Hard questions continue to haunt the Federal Reserve

Let me say this: I am not for the outright abolition of the Fed. I’ve yet to be convinced by the arguments made by those who think that ending the Fed is a good idea. Conversely I do think there’s great good in having a body to oversee a banking system as complex and an economy as globally interconnected as that of the United States.

But reading Senator Bernie Sanders’ take on the Government Accountability Office’s second Fed audit, and then reading the GAO’s own report, made me want to tear up the Federal Reserve Act and toss it like so much confetti onto the steps of the Eccles Building.

Never before have I read of a system so perfectly designed to nurture, well, there’s really no other word for it–corruption. And I do not use this word lightly.

Note: this is not the impression you’re meant to be left with after reading the GAO’s own report. At one hundred and twenty-seven pages, it’s dense and anodyne and nibbles politely around the edges of the blatant design failures of the system that gave more than a $1 trillion dollars in emergency aid to U.S. banks. To be clear, I’m not looking for the Government Accountability Office to summon the outrage: (1) that’s not their role and (2), even if it were, they are clearly constrained by politics from just coming right out with it and saying, “This system is a travesty.” However I am looking for a bit of intellectual honesty and a decent amount of rigor. And here it fails, big time.

Just look at how the report opens, with this fragment from the executive summary on the front cover (emphasis added):

As the financial services industry evolves, more companies are becoming involved in financial services or interconnected with financial institutions. As a result, [Reserve Bank] directors of all three classes can have ties to the financial sector. While these relationships may not give rise to actual conflicts of interest, they can create the appearance of a conflict as illustrated by the participation of director-affiliated institutions in the Federal Reserve System’s emergency programs.

This is absolutely preposterous and offensive to anyone with a shred of intelligence. Finance Addict readers are a smart bunch, so I’m sure that you realize that a conflict of interest is an endemic state. It’s like being pregnant or being of a certain ethnicity–either you are or you aren’t. Reserve Bank directors who have ties to financial institutions that participated in Fed emergency programs are conflicted–full stop. Whether these conflicts led to inappropriate actions on their part is another question, but there’s no doubt that there were, in fact, really and truly, conflicts of interest. 

Here, the GAO version already distinguishes itself from Bernie Sanders, who has no problems calling a spade a spade. To wit:

This report focuses on the enormous conflicts of interest that existed at the Federal Reserve during the financial crisis.

Perhaps the GAO doesn’t want to put an honest label on this issue because, as the rest of the report makes clear, conflicts of interest are built into the heart of Federal Reserve system as its exists today. Any cosmetic changes that the GAO might suggest will probably not fix this. Here’s an example from the report (emphasis mine):

[T]he Federal Reserve  Act has required the Reserve Banks to include Class A directors on their boards to be representative of the member banks. While Class A directors are not required to be officers or employees of member banks, in practice, most Class A directors are officers or directors of member banks in the district. The requirement to have representatives of member banks creates an appearance of a conflict of interest because, as noted previously, the Federal Reserve System has supervisory authority over state-chartered member banks and bank holding companies.

Again, remove the words “an appearance of” and what do you have? An indictment of the very design of the Fed system. Yet the GAO seems to go out of its way to make this unclear. All throughout the report fails to draw the connections that a seven-year old would spot. One can only be left with the impression that this is done intentionally. Its description of the Stephen Friedman incident is a prime example.

Stephen Friedman was appointed to the board of the Federal Reserve Bank of New York in January 2008. He was appointed as a Class C director, who as the GAO explains,

“are appointed by the Federal Reserve Board [where Bernanke sits] to represent the public.”

Inconvenient query #1: is a “former chairman and a current board member and shareholder of the Goldman Sachs Group, Inc.” the best embodiment of ‘the public’ that the Fed Reserve Board could find?

When Friedman joined, Goldman Sachs was still an investment bank and therefore not supervised by or eligible for extraordinary aid from the Federal Reserve System. However after the September 2008 bankruptcy of Lehman Bros. it realized that it needed the extraordinary Fed aid. So much so, in fact, that it decided to convert itself to a bank holding company to be eligible for it.

This change meant that Stephen Friedman, who was by then the chairman of the board of the FRBNY, was a director and shareholder of a bank holding company. Something that was forbidden for Class C directors. So what happened? Says the GAO:

Without consultation with the full FRBNY board, FRBNY sought a waiver [in October 2008] to allow [Friedman] to continue to serve on the board.

Why?

First, finding a new chairman during the financial crisis would have been difficult, given that FRBNY already had one director vacancy on its board at the time.

Oh, I see. Doesn’t explain why they didn’t consult the full FRBNY board, but carry on.

Further, the event leading to the need for a waiver was unexpected and unforeseen.

True enough.

Plus, a final reason mentioned by the report: Tim Geithner was about to leave FRBNY to become Treasury Secretary and as chairman of FRBNY Friedman would actually need to lead the search for a Geithner replacement.

It all seems plausible enough, right? So why, if the waiver was applied for in October 2008, did the Federal Reserve Board not get around to approving it until three months later, in January 2009? Something smells a little funny here. At the very least the Federal Reserve Board did not give two shakes about the reputational risk of the Federal Reserve system. At worst we are not getting the whole story. But that’s nothing compared to this next twist:

The waiver was granted by the Federal Reserve Board in January 2009 on the basis of these considerations. However, the Federal Reserve Board was unaware that [Friedman] had purchased additional shares in Goldman Sachs via an automatic stock purchase program.

No detail is given as to when exactly these stock purchases occurred. Also, don’t be taken in by the use of the modifier “automatic”–who doubts that any pre-planned purchase could have been stopped by one call from Friedman to Goldman Sachs HR? Finally while it’s said that the Federal Reserve Board wasn’t aware of the stock purchase, no similar claim is made about the board of the Federal Reserve Bank of New York being unaware, either before or after requesting the waiver. How can this be explained? Did Geithner’s career aspirations have something to do with this? Did the GAO forget to ask, or do they simply not want to reveal the answer?

Just for kicks, let’s compare the Fed’s policy on these sort of matters with Goldman Sachs’ own policy for its equity research analysts:

Goldman Sachs policy prohibits its analysts, professionals reporting to analysts and members of their households from owning securities of any company in the analyst’s area of coverage.

Leave it to Goldman to have all the angles covered.

All of this and I’ve not yet even finished digging through the entire report. I’m curious to see what else is in there. Stay tuned. See more about this topic here and here.

Tags: Federal Reserve, FRBNY, Goldman Sachs, Stephen Friedman, Timothy Geithner

Category: Federal Reserve