Notes on Fed Policy and Financial Regulation

I’m not likely to be able to comment when the FOMC announces its lack of action today.  The Fed will continue to keep policy loose, while slowly closing down ancillary lending programs, and bloating their balance sheet with mortgage backed securities [MBS] guaranteed by Fannie and Freddie, and ultimately by the Federal Government, which gets the profit or loss from the Fed’s financing (of the mortgages at 0% interest for now).

Going back to last night’s post, strip away the complexity, and what you have is the Federal Government intervening in the MBS market, and forcing down yields, at a cost of indebting future generations (should they decide to make good on those).  This will eventually fail as a strategy.  Unless the Fed wants to keep its balance sheet permanently larger, yields on MBS will rise when they stop buying.  And, the moment that they hint that they will start unloading, rates will back up significantly.  They are too large relative to the MBS market.

They can engage in fancy strategies where they try to remove policy accommodation either through rates or the size of the balance sheet, but one thing Fed history teaches us is that the Fed doesn’t know what will happen when a tightening cycle starts, but usually it ends with a bang — some market blowing up.

Two more notes: it doesn’t matter who the Fed Chairman is.  The structure of the Fed matters more than the man.  That said, Bernanke has promised transparency but has not given it at the most crucial times — those dealing with the bailouts.  All of the talk to audit/limit/shrink/end the Fed comes from abuse of those powers, which should be done by the Treasury and Congress, so that voters can hold them accountable.

Finally, one quick note on regulation of financials.  Laws don’t mean squat if regulators won’t enforce them.  There was enough power in prior laws for regulators to have curbed all of the abuses.  The regulators did not use their powers then; what makes us think that they will use expanded powers?  Regulatory capture has happened in the banking industry; regulators will have to get ugly with those that they regulate if they genuinely want to regulate.

This includes changing risk-based capital formulas to remove the advantage of securitizing debt.  I’m not saying penalize securitization, but put it on a level playing field so that the inherent leverage involved in securitization gets a higher capital charge relative to straight debt of a similar risk class.

That also includes not letting banks fudge asset values to give the appearance of solvency, but more on that tonight.  I gotta fly now on business.