We recently wrote about a long overdue shot across the bow from the Senate Banking Committee about initiatives by the Treasury and now the Fed that amount to a regulatory land grab. Why do we think Congress should have done more, sooner? Because the proposed action put the Fed in the position, as with the Bear bailout, of taking actions that have fiscal implications. That’s the purview of Congress, not the central bank, and Congress has every right to reassert its authority over the public purse.
And having an Administration that is a blatant enabler of financial services industry assign itself sole responsibility for financial services reform is not just letting the fox into the henhouse but per reader Zippy is turning it into a chicken wing bordello.
Well, the Fed has gone ahead anyhow, and so far no one has interceded. In fact, there has been perilous little media recognition of its significance, which may account for the lack of pushback.
Peter Wallison in a comment at the Financial Times, “The Fed and investment banks,” makes a case that many readers would support: that this move will increase moral hazard and that investment banks are not too big to fail.
Wallison also notes that Congress could nullify or limit the Fed’s agreement. If you aren’t happy with this move, now is the time to let your Congressman know.
From the Financial Times:
Since the Bear Stearns bailout, most commentators in the US have assumed that the Federal Reserve’s action would eventually result in Fed regulation of investment banks – a superFed, as some have called it. But it was always assumed that this would occur through legislative action, as Congress considered whether to place the resources of the US government behind the investment banking industry, as those resources have been placed behind commercial banks.
However, on Monday, with the support of the Treasury, the Securities and Exchange Commission and the Fed signed a memorandum of understanding that, in effect, puts the key elements of a Fed regulatory structure – and implicit Fed backing for the large investment banks – into place. What this amounts to is a straightforward Fed reach for important new regulatory authority, an unprecedented step in which a weak SEC – chastened after the failure of Bear Stearns – has been complicit. It would be perfectly acceptable if the agreement covered only the emergency period the markets are now experiencing, but it has no time limit.
The agreement is very bad news for US taxpayers. Fed involvement with the regulation of investment banks will introduce moral hazard into the securities business for the first time and pave the way for a vast new US government liability. The agreement between the Fed and the SEC will seriously compromise market discipline, which only exists when creditors and other counterparties believe that they are financially at risk. What now amounts to ongoing supervision of the financial condition of investment banks by the Fed sends an unmistakable signal to the markets that the government believes itself to be at risk. Under these circumstances, investors will be justified in believing that the US government will ultimately stand behind the large investment banks. This will irretrievably compromise market discipline, which in turn will produce the very risk-taking and subsequent losses that regulation – as recently as the savings and loan debacle – has never been able to prevent.
The key question arising out of the Bear Stearns bailout is whether the surrounding crisis was a unique event, or just the first of many similar crises resulting from a secular change in the market itself. If we are to make significant changes in policy, there should be substantial evidence that the financial market is materially different today than it has been in the past.
But there is little evidence of this. In mid-March, when the bailout occurred, the financial markets were on the edge of chaos. This was – and in many respects still is – an unprecedented event. In the 70 years since the Depression, there has never been a crisis that the Fed could not address simply by flooding the market with liquidity. This crisis, however, was not a case of one institution’s insolvency causing others to become temporarily illiquid; this was a case where the financial stability of virtually all the world’s largest financial institutions was simultaneously in question. Ultimately, the Fed had to take credit risk on to its own balance sheet in order to stem the panic. In short, this unprecedented event should not be the basis for a major change in regulatory policy unless there is evidence that it will routinely recur in the future.
One reason frequently cited for viewing today’s market as different is the advent of the credit default swap. These seemingly mysterious derivatives are said to make the market more “interconnected”, so that the failure of a large investment bank might cause a systemic collapse. This is not correct. A CDS is like insurance or a performance bond; it moves risks by contract from one place to another, but does not create risks that did not already exist. Thus, even if a Bear Stearns failure had triggered obligations from those who had written CDS protection against a Bear default, the counterparties who were covered by this protection would have been relieved of a loss they would otherwise have suffered. The total amount of risk in the market is the same; it is just held by different institutions. To be sure, the unwinding in the Bear Stearns case would have been complicated, but that is a reason to set up a clearing house for swaps, not to regulate investment banks.
Moreover, unlike commercial banks, investment banks are unlikely candidates ever to cause systemic risk. Investment banks collateralise their borrowings. If they fail, their creditors can usually sell the collateral to make themselves whole. In contrast, the failure of a large commercial bank leaves its depositors and other creditors without funds until it is resolved. That is why large commercial banks, which have open account obligations to thousands of other banks, creditors and counterparties, can be said to be too big to fail. Applying the too-big-to-fail label to investment banks reflects a serious misunderstanding of how their business model differs from that of a commercial bank.
In order to sign their agreement, the Fed and the SEC had to ignore a request by two powerful senators – Christopher Dodd and Richard Shelby, the chairman and ranking member of the Senate banking committee – who asked the two agencies in a letter last week to respect the prerogative of Congress to assign responsibilities to regulatory agencies. Instead, the two agencies have created a fait accompli that takes the question out of the hands of Congress. If Congress wants to have anything important to say about the regulation of the financial markets and the liabilities to be borne by the taxpayers, it should step in now to nullify this agreement or limit it to the emergency lending programme the Fed began in March.
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A very interesting article in the Financial Times yesterday claimed that saving Bear Stearns was really done by the Fed to prevent collapse of the private “tri-party repo” system, whose depositaries are BNY Mellon and JPMChase. Thus the bailout was done to save BNY and Chase, and to prevent the tri-party funding burden from rebounding to the Fed. Your wisdom on this take?
Alan Antrim
The FT Tri-party repo link is here:
http://us.ft.com/ftgateway/superpage.ft?news_id=fto070820081724589016&page=2
I probably sound extremely naive since I really don’t know much about the subject, but this doesn’t sound right:
“This is not correct. A CDS is like insurance or a performance bond; it moves risks by contract from one place to another, but does not create risks that did not already exist.”
I thought that you don’t have to own the security in question to be a counter party in a CDS? Isn’t that just pure speculation and similar to being the seller in a naked put? that sounds like extra risk to me…
Yves, this is wonderful site. I read it every day!
The mere fact that the Fed and SEC were not compelled to even respond to Congress is quite telling. If Congress let this “fait accompli” stands, they will set themselves for obvious irrelevance.
Good Bye checks and balances!
I say let the technocrats run things. Do we really think the freshman senator from Ohio knows anything about how to run an economy.
I am actually being facetious. I don’t know where along the line we forgot about the free market but we sure did. The idea that a few people at the FED know what the right interest rate should be is truly silly. Let the the markets work! Abolish the FED.
Hmm, as one of the posters above mentioned, I don’t think there was too much digging re CDS and Bear.
I was under the impression that they were the seller of a bunch of CDS (a lot to JPM), and backruptcy would turn that to dust.
The risk with CDS is the counterparty risk – no use buying insurance if the insuer goes bust. There are rules for the insurance industry but of course if you call the product CDS it’s not insurance, right?
Cheers
re: CDS and risk. Here’s my view:
These days I’m sure that most of the major oil companies have insurance policies that will reduce their costs in case of an environmentally damaging oil spill. Let’s say a typical policy allows the firm to buy $10 million of coverage for $100,000 per year. Now imagine if all of the current and former employees of these oil companies, as well as their friends and family members, could pay a premium of $100,000 to receive the same payment – i.e. up to $10 million – that the firm receives in case of an oil spill. Do you think the likelihood of an oil spill will go up or down?
Of course, in the world of real assets insurance companies aren’t stupid enough to offer the bloke who drives the oil tanker a $10 million payoff for causing an environmentally devastating oil spill. They require that anyone who purchases insurance have an “insurable interest.” The oil company has an insurable interest, because the oil company is at risk of having to spend tens of millions of dollars cleaning up an oil spill. The employee of the oil company isn’t liable for the clean up costs and therefore isn’t eligible to buy a policy that covers them.
Given that offering to pay members of the financial community millions of dollars if they do their jobs badly is on the face of it every bit as stupid as paying the captain of an oil tanker off when a spill occurs, how come so many of these insurance contracts with no insurable interest were written? The answer is simple: the people who were “investing” in synthetic and hybrid CDOs didn’t understand that this “investment” was equivalent to selling insurance.
Yves,
I doubt many people will respond to your call to arms, but I’m going to write my state retard, who I assure you has no concept of what’s going on now, just as she didn’t with The Pension Protect Act…… this crap makes me wonder why I bother, because this string of nepotism and the idiots that get elected by fools is simply disgusting — the worst representation in American history and they should be shamed out of office ASAP:
U.S. Sen. Patty Murray, D-Seattle, 173 Russell Senate Office Building
Washington, D.C. 20510; 202-224-2621; Email Sen. Murray; In Seattle: 2988 Jackson Federal Building
915 Second Avenue Seattle, 98174; 206-553-5545
I want to add, I’m a registered Independent and will vote against every person holding office, regardless of party, regardless of hype, because they are all bought and paid for by lobbies — lobbies will win the election, as usual with payoffs to every public official, bar none!!
Doc
Since Congress rarely writes specific legislation, prefering to pass broad bills and leave it to the agencies to draft the specific regulations why do you think they will get their hands dirty with this. They don’t want to be within a thousand miles of drafting specific regulatory statutes and are perfectly happy to let the Fed, SEC and whomever else is foolish enough jump in. Why put your head on the chopping block when others are willing to do so for you. These were my brief thoughts on it a couple of days ago. http://blog.metro-real-estate.com/?p=681
The Securities Act of 1933, the Securities and Exchange Act of 1934, the Trust Indenture Act of 1939 and the Investment Company Act of 1940, all passed by Congress, are the cornerstones of securities regulation in the US and have held up surprisingly well. However, they focused on equity markets, which is where the abuses of the 1920s occurred, and have comparatively little sway over almost entirely OTC credit markets.
The US is supposed to have a system of checks and balances. Congressional control over the budget is an important constraint against an imperial executive branch. Unfortunately, we now appear to be in the bread and circus stage. The powers that be prefer to let decay run its course rather than intervene.
And You Are Surprised !
The banks not only want a piece of the action, they want all the action.
The Government as it is currently constituted does not have the balls to take on the privately owned and operated Federal Reserve. Remember that Bush’s lineage is of bankers and most of Congress doesn’t know diddly about the creation of money.
What ought to happen is the nationalization of the Federal Reserve whereby the US Government can produce money without interest as is pronounced in the Constitution of the United States.
We have given away our right to print our money to the private banking industry. This is the biggest subsidy in the United States and in the world. Trillions and trillions have been given the bankers to line their own pockets.
The American taxpayers are going to get a big phallus rammed in the rear good and hard.
“What ought to happen is the nationalization of the Federal Reserve whereby the US Government can produce money without interest as is pronounced in the Constitution of the United States.”
You’re absolutely right. The Fed must return the keys to our mint peacefully, while they still have a chance.
Sy Krass said…
THIS SHIT IS GREAT!!! I’M LAUGHING OUT LOUD!!! THIS SHOULD BE PASTED ON THE FOREHEADS OF ALL THE PROGRAMMED ROBOTS AT CNBC AND FOX FINANCE, OR WHATEVER THE HELL ITS CALLED. I’M LAUGHING IMAGINING THE SIGHT OF LARRY KUDLOW SHORT CIRCUITING LIVE ON THE AIR!!! Yves, this should be put in a time capsule so that future generations of archeologists know that the once great civilization of the United States of America had a sense of humor as it was headed toward the executioners ax…
Anonymous:
I labeled the “Bear Stearns” bailout a JPMorgan bailout immediately after it happened.
I second the abolish the Fed motion along with reverting to the Treasury issuing interest free notes (whadda concept).
Wiping out the bankers bread and butter is akin to passing a flat tax and putting the IRS out of business.
Please, BS failing would have taken out the whole world of banking due 30, 40, 50+ leveraging. There is not enough paper currency in the world to payoff when that debt comes due.
This joint Fed-SEC initiative brings to my mind three implications, all of them quite negative.
First, I do not see this as regulatory grab by the Fed so much as a backdoor soft coup by the ibanks: they just acquired operationally permanent, unlimited, unregulated, and unquestioned lender-or-last-resort and recapitalization access to the Fed. In short, they just _took over the Fed_, functionally speaking since they neither tell the Fed what they do or are seriously constrained by regulation but can force the Fed to back them, now and forever. That is extraordinarily unacceptable, especially as an undebated, stroke-of-the-pen action.
Second, the Bushies via Paulson had been proposing their personal ‘Let them sell bonds’ non-regulatory loinclout for the ibanks—which has gone nowhere with Congress of the public for good reason: the Bushies have negative political capital, and the policies were weak and stinking. Soooo in typical Bush-Cheney macro-arrogance we now find the same goals pursued through an end around cronies’ bargain between an Executive agency and a quasi-Executive agency _specifically structured so as to exclude Congressional action_. That’s indescribable. The public cannot and will not get anything like good governance from such a process; rather, we will get unrestricted public bailouts of failed plutocrats on a crony capitalist basis.
Third, I suspect this Thieves’ Accord was pushed through specifically because the Fed expects the imminent failure of a major ibank and wants to have some kind of public fiction of authority to wave about on a handbill when they open the till massively to step in. Put another way, Lehman’s is gonna blow, and the Fed plans to whap down it’s wallet preemptively using this rag of lies as its ‘covering authority.’
All of this speaks extremely ill of Ben Bernanke, I might add with some regret. The law and consequences be damned, he’s got his ‘nukes’ and he means to use them rather then let them moulder in their silos. The man has just completely lost his head, to me, in making this move. Or to pull these thoughts together, he is now manifestly a creature in pawn to the ibank CEO’s, Big Money’s Bitch. Ben, those men are Not Your Friends. They are not your partners. They are your enemies, and the economy would be better without them. Getting there, admittedly, is the Sucktastic Journey. However, giving them drawing rights to your drawers is not in the public interest.
“Moreover, unlike commercial banks, investment banks are unlikely candidates ever to cause systemic risk. Investment banks collateralise their borrowings. If they fail, their creditors can usually sell the collateral to make themselves whole. In contrast, the failure of a large commercial bank leaves its depositors and other creditors without funds until it is resolved. “
This seems rather disingenuous in a mark to market world. If a large investment bank failed and its creditors tried to liquidate their collateral at the same time, it would cause massive writedowns across the whole (global) financial system with all the consequences for capitalisation that we’ve seen in this crisis. Even the prospect of liquidation would put serious pressure on prices.
@ Richard Kline…only hope is that with the prospect of an election around the corner, even Bernanke won’t have the ability to bailout another i-bank.
Agree with the rest of your post the Fed’s potential new powers are unearned/unwarranted/unauthorized.
I agree with previous comments that Congress has no clue how to deal with the hugely complex shadow financial system (ultimatley very few understand it completely) and are all too glad to do some posturing for the cameras, then wash their hands and abdicate responsibility rather than do the enourmous hard work to comprehend the situation and advocate solutions.
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