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The Fed Talking About Reducing Leverage Is Like A Crack Cocaine Dealer Handing Out "Just Say No" Stickers

George Washington's picture




 

Washington's Blog.

The New York Federal published a report in July entitled "The Shadow Banking System: Implications for Financial Regulation".

One of the main conclusions of the report is that leverage undermines financial stability:

Securitization
was intended as a way to transfer credit risk to those better able to
absorb losses, but instead it increased the fragility of the entire
financial system by allowing banks and other intermediaries to
“leverage up” by buying one another’s securities. In the new,
post-crisis financial system, the role of securitization will likely be
held in check by more stringent financial regulation and by the
recognition that it is important to prevent excessive leverage and
maturity mismatch, both of which can undermine financial stability.

And as a former economist at the New York Fed, Richard Alford, writes today:

On Friday, William Dudley, President of FRBNY, gave an excellent presentation
on the financial crisis. The speech was a logically-structured,
tightly-reasoned, and succinct retrospective of the crisis. It took one
step back from the details and proved a very useful financial
sector-wide perspective. The speech should be read by everyone with an
interest in the crisis. It highlights the often overlooked role of
leverage and maturity mismatches even as its stated purpose was
examining the role of liquidity.

While most analysts attributed the crisis to either specific instruments, or elements of the de-regulation, or policy action, Dudley correctly identified the causes of the crisis as the excessive use of leverage
and maturity mismatches embedded in financial activities carried out
off the balance sheets of the traditional banking system. The body of
the speech opens with: “..this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.”

In fact, every independent economist has said that too much leverage was one of the main causes of the current economic crisis.

Federal Reserve Bank of San Francisco President Janet Yellen said
today it’s “far from clear” whether the Fed should use interest rates
to stem a surge in financial leverage, and urged further research into
the issue.“Higher rates than called for based on purely macroeconomic
conditions may help forestall a potentially damaging buildup of
leverage and an asset-price boom,” Yellen said in the text of a speech
today in Hong Kong.

And on September 24th, Congressman Keith Ellison wrote a letter to Bernanke and Geithner stating:

As
you know, excessive leverage was a key component of the financial
crisis. Investment banks leveraged their balance sheets to
stratospheric levels by using short-term wholesale financing (like
repurchase agreements and commercial paper). Meanwhile, some entities
regulated as bank holding companies (BHCs) used off-balance-sheet
entities to warehouse risky assets, thereby evading their regulatory
capital requirements. These entities’ reliance on short-term debt to
fund the purchase of oftentimes illiquid and risky assets made them
susceptible to a classic bank panic. The key difference was that this
panic wasn’t a run on deposits by scared individuals, but a run on
collateral by sophisticated counterparties.

The Treasury
highlights this very problem in its policy statement before the recent
summit of G-20 finance ministers in London. To address this problem,
the Treasury advocates stronger capital and liquidity standards for
banking firms, including “a simple, non-risk-based leverage
constraint.” The U.S. is one of only a few countries that already has
leverage requirements for banks. Leverage requirements supplement
risk-based capital requirements that federal banking regulators have in
place pursuant to the Basel II Accord, an international capital
agreement. While important features of our system of financial
regulation, leverage requirements only apply to banks and bank holding
companies and therefore have not covered a wide array of financial
institutions, including many that are systemically important. Moreover,
leverage requirements have generally not captured the considerable
risks associated with off-balance-sheet activities.

Of course,
the Administration looks to address the shortcomings in the existing
regulatory system through a proposal to regulate large,
systemically-significant financial institutions as Tier 1 Financial
Holding Companies (FHCs). Building upon its existing authority as the
consolidated supervisor of all BHCs (which includes FHCs), the Federal
Reserve would be responsible for overseeing and regulating the Tier 1
FHCs under the plan. In the legislative draft of the proposal, the
Federal Reserve would have the authority to prescribe capital
requirements and other prudential standards for these institutions that
are stronger than those for all other BHCs. To that point, the text
specifically says, “The prudential standards shall be more stringent
than the standards applicable to bank holding companies to reflect the
potential risk posed to financial stability by United States Tier 1
financial holding companies and shall include, but not be limited
to—(A) risk-based capital requirements; (B) leverage limits; (C)
liquidity requirements; and (D) overall risk management requirements.”

The
application of leverage limits – as advanced by the Treasury’s G-20
policy statement and by the Administration’s financial regulatory
reform plan – is a simple and elegant way to limit risk at specific
financial institutions (and within the overall financial system). The
financial crisis has underscored the importance of leverage
requirements and manifested the problems associated with relying upon
risk-based capital requirements alone ...

Nevertheless, there
are some open questions regarding exactly how a leverage requirement
should be applied. Some scholars and policy experts have advocated
putting in place a leverage requirement for banks and other financial
institutions that is set in statute. As Congress moves forward on
comprehensive financial regulatory reform, it may consider such a
requirement. I would therefore be interested to hear your views
regarding the wisdom of such an approach.
As you know, setting
capital standards requires decisions regarding what institutions would
be covered, how capital would be defined, and what levels the
requirements would be set. In light of that, what specific difficulties
would you anticipate Congress facing with respect to specifying such a
requirement? In addition, would a statutory requirement be too
inflexible and place too many constraints on regulators with respect to
refining regulatory capital requirements and negotiating with bank
regulators from other countries?

On November 13th, Bernanke responded to Ellison (I received a copy of the letter from a Congressional source):

The
Board's authority and flexibility in establishing capital requirements,
including leverage requirements, have been key to the Board's ability
to require additional capital where needed based on a banking
organization's risk profile. One of the lessons learned in the recent
financial crisis is the need for financial supervisors to have the
ability to react quickly to changing circumstances, as in the capital
assessments conducted in the Supervisory Capital Assessment Program.
The Board and other federal banking agencies initiated this program to
conduct a comprehensive, forward-looking assessment of the capital
positions ofthe nation's 19 largest bank holding companies (BHCs). The
Board's authority to mandate specific levels of capital was critical to
this exercise because each BHC had a unique set of risks and
circumstances that demanded careful supervisory scrutiny and evaluation
in order to identify the amount of capital appropriate for its safe and
sound operation. The Board required corrective actions on a
case-by-case basis and continues to assess the capital positions
ofthese institutions as well as all others under its supervision.

We
note that in other contexts, statutorily prescribed minimum leverage
ratios have not necessarily served prudential regulators of financial
institutions well. Previously, the minimum capital requirements for the
housing government-sponsored enterprises Fannie Mae and Freddie Mac
(collectively, "GSEs") were fixed in statute; the risk-based capital
requirement for the GSEs was based on a stress test that was also set
forth in statute; and the GSE's regulator, the Director ofthe Office of
Financial Housing Enterprise Oversight (the predecessor agency to the
Federal Housing Finance Authority) did not have the authority to
establish additional capital requirements for the GSEs. This limitation
was different from the authority that the federal banking agencies have
to set the leverage and risk-based capital requirements for banking
organizations. In 2008, Congress enacted the Housing and Economic
Recovery Act of 2008, which created FHFA and empowered it to establish
additional minimum leverage and risk-based capital requirements for the
GSEs.

With regard to the Board and other U.S. banking agencies'
efforts to join with international supervisors to strengthen capital
requirements for internationally active banking organizations, the
Basel Committee is working on proposals for an international supplement
to minimum risk-based capital ratios. While this work is in process, it
is likely that these efforts will take the form of a minimum leverage
ratio. It will be important for the international regulatory community
to carefully calibrate the aggregate effect ofthis initiative, along
with other efforts underway that are intended to strengthen capital
requirements, to ensure that they protect against future financial
crises while not raising capital requirements to such a degree that the
availability of credit to support economic growth is unduly
constrained. The current authority and flexibility the Board has to
establish and modify leverage ratios as a banking organization
regulator is very important to the successful participation of the
Board in the process of establishing and calibrating an international
leverage ratio.

The Supervisory Capital Assessment Program Bernanke refers to were the infamous "stress tests". There's just one little problem: the stress tests were a complete complete sham.

In reality, the Fed has been on the biggest enablers for
increased leverage. As anyone who has looked at Bernanke and Geithner's
actions will tell you, many of the government's programs are aimed at
trying to re-start securitization and the "shadow banking system", and to prop up asset prices for highly-leveraged financial products.

Indeed, Bernanke said in February:

In an effort to restart securitization markets
to support the extension of credit to consumers and small businesses,
we joined with the Treasury to announce the Term Asset-Backed
Securities Loan Facility (TALF).

And he said it again in September:

The
Term Asset-Backed Securities Loan Facility, or TALF ... has helped
restart the securitization markets for various types of consumer and
small business credit. Securitization markets are an important source
of credit, and their virtual shutdown during the crisis has reduced
credit availability for many borrowers.

The Fed talking about reducing leverage is like a crack cocaine dealer handing out "just say no" stickers.

Indeed, the central bankers' central banker - BIS - has itself slammed the Fed:

In
a pointed attack on the US Federal Reserve, [BIS and its chief
economist William White] said central banks would not find it easy to
"clean up" once property bubbles have burst...

 

Nor does it
exonerate the watchdogs. "How could such a huge shadow banking system
emerge without provoking clear statements of official concern?"

 

"The
fundamental cause of today's emerging problems was excessive and
imprudent credit growth over a long period. Policy interest rates in
the advanced industrial countries have been unusually low," [White]
said.

 

The Fed and fellow central banks instinctively
cut rates lower with each cycle to avoid facing the pain. The effect
has been to put off the day of reckoning...

 

"Should governments
feel it necessary to take direct actions to alleviate debt burdens, it
is crucial that they understand one thing beforehand. If asset prices
are unrealistically high, they must fall. If savings rates are
unrealistically low, they must rise. If debts cannot be serviced, they
must be written off.

 

"To deny this through the use of gimmicks and palliatives will only make things worse in the end," he said.

The head of the World Bank also says:

Central
banks [including the Fed] failed to address risks building in the new
economy. They seemingly mastered product price inflation in the 1980s,
but most decided that asset price bubbles were difficult to identify and to restrain with monetary policy. They argued that damage to the 'real economy' of jobs, production, savings, and consumption could be contained once bubbles burst, through aggressive easing of interest rates. They turned out to be wrong.

(Large amounts of leverage increase bubbles, and so the two concepts are highly interconnected.)

Remember also that Greenspan acted as one of the main supporters of derivatives (including credit default swaps) between the late 1990's and the present (and see this). Greenspan was also one of the main cheerleaders for subprime loans (and see this).
Both increased leverage, especially since the shadow banking system -
CDOs, CDSs, etc. - were largely stacked on top of the subprime
mortgages.
In fact, as I've repeatedly pointed out, Bernanke
(like Summers and Geithner), is too wedded to an overly-leveraged,
highly-securitized, derivatives-based, bubble-blown financial system.
His main strategy, arguably, is to re-lever up the financial system.

The financial system is undergoing a period of deleveraging that cannot be stopped. For example:

  • Barrons is running an editorial entitled "The Crash Must Come: Intervention can't stop the business cycle".
  • The Economist writes, "Once started, the process [of deleveraging] is hard to stop."
  • The Financial Times quotes
    the Bank of Tokyo-Mitsubishi in saying, "There seems little what the
    authorities can do to reverse the process of deleveraging that is
    taking place with financial institutions all contracting their balance
    sheets at the same time".

As derivatives expert Satyajit Das writes:

Ultimately, “all the king’s horses and king’s men” cannot prevent the de-leveraging of the financial system under way.

***

Like
a giant forest fire the de-leveraging process cannot be extinguished.
Thoughtful actions can create firebreaks that limit preventable damage
to the economy and the international financial system until the fire
burns itself out.

As former head BIS economist William White
wrote recently, we have to resist the temptation to re-start high
levels of leverage and to blow another bubble every time the economy
gets in trouble:

Forest
fires are judged to be nasty, especially when one’s own house or life
is threatened, or when grave harm is being done to tourist attractions.
The popular conviction that fires are an unqualified evil reached its
zenith after a third of Yellowstone Park in the US was destroyed by
fire in 1988. Nevertheless, conventional wisdom among forest managers
remains that it is best to let natural forest fires burn themselves
out, unless particularly dangerous conditions apply. Burning appears to
be part of a natural process of forest rejuvenation. Moreover,
intermittent fires burn away the undergrowth that might accumulate and
make any eventual fire uncontrollable.

Perhaps modern
macroeconomists could learn from the forest managers. For decades,
successive economic downturns and even threats of downturns
(“pre-emptive easing”) have been met with massive monetary and often
fiscal stimuli...

Just as good forest management implies cutting
away underbrush and selective tree-felling, we need to resist the
­credit-driven expansions that fuel asset bubbles and unsustainable
spending patterns. Recent reports from a number of jurisdictions with
well-developed financial markets seem to agree that regulatory
instruments play an important role in leaning against such phenomena.
What is less clear is that central bankers recognise that they might
have an even more important role to play. In light of the recent surge
in asset prices worldwide, this issue needs urgent attention. Yet
another boom-bust cycle could have negative implications, social and
political, stretching beyond the sphere of economics.

The Fed may be talking like Smokey the Bear, but it continues to hand out matches trying to increase leverage.

 

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Tue, 11/17/2009 - 20:02 | 133862 Anonymous
Anonymous's picture

Just read this from bloomberg http://www.bloomberg.com/apps/news?pid=20601087&sid=aQWV0pN.Y1LQ&pos=1

it seems that Goldman Sachs and Warren Buffet are going to 'help' small business with a 500 million dollar progam. More like enslave them. This is unbelievable, they really are going to become the lords while the rest of us become serfs.

bring back socialism and end this fascist tyranny that is emerging.

Tue, 11/17/2009 - 19:23 | 133815 deadhead
deadhead's picture

Very, very well done piece.  Thank you!

Tue, 11/17/2009 - 18:53 | 133710 Fibozachi
Fibozachi's picture

Well written piece but it still misses both the nature of the crisis still at hand as well as the very nature / intent of the Fed / Treasury.

 

Their provided liquidity, which is effectively a series of targeted credits for financial intermediaries and not paper for circulation, is by design inflationary in order to explicitly obfuscate the underlying specter of all-encompassing deflation.  As such it has nothing to do with either core inflation or inflationary pressures throughout the system.  Moreover, every single incessant utterance of "dollar be dead" simply serves to underscore its speaker's / writer's failure to understand not only the concept of the inflation adjusted Real Dow but also, and much more importantly, how central banks, FX cross rates, Domestic Repos, International Swap Lines, Uncle Ben, Tiny Tim and the very concept of collective social mood each are inherently intertwined.

 

Official Fed policy is a battleship that can not be turned on a dime; hence the lonely pedestal that Volcker's draw of the straw has placed him upon.  It takes time "to steer the ship," especially when there is NO steering wheel and the captain of the ship, who simply navigates the waters around him, has convinced each and every passenger below that he, and only he, has: 1) any idea how to effectively steer the ship; 2) has a steering wheel that allows him to gently guide its course.  In reality, the Fed has very, very little over free, yes, free market rates that the public determines.  That said, they have effected exceptionally aggressive tactics, which are wholly unoriginal. 

 

And while everyone and their mother cites the Weimar Republic (incorrectly), Zimbabwe and the video game Populous to be cute and topically relate to one another through collectively shared emotions that are extraordinarily palpable ... they fail to understand that such intense bouts of Deflationary Recession / Depression (we are currently mired within a FULL blown depression) are not only recurringly 'commonplace' but also that they have been ameliorated the exact same ways for well over 400 years; and that is being tremendously conservative w/o citing Armstrong Research, Prechter or Kindleberger. 

See if you can dig up what Uncle Al's "lost" 'thesis' was about.  I'll save you the trouble: it's centered on today, what we face right now ... it is a rigorous analysis of "employing" inflationary tactics and explicitly covert inter-market stabilization efforts across specifically timed interval periods, at specifically measurable points within collective social mood during a deflationary depression of Supercycle or Grand Supercycle scale.  Cmon, you really, really think Al was that dumb?  Uncle Ben too?  Seriously?  You think "we're becoming Japan," without thinking about Japan as our test run??

Tue, 11/17/2009 - 19:08 | 133784 for shizzle my ...
for shizzle my nizzle's picture

How about --- if they are not that dumb, then, how smart are they for things to be so screwed up?

If it is not a dumb / smart issue --- then what is it? 

Tue, 11/17/2009 - 19:32 | 133826 Fibozachi
Fibozachi's picture

One has nothing to with the other and the fact remains that the Fed has very, very little control (not influence) over actual market direction.  The Fed, just like every single one of us, is almost entirely dependant upon the direction and development of collective social mood.  Don't take my word for it, just read Uncle Al's comments / speeches that explicitly quote Socionomic Theory without quotation, damn near verbatim. 

To borrow / botch a quote and take it admittedly out of context (from early 20th century re: the employment of EW, Fibonacci, Gann and Astro-harmonics): millionaires don't care about such things, billionaires do.  We think that about sums it up.

Tue, 11/17/2009 - 19:08 | 133783 for shizzle my ...
for shizzle my nizzle's picture

How about --- if they are not that dumb, then, how smart are they for things to be so screwed up?

If it is not a dumb / smart issue --- then what is it? 

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