MF Global & NY Fed—Part 2
November 6, 2011
David R. Kotok
Many thanks to readers for their supportive email re yesterday’s comments on MF Global and the NY Fed. We have a little follow-up.
Corzine resigned and has retained “white-collar” counsel. The FBI investigates. There’s more to be revealed. Meanwhile we wonder, how did $600 million of clients’ assets held at MF get to JPMorgan Chase. And why? This is a puzzle for us. Cumberland Advisors is a boutique firm (26 people) with a few billion in client’s assets under surveillance. We try to know where every dollar is every day. Daily reconciliation reveals any discrepancies and resolves them quickly. We do not understand how MF did not know where the assets were and how JPM was not sure. Note that Cumberland has/had no exposure to MF Global (readers asked), and we did not buy their debt, even though it was rated investment-grade.
Gretchen Morgenson and Josh Rosner covered the issue of NY Fed audit and supervision in their book, Reckles$ Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon (pp. 42-44). I read this book and recommend it to readers. They mentioned the fact that in January 1992 the Fed ended its primary dealer surveillance program that it had long used to audit and inspect Wall Street firms. From then on, the Fed had to rely on reports filed by the firms, which were verified by other regulators. “It was, to some Fed officials, a dangerous delegation of an important duty that had given the central bank access to crucial information about the soundness of the Wall Street firms it was dealing with,” the authors wrote.
Let’s flesh out some history.
The Fed stopped (1992) this surveillance activity following the bankruptcy of Drexel Burnham, then a primary dealer. The Fed was motivated by the Salomon Brothers episode, according to a document review. The Salomon affair came after Drexel.
In his January 13, 2010 letter to the US Senate Banking Committee, Fed Chairman Ben Bernanke cited the Drexel case as an example of the Fed’s surveillance used with a positive outcome. Readers note that the NY Fed policy statement on primary dealers that I cited in my previous commentary was published just two days before Bernanke sent this letter. That is the statement in which the NY Fed disclaims supervision and says it relies on the accuracy and transparency of the information the primary dealers report to the NY Fed. Boldface is mine for emphasis. Bernanke wrote:
“A similar example emerged in the case of the failure of Drexel Burnham Lambert in February 1990. Drexel’s rapid collapse posed a risk of gridlock in the financial markets. Notably, because of their parent’s failure, Drexel’s solvent broker-dealer and government securities dealer subsidiaries experienced serious difficulties liquidating their positions. Because of its ongoing supervisory relationships with the banks that provided settlement services to Drexel’s subsidiaries and its knowledge of the payment and settlement system’s infrastructure, the Federal Reserve had the access, contacts, and in-depth knowledge that enabled it to obtain the information it needed to evaluate this complex problem and formulate a plan to address it. The Federal Reserve understood the potential problems of Drexel’s counterparties and clearing banks and was able to work with the banks and securities firms to identify developing problems and fashion procedures that enabled an orderly winding down of Drexel without adverse effects on other market participants or further disruption to financial markets.”
The full text of Bernanke’s letter is here: http://www.federalreserve.gov/BoardDocs/RptCongress/supervision/supervision_report.pdf. When you read it you will note the argument for surveillance and supervision. And you will see that it is silent on the behavior about the NY Fed’s surveillance or lack of same.
We did some digging into the 1992 decision, which was motivated not by Drexel but by the Salomon Brothers episode. Then NY Fed president Jerry Corrigan is quoted in the minutes of the FOMC conference call of January 9, 1992. The minutes were released to the public in 1997, five years after the event. Readers may find the transcript at http://www.federalreserve.gov/monetarypolicy/files/FOMC19920109confcall.pdf. Readers please note that Corrigan is identified as vice-chairman because the president of the NY Fed is the traditional vice-chairman of the Federal Open Market Committee of the Fed, and this is a transcript of an FOMC conference call. Today. NY Fed president Bill Dudley is the vice-chairman of the FOMC.
We excerpt from Corrigan (1992). Boldface is mine.
VICE CHAIRMAN CORRIGAN. All I can say, Bob, is that the point you raised has been at the heart of this issue since time immemorial. There is only one solution to the problem that I know of and that solution would be that the Federal Reserve should have a full [unintelligible] and regulatory authority, something that the Federal Reserve itself historically has never been crazy about. It is also something that as a practical matter would be extremely difficult to achieve in political terms …”
At the November 12, 1997 FOMC meeting, then NY Fed official Peter Fisher stated the following in his report. For the minutes of that meeting see: http://www.federalreserve.gov/monetarypolicy/files/FOMC19971112meeting.pdf.
Peter Fisher’s report is excerpted below. Boldface is mine.
“Criteria for primary dealer relationships with the FRBNY were revised in February 1992 following the Solomon Brothers episode. At that time, we identified “drawbacks” of the then-existing primary dealer system as including: “… the pubic impression that, because of the Federal Reserve Bank’s standards for selecting and maintaining these relationships, the Fed is in effect the regulator of the primary dealer firms [and that] . . . the primary dealer designation has been viewed as conferring a special status on these firms that carries with it elements of “franchise value” for the dealer operation ….”
As a consequence, the criteria were revised, dropping the requirement that dealers maintain a one-percent share of total customer activity. At the same time, the FRBNY discontinued its “dealer surveillance” activities.
So here is the question for the NY Fed and, by reference, the FOMC.
You have the power to write the rules and policies for primary dealers. You cannot do it for the entire system, because you need the Congress to legislate, but you can do it for the primary dealers that transact directly with you. You choose them. You set the terms of admission to this club. You had a surveillance operation and ended it in 1992. The evidence shows that the surveillance function worked prior to that ending decision. Your Board of Governors Chairman noted how successful it was in keeping the Drexel failure from becoming a systemic meltdown. Your Fed Chairman cited the repeated role of the Fed in numerous crises and how the Fed responded to limit systemic damage.
So why do you not require compliance with a surveillance team as a condition of primary dealer status? Without the surveillance team, we have witnessed Countrywide, Bear Stearns, Lehman, Merrill, and now MF Global. Would a defined role for a surveillance team have changed things? Maybe. It did with Drexel, when you had the team in place. You admitted MF Global to primary dealer status in February, 2011. Had there been a surveillance requirement, would they have applied? Would you have granted them this status? If yes, would their behavior have been different? Would Lehman’s? Would others?
The great sage Albert Einstein suggested that repeating something and expecting a different outcome is “insanity.” The NY Fed is repeating its reliance on primary dealers to be transparent and accurate and to do so voluntarily. That 1992 policy change has been and is a disaster. The Fed Chairman made the case for surveillance and supervision in his letter to the US Senate.
Question for the NY Fed and FOMC: you have the power to change this. What are you waiting for?
David R. Kotok, Chairman and Chief Investment Officer