The Fed Is Serving the Wall Street Banks Not the Republic

In times such as these we like to look past the bought and paid for house economists and over-eager-for-an-Undersecretary-of-the-Treasury-appointment academics for serious, seasoned, and meaningful commentary from those who have been in and actually understand the markets.

14 April 2008
The Fed Has Power, but No Will
By MARTIN MAYER
Barron's Online

THERE'S SOMETHING STRANGE ABOUT THE TREASURY DEPARTMENT'S suggestions for the reform of banking regulation and about the cascade of commentary on it. From one end to the other, there's an assumption that the Federal Reserve has somehow lacked the information and authority it could have used to prevent the insanity that has engulfed the credit markets.

The Fed, we are told, had access through its examiners to what the commercial banks were doing, but not to what the investment banks were doing. Yet the investment banks that mattered, including Bear Stearns (and Morgan Stanley, Merrill, Lehman and Goldman, not to mention the mortgage lender Countrywide), were all among the 20-odd primary dealers who help the Fed distribute Treasury bills in the weekly auctions that fund the federal government.

All participants in those auctions were supposed to keep the Fed informed of any significant changes in their balance sheets-on a continuous basis. When Joe Jett's purchase of strips and reconstitution of Treasury bonds led to a weakening of Kidder Peabody's financial position in 1994, there was all hell to pay at the Federal Reserve Bank of New York, because its government-securities division was not promptly informed.

Our present regulatory structure goes back not to the Great Depression, but only to 1999 and the Gramm-Leach-Bliley Act, which undid the Depression-era Glass-Steagall Act.

The great controversy as the repeal bill moved to passage was about responsibility for supervising the banks in their exercise of new powers. If nationally chartered banks were permitted to be brokers and dealers and underwriters and mutual-fund managers, their work would be supervised by the Comptroller of the Currency, whose examiners inspected these banks. But if the law gave the new powers only to the holding companies that owned the banks, everything would be controlled by the Fed, which was to be the umbrella regulator for the new financial-services institutions.

THAT'S WHAT THE FED WANTED. Rep. Jim Leach, who was chairman of the House Banking Committee, was a great admirer of Alan Greenspan and the Federal Reserve, so that's what the Fed got.

Most commentators on the current credit crisis have argued that the banking regulators and supervisors played no role in its inception, because the bad mortgages were written and sold and packaged by unregulated mortgage brokers and mortgage bankers. But all the bank-holding companies had subsidiaries that were active in the mortgage market, and virtually all the mortgages packaged for sale by private entities passed through some subsidiary of some bank-holding company or some bank-controlled investment vehicle at some time between the inking of the contract and its disappearance into a collateralized security.

There was plenty of opportunity for bank examiners checking out the holding companies to notice that some of the paper in the vaults had inadequate or dishonest documentation, and to "classify" it. When the examiner classifies an asset, he forces the bank to reduce its reported profits and discourages further investment in similar assets.

Of course, Fed examiners don't look at individual loans any more; they just ask banks whether they are living up to their own standards of due diligence, and if it's OK with the bank it's OK with the Fed.

MEANWHILE, THE FINANCIAL SECTOR under the Fed's umbrella regulation was building a highly unsafe structure that abandoned many private-sector security features that had been created in the 1970s. With the systems developed then and perfected more recently, the buyers and sellers of stocks or exchange-traded futures or options have no contact with each other once the trade is confirmed by both sides later that day. At that moment of confirmation, the entire market, in the form of the clearinghouse, becomes the counterparty -- the guarantor that the buyer will get his stock or option or future and the seller will get his cash.

Among the useful attributes of this arrangement for the options and futures markets is that most contracts are extinguished by the purchase of an opposing contract: A previous seller buys, or a previous buyer sells, and the contract with the clearinghouse disappears. At the end of every day, the clearinghouse reports trades and "open interest."

But as banks honed the profitability of derivatives trading, they made more and more individual over-the-counter trades that involved payment from buyer to seller, delivery from seller to buyer, no clearinghouse, and a continuing relationship of the two counterparties. This was presented as innovation, and the Fed was committed not to discourage innovation. Now it can be seen as the retrograde development it really was. Like the stock market of the 1960s, this over-the-counter system has blown up, leaving behind gaseous waves of mistrust.

In the OTC derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It's an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit.

The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps.

BEAR STEARNS APPARENTLY had created trillions of dollars of positions this way, which is why it had to be kept in business. Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don't know who will wind up with obligations they thought they had insured against and they can't meet. Suddenly, all counterparties for all sorts of trade become suspect. We should note in passing that the big beneficiaries of the Fed's action on Bear Stearns were the sellers of credit derivatives insuring Bear's obligations. The counterparties' paper had been worth very little on Thursday night and quite a lot on Sunday afternoon.

The Fed could easily have prevented this ruinous expansion of OTC credit-default swaps by requiring banks to keep extra reserves against such holdings, larger than the margin requirements of the exchanges where derivatives were traded, cleared in a clearinghouse, properly settled and extinguished. Instead, the Fed promoted the false idea that the banks in their own interest would police the gambling of the mortgage bankers and the credit-gobbling quantitative traders and the leveraged-buyout fakirs -- and that the hidden trading of non-standard, bilaterally settled, opaque derivative instruments would improve the stability of markets. Such ridiculous claims are still being made.

Quite apart, then, from the philosophical question of whether bank examination and control of monetary policy fit well together (they don't), the Fed has done nothing to deserve Treasury Secretary Henry Paulson's recommendation that its role in supervising the markets should be expanded by new laws.

The truth is that the Fed had plenty of authority to take the steps that would have avoided today's dangers and its own embarrassments. The problem was that the Fed lacked the will to supervise. Before we can restore the self-confidence of the market, we will need to create a Federal Reserve that believes in its own regulatory mission more than it believes in prudence at the banks.

MARTIN MAYER is a guest scholar at the Brookings Institution and author of numerous books about banking and finance. "If anyone knows more about money, banking, and investments, that individual is keeping the information to himself," wrote James Grant of Grant's Interest Rate Observer in reviewing Martin Mayer's 1991 book Stealing the Market. In 1993, Publisher's Weekly described Mayer's Nightmare on Wall Street as "A landmark treatment of the money world." Martin Mayer has been writing about business and financial subjects for forty years. Mayer's latest book, The Bankers: The Next Generation, was published in January 1997.