Proxy Fight

Regular readers know I've written before about the possibility of government intervention in the stock market. I'll explain shortly why this issue just became more urgent. For now, here are some of the reasons this matters. The details of any intervention would determine the degree to which these apply, but conceptually these are the main implications:

1. It would reward the speculator class at the expense of the investor class. The former includes high-frequency traders and algorithmic, program-oriented, and momentum players. The latter prefers to buy stocks at favorable valuation levels, incrementally and over a period of time. This becomes harder when intervention prevents stocks from finding their natural levels.

2. It would constitute a backdoor bailout of Wall Street, which obviously depends in many ways on rising stock prices.

3. It would essentially make the stock market a giant money laundering mechanism for corporate insiders, with public funds used to buy stocks and keep the market inflated while insiders sell.

4. It would affect the perception of risk across the entire asset spectrum (not just stocks) and encourage the same malinvestment and misallocation of capital that contributed to the credit bubble. (As a former trader on one of Wall Street's top sell-side desks, I've seen how belief in the existence of a backstop influences the perception and tolerance of proprietary risk.)

5. It would create the potential for abuse if a Wall Street firm is involved in the scheme. This would include frontrunning the orders before they are executed or tipping off other parties to the activity. If the scheme involves a government promise to backstop the Wall Street firm against losses, insufficient controls would allow the firm to claim losses greater than what it incurred.

6. It would have various political implications, including the ability to boost the stock market before an election, after an important presidential speech, or during or after high-profile testimony by Federal Reserve or other economic officials.

During the debate over Ben Bernanke's reappointment, I posted this list of questions for him. Sen. Jim Bunning then submitted those questions in writing to Bernanke. One of the questions was the following:

Before the financial crisis there was a widespread sense, especially on Wall Street trading desks, that the stock market was strangely resilient. This encouraged excessive risk-taking in various types of assets. Do you have direct or indirect knowledge of the Federal Reserve or any government entity or proxy ever intervening to support the stock market (or any individual stock) via futures or in any other way? If yes, who decides the timing of such intervention and with what criteria? How is it funded? Which Wall Street firm handles the orders, and who sees them before they are executed?

Bernanke's written response (page 25 here):

The Federal Reserve has not intervened to provide support to the stock market or individual stocks by trading in futures or any other financial instrument. I have no knowledge of any other U.S. government entity providing such support.

I then wrote that Bernanke's response was incomplete because he ignored the word "proxy," an important part of the question. After I posted about Bernanke's dodge, I was contacted by Rep. Alan Grayson's office for input on this issue and a possible follow-up question. In February, Grayson submitted various written questions to Bernanke (the full set along with responses is here). This question was first on the list (my bolds):

The Federal Reserve has taken extraordinary measures to prevent losses by large financial institutions. This has led to widespread speculation that such measures might include intervention in the stock market. Has the Federal Reserve--alone or in concert with the Treasury Department or any part of the government--ever taken any action with the purpose or effect of supporting the stock market or an individual stock? The means to do so included in this inquiry include, but are not limited to, the futures market, the Exchange Stabilization Fund, foreign custody accounts, the System Open Market Account, and any other account, mechanism or financial instrument. Has the Federal Reserve, Treasury, or any part of the government ever directed, acted in conjunction with or otherwise engaged a proxy or intermediary--including but not limited to a private sector entity or foreign central bank--with such a purpose or effect? Please respond to both parts of this question. Please note that we are asking you to enumerate each such action, with a description on each occasion of who, what, when, where and why.

This question was designed to prevent another Bernanke dodge. It specifically and explicitly asked him to respond to the proxy/intermediary issue. Here is his complete written response, which Grayson has now received after three months:

The Federal Reserve has not intervened to support the stock market or an individual stock.

That's it.

Whatever one might say about Ben Bernanke -- and regular readers know I've said a lot in the past -- inattention to detail is not part of his personality. Whether written or spoken, his answers to questions are clear, strikingly thorough, and often expansive (indeed, see his responses to the rest of Grayson's questions here, and note his diligence in addressing each part -- every sentence and every word -- of the other questions). A momentary lapse on one question (Bunning's) is possible. For Bernanke, twice is inconceivable, especially in the context of the question's specific request to "respond to both parts."

Recommendations:

1. Congress has oversight of the Fed. The Fed's chairman is refusing to respond fully to a question from Congress. Congress needs to find out why. That means submitting the question again in writing, noting that the previous response was incomplete and suggesting that it should not take another three months to answer a single question (and if it does, that would say something deeper about this issue). There is no need to change the question's language; it is already as specific and comprehensive as possible. If the opportunity arises to ask Bernanke the question in testimony, it should be taken, but getting an answer in writing is important for this type of question. Fed General Counsel Scott Alvarez should also be asked this question in writing.

2. Tim Geithner should be asked the same question for several reasons. In his response to Bunning in December, Bernanke said that he had "no knowledge of any other U.S. government entity providing such support." In his recent response to Grayson, Bernanke limited his answer to the Fed. In the months between those two responses, did Bernanke learn of some sort of activity at Treasury? Or did he regret his previous answer? Was he advised, perhaps by a Fed attorney, to limit the scope of his response to Grayson?

Another reason to query Geithner is explained by the New York Post's John Crudele, who wrote this column in which he referenced my original question for Bernanke verbatim (Crudele has been all over this issue for many years). Briefly, if Treasury is running market intervention, it could do independently of the Fed (almost). Treasury's possible role in an intervention scheme has been the subject of speculation for years, partly because of Alan Greenspan's comments in two 1995 FOMC meetings. From the January 31 transcript: "I am really sensitive to the political system in this society. The dangers politically at this stage and for the foreseeable future are not to the Federal Reserve but to the Treasury. The Treasury, for political reasons, is caught up in a lot of different things." From the March 28 transcript: "We have to be careful as to precisely how we get ourselves intertwined with the Treasury; that is a very crucial issue. In recent years I think we have widened the gap or increased the wedge between us and the Treasury, as Ted was mentioning. In other words, we have gone to a market relationship and basically to an arms-length approach where feasible in an effort to make certain that we don't inadvertently get caught up in some of the Treasury initiatives that they want us to get involved in. Most of the time we say "no." In both cases, Greenspan's comments were in the context of Treasury's use of the Exchange Stabilization Fund for Mexico.

Moreover, in 1998 Ron Paul submitted a written question to Treasury that was similar to Grayson's, in which he specifically asked about the proxy issue and use of the ESF to intervene in the stock market. Treasury took a full year to reply, and even then its response was incomplete.

3. As a practical matter, since Treasury lacks the trading infrastructure to conduct intervention, it would probably have to use the Fed's New York desk. This would likely be the operational nexus for any intervention, whether Treasury or Fed-directed. Officials there need to be asked the same question that Bernanke dodged. That should certainly include William Dudley, as well as Brian Sack and related employees. While Bernanke and Geithner are clearly "all in" and willing to say anything at this point, less-senior cogs in a scheme may not be willing to risk legal consequences by providing false answers, especially to conceal something in which they might be unwitting or reluctant participants.

This issue has always been seen as the province of conspiracists and bitter short-sellers. It was also long understood in Washington that there were certain questions one didn't ask in public, and this was one of them. Because of the Fed's conduct during the past few years, that taboo is gone. With the assumption of intervention now widespread on Wall Street and in the hedge fund community, and risk perceptions influenced accordingly, this issue is important. Bernanke's selective and uncharacteristic brusqueness makes it even more so.