Friday, November 2, 2007

More on Who's to Blame - Federal Reserve edition


Two things, with very long explanations:

  1. In my opinion you are WAY oversimplifying the Federal Reserve, its role in general, and its culpability in this instance.

    The Federal Reserve is, in fact, a regulator. As I noted in my follow up comment, I exaggerated the relatively free markets we enjoy by referring to "unregulated."

    You said "The board of governors of the federal reserve system determines monetary policy and how to implement it."

    That is partially true. The Federal Reserve determines monetary policy, but they have only specific tools with which to implement it. Specifically, according to page 27 of The Federal Reserve System: Purposes & Functions:

    By conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing balances, and extending credit through its discount window facility, the Federal Reserve exercises considerable control over the demand for and supply of Federal Reserve balances and the federal funds rate. Through its control of the federal funds rate, the Federal Reserve is able to foster financial and monetary conditions consistent with its monetary policy objectives.

    Other than using the Discount Rate and open market operations to manage the Federal Funds Rate, the Fed's other main tool is to change reserve requirements, but that is very tricky to do without major market disruptions.

    I'm not sure how to specifically address the other related comments. The division of supervision over certain financial institutions (which does NOT include all of the players in the markets), from page 60 of The Federal Reserve System: Purposes & Functions is:

    The primary supervisor of a domestic banking institution is generally determined by the type of institution that it is and the governmental authority that granted it permission to commence business (commonly referred to as a charter). Banks that are chartered by a state government are referred to as state banks; banks that are chartered by the OCC, which is a bureau of the Department of the Treasury, are referred to as national banks.

    The Federal Reserve has primary supervisory authority for state banks that elect to become members of the Federal Reserve System (state member banks). State banks that are not members of the Federal Reserve System (state nonmember banks) are supervised by the FDIC. In addition to being supervised by the Federal Reserve or FDIC, all state banks are supervised by their chartering state. The OCC supervises national banks. All national banks must become members of the Federal Reserve System.

    There are no governmental bodies that regulate the Ratings Agencies (although Congress is looking into that - scary thought). The users of their products, however, are accredited investors. Accredited investors ARE expected to be able to understand the meaning of the reports from the ratings agencies. That's not to say that there won't be litigation against the agencies (I'm sure there will), it's just not a slam dunk (forgetting George Tenet for a minute).

    You also seem to be stating that it's the Fed's job to determine whether assets are becoming overpriced. In fact, that is NOT THE FED's ROLE! In fact, the Federal Reserve Act states:

    The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates (emphasis added).
    You seem to expect too much of the Fed and other regulators.

    Keep in mind that the reason the Federal Reserve cut rates to the level that they did was in response to a recession and the economic effects of 9/11.

    Another important thing to keep in mind is that the Federal Reserve only can act on short term interest rates. When the Fed started to raise rates in June 2004, the long term interest rates fell, first to the point where we had a flat yield curve, and then the yield curve inverted in July 2006.

    The liquidity (at least in my opinion) was coming from overseas. Exporters, such as China, kept their dollar revenues in the US and invested them in liquid securities (primarily long term Treasuries), pushing down yields (if they hadn't, they would have imported inflation since their currency is, arguably, overvalued and there are not enough productive opportunities to invest the cash locally).

    The desire by other investors for higher yields drove them to compress the spreads on all other investments, effectively pricing risk at zero. It was that environment that created the bubble.

    In order to counteract this effect, the Federal Reserve would have to had increased short term rates to a level that would have created a terrible recession, if not a depression - EXACTLY THE OPPOSITE OF THEIR MANDATE!

    I guess the short way of expressing it is that we had a choice, we could lower the cost of capital, risking excessive asset investment, but keeping the economy running and people employed (without inflation); or we could increase the value of the dollar at the expense of increased unemployment and possible deflation (which would be deadly to the economy - it means that you wait until the last minute to consume because prices will be lower tomorrow).

    There are no easy answers.

    Also, I think you misused "moral hazard."

    Moral hazard is the belief that, if you make a bad investment, somebody else will reimburse you (effectively) for the loss.

  2. The Citibank / CitiGroup issue is a little simpler. Their explanation of "maximum exposure" is incredibly misleading. Their explanation is:
    "For this purpose, maximum exposure is considered to be the notional amounts of credit lines, guarantees, other credit support, and liquidity facilities, the notional amounts of credit default swaps and certain total return swaps, and the amount invested where Citigroup has an ownership interest in the VIEs."

    They don't really explain the meaning of "Notional Value".

    If you read the definition (and you can find others using Google), what they are saying is that if they own an option to buy something for $50 and hold an option to sell it for $50, they have $100 dollars of exposure (despite the fact that the position is perfectly hedged). Furthermore, if they own a Call to purchase a security at $50 that cost them $1, they can only lose $1.

    Notional values are a common term in the finance/derivatives world, but the meaning is not obvious to people outside of that world.

    If Citi said that they had $20 trillion of notional positions, that wouldn't tell you what they could lose, if anything. It is fully possible that they could have $20 trillion of notional valued positions and have nothing at risk.

    Of course, there may still be counter-party risk, but that's a story for another day.

It's after 2:00 AM. I'm going to sleep! :-)

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