Derivatives Regulation New Rules for Derivatives http://www.nytimes.com/2009/05/15/opinion/15fri1.html?

_r=1&scp=3&sq=derivatives&st=cse Published: May 14, 2009 President Obamas new proposal to regulate derivatives would go a long way toward reining in the complex products and reckless practices that have been a big factor in the financial crisis. But it would not go far enough. In apparent deference to those who have made major profits from unfettered derivatives trading, the proposal stops shy of creating a fully transparent market. Transparency is the best way to avoid a repeat of the disaster triggered in recent years by these unregulated financial products, which are supposed to help investors manage risks, like the possibility of default or of interest-rate swings. As the financial bubble burst mid-decade, many of these derivatives didnt work as advertised. Rather than reduce risk, they created or amplified it, to the point as in the case of the American International Group that the failure of one party to various derivatives contracts threatened to topple the entire system. Worse still, the debacle caught regulators flat-footed and taxpayers have been paying for bailouts ever since. The tab for A.I.G. alone, so far, is some $180 billion, and there are trillions of dollars more for which taxpayers are on the hook. Derivatives are not entirely to blame for the fiasco, but they are implicated in much of it. The administrations proposal rightly seeks to repeal much of a law from 2000, the Commodity Futures Modernization Act. It put derivatives beyond the reach of federal regulators. It calls for certain derivative trades, though not all, to be handled through clearinghouses. It also requires that derivatives be backed by collateral, ensuring that a trader is able to make good if called upon to pay up. It would allow federal regulators to police the market for fraud and manipulation basic safeguards missing from current law. In a far-reaching change, the proposal also would subject participants in the derivatives market to capital requirements and to record-keeping and reporting requirements. These would allow regulators to track their activities, presumably intervening as necessary to avert systemwide problems. For all that, the proposal pulls its punches. It does not call for trading derivatives on fully regulated exchanges, the most visible and reliable way of reining them in. It also makes a distinction between standardized and customized derivatives and proposes a lighter regulatory touch for the custom variety. That could open the door to gaming the new system, a door that would be shut if all derivative contracts were traded on exchanges. In some important respects, it appears to give regulators the discretion, though not the duty, to police markets more closely. The proposal also seems to invite tension between the Securities and Exchange Commission and the Commodity Futures Trading Commission, the main regulators that would oversee derivatives. Regulatory jurisdiction must be clarified if the new rules are to have any teeth. Another tension is that, in carrying out the new rules, President Obamas nominee to lead the Commodity Futures Trading Commission, Gary Gensler, has a credibility problem. During the Clinton administration, Mr. Gensler along with Lawrence Summers, Mr. Obamas top economic adviser championed derivatives deregulation. That caused two senators to place a hold on his confirmation, even though Mr. Gensler supported greater regulation during his confirmation hearing. They released the hold on Thursday only after the new regulatory proposal was made public. The Obama proposal starts off in the right direction. It is up to Congress to shore up its protections and provide regulators with the resources and political support they would need to carry out their new mandate.

Comments: Editors, I was curious how you'd deal with the issue of derivatives. Your opening understatement left me with a smile: the Obama proposal to regulate derivatives "would not go far enough." You point at several serious flaws including insufficient transparency, conflicting regulatory bodies, and how easy it would be to cheat, but your lack of hard -- or even speculative -- numbers as to the dimension of the problem left me wondering. You mention the A.I.G. tab of "some $180 billion," and follow with "there are trillions of dollars more for which taxpayers are on the hook." How many trillions? I've read that the total derivatives outstanding could be $1.28 Quadrillion- with 95 percent on margin. I've seen $1,000 Trillion and $684 Trillion. I capitalize the T to emphasize this is not a typo. Anyone can Google "derivatives outstanding" and see the spread of numbers and disturbing dimensions. While I am not saying we have a derivative problem a quadrillion bucks in size -- for presumably most of this is hedging and funny money of one sort or another -- we do need to consider the astronomical scope of the problem. Which brings us to the question of what solution to try. Bolting the barn door after a few trillion horses have escaped is not going to solve the problem. What do you propose? What does Dr. Krugman or Dr. Stiglitz propose? What could possibly be done? Probably I'm dead wrong, but I'd like to hear debate on abrogating all derivatives contracts -- worldwide -- with the stroke of a pen, or multiple pens by the G-20 nations and others. Just take everyone off the hook simultaneously and then put some reformed derivatives exchange in place. Or perhaps design the exchange and have it ready, then wham-o, all old bets are off and come to the new, transparent exchange for something we can see. As to the "custom" derivatives, they'd be gone too, and we'd have to work out rules and boards to deal with these in the future. All this, of course, assuming that derivatives are even needed. Are they? The really disturbing part of this regulatory proposal by the Obama administration is its intent to deceive. I thought those days were over. It pretends to regulate derivatives while including an enormous loophole for "customized" instruments, the riskiest form of derivatives, precisely the mysterious, opaque, impossible to price and poorly understood contracts that imploded. Geithner insults the intelligence with a regularity that is really starting to make me angry. While it is true that derivatives did not entirely cause this crisis, it is also undeniably true that without the sudden, exponential growth in OTC "customized" derivatives activity, originating and emanating from financial institutions in the United States, the global economic crisis does not occur. Look up the numbers at the Bank for International Settlements. Face head on what business as usual became over the past 10 years. Face the fact that massive unregulated derivatives activity is not just a problem of the banks, but a problem in the secretive hedge fund world, the world that spawned Bernie Madoff. Stop being a coward, Mr. President. Derivatives aren't the problem. Many banks in the U.S. that lent money went belly up because the borrowers' defaulted without any losses on derivative positions. In fact, these banks might have benefited greatly if they had entered into credit default swaps as hedges of their credit risk. Don't think if CDS are outlawed that companies will stop losing money from being exposed to financial risks. Airlines can go out of business if jet fuel prices rise. Companies with foreign operations will suffer when their foreign earnings depreciate as the USD rises. The world is full of risks and companies are constantly trying to decide which risks the market pays them to take on, and those that they shouldn't. The Credit Default Swaps are in reality, an elegant and very effective way to reduce credit risk to a counterparty. The irony is that companies are more sensitive to their exposure to credit risk more than ever before, and if anything, the CDS market is the way they can effectively manage it. Otherwise, companies will be more cautious on any agreement that exposes them to counterparty risk and banks will find it difficult to lend - and both are bad for the economy. Treasury needs to find a way to reduce some of the systemic risks that are inherent in the market since after all, doesn't the company that enter into the CDS to avoid credit risk with a supplier also have credit risk to the entity that sold them the hedge? 2

THE RECKONING Taking Hard New Look at a Greenspan Legacy http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html? scp=6&sq=derivatives&st=cse Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient. Alan Greenspan in 2004 George Soros, the prominent financier, avoids using the financial contracts known as derivatives because we dont really understand how they work. Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential hydrogen bombs. And Warren E. Buffett presciently observed five years ago that derivatives were financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives exotic contracts that promised to protect investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street. What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldnt be taking it to those who are willing to and are capable of doing so, Mr. Greenspan told the Senate Banking Committee in 2003. We think it would be a mistake to more deeply regulate the contracts, he added. Today, with the world caught in an economic tempest that Mr. Greenspan recently described as the type of wrenching financial crisis that comes along only once in a century, his faith in derivatives remains unshaken. The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University, intimating that those peddling derivatives were not as reliable as the pharmacist who fills the prescription ordered by our physician. But others hold a starkly different view of how global markets unwound, and the role that Mr. Greenspan played in setting up this unrest. Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the deregulation of derivatives, said Frank Partnoy, a law professor at the University of San Diego and an expert on financial regulation. The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them. If Mr. Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to 2006, many economists say, the current crisis might have been averted or muted. Over the years, Mr. Greenspan helped enable an ambitious American experiment in letting market forces run free. Now, the nation is confronting the consequences. Derivatives were created to soften or in the argot of Wall Street, hedge investment losses. For example, some of the contracts protect debt holders against losses on mortgage securities. (Their name comes from the fact that their value derives from underlying assets like stocks, bonds and commodities.) Many individuals own a common derivative: the insurance contract on their homes. On a grander scale, such contracts allow financial services firms and corporations to take more complex risks that they might otherwise avoid for example, issuing more mortgages or corporate debt. And the contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur. Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. In meetings with federal officials, 3

celebrated appearances on Capitol Hill and heavily attended speeches, Mr. Greenspan banked on the good will of Wall Street to self-regulate as he fended off restrictions. Ever since housing began to collapse, Mr. Greenspans record has been up for revision. Economists from across the ideological spectrum have criticized his decision to let the nations real estate market continue to boom with cheap credit, courtesy of low interest rates, rather than snuffing out price increases with higher rates. Others have criticized Mr. Greenspan for not disciplining institutions that lent indiscriminately. But whatever history ends up saying about those decisions, Mr. Greenspans legacy may ultimately rest on a more deeply embedded and much less scrutinized phenomenon: the spectacular boom and calamitous bust in derivatives trading. Faith in the System Some analysts say it is unfair to blame Mr. Greenspan because the crisis is so sprawling. The notion that Greenspan could have generated a totally different outcome is nave, said Robert E. Hall, an economist at the conservative Hoover Institution, a research group at Stanford. Mr. Greenspan declined requests for an interview. His spokeswoman referred questions about his record to his memoir, The Age of Turbulence, in which he outlines his beliefs. It seems superfluous to constrain trading in some of the newer derivatives and other innovative financial contracts of the past decade, Mr. Greenspan writes. The worst have failed; investors no longer fund them and are not likely to in the future. In his Georgetown speech, he entertained no talk of regulation, describing the financial turmoil as the failure of Wall Street to behave honorably. In a market system based on trust, reputation has a significant economic value, Mr. Greenspan told the audience. I am therefore distressed at how far we have let concerns for reputation slip in recent years. As the long-serving chairman of the Fed, the nations most powerful economic policy maker, Mr. Greenspan preached the transcendent, wealth-creating powers of the market. A professed libertarian, he counted among his formative influences the novelist Ayn Rand, who portrayed collective power as an evil force set against the enlightened self-interest of individuals. In turn, he showed a resolute faith that those participating in financial markets would act responsibly. An examination of more than two decades of Mr. Greenspans record on financial regulation and derivatives in particular reveals the degree to which he tethered the health of the nations economy to that faith. As the nascent derivatives market took hold in the early 1990s, and in subsequent years, critics denounced an absence of rules forcing institutions to disclose their positions and set aside funds as a reserve against bad bets. Time and again, Mr. Greenspan a revered figure affectionately nicknamed the Oracle proclaimed that risks could be handled by the markets themselves. Proposals to bring even minimalist regulation were basically rebuffed by Greenspan and various people in the Treasury, recalled Alan S. Blinder, a former Federal Reserve board member and an economist at Princeton University. I think of him as consistently cheerleading on derivatives. Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, says Mr. Greenspan opposes regulating derivatives because of a fundamental disdain for government. Mr. Levitt said that Mr. Greenspans authority and grasp of global finance consistently persuaded less financially sophisticated lawmakers to follow his lead. I always felt that the titans of our legislature didnt want to reveal their own inability to understand some of the concepts that Mr. Greenspan was setting forth, Mr. Levitt said. I dont recall anyone ever saying, What do you mean by that, Alan? Still, over a long stretch of time, some did pose questions. In 1992, Edward J. Markey, a Democrat from Massachusetts who led the House subcommittee on telecommunications and finance, asked what was then the General Accounting Office to study derivatives risks. Two years later, the office released its report, identifying significant gaps and weaknesses in the regulatory oversight of derivatives. 4

The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole, Charles A. Bowsher, head of the accounting office, said when he testified before Mr. Markeys committee in 1994. In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers. In his testimony at the time, Mr. Greenspan was reassuring. Risks in financial markets, including derivatives markets, are being regulated by private parties, he said. There is nothing involved in federal regulation per se which makes it superior to market regulation. Mr. Greenspan warned that derivatives could amplify crises because they tied together the fortunes of many seemingly independent institutions. The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence, he said. But he called that possibility extremely remote, adding that risk is part of life. Later that year, Mr. Markey introduced a bill requiring greater derivatives regulation. It never passed. Resistance to Warnings In 1997, the Commodity Futures Trading Commission, a federal agency that regulates options and futures trading, began exploring derivatives regulation. The commission, then led by a lawyer named Brooksley E. Born, invited comments about how best to oversee certain derivatives. Ms. Born was concerned that unfettered, opaque trading could threaten our regulated markets or, indeed, our economy without any federal agency knowing about it, she said in Congressional testimony. She called for greater disclosure of trades and reserves to cushion against losses. Ms. Borns views incited fierce opposition from Mr. Greenspan and Robert E. Rubin, the Treasury secretary then. Treasury lawyers concluded that merely discussing new rules threatened the derivatives market. Mr. Greenspan warned that too many rules would damage Wall Street, prompting traders to take their business overseas. Greenspan told Brooksley that she essentially didnt know what she was doing and shed cause a financial crisis, said Michael Greenberger, who was a senior director at the commission. Brooksley was this woman who was not playing tennis with these guys and not having lunch with these guys. There was a little bit of the feeling that this woman was not of Wall Street. Ms. Born declined to comment. Mr. Rubin, now a senior executive at the banking giant Citigroup, says that he favored regulating derivatives particularly increasing potential loss reserves but that he saw no way of doing so while he was running the Treasury. All of the forces in the system were arrayed against it, he said. The industry certainly didnt want any increase in these requirements. There was no potential for mobilizing public opinion. Mr. Greenberger asserts that the political climate would have been different had Mr. Rubin called for regulation. In early 1998, Mr. Rubins deputy, Lawrence H. Summers, called Ms. Born and chastised her for taking steps he said would lead to a financial crisis, according to Mr. Greenberger. Mr. Summers said he could not recall the conversation but agreed with Mr. Greenspan and Mr. Rubin that Ms. Borns proposal was highly problematic. On April 21, 1998, senior federal financial regulators convened in a wood-paneled conference room at the Treasury to discuss Ms. Borns proposal. Mr. Rubin and Mr. Greenspan implored her to reconsider, according to both Mr. Greenberger and Mr. Levitt. Ms. Born pushed ahead. On June 5, 1998, Mr. Greenspan, Mr. Rubin and Mr. Levitt called on Congress to prevent Ms. Born from acting until more senior regulators developed their own recommendations. Mr. Levitt says he now regrets that decision. Mr. Greenspan and Mr. Rubin were joined at the hip on this, he said. They were certainly very fiercely opposed to this and persuaded me that this would cause chaos. Ms. Born soon gained a potent example. In the fall of 1998, the hedge fund Long Term Capital Management nearly collapsed, dragged down by disastrous bets on, among other things, derivatives. More than a dozen banks pooled $3.6 billion for a private rescue to prevent the fund from slipping into bankruptcy and endangering other firms. Despite that event, Congress froze the Commodity Futures Trading Commissions regulatory authority for six months. The following year, Ms. Born departed. 5

In November 1999, senior regulators including Mr. Greenspan and Mr. Rubin recommended that Congress permanently strip the C.F.T.C. of regulatory authority over derivatives. Mr. Greenspan, according to lawmakers, then used his prestige to make sure Congress followed through. Alan was held in very high regard, said Jim Leach, an Iowa Republican who led the House Banking and Financial Services Committee at the time. Youve got an area of judgment in which members of Congress have nonexistent expertise. As the stock market roared forward on the heels of a historic bull market, the dominant view was that the good times largely stemmed from Mr. Greenspans steady hand at the Fed. You will go down as the greatest chairman in the history of the Federal Reserve Bank, declared Senator Phil Gramm, the Texas Republican who was chairman of the Senate Banking Committee when Mr. Greenspan appeared there in February 1999. Mr. Greenspans credentials and confidence reinforced his reputation helping him to persuade Congress to repeal Depression-era laws that separated commercial and investment banking in order to reduce overall risk in the financial system. He had a way of speaking that made you think he knew exactly what he was talking about at all times, said Senator Tom Harkin, a Democrat from Iowa. He was able to say things in a way that made people not want to question him on anything, like he knew it all. He was the Oracle, and who were you to question him? In 2000, Mr. Harkin asked what might happen if Congress weakened the C.F.T.C.s authority. If you have this exclusion and something unforeseen happens, who does something about it? he asked Mr. Greenspan in a hearing. Mr. Greenspan said that Wall Street could be trusted. There is a very fundamental trade-off of what type of economy you wish to have, he said. You can have huge amounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either, he said. Later that year, at a Congressional hearing on the merger boom, he argued that Wall Street had tamed risk. Arent you concerned with such a growing concentration of wealth that if one of these huge institutions fails that it will have a horrendous impact on the national and global economy? asked Representative Bernard Sanders, an independent from Vermont. No, Im not, Mr. Greenspan replied. I believe that the general growth in large institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically I should say, fully hedged. The House overwhelmingly passed the bill that kept derivatives clear of C.F.T.C. oversight. Senator Gramm attached a rider limiting the C.F.T.C.s authority to an 11,000-page appropriations bill. The Senate passed it. President Clinton signed it into law. Pressing Forward Still, savvy investors like Mr. Buffett continued to raise alarms about derivatives, as he did in 2003, in his annual letter to shareholders of his company, Berkshire Hathaway. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, he wrote. The troubles of one could quickly infect the others. But business continued. And when Mr. Greenspan began to hear of a housing bubble, he dismissed the threat. Wall Street was using derivatives, he said in a 2004 speech, to share risks with other firms. Shared risk has since evolved from a source of comfort into a virus. As the housing crisis grew and mortgages went bad, derivatives actually magnified the downturn. The Wall Street debacle that swallowed firms like Bear Stearns and Lehman Brothers, and imperiled the insurance giant American International Group, has been driven by the fact that they and their customers were linked to one another by derivatives. In recent months, as the financial crisis has gathered momentum, Mr. Greenspans public appearances have become less frequent. His memoir was released in the middle of 2007, as the disaster was unfolding, and his book tour suddenly became a referendum on his policies. When the paperback version came out this year, Mr. Greenspan wrote an epilogue that offers a rebuttal of sorts. 6

Risk management can never achieve perfection, he wrote. The villains, he wrote, were the bankers whose self-interest he had once bet upon. They gambled that they could keep adding to their risky positions and still sell them out before the deluge, he wrote. Most were wrong. No federal intervention was marshaled to try to stop them, but Mr. Greenspan has no regrets. Governments and central banks, he wrote, could not have altered the course of the boom.

May 27, 2009, 3:41 pm Bill Clinton, on His Economic Legacy By David Leonhardt http://economix.blogs.nytimes.com/2009/05/27/bill-clinton-on-his-economic-legacy/? scp=2&sq=derivatives&st=cse Given the range of issues Peter Baker covers in his article about Bill Clinton for the coming New York Times Magazine, there was not room for anything close to Mr. Clintons entire comments on his economic record. And theyre fascinating (as is the article). So were going to post, below, the transcript of that portion of the discussion between Mr. Clinton and Mr. Baker. In several places, I have annotated it, in italics. Id be interested in hearing the thoughts of readers and other bloggers, too. (Update: Noam Scheiber, Mark Thoma and Matthew Yglesias weigh in.) NEW YORK TIMES: Speaking of banks and toxic assets, you know theres been this debate among a lot of people about trying to figure out where did we get to this point, how did we get to this point. You know that Time magazine named you and said you should have done this, that or the other thing. What do you say to that? Is there anything you would have done differently? Mr. CLINTON: Yes. Well, I dont know if I would have done anything different. First, I always ask. I do not believe this would have happened in this way if I had been in office or if Al Gore had been elected. I just dont. I think we would have caught the housing bubble and taken steps to stem it before it got out of hand. And I know that having Arthur Levitt at the Securities and Exchange Commission would have made a huge difference. ECONOMIX: This is a reasonable argument. But is there tangible evidence in its favor? Were there instances in which Mr. Levitt or other Clinton advisers, like Timothy Geithner, Robert Rubin, Gene Sperling, Lawrence Summers and Laura Tyson put a stop to financial excesses in the 1990s? This would add weight to the notion that they would have pricked the housing bubble in the current decade and put a halt to the Wall Street excesses that depended on that bubble. There is a real counterargument that a Clinton or Gore administration might not have. Alan Greenspan would still have been at the Federal Reserve and, in all likelihood, still been influential with the White House. Mr. Geithner, at the New York Fed during the Bush administration, did not stop the buildup in Wall Street leverage that has turned out to be so damaging. Mr. Summers issued warnings about the financial crisis before many others, but he did not issue them, at least not very loudly, in 2005, 2006 or even into 2007. Mr. CLINTON: Now, there basically have been three charges, if you will, laid at our doorstep, because everybody recognizes that I vetoed the securities reform bill and that we had a very different economic philosophy. But they the three charges are one, because I enforced the Community Reinvestment Act for the first time and over 90 percent of all lending done under that law was done when I was president, $300 billion, that part of that was a lot of little banks made loans to people they had no business making loans to to buy houses so they could check the box for the Community Reinvestment Act. Thats the right-wing argument. Then theres the argument from the left that I shouldnt have signed the bill that got rid of the GlassSteagall law because that enabled banks and investment banks in effect to merge their functions. And then theres the argument that I make, which is that I should have raised more hell about derivatives being unregulated. I believe the last one is by far the most valid ECONOMIX: This seems impressively honest. Former presidents dont often engage in such selfcriticism. Mr. CLINTON: although I dont think that the Congress would have permitted anything to be done because Alan Greenspan was against it. 7

So lets take them in reverse order. The argument against regulating derivatives, which Greenspan urged and this is one of the few things I think I think Bob Rubin and Larry Summers and those guys have gotten a little bit of a bum rap on this lately, you know, something goes wrong and the whole last 30 years were the same. Thats just not true. The economic consequences of what happened in our eight years were dramatically different than what happened in the 12 years before or the eight years after. And the policies were different, including policies for the poor, policies for working people. The economic policies were completely different. Its just if youre against all trade, youre just all in. If you think the Democratic Party should have become an anti-trade party, then you can say that. But otherwise, I think its just not accurate including the fact that we consistently argued for putting labor and environmental standards in the trade agreements and actually made real progress on that in the last few years I was in office and the Republicans undid it. So I dont buy that. But I do believe on the derivatives they made the argument, the people who were against regulating it, that people like you werent buying derivatives. It wasnt like you were investing your 401(k) in derivatives. You were investing your 401(k) in mutual funds, which were subject at least under normal times to the jurisdiction of the S.E.C., which was supposed to be minding the store. And so because we had a hostile Republican Congress which threatened not to fund I dont know if you remember this but we had a huge knock-down fight when they threatened not to fund the S.E.C. because of what Arthur Levitt was doing to try to protect the American economy from meltdowns. They said, Oh, hes interfering with a free market and all that. This is what hes supposed to do. They argued that nobodys going to buy these derivatives, well do it without transparency, theyll get the information they need. And it turned out to be just wrong; it just wasnt true. And once you got that massive amount of money invested in derivatives that people thought its like these credit default swaps, where people thought, the Lehman people talk about it, they thought, or the A.I.G. people, they thought it was 100 percent safe investment, they thought there would never be defaults on these mortgage securities. So of course you wanted insurance there because you got the insurance premium, you make the profit and you couldnt possibly lose money, right? Well, it turned out to be all wrong. That rested on a lot of assumptions, including the fact that the ratings agencies would do a good job, which didnt happen, in evaluating risk. So I very much wish now that I had demanded that we put derivatives under the jurisdiction of the Securities and Exchange Commission and that transparency rules had been observed and that we had done that. That I think is a legitimate criticism of what we didnt do. On the Glass-Steagall, Ive really thought about that because No. 1, nonbank banking was already a major part of American life at that time. Letting banks take investment positions I dont think had much to do with this meltdown. And the more diversified institutions in general were better able to handle what happened. ECONOMIX: President Obama has made a similar point. Perhaps the strongest piece of evidence in its favor is that the first institutions to collapse, like Lehman Brothers and Bear Stearns, had not combined standard banking and investment banking. Some firms that did combine the two, especially J.P. Morgan Chase, have weathered the crisis considerably better. Mr. CLINTON: And again, if I had known that the S.E.C. would have taken a rain check, would I have done it? Probably not, but I wouldnt have done anything. In other words, I would have tried to reverse everything if I had known we were going to have eight years where we wouldnt have an S.E.C. for most of the time. But I believe if you look at the blurring of the lines which already existed before that bill was signed the bill arguably gave us a framework, at least, for which this process, which was happening anyway, could be regulated. So I dont think thats such a good criticism. I think actually, if you want to make a criticism on that, it would be an indirect one; you could say that the signing of that legislation sped up what was happening anyway and maybe led some of these institutions to be bigger than they otherwise would have been and the very bigness of some of these groups caused some of this problem because the bigger something is and the newer it is the harder it is to manage. And I do think there were some serious management problems which might not have occurred. Not all of these people were lazy or flagrant or blindly greedy. You know, some of this stuff, I think, was just people were trying to manage more than they could manage. That has a little leverage with me but on the merits I dont think so. 8

And the first argument, I think its totally without merit. If you look at the community banks in this country actually I never believed Id cite her as an authority, but Arianna Huffington had a great piece on the success of community banks yesterday in the Huffington Post. You ought to get it NEW YORK TIMES: Do you read the Huffington Post? Mr. CLINTON: A lot. I read a lot of the blogs. I try to keep up with what theyre saying. But the point is all she did was report that most of these community banks were in good shape, theyre loaning money. I talked to a friend of mine from Laredo the other day and he said as far as he knew there was no bank in from San Antonio south of Texas that was in trouble unless it was a national affiliate of something, that if they were community banks and loaning money to their depositors, they were going great. So thats just a totally off the wall, crazy argument. It just doesnt have any merit. The banks that took care of the people even if they gave some of those faulty loans, even if they gave a few subprimes, they are not in trouble. They were not part of the problem here. The community reinvestment requirement is a good one. Its one of the reasons that we had the broadbased economic growth we had and one of the reasons we were able to lift incomes and wealth levels for people who otherwise would have been left out of what happened in the 1990s because banks had to loan a certain percentage of their money back to their depositors in the community. Thats my take on it. The Time magazine thing, I thought, if you actually read what they said, they kind of hedged. They said Well, here are some of the things people say. But if you ask me to write the indictment, Id say, I wish Bill Clinton had said more about derivatives. The Republicans probably would have stopped him from doing it but at least he should have sounded the alarm bell. Because it was irrelevant that only one-tenth of one percent of the American people could ever invest in derivatives and a small percentage of people around the world. Because once you had that much volume, if they all failed anyway, they would impact everybody else. NEW YORK TIMES: Who told you that? In other words, when you were thinking about this in the 90s, who were you listening to? Mr. CLINTON: Oh, I talked to a lot of people. I talked to actually Greenspan about this once. I said how can we have all this money you remember we had one institution failed that the New York Fed had to bail out. It had some derivative investments and it went down. Do you remember that? NEW YORK TIMES: I dont. Mr. CLINTON: What was the name of that? There was a bank that failed that the New York Fed bailed out an institution that had some derivative exposure? And so I talked with them. NEW YORK TIMES: In 98-ish? Mr. CLINTON: Yeah. But you got to understand, again, we were living in a different world. We had a lot of confidence in the S.E.C. We had a lot of confidence in the broad-based nature of our economic growth. We never dreamed thered be a time like in the first five years of this decade where literally the whole growth of the country would be in the housing, finance and consumer spending because we had no other investment strategy. ECONOMIX: This is a bit of an oversimplification. Its true that economic growth in the 1990s was far more broadly based and significantly faster than growth during George W. Bushs presidency. Mr. Clintons policies deserve some credit for the 1990s growth. But so does an enormous stock-market bubble. The popping of the bubble, starting in 2000, led to the recession of 2001. It was an accident of history that Mr. Clinton left office before that recession began. The fact that the Clinton administration did nothing to stop the 1990s stock bubble is the main reason to be skeptical it would have done much to stop the housing bubble. Mr. CLINTON: I think, you know, maybe you could say, well, you should have anticipated Al Gore would lose the election and thered be nobody home at the S.E.C. I made the best call I could. But I do wish I always felt a little queasy about the derivative issue. Otherwise, I think we did a good job and I do not believe when anybody asks me that, I ask them, I look at them and ask them, Do you think this would have happened if we had been there? Look me in the face and say yes. I havent found any takers yet.

http://www.nytimes.com/2009/05/14/business/14regs.html White House Pushes Broad Rules for Derivatives May 13, 2009, 3:08 pm http://dealbook.blogs.nytimes.com/2009/05/13/white-house-to-offer-plan-to-regulate-derivatives/? scp=5&sq=derivatives&st=cse Update | 8:22 p.m. In its first detailed effort to overhaul financial regulation, the Obama administration on Wednesday sought new authority over the complex financial instruments, known as derivatives, that were a major cause of the financial crisis and have gone largely unregulated for decades. The administration asked Congress to move quickly on legislation that would allow federal oversight of many kinds of exotic instruments, including credit default swaps, the insurance contracts that caused the near-collapse of the American International Group, The New York Timess Stephen Labaton and Jackie Calmes report. The Treasury secretary, Timothy F. Geithner, said the measure should require swaps and other types of derivatives to be traded on exchanges and backed by capital reserves, much like the capital cushions that banks must set aside in case a borrower defaults on a loan. Taken together, the rules would probably make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets. The proposal will probably force many types of derivatives into the open, reducing the role of the socalled shadow banking system that has arisen around them. This financial crisis was caused in large part by significant gaps in the oversight of the markets, Mr. Geithner said in a briefing. He said the proposal was intended to make the trading of derivatives more transparent and give regulators the ability to limit the amount of derivatives that any company can sell, or that any institution can hold. The initiative was well received by senior Democrats in Congress with jurisdiction over the issue. The proposal had been expected, but some lawmakers, impatient with the pace of the new administrations efforts, had begun moving ahead themselves. Hinting at a lobbying campaign to come, Robert Pickel, the chief executive of the International Swaps and Derivatives Association, a trade group, said his organization looked forward to working with policy makers to ensure these reforms help preserve the widespread availability of swaps and other important risk management tools. But some in the financial industry say that regulation is inevitable. Nobody is in a just say no mode, said Steve Elmendorf, a former House Democratic leadership aide who represents several major financial institutions and groups. Everybody understands that weve been through a financial crisis and that change has to happen. And the only question is how the change happens. The administration is seeking the repeal of major portions of the Commodity Futures Modernization Act, a law adopted in December 2000 that made sure that derivative instruments would remain largely unregulated. The law came about after heavy lobbying from Wall Street and the financial industry, and was pushed hard by Democrats and Republicans alike. It was endorsed at the time by the Treasury secretary, Lawrence H. Summers, who is now President Obamas top economic adviser. At the time, the derivatives market was relatively small. But it soon exploded, and the face value of all derivatives contracts a measure that counts the value of a derivatives underlying assets outstanding at the end of last year totaled more than $680 trillion, according to the Bank for International Settlements in Switzerland. The market for credit default swaps a form of insurance that protects debtholders against default stood around $38 trillion, according to the international swaps group. That represents the total amount of insurance that has been written on various kinds of debt, but the amount that would have to be paid out if the debt went into default is considerably less. As the credit crisis has unfolded, trading in credit default swaps has cooled, market participants said. The collapse of A.I.G. took a huge player out of the market and banks, hobbled by loan losses, have 10

curbed their activities in the market. Still, derivatives trading desks have been one of the few profit centers at major banks recently. The biggest banks like JPMorgan Chase, Citigroup and Goldman Sachs, as well as big insurers, are all major players in derivatives. Derivatives are hard to value. They are virtually hidden from investors, analysts and regulators, even though they are one of Wall Streets biggest profit engines. They dont trade openly on public exchanges and financial services firms disclose few details about them. The new rules are meant to change most, but not all, of that opacity. Used properly, they can reduce or transfer risk, limit the damage from market uncertainty, and make global trade easier. Airlines, food companies, insurers, exporters and many other companies use derivatives to protect themselves from sudden and unpredictable changes in financial markets like interest rate or currency movements. Used poorly, derivatives can backfire and spread risk rather than contain it. The administration plan would not require that custom-made derivative instruments those with unique characteristics negotiated between companies be traded on exchanges or through clearinghouses, though standardized ones would. If approved, the plan would require the development of timely reports of trades, similar to the system now used for corporate bonds. The letter suggested that the Commodity Futures Trading Commission would play a leading role in the oversight of the market, although it would also leave important elements to the Securities and Exchange Commission. Over the years, the turf battle between those agencies contributed to the neglect of that market by government overseers. Some lawmakers in the House and Senate have already introduced measures to regulate derivatives. But a number of members have pressed the administration to put out its own plan. Representative Barney Frank of Massachusetts, the chairman of the House Financial Services Committee that oversees the S.E.C., and Representative Collin C. Peterson of Minnesota, chairman of the House Agriculture Committee with oversight of the C.F.T.C., on Wednesday released a joint statement saying, we agree there must be strong, comprehensive and consistent regulation of derivatives. We will work closely together to achieve that goal, they added. While derivatives regulation will be a focus of some market players, of equal concern to many in the financial industry are what the Obama administration and Congress might do to regulate compensation for executives across the board, not just at institutions that have accepted federal bailout money. The Treasury is acting on two paths. First, it plans as soon as next week to announce revised compensation rules for companies getting assistance, to make those rules conform with a law Congress passed in February that was more stringent than the Treasurys own earlier guidelines. Separately, Treasury officials have just begun discussing with the Federal Reserve and the S.E.C. what the government can do industrywide through incentives, restrictions or a mix of the two for corporate boards to guard against eye-popping compensation that rewards excessive risk-taking of the sort that contributed to the current crisis. The fear among many in the industry and some in the administration is that whatever limits Mr. Obama proposes, Congress will seek to add even more, in response to widespread public anger at Wall Street. In addition to the regulatory changes it is seeking, the administration is also continuing to expand its bailout programs for various industries. Mr. Geithner announced on Wednesday that the administration would provide a new round of capital assistance to smaller community banks, and would increase the amount that they can borrow from the program. Beyond derivatives, he also said that the administration would be presenting a comprehensive proposal to overhaul the regulation of the financial system. He provided few specifics, but said a central goal would be to eliminate the ability of companies to pick the least onerous regulator. We need a much simpler financial oversight structure, he said. Its not going to be comfortable for everybody but its important to do.

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http://www.treasury.gov/press/releases/tg129.htm May 13, 2009 Regulatory Reform Over-The-Counter (OTC) Derivatives The crisis of the past 20 months has exposed critical gaps and weaknesses in our financial regulatory system. As risks built up, internal risk management systems, rating agencies and regulators simply did not understand or address critical behaviors until they had already resulted in catastrophic losses. Those failures have caused a dramatic loss of confidence in our financial institutions and have contributed to a severe recession. Last March, Secretary Geithner laid out new regulatory rules of the road to ensure we never face a crisis of this magnitude again. An essential element of reform is the establishment of a comprehensive regulatory framework for over-the-counter derivatives, which under current law are largely excluded or exempted from regulation. As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by both regulators and market participants. But even if those risks had been better known, regulators lacked the proper authorities to mount an effective policy response. Today, to address these concerns, the Obama Administration proposes a comprehensive regulatory framework for all Over-The-Counter derivatives. Moving forward, the Administration will work with Congress to implement this framework and bring greater transparency and needed regulation to these markets. The Administration will also continue working with foreign authorities to promote the implementation of similar measures around the world to ensure our objectives are not undermined by weaker standards abroad. Objectives of Regulatory Reform of OTC Derivatives Markets Preventing Activities Within The OTC Markets From Posing Risk To The Financial System Regulators must have the following authority to ensure that participants do not engage in practices that put the financial system at risk: The Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCP): o CCPs must impose robust margin requirements and other necessary risk controls and ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP. o For example, if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared. All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include: Conservative capital requirements Business conduct standards Reporting requirements Initial margin requirements with respect to bilateral credit exposures on both standardized and customized contracts Promoting Efficiency And Transparency Within The OTC Markets -- To ensure regulators would have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets, this new framework includes: Amending the CEA and securities laws to authorize the CFTC and the SEC to impose: Recordkeeping and reporting requirements (including audit trails). Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository. CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public. CCPs and trade repositories must make data on individual counterparty's trades and positions available to federal regulators. 12

The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems. The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information. The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives. Preventing Market Manipulation, Fraud, And Other Market Abuses The Commodity Exchange Act (CEA) and securities laws should be amended to ensure that the CFTC and the SEC have: o Clear and unimpeded authority for market regulators to police fraud, market manipulation, and other market abuses. o Authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets. o A complete picture of market information from CCPs, trade repositories, and market participants to provide to market regulators. Ensuring That OTC Derivatives Are Not Marketed Inappropriately To Unsophisticated Parties Current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. But the limits are not sufficiently stringent. The CFTC and SEC are reviewing the participation limits in current law to recommend how the CEA and the securities laws should be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.

Regulators should be neither bubble poppers nor blowers http://www.theaustralian.news.com.au/business/story/0,,25552776-31478,00.html Alan Wood | May 29, 2009 Article from: A COMMON view of the global financial crisis is that it is the outcome of the bursting of a huge asset price bubble or bubbles. The process is a complex story involving failures of market regulation, a remarkable expansion of investors' and households appetite for risk and leverage, an ultimately destructive explosion in financial innovation and a related failure of financial institutions to appreciate the extent of their exposure to risk, loose monetary policy and serious global financial imbalances leading to a global savings glut. But was it a bubble? Not according to the efficient markets hypothesis, the academic paradigm that has ruled in the era of increasingly deregulated financial markets. This maintains that asset prices reflect the collective information and wisdom of traders in asset markets, where arbitrage quickly eliminates price anomalies, speculation is stabilising and diversification and financial innovation greatly reduce risk. These markets are also self-correcting in the face of shocks. And as a former deputy governor of the Reserve Bank of Australia, Stephen Grenville, remarked in a caustic attack on efficient market theory, efficient markets have no need for constraining rules or intrusive supervision. There was also a belief that self-interest would ensure banks and other financial institutions would protect the interests of their shareholders. Another central banker, president of the Federal Reserve Bank of San Francisco, Janet Yellen, said in a speech last month: "It seems to me that this argument is particularly difficult to defend in light of the poor decisions and widespread dysfunction we have seen in many markets during the current (financial) turmoil". But the most spectacular retraction came from the best-known central banker of them all, Alan Greenspan, who told a US congressional committee in October last year that the financial crisis had left him in a state of shocked disbelief. "This modern risk-management paradigm held sway for decades," Greenspan said. "The whole intellectual edifice, however, collapsed in the summer of last year." 13

Where does this lead? Well, not to the conclusion many on the Left have reached: much greater government intervention in markets via extensive regulation. US economist Nouriel Roubini, whose reputation has been considerably enhanced by his perceptive analysis of the financial crisis, recently summed up his view this way: "I believe in market economics ... But I also believe that market economies sometimes have market failures, and when these occur, there's a role for prudential, not excessive, regulation of the financial system." The need for improved regulation is widely accepted. Controversy has arisen over the issue of whether there is a need for central banks to act not only against inflation but also excessive rises in asset prices. Central bankers in the US and in Australia are increasingly asking themselves this question. In Australia, the most comprehensive case against such intervention has been put in a policy monograph for the Centre for Independent Studies by economist Stephen Kirchner, Bubble Poppers: Monetary Policy and the Myth of 'Bubbles' in Asset Prices. It is impossible to do justice to Kirchner's detailed arguments here, but a flavour of them is in the term bubble poppers. It comes from US Federal Reserve chairman Ben Bernanke, an authority on the Depression. Bernanke concluded the cause of the Depression was not the one popularly believed, that the stock market became overvalued, crashed and caused the depression. Instead Bernanke found that monetary policy tried to overzealously stop the rise in stock prices, which the Fed regarded as caused by a speculative bubble. The Fed fell under the control of "a coterie of bubble poppers". The message is that the Depression is a powerful lesson in the dangers of central bankers concluding that markets are in a bubble and intervening to pop it. In a speech two weeks ago an assistant governor of the RBA, Guy Debelle, argued that the costs in terms of economic growth and unemployment of intervening to pop an asset bubble were too high. Instead central banks should stick to targeting inflation and look to other means, namely prudential regulation, to address asset prices. This was a personal view, not the RBA's. Much of this debate casts the issue in too narrow a context and the argument about whether or not bubbles exist is a distraction. Nobody denies asset price booms and busts exist, nor that some of these episodes, notably the current one, have been associated with financial crises and recessions. Central bankers have always taken asset prices into account in setting monetary policy and in Australia's case successfully intervened in the housing market via both interest rates and jawboning by then governor Ian Macfarlane and head of Australian Prudential Regulation Authority, John Laker, a former Reserve banker, to cool off reckless lending and overheating in housing prices. Kirchner dismisses this episode as unsuccessful, and the Howard government certainly didn't like it. But the ratio of house prices to income fell markedly after 2003, when the RBA raised rates by 0.5 percentage points in two back-to-back hits. And Australia has so far not suffered anything like the housing price collapses in the US and Britain. The debate is not about intervening in every asset price episode, but in those rare cases that have characteristics such as rapid credit growth, a rapidly rising leverage, very low margins for risk and, frequently, falling inflation because they have been triggered by supply side productivity-boosting innovations. Such episodes, whether or not we call them bubbles, led to severe economic dislocations. The idea isn't to set targets for asset prices in the way central banks now have inflation targets, but to run monetary policy in a way that avoids excessive credit creation and leverage, doesn't allow official interest rates to diverge significantly from a neutral level for extended periods and avoids mistakes like excessively lowering interest rates because inflation is low. There is also general agreement on the need for much better quality macro and micro prudential regulation and other reforms of the sort now being discussed in the Group of 20, the International Financial Stability Board and other forums. As the Depression illustrates, we don't want a coterie of bubble poppers running central banks, but nor do we want central bankers captured by mistaken views on the wonders of unfettered financial markets.

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Comments: Macro managing asset markets, easily said than don Now it is high time to have a debate on a macro approach to asset prices, in the context of the great recession following the financial crisis that had its direct root of the bursting in the bubbles of asset markets, including housing and equity markets. The current recession has been characterised by some as balance sheet recession. Balance sheet, no matter it is for banks, firms, or households, is affected by asset market conditions and asset prices. Although the current recession is a highly synchronised one, there have been these types of so called balance sheet recessions before, such as Japan in the 1990s. In macroeconomics, there are goods, money, labour markets, but no other markets explicitly, such as housing and equity markets. The three markets in the macroeconomic framework jointly determine interest rate, output/employment, aggregate price (inflation). Without a workable macro framework which includes important asset markets, it will be extremely difficult to see what macro policies should be used and how they will work in dealing with any perceived or real problems in those markets. The current debate should and will prompt economists to come up with some workable macroeconomic frameworks that can guide policy makers in managing the economy more effectively than they have been. The great recession has presented economists with a very practical and urgent task in their research. They need to meet the challenges of our time. It's interesting this topic has recived more airplay - particularly as the horse bolted some time ago and RBA member now resort to jawboning in most of their 2009 speeches. Australia has been no different than other western nations in that massive excess credit creation has set the scene for a massive bust. If the central bank took more action in 1999 when consumer debt to GDP exceeded 100%, or when M3 exceeded 10% yoy in 2001, we, and our banks, would not be in the potentail calamity we face. (To be fair on the RBA, government policy and lax bank lending standards played it's role in bubble inflation as well). Questions? If our banks were such pillars of soundness, why has the govt stepped in with the guarantee, why has the govt. gone with such measures to prop up house prices?, and why has the RBA gone so big with repos from the big banks???? Could it be because foreign investors - half of bank funding - were going to pull the pin?? Our residential housing bubble, and by extension the big bank balance sheets, has grown too big too fail - evidenced by Rudd price propping grant and expected incentives for investors comign in the Henry tax tinker, sorry, review. Central bankers are responsable for the low interest rates that fueled the political move that allowed people who could not afford to pay off a mortage to buy homes . to say that banks should be more dissmissive of intervention is one thing but to my mind they were forced to act according to politicaly manufactured errors of judgement, the bill clinton initiated mortage problems and then the bush low interest rates that helped fuel the first error, certainly banks are NOT the innocent party here, and among themselves they created another money cow from the same crises,the other issue on allowing market corrections to fully correct on their on terms rather than central bank intervention, can you imagine the outcry of business when they realized they were were not going to get assistence-read welfare- from govt and or banks.now that I would love to see, rod qld You should have mentioned, as did Debelle, the concept of "macro-prudential stabilisers". The concept can be understood better in prudential regulation based on Basel I, with a simple capital adequacy ratio based on risk-weighting of certain asset classes and amount of capital required to fundthe portfolio. In such a system the risk assessment of an asset class could be increased automatically if the prices of the assets are increasing "too quickly" (as assessed against the overall price level). This becomes more problematic in a Basel II type world, where ultimately the "risk" of assets was determined by ratings agencies. One of the many problems we've encountered was the way ratings agencies dealt with increasing house prices - they assumed this made lending more secure as a potential defaulter woul have an asset worth more than the original purchase. This, of course, is a great theory so long as the price path continues. However, it works disasterously when, as it did with sub-prime mortgages, it feeds the machine that offers increasingly risky loans. Apart from building rules into risk assessment that should 15

discount the value of assets undergoing excessive aset-specific inflation, another very simple policy instrument is consumer credit laws as apply in Australia. In Australia a lender canot make a loan merely on the basis that the loan is "secure", the lender also needs to be satisfied that the borrower can adequately service the loan (and not by refinancing, which was the other under-pinning assumption with some sub-prime loans). Monetary policy is definitely not a good mechanism for popping bubbles - as bubbles are by definition increases in the price of one asset class out of sink with the price level in general. Monetary policy can only work on the overall price level. That does not mean that we don't need to take regulatory action globally to ensure improvement in risk assessment of assets undergoing excessive price growth, and some "duty of care" legislation on lenders. Finally, the other lesson we learnt in the process is that the assumption that corporate finance markets need less direct supervision than consumer markets on the assumption that the lenders and borrowers are better able to "protect and inform" themselves is complete and utter nonsense.

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http://www.bloomberg.com/apps/news?pid=20601039&sid=aE0vdrv_8E98# Economists Stuck in 1930s Need a Decade Update: Caroline Baum Commentary by Caroline Baum May 20 (Bloomberg) -- Depression avoided. Another recession to follow? That seems to be a concern for some academics, including Princeton economist Alan Blinder. Writing in the Sunday New York Times, Blinder says a combination of expansionary monetary and fiscal policies prevented 2009 from turning into 1930. Mission accomplished it isnt. Premature withdrawal of the stimulus could turn 2010 into 1936, when a series of missteps -- the Federal Reserve raised reserve requirements while FDR balanced the federal budget -- sent the recovering economy down for Part II, according to Blinder. To avoid a replay of the policy disasters of 1936-1937, both the Fed and our elected officials must stay the course, he writes. While the current recession is the worst in the last 50 years, the issues facing policy makers are the same: How do they know when enough is enough? Policy makers arent exactly sequestered. They have lots of information, both quantitative (economic data) and qualitative (surveys of businesses and consumers), at their fingertips to help them decide when the time is right to wean the patient from life support. They have econometric models, whose flaws are generally exposed after the fact. And they have (hopefully) the experience, wisdom, good judgment and fortitude to do what may be politically unpopular in the short run but vital in the long run for the health of the economy. Leaders Lead Lets start with monetary policy and see what the seven men and women in Washington and 12 across the country could use as a guide. Business cycle economists are forever testing indicators to see what leads, whats concurrent with and what lags the economys ebb and flow. (Ive never understood the value of the laggards.) The Conference Board maintains an Index of Leading Economic Indicators, which peaked in March 2006, moved sideways for more than a year and came within 0.1 point of the peak in July 2007 before heading down. 19

The LEI is widely ignored in the best of times and dismissed when it doesnt agree with the forecast. The 10 components, most of which are known by the time the index is released, get the same treatment. The April LEI, due tomorrow, is expected to show a 0.8 percent increase, according to the average forecast of 56 economists surveyed by Bloomberg News. That would be the first increase since June, with stock prices, the spread between the federal funds rate and 10-year Treasury note yield, and consumer expectations contributing to the expected increase. Sensitive Nomenclature One month does not make a trend. Nor does it reverse the gloomy message reflected in the six-month annualized change in the LEI and the six-month diffusion index, measures preferred by Conference Board economists to the monthly change. Then theres the possibility historical revisions will change the leaders outlook: Januarys 0.4 percent initial increase became a 0.2 percent decline with subsequent revisions. For the moment, the financial, or intangible, indicators -- the interest-rate spread, the stock market and real M2, which probably didnt show an April increase but has soared since September -- are showing hopeful signs. And they typically lead more concrete measures, such as jobless claims, building permits and orders for capital goods. Raw materials prices are sending a similar message. The CRB Spot Raw Industrial Price Index, which excludes oil, bottomed in December and went nowhere for three months before heading higher. Theres a reason theyre called sensitive materials prices: They respond to slight changes in demand. Manufacturers can step up their purchases of copper and steel scrap faster than raw materials suppliers can increase output. Prices rise as a result. Touchy Feely Rejection Intangibles and price signals arent enough for the Fed, which is why monetary policy tends to overstay its welcome. Blinder can rest easy on that score. When it comes to the possibility of fiscal restraint, the only possible reason to worry is the Obama administrations expressed desire to tax the rich and unexpressed need to tax everyone else to pay for the proposed spending. Congress enacted a $787 billion fiscal stimulus bill in February (only 11 percent has been spent so far) and a $3.55 trillion budget last month. The projected deficit for the current fiscal year is $1.84 trillion and $1.26 trillion for fiscal 2010. And thats before the dream of universal health care is realized. The idea that Congress can revamp onesixth of the U.S. economy before the August recess is either folly or hubris. Either way, its frightening. Decade Identification President Barack Obama has said current deficits are unsustainable, but that will be for foreigners to decide and us to find out. At some point, they will demand higher returns on their dollars or return their dollars. That would be a sure sign the government waited too long to tighten fiscal policy. If that coincides with monetary policy that has overstayed its welcome, fanning inflation expectations and actual inflation down the road, it might not be long before Blinder starts worrying about a replay of the 1970s, not the 1930s. (Caroline Baum, author of Just What I Said, is a Bloomberg News columnist. The opinions expressed are her own.) Last Updated: May 20, 2009 00:01 EDT

http://www.bloomberg.com/apps/news?pid=20601039&sid=ae5Y7Lc6IrTw# Curve Watching Beats Room Full of Forecasters: Caroline Baum Commentary by Caroline Baum May 12 (Bloomberg) -- Like clockwork, the alarm bells are going off as long-term Treasury yields start their inevitable climb. Rising Government Bond Yields Frustrate Central Banks, trumpets yesterdays Wall Street Journal. Rising bond yields present fresh Fed challenge, according to the April 29 edition of the Financial Times.

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Its a funny thing about long-term interest rates. Theyre pro-cyclical. They tend to rise when the economy is doing well, when demand for credit is strong. They fall when the economy is in the tank, and the private sector isnt much interested in investing and spending. If theres a way to accommodate the increased demand for credit that goes hand in hand with recovery without pushing up the price, no one has figured it out just yet. For a time, the federal governments increased borrowing needs, both current and expected, were being met by more-than- willing lenders. The flight-to-quality into Treasuries drove yields to historic lows, with the benchmark 10-year note bottoming at 2.04 percent in December. Last Friday, the 10-year yield touched 3.38 percent as a proliferation of green shoots calmed investor fears of an endless dark winter. Thats not good news for the Treasury, which has to pay interest on the rapidly expanding debt. For the Fed, however, rising yields are a sign its medicine is working. Good News Unlike market-determined long-term rates, the overnight interbank lending rate is set by the central bank. Other short- term rates gear off the fed funds rate, with an added premium for perceived risk. Treasury bill yields actually went negative for a spell in December, right around the time the Fed slashed the funds rate to a range of zero percent to 0.25 percent. In other words, investors were willing to park money with the government for three or six months and receive less when the bills matured. Even the mattress can top that. Long-term rates are the sum of the current and expected future short-term rates. With short rates virtually at zero, what would falling long rates say about prospects for the U.S. economy? Not much, Im afraid. After throwing so much monetary and fiscal stimulus at the economy, policy makers should be grateful for a sign things are working. If this sounds familiar, it is. I probably write about the yield curve more than any single subject. I both understand and believe in it. Too Simple to Understand The yield curve, or spread, has several things going for it: First, its a leading economic indicator, officially added to the index designed to predict the economys ebbs and flows in 1996. It was a leader well before that, even though it was unofficial. Second, what you see is what you get. The spread is never revised, always available and in no way proprietary. Third, and most curious, the majority of economists dont get it. They see rising bond yields in isolation -- without paying attention to what that price-setter, the Fed, is doing at the front end of the curve. Its the juxtaposition of short and long rates, not their level, that conveys information about monetary policy. In a July 2008 working paper, San Francisco Fed economists Glenn Rudebusch and John Williams examined the tendency for professional forecasters to ignore the spread. They compared the forecasts provided by the Survey of Professional Forecasters (SPF) to that generated by a simple, real-time model based on the yield spread. Guess who won? And it wasnt even close. Slow Learners Why, in the face of the yield curves superior track record, would economists choose to ignore it? If you think monetary policy matters, you should care about the spread, says Jim Glassman, senior economist at JPMorgan Chase & Co. With the Feds ability to anchor short- term rates at artificial levels, the spread is a way of looking at the stance of monetary policy. Rudebusch and Williams found forecasters to be slow learners when it came to incorporating the usefulness of the yield spread for forecasting recessions, they say in Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve. Even when economists are fully apprised of the yield curves significant real-time predictive power for distinguishing between expansions and contractions several quarters out, they find a way to explain away the message. What, Not Why Signals from the yield curve have often been dismissed because of supposed changes in the economy or special factors influencing interest rates, Rudebusch and Williams write. In other words, this time is different.

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Remember the cries that went out when the yield curve inverted in the middle of 2006 and remained that way through early 2008? China was buying our bonds, pushing down long-term rates. It was a conundrum, but it was dismissed. Therein lies the beauty of the spread. The why matters less than the what. It is what it is. The steepening yield curve is not going to nip the recovery in the bud. (These warnings are sure to follow.) To the contrary, its a sign that things are improving. The yield curve was almost vertical in the early 1990s, another period where bank balance sheets were impaired. It took a steep curve for a long time to heal the banks, which borrow short and lend long when they arent getting into trouble with newfangled products. If the Fed wants to worry about something, it should forget long-term interest rates. They will take care of themselves. Policy makers have much bigger concerns, namely the ability, and political wherewithal, to shrink the Feds $2 trillion balance sheet when the time comes. And when will that be? The yield curve will provide valuable input, assuming anyone is listening. (Caroline Baum, author of Just What I Said, is a Bloomberg News columnist. The opinions expressed are her own.) Last Updated: May 12, 2009 00:01 EDT http://www.bloomberg.com/apps/news?pid=20601039&sid=aHEie5ri2clo# Capitalism Still Has Legs That Are Long and Sexy: Caroline Baum Commentary by Caroline Baum April 30 (Bloomberg) -- What would Milton Friedman say? Everywhere you turn, billboards are advertising the failure of capitalism. Not literally, of course, but the equivalent. The view that the current financial crisis is always and everywhere a market failure is cropping up in the most unlikely places, including that bastion of free-market capitalism, Chicago. The latest convert to the cause is Richard Posner, judge on the U.S. Court of Appeals for the Seventh Circuit, senior lecturer at the University of Chicago Law School and author of a new book, A Failure of Capitalism: The Crisis of 08 and the Descent into Depression. I havent read Posners book yet. I heard him talk earlier this week at the New York City chapter of the Federalist Society. He never made the connection between his diagnosis of the crisis and the title of his book. Posner made two points: one, banking is inherently risky and was made riskier, starting in the 1970s, by deregulation; and two, the Federal Reserve kept short-term rates too low for too long, sparking a real-estate bubble whose undoing proved near-fatal to the banks. Lets start with the claim that deregulation was to blame. Its exactly the opposite, said Sam Peltzman, professor emeritus at Chicagos Booth School of Business, when I asked him what Friedman, his former professor and colleague, would have said. Regulation was there to make the banking industry safe. It conduced to do just the opposite. Regulation Aversion Financial institutions respond to regulation in ways that offset the original intent, according to Peltzman. When regulators increased capital requirements, banks took greater risk with their capital, Peltzman said. When the Basel Accord sought to align capital requirements with risk, banks took risk off their balance sheet, creating structured investment vehicles to house the wayward assets, he said. That made it worse. Regulation didnt prevent the savings and loan industry from getting into trouble in the 1980s, he said. Nor did it prevent large banks from lending to Asia a decade later. Latin Americas less developed countries of the 1970s and 1980s may have morphed into Asias emerging markets by the 1990s, but that did nothing to change the nature of risky loans. Regulation is unlikely to prevent the next crisis either, Peltzman said. For the record, Friedman was in favor of deposit insurance, if only as a way to prevent destabilizing bank runs. Price Fixer As for Posners contention that the Feds erring on the side of low interest rates constitutes a failure of capitalism, Friedman would have said it was total nonsense, said Michael Bordo, professor of economics at Rutgers University in New Brunswick, New Jersey, who earned his Ph.D. in economics from Chicago. It was not a failure of capitalism; it was a failure of the central bank. 22

The odds that 19 men and women (a.k.a. the Federal Open Market Committee) will be able to select the overnight interest rate that keeps the U.S. economy growing at its potential in perpetuity are next to nil. There would be a huge outcry if the Fed set the price of oil or copper or soybeans. Yet we accept the central bank as a price setter, a monopolist, when it comes to the interbank lending rate. No one should be surprised to learn that Friedman would have disapproved of the bailouts. He would have said GM and Chrysler should have been gone a long time ago, Bordo said. And what about his take on the 19 largest banks that have been declared too big to fail? Friedmans view was that no one is too big to fail, that bankruptcy is a way of reallocating resources, according to Bordo. Whose Failure? I asked Posner why the Feds errors constitute a failure of capitalism. He said the central bank was part of the capitalist structure, along with property rights and a judicial system to enforce them. To the extent that the Fed mismanaged the money supply (or interest rates) and failed to assure a reasonable degree of economic stability, it has to be regarded as a failure of capitalism. I make clear in my book that I am not advocating the replacement of capitalism by any other economic system! Posner wrote in an e-mail exchange. The alternative explanation for the crisis is a failure of government, well-intentioned as its policies may be. Friedman is solidly in that camp. Channeling Friedman He wouldnt agree it was a failure of capitalism, said Anna Schwartz, a research associate at the National Bureau of Economic Research and Friedmans co-author on A Monetary History of the United States, 1867-1960. It was a failure of government. The Fed conducted very easy monetary policy, which permitted the asset-price boom, she said yesterday in a telephone interview. It had nothing to do with capitalism failing. It had to do with the policies and institutions that conducted them. Even Posner, the title of his book notwithstanding, said hed like a moratorium on regulatory reform until this is over. Milton Friedman would have said the same thing, only his moratorium would have been permanent. Last Updated: April 30, 2009 00:01 EDT http://www.bloomberg.com/apps/news?pid=20601039&sid=auFHtpfT9hRI# Inflation Cure Exposed When In-Laws Move In: Caroline Baum Commentary by Caroline Baum May 22 (Bloomberg) -- When Ben Bernanke arrived at the Federal Reserve, first as a governor in 2002 and then as chairman in 2006, he was known as an inflation targeter. He had written the book (literally) on the subject, based on his empirical research, and had come to believe -- at least until the financial crisis turned him into chief liquidity officer -- that adopting an explicit numerical inflation target is the best way for central banks to increase their credibility and achieve price stability. Bernanke probably never dreamed hed be asked to use inflation targeting to achieve higher prices. But thats exactly what some respected economists are recommending, according to a May 19 Bloomberg News story. Harvard Universitys Ken Rogoff and Greg Mankiw think more is better when it comes to inflation. Rogoff said he advocates 6 percent inflation for at least a couple of years. That would alleviate the strain deflation imposes on debtors, including the U.S. government, who have to pay back their loans in appreciated dollars. In the Middle Ages, they threw people who failed to repay their debts into debtors prisons. Today debtors are rewarded with all kinds of government perks. Look how far weve come! Borrowers took out mortgages they couldnt qualify for to buy homes they couldnt afford. When the housing market collapsed, they were rewarded with government-subsidized mortgage modifications and, in some cases, partial forgiveness on their loan balances. And now, under Rogoffs 6 percent solution, debtors would see more of their burden lifted. And we, the savers, get screwed again. Zimbabwe Solution Hows that for creating the wrong incentives? Retirees who worked and saved their whole lives and are living on fixed incomes can look forward to their dollars buying less in their old age. Those of you who are still working can make room for your mother-in-law, who is moving in tomorrow. 23

Its hard to know exactly what Rogoff was thinking when he suggested Bernanke fan the inflation flames. (He didnt respond to multiple interview requests.) I would have asked him: If 6 percent is good, is 10 percent better? The idea was given short shrift in the blogosphere, especially by those whose economics is decidedly Austrian. The Mises Economic Blog calls Rogoffs and Mankiws descent into madness the Zimbabwe Solution. Kevin Depew, executive editor of Minyanville, chides the economists for peddling snake oil, which is what inflation is. And who says the Fed can orchestrate 6 percent inflation and not let it get out of hand? You know what would happen to those well-anchored inflation expectations: Ahoy, matey, its out to sea with you. Trapped Logic Trying to manage a slight increase in the rate of inflation in a discretionary way is not practical, says Marvin Goodfriend, professor of economics at Carnegie Mellons Tepper School of Business in Pittsburgh. Or consider this: If the Great Moderation of the last 25 years has seen the purchasing power of the consumer dollar cut by more than half, imagine what 6 percent inflation would do. The year-over-year change in the consumer price index hasnt exceeded 6 percent on a consistent basis since the early 1980s. The idea that a central bank would want to throw away its hard-won credibility at a time when monetary policy is on overdrive is just plain silly. Whats more, advocating higher inflation presumes central banks cant stimulate the economy at the zero bound without creating inflation, Goodfriend says, referring to a presumed problem when the overnight rate is at zero. That type of thinking is nothing more than an updated version of Keynesian liquidity trap argument, he says, referring to the idea that central banks become impotent when nominal rates approach zero. And it makes about as much sense. Negative Nominal Rates Mankiw didnt specify his preferred inflation rate in the Bloomberg story. He was too busy to give me an interview, directing me instead to his New York Times column from last month where he proposed the idea of negative interest rates: not negative real rates, adjusted for inflation; negative nominal rates. The idea is to make holding money less attractive so people will spend it. (Mankiw credits one of his graduate students with coming up with a way for the Fed to implement negative nominal rates.) I like Greg Mankiw. The fact that he included my traditional Thanksgiving column in his macroeconomic textbook has nothing to do with it. I read his blog regularly because he makes good economic (read: non-ideological) sense. This inflation idea is the exception to the rule. Two Roads Diverged Right now the investment community is divided over the direction of prices and the Feds ability to determining them: Its either deflation or inflation, with no middle ground. The deflation camp is looking at the burst credit bubble and the de-leveraging under way. Credit events are deflationary by nature: When lenders are hit with losses, they cant make new loans. The inflationists are looking at the Feds bloated balance sheet and the $877 billion of excess reserves banks are holding at the Fed. Pre-crisis they held some $1 billion to $2 billion of reserves over and above what theyre required to hold. The fear is that these reserves will morph into money -- and inflation -- quicker than the Fed can drain them from the banking system. The last thing a central bank would want to add to this already potent brew is actual inflation of 6 percent. Last Updated: May 22, 2009 00:01 EDT http://www.bloomberg.com/apps/news?pid=20601039&sid=amkTORldgMYA# Legacy of Debt Gives Fiscal Stimulus Bad Name: Caroline Baum Commentary by Caroline Baum June 5 (Bloomberg) -- By the time the U.S. government unveiled its Public Private Investment Partnership in March, the toxic loans and securities clogging bank balance sheets had become legacy assets. What if deficit hawks took the same tack and marketed the $787 billion fiscal stimulus as legacy debt? The $787 billion the U.S. Treasury will be borrowing or confiscating from you via taxation will saddle future generations with a legacy of debt, the press release might read. Your children and grandchildren can look forward to higher taxes, a lower standard of living and minimal government support in their old age. 24

Maybe the public would balk. And maybe some member of Congress would be bold enough to sponsor a measure to call off the still-uncommitted expenditures. After all, the economy appears to be recovering without fiscal stimulus. The rate of decline in real gross domestic product has slowed from an average 6 percent in the fourth quarter of last year and first quarter of 2009. Real GDP is expected to fall 1.9 percent in the current quarter, according to the median forecast of 61 economists in a Bloomberg News survey from early May. Less negative is the first step toward positive. And thats before any real money gets spent. So far $36.7 billion has been distributed via various government agencies, according to Recovery.gov, the Web site that tracks where your tax dollars are going. Thats 7.4 percent of the $499 billion of outlays ($288 billion of the $787 billion is tax relief) and 29 percent of the funds that have been committed to a purpose or a project. Patient, Heal Thyself Tax relief comes in the form of larger monthly paychecks for workers and tax credits -- for investment in renewable sources of energy, for first-time home buyers -- that are encouraging activity now even though the benefit is in the future. Still, its a trickle, not a waterfall. So if fiscal stimulus cant take credit for the improvement in the economy, what can? The answer is a combination of monetary policy and self-healing (an economys natural tendency is to grow). The Federal Reserve has thrown the kitchen sink at the economy, using traditional and non-traditional means to provide liquidity and credit when the banking system wasnt up to the task. Feds CPR Even before the Fed lowered the overnight interbank lending rate to 0 to 0.25 percent in December, the central bank was already ministering to markets and institutions outside its normal discount window customers, otherwise known as depository institutions. It was supporting the commercial paper market; had committed to purchase mortgage-backed securities and agency debt; had agreed to finance investor purchases of asset-backed securities; and had leant support to specific institutions, taking on some of Bear Stearnss toxic, I mean, legacy, assets in March 2008 and bailing out American International Group in September. Thats the beauty of monetary policy. It can be implemented instantaneously. The Feds challenge is to be as quick on the return trip. The problem with fiscal stimulus, aside from the fact that its a misnomer, is that it arrives too late. At least that was the standard criticism prior to the enactment of the $787 billion American Reinvestment and Recovery Act of 2009 in February. The governments tax and spending policies require the approval of a majority of the 100 senators and 435 members of the House of Representatives. And as we know, these 535 individuals sometimes confuse the peoples business with their own: getting re-elected. Preferred Stimuli This time around, a new president with solid majorities in both Houses of Congress was able to saddle future generations with trillions of dollars of debt less than a month after he took office. The Congressional Budget Office projects the debt- to-GDP ratio rising to 70 percent in 2011, the highest since the early 1950s, when the U.S. was winding down the war effort. If you believe, as I do, that monetary policy is the more potent of the stimuli, that fiscal stimulus just transfers spending from tomorrow to today and from the private sector to the government, with no net long-term gain, then maybe its time to stand up for the next generation. Besides, where is it written that the ill effects of years of over-consumption and under-saving have to be repaired in a year? Instant gratification means future deprivation. Word Choice Fed Chairman Ben Bernanke used part of his June 3 testimony to the House Budget Committee to warn of the consequences of unchecked spending, even in the face of recession and financial instability. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth, he said. If it takes a marketing gimmick -- labeling fiscal stimulus a legacy of debt -- to convey the message to the public and Congress, so be it. (Caroline Baum, author of Just What I Said, is a Bloomberg News columnist. The opinions expressed are her own.) Last Updated: June 5, 2009 00:01 EDT

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http://www.bloomberg.com/apps/news?pid=20601039&sid=aR6GmPBr1Of0# Masters of Universe Find Opportunity in Crisis: Caroline Baum Commentary by Caroline Baum May 5 (Bloomberg) -- Being a bond trader used to be a big deal. It may be a big deal again. Before private-equity and hedge funds started to throw their weight around, before the advent of the quants and the derivative geeks, bond traders were the gunslingers of Wall Street, pulling down big profits and reveling in the status that went with them. In the 1980s, these Masters of the Universe, as Tom Wolfe dubbed them in The Bonfire of the Vanities, gravitated to an exclusive club of primary dealers. These are the banks and securities firms that deal directly with the Federal Reserve in its open market operations and are required to bid at Treasury auctions. The primary dealer system was created in 1960 with 18 members. It was a sleepy sort of club until the late 1970s, when volatility in interest rates, rising deficits and an historic bull market provided the means and opportunity to reap huge profits. Large institutional investors would only do business with primary dealers. Dealers, in turn, benefited from the information gleaned from customer flows. The number of primary dealers peaked at 46 in 1988 before starting a steady descent, largely a result of consolidation, to 16 today. Even as banks swallowed up other banks, events were conspiring to reduce the allure of primary dealership. The availability of brokers screens to non-dealers increased transparency and chipped away at bid-ask spreads. The Japanese invasion of the 1980s -- first as investors, then as primary dealers -disrupted the cushy franchise of dealers, who socialized with one another and were known to get together to coup an auction (collusion by any other name). Feast or Famine Electronic trading increased liquidity in the market, making it cheaper and easier to buy and sell plainvanilla Treasuries. Customer business became a loss-leader for primary dealers, many of whom reinvented themselves as proprietary traders to justify (and underwrite) their existence. By the time the federal budget swung into surplus in the late 1990s, there were still 37 primary dealers sitting around picking their noses, worrying what theyd do in a world with no Treasury bonds. (Dont laugh: This was a real concern, especially for the Fed in its conduct of open-market operations.) Who would have guessed brokering bonds would become a lucrative business again? No One There In a curious twist of fate, the Treasury finds itself facing monstrous financing needs with only a handful of primary dealers to underwrite the debt. The Congressional Budget Office is projecting a deficit for fiscal 2009, which ends Sept. 30, of $1.85 trillion, based on President Barack Obamas preliminary budget request. Last week the Treasury said it expects to borrow $361 billion in the April-June quarter -- a traditionally light quarter because of the April 15 tax payment deadline -- and $515 billion in the third calendar quarter. Rare is the day when there isnt a Treasury auction of some kind. (The only obvious break in the auction calendar is for official holidays.) Treasury revived old issues (the three- and seven-year note), boosted auction sizes and expanded the menu of cash management bills, historically used to manage shortterm borrowing needs, to include 272-day and 296-day varieties. This week, the Treasury will sell a record $71 billion of notes and bonds to raise $18.8 billion of new cash. This is happening at a time when dealers are taking less risk and are constrained by the balance sheet. Back to Basics The result has been a widening of bid-ask spreads, which means an opportunity to make money the oldfashioned way. The steep yield curve is an added inducement. Dealers can buy, say, a 10-year Treasury note yielding more than 3 percent and finance it (borrow against the securities) at the overnight repo rate of 0.2 percent. No wonder some broker-dealers are applying to the New York Fed to become a primary dealer. At least one dropout is looking for readmission. Not only is it a good time to be a primary dealer, its a great time to be a bank -- assuming you arent one already. The Fed is practically giving money away to almost anyone that asks. 26

Even if private credit demand is sluggish -- it always is in recession -- Uncle Sam has a huge appetite. Banks can borrow from the Fed at 0 percent to 25 basis points, turn around and lend to Uncle Sam, with the difference going to the bottom line. It may just be weve come full circle. The crisis saw big investment banks, such as Goldman Sachs and Morgan Stanley, apply for a commercial bank charter, accepting a greater degree of regulation in exchange for a steady source of funding (consumer deposits). Primary dealers are in a growth industry. Banks and brokers are chasing customer business instead of engineering profits from exotic derivative securities. Who knows? Before long, the U.S. may start manufacturing stuff again. Last Updated: May 5, 2009 00:01 EDT

June 14, 2009 As U.S. Overhauls the Banking System, 2 Top Regulators Feud By STEPHEN LABATON and EDMUND L. ANDREWS http://www.nytimes.com/2009/06/14/us/politics/14power.html?_r=1&em WASHINGTON Two of the nations most powerful bank regulators were once again at each others throats. At a public meeting three weeks ago, John C. Dugan, the comptroller of the currency, blasted a proposal to impose stiff new insurance fees on banks as unfair to the largest banks, which he regulates. The financial crisis stemmed in part from problems at small banks, he insisted. Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation and the regulator for many smaller, community banks, could barely hide her contempt. The large banks, she said, had wreaked havoc on the system, only to be bailed out by hundreds of billions, if not trillions, in government assistance. She added, Fairness is always an issue. Behind the scenes, the two regulators have been clashing over a host of issues, officials said, be it the administrations coming regulatory overhaul or Ms. Bairs campaign to shake up the top management at Citigroup. The long-running and deeply personal feud between Mr. Dugan and Ms. Bair, two Republican holdovers with similar career paths in Washington, is now helping to shape President Obamas attempt to revamp financial regulation aimed at preventing the regulatory lapses that contributed to the economic crisis. Some of Mr. Obamas advisers and some senior Democratic lawmakers have suggested creating a single bank regulator. But the administrations current version, which could be announced as early as this week, would not combine the regulatory agencies. Instead, it would give Mr. Dugan and Ms. Bair significant new powers and could intensify their turf battles. Ms. Bair and Mr. Dugan declined to comment for this article. The Treasury secretary, Timothy F. Geithner, the main author of the administrations plan, in recent weeks has refereed among the competing views of Ms. Bair, Mr. Dugan and Ben S. Bernanke, the Federal Reserve chairman. The four generally agree that, if starting from scratch, they would not create the cumbersome system that has evolved piecemeal over the last 150 years. But with the administration and crucial lawmakers rejecting a single agency, the four officials have often disagreed on just how to streamline and strengthen regulation. Some points of contention include views on which agencies should play central roles in overseeing financial companies whose troubles could pose problems for the overall system, and whether to create a new agency to protect consumers from abusive mortgages or credit cards. Officials say the latest version of the plan, in large part, is a compromise of various viewpoints. On an issue like regulatory reform, with so many differing opinions, the expectation is not that all sides will agree on the final product, said Andrew Williams, a Treasury spokesman. But the administration worked hard to gather information from all parties to prevent a crisis like this from ever happening again. 27

Mr. Obamas economic team has often had internecine battles over policy, but the presidents advisers generally fall in line once he makes the final decision. But Mr. Dugan and Ms. Bair are semiindependent regulators whose feuds have multiplied and at times erupted in public. Most of the banking industry couldnt be happier with the current system. Bank executives and lobbyists say that the system, while flawed, enables regulators to tailor rules for a variety of financial institutions. They maintain that the policy issues for small banks differ markedly from, and often conflict with, those involving the large banks. Its healthy that the regulators disagree, said Camden R. Fine, head of the Independent Community Bankers of America. Out of their tension comes good, balanced policy. But the fractured nature of regulation also makes it easier for financial institutions to shop for the friendliest regulator or pit agencies against one another, lawmakers say. To reduce that risk, the administration is expected to propose eliminating one of the weakest agencies, the Office of Thrift Supervision. The agency was faulted for missing problems at some of the largest savings associations, like Washington Mutual and IndyMac, as well as at the American International Group, which it regulated because the company owns a thrift. Two Democratic senators, Christopher J. Dodd of Connecticut and Charles E. Schumer of New York, have urged Mr. Geithner to combine the four federal bank regulators into one. With multiple bank regulators, you get the worst of both worlds, Mr. Schumer said. Some banks get conflicting signals. Other banks get no signals at all. Mr. Dodd said that, despite his support for a single regulator, he favored the F.D.I.C.s continued role as the manager of the bank insurance fund. He said the plan was intended to reduce regulatory gaps but not discourage healthy debate among officials. Despite the fact that Im an advocate of a single regulator, I like the idea of some tension, Mr. Dodd said. Other Democrats, notably Representative Barney Frank of Massachusetts, have so far succeeded in convincing the administration that such a proposal is more political trouble than it is worth. And some banking experts say that the number of regulators is not the crucial factor. Whats most important is who the leaders are, said William K. Black, a former senior lawyer for the agency that became the Office of Thrift Supervision, and who brought cases against many savings and loans in the 1990s. The Obama plan, still being drafted by Mr. Geithner, is likely to give the F.D.I.C. new authority to seize and shut down financial companies in serious trouble. The administration is also expected to propose an agency to oversee financial products sold to consumers, like mortgages and credit cards. Both those ideas were supported by Ms. Bair and challenged by Mr. Dugan. The regulatory plan would also establish the Federal Reserve as a super-regulator to police risk across the financial system, a proposal supported by Mr. Dugan and criticized by Ms. Bair. The fighting between Mr. Dugan and Ms. Bair reflects the institutional interests of their respective agencies, as well as the differences between big banks and small banks. The F.D.I.C.s primary role is as the deposit insurer, so it is inclined to be risk averse, said Brian C. McCormally, a former regulator in the comptrollers office who is a partner at the Washington law firm Arnold & Porter. Ms. Bair and Mr. Dugan have fought over many other issues. In recent weeks, Ms. Bair has sought management changes at the large troubled banks, including Citigroup. Mr. Dugan, on the other hand, has advocated giving Citigroup managers more time to put their house in order. The rsums of the two regulators might make it seem as if they would get along. Both began their political careers as aides to Republican senators and both served as assistant Treasury secretaries under Republican presidents, at different times. Ms. Bairs approach to policy has evolved significantly from a conservative Republican aide to Senator Bob Dole of Kansas to a top regulator who now derives much of her political clout from her close ties to senior Democrats, notably Mr. Frank and Mr. Dodd. Both lawmakers urged the White House to retain Ms. Bair. Shes been brilliant, Mr. Frank said in an interview. Mr. Frank said she recognized long before officials in the Bush administration that it was vital for the government to more aggressively support the 28

housing market and reduce foreclosures. He also lauded her for a series of decisions that have helped community banks. But at the Treasury and the Federal Reserve, Ms. Bair is viewed as someone who pushes her and her agencys interests rather than someone who finds common ground with other policy makers. Besides Mr. Dugan, she has antagonized many other leaders in Washington. Officials at the Federal Reserve and the comptrollers office said she exasperated them last fall when she balked at allowing Citigroup to take over Wachovia, a major bank that was about to collapse. In bruising negotiations that lasted until 4 a.m., Ms. Bair squared off against Mr. Bernanke, Mr. Dugan and the Treasury secretary at the time, Henry M. Paulson Jr. The stand-off left many officials, who thought the broader financial crisis had given them no alternative but to finance the deal, fuming. When Wells Fargo a few weeks later made a more generous offer for Wachovia that required no government aid, Ms. Bair enraged Citigroup executives, some bank officials said, when she backed Wells Fargo and helped scuttle Citis deal. Her supporters said she believed that she had a duty to take an active role and could not afford to sit on the sidelines, hoping that the plans of the Fed and Treasury turned out well. Mr. Dugan, a more low-key regulator, has also worked as a lawyer representing some of the largest banks. He derives much of his influence from his close relationship with Mr. Geithner, reinforced when they worked on the banking crisis last year under the Bush administration. The proposal to overhaul financial regulation must be approved by Congress, where it could be reshaped drastically. This is the kind of thing that reminds me of the anecdote about the old man and the sea, said Mr. Dodd, the Senate Banking Committee chairman. Its going to take so long to drag it in that by the time it gets to the boat, it could come in as a set of bones.

http://money.cnn.com/2009/04/27/news/economy/Obama_bank_regulation/index.htm? postversion=2009042811

Fed's future role at issue on Hill

Congress struggles with complex plan for reordering financial regulation. A key hangup is how much new power to give the Federal Reserve.
By Jennifer Liberto, CNNMoney.com senior writer April 28, 2009: 11:21 AM ET WASHINGTON (CNNMoney.com) -- A major Obama administration plan to deal with financial companies too big to fail is becoming too big to zoom through Congress. Top White House and Treasury Department officials have been working behind the scenes for weeks to push lawmakers to start tackling legislation aimed at rescuing giant financial companies on the brink of failure -- like American International Group (AIG, Fortune 500). But the legislative effort has gotten bogged down and made little progress over the past month, because it's tied to bigger, controversial questions. One of the big ones: Whether the Federal Reserve's regulatory role should be expanded.

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The delay is significant, because reforming financial regulation is key to preventing future financial market crises. In addition, President Obama has promised global partners in the Group of 20 that the United States is dedicated to strengthening regulation of big companies. One of the problems is that Congress is tackling two difficult things at once: Reform financial rules going forward and create a new system for cleaning up big companies like AIG that fall through the regulatory cracks. That makes the issue monster big, meaning Congress would be lucky to get it done before the end of the year, experts say. "I have great concerns about moving the entire regulatory process in the middle of a crisis," said Sen. Bob Corker, R-Tenn. "Figuring out a resolution authority ... that's probably more urgent. But if it's all going to be done at the same time, let's not deal with that today. Let's deal with it in a prudent and thoughtful way." And the role of the Fed, which many on Capitol Hill blame for missing warning signs of the current crisis, remains the central unresolved issue. "There's a little bit of suspicion of the Federal Reserve and granting so much power to any one agency," said Wayne Abernathy, a lobbyist for the American Bankers Association who worked at Treasury under Secretary John Snow. Dancing with the Fed Congress and the Federal Reserve have acomplicated relationship. The central bank is designed to be independent and non-political, although it regularly reports to Congress. When the financial crisis struck, many on Wall Street and in Congress accused the Fed of contributing to the collapse by not cracking down on the kind of excessive leveraging that had grown common among banks. Sen. Chris Dodd, D-Conn., who runs the powerful Senate Banking committee, has expressed concerns about entrusting more power to the Fed. Senate Republicans, particularly Sen. Richard Shelby, R-Ala, have been pounding their chests about the Federal Reserve for months. "Sen. Shelby has serious concerns with granting the Fed that authority given its recent regulatory failures," said Jonathan Graffeo, spokesman for the top GOP senator on the banking committee. Relations between the Fed and some lawmakers grew particularly tense after the Fed refused lawmakers' requests to reveal which major financial firms received billions in bailout dollars through the rescue of AIG. The Fed later released the information. Later, when public outrage boiled over about bonuses paid to the same unit of AIG responsible for the company's demise, some lawmakers were irked to discover that the Fed had known for months about the bonuses. During a hearing in March, the House Financial Services Committee called Fed Chairman Ben Bernanke, along with Treasury Secretary Tim Geithner, to testify about the AIG bonuses. During one tense exchange, Bernanke called a question from Rep. Donald Manzullo, R-Ill., "poorly posed." The Senate signaled its distrust earlier this month when it voted 59-39 to pass a nonbinding amendment calling on the central bank to reveal the names of all financial institutions that get emergency loans. The Fed has strongly opposed such disclosure. 30

"The role of the Fed has changed dramatically," said Senate Finance Committee Chairman Max Baucus, D-Mont., during a March 31 hearing. "So the usual defense that we shouldn't intrude in the integrity and independence of the Fed, I think no longer applies." Behind the scenes, Bernanke, a former chairman of the Princeton economics department, has made efforts to address tensions by being more accessible to Congress than past chairmen. In recent weeks, Bernanke has made two quiet trips to Capitol Hill to talk face-to-face with small groups of Democrats. One meeting last Wednesday afternoon lasted more than an hour. Bernanke's spokeswoman said he also regularly talks with Republican lawmakers. "We've not had a Fed chairman as accessible as he," said Rep. Al Green, D-Texas. Green was one of a dozen lawmakers -- including Rep. Barney Frank, D-Mass., Rep. Carolyn Maloney, D-N.Y., and Rep. Mel Watt, D-N.C. -- who discussed with Bernanke the idea of making Fed programs more available to minority-owned businesses. "I find it quite refreshing that he answers questions instead of giving us doublespeak in language that's difficult to process," Green said. Big questions for big changes The political challenges have left the near-term future of the administration's efforts to reform regulation unclear. Earlier this year, Frank and others had spoken publicly about empowering the Fed with supervision of systemically significant institutions such as hedge funds, large insurers and nonbanking firms. Now, alternative options are also being discussed on Capitol Hill, according to congressional aides and lobbyists. Those include creating a super-panel consisting of different agencies, along with the Fed, or granting the Fed more power for a short period of time, such as two years. For their part, the Treasury and the Fed have floated draft legislation to unwind big companies but neither entity has suggested publicly who should be the overarching regulator. They both recommended the Fed should have a fairly big role in deciding when a big financial firm has become too risky and needs government intervention. Frank's committee is planning to hold a public hearing about creating a tougher regulatory system next month, according to a committee aide. The Senate has no similar plans yet. When asked on Friday about Congress' slow pace on regulatory reform, Geithner said that he wasn't worried and believes "there is broad support" for action. "Our basic imperative is to get it right and make sure we have a set of comprehensive set of reforms people can look at together that can become the law of the land," Geithner said.

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