Thursday, June 19, 2008

Paulson pusing harder for Fed as a financial stability regulator

I really wish the Bush administration was over, now. Here we have the Treasury secretary calling for the nation's central bank, which already has internal tensions in its charter (preserving the soundness of the banking system, keeping inflation low and stable, and maintaining full employment) to also be in charge of financial stability:
Mr. Paulson appears to agree with the broad principle. "We should quickly consider how to most appropriately give the Fed the authority to access necessary information from highly complex financial institutions and the responsibility to intervene in order to protect the system, so they can carry out the role our nation has come to expect -- stabilizing the overall system when it is threatened," Mr. Paulson will say.

Since when does "the nation" expect the Fed to ride in to the rescue? That's Wall Street's fond wish, but in Bush Administration logic, the desires of the financial services industry are identical with the national interest.

The article notes that this speech by Paulson (to be made tomorrow) reaffirms his vision of consolidation of banking and securities regulation under the Fed's aegis. and also promotes the idea of the central bank as a financial stability regulator. That was a grand (one might say overreaching) idea from a Treasury secretary with less than a year remaining in office. But rather than act like an adult and recognize that this program will fall to his successors, who will decide which if any elements to adopt, Paulson has decided to try to push it forward, with emphasis on expanding the Fed's purview.

It hasn't done very well on any of its current responsibilities. Absent some seasonal adjustments that BreakingViews($) deemed "dubious" the last three months inflation would have reached an annualized rate of 8.3%. Similarly, many analysts have started looking past headline unemployment, and find the trends in broader measures even worse. U-6, the broadest measure of unemployment, stands at 9.7%, up from 8.3% a year ago (while U-3, the official unemployment rate, was 5.5% this May versus 4.5% the May prior). And we don't need to discuss the health, or rather, the flagging-even-while-on-life-support status of the banking system.

But no, the latest Bush proposal is to expand the mandate of the very body that had a large role in creating the mess we are in, via overly lax monetary policies and a distaste for its supervisory responsibilities, and officially put it in charge of stability.

And what does financial stability extend to, exactly? The stock market? The commodities market? Why don't we simply officially declare the end of capitalism and make the government the underwriter of all risk. We might as well be honest about what's afoot.

In fact, one can argue that our financial distress is the result of the central bank's mission creep. As one former Fed economist friend observed, Greenspan's big problem was that he needed to be liked. Another former Fed economist, Richard Alford, described at some length how the Fed compromised its independence by throwing its weight behind various Administration policy initiatives, when true independence would dictate remaining silent. Greenspan backed the Clinton deficit reduction, the Bush ownership society (by talking up ARMs) and its Social Security reform program.

And Greenspan took an undue, unprecedented interest in the stock market. A May 2000 Wall Street Journal front page story reveled the then-called Maestro not only pouring over market-related data himself, but putting Fed economist on the task as well. Similarly, the Fed's orchestration of the rescue of LTCM was controversial at the time. It isn't clear that an LTCM collapse would have been a systemic event, and the central bank leaned on firms over which it had no formal jurisdiction. In retrospect, had LTCM failed, even if it produced considerable dislocation, it would have led to new-found caution and respect for risk, particularly counterparty exposures.

In fact, a financial stability role conflicts with tough oversight. Shuttering weak firms creates worries; sweeping problems under the rug and hoping they go away keeps confidence high. And markets are all about confidence.

Think that is an exaggeration? Consider another Wall Street Journal story today with the misleading headline, "Banks Find New Ways To Ease Pain of Bad Loans." A more accurate title would be "Banks Play Accounting Tricks To Disguise How Bad Things Really Are":
In January, Astoria Financial Corp. told investors that its pile of nonperforming loans had grown to about $106 million as of the end of last year. Three months later, the thrift holding company said the number was just $68 million.

How did Astoria do it? By changing its internal policy on when mortgages are classified on its books as troubled. The Lake Success, N.Y., company now counts home loans as nonperforming when the borrower misses at least three payments, instead of two....

From lengthening the time it takes to write off troubled mortgages, to parking lousy loans in subsidiaries that don't count toward regulatory capital levels, the creative maneuvers are perfectly legal....

"Spending all the time gaming the system rather than addressing the problems doesn't reflect well on the institutions," said David Fanger, chief credit officer in the financial-institutions group at Moody's Investors Service, a unit of Moody's Corp. "What this really is about is buying yourself time. ... At the end of the day, the losses are likely to not be that different."....

At Wells Fargo & Co., the fourth-largest U.S. bank by stock-market value, investors and analysts are jittery about its $83.6 billion portfolio of home-equity loans, which is showing signs of stress as real-estate values tumble throughout much of the country.

Until recently, the San Francisco bank had written off home-equity loans -- essentially taking a charge to earnings in anticipation of borrowers' defaulting -- once borrowers fell 120 days behind on payments. But on April 1, the bank started waiting for up to 180 days.....

BankAtlantic Bancorp Inc., which is based in Fort Lauderdale, Fla., earlier this year transferred about $100 million of troubled commercial-real-estate loans into a new subsidiary.

That essentially erased the loans from BankAtlantic's retail-banking unit. Since that unit is federally regulated, BankAtlantic eventually might have faced regulatory action if it didn't substantially beef up the unit's capital and reserve levels to cover the bad loans.

Now one can argue that the Fed isn't the only banking regulator (true) and that regulators can't do much if banks exploit loopholes (particularly if they drop their federal charters become state-chartered banks and are no longer under the purview of the Fed or the OCC). Nevertheless, there is plenty a regulator can do to discourage behavior that it technically permitted but it dislikes (beyond changing the regs). A simple tactic is to make clear that banks that engage in skirting-at-the-margin practices will be subject to far more aggressive supervision and audit. It's possible to make audits punitive (one ploy of the Japanese Ministry of Finance). But as the subprime mess attests, the OCC used its authority to put some limits on subprime lending, while the Fed cast a blind eye.

Having said that, if we must have a stability regulator, it most certainly should not be the Fed. England has some division of roles, with the FSA having supervisory responsibilities, and the Bank of England tasked with monetary policy and financial markets stability. Yet Sir John Gieve, the Deputy Governor of the Bank of England who was responsible for stability, suddenly resigned, presumably over the handling of the Northern Rock meltdown. Yet the Bank of England is more of an old-fashioned central bank, concerned with probity and moral hazard, so Gieve's departure may serve as proof of the difficulty of having the two roles sit under the same roof.

One of the most successful elements of the American political system is its system of checks and balances (which sadly is eroding as imperial presidents chip away at the other two branches). Having one body responsible for both monetary policy and market stability is too much power, and with conflicting objectives. Despite the example of the Greenspan and Bernanke Fed, a central bank should have a bias towards tight credit and a sound currency, while a stability-minded regulator will want to break glass and increase liquidity at the first sign of trouble. Much better to split the roles and let independent bodies duke it out.

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