Often when we talk about the Fed, we talk about a dual mandate — low inflation, and low labor unemployment.  But as I suggested at RealMoney many times, there is a hidden third mandate: protect the integrity of the banking system.

Often,  a tightening cycle would end with a bang, with some credit starved entity (Residential Housing, Nasdaq, LTCM, Lesser-developed Asia, Mexico, etc.) dying.  The Federal Reserve would then spring into action and say, “We must fight the threat of unemployment.”  Would they?  No, they would invoke protecting the financial system, which protects the banks.  After all, monetary policy does not work when banks are compromised, as they are today.  No wonder there is Credit Easing.

So when I hear the Fed proposed to be the systemic risk regulator, I have two thoughts:

1) You did a bad job with monetary policy and bank supervision, but you are nice guys, because you do for the US Government all of the things the Treasury Department can’t Constitutionally do.  Now let’s see if you can do better with controlling systemic risk, even though we haven’t granted you control over all the levers necessary to do so.

2)  Maybe this will make them better with monetary policy; it makes the triple mandate explicit.

My view is that the Fed is one of the major creators of systemic risk in our economy through the use of monetary policy to stimulate our way out of bad times.  The temptation that Greenspan succumbed to was to throw liquidity at problems too early, which avoided liquidation of marginal debts, and the debt levels built up.

If the  Fed has to minimize systemic risk in the economy, maybe it becomes less willing to loosen policy profligately.  I would hope it would work that way.

That said, given the lack of success for the Fed on its goals, I suspect that if it were given the task of reining in systemic risk, it would fall prey to political pressure, and fail at that as well.

I go back to my earlier proposal — the Fed would have to keep the US economy under a limit of private debts being less than 2x GDP.  But can you imagine the Fed tightening during a boom to avoid systemic risk, or raising margin requirements?  I can’t, so even though ideally the Fed would be the right player to manage systemic risk, in practice, systemic risk is unmanageable, because there are too many interests that benefit from boom times.  That’s why I don’t expect much from the proposals to manage systemic risk, regardless of who gets the power to do so.

When people look at this crisis, they look for simple answers — they want to find one or two parties to blame, not many, a la my Blame Game series.  The economic system is an interconnected web, and it is not easy to change one part without affecting many others.  Intelligent ideas for change consider second order effects at minimum.  This piece, and any that follow under the same title, will attempt to point at things that are not easily done away with.  Some of these will be controversial, others not.

1) Derivatives.  What is a derivative?  A derivative is a contract where two parties agree to exchange cash flows according to some indexes or formulas.  There are some suggesting today that all derivatives must be standardized, and/or traded on exchanges.  That might make sense for common derivatives where there are large volumes, but many derivatives are “out in the tail.”  Not common, and standardization of what is not common is a fool’s errand.

To regulate derivatives fully is to say that certain types of contracts between private parties may not exist without the consent of the government.  Thinking about it that way, what becomes of free enterprise?  Granted, there are some contracts that cannot be considered enforcable, like that of a hit man, arson for hire, etc.  Those are matters that any healthy government would oppose.

What makes more sense is to bring the derivatives “on balance sheet.”  Let the effects of the notional value play out, showing owners what is happening, rather than hiding it.

2) Rating agencies — Moody’s, S&P, and Fitch deserve some blame for what happened, but the regulators needed the rating agencies.  They still do.  The rating agencies make imperfect estimates of relative credit quality for a wide munber of instruments, which then feed into the risk-based capital formulas of the regulators.  To rate such a wide number of instruments means that the issuers must pay for the rating, because there is no general interest for most ratings.

Yes, let more rating agencies compete, but they will find that the “issuer pays” model is more compelling than the “”buyer pays” model.  The concentrated interests of issuers in a rating trumps the diffuse interests of buyers.  Bond buyers need to learn to live with this, and employ buy-side analysts that don’t take the opinion of the rating agencies blindly.  What the analysts at the rating agencies write is often more valuable than the rating itself, though it doesn’t change capital charges.

Rating agencies make the most errors with new asset classes.  Better that the regulators do their jobs and prohibit immature  asset classes where the loss experience is ill-understood.

I don’t think that rating agencies are going away any time soon.  I do think that the government and regulators contemplated this, but concluded that the changes to the system would be too drastic. (Contrary opinions: one, two)

3) Yield-seeking — the desire to seek yield is near-universal.  As a bond manager, I found it rare that a manager would do a “reduce yield, improve quality or certainty” trade.  The pattern is even more pronounced with retail accounts.  They underestimate the value of the options that they are selling, and take a modicum of yield in exchage for lower certainty of return.

Can this be banned, as some are proposing with reverse convertibles?  I don’t think so, there are too many variables to nail down, and too many people in search for a yield higher than is reasonable.  Yield-hogging is an institutional sport, not only one for retail fans to grab.  As one of my old bosses used to say, “Yield can be added to any portfolio.”  How?

• Offer protection on CDS
• Lower the quality of your portfolio.
• Buy all of the dirty credits that trade cheap to rating.
• Buy securities from securitizations — they almost always trade cheap to rating.  (Ooh! CDOs!)
• Sell a call option on the securities you hold.
• Buy mortgage securities with a lot of prepayment or extension risk.
• Accept the return in a higher inflation currency, assuming that their central bank will tighten.
• Do a currency carry trade.
• Lever up.
• Extend the length of your portfolio.
• Underwrite catastrophe risk through cat bonds.

Adding yield is easy.  The transparency of that addition of yield is another matter.  Reverse convertibles have been the hot issue recently since this article.  Here is a small sample of the articles that followed: (one, two, three).  Reverse convertibles, and other instruments like them give bond-like performance if things go average-to-well, and stock-like performance if things go badly.  The inducement for this is a high yield on the bond in the average-to-good scenario.

What to do?

I have three bits of advice for readers.  First, don’t buy any financial instruments tht you don’t understand well. This especially applies when the party selling them to you has options that they can exercise against you.  Wall Street excels at products that give with the right hand and take with the left, so beware structured products sold to retail investors.

Second, don’t buy any financial product that someone appears out of the blue and says, “Have I got a deal for you!”  Stop.  Take your time, ask for literature, maybe, but say that you need a month or more to think about it.  Haste is the enemy of good financial decision-making.  Instead, do your own research, and buy what you conclude that you need.  Consult trusted advisors in either case.

Third, don’t be a yield hog.  Yield is rarely free.  There are times to take risk and accept higher yields, but those are typically scary times.  At other times, make sure you understand the portfolio of risks that you accept, and that you are being adequately paid for those risks.  Better to have a ladder of high quality noncallable debt, and take some risk with equities than to take risk in a series of yieldy and illiquid bonds that you don’t understand so well.  At least you will be able to know what risks you have, and that is an aid to asset management.

Final Question

This article began as a discussion of things that are very hard to change in the current environment.  I thought of several here:

• The continuing need for derivatives, and the impossibility of full standardization
• The continuing need for rating agencies
• Human nature makes us yield hogs.
• Wall Street builds traps for investors off of that weakness.

What other things are very hard to change in the current environment?