Friday was possibly one of the worst days in the career of new Federal Reserve head Janet Yellen. On that day, two distinctly different pieces of news emerged: First, a public radio broadcast  that cast deep aspersions on the role of the Fed as regulator, particularly citing the apparent conflicts of interest inherent in the way New York Fed treated its wards and of course, the “vampire squid” itself, Goldman Sachs.
Put simply, instead of being a regulator, the NY Fed acted more like a consultant, providing Goldman Sachs advice on what it could and couldn’t do, and, more importantly, how it could do what it wouldn’t be allowed to do under the laws of the land.
Second, the resignation from PIMCO of Bill Gross, the longest-serving bond fund manager and the man widely acknowledged as the “go to” person for all quick opinions on the state of the bond market. His bond fund  was the biggest of its kind in the world, with a stunning ability to move markets from time to time.
While his record of non-US investments were spotty at best, Bill Gross mostly called the US bond markets correctly and presciently, as shown by his multi-decade track record as the world’s best bond fund manager.
First let’s tackle the bit about the Fed being “bent” – an English slang meant to communicate someone who is morally corrupt, bereft of purpose and prone to substantial conflicts of interest. Going through the broadcast and the ProPublica article [see 1], it is quite clear that some topics, such as questioning the probity and integrity of people at Goldman Sachs, were completely verboten at the NY Fed.
Now take the other side of the story: any regulator has a dual role – first, to keep the banks under its purview under sufficient supervision to ensure that adequate standards of capital and internal credit discipline are being maintained. The second function of any banking regulator, though, could provide conflicts, as we saw in the case of the Bank of England and its treatment of Northern Rock many years ago : this is the function to promote and protect investor confidence in the system.
When regulators are both responsible for supervision and promoting confidence, the most obvious source of conflict is what to do when one of the 500-pound gorillas under your care starts going a bit, what’s the medical term for it? – nuts? At that point, you have to ensure that the gorilla doesn’t mess around with “your” banks – but allow it to go ahead and wreck mayhem with other people’s banks.
This, on all counts, is what the NY Fed allowed Goldman Sachs to do. As long as its predatory activities only affected non-banks in the United States and non-US banks, it was allowed to do whatever it pleased.
There are a number of such deals being discussed, one of which, involving Banco Santander, was especially highlighted by Bloomberg columnist Matt Levine. Specifically, he makes the point about Goldman Sachs being involved in a round-tripping exercise where form scored over substance with the ultimate objective of fooling the Spanish central bank:
… One conclusion you might draw from the tapes is that the regulators and the banks had a very different conception of what social practice they were engaged in. Goldman was helping Santander play a game against its regulators, while the New York Fed just wanted to be friends with Goldman and not make too much trouble. It certainly makes it easier to win a game if the other side doesn’t know it’s playing.
Over the weekend, in possibly a transparent move to seize back the headlines, Goldman Sachs announced that it was now prohibiting its investment bankers from trading individual stocks and bonds.
The curious thing about the announcement, from the perspective of anyone who has worked in the financial sector, is that previously, investment bankers were allowed to buy individual stocks and bonds at all. This is expressly prohibited by a number of banks; in banks where bankers are allowed to make such investments in their personal accounts, rigorous conflicts of interest and compliance checks must first be carried out, and approvals given before the bankers can purchase the individual assets. That is why most bankers primarily invest in mutual funds and exchange-traded funds (ETFs) rather than individual stocks and bonds in their personal accounts.
In any event, what the above shows is that the Fed is culturally compromised; or to use the colloquial expression, bent.
And now, blind
Even before its role in supervising banks and ensuring system integrity, the primary function of the Federal Reserve is, of course, to set interest rates and to dictate the monetary policy (ie determine the quantum of money in circulation) of the US.
At this stage, this article could go into some arcane details of how the Fed is supposed to act in the face of inflation or deflation, and what its role is in terms of employment in the economy (previously none, but now, apparently, one of its most focused indicators of monetary policy efficacy).
Instead of going into the arcane details, suffice to say that primary macro indicators such as non-farm payrolls (and average pay), retail sales and housing starts typically provide enough evidence and inputs for the Fed to make its determination of monetary policy. That said, since at least 2000, the key change has been (a) rising US fiscal deficits as the George W. Bush government instituted a series of tax cuts for wealthy people, and (b) geopolitical risks that started in September 2001 and have been a dominant factor of Fed thinking ever since.
Between these mutually contradictory factors – rising fiscal deficits would push up interest rates, while rising geopolitical risks would dent consumer confidence and hence push down interest rates – markets became more volatile. This volatility made monetary policy a matter of great interest, especially given the rising size of US government debt.
If bond markets sold off government debt over fears of rising deficits, then the US risked falling into the typical emerging-market debt trap: rising debt produces rising interest costs, which in turn increase the deficit, leading eventually to a market bust.
To make matters worse, the bond market was highly fragmented, with bonds being ultimately held by millions of individuals through their retirement accounts, mutual funds and of course, bank deposits; not to mention global investors such as central banks and sovereign wealth funds.
So what the Fed needed was a reliable bellwether: something that told the Fed exactly how the “market” would react whenever it moved policy one way or the other. As a talking shop already for academics – both former Fed chairman Ben Bernanke and now Yellen were formerly professors with no actual trading experience in bond markets – the job of monitoring the market reaction fell naturally to an outsider.
That outsider was Bill Gross, manager of the PIMCO Total Return Fund but also the firm’s co-founder and the man credited with making it one of the world’s largest managers of other people’s money. In his monthly “Investment Outlook” series, as well as in a number of media interviews, Mr. Gross – a former card-counting genius on the tables of Las Vegas – laid out his views of where the market would be headed.
Whilst widely acknowledged to be “talking his book”, ie extolling the virtues of his already chosen investment strategy, Gross did gain credibility for his generally bullish views on the bond markets, which eased the pressure on the Fed when it came to monetary policy. For one thing, there was no immediate reason to rush in and counter the government’s ever-increasing deficits with stricter monetary policy, as Gross cogently argued that the lack of inflation was more important than the rising volume of debt.
In turn to the Fed paying heed to his counsel, Gross also improved his own standing in the investment world as shown by ever rising inflows. All of that worked until 2012, when Gross was caught off-side by the Fed’s decision to increase quantitative easing (QE). Even as he had started getting more bearish on the markets, the Fed stepped in and started buying US Treasuries directly.
By 2012, when this was widely expected to stop, Gross had begun adjusting his positions to reflect more volatility ahead for bonds. Instead, the Fed continued its purchases for two more years and ended up severely denting the returns posted by Gross.
Already suffering from what organizational experts term a “personality deficit”, declining performance at his main fund marked out Gross politically inside the firm he had founded. The departure of his heir apparent, Mohammad El-Erian, earlier this year proved to be the death knell for his glittering career at PIMCO.
This is where things get interesting. Instead of leaving the firm and the industry – Gross is after all 70 years old and can be forgiven for retiring now – he has gone to a competitor (Janus) to manage a fund that had all of $13 million being managed No that’s not a typo. (Gross was “in charge of $2 trillion as chief investment officer at Pacific Investment Management Co”, according to Bloomberg). Obviously, Gross would try to increase the assets under management, and in so doing is likely to go vastly “off script”, ie, explain lots more about his detailed thinking of where US interest rates are headed.
What is worse, the firm he leaves behind, PIMCO, still runs over $2 trillion largely on the investment strategies he had determined. These will obviously change in coming months, partly on the back of expected redemptions but also to reflect the views of the managers of PIMCO now that they will have a more independent reign. Lastly, the major competitors of Mr. Gross – including Jeffrey Gundlach of DoubleLine – will lay claim to Gross’s legacy, speaking as they will for the markets.
For the Fed, all this means that from a reliable voice of the markets, there will now be a cacophony. At a time when the Fed has already signaled its intention to increase interest rates by March 2015, this volatility in views and opinions would likely translate to greater investor concerns.
Yellen, from her academic background and lack of appreciation of trading minutiae, doesn’t inspire confidence among many investors, including the major central banks and sovereign wealth funds. To investors in the bond markets, the travails of the Fed could have just begun, and a very rough ride could well be the result.
1. “This American Life” by Jake Bernstein, which received 46 hours of tape recordings primarily made by a former regulator of NY-based banks, including Goldman Sachs, Carmen Segarra. There is also a detailed article over at ProPublica see here.
2. PIMCO globally managed over $2 trillion as of Friday when Gross quit. While Gross only managed personally a fraction of that amount, his role as chief investment officer meant that in effect all other bond managers in the firm reported to him and had to get his approval for the views they were expressing in their funds, be they emerging market bonds or US corporate bonds. Analysts claimed after Gross quit that some 10-30% of PIMCO assets could follow him to his new employer, Janus.
3. See Rocking the land of Poppins, Asia Times Online, September 22, 2007, by this author.