Secret Fed bank loans make definitive case for requiring the financial system be based on ultra transparency

Bob Ivry wrote a must read article for Bloomberg on how secret Fed loans during 2008-2009 gave banks an undisclosed $13 billion boost to income.  As Mr. Ivry observes, 'a fresh narrative of the financial crisis emerges' when actions by the Fed, like the loans, are examined.

In fact, the narrative that emerges is my narrative on an opacity driven solvency crisis where the only way to fix the financial system is to require ultra transparency from all market participants, including banks and the Federal Reserve.

These loans illustrate everything that is wrong with the current financial system including:

• The opacity of banks.  This blog has frequently cited Bank of England's Andy Haldane referring to banks as 'black boxes'.
• As documented by the Financial Crisis Inquiry Committee, the crisis began with banks asking the question of which banks are solvent and which are not.  Clearly, there was inadequate disclosure.  The fact that the Fed could make secret loans confirms this inadequacy and the need for banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.
• The reason that banks were asking about solvency was the exposure of banks to opaque, toxic securities -- CDOs, sub-prime mortgage backed securities.  Clearly, ultra transparency needs to be applied to these securities too.

• The relationship between banks and their regulators.  
• In a NY Times article, Gretchen Morgenson and Louise Story covered how the Office of Thrift Supervision advised IndyMac to misrepresent its capital to market participants.  How is offering secret loans to the banks any different than advising the banks to misrepresent their capital to market participants?
• The Nyberg Report on the Irish Financial Crisis showed how even when a member of the regulatory body saw that something was wrong, the regulatory bureaucracy pushed to suppress this finding.  Contributing to this result was both political pressure on the regulator and lobbying from the banks.

• The dependence of market participants on the regulators because of the regulators' information monopoly.
• Unlike every other market participant, banks are not a black box to financial regulators as they have access to all the useful, relevant information.  This includes access to the bank's current asset, liability and off-balance sheet exposure details.  The result of this access is that market participants rely on the regulators to properly assess the risk of the bank and to communicate this risk to the market.
• The moral obligation to bailout investors after each round of stress tests where the banks are deemed to be solvent.

I could go on, but the more the facts behind what caused the financial crisis and how the crisis was handled come out, the stronger is the case for requiring ultra transparency.

The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. Now, the rest of the world can see what it was missing. 

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. 

Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. 

And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue. 

Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse. 

A fresh narrative of the financial crisis of 2007 to 2009 emerges from 29,000 pages of Fed documents obtained under the Freedom of Information Act and central bank records of more than 21,000 transactions 

While Fed officials say that almost all of the loans were repaid and there have been no losses, details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger....

The size of the bailout came to light after Bloomberg LP, the parent of Bloomberg News, won a court case against the Fed and a group of the biggest U.S. banks called Clearing House Association LLC to force lending details into the open. 

The Fed, headed by Chairman Ben S. Bernanke, argued that revealing borrower details would create a stigma -- investors and counterparties would shun firms that used the central bank as lender of last resort -- and that needy institutions would be reluctant to borrow in the next crisis....

Here we have the major bank regulator in the US arguing for opacity.  Chairman Bernanke takes the position that market participants should not know the true condition of the banks because if they did the market participants might properly assess the risk of the banks and adjust the amount and price of their exposure accordingly.

Think of how absurd a position that is for the Chairman of the Federal Reserve to be arguing.  Particularly one who is a scholar of the Great Depression and the introduction by FDR of a financial system based on transparency.

There is only one way to prevent any Fed Chairman from ever being in a position for making this argument again and that is requiring ultra transparency.

Had ultra transparency existed for the structured finance securities, CDOs like Abacus could never have been sold.

Had ultra transparency existed for banks, market discipline would have restricted casino banking activities to what a bank could have afforded to lose.  If the bank insisted on taking more risk than this, its cost of funds would have gone up and its access to funds down as investors adjusted their exposure to reflect the risk of the bank.

Had ultra transparency existed for the Fed, it would never have violated Walter Bagehot's advice to lend against good collateral at high rates of interest.  There would not have been a $13 billion gift from the Fed to the banks.

Bankers didn’t disclose the extent of their borrowing. 

On Nov. 26, 2008, then-Bank of America (BAC) Corp. Chief Executive Officer Kenneth D. Lewis wrote to shareholders that he headed “one of the strongest and most stable major banks in the world.” He didn’t say that his Charlotte, North Carolina-based firm owed the central bank $86 billion that day....

Is this a fundamental misrepresentation similar to the advice of the Office of Thrift Supervision to IndyMac on its capital?

With ultra transparency, regulators are permanently blocked from inadvertently supporting misrepresentations to the financial markets.  Market participants could have seen that BofA was borrowing from the Fed and that IndyMac did not have adequate capital.

The Fed has been lending money to banks through its so- called discount window since just after its founding in 1913. Starting in August 2007, when confidence in banks began to wane, it created a variety of ways to bolster the financial system with cash or easily traded securities. 

By the end of 2008, the central bank had established or expanded 11 lending facilities catering to banks, securities firms and corporations that couldn’t get short-term loans from their usual sources.

“Supporting financial-market stability in times of extreme market stress is a core function of central banks,” says William B. English, director of the Fed’s Division of Monetary Affairs. “Our lending programs served to prevent a collapse of the financial system and to keep credit flowing to American families and businesses.”...

As regular readers know, restoring and maintaining confidence in banks comes from providing market participants with access to ultra transparency so that the market participants can independently analyze each bank.

None of the lending programs engaged in by the Fed restored confidence.  This is supported by the fact that the Fed announced that its late 2011 round of stress tests is designed to restore confidence.

As previously discussed on this blog, all the Fed's latest stress tests will do is create a moral obligation for the Fed to bailout investors.  After all, investors cannot be expected to incur losses on a bank that is reported as solvent under the Fed's stress tests subsequently blows up ... look at the need to bailout the investors in Dexia after the latest round of European stress tests found it adequately capitalized.

While the emergency response prevented financial collapse, the Fed shouldn’t have allowed conditions to get to that point, says Joshua Rosner, a banking analyst with Graham Fisher & Co. in New York who predicted problems from lax mortgage underwriting as far back as 2001. 

The Fed, the primary supervisor for large financial companies, should have been more vigilant as the housing bubble formed, and the scale of its lending shows the “supervision of the banks prior to the crisis was far worse than we had imagined,” Rosner says.

Ultra transparency is needed so that the failure of bank supervision no longer puts the financial system at risk.

With ultra transparency, market participants are no longer reliant on the regulators to properly assess the risk of the banks.  Market participants can assess the risk for themselves.

“I believe that the Fed should have independence in conducting highly technical monetary policy, but when they are putting taxpayer resources at risk, we need transparency and accountability,” says Alabama Senator Richard Shelby, the top Republican on the Senate Banking Committee....

So Senator Shelby when can I expect a call from your staff to discuss legislation bringing ultra transparency to the financial markets before December 31, 2011?

“Some might claim that the Fed was picking winners and losers, but what the Fed was doing was exercising its professional regulatory discretion,” says John Dearie, a former speechwriter at the New York Fed who’s now executive vice president for policy at the Financial Services Forum, a Washington-based group consisting of the CEOs of 20 of the world’s biggest financial firms. “The Fed clearly felt it had what it needed within the requirements of the law to continue to lend to Bear and Wachovia.”

Ultra transparency ends regulatory discretion of picking winners and losers.  That is the job of the market.

On May 4, 2010, Geithner visited Kaufman in his Capitol Hill office .... At the meeting with Kaufman, Geithner argued that the issue of limiting bank size was too complex for Congress and that people who know the markets should handle these decisions, Kaufman says....

Provide ultra transparency and banks will come under enormous pressure from the market to reduce their risk and shrink their asset base.  It will also be harder for them to run their casino banking business because everyone can see their proprietary positions ... a trader's worse nightmare because of the potential to be front run when buying or selling.

Dean Baker, co-director of the Center for Economic and Policy Research in Washington, says banks “were either in bad shape or taking advantage of the Fed giving them a good deal. The former contradicts their public statements. The latter -- getting loans at below-market rates during a financial crisis -- is quite a gift.”...

Regardless of which one, requiring ultra transparency eliminates this from occurring again in the future.