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Quantitative Easing: The Real Reason the Fed May Go For QE3

[Editor's Note: Retired hedge-fund manager Shah Gilani is one of the industry's foremost experts on the global financial crisis - and all the worldwide ripple effects that this financial scandal has caused.]

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.

Raising Questions

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.

That's frightening.

But, that's only the beginning.

Toxic Mess

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.

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.]

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

Read full bio

  1. Ben P | December 10, 2010

    Always wondered why we, here in Ireland, didn't call it "Quantative Easing" instead of "Bank Bailout" !!! Might have saved us a whole heap of trouble !!

    Gold is set for the moon; rumours from well respected minds here in Europe suggest the Euro is in for a hammering in the new year as Germany eventually says "enough is enough" and there is every possibility of the Euro failing leaving two options,

    1 a two tier Euro with some sort of exchange rate mechanism built in
    2 the reversion to our original currencies and an exchange rate mechanism

    Either way, any economics student can tell you that having an exchange rate is the only proven market system for dealing with these issues and the sooner we return to it, the sooner we can all get on with ignoring so called "policy makers" and let the markets solve the problems.

    It seems to me that the "policy makers" seem to be blaming the markets for excessive bond yields and the current instability yet, markets are only re-active. It should be the "policy makers" that are legislated against.

    "Beware America" as the holiday season ends there will be a lot of wringing of hands in the new year as anxious faces turn towards Europe. The truth will out and there are a whole heap of skeletons in the US banks cupboards, presently the door is only open a crack but when the lock breaks the door always bursts open spewing its contents into the light.

    I'm beginning to believe that here in Ireland we are actually ahead of the game as all our cards are on the table for all to see. Maybe, in the not to distant future, investing in a state owned bank might not be so unusual !!!

  2. Bob | December 10, 2010

    Since the FED, the Big Banks, Congressmen, and the other powers to be see the "need" for QE2, QE3, etc. to serve their own self-interest and to "save themselves", what choice to the people have but to rebel, create chaos, riot!? This is where this is heading. NO ONE is there to really stand up and represent the small businesses and the people. All the fraud, illegal and unconstitutional activities of the FED, of the "to-big-to-fail" banks and even of some of our politicians is happening openly before our eyes and no one is being prosecuted, not even indicted. Unbelievable! Somewhere around a 1000 bankers went to jail during the S&L crisis in the 1980's. How many today in this crisis and mess? ZERO! These so-called "smart" people in the FED are going to take down the entire economy while the say they are fighting the "Ghost of Deflation". SAD SAD SAD!! And it doesn't have to happen!

    • USeless | December 10, 2010

      Wikileaks mate is getting ready to release a lot of damning documents on the big banks.
      The powers that be may not prosecute anyone for this mess but with platforms like Wikileaks it will be harder for the guilty to hide.

  3. Euripides | December 10, 2010

    Dear Mr. Gilani: While I totally enjoy reading your messages and will continue to do so, I really wish you would refrain from slandering the Kool-aid brand of children's drink. As a kid in North Carolina, I grew-up drinking Kool-aid in the summer time and thoroughly enjoyed it. Please issue a retractraction to that comment.

  4. eman | December 10, 2010

    Bernank was one of the advisory brains behind the Japanese scenario. Whats new? Surely someone in the MIT brain bank is advising Bernank.I know its complex but you do not need a parachute to skydive. You only need a parachute to skydive twice. Who is the CFO managing the books on all the central bank, bank, financial institution and commercial and etc pay backs? Doesnt the QE financial plan call for a Return On Investment? The answer to that is "you don't really want to know". Go get em Ron Paul, but more likely it will be WikiLeaks.

  5. Walter John Mitchell | December 10, 2010

    Is there a "safe" bank on the moon?
    Thanks to all you wizkids NNNNNOOOOOOTTTTTT.

    • DD | December 13, 2010

      I am inclined to agree with you that it is all these academic wiz kids (and alike) that is partly to blame for this mess (o/s of pure greed). Perhaps the college education is not what it's supposed to be and I find a lot of academics underneath it all, can't budget their own lives, so how are most supposed to work with a company's financials and have key positions in companies? This was and is an opportunity for pure greed at the expense of perhaps the lesser educated Main Street. I for one, am somewhat glad to see these over-rated BA’s, MA’s etc., become worthless. Let’s see ‘common sense’ take over the academic place instead.

      Common sense = most academics do not have it.

  6. Steve | December 10, 2010

    If the small community banks are indeed targeted for "planned extermination" or even if they are just allowed to wither on the vine, in either case the fate of small business and entrepreneurship in the United States will be sealed. If big banks and Private Investment Groups are left to fill the void, entrepreneurial activity will come to a halt becasue who in their right mind is going to start or expand a small business if in the final analysis the ROI goes to the bank and/or the PIG – and rest assured, it will! Without active small business entrepreneurs operating aggressively in this county the U.S. economy is in for some real tough sledding.

  7. Tim Challenor | December 10, 2010

    You wrote;

    "But they're doing this without really knowing what their liabilities, capital requirements and future revenue will actually be.

    And that says it all."

    Not knowing what one's liabilities are is inexcusable, but I'd like to think that perhaps you really meant to write that "some do not know the precise extent of their liabilities from time to time", which is perfectly reasonable.
    More importantly, I have to remind you that we *all* do what we do without the ability to see into the future. If you know differently perhaps you would share it with us?

  8. John | December 10, 2010

    My compliments to Shah Gilani, for doing the research and analysis we need. This article and many others like it illustrate how big business in using the federal government to cover their sins and loot the United States of America. For any "small" business principal, owner or director that is not, and has not been, politically engaged, now would be a good time to start. I ask fellow CPAs and business owners if they have sent a letter to their legislator(s) in the past four years. Overwhelmingly, the response is "No." No matter what side of the isle you stand, the last four years have been a call to action. In my eyes, this is the true epicenter of our economic crises; non-action by the majority of moral business owners. I think it is time for the small business community to save the elites from themselves. What sense does it make to save some money on the Bush Tax Cuts, only to see your bond or stock portfolio cut in half? Where is the gain in this? Can a culture of lie-cheat-and-steal lead to anything but destruction? (for everyone) To the small busines owner reading this, who needs a local banker, think seriously about what Shah Gilani is saying here. The empirical evidence and corollaries to other industries, aside from banking, is mounting. I do not have to strech my imagination much to see what it will be like to have the bank consider me too small and unimportant for decent financing. I have traveled to eastern European countries where the small businessmen fund their own security force. (A car in front and another in back.) They drive down the road with ther eyes searching wildly. The police cannot be trusted or relied upon. Can you afford such an expense, and would you want to live like that anyway? I urge everyone reading this to think seriously. Is it a wise choice to delegate the protection of your business and culture to a cabal of elite cheats? Let's be honest; we are many and they are few. Please, no more monday morning quarterbacking, whining and apathy. Do what you know how to do….Take wise, peaceful action while conditions are still salvageable.

  9. John R | December 10, 2010



    Our crooked political leaders and most shamefully, our lawmakers who are in bed with Wall St investment banker/financier/parasites, essentially take and don't give fair shares of the 'money-power pie' back to the working people, as they continue to set bad and destructive examples to our younger generations.

    America's lawyers in particular, many who are lawmakers, must be cut down to size, as they are largely responsible for converting what is supposed to be our legal/justice system into a game used for their and others' selfish, greedy, personal money and power ends.

    In addition, our aforementioned leaders provide safe and clean lives, homes and jobs for themselves and their family members, while sending 'other' – mostly poor and non-white – young people to serve, lose limbs,get maimed, and die in the military, in order that said crooked leaders maintain their rich, luxurious, safe, parasitic lifestyles!

    The corruption, selfishness, greed, and inconsideration of others, that is part and parcel of our leaders' lifestyles, must be brought to an end via education and re-socialization…

    … or this country and its people have virtually no chance to achieve a safe, fair and just future.

    It's long overdue to heavily tax the mostly non-productive, non-contributing WEALTHY, while for for example, waiving taxation, road, bridge and tunnel tolls for the average working person!


  10. Danny | December 10, 2010

    Bernanke should be tried as a criminal and a traitor to America's interests. He should be made an example of because he is the responsible head of the destructive Keynesian policies he is pursuing that are destroying the American economy.

    The American people are fed up with these children experimenting and playing games with the future of the Republic. The Fed MUST be abolished. And NOW is not too soon!

  11. JM | December 10, 2010

    Nice article! Our sinking ship is being filled with more water (lies,debt,etc)… The future could be scary! SOS

  12. Svet | December 10, 2010

    Everything about the politics and FED is false and untrue:FACT! There IS inflation in the States. Banks DO NOT need liquidity. Employment NEEDS restructuring. Instead, the Administration and FED are stubbornly focusing on taxes and week dollar. In their vision everything will be fine if the dollar gets down to 3 yuan, 1 Euro gets up to 2$ and Japanese yen surges up to 50.
    Printing money will not solve any of your problems, folks. What you have to do is bring manufacturing back to the States. What you have to do is make credit to businesses more available and consumer and mortgage credit less available. Thus you will make the Americans learn to live within their means and buy American produce. You will not make the Germans buy Chrysler instead of BMW just because the dollar is worth nothing. You will not make the Japanese buy Maytag because they have Hitachi which is technologically light years ahead. You will not make the Chinese buy anything unless you get Michael Dell and Steve Jobs out of there and BRING THEM BACK TO THE STATES !!!!
    And you will get all sorted out if you kick Greenspan's entourage out of power.

  13. Bob | December 11, 2010

    You are quite right Shah. I saw QE2 as a further bailout of the banks from the beginning. However for the Fed Reserve to admit this would be a hard sell. It really pains me to see public funds being spent for this purpose and also to continue subsidizing gambling by these banks. If some of these banks are in trouble arrange for a takeover by the stronger banks, provided there are any. If Swissbank Corp. could effectively take over huge, stumbling Union Bank of Swiss in 1998, why can't the large US banks do the same? Furthermore I find it objectionable that Bernanke would attempt to justify QE2 by explanations that even an Economics 101 student would reject. He is insulting the intelligence of the American people! Hopefully Ron Paul, the new head of the Congressional Oversight Committee on the Fed Reserve can put a stop to QE2.

  14. Mannstein | December 12, 2010

    If the banks are in such dire straights why is it that they are still handing out big fat bonuses to their workers at our expense. Letting some fail would be the right signal to send that in the future the taxpayers are not going to be there to save their ass from the fire.

    It's high time that the banks are broken up into smaller entities so that we don't have a repeat of this rip off.

  15. David Piller | December 14, 2010

    QE2 (and what can be expected to be future rounds of QE — QE3 and beyond) will pump interest charges out of the taxpayers' pockets and into the pocket of the Fed. This insidious flow will recompense the Fed for the massive losses it will realize as a result of its overpaying (at 100 cents on the dollar) for the toxic crud it acquired during QE1 and QE1.5. Yes, the Fed's charter says it must rebate any 'excess' earnings back to the Treasury/taxpayer, but that rebate flow will only restart AFTER the Fed has recouped all of its massive bailout-related losses AND paid out its sweet 6% dividend to member banks (really a 12% dividend because the member banks only have to place half of their capital on deposit with the Fed and can "play with" or loan out the other half).

  16. Jim | December 15, 2010

    I don't know anything about economics, economies and the like. I received my Master's degree in Psychology. I worked my way through college, worked 34 years in 2 jobs and had to retire on a 75% income and Social Security benefits. If either is cut by bad bonds or by the SS administration, I will be homeless, as I could no longer afford the house I built during the "good years". I have a fatal disorder, which is OK with me since I have Major Bipolar Disorder and hydrocephalus. I will, at some time, Dr'S say, slip into dementia. Could live for decades in dementia before my body gives out. Some people want to cut "entitlements". I have paid in more than most of them to so-called Social Security.
    Here's what I do know about the subject at hand: Every time I go to the store for groceries, nothing has deflated, quite the opposite. If Obamacare stands, as I sincerely hope will never happen, I'll be placed in a nursing home attended to by illegalos who will care less if I shit myself and need a bned change. I will be one of those on the "death list" which I assure you they have under another name, and die in filth in the most depressing place in the world.
    Somebody's getting rich, it sure isn't me. Some folks want Big Brother to care for ALL their wants and needs. The gov't is complying. Now the gov't is mandating what our lunchrooms can serve to our kids. Soon the general population will be forced to eat "healthy" food. Goodbye steaks, hello soy beans.
    How long will it take this country to riot for change? That, to me is the question.
    Merry CHRISTMAS, everyone.

  17. usedkarguy | December 26, 2010

    "The Greatest Fraud On Earth" just keeps going. Thank you for an insightful article. Now let's stop the blanket "blame the borrower" theories and put some of these criminals in jail.

  18. Quantitative Easing | January 12, 2011

    Central banks tend to use quantitative easing when interest rates have already been lowered to near 0% levels and have failed to produce the desired effect. It is really very difficult to decide whether QE3 should be implemented or not.

  19. kenton dunbar | February 3, 2011

    Tunisia, Egypt and just maybe someday the USA, or are we just too spoiled and lazy to stand up for ourselves? The alternative, a full on police-state regulated and controlled by the political corporate big kids at the top through the Pentagon to keep those at the bottom where they belong–poor and subservient! love

  20. burnerJack | February 12, 2011

    What happens when The People find the value of their savings decimated, almost no prospects for gainful employment despite the prizes borne by mountains of student loan debt and (surprise!) due to budget constraints the "social safety net" fails at the exact time its most needed? This all happens at the crest of the retirement peak of the baby boomers.

    If the global economy is indeed a zero sum game, where IS all the money?
    Without the demand from Main ST. Wall St. is a shaky house of cards.
    One must wonder if a global "reboot" is inevitable.

  21. deanc | February 22, 2011

    And he causeth all… both small and great, rich and poor ,free and bond,to receive a mark in his right hand or forehead ,and that no man might buy or sell,save he that had the name ,or the mark of the beast, or the number of his name ,and here is wisdom,let he that readeth understand,that number is the number of a man ,and that number is six hundred three score and six….Revelation13 verses16-18….Here is how unbeleivers will be forced to buy and sell after the great worldwide economic collapse.,repent and seek God now while there is still time.He's waiting for you,that's why Jesus hasn't returned yet ,he wants no one to be lost,…but he can't wait forever.

  22. Fritz | February 25, 2011

    What is needed is to round up all these crooks and put theym in a labor camp in Siberia.

  23. huntlone | April 6, 2011

    every body is complaining about this and that, but what we have here is an chance of a life time to get rich. You can not do anything about the banks and the fed let them all fail let the world fail. Sell every thing you have all your toys, the second car even your house, and buy silver. You have to save your self first before you can save the world.

  24. Bill | April 29, 2011

    Yes I would like to receive your news letter.

  25. Louise Cave | May 13, 2011

    I know so little about U.S. and global economic theories, but a lot about food prices at the supermarket. I'm considerably frightened but somewhat enlightened by what I read in your articles. Reality is that nobody is going to de-throne a spendthrift administration, nor send Bernanke to jail. And we'll be very lucky if a new administration in 2012 knows how to unravel a giant extravagance of both political parties over several decades! I haven't enough capital to make astute investments in the market—I can only buy a gold or silver coin here and there. If the Fed targets Social Security, I'll have to start spending those coins. Thanks for the info anyway.

  26. ubaldo pietrantonio | May 16, 2011

    where is u.s.a. power? to go make little big wars.spend billion dollars,while china gets all the business and make money,manifacturing goods, and buying all gold and other metals. please america use your power to stop these emergencies.use your power, stop this,use your power to bring your dollar up.PRODUCE WHAT YOU NEED,.Don't make other nations produce it for you.( at least for the time being ) don't make people steal with big bonuses.increase your income taxes in the high bracket.
    . t

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