Volcker Decries Fed Response

Barron's: Up And Down Wall Street
Volcker Decries Fed Response To 'Mother Of All Crises'
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By Randall W. Forsyth | 9 April 2008

Former federal reserve chairmen, unlike the old soldiers cited by Douglas MacArthur, rarely fade away. Still, it's unusual for two of them to make news in a single day, and rarer still that they both deliver pointed comments about the crisis that besets the current chairman. But Tuesday, former Fed chief Alan Greenspan was continuing his campaign to counter his critics, who assert his policies inflated the credit bubble, and in so doing, are responsible for the current bust. Then Paul Volcker, Greenspan's predecessor as Fed chairman, delivered a sharply critical assessment of the recent steps taken by the central bank in addressing what he called "this current mother of all crises."

At the same time, the current Fed under the leadership of Ben Bernanke is trying to cope with credit crisis and the weakening economy feeding on each other in a vicious circle— even as inflationary pressures intensify. In an op-ed piece in Monday's Financial Times and a page one story in Tuesday's Wall Street Journal, Greenspan defended his record against critics who contend the Fed pushed short-term rates too low and held them down too long in 2003-2005. In so doing, they say, the Greenspan Fed helped to ignite the boom in mortgage lending at adjustable rates and to subprime borrowers that now is coming unraveled. Of course, Greenspan bristles at this version of history.

Meanwhile, Volcker, in a speech to the Economic Club of New York, took issue with the Bernanke Fed's response to the current crisis, especially in lending to investment banks and in its role in the takeover of Bear Stearns by JPMorgan Chase. "The immediate response to the crisis has been to resort to untested emergency powers of the Federal Reserve. Out of perceived necessity, sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank," Volcker said [[but much to the advantage of the member and other 'large' banks— a bailout with taxpayer's money: normxxx]].

Referring to the Fed's role in financing JPMorgan's acquisition of Bear, Volcker said: "What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis— 'lend freely at high rates against good collateral'— to the point of no return."

The former Fed chief, whose defeat of inflation was the signal accomplishment of his tenure from 1979 to 1987, worried about that particular risk as a result of this rescue effort. "The apparent pressure of the Federal Reserve to take many billions of uncertain assets onto its own balance sheets raises questions that must be decisively answered by demonstrating the commitment to deal with emerging inflationary pressures— that is all the more important in the midst of the weakness of the dollar internationally and our dependence on foreign capital," Volcker added.

Yet, as minutes of the March 18 meeting of the Federal Open Market Committee indicate, the central bank was wary of inflationary pressures but felt it had to grapple with a downward spiral of tightening credit exacerbating weakness in the economy. "Indeed, some believed that a prolonged and severe economic downturn could not be ruled out given the further restriction in credit availability and ongoing weakness in the housing market," according to the FOMC minutes, which were also released Tuesday. Thus, while the Bernanke Fed grapples with arguably the worst financial crisis since the Great Depression, the most recent former chairman claims it wasn't his fault while the one before charges the present one is in danger of doing too much.

Of course, they all have a point. Up to a certain point.

Greenspan continues to assert that it's impossible to spot a bubble before it bursts. He also had said the central bank can counter busts after they happen, but the current episode suggests it isn't so easy. Volcker, for his part, says the current crisis has its roots in the lack of restraint inherent in the highly leveraged system that evolved, one in which winners were rewarded exorbitantly but the inverse didn't [[and doesn't: normxxx]] seem to hold [[the Fed is currently in process of rewarding the worst malefactors of our recent debacle: normxxx]].

All the while, the Bernanke Fed had to deal with the risk of the collapse of one of the major counterparties in credit derivatives, which had the potential to produce a meltdown of the financial system. Could that have happened? Maybe not, but it wasn't a chance worth taking. So, Bernanke & Co. erred in that direction [[but they could have made it a lot more painful to JPM, who stood to lose the most in a BS/CDS market meltdown (JPM is said to be involved in some 55% of all CDS swaps): normxxx]].

A repeat of the rescue of Bear Stearns is made less likely by the innovative new mechanisms put in place by the Fed— its Term Auction Facility of loans, its Term Securities Lending Facility, which swaps illiquid MBS for Treasuries, and the Reporting Dealer Credit Facility, which effectively opens up the discount window to investment banks.

Volcker pointed out much has changed since the time when finance revolved around regulated entities with tight regulatory oversight and a safety net, notably commercial banks. Central banks were created to provide liquidity when large banks faced too high withdrawals (i.e., a 'run on the bank') of their short term deposits funding their illiquid assets, such as long-term loans[[and, strangely enough, less necessary for this purpose in today's world, where there is normally a market for such long-term debt, at a discount: normxxx]]

Securities firms are funded through the market, mainly through repurchase agreements, which are short-term and can be pulled in an instant, as Bear Stearns can attest. In the 21st century finance system, where most credit is created outside of commercial banks, it's arguable that central banks should provide the same backstop for repo lines as they did for bank deposits.

Clearly, as Volcker suggests, this is not a change to be undertaken lightly. But as he also noted in his speech, the notion of returning to the old days of regulated, purely domestic banks is mere nostalgia.

  M O R E. . .

Normxxx    
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