David Stockman: How The Fed Got Cramer’d

David Stockman, Budget Director under President Reagan, then a partner and private-equity guru at Blackstone Group, and now bestselling author, graciously gave me permission to post the particularly relevant and prescient Chapter 23 of his book, The Great Deformation: The Corruption of Capitalism in America. Here is the second installment.

The Fed’s abject surrender to the Cramerite tantrums in the fall of 2007 was rooted in ten years of Wall Street coddling. Mesmerized by its new “wealth effects” doctrine, the Fed viewed the stock market like the famous Las Vegas ad: it didn’t want to know what went on there, and was therefore oblivious to the deeply rooted deformations which had become institutionalized in the financial markets. The sections below are but a selective history of how the nation’s central bank finally reached the ignominy of being Cramer’d by financial TV’s number one clown.

The monetary central planners only cared that the broad stock averages kept rising so that the people, feeling wealthier, would borrow and spend more. It falsely assumed that what was going on inside the basket of 8,000 publicly traded stocks was just the comings and goings of the free market – and that this was a matter of tertiary concern, if any at all, to a mighty central bank in the business of managing prosperity and guiding the daily to-and-fro of a $14 trillion economy.

But what was actually going on in the interior of the stock market was nightmarish. All of the checks and balances which ordinarily discipline the free market in money instruments and capital securities were being eviscerated by the Fed’s actions; that is, the Greenspan Put, the severe repression of interest rates, and the recurrent dousing of the primary dealers with large dollops of fresh cash owing to its huge government bond purchases. This kind of central bank action has pernicious consequences, however. By pegging money market rates, it fosters carry trades that are a significant contributor to unbalanced markets. Carry trades create an artificially enlarged bid for risk assets. So prices trend asymmetrically upward.

The Greenspan Put also compounded the one-way bias. For hedge fund speculators, it amounted to ultra-cheap insurance against downside risk in the broad market. This, too, attracted money flows and an inordinate rise in speculative long positions.

The Fed’s constant telegraphing of intentions regarding its administered money market rates also exacerbated the stock market imbalance. By pegging the federal funds rate, it eliminated the risk of surprise on the front end of the yield curve. Consequently, massive amounts of new credit were created in the wholesale money markets as traders hypothecated and rehypothecated existing securities; that is, pledged the same collateral for multiple loans.

The Fed’s peg on short-term rates thus fostered robust expansion of the shadow banking system, which as indicated previously, had exploded from $2 trillion to $21 trillion during Greenspan’s years at the helm. This vast multiplication of non-bank credit further fueled the “bid” for stocks and other risk assets.

Fear of capital loss, fear of surprise, fear of insufficient liquidity—these are the natural “shorts” on the free market. The paternalistic Dr. Greenspan, trying to help the cause of prosperity, thus took away the market’s natural short. In so doing, he brought central banking full circle. William McChesney Martin said the opposite; that is, he counseled taking away the punch bowl, thereby adding to the short. Now the punch bowl was overflowing and the short was gone.

Speculators were emboldened to bid, leverage their bid, and then to bid again for assets in what were increasingly one-way markets. As time passed, more and more speculations and manipulations emerged to capitalize on these imbalances.

“Growth stocks” were always a favored venue because they could be bidup on short-term company news, quarterly performance, and rumors of performance (i.e., “channel checks”). During these ramp jobs, which ordinarily spanned only weeks, months, or quarters, traders could be highly confident that the Fed had interest rates pegged and the broad market propped.

Financial engineering plays such as M&A and buybacks came to be especially favored venues because these trades tended to be event triggered. Upon rumors and announcements, these trades could generate rapid replication and money flows. Again, speculators were confident that the Fed had their back, while leveraged punters were pleased that it had seconded to them its wallet in the form of cheap wholesale funding.

At length, the stock market was transformed into a place to gamble and chase, not an institution in which to save and invest. Since this gambling hall had been fostered by the central bank rather than the free market, it was not on the level. That means that most of the time most of the players won and, as shown below, the big hedge funds which traded on Wall Street’s inside track with its inside information won especially big and unusually often.

Needless to say, frequent wins and hefty windfalls created expectations for more and more, and still more winning hands. As the Greenspan bubbles steadily inflated—both in 1997–2000 and 2003–2007—these expectations morphed into virtual Wall Street demands that the Fed keep the party going. Wall Street demands for a permanent party, at length, congealed into the presumption of an entitlement to an ever rising market, or at least one the Fed would never let falter or slump.

Finally, this entitlement-minded stock market became a blooming, buzzing madhouse of petulance, impatience, and greed. Cramer embodied it and spoke for it. By the time of his rant, the Fed had become captive of the monster it had created. Now, fearing to say no, it became indentured to juicing the beast. After August 17, 2007, there was no longer even the pretense of reasoning or deliberation about policy options in the Eccles Building. The only options were the ones that had gotten it there: print, peg, and prop. By David Stockman.

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