The Federal Reserve

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The Federal Reserve: Dispensing the Wrong Medicine

by Floyd G. Brown, Advisory Panelist, Investment U
Wednesday, March 19, 2008: Issue #777

Watching the Federal Reserve intervene repeatedly in the free market to prevent the bankruptcy of firms “deemed too large to fail,” I am plagued with questions about what future problems they may be creating.

As an undergraduate of economics in the late 70s and early 80s, I had the unmitigated good fortune to study under some wonderful free-market thinkers. One lecturer that became a mentor was my faculty advisor at the University of Washington, Dr. Paul Heyne. He was taken from us by kidney cancer a few years ago, but I often wish I could call upon his wisdom in times of crisis in the financial markets.

I still remember his challenge to us undergraduates with what he called an “economic way of thinking.”

What would he have to say this week? What would he say about the repeated Fed bailouts, the latest being the NY Fed loans arranged to rescue Bear Stearns? I can only speculate…

The Federal Reserve & The Housing Market

I think he would say that the Federal Reserve is largely responsible for the current deflation in housing market prices. By keeping interest rates artificially low in the period of 2001 to 2004, the Fed spurred over investment in real estate and housing. This over investment is now being eliminated through the pain of a market bust. Had the Fed promoted price stability and a stable currency, instead of promoting economic growth, this bust wouldn’t have been the inevitable result of the earlier boom.

Dr. Heyne taught us that political intervention in free markets resulted in the boom and bust business cycle that is so oft been repeated in America’s economic history. His solution was always to allow the marketplace to correct imbalances and then to leave it alone and let the market decide its own course apart from political manipulation.

Yet Ben Bernanke, with his Ph.D. in economics, has failed to trust free market solutions.

When Wall Street investment banks believe that the Federal Reserve will step into the marketplace and protect them, they are more likely to make risky bets. If they instead believed that imprudent risks would wipe them out financially, they would have hesitated to make some of the reckless decisions that have been made in the last half-decade.

Failure can actually hasten a recovery…

During the 90s, several Japanese banks were allowed to limp on because the Bank of Japan intervened when they should have been liquidated more quickly. Today’s shareholders of financial firms with too much leverage, poor risk management and incompetent stewardship need to be wiped out. After bankruptcy, the assets can pass to more competent hands.

Reckless Borrowing Traced Back to the Federal Reserve

In 2006, I bought a new home. I selected an elegant house in a great location for $672,000. My mortgage banker and real estate agent were aghast.

“Floyd,” they said, “our analysis of your finances shows that you could easily qualify for a mortgage two or three times larger.”

Of course, fabulous scenic views and extraordinary features of a more expensive home could have easily seduced me. And had I been a younger and less experienced investor, I might have succumbed to the talk – which was directed straight at my ego.

This type of reckless encouragement to borrow can all be directly attributed back to a Federal Reserve that was giving the large commercial banks too much easy money. In turn, these large commercial banks gave the mortgage banks too much easy money. Then the mortgage banks gave my mortgage broker too much easy money… that he was trying to pass on to me.

In fact, he once called himself “the evil banker that wants you to borrow more money.”

It all started with the Fed and ended up with the consumer. And every participant, just like teenagers, repeatedly used the excuse: “It’s not my fault.”

Over-Speculation Should Be Punished

My father functions as a private banker. He buys and sells real estate using contracts. He finances homes for private individuals, and carries notes secured by the real estate. When he does it, he always has a keen understanding of the borrower’s employment, the real estate acting as collateral, and the market in his hometown.

Mortgage bankers haven’t exercised such prudence in the last half-decade.

Today’s mortgage brokers enter numbers in a computer. The software program spits out an analysis, and then the mortgage broker thinks he has no accountability because the loan will be off his books in the blink of an eye. Once they unload this hot paper, they don’t have to worry.

What we shareholders are now learning is that the risk wasn’t decreased, only transferred. We all have accountability. Just look at the share price of Countrywide Financial, Indy Mac Bank, or even New Century Financial (New Century filed for bankruptcy in April 2007 and is currently being liquidated).

Call me callous or mean, but in financial markets, over speculation should be punished. Companies such as Bear Stearns and Countrywide should be allowed to go to the same graveyard as New Century Financial. If we don’t watch out, the new liquidity the Federal Reserve is pouring out will create a bubble in the current hot sector: the commodities market.

Good investing,

Floyd

Floyd Brown, a regular contributor to Investment U and The Oxford Club, began his highly successful investing career while still in high school… and made his first million before turning 30. To see what he’s recommending, here are the five energy picks he likes right now.

Today’s Investment U Crib Sheet – Shares of Visa Begin Trading…

Fed intervention and subprime fallout aside, history’s biggest IPO just hit the Street… Late yesterday, Visa (NYSE: V) priced the highly anticipated offering of 406 million shares at $44 each, which raised $17.9 billion. When shares began trading this morning, demand surged and sent shares more than 30% higher.
Should you get in? Our IPO specialist, Louis Basenese, has shown time after time that you don’t have to get an initial allocation of an IPO to hit it big. In Investment U Issue #638, IPO Stock Offerings: $24 Billion Is About to “Go Public” Louis shows you why just as much upside exists in the “aftermarket.”In the case of Visa, Lou’s been tracking the IPO for weeks, and will write a full analysis for you on Friday, once shares settle down and the market “agrees” on a fair price.