn’t approve TARP and deal with the banks' toxic assets, the entire financial system would collapse. Now he was about to be exposed as either a liar or just completely wrongheaded, because the toxic assets were still on the banks’ books and he was using TARP money elsewhere. What I believe the Fed did next was fraudulent and deceitful, its full impact still hidden from the American public.

The Fed, I am convinced, went to these commercial banks and offered to take many of their toxic mortgage assets off their books, often accepting them as collateral for loans to the banks. In exchange, the Fed credited the commercial banks with an increase in the reserves held at the Fed, so long as the banks agreed not to withdraw the excess reserves immediately. Magically, the Fed was able to take a bad asset like a CDO and transform it into a sparkling good asset: bank reserves at the Fed. The irony is that the CDO itself began as a compilation of leaden BBB subprime mortgages and had been transformed into a golden AAA security only through the alchemy of the CDO process. And I think the record will show that the Fed intentionally overpaid for these securities, so that the banks wouldn't have to acknowledge life-threatening losses on the sales or the remarking of their inventory of similar assets. The Fed also began buying mortgage securities directly in the marketplace in an attempt to create demand in the absence of a healthy securitization program.

So the Federal Reserve, with no approval by the president, the Congress, the people or their elected representatives, ended up purchasing $1.5 trillion of new assets of unknown quality. The Fed is controlled by our nation's banks, and so it shouldn't surprise us when it uses taxpayer money to save these very same commercial banks.

What concerns many knowledgeable investors is that the Fed doesn't have the money needed to purchase these assets and instead prints new money. As of March 2010, there was approximately $1 trillion of currency outstanding in the country, not including the more than $1 trillion of bank reserves at the Fed. So if the Fed doesn't shrink its balance sheet, we can expect inflation to come roaring back as banks increase lending in the future.

Some have suggested that the Fed is well-aware of this problem and is reviewing creative, if not necessarily transparent, methods to take care of it. Bernanke has said that he is opposed to the outright sale of these assets in the marketplace. One rumor is that the Fed is looking at selling more than $1 trillion of mortgage securities back to Fannie Mae and Freddie Mac. This would complete the circle of deceit, because Fannie and Freddie could fund their purchase with increased borrowings guaranteed by the government, which wouldn't show up on the government's balance sheet because Fannie and Freddie aren't consolidated entities of the federal government (even though they are now owned by the government). Total government debt would increase by $1 trillion, but it would be hidden from the taxpayer, off the balance sheet. The plan has the added advantage of the Fed never having to recognize the losses on any toxic assets included in the transfer, as Congress has already said it will commit unlimited resources to fund any future losses at Fannie or Freddie. Fannie and Freddie are the ideal places for toxic assets to go to die....