Simon Johnson: WILL THE FED CRUMBLE?

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Is the New York Fed Making a Big Mistake?

EDITORIAL COMMENT:

You might think that getting rid of the FED is a good idea and if there are no changes in FED policy I might agree with you. I still maintain my optimistic and my hope.

Johnson, a well-known, well respected economist formerly with the IMF called the shots in advance, told us the consequences, told us the remedy and still we do nothing. Policy makers are tone deaf to the fact that we are still playing the same game with Wall Street,and that the “banks own the place.” (Senator Dick Durbin, Illinois). Johnson is joined by dozens of well-known and well respected economists and financial analysts who see us merrily speeding toward our doom. The average Joe and Jane on the street understands that we need to address the truth of this matter — we let Wall Street get out of hand and we are slow to put referees back on the field who understand the game.

The former home of our current Treasury secretary, the NY Federal Reserve, is leading the way on terms and data supplied strictly by Wall Street without regard to those of us who understand that things can get worse although it is difficult to imagine the scenario. Johnson is once again sounding the alarm. Is anyone listening? There is plenty to do including dismantling the behemoth monstrosities whose management doesn’t even possess the resources to track all the activities of any one, much less all, of the mega banks. If they are unmanageable they are clearly not regulatable (if that is a word). With “financial services” accounting for close to 50% of what we now count as our gross domestic product servicing an economy that seems to be doing less and less in real services and products, there is lot to do.

But instead of rolling our sleeves up and getting into the dirt to clean up the mess, the NY Federal Reserve continues the same path that led the FED and the country (along with the rest of the world) off a cliff. BOTTOM LINE: LIP SERVICE INSTEAD OF CORRECTIVE ACTION. PROGNOSIS: TERMINAL.

Like the famed Ostrich, our decision-makers are stuck in the sand examining one grain of sand at a time. The elephant in the living room is that proprietary currency, at the urging of Alan Greenspan while FED chairman, has out-paced genuine government currency 12:1, and the situation is getting worse.

Without tackling the challenging task of dismantling of the bank oligopoly, the amount of leverage the FED has on monetary, fiscal or economic policy is minimal. Do the math. Right now the Fed is busy supplying more money through purchases of Treasury bonds, made necessary because the government is out of money. The amount: $600 BILLION. Sounds like a lot of money, right? Wrong. The notional value of all proprietary currency is around one thousand times the size of the latest FED move, which places the effect at just around one-tenth of one percent.

Thus while Johnson and others cry out for reform that will do us some good, the FED is playing around with a few basis points like a $2 broker of yesteryear. In plain language we are still wandering off course without meaningful policy decisions being made by government. The “banks own the place” (Senator Durbin, Illinois) and we are sitting ducks in a zoo of animal analogies.

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By SIMON JOHNSON
Today's Economist

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

An uncomfortable dissonance is beginning to develop within the Federal Reserve.

On the one hand, current and former senior officials now generally agree with the proposition that our leading banks need more capital – that is, more equity relative to what they borrow. (The argument for this has been made most forcefully by Prof. Anat Admati and her distinguished colleagues.)

The language these officials use is vaguer than would be ideal, and they refuse to be drawn out on the precise numbers they have in mind. The Swiss National Bank, holding out for 19 percent capital, and the Bank of England, pushing for at least 20 percent capital, seem to be further ahead and much more confident of their case on this issue.

But an important split appears to be emerging within the Federal Reserve, with the Board of Governors (perhaps) and some regional Feds (definitely) tending to want higher capital levels, while the New York Fed is – incredibly – working hard to enable big banks actually to reduce their capital ratios (in the first instance by allowing them to pay increased dividends).

Officials at the New York Fed with whom I and others have spoken appear to be hardening their position against requiring big banks to maintain more capital (beyond the insufficient increases in the Basel III agreement), though no formal position has yet been taken. These officials will not speak on the record nor provide any details about their arguments or whatever evidence they have developed to support them.

So it is hard to know if any analytical basis exists for their evolving position. They have certainly put up no meaningful counterarguments to the powerful points made by Professor Admati and her colleagues – both in general and against allowing United States banks to increase their dividends now (see also this letter published in The Financial Times).

The single public document from the New York Fed on this issue is a working paper that appeared recently on its Web site. This paper simply assumes the answer it seeks: that higher capital requirements will lower growth, and it refuses to engage with the arguments and evidence to the contrary.

The empirical findings presented fall somewhere between weak and unbelievable. If this is the basis for policy making within the Federal Reserve System, I will be very surprised.

The key point is this. Given that the final capital requirements under Basel III remain to be set by the Fed – and top officials say they are still working on this – what’s the big rush to pay dividends? Retaining earnings (that is, not paying dividends) is the easiest way to build capital (shareholder equity) in the banks.

There is strong logic behind not paying dividends until capital is at or above the level needed for the future.

Without any substance on its side, the New York Fed is increasingly creating the perception that it is just doing what its key stakeholders – the big Wall Street banks – want.

Bankers traditionally dominate the boards of regional Feds. We can argue about whether this is a problem for most of them, but for the New York Fed the predominance of big Wall Street institutions has become a major concern.

At the bottom of the Web page listing its current board members, you can review who belonged to the board every year from 2000 to 2008. Note the presence of influential bankers in the past such as Richard Fuld (Lehman), Stephen Friedman (Goldman) and Sanford Weill (Citigroup). Their firm hand helped guide the New York Fed into the crisis of 2007-8.

The Dodd-Frank legislation reduced the power of big banks slightly in this context, so that the president of the New York Fed is no longer picked by Wall Street’s board representatives (as was Timothy F. Geithner, who was president of the New York Fed until being named Treasury secretary, and William Dudley, the current president and former Goldman Sachs executive).

But the current board of the New York Fed still includes Jamie Dimon, the head of JPMorgan Chase and an outspoken voice for allowing banks to operate with less capital by paying out dividends.

In fact, Mr. Dimon has a theory of “excess capital” in banks that is beyond bizarre – asserting that banks (or perhaps any companies) with strong equity financing will do “dumb things.” This is completely at odds with reality in the American economy, where many fast-growing and ultimately successful companies are financed entirely with equity.

If the New York Fed’s top thinkers have convincing reasons for not wanting to increase capital in our largest banks – if, for example, they agree with Mr. Dimon – they should come out and discuss this in public (and some evidence to support their thinking would be nice).

If the New York Fed were really pushing for higher dividends at this time — for example, by constructing a stress test to justify this action — it would be setting us up to mismanage credit, allowing the megabanks to misallocate resources during the good times and crash just as badly when the next downturn comes.

The top leadership of the New York Fed has a responsibility to engage constructively and openly in the technical debate. Yet some Federal Reserve officials act as if they have a constitutional right to run an independent central bank. This is not the case: Congress created the Fed, and Congress can amend how the Fed operates.

The legitimacy of the Federal Reserve System rests on its technical competence, its ability to remain above the political fray and the extent to which it can avoid being captured by special interests.

The danger that the New York Fed will fatally undermine the fragile credibility of the rest of the Federal Reserve System is very real.

18 Responses

  1. Well — all IS about “impressions” —- “You can fool some of the people all of the time and all of the people some of the time but you can’t fool all of the people all of the time.”

    Quiz — Who said that??

  2. cubed2k- here’s my example as per my previous post: If I decide to sell my house,the buyer will have to put down 20%. This is going to severely limit if not eliminate a possible sale. If,on the other hand, the same buyer purchases a bank-owned property,for which the “bank” paid nothing, and is willing to take 5% or less down with a lower interest rate, then that is the way they will lean. But the banks will defend their 20% down stance as “getting tougher” so as not to encourage any more” deadbeat borrowers who have no skin in the game”. This will further boost the banks’ earnings and give the ongoing impression of a “recovery”.

  3. True. We need to get three chimpanzees and an orangutan, and let them run the formulas with dice and a touch screen computer.

    It really can’t get any worse, than this catatonic waffling will result in. IMO

  4. Ian, people ought to start occupying those vacant homes, squanters rights. Haha.

  5. Ian, so the banks now want 20% down. What does this mean? I don’t know. Just thinking. They need now high down payment because they have to lend on the loan as opposed to selling it into MBS because the market for MBS is dry? But I read somewhere Investors are buying foreclosed homes CASH, not loans. Why aren’t deep pockets buying all the real estate, maybe no clear title. We at our end never know. I just wish to
    God that Congress would outlaw ABS and MBS, that is what has screwed everything up, Neil is right. They have turned a home into an investment. It is a home, where people hang there hat is peace. And when they pay it off, they own it, outlaw property tax as well. What the *uck is wrong with people. One can’t own anything outright without some yahoo sometime someplace saying they own the rights. I think this is called freedom, liberty, whatever.

  6. cubed2k- although the fed might raise interest rates just just to show or attempt to show that they are serious about inflationary pressure, I feel that the fed,treasury and banks have one more hand to play. In yesterday’s WSJ (paper,not sure if online),a number of banks were quoted as stating that they will very soon,or are already, requiring 20% down for home purchases. In a declining market, no less. There are already over 1 million vacant homes which are bank owned or GSE owned, these will probably be sold for 0-5% down, and lower rates,as this real estate cost the banks nothing. Which homes do you think that homebuyers will buy? This “rebound” in home sales and bank profits will kick the can down the road a little farther.

  7. If the Fed raises interest rates, house prices will go down faster from the already decline from foreclosure. If housing continues decline, more and more people going underwater = more foreclosures or walk aways.

  8. The Fed is pushing it’s self into a corner. QE has been the cause of the run-up in the stock market — that was the Fed’s goal – to increase corporate capital and give the illusion of wealth to Americans – so that we may spend our way out of the mess — which, of course, they blamed as the cause for the financial crisis — “Consumers spent too much.”

    If the Fed had not implemented QE — our stock market, corporate capital, and current economy would be in a very different position. And, perhaps the Fed would have been forced to address the mortgage/foreclosure fraud. But, the Fed started it’s game — and had indicated that it has no plans in near future to stop QE.

    QE will eventually backfire. Inflation is escalating and – inflation will be MUCH harder to control. Also, the US dollar as dominant currency will be brought to question.

    Mr. Bernanke looks nervous when he speaks – and he has good reason to be nervous.

  9. My t-shirts read- Got MERS?
    homeowners fighting back

  10. Neil,

    You should contact Jeff Thigpen of Guilford County in North Carolina.

    He is: SEEKS INVESTIGATION OF “MERS” FOR REIMBURSEMENT OF $1.3 MILLION IN LOST REVENUE TO GUILFORD COUNTY

    http://www.zerohedge.com/article/nc-register-deeds-jeff-thigpen-takes-mers-questions-if-county-owed-millions-titles-compromis?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+zerohedge%2Ffeed+%28zero+hedge+-+on+a+long+enough+timeline%2C+the+survival+rate+for+everyone+drops+to+zero%29

  11. […] Simon Johnson: WILL THE FED CRUMBLE? […]

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