June 25 - The Fed announced today that it would extend and modify many of its liquidity programs.  These changes followed upon the two day meeting of the Federal Open Market Committee (FOMC). 

The changes reflect improvements in some markets, redesign of specific facilities, but on the whole continuing fragility in most parts of the financial system.

The TALF (Term Asset-Backed Securities Loan Facility) will be left in place to run until the end of the year. The TALF is the most non-conventional facility of all, to support with considerable resources markets far afield of the Fed's usual domain and involving assets that never before had any relation to the Fed balance sheet (the auto, student loans, credit card, business equipment and commercial mortgage markets).

Depository institutions - The Fed is reducing the amount of fixed term loans auctioned to depository institutions (banks) through the TAF (the Term Auction Facility), slightly at first.  The TAF was the first special facility created in the crisis (essentially the discount window redesigned to provide credit through a more anonymous auction process.) Demand for TAF facilities has declined in recent auctions, partly a sign of improvement in the underlying marketplace.

Foreign currency swap arrangements -With the crisis being global, , foreign currency swaps have been crucial to ensure the smooth functioning of the world financial system.  Today, the Fed announced extension of its dollar swaps with 13 central banks and foreign currency swap arrangements with the major European central banks.

Primary dealers - The Fed also decided to suspend and/or shift the auction schedule for the Term Securities Lending Facility (TSLF), the facility providing basic Treasury securities liquidity to primary dealers which was established when Bear Sterns was on the verge of collapsing.  A related facility, the Primary Dealer Credit Facility (PDCF) however was extended to provide a liquidity back stop to primary dealers if needed, even though no credit is currently outstanding through the facility.    

Money market funds - In probably a positive sign, the  Fed did not extend authorization for the Money Market Investor Funding Facility (MMIFF), which expires on October 20, 2009.  The MMIFF was established to specifically address a panic in the money market mutual funds market when Lehman Brothers failed and the oldest fund "broke the buck" (ie, went below $1). 

The other facilities were extended through February 1, 2010, some with program modifications (the AMLF, or Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; the CPFF, or Commercial Paper Funding Facility).     

June 17 - Today the White House released its plan to overhaul the financial sector.  If adopted, will the proposals prevent another financial crisis, yet still allow sufficient financial innovation, both of which would benefit us all?  In other words, is the administration proposing "smart regulation", which will mean less cost to U.S. taxpayers - now potentially on the hook for billions of dollars as a result of the financial market meltdown?  At first glance, the administration's proposals are comprehensive and would appear to improve financial market regulation and oversight in most of the areas creating the worst problems. The nation's financial sector has changed dramatically in the past 20 years and the regulatory structure has not kept pace.  

One of the challenges from the financial crisis is that our financial system has become a market-based rather than a bank-based financial system (ie, more reliance on securitization and all the structured financial products most of us have learned about as a result of the financial crisis, versus bank deposits).  The regulators are still trying to catch up.  We must have a regulatory system for our 21st century financial markets.  

But would the changes be "smart enough"?  Even with some consolidation, the regulatory structure would remain complex.  Moreover, worrying gaps would remain between the federal and state levels (state-chartered banks remain an important part of the U.S. system) and at the state level, most particularly in the housing market, which has been at the heart of the crisis.  In addition, the status of Fannie Mae and Freddie Mac, the government sponsored enterprises so directly a part of the housing market crisis (whose rescue has cost the taxpayer) is not tackled now.   Official interagency discussions on Fannie and Freddie will take place and proposals brought forward with the 2011 budget.   

Would moral hazard be minimized so that financial firms - especially those traditionally considered "too big to fail" - would not take risks that the taxpayer checkbook would end up covering? The proposals would appear to reduce incentives for risk and establish a higher level of monitoring and tools for prompt corrective action, as needed. However, implementation and in the end judgment will be critical and those are very difficult to shape and predict. 

The highlights of the proposal:

(1) To bring non-bank players into the regulatory fold.  Many players, including those involved in the securitization and derivatives markets, have operated outside the regulatory system even though they account for a large share of U.S. financial activity.  A number of those firms have been key players in the financial crisis. Regulators have not been able to adequately monitor and take corrective action.  It is essential to improve the current situation, but there will be a debate over the extent regulatory requirements should be placed on these firms, which have been a strong source of innovation and growth - as well as high risk.

(2) To reduce incentives for extremely risky investments, particularly those leading to the financial crisis.  Capital and liquidity requirements would increase, on both a national and presumably international basis (since this is a global financial crisis).  Regulators' ability to monitor and limit extreme risk would be increased.   It is important to bring incentives for risk more in line with firm activity, so that firms can continue to gain from the upside of a market but also have the discipline of any downside.

(3) To reduce regulatory gaps so that comprehensive supervision and regulation of interconnected and systemically critical financial firms would take place routinely.  One of the great challenges in addressing the financial crisis has been regulatory holes and inconsistencies.  In this context, the President would strengthen comprehensive supervision and regulation under the Federal Reserve.  While politically controversial, if not the Fed, then who ?  (The Fed has invoked emergency clauses under the Federal Reserve Act to take its extraordinary financial crisis actions. See forthcoming CRFB Fiscal Roadmap Project paper.) He would also create a new interagency Financial Services Oversight Council, chaired by Treasury, to monitor and assess systemic risk (essentially an elevation of the present working party looking at financial market matters); eliminate the federal thrift charter and regulator;  set up a new National Bank Supervisor to supervise all federally chartered banks (a combination of the thrift supervisor and present Office of the Comptroller of the Currency);  create an Office of National Insurance within Treasury (this would be a major change that nearly every recent administration has tried to achieve, since insurance is regulated at the state level);  and to require SEC registration for advisers of hedge funds and other private capital funds, while transferring some SEC powers to the Fed (this would mark the first time anything hedge-fund related would be brought under a regulator, despite an earlier attempt by the SEC that was rejected by the courts). Despite the laudable objectives of the proposals, the regulatory system, while simplified, would remain complex.

(4) To give regulators more tools to resolve crises, along the lines of what the FDIC does to resolve insolvencies in an orderly fashion.  The objective would be to avoid a Lehman-type situation in which federal regulators saw the only choices as being between a government bailout or Lehman collapse.

(5) To establish a new Consumer Financial Protection Agency to protect consumers from "unfair, deceptive and abusive practices".  It is not entirely clear what this agency would do, although it may be a vehicle to target housing market fraud and abuse, alot of which was missed by the responsible authorities.  Credit card issues may also be part of the responsibilities of the agency.      

June 10 - It seems like a no-brainer that the US should start planning how it will get its fiscal house in order when economic and financial recovery takes hold.  But sometimes outside pressure helps to remind us what the stakes of not cleaning up our act might be.  

According to a report from Bloomberg today, officials from Russia's central bank stated that they may be reducing their holdings of Treasury instruments and switching to International Monetary Fund bonds.  Russia is one of our largest creditors.  Brazil's Finance Minister is reported to have made similar comments. 

At the end of May, South Korea's National Pension Service, the country's largest investor, said that it would reduce its weighting of Treasury holdings. 

In March, Chinese Premier Wen Jiabao commented that China is worried about the safety of its US assets.  In the past year as the economic and financial crisis unfolded, China has increasingly voiced concerns over US fiscal mismanagement. 

What our foreign creditors say about our fiscal management is important.  With our low savings relative to our borrowing needs, we rely heavily on foreign creditors.  Foreigners own half our public debt (excluding debt held by the Fed and intragoverment holdings).  Of the total $3.3 trillion Treasury securities held by foreigners at the end of March, China was our largest creditor ($768 billion), followed by Japan ($687 billion) and the EU countries, taken together.  The oil exporters, Russia, the UK and Brazil are also large single holders of US debt.    

Some shift out of Treasuries in the near future and then over the next few years should be anticipated as investors increase their appetite for risk, no longer need a strictly safe haven for investment, and move to other attractive assets over the next few years.  Fears that countries will dump Treasury securities over a loss in confidence at some point are however probably overblown, as the US market should be expected to still have considerable relative appeal once things return to a new normal, particularly in view of limited prospects elsewhere. 

However, we cannot afford to take creditor interest for granted. For the first time in a long time - and certainly for the first time ever when our borrowing needs are so high -  there are fundamental doubts about US fiscal and financial management in the global capital markets we depend so much on. Investors have lost alot of money because of problems originating in the US. If they perceive US assets as more risky as things return to "normal", we will need to pay them a higher return to induce their investment. If our creditors perceive that they can earn a higher return elsewhere without enormous risk, they may move more away from US assets.  A significant reassessment of US Treasury holdings could put downward pressure on the dollar and upward pressure on interest rates, thereby dampening economic activity here. 

So why take a chance ?  As Fed Chairman Bernanke recently urged, we should start planning now to put our fiscal house in order.  It is less costly to be proactive, rather than to be forced into action by the markets. 

For Treasury Department data: http://www.treas.gov/tic/mfh.txt.

For today's Bloomberg article on Russia, Brazil, China and other US foreign creditors:  http://bloomberg.com/apps/news?pid=20601087&sid=aYeNpqVLsH94