Betting the Fed

The Federal Reserve can do what democratic institutions can't. But its days as a shadow government may be numbered.

In the banking panic of 1907, J. Pierpont Morgan personally organized a
syndicate of financiers to provide $25 million to collapsing banks. It
was this panic that finally persuaded Congress in 1913 to create the
Federal Reserve System -- not a single central bank but 12 regional
reserve banks and a weak board of governors in Washington. The New York
Federal Reserve Bank, with its intimate links to Wall Street, quickly
became the reserve system's most influential player. Congress hoped
that with this new system in place, financial crises would be rare, and
relief would no longer depend on individual bankers like Morgan.

A century later, the Federal Reserve itself turned to JPMorgan
Chase, the successor to the original House of Morgan. In the March 2008
midnight rescue of Bear Stearns, an insolvent $600 billion investment
bank with anxious creditors throughout the banking system, the Fed put
up $29 billion to guarantee Morgan's emergency takeover of Bear. In a
century we have come full circle, from Morgan serving as central banker
to the nation, to the Federal Reserve serving as investment banker to
Morgan, Citigroup, Bank of America, and numerous others.

The Federal Reserve is unique among America's governing
institutions. Its combination of outsized power and lack of democratic
accountability exceeds even that of the CIA, which at least reports
directly to the president. The Fed's powerful regional banks are
accountable to private boards made up mostly of bankers. When current
Treasury Secretary Timothy Geithner was named president of the New York
Fed in 2003, the search committee was chaired by private-equity mogul
Peter G. Peterson and dominated by private financiers. The campaign to
get Geithner the job was led by Robert Rubin of Citigroup.

All of this clubbiness was by design. In creating the Fed, Congress
appropriated a radical idea from the populists for a more stable and
resilient banking and currency system -- but put it in the safely
conservative hands of private bankers. This insularity is troubling
enough in ordinary times. It is downright scandalous in the aftermath
of an economic crisis brought on by banking excesses that in turn were
enabled and indulged by the Fed.

The economy was crashed by the activities of a shadow banking system
-- mortgage companies, hedge funds, private-equity firms, buyers and
sellers of credit-default swaps, and corrupted credit-rating agencies
-- none of which were regulated by anyone and none of which troubled
the Fed. The system's financiers were often bank holding companies
whose activities were supposed to be supervised by the Fed but in
practice were not.

As a shadow government, the Fed has mirrored the shadow banking
system. Now the Fed has put its own balance sheet at risk, courting
inflation down the road -- and inviting a long-overdue backlash.

Arguably, there is some justification for the Fed's insulation from
short-run political pressure when it comes to monetary policy. But
critics across the spectrum are asking why the Federal Reserve should
not be subject to the same kind of scrutiny as other agencies in its
roles as regulator and emergency lender. Instead, these functions have
become entangled in a fashion that defies accountability.

By creating massive liquidity that will eventually either find its
way onto the national debt or be monetized as inflation, the Fed is now
conducting fiscal as well as monetary policy. It is picking winners and
losers, with no stated criteria. The Fed continues to waive regulatory
scrutiny in the hopes of coaxing a wounded financial system back to
life. It bails out institutions deemed "too big to fail," but in
preventing the collapse of several banks, from Merrill Lynch to Bear
Stearns to Wachovia to National City, its preferred strategy has been
to orchestrate mergers to create even bigger banks, thus redoubling the
too-big-to-fail problem.

The Fed has all but taken over the banking system, stretching its
emergency powers beyond their limits, flooding in trillions of dollars
using its power to create money, orchestrating shotgun mergers,
contriving jerry-built schemes to inflate the value of dead financial
assets, while largely ducking public accountability. Treasury Secretary
Geithner, a far less self-assured public figure than Fed Chair Ben
Bernanke, has been the political lightening rod for congressional
frustration and withering media coverage. But these schemes depend
entirely on the deep pockets of the Fed. And of course before Geithner
moved to Treasury, he was point man for the Fed.

There is plenty to criticize in Geithner's stewardship, but the
all-powerful institutional role of the Fed is the more important story.
Until recently, the Fed, despite its missteps, retained something of
its aura of neutral servant of the public good, above politics and
beyond reproach. But this may be changing, and fast.


In 2006, before the sub-prime crisis, then?Treasury Secretary Henry
Paulson floated the idea, with few details, of making the Fed a
"systemic risk regulator," usurping powers from other bank regulators
and the Securities and Exchange Commission (SEC). At the time, the Bush
administration was promoting further deregulation, and the idea of a
systemic risk regulator was a useful fig leaf; the Fed is the most
ideologically tame and Wall Street?friendly of the regulatory bodies.

Paulson's plan was the antithesis of sound regulation. If bank
regulators did their day-to-day jobs and there were no holes in the
regulatory structure, no financial institution would ever reach the
point where it posed systemic risks. Conversely, if the Fed gained
power at the expense of tougher regulators, there would be more
systemic crises requiring costly bailouts.

In late April, startling testimony by former Bank of America CEO Ken
Lewis revealed that the Fed and Treasury had strong-armed him into
purchasing Merrill Lynch even after it came to light that Merrill's
losses were far larger than had been revealed. Legally, when there is a
"material change" in the condition of a merger partner, the acquiring
party may back out of the deal. But according to Lewis' testimony,
confirmed both by Paulson and by official minutes of meetings, Paulson
and Bernanke pressured Lewis into violating his own legal fiduciary
duty to his shareholders, who had to approve the deal based on accurate
information. Relying on no legal authority whatsoever, the Fed and
Treasury threatened to remove the board and management of Bank of
America if they refused to go forward and demanded that Lewis not
divulge the conversation. Based on these revelations, Attorney General
Andrew Cuomo of New York wrote a five-page letter to the SEC and key
Congressional committee chairs, suggesting that the Fed and Treasury
may have improperly interfered with Bank of America's legal duty to its

The idea of a systemic risk regulator has now morphed into something
potentially more robust -- but there is little Congressional appetite
to entrust the function to the Fed. As understood in the current policy
debate, a systemic risk regulator would monitor unregulated
institutions such as private-equity firms and hedge funds, it would
conduct more stringent examinations of any very large institution, and
it would look at the potentially risky interconnections among
institutions. As one senior congressional staffer explains it, "You
could have 15 banks that all look fine when you examine them
separately, but if it turns out that they all made the same bets and
the bets go bad, it could take down they system. Nobody currently has
the authority to explore these interconnections."

However, the idea of giving the job to the Fed is now all but dead
because of its overreaching. As recently as mid-April, Barney Frank was
favorable to lodging systemic risk regulation in the Fed, but a
majority of his own House Financial Services Committee has turned
against the plan. So have Chris Dodd, chair of the Senate Banking
Committee, and the ranking Republican, Richard Shelby of Alabama. "Some
of the biggest failures in the world occurred on their watch," Shelby
recently said of the Fed. The backlash is bipartisan.

The consensus candidate for systemic risk regulator is now a panel
of the several regulatory agencies, while regulation of hedge funds and
private-equity firms is more likely to go to a strengthened SEC. Other
indications of backlash against the Fed's role as shadow government
include a provision attached to the budget resolution in the Senate
that requires the Fed to identify the financial institutions that have
received $2.2 trillion in taxpayer-backed loans, something the Fed has
refused to do voluntarily. Advocates for the provision in the House
range from left-liberal Congressman Alan Grayson of Florida to arch
libertarian Ron Paul of Texas. A very senior regulatory official told
me, "People are now waking up to all the dubious stuff the Fed has
taken onto its own balance sheet and all of the things it has done with
absolutely no accountability. It is totally turning people off to the
idea of giving the Fed even more power."


The Financial collapse turned critical in a frantic week last
September, which began with the Fed and Treasury's joint decision not
to save Lehman Brothers. Barely a day later, the trio of Paulson,
Geithner, and Bernanke reversed course and decided to bail out the
insurance conglomerate American International Group. This was also the
week that the Treasury and the Fed orchestrated the shotgun acquisition
of Merrill Lynch by Bank of America.

The events set off a belated stock market crash, and the week ended
with Paulson coming before Congress to warn of an imminent financial
collapse and to request emergency funding of $700 billion for the
banks. This should have been the moment for policy to shift gears, into
a more systemic and transparent long-term strategy for the
recapitalization and regulation of the banking system.

In every systemic financial crisis of the past century, Congress had
stepped in to legislate remedies rather than allow the Federal Reserve
to spend un-appropriated or un-accounted funds. But far from
representing a return to the normally transparent process of government
aid to industry, Congress' reluctant approval of $700 billion for
Paulson's Troubled Asset Relief Program (TARP) program on Oct. 3 was a
momentary departure from a process that continues to be orchestrated
behind closed doors by the Treasury and the Federal Reserve, largely
shrouded in secrecy. According to The Washington Post, the
latest Geithner-Bernanke plans were conceived and drafted by such
leading investment houses as Goldman Sachs and Pimco, which of course
stand to gain or lose many billions depending on what the government

Treasury's role in the plan is at least subject to review by the
Congressional Oversight Panel and the special inspector general,
provisions that were added by Congress as conditions for legislating
the money. Both agencies have the right to demand documents, and both
have been scathing in their criticism of the Treasury. But neither the
panel nor the inspector general has any authority over the Fed.

The cycle of nontransparent financial rescues has fed upon itself.
As a surly Congress has resisted additional direct appropriations, the
Fed and Treasury have invented ad-hoc programs with names like the Term
Auction Facility, the Commercial Paper Funding Facility, TARP, TALF,
CAP, P-PIP -- about 15 in all -- relying mostly on Fed funding. The
details are mind-numbing, but the basic idea is to pump money into
banks and non-banks alike, in exchange for the dubious collateral that
financial institutions want to unload -- securities backed by used-car
loans, credit cards, commercial paper, credit-default swaps, and
sub-prime loans.

P-PIP, which stands for Public-Private Investment Program, is an
especially dubious policy. The Treasury will leverage its last $100
billion of TARP money against a trillion dollars of credits and loan
guarantees mostly from the Fed. This money will ostensibly be used to
attract private capital, but the private capital from hedge funds and
private-equity companies will be as little as 6 percent of the total.
The government will guarantee the losses, but share only half the
gains. Skeptics point to the opportunities for gaming the system in
multiple ways and note that creating a gamblers' market in toxic assets
is unlikely to bring their true value back from the dead.

Criticism of the Fed's expanding role hasn't only come from members
of Congress. At least three presidents of regional reserve banks have
not been shy about questioning the rescue plan. Thomas Hoenig,
president of the Kansas City Federal Reserve Bank, warned that unless
the Fed gets its money back from these dubious new loans, "I think we
risk a very serious inflationary problem with new bubbles." William
Poole, president of the St. Louis Federal Reserve Bank until March
2008, declared that the Fed was risking "massive inflation." In
February, Jeffrey Lacker, president of the Richmond Federal Reserve
Bank, refused to go along with the Fed-Treasury plan until the Treasury
signed an unprecedented accord promising to absorb any losses incurred
by the Fed.

Where will the Treasury get the money? It will issue bonds, adding
to the national debt. You could say that the Fed is essentially serving
as a money laundry for eventual Treasury borrowing. Alternatively, the
Fed could just create more credit, a process that risks inflation --
increasing unease among many of its senior officials.

The dissent expressed by the Fed bank presidents reflects a classic
axis of the heartland versus New York. This tension has always existed,
but in the current crisis there is deep resentment on the part of the
regional banks that Wall Street is getting gentler treatment than
community banks that were far less implicated in the financial
engineering that caused the crisis but which are now suffering as
demand for good credit dries up and are paying higher fees to cover the
Federal Deposit Insurance Corporation's (FDIC) losses from less careful
banks. Bank examiners are being far tougher on the loan portfolios of
ordinary commercial banks than on the securitized junk clogging the
balance sheets of the big, money-center banks. Hoenig reflected this
feeling of a double standard when he recently testified before Congress
that the 12 regional reserve banks were established by Congress
"specifically to address the populist outcry against Wall Street." The
Fed suffered a further setback to its credibility when it was revealed
that Stephen Friedman, a Goldman Sachs board member who is also chair
of the New York Fed, bought up distressed Goldman shares for a tidy
profit after the Fed had expedited conversion of Goldman to a bank
holding company that could get government benefits.


The Fed became an all-purpose piggy bank by default. Even in normal
times, the Fed and its decision-making should be rendered more
accountable. In this financial emergency, we need to create a
transparent, democratic alternative to the secret bank rescues, one
that would rely on explicit legislation, direct appropriations, and
temporary receivership for insolvent banks. A government corporation or
expanded FDIC would be given explicit authority to take a large failed
bank into receivership, audit its losses, replace existing management,
decide how much of the financial hole should be made up by bondholders
versus taxpayers, and then return a restructured bank to health. This
process is known as resolution, and it gets the bank and banking system
back to health fast.

This alternative has been fiercely resisted by Wall Street, since it
would likely end in the breakup of at least two large banks, with
management displaced and stockholders wiped out. Both Geithner and
White House economic chief Larry Summers disparage this approach as
"nationalization." However, this is almost exactly the approach used in
the bailout of automakers. It is the approach used by the FDIC when it
shuts down and reopens failed smaller banks. And the same strategy was
followed in the late 1980s and early 1990s when Congress created the
Resolution Trust Corporation to revive a collapsed savings and loan
industry. The Reconstruction Finance Corporation of the 1930s --
invented by Herbert Hoover, expanded by Franklin Roosevelt -- did much
the same thing.

This alternative has the support of some conservatives, such as Alex
Pollock of the American Enterprise Institute and Walker Todd, a former
senior official of the Federal Reserve banks of Cleveland and New York,
who is a leading historian of Roosevelt's Reconstruction Finance
Corporation. Hoenig has called for a new RFC, with the enthusiastic
backing of Kansas' very conservative Republican senator, Sam Brownback.
Why do many on the right prefer something seemingly socialistic? As
Todd explains, "It's far better to do this transparently through a
public agency than to pervert the mission of the Federal Reserve."

As evidence of the emerging left-right consensus on this proposition, The Wall Street Journal
recently ran an editorial that reads as if it could have been written
by Joseph Stiglitz or Paul Krugman. "The sounder strategy," the Journal
argues, "is to address systemic financial problems the old-fashioned
way: bank by bank, through the Federal Deposit Insurance Corp. and a
resolution agency with the capacity to hold troubled assets and work
them off over time. If the stress tests reveal that some of our largest
institutions are insolvent or nearly so, it's then time to seize the
bank, sell off assets and recapitalize the remainder. (Meanwhile, the
healthier institutions would get a vote of confidence and could attract
new private capital.)"

The administration insists that it has to use the Fed because
Treasury can't get any more money out of Congress. But if the Treasury
and Fed were more forthcoming with Congress, and were willing to shut
down zombie banks and force shareholders to take losses, the plan would
be more credible, and Congress would be more likely to provide funds.
So-called "stress tests" -- not comprehensive examinations but
projections of how much capital different banks would need under
different economic scenarios -- are another awkward policy ploy by
Geithner and Bernanke, mainly to buy time. However, few observers think
that Citigroup or Bank of America can raise the capital it needs within
the mandated six months. While Geithner and Summers have insisted that
they oppose "nationalization," the administration is supporting
legislation for standby resolution authority -- which amounts to the
same thing. So by next fall, Geithner and Bernanke may well find
themselves back before Congress with a plea for funding to finally do
the job of recapitalizing banks properly.


When I was a young congressional assistant in the 1970s, the banking
committees were often in the hands of old-fashioned progressives who
had an abiding wariness of the Fed. In the House, Wright Patman, a
Texan populist, had the radical idea that the Fed should be a fully
accountable public institution. One of Patman's successors was another
Texan progressive, Henry Gonzalez, who regularly badgered the Fed to
let in more sunlight. Both men were treated by the press as kooky
relics of the William Jennings Bryan era, while Fed chairs such as
Arthur Burns, William McChesney Martin, Paul Volcker, and Alan
Greenspan were deified as apolitical stewards of the public interest.
In the Senate, more mannered progressives who chaired the banking
committee, such as my former boss William Proxmire of Wisconsin and
later Paul Sarbanes of Maryland, also sought to bring the Fed under
greater public scrutiny, with only limited success. In retrospect,
Patman looks less like a kook than a seer.

Greenspan has already fallen from grace, and Bernanke could be next.
And though the Fed continues to play an outsized role in containing the
crisis, its influence as a largely unaccountable shadow government has
already peaked. The only question is how much further damage we will
have to endure before both the financial system and its
all-too-friendly central bank are rendered more accountable to a broad
public interest.

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