Baltimore – (TFN): All eyes and ears are on the Fed this week. With Bernanke in New York discussing potential new bubbles and the New York Fed getting heat for overpaying AIG’s many creditors, investors are having a tough time knowing exactly who to follow.

For those of you who hold up the “Fire the Fed” signs, move over. I am thinking about joining your camp.

First, the real bad stuff. According to Neil Barofsky, TARP’s special inspector general, New York’s Fed (under the leadership of Tim Geithner) failed to use its leverage as the top-banking regulator to tell AIG’s lenders to take less than they were owed.

Instead of taking an across-the-board “haircut” as Obama and Pelosi told us we all should, finance giants like Goldman Sachs, Merrill Lynch and Societe Generale said they want 100% of what they were owed.

The only holdout, UBS, said it would be willing to take 98%. But after tough looks from the guys from across the table, that offer was quickly rescinded.

According to Barofsky, the move cost the country billions of dollars and much, much more in confidence for the nation’s banking cops.

Thanks, Tim!

With that bit of news in today’s headlines, it is tough to find the confidence in some of the Fed’s latest plans to help pull the country from financial failure.

As the nation slowly recovers from last fall’s economic collapse, Bernanke and his troops at the Fed are now facing the difficult task of unwinding massive expansionary policies.

One trick discussed today is shortening the length of emergency loans from 90 days to just 24 days starting in January. It’s a pretty mundane move that will have little tangible effect on the markets.

But what could have a much larger impact, with much less transparency, is Bernanke’s recent discussion of paying interest on the reserves banks place with the Fed.

A popular move with many overseas central banks, the interest rates paid on reserves helps to establish a rate floor that regulators can gradually increase without raising overall interest rates.

Essentially, the move is a way of mopping up excessive liquidity without draining or lowering the water in a much larger pool of lending capital.

Like many things, the idea sounds great on paper, but so did letting the Fed negotiate with AIG’s trading partners and we now know how much that cost us.

Let’s face it. The markets like transparency and predictability. Anything less gives us what Friedrich Hayek called “malinvestment.”

As the Fed gets more and more creative in its efforts to boost the economy without creating deadly bubbles, transparency will go out the window.

Toss in growing political pressure from the folks from Washington and one thing is certain.

Anything the Fed does will cost you and I more money.

The same bank whose employees were Wall Street’s biggest contributors to President Obama’s electoral campaign.

Still stuck? Here’s another hint: It rhymes with “Golden Sacks.” That’s right! Since Team Obama took over the reins of power, shares in Notes’ favorite whipping boy, Goldman Sachs, are up 132%. Now, there’s a coincidence.

And if you aren’t convinced that there are certain “perks” tied to the close relationship between Goldman Sachs and the government, consider the case of New York Fed chairman Stephen Friedman.

According to The Wall Street Journal, Friedman, who once ran Goldman, made a tidy $1.7 million from the purchase of 37,300 of the bank’s shares while chairman of the New York Fed.

Why is this noteworthy? Because last September the New York Fed speedily approved Goldman’s application to become a bank holding company and therefore qualify to receive a $10 billion tax-funded cash injection. And members of the New York Fed’s board are prohibited from owning shares in bank holding companies.

Not that this ban worried Friedman too much. While the Fed considered an application for a waiver on the rule, Friedman not only kept his existing holding Goldman shares, but also bought 37,300 more Goldman shares in December. Friedman says there was no conflict of interest in his purchase of the shares. He is stepping down as chairman of the New York Fed at the end of the year, when the waiver allowing him to own the shares expires. Presumably, he wants to hold onto his $1.7 million gain.

I won’t take a position on this myself.  I will instead marshal facts and evidence you can use to make your own guess in the comments section.

Let’s start with a piece in the International Herald Tribune, which surveys a host of establishment economists, all arriving at the same conclusion:  Many of the major banks are insolvent, and Geithner’s TARP II plan — even once the details are fleshed out — will be inadequate to the task.

Hmmm… A Geithner brainchild that even by conventional, interventionist standards is a dud.  Where’ve we encountered that before?  Oh yeah, the decision to let Lehman go under last fall when Geithner was still head of the New York Fed.* Seemed like a good idea at the time, until it unleashed the Counterparty Cascade from Hell — nearly taking down AIG (NYSE:AIG), forcing money-market funds to “break the buck,” and by some accounts bringing the U.S. financial system within three hours of meltdown.

Our next item of evidence is a report that Goldman Sachs (NYSE:GS) called an emergency meeting of its biggest clients — hedge funds, private equity guys — on Tuesday after Geithner floated his TARP II turkey.  Goldman first denied the meeting ever took place.  Then it tried to spin the meeting as having been scheduled weeks in advance.  Whatever the truth, clearly some of the meeting’s participants wanted it known they weren’t happy with the plan and strategically leaked the assertion that it was called at the last minute.

For someone who’s a Goldman guy through and through, Geithner doesn’t seem to be getting much of a vote of confidence here.  No, Geithner’s never been on the payroll, but his designated chief of staff was a Goldman lobbyist, one of the board members of the New York Fed that Geithner used to run was a Goldman guy, and he’s a protege of uber-Goldman guy Robert Rubin.

So there’s the evidence, gleaned just from taking in my usual morning news diet.  Again, I won’t take a stand on how long Geithner will last, although I strongly doubt he’ll be fired outright, which is why I call this the Geithner Resignation Pool; whenver the time comes we’ll get the usual song-and-dance about wanting to spend more time with family.  So fire away with your own guesses about the timing.

* I’ve been misinterpreted on this before, so let me be clear:  I’m a free-market guy who thinks all mismanaged banks should get what’s coming to them; better to purge the rot from the system and get it over with.  I’m merely pointing out how Geithner blows it even using the yardstick of conventional bankster wisdom.

Source: The Geithner Resignation Pool

Chris Rupkey, senior economist at The Bank of Tokyo-Mitsubishi in New York, represented general market sentiment as he hailed the selection: “A fantastic choice to help lead the financial markets out of the wilderness,” Rupkey said. “A crisis manager par excellence who will hit the ground running as he has been on the case since the global funding crisis began way back in July 2007.”

We’ll have to wait and see whether having a key Fed official proves a smart choice to be in charge of the bailout, but at this point even Joe the Plumber seems like a better option than Goldman’s Hank Paulson, who now seems merely confused.

And speaking of Goldman Sachs, economists at the investment bank forecast that the U.S. unemployment rate will reach 9%, from 6.5% currently, by the end of 2009, and that the economy will shrink in each quarter until mid-2009.

If unemployment does go that high, it would be “unequivocally the worst single downturn on record since World War II,” Goldman’s analysts wrote.

Source: Dollar lower against euro - Goldman predicts 9% unemployment.

The economic news of the day was mostly negative.

The New York Fed’s Empire State Manufacturing index fell to a reading of negative 3.2 in May from a positive 0.6 in April. In Philadelphia, factory activity rose to negative 15.6 in May from 24.9 in April. New York’s data was worse than projected, but Philly’s was better.

The Fed also reported that industrial output of the nation’s factories, mines and utilities dropped 0.7% in April in a broad-based decline led by falling production of motor vehicles. That was worse than a predicted 0.6% decline.

And the Labor Department reported that the number of people filing for the first time for unemployment benefits rose 6,000 to a total of 371,000 on a seasonally adjusted basis in the week ended May 10.

“The recent downward tilt in industrial production and ongoing moderate job losses suggest the U.S. economy is in a mild recession,” wrote Sal Guatieri, economist at BMO Capital Markets.

It’s mild, of course, unless you’re directly affected.

Source: Dollar Makes Small Gains

The goal of the FED, as with all central banks, is three-fold: (1) to protect the largest
commercial banks from their depositors, who occasionally exercise their contractual right to withdraw currency (the ungrateful cads); (2) to control entry of newcomers into the bankers’ cartel (interlopers); (3) to keep the stock market from collapsing in a panic, thereby persuading depositors to withdraw currency.

With the Federal Reserve System’s latest proposal, presented to the public by Secretary of the Treasury Henry”Goldman Sachs” Paulson, the FED is asking the United States government to make it the Great Protector of Capital.

Think of the bank run scene in “It’s a Wonderful Life.” Ben Bernanke wants us to view him as kindly Jimmy Stewart, handing out his honeymoon money to save the family
business from fearful depositors who want their money back. Sorry, but the best I can mentally conjure is an image of Donna Reed with a beard.

The Federal Reserve System has always been presented to the voters as the lender of last resort, the provider of the national safety net. But because of the now-admitted
fragility of the present leveraged financial system, the FED has become the deal-doer of first resort. When the New York FED intervened on Sunday, March 17, to cobble together an emergency deal for J. P. Morgan Chase to buy out Bear Stearns’ investors for $2 a share (the price had been $10 on March 15 and $68 on March 11), the New Domestic Order was made visible. The FED, not the capital markets, will set prices of financial institutions whenever the FED’s bureaucrats deem this necessary.

Anyone who says that the FED is not using its government-granted monopolistic power over money to protect the capital markets from the now-unpleasant effects of the
FED’s actions under Alan Greenspan deserves to be a Bear Stearns investor.

MORAL HAZARD AND UNCLE SCROOGE

“Moral hazard” is the phrase that describes one negative effect of guaranteeing the survival of a group of companies or an entire industry that have made bad investments, but which are then bailed out by the government or its licensed agent, the Federal Reserve System.

What is this negative effect? To promote future high-risk loans or investment strategies that offer above-market rates of return because of this risk.

The decision-makers, knowing that their rich uncle has previously guaranteed that several large firms were not allowed to go bankrupt, now pursue investment strategies
which they would not pursue if they believed that they would be held fully accountable for their actions. Senior managers see that their peers were bailed out. They think,
“We will be bailed out, too.” Uncle Sam is the rich uncle. And also Uncle Ben –
not the rice fellow: the FED fellow.

There is another Uncle with a lot of money: Uncle Scrooge. Uncle Scrooge was never dumb enough to offer his nephew Donald an insurance policy for Donald’s schemes to
make money. If he had, he would have found himself handing out a lot of money.

Uncle Scrooge understood the effects of insuring profit-seeking schemes by people who have been given security from their own mistakes. How do I know what Uncle Scrooge thought? Because I knew him personally. Well, not quite. I knew his advisor.

For many years, the man who wrote the story lines for the Uncle Scrooge comic books was Vic Lockman. He was a professional cartoonist. Back in 1969, he published a
cartoon booklet on the Federal Reserve System, “The Official Counterfeiter.” That booklet deserves to be posted on some website, or lots of websites.

Uncle Scrooge had a vault full of gold coins. So does the Federal Reserve System, or so we are told. Uncle Scrooge owed his coins. The FED holds gold bullion bricks
as a reserve for a part — a fixed part — of the money supply of the United States. It does this on behalf of the United States (it says here). That gold may still be in the vault at the New York FED, or it may not. Members of Congress do not know, nor do they know what, if anything, is in the vault at Fort Knox. Congress is assured that the gold is there. By whom? By the handful of Treasury and Federal Reserve bureaucrats who have access to these vaults.

So, with gold as a reserve — we hope — and with government debt as a reserve, and with mortgages handed over to the FED by banks and financial institutions in exchange for Treasury debt, the Federal Reserve System regulates America’s money supply, or tries to.

It now wants to regulate far more than the money supply. It wants to regulate the institutions that lend or invest large chunks of the nation’s money supply. Why? Officially, because of the fragility of the financial system. That, at least, is the implication of Secretary Paulson’s published statements. The financial system was not seen as fragile in July, 2007, but it is now. On the contrary, the system was said to be A-OK in July, 2007, but not now. Everything is different today.

It isn’t different, of course. It is the same. What is different is that what was always implicit has now become explicit: the threat of falling dominoes. If the proposed legislation passes — and it will — things will be even more different in the future.

BAD MORTGAGES? LET’S WRITE MORE!

Recently, a memo issued by Wachovia Bank indicated that it would no longer make high-risk loans to home buyers. This sounds to me like locking the barn door after the horses have escaped. The memo got leaked. Then an amazing thing happened.
Wachovia’s response was neither to confirm nor deny.

You think, “Wait a minute. Why not confirm it? Why not admit that making high-risk loans is a bad policy?” Because Wachovia is regulated by the United States government. It must be very careful about refusing to make high-risk loans.

There is a bank lending policy called red-lining. Banks in the past refused to make mortgage loans in neighborhoods where there is a past record of high default rates. This policy is today illegal. The Federal government subsumes it under racial discrimination.

It’s not that red-lining was aimed at the Sons of Tonto. It was aimed at high-risk neighborhoods. And, because birds of a feather are said by the U.S. government
never to flock together, it’s illegal to discriminate against birds of a certain color.

We know that zip code marketing is very profitable. The Claritas company has broken the United States into 66 different neighborhood types: income, age, education, etc.
These are tied to nine-digit zip codes. It sells this information to marketers who want to plan sales campaigns for certain products.

Claritas has been doing this for years. How? Because birds of a feather really do fly together. Response rates to direct-mail solicitations do differ in terms of zip codes, right down to all nine digits.

Wachovia is still making loans called option ARMs. These loans involve an offer to a borrowed to pay less per month than is required to repay the loan. Each month, the
money left unpaid is added to the loan’s principal. Then, at some contractual trigger price for principal, the loan’s monthly payment jumps. The borrower may have to pay twice
what he had been paying. He may pay even more than double.

Why would anyone agree to accept such a loan? Two reasons: (1) he expects his income to rise sharply in the next year or two; (2) he is a person who does not read or
understand contracts and also believes in something for nothing. Here is a description of who might reasonably take such a debt.

Option ARMs are best suited to sophisticated borrowers with growing incomes, particularly if their incomes fluctuate seasonally and they need the payment flexibility that such an ARM may provide. Sophisticated borrowers will carefully manage the level of negative amortization that they allow to accrue.

In this way, a borrower can control the main risk of an Option ARM, which is “payment shock”, when the negative amortization and other features of this product can trigger substantial payment increases in short periods of time.

http://www.GaryNorth.com/snip/532.htm

We are now in a recession. The number of people who can expect big increases in their income next year is a small and declining figure. But Wachovia is still making
option mortgages. But aren’t option ARM’s the most vulnerable to default
of all mortgages? Yes.

So, Wachovia has a big problem. (1) It wants to make more of these loans; (2) it does not want to get prosecuted for red-lining. This led to the memo. On the one hand, Wachovia made no bones about its desire to continue to make option ARM loans. Where? In California. California? Where housing prices are plummeting? Yes.

Certain markets looked more risky than others. So, in these markets — Caucasian, middle-class places like Riverside County, where I lived for a decade — Wachovia
decided it might be wise to cut back on such loans. You and I know what happens to internal memos. They get leaked. But high-level people write memos never catch
on. So, the “Los Angeles Times” got a copy and published a story on it. The memo identified 17 counties where property values have fallen so far that the bank would no
longer write new option ARMs.

When asked to explain this memo, a bank official refused to comment. The policy is merely “under consideration.” The memo was sent “prematurely.” This is a tried and true response to embarrassing memos that probably goes back to Middle Kingdom Egypt.

http://www.GaryNorth.com/snip/533.htm

The present subprime mortgage crisis has been in full swing since August, 2007. Why in March was Wachovia still making these loans — in California, Missouri, or anywhere
else? This rule comes to mind: “When you’re in a hole, stop digging.” Why isn’t Wachovia honoring it?

I don’t know about you, but my assessment is that option ARMs are really bad ideas today. I first heard of these loans 30 years ago. They were not called option ARMs. They were called backward-walking mortgages. They were written by sellers of homes who wanted to take back those homes after a hopeful buyer defaulted on his loan. It was an interim program to get a house sold when the seller expected the house’s price to rise. He wanted a buyer to occupy the house. A renter usually does not take care of a house as carefully as a buyer does. So, house sellers used backward-walking mortgages to get a down payment out of a person who was virtually guaranteed to default. The person moved in, took care of the house, and was evicted right on schedule.

No one ever sold a house with a backward-walking mortgage if he expected the house to fall in price. So, I understand Wachovia’s concern with 17 counties in California. Frankly, I think this concern applies to 3,000 other counties in the United States.

But I don’t understand this aspect of the deal. Wachovia, unlike a seller of a home who is in the business of buying and selling homes, does not want to foreclose. Wachovia is not in the house-flipping business, except as a lender to house-flippers — a bad idea these days. Wachovia presumably makes loans that it wants borrowers to pay off. Then why does it still write option ARM loans?

My guess: because it can get more borrowers to sign the loans than if the borrowers understood that the loan contract they are signing is a backward-walking mortgage.
They want borrowers now. They don’t care about foreclosures tomorrow. They expect enough borrowers to keep paying. I think they are wrong. But I don’t make policy at
Wachovia.

According to Bloomberg, traders now see a one-in-five chance of a half-point reduction in the benchmark rate, to 1.75 percent, at the April 29-30 Fed meeting.

Bernanke told congress yesterday that the Fed is “ready to respond to whatever situation evolves,” and referred to “considerable stress” in markets.

New York Fed President Timothy Geithner said yesterday that policy makers must “continue to act forcefully.”

“Today, with progressive calls for action in the face of the credit crisis, the Fed’s tentacles are potentially reaching directly into the credit and securities markets,” says Ed Bugos in The Daily Reckoning.

“This week alone, the headlines are rife with news of its “sweeping” new powers under Treasury Secretary Hank Paulson’s ‘plan.’”

“The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain ‘growth.’”

“Expect a continued erosion of the US dollar as interest rates are lowered further to avert depression and as inflation subsequently morphs into hyperinflation,” says John Browne in Today’s Financial News.