Adrian Douglas: Deception and cover-up at the Fed

Section:

How the Fed hid the disappearance of $32 million and its recognition of the stock market bubble.

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By Adrian Douglas

The title of this article is borrowed and modified from the book "Deception and Abuse at the Fed" by Robert C. Auerbach.

The minutes of each Federal Open Market Committee (FOMC) meeting are released within weeks of the meeting having occurred. The full transcript is available only five years later. I recently started reading in depth the transcripts of the FOMC meetings and discovered some shocking information.

Let's consider the December 21, 1999, meeting. The minutes can be found here --

http://www.federalreserve.gov/fomc/minutes/19991221.htm

-- while the full transcript is here:

http://www.federalreserve.gov/monetarypolicy/files/FOMC19991221meeting.p...

In the minutes the Board unanimously accepted the accounts of the System Open Market Account:

"The Report of Examination of the System Open Market Account, conducted by the Board's Division of Reserve Bank Operations and Payment Systems as of the close of business on September 10, 1999, was accepted."

... Dispatch continues below ...



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One would think that there was nothing of interest to see here; just mundane approval of accounting. But if we look at the transcript we get an entirely different picture that shows that the Fed contemplated that there could have been fraudulent diversion of funds or errors in accounting in the famous Exchange Stabilization Fund (ESF) that has received so much attention from GATA as one mechanism for manipulation of the gold market.

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CHAIRMAN GREENSPAN. Without objection. Peter Fisher, you wanted to discuss the report of examination, I understand?

MR. FISHER. Yes. I wanted to elaborate a little on Louise Roseman's memo to Don Kohn about the unresolved difference between the internal accounting records of the Markets Group Accounting and Control Unit and those reflected in the Integrated Accounting System regarding the System's net interest accruals on foreign currency investments. I thought it would be helpful if I gave a couple minutes of background, if you will bear with me.

Last spring, as members of the Committee will recall, we entered into a series of transactions with the ESF to re-balance our euro and yen holdings so we could come to a better split both in terms of total holdings and the currency mix. This involved a number of transfers of ownership of a series of investments and resulted in quite a significant amount of accounting activity. In the course of reviewing that, our own accounting staff identified an error that had been introduced in the prior year in our treatment of the premium on bonds held in the accrual account, overstating the accrual account by about $5 million.

In the course of confirming that, they identified an additional $26.6 million overstatement in the accrual account for interest on foreign currency investments. We have had a number of staff members working full time trying to trace the source of that $26.6 million overstatement. They have worked back through the records to December 1994, before which detailed records at the transaction level just no longer exist due to the routine and appropriate destruction of documents.

The Board examiners were at our Bank to conduct an examination of the System Open Market Account in September and PricewaterhouseCoopers also has looked over our methodology to try to trace this overstatement back through time and find its source. Pricewaterhouse-Coopers is confident that we have traced it back as far as we can. They have tested our work papers and agree with our conclusion that we simply can't go back any further.

There are two possible causes of this overstatement that we have to confront. One is the diversion of funds and the other is error. Now we cannot rule out the possibility of a diversion of funds. But people from our own audit function and from Pricewaterhouse-Coopers have reviewed the control procedures we've had in place for the last decade and are very comfortable with the conclusion that these control procedures are sufficiently robust that the likelihood of diversion is remote. It cannot be ruled out, but for diversion to have occurred it would have had to involve the collusion of many people -- just an extraordinary number of people -- on several different staffs. If anything, our control procedures run a little to the "belt and suspenders" direction in regard to control of the flow.

So there is reasonable confidence that no diversion of funds occurred. The much more likely cause is a simple accounting error. The failure to credit the accrual account when cash was received would have left this account overstated. But we have worked the accounting back as far as we can take it and cannot find the erroneous entry or entries.

Dave Sheehy, the New York Fed's General Auditor, and I are both looking into a fundamental reappraisal of our control procedures. We have introduced an additional mechanical check to maintain detailed records of the accrual stream by instrument, so that when a final principal payment is received we can trace the record all the way back on each instrument and double check the accounting.

More fundamentally and more importantly, what troubles us is how we could have gone for so many years without scrubbing this account more vigorously. That is something we are looking into and we are going to be revising our control procedures -- both the audit procedures and those in our own Markets Group. The Board's staff and our accounting function at the New York Fed have worked out an accounting treatment to correct for both the $5 million and the $26.6 million errors. That involves reducing the accrued interest asset account by the entire $31.6 million, with an offsetting reduction in interest income on foreign currency investments. We will make that adjustment before the end of the year and spread it among all the Reserve Banks.

Of course, for all of us with responsibilities for SOMA this is an embarrassing, indeed humbling, event. As a technical matter, though, I understand that Pricewaterhouse-Coopers is comfortable with the conclusion of both our accounting and audit function and the Board staff that this is not a material event for purposes of disclosure for any Reserve Bank. I would be happy to try to answer any questions.

CHAIRMAN GREENSPAN. Is there any evidence of a surprising rise in standards of living of key people involved?

MR. FISHER. No, there is not.

CHAIRMAN GREENSPAN. Has somebody looked?

MR. FISHER. Yes, we have looked into that. Many of the staff people are still at the Bank, though others are not. But we have found nothing of that nature.

CHAIRMAN GREENSPAN. Were it an embezzlement, prior to what period would it have occurred?

MR. FISHER. We only know that the difference existed prior to December 1994.

CHAIRMAN GREENSPAN. It could have been any time prior to that? Is there a beginning point, other than 1914?

MR. FISHER. The details certainly don't exist for pre-December 1994 records, so I don't know how we could determine the beginning point -- in 1973 or 1963 or where. Prior to 1994, the only interest income we were receiving in that account was coming from the BIS, the Bundesbank, and the Bank of Japan. So the source of the income was official institutions. It was really a very simple accounting process to bring that income in at that point; the complexities have been introduced since that time. So, as I say, Pricewaterhouse-Coopers and our audit function are confident in looking over the control procedures we have had in place that it's implausible that a diversion could have occurred. But we cannot rule it out.

* * *

What is the solution to this accounting problem? Just fudge the accounts! They reduced reported income to make the 31.6 million dollar problem go away. Here is a repeat of the relevant section:

The Board's staff and our accounting function at the New York Fed have worked out an accounting treatment to correct for both the $5 million and the $26.6 million errors. That involves reducing the accrued interest asset account by the entire $31.6 million, with an offsetting reduction in interest income on foreign currency investments. We will make that adjustment before the end of the year and spread it among all the Reserve Banks. Of course, for all of us with responsibilities for SOMA this is an embarrassing, indeed humbling, event. As a technical matter, though, I understand that Pricewaterhouse-Coopers is comfortable with the conclusion of both our accounting and audit function and the Board staff that this is not a material event for purposes of disclosure for any Reserve Bank.

It is shocking that PriceWaterhouse-Coopers should be "comfortable" that this is not a "material event" for the purposes of disclosure. Clearly the system is set up to deliberately deceive the public and avoid any transparency. Full transcripts of the FOMC meetings are available only after five years -- and what is the time limit before they destroy detailed records? You guessed it: five years.

But there is more deception revealed in the transcript on an entirely different topic: Greenspan claimed that the Fed cannot recognize a bubble until after it has burst. That is a lie as shown by another section of the transcript.

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MR. PRELL: All of this may well be stretching the point statistically, but I think it's worth sounding a note of caution that strong productivity gains and intense competition -- even accelerating productivity and intensifying competition -- do not by themselves ensure that there can be no step-up in inflation. Unless supply is completely elastic, which seems unlikely in the short run, demand can become excessive.
That, we fear, is the current situation, with the rising stock market overriding the effects of monetary tightening.

Once again in recent weeks, the market has defied our notions of valuation gravity by posting an appreciable further advance. Moreover, it has done so in a way that seems to highlight the risk that it will continue doing so. I refer to the incredible run-up in "tech" and e-commerce stocks, some of which have entered the big-cap realm without ever earning a buck.

To illustrate the speculative character of the market, let me cite an excerpt from a recent IPO prospectus: "We incurred losses of $14.5 million in fiscal 1999 primarily due to expansion of our operations, and we had an accumulated deficit of $15.0 million as of July 31, 1999. We expect to continue to incur significant ... expenses, particularly as a result of expanding our direct sales force. ... We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it."

Based on these prospects, the VA Linux IPO recorded a first-day price gain of about 700 percent and has a market cap of roughly $9 billion. Not bad for a company that some analysts say has no hold on any significant technology.

The warning language I've just read is at least an improvement in disclosure compared to the classic prospectus of the South Sea Bubble era, in which someone offered shares in "A company for carrying on an undertaking of great advantage, but nobody to know what it is." But I wonder whether the spirit of the times isn't becoming similar to that of the earlier period. Among other things, it may be noteworthy that the tech stocks have done so well of late in the face of rising interest rates. Earlier this year, those stocks supposedly were damaged when rates rose, because, people said, quite logically, that the present values of their distant earnings were greatly affected by the rising discount factor. At this point, those same people are abandoning all efforts at fundamental analysis and talking about momentum as the only thing that matters.

If this speculation were occurring on a scale that wasn't lifting the overall market, it might be of concern only for the distortions in resource allocation it might be causing. But it has in fact been giving rise to significant gains in household wealth and thereby contributing to the rapid growth of consumer demand -- something reflected in the internal and external saving imbalances that are much discussed in some circles. Whether our assumed 75-basis-point increase in the fed funds rate would be a sufficient shock to halt this financial locomotive is open to question.

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The Fed clearly recognized the tech bubble and even made reference to the infamous and most speculative South Sea Bubble. But they did not want to do anything because it was making the whole economy expand due to the wealth effect:

If this speculation were occurring on a scale that wasn't lifting the overall market, it might be of concern only for the distortions in resource allocation it might be causing. But it has in fact been giving rise to significant gains in household wealth and thereby contributing to the rapid growth of consumer demand.

Greenspan lied that the Fed could not recognize a bubble in advance. They did recognize it and even compared it to the South Sea Bubble and they purposefully let it continue because it was adding to household demand, a large part of that being driven by housing demand, and it was all founded on companies that had no or little fundamentals that were commanding ridicules valuations that were bound to crash bring the entire economy with it. And that is what happened.

This transcript shows that the Fed cannot even manage the multi-billion dollar ESF fund, so how can they be trusted to run a multi-trillion-dollar bailout operation as was instigated in 2008?

The answer is we can't; the recently released list of banks and institutions that received TARP funds and how much, pried loose by a Freedom of Information Act request by Bloomberg News reveals that yet again the Fed deceived Congress and the public by requesting the TARP funds to bailout America but sent much of the funding to foreign institutions.

The transcript shows that when it discovers an accounting problem, the Fed fudges the accounts and decides that this is not a material event that needs to be disclosed in the annual reports of the Federal Reserve Banks.

The Federal Reserve acts as the supervisor and regulator of the banking system. Clearly such breaches in fiduciary duties and accounting standards explains why the banks they supervise can thumb their noses at any banking regulations and run fast and loose with off-balance-sheet transactions, report falsely inflated and often record profits coming out of the biggest recession and banking crisis in 80 years, and pay their executives obscene bonuses.

The FOMC transcripts give us only a glimpse of what is really happening in secret at the Fed. But from just scratching the surface one can be justified in extrapolating that it is hiding a web of corruption, lies, and deceit.

This band of liars and cheats is responsible for the only global reserve currency, the U.S. dollar. If you own and hold precious metals bullion instead of dollars there are no counterparties, let alone counterparties who lie every time they move their lips and operate under a secrecy that is only partially lifted after five years, which is coincident with the destruction of all detailed records.

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Adrian Douglas is editor of the Market Force Analysis newsletter (www.MarketForceAnalysis.com) and a member of GATA's Board of Directors.

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