The View From 1776
Wednesday, November 10, 2010
Case Study: Fed-Induced Speculation
A Citibank loan illustrates the decline of credit judgment that that occurs when banks are awash with money pumped into the system by the Federal Reserve’s ill-advised efforts to boost employment and perpetuate a speculative boom.
In earlier years, when I had to finance a deal that fell short of prevailing credit criteria, I tried to bring it to market around November, rather than earlier in the year. Reason: institutional investors usually had budgeted funds that had to be put into deals before year-end, so they often would bend their standards just to get the money out.
In a period of speculative frenzy, when the Fed keeps pumping money into the system, that phenomenon is writ very large. Lenders begin to compete to see who can make the biggest deals, with less and less regard for quality. Indeed, there may be very few quality deals in such an atmosphere.
As Austrian economic theory explains, the Federal Reserve’s over-expansion of the money supply, which artificially lowers interest rates, leads to gross misallocation of investable funds that necessitates a recession to liquidate businesses and assets not supportable by normal economic activity.
An illustrative case appears in a Forbes Magazine article (Citigroup’s Bad Boy, by Nathan Vardi, November 4, 2010) describing a $126 million loan made at the peak of the Fed’s speculative bubble. The borrower had no real credentials to support a deal of the size and type for which Citibank lent him $126 million.
[The borrower, Mr. Stern] had an opportunity to purchase 11 shopping malls in the southeastern U.S. for some $130 million. Stern had never done a commercial real estate deal of anywhere close to that size. In fact a few years earlier he had run two clothing companies that ended up in bankruptcy. But during the giddy precrash era, that track record gave little pause to Citi or others. “Several banks were pitching me at the same time,” says Stern. “Every bank, including JPMorgan Chase and Deutsche Bank, wanted product.”
For Citibank in particular and the banking industry as a whole, the $126 million loan to Mr. Stern was just one of many failures of judgment as the Fed’s speculative bubble expanded.
New York Magazine reported (November 24, 2008):
Over the weekend, federal regulators met with Citigroup executives to save the banking giant from collapse, and ultimately decided to provide the bank with $306 billion in loans and securities and a direct investment of about $20 billion. While they were hammering out that plan, the Times hammered former Treasury secretary, current Citigroup director, and Obama economic adviser Robert E. Rubin, who, according to the Times account, played a “pivotal role” in the bank’s undoing by pushing its executives to move into the packaging and trading of the now-infamous collateralized debt obligations.
Reuters reported (January 9, 2009):
Robert Rubin, a former Treasury Secretary, resigned from Citigroup Inc on Friday following months of criticism of his performance at the giant U.S. bank, whose sinking share price led to a government rescue.
A November 23 front-page story in The New York Times called Rubin “an architect of the bank’s strategy” to chase profit by expanding in collateralized debt obligations and other risky products. Citigroup has rejected the Times’ characterization of Rubin’s role.
The strategy backfired as credit markets tightened and housing prices fell. Many commentators, editorial pages, websites and blogs have also faulted Rubin’s role. Citigroup is now trying to shed 52,000 jobs.
No amount of new regulations conceived by Congressman Barney Frank or Senator Chris Dodd would have prevented such bad judgment by lenders. When a speculative fever overtakes the financial markets, caution is progressively abandoned.
The only reliable way to minimize and largely prevent such lending lunacy is to stop the Federal Reserve from attempting to manage the whole economy by flooding the market with fiat money whenever the stock market lags and unemployment rises. If bankers and institutional investors don’t have money coming out of their ears, they will be more careful about where they lend and invest their funds.
Note that it’s the securities brokerage community who now applaud the Fed’s QE2 program to raise the rate of inflation (i.e., devalue the dollar). Corporations are reporting higher earnings, compared to last year’s depressed levels. At the same time, they are cautioning that sales growth is anemic and cost-cutting opportunities have been exhausted, which means that the outlook for continued higher earnings is unclear. The stock market rise is essentially floating on a rising tide of the Fed’s fiat money.
It also means that the Fed, by pumping up the stock market, is well along the path to creating the next speculative boom and recession.