The Institutional Risk Analyst: Is Ben Bernanke Greenspan's Fall Guy?

One of the establishment papers Federal Reserve Board�Chairman Ben Bernanke hopes you don't read during summer vacation was issued by the Bank for International Settlements in April 2006. Entitled "Is Price Stability Enough?" �the paper speculates that the Fed's sacrosanct goal of price stability may not forestall bad economic consequences.

"It will be argued in this paper that price stability is indeed desirable for a whole host of reasons," writes William R. White. "At the same time, it will also be contended that achieving near-term price stability might sometimes not be sufficient to avoid serious macroeconomic downturns in the medium term.� Moreover, recognising that all deflations are not alike, the active use of monetary policy to avoid the threat of deflation could even have longer term costs that might be higher than the presumed benefits."

Since the inflation of the 1970s and particularly since the October 1987 market break, the FOMC has never denied the financial markets liquidity, this all the while protesting an increasing devotion to price stability to keep pace with the political ascendancy of the GOP. Particularly under Chairman Alan Greenspan, a man whose political skills always exceeded his economic vision, the FOMC has eagerly accommodated the liquidity needs of both political parties in Washington, helping to finance the Treasury's mounting deficits, America's trade deficit and�various financial bubbles in everything from tech stocks to Asian startups to Manhattan real estate.

Given the Fed's complicity in the mountain of debt accumulated by the US economy over the past decade or more, we cannot�help but�be amused by reports that the central bank intends finally to eliminate the free�intraday float on the Fedwire. On July 20, the Fed will no longer give free credit to "government sponsored"�debt issuers including foreign central banks,�Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE) and the Federal Home Loan Banks, among others.�

In essence, the change means that these issuers will lose a day of free float, for example�when an existing debt issue matures and the new issue that re-finances it settles later in the day or even the following morning. This "daylight overdraft" or "DO"�can sometimes be huge, tens or even hundreds�of billions of dollars per day.� The GSE are the biggest users.� In the works for more than a decade, the change�comes as a result of a rule-making process begun two years ago that was spurred, we understand, by rising hostility to�Fannie�and Freddie. DOs have been a big problem generally for a long time, not only as to their existence, but also as to their pricing.

Back in 1980 and afterward,�DOs became an issue as�a means whereby the Fed�subsidized private commercial�banks.� Senator Bill�Proxmire, the great Wisconsin Democrat who served as the Chairman of the Committee on Banking, Housing and Urban Affairs from 1975 to 1981 and again from 1987 to 1989, tried to force the Fed to price DOs explicitly. The Fed has balked over the years in fully pricing its array of reserve bank "priced services," as they are ironically identified, preferring to use them as a political lever.� As the Fed official responsible for managing the change told Marketwatch: "We believe firmly in free markets."

We hear that F&F have greatly contributed to the Fed's willingness to end the free lunch, this after almost a decade "studying" the issue. Both Greenspan and Bernanke have said that the Fed would be working to tighten up the practice, because it was getting a bit out of hand. They said this not in a punitive tone, just that it needs to be done;�and that�the Fed would be working with the GSEs to get it done.� "Working," as used here, means�reducing the GSEs need for DO's by reducing their assets and therefore the size and frequency of their trips to the funding trough. In the meantime, the GSE are going to need to fund their daily liquidity shortfalls�in the private markets or pay the Fed an even higher rate for intraday credit.

Seen in the context of the Fed's view that the GSEs are a source of systemic risk and in the face of the GSEs' resistance to reform legislation, and the unwillingness of the Treasury and SEC to do anything that might offend the GSEs or their investment bankers, moving to eliminate DOs illustrates the Fed's leverage -- sort of.� Of course, if the Fed decided to use this as leverage on the GSEs, it wouldn't necessarily say so.� Just�recall�the doctrine of "Constructive Ambiguity" codified by�former New York Fed chief Gerry Corrigan and all will be clear.� But while the Fed may force F&F to pay for the liquidity they borrow intraday, don't for a moment think that the GSE are off the "too big to fail" list, an honor roll which includes the money center banks and various other large financial players.

A big factor behind the growth in GSE balance sheets has been the boom in US real estate prices engineered by Chairman Greenspan and the FOMC.� Imposing market pricing on DOs amounts to putting lipstick on the proverbial pig, this as collateral values are visibly cracking.� We wonder: Do Fed Chairman Bernanke and the other members of the FOMC understand that they are the fall guys and gals in this scenario?

By ending the free intraday float, the�Fed advances a very reasonable�solution to a problem it created in the first instance, even while it claims to be reducing "operation risk" to the reserve banks and, don't forget, fighting inflation.� What about the increased operational risk to financial institutions, investors and the entire marketplace due to�the Fed's irresponsible, politically tainted expansion of the money supply?�

As long as you appreciate that in Washington every day is Halloween, to quote our friend�Jim Lucier at Prudential Securities, it all makes perfect sense.