Did the Fed Fail as a Financial Supervisor?

No need to remind dear reader that the Fed is certainly under attack from all sides these days. Ben Bernanke recently gave testimony in the House Financial Services committee, explaining how the Fed had no idea about what was going on at Lehman's; see Fed Had Limited Oversight on Lehman.

What is going on here? Is the Fed really this clueless? Can we really trust the Fed in its proposed supervisory role, given its pathetic record in this regard?

Well, I'm not sure. But let me share with you a few things that I do know (or think I know).

THE FED AND BANKING SUPERVISION

[1] The U.S. has a primary regulator system for the nation's 8000+ commercial banks and thrifts; the primary regulator has the key authority for the regulation of the bank in question.
[2] Before the crisis (as of Jan 2007), the Fed had primary regulator responsibility for about 12% of all banks (14% by assets).

In other words: more than 85% of banks and bank assets had non-Fed primary regulators.

THE FED AND THE FINANCIAL LANDSCAPE

[1] Banks are only one part of the financial landscape. As the crisis began, 20 firms accounted for about 80% of S&P financial sector assets in the U.S.
[2] About 1/3 of this total was in banks; about 2/3 of this total was in non-bank financial firms, including government-sponsored-agencies (Fannie Mae and Freddie Mac), investment banks, insurance companies, and thrifts.
[3] Non-bank financial firms turned out to the most troubled entities in the crisis.

The Fed had no supervisory authority over these entities, including

• Investment banks, like Goldman Sachs and Bear Stearns
• Insurance companies, like Prudential and AIG
• Financial hybrids, like GE Capital and GMAC

And so, whether by accident or design, the Fed in fact had authority over only a very small segment of the financial market. Nevertheless, when the crisis hit, the Fed was widely expected to act quickly in its role as lender-of-last-resort. Many of the Fed's decisions, subject to great criticism today, involved "bailing out" non-bank firms like Bear Stearns and AIG -- firms for which the Fed had no supervisory authority.

THINK ABOUT IT

Imagine putting yourself in this situation. You are legally prohibited from supervising the vast majority of financial sector actors. You are not privy to any of their financial information. But when a crisis hits a group of these firms, you are asked to supply emergency loans...today...not next week, or one month from now. You are told, and you may even suspect it a possibility, that the entire financial system may collapse if you do not provide this emergency lending. So, what do you do?

Personally, I think I would not have done it (though this is easy to say from my office chair). But the Fed did it. Can you really blame them? And the lending had to be extended to agencies not even under the Fed's supervision. Are we to be surprised if "mistakes" were made? Who is to blame for all this? The Fed?

Make no mistake. The Fed, like any institution, should be subject to criticism and review. At the same time, any such criticism should be fair and balanced (especially if one expects enlightened legislation to emerge from the impending Dodd Bill).

Information Disclosure Policy for the Fed

This constitutes a bit of a follow-up on my earlier post "Will Federal Reserve Secrecy Conceal Incompetence and Corruption "; see here.

Judging by the people I talk to, not many appear to have an accurate knowledge of what exactly the Federal Reserve Bank is, what it does, or what it is supposed to to. These same people, however, appear fairly certain that the Fed has secretly bailed out privileged groups with its extraordinary power of printing money. No doubt about, the Fed should be audited; it is an outrage that it is not.

Let's all calm down a bit and get some facts straight first.

The first thing that the general public should know is that the Fed is, in fact, audited. It is audited extensively and frequently at many different levels and by different agencies. One of my colleagues has estimated that more than 425,000 manhours are devoted to auditing the Fed every year (I do not know exactly how he came up with this number, but suffice it to say that no matter how you slice it, the number is large).

Each of the 12 Federal Reserve Banks have their own internal auditor, who reports to the audit committee of each regional Fed's Board of Directors. This is, I think, analogous to the manner in which any public corporation is audited.

Each regional Fed is also subject to oversight from the Board of Governors (I think from the Division of Bank Operations). On top of this, there is an external auditor (Deloitte). And last, but certainly not least, the Fed is subject to auditing by the U.S. Government Accountability Office (GOA), an agency of the U.S. Congress.

Of course, this does not mean that all aspects of Fed policy are made public. For example, it has been a matter of standard practice not to disclose the identity of those agencies making use of the Fed's discount window (Fed lending to banks with liquidity problems). The Fed, and other federal agencies like the OCC and the FDIC do not disclose their assessments of the financial health of private banks under supervision (CAMELS ratings).

The stated justification for these types of nondisclosure policies is that it encourages liquidity constrained banks to use the discount window (they avoid the apparent stigma associated with using the discount window). This policy has been, as far as I can tell, rather noncontroversial...at least up to the recent crisis.

During the crisis, the Fed opened up a number of additional emergency lending facilities. I don't want to get into the details here but very quickly: the Fed made emergency loans backed by what it considered to be high-quality collateral. The loans have all now been repaid, the emergency programs have almost completely shut down, and the Fed, apparently, has made a handsome profit.

In the middle of the financial crisis, the Fed was challenged by Bloomberg concerning the details of these transactions. The Fed refuses to make these details public. Here is a recent update "Fed Shouldn't Reveal Crisis Loans, Banks Vow to Tell High Courts."

Conspiracy and cover up...right? Possibly. But let's not get too carried away just yet. The most telling sentence in the piece is this:

“Our member banks are very concerned about real-time disclosure of information that could cause a run on the banks,” said Paul Saltzman, the group’s general counsel, in an interview yesterday.

The concern here appears not to be with respect to disclosure per se; but rather, with real time disclosure.

This suggests that a happy medium might be struck. Of course, the Fed should reveal the details concerning its emergency lending practices. But only with a sufficient time-lag. The exact length of this time-lag is something that can be debated. Does 5 years sound reasonable?

Are Mortgage Defaults Driving Consumer Demand?

Came across this "funny" story: Mortgage Defaults May be Driving Consumer Spending.
You've got to like this one:

First he describes a case study of someone who applied for the government's Home Affordable Modification Program. The person had an $1,880.00 monthly mortgage payment on which they'd defaulted, but said person's monthly bank statement showed payments to a tanning salon, nail spa, liquor stores, DirecTV bill with premium charges, and $1,700.00 in retail purchases from The Gap, Old Navy, Home Depot, Sears, etc.

The article does not say whether this person was ultimately given government assistance. What would you guess?

Some Interesting Tax Facts (US Style)

Canadians (yes, I am one of them) are sometimes led to believe that the Canadidan tax system is much more redistributive than in the U.S. I am not sure whether this is true or not, but I came across this article today that made me reflect on this: Nearly Half of U.S. Households Escape Fed Tax.

Some interesting tidbits:

[1] About 47% of Americans will pay no federal income tax in 2009
[2] The top 10% of earners pay about 73% of all income tax collected by the federal government
[3] The bottom 40% of earners will (on average) pay negative taxes (are net recipients of transfer income)

Steve Williamson's New Monetarist Blogspot

Check out Steve Williamson's new blog site here. (I especially like his review of the Krugman interview...what a hoot).

Greenpeace or Greenterror?

Ah, Greenpeace. Founded in my home town. Yep, I'm mighty proud.

Well...except for this fine blog entry by "Gene from Greenpeace India:" Will the Real ClimateGate Please Stand Up? Here is an excerpt:

Emerging battle-bruised from the disaster zone of Copenhagen, but ever-hopeful, a rider on horseback brought news of darkness and light: "The politicians have failed. Now it's up to us. We must break the law to make the laws we need: laws that are supposed to protect society, and protect our future. Until our laws do that, screw being climate lobbyists. Screw being climate activists. It's not working. We need an army of climate outlaws." The proper channels have failed. It's time for mass civil disobedience to cut off the financial oxygen from denial and skepticism.
If you're one of those who believe that this is not just necessary but also possible, speak to us. Let's talk about what that mass civil disobedience is going to look like.

If you're one of those who have spent their lives undermining progressive climate legislation, bankrolling junk science, fueling spurious debates around false solutions, and cattle-prodding democratically-elected governments into submission, then hear this:

We know who you are. We know where you live. We know where you work.
And we be many, but you be few.

So there you go. Green "peace" my ass.

The Efficient Markets Hypothesis: What Have We Learned?

Thanks to Fernando Martin for passing this along: The Global Financial Market Crisis and the Efficient Markets Hypothesis: What Have We Learned? (by Ray Ball, U. Chicago).

Abstract: The sharp economic downturn and turmoil in the financial markets, commonly referred to as the “global financial crisis,” has spawned an impressive outpouring of blame. The efficient market hypothesis - the idea that competitive financial markets ruthlessly exploit all available information when setting security prices - has been singled out for particular attention. Like all good theories, market efficiency has major limitations, even though it continues to be the source of important and enduring insights. Despite the theory’s undoubted limitations, the claim that it is responsible for the current worldwide crisis seems wildly exaggerated. This essay discusses many of those claims. These include claims that belief in the notion of market efficiency was responsible for an asset bubble, for investment practitioners miscalculating risks, and for regulators worldwide falling asleep at the switch. Other claims are that the collapse of Lehman Bros. and other large financial institutions implies market inefficiency, and that an efficient market would have predicted the crash. These claims are without merit. Despite the evidence of widespread anomalies and the advent of behavioral finance, we continue to follow practices that assume efficient pricing.