This is a guest post by Precision Capital Management.

William Dudley

Chief executive officer and president of the Federal Reserve Bank of New York (and ex-Goldmanite), William Dudley,  delivered a speech last week that contains, with supreme gall and irony, a subsection called “Transparency.”  The title of the speech was thoughtfully crafted to allow a redirect.  So here we go…

[To] Dudley:  Some Lessons [for the Fed] from the Crisis.”

Transparency

In some critical segments of our financial markets, both before and during the crisis, limited or ineffective disclosure undermined market discipline and this contributed to the accumulation of risk.

Does this limited or ineffective disclosure undermine market discipline when it is carried out by the Federal Reserve, or do market participants turn forever a blind eye to the accumulated risk on the Fed’s balance sheet?  For how long will foreign CB’s snap up 30 year T-bonds at 4.0%?

In the years leading up to the crisis, the lack of transparency contributed to increased risk and leverage in off-balance sheet vehicles, structured credit products and in over-the-counter securities such as asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) and their associated derivatives.

These would be the same Agency MBS being created from no-doc loans issued by the FHLA for the sole purpose of reigniting the housing bubble—to the tune of $1.25 trillion–correct?  The same CMBS that will eventually be refinanced by TALF 3.0—correct?  Good thing they’re AAA rated by a group of cherry-picked ratings agencies.

Once the crisis was underway, the opacity of many of these vehicles, structures and securities contributed to the concerns about counterparty credit risk. This uncertainty exacerbated the erosion in market liquidity conditions and further intensified the crisis.

Fortunately, the counterparty risk to the Fed for this and other programs is now gone as it has been assumed by a combination of Treasury, FDIC and, of course, the Fed itself.  Note: counterparty credit risk cannot be removed by a tautology.

This lack of transparency was present in a number of different places:

Valuation. CDOs and other securitized obligations were complex and difficult to value. This reduced liquidity, pushed down prices and increased uncertainty about the solvency of institutions holding these assets.

Prices. The lack of pricing information led to a loss of confidence about accounting marks. Sometimes identical securities were valued differently at different financial institutions.

Fortunately, the Fed’s assets are reported at par—no need to value anything here—as long as they were taken in under the AAA stamp of approval.  With that out of the way, any question of insolvency cannot be addressed.  So, who needs an audit?

Concentration of risk. Because there was no detailed reporting of exposures, market participants did not know much about the concentration of risk. This led to a reluctance to engage with counterparties, which, in turn, pushed up spreads and reduced liquidity further.

Well, we know where all the risk is concentrated now…in the world’s largest central bank cum hedge fund.

Thanks for the lesson on transparency, Mr. Dudley.