The Lessons Unlearned...

Today's FT has an OpEd piece by Glenn Hubbard, Halt Scott and John Thornton, on the risks to the Fed's Independence, available here.

The critical point here is not so much that the Obama Administration would love to control the Fed - even I think that this isn't really what they're thinking - but much more the dangers of where we are headed here.

Over many decades and especially in this financial crisis, the Fed has used its balance sheet to be a classic lender of last resort. But its ability to do so depends upon its economic credibility and political independence, attributes the Fed has compromised in this crisis.

Important words: last resort. The Fed is like the Governor's office when someone is about to be executed, there's always the hope that the Governor will intervene before that switch is flipped or the timer runs out and the injections begin. The lender of last resort means that there is no one left to go to.

Which also means that when problems kept on being pushed upstairs, they tend, increasingly, to land on the Fed's lap. In other words, the problems that the Fed is facing are the sum of all the problems that cannot be dealt with at lower levels: the Fed carries the burden of dealing with all of the residual problems (not residual in the sense of being left over, but rather residual in the sense that no one else can deal with them) that the economy generates.

Normally an economy is in equilibrium: everything sell-able gets sold, everyone's needs are met for that period of time, and there's not some horrible looming event on the horizon that no one is aware of.

These actions have had a big impact on the Fed's balance sheet. As of June 2009, its total assets had risen to over $2,000bn compared with $852bn in 2006, and only 29 per cent of these assets were Treasury securities, compared with 91 per cent in 2006. Traditional loans by a lender of last resort are sufficiently collateralised to prevent moral hazard for borrowers and reduce risk to the central bank. However, the adequacy of the collateral of these new Fed positions is unclear.

This last is the critical sentence: adequate collateral for the debt is unclear.

For many years now not a few economists have warned that the US was over-consuming, acquiring debt beyond its ability to repay, which if anything is the definition of inadequate collateral.

Now, what exactly is unclear?

Much of the emergency Fed lending was based on Section 13(3) of the Federal Reserve Act, which allows the Fed in "unusual and exigent circumstances" to lend to "any individual, partnership, or corporation," against "notes" that are "secured to the satisfaction of the Federal Reserve Bank".

The question that has been raised by not a few is whether the Fed is playing too loose with the their definition of what is or is not satisfactory.

While the writers of the OpEd piece do indeed understand the problem, I think you have to go back one step further:

Quite apart from the legal issue, the Fed's assumption of credit risk by lending against insufficient collateral could compromise its independence by: making it more dependent on the Treasury for support in the conduct of monetary policy, as illustrated by the supplemental finance facility; jeopardising the Fed's ability to finance its own operations and thus require it to seek budgetary support from the government; tarnishing its financial credibility in the event that it incurred big losses; and generally making it more subject to political pressures.

The real problem isn't that the Fed could somehow compromise its independence by lending against insufficient collateral, but rather that the Fed is making such loans at all: this is, after all, where the trouble started: loans that should never have been made.

I think that the Obama Administration has chosen this path: it has consistently pushed the fact that there are literally billions of dollars out there in non-performing loans - non-performing because they should never have been made in the first place - into the hands of the Fed, not because they think that the Fed can handle this, but rather because of what the Fed is: the lender of last resort.

In other words, this is where the buck stops.

But the Obama Administration sees it a tad differently, wanting to avoid an accounting:

...the Obama administration's reform proposal recommends amending Section 13(3) to require the written approval of the secretary of the Treasury for any emergency extension of credit. This would be a startling expansion of Treasury power over the Fed's use of liquidity facilities in classic lender of last resort situations – that is, where there was adequate collateral. Instead, the lines of authority should be clear. The Fed should have strengthened authority to loan against adequate collateral in an emergency. And the Fed should have no authority, even with the approval of the Treasury, to lend against insufficient collateral.

In other words, the Obama administration basically wants the Fed to "deal" with all of those bad loans by ... making more of them.

This isn't just a bad idea, this way lies madness.


What people in Washington and elsewhere really haven't come to grips with is the fact - and it is a fact, regardless of what spin and strange new hopes one can make - that nonperforming loans have to be written off as losses. The toxic assets are exactly that: toxic.

But letting the Fed make unsecured loans at its own volition, requiring merely the written approval of the Secretary of the Treasury to do so, is tantamount to more of the same.

There is no way out of this: the sub-prime crisis, fueled by market distortions willfully placed by more than one US Congress and President, is a crisis that was and is driven by bad business practices. Allowing the continuation of these business practices is sheer and simple madness, further worsening the solution.

The only real solution?

Liquidation of bad loans; foreclosures and losses on the real estate markets for years to come; extremely tight credit for at least 10 years to recover from these massive bad debts; impoverishment of hundreds of thousands of baby boomers who are relying on speculative profits from their houses to finance their retirements; hundreds of thousands of bankruptcies from those being foreclosed on; the list goes on.


Unfortunately, the politicians who caused these problems - who are those in power in Washington, DC - refuse to believe that they cannot finesse their way out of the situation. These are the Democrats who turned the the Fannies into the sumps of corruption and incompetence that they are. They have built the edifice and profited enormously from the largess when times were good.

It is now time for them to pay.

The lesson unlearned from the sub-prime crisis is that bad business practices, even when they are legislated, always end in tears. Until that lesson is learned by not only those responsible, but also learned by the common man on the street, history is doomed to repeat itself.

And we know that the second time is a farce. The clowns are already in Washington. All we need is for the Fed to complete the circle.