Wed, Mar 04, 2009 page9

• At the US Federal Reserve, nothing succeeds quite like failure

  The institution that had the most direct responsibility to prevent the financial crisis has taken little heat, and Congress seems ready to increase its powers

  • By Floyd Norris / NY TIMES NEWS SERVICE
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  “Wall Street may be more comforted by an approach that gives banks bailouts with no strings and that holds nobody accountable for their reckless decisions, but such an approach won’t solve the problem,” US President Barack Obama said on Feb. 24.

  It’s not much fun to be a banker these days. One leading European banker says a poll showed that the only groups now held in lower regard are prostitutes and convicted felons. There are plenty of people who would be quite happy to see a few bankers join the latter group.

  The opprobrium is well earned. The banks invented toxic securities and thought they were making lots of money from them, but the bosses seem to have been too busy flying around on their private jets to understand the risks they were taking. Now their banks are in business only because the government has poured hundreds of billions of dollars into them.

  But it was not all their fault. These were regulated institutions, and the regulators failed.

  Remarkably, the institution that had the most direct responsibility to prevent the debacle — the Federal Reserve — has taken little heat for its own failures. There has been no congressional hearing where Fed officials were treated to anything like the grilling that the division chiefs of the Securities and Exchange Commission (SEC) received three weeks ago.

  Instead, Congress appears ready to increase the Fed’s powers.

  Sometimes nothing succeeds like failure.

  In his speech to Congress, the president asked legislators to quickly reform financial regulation. It appears Congress may act quickly, but not on an overall reform plan. Representative Barney Frank, the chairman of the House Financial Services Committee, told me after the speech that he expected to pass a bill this year to make the Fed into a “systemic regulator,” able to take jurisdiction over any financial institution if it threatens the financial system.

  When I asked about other regulatory reform ideas, like giving the SEC powers similar to those of the Food and Drug Administration, so that a new financial product could not be sold widely without approval, Frank said those would be for a later round of legislation.

  Books will be written on the failure of the Fed in the last cycle. It decided that it did not need to worry itself over rising asset prices, so it stood by — first in the technology stock bubble, then in the housing bubble. It saw credit getting excessively loose and leverage piling up, but comforted us with assurances that if there was a bubble, the Fed knew how to clean up after it burst, principally by cutting interest rates.

  It championed letting the shadow financial system grow without oversight and shied away from doing anything about highly risky mortgages.

  Perhaps most important, the Fed and other regulators had no idea how much risk they had allowed into the system. They knew that various financial innovations were designed to let banks make more money without being required to put up more capital, but they did not figure out that that meant the capital there might be inadequate. They threw up their hands at the complexity of it all and said banks could use their own models to assess risk.

  In sum, the Fed thought it had learned the lessons of the 1930s, but it had not learned the lesson of the 1920s, that allowing asset prices to soar to absurdly leveraged heights could lead to financial collapse as the need to repay loans forced sales that drove prices lower, resulting in the need to repay more loans, and so on.

  The Fed was not alone, of course. Congress was quite happy with free-flowing credit and pushed to assure that financial innovations were allowed to blossom. The SEC did miss some criminals — most notably Bernard Madoff — and failed in its regulation of Lehman Brothers and Bear Stearns. The Commodity Futures Trading Commission seemed more concerned with exempting new products from regulation than with investigating their potential systemic risks.

  But it was the Fed that encouraged Bank of America to buy Merrill Lynch without much due diligence. And it supported Citigroup’s offer to buy Wachovia, a deal that thankfully was not completed. Only months later, it appears that the regulators seriously underestimated the financial risks faced by both Citi and Bank of America.

  Fed Chairman Ben Bernanke is not responsible for that long list of errors, although he conceded this week that he did seriously underestimate the gravity of the problem as recently as last fall.

  And he deserves credit for recent actions. The Fed has done about all it conceivably could do, cutting the interest rate it controls almost to zero, lending money against virtually any collateral a bank has and buying anything it can legally purchase. In retrospect, it may have moved too slowly, but it was faster than other major central banks.

  The New York Fed, under the leadership of Timothy Geithner, who is now the Treasury secretary, also deserves credit for its work on credit-default swaps. Most of the reforms he pushed for have yet to be adopted, but he did focus the attention of senior bankers on that market, which may have reduced the damage from corporate defaults.

  There is one clear advantage in giving systemic duties to the Fed rather than any other regulator. The Fed is not dependent on Congress for funding, so it would be easier to hire staff to handle the new responsibilities. Other regulators have periodically felt budget pressures to hold down spending to levels that turned out to be unreasonably low.

  But the Fed also has a major disadvantage. Unlike the SEC, which instinctively looks for more disclosure and openness, bank regulators are inclined to secrecy, particularly in times of stress. They want us to trust that they have the situation in hand.

  Even now, the banks being bailed out have not been required to detail the toxic securities they own. Without that information, it is impossible even for sophisticated analysts to assess whether each bank has taken all the writedowns it should. That is one reason banks are hesitant to trust each other.

  Bernanke’s predecessor, Alan Greenspan, has been trying to restore his reputation without admitting to any error beyond assuming that banks would act rationally in making loans, and therefore not requiring large enough capital buffers.

  “The real lesson here appears to be that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic or whether a particular tranche of a collateralized debt obligation will default, or even if the financial system will seize up,” he said in a speech last week to the Economic Club of New York.

  It sounded to me a little like a failing student protesting: “Dad, nobody could have passed that test.”

  Is the current Fed leadership so modest about its abilities? No doubt it cannot “fully or accurately” forecast what will happen, but does it think that it can do a much better job now than it did in the years leading up to the crisis? If so, how? What reforms are needed in the Fed’s own regulatory operations? Would such reforms have enabled regulators to see what was happening in time to at least reduce the damage?

  Those are questions Congress might want to ask before it gives the Fed a broad mandate to expand its authority.
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