Saturday, August 29, 2009

Mission Creep and the Fed

I have written about the foreign currency swap arrangements made by the Fed before. Thankfully, they are decreasing. However, I wanted to point out this testimony by Mr. Bernanke. Pay particular attention to the portion of his testimony wherein he received legal counsel stating that the Fed conducted these swaps under authority of Section 14 of the Federal Reserve Act.

Section 14 of the Federal Reserve Act can be found here. There is no specific power granted to the Fed to conduct swaps or otherwise care about the relative financial positions of foreign central banks. Also, Fed's dual mandate of price stability and economic growth cannot apply to foreign governments.

This activity reminds me immediately of the Maiden Lane situation, where the Fed formed an LLC in order to circumvent restrictions designed to limit outright purchases of assets that are not U.S. obligations. Here, the Fed has not overtly purchased foreign currency, but rather have entered into derivative contracts that are linked to cross currency obligations.

The risk for both situatons is similar: if there is default or an impairment in the ability to pay, the Fed will seize the collateral. In this case, the collateral is currency. While this may not be a problem for relatively stable jurisdictions like the Euro area (and that of course is debateable), for smaller or more volatile jurisdictions (like Mexico) there is a significant risk of total loss, especially considering these swaps were entered into during a global financial crisis.

This is a classic example of mission creep, and powers not explicitly granted by law will be implicitly seized, and active oversight is impossible in hindsight.

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