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.