Every time I read a Bernanke speech, I cannot screen out my memory of Ron Moody as Fagin in Oliver! “I’m reviewing the situation.” Fagin was boxed in, facing tough decisions. Every option was a looming disaster. But Fagin remained confident that there was a way out, somewhere, somehow. Moody’s performance was pure Bernanke, four decades early. He even had a beard. See the video. I wish every member of Congress would. It would help dissipate the illusion.
Here is the latest example: his July 8 speech. It sent the Dow up by over 150 points. The market had been struggling all day until the speech. Yet the speech offered nothing new.
Officially, the speech dealt with mortgage lending, as well it should. This is the hole in the financial dike.
As always, he surveyed new policies to deal with a future crisis that will do nothing to end this crisis — merely cover up its effects on large banks’ balance sheets.
The recent experience, including the broader turmoil we have seen in the financial markets, will have — indeed, is already having — important consequences for U.S. regulatory policy. First, regulators are taking action to strengthen consumer protections. Next week, the Federal Reserve Board will issue new rules on mortgage lending, using its authorities under the Home Ownership and Equity Protection Act. These new rules, which will apply to all lenders and not just banks, will address some of the problems that have surfaced in recent years in mortgage lending, especially high-cost mortgage lending.
The new rules will apply to future loans. But what of the horse that is out of the barn? What about falling real estate prices, falling mortgage equity, and falling consumer confidence? He did not say.
Second, regulatory policy can help to ensure that mortgage credit is available to qualified borrowers, including those of low and moderate incomes.
It was the absence of qualified borrowers that created the crisis. The entire regulatory structure was deliberately set up to encourage — read: subsidize — home ownership by people who were not qualified borrowers. The subsidies worked! Oh, how well they worked! The borrowers are now unable to make their mortgage payments. There are millions of them. Who will replace them as mortgage-paying owners? Bernanke did not say. What institutional negative sanctions against delaying the sale of these foreclosed empty houses at market-clearing prices will be imposed by the new regulatory program? Bernanke did not say.
The new program will operate on the assumption that Fannie Mae and Freddie Mac — whose stocks have collapsed by 60% so far this year — will be solvent and active. Note the key word: if.
In particular, I welcome recent efforts to improve the regulatory oversight of the government-sponsored enterprises, Fannie Mae and Freddie Mac. If these firms are strong, well-regulated, well-capitalized, and focused on their mission, they will be better able to serve their function of increasing access to mortgage credit, without posing undue risks to the financial system or the taxpayer.
Then, as always, he surveyed what everyone knows. A survey of the obvious is a large section in every Bernanke speech.
Third, instability in our financial system over the past year or so has importantly affected the availability and terms of credit and the pace of economic growth. Thus, beyond actions focused on mortgage markets, regulators must consider what can be done to make the U.S. financial system itself more stable, without compromising the dynamism and innovation that has been its hallmark.
This is sometimes referred to as squaring the circle. Or putting round pegs in square holes. It is the Goldilocks goal: getting things just right. Who will achieve this? The same regulatory agencies that oversaw the bubble and did nothing to stop it; indeed, which funded it. No one has been fired for incompetence. The same equally alert government planners are still in charge, still doing their job in the name of The People.
There is good news, he said: government committees have studied the whole question.
Several bodies, including the President’s Working Group (PWG) in the United States and the international Financial Stability Forum, have recently issued comprehensive reports on the lessons of the financial turmoil with recommendations for regulators and the private sector. Many of these recommendations are being implemented. . . .
Then he got to the point: “In the remainder of my remarks, I would like to discuss this more general issue of promoting financial stability, including some of the lessons learned, what the Federal Reserve is already doing, and how we as a society might wish to go about strengthening our financial system for the future.”
He surveyed the Bear Stearns collapse.
The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns’s borrowings were largely secured — that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Hence, they refused to renew their loans and demanded repayment.
All true. All unsolved. All waiting to happen again.
Bear Stearns’s contingency planning had not envisioned a sudden loss of access to secured funding, so it did not have adequate liquidity to meet those demands for repayment.
Translation: “It was nip and tuck.”
If a sale of the firm could not have been arranged, it would have filed for bankruptcy. Our analyses persuaded us and our colleagues at the Securities and Exchange Commission (SEC) and the Treasury that allowing Bear Stearns to fail so abruptly at a time when the financial markets were already under considerable stress would likely have had extremely adverse implications for the financial system and for the broader economy. In particular, Bear Stearns’ failure under those circumstances would have seriously disrupted certain key secured funding markets and derivatives markets and possibly would have led to runs on other financial firms. To protect the financial system and the economy, the Federal Reserve facilitated the acquisition of Bear Stearns by the commercial bank JPMorgan Chase.
He is sill arguing that the financial system was bordering on collapse. He may even believe it. But no one saw it coming at the beginning of the week in which the collapse almost took place.
Why should we believe that anyone will see the next one coming?
Then came the Great Securities Swap.
We supplemented our actions regarding Bear Stearns by establishing the Primary Dealer Credit Facility (PDCF). Under the PDCF, the Fed stands ready to make fully collateralized loans to the remaining four major investment banks plus other broker-dealers, called primary dealers, that transact regularly with the Federal Reserve. The Fed also created the Term Securities Lending Facility (TSLF), which allows primary dealers to borrow Treasury securities using other types of assets as collateral. These new facilities assured the secured creditors of primary dealers that those firms had sufficient access to liquidity, reducing the danger of runs like the one experienced by Bear Stearns. Although short-term funding markets remain strained, they have improved somewhat since March, reflecting the availability of several Fed lending facilities as well as the ongoing efforts of financial firms to repair their balance sheets and increase their liquidity.
The FED surrendered about half of its accumulated Treasury debt assets in a few weeks — reserves that had taken since 1914 to accumulate. This should make investors calm? What happens when the piggy bank of Treasury debt is empty? What will serve as additional legal cover up for primary dealer balance sheet insolvency then? The FED will cross that bridge when it comes to it.
It is clear that there is nothing temporary about the program. It will continue until the FED runs out of Treasury debt to swap. That could be next year. See this chart.
It was an emergency, so the program was justified. But what justifies its continuation? Obviously, a continuing emergency. But he did not draw this conclusion. Neither did stock market investors.
The PDCF and the TSLF were created under the Federal Reserve’s emergency lending powers, with the term of the PDCF set for a period of at least six months, through mid-September. The Federal Reserve is strongly committed to supporting the stability and improved functioning of the financial system. We are currently monitoring developments in financial markets closely and considering several options, including extending the duration of our facilities for primary dealers beyond year-end, should the current unusual and exigent circumstances continue to prevail in dealer funding markets.
Translation: “The temporary bailout is far from over. The banking system is still at risk.”
He assured his listeners that other plans are being considered. But all of them are merely monitoring issues. There is no solution offered. He promised this: Prudential Regulation and Supervision. But that was what we supposedly had from 2000 to 2006. It failed.
He admitted that there were — and are — serious problems.
From a regulatory and supervisory perspective, the investment banks and the other primary dealers raise some distinct issues. First, as I noted, neither the firms nor the regulators anticipated the possibility that investment banks would lose access to secured financing, as Bear Stearns did.
Translation: “Nobody saw it coming.”
Second, in the absence of countervailing regulatory measures, the Fed’s decision to lend to primary dealers — although it was necessary to avoid serious financial disruptions — could tend to make market discipline less effective in the future.
Translation: “It was a big bank bailout, pure and simple — moral hazard in action. It was the number-one task of all central banks has always been: protecting the commercial banking cartel from a breakdown due to the failure of one or more large banks.”
Going forward, the regulation and supervision of these institutions must take account of these realities. At the same time, reforms in the oversight of these firms must recognize the distinctive features of investment banking and take care neither to unduly inhibit efficiency and innovation nor to induce a migration of risk-taking activities to institutions that are less regulated or beyond our borders.
Translation: “We could sink the economy either way. We don’t know what we’re doing, any more than Bear Stearns did. But we talk a good line. And we still have half our Treasury debt in reserve. So far, so good.”
Since March, the Federal Reserve has been working closely with the SEC, which is the functional supervisor of each of the primary dealers and the consolidated supervisor of the four large firms that are not affiliated with banks (the so-called investment banks).
Translation: “The Federal Reserve System and the Securities and Exchange Commission are like two drunks trying to make it home after a night on the town. We hold up each other.”
Federal Reserve examiners are in place at the four investment banks and, along with our SEC colleagues, are monitoring the conditions of the other primary dealers. In cooperation with the SEC and the investment banks themselves, we are evaluating the capital and liquidity positions of these firms with the objective of ensuring that they are strong enough to withstand severe stresses in the financial environment. In the past few months, these firms have raised capital and expanded their liquidity cushions to protect themselves against extreme events.
Translation: “We do a lot of monitoring. We watch the patient’s EKG. We will know when to bring in the electro-shock pads. Trust us.”
To formalize our effective working relationship, the SEC and the Federal Reserve recently agreed to a memorandum of understanding (MOU). Under the MOU, the SEC and the Fed will freely share information and analyses pertaining to the financial conditions of primary dealers. The two agencies have also agreed to work jointly with the firms to support their continued efforts to strengthen their balance sheets, their liquidity, and their risk-management practices.
In short, don’t worry. “Everything is OK. We have an acronym: MOU. Already, you should feel better.”
The Federal Reserve, together with other regulators and the private sector, is engaged in a broad effort to strengthen the financial infrastructure. In doing so, we aim not only to help make the financial system better able to withstand future shocks but also — by reducing the range of circumstances in which systemic stability concerns might prompt government intervention — to mitigate moral hazard and the problem of “too big to fail.”
Translation: “Mitigate = Guarantee.”
More generally, both the operational performance under stress of key payment and settlements systems and their ability to manage counterparty and market risks are critical to the stability of the broader financial system. Currently, the Federal Reserve relies on a patchwork of authorities, largely derived from our role as a banking supervisor, as well as on moral suasion to help ensure that the various payments and settlements systems have the necessary procedures and controls in place to manage their risks. By contrast, most major central banks around the world have an explicit statutory basis for their oversight of payment systems, and in recent years a growing number of central banks have been given statutory authority to oversee securities settlement systems as well. Given how important robust payment and settlement systems are to financial stability, a strong case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.
Translation: “To centralize power, a private monopoly needs a frightened Congress. Congress today is peeing in its pants. The Great Centralization is on the way.”
As part of its review of how best to increase financial stability, and as has been suggested by Secretary Paulson, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools.
Translation: “Sit up. Roll over. Good Congress!”
That said, holding the Fed more formally accountable for promoting financial stability makes sense only if the institution’s powers are consistent with its responsibilities.
Translation: “Accountable = more power.”
The Federal Reserve will continue its efforts to make our financial system stronger and more resilient, so that it can continue to play its necessary role of supporting economic growth and making credit available to all qualified borrowers.
Translation: “The FED has created every boom-bust crisis since 1914. It gets more power from Congress after every crisis. There will therefore be more crises. Get used to it.”
This is the same old government-licensed, monopolistic song and dance. The cure for failure is to transfer even greater power to the agency in charge. The cure for the horse that escaped from the barn is a new, improved system of regulations governing barn door oversight. This has been going on since 1914. Congress never figures it out.
If you want to figure it out, watch the Mises Institute’s video. Click here.
If this is too much, then watch Ron Moody’s 4-minute explanation of fractional reserve banking, “You’ve got to pick a pocket or two.”
July 10, 2008
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