MF Global& NY Fed – Part 3
November 21, 2011
David R. Kotok
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We thank readers for their emails and messages regarding our MF Global – NY Fed commentaries. Parts 1 and 2 are available on Cumberland’s website, www.cumber.com . In part 3, we want to discuss whether the NY Fed’s decision to stop surveillance of primary dealers led to the behaviors that caused or exacerbated the systemic meltdown in 2008.
In our first two pieces, we noted how the Fed had surveillance in place during the Drexel Burnham and Salomon Brothers events. We quoted Bernanke’s reference to Drexel and we cited the Corrigan memo, which altered Fed policy and removed surveillance after the Salomon Brothers affair. In sum, the Fed went from a “we have surveillance on primary dealers” mode to a “let the other regulators do it” mode. Quotes are mine for emphasis.
How did the Fed convey the change? In the 1990s, it was a very quiet change. In those days, the emphasis on transparency was much less intense. Under Greenspan, the change occurred without any fanfare. NY Fed president Gerry Corrigan pitched it and the FOMC approved it. Nothing immediately happened after the deed was done. We quote former Fed official Peter Fisher in his 1997 report, in which he affirmed the change.
We want to start today’s extended essay with two quotes. The first is a repeat from a prior essay and originates with the NY Fed’s policy manual on primary dealers. Here is the text used by the Fed as it tries to warn the public not to attribute any special status to primary dealers. Boldface emphasis is ours.
“The New York Fed continues to emphasize that the nature of its relationship with primary dealers is a counterparty relationship, not a regulatory one. This policy establishes the framework by which the New York Fed will prudently manage its counterparty risk consistent with its mandates to implement monetary policy and promote financial stability. The New York Fed also recognizes the value of maintaining transparency in its administration of its relationships with the primary dealers. In light of the foregoing, third parties are reminded that the designation of an entity as a primary dealer by the New York Fed in no way constitutes a public endorsement of that entity by the New York Fed, nor should such designation be viewed as a replacement for prudent counterparty risk management and due diligence.”
Ok. We see what the Fed is telling us, if any of us are inclined to search it out and read it. Try to find this on your own. Measure the time it takes you and see how “user-friendly” this warning is for you as a reader who follows investing and financial markets or as a financial journalist or researcher.
Now let’s look at the press release announcing MF Global as a new primary dealer. Note that this did not come from the NY Fed, it came from MF Global. The NY Fed seems to leave these announcements to the respective firms. Note the quote from former US Senator and NJ Governor Jon Corzine, who was the CEO of MF Global until his recent resignation coinciding with his firm’s bankruptcy. Boldface emphasis is ours.
“NEW YORK, Feb 02, 2011 — MF Global Holdings Ltd. (NYSE: MF), a broker-dealer providing trading and hedging solutions, today announced that it has been designated a primary dealer by the Federal Reserve Bank of New York. MF Global is now one of 20 primary dealers, which serve as counterparties to the Federal Reserve Bank of New York in open-market operations, participate directly in Treasury auctions, and provide analysis and market intelligence to trading desks at the Federal Reserve Bank of New York.
” ‘Being designated a primary dealer by the Federal Reserve Bank of New York is consistent with our global strategy of expanding our broker-dealer activities, as we seek to serve our clients with broader execution services and greater market insight and ideas,’ said Jon S. Corzine, chairman and chief executive officer, MF Global.
” ‘We are delighted to join the group of dealers trading directly with the Federal Reserve Bank of New York,’ said Peter McCarthy, global head of fixed income, MF Global. ‘This designation is a natural next step as we continue to build our fixed income platform to provide broad access and liquidity to global markets.’ ”
This press release is from 2011 and subsequent to the new text of the NY Fed’s policy statement (2010). Note that in a press release by another primary dealer, Jefferies, in 2009, the same essential first paragraph was used. Here is that release:
“NEW YORK, June 17, 2009 — Jefferies & Company, Inc., the principal operating subsidiary of Jefferies Group, Inc. (NYSE: JEF), today announced that it has been designated as a Primary Dealer by the Federal Reserve Bank of New York (FRBNY), effective June 18, 2009. As a Primary Dealer, Jefferies will be a counterparty to FRBNY in its open market operations, will participate directly in Treasury auctions, and will provide market information and analysis to the trading desks at the FRBNY. ‘We are very pleased to announce that Jefferies has been named as a Primary Dealer by the Federal Reserve Bank of New York and see this designation as a natural extension of and complement to our existing businesses,’ commented Richard B. Handler, Chairman and CEO of Jefferies.”
This release preceded the new policy statement from the NY Fed. Note how it reads the same as the MF Global press release. Note how the first paragraph is nearly identical. Note how there is no warning in the press release. In addition, note how there were no announcements by the NY Fed that might have incorporated a public warning with respect to counterparty risk management and due diligence, such as we see in the policy statement. If there were any such announcements, we cannot find them listed in the public press releases of the NY Fed.
Here is a question for the NY Fed. When you designate a primary dealer, shouldn’t you make an announcement and in it shouldn’t you repeat the public warning that is buried in your policy statement? You announce publicly when you suspend a primary dealer, as you did with MF Global; why not announce publicly when you appoint one? You obviously direct and approve the language used by a new primary dealer when that firm makes an announcement. Clearly, the nearly identical text in the two releases above is not a coincidence.
Ok, let’s get to the question of surveillance or no surveillance.
Surveillance is an assumption of a responsibility. If the NY Fed is responsible for it, then the behavior of the primary dealer is monitored. If the NY Fed passes this responsibility solely to another regulator like the SEC or the CFTC and the NY Fed disclaims it, then the NY Fed role is limited to the counterparty risk that the Fed has for its own purposes. In other words, the Fed gets the collateral, is paid, and moves on. The systemic risk is not theirs to own.
Dear reader: We have just been through and are still going through a financial crisis. No one wants to own up to responsibility for it. The post-Lehman Fed is a much different animal from the pre-Lehman Fed. Just look at the Fed’s balance sheet for evidence.
Which policy works and which one fails? To paraphrase Willy Shakespeare: “To surveil or not to surveil, that is the question.”
There are those who believe the Federal Reserve’s role in regulation and supervision of non-banks should not be altered. They argue that the Fed is not prepared, equipped, willing, or interested in implementing such supervision. They argue that monetary policymaking should not be distracted by such activity. They also argue that existing regulators like CFTC are supposed to have the power and resources to supervise. They specifically note that those agencies cannot easily defend against any alleged fraud that may have occurred with MF Global or elsewhere. They argue that, after the fact, those agencies need to come in, imposing rules or regulations to confront issues that are uncovered.
People who argue the other side of the regulatory burden point to the failure of the regulators. The SEC (Securities and Exchange Commission) is an example. CFTC is now another one. These agencies regulate countless firms. Many of the agencies are underfunded by Congress. The post-Madoff SEC has become a target for all those who are supervised by it. This is doubly so because a “whistleblower” tried to tell the Madoff story years before it happened. Others critics point to some behaviors that have occurred with the CFTC. Still others suggest that the U.S. Commodity Futures Trading Commission had leadership, which, in prior periods, had familiarity with the leadership of primary dealers, Jon Corzine being one of them.
The NY Fed’s present position is simple: others regulate and supervise – that is not our role, and we are not interested in undertaking that role; there is no reason for the process to be duplicative. This is the legacy of Corrigan’s memo and its adoption by the FOMC.
The counterargument concerning MF Global and the NY Fed has its roots in pre-Corrigan history. The Fed had a surveillance team in place during the periods of the Drexel Burnham and Salomon Brothers events. In those episodes, there were no systemic meltdowns. There were shocks, there were losses, there were issues that had to be confronted, but a systemic failure of the type we experienced in 2008 did not occur.
The inflection point is 1992. That is when the Fed removed some formal “surveillance” operations that had previously existed. The Federal Reserve made this decision on its own, without instruction from Congress; so this is an internal Fed policy and is not a requirement of legislation. Thus the Fed has the power to institute surveillance of primary dealers today, if it chooses to reverse its decision made 20 years ago.
Supporters of the Fed surveillance approach discuss the fact that the evidence since the change in rules in 1992 is sufficient to suggest that the Fed should reexamine their position. In 1992, the vice-chairman of the Federal Open Market Committee, Gerald Corrigan, who was then the president of the Federal Reserve Bank of New York, sponsored the change. At that time, Chairman Greenspan was favorably disposed towards this position; and so between them and the other members of the FOMC, the rules were changed, a new policy was adopted, and the surveillance activities, which had existed prior to that period, ceased.
Supporters of the Fed say that it is still monitoring what the primary dealers do and is engaged with them on a daily basis. Most of the activities of the Federal Reserve go through the primary dealers, and the NY Fed’s role with the primary dealers is narrowly defined.
One former senior Fed official was very clear with me in arguing that the Fed’s role should be limited. Its job, he pointed out, is to protect the Federal Reserve in these transactions, to monitor the counterparty risk with the primary dealers, and to be paid in full on the transactions that the NY Fed undertakes. The point is, he argued, that if the Fed is paid, which it nearly always is, then it has accomplished its task.
He defended the Fed by pointing out that the Fed issues a disclaimer and warns the general public and financial industry not to read anything into its selection of a primary dealer. He argued that the Fed is not attributing some unusual and specifically supported standing to the primary dealer.
Arguments on the other side say the primary dealers have always had an aura about them, despite what the Federal Reserve might say. Furthermore, they point to behaviors of the Federal Reserve when it comes to the primary dealers, that are different from how it behaves with other firms that are not primary dealers.
For example, in the present crisis period, Countrywide was the first primary dealer to get into trouble. It was merged with Bank of America. The Federal Reserve accommodated the merger by changing a rule, or reinterpreting a rule, to allow Bank of America to have a deposit limit of 10% of the total deposits in the United States and allow the Countrywide to be a separate entity with respect to deposit taking, and to also have up to 10% of the deposits in the United States. At the time, this was very enticing to Bank of America’s leadership, because they could see that by investing a few billion dollars and taking on a merger with Countrywide, they would be able to expand their franchise and their mortgage-servicing operation to a national, supermarket level. At the same time, they would have access to deposits that could fund their operations in a huge way. Bank of America took the bait and made the deal.
Now, contrast Bank of America’s outcome with Countrywide versus IndyMac, a large banking institution, one that was resolved by the Federal Deposit Insurance Company (FDIC), at a cost of nearly 11 billion dollars. IndyMac was a failure of a size of approximately 32 billion dollars. It was in a similar business line as Countrywide, and it was not a primary dealer.
Look at the messages that were sent by the Federal Reserve with regard to these two firms. In the case of Countrywide, a primary dealer was merged. IndyMac, not a primary dealer, was allowed to fail and be resolved by the Federal Deposit Insurance Corporation.
E-mailers who agree with our view that the Fed should implement some type of surveillance system and be transparent about it and responsible for it point to this difference, and they make it very clear that if the Fed did that, the behaviors of primary dealers might change. We do not know for sure, but we have years of history to guide us.
Would Countrywide have acted differently? Would the Federal Reserve’s surveillance have observed things that would have suggested behavioral changes? Could the Fed’s ability to withdraw primary dealer standing have had some influence on the way Countrywide funded itself or operated?
There are a million “what if” questions about primary dealer status. There are rules in the policy statement about what it takes to get it. What about what it takes to lose it?
These commentaries about MF Global and the NY Fed are focused on an inconsistency. The inconsistency is reflected in several quotes, documents, statements, speeches, and a letter to the US Senate by Fed Chairman Ben Bernanke.
Some readers have emailed me and said my essays constituted a personal attack on people at the Fed. They are and were wrong. There is no personal attack here. As far as my experience goes, those in the Fed whom I know are publically spirited citizens who are attempting to do their jobs as best as they can under very difficult circumstances. I, for one, have been one of the Fed’s supporters and a defender of the central bank throughout the entire crisis period. My organizational affiliations clearly support central banking independent activity and specifically the regional Federal Reserve banks and their roles.
The point of writing about MF Global and the NY Fed is to elevate the discussion about the definitions, roles, and clarity involved in the selection of primary dealers. What do they get? What is the benefit they obtain, and what do they have to exchange in order to get it?
There are other elements. Some writers pointed to large firms that chose not to be a primary dealers. We do not know the details of that, but the writers surmised that the firm determined it did not stand to gain an economic benefit. Another writer emailed me about transactions his firm had with certain other agencies that deal in federal obligations. He pointed out how his firm had to engage in those transactions, and because they were forced to do so they took losses on certain transactions as a way to accommodate their role. That led to another question concerning how communication informally occurs with primary dealers. Who talks to whom between the NY Fed and the primary dealer desks? What do they say? How are those conversations monitored? A million questions were raised by readers and others about the system.
Our conclusion is that history is guiding us. There were sequential primary dealer failures in the last four years. The most notorious was Lehman Brothers, and in that case the role of the NY Fed has certainly been questioned in great depth. The CEO of Lehman Brothers remained on the board of directors of the Federal Reserve Bank of New York during a period in which his firm was getting maximum attention from the NY Fed. Is there not a conflict of interest between sitting on a board of a Federal Reserve Bank and managing a firm that is a beneficiary or a participant in transactions with that Federal Reserve Bank?
We believe that the issue of primary dealer status – the role of the primary dealers, the significance of foreign firms and their importance in the primary dealer process, versus domestic US firms – needs to be examined. It needs to be aired publically. It needs to see expert discussions in the light of day. The same is true for the differentiation among and between banks and non-banks. That too warrants examination.
Such an examination would benefit the monetary system, the Federal Reserve, and the financial markets. The whole notion is: get it out in the open, examine it, be willing to admit errors, and change the system if change is necessary.
Had we not seen Countrywide merged, Lehman failed, Merrill merged, Bear Stearns merged with $29 billion of Federal Reserve assistance, and now MF Global failure – had these events not occurred, we would not be asking the questions.
We thank the readers and commentators who took the time to thoughtfully address and respond to parts 1 and 2 of this series. For those who spoke with us privately about our views and articulated both pros and cons, we also thank you.
We hope readers enjoyed hearing about and perhaps thought about the issues of primary dealer status. It took much research work for our firm to dig through many minutes and discussions within the Federal Reserve to come up with the precise sequence of Federal Reserve activity. To the credit of the Federal Reserve, all information is publically available now on their websites, if one chooses to take the time to execute the research. The Fed is transparent about its history, from what we can see.
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David R. Kotok, Chairman and Chief Investment Officer
