naked capitalism

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

The Fed has recently come under heavy criticism, largely for its role in the AIG bailout. The Fed deserves criticism for decisions it made in the run-up to the crisis as well as for the role it played in the AIG bailout. However, some of the charges are misdirected and the suggested remedies are counter-productive.

One of the most frequent and misdirected criticisms of the Fed involvement in the AIG bailout was repeated in the SIGTARP report: the Fed failed to have a contingency plan for an AIG failure in place before the crisis hit.

The Fed had no regulatory or supervisory responsibility for AIGFP. How exactly was the Fed supposed to develop contingency plans for a business about which it knew next to nothing, attached to an industry- insurance-about which it knew nothing and was not subject to any oversight by any Federal agency? Let us not forget the Fed (and all of officialdom) was at the same time struggling to deal with the fallout from Lehman and the Primary Reserve Fund having broken the buck.

Furthermore, the problems at AIGFP and at the holding company were capital inadequacy-based and not liquidity based. Support for an insolvent institution has not been part of the Fed mandate and is an intrusion into the realm of the fiscal authorities. This point is reinforced in Phillip Swagel’s (Assistant Secretary of the Treasury for Economic Policy, December 2006-January 2009) Brookings publication “The Financial Crisis: An Inside View”.

Fools Rush In

Swagel lamented that the Treasury and authorities were always behind market developments and were “reactive”. This admission of the Treasury being behind the curve is ironic when juxtaposed with one of Swagel’s opening assertions that in the summer of 2006 Paulson told the Treasury staff that it was time to prepare for a financial system challenge. Furthermore, a cursory review of Swagel also indicates that Treasury abdicated its responsibility to the financial system and the country as it avoided or postponed difficult political battles with the Congress.

Swagel also noted the narrow role Treasury had envisioned for itself prior to Bear:

Treasury had urged institutions to raise capital to provide a buffer against possible losses, but had not contemplated fiscal actions aimed directly at the financial sector. Instead, the main policy levers were seen as being the purview of the Fed, which had cut rates and developed new lending facilities in the face of events.

Bear was the first bailout. Treasury played no role in funding the assistance given to facilitate the JPMC/Bear merger. The Fed provided collateralized (by dodgy assets at significant haircuts) non-recourse loans to a presumably liquid and solvent JPMC to facilitate the takeover of a capital impaired/insolvent Bear -a giant step away from the traditional central bank function of providing liquidity to solvent, but temporarily illiquid banks. (Swagel asserts that the deal would have been received badly in the Congress if anyone in the Congress had understood what “non-recourse” means.) This precedent setting, mandate busting Fed involvement was required, because the Treasury had no contingency plans in place for anything but a liquidity crisis. And that plan consisted of having the Fed cuts rates and developing new lending facilities.

Swagel went on to note that the Bear crisis taught Treasury lessons, one of which was:“ We better get to work on plans in case things get worse”.

Treasury set to work “on the so-called “break the glass options—the reference being what to do in the case of an emergency”. Swagel went on:

This work evolved from a recurring of theme input from market from market participants, which was that the solution to a financial crisis was for the Treasury to buy up the “toxic” assets on the bank balance sheets. Eventually a memo was written at Treasury that listed options to deal with a financial crisis arising from an undercapitalized system—the memo went through more than a dozen iterations in discussions around Treasury and with other agencies between March and April.

The options were to buy the toxic assets, turn the Treasury into a monoline and insure the assets, directly buying stakes in banks to inject capital, or use a massive scheme to refinance risky mortgages into government –guaranteed loans…

These options would move the focus of financial markets back from the Fed to the Treasury which would be appropriate in it was a problem reflecting inadequate capital rather than insufficient liquidity. But these actions all required Congressional action and there was no prospect of getting approval for any of this. Such a massive intervention in financial markets could only be proposed if Secretary Paulson and Bernanke went up to Congress and told them that financial system and the economy were on the verge of collapse. By then it could well be too late.

In a nutshell, the post-Bear Treasury had determined that financial problems resulting from inadequate capital should be addressed by Treasury, not by the Fed. Furthermore, it developed a proposal along those lines, but would/could not to seek the required legislation until the “financial system and the economy were on the verge of collapse”. Hence, if any agency is to blame for the absence of a satisfactory mechanism to resolve AIG, it is Treasury. If Treasury’s assessment of the Congressional response to what became the basis for TARP is correct, then Congress should also shoulder some of the blame.

Is the Fed blameless? No. It never should have become a principal in the AIG bailout/rescue/fiasco. However, there was a way for the Fed to have played a constructive and appropriate role in assisting Treasury as it did two months earlier.

In July, Fannie and Freddie’s financial problem reached crisis proportions as the housing crisis continued. Questions about their solvency lead to declines in their stock prices and a widening of their credit spreads. Swagel characterized the situation this way: “The options were all unpleasant and all required Congressional action.”

On July 13, Secretary Paulson announced a rescue plan. The Fed created a bridge loan facility to serve as a backstop while Congress considered the proposal. The necessary legislation was enacted on July 30.. The Fed helped avoid a potential crisis without assuming any ownership interest in the GSEs, paying off any creditors (with public monies), or involvement in any management decisions. The fiscal authorities set all the parameters for the bailout.

I have to assume that a bridge loan option was discussed at the Fed when the AIG crisis blossomed. I just cannot understand why the Fed did not employ it. The AIG crisis hit on Sept. 16 and the Fed presumably began providing liquidity. On the 18th Paulson presented a three-page outline of what was to become TARP. Given the memos and plans of March and April, the internally held view that it was inappropriate for the Fed to be involved in solvency crises, why didn’t Treasury announce a more detailed proposal including a Fed role limited to bridge financing? Why didn’t the Fed require it as a condition for supplying “liquidity” to the capita-impaired AIG? Why didn’t the Fed require a commitment from Treasury to assume AIG assets it acquired subject to legislation being enacted? Why didn’t the Fed leave the responsibility for management of AIG with Treasury? Why did the Fed permit itself to be used as an off-balance sheet slush fund by Treasury? Why did the Fed permit itself to be put in a position wherein it would have to pay out public monies on behalf of a capital impaired-institution? Why did the Fed turn itself in to a political punching bag?

Fools Stay In

After the passage of TARP, Treasury only assumed about one-half of the original Fed loan to AIG. Why not all of it? Why didn’t Treasury compensate the Fed and take the remaining loan to AIG and the Maiden Lanes off the hands of the Fed? Fed involvement was inappropriate. Treasury’s was appropriate. The legislation was in place. The funds were available. Why hadn’t the Fed involvement been made contingent on a buyout at the first available opportunity?

Instead, the Fed has accepted a role that stretches its legal mandate. It has accepted a role that requires it to resolve questions, e.g. the CDS payouts, which should have been left to either the Treasury and the Congress or the courts. It has assumed a quasi-fiscal role paying out public money to various AIG counterparties. It has permitted the Treasury to avoid its responsibility. Furthermore, it has aided Congress in avoiding its’ responsibilities as it minimized the impact of the bailouts on the Federal balance sheet. Insofar as Fed actions have disguised the cost of the bailout, it has also been a party to deceiving the American people.

Did Treasury negotiators overwhelm the Fed or did the Fed just not realize what it was getting into? The SIGTARP report argues the Geithner did not negotiate aggressively enough with AIGFP’s CDS counterparties. The real problem it seems is that Geithner didn’t negotiate aggressively enough with Treasury!

A Way Out?

Commentators and legislators are as busy discussing how to curb the Fed’s independence as they are at taking steps to preclude a repeat of the current fiasco. Three of the proposed legal actions to curb the Fed are:

• Stripping the Fed of bank supervision and regulatory responsibility
• Auditing of the Fed, and
• Requiring Senate approval for regional Reserve Bank Presidents

In a troubling display of political naiveté, the Bernanke Op-Ed in the Washington Post took issue with the moves that would strip the Fed of supervisory responsibility and expand audits of the Fed, but did not offer an argument against the further politicalization of monetary policy inherent in requiring Senate approval the regional reserve bank presidents. If the law is changed and the Senate is the power to appoint or reject regional Reserve bank presidents, the Fed will well on its way to becoming Fannie and Freddie writ large.

I offer a “compromise”.

• The Fed agrees to cease and desist from lending to any capital impaired institution unless specifically authorized by law.
• The Fed agrees to cease and desist from acting in a fiscal role.
• The Fed agrees to never again assume management responsibility for a capital impaired institution unless specifically authorized by Congress
• Treasury assumes all the Fed assets related to AIG and Bear. I believe that there is enough TARP money left.
• The selection process for reserve bank presidents is left unchanged.
• The audit provisions are left unchanged.

I believe that the compromise outlined above will be rejected by all parties.
The Fed evidently wants to continue in its quasi-fiscal role. It just doesn’t want to be audited when it does. Furthermore, the Fed evidently attaches a loss of political independence to having its quasi-fiscal activities audited, but not to further politicalization of the FOMC.

Congress and the Treasury would rather continue the present arrangement and to have the Fed finance the emergency bailouts off-balance sheet rather than playing an active role: specifying the terms of and appropriating monies for the bailouts. The current arrangement requires the Fed to make difficult decisions with insufficient information and permits the Treasury and the Congress to after the fact blame the Fed for the politically unpopular ones.

Yves here. I’d like to add a few observations:

The Fed set itself up for expectations that it would be responsible for exercises that by any reasonable stretch of the imagination, were outside its reach, like the rescue of AIG, via its mission creep, or one might more accurately say, mission grab. Congress has given the Fed the authority to assure the safety and soundness of the banking system, maintain price stability, and assure full employment (yes, Virginia, those roles are not fully consistent). The Fed has never been authorized to act as a financial stability regulator; it’s just taken, on its own, to adding that idea to its mission statement and carrying itself as if that was part of its job description. So is it any wonder that some people are complaining that it was asleep at the switch re AIG?

Despite the dozen iterations of the “break glass” memo per Swagel, I never saw it as a serious exercise, based on its brief description in Sorkin’s “Too Big Too Fail.” As this longer form account makes clear, the main thrust were not implementable. But instead of Paulson & Co. realizing that, we instead get MLEC (the failed SIV rescue program) of trying, by dint of effort, to make a non-starter work.

This post illustrates that the idea that our system worked pretty well and the UK’s tripartate system was much worse is a canard. The UK had a big coordination failure on Northern Rock, but the flip side is their only partial deposit guarantee system made runs likely. Per Alford, the US had very large coordination failures that have not been described as such.