FYI: The Fed Officially Kicks Off the Next Recession

March 12, 2006

The Fed Officially Kicks Off the Next Recession
by Robert McHugh


It is official. A recession is coming. How do I know? Because this
week new Fed Chairman Ben Bernanke gave an official warning to bankers
about commercial real estate loans. That is always the kickoff to a
recession. It is the starter's gun, the national anthem before a
ballgame, the opening hymn at a church service. Here is how it works.
The Fed has three official tools to control the money supply: Setting
reserve requirements (telling banks how much of their deposits they
cannot lend. The higher the reserve requirements, the less loans, the
less money creation by the economy). The second tool is open market
operations. Here they set the amount of money in the system by buying
or selling securities. Third is setting the discount rate, the rate of
interest banks must pay to borrow money at the Fed. Theoretically, the
higher the rate, the less money banks will borrow, the less they have
to lend, and the less money that is created by the banking system.

However, there is a fourth tool, a stealth tool, which has more power
and impact than the other three. It is called the Federal Reserve Bank
examiner. He/she is the person who goes into a bank about once a year
and decides which loans are good and which are bad. Based upon their
holy edict, a loan is classified in one of several categories which
determines how much money the banks must set aside from earnings to
reserve for possible losses. It is completely an estimation game. So
the rules can and do change, based upon the whims of the examiner,
taking his marching orders from the Fed Chairman. If the Fed wants the
money supply to expand, then Fed examiners come in with reasonable
standards for review of loans, and classify those loans with a general
leaning that they will be repaid according to terms. Thus banks do not
have to reserve as much for possible estimated losses and are in
effect not discouraged from making more loans. When the Fed wants
money supply to grow, aggressive lending standards often get passing
grades. That's when you business people will see your friendly bank
commercial lender more often, jawing you into that expansion project
you've been thinking about, inviting you to golf outings and ball
games. They want more loans. They need your expansion project.

However, once the Fed Chair sounds the alarm about commercial real
estate loans, it starts an entire chain of events that ultimately and
unequivocally leads to economic recession. Here's what happens. Out of
the blue (that seems to be a favorite modus operandi for all Fed
operations) those friendly back-slapping Federal Reserve examiners
(not really, they are never overly nice -- okay I've met two or three
out of a pool of three hundred -- Mike, Eddie, Eric, you know who you
are and I know you read my stuff) show up with a scowl that droops
like the golden arch. They ask for the files, a table, an outlet, a
coffee pot, and the key to the little boys and girls room. About two
days after they arrive, the banker knows something has changed,
something serious, and he gets this knot in the pit of his stomach
that will last for about three years. Examiner Margo asks for a
meeting with banker Joe. She brings her supervisor to raise the fear
level of the meeting. The Bank's President, Joe, brings his top
commercial lender for protection of his fanny, and that lender brings
his junior lender who will ultimately be the sacrificial lamb and get
the ax should things blow up.

Bottom line: Margo feels that a good commercial real estate loan,
paying on time, plenty of collateral, doesn't quite throw off enough
cashflow on its financial statements in file, and is now suddenly
rated below satisfactory. Not quite doubtful. What this means is the
banker now has to set aside 20 percent of the loan in reserves for
possible losses. That reduces income, and he has a big one-time hit
coming to earnings this quarter. The banker defends the loan with
dexterity -- he has to fight back, but cannot tick them off too much
as they hold all the cards -- but the discussion is going nowhere.
Finally Margo's supervisor, Lead Examiner Harry, whose head hasn't
moved an inch -- just his eyes, rolling back and forth from speaker to
speaker -- drones out, "This loan is less than satisfactory," then
gets up and goes back to his room full of tables, laptops, and loan
files. This goes on for days. Toward the end of the examination, about
a month later, they bring out the heavy artillery. More senior
examiners from the regional office arrive and the meetings get larger
and longer as satisfactory loans have now been declared doubtful, and
doubtful loans are now downgraded to total loss. They especially
target commercial real estate loans. First ones to go. Again, nothing
regarding the loan itself has changed, the game is one of judging the
subjective quality of the loans, and for no apparent reason, the
subjective quality of myriad loans has remarkably deteriorated. The
banker is left with a list of suddenly crappy loans in his portfolio,
and a required loan loss reserve that is about 80 percent higher than
he has on the books. He is then told in a wrap-up meeting that because
of this "loan quality problem" in his bank, his bank's overall rating
has been dropped from a 1 to a 2 or a 2 to a 3 (banks are rated 1 to 5
with 1 being the best. Ratings below "2" get bank presidents fired.
Ratings below 3 get the Chairman of the Board of Directors removed,
with lots of fearful warnings to the Board of Directors of the bank
about Director liability and civil money penalties). This rating is
confidential, with criminal prosecution should the banker reveal it.
In fact everything in the examination report is confidential, with
criminal penalties should he reveal its contents. There is no appeals
process.

Needless to say, after the examiners pack up their newspapers,
laptops, and locked suitcases, the banker and his crew of commercial
real estate lenders are left in shock. The Board of Directors gets a
visit about a month later from the Head examiner and the top
Regulatory folks at the regional Fed office. If they bring someone
from "Washington D.C.," then the bank President and Senior Lender are
toast. The Board of Directors politely listen as the Head Examiner and
his boss cite every blemish and foul found in the place with smiles
intermittently flashed with icy stares, a game of intimidation.
Warnings are given, then the Fed folks get up, make sure they shake
everybody's hand in the room as if its "business, not personal," and
leave.

At the end of the day, a junior lender gets canned, the Board steps up
the heat on the President to do something about this, and banker Joe
and his senior lender immediately decide to stop making commercial
real estate loans.

For the economy, this means a credit crunch has started. Expansion
stops. Willing buyers can no longer obtain financing to buy
properties. This reduces demand for properties at the exact same time
bankers are encouraging these suddenly classified borrowers on their
books to sell their properties and pay back the loans. This increases
the supply of properties for sale at the exact wrong time, lowering
prices.

But the black hole is just getting started -- just beginning to suck
the economy into the abyss. What I outlined above is merely round one.

About six month later, property values have dropped from this excess
of supply and lack of demand due to the curtailing of bank commercial
real estate loans. This means the collateral values of the loans on
the bank's books have declined.

Another Fed examination is scheduled, they are back in, and with the
battle well under way, it is time for these public servants to start
shooting the wounded. They are fully aware that property values have
dropped, and -- ignoring the fact that they caused them to drop --
they march to the file room, grab their favorite previously classified
loans, and get to work. They assign the most experienced examiners to
review the classified loans while they send the rookies to find
potential problems among the previously good loans. But the action is
with the classified bad boys.

That loan they rated less than satisfactory because of cashflow
problems the last time they were in has now deteriorated to doubtful
because of the compounded affect of collateral undervaluation. That
means instead of setting aside 20 percent of the loan amount into the
reserve for possible losses, banker Joe must now set aside 50 percent,
another big hit to earnings. He had promised the Board of Directors
that last year's one-time hit for potential loan losses would be a
one-time occurrence. He realizes that is not the case, and begins to
wish he had become a UPS delivery man.

At the end of the day, the bank's rating has dropped, the Board is
scared about Director liability, and Joe is pulling out every
political favor he's accumulated among a majority of the Board to keep
him around for one more year. He agrees to sacrifice the bank's Senior
Lending officer, who has served as a shield the past year, not making
loans, but sitting in his office, ready to be ejected for the good of
banker Joe's considerable stock options portfolio and other bennies
that come with holding on to a bank presidency for a decade or so. The
senior lender is replaced by a credit hack, someone with no people
skills, adept at strong-arming bank borrowers into paying back the
money. The goal is to shrink the loan portfolio by not making new
ones, using the normal cashflow from payments to reduce outstandings,
and to sell at a discount or coerce partial payments from existing
loan customers who were rated unsatisfactory by the Federal Reserve's
finest. This means lawyers get involved, lots of lawyers, skilled at
scaring borrowers into "working out" loan repayments with this new
nasty bank lender. This means less money is available for potential
buyers of property in the economy, more distressed sale supply hits
the market, and real estate values fall even further.

It is about now that everyone recognizes a recession is well underway,
led by a real estate collapse. The truth of the matter is, the rules
were changed by the Fed and nobody was told until it was too late, and
the economy plunges. Voters scream, a few politicians get tossed, and
the phrase "credit crunch" becomes a darling of the media. It takes
action by the President of the United States to haul in the Federal
Reserve Chairman, and explain to him the reality of the reappointment
process every four years. Suddenly, at the next bank exam, a new
friendlier, examination teams shows up, drinks more coffee, has a few
extra newspapers tucked next to their laptops, are asking for fewer
files, complain they have to rush to another job in two weeks so won't
be there as long as the last time, and leave with little fanfare. The
bankers are told in the wrap-up meeting, that they've improved their
loan quality, the bank's rating is boosted one grade, and all is well
with the world -- end of recession.

On March 8th, 2006, Federal Reserve Chairman Ben Bernanke announced at
the Independent Community Bankers of America conference, "The rapid
growth in commercial real estate exposures relative to capital and
assets raises the possibility that risk-management practices in
community banks may not have kept pace with growing concentrations and
may be due for upgrades." Fed examiners are warming up their laptops.
The barbarians are headed for the gates.

The Fed announced again on March 9th, with no palatable explanation,
that they will no longer publish M-3 as of March 23rd. While they
claim that M-3 is useless, in the blurb on their website, the fact is
banks are still reporting all the data on their Call Reports used to
calculate M-3. The Fed has not eliminated the unique M-3 components
from the Bank Call Reports.

Why don't they want to be transparent with the most important
statistic, the very measure of why they were established by a minority
of Congress during a late night session back in 1913? Because they
cannot wait to pump money to high heaven like some sort of fiat tower
of Babel.

M-3 was increased by $28.3 billion last week, a 14.2 percent
annualized rate of growth. Over the past 2 weeks, M-3 was boosted an
amazing $81.9 billion, for an annualized rate of growth of 20.7
percent! Over the past 8 weeks, M-3 is up 129.6 billion, an 8.2
percent rate of growth, and is up a whopping $249.7 billion over the
past 12 weeks, a 10.7 percent annualized rate of growth, a $1.0
trillion annual expansion.

What is happening here? How does this reconcile with the Bernanke
announcement that bank commercial real estate lending will be
curtailed?

There are two ways for the money supply to grow. First is through the
bank lending function. The more lending, the more spending, the more
bank deposits, which is at the core of the money supply definition.
The Fed has apparently decided to slow the velocity of money creation
by slowing or shutting down lending. However, the Fed knows it needs
money to buy financial markets and monetize our debt. The lending
function is too much out of the direct control of the Fed. In other
words, money is created that way, however the Fed doesn't get to
decide where that money goes. It is going to businesses for expansion
and jobs, etc... No, the Fed wants to decide where money goes. So it
will replace money created through the lending function with money
created from thin air by the Fed itself. The way for that electronic
money to enter the economy will be from the Fed directly buying
something, or lending money to someone. In effect, the Master Planners
will decide where fresh money goes. They will control more of the
spending. But they cannot let us know this. Because it would be too
easy to prove they are doing this if M-3 remains transparent. You
would simply compare commercial and consumer loan data to the M-3
figures. If we saw debt declining but M-3 rising, voila, we would
clearly see the Fed is directly pumping and funneling that money
someplace, which would beg the tough question, where? You can bet most
honest, patriotic, free-market Americans would not appreciate the
answer.