Ben Bernanke has a secret.
And it's a secret that very likely terrifies him and his policymaking brethren at the U.S. Federal Reserve.
That secret has to do with his latest round of "quantitative easing," a liquidity-push known as "QE2."
What Bernanke & Co. don't want Americans to know is that painfully slow growth – or even a double-dip recession – isn't their greatest fear. Bernanke's greatest fear is that without this liquidity, one or more of the massive, already-bailed-out U.S. banks could stumble and once again undermine the global financial system.
And this time around, the outcome would be much, much uglier.
If you think about it, the proof of what I'm saying is right in front of each of us. You just have to take a step back and look at it objectively.
Last Sunday, in an appearance on CBS News' "60 Minutes," Bernanke said he could raise interest rates in 15 minutes if inflation ever became a problem. Not to worry, there's no sign of inflation, at least according to him.
Well, there's no sign of deflation either, and thanks to Fed policies, interest rates are at historic lows. So why embark upon "Round Two" of quantitative easing (known as "QE2") and state on one of the nation's most-watched television news programs that additional rounds might follow?
I'm going to break the magician's code and tell you what the trick is and how it works.
Financial Sleight of Hand
The "outward" trick the Fed is pulling off is adding massive liquidity to the U.S. banking system to tide the big banks over in case they face insolvency issues in the near future.
Remember, most of these big banks were in the "too-big-to-fail" category. That's why back in 2008-09 they got all that bailout money: Given their size and influence, the worry was that should one or more of these fail, the whole financial system could come crashing down.
But here's the problem. Since that time, many of those big banks have gotten bigger. And their risks have been steadily increasing: Many of them now face litigation, as well as the balance-sheet, credit and liquidity risks that could cause any one of them to fail – which could take the financial system down with them.
What the Fed is hiding under its cloak is the inside knowledge of:
- What the banks still have on their balance sheets in the way of so-called "toxic assets" – for starters, $2.4 trillion in mortgages and more than $1 trillion in mortgage-backed-securities.
- How the banks have been able to juggle accounting rules to make their books look better.
- How they've made their recent profitability look robust by moving loan-loss reserves back over into the revenue columns of their income statements – booking that as top-line growth.
- And the onslaught of litigation banks now face that could force them to mark down their assets at the same time that they will have to buy back tens of billions of dollars of non-performing mortgages they originated and securitized.
Banks are subject to "put-backs" or "buybacks" of the mortgages they place into securities if it can be proven that the quality of the mortgages weren't what they were represented to be when the securities contracts were originated. That's not hard to prove.
Regulators are very worried about the size of the put-back problem. In an attempt to assess the put-back risk faced by individual banks, the Fed has embarked on internal investigations.
When asked in recent testimony about the depth of the problem, Fed Governor Dan Tarullo, while not willing to quantify banks' put-back risk, termed it "substantial."
Put-back risk is one key reason the Fed will be conducting another round of stress tests on the country's 19 biggest banks. Only this time they're keeping the results to themselves.
But, that's only the beginning.
The U.S. Securities and Exchange Commission (SEC) is investigating the banks for their part in falsely – if not fraudulently – spreading their toxic financial Kool-Aid around to other institutions.
Hints that a settlement was in the works last week quickly got squashed. Besides costing the banks penalties in settling charges, by settling and admitting any kind of guilt, they would be subject to lawsuits for decades to come. And since the litigation costs and the damages themselves could reach into the hundreds of billions of dollars, banks would have to set aside capital and reserves against future liabilities.
Now that this cat is out of the bag, it's doubtful that the SEC can let the banks off that easily.
- The bottom line here is that banks are facing years of possible litigation and massive potential losses – just as their revenue will be squeezed by the many reforms laid out in the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Additionally, new Basel III international capital standards are being imposed on banks, which will mean changes in how they classify the risk profile of various assets over time and how much capital will have to be held in reserve. (A recent report in The Financial Times suggested that U.S. banks – related to Basel III alone – face a $100 billion shortfall.)
And while all this is happening, the U.S. Treasury Department sold its Citigroup Inc. (NYSE: C) stake for a tidy little profit (thanks to the Fed's easy money-inflating equity prices) and banks are saying they're planning on raising dividend payouts in 2011.
The Ultimate Objective
It's a high-stakes poker game. The Fed is bluffing and the banks are playing their hands – and will be big beneficiaries if the central bank pulls this off.
Just this Tuesday, at the Goldman Sachs Group Inc. (NYSE: GS) financial services conference in New York, Bank of America Corp. (NYSE: BAC) Chief Executive Officer Brian Moynihan said the big bank has fixed its balance sheet and is planning to raise its dividend next year.
And, Wells Fargo's CEO John Stumpf projected confidence about growing market share in 2011 and said the bank "was optimistic it can steal loan customers from community banks that are retrenching after overextending themselves before the downturn," according to an American Banker story on the meeting.
That brings us to the trick behind the trick. What QE2 and any subsequent quantitative easing actions (as well as the original quantitative easing move that was worth $1.7 trillion) really does is create a direct liquidity lifeline into the big banks.
The big banks got to stuff themselves with liquidity to enhance their capital ratios and balance sheets. And when that money had no place to go (it wasn't being lent out), it found its way into the stock and bond markets, giving them a very nice run.
But small U.S. community banks got nothing.
In fact, they got less than nothing.
Community banks got overly cautious regulators from the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corp. (FDIC). Those OCC and FDIC visits sucked the life out of the community banks because, after missing all the banking problems that led to the credit crisis in the first place, bank examiners are now erring on the other side of caution.
There's no question that things are bad at community banks. But while big banks reap the benefits of the Fed's direct triage efforts, community banks are being left for dead. That works out fine for the big U.S. banks. They want to grab market share, and can do so in a big way when these community workhorses are put out to pasture.
The difference between big banks and community banks comes down to economies of scale and size. Big banks want to serve big clients with big loans and capital markets services. They don't want little-guy loans, they're too small to be profitable relative to the allocation of resources.
Now, more than ever, that's especially true. With all the problems inherent in the securitization market, big banks aren't interested in small loans because they can't package them into big loans and offload them to investors.
It's going to be a long time before securitization of small loans from disparate originations makes sense again to investors.
Community banks could be facing planned extermination. Of course, the big banks will say that community banks did it to themselves. Without the necessary support to backstop their shaky balance sheets and with capital so difficult to raise because of their weak future prospects, community banks are in great jeopardy.
Since all real estate is "local" and job growth comes from small businesses, who better than community banks to take back the high ground of personal-relationship banking to serve local banking needs that can be better assessed by local bankers?
If we want to empower small businesses to take chances, they need a more-direct access to capital. Since that capital isn't coming from the big banks, we better take another look at whom quantitative easing is benefiting and whom it is hurting.
If the Fed really wanted to shore up community banks, it could backstop most of the "local" commercial real estate and local commercial and industrial loans at community banks with less than $100 billion in assets.
That would give the community banks room to breathe and money to lend to local small business start-ups. Some of the 18 million unemployed folks in America could sure use that kind of backstopping.
If you couldn't initially see the ultimate objective in the QE2 trick, you could be forgiven. But now you know. The fact is that banks are being made to look healthy by means of massive liquidity thrown at them. To foster that "illusion," the U.S. Treasury is cutting them free, and the banks themselves are talking about a future bright with dividends and buyouts.
But they're doing this without really knowing what their liabilities, capital requirements and future revenue will actually be.
And that says it all.
[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.
When that downdraft came, Gilani was ready – and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.
Gilani shows investors the monster "capital waves" now forming, and carefully demonstrates how to profit from every one.
But he doesn't stop there. He's also the consummate risk manager. As the article above demonstrates, Gilani also makes sure to highlight the market pitfalls that can ruin years of careful investing and saving.
Take a moment to check out Gilani's capital-wave-investing strategy – and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. Those essays can be accessed by clicking here.]
News and Related Story Links:
Bernanke on 60 Minutes
Bernanke on 60 Minutes (Video).
- Money Morning News Archive:
Stories by Shah Gilani
- The Wall Street Journal:
Banks Could Face $120B In Mortgage 'Put-Back' Costs—JPMorgan
- Money Morning News Archive:
- Bank Investment Consultant:
Regulators See Growing Threat from Put-Backs
- Wall Street Journal:
Banks in Talks to End Probe
- Money Morning News Analysis:
By Yanking the Teeth Out of Dodd-Frank Act Ratings Rules, SEC Blunts Hope for Real Financial Reforms
- The Financial Times:
U.S. Banks Face $100 billion Basel III Shortfall
Bank of America Dividend Raises Likely
- American Banker:
Bank CEOs More Upbeat on M&A and Dividend Increases
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.