Dialogue with the Fed participants in St. Louis and Memphis ask questions of Stackhouse and a panel of other St. Louis Fed experts: William Emmons, assistant vice president and economist; and Mary Karr, senior vice president and general counsel.
Julie Stackhouse: Okay. So that wraps it up. I want to leave plenty of time for your questions. And what we're going to do is this, is three of my colleagues are going to be joining us. Do you want to come on in? And they'll be coming up. I want to briefly let you know who we have here. First is Mary Karr. You can go ahead and sit down. Mary is the general counsel of the Bank. Mary is very well-schooled on the Dodd Frank Act. I know there are a few people here who had questions about Dodd Frank and we want to be sure and address those.
Next is Bill Emmons. Bill is an economist on the staff, in my staff in the Banking Supervision area. He has his PhD in finance and is very much an expert on the housing markets. He will also be our speaker next month as we talk about the issue of the fiscal deficit.
Finally is Silvio Contessi. I did say that right, Silvio? And Silvio has got a very interesting background. You're from Italy originally. He has a PhD in economics. I think he brings just a wealth of knowledge, at least in my view, on foreign markets, as well as the domestic economic situation.
So what we'd like to do is this. Is we'd like to invite your questions. So as you've been thinking there sitting, I think we'll go ahead and start in this room, and let's see if anyone has a question. Yes? Thank you for turning your mic on, by the way.
Q: Okay, be it Dodd Frank satisfied the issue between the veil that had been created between regular banking and investment banking that was in place with, I think it was the Glass-Steagall Act, and if not, why?
Mary Karr: Okay, let's see. Yeah, my mic is on. I'll try to take that one and then anybody else who wants to chime in can feel free. Dodd Frank has tried to bring securities firms that are considered systemically important under the ambit of the Fed's regulatory authority. But there's still regulation from the SEC, if I understand your question correctly. So—And the other thing that Dodd Frank is looking at is in traditional financial institutions there is a requirement that Dodd Frank separate financial institutions trading for their own account from the trading that they do on behalf of their customers. Those rules aren't done yet and we don't know where they will come out. But that was what was known as the Volcker Rule that said that some of the traditional banking institutions were being subjected to excessive risks perhaps by doing too much trading for their own account. So that rule making is yet to happen.
And I'm not sure if I've really addressed your question, so if there's a follow-up from you?
Julie Stackhouse: And maybe to add to that...
Q: Yeah, let me think about that for a second.
Julie Stackhouse: Okay. To add to that a little bit, one of the things we saw—and the reason Glass-Steagall was repealed is that investment banking and banking became so intertwined it was no longer easy to separate them. And so there we are. And now some have said, well, if you could just reinstitute Glass-Steagall, would that solve the problem? And unfortunately it's not that easy, because so much of our financial markets today rely on investment banking activities. There are just a lot of activities, like hedging interest rate risk, that have to be done. And there's this very close tie to investment banks.
What the Volcker Rule, thanks, Mary, for saying that, I remember hearing Mr. Volcker talk about this, and he said, you know, this whole issue of, they called it proprietary trading. It's sort of betting the bank. He said it's like pornography. You know it when you see it. And so that's the piece, yeah. (Laughter) I don't know, I don't look at it. I work for the Federal Reserve, remember.
So that's the piece though that I think is very, very tough, because that is the piece that the intent is to very much reduce or eliminate the risk in. The question is how do you define it without creating an unanticipated consequence that takes the good with it. And that's where all these rules are still yet to come. So we're waiting for those, but that is what Dodd Frank intends to do, is to separate that.
William Emmons: Julie, a follow-up too, I think there's no consensus among economists or policymakers that Gramm-Leach-Bliley, that is the repeal of Glass-Steagall, was the problem. Of the institutions Julie talked about, think about Fannie Mae, Freddie Mac, Lehman Brothers, AIG and Lehman Brothers, none of them had anything to do with Glass-Steagall. They were unaffected by the Gramm-Leach-Bliley Act of 1999.
Julie Stackhouse: Yeah. Which is why we know, and one of the lessons learned is this will all morph. The risk will be something different tomorrow. And the challenge will be trying to figure out what the next thing is so that it doesn't get ahead of the system designed to oversee it and watch it.
Yes, we'll take one more question here?
Q: Yes, you showed what was going on with the Fed's balance sheet. The flooding of liquidity around the world in concert with other central banks around the world, I think, was quite significant. I'm just interested in what's going on with the balance sheets of the other central banks.
Silvio Contessi: What's the question again?
Julie Stackhouse: What's happening with the balance sheets of other central banks?
Silvio Contessi: If you look at central banks like comparable countries like Europe or Japan or...
Julie Stackhouse: Oh, your mic is not up.
Silvio Contessi: So the balance sheet of other central banks looks very similar. Most of them implemented quantitative easing programs and they're trying to wind them down a little bit. Now the current situation in Europe is forcing them to keep the programs open. And the instruments are available if things get really worse. And so they're very, very similar.
Q: So in combination they don't show a huge worldwide problem? What's the...?
Silvio Contessi: Well, the liquidity is there to be provided in case it's necessary. If you think that could create inflation, we are not observing inflation at the moment.
Julie Stackhouse: So I think part of the question was the other central banks, particularly central banks in Europe, have stepped in to provide liquidity to their financial institutions. And the situation in Europe is its own topic because of the many challenges and many interrelationships. But the central banks have worked very closely to be sure that the panic piece of this is addressed. There's a separate piece of solvency. And I think that's right now what financial markets are trying to figure out, is what is the situation in Europe and are these financial institutions solvent or how much are they harmed by their investments in each other.
The U.S. central bank, the chart I showed, I hope maybe gave a little bit of a sense first of all of how the Fed's balance sheet has changed. So we saw that it ramped up for the financial crisis and it came down. And now we see the effects of monetary policy, the decision to stimulate the economy by putting more money into the financial system. And I'm simplifying that, because it's a little bit more process-oriented than that.
The question often raised to us, so I'm going to try and predict this question, isn't that going to result in rampant inflation? Susan, don't you teach that in economics, that if you put too much money out there there'll be rampant inflation? And I think that's clearly one of the chief concerns of people like Jim Bullard, is walking that line between an economy that needs to have a very favorable monetary policy, the recovery is very weak, but not keeping the money and the money supply so long that it results in inflation that is at unacceptable levels. And that is the job of the FOMC, to walk that line, and to make those tough decisions about when to begin to retract the money that is on that balance sheet. Or if the recovery is very weak, what needs to be done to stimulate as well.
Oh, my gosh, we have a lot of questions. Let me just real quick if I might just check with Memphis to see if we have any questions there. Martha? Can you just, a little bit louder, please?
Q: Yes, Julie, one of the lessons we've learned from the financial crisis was the power of contagion on an international basis. And when we think of what is transpiring in Europe with the Euribor IOS going higher with southern Europe potentially going into recession, the limit on Germany in terms of dealing with the sovereign debt risk, and the challenge to Italy in terms of its debt to GDP and its cost of funding for future borrowing, and the potential disorderly default of Greece. How does America deal with a financial crisis that's born in Europe and not have that contagion bring us back into another financial crisis or a serious recession?
Julie Stackhouse: Okay. That was the question. That's a tough question. And if you didn't totally hear it, essentially the question was we saw in the financial crisis that contagion was a huge issue. Panic assailed and it cost us dearly. So we've got a situation in Europe that's volatile right now. How do we think about that? Are we at the point of we need to be real worried? Or is this something that essentially we'll be able to work our way through? Anyone want to take that? Silvio?
Silvio Contessi: Yes. So the instruments are there to be...
Julie Stackhouse: Your mic.
Silvio Contessi: Sorry. So there are lots of instruments available to central banks. The European Central Bank is working actively to keep buying treasury bonds from various European countries. The question is whether the crisis is going to be contained. It's not exactly clear. All these countries are trying to take care of the problems on the fiscal side with moderate success. The direct exposure of the U.S. to the Greek system, to the Greek's banking system is not really large, but there are lots of indirect exposures because lots of European banks, obviously, own Greek debt. And then there are lots of bilateral relationships between the U.S. banks and European banks. So there is a chance that things may turn ugly. In, you know, there is earlier on the balance sheet of the Fed all these programs ready to be used. Most of them are still open, so hopefully there will be an orderly resolution of the fiscal crisis in Europe. At the moment there is a lot of tension, as you can observe in the markets.
Julie Stackhouse: Yeah, Greece is a very small country in a sense. We read a lot about it, but if you just could take Greece and you didn't have interrelationships, you could maybe let it default and move on. There have been other defaults on debts in different countries over time. The problem with Greece is that many other countries hold Greek debt and that's Silvio's point, which is one country owns the debt of this small country, but if the first country defaults, and then the second country has a problem, and then we do have some issues with the economies and European countries like Portugal, Italy, Spain. Which one am I forgetting?
Silvio Contessi: Ireland.
Julie Stackhouse: Ireland, thank you. And by the way, I had to learn all this, and I learned that they are the PIGS. So, you know, go—it was interesting. At least I can remember it by using that acronym. But then you start to say what is the collected impact and to what extent then does that affect healthier countries, like Germany, maybe the U.K., and then what investment does the U.S. have in those. So that's where we call this contagion. That's where panic is very dangerous. Central banks' roles are to step in and calm the fears by making sure that payments can be met when otherwise solvency exists. And, of course, the hard thing often to judge is when solvency exists.
William Emmons: I'll just add, I can tell you Jim Bullard and his colleagues are following this very closely. I think one of the points that Julie made was the contagion that came from the United States then went to other countries. There's no question with banking systems and financial markets as integrated as they are today that problems, particularly in a large important area like Europe, definitely have the potential to spill over into other areas.
Julie Stackhouse: Yeah. Remember, the European situation, while it's escalating, it's been out there for quite some time, and probably it's become a little bit more to the attention of U.S. investors and others more recently because of the headlines out there. But it has been watched and monitored.
Here's the other thing that's important. It's not important just for Europe. It's important for us. And Bill is going to hit on this. All of those countries have government fiscal situations where spending was out of line relative to income. That's a bad place to be. And, again, that's a hard message to deliver because all government spending benefits someone or something. And that feels pretty good when you're the recipient of that money. When you've got to make that change and pull back on spending, someone or something gets affected, and politically that's not real popular. But it's also sometimes what's necessary to ensure that you do have solvency in your country. So whether it's in Europe or whether it's in the United States, those are some of the tough choices that have to be made. And that will be Bill's topic for next month.
Let's take another question here in St. Louis. Oh, gosh. Okay, yes, in the second row?
Q: Julie, would supply side economics...
Julie Stackhouse: Can you get just a little closer?
Q: Would supply side economics have any positive impact on us? I mean, the Keynesian economics really hasn't been effective or popular. So if a supply side economics were implemented, would we see a positive turnaround?
William Emmons: Are you saying maybe a preference for tax cuts versus government spending?
William Emmons: Well, we're trying both. And I think the president's proposals this week involve both tax cuts and spending programs.
Julie Stackhouse: Do you want to talk a little bit maybe more about some of the economic theory on what tends to be most effective, at least historically?
William Emmons: Well, it's not, I would say again it's not a settled matter, what is the most effective. Julie mentioned the economic stimulus and some of the other programs in 2008 and 2009, '08 and '09. And there was a lot of controversy about where you get the most bang for the buck. For example, one of the things that was tried was for the federal government to downstream money to state and local governments. You know, all sorts of various, the Cash for Clunkers, the first time home buyer tax credit. Still we're talking about infrastructure spending. So all sorts of different ideas and different people have different estimates of how quickly that might translate into jobs or growth.
And at the time there have been reductions in tax rates. We've deferred some tax increases that were scheduled to take effect. The president is talking about extending Social Security tax cuts on now both employee and employer side.
So I think it's safe to say that if there's been any sort of reasonable case for it, we've tried it. And so it's not an either/or situation.
Julie Stackhouse: Okay. Yes?
Q: Hi. You know, we talk about the banking crisis as being over to some extent. We looked at '08 and '09. But taking a look at some of the graphs that you have there, particularly the percentage of people who are underwater in their mortgages, do you feel—what are the possibilities? Do we really know the ultimate value of the assets that are on those books at the financial institutions or do we really still have a financial crisis out there that we just haven't put down in our books yet?
Julie Stackhouse: So that's a good question. I worry about that. One of the things that is out there in massive numbers are something called home equity loans. And so one of the things we understand is that if a mortgage defaults, the home equity loan is almost always a total loss, because the first mortgage gets to collect first. And so there's a lot of those.
And so some of the worries tend to be framed this way, which is right now we kind of know, you know, unemployment has stabilized, so we kind of know that second wave of people who have defaulted on mortgages because they lost their job. So it is pretty stable. And actually these delinquency rates don't look that bad. But what happens if someone decides that I no longer want this home because it's just hanging on me like a wart and I want it off and I walk away. And some have termed that strategic default. And we haven't seen significant amounts of strategic default to date, but it's one of the risks that we're very conscious of because should that become popular that would clearly have an impact on financial institutions that have large amounts of home equity loans, much less what might be lost on the first mortgages as they walk away. So, yeah, that is a risk.
The other crisis we have—I'm going to be real quick—is community banks. And so often when you read the periodicals it talks about JP Morgan Chase or Citi or Bank of America. Regents—No. I've been picking on Sally tonight. We have so many community banks in this country. Well over 850 banks out of about just under 8,000 that are really, really sick. In our rating system they're rated the worst. They rate at fours and fives out of a scale of one through five. And they're not getting better quickly. And that too, I think, is one of the things that we worry about. It's just going to take time to work through those, because inevitably every one of those banks there's a lot of real estate loans on their books. And when you have those sort of problems, those banks are not in the business to be doing new lending. And, of course, that's very frustrating to many of you who are looking for credit because some of those banks are out of the game.
Now on the other side of it, we've got 88 percent of the banks that are fairly healthy. Those are the ones that are in the lending game. Of course the question is do the borrowers meet the standards. And banks have now said, because banks are pickier than they were just a few years ago.
Okay, so, yes, right up there.
Q: Hi, Julie. If I can ask two quick questions. The first one is, there's been a lot of discussion with policymakers and economists, specifically about demand and reducing uncertainty. Demand being one item, reducing uncertainty going forward a separate one. I read in The Wall Street Journal about a week and a half ago where the Fed is thinking of three initiatives that was in the paper. One of them, of course, was another quantitative easing. But the one that caught my interest was reducing long-term interest rates, which driving down long-term interest rates to have an inverse relationship with short-term. So if somebody on the panel can comment on that. And the quick second question is, and I think it's probably for Mary, on Dodd Frank, sorry about that, I didn't want to pick on you, but it's an easy one. You know, we talked about transparency and Dodd Frank and regulatory things and that kind of thing. Can you comment about the derivatives market and whether any of the changes that have been made in terms of a transparency affect that market?
Julie Stackhouse: Okay. Want to take the twist?
William Emmons: Well, obviously, Jim would be the best person to speak, but given that the FOMC is just about to meet he obviously can't talk about that. And all I will say is that I think that there's been a tremendous amount of discussion. The chairman and Jim himself recently talking to the media have laid out exactly the options that you talked about. And I've heard Jim say, and I believe him, that they have made no decisions. That they're going to go to Washington and weigh all the options. You know, the betting is maybe this, maybe that. But they don't know themselves what actions they might take.
Julie Stackhouse: Mary?
Mary Karr: On derivatives, I guess, first of all, yes, Dodd Frank has a lot of provisions in it that are intended to make that market more transparent. How is the rule making process going to make that a reality? Very slowly. So that's my quick answer to your question.
You know, some of it has been capacity in the agencies, because there are a number of areas where the Securities and Exchange Commission and the Commodities Futures Trading Commission are supposed to be working together. There's been a lot of concern about the resources that they have to devote to this and whether they've received appropriate support from the budgetary processes to support that. So I think we haven't seen as much yet as we will see. But when is a good question. And I don't really have a good answer for you on that.
Julie Stackhouse: Yeah. And that's, of course, a concern to financial organizations because it's sort of like healthcare for many of you and your businesses. You're like, well, what is it going to be two or three years out? And how do I, do my business planning because of that?
I'm a regulator, so you would think I would like regulations. I think those of us that are in the regulatory field understand that this many regulations will have consequences somewhere in the industry, whether it's going to be new costs—that's pretty inevitable—and whether those will be passed on to you, or whether it will be something else. Because I have new costs, I no longer offer this type of credit. There will be consequences and it's just too early to fully understand those.
So let me do a quick check in Memphis again?
Q: Julie, we don't have any further questions.
Julie Stackhouse: Okay, thanks. So just a quick check.
Q: Julie, I apologize.
Julie Stackhouse: Okay.
Q: I see a hand over here.
Q: It was mentioned earlier that there is liquidity available should the need arise. Could someone speak to—and I meant on a global basis—is the available amount of liquidity sufficient to cover the day-to-day needs of simply interbanks' needs and corporate needs?
William Emmons: The simple answer is yes. The major central banks, we're in a fiat currency system, so they can create the amount of liquidity that's needed. I think the question in Europe today, and it was an issue back in the period Julie was talking about, 2008, is we don't want the central bank to be the only provider of liquidity. It's an emergency, the lender of last resort. But we want the interbank markets to be the primary, or almost exclusively the source of liquidity, and that's problematic in Europe right now, I think. Silvio, is that a fair statement?
Julie Stackhouse: Yeah, central banks too, and I think this is the case in the European countries, require that if we lend to banks to stem this panic, that good collateral has to be pledged. That's one of our challenges. I think there's sometimes a misunderstanding that the Fed just throws the money out there and you get it for the taking, but it's actually a very thoughtful process where the financial health of the institution is assessed and the credit is actually collateralized.
Silvio Contessi: If I can add something to that. So the problem with the European Central Bank is that the value of the collateral is not exactly very well defining moment because if any of these countries defaults, then the value of the treasury bonds that banks hold may be very different within a few days from potential default. So that's exactly the problem in Europe. Nobody questions the value of U.S. treasuries as collateral, but, you know, not each bank posting Italian treasury bonds as collateral. That may be an issue in three weeks. I mean, it's not clear it's going to be. Hopefully not. But that's exactly the problem it is facing, the European Central Bank.
Julie Stackhouse: Okay. So I'm going to do a quick check with you. First of all, we are willing to stay here until midnight to answer all your questions. But there are some of you who don't want to stay here until midnight. So this is what we're going to quickly do. I'm going to do one last poll and then everybody that wants to stay to hear the rest of the questions, we're going to stay here for that purpose so that you can get your questions answered. So let me quickly do our closing poll questions.
Okay. Remember this question. It's pretty close. Hint: Number 6 is a new item. So if you'll take out your clickers and please vote on what you think was the cause of the financial crisis. And we'll have the polling open.
It's always nice when the teacher tells the answer to the test, isn't it? (Laughter) It's okay. We're really not finding out who said what answer, so you're good. You can hide. Okay. All right. Close enough. Okay. Well, yeah, that's okay. And some of all. I mean, I think you can put different weights on these and you can get them all right. But clearly lots of factors were involved.
Okay. This is the big one. (laughter) You have an opportunity to attend two more sessions. Do you plan to attend another speaker series question? Okay. That's good enough. And the answer is... Yeah. Okay.
Okay. I did my job. Whew.
Okay. And, again, that does conclude our program tonight. We would love to have you stay. For those that are interested in having your questions answered, just feel free to stay and we'll reconvene.