Fed must change trading rules after decisions by two officials raised eyebrows


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Senator Elizabeth Warren called on the Fed’s 12 district banks to change their codes of conduct to ban stock trading by their executives.

Alex Wong / Getty Images

“Ethical behavior is about doing the right thing when no one else is watching, even when doing the wrong thing is legal. This quote, attributed to philosopher and environmentalist Aldo Leopold, is recalled by the recent revelation that two Federal Reserve district presidents traded stocks last year as their monetary policy deliberations had profound impacts on markets. financial.

After it was reported, the duo – Robert Kaplan of Dallas and Eric Rosengren of Boston – said they would sell their stocks and avoid individual stocks for the remainder of their term, in favor of funds or cash accounts. Their business had not violated the ethical rules of their banks, but if they had really done the right thing, according to Leopold’s definition, there would be no reason not to continue. And, given that their activities were legal, the Fed began last week to review the investment rules of its officials.

Senator Elizabeth Warren (D., Mass.), A frequent critic of the Fed and financial institutions, called on the Fed’s 12 district banks to change their codes of conduct to prohibit stock trading by their executives.

District banks are quasi-private institutions owned by local banks and supervised by boards of directors drawn from the private sector. The members of the Fed’s board of governors in Washington are appointed by the US president and confirmed by the Senate.

Fed officials must disclose their investments and transactions. Kaplan and Rosengren’s disclosures stood out due to the Fed’s extraordinary response last year to the turmoil in financial markets due to the sharp economic downturn caused by the pandemic.

In addition to cutting interest rates to near zero and aggressively buying mortgage-backed securities from the U.S. Treasury and agencies, the central bank has made unprecedented interventions, some through funds. traded on the stock exchange, on the corporate bond market.

Both Fed chairmen had personal investments in areas in which the central bank operated. Rosengren owned a real estate investment trust that invested in mortgage-backed securities purchased by the Fed.

Additionally, mortgage REIT yields are extremely sensitive to changes in interest rates because they use leverage, i.e. money borrowed, typically at short-term rates that the Fed control directly. These REITs generally hedge their interest rate risk with derivative instruments, sensitive to both the level and the volatility of rates, over which the Fed also has a strong influence.

Kaplan owned and traded stocks worth over $ 1 million in the

IShares Variable Rate Bond

ETF (ticker: FLOT), according to its disclosure form. The ETF is made up of good quality securities with variable interest rates, a very defensive position that would tend to be stable if rates rise.

Kaplan also had two closed-end funds that invest in floating rate instruments, the

BlackRock Floating Rate Income Trust

(BGT) and the

BlackRock Floating Rate Income Strategies

(FRA), with positions exceeding $ 1 million for both.

CEFs are leveraged and invest in senior loans from lower quality borrowers. Although their leverage is generally not risky, since the cost of their borrowing and the return on their assets tend to move in tandem, their holdings carry credit risks, similar to bad bonds ”(although loans are generally secured and ranked first in the bond credit structure). Like almost all corporate credit instruments, Lending CEFs plunged during the market meltdown of March 2020, and then recovered, in large part due to actions by the Fed.

The speculative-grade assets of private floating rate companies, which are benefiting from an economic recovery and resistance to rising rates, have been an ideal combination for 2021. As of September 15, BGT had reported 15.62 %, while FRA reported 14.39%, according to

The morning star

This compares to 3.68% for the

iShares iBoxx $ High Yield Corporate Bond


For Fed officials, avoiding individual stocks now shouldn’t be a sacrifice, given the proliferation of ETFs, which cover virtually all investment sectors. The current ban on these officials from holding bank stocks may well be extended to financial ETFs.

Indeed, given the Fed’s entry into sectors where it had not previously traded, such as corporate bonds, central bank officials should avoid any appearance of conflict of interest by sticking to the spread of interest-sensitive instruments. Would that include the actions of home builders? Or foreign securities, which could be affected by exchange rates, which the Fed does not directly control but influences through its interest rate decisions? It is worth discussing.

There was a time when Fed officials avoided even the slightest suspicion of impropriety. In 1998, then-president Alan Greenspan kept almost all of his personal investments in short-term treasury bills. A Fed spokeswoman said this did not reflect any views on the stock market, but rather Greenspan’s desire “to avoid conflicts of interest.”

With Treasuries paying next to nothing now (also due to the Fed’s decisions), this shouldn’t be necessary. A balanced portfolio of large equity and bond index funds would avoid a conflict of interest, without anyone watching.

Write to Randall W. Forsyth at [email protected]

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