In Fed We Trust

Via Robert A. Eisenbeis and Ellis Tallman of Cumberland Advisors:

David Wessel’s book, In Fed We Trust: Ben Bernanke’s War on the Great Panic, is the definitive chronicle of the 2007-2009 financial crisis, but it is much more.  The book gives us an inside view of how policy making took place in response to the striking events. Wessel provides insights into the key players and decision makers, and conveys a very real sense of what they were thinking as those events unfolded.  In doing so, however, his account triggers serious questions about the Treasury/Federal Reserve decision-making process.  Here, we emphasize three serious flaws in the policy-making process that Wessel describes: the consistent lack of a plan and short-time horizon of the decisions, the insularity of the decision makers, and the apparent disregard for FOMC information-security rules governing meetings and associated documents.  We conclude by noting some oversights in Wessel’s account of the Great Depression and the Panic of 1907.

Lack of a Plan

The insider’s view of the policy making is the unabashed strength of this book, and Wessel provides an extensive chronology of how the crisis unfolded.  It is not a pretty picture.  His most telling observation is that the principals seem to have lurched from event to event without a plan, even after it should have been apparent that one was needed.

The discussions among key participants – namely Chairman Bernanke, Secretary Paulson, then-president Geithner, and Governors Kohn and Warsh – seem rushed, from Wessel’s descriptions of them.  The policy discussions tended to focus on short-term problems, pushing off potential longer-run consequences of the policy responses as a matter of expediency.  The sense is that the participants expected each decision to be sufficient to return markets to normalcy; but of course, they were not.  The ad hoc, short-term nature of policy process, as described in the book, carried with it the risk that not all decisions would be good and would carry with them unintended consequences.  For example, the problems of exiting from many of the policies are now significant and have yet to be addressed.

Wessel alleges that the policy makers continually underestimated the crisis and that there was no long-range planning undertaken from the time that the crisis initially erupted.  This should come as no surprise to anyone reading closely the financial press throughout the crisis, and yet it remains disappointing.  It is important to note that not all the decisions had the time constraints that surrounded the issue of the Lehman failure in the fall of 2008.  That event was preceded by almost a year of financial turmoil, serial reports of losses, failures or mortgage related institutions, and market disruptions that should have signaled to policy makers that something serious was at hand and that they weren’t simply facing a short-term liquidity problem.

By now, it is apparent that the crisis was misdiagnosed as a liquidity problem when in fact it was a solvency crisis.  Funds didn’t suddenly dry up and markets did not stop functioning because there were no funds available.  Rather, because of the trail of losses and preceding events, financial markets finally became wary of the solvency of key counterparties, as the Bear Stearns episode clearly demonstrated.  This was long before the problems in Lehman Brothers emerged.  Market participants’ concerns, as subsequent events proved, were well-founded.  It took policy makers too long to recognize the capital deficiencies relative to the risk exposures of major primary dealers, which then left them with insufficient time to design resolution plans.  Most of the largest financial institutions – both domestic and international – proved to have inadequate capital.  Some failed, and many were bailed out by their respective governments.

Wessel’s description of the decision-making process reminds one of a perpetual Chinese fire drill rather than a considered, analytic approach to the problems as they unfolded over time.  The latter implies a systematic plan, and the former implies a sequence of ad hoc responses to unrelated shocks. Even if an initial plan proved inadequate, the experience would have permitted corrections as events evolved.  And lacking a plan, it is harder to see if and when a decision was wrong.

Delegated and Concentrated Decision Making

The second issue that emerges from Wessel’s account is the insular and concentrated nature of the decision-making process, which excluded many members of the Board of Governors and FOMC.  Three governors and the president of the NY Fed apparently took on the decision-making responsibility for the central bank in the midst of the crisis. From the narrative, it seems as if this core group effectively froze out the remaining two members of the Board and FOMC members from both decision making and access to key real-time information.

Why did it happen?  Under what authority did this happen?  One plausible answer is that the core group felt that the existing structure was too cumbersome to effectively coordinate policy among so many principals, and so they simply exploited a loophole in the law governing open and closed meetings of government agencies.  Let us explain.  Normally, there are seven members of the Board of Governors, so that a gathering of four would constitute a majority and could officially make decisions.  According to the 1976 Government in the Sunshine Act, which sets out the rules meetings of  federal governmental agencies, official Federal Reserve Board meetings in which policies are considered must be announced in advance and,  at a minimum, an agenda must be provided,.  For this reason, only three governors can get together in the same room without it constituting a “meeting”  and invoking the provisions of the Sunshine Act.   But during the entire crisis there have only been five governors on the Board, with two vacancies.  (David Kotok has written extensively on this issue in previous commentaries.)  Thus, the gathering of the three governors in the meetings that Wessel describes meant that while not technically meeting the legal requirement for a meeting, the three de facto constituted a majority of the sitting governors and could actually make decisions.  Coordinating policy with the entire FOMC would have been more cumbersome and likely would have also required that a written transcript be prepared.  It could be that the core principals felt that a smaller group would make decisions more quickly, and the sense of such a desire for quick decisions comes across in the narrative.  Nevertheless, one can’t help but feel that it might have been beneficial to have been able to tap the broader experience and expertise of the Federal Reserve Bank presidents, especially since so many of the key principals making the crucial decisions were relatively new to their jobs.

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Origins of the Federal Reserve

Via Mises.org:

The Federal Reserve Act of December 23, 1913, was part and parcel of the wave of Progressive legislation on local, state, and federal levels of government that began about 1900. Progressivism was a bipartisan movement that, in the course of the first two decades of the 20th century, transformed the American economy and society from one of roughly laissez-faire to one of centralized statism.

Until the 1960s, historians had established the myth that Progressivism was a virtual uprising of workers and farmers who, guided by a new generation of altruistic experts and intellectuals, surmounted fierce big business opposition in order to curb, regulate, and control what had been a system of accelerating monopoly in the late 19th century. A generation of research and scholarship, however, has now exploded that myth for all parts of the American polity, and it has become all too clear that the truth is the reverse of this well-worn fable.

In contrast, what actually happened was that business became increasingly competitive during the late 19th century, and that various big-business interests, led by the powerful financial house of J. P. Morgan and Company, tried desperately to establish successful cartels on the free market. The first wave of such cartels was in the first large-scale business — railroads. In every case, the attempt to increase profits — by cutting sales with a quota system — and thereby to raise prices or rates, collapsed quickly from internal competition within the cartel and from external competition by new competitors eager to undercut the cartel.

During the 1890s, in the new field of large-scale industrial corporations, big-business interests tried to establish high prices and reduced production via mergers, and again, in every case, the merger collapsed from the winds of new competition. In both sets of cartel attempts, J. P. Morgan and Company had taken the lead, and in both sets of cases, the market, hampered though it was by high protective, tariff walls, managed to nullify these attempts at voluntary cartelization.

It then became clear to these big-business interests that the only way to establish a cartelized economy, an economy that would ensure their continued economic dominance and high profits, would be to use the powers of government to establish and maintain cartels by coercion, in other words, to transform the economy from roughly laissez-faire to centralized, coordinated statism. But how could the American people, steeped in a long tradition of fierce opposition to government-imposed monopoly, go along with this program? How could the public’s consent to the New Order be engineered?

Fortunately for the cartelists, a solution to this vexing problem lay at hand. Monopoly could be put over in the name of opposition to monopoly! In that way, using the rhetoric beloved by Americans, the form of the political economy could be maintained, while the content could be totally reversed.

Monopoly had always been defined, in the popular parlance and among economists, as “grants of exclusive privilege” by the government. It was now simply redefined as “big business” or business competitive practices, such as price-cutting, so that regulatory commissions, from the Interstate Commerce Commission (ICC) to the Federal Trade Commission (FTC) to state insurance commissions, were lobbied for and staffed with big-business men from the regulated industry, all done in the name of curbing “big-business monopoly” on the free market.

In that way, the regulatory commissions could subsidize, restrict, and cartelize in the name of “opposing monopoly,” as well as promoting the general welfare and national security. Once again, it was railroad monopoly that paved the way.

For this intellectual shell game, the cartelists needed the support of the nation’s intellectuals, the class of professional opinion molders in society. The Morgans needed a smokescreen of ideology, setting forth the rationale and the apologetics for the New Order. Again, fortunately for them, the intellectuals were ready and eager for the new alliance.

The enormous growth of intellectuals, academics, social scientists, technocrats, engineers, social workers, physicians, and occupational “guilds” of all types in the late 19th century led most of these groups to organize for a far greater share of the pie than they could possibly achieve on the free market. These intellectuals needed the State to license, restrict, and cartelize their occupations, so as to raise the incomes for the fortunate people already in these fields.

In return for their serving as apologists for the new statism, the State was prepared to offer not only cartelized occupations, but also ever-increasing and cushier jobs in the bureaucracy to plan and propagandize for the newly statized society. And the intellectuals were ready for it, having learned in graduate schools in Germany the glories of statism and organicist socialism, of a harmonious “middle way” between dog-eat-dog laissez-faire on the one hand and proletarian Marxism on the other. Big government, staffed by intellectuals and technocrats, steered by big business, and aided by unions organizing a subservient labor force, would impose a cooperative commonwealth for the alleged benefit of all.

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There’s No Such Thing As Too Big to Fail in a Free Market

Via Niall Ferguson in the Telegraph.co.uk:

This crisis was not the result of deregulation and market failure. In reality, it was born of a highly distorted financial market, in which excessive concentration, excessive leverage, spurious theories of risk management and, above all, moral hazard in the form of implicit state guarantees, combined to create huge ticking time-bombs on both sides of the Atlantic. The greatest danger we currently face is that the emergency measures adopted to remedy the crisis have made matters even worse.

It has often been said since the crisis began that an institution that is “too big to fail” (TBTF) is too big to exist. I agree. The question is how we can best get rid of the TBTFs without increasing the power of government in the economy still further.

Economists have long held that bank failures pose a “systemic” economic risk, because failed banks are associated with monetary contractions for the economy as a whole. There is therefore a presumption that, if big banks are threatened with liquidity or solvency problems, they should be bailed out by the action of the central bank or government. Despite much pious talk of “moral hazard” prior to 2007, little was done to disabuse big financial institutions of this notion. They could and did assume that they enjoyed an implicit government guarantee.

With the exception of Lehman Brothers, they were right. Beginning with the British Government’s takeover of Northern Rock in 2007 and culminating in the US Government’s vast injections of capital into AIG, Citigroup and other institutions, the Western world has witnessed a succession of government interventions in the banking system unprecedented other than in time of war. These measures can be justified on the ground that without them there would have been a banking crisis comparable with that of 1931, which did as much as the 1929 stock market crash to plunge the world into a Great Depression.

But there is a danger that justified emergency measures give rise to unjustifiable permanent conditions.

Read the full article here

Risk-averse Risk Takers

Via EconLog:

A lot of the trick of investment banking is to figure out a way to transfer risks to taxpayers. And the investment bankers have gotten really good at it, particularly in the last thirty years. That is why there are those of us on the right (Russ Roberts and myself, to name two) and those on the left (Simon Johnson and James Kwak,, to name two) who are skeptical of the incumbent regulators when they say that they can control moral hazard. Our view is that the moral hazard problem is much more profound than the regulators acknowledge.

Another really profound issue, which Felix Salmon raises, is why so many people prefer debt-like contracts to equity-like shares in enterprises. If he were to read This Time is Different, by Carment M. Reinhart and Kenneth S. Rogoff (and perhaps he already has), Salmon would have even more reason to raise this issue.

My theory is that people have the illusion (and again, government policy can foster this illusion and sometimes make it come true) that they will not be victims of default. Every individual thinks, “Of course, if I see trouble coming, I’ll be able to get out (or be bailed out) before I take a loss.” When a default occurs, somebody will be left holding the bag. However, as individuals, none of us believes that that we are going to be the bagholder.

Another theory I have is that governments take advantage of these individual beliefs in the safety of debt. People treat government debt as risk-free, even though it clearly is not, as Reinhart and Rogoff remind us.

Read the full post here

Further reading: The unwilling risk-takers

The Impact of High-frequency Trading

Via Knowledge@Wharton:

According to some estimates, high-frequency trading by investment banks, hedge funds and other players accounts for 60% to 70% of all trades in U.S. stocks, explaining the enormous increase in trading volume over the past few years. Profits were estimated at between $8 billion and $21 billion in 2008.

Some market observers, members of Congress and regulators are worried. Are those profits coming out of ordinary investors’ pockets? Is Wall Street’s latest qet-rich-quick scheme going to harm innocent bystanders? “I don’t think it would hurt people to become educated as to the intent of these strategies,” says Wharton finance professor Robert F. Stambaugh. “What is their effect on the markets? There is a little sense of 2001: A Space Odyssey [in that it] does kind of create an air of mistrust.”

Its defenders say high-frequency trading improves market liquidity, helping to insure there is always a buyer or seller available when one wants to trade. And so far, high-frequency trading doesn’t look threatening, according to several Wharton faculty members. Indeed, it may well provide benefits to mutual fund investors and other market participants by reducing trading costs. But at the same time, several note that not enough is known about how trading at light-speed works, whether it can be used to manipulate markets or whether benign-looking moves by different players could interact to produce a new financial crisis.

“High-frequency trading involves investors with good computers taking advantage of small discrepancies in prices,” says Wharton finance professor Marshall E. Blume. “Generally, economists think that drives prices back to where they should be…. If they bring liquidity to the market and make prices more accurate, then that’s good. Now a concern, which is hard to document, is that somehow these traders manipulate the market, which would be bad.”

Turning decision-making over to machines has not always benefited humans, notes Wharton finance professor Itay Goldstein. “People believe the crash of ’87 was caused by this kind of computer-based trading.” In that case, a vicious cycle swirled out of control as computerized trading programs dumped stocks in response to falling prices, causing other programs to do the same.

Traveling at Light Speed

High-frequency trading refers to computerized trades seeking to profit from conditions too ephemeral for a human to exploit, like a miniscule increase in the spread between bid and ask prices for a given security, or a slight price difference for a stock traded on various exchanges. Trading is so fast that some firms locate their server farms near the exchange’s computers, to shorten the distance orders must travel through cables at light speed.

Aside from being made possible by the proliferation of high-speed computers, high-frequency trading has evolved out of several regulatory changes. In 1998, the Securities and Exchange Commission’s Regulation Alternative Trading Systems opened the door to electronic trading platforms to compete with the major exchanges. A couple of years later, the exchanges started quoting prices to the nearest penny rather than 16^th of a dollar, causing spreads between bid and ask prices to narrow and forcing traders who made money on those price differences to look for alternatives. Finally, the SEC’s Regulation National Market System of 2005 required that trade orders be posted nationally instead of only at individual exchanges. This allowed quick-moving traders to profit when a stock traded at a slightly different price at one exchange versus another.

With the effects of the subprime crisis still being felt, regulators and lawmakers are especially alert to any dangers that might lurk in unfamiliar Wall Street products and strategies. Alarm bells started going off with news accounts this summer about “flash orders,” a subset of high-frequency trading that exploits regulatory loopholes to give favored traders notice of orders a fraction of a second before they are transmitted to everyone else. Flash trading has been widely condemned as giving a favored few an unfair advantage.

“Some people are getting advantages that others aren’t, and that may lead to abuse,” says Wharton finance professor Franklin Allen. “It is a form of front running.” Front running, which is generally illegal, means improperly profiting by using advance information to jump ahead of someone else’s trade. In the textbook example, a broker receives a customer’s order to buy a stock for up to $10 a share. The broker buys the shares at the market price of $9.75 and sells them to his customer at $10, cheating the customer out of 25 cents a share. Flash orders can do the same thing, much faster and more often.

Flash trading now appears to be on the way out. In mid-September, the SEC proposed a ban, and the Nasdaq market quickly moved to prohibit the practice. A number of firms that had offered flash trading to clients have exited the business. The SEC ban requires a second vote by commissioners to become final.

Because many people have been unclear about the distinction, the flash-trading controversy has triggered worries about high-frequency trading, which involves strategies that appear to be perfectly legal. In some cases, high-frequency traders test prices by issuing buy or sell orders that are withdrawn in milliseconds, giving those traders insight into investors’ willingness to trade at specific prices. High-frequency traders can also earn tiny profits, millions of times over, from “rebates” provided by exchanges to players willing to buy and sell when there is a shortage of other traders.

Read the full article here

Fed Growth Effort May Be Undermined by ‘Tight’ Credit

Via Bloomberg:

Federal Reserve Chairman Ben S. Bernanke’s efforts to stoke a U.S. economic recovery may be undermined by the central bank’s other goal of restoring the banking system to health.

The Federal Open Market Committee, at the conclusion tomorrow of a two-day meeting, will probably maintain its assessment that “tight” bank credit is impeding growth, said economists including former Fed Governor Lyle Gramley. Lending contracted for five straight weeks through Sept. 9, a drop that in part reflects Fed orders to banks to raise more capital and toughen lending standards, analysts say.

A failure to restore the flow of bank credit carries the risk that the economic recovery will be slower than the Fed anticipates, or even that the U.S. lapses into another recession, economists say. That would make it more likely the Fed will keep its main interest rate close to zero for a longer period.

————

“Even though from a technical perspective the recession is very likely over at this point, it’s still going to feel like a very weak economy for some time,” Bernanke said in response to a question after a speech in Washington. Fed officials in June predicted that GDP will expand 2.1 percent to 3.3 percent next year after shrinking 1.5 percent to 1 percent this year, according to the central tendency of their forecasts.

Banks have plenty of reasons to hold back on lending, analysts say.

Americans fell behind on their mortgage payments at a record pace in the second quarter, with delinquencies rising to 9.24 percent, according to an August report by the Mortgage Bankers Association.

“Consumers aren’t necessarily that creditworthy a proposition right now,” said John Ryding, chief economist and founder of RDQ Economics LLC in New York.

Falling values of commercial real estate are also a problem for banks, with an “uncertain degree of losses” to come, said Ryding, a former Fed researcher. Loans made for commercial property will probably sour and lenders will need to raise more capital to cover credit losses, Mike Mayo, a banking analyst at CLSA Ltd., said today at a conference in Hong Kong.

Read the full article here

Video: Frontline – Breaking The Bank

H/T to Simoleon Sense for bringing this video to my attention. If you missed it the first time around, or you want to watch it again, here is the great FRONTLINE piece on Ken Lewis.

Introduction (Via PBS)

In Breaking the Bank, FRONTLINE producer Michael Kirk (Inside the Meltdown, Bush’s War) draws on a rare combination of high-profile interviews with key players Ken Lewis and former Merrill Lynch CEO John Thain to reveal the story of two banks at the heart of the financial crisis, the rocky merger, and the government’s new role in taking over — some call it “nationalizing” — the American banking system.

“This is more than a story about just one man or one bank,” says producer Michael Kirk. “This is the story of the most important change in the relationship between government and private business in a generation.”

Watch the video below or click here for the PBS FRONTLINE page

The Hypocrisy of the Fed

Paul La Monica has a great article in CNNMoney.com regarding the Fed’s two-faced view on risk:

Are there any mirrors in the headquarters of the Federal Reserve? If so, I think it’s time for Ben Bernanke and his colleagues to look into one.

The Fed, according to a Wall Street Journal report Friday, is said to be considering a plan that would allow regulators to closely monitor and even change the pay practices at financial firms in order to make sure that these companies aren’t encouraging excessive risk-taking.

Considering that the mess that we find ourselves in is partly due to big banks and insurance firms failing to recognize the many subprime warning signs in order to satisfy Wall Street’s myopic focus on quarterly profits, reining in bonuses and other compensation tied to stock performance may not sound like a bad idea.

But riddle me this Bat-readers: Isn’t it more than a tad hypocritical for the Fed to be trying to tell banks that too much risk is a bad thing?

After all, the Fed has kept its key overnight bank lending rate near 0% since December and has shown no indication that it will raise this rate anytime soon.

And the Fed has pumped trillions of dollars into the financial system through a variety of programs in order to try and get banks to loan more again. The business of lending is inherently risky. So what kind of message is the Fed trying to send here?

…It’s hypocritical plain and simple. Isn’t all this cheap money designed to push banks to take on more risks? The Fed wants to slap banks on the wrist for paying its employees too much because that might encourage them to get reckless. But at the same time, the Fed is tempting banks to lapse into bad habits with what may be an overly accommodative monetary policy.

This is the equivalent of your doctor telling you that he wants to approve every meal you eat for the next few months so you don’t gain a lot of weight — while handing you coupons for McDonald’s and Krispy Kreme on your way out of the office.

Read the full article here

Ron Paul: End the Fed

Volcker: Make Banks Less Risky

From the WSJ (Hat tip to The Big Picture). Paul Volcker with a novel concept:

The activities Mr. Volcker criticized have caused banks to incur major losses in recent years. Nonetheless, proprietary trading and related activities appear to be making a comeback as markets have thawed.

Mr. Volcker said banks should be banned from “sponsoring and capitalizing” hedge funds and private-equity firms, which are largely unregulated. He also said “particularly strict supervision, with strong capital and collateral requirements, should be directed toward limiting proprietary securities and derivatives trading.”

He also said collateral and leverage restrictions against the largest nonbank financial institutions “may be needed.”

The comments reflect Mr. Volcker’s long-held view that banks should act more in line with their traditional role and not take extremely risky gambles, which could threaten the viability of commercial banks and expose the Federal Reserve and taxpayers to large risks. Asked after his speech if his comments represent a break with the White House’s proposal, he replied: “Nothing I said today should be a surprise” to the administration.

Read the full article here

Book: Paul Volcker: The Making of a Financial Legend

Why a Lehman Deal Would Not Have Saved Us

Niall Ferguson writing in the Financial Times:

All would not have been for the best in the best of all possible worlds if only Lehman Brothers had been saved. On the contrary, a decision to bail out Mr Fuld would almost certainly have had worse consequences than letting him and his company go under.

…Lehman’s chief executive persistently over-played his hand, overvaluing the property assets on the bank’s balance sheet by as much as $25bn-30bn. Mr Fuld was adamant: “As long as I am alive this firm will never be sold. And if it is sold after I die, I will reach back from the grave and prevent it.”

…But there was a reason why no buyer could be found in this universe. Lehman was a firm in its death throes. It had lost $6.7bn in the space of six months. It had debts in excess of $600bn. Its assets were collapsing in value. Even when a deal with Barclays seemed within reach, the British Financial Services Authority vetoed it. Alistair Darling, the chancellor of the exchequer, made it clear: “We are not going to import your cancer.”

…Not everything in history is inevitable; contingencies abound. Sometimes it is therefore right to say “if only”. But an imagined rescue of Lehman Brothers is the wrong counterfactual. The right one goes like this. If only Lehman’s failure and the passage of Tarp had been followed – not immediately, but after six months – by a clear statement to the surviving banks that none of them was henceforth too big to fail, then we might actually have learnt something from this crisis.

The real tragedy is that the failure of Lehman has left Wall Street’s survivors both bigger in relative terms and more secure politically. As long as the big banks feel confident that they can count on the government to bail them out – for who would now risk “another Lehman”? – they can more or less ignore calls for lower leverage and saner compensation.

If only we had learnt from Lehman that no bank should be “too big to fail”, we might still have a real capitalist system, instead of the state-guaranteed monstrosity that is the real legacy of last year’s crisis. If only.

Read the full article here

Niall Ferguson: The Ascent of Money: A Financial History of the World