Opinion

The Great Debate

Is the Fed up to examining your trillion dollar bet?

By Mark Williams
January 30, 2009

Mark_Williams_Debate– Mark T. Williams, a professor in the Boston University School of Management’s Finance & Economics Department, was a former Federal Reserve bank examiner in San Francisco and Boston. The views expressed are his own. –

Washington is doling out more than $1 trillion to banks, a hefty capital commitment putting taxpayer money at risk. Meantime, Congress is moving to expand financial sector oversight and the Federal Reserve Bank is likely to take on this additional duty.

As the government’s financial involvement increases, the Fed must be ready for this expanded role. Unfortunately, the current fleet of Fed examiners is in way over their heads. I should know: I used to be one.

The root cause of the financial crisis has been bank driven. Under the Fed’s watch, Wall Street wizards were allowed to concoct, sell and speculate on risky credit-related products. In addition to monetary policy, the Fed has an important duty to maintain a safe and sound banking system. Although this supervisory role is well understood, banks still overdosed on risk — not overnight but over time. This significant risk trend was missed by the Fed and its examination force.

In maintaining safety and soundness, bank examiners are the first line of defense. They are the foot soldiers, the Fed’s eyes and ears. The examination process includes physical sampling, on-site visits, and executive interviews, culminating in a formalized bank rating and written report. These ratings are an important risk measurement and provide a bank’s financial health scorecard. The Fed does not make these ratings public but uses these to assemble lists of the weaker banks that need further attention and oversight.

Data from bank examination reports are also used to evaluate longer-term risk trends on a local, regional, and national basis. As the Fed conducted on-site examinations, it is difficult to imagine how they missed this growing credit storm. The Fed could have quickly put the brakes on risky lending practices, reduced the number of bank failures and better protected the financial strength of this vital industry.

The Fed missed spotting the risk because many of its field examiners lacked the needed sophistication, training and measurement tools. While the bets being placed by regulated banks grew in size and complexity, Fed examiners were ill-equipped to adequately measure, monitor and report on these risks.

This growing gap in examiner knowledge and skills provided greater opportunity for banks, armed with generous bonus plans and sophisticated models, to overindulge in risk.

The banking industry continues to consolidate. In the last 25 years, the number of U.S. commercial banks has declined from over 14,000 to approximately 7,300. This significant trend has caused greater concentration of risk as more assets are being controlled by fewer banks. One botched Fed examination at a major bank can have much more far reaching implications than just 20 years ago. In addition, recent strategic miss-steps by major banks, such as Citigroup and Bank of America, have obliged more day-to-day surveillance and stressed an already wobbly examination force.

The on-going financial crisis has also forced investment banks, such as Goldman Sachs and Morgan Stanley, to adopt commercial banking status. As a result, the Fed now has a new type of “risk-taking” animal to tame and put under regulatory oversight. Unlike commercial banking, investment banks historically have taken more risk and used more leverage in seeking profits. The Fed must quickly and thoughtfully retool its examiner force so it can better carry out the critical role of maintaining a safe and sound banking system.

With significant taxpayer money on the line and more slated to be released, Fed examiners in today’s marketplace must better protect our investment as well as keep banks from inflicting financial harm to themselves and to the broader economy.

To upgrade Fed examiner capabilities, there are four critical areas which needs fixing:

1. The Fed must immediately hire more specialized bank examiners to provide better risk training and establish adequate incentives so the best will be encouraged to stay.

Fed examiners need to show a strong aptitude and understanding of the risk-taking activities which now drive bank earnings. The Fed should hire from the very institutions it regulates. In the last decade, the flow of hiring has been primarily from the Fed to such banks, which has further eroded the strength of the national examination force. In addition, adequate incentive systems need to be put in place to minimize the brain drain and insure that the best examiners have financial incentives to stay.

2. The Fed must tighten regulation and leverage-ratio requirements of investment bank-related activities.

Recent financial losses, including such high profile bankruptcies as Lehman Brothers, the shot-gun marriage of Bear Stearns to J.P. Morgan, and the continued financial harm inflicted by Bank of America’s ill-conceived acquisition of Merrill Lynch division, reinforce the danger of using excessive leverage. The Fed needs to re-examine its position on what is acceptable leverage and provide clear policy.

3. Compensation schemes at commercial and stand-alone investment banks must be re-evaluated with tighter oversight and linkage to overall ratings.

Bank-derived compensation systems can reinforce good as well as destructive behavior. The Fed should take a more active role in better identifying when incentive systems are positively aligned or when they encourage excessive risk taking.

4. The Fed must provide tighter regulation oversight on bank prime-broker operations.

Many commercial banks offer prime-brokerage lending services to unregulated, high-risk hedge funds. Up until recently, this business segment has grown substantially. There are more than 6,500 hedge funds in the U.S. that control more than $1.2 trillion. A bank can only be as strong as its customers. Given that the hedge-fund industry is looking shakier every day, the Fed must strengthen its expertise in regulating and tightening up lending standards in the prime-brokerage areas of its member banks.

By focusing on these four areas, stronger Fed examination staff and oversight will strengthen our banking system and go a long way toward protecting your $1 trillion bet.

Comments
29 comments so far | RSS Comments RSS

Thank you Mark Williams for providing the readers with some details about how the examination process actually works.

I too believe the issue of massive regulatory failure needs to be addressed much more explicitly. I am a former bank regulator (a Director of Research of the New York State Banking Dept.) and I have spent many years in the investment banking world involved in risk management, risk reporting and risk technology. Lately there have been several proposals for revising the regulatory process, including establishing a clearing house for credit-default swaps. consolidating regulators, new reporting requirements, etc. But there seems to be a failure to recognize that the regulatory process can only work if there are good regulatory people looking at the matters every day. If I may let me offer the following comments:

1. The bank regulators have had the authority to examine any aspect of a bank’s activities. They had the authority to figure out what was going on at the banks and to limit it. The regulators did nothing. So all the new regulations on paper will mean nothing if the regulators cannot or will not do their jobs.

2. Mr. Timothy Geithner recently said “First, the multitude of overlapping regulators must be rationalized into a coherent few, the communication between them improved and their turf battles ended”. Unfortunately consolidating the regulators will produce some streamlining but will not likely achieve the desired goals. Sending a regulator who makes $50,000 dollars a year to examine the activities of sophisticated financial traders who make millions of dollars a year is not a fair battle. And if you have ever worked in a government agency, as I did for over 4 1/2 years, you will be intimately familiar with the viciousness of the turf battles among the senior officials. There is a lot of deadwood at the top of the agencies and it needs to be cleaned out. A Herculean task if there ever was one.

Posted by S. Hellinger | Report as abusive
 

The US needs to examine the books of the private corporation known as the US Federal Reserve (The Fed). Do you know it is illegal to audit the Federal Reserve’s books?

Read President Wilson’s quote on why he should not have given control of our money to the Federal Reserve.

Note US Presidents advocating for returning the control of money to the US. Remove it from the Federal Reserve or other private banks before.

Presidents advocating the return of monetary control to the US public: Andrew Jackson (nearly paid off our national debt and advocating creating a National Bank; quick reversal after an assassin’s knife attack); President Lincoln (Printed US money without ceding to a private bank to finance the Civil War; assassinated by a shot to the head); President Garfield (advocated a public bank; assasinated by a shot to the head); Ronald Reagan (advocated a public bank; assassin missed head and Reagan survived).

Listen to Ron Paul.

Posted by skinner | Report as abusive
 

Re: skinner
You are right, though you missed Kennedy who also started releasing silver backed money and was as well assassinated.

Long Live Ron Paul

Posted by ppsychol | Report as abusive
 

Maybe someone can help me out and gain a better grasp on things. I read this article and it was very insightful to the examination process. However, when it calls out that these examiners “lacked the needed sophistication, training and measurement tools” I fail to understand how anyone could not produce the basic question and challenge of if a borrower is unable to pay off their ARM loan how is the debt handled to prevent it becoming insolvent? If I received an answer that suggested the debt would always be paid, my immediate response to the individual(s) would be simply “you did not answer my question”.
I also did not understand how the borrowed the funds were subject to multiple investors so that in the event of struggling payments instead of it being only 1 investor to negotiate new terms with, rather it would be multiples (essentially impossible).

I’m not an economics student but I just fail to grasp how anyone could justify handing out those loans to high risk customers without it being questioned by simple, straight, practical points.

Posted by Michael | Report as abusive
 

Skinner, the Federal Reserve has been audited repeatedly by the GAO. The results are available here:
http://www.federalreserve.gov/boarddocs/ rptcongress/

Please do some homework before posting claims.

 

Re: http://www.federalreserve.gov/boarddocs/ rptcongress/

Yes, part way. The Fed does disclose minutes, budget reports, and policy reports.

As custodian of our money supply, the US Fed should have and provide external audit reports. It does not and will not.

It is good that the Federal Reserve does provide: its
FOMC Minutes (public corporations should and often do provide transcripts of meetings dealing with such important items as quarterly and annual reports; the Fed refuses to do so).

Budget, planning and policy reports are a start.

An external audit would shine the light of day on a very mysterious private corporation that will not tell even congress. Where are the $ trillions sent out in the last 3 months? Only the US Fed knows; however hard Congress presses, the US Fed ain’t telling.

Please help us citizens and taxpayers see where our money is crated and sent out. After all is said and done, we are to pay the interest on the US Fed debt.

Posted by skinner | Report as abusive
 

@Skinner
100% agree!!!
Nationalize FED and abdolish frctional reserve system.
Those two are the root cause of all financial crises.

Posted by PwlM | Report as abusive
 

Michael…the banks in question knew what was going to happen but in absolute honesty, they didn’t care, they wanted to write the loans and then mix the questionable loans with good loans in a combined portfolio and sell them off in the secondary market. A lot of those are ALT-A paper and weren’t backed by Freddie or Fannie but sold in the secondary market. Unfortunately the due diligence on the end of the purchasers of these portfolios was little to none, hence the situation we are in. That is only a fraction of the problem.

Posted by Damian Palmares | Report as abusive
 

It is a total disregard to ethical behavior…they caved to greed in a nutshell.

Posted by Damian Palmares | Report as abusive
 

PROBLEM1
Classic lending for houses was 5-10% down (20% for no MIP) and 2-3 times income. This incentivized the homeowner not to default. Another incentive not to default was that they couldn’t get another mortgage and were stuck with renting.
SOPHISTICATION? Just go by these metrics and a credit score!

PROBLEM2
Computer Models that said “houses have never gone down NATIONWIDE in a calendar year”. The problem was that the data only went back 50 years. NOTE, this didn’t include the 1929 stock market crash when, there was a housing bubble. Duh!

PROBLEM3
The banks have lost trillions of dollars and now they are trying to figure out a way to “mask” these losses.
GET OVER IT!
The money is gone. The banks are essentially bankrupt. Only time will fix this problem, and if they wanted to do anything correct they would have done the following:

Let the banks fail and use the 800 Billion and have a new “GOOD” bank. This bank could lend, say 10x its 800Billion in equity. So, that’s 8 Trillion and if the problem is not wanting to lend, then this bank would be able to.
WHAT HAPPENS TO THE BAD BANKS? Out of business!

HOW TO HELP THE EXISTING MORTGAGES? Let the government enable a 1 time refinance of a 3.5% interest rate – not transferrable. This would subsidize these houses and prevent many from coming onto the market. This would stop all of the teasers/balloons from happening and causing people to not be able to afford their mortgages. We need 3-4 years to suck up the excess housing inventory. People live in houses on average about 5-7 years before moving.

Posted by Steve | Report as abusive
 

Absolutely agree that the regulators must be able to do a far more effective job than they are doing at present. However there is a problem that has to be dealt with or the regulators will continue to be ineffective.

Much is being said about the culpability of many bankers, investment bankers, hedge fund operators, etc. Most of the criticism is justified.

To me a far more telling issue is the clear inability of so many highly regarded financial practitioners to make meaningful suggestions to help solve the problems. This is extremely revealing because it suggests that many of these financial wunderkinder are men and women of straw who did little more than ride a wave of global prosperity to vast personal wealth. Their behaviour suggests that they are not only inadequately equipped to contribute to a solution but they are indifferent to the need to ensure that this never happens again.

Part of the process of making the regulators more effective is to force these toxic people out of the financial services industry.

Posted by anton kleinschmidt | Report as abusive
 

This commentary is the most useful and thoughtful one I have read in at least a year. Many people overlook the importance of line workers, like bank examiners–the people who do the most critical function of the organization, especially for the Fed and the FDIC. I have never been or wanted to be one, but I knew the crisis was going to happen at least by 2006. It was inevitable with the existence of no income or asset verification mortgages which grew rapidly as a percentage of all mortgages once the initial wave of refinances ended.

Banks sometimes due dumb things and bankers function like dogs in a pack following the leader. For example, if my information from a phone call is correct, Chase is doubling its credit card minimum payments to 5% plus adding a $10 a month new charge for account maintenance, unless people voluntarily agree to a higher interest rate on their past promotional offers. The increase to 5% is a good idea, but not applied to or forced to apply to past transactions. For anyone in financial stress and with high balances from past 3.99% until paid off debt, that will kick them into default and bankruptcy resulting in a near total loss on the accounts, whereas at their present cost of money those old accounts still paid more than the cost of loans from the Fed and depositor accounts.

One of the root problems in business today is that generally, pay, stock options, bonuses and other compensation is based in business primarily on the past 12 months. Higher executives and their governing boards should be required to calculate extra compensation, like stock options and bonuses based on the average of the previous five years and the future five years of returns (market value plus dividends) of the company or work units on the average return including both past and future returns. Today means nothing if your company (including banks) fails and your options become worthless, your retirement is eliminated or capped, and your board, investors fire you and blackball you from future work in any company with decent pay.

This 10 year method would also average out household earnings and lead to collection of stock options and bonuses for five years after leaving a company, while you are establishing a performance record at a new company. This type of change favors those who are NOT prone to excessive risk taking and who appreciate good future marketing plans, etc.–the people who keep the company in business and the stock appreciating over the life of companies and their stock. Right now it is just way too easy for individuals to put their personal financial gain above the interests of share holders and employees. Such a change would have to be in statute and have sufficient auditing record and enforcement.

Posted by Walter L Johnson | Report as abusive
 

As the Fed remains a non-appropriated agency, it has the wherewithal to begin funding whatever expansion and upgrading of its bank examiner corps is needed. Under the current circumstances, I cannot think of many better ways for the Fed to use its resources to set the stage for a banking system that is prudential and stable for the medium- and long-term. Crewing the liquidity pumps is a necessary short-term measure, but thought and resources must be committed to correcting the systemic flaws that created the mess in which we now find ourselves.

Of course, other regulatory agencies — FDIC, SEC, etc –need to be shored up as well, and the Fed is in a position to give a strong lead here.

Posted by William Crane | Report as abusive
 

The answer to the question post in the title is, “no, they are not”. Here is why.
They weren’t able – some claim the Fed did realise under Greenspan, but wasn’t willing to do anything about it – to detect what was going on in the financial sector, so what makes us think that they suddenly would see and understand what is going on?
It is much more likely, that the financial industry will continue to rip everyone off, as they have always done. Remember “it’s in their genes”, as a recent article on Reuters put it.
Methinks, the Fed and Treasury are unable to see the danger lurking behind the façade and will allow the banks, worse even help them and be complicit in, ripping the public off by taking on trash that is worth nothing and leaving the managers and investors of financial institutions with a hefty windfall. As their share-prices will be going up once the trash is off-loaded, giving them a huge profit and boni.
I think the Fed is blind, so is the Treasury.
So, no they won’t be able to meaningfully protect the taxpayer unless they nationalise the financial industry.

Posted by Robynne | Report as abusive
 

The Fed missed spotting the risk because many of its field examiners lacked the needed sophistication, training and measurement tools. While the bets being placed by regulated banks grew in size and complexity, Fed examiners were ill-equipped to adequately measure, monitor and report on these risks.
——————————————————–
What makes the author think that this was or is not done on purpose? After all, it’s in the interest of the financial industry to have a regulator that is toothless and clueless. This is best achieved by understaffing, underpaying and demotivating the staff.

Posted by Robynne | Report as abusive
 

Some people say that companies like JP Morgan benefitted enormously following the 1929 crash. If this is true then they seem to have benefitted once again, with Fed assistance, by taking over Bear Stearns and WAMU for a pittance thus increasing their proportion of control over US financial market.

In my view, it makes a lot more sense if the taxpayer is in control of the monetary system through the formation of a National US bank. This would enable decisions to be made that are for the general good rather than a specific interest group (excuse the pun).

Posted by Gregory | Report as abusive
 

Not enough is being said of the political, legislative, and institutional antecedents that lead to our worldwide economic debacle. In an attempt to better cope with globalization, central bankers formalized an inadequate plan to standardize capital requirements internationally in the Basel II Agreement. Politically, an economic consensus had formed in the USA & UK that emboldened the bankers, and weakened the regulatory environment. Here we passed GRAMM-LEACH-BLILEY which specifically authorized the CONSOLIDIZED SUPERVISED ENTITIES PROGRAM thereby instititutionalizing Basel II. A year later the COMMODITIES FUTURES MODERNIZATION ACT of 2000 passed without debate, and prohibited regulation of derivatives. The result was huge bets made on unregulated instruments using obscene leverage. http://www.aba.com/ABASA/ABASA_GLB.htm

 

The problem is in greed.All the Investment banks need to make lot of money in a short term. And against every gainer there is a loser and most of the time the loser was the citiznes. Now the financail world is paying his debt back to the people.

Posted by mario | Report as abusive
 

A nasty confluence of events has precipitated the present financial meltdown. There is plenty of blame to go around. All one need do is ask who made money, who stood to make money and stay in power, and who was able to live above their means on credit cards, interest-only mortgages, and home-equity loans. Over-leveraging was a huge problem. Repeal of the 1933 Glass-Steagall act was another (thanks to Phil Gramm).

But a forensic reconstruction of how we got here can only inform us how to not repeat this specific path in the future. Of much more importance is getting out of the current mess. Opinions are divided in government. Both agree to spend, spend, spend, but the GOP wants tax cuts (raising the Federal debt) and Democrats wants to ‘tax and spend’ — truly a well-worn perjorative mantra coming from the GOP.

Will the dollar collapse? Demand for T-bills is waning dramatically this week, so keeping parity between expenditures and income may be warranted, but even this act may prove incapable of maintaining the confidence sufficient to continue to roll over the existing Federal debt.

We can’t borrow $5 trillion and get away with it, can we?

Posted by tanzkuchen | Report as abusive
 

“This significant risk trend was missed by the Fed and its examination force.”

“examination force?”!! The top man, Greenspan himself, said everything was fine and dandy with the “financial weapons of mass destruction.”

Posted by Mearsheimer | Report as abusive
 

1)”Economics is the dismal science”
2)Government exists for those who work for it, not so much for those it is meant to serve. Fed examiners? Whatever.
3)I’m sure glad the SEC put Martha Stewart in jail.

Posted by JRaymond | Report as abusive
 

While I applaud the author’s detailed inside account of the inadequacy of the regulatory process, it does not get to the heart of the matter. This melt-down was precipitated by a criminal hands-off policy that was publicly stated and demonstrated by the executive branch and the the Fed directors. If the leadership is cheerleading for looting and plundering, why would anyone expect the lowly regulators to spoil the party?

Until criminal charges are brought against the very top leadership, this debacle will continue. Since that is unlikely to happen by the complicit Democrats, hold onto your seat, we are in for a very bumpy ride.

The only solution to this fiasco is what John Stewart, the news comedian suggested. Give the bailout money directly to the household debtors for use in paying of their debt. Turn the debt over to a “Debt Resolution Corporation”. Allow the debtors to pay off with reduced payments over a longer period of time with an additional premium tacked on for the privilege.

Sad commentary when the most intelligent solutions come from the comedians!!

Posted by Jonathan Cole | Report as abusive
 

Interesting insider’s perspective.
Having spent a lot of time on governance and regulatory issues, I thought the discussion and proposed solutions skipped some key points. In particular:
- How clear are the instructions to banks and to examiners, with what oversight and what reporting streams?
- What exactly are the incentives on the examiners?

Unless there are clear instructions, reporting, oversight and good incentives, any examination system will tend to suffer from client capture and turn mushy over time. The privacy of the system doesn’t help – it becomes a club. I understand that publically identifying weaker banks will make it more difficult for them to recover, but there are other techniques to bring a little fresh air into the room.

 

I think this fraud is at a much higher level than most people would want to believe or even think about. How could our Fed not have seen what was going on, unless there were other agendas behind this financial meltdown, but I am accusing no one of anything directly, merely voicing my opinion. One of the reasons I left the mortgage industry to go back to school was because of the amount of fraud and forgery that was happening at a broker level; it was almost a daily occurrence and it was looked upon by managers and other brokers I have worked for in numerous offices as “this is how it’s done”. I never took part, I never sold an option ARM because I knew the general public wouldn’t know what to do with this financial weapon and would not put their savings elsewhere but spend it and keep paying a min payment or interest only thinking their house would keep going up in value, which people wont listen…they hear 10% increase per year in house value but don’t look to the future when the bubble collapses. I have closed several NINA, no doc loans but only to small business owners who had a valid business and income but had written off most of their paper revenue on personal returns and wouldn’t qualify without bringing in business tax returns and the rate was close to the same. However, I stayed away from those loans as much as I could, while they were being pushed by fellow brokers to ordinary people who could not qualify for a home loan based on income but had the credit qualifications. I stuck with fixed rate refinances, mostly sub-prime to A paper once they were able to qualify for A-paper. I saw this coming 4 or so years ago and have been waiting for it to actually happen not in a good way but because I knew eventually it would all come undone. I think the Federal Reserve shouldn’t be private either and I also think nationalising the banks wouldn’t be such a bad idea until we can sort this situation out and sell them back to the public after the financial sector has been reformed. People need to be held accountable, including mortgage brokers and originators that were fraudulent in their activity and investors as well. I say we go after them all and teach them a lesson, Wall Street included.

Posted by Damian Palmares | Report as abusive
 

Two comments :
1) Fed examiners go after setting up fences for loan/debt portfolios. We also need investigators to go after the thieves. There is too much of an assumption that everyone was acting above board.

2) Neither the lender nor the borrower should escape from carrying the burden of the bad debts. Both sides were feeding the frenzy of these loans. In addition, there are 3rd parties, other than the banks, who have not only benefited in the high volume of transactions, but have also increased the SERVICES FEES beyond what was used to be OK. They were as complicit in the scheme as the banks. Real Estate agent fee of 6% on a $300K transaction at fair value vs 6% on an overvalued $500K property.

Posted by Jay Jones | Report as abusive
 

I knew some honest brokers and still do that still have their offices open but it seemed to me, in that business, there were more dishonest brokers then there were honest ones. World Savings, I believe was their name, used to push the option ARM loans like crazy, if it’s the same one I’m thinking about and Wachovia may have purchased them after they went bankrupt…I’m pretty sure they went bankrupt because that was one of their largest portfolios.

Posted by Damian Palmares | Report as abusive
 

Let them fall…here’s more proof of the hoarding going on…. http://www.forbes.com/2009/02/03/banking -federal-reserve-business-wall-street-02 03_loans.html

What do you expect from that industry? It’s time to let them fail and move on.

Posted by Damian Palmares | Report as abusive
 

Oops, wrong debate…sorry.

Posted by Damian Palmares | Report as abusive
 

After 911 I was under the impression that financial markets would be closely monitored for unusual transactions and trading activities through the use of data mining and algorithmic models. My basic argument is that oversight should be systematic and computerized. Without even knowing any specifics about account holders, aggregated data would have indicated problems. Instead we have a lot of old technological illiterates around a table discussing obscure, academic and largely unproven notions of economic stability. It has been my great pleasure to take their cash.

Posted by Don | Report as abusive
 

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