Wall Street’s not so-secret profit engine (the Fed)

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Henny Sender has a story in the FT about the fact that Wall Street firms have been making lots of money trading with the Federal Reserve. I can think of two valid reactions to this:

1) No duh! Ensuring the health (a.k.a. profitability) of the financial system is a major responsibility of the Fed. The financial system was near collapse last fall, so enabling some easy trading profits is a straightforward way to get banks back on their feet.

2) What an outrage! Traders on Wall Street are going to be getting multi-million-dollar bonuses for doing nothing but taking advantage of the Fed’s largesse.

Here’s some detail from Sender’s article:

The Fed has emerged as one of Wall Street’s biggest customers during the financial crisis, buying massive amounts of securities to help stabilise the markets. In some cases, such as the market for mortgage-backed securities, the Fed buys more bonds than any other party.

However, the Fed is not a typical market player. In the interests of transparency, it often announces its intention to buy particular securities in advance. A former Fed official said this strategy enables banks to sell these securities to the Fed at an inflated price.

The resulting profits represent a relatively hidden form of support for banks, and Wall Street has geared up to take advantage. Barclays, for example, e-mails clients with news on the Fed’s balance sheet, detailing the share of the market in particular securities held by the Fed.

I get those Barclays e-mails every week, by the way. I’ve failed to take advantage of the information contained in them to make big trading profits. The reason (aside from the various Time Inc. restrictions on employee trading and the fact that I’ve mostly resigned myself to index-fund investing) is that I’m simply not a big enough financial player. Which is sort of the way it has worked with all the Fed’s bailout actions. I’m willing to believe that most of them have been sincerely intended to keep the financial system from breaking down, which benefits all of us. But the structure of our financial system means that the greatest share of the benefits flow to those at the center of it.

What could we do to remedy this? Here are four approaches that spring to mind—all with their flaws.

1) Shut down the Fed. Of course, the Fed was created partly in reaction to Congressional outrage about the way those at the center of the financial system (J.P. Morgan in particular) profited from halting the Panic of 1907. So it’s not like the phenomenon would disappear—government’s role in it would simply be diminished.

2) Put the Fed under more explicit political control. Then at least our elected representatives—not a bunch of unelected bureaucrats—would be deciding who benefits from its largesse. But there’s lots of evidence that central banks under the complete control of elected officials tend to be bad at another key task, controlling inflation.

3) Separate the the basic functions that keep the financial system going on a day-to-day basis (the financial utilities) from all the riskier, higher-profit stuff. Then the Fed would be responsible for keeping the former going, but not the latter. This would be sort of a new Glass-Steagall, albeit with different dividing lines than the old one. But what where would those dividing lines be? And could they be relied upon to stay in the same place?

4) Limit employee compensation at firms that benefit from government largesse. This happens to be Washington’s current strategy.  But in light of the FT article, Congress and the Administration may be defining largesse (the main pay restrictions are only for firms in which taxpayers still own a stake) a little too narrowly.

Got any better ideas?