Friday FOMC Memories: Wachovia and Bagehot

Despite the obvious disinterest from pretty much everyone in the media, I still find tremendous relevance and value in the 2008 FOMC. The entire year was spent in a comedy of errors that should make even the most ardent monetarist shameful. This is not to say that I would have preferred more diligent and swift action on the part of the Federal Reserve System; not at all. Perhaps most essential, and thus most relevant, is that the Fed should have simply acted more mechanically. Central bankers have been crying for incremental “flexibility” since they first blamed the gold standard for 1930-33, but the transcripts prove less “flexibility” would have been far superior an operational model.

If you have even a passing interest in how we got where we are today, the monetary trap the “best and brightest” laid not for just the economy but for themselves (taper demands taper), it is all laid out for you in the policy discussions of 2008.

In the emergency conference of September 29, 2008, discussing the potential for TARP passage and the dramatic events of the weeks after Lehman’s failure, Bill Dudley essentially lays out what should have been mechanical,

DUDLEY. Our strategy all along has been not to prevent the deleveraging or the unwinding that developed earlier but to stretch it out a little so fewer things break. The swap lines are just one more tool to help that process unfold without severe systemic consequences occurring.

So far so good, as that has been, supposedly, the central tenet of central banks going back to Walter Bagehot. It is a nod to the markets about exactly what is taking place in the most basic formulation – an imbalance is being cleared by decay and a central bank’s place, should it actually have one, is to manage, as Dudley suggested, that decay and try to prevent throwing out “good” institutions with the “bad.” That has been distilled in the cliché, attributed often to Bagehot, to “lend without limitation at high rates on good collateral.” Doing so would mean good institutions would remain afloat, strained by penalty rates but alive, all measured by “good collateral.”

In his very next sentence, however, Dudley immediately strays and contradicts those basic mechanics.

DUDLEY. Obviously, things are breaking, even with all the tools that we’ve rolled out. So I think that just suggests that more force needs to be applied. Clearly, confidence in the markets is extraordinarily poor and fragile, and that’s another reason that an escalation in the authorizations is important—to reassure people that the central banks are prepared to be there, if necessary.

Bagehot’s limitation should have applied here as it should have been clear, under this framework, about where the line existed. If institutions did not have “good” collateral, they were, by this very definition, “bad” institutions in need of being cleared out of the system. Dudley’s very suggestion, echoed by all the FOMC members, was that “more force” would be needed not to keep good institutions afloat and “stretch a little further”, but rather to “prevent the deleveraging” in the first place.

The impetus for that very meeting was a review of crisis measures, more “force” in Dudley’s terms, including the Wachovia “merger.” Citigroup “won” the bidding on Wachovia, but would only do so with institutional support from the FDIC (with the Fed approving capital waivers). Citi was only going to take a first loss position up to $54 billion on what was estimated as Wachovia’s book value of $312 billion of MBS and structured assets. That sounds pretty reasonable on Citi’s part, I guess under the circumstances, except that the reason for the FDIC backstop, and the capital waiver, runs back to the mismark of those asset prices in Wachovia’s book.

ALVAREZ. The $312 billion was the value on the books of Wachovia, and so Citi is providing the cushion in several ways. One is marking them down $30 billion to begin with, to be more in line with what Citi’s own marks are and to add to reserves to supplement the potential losses there. Then the rest is a loss-sharing.
MR. PLOSSER. Does the first $30 billion markdown come out of the $54 billion?
MR. PLOSSER. So they have already taken roughly $30 billion of the $54 billion losses they’ve promised they’d take?
MR. ALVAREZ. That’s correct.

There are two pertinent facts to this exchange. The first is that Wachovia had been overstating its assets, collateral as it really was, on its books by at least 10%. The fact that Citi put a $54 billion limit on it was not an idle calculation, but rather that the bank was clearly expecting at least a good possibility that Wachovia’s book here was overstated by closer to 20% or more.

Second, from that we can now view Wachovia as having no “good collateral” left on its book to keep itself afloat through the normal channel of at least the discount window, let alone the numerous other acronymed programs that were unleashed in 2008. That means the Fed and the FDIC were, in fact, preventing a deleveraging and doing so by abetting what really constitutes fraud. The “market’s” judgment about Wachovia was true and righteous, and it was being overwritten by the Fed betraying its primary principles as laid out by Dudley’s first statement above.

Now some of this analysis is intentionally naïve, particularly in that I don’t actually believe the Fed conforms to the mechanical interpretation beyond disposable expressions. And that is the real point here. The FOMC and Federal Reserve Board have reserved the rights for themselves to act as they see fit whenever it suits them. There is no rule of law in monetary policy and action, only fiat and whim of the psuedo-elitists. That is courting trouble in any circumstance, but it is particularly so given just how little these “economic elites” actually know about their own province and providence.


Click here to sign up for our free weekly e-newsletter.

“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, contact us at: or 561-686-6844 . You can also book an appointment for a free, no-obligation consultation using our contact form.