Return to Part I

Bernanke's Parting Error

We do get some insight into the current thinking about bubbles at the Fed, when Ben Bernanke reveals what its 'bubble prevention policy' currently consists of. In essence he simply repeats his flawed analysis of what caused the housing bubble and this analysis is what the new policy is based on (basically, bubbles have nothing to do with interest rates according to Bernanke – all we need is more regulation and especially alert, super-human regulators):

“The Fed’s zero-interest-rate policy is prompting investors to take greater risks with their money. The extra yield that buyers demand to own older, smaller junk bonds that trade infrequently shrank to an average 0.25 percentage point in the first half of this month from more than 1 percentage point a year ago, according to Barclays Plc data.

Bernanke, 60, has set out a two-stage process for identifying potentially dangerous buildups in speculation. First, officials try to pinpoint asset markets where prices are grossly misaligned. Then they consider whether a sudden drop in those prices would be amplified throughout the financial system, as happened during the housing bust. Such intensification could occur if the investors holding those assets were highly leveraged, illiquid or interconnected with others.

The Fed’s “first, second and third lines of defense” for dealing with such imbalances is to rely on supervision, regulation and so-called macro-prudential policies, such as mortgage loan-to-value restrictions, Bernanke told the Brookings Institution in Washington on Jan. 16. Only as a last resort would it consider raising interest rates.”

(emphasis added)

So let's get this straight: the zero interest rate policy is “prompting investors to take greater risks with their money” – not according to Bernanke to be sure, but according to the data and common sense.  But raising interest rates is only deemed a 'last resort' if the Fed happens to spot emerging financial system risks – which we can already guarantee it won't.

The paragraph in the middle which we highlighted is ludicrous from beginning to end: “First, officials try to pinpoint asset markets where prices are grossly misaligned.” These guys have proved over and over again that they are utterly incapable of recognizing bubbles that are staring them right in the face. It is in fact ridiculous that the same people who are responsible for the misalignment of prices are expected to 'pinpoint' said misalignment. The economy's entire structure of prices is distorted when interest rates are artificially suppressed below the natural rate dictated by society-wide time preferences. All prices are thus 'misaligned' as a result of the policy. There is no need to go out and try to 'pinpoint' anything.

“Such intensification could occur if the investors holding those assets were highly leveraged, illiquid or interconnected with others.” – So where exactly in the current bubble era are investors who are not 'highly leveraged' or 'interconnected with others'? That must be a group of investors stranded on a remote island without access to telecommunication (and presumably speculating in coconut milk futures priced in cowry shells). Even though the banking system is superficially better able to deal with bank runs than prior to 2008 because 'QE' has increased the amount of covered relative to uncovered money substitutes outstanding, there are far more deposit liabilities in existence now. Moreover, there are countless ways in which risk has been shunted into other, even more opaque corners of the financial markets. It is not even necessary to mention the endless rehypothecation chains employed by the shadow banking system or the one quadrillion dollars in outstanding derivatives notionals (in spite of netting out reducing this exposure considerably, these will in extremis depend on the ability of links in the chain to actually perform. We saw what can happen when a big link threatens to break when AIG suddenly realized that the CDS contracts it had written were bankrupting it practically overnight). Just look at this example that concerns one of the biggest currently raging bubbles (one of those neither Bernanke nor Yellen profess to be able to see):

“A U.S. bank regulator is warning about the dangers of banks and alternative asset managers working together to do risky deals and get around rules amid concerns about a possible bubble in junk-rated loans to companies.

The Office of the Comptroller of the Currency has already told banks to avoid some of the riskiest junk loans to companies, but is alarmed that banks may still do such deals by sharing some of the risk with asset managers.

"We do not see any benefit to banks working with alternative asset managers or shadow banks to skirt the regulation and continue to have weak deals flooding markets," said Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the OCC, in a statement in response to questions from Reuters. Among the investors in alternative asset managers are pension funds that have funding issues of their own, he said.

"Transferring future losses from banks to pension funds does not aid long-term financial stability for the U.S. economy," he added.

The breadth of the statement from the OCC is unusual because it technically oversees banks and not asset managers. Regulators are eying a number of risks to the financial system as they aim to prevent a repeat of the mortgage bubble that spurred the 2008-2009 financial crisis. They are not comfortable with different players sharing risk if the total level of risk in the system is getting dangerously high.

That may be happening with leveraged loan issuance, which hit a record $1.14 trillion in the U.S. in 2013, up 72 percent from the year before, according to Thomson Reuters Loan Pricing Corp. A measure of the riskiness of these loans has also been rising – the average size of the debt for companies taking these loans in 2013 was 6.21 times a form of cash flow known as EBITDA or earnings before interest, tax, depreciation and amortization, up from 5.86 times in 2012 and the highest since 2007, LPC said.”

(emphasis added)  

Mind that this is just one example of how Bernanke's echo bubble has once again increased systemic risk. We would be willing to bet that no-one at the Fed has ever raised this particular issue. It is also worth pointing out that the main reason why regulators have become cognizant of this risk at all is because it is already too late to do anything about it. The fact that they have even noticed that something is possibly amiss proves ipso facto that the bubble in this corner of the financial universe has become so gargantuan that all that is left to do is to wait until it bursts and maybe say a few prayers.

Conclusion:

There is no point in trying to avert or prevent bubbles caused by monetary pumping by regulatory means. If one avenue for bubble formation is cut off, the newly created money will simply flow into another area. In fact, new bubbles almost always become concentrated in new sectors. If there were a genuine desire to keep the formation of bubbles in check, adopting sound money would be a sine qua non precondition. However, no-one who has any say in today's system has a desire to adopt sound money and give up on the failed centrally planned monetary system in favor of a genuine free market system. Our guess is that the booms and busts the current system inevitably produces will simply continue to grow larger and larger until there comes a denouement that can no longer be 'fixed'.

Janet Yellen: I swear there's no bubble in sight anywhere!

(Photo credit: AP)