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Why It's Time to Abolish the Fed


Regulators only act in hindsight.

The Federal Reserve Bank of Cleveland is proposing a 3-tiered system for regulating systemically important financial institutions (SIFI).

Tier 1 would include high-risk institutions, such as large, interstate banks and multi-state insurance companies.

Tier 2 would include moderately complex financial institutions, such as larger regional banks.

Tier 3 would include non-complex financial institutions, such as community banks.

Each would receive varying degrees of oversight and regulation. In the accompanying video, the author claims: "Really bad drawings…real simple explanations."

Drawing Board: How To Address SIFI

SIFI Framework

1. Size:

As a starting point for a size-based definition, a financial firm would be considered systemically important if it accounts for at least 10% of the activities or assets of a principal financial sector or financial market or 5% of total financial market activities or assets.

2. Contagion:

A financial institution would be considered systemically important if its failure could result in the collapse or freezing up of one or more important financial markets.

3. Correlation:

Correlation, as a source of systemic importance, is also known as the "too many to fail" problem.

4. Concentration:

Concentration has 2 important aspects: the size of the firm's activities relative to the contestability of the market. That is, concentration is less likely to make a financial institution systemically important if, other things being equal, the activities of a distressed institution can easily be assumed by a new entrant into the market or by the expansion of an incumbent firm's activities. Hence, it's logical to adjust concentration thresholds to account for contestability.

5. Conditions/Context:

This pertains to the fragility of the markets at the time, for example: New York Fed's reluctance to allow the failure of Long-Term Capital Management resulted largely from the fragility of financial markets at that time -- due to the Southeast Asian currency crises and the Russian default. This might explain, in part, why LTCM was treated as systemically important and Amaranth (which was more than twice as big) wasn't.

Another example would be intervention to prevent the bankruptcy of Bear Stearns by merging it (with assistance) into JPMorgan Chase (JPM) in early 2008, whereas Drexel Burnham Lambert was allowed to enter bankruptcy in early 1990. Firms that might be made systemically important by conditions/context are probably the most difficult to identify in advance.

Preventing the Last Crisis

The video is cute and will likely be well received. However, I ask: To what extent is all of this regulation attempting to prevent the last crisis?

Moreover, please recall that 18 months ago, Bernanke thought housing would rebound in 2008, the housing problems were contained to subprime, and there was no national bubble to burst.

FHA , The Next Fannie Mae

In spite of the now-known problems with leverage at Fannie, Freddie (FRE), and American International Group (AIG), and in the wake of the blowup of Lehman and Bear Stearns, and the near blowup of Citigroup (C), Bank of America (BAC), and Wells Fargo (WFC), etc., no one is acting to rein in the FHA.

Please consider The Next Fannie Mae.
"Last week, Ginnie announced that it issued a monthly record of $43 billion in mortgage-backed securities in June. Ginnie Mae President Joseph Murin sounded almost giddy as he cheered this 'phenomenal growth.' Ginnie Mae's mortgage exposure is expected to top $1 trillion by the end of next year -- or far more than double the dollar amount of 2007. Earlier this summer, Reuters quoted Anthony Medici of the Housing Department's Inspector General's office as saying, 'Who would have predicted that Ginnie Mae and Fannie Mae would have swapped positions' in loan volume?

"Ginnie's mission is to bundle, guarantee and then sell mortgages insured by the Federal Housing Administration, which is Uncle Sam's home mortgage shop. Ginnie's growth is a by-product of the FHA's spectacular growth. The FHA now insures $560 billion of mortgages -- quadruple the amount in 2006. Among the FHA, Ginnie, Fannie and Freddie, nearly 9 of every 10 new mortgages in America now carry a federal taxpayer guarantee.

"Herein lies the problem. The FHA's standard insurance program today is notoriously lax. It backs low down payment loans, to buyers who often have below-average to poor credit ratings, and with almost no oversight to protect against fraud. Sound familiar? This is called subprime lending -- the same financial roulette that busted Fannie, Freddie and large mortgage houses like Countrywide Financial.

"On June 18, HUD's Inspector General issued a scathing report on the FHA's lax insurance practices. It found that the FHA's default rate has grown to 7%, which is about double the level considered safe and sound for lenders, and that 13% of these loans are delinquent by more than 30 days. The FHA's reserve fund was found to have fallen in half, to 3% from 6.4% in 2007 -- meaning it now has a 33 to 1 leverage ratio, which is into Bear Stearns territory. The IG says the FHA may need a 'Congressional appropriation intervention to make up the shortfall.' "
Would Regulation Have Prevented The Crisis?

We can appoint all the regulators in the world but what good will it do? How many people turned in Bernie Madoff only to have the SEC look the other way? If the proposed framework for SIFI was in place 3 years ago, would it have done any good?

More than likely, not a damn thing would have been accomplished by this regulation 3-5 years ago. The reason is all the models were flawed from Moody's, Fitch, and the S&P on down, and as noted, Bernanke never saw this coming.

Hells bells, the adverse scenario for the Fed's Stress Tests were wildly optimistic on housing and unemployment and that model was made well after these problems were in full light of day.

Please see Optimistic Unemployment and Housing Forecasts Looking Downright Silly for a discussion of the Fed's baseline and adverse scenarios for 2009 and 2010.

Any guesses as to what the "adverse scenario" would have looked like 3 years ago? I'll take a stab at 6.5% unemployment and a short V-shaped recovery; in other words, a big yawn that wouldn't have been acted on.

Regulation Always Late

The market has long ago taken matters into its own hands. Foreclosures and bankruptcies are soaring. Lending standards have tightened across the board, except of course those created by regulation: Ginnie Mae and the FHA.

In a free market, Fannie, Freddie, the FHA, HUD, and Ginnie Mae wouldn't even exist. In a free market, interest rates would never have gotten to 1% with credit running rampant. In a free market, the Fed wouldn't exist. In a free market with sound money, housing would never have gotten this far out of hand. In a free market, there's no such thing as too big to fail. In a free market, there wouldn't be FDIC and banks like Bank United and Corus Bank would never have gotten funds to build all of those condo towers that are now imploding.

On the surface, this regulation sounds good. The reality is it will fail some point down the line because the next crisis won't be the same as this one. There will always be a failure to regulate because the next crisis will not be the same as the last, and at best, the only thing regulation ever does is act in hindsight to prevent the last crisis, long after the market has already acted.

Instead of a 3-tiered framework for addressing SIFI, how about a 3-phased plan to abolish the Fed and fractional reserve lending along with it?
No positions in stocks mentioned.
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