Brave New Fed

The turmoil in financial markets has exposed critical failings in the oversight of new forms of lending, borrowing, and investing activities in recent years. The business of banking is nothing like it used to be in the past. Securitization, leverage, and the offloading of risk have created the explosive problems that we are now witnessing. This realization has motivated the Treasury Secretary to release a preliminary plan to rework the regulatory framework The Federal Reserve is to be commended for its recent creativity in dealing with the mess. Make no mistake, though, the Fed’s new and expansive techniques of problem solving are profoundly different from anything that has gone on before now. The “lender of last resort” is now the “market-maker of last resort” and perhaps much more. It’s a new world and a new Fed.

Unless you are involved directly with financial reporting, accounting issues tend not to get all that much consideration. However, some rather significant things are brewing at the Financial Accounting Standards Board (FASB), and bank asset/liability professionals should be aware. In most cases, the issues discussed in this article probably will not affect market participants’ strategies or tactics, but the financial disclosures relating to these activities will likely change. Moreover, complying with these new accounting rules will probably require an allocation of additional resources.

From an economic, interest-rate and banking perspective, 2007 will be remembered for a lot of reasons, including the credit crunch, the implementation of SFAS 157 and SFAS 159 (remember how much fun that was?), and stock and bond markets acting in odd and volatile ways, particularly during the second half of the year. Now that 2008 is well underway, we can ask ourselves how long this difficult and confusing environment will continue to look like last year. And if it does continue, what measures should your bank take?

Financial institutions invest in a variety of fixed-income securities, including Treasuries, agencies and municipal bonds. Banks also invest in mortgage products, such as mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs), as a way to pick up additional yield or spread. These products include a wide variety of issuers, collateral, maturities, weighted-average lives, coupons (fixed and floating) and cash flow structures. In today’s investment climate, agency-backed MBS represent good relative value due to wider starting spread, solid credit quality, favorable cash flow characteristics, and lower prepayment risk.