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Audit the Fed: Why The Current Audit as it Stands is Not Enough

09 Aug

This latest from Naked Capitalism includes in large part the most recent work of Chris Whalen of Institutional Risk Analytics. As Yves Smith notes, it is worth taking the time to go to that site and read his other bombshell on the latest new bubble being genearted in the structured credit products markets.

“Technically Incompetent” NY Fed Examiner of Biggest Banks Pre Crisis Promoted for Blowing Up the Economy

from naked capitalism by Yves Smith

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We pointed out that reappointing Ben Bernanke as Federal Reserve chairman would be inconceivable in the private sector, since CEOs who preside over disasters are dismissed (captains have the good taste to go down with their ships).

But of course, Bernanke is a failure only if you believe that the Fed’s official mandate – soundness and stability of the banking system, full employment and price stability – is the real one. But if you think his job, like that of Soviet apparatchiks, is to preserve the existing order, no matter how rotten it and its incumbents are, then he has succeeded admirably.

The true raison d’etre of the Fed, that of serving as the protector of large banks and their executives, is evident in the disgraceful promotion of Sarah Dahlgren, the recent head of the Federal Reserve System’s Large Financial Institution Group from 2004 onward. That makes her not only the regulatory analogue of the captain of the Titanic, but to add insult to injury, she ignored warnings from outside and inside the Fed and refused to require AIG counterparties to take bigger haircuts and along with other Geithner followers, kept information from the Federal Reserve Board of Governors.

Chris Whalen of Institutional Risk Analytics offers a blistering commentary on this shameful development, which separately illustrates why a full Audit the Fed program, rather than the watered-down version included in the Dodd-Frank bill, is still badly needed.

I’m taking the liberty of reproducing this discussion, which is the bulk of his current newsletter, in full (but please do visit his site, before he turns to l’affaire Dahlgren, he presents a second bombshell, how the authorities are ignoring the deliberate blowing of a new bubble in structured credit products).

From Institutional Risk Analyst:

Shall We Reward Incompetence? The Case of Sarah Dahlgren and the Fed of New York

Despite initial indications that Congress would reduce the scope of Federal Reserve’s financial company supervision, in the end the Dodd-Frank legislation substantially increases the Federal Reserve’s responsibility. Chairman Ben Bernanke and other Federal Reserve officials made the argument that the Fed’s supervision function didn’t do any worse than any other financial regulators — an assertion we cannot validate. This combined with heavy lobbying by other Reserve Bank Presidents and the grudging acknowledgement to the Congress by Fed Chairman Bernanke and Fed Governor Daniel Tarullo that significant improvements are necessary ultimately won the day.

Given its second lease on regulatory life, one might expect that the Fed’s bank supervision function would be gearing-up to take a fresh, smart, and tough line with respect to financial company oversight. However, a recent key supervisory officer appointment by the Federal Reserve Bank of New York (FRBNY) indicates this may not be the case. The largest and most important of regional Reserve Banks appears to be going back to the future with its choice of Sarah Dahlgren as Head of Supervision. See FRBNY press release link below

http://www.newyorkfed.org/newsevents/news/aboutthefed/2010/oa100723.html

If the name sounds familiar, that’s because Ms Dahlgren has been at the center of many of the Federal Reserve’s most embarrassing failures in the area of bank supervision and in particular with respect to the failure of American International Group (AIG). Going back in time now and remembering the period before the crisis, Dahlgren typified the arrogance and refusal of Fed officials to acknowledge warnings from various members of the financial community that the subprime mortgage market was melting down after years of unsafe and unsound lending and underwriting practices by the largest banks. Roger Kubarych, a former economist for the FRBNY, described the refusal of Fed officials to acknowledge the crisis in a 2008 interview with The IRA (’Fed Chairmen and Presidents: Roundtable with Roger Kubarych and Richard Whalen’, October 30, 2008).

“It makes me so mad to think back how ignorant, arrogant, and dismissive she was with people who knew what they were talking about pre-crisis,” one former Fed colleague told The IRA. Dahlgren was running the AIG show for the FRBNY. She ignored the recommendations from the Fed’s own advisors and the Board of the FRBNY that AIG counterparties be forced to take haircuts. For her to ignore good advice on AIG and then deliberately take steps to hide that decision from the Congress and the public, and then be rewarded with a promotion, is quite disheartening.”

Below we pull some quotes from the press release announcing Dahlgren’s promotion, add some background, and pose a few questions. Our purpose is not to attack Dahlgren personally. Rather, we ask several questions about her job performance to date and whether she is the best qualified officer of the FRBNY for the job:

* First, does Dahlgren’s performance with respect to AIG and other matters warrant promotion?

* Second, has her complete lack of experience in the financial industry and educational background in finance contributed to what a number of current and former colleagues at the Fed believe is a record of failure?

* Third, did her close and continuing relationship with then-FRBNY President Timothy Geithner lead Dahlgren to withhold information about AIG and other sensitive situations from Fed Chairman Bernanke and other members of the Fed’s Board of Governors?

Ms. Dahlgren was responsible for the “relationship management” function in the Bank Supervision Group, with oversight responsibility for the Group’s portfolios of domestic and foreign banking organizations. As the head of relationship management at the Fed, a term along with others like “business partner,” “constituent” and “client” we believe should be forever eliminated from the regulatory vocabulary, Ms Dahlgren reportedly was able to stifle many pre-crisis efforts to gather and analyze data, enforce rules, and independently assess key risk areas of the largest banking companies. But Dahlgren’s pandering to the big banks is hardly unique. Former Office of Thrift Supervision (OTS) head John Reich used the term “constituent” to describe his relationship with the banks he was tasked by law to supervise in Senator Carl Levin’s (D-MI) hearings on the failure of Washington Mutual.

Starting in 2004 and continuing into the depths of the financial crisis, Ms. Dahlgren headed the Federal Reserve System’s Large Financial Institution Group (the so-called “LFI” ) which is primarily the responsibility of the Fed of New York. The LFI group had oversight responsibility for the largest Federal Reserve supervised financial companies (e.g. Citibank, JP Morgan Chase, Bank of America, UBS, Wells Fargo, Wachovia, etc).

Working in partnership with the equally compromised Office of the Comptroller of the Currency (OCC) — the regulator of the largest nationally chartered lead banks from whom the OCC derives its operating budget — the LFI relationship management function led by Dahlgren determined, in a centralized fashion, what enterprise-wide information should be analyzed on an ongoing basis, what examinations should be performed each year, and ultimately what supervisory ratings the Federal Reserve assigned to the most important banking firms.

The issue of industry funding for the Fed and OCC’s operations is an important problem that remains underappreciated by the press, the Government Accounting Office (GAO), Congress, and the American public. The heretofore chief regulatory authority of our nation’s largest banks (i.e., the OCC) cannot operate without funding from those it is tasked to regulate.

A former senior Fed Central Point of Contact (CPC) for one of today’s big banks told The IRA that Hugh McColl, the famed former CEO of Bank of America and Nations Bank, used to consider these OCC exam fees a call option on influence over supervisory issues, and therefore well worth the millions paid per annum. These examination fees continue to be used to subsidize additional OCC operations, and represent the same fundamental conflict that the OTS had – in extremis – with troubled institutions such as Countrywide and Washington Mutual.

Fed insiders know of the time-consuming vetting processes that large bank and holding company ratings and exam plans underwent at the NY Fed under Dahlgren’s tenure. The process was described by several Fed officials as was largely a tree-killing exercise supported by minimal analysis which centered on senior LFI oligarchy, led by Dahlgren and FRBNY risk head Brian Peters. This pair would reportedly attack Fed field examiners with respect to any criticisms they dared to voice about bank risk taking. A particular vetting discussion in 2006 is paraphrased below:

Dahlgren: Can you prove this issue you are concerned with is a problem at the firm?

Examiner: No but the surrounding evidence and behavior of bank management points to problems. I think we should take a closer look

Dahlgren: Well if you just think there is a problem, we don’t have the resources to chase down potential problems.

This was typical of the approach of Tim Geithner and his FRBNY supervision lieutenants such as Dahlgren: 1). Don’t look for evidence of wrong-doing. 2). Containing problems is what the Fed should do. 3). The supervisory staff is not smart enough to get ahead of problems; the LFIs have smart people that we (i.e., senior FRBNY bank supervision and executive officers) are talking to banks about potential problems.

As for the rest of this particular story, the examiner was a former Wall Street trader and very seasoned. It turned out he was bringing up a very valid issue that turned out to be a very large problem at a very large banking firm. Within months after the tongue-lashing Dahlgren administered in front of his peers, the examiner left the New York Fed. Keep in mind that Dahgren has never worked in finance and probably could not do so. But let’s move on to the rest of the press release.

Previously, Ms. Dahlgren was responsible for the Group’s information technology and payments systems exam programs, as well as its Year 2000 readiness efforts.

So before becoming the chief relationship manager, she ran the IT and payment-system risk side of the bank supervision function at the FRBNY. Most in the industry and within supervision know how weak the large banks’ IT systems are; particularly their ability to aggregate risk exposures in the 2000s. We see no evidence of backbone or willingness by Dahlgren to push banking firms in this area.

In fact, the current Systemic Resolution Authority (SRA) that Dodd-Frank gives, in part, to the Federal Deposit Insurance Corporation (FDIC) – a regulatory agency that has been thoughtfully pursuing underlying data in its efforts to work on the living wills requirement of Dodd-Frank and enhance resolution capabilities – has already revealed that many of the largest LFIs cannot produce basic position level data, not only of certain small product lines but of entire businesses.

Keeping true to Ms. Dahlgren’s historical example, the FRBNY and the OCC continue to build walls around the sharing of information both within and across regulatory authorities. Officials from the FRBNY, for example, have openly stated their desire to exclude the FDIC from participation in the Office of Financial Research in the Dodd-Frank legislation.

What about a market or credit risk management role at the Fed? Well Ms. Dahlgren did …have responsibility for the Bank’s credit risk management function. But don’t be confused. Dahlgren did not run the risk area that looked-over large complex banking company credit risk and risk management issues. She ran the New York Federal Reserve Bank’s own credit risk (see description here: http://www.newyorkfed.org/aboutthefed/orgchart/krieger.html ). This area deals with intraday credit and discount window lending to banks. These programs became important and many adjustments (i.e. loosening) occurred once the crisis ensued, but they weren’t a cause of the crisis and weren’t of particular importance during Dahlgren’s stewardship.

Perhaps Ms. Dahlgren has some strong financial markets background prior to joining the NY Fed?

Prior to 1990, Ms. Dahlgren was responsible for budget and policy at the Substance Abuse Intervention Division at Riker’s Island, part of the New York Department of Corrections

To paraphrase, she did budgeting for a prison. A noble occupation, to be sure, but not exactly applicable to understanding the complex risks within a portfolio of synthetic CDOs, understanding interconnected risks, or developing a view on financial company regulatory capital requirements.

What about academic credentials?

Ms. Dahlgren holds a bachelor’s degree from Cornell University and a master’s degree from Duke University.

No PhD, but those schools certainly rank near the top. However, the release leaves out the facts that Dahlgren’s master’s degree is in public policy and her bachelor’s is in government. Is it too much to ask that one of the most important financial supervisors have a degree in finance, accounting, or economics? At a minimum, perhaps such senior regulators should attain some, a supplemental education in finance and risk via the Professional Risk Managers International Association (PRMIA) or the CFA Institute.

Another red-flag is Ms. Dahlgren’s apparent self-perception and ego. She lists herself as a central banker on her public campaign contribution filings rather than a bank supervisor. The FRBNY Board’s conflicts of interest have been well-documented by now, but the modest changes in new legislation regarding Reserve Bank President appointments apparently can’t change the inclinations of the people running the day-to-day operations of the Reserve Banks.

Finally, the press release notes the support of Bill Dudley, the President of the FRBNY and a former economist for Goldman Sachs (GS), a major beneficiary of Ms. Dahlgren’s generosity:

Sarah is a proven leader who has been battle-tested in the crisis.

Yes, she unknowingly led the Federal Reserve Supervision function into the greatest financial crisis since the Great Depression. Before and during the crisis she was, even in the best light, technically incompetent. As noted above, Dahlgren was part of the brain-trust that secretly decided to bail-out all of AIG’s counterparties at 100 cents on the dollar. The emails and contracts with her name on them are now public. See discussion of AIG bailout involvement by Dahlgren and other FRBNY officials below:

http://www.businessinsider.com/the-15-culprits-at-the-heart-of-the-aig-bailout-fiasco-2010-1#sarah-dahlgren-the-spin-doctor-3

In the final analysis this appointment sends the wrong signal to the FRBNY supervised financial companies. Dahlgren is a central figure in the financial crisis who had authority but failed to act when confronted by her own staff with evidence of financial firm excesses and risk management weaknesses. In the midst of the crisis and under a thick veil of secrecy she sent American tax dollars to sophisticated counterparties of AIG; institutions who themselves knew they deserved a haircut for their risk management failures. Now, just days after Dodd-Frank has been made the law of the land, Ms. Dahlgren becomes a primary player responsible for implementation and enforcement. We wonder, for example, if Dahgren has reported to the Board about the growing market in complex structured assets being created by the OTC derivatives community in response to ZIRP?

Even if Dahlgren had the skills to lead FRBNY supervision, her appointment makes it seem like the Fed is thumbing its nose at Main Street by appointing someone who is so publicly tarnished by the bailouts of AIG, GS and other OTC dealers. Does Governor Tarullo really believe the world wants a self-described central banker and bank relationship manager with no significant risk or financial experience, and who is tainted with supervisory failures and bailouts, to run the most important Federal Reserve Bank’s financial company supervision? We thought Governor Tarullo and Chairman Bernanke had taken control of Reserve Bank supervision and was starting to enforce some accountability. But it seems the despite the McFadden Act and other legislative changes since the Fed’s creation in 1913, the FRBNY still can’t be controlled by the Board of Governors.

The final point to be made stems from the issue of Reserve Bank compliance with the authority of the Board and the law. During the worst part of the financial crisis, a period of open warfare reportedly existed between the FRBNY and the Fed Board in Washington as the two institutions fought over policy questions. These were difficult days and tempers were obviously short in Washington and New York.

During this time Dahlgren and other Fed officers loyal to then-President Timothy Geithner reportedly were withholding information from Chairman Bernanke and other members of the Fed Board of Governors. This is not a trivial point. All of the authority of the Reserve Banks to act in the financial supervision area comes from delegated authority from the Board. Indeed, the Board must approve all bank applications and all emergency loans that are not part of normal open market operations.

If Dahlgren was indeed part of the pro-Geithner cabal at the FRBNY which failed to provide timely information to and seek authority from the Board to act, even after Tim Geithner left the FRBNY and went to Treasury in January 2009, we think that this is a legitimate area of concern.

We think that the Congress and the General Accountability Office need to focus on the issue of governance and internal controls at the Board and the FRBNY with respect to role of Sarah Dahlgren and other officials in the bailout of AIG and other rescue operations. In particular, we think that the GAO needs to confirm the timeline of events around all of the major loans and investments made by the FRBNY and particularly when then-President Geithner obtained Board approval to make financial commitments and decisions regarding haircuts of the AIG counterparties.

IOHO, the only way that anything like the intent of Dodd-Frank will ever become a reality is if Chairman Bernanke, Governor Tarullo and the rest of the Board regain control of the shambles left behind by Tim Geithner at the FRBNY. Everybody deserves a second chance and we have no personal agenda with respect to Sarah Dahlgren, but does Chairman Bernanke and the rest of the Fed Board really want to gamble on having Sarah Dahlgren and her cohorts calling the shots as the senior bank supervisor for the largest U.S. banks? We think that the Congress needs to put that question directly to both of these men at the earliest opportunity.

 

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