The Forthcoming Financial Reform

March 13, 2010

We are about to enter the great debate on financial reform. Unlike other stymied political initiatives, this one is likely to pass. The final form is still unknown but the details are being shaped up, and there is where the devil will emerge. The Obama administration will not cure the issues involving housing finance by proposing a fix to Fannie and Freddie. Thus, the GSEs will remain in need of change. Although they constitute the largest examples of the troubled financial enterprises needing radical surgical reform, they will not get it. So much for the so-called comprehensive reform.

What we will get is a major alteration of the role of our Federal Reserve. That is a certainty. Herein we see the great debate. Should a central bank keep its role narrow and focused on monetary policy? Or should the role be broad and include oversight, regulation, consumer protection, and supervision? Are these roles better if they are separated among parties, or combined under one roof?

When the political dust settles the outcome will likely be the one-roof version, and our central bank will be quite different than we are used to. Sure, it will still set the nation’s policy-making interest rates, and sure it will still talk about monetary policy and inflation or deflation, but the direction of the Fed and the composition of the Board will have changed.

After almost four years, the new Board of Governors will finally get a full complement of seven members, given the probable three new additions. Experienced, predictable, and accomplished San Francisco Fed president Janet Yellen will join chairman Bernanke as vice-chair. Yellen is her own person and an exceptionally skilled monetary economist. She also realizes the importance of a consistent policy and a clear message. It is hard to see any controversy arising from the paired chair and vice-chair.

The rest of the board will present a different picture than we are used to. After Kohn retires, the remaining present governors are Warsh (knowledgeable of financial markets but not a trained monetary economist), Duke (an experienced banker but not a trained monetary economist), and Tarullo (a lawyer regulator but not a trained monetary economist). According to some press reports, the two likely new governors are “Sarah Bloom Raskin, Maryland’s commissioner of financial regulation, and Peter Diamond, an economics professor at the Massachusetts Institute of Technology. Raskin would presumably focus on regulatory issues. Diamond’s research has been focused in public finance, pensions, and Social Security and does not provide much guidance on what his monetary policy leanings are likely to be.” Source: Barclays Capital

We know that other skilled monetary economists were considered for these positions. That leads us to the conclusion that the bias of the Obama administration is toward the regulatory and supervisory role.

Let’s speculate about the future of monetary policy.

Consider the 12-voter structure of the Federal Open Market Committee (FOMC) in the post-Kohn format. We will see the seven Governors plus NY Fed president Bill Dudley, who holds a permanent seat on the FOMC. Dudley is a skilled monetary economist and also a team player. It is highly unlikely he would ever dissent from the chair/vice-chair nexus.

The other four voting seats rotate among the other eleven regional bank presidents. Some are “hawks.” Others are mildly dovish, but most are centrist. Conclusion: there may one or two dissenting voters, but the policy of the Bernanke-Yellen axis will prevail on all monetary issues. Since the chair and vice-chair have knowledge and argumentative power, it is not likely that any other governor will oppose their combined and coalesced view of policy.

We expect the monetary policy of our central bank to continue as it has been for some time. We believe they will continue the use of the term “extended period” to describe the ongoing very low interest rate policy. Discussion and testing of various “exit strategies” will continue, but the implementation of them is still in the distant future. To change policy the Fed needs to see the economic recovery on a more sustainable path. It needs to see the employment situation in the United States improving, and not because of the temporary hiring of census workers. And it needs to see how the housing and commercial real estate markets stabilize after the present stimulus stops and attempts are made to normalize those sectors.

We expect to see continued very low short-term interest rates for the rest of this year. They will anchor the longer end of the bond market, and they will provide impetus for cash to move into stocks and bonds from the present very large and fear-driven multi-trillion-dollar hoard.

Readers are advised to review the recent reports about the Lehman mess. The NY Times has accomplished terrific journalism in the last few days on this subject. The 2200 pages of the court-appointed examiner’s report are a lot to read and digest, but the revelations are already sufficient to impugn the integrity of many. And one has to wonder about the role of the NY Fed, given that Mr. Fuld was a member of its board of directors and our present Treasury Secretary, Tim Geithner, was the NY Fed president during this critical time. We still have not learned the full inside story of what occurred in and around the NY Fed during the period between the Bear Stearns merger and the Lehman failure.

We are told by those powerful decision makers at Treasury, Congress, and the Fed that they saved us from a worse disaster. Geithner repeats that constantly. Maybe so. It is easy to say that, since there is no way to prove otherwise. But we haven’t seen any evidence that the very same people who will now be asked to operate and manage the newly reformed supervisory structure in the United States will be able to do it any better in its new form than they did in the old one.

In America, history shows, every major financial reform that followed a crisis and was offered to us as the way to avoid the next one. Each of those efforts failed. As for this newest one, the burden of proof is on the politicians in the Congress and the Obama administration. Time will tell.

We are presently scheduled to discuss the financial reform initiative on CNBC at 11 AM on Monday, March 15.

David R. Kotok, Chairman and Chief Investment Officer