This remains a key issue in need of attention, and it requires deep thinking about whether assumptions used to pass legislation over the past 40 years still hold.

Interestingly, a few days ago I was surprised to come across a letter by Senator Sherrod Brown indirectly addressing part of this through a question I share about the Fed’s dual mandate (hat tip Yves Smith). Writing to Secretary Geithner and Director Summers under the backdrop of the Dodd bill and key openings at the Fed, the Senator explained:

As Chairman of the Senate Banking Committee’s Subcommittee on Economic Policy, with jurisdiction over the Federal Reserve System’s monetary policy functions, I am acutely aware of the importance of monetary policy at the Fed. Both the full Banking Committee and the Economic Policy Subcommittee have examined the causes of the financial crisis and the resulting effects on lending, access to credit, and employment. The evidence presented to the Committee about the role that Fed policy decisions played in the financial crisis and the economic downturn has led me to conclude that the Fed’s monetary policy has focused almost entirely on controlling inflation rather than maximizing employment and that the Fed has too often put banks’ soundness ahead of its other responsibilities.

In concluding that the Fed regularly prioritized inflation control over maximum employment, Senator Brown was in fact making a direct swipe at the core short-term yin/yang at play within our modern central banking system.

To understand how these forces work, we must first understand that our modern Fed (as restructured by Humphrey-Hawkins in the 1970s) was designed for most practical purposes to have two core mandates, the “pursuit” of (a) maximum employment and (b) stable prices. By cause and effect, most other duties laid out in its mission statement — including maintenance of long-term interest rates, safety in our banking system, containing systemic risk and providing services to depository institutions — had been considered either derivative of, or related to, price stability. (Whether this is still the case is another matter.)

These core mandates were also what one might call “dueling” in nature, the logic for which can be traced to a paper written by William Phillips in 1958 called “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom.” In his paper, Phillips put forth an outline for the “Phillips curve” which described an inverse (though non-linear) relationship between unemployment and inflation.

If this relationship were to hold perfectly, the Fed was indeed the best repository of both mandates — with its powerful toolkit over money supply, the Fed could simply adjust policy until achieving the balance for these opposing but equally important goals.

In practice however, even Phillips noted weaknesses in the relationship; namely, it was effective only in the short-run and within a tight band considered “normal” conditions. (For a worthy read on the technical underpinnings of modern Fed policy, see The Taylor Rule and the Transformation of Monetary Policy by the Kansas City Fed).

Unfortunately the current economic conditions are far from normal. Furthermore, I fear that over time the Fed’s dueling mandates have taken their toll on the human side of central banking, the result being (metaphorically, if not actually) that the Fed must now make almost daily calculations reflecting the tradeoff between “protecting consumers” and “protecting banks.” This was not the original intent of the 1970s overhaul and it’s also a terrible conundrum in which to place an institution.

In concluding his letter, Senator Brown states three characteristics he believes should define any new member selected for the Fed’s governing committees:

1. Recognition of the causes of the financial crisis before it occurred
2. Demonstrated dedication to protecting consumers and maximizing employment
3. Commitment to releasing e-mails related to the Fed’s involvement in the AIG bailout

Of the three, I can only wholeheartedly support the final point.

On the first, I would argue that just because someone was correct once it does not prove that person will be correct again. While this is a useful criterion to explore, making it the #1 requirement appears to be more about political optics than helpful substance.

On the second, I would agree in spirit if not practice; increased consumer protections are definitely not a bad thing. However, I am concerned they would ultimately prove ineffectual at the Fed under future crises or even normal operations — consumers need a strong, independent agency that does not have inherent conflict within its core mission statement. Conversely, the Fed needs clarity to focus on its best strengths relating to price stability.

On the third, I couldn’t agree more; checks and balances are a fundamental component to our government. For the most part, the debate over Fed transparency has been dominated by two camps, one for “accountability” and one for “independence.” I respect the Fed and believe it can (and needs to) have both.

Co-published with the Huffington Post.

Top banks will need an extra $221 billion of capital and see annual profits slump by $110 billion if all proposed regulations to reform the industry are brought in, leading analysts said on Wednesday, Reuters reported.

If all the initiatives from regulators are implemented it would cut the average return on equity to 5.4 percent from 13.3 percent next year, hurt economic growth and raise costs for bank services, JPMorgan analysts warned, according to the news service.

“The cumulative impact of all the proposed regulation suggests that there is a real risk that we may move from a system that was under regulated to one that is over regulated and that that could cause a significant increase in lending costs and a negative impact on the economy,” Nick O’Donohue, head of research at JPMorgan, said in a research note.

This saddens me in that it appears much like a threat levied against the entire non-banking economy if we allow the “extreme” case (using the article’s words) of regulation to pass. I believe this plays into the continued vitriol that hurts American discourse and foments distrust as a theme we feel about our media, our representatives and now our banking system. I’ve even dedicated an entire post to wishing that Elizabeth Warren would also tone it down in her rhetoric.

It should additionally be noted that the simple math here is both interesting and misleading as presented. For example, I would wonder if anyone at JPMorgan has modeled what a roughly 20% reduction in year-end bonus compensation would do to erase portions of this hypothetical shortfall. Perhaps it might even exceed it within certain parts of the industry. (I’m confident in fact they have done this, they just aren’t sharing it publicly).

In financial analysis we learn that the devil is in the details. In investment banking we carefully negotiate small terms because those terms translate into big dollars for our clients. In financial modeling, the law of GIGO (“Garbage In, Garbage Out”) is an important rule we should never forget.

If lending costs go up, rational individuals may choose to view this as the simple new cost of living safely in a post-crisis world. This is my own personal view.

However, I suspect that the actual outcome would be more complex than this article represents, and competitive pressures would drive compensation down almost as much as they would allow banks to collectively exert pricing control. In economics, one likely sign that an oligopoly exists is when a group of companies have the carte blanche power to pass 100% of cost increases directly to customers. In healthy competition, cost increases would either be absorbed by the firm, shared by the firm and customers, or cause innovation to occur.

In general markets are very good at sorting out the details when we let them function safely and properly.

Co-published with the Huffington Post.

Eight years later we could be singing a different tune in both the media and Congress. After all, we’ve had a financial crisis, $23.7 trillion of potential government financial backstops and a “Great Recession” that were all exacerbated and partially caused by a FWMD explosion. With some notable exceptions however we haven’t changed enough, and these contracts remain poorly understood even as the markets have evolved beyond the levels for which Mr. Buffett first expressed concern.

At the time of his statement, Buffett’s reasoning was simply that credit derivatives were “time bombs” where parties would enter highly leveraged contracts with risks they often didn’t understand or couldn’t evaluate. This was effectively describing the problem AIG would later face (and he wanted Berkshire to avoid). In explaining how impossible to value some contracts were, Buffet gave the example that, if desired, he could easily purchase a speculative position on “the number of twins to be born in Nebraska in 2020.” Those words should have raised red flags on how improper derivative contracts could easily simulate a massive underground gambling house.

This would not be the worst of it.

When Buffett wrote his letter, a subset of the market known as credit default swaps (“CDS”) was still young. In 2000, the entire notional value of this market was just $900 billion, mostly reflecting bona fide “good faith” buyer hedging. For an individual, bona fide hedging is like buying insurance on your home; in return for a monthly premium (the contract’s “spread”), you receive downside protection that pays in the event of catastrophic loss.

But in the early 2000s the CDS market started to change, and new investors whose primary purpose was to take speculative positions emerged in greater force. The reasons why are not hard to understand as potential payouts are enormous; buying $1 million of CDS protection can return as much as $200 million if the underlying company collapses. This 200X return is in contrast to the maximum 2X (ie, 100% profit) return an investor would receive using a generic equity short under the same scenario, because CDS by themselves are more inherently leveraged (ie, they simulate higher levels of debt).

By 2007 the CDS market had mushroomed to a notional value in excess of $45 trillion. At those levels, at least $20 trillion was primarily speculative — we know this because the combined underlying markets they were based on (bonds and certain structured products) had a total value of less than $25 trillion. This would be like buying a home insurance plan worth $450,000 on the same day you acquired the house for $250,000.

That minimum of $20 trillion in contracts was therefore “naked,” or at least mostly so. In finance, being naked generally means transacting in an asset without any ownership or correlated upside in that asset.

Put another way, buying a 5-year naked CDS is like buying life insurance on a stranger. The main point is that you would receive zero benefit if the stranger does well in life; in fact, you would stand to lose money (the premium) if they survived to the end of the contract. However, if they didn’t do well, you would earn a fortune. This is both immoral and illegal for an individual but allowed to investors under current law.

If that were the end of it — simple speculative insurance — it would be problematic enough. In theory, we might even derive some benefits in the form of increased liquidity and better pricing for all insurance contracts.

However, this would only work in a world without avarice. In fact, the pure logic of buying life insurance on a stranger actually has a moral advantage to buying a naked CDS — at least with individuals, the act itself of buying life insurance doesn’t harm the stranger. It only creates financial incentive to do so.

In the case of naked CDS, buying insurance creates both incentive for harm and the circumstance for actual harm. This is similar to how a naked short works, except that naked shorts are quite rare and illegal under most instances. There are also two structural differences:

1. CDS are more intrinsically leveraged (remember, 200X vs 2X).




2. CDS relate to a different part of the capital structure, debt instead of equity.

In the case of a theoretical naked short manipulation, a speculator would sell large quantities of a company’s equity in order to drive the price down, but do so with shares they either don’t own or that don’t exist (“phantom” shares). This creates a highly concentrated burst of selling activity in excess of what would be possible using only “real” shares, shares that could either be borrowed or owned outright.

For companies that don’t access the capital markets regularly, CDS pressure can be frustrating but not debilitating. However, for leveraged financial companies — who often rely on short-term, daily funding sources — the results of a spiraling and unknown increase in their CDS would directly affect the core business and be much more dangerous. At minimum this would hurt their cost of capital, reducing profit margins in a healthy bank or causing a weak bank to lose money more quickly. In extreme scenarios, this would even create a confidence-liquidity trap and the modern-day equivalent of a bank run. The only difference here is that we would have institutions rather than consumers lining up for their money, and they would technically not be taking money out but refusing to put money in.

I’ve heard it speculated that this is exactly what happened in the cases of both Bear Stearns and Lehman Brothers. The evidence — circumstantial at best — is that one can see a series of sharp increases in CDS spreads for both companies prior to public awareness of any issue. Sadly, forensically determining what happened is next to impossible because the players leave few traces and are exempt from oversight since the Commodity Futures Modernization Act of 2000. Whether or not CDS pressure was exerted however, what remains likely is that had a similarly weak peer institution (say, Merrill Lynch) experienced the CDS run-up instead of Lehman, their situations and timing of collapse could easily have reversed.

More recently, I have read rumors that a dispute between a TARP-receiving investment bank and the fiscal authorities of Greece escalated into the use of CDS pressure by the bank and two hedge funds to increase the government’s cost of debt. This is probably not true, however it is probably also plausible; George Soros famously “broke” the Bank of England using less aggressive instruments and with far less market power than the big banks have today.

In summary:

1. Credit default swaps are not complicated; they are simply corporate insurance. They should be treated like insurance by the authorities, especially after their misuse became a focal point in the US financial crisis.




2. Naked CDS are the corporate equivalent of buying life insurance on a stranger. They should be treated no differently than the theoretical potential for naked equity shorting abuse.

I hope that readers and staff of the Huffington Post may join me in calling for regulators to propose a ban on abusive naked CDS that is at minimum similar to the one already in place that bans abusive naked shorts. In addition, I hope that together we can push more elected officials into doing the work needed to genuinely understand these issues beyond basic sound bytes. If they do, I am confident that more attention will be paid to smart proposals for dual-regime oversight such as the one put forward by CFTC Chairman Gary Gensler. In it, he establishes the basis for overseeing not just the markets (through exchanges, clearing houses, etc) but also the dealers themselves. Without a dual-regime approach, it is just a matter of time before smart, unregulated traders find new ways around the system because it is their financial incentive to do so.

Co-published with the Huffington Post.

However, in her most recent Wall Street Journal Op-Ed, “Wall Street’s Race to the Bottom,” I believe Professor Warren makes unfortunate leaps that weaken her purpose and give credence (if not, outright strength) to the destructive ongoing debate around financial regulation. This debate continues to paralyze our political system, change nothing about the underlying causes of the crisis and offend just about everyone. As American citizens we need to hold our elected officials accountable to get something done now, or history is bound to repeat itself.

So…where does this great thinker go wrong? Oddly, she doesn’t get her villains right (from a productivity standpoint,  at least).

Before I explain, let me be clear – I have few doubts that weak lending standards, NINJA (“No Income, No Job, no Assets”) loans, option ARMs and other complex financial products sold to consumer were among the multiple contributors to our current economic climate. Even Ben Bernanke himself purchased an option ARM that “exploded” and had to be refinanced. (See the Chairman’s own words on page 11 from his Time Magazine 2009 Person of the Year Extended Interview.)

However, I believe that in blanket vilifying Wall Street, policymakers fall into a familiar pattern of scapegoating that occurs irrespective of party affiliation or ideology. They find the most obvious target from outside the ranks of Capitol Hill and foment public frustration in a manner that isn’t entirely productive. Blaming Wall Street for pursuing profit is like a vegetarian getting angry at tigers because they eat meat.

The simple truth is that when American corporations pursue profit — successfully or not — as long as they stay within the law they are functioning exactly as we designed them to. Wall Street firms are legally obligated to focus on their fiduciary responsibility to shareholders and employees. This reaches to the core of what it means to be American, and how capitalism has helped make the United States the extraordinary nation it is today.

Elected officials, by contrast, have a very explicit moral responsibility to taxpayers and should make 100% of their decisions for the benefit of citizens they represent. Sadly, a great number of them act like this doesn’t matter, and they end up protecting the wrong constituency. This is the graver issue deserving of Professor Warren’s considerable attention.

At the end of the day it is important to remember, Jamie Dimon doesn’t have the final say on regulation no matter how much he wishes he does. In concluding her article, Professor Warren calls on Wall Street CEOs to directly support consumer protections that will cost the largest banks billions in lost revenue. I do not believe this is the most realistic course for achieving progress on financial reform.

Co-published (with edits) on the Huffington Post.

I have to believe a priori that because the system always functioned this way (and there is nothing wrong here intrinsically, it’s a good business to be in), then our policy makers were aware of this fact; to presume any less would be to presume they aren’t individually competent. I believe they are very competent so this leads my conclusions into a rather awkward frame of reference.

Unfortunately, the fact that government officials chose $90 billion as the amount for this new tax (what they are calling the “Financial Crisis Responsibility Fee”) appears almost entirely political as well and simply creates a distraction from the main point. Basically, the administration wants to mirror the tax against roughly 17% most recently projected losses on total TARP outlay. Of course, since TARP only represents <3% of the total, this whole thing starts to look rather retroactive and reactive at the same time.

• Clearly this wouldn’t be happening if it wasn’t an election year.
• Clearly it wouldn’t be happening without populous angst.
• Clearly one-time taxation will not change anything and basically sends the signal: Screw You Wall Street!

Really??

Of the two high level options (“earn out” vs “allow to fail”) we may never know which was the better choice; that ship has sailed. Today in 2010 we’re just trying to cure one of the worst hangovers ever (a $23.7 trillion one) when the only real choice should have been stopping at 2 rather than 20 (or 200) drinks the night before.

Personally, I don’t think it’s necessarily a bad move by government, I simply question the execution, timing and short-term nature of it. If this were indeed a crisis responsibility fee and officials were aware of the more obvious repercussions inherent to their policies…then we should have addressed these issues while writing term sheets for TARP, PPIP, TALF and the myriad of other programs (not to mention quantitative easing). I lament that we clearly continue to “retro-reactively” make policies as new political symptoms of the disease appear. All of us on Wall Street, Main Street and Pennsylvania Avenue would be far better off if we could for once keep the focus to systemic issues rather than evanescent ones.

By Jason Paez

Instead of focusing on the Chairman, I’d like to see more interest in the system-wide incentives that drive the current structure. Arguably, almost anyone could have been chairman and the results would have been the same (or far worse).

I’ve previously expressed skepticism on the Fed’s dual mandate. This time I’ll ask: should “chief protector” (ie, Fed’s role as banker’s bank) and “chief regulator” co-exist? This is a government-sponsored entity and if we don’t change it, it’s hard to blame anyone but ourselves when the issue explodes into financial calamity.

Fed’s approach to regulation left banks exposed to crisis

By Binyamin Appelbaum and David Cho
Washington Post Staff Writer
Monday, December 21, 2009; A01

Foreclosures already pocked Chicago’s poorer neighborhoods but the downtown still was booming as the Federal Reserve Bank of Chicago convened its annual conference in May 2007.

The keynote speaker, Federal Reserve Chairman Ben S. Bernanke, assured the bankers and businessmen gathered at the Westin Hotel on Michigan Avenue that their prosperity was not threatened by the plight of borrowers struggling to repay high-cost subprime loans.

Bernanke, who was in charge of regulating the nation’s largest banks, told the audience that these firms were not at risk. He said most were not even involved in subprime lending. And the broader economy, he concluded, would be fine.

“Importantly, we see no serious broad spillover to banks or thrift institutions from the problems in the subprime market,” Bernanke said. “The troubled lenders, for the most part, have not been institutions with federally insured deposits.”

He was wrong. Five of the 10 largest subprime lenders during the previous year were banks regulated by the Fed. Even as Bernanke spoke, the spillover from subprime lending was driving the banking industry into a historic crisis that some firms would not survive. And the upheaval would shove the economy into recession.

PIECE TRUNCATED – Get the rest at WashingtonPost.com

Two revisions later — first down to 2.8% and yesterday to 2.2% — and things don’t look nearly as rosy. I wholeheartedly agree that policymakers need better forecasting tools; there were other private sector analysts with better forecasts even without the benefit of government data.

However, I’m not sure this call to arms is realistic or feasible; forecasting is sometimes more art than science due to a naturally-occurring phenomena known as GIGO (“Garbage-In Garbage-Out”). Headline numbers are incredibly easy to manipulate based on expectations — if this were not the case then we’d never have had a financial crisis to begin with.

Policymakers Need Better and More Timely Economic Data

By Mark Thoma

When it was announced two months ago that GDP had grown by 3.5 percent in the third quarter of this year, it took the sails out of any movement toward another stimulus package. Now the number has been revised downward to 2.2 percent.

At a growth rate of 3.5 percent, the economy would be growing slightly faster than the long-run trend so that, although progress would be very, very slow, the economy would at least be catching up to the long-run trend (in the recovery from previous recessions, it was not unusual for GDP to grow at 6 or 7 percent, but even at those high growth rates the recovery takes time). At a growth rate of 2.2 percent, the economy is not even treading water let alone making up for past losses.

The economy needs more help, but they way in which the GDP numbers arrived, with the 3.5 percent initial figure heralded as the sign that better times were just around the corner, undermined the case for a new fiscal stimulus package and likely caused the Fed to back off of any further plans it might have had to do more to help the economy recover. Now we know the 3.5 percent figure was overly optimistic, but two months have passed and any momentum towards providing additional stimulus has largely faded from discussion.

This points to the fact that policymakers need better and more timely data. The fourth quarter is almost over yet we are still trying to figure out what happened in the third quarter, and we still don’t know for sure. There has been lots of criticism of how policymakers have reacted in this recession, much of it deserved, but little of that discussion has recognized the data problems. I don’t know for sure what the problems are in collecting data in nearly real time, or if data collection can be improved, but it seems we can do better in the digital age sand it would certainly be worthwhile for Congress to look into this carefully and see if some investment into data collection would be helpful. If we can give policymakers better and more timely guidance about the state of the economy, it could improve policy considerably, and that would be money well spent.

In any case, let me say one more time as loudly as I can that given the data that we do have, it’s clear that the economy — the labor market in particular — needs more help.

It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house. But it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street–and the mortgage won’t even carry a disclosure of that fact to the homeowner. Similarly, it’s impossible to change the price on a toaster once it has been purchased. But long after the papers have been signed, it is possible to triple the price of the credit used to finance the purchase of that appliance, even if the customer meets all the credit terms, in full and on time.

Even Ben Bernanke bought an ARM that “exploded” and had to be refinanced. Fortunately he had a job and good credit to fall back on else he’d face the same scenario as Steve Waldman describes below.

Strategic default and the duty to shareholders

By Steve Waldman

Megan McArdle thinks strategic default by underwater homeowners is not okay:

I am afraid that I am one of those people who have no patience for people who refuse to pay their debts… There is a sizable school of thought that says why shouldn’t they? They made a contract with the bank under known rules, and as long as they’re willing to pay the penalties, why shouldn’t they just walk away, the way a corporation would? Well, for one thing, companies don’t always behave like this, and those who get a reputation for stiffing their suppliers run into trouble. But for another, because society doesn’t really work on such clean logic. The reason we can have easy bankruptcy and a pretty robust credit market (usually) is that most people act like debts are obligations which should always be paid off if possible.

I would like to agree with her. I think that if we structured the economy so that I could agree with her, we’d have both a better world and a more prosperous economy.

But, in the world as it is, in this mess as we’ve made it, her position is beyond unfair. Businesses walk away from contracts all the time, whenever the benefits of doing so exceed the costs under the terms by which they are bound. McArdle is certainly right to point out that companies frequently honor costly bargains they could get away with breaking, because their reputations would be harmed by walking away. But, reputational costs are economic costs. They are a part of the cost/benefit analysis that firms use in making decisions. It is not virtue that binds them to keep their word, but medium-term self-interest. Similarly, homeowners consider the hit to their credit rating and potential loss of social standing prior to walking away.

The question is whether debtors should keep paying off loans simply because it is the “right thing to do”, even when, taking all financial and non-financial costs into account, they would be better off reneging. A human being can choose to be “upright” in this way, if she wants. But under the prevailing norms of business, managers of all but the smallest firms can not so choose. To do so would be unethical.

Let’s recall Milton Friedman’s famous essay, The Social Responsibility of Business is to Increase its Profits:

In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers… Of course, the corporate executive is also a person in his own right. As a person, he may have many other responsibilities that he recognizes or assumes voluntarily… He may feel impelled by these responsibilities to devote part of his income to causes he regards as worthy… spending his own money or time or energy, [but] not the money of his employers… [T]o say that the corporate executive has a “social responsibility” in his capacity as businessman…must mean that he is to act in some way that is not in the interest of his employers…spending someone else’s money for a general social interest… Insofar as his actions…reduce returns to stockholders, he is spending their money. Insofar as his actions raise the price to customers, he is spending the customers’ money. Insofar as his actions lower the wages of some employees, he is spending their money. [H]e is in effect imposing taxes, on the one hand, and deciding how the tax proceeds shall be spent, on the other… [He] is…simultaneously legislator, executive and jurist.

In 1970 when Milton Friedman published these words, I think they must have seemed a bit radical and weird. But today this view is triumphant, both in theory and in practice. Mainstream theory and law view a corporation as a “nexus of contracts” between consenting individuals. Firm managers are agents, employed to act in the interest of shareholders. Shareholders are imagined to unanimously share a single goal — maximizing financial value. When a manager acts in a manner inconsistent with that overriding goal, for motives virtuous or vile, she is imposing “agency costs” on her employers, expropriating resources which are not hers. She is behaving unethically.

An individual, on the other hand, is not so conflicted. Her resources are her own. If she acts against her interest, she harms only herself, and most of us agree that there are times that virtue demands she do so (though we’ve no consensus on just when). McArdle can argue that individuals should pay obligations they’d be better off shirking, in the name of a larger, social good. But under the now prevailing view, she can’t ask that of businesses, because that choice is not firm managers’ to make. If managers or some shareholders wish that a costly action be taken in the name of social responsibility, Friedman helpfully reminds us that they “could separately spend their own money on the particular action if they wished to do so.”

In practical terms, exhortations to individuals that cannot apply to firms leave us with what Felix Salmon aptly describes as “the world’s largest guilt trip“:

The result is a system tilted enormously in favor of institutional lenders who exist in a world of morality-free contracts, and who conspire to lay the world’s largest-ever guilt trip on any borrower who might think about joining them in that world. It’s asymmetrical, it’s unfair… no one would expect a capitalist company to behave in the way that individuals are being told to behave…

Individuals must operate in a competitive economic environment dominated by entities constitutionally incapable of overriding self-interest to “do the right thing”. Virtuous individuals can expect no reciprocity from the firms with which they contract. They have two choices: live nobly and get screwed, or adopt the amoral norms of their counterparties. It has taken some time, but we are all coming around to the only supportable view. “It’s just business,” we shrug, even if we never wanted to be businessmen.

At this moment, the amorality of the transactional, profit-maximizing firm has seeped into most of our commercial relationships. This contributed grievously to the financial crisis: employees of Wall Street firms do not view themselves as morally bound to the fate of their employers, but as atoms negotiating the best terms that they can for themselves. When they found themselves able to enter into arrangements that offered irrevocable cash payments against uncertain accounting profits, they did so eagerly. When flippers discovered they could borrow huge sums of non-recourse money for real estate, and capture huge gains with little personal wealth at risk, they did that too. Asking flippers not to put back underwater property is precisely analogous to asking Wall Street whizzes to give back their exorbitant pre-crisis earnings. The latter won’t happen, so the former should not. Given where we are, every underwater homeowner should absolutely act ruthlessly in her self-interest. If that leads to further turmoil and collapse at the banks, so be it. I see no reason why deeply flawed institutions should be sustained on the backs of the virtuous, via a kind of stupidity tax.

It didn’t have to be this way, and going forward, perhaps we can find a way out. As I said at the start of this essay, I’d prefer to live in a world where I could agree with Ms. McArdle. It was not inevitable that we conceive of the firm as a nexus of contracts without agency for moral action except via implausible relegatation to shareholders. That is just one of many possible ideologies, and a rather idiotic one. The core notion that shareholders “own” the firms they fund is, in my view, a poor definitional choice.

But so long as the “social responsibility of business is to increase its profits”, the social responsibility of customers is to look to their own self interest. Even if that means dropping their house keys in the mail and renting the place next door.

Debating a New Role for the Fed

Author: Roya Wolverson, Staff Writer

Introduction

The role of the Federal Reserve has come under increasing scrutiny in the wake of the global financial crisis. While the U.S. central bank took unprecedented actions to mitigate the effects of the crisis, some experts argue that its policies over the past decade actually contributed to the financial meltdown by encouraging excess borrowing and exercising loose regulatory oversight of banking activity. As Congress considers legislation to overhaul supervision of U.S. financial institutions, some policymakers have called for a substantial expansion of the Fed’s regulatory authority to monitor so-called “systemic risk” and prevent future crises. Others have suggested stripping the Fed of its responsibility to oversee banking institutions, monitoring expanded Fed powers through a government audit, or broadening how Fed policies are measured and reported to increase its accountability. While most experts agree that regulating systemic risk is a needed element of financial reform, many disagree about whether assigning this task to the Fed, along with individual bank regulation and monetary policy, would strengthen or weaken the overall financial system and the Fed’s performance.

The Federal Reserve’s Role

The Federal Reserve, established in 1913 after a series of financial panics in the United States, has two main responsibilities. The first is to manage U.S. monetary policy; the second is to regulate bank holding companies and other member banks, which include state-chartered banks and foreign banks operating in the United States.

• Monetary Policy: Historically, the Fed’s main tool for conducting monetary policy has been to vary its fed funds target by altering its purchases and sales of U.S. Treasuries and federal agency securities. The purpose of the fed funds target is to achieve the central bank’s so-called “dual mandate,” which, as defined by the Federal Reserve Act of 1913, is to maximize price stability and minimize unemployment while maintaining moderate interest rates. The current benchmark for judging the aptness of Fed policy is the so-called Taylor’s rule, a formula developed by Stanford economist John Taylor which indicates that interest rates should be raised when inflation or employment rates are high and lowered under the opposite conditions.

• Bank Regulation: The Fed also has authority to decide what constitutes allowable financial activities within bank holding companies and member banks and which banks should be allowed to merge. This authority came from the Gramm-Leach-Bliley Act of 1999, which legalized the merger of securities, insurance, and banking institutions that were formerly separated under the 1933 Glass-Steagall Act. It supervises the day-to-day activities of these bank holding companies and some banks and is responsible for ensuring banks’ soundness by enforcing existing “micro-prudential” or individual bank regulations such as minimum capital requirements, banking consumer protections, anti-trust laws, and prevention of money laundering.

Holes in the System: Origins of “Systemic Risk”

Experts have sought to identify the key drivers of so-called “systemic risk,” or the financial interdependencies that allowed a seemingly limited subprime mortgage crisis to culminate in widespread financial panic in the United States and abroad, as well as the failure of some of the country’s most prominent financial institutions. Some critics of Fed policy consider its actions from 2003 to early 2005 at least partially to blame. During this period, the Fed, under the direction of then-chairman Alan Greenspan, kept the federal funds rate at a low 1 percent and allowed for significant credit expansion. In the 2009 book The Road Ahead for the Fed, Carnegie Mellon’s Tepper School of Business professor Allan Meltzer writes that, judging by the Taylor’s rule guidelines on setting interest rates, Greenspan’s Fed policy was too expansive, considering that short-term interest rates remained negative as the economy continued to grow. Greenspan attributed this policy to his belief that the U.S. economy faced a risk of deflation (a decline in prices due to a tightening supply of credit) similar to Japan’s experience in the 1990s.

Other experts point to the 1999 repeal of the Glass-Steagall Act, which led to a significant escalation in the number of non-bank institutions responsible for issuing credit. The share of credit extended by banks in the United States dropped from 60 percent half a century ago to 20 percent in 2009. Mauro Guillén, professor of management at the University of Pennsylvania’s Wharton School of Business, says the repeal of Glass-Steagall was part of a regulatory “race to the bottom” between Britain and the United States in the 1980s and 1990s as they competed to woo financial firms. Federal Reserve Chairman Ben Bernanke has also cited lax government regulation and gaps in oversight as causes of the crisis. In a March 2009 speech at the Council on Foreign Relations, he said, “The risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets.”

Proposed Changes to the Fed’s Role

Some see the Federal Reserve as an ideal candidate for monitoring systemic risk, since it already acts as a regulator of market cyclicality through its monetary policy. Others say using the Fed in this role would reduce accountability in financial regulation, since the Fed is not overseen by Congress and many attribute past crises to its light touch regulation. “A strong single regulator with a Senate-confirmed head would be better able to avoid gaps in coverage and improve accountability,” says Brookings Institution senior fellow Martin Baily. The three main proposals on reforming the Fed’s role are outlined as follows:

“A strong single regulator with a Senate-confirmed head would be better able to avoid gaps in coverage and improve accountability. ” – Martin Baily, Brookings Institution

WHITE HOUSE: Under the Obama administration’s proposal (PDF), the Fed’s responsibilities would expand to include supervising all institutions that could pose a threat to financial stability, such as insurance conglomerate American International Group or large hedge funds, rather than just bank holding companies and member banks. The Fed would be responsible for monitoring both the day-to-day operations of individual banks and systemic risk and would be advised by a new Financial Services Oversight Council, chaired by the Treasury secretary to identify firms that could pose systemic risk.

SENATE: The Senate bill (PDF), spearheaded by Banking Committee Chairman Christopher Dodd (D-CT), would curb the Federal Reserve’s power. The bill proposes a separate single banking regulator to monitor the day-to-day operations of all federal banks, a council of regulators to monitor systemic risk and the country’s biggest and most complex financial institutions, and the creation of a Consumer Financial Protection Agency to regulate consumer financial products such as mortgages and credit cards. The plan would limit the Fed’s ability to offer emergency loans to companies and eliminate its banking supervisory powers and banking consumer protection oversight. It would also give Congress and the White House some authority on determining how the Federal Reserve’s twelve regional banks are governed.

HOUSE: The bill sponsored by Financial Services Committee Chair Barney Frank (D-MA), which passed in December, supports the Obama administration’s proposal to have the Fed regulate systemically important institutions and a Financial Services Oversight Council to monitor emerging systemic risks. The bill also gives the Government Accountability Office more oversight power to audit all aspects of the Fed’s balance sheets and its regional banks, while exempting Fed interest rate discussions from the audit. The Fed would have to disclose after one year the names of recipients of emergency lending and would curb its authority to lend money to individual institutions in “unusual and exigent” circumstances, requiring the Council’s and Treasury’s approval. The bill also removes consumer protection power from the Fed, transferring it to a new Consumer Financial Protection Agency.

Conflict of Interest Concerns

Were the Federal Reserve charged with overseeing systemic risk, experts question how it could best respond to systemic threats while still being held accountable for its “dual mandate” of taming inflation and unemployment. Some argue that managing monetary policy (by varying the fed funds rate) and systemic risk simultaneously would make it more difficult to define a clear set of objectives for the Fed and assess its performance.

“It’s fair game to say the Fed reached to the edges of its authority, but had it not done so, there’s little doubt we’d be in a far more tragic situation today. ” – Darrell Duffie, Stanford University

In a September 2009 Cato Institute paper, American Enterprise Institute visiting fellow Charles Calomiris writes that under these circumstances, the Fed might be able to justify straying from its fed funds targets based on the need to maintain financial stability. Its departure from the Taylor rule from 2002 to 2005, says Calomiris, encouraged easy credit and “helped set the stage for the subprime crisis.” More recently, its decision to hold interest rates near zero and then take further steps to purchase and support various private securities makes it “extremely hard to predict monetary policy, or to hold the Fed accountable to achieving its unannounced and unobservable goals.” For these reasons, Calomiris argues that policy tools to respond to systemic risk should not be factored into measurements that assess the Fed’s monetary policy, as some economists have proposed. Instead, he says systemic risk regulation–whether conducted by the Fed or another regulator–should be measured and evaluated in terms of increased minimal capital standards, provisioning standards, and reserve requirements.

But Darrell Duffie, professor of finance at Stanford University, says conflicts with monetary policy would exist regardless of whether the Fed regulates systemic risk, since it would be in charge of providing liquidity to systemically important banks in distress regardless of whether another agency were identifying those risks. Duffie also notes that the Fed’s biggest shortcomings during the recent crisis resulted from its lack of authority over systemically important financial firms, rather than incompetence. “It’s fair game to say the Fed reached to the edges of its authority, but had it not done so, there’s little doubt we’d be in a far more tragic situation today,” he says.

Accountability vs. Independence

Experts also question whether the Fed should be subjected to more oversight, given its unprecedented actions during the financial crisis and the potential fallout for the American taxpayer. By increasing its balance sheet from roughly $800 billion at the outset of its bailout plan to more than $2.2 trillion a year later, and by purchasing an unprecedented amount of illiquid assets, some lawmakers and economists say the Fed worked too closely with the Treasury department, sacrificing its independence and leaving the country vulnerable to the risk of inflation. Others say the Fed’s inconsistent decisions, allowing some institutions to fail while arranging supports or takeover for others, encouraged the problem of “moral hazard,” whereby banks take on more risk and increase leverage assuming that Congress, the administration, or the Fed will bail them out, since there is no clear policy to follow.

“It’s not obvious to me that [the Fed] can or should take on the role of manager of the entire financial system and remain both obscure and independent.” – John Cochrane, University of Chicago

Some members of Congress, led by Rep. Ron Paul (R-TX), support legislation that would require the Government Accountability Office to audit all Fed activities. Many economists strongly oppose this idea. In a November 2009 Wall Street Journal op-ed, University of Chicago Business school professor Anil Kashyap and Columbia University business school professor Frederic Mishkin argue that subjecting the Fed to the political pressure of GAO monitoring might lead the central bank to seek to lower unemployment more in the short run, ignoring the long-term threat of inflation. In a July 2009 petition signed by more than four hundred economists, Kashyap and Mishkin said such oversight would put upward pressure on interest rates without lowering unemployment in the long run, raising the risk of inflation and causing borrowing costs to rise.

Rep. Mel Watt (D-NC) has proposed an alternative amendment (PDF) to allow the GAO to audit the Fed’s new lending facilities while exempting the Fed’s normal monetary policy actions from such oversight. The proposal would disclose the borrowers from these facilities one year after the facilities close, enabling Congress to oversee them without creating a “stigma problem,” in which borrowing from emergency lending facilities makes it harder for borrowers to operate because investors know the borrower is having financial difficulties.

Others question whether the Fed should be taking on emergency measures at all. Carnegie Mellon’s Meltzer says the Fed’s role should be pared down to monetary policy and serving as the lender of last resort for distressed banks, “provided they have good collateral. If not, the [banks] should fail,” he says. John Cochrane, professor of finance at the University of Chicago, says the Fed’s independence has historically been predicated on its powers being limited to monetary policy. “It’s not obvious to me that [the Fed] can or should take on the role of manager of the entire financial system and remain both obscure and independent,” he says.

Weigh in on this issue by emailing CFR.org.

Today, the group released its high level predictions for 2010. They suggest:

1. We are officially in a “post real estate boom phase” and shedding exposure is a tactical necessity (Whitney Tilson at T2 Partners argues similar points and is one of smartest investors I know on the subject).
2. The US banking industry will continue to shrink but hit its peak loss rates during the upcoming year.
3. State budgets will continue to worsen and we will see further unwinding of government programs.
4. We’ve only scratched the surface in understanding the new quasi-fiscal roles our Federal Reserve has taken through crisis capital lending arrangements and quantitative easing. This debate will grow significantly in 2010.

I can’t find much to argue in any of their points and have already suggested some of my thoughts on Item #4.

Predictions for 2010: The Best is Yet to Come

December 21, 2009

As is our custom at the end of a year, we below provide our thoughts on the coming year and reflect on the year that was. We wish all of the readers of The IRA a very happy holiday and a safe and prosperous New Year.

And remember that the special rate for subscriptions to the past articles from The Institutional Risk Analyst expires 12/31/09 when we transition to a paid model for past commentaries. Makes a perfect stocking stuffer for that aspiring young student of American political economy.

The first issue we see in 2010 is “completing the transition into a new reality that the country has moved into a post real estate boom phase,” as IRA CEO Dennis Santiago wrote in his “Picking Nits” blog on December 8th (“Industry and Bankers: Chasing Quality”). He continued to describe the situation in the banking industry revealed in the Q3 2009 Bank Stress Index and supporting metrics:

“Shedding exposure is a tactical necessity. This means banks need to tend to their own health particularly with respect to the lingering cancer of losses from distressed real estate still in their bloodstreams. Projected real estate loan losses still to come are massive. The bulk of Option-ARM reset dates are in the still to come in 2010 and 2011 bucket. The reality is that these loans were never meant to survive the reset. Unless an alternative is created, the human pain and loss will be massive.”

The second issue related to the first point will be the peak of loss experience for some US banks as the credit cycle plays out during 2010. Some of the most trouble-looking institutions will actually start to improve, while other banks that during the past year or more have seemed to be paragons of virtue will finally, grudgingly be force to take their lumps. In a very real sense, some banks will be changing places in 2010 even as the worst of the credit crunch plays out in the real economy.

In any event, we expect to see the US banking industry continue to shrink in terms of assets and the number of FDIC-insured institutions as losses are taken and banks are resolved and sold. Dennis describes the position of the US banking industry as of Q3 2009 in Pickin Nits.

PIECE TRUNCATED – Get the rest at InstitutionalRiskAnalytics.com