First:   As the Federal Reserve starts its two day meeting today, Chris Whalen just released his notes regarding an unpublished Fed research work.  The summary is below.   The link to his letter is:  http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=348 .

“The following article on fair value accounting ("FVA") was authored in May 2007 by a researcher who at the time worked for the Federal Reserve System. The paper, which was not approved for publication by the Fed Board's bank supervisory staff, outlines some of the issues in a transition to FVA, issues that have turned out to be critical. Many of these issues now may be obvious to students of financial institutions and the general public thanks to the financial crisis, yet two years ago the paper was dismissed by the Fed's staff in Washington. To us, the story around this article provides yet another example of how the intellectual closed-mindedness of the Fed's Washington staff results in bad public policy.

Some background for context. The Fed and other bank regulators historically did not push back on supervised firm accounting "choices" or otherwise second guess the external auditor on valuation issues for financial firms. That is, if a financial firm could get its paid accountant to sign off on a choice of valuation methodology -- choices which in many cases are based purely on "stated intent" at the time to hold an asset for sale or to maturity, then the paid regulator at the OCC (figure roughly 50 examiners for each too-big-to fail bank) and its more poorly staffed step-brother, the Fed (roughly 7 examiners per TBTF bank), would simply accept the decision without question or review.”   

Source: Christopher Whalen, Institutional Risk Analytics, March 17, 2009

Second:  we want to correct an error in our piece entitled “systemic risk”.   We noted that the Fed’s Term Auction Facility (TAF) started slowly and was expanded as the crisis unfolded.   That is correct.   We erroneously wrote that the TAF did not pre-exist the failure of Lehman Brothers.   That was wrong.   The TAF actually started in December, 2007.   It then ceased temporarily and then was resumed by the Fed and expanded as the Bear Stearns affair unfolded in Spring of 2008.   Ultimately the TAF was expanded worldwide with coordinated activity involving several foreign central banks.   Tracking of the TAF and other Fed tools may be found on our website www.cumber.com.  We thank those readers who caught the typo in our text.

Third:  attention will be focused on this Fed meeting as the Fed discusses the possible implementation of a policy where it will buy longer dated treasury notes and bonds.   This is a very complex issue.   If markets know that the Fed is creating a floor price (ceiling yield) there may be a wave of selling by large foreign holders who were fearful of trying to unload treasury bonds into a thin market.   If the Fed mentions this as a possibility but does not offer a clear policy, it will add an uncertainty premium to market pricing.  That premium will cause rates to be higher than they would otherwise be.   If the Fed is silent, it will send a message that policy options are still under debate.  That will cause a different type of uncertainty premium to be factored into market prices.

The Fed has placed itself into a difficult position by discussing this issue without some firm and resolved structure.   It is now between a rock and a hard place or, as one Fed Governor described it, “it is more like standing between the dog and the tree.” 

Announcements from this Fed two-day meeting will be instructive and require close attention to verbiage; there will be no change in interest rate policy.