Wednesday, July 15, 2009

Goldman's Influence and the CFTC Exception

There has been a lot of notice of the significant number of alumni of Goldman Sachs who have entered into the government. This has gotten so obvious that, near the end of the last Administration, one reporter remarked to me that there just might as well be a sign at the Treasury Department saying "Goldman Sachs South."

Recently, a sensational article about Goldman Sachs appeared in Rolling Stone -- "The Great American Bubble Machine" by Matt Taibbi. The author seeks to blame Goldman for financial market bubbles going back to the 1920s. There is much to criticize about this article and its simplistic approach of focusing on the actions of one firm without much analysis of what else was going on. Current Goldman management is reportedly upset by what they view as an unfair characterization of their firm.

However, while I disagree with much of the Taibbi's article, the point about regulatory capture is valid. If the political appointees going to the Treasury and the financial regulatory agencies share similar Wall Street backgrounds, they are probably more inclined to see things the same way as those currently on Wall Street and to be more receptive to their point of view than that of others. There are, of course, exceptions.

Curiously, the biggest exception at the moment is Gary Genlser, who worked at Goldman prior to his appointment to the Treasury Department in the Clinton Administration. His nomination by President Obama to head the CFTC was held up by Senators Bernie Sanders and Maria Cantwell, who were skeptical of him because, as a Treasury official, he worked to get the Commodity Futures Modernization Act of 2000 passed. When the holds were released after the Treasury announced more details about its plans for regulating the entire OTC derivatives market, my guess was that the two Senators would be pleasantly surprised by Gensler.

In fact, Gensler has been talking tough about both OTC derivatives and oil futures. With regard to oil, his apparent inclination to put on restrictive speculative position limits on oil futures has many market participants upset. He is doing no favors to Goldman and others by following this course.

The irony is that, while Gensler is convincingly demonstrating that he is not under the influence of Goldman or Wall Street generally, he may not be right in his analysis in this case. Analysts of the oil market are puzzled by the movement of oil prices. (For example, see this recent Washington Post article.) The conclusion is that it must be the speculators and the futures markets.

But that is a jump without any analysis behind it. Remember, that in the oil futures markets, as in all futures markets, the total long positions exactly equal the total short positions and that oil futures are forced to converge with the cash market because of the potential (or threat) of delivery. In other words, for there to be significant moves in the price of oil, something has to be happening to underlying supply and demand conditions in the cash market.

For example, if oil futures prices increase above the cost of carry, the arbitrage is to buy oil in the cash market, store it somewhere, and sell in the futures market. If enough oil is held off the market, then the price will rise.

Given the expense of storage, the voluminous nature of oil, and the limited amount of storage facilities, there are not that many entities that can hold oil off the market once it is out of the ground. Once oil is pumped out of the ground and enters into a transportation, refining, and distribution system, most of it has to be sold in order to make room for the oil entering into this system.

In other words, any analysis of oil prices that focuses solely on the futures market is incomplete. To understand what is going on, one needs to study the large and not very transparent global cash market.

I doubt that putting tough speculative position limits on oil futures will materially affect the price. As an aside, it is funny that no one blames the speculators when oil prices fall sharply, but, of course, speculators don't care about the direction of prices, they only care that they have bet correctly.

If Gensler gets his way on this, restrictive speculative position limits may also not have the dire affect on the ability of entities to hedge. It may turn out not to be that important

What is interesting is that Gensler is pursuing this issue aggressively, even though it not only runs counter to Wall Street interests but to the economic analysis of his own agency in the previous Administration.

Tuesday, April 7, 2009

Increasing Criticism of Public Private Partnership Investment Program

There has been recently fairly strident criticism of the Public Private Partnership Investment Program announce by Treasury. One of the sharpest is that made by Professor Jeffrey Sachs, who posted his critique on the Huffington Post website -- "The Geithner-Summers Plan is Even Worse Than We Thought." Mr. Sachs' main point is that there is the possibility of gaming the system by a bank essentially selling worthless assets to a partnership the bank or a confederate has entered into with the government. When the assets prove worthless, the government takes most of the loss, but the bank is ahead by the upfront money it received in the sale minus its small loss in the partnership.

Business Week also criticizes the plan in an article entitled "Geithner's Plan: Loopholes Galore." The article outlines five possible ways, depending on the final rules, to game the new program.

Joe Stiglitz weighs in with an op-ed in the New York Times -- "Obama’s Ersatz Capitalism." A key sentence in the piece: "Even in an imperfect market, one shouldn’t confuse the value of an asset with the value of the upside option on that asset." Stiglitz also states: "Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time."

Peyton Young also piles on in the pages of the Financial Times. The article, "Why Geithner’s plan is the taxpayers’ curse," analogizes the "winner's curse" in the economic literature on auctions to the position of taxpayers under the current Treasury plan -- "This is the singularly perverse feature of the Treasury proposal: the greater the competition among the bidders, the worse off the taxpayers and the more distorted the so-called “market” prices that result." The article further states: "It is truly dismaying that the Obama administration, which publicly champions greater transparency, should put forward a proposal whose main object is to subsidise the banks without appearing to do so."

Paul Krugman, of course, can be counted on to criticize the plan. In his March 23 op-ed article in the New York Times, "Financial Policy Despair," he writes that "the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets." While conceding that "troubled assets may be somewhat undervalued," Krugman argues that the "Geithner plan" is "financial hocus-pocus" that will not work. Financial executives, he argues, lost their bet on the housing bubble and "the related belief that unprecedented levels of household debt were no problem."

Steven Pearlstein, who was an original supporter of the TARP plan to buy assets that Secretary Paulson proposed and then abandoned, strongly and sarcastically criticizes Krugman in a March 24 column in the Washington Post -- "Optimism over Despair." In the article, Pearlstein argues against "nationalization" of big banks. He also argues that, in regard to the assets it is directed at, the Administration's plan "merely restores things to a more normal situation in which the market prices reflect expected cash flow rather than reflecting the unavailability of reasonable financing."

A less pugnacious defense of the plan appeared in the same paper that Krugman writes for -- Joe Nocera's March 28 article, "This Time, Geithner's Plan for Banks Makes Sense." Mr. Nocera argues that the government is not bribing investors "to purchase the assets at inflated prices ... Instead, it appears that the government is trying to return some normalcy to the workings of the market." He concludes that the plan is not perfect or "guaranteed to do the trick," but " could, in the best case, make our banks a little healthier and a little better to extend credit."

Willaim Black, a former official with the Federal Home Loan Bank Board (now defunct) and the Office of Thrift Supervision, is extremely blunt in his criticisms of the current approach to the banking crisis in an interview on Bill Moyer's Journal last Friday. Among other charges, he argues that government officials in the Bush and Obama administrations are violating federal bankin law by not closing down insolvent banks according to the prompt corrective action provisions enacted in reaction to the S&L crisis.

Andrew Ross Sorkin of the New York Times raises another legal issue in an April 6 article, "‘No-Risk’ Insurance at F.D.I.C" (reproduced here along with excerpts from the relevant statute). He suggests that the amount of the guarantees that the FDIC is planning on extending stretches current law, and that, in order to comply with its interpretation of the law, the FDIC is projecting that the expected cost of the guarantees to the FDIC is zero.

Finally, for a depressing view of out current economic situation, there is Simon Johnson's article in the forthcoming May Atlantic, "The Quiet Coup." Among other points, the former chief economist for the IMF argues that Wall Street has way too much influence in Washington. His disturbing conclusion is: "The conventional wisdom among the elite is still that the current slump 'cannot be as bad as the Great Depression.' This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances."

The Adminstration is betting that Mr. Johnson is completely wrong, and that economic conditions will soon begin improving. In that case, the Administration plan with respect to the troubled, toxic, or legacy assets (or whatever their new name is) will look good, at least if the Administration can police it sufficiently to avoid it being gamed. Even then, if some investors are perceived as making too much money, there could be some political problems.

If, on the other hand, the economy continues in a slump, even if not as bad as Simon Johnson fears, then the Administration will be facing all sorts of charges of mismanagement. That liberals are currently attacking the program means that the Adminstration will not have a lot of political capital if things turn wrong and it has to go to another plan and ask the Congress for more money.

The lack of an effective response by the Administration to the criticisms, especially those involving gaming the new program, is surprising. They should have been able to anticipate this. When it comes to these types of programs, which can be easily painted as helping out Wall Street executives who already are too wealthy, it is not enough to have a program which you think is the correct one. You need to be able to sell it. If you cannot figure out how to do that, maybe you need to rethink the plan.

Monday, April 6, 2009

Treasury and Mortgage Fraud -- A New Focus

The U.S. Treasury Department issued a press release today concerning mortgage fraud -- "Federal, State Partners Announce Multi-Agency Crackdown Targeting Foreclosure Rescue Scams, Loan Modification Fraud." The focus on this is new for the enforcement staff at Main Treasury.

In the Bush Administration, after the enforcement mission and staff of Treasury was altered by the creation of the Department of Homeland Security, the chief interest of the relevant offices had been terrorist financing. One indication of this is the name of the umbrella office the Under Secretary in this area heads -- "Terrorism and Financial Intelligence." Interestingly, the Under Secretary is Stuart Levey, who was held over from the Bush Administration.

The Main Treasury staff reporting to Stuart Levey is small, if one excludes the Office of Foreign Assets Control, which is technically a Main Treasury office but given its size and mission is somewhat split off from the rest of Treasury. The key people under Levey have in the past been most concerned about terrorism and other national security issues, such as the proliferation of "weapons of mass destruction." They are undoubtedly still very focused on those issues, but that they are now making a public effort on mortgage fraud is reflective of how things have changed. No doubt, especially since the enforcement structure at Main Treasury is relatively new, these offices want to be perceived as relevant. We can all hope, though, that Treasury can contribute in this area through its own staff and through its bureau, the Financial Crimes Enforcement Network ("FinCEN").

Saturday, April 4, 2009

Sanders and Gensler

In a previous post about the nomination hearing of Gary Gensler to be Chairman of the Commodity Futures Trading Commission, I stated that "it is very likely he will be confirmed." His nomination has, according to press reports, hit a roadblock -- holds by Senator Bernie Sanders and another unnamed Senator.

Often Senators who put holds on nominations are holding out for something they want from the Administration, not because they have a strong objection to the nominee. This is not true in this case though. Senator Sanders objects to Gary Gensler because of his role in the Clinton Administration in getting the Gramm-Leach-Bliley Act and the Commodity Futures Modernization Act enacted. Even though Mr. Gensler has made all the right statements to convince Senator Harkin that he would be tough regulator, it is hard to see what the Administration can offer Senator Sanders to release his hold. It is not clear whether the Senate leadership feels strongly enough about this nomination to bring it to the floor despite Senator Sanders' and the unnamed Senator's objections. To an extent this is a test of will and patience. Mr. Gensler will probably be ultimately confirmed, but it is not a sure thing.

The problem this nomination is having also highlights a problem for the Obama Adminstration. There is a growing consensus that the financial regulatory structure needs to be changed and that some regulatory oversight needs to be strengthened. While the Obama Adminstration can point to what they consider failures in regulatory policy under Bush, two key pieces of legislation, the GLB Act and the CFMA, were enacted in the Clinton Administration and with its support. Some of the people who were involved in the Clinton Administration with these legislative initiatives are now officials or advisers in the Obama Administration. To paraphrase Mr. Gensler in his nomination hearing, views have "evolved."

Greenspan and Too Big to Fail

Last fall, I believe, Senator Bernie Sanders said something to the effect that a financial institution that is too big to fail is too big to exist. This position, though, is not confined to people on the left, and it is an issue that needs to be considered in the debate about financial regulatory restructuring that is coming.

In a March 26 article in the Financial Times (“We need a better cushion against risk”), Alan Greenspan argues that institutions that are too big to fail have “a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage.”

That is an interesting idea and a reversal of arguments I heard when I was devising capital rules for a relatively small group of specialized government securities brokers and dealers that capital requirements for large firms should be less because their size and diversification made them less risky. Large banks are likely to fight Greenspan’s idea if it gains traction.

In addition to “too big to fail,” we also have to be concerned about “too important” or “too interconnected” to fail. For example, the clearing of government securities transactions for the major dealers is handled by only two banks – JPMorgan Chase and Bank of New York Mellon. There are not likely to be any new entrants anytime soon into this business because of its high barriers to entry. The clearing function of these two banks is vital to the functioning of the market for Treasury securities, which has enormous importance for fixed-income markets generally, as well as being essential to both the Treasury and the Federal Reserve. Whatever happens to these banks, this clearing function needs to continue. Moreover, neither banks is likely to want to have the entire market for clearing to itself, because of the risk this entails.

The issue of what to do about systemic risk is not easy. Simply stating that we will give the Fed unspecified authority to deal with it is not anywhere near a complete answer. If we are to change our regulatory system, there needs to be serious thought and debate about what kind of financial sector we should have and whether it is desirable to reverse the consolidation of financial institutions that has been facilitated by legislation, most notably in recent years by the Gramm-Leach-Bliley Act. It is interesting that Greenspan has entered into the fray on this subject with an idea likely to be opposed by the major banks.

Wednesday, April 1, 2009

The Role and Worries of the Federal Reserve

Much of the burden of dealing with the current financial crisis has fallen on the Federal Reserve. If Treasury is not able to get approval for new programs and appropriations to fund them, the Fed may feel called upon to do even more if conditions do not improve.

The Fed, which cherishes its independence but realizes that it has limits, is clearly concerned that it may be getting into areas more properly labeled as fiscal policy. This appears to be what motivated a joint Fed/Treasury statement on March 23 -- "The Role of the Federal Reserve in Preserving Financial and Monetary Stability." This statement did not attract much attention since it was buried by other news.

The Federal Reserve clearly does not want to be in the credit allocation business and wants Treasury to take off its hands as soon as it can the "so-called [and opaque] Maiden Lane facilities." The statement also highlights the difficulty the Fed has had with both implementing monetary policy and dealing with the crisis, and it makes reference to the help the Treasury has provided the Fed in this regard with the Supplementary Financing Program. In addition, the statement mentions that Treasury and the Fed will ask for legislation "to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves." This probably means that the Fed wants to be able to issue its own securities, an idea that has some problems which I am sure will surface in Congressional hearings if pursued.

What this all shows is the continuing overlap in monetary and fiscal policy. The Treasury has been helping the Fed in monetary policy by borrowing funds it does not need, and the Fed has been using its ability to provide financial assistance to certain institutions and sectors of the economy because the Treasury does not have the resources to do it in a more accountable manner.

Treasury Cash

An arcane sign of how much economic conditions have changed is worth noting. Treasury’s cash management has changed. It had been the practice until September of last year for Treasury to maintain about $5 billion at the Federal Reserve and the remainder at commercial banks in Treasury Tax and Loan Accounts. This began to change last September, when Treasury and the Federal Reserve announced that Treasury would issue bills in order to deposit cash in a special “supplementary financing account.” As I discussed in the first post to this blog, this was intended to help the Federal Reserve with it monetary policy operations.

Beginning in late October, the balances that Treasury holds in its general account at the Federal Reserve began increasing, along with cash in the supplementary financing account that topped $500 billion. Subsequently, the amount of cash that Treasury held at commercial banks began decreasing to the $1 to $2 billion level. Currently, holdings of $60 to $70 billion in the general account are typical along with somewhat under $2 billion in Tax and Loan Accounts. Also, as of the end of March, Treasury had almost $200 billion in the supplementary financing account at the Fed. (The Treasury has continued with this program; the latest cash management bill to finance this account was announced on March 30 to be auctioned on April 3. Treasury is offering $35 billion of 56-day bills.)

Treasury does not appear to have made any statements concerning the change in cash management practices. Here are some reasons that come to mind that may explain the changes.

  • The amount of collateral banks are willing to pledge as collateral to accept Treasury deposits may have decreased.
  • The interest rate on TT&L accounts is set at 25 basis points lower than the fed funds rate. This means that Treasury is not be getting any interest on its TT&L deposits. While deposits at the Fed do not explicitly earn interest, they do drain reserves from the banking system. The Treasury may figure that Fed earnings increase because of the offsetting actions the Fed takes. Since increases in Fed earnings increase the amount the Fed pays Treasury as “interest on Federal Reserve notes,” this is the equivalent of receiving interest on the deposits. If this is a factor in the change in Treasury cash management practices, it is not clear how much implicit interest the Treasury considers it is earning on its deposits at the Fed. Complicating the analysis is the interest that the Fed pays on required reserves and excess reserves since last October.
  • Treasury may be holding substantial amounts of cash in order to have it ready in order to be able to respond to financial developments quickly.

By way of background, when interest rates began climbing in the 1970s, Treasury began holding higher balances at the Fed since at the time there was a prohibition on banks paying interest on demand deposits. Increases in Treasury deposits at the Fed forced it to take offsetting actions in the repo market, which served to increase Fed earnings and consequently the amount it paid to Treasury periodically. (The Fed remits its earnings above its expenses to the Treasury.) The Fed was not happy about the operational difficulties of offsetting Treasury cash balances, which can fluctuate considerably. Legislation was passed in the late 1970s that enabled banks to pay interest to the Treasury on its deposits. The Treasury set the interest rate at the fed funds rate minus 25 basis points, which at the time was a good proxy for the overnight repo rate. To help the Fed out with its operational concerns with fluctuations in Treasury cash balances, Treasury targeted a fixed cash balance at the Fed. There continued to be times when the balance at the Fed was over the target level. A principal cause of this was the amount of collateral the banks wanted to pledge to accept Treasury cash was limited. Over the years, Treasury has broadened the types of collateral it will accept in order to increase the amount of cash the banks would be willing to accept in TT&L accounts.

(Data on Treasury cash balances are reported in the Daily Treasury Statement.)

Thursday, March 19, 2009

The Importance of Impressions

Given the magnitude of the problems in the financial sector, the government programs initiated to ameliorate the situation ultimately depend on a good degree of public support or, at least, acquiescence. This poses a special challenge when it comes to the arcane issues of the banking system and financial markets.

It is somewhat surprising that in this regard the Federal Reserve has recently done a better job than the Treasury in explaining itself. Normally the Fed is secretive and strives to maintain an aura of omniscience. The attitude they often project is that lay persons need not bother with the details known only by the Fed’s high priests. There is a reason, after all, that William Greider chose the title Secrets of the Temple for his 1987 book on the Fed.

Earlier this month, though, Chairman Bernanke, in an unusual public relations move and a welcome change, granted 60 Minutes an extensive interview. (It can be viewed here.) Whether or not one agrees with all that the Fed has done in response to the crisis, my impression was that the interview served Bernanke and the Fed well. It humanized the Fed chairman, and he explained what he was trying to do. The Fed seems to realize that it is necessary to explain itself as best it can as it continues to take large and unprecedented actions.

It is worth noting that Michelle Smith, who worked at Treasury in Public Affairs and eventually headed it during the Clinton Administration, is one of the key people at the Fed directing its public relations strategy. Secretary Rubin, one of the Treasury Secretaries for whom Smith worked, had one of the best public images of any Secretary while he was in office. Some of the credit for that goes to Treasury's Office of Public Affairs.

The Treasury’s current public image needs improvement. The rollout of the strategy to address the problems of the financial sector was widely panned. The AIG bonus and retention payment fiasco is threatening to undermine that strategy, both because it has weakened public and Congressional support for new initiatives and because it has caused private entities with whom Treasury wants to have help it price and purchase “toxic assets” reevaluate whether they want to enter into a partnership with the government. The New York Times in an article today entitled “A.I.G. Uproar Is a Defining Moment for Geithner” called this week “perhaps the worst week in a string of bad weeks for the Treasury secretary.” Criticism is coming from across the ideological spectrum in Congress and elsewhere.

Secretary Geithner can probably surmount his current troubles if he can provide a credible plan to deal with the current financial problems and can get his political team in place. He also has to figure out how to sell his programs to the public and to Congress. He has some time, but it is finite.

What Treasury and the Administration need to avoid is prompting comments such as that Simon Johnson posted on the Baseline Scenario on March 11: “At last, our long wait to learn the Administration’s policy on banking is over. The policy is: wait.” Somewhat better was David Wessel’s article in today’s Wall Street Journal – “Believe It or Not, Treasury Has a Plan to Fix Banks.” The concluding sentence, though, reads: “The Geithner plan might not work. It does exist.”

Geithner needs to be both creative in his approach to the problems in the financial sector and in explaining his initiatives. We should all hope he succeeds.

Tuesday, March 10, 2009

Treasury's Troubles

The continued absence of a fully formed, credible plan to deal with the banking crisis is troubling. Alan Greenspan, Paul Krugman, and Simon Johnson all think that some form of temporary nationalization of some major banks is necessary. The banks would be cleaned up, and sold back to the public without their “toxic assets.” The Obama Administration has so far dismissed this idea as impractical. Alan Blinder, writing in Sunday’s New York Times, also criticizes “nationalization,” but his “good bank/bad bank” proposal seems similar. No one is very clear about the details of how their preferred solution would work.

Criticism of Treasury is increasing. For example, Secretary Geithner’s was interviewed for NPR/Planet Money. A post by James Kwak on The Baseline Scenario website takes Geithner to task on his statements concerning valuing bank assets and nationalization in that interview. Simon Johnson, writing for the same website, finishes a comment on the interview by asking: “How long can you say, ‘we are being bold’ when in fact you are not?” Paul Krugman has been equally critical, while some Republicans on the Sunday talk shows are saying that some banks should be left to die.

Meanwhile, the absence of senior political appointees at the Treasury has received significant attention. According to the press, two people who were being considered for top Treasury posts – Annette Nazareth for Deputy Secretary and Caroline Atkinson for Assistant Secretary for International Affairs – have withdrawn from consideration. The Washington Post this morning is reporting that Lee Sachs, who reportedly was being considered for Under Secretary for Domestic Finance, is also contemplating withdrawing his name. It is unclear what is going on.

The press is painting a picture of Secretary Geithner being all alone at Treasury. Of course, this is not quite accurate. Treasury career staff is on the job, as well as political types, such as Lee Sachs, who have been helping in capacities that do not require Senate confirmation. Stuart Levey, Under Secretary (Terrorism and Financial Intelligence), a holdover from the previous Administration, has been asked to remain and is still on the job. Ted Truman, an Assistant Secretary for International Affairs in the Clinton Adminstration and a long-time senior Fed staffer, has agreed to work at the Treasury providing advice on international issues for six weeks.

Still, Treasury needs to fill the Deputy Secretary and the Under Secretaries for Domestic Finance and International Affairs positions and the Assistant Secretary slots reporting to these Under Secretaries soon. Senior career staff cannot speak with the authority of Senate-confirmed appointees, and many may be leery of formulating and advocating bold policy initiatives.

"Bad Bank" -- This American Life

This American Life (a radio program) recently had an interesting show on banks and the financial crisis. It starts out with a very simple and entertaining explanation of a bank balance sheet showing negative net worth. For those of you for whom this is too elementary, stay with the program; it gets more interesting. The program ends with a story of two entrepreneurs in New Jersey who are doing their small part to help homeowners and make money for themselves at the same time. They buy non-performing mortgages on properties they are familiar with at low prices from hedge funds and then make deals with the homeowners.

The most amusing line in the program is during the discussion of a research note written by an economist at Deutsche Bank. The research note states that the taxpayer one way or another is going to pay for the banking crisis. Simon Johnson, a professor at MIT Sloan School of Management and former chief economist at the IMF, call it a "ransom note." At some point someone in the program says something like: "That's a nice global financial system you have there. It would be a shame if anything happened to it."

The program can be listened to or downloaded here.

Friday, February 27, 2009

Gary Gensler’s Nomination Hearing

On February 25, Gary Gensler appeared before the Senate Committee on Agriculture, Nutrition & Forestry at a hearing on his nomination to be Chairman of the CFTC. The hearing went well for Mr. Gensler, and it is very likely that he will be confirmed.

Not surprisingly, Gensler stated that his views had “evolved” concerning OTC derivatives, since he was a Treasury Under Secretary advocating passage of the Commodity Futures Modernization Act of 2000. He stated that OTC derivatives dealers should be regulated but was careful not to specify under what statutory framework nor by which agency. Given that the Obama Administration will be making proposals concerning financial regulation, that was prudent on Gensler’s part.

He also spoke favorably concerning establishing clearinghouses for standardized products. That has become conventional Washington wisdom, though there may be some push back on mandating central counterparties by industry participants. Arguments against this include that the concentration of risk in a single entity is itself a source of systemic risk and that netting efficiencies may not be realized. (On the latter point, see this draft paper by Darrell Duffie and Haoxiang Zhu of Stanford University, “Does a Central Clearing Counterparty Reduce Counterparty Risk?") Arguments for a central counterparty include greater transparency, increased discipline (including consistent rules about the posting of collateral), operational efficiencies, and easier access by government regulators to information. In addition, regulators could exert more control over the market by regulating a clearinghouse and central counterparty, which, depending on who you are, is either a pro or a con.

Gensler went to great lengths to reassure the Senators that he would be a tough regulator. I see no reason not to believe him. The OTC derivatives industry will also likely not be entirely comfortable with him at the CFTC, though it is not clear at this point what the extent of his authority and influence on OTC derivatives policy issues will be.

What was somewhat surprising in the question and answer portion of the hearing was Gensler’s remarks about the price runup in tangible commodities prices, especially oil last summer. He stated that tangible commodities had come to be viewed as a separate asset class for those seeking diversification, and he said this was a major cause of the increase in prices. He also said that those who invested in commodities such as oil expected prices to increase, but like those investing in real estate, they proved to be “terribly wrong,” with adverse consequences for the American people.

The price of oil is notoriously volatile, and this has been true for a long time. It seems hard, though, to give credence to the argument that the futures markets were the cause of the increase in prices, if that is what Gensler meant. Something has to happen in the cash market for this to happen. The potential for or threat of delivery on the futures market is what causes the price of futures and the underlying cash commodity to be linked and to converge at maturity.

In this connection, Gensler talked about the Hunt Brothers and silver. It is true that the Hunt Brothers took large position in silver futures which eventually resulted in financial disaster for them when silver prices came crashing down from a high of about $50 an ounce in early 1980. But an important point to remember about that episode is that the Hunt Brothers were active in the cash market by buying physical silver and were taking delivery of silver on the futures market.

With respect to oil, it is a voluminous commodity for which there is limited storage capacity. As a CFTC economist once characterized it to me a long time ago, it is a “flow through” market. Once the oil is out of the ground and in the system of tankers, refineries, and delivery of refined products to users, it has to be kept moving and therefore sold at the market clearing price. Room has to be made for the oil that keeps coming. Very few market participants have the capacity to store a significant amount of oil somewhere and therefore drive up the price. If the futures market gets out of line with underlying cash market fundamentals, the likely result is that knowledgeable traders will take the opposite side of the trade, since they know the futures price has to converge with the cash market price. In other words, the explanation of the runup in oil price last summer has to be sought elsewhere than in the futures market.

Gensler went further in this discussion of tangible commodity prices and advocated position limits, thus implying that those in place are not tough enough. One hopes that this does not mean that the CFTC or the exchanges should use tools such as imposing stricter position limits in order to affect market prices. The CFTC prides itself on being a market neutral regulator. The futures markets, ignoring transaction costs, are a zero-sum game – the gains and losses exactly offset each other. The regulator should not be taking sides.

In any case, the imposition of stricter position limits on oil futures would be unlikely to affect the market price in any significant way. Also, the price of oil has come down – where is the chorus of complaints about the short sellers? – and OTC derivatives issues are more likely to be an immediate issue for Gensler, as well as the managing of the CFTC’s relationships with the SEC and the bank regulators.

Wednesday, February 18, 2009

Further Thougts on Financial Regulation

The ability of the federal and state governments to navigate the current economic and financial troubles is in some doubt. The U.S. Congress divided on partisan lines on the stimulus bill, and the political mess in Sacramento, which one can only hope does not lead to an avoidable economic disaster, does not make one sanguine about what may come next.

With emotions heightened by economic fears and distress, the issue of restructuring the financial regulatory system in the U.S. will be taken up, probably sometime this year. There will be demands to do something, but it will be difficult to agree on what that should be. The hope is that the necessity to compromise on legislation and incorporate ideas from people with different philosophies results in laws that are both widely accepted and effective. Sometimes, though, this results in poorly drafted and self-contradictory legislation, and the courts are left to sort out the resulting mess.

For example, the Commodity Exchange Act is a badly drafted statute, and has generated much litigation over its meaning, with the SEC and the CFTC often offering courts opposing briefs. The litigation reached the point of near absurdity, at least from this non-lawyer’s point of view, when a Supreme Court case hinged on the definition of the word “in.” The 1997 case, Dunn v. CFTC, concerned what would seem like a simple question – whether or not the CFTC had jurisdiction over OTC foreign currency options. But this question, and others revolving around the limits of CFTC jurisdiction over derivatives, consumed an inordinate amount of time and energy in disputes among government agencies and different industry groups for approximately 25 years. This is something to be avoided.

But will it be? The concern rises from both the charged political atmosphere and the Paulson Blueprint, which many think, or are hoping, will provide the framework for considering regulatory restructuring issues.

The difficulty of dealing with these issues in an atmosphere of economic fear and political calculations needs no explanation. It should be noted, though, that financial regulatory issues are often difficult to deal with, even in somewhat calmer times. The Gramm-Leach-Bliley Act, enacted in November 1999, for example, led to a long, bitter fight between the SEC and the bank regulators over what securities activities bank trust departments could engage in without triggering SEC broker-dealer registration and other requirements.

The Paulson Blueprint posits as the “long-term optimal regulatory structure” a regime governed by three “distinct” regulators. Each of these regulators would be focused on one of “three key” areas – market stability, prudential financial regulation for entities benefitting from government guarantees, and business conduct regulation. The market stability regulator would be the Federal Reserve; the two others would be newly created agencies. In addition, two other government agencies would be created – the “Federal Insurance Guarantee Corporation,” with very limited regulatory authority, and a “Corporate Finance Regulator.”

Part of the problem with this structure is the potential overlap in the three areas. For example, the catalyst for the current financial crisis was the problems with subprime mortgages. Extending mortgages to individuals for more than they could afford on the belief that a rising housing market would make everything all right, and in any case the mortgages would end up in someone else’s portfolio, would seem to be a business conduct issue. But it turned out to be also something that would involve prudential financial regulation and market stability. Who would be responsible for something like this under the new structure. What if the three regulators disagreed?

Another issue that raises some concern is the role of the Federal Reserve in this structure. It is clear why the Paulson Blueprint assigned the Fed this authority, since there is no clear alternative. The Treasury Department is not set up to do this, and it does not have the continuity in the most senior positions to perform this function with any degree of consistency over time.

The Fed, though, would be losing its current authority over Fed member state-chartered banks. It would be monitoring and gathering information on potential risks to the system, without being involved in the normal examination process. One could well imagine that the Fed would be looking for things to do, and that this would bring it in conflict with the other two regulators.

Moreover, many observers think the Federal Reserve has made some mistakes in recent years that have contributed to the current crisis. Arguably, interest rates were kept too low for too long, especially in the face of a housing bubble that the Fed was late to recognize, and it did not use its authority to curb abuses in subprime mortgage lending practices. While this will be debated, if the Fed’s monetary policy is mistaken at some future point and is leading to market instability, how can it adequately perform the role of market stability regulator? There is no good answer to this question, and, if one thinks that there should be a dedicated market stability regulator, the Fed is the logical choice, but there may need to be a change in the Fed’s structure to do this well. Or, one may want to rethink this issue.

The Paulson Blueprint appears to take a middle position between the very fractionated regulatory system in the U.S. and the single financial regulator in the U.K. Otherwise, the Blueprint likes the idea of “principles,” rather than rules-based regulation, said to be operative in the U.K. It is not totally clear what this distinction means, since the U.K.’s Financial Services Authority has issued plenty of rules, and, one hopes, financial rules are based on principles. At the time, “principles-based” regulation seemed to be easily deciphered code for lighter regulation, but that is clearly not going to happen any time soon.

In any case, both the U.S. and the U.K. regulatory structures did not perform well as the seeds of the current crisis were germinating. The current buzz phrase is “smart regulation,” as contrasted with tougher or weaker regulation. This sounds good, but what does it mean? No one is for stupid regulation.

The Administration and Congress should proceed carefully and thoughtfully as it considers regulatory structure and not pass something just so that they can say they did something. The U.S. regulatory structure was not planned and is the result of particular historical circumstances. It can be improved. But there are limits on what can be accomplished now to deal with future problems. We do not know what those will be, and ultimately we will depend on the people in power at the time to develop appropriate policy.

Wednesday, February 11, 2009

The Regulators’ Dilemma

Listening to the chatter about the economy, one could be excused from concluding that the problem is that Americans both do not save enough and do not consume enough. While we are taken to task for our low savings rate, arguments rage about how much of a tax rebate will be spent and, therefore, “stimulate” the economy. The politicians hope rebates will be spent, and the personal finance columnists urge that individuals use them to increase savings or pay down debt.

Remember the discussion of the “paradox of thrift” and the “fallacy of composition” in the Samuelson economics textbook that used to have a near monopoly for introductory economics courses. If each person acts in his best interest, this may not always serve the common good, it was argued. An example is everyone standing up to watch a critical play at a sporting event.

These concepts can be imported to the current banking situation. While part of the blame for the current financial crisis is ascribed to banks for lowering their credit standards and making risky loans, the banks are now being urged to make more loans. From the point of view of any particular bank, however, lending has gotten riskier given the state of the economy. Hence, having been burned on some of the loans and investments they made when times were good, they are understandably cautious in their lending activities now. The economy, though, could benefit from increased lending, thus serving to lower the overall default rate.

Given this, what is the federal government and the numerous regulators of banks supposed to do? Should they crack down on lending practices to make sure their charges do not get into further trouble, or should they somehow encourage increased lending? This dilemma may have been avoided if the regulators had been tougher when times were good, but then most people thought things would never get this bad.

Wednesday, February 4, 2009

Organizational Boxes and the Limits of Financial Regulation

Now that it has happened, the current financial and economic crisis can be said to be overdetermined. Choose whom or what you want to blame – the Fed for keeping interest rates too low for too long and not using its existing authority to limit subprime mortgage abuses, financial market participants for employing excessive leverage and/or lax credit standards, Fannie Mae and Freddie Mac for undertaking too much risk with too little capital and contributing to the weakening of mortgage underwriting standards, novel financial products such as certain OTC derivatives and CDOs for creating hard to understand linkages among market participants and contributing to excessive risk-taking, regulators for failing to do their jobs, etc. It now all seems so clear that this was inevitable, but, before it happened, the consensus not so long ago was that the worst that could happen was perhaps a leveling off of housing prices and some containable problems with subprime mortgage defaults and foreclosures. Those predicting disaster were dismissed, at best, as having an interesting point of view.

In reaction to the current economic travails, there are calls for restructuring our financial regulatory system to make sure this does not happen again. Our financial regulatory system has some obvious flaws, and the performance of regulators has been less than optimum. The system could benefit from change. But we should not delude ourselves that there is some ideal regulatory structure that will prevent all further crises. After all, most people, in and out of government, missed that the financial system was waiting for a match, which turned out to be the problems in subprime mortgages, to start the forest fire with which we now have to contend. Moreover, neither the single regulator model in the U.K. nor the fragmented regulatory structure in the U.S. performed admirably as this crisis was developing.

In any case, regulatory restructuring will be difficult to accomplish. For evidence, just look at the Special Report on Regulatory Reform by the Congressional Oversight Panel (created by the TARP legislation). The three members of that panel appointed by Democrats approved the report, and the two members appointed by Republicans essentially produced another report. To compound ideological differences, there will also be turf considerations among Congressional committees and government agencies and the business interests of those subject to regulation as legislative proposals are considered.

An obvious problem that should be corrected at some point is the fragmented nature of bank regulation and the budgetary incentives for the Office of the Comptroller of the Currency and the Office of Thrift Supervision to retain the institutions they charter. But making wholesale regulatory reform as was done in the 30s should not be done in haste. Some consensus needs to be formed about what it is we expect from financial regulators.

An example of regulation that was done badly was the creation of the Office of Federal Housing Enterprise Oversight (“OFHEO”) in the early 1990s as the financial safety and soundness regulator of Fannie Mae and Freddie Mac. There was justifiable concern in the George H.W. Bush Administration about the risks these institutions posed to the financial system and to the federal government, which everyone knew would be called upon to help out if the firms got into financial trouble. But OFHEO failed. Fannie Mae and Freddie Mac became riskier, not safer, during the period they were regulated by OFHEO. The mistake of establishing a small regulator charged with overseeing two enormous and politically powerful entities is not likely to be repeated. But that does not mean other mistakes will not be.

Among other issues, careful thought is needed concerning how much power should be concentrated in one or several agencies, how to resolve issues of regulatory overlap if there is more than one agency, and the proper regulatory role of the central bank. Also the management of potential conflicts among agencies need to be considered, such as one agency charged with encouraging prudential lending practices and another agency concerned that a credit crunch is stifling economic growth.

Thursday, January 29, 2009

SEC/CFTC Merger?

Reform of the financial regulatory system is high on the public policy agenda, since it is widely perceived that the current system has failed us. One of the options that always comes up in these discussions is merging the SEC and the CFTC.

The case for merger is simple. Since the CFTC began operations in 1975, the importance of the financial products it regulates has grown and become the largest area it regulates. In addition, the CFTC and the SEC regulate similar products in different ways. Questions about which regulatory scheme, the SEC’s or the CFTC’s, governs innovative new products as they are introduced have plagued the relationship between the two agencies right from the start and continue to cause difficulty. Would it not be easier to resolve these issues and achieve consistent regulation for similar products if there were only one agency?

This case makes sense, and, if one were to design a regulatory scheme from scratch, one would not create a separate SEC and CFTC. But we are not starting from scratch. Merging these two agencies would require great effort. The politics are difficult, as are the details.

The Paulson blueprint for regulatory reform recommended merging the two agencies as an interim step. It also recommended that the resulting agency become a “principles-based” regulator, on the model of the CFTC after the passage of the Commodity Futures Modernization Act (“CFMA”).

That last recommendation is not likely to fly in the current environment. Recall that the motivation for the Paulson blueprint was the perception of some that London was taking financial business away from New York because the British employed a lighter regulatory touch and did not burden financial intermediaries with too many rules. That perception is debatable, but the current consensus is that the financial regulatory system has been too permissive, not that it has been too tough.

The political problem of going the other way, that is, imposing SEC-type regulation on the futures exchanges, is obvious. There are also a myriad of other issues and details that would need to be resolved in order to accomplish merger.

The SEC and the CFTC signed a memorandum of understanding on March 11, 2008, in an attempt to manage their jurisdictional issues. (I wrote an article about this for the Journal of Taxation of Financial Products, vol. 7, no. 3.) This is an appropriate way for the agencies to manage their potentially overlapping jurisdiction under the current regulatory structure. Moreover, the heated jurisdictional debates between the CFTC and other financial regulators have abated since the enactment of the CFMA. Whatever else one may think about that legislation, it did accomplish that.

At the moment, addressing the failures of the bank regulators and the SEC should have priority over merging the SEC and the CFTC. Given the enormous effort it would take to merge the two agencies, it should not be undertaken except as possibly part of a more comprehensive reform of the financial regulatory system. And before that can be done, policymakers need to decide what they believe financial regulation should do and what it should not do. Then they can think about making changes in how the Executive Branch is organized to accomplish this.

Thursday, January 22, 2009

Brooksley Born and the Regulation of OTC Derivatives

An important agenda item for the new Administration is reform of financial market regulation. As of now, it is not clear what the Administration will propose. There is a general feeling that the current regulatory system has failed, especially the bank regulators and the SEC.

The CFTC has for the most part remained in the background. It has over the past year received some attention because of increases in energy prices, which some would blame, with little evidence or logic, on the activity of speculators in futures markets. Now that energy prices have come down, that issue has receded. The current financial crisis has not shined the spotlight on the CFTC, for which I am sure the people who work there are grateful.

Currently, there is a tendency to lionize former CFTC Chairperson Brooksley Born for her stand on the regulation of OTC derivatives in face of the opposition of Secretary Rubin and Chairman Greenspan. The story is a little more complicated than that. Here is a brief account of what I remember from that time.

It is true that the CFTC under Chairperson Brooksley Born had pushed for greater regulation of OTC derivatives. The CFTC had in mind clawing back 1993 exemptions for swaps it had issued after being granted the authority by the Futures Trading Practices Act of 1992.

Brooksley Born failed in this effort. One of the reasons for her failure is that she stubbornly maintained that OTC derivatives were subject to the Commodity Exchange Act (“CEA”), an argument, which, for technical reasons, put into question the legality of certain outstanding derivatives, such as total return swaps based on equity securities. It also seemed by her insensitivity to this issue that she was motivated too much by turf considerations. That guaranteed that others, especially the bank regulators, would oppose the CFTC on this.

Secretary Rubin was, in fact, concerned about OTC derivatives because he felt that they might be increasing systemic risk. (It should be kept in mind that the Treasury had little turf to be concerned about with regard to this issue, except that of the Office of the Comptroller of the Currency, which is fairly independent from the Departmental Offices and, consequently, is often left to fend for itself.) Because Rubin had sympathy with Born’s policy concerns, though not her legal arguments or apparent turf grabbing, he proposed that the President’s Working Group on Financial Markets ask a series of questions to the public about OTC derivatives, similar to the questions the CFTC had prepared for a concept release on the subject. Born refused, and despite pleas from the other members of the PWG, went ahead with the concept release in May 1998.

Her intransigence on this subject drove Rubin into Chairman Greenspan’s corner, much to the relief of the major OTC derivatives dealers who were not unaware that the Secretary was not entirely comfortable with their business. There is a chance that, if Born had approached Rubin and SEC chairman Arthur Levitt with her policy concerns rather than with her legal arguments, she might have been able to get their support for some greater oversight of the derivatives industry. It is possible that some of the discussion would have focused on how to do it and who should do it, though Greenspan and others would have continued to argue that any government interference in the form of regulation of this market would be harmful. In any case, that would have been a healthier and more productive debate than the endless, and ultimately boring, legal debate over whether swaps are futures.

Both Brooksley Born and Secretary Rubin left their government posts in mid-1999. They were replaced by William Rainer at the CFTC and Larry Summers at Treasury. The change in personnel made possible for the PWG to make unified recommendations on the CEA in a November 1999 report, Over-the-Counter Derivatives Markets and the Commodity Exchange Act. This paved the way to the eventual enactment of the Commodity Futures Modernization Act of 2000 at the end of the Clinton Administration.

The CFTC under Rainer gave up any ambitions to regulate the OTC derivatives market and accepted lessened regulatory authority over the futures exchanges. But now with talk of both merger of the CFTC with the SEC and the desire, though hardly universal, for greater regulatory oversight of the OTC derivatives market, the issues of how to rationalize regulation in this area will come to the fore. The issues are both substantively and politically very difficult.

Friday, January 16, 2009

Stretching the TARP

On September 20, 2008, the text of a legislative proposal the Treasury Department had delivered to Congress to deal with the ongoing financial crisis became available on the internet. It was a short document -- 3 pages. It was also breathtaking in the non-reviewable authority it gave the Secretary.

Alan Blinder was so flabbergasted by the proposal that he said on the Diane Rehm show (a radio talk show produced by Washington, DC's WAMU and also heard on other NPR stations) that Secretary Paulson "should be dismissed." He went on to say that the Constitution was more "precious" than the financial system.

The legislation enacted on October 3, 2008, setting up the Troubled Assets Relief Program ("TARP") was considerably longer than 3 pages and dealt with other issues in addition to TARP. However, as it turned out, the legislation could be interpreted broadly, probably more broadly than many in Congress realized.

While the legislation is clearly aimed at providing the Treasury the authority to purchase mortgage-related assets, the Treasury up to now has not used the TARP money to do that. The definition of "troubled asset" in the Act allows the term to mean, in addition to mortgage-related instruments, "any other financial instrument that the Secretary, after consultation with the the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress." That provision is apparently what was used to justify the use of TARP money to inject equity into banks. (Nouriel Roubini posted an interesting account on his RGE Monitor website of how a colloquy on the House floor between Congressmen Jim Moran and Barney Frank to create legislative history on this point was arranged. See "How authorization to recapitalize banks via public capital injections (“partial nationalization”) was introduced - indirectly through the back door - into the TARP legislation." Registration may be required to read the whole post, but there is no charge for this.)

The justification for using the TARP money for loans to General Motors and Chrysler is dicier, and it is probably one of the reasons that the Administration urged Congress to pass separate legislation on helping the auto companies.

The authority granted to the Secretary is to use TARP funds "to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution..." Making a loan, I suppose, can be viewed as the purchase of a "troubled asset," even if a newly created one, but one doesn't usually think of GM and Chrysler as "financial institutions."

The definition of financial institution in the legislation reads as follows: "The term ‘financial institution’ means any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company, established and regulated under the laws of the United States or any State, territory, or possession of the United States, the District of Columbia, Commonwealth of Puerto Rico, Commonwealth of Northern Mariana Islands, Guam, American Samoa or the United States Virgin Islands, and having significant operations in the United States, but excluding any central bank of, or institution owned by, a foreign government."

As far as I can tell, the Treasury has not provided a rationale for GM and Chrysler being financial institutions under this definition, but Professor Randy Picker of the University of Chicago Law School has ("Can You Put Cars Under the Tarp?"). His argument is that, according to this definition, a financial institution is "any institution," with some foreign exceptions. He does not address the meaning of "established and regulated."

In other words, according to this reading, the word "financial" is to be ignored and the non-exclusive list of financial institutions does not really mean much. In any case, the professor argues, the Treasury, as the agency entrusted with administering the Act, is owed "Chevron deference."

Well, it seems a bit of a stretch, whatever one thinks of the merits of bailing out the auto industry. As one might expect, there was criticism from the right -- for example, see Rich Lowry's post, "Paulson’s Pliable Plan." But Robert Reich, a supporter of helping the auto industry was also troubled as he said in a posting on his blog -- "The Big Three and TARP: What Happened to Democracy?" He essentially argues that this use of the TARP money made it a slush fund.

The Treasury probably did not want to be this aggressive in using the TARP authority, but top Treasury officials probably thought that, as long as they had an argument, they had to do this.

It looks to me that Senator Corker and others wanted to break the UAW. Nobody blinked, and the Administration felt it could not let GM and Chrysler file for bankruptcy on their watch. The Republicans probably pressed too hard against the union. After all, the UAW will be less powerful for some time because it has been unsuccessful in organizing the foreign-owned factories and because of the financial condition of the U.S. car companies. They know this.

I doubt that very many members of Congress thought they were giving the Treasury Secretary the power to make a loan to any U.S. entity that is an "institution" when they passed the TARP legislation. Congress will probably be motivated to be more careful about their drafting on this subject in the future. I think this will be more a political issue rather than a legal one, since I don't think the courts will be asked to decide it.

Thursday, January 8, 2009

The Treasury Stretch

In response to the current financial crisis, the Treasury and the Fed have been creative in using their legal authorities. In a previous post, I discussed the Treasury's issuance of Treasury bills to help the Federal Reserve out, not because it needed the additional money.

Treasury announced this program on September 17, stating that it "will provide cash for use in the Federal Reserve initiatives." On the same day, the Federal Reserve Bank of New York was more upfront about the purpose of the program, stating that the funds raised and deposited in a supplementary financing account "serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives."

This has been no small program. On November 12, the amount in the supplementary financing account totalled about $559 billion, which appears to be about the peak amount. The Treasury issued a press release on November 17 that said: "The balance in the Treasury's Supplementary Financing Account will decrease in the coming weeks as outstanding supplementary financing program bills mature. This action is being taken to preserve flexibility in the conduct of debt management policy in meeting the government's financing needs." The amount in the supplementary account at the end of last year had decreased by $300 billion to about $259 billion.

The Treasury's undertaking this program to help out the Fed in an extraordinary situation seems reasonable, though, as I remarked in my previous post on this topic, it has implications for the responsibility for monetary policy if it becomes a habit. I am, however, disappointed that the Treasury obfuscated what the real purpose was and was glad to see that the FRBNY described what was happening accurately.

But there is another issue. To my knowledge, the Treasury has not provided any legal rationale for its authority to undertake this operation. The relevant portion of Chapter 31 of Title 31 of the U.S. Code granting the Secretary of the Treasury the authority to issue Treasury bills reads as follows:

"(a) The Secretary of the Treasury may borrow on the credit of the United States Government amounts necessary for expenditures authorized by law and may buy, redeem, and make refunds under section 3111 of this title. For amounts borrowed, the Secretary may issue—

(1) certificates of indebtedness of the Government; and

Treasury bills of the Government."

Exactly how the Treasury interpreted this language or any other laws to provide the authority to issue T-bills in order to help the Fed is unclear.

For now, this probably does not matter in a practical sense, because Treasury will not likely be challenged on this.

The issue of legal authority has also come up in the use of the TARP funds to help out GM and Chrysler. That has received more attention than the admittedly arcane subject of this post. The legal issues in the auto company bailout are likely to continue to be raised in a political context.

Wednesday, January 7, 2009

California Scrip?

The California budget impasse continues. Yesterday Governor Schwarzenegger vetoed tax measures passed by the Democrats in the California state legislature. The state is forecast to run out of cash soon, and there is even talk about it issuing IOUs ("registered warrants") for tax refunds. It is unclear whether banks will accept this scrip or whether a market will develop for them.

If this happens and the scrip is outstanding for a while, it could be similar to California issuing its own money (even if not very good money), though I am sure the state's lawyers will have prepared arguments about why the warrants are not money.

In 1992, the last time California issued scrip, it was used to pay California state employees. Using it for tax refunds raises the profile of this maneuver to a new level. Maybe this will force the needed two-thirds of the state legislature and the governor to come to a compromise on the budget. (For the type of comment about this that would become more general if the warrants are issued on a large scale, click on this link.)

California's financial situation also highlights the general problem that, as the federal government plans a stimulus package, this will be offset to some extent by state governments being forced to cut spending, raise taxes, or some combination of both. Paul Krugman recently had a column about this problem ("Fifty Herbert Hoovers").

Saturday, January 3, 2009

The Beginning of an Occasional Blog

One of the disconcerting aspects of working for the government is reading misleading or inaccurate descriptions of policy and finding these difficult or impossible to correct. One of the purposes of this blog is to let me publish my observations about these descriptions, though at this point I don’t know if many will stumble on this blog to read them.

A case in point. A few months ago I read that the Treasury was issuing Treasury bills not because it needed the money but to enable the Fed to “expand its balance sheet.” But the Fed needs no help from Treasury to expand its balance sheet. All it needs to do is buy something or make a loan. When it does this, it credits a bank with reserves, which is a liability on the Fed’s balance sheet. The offsetting asset is whatever the Fed bought, most likely a security, or the loan it made. This process is often referred to as “printing money.” I prefer to call it “creating money,” since the former term may give some the impression that the Treasury’s Bureau of Engraving and Printing is operating at a feverish pace.

What really was going on was that the Fed’s holdings of unencumbered Treasury securities had fallen to a very low level as a result of its aggressive programs to help out the financial system. It was uncomfortable reducing its holdings of Treasury securities further to reduce the amount of bank reserves it had created through these programs. Therefore, it asked the Treasury to sell bills and deposit the resulting cash at the Fed.

This has the same effect on bank reserves that would result from the Fed selling Treasury securities from its portfolio. The only way the Treasury operation can be said to expand the Fed’s balance sheet is that the Treasury’s operation does not contract the Fed’s balance sheet but a Fed sale of Treasury securities does. In other words, the Fed’s balance sheet is larger than it would have been if the Treasury had not sold the bills but the Fed had achieved the same monetary policy effect through an open market operation.

In the U.S., it has long been thought to be a good idea to keep monetary and Treasury debt management policy separate. Treasury officials and others were most likely sensitive about the blurring of this line in undertaking this operation. It is normal for there to be coordination between the Treasury and the Fed on a daily basis with respect to Treasury cash management, given the flows of Treasury funds between the private banking system and the Fed, but directly using Treasury borrowing operations to assist in monetary policy is a new step.

If the Fed continues to find it necessary to ask the Treasury for help in carrying out monetary policy, this could lead to greater Treasury influence on monetary policy because it can always refuse a Fed request to borrow funds it does not need. The apparent goal of government officials was, if possible, for the issues surrounding the Treasury’s assistance to the Fed not to be raised. They succeeded.