This is Part 2 of a guest contribution by David Kotok* and Bob Eisenbeis** of Cumberland Advisors. (Click here for Part 1.)

Note to Readers:  This is the second of our two-part commentary on the Fed’s exit strategy and the role the Fed has played in complicating its own operating strategies and ability to conduct monetary policy.

In their Wall St. Journal op-ed entitled “The BLOB That Ate Monetary Policy” (September 27, 2009), the Dallas Fed’s Fisher and Rosenblum use the movie metaphor of the BLOB to describe the “too big to fail” banks.  They argue that these BLOBs stood in the way of the Fed’s monetary policy’s low interest rates and thereby “gummed up” the “monetary policy channel,” which would otherwise be able to stimulate economic activity.

The op-ed doesn’t name names.  But we will.  If you examine the list of the Fed’s primary dealers, the banks on the list are all among 19 banking institutions that were deemed “too big to fail.”  It is this “club” of primary dealers with whom the Fed transacts every day, and it is through transactions with them that the Fed pursues the implementation of monetary policy.

There are non-US primary dealers, too.  They have not had apparent problems that were detrimental to monetary policy implementation, and they are certainly not the subject of America’s “too big to fail” debate.  However, many essentially were deemed too -big -to fail by their respective countries.  Virtually all on the list are too -big -to fail from some country’s perspective.

Unlike the European Central Bank (ECB). which has more than 500 counterparties, the New York Federal Reserve Bank’s Desk has pursued a “club” policy of dealing with only a select few institutions.  This club consists of the world’s largest banks and investment banks.  They were given preferential access to Fed transactions in return for distributing the Fed’s open market operations through their dealer networks.  Historically, these institutions were the “best of the best” in terms of financial soundness and reliability.  Clearly this was a myth, which has been dispelled by the mergers of Countrywide, Bear Stearns, and Merrill Lynch and the failure of Lehman Brothers. These four firms were among the 20 primary dealers that existed prior to the onset of the financial crisis.

At the end of the crisis’ most intense period and following the failure of Lehman, the number of primary dealers had been reduced to 16, with nine of them being US-based firms.  Jefferies has recently been added and is number 17.

The Fed went through a detailed process in the selection of Jefferies.  But one has to ask what was the process of supervision of the primary dealers when there were twenty members of the club, pre-crisis.  Did the Fed fail to hold its primary dealers to the standards that would have prevented them from engaging in the risk-taking activity we now know so well?  Only those inside the Fed can answer this question.

Let’s get back to the RP issue.  Given the volume of liquidity that has to be neutralized, the concern is about the capacity of the “club” to participate on the scale that will be required.  Estimates run as high as $500 to $600 billion.

Because of the crisis, the “club” is now smaller, and its members are capital-constrained but now presumably too -big -to fail.  By broadening the club to mutual funds, there is the risk of perpetuation of the too -big -to fail problem, which means that (except for Lehman) a primary dealer would not be permitted to fail.

Given that the government has already stepped in to protect MMFs once, even the phase-out of the recent mutual fund support/guarantee program won’t erase this implicit guarantee from investors’ memories. Presumably, investors would quickly perceive the value of this implicit guarantee, which would convey a competitive advantage to those large funds that participated in the Fed’s reverse RP program.  Competition among mutual funds will also be affected, since some will be admitted to this new “club,” while others will not.  For reference, note how Countrywide was perceived as receiving special treatment as a primary dealer in its merger with Bank of America, while IndyMac was seen as a single, large failed bank because it was not a primary dealer.

In short, the Fed’s reliance upon only a small group of primary dealers laid the groundwork for its need to step in and protect them when they experienced financial difficulties.  Thus the Fed reinforced the too -big to fail perception.  Now the Fed is proposing to do it again.

Source: Bob Eisenbeis and David Kotok, Cumberland Advisors, October 4, 2009.

* David R. Kotok is the Chairman and Chief Investment Officer of Cumberland Advisors.  He cofounded the firm in 1973 and has guided its investment strategy from inception.  Mr. Kotok holds a B.S. degree in economics from The Wharton School as well as dual master’s degrees from the University of Pennsylvania.

** Dr. Robert A. Eisenbeis has joined Cumberland Advisors as Chief Monetary Economist.  In that capacity, he will advise Cumberland’s asset managers on developments in US financial markets and the domestic economy and their implications for investment and trading strategies.

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