The stock market fell 27% in a single day. Bank of America suspended ATM payouts and JP Morgan applied for bankruptcy protection. Citigroup defaulted on its bonds and Deutsche Bank shares weren't allowed to trade on Europe's stock markets after its shares fell 86% on America's stock market.
None of this happened on Wednesday. But it would have if anyone believed Federal Reserve Chairman Ben Bernanke's sworn testimony to Congress. Instead, he was either ignored or called out as a complete liar.
Bernanke made one of the most explosive and dangerous claims a Federal Reserve Chairman could possibly make, and the market didn't tank. Instead it rallied. It's crucial to understand why if you want to prepare for the fateful day his lie will be exposed.
Here's what went down at the Congressional hearing.
Senator Elizabeth Warren asked Bernanke about the fact that the 'too big to fail' banks were able to borrow money cheaply because they had the Federal Reserve and government backing them. According to a study, the big banks' borrowing costs are $83 billion dollars less because of the implicit subsidy. Here's what Bernanke answered:
'Well the subsidy is coming because of market expectations that the government would bailout these firms if they fail. Those expectations are incorrect. We have an orderly liquidation authority.'
This is a truly surreal claim. Bernanke is saying he will not bail out banks like Lehman Brothers and Bear Stearns if they fail. Instead, he will try to liquidate their assets, a kind of managed bankruptcy. Remember, the financial crisis really took off when the Federal Reserve tried to do this in 2008 with Lehman Brothers and AIG.
The irony here is so thick it hurts. First of all, the whole purpose of a central bank used to be to save too big to fail banks. It was the financial system's backup. The idea that a central bank should manage the economy is comparatively recent. Now that the Fed is declaring its original purpose null and void, it's only left with managing the economy. It's gone from being a back up failsafe to a central planning authority.
Secondly, Bernanke is clearly bluffing. He wouldn't hesitate to bail out a failed financial institution. Lehman Brothers and AIG are in the 'what not to do' section of the central banker's handbook. So why is he claiming banks will be allowed to fail?
If Bernanke comes out and says 'we'll bail out anyone big enough', that will increase something called moral hazard. A government guarantee is a license to misbehave at someone else's expense if things go wrong, but to your benefit while it all goes well. Bernanke can't be seen encouraging that openly. It must all be implicit. By the time banks need bailing out, no politician will be brave enough to remind Bernanke that he promised not to.
The stock market knows Bernanke is bluffing. It didn't blink when he gave his remarkable testimony. As Senator Warren pointed out, past experience from the financial crisis proves Bernanke is willing to bail out everyone he can:
Warren: 'You did not wipe out the shareholders of the largest financial institutions, did you -- the big banks.'
Bernanke: 'Because we didn't have the tools. Now we could. Now we have the tools.'
Warren: 'Whatever you're saying Mr Chairman, $83 billion dollars says that there really will be a bailout for the largest financial institutions if they fail.'
Bernanke: 'No that's the expectations of the market, but that doesn't mean that we have to do it.'
This is a wonderful case of the emperor having no clothes. Nobody believes Bernanke's sworn testimony. Remember the days when that could land you in gaol?
The thing is, none of his facade does anything to improve the economy. At some point, Bernanke's bluff will be called. He will have to bail out another financial institution. If he suggests using the 'liquidation authority', the stock market will drop out from underneath his feet. Instead, he will step up rescue efforts.
And that leads us to the bigger bluff at hand.
Imagine you bought jewellery for your mistress. There are two ways of doing it. One, you pay cash. The other, you pay by credit card, using the bank's money. Do you think your wife would care which way you paid if she found out? Explaining that the bank bought the jewellery, not you, probably wouldn't make a difference.
Bernanke is trying pretty much the same argument he used in testimony to Congress back in 2009. Then, a representative asked him 'Will the Federal Reserve monetise this debt?' He replied, 'The Federal Reserve will not monetise the debt'.
Since then, the Fed has purchased vast amounts of government bonds with money it creates in the process. But because the Fed doesn't buy the bonds directly from the government, it's not called 'monetising'. At least as far as they're concerned.
Just like with the jewellery for your girlfriend, the banks are playing middle man. The Fed buys the banks' bonds and the banks buy the new bonds from the government. The end result is the same. The Fed is in all but name monetising the government's borrowings.
Of course, the banks only do so because they get to skim off a bit of the cream in the process. They earn vast amounts of money for doing something their customers don't really want or need, while playing their part in a bigger scam. Think of them as Rufus in the movie Love Actually.
It's not just government bonds the Fed is buying. Bloomberg reports that the Fed's latest money printing efforts are 'effectively absorbing about 90 percent of net new dollar-denominated fixed-income assets...' That's 90% of the increase in total US dollar denominated fixed income assets, not just government bonds. The Fed is buying the entire jewellery store. No wonder financial assets are going up in price.
The real fear is that the Fed will have to reverse all these purchases at some point. When inflation takes hold the Fed will have to drain the money it pumped into the economy back out. But doing so involves selling the assets it bought back into the financial markets of the world. Imagine dumping several years' worth of the US's fixed income assets onto markets. Interest rates would skyrocket and prices would tumble.
Slipstream Trader editor Murray Dawes has all this figured out, going by his last bunch of trades. He's heavily short the industry that will suffer if Bernanke makes a mistake and equally long the industry that will profit. But it's his unique style of trading that he is focusing on in his upcoming video to subscribers. Keep an eye out for it.
The Daily Reckoning Weekend Edition
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About the Author
Nick Hubble is feature Editor of The Daily Reckoning Australia – weekend edition. You can subscribe to the Daily Reckoning for free here. Nick has spent the last three years discovering lots of new, exciting and surprisingly simple ways to generate money for retirement. He’s put all these ideas into his investment publication The Money for Life Letter. If you're already a subscriber to these publications, or want to follow Nick's financial world view more closely, then we recommend you join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.