Guest Post: The Manhattan Project: Did Bernanke Use The Monetary Nuclear Option?

Submitted by Geoffrey Batt.

May 2004

Ben Bernanke and Vincent Reinhart (who until 2007 was Director of the Division of Monetary Affairs for the Board of Governors of the Federal Reserve System) publish “Conducting Monetary Policy at Very Low Short-Term Interest Rates” in The American Economic Review.  How, they ask, can a central bank effectively move beyond conventional policy measures when short term rates are at or approaching zero?  Bernanke and Reinhart suggest three strategies:

1. Convince market participants rates will stay low for a period beyond current expectations
2. Change the composition of the central bank’s balance sheet (credit easing)
3. Increase the size of the central bank’s balance sheet to a level exceeding what is necessary to achieve zero short term rates (quantitative easing)

Strategy #2 is radically aggressive insofar as it contemplates altering the composition of a central bank’s assets- which, in non-crisis conditions, consists almost entirely of Treasuries of various maturities- to include other, perhaps even riskier assets.  For instance:

As an important participant in the Treasury market, the Federal Reserve might be able to influence term premiums, and thus overall yields, by shifting the composition of its holdings, say, from shorter-to longer- dated maturities.  In simple terms, if the liquidity or risk characteristics of securities differ, so that investors do not treat all securities as perfect substitutes, then changes in the relative demands by a large purchaser have the potential to alter relative security prices.  The same logic might lead the central bank to consider purchasing assets other than government securities, such as corporate bonds or stocks or foreign government bonds.  (The Federal Reserve is currently authorized to purchase some foreign government bonds but not most private-sector assets, such as corporate bonds or stocks.)1

October 31, 2008

In the context of rapidly deteriorating market conditions, Jan Hatzius, Chief US Economist for none other than Goldman Sachs publishes “Getting to the End of the Rate Cut Road” in US Economics Analyst.  With overnight Fed Funds at 1%, Hatzius argues the time for more aggressive monetary policy may be at hand.  Specifically:

…Fed officials could start to purchase risky asset[s] such as corporate bonds and even equities.  At present, such an aggressive approach is legally quite problematic, as the Federal Reserve must not take on a material amount of default risk.  Thus, the purchase of risky assets would probably require an explicit stamp of Congressional approval.  Should the economic and financial environment continue to deteriorate, however, it would be foolish to rule out such a more radical approach.2

November 14, 2008

Hatzius publishes “Marco Policy in a Liquidity Trap” in US Economics Analyst, advocating still more radical policy measures.  In his words:

The most radical step would be debt- or even money- financed purchases of risky assets such as nonconforming mortgages, corporate bonds, or equities… Policy makers could focus specifically on the mortgage market, buying up mortgages or entire mortgage-backed securities in size, restructuring the terms on a loan-by-loan basis, and then holding the loans to maturity.  Alternatively, they could target risky assets more generally- private-label mortgages as well as corporate bonds, equities, and potentially a whole host of more exotic securities.  Especially, if such a program were financed by money creation, it would be considerably more radical than anything seen previously.  Hence, the hurdle for adoption is high one, and the political scrutiny in Congress would likely be intense.  Nevertheless, we believe it could become a serious possibility should the economic and financial slump deepen in 2009.3

November 21, 2008

Hatzius publishes “What’s Needed to Stop the Rot?” in US Economics Analyst reiterating his call for unconventional policy action even while noting that it currently sits on shaky legal ground.  That is:

…the Congress should consider providing explicit authority to either agency [Treasury or Fed] to buy a broader range of risky assets, including corporate debt and even equities.  Although many politicians have difficulty swallowing this on philosophical grounds, this week’s market action should convince them that the risks of inaction are serious.  However, such a more radical step is unlikely until sometime in 2009.4

March 13, 2009

Chaos reigns globally.  Respected academics and high ranking politicians call for bank nationalization.  CNBC reports of “secret” meetings at Goldman Sachs amid fears Geithner cannot get the job done.  US equity indices are down more from their highs than the corresponding period in The Great Depression.  Pension funds, 401k plans, endowments, insurance companies, etc., are fully exposed, taking heretofore unimagined losses.  With nearly everyone in the country exposed to equities in one way or another, the unthinkable begins to seem increasingly plausible.  Insurance companies cannot pay claims; pension funds cannot meet their obligations; universities suspend session; Mr. and Mrs. Smith, told just months earlier an unprecedented $700 billion bank bailout was designed to save them and their neighbors on Main St., stand to lose everything.  The Fed, having thrown just about everything in its arsenal at the crisis, appears to be losing control.  In the most desperate of times, Hatzius calls for the most desperate of measures:

…Fed officials might need to expand their balance sheet by as much as $10 trillion to make policy appropriately accommodative (pg. 2)…To be sure, “quantitative easing”- an increase in base money beyond what is needed to keep the funds rate at zero- by itself may not be sufficient on its own because Treasury bills become perfect substitutes for base money once short-term interest rates have fallen to zero.  But the Fed can engage in “credit easing” by purchasing assets whose yields are still positive, including longer-term Treasuries, commercial paper, mortgages, corporate bonds, and perhaps even equities.5

Five days later, the Fed shocks the world (though not, it seems, Goldman Sachs) with its most aggressive policy action yet, expanding both the size and composition of its balance sheet via increased purchases of mortgaged-back securities, agency debt, and long-dated Treasuries.  Spreads immediately tighten; Bonds- both IG and HY- scream higher; equities stage one of the most explosive rallies in history; the debate shifts from bank nationalization to record bank profits and excessive pay; financial collapse, along with the terrifying social, political, and economic consequences associated with it, is averted.  The war, we are confidently told, is over.

Mission accomplished.

Questions, however, still remain:

1. Forget the "Paulson Bazooka," if Lehman’s collapse was a financial Pearl Harbor, was the Fed’s policy response on March 18, 2009 the financial equivalent of Fat Man and Little Boy? (The direct purchase of equities?)
2. In the face of the unthinkable, did the Fed exceed its policy statement by directly buying assets not contemplated therein?
3. Did Bernanke, encouraged by Goldman’s Hatzius, heed his own advice and monetize the equity markets?

At best, the evidence offered here is circumstantial.  This is not, to be sure, conclusive proof the Fed bought equities- nor is it intended to be.  All I have endeavored to do is raise a rational doubt, one that could easily be done away with if Bernanke answered (finally) under oath direct questions as to the Fed's purchase of equities at any point during his tenure as Chairman.  Perhaps Alan Grayson might put his worries about foreign currency swaps to the side, and ask Chairman Bernanke about equities.

(The author would like to acknowledge the generous help of Zero Hedge's Marla Singer in the production of this article).

• 1. The American Economic Review, Vol. 94, No. 2., p. 86. (Emphasis ours).
• 2. "US Economics Analyst," Vol 08, Number 44, Goldman Sachs, October 31, 2008, p. 6.
• 3. "Macro Policy in a Liquidity Trap," US Economics Analyst Issue 8 Number 46, Goldman Sachs, p. 6. (Emphasis ours)
• 4. "What's Needed to Stop the Rot?" US Economics Analyst, Issue 08, Number 47, Goldman Sachs, p. 3.
• 5. "The Specter of Deflation," US Economic Analysis, Issue 09, Number 10, Goldman Sachs, March 13, 2009, pg.3. (Emphasis ours)

Comments

[Bear]

We live in a country where the rule of law (as contorted as it is) will ultimately bring down the whole house of cards just as it did with Nixon. However, this time we and all go down with it.

Who will win the Pulitzer for cracking open the FED door?

[deadhead]

Who will win the Pulitzer for cracking open the FED door?

The insiders will have to come out and speak.

tips at zerohedge dot com

[arnoldsimage]

it's no wonder that jesus talked about money more than any other topic in the new testament.

[Bolweevil]

Never in my brief existence have I been more proud to be American. Not for the travesty of self centeredness inflicted upon us by those who look to improve their own lives and their minions, but for the ability to share in this process with others of enormous diversity. I too commend dearest Marla and Geoffery for their ability and more importantly their courage. Keep pushing BB, Mr. President, Henray, Timmay. Keeeep pushing. "sync, load and fire 'til the empire reaps what they sowed." chris cornell

[janchup]

If true, this is fucked. Sorry for the profanity. Really fucked.

[janchup]

Pardon me but this would be -holding back the word "is" - fucked.

[Johnny G.]

Can someone help me?  My recollection is that open interest on S&P Dec1000 and Sep1000 increased 100,000+ contracts long in late Mar.  Such a large nominal interest, for a small bet of $50MM - $100MM would cause a huge hedge.  I personally don't know anyone who is willing to bet on a 50% increase in the index for such a large amount.  But I'm fairly certain we all know of somebody who doesn't think that's a lot of money.

[Apocalypse Now]

I'm getting an evil madmen vibe, perhaps Bond movies didn't go far enough.  I can understand PPT in the case of a foreign financial war attack or disturbance, but I have said this many times - this is using unlimited free funds to take over property and the shares of corporations, in short a takeover.

Swine flu has just been declared a national emergency (what?), FDIC issued a request for a state of calm, the banking industry had a nation wide disaster plan drill this weekend, and Obama just insisted that global warming is man made (there is now undisputed proof that this is a scientifically proven falsehood - so his statement is a falsehood). 

Al Gore worked with Ken Lay of Enron (before he went to prison) to set up the carbon trading along with executives from goldman, he admitted this was the first step in global government and is set to make billions along with the goldman associates.  If they pass this bill, you will be regulated because you would immediately be conisdered a pollutant due to your exhale.  We will have to come up with a new saying instead of don't hold your breath - hold your breath and save the world (population control).  Fines will be arbitrarily applied to bankrupt any company that the club wishes.

Obama argued that the fight against climate change was not just necessary for the health of the planet, but should also spur a new range of green jobs and technologies that could unleash economic growth and promote energy independence.  I can understand the need for another growth curve but don't want to do it on a lie - I would rather focus on anti-pollution excluding CO2 which is essential for our planet.  Sunspots cause almost all variation in temperature and we are in a cooling cycle.  Greenland was called Greenland because hundreds of years ago the vikings found the island to be much warmer and green (before getting Brett Favre from Green Bay). 

These same laws are being passed in countries around the world to reduce country self rule and move into a world government.  All production will be controlled and the population will be reduced.  Call your representatives and stop this - Obama is going to sign a treaty but it has to be passed by congress.

[geopol]

Your spot on,

Everything is being standardized, food under Codex Alimentarius.

We are going one world and I don't see how the cretins in the district of criminals is going to be sympathetic to our calls. I remember all the work I engaged in to stop TARP and they gave me the finger.

[Gilgamesh]

The banksters are going to be taking over A LOT of RE before it's time for hyperinflation.

It's just amazing to watch the AUD (and then other carry currencies) rally on lower than expected Aussie PPI.

Down is the new up.

[Anonymous]

Anyone who observed the equity markets on a daily basis from March 2009 through June 2009 knows the PPT was in action.

[Anonymous]

The FED should be terminated with extreme prejudice and its buildings repurposed into Financial Holocaust Museums.

[geopol]

I agree, but you need to come out of your shell..

[Hunch Trader]

From a trend point of view, what they need to do is to show that there are no triple tops, and that it's about a triple top, not bottom. How much would be the minimum for a reliable looking breakout, 10%? So SPX ~1700-1720 first stop.

Yep that is some 50% higher from today. Not saying that will happen, only observing that IF the markets were truly manipulated, that's where the goal would be.

In theory the US should be in for a long term of deflation, unfortunately US can't afford this because of the debt, and must do anything possible to create an inflatory scenario. I wish it wasn't so. US people will not exactly be better off after that in the global view of things, but the authorities might take the view that their lambs are so well herded that a global comparison does not matter. Just keep watching that TV and you'll be fine.

[Anonymous]

I just think there were too many interests that needed the S&P higher.

Pension funds and insurance annuities would've blown up in a spectacular fashion.

We all know, even back in March, there wasn't a chance in hell of TARP 2.0 getting through Congress. The Fed's only chance to save the FIRE economy was to nurse banks along on the yield curve, on trading profits from a unidirectional move higher in the equities markets and on the ability to issue additional debt and secondary offerings.

[anynonmous]

Rubin Should Teach Paulson Secret PPT Handshake: Caroline Baum

Instead of pumping reserves into the banking system in a crisis, ``wouldn't it be more efficient and effective to supply such support to the stock market directly?'' Heller said.

Clarification

The idea sounded kind of loopy, especially since stocks aren't on the list of securities the Fed is empowered to buy, according to the Federal Reserve Act of 1913 and subsequent amendments. So I called Heller yesterday to drill him on his views.

Back in those days, ``I was not comfortable with how things were proceeding,'' in terms of the pressure on banks to lend to investment banks in a crisis, Heller said. (This was before the Glass-Steagall wall separating the two came down.) Under the circumstances, he advocated ``intervention in the futures market,'' buying S&P 500 contracts or another index.

``If markets cease to function -- if bid-ask spreads widen a lot -- under those circumstances it makes sense for government to step in,'' Heller said in a phone interview.

So did Heller have any evidence that anyone at the Fed or elsewhere had run with his idea? He said no. How about some inside info on the PPT since he seemed to be a member in good standing?

``I didn't know a cabal existed until a reporter called me up and asked me about the PPT, saying `you invented it,''' he said.

http://www.bloomberg.com/apps/news?pid=20601039&sid=a87VERwuZP8c

[contrabandista13]

The question is not whether the Fed has violated it's policy statements, only a moron, a fool, a larcenist or a financial pedophile could argue otherwise.

"Hey... hey... easy on the candy kid...."

Best regards,

Econolicious

[anynonmous]

OT discovered this site when looking for info on Heller - here is their page on Goldman

http://www.nndb.com/company/076/000057902/

[Brett in Manhattan]

I don't see why the fed would have to do this. By accepting equities as collateral, the Fed has already granted its member banks the ability to buy unlimited amounts of stock.

JPM can buy stock, use it as collateral for a loan from the Fed, which can be used to buy more stock...rinse, repeat.

Of course, the entire financial system is at the mercy of stock price fluctuations, but why sweat the small stuff?

[time123]

The big question now is: How long will the market support last? You do not want to be the last one holding when they stop propping the markets. That is why market timing rather than buy and hold are best for this market.

time123

timing signals at http://invetrics.com

[Edna R. Rider]

The longer I read the history of the great crash of 29 and subsequent actions the more clear it has become that indeed the large players (the Fed, the Wall Street banks, etc.) were buying everything, bonds, equities, treasuries.  The famous bankers (of 29) tried this and it temporarily worked.  In fact, the single event earlier this year that has always creeped me out and made me angry for not acting more aggressively is when Obama essentially made a market call to buy stocks, about 7 trading days before it bottomed.  Someone as bright and insecure (he was just starting the job) as Obama would never, not in a million years, have made such an outrageous call unless the "fix" was in for someone to do some heavy buying.  The memo out of Citi, the massive early call buying on FAS (Thu 5 Mar, Fri 6 Mar), so many things appear to have been organized for this first 2 week push.  It also struck me as slightly lunatic (for not noticing) that XLF had gone down YTD as of 6 Mar 50% (almost exactly), and SPY went down almost exactly 25%.  Maybe chartist suddenly believed their own magic, but this is all just a little too programmatic and perfectly organized.  After that the government could keep the markets pumped up by just following through with its rule changing announcements:  the toxic asset program outlined more clearly, 23 Mar, the mark-to-market announcements (essentially decided and telegraphed long before, and even championed by left (B. Frank) and right (Steve Forbes)).  Every lull in the market (near the end of March, when it looked like financials were headed back down), and the early April push, then finally the WFC announcement of a large "profit."  In hindsight everything seems obvious, every trade, every major turning point.  But this was just too bizarre.  How often have US Presidents told the world that "now is a good time to invest?"

[trillion_dollar...]

Agreed. Just think about that 3- 4 week period:

- Obama says to buy stocks on the 3rd

- Market bottoms on the 9th

- Fed announces QE on the 20th

- Obama meets with all the bankers at the WH on the 27th

All the while the huge debate over the PPIP or whatever the hell it was eventually called had been raging for two months. It was almost like the PPIP was created to divert attention away from the "real" plan. Nah, they'd never do something like that.

I've been reading ZH since January. This is by far the most interesting thread I've seen here. Great work everyone.

[AN0NYM0US]

Off topic - I am no fan of HuffPo but this editorial is worth a read

Arianna Huffington: Sunday Roundup

This week, Obama's pay czar announced he'd be slashing executive pay at seven of the biggest recipients of bailout billions. So it's no surprise that many of Wall Street's Masters of the Universe didn't turn up at the New York fundraiser President Obama spoke at -- choosing instead to attend a party thrown to toast the release of Too Big To Fail, Andrew Ross Sorkin's blow-by-blow account of the meltdown. There, enjoying cocktails and finger food, were many of the central players, including Jamie Dimon of JP Morgan and John Mack of Morgan Stanley. Which is kind of like Hannibal Lecter showing up for the opening of Silence of the Lambs. Perhaps they take comfort in Sorkin's assessment that when it comes to reforming Wall Street "the Obama administration seems to have moved on to other priorities." I need a drink.

Read more at: http://www.huffingtonpost.com/

[Sqworl]

In the end the Fed saved only those it owned...

[Anonymous]

Bernanke's trillion-dollar decision
The biggest decision of the economic recovery will be made in the next six months, and Barack Obama will have almost nothing to do with it.Forget the debate over TARP, and never mind the questions about a second stimulus. This decision is about when to pull out $1 trillion that’s propping up the U.S. banking system. And it will be Federal Reserve Chairman Ben Bernanke and his Fed colleagues who make the call.
Last fall, the Fed injected $ 1 trillion-plus into the nation’s banking system – at times, by providing financial institutions with cash to cover their losses as the global meltdown spread. Now Fed officials are already talking about the need to withdraw the funds injected into the economy during the darkest days of the crisis, moves that are credited with largely saving the United States from plummeting into an economic depression.

http://news.yahoo.com/s/politico/28677

[SDRII]

Jamie dimon is not just a favorite he is a loong time democractic operator. Geithner is a placeholder and was essentially in the pay of both Dimon and Fuld, who were on the board of the NY Fed during the debacle. Dimon is being set up to be the hero who comes in to "save" the system. It will be said that he was critical in "saving" bear stearns and in preserving order during those harrowing days. He will be protrayed the same way that the elder Morgan is remebered, truth or otherwsie. Geithner was always a place holder. Dimon will be fawned over by the media complex (think Rattner and Tisch) and be held up as the white knight who will save the system. Timing unknown, but the gameplan seems abundantly clear. Dimon will go out with everyone beliveing that JPM is the model of solbvvency - just as GS didn't need tarp.

[Anonymous]

Take a look at the WSJ from October 1930!

Saturday, October 25, 1930: Dow 195.09 +6.99 (3.7%)
Assorted historical stuff:
Glass Senate subcommittee to meet about Nov. 15 to investigate financial matters, particularly use of Federal Reserve funds to help finance speculative operations.

Any takers on history repeating itself?