The Federal Reserve is the Jedi Council of the financial universe, its chieftains wielding the power to move markets with as much ease as Obi-Wan Kenobi manipulates the mind of an Imperial storm trooper.
You might assume that such power comes with guardrails to prevent abuse, such as prohibiting the central bank’s top officials from owning investments whose value they could influence with their public pronouncements on the economy.
But you’d be wrong, as was I. There is no such restriction. And that surprisingly lax approach to managing conflicts of interest has left the Fed vulnerable to allegations that a few senior officials engaged in unethical trading.
The controversy has damaged the Fed’s credibility — and complicates chairman Jerome Powell’s chances of being reappointed by President Biden. It also played a role in the accelerated retirement of Federal Reserve Bank of Boston president Eric Rosengren.
Powell has ordered a full review of the Fed’s financial ethics policies. But the solution is clear. What’s needed to restore confidence is a ban on personal trading by officials privy to monetary policy discussions.
Some, including the opinion editors at Bloomberg, say the Fed should limit holdings to broad-based mutual funds. But even that may not quiet critics such as Senator Elizabeth Warren, who said Tuesday on the Senate floor that there is a “culture of corruption” that goes right to the top of the Fed.
The Massachusetts Democrat called out Fed vice chairman Richard Clarida for selling a bond fund and buying stock funds the day before Powell alerted the public in February 2020 that the Fed might take emergency action as COVID infections soared.
Rosengren, who led the Boston Fed for 14 years, abruptly stepped down last week, just nine months before he would have reached mandatory retirement age. He said a worsening kidney condition prompted his decision. But it seems obvious to me he also was taking one for the team — resigning earlier than planned to help the Fed brass in Washington, who are desperate to deflect the withering criticism from Warren and others.
The Fed began taking flak last month after a financial filing by Dallas Fed president Robert Kaplan showed he held million-dollar-plus positions in 17 publicly traded stocks, including Apple, Facebook, and General Electric, and was a frequent trader last year. Watchdog groups pounced, and even a former Fed executive was surprised by the scope of his trading.
Rosengren was dragged into the controversy even though his investing activity was far more modest. That’s largely because his annual disclosure form listed shares in four real estate investment trusts, or REITs, that hold securities backed by residential and commercial mortgages.
Why the uproar over those mortgage REITs? The Fed, as part of its unprecedented efforts to keep financial markets from seizing up in the early days of the pandemic, was buying securities like the ones owned by the REITs at a $40 billion-a-month clip.
Powell, perhaps angling to keep his job, declined to defend Rosengren and Kaplan during a news conference on Sept. 22. Five days later, within hours of each other, both had announced their intention to retire.
I’ve since spent a fair amount of time assessing Rosengren’s financial disclosures, as well as those filed by the 11 other regional Fed presidents, Powell, and Clarida. Here’s what I learned.
1. The Fed’s personal investment rules — laid out in its “Voluntary Guide to Conduct for Senior Officials” — aren’t worth the PDFs they’re printed on.
There are some no-brainer proscriptions, including no trading during blackout periods around the Fed’s policy meetings. Most germane to Warren’s blast about a culture of corruption, Fed officials are urged to “carefully avoid engaging in any financial transaction the timing of which could create the appearance of acting on inside information concerning Federal Reserve deliberations and actions.”
But here’s the problem: It’s not just during the blackout period that Fed leaders are in possession of inside information. They know things that no other investor knows 24/7, 365 days a year.
It’s impossible for them to trade stocks or bonds and uphold their “special responsibility” to protect the Fed’s “integrity, dignity, and reputation.” Every trade is tantamount to an insider trade.
“That undermines and erodes the trust in the integrity of the Federal Reserve,” said John Pelissero, a senior scholar at the Markkula Center for Applied Ethics at Santa Clara University.
2. Kaplan was an outlier.
Most Fed officials stick to mutual funds, exchange traded funds, and retirement accounts; some also hold real estate and private investments. Kaplan invested like the high-flying Goldman Sachs honcho he was for 23 years. (He later taught at Harvard Business School.) In addition to stocks, he reported owning mutual fund, ETFs, and private investments, including a $1 million-plus stake in the Kansas City Royals.
Another difference: Unlike the other regional Fed presidents, he didn’t bother to list the dates of trades, making it impossible to discern just how aggressive he was. This should have come as no shock: Kaplan’s disclosures were similar in 2019 or 2018.
“I think it is shameful that a professor, and former senior associate dean of HBS, who has written on government accountability and leadership, viewed it as acceptable to engage in these trades simply because he could, rather than consider whether he should,” said Daniel Taylor, an associate professor at the Wharton School of the University of Pennsylvania.
3. Rosengren should have known better.
He wasn’t in the same investing league as Kaplan, but Rosengren was much more active in individual stocks than other regional Fed bank presidents, who traded infrequently, if at all.
Early in 2020 — before the pandemic tanked the stock market and the Fed began pumping trillions of dollars into the financial system — Rosengren sold off several Chinese tech stocks, including Tencent and Alibaba, and bought shares of mortgage REITS Annaly Capital Management and Two Harbors Investment, and added to his holdings of Invesco Mortgage Capital. All three plunged during the market crash from the end of February to late March.
In May of that year, as the market was rebounding, he increased his investments in the mortgage REITs and added another, AGNC Investment.
Rosengren, 64, declined to comment, so I don’t know what his game plan was.
REITs typically have heftier dividends than most common stocks, and maybe his purchases and other portfolio changes were part of shift to income-producing assets in advance of retirement. Even if that was the case, the 35-year Fed veteran should have understood the bad optics of making more than 30 trades in investments so closely tied to interest rates.
4. There is a larger problem threatening the Fed: a dismal lack of diversity.
According to a survey by watchdog coalition Fed Up, 83 percent of the regional bank presidents are white and 75 percent are male. Among Fed governors, all are white and two-thirds are male.
Moreover, many Fed leaders come out of banks, Wall Street, or big corporations. The interests of labor, consumers, and small businesses are poorly represented.
Restricting trading “is low-hanging fruit,” said Benjamin Dulchin, director of the Fed Up Campaign at the Center for Popular Democracy. What’s more important is a “fundamental commitment to diversity at all levels to ensure that the professional backgrounds and life experiences [of Fed officials] mirror those of the public.”
Warren and others will succeed in getting the Fed to adopt much stricter personal trading policies. But remaking central bank leadership to look more like the country?
That may be a job for Obi-Wan.