NY Fed Creates an Elite 'Special Team' for the Investment Banks

Fed Keeps Watch on Wall St. -- From the Inside
By Neil Irwin
Staff writer
Washington Post
Tuesday, May 27, 2008

In the two months since the government rescue of Bear Stearns, the Federal Reserve has built on the fly a new system of monitoring investment banks, radically redefining the central bank's role overseeing Wall Street.

New York Fed employees are working inside major investment banks every day, alongside the Securities and Exchange Commission staff members who are the firms' main regulators. The Fed employees are trying to gather information the central bank can use to make sure the billions of dollars it is lending the investment firms, through a special emergency loan program enacted in March, are not being put at undue risk.

This new approach, which is still at a relatively small scale, offers a window into how the nation's system of regulating financial firms might evolve as policymakers sift through the financial wreckage of the past nine months.

The Bush administration has proposed that the Fed become an all-purpose guarantor of the financial system, with the power to poke its head into any company that poses risks -- not just the large commercial banks it now supervises. Congress is likely to consider legislation overhauling financial regulation next year.

"Bear Stearns has forced an issue that we should have been thinking about anyway," said Douglas Elmendorf, a senior fellow at the Brookings Institution. "The issue isn't just that the Fed did this thing in March. It's that the Fed did what it did in March because investment banks posed risks to the overall financial system and the economy."

But it also creates risks. With the Fed having made emergency funds available to investment banks, lenders and those who work with them might become complacent about risks, expecting a government bailout if anything goes wrong. That could destabilize the financial system further.

"Once the Fed starts investigating and looking at the risks that they're taking, the market could back off and say, 'Well, the Fed's in there, so there can't be much risk,' " said Peter J. Wallison, who studies financial regulation at the American Enterprise Institute. (Those would also be known as 'famous last words' - Jesse)

The Fed currently lacks the legal authority to order investment banks to strengthen risk control systems or change their accounting for exposure to complicated derivatives. The SEC has those powers, though its historical mission has been to ensure that investors are protected, not to protect the integrity of the financial system as a whole.

On March 16, the Fed backed the emergency acquisition of Bear Stearns by putting $30 billion (since changed to $29 billion) in public funds at risk and opened an emergency lending window that last week lent $14.2 billion to investment firms.

Both actions, meant to prevent panic from causing a cascade of failures that could have had a catastrophic impact on markets and the world economy, defied 90 years of precedent, insinuating the central bank into the workings of Wall Street as never before.

Fed leaders concluded that they would have to step up their involvement in Wall Street, if only to make sure that those loans were likely to be paid back. So it insisted that banks, in exchange for the new lending, open up about the details of their operations -- a deal that the investment firms readily agreed to.

They have not, however, reached any firm conclusions about what form the ultimate regulation of the financial system ought to take and are not presuming that the improvised system established in the past two months will expand and become permanent once Congress acts.

In the meantime, a special unit has been created in the New York Fed, answering directly to President Timothy F. Geithner. Information about its operations is closely held by Geithner and other senior employees in New York, such that even Federal Reserve governors and presidents of other regional Fed banks know little about what the new unit is doing.

The unit is composed of individuals from the bank supervision staff, whose normal work is to regulate commercial banks; the markets group, which monitors the behavior of all sorts of financial markets watching out for threats to their functioning; and the legal department.

The Fed staffers accompany SEC regulators in frequent visits to the major investment banks Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers. They typically speak to risk managers, auditors, comptrollers and sometimes senior executives.

"What they're doing is not so much regulation, telling the banks what to do, as the Fed is saying, 'I'm lending you money, I'm doing my due diligence,' " said Ernest Patrikis, a partner at law firm Pillsbury Winthrop Shaw Pittman and a former senior official at the New York Fed.

In the past, collaboration between the Fed and the SEC has been more haphazard. Officials of the two organizations would frequently talk on the phone and meet every few weeks to discuss risks being taken by Wall Street firms, over lunch in the cafeteria at the vault-like headquarters of the New York Fed, for example, or on a balcony there overlooking the narrow streets of lower Manhattan.

As concern grew about the risks taken by hedge funds in 2006, Fed officials and their SEC counterparts had a series of discussions in which each side explained to the other how the institutions they directly supervise -- commercial banks for the Fed and investment banks for the SEC -- measure and manage the risks they are taking by lending to hedge funds.

Now, the interaction is more constant. The SEC is crafting a formal memorandum of understanding that lays out their roles, but it is in an early stage. It will mainly seek to formalize the information-sharing and cooperation that is occurring already, SEC officials have said.

"The collaboration is wide open," said Robert L.D. Colby, deputy director of the SEC's market regulation division. "We're essentially operating as if we're all within one agency. We are telling them what we know and how we think, and they're reflecting back what they know and want to learn. You don't always ask the same questions, and sometimes you get information the other might not have picked up."

Banks Anxious to Dump Debt Threaten Monolines Solvency

It looks like bad debt tends to flow downhill, from the banks to the monolines, with the facilities of the NY FED in charge of wiping up.

At the end of the day, at the end of the line, are all the holders of US dollars. If you are holding dollars, you are holding the bag. The dollar is the limit of the Fed's ability to absorb losses in the greatest transfer of wealth in modern history, from the many to the few.

A DEBT END FOR BANKS
Insurers Face Defaults
By MARK DeCAMBRE

May 27, 2008 -- Battered investment banks trying to dump billions in soured mortgage securities are being challenged by struggling insurance companies that claim such efforts could cause them further pain.

It's a battle that pits large financial firms like UBS, Merrill Lynch and Citigroup against insurers MBIA, Ambac and others. These insurers, which the industry refers to as "monolines," provide specialty insurance used to protect investors from losses on various types of debt securities.

At issue is a type of protection that banks have obtained against defaults that is now preventing them from purging portions of their holdings of arcane mortgage securities known as collateralized debt obligations.

Under the terms of this protection, the banks need approval from the monolines in order to unwind these securities - and obtaining that OK is proving difficult in some cases.

For the past several months as the credit crunch has pummeled mortgages and other forms of debt, a lot of collateral used to form CDOs has triggered defaults due to rating agency downgrades. As a result, if the banks begin dumping these problem securities, financial guarantors would be forced to pay default claims almost immediately - a tall order for companies whose financial future is already murky.

Typically, monolines pay out claims on losses over a period of 20 or 30 years, but the types of sales that the banks are looking to score would accelerate those payments and further hammer companies already hurting.

The banks appear to recognize that the insurers are unlikely to be able to cough up the cash needed to pay off these losses.

That has led to discussions about whether to waive claims payments in exchange for cash or warrants in certain publicly traded monoline companies.

"Clearly, liquidation into this market is tough but holding on long term might not be your best case," said Joe Messineo, who runs a New York-based structured finance consulting firm. "Not many people envisioned the magnitude of this would come down to documents."

None of the monolines embroiled in this battle returned calls for comment. Neither did the banks.

Although there are hardly any buyers for CDO paper, the banks would be able to unwind the CDOs and essentially purchase the assets that comprise the complex debt structures - a move that might allow them to better assess the value of the assets and at least eliminate the fees associated with holding onto the debt as CDOs.

mark.decambre@nypost.com

Pigs Fly, Paris Hilton Takes the Veil, and HSBC CEO Calls for Higher Rates and More Regulation

HSBC CEO calls for higher rates to fight inflation
27 May, 2008, 1714 hrs IST,
REUTERS

HONG KONG: The chief executive of Europe's biggest lender on Tuesday called on central bankers to raise interest rates in order to combat inflation, and said more regulation may be needed in the wake of the credit crunch.

Michael Geoghegan, group chief executive at London-based HSBC Holdings, also said he expects it will take three years for the bank to turn around its HSBC Finance unit in the United States.

The consumer finance business, previously called Household International, was one of the earliest casualties of the subprime mortgage meltdown in the United States.

Geoghegan said central banks were not yet committed to taming inflation, and predicted U.S. interest rates would rise after the U.S. presidential election in November.

"Inflation is a long-term problem because there is no long-term will to solve it," Geoghegan said in a speech.

In a number of economies, central banks have either cut interest rates or kept them low to support growth at a time when lending between banks has stalled and housing markets around the world have plummeted.

However, energy and food prices have surged, feeding inflation and crimping consumer spending. For example, since a flood of homeowners defaulting on their mortgages snowballed into a credit crisis last summer, U.S. consumer inflation has risen from an annual rate of 2 percent to 3.9 percent in April.

Geoghegan also said the industry's investment banking model would need to be changed over time to avoid a repeat of the past year's credit crunch.

"I'm not a great fan of regulation ... but there will be a need to look at the model in that area," he said, adding that banks should focus on lending and investment advisers on advising clients, although he did not call for any specific measures.

"The investment banking model is flawed," Geoghegan said. "If banks aren't strong, they should be restructured or taken over," he added.

HSBC, which Geoghegan said has no plans for a share buyback, has managed to weather the credit crisis that erupted last summer better than many of its peers thanks to a significant presence in emerging markets in Asia and the Middle East.

In the first quarter of this year, the lender booked a bad debt charge related to its U.S. consumer finance business of $3.2 billion, less than the $4.6 billion in the previous quarter but double the level of the first quarter in 2007.

Geoghegan, speaking to reporters following an informal shareholders' meeting in Hong Kong, declined to project any further provision to cover subprime losses, but added that 80 percent of customers in the U.S. finance unit are still paying their mortgage bills. (Wow only a 20 percent default rate? That a glass half full description - Jesse)

Earlier this month, the bank said first quarter profit was higher than a year ago despite some $5 billion in write-downs and charges related to bad debts.

HSBC, whose shares were down 0.44 percent in London trade on Tuesday after closing 0.31 percent higher in Hong Kong, is due to report its first-half results on Aug 4.