October 6, 2021 | Updated | Two weeks ago, most observers believed that Federal Reserve Board Chairman Jerome Powell was likely to be reappointed. Today his stock is trading at a steep discount and the entire Federal Reserve Board is now discredited, and subject to attack and ridicule by more radical members of Congress. But we think that Jay Powell will survive the firestorm of reputational risk.
There is no "culture of corruption" at the Fed, as Senator Elizabeth Warren (D-MA) madly rants, but the Fed is now vulnerable due to profound errors in judgment by Powell and the Fed's legal division. Chairman Powell needs to quickly and forcefully put in place a new conflicts standard for all Fed employees that exceeds that required for private financial institutions. Indeed, he can simply copy the policies of the US Treasury.
Boston College Professor Ed Kane, a long time member of the Shadow Open Market Committee, told The IRA:
"I think the question is why did this negative information surface at precisely this point in time and not years ago? Whose purposes does it serve to undermine the reputation of top Fed officials when their success as pandemic fighters had taken it to new heights? Someone wanted to put them in their place and gave this information to the Senator, knowing what she would do with it."
The spectacle of Chairman Powell experiencing the bitter taste of reputation risk is reason for quiet satisfaction among many big bank managers. For more than a decade now, since the 2008 mortgage meltdown and the passage of the Dodd-Frank monstrosity by Congress in 2010, the Fed has lectured the managers of the big banks to avoid headline risk.
Since 2008, US commercial banks have fled consumer facing credit exposures, including virtually all government mortgage lending and also subprime auto loans and credit cards. The impact of the cautionary regulatory guidance from Fed bank examiners, combined with Basle III, Dodd Frank and the National Mortgage Settlement with the states, has been to turn banks into neutered islands of liquidity that no longer support economic growth or market function.
When Senator Warren calls Chairman Powell “dangerous,” she is far too modest. Elizabeth Warren has done more damage to US banks and the employment prospects of Americans than anyone else in politics today. Her profound lack of understanding of banking and finance, combined with malignant narcissism and an endless desire for public attention, makes Senator Elizabeth Warren the most dangerous person in America today. And she will say or do anything to get attention.
On the question of insider trading, however, Senator Warren is 100% correct. The rules of the Securities and Exchange Commission and FINRA are clear. Once you are tainted by non-public information that would be considered significant to investors, you are obliged to wait 48 hours after the public disclosure of that information before taking any action. The test of materiality, of note, refers to whether the information is significant to investors, not lawyers or bankers.
Most banks and broker dealers regulated by the Fed, SEC, FINRA and other agencies have in place strict conflict rules that require disclosure of personal trading activity and, in some cases, a total ban on active investing. Research analysts, investment bankers and credit rating professionals, for example, must observe heightened levels of disclosure and often times total restrictions on personally-guided investments.
Memo to Powell: When Fed governors and employees go to work every morning, they are tainted and thus should not make personal investment decisions, period. When we worked in the world of credit ratings at KBRA, for example, we were required to put all investments into passive, managed accounts. Whether you are a Fed governor, bank president or are working in research, you should be assumed to have non-public information. Duh!
For some reason, the legal division at the Fed’s Board of Governors thinks that Fed officials are above such laws and regulations. But the hideous appearance created by the Fed’s casual approach to managing financial conflicts is the true culprit. Put it down to arrogance or hubris, but the Fed’s legal division in Washington needs to be cleaned out and repopulated with lawyers that actually understand financial compliance.
We understand that there is some sort of unpublished conflicts regime in place at the Fed, but the rule has been proven entirely inadequate in terms of the practical test of public disclosure and partisan politics. The disclosures of trading by sitting Fed presidents and governors essentially gutted the Fed Board and opened the key policy making body at the central bank to political attack. And we understand that more revelations are forthcoming.
“Think about Chairmen such as Martin, Burns, Volcker, Greenspan, and Yellen,” notes David Kotok, Chief Investment Officer of Cumberland Advisors. “Never have we seen this string of disclosures. Add three departures -- Clarida, Kaplan, Rosengren -- to vacancy, Randall Quarles, and now a Powell in political trouble. Governor Lael Brainard carries a public contribution to Hillary Clinton as political baggage.”
“We have a central bank in turmoil,” Kotok continues. “Biden now faces four appointments to the Board of Governors, plus several regional Fed banks now are under microscopic surveillance. Hell of a mess to make profound monetary policy decisions. The most important central bank in the world now has to run a marathon of several years to some stabilization of policy and it has to do it with a broken leg.”
Some of the names being floated to replace Chairman Powell include James Bullard at the St Louis Fed, Loretta Mester in Cleveland and Raphael Bostic in Atlanta. Either Mester or Bostic would be good choices for President Biden, who now also has a new and unanticipated problem to deal with along with the debt ceiling and federal budget. But we suspect that Jay Powell will survive the crisis.
We understand that Larry Summers and Roger Fergusson have also been discussed at the White House in recent days, but just imagine what Senator Warren and other members of the crazy, noisy progressive wing in Congress will say. Bottom line is that more than any commercial bank, including the notable examples of Citigroup (C) and Wells Fargo (WFC), the Federal Reserve Board has set a new standard for self-immolation via reputational risk.
Amidst this scene of confusion and disarray at the Fed, there are rays of hope. Kotok notes: "Biden has precious little political capital to use. This means that a Powell reappointment still is the most likely outcome. Chairman Powell can handle the shrill screams from Warren & Co. And there is no evidence of Powell doing anything wrong himself." From your lips to God's ears David.