Richard Alford: The Fed’s Mission Creep – Taking Too Many Roles Means Doing None of Them Well

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.

In the 1960s and 70s, an arm of the US government destroyed villages in Vietnam in order to save them. Fifty years later, it appears an arm of the US government has been saving/supporting a TBTF financial institution only to sue it for misrepresenting loans it packaged. However, because the institution is too big to fail, the same arm of the government will continue to fund it at near zero rates in the hope that it will generate rates of return that attract more capital and make more loans. It has faith that cheap and abundant access to borrowings is the royal road to salvation, even though it appears that the real reason this bank, like others, can’t make more loans isn’t lack of low cost money, but lack of demand from borrowers.

The Fed has truly put itself in a strange position. For a time, the Fed sought to pursue inflation-only targeting despite its dual legal mandate to promote price stability and full employment. The rationale for the exclusive focus on inflation was that it could better achieve price stability, which it thought would guarantee economic and financial stability. Now after back tracking on seeking to avoid the complexity of trying to balance the simultaneous pursuit of low inflation and full employment, the Fed has also embraced being an investor in privately issued financial assets, as well as maintaining exposures (on a non-fully collateralized basis) to financial institutions over which it has regulatory responsibility.

This will inevitably raise more questions regarding the Fed’s ability and motivations as it pursues what will be seen as a hydra-headed mandate: inflation, full employment, support of TBTF institutions, and maximizing the return on its portfolio (fiduciary responsibility to taxpayers). If altering policy in response to increased unemployment raised questions about the Fed’s commitment to price stability, what will being an investor do to its perceived standing as an unbiased regulator of financial markets and institutions as well as the implementer of monetary policy itself? (See Bloomberg article.) Furthermore, it will be seen as playing a shell game: making taxpayers whole at the expense of Bank of America, and possibly others, only to subsidize the rebuilding of those institutions’ capital through super-low interest rates that penalize savers and yield-oriented investors and encourage speculation.

The Fed never should have played the role that it did in JP Morgan’s acquisition of Bear or in the de facto nationalization of AIG, which together resulted in the creation of the three Maiden Lane entities, which amout to off balance sheet funding vehicles, conveniently under the Fed’s purview. These rescue operations instead should have been funded by the Treasury, but that would have exposed those bailouts to Constitutionally-mandated budgetary funding and no doubt exposed them to much greater public oversight. The Fed should have limited its role to lending to temporarily illiquid but solvent entities and providing bridge financing to the Treasury as it sought authorization to liquidate or reorganize insolvent systemically important firms: the Fannie and Freddie model.

Given the existence of the Maiden Lane vehicles and the absence of any monies available for Treasury to use to buy them from the Fed, what can be done?” James McAndews, co-head of research at the Federal Reserve Bank of New York speaking in Boston on a somewhat different topic, offered a solution. As quoted on the Wall Street Journal blog:

The Fed is earning and turning over to the Treasury an enormous amount There is a case that of these extraordinary earnings today, some portion of those could be set aside.

McAndrews was speaking of setting aside a portion of current Fed earning (about $60 billion YTD) to cushion possible future losses given the size, composition and duration of the Fed portfolio. However, the monies could just as easily be used to allow the Fed to accumulate a capital surplus that would permit it to write the value of the Maiden Lane entities down to zero and “gift” them to Treasury.

The Maiden Lane entities are currently valued at about $65 billion. Legal and accounting issues might be insurmountable for mere mortals, but not the Fed. The Fed “sold” the acquisition of a 79.9% interest in AIG as a loan. It “sold” the acquisition of the assets in Maiden Lane as a loan. The Fed is as good at imaginative structuring as any house on the street.

It would be a win, win, win, win, win.

The Fed would win as it would avoid the possible perceived conflicts of interest.

The financial markets would win as clouds over the central bank and regulatory policy would be lifted.

Society and the democratic process would win as inherently political questions would be dealt with by people in political offices.

Treasury would win big. The Maiden Lane entities would be reunited with Geithner who was largely responsible for their creation. He liked them then and he will love them now. Given that they would be gifted (zero cost) to Treasury, Geithner could set up PPIP 2.0,: mark it to market: declare immediate profits, and take credit for reducing net public indebtedness.

From a taxpayer perspective, it would be a zero-sum shell game. The “gift” would have been paid for by lower Fed contributions to Treasury, but taxpayers would gain from the transfer of assets in the Maiden Lane entities to Treasury or some creation of the Executive and Legislative branches where they always belonged.