In today’s Wall Street Journal, David Wessel pointed out that the Federal Reserve which was created in 1913 was equipped to prevent and respond to commercial banking panics. The problem in the current crisis is that the institutions that are in trouble—hedge funds, mortgage banks, real estate investment trusts—cannot be helped by the Federal Reserve charter directly. Stated differently, Federal Reserve actions mainly impacts commercial banks. Thus, the Federal Reserve does not have the tools at its disposal ways to help non commercial banks who are suffering a liquidity crisis. It is irresponsible not to dramatically overhaul the mandate of the Federal Reserve given the seismic changes in the world financial economy since 1913.

Unfortunately, the Wall Street Journal failed to provide specifics of the magnitude of the problem. Let me try to elaborate on the big picture. The magnitude of the leveraged balance sheets of mutual funds, hedge funds, investment banks, private equity funds, and mortgage banks involves trillions of dollars. The equity supporting the massive balance sheets of these institutions is a small fraction of their liabilities. Thus, any panic that causes investors or lenders to these institutions to withdraw funds causes massive dislocations that produce financial ripples globally.

In essence, the power of the Federal Reserve needs to be expanded significantly to prevent a financial crisis in the twenty-first century. That is, Congress needs to address whether the Federal Reserve Charter should be expanded to provide oversight to hedge funds, investment banks, mutual funds, mortgage banks, etc. Stated differently, the major players in today’s financial world comprise institutional classes outside the supervision of the Federal Reserve. Since a problem at for example an investment bank, hedge fund, or mortgage bank has a rippling impact throughout the financial system we need to update the mandate of the Federal Reserve. Otherwise, intervention by the Federal Reserve cannot remedy the problems of these major financial players. We should recall that in 1913, mutual funds, private equity funds, and hedge funds did not even exist. Moreover the balance sheet of investment banks was a pittance. For example, the balance sheet of investment banks like Lehman Brothers, Goldman Sachs, Morgan Stanley, Dillon Reed, Kuhn Loeb, were less than $25 million dollars when I came to Wall Street in 1969. Today, Lehman Brothers, Goldman Sachs, Bear Stearns, and Merrill Lynch each have balance sheets that range from $50 billion to $ one trillion dollars.

The problem is compounded because today there is at best a nominal relationship between borrowers and creditors. That is, historically lenders knew personally their creditors. Today, because Wall Street has created financially engineered products, primarily asset-backed securities and derivatives, the interaction between debtor and creditor is virtually non existent. Stated differently, the creditors and borrowers feel no fiduciary obligation to each other. Instead, they look to the middleman, the securities dealer, to furnish an active, vibrant secondary market. That is, the system only works if creditors or investors can achieve their liquidity objectives through the marketing and principal resources of a middleman. Moreover, when the market dries up because of changed perceptions due to credit rating changes, economic dislocations, political instability, volatile price swings, and the system goes into a crisis mode outside the corrective capabilities of the Federal Reserve. Moreover, many of these products are “high” octane, that is there price volatility is immense.

Let me give you some real world examples of the problem.

Currently, institutions are now anxious to sell financially engineered products such as mortgage-backed securities; however, because of the panic in the system, they are unable to do so. Thus, a financial logjam has been created. The bottom line is that mortgage banks have made mortgage commitments to home owners that they cannot honor or hedge funds owning mortgage-backed securities have failed because declining security values eliminated their relatively tiny equity values. The problem was exacerbated because the rating agencies over the past few months on a broad scale have downgraded their credit ratings on asset-backed securities. Thus, the holder now has an asset which has been devalued and illiquid. The holder of securities has a limited staying power because its sources of funds, investors, are trying to withdraw their cash. That is, when the problems surfaced, the investors recognized the precarious nature of their investment. Furthermore, the problem took on even global dimensions, because institutions such as German mid-sized banks invested too heavily in these securities.

The panic intensifies when mutual funds or hedge funds have withdrawals from their investors. In order to raise money, the mutual funds or hedge funds need to sell securities. If they cannot sell these securities to meet the financial drain coming from withdrawals, then the mutual fund or the hedge fund suffers a financial crisis. To reiterate, in 1913, the creditor and the borrower knew each other and could possible reach accommodation. Today, these institutions have scant contact. The lending process is facilitated by a prospectus or credit report that might contain flawed information or information that becomes obsolete because of changing financial conditions.

Unfortunately, the magnitude of leverage in the financial system creates a very unstable fulcrum for the business world. Let me give you an extreme example. A private-equity buy-out of Sallie Mae (Student Home Loan Mortgage Association) will not take place under the original terms. When this potential buy-out was announced, the financial leverage of Sallie Mae was close to 100 to one. There are a number of other billion dollar leveraged equity buyouts that are also cratering.

Are there potential solutions?

  • The Federal Reserve should be able to limit the leverage of investment banks below current levels which are reaching 30 to 1.
  • The Federal Reserve should be able to limit the leverage of mortgage banks.
  • The Federal Reserve should put much higher margin requirements on junk bond loans.
  • The Federal Reserve should require that money market funds buy financial insurance to protect investors similar to the protection afforded depositors of commercial banks.
  • The Federal Reserve must take regulatory responsibility over the hedge funds. These regulations should limit the amount of leverage employed by a hedge fund and limit investors ability to withdraw funds.

Originally published in the Sarasota Herald-Tribune