The Doomsday Book

One story that came out last week but did not gain a lot of attention was the release of the “Doomsday Book” by the NY Fed. Although it sounds like something right out of Harry Potter, it’s a real life book that interested parties have been trying to get ahold of for quite some time. Why was it released only now? Emre Kuvvet, a professor of finance at Nova Southeastern University, filed a Freedom of Information (FOIA) request to the NY Fed. Despite previous rejections, the Fed dutifully complied, and Professor Kuvvet was sent an 84 page, partially redacted, copy.

Disappointing to conspiracy theorists, the book reveals itself to be more of a legal document than anything else. As usual, the truth is kind of boring. What’s in the Doomsday Book? Turns out it’s an internal document “…intended to help lawyers of the Federal Reserve Bank of New York aid senior bank official in crisis management,” and discusses “…the legal authority of Federal Reserve Banks to provide various kinds of emergency services and facilities that they are not in the habit of providing under ordinary circumstances.” In short, what can or can’t the Fed legally do in emergency situations?

The answer is a little scary. Apparently, and as guided by the NY Fed, the Fed relies upon practice, precedent, and discretion, rather than clear legislative authority, to inform its actions during crises. It argues that effective crisis management in a complex and volatile financial environment requires flexibility and actions not necessarily clearly spelled out in existing legislation. In other words, the Fed seems to believe that they can do anything they have done previously, as well as anything new they deem required. Dodd-Frank has added additional cover for this opinion. Although the Federal Reserve Board of Governors tends to take a more conservative approach, historically they have acquiesced to the NY Fed interpretation.

My conclusions? First, the Fed is deciding unilaterally which powers it holds to regulate the economy and financial markets during emergencies. This will probably come as a surprise to many in Congress. Second, and since each financial emergency tends to be different from the last, the Fed can undertake new and more far-reaching actions during each crisis. Relying upon precedent as a justification to determine their legality, the Fed’s size and scope will therefore ratchet up after each crisis. That is, unless Congress intervenes to more clearly define their new-found powers. Bureaucracies expand, but rarely shrink.

Equities vs. Bonds: And the Winner Is?

Quick — which is better in the long term, equities or bonds? Personally, I thought the answer to this question was settled way back in the early 90s, the conclusion being that equities easily outperformed bonds regardless of holding period. Measured since 1871, and over a 10-year period, median outperformance was 2.3% per annum; over a 50-year holding period, it increased to 4% per annum. This is the so-called equity “risk premium,” whose explanation has bedeviled finance professors and their models for decades.

That’s impressive, but there are two important caveats that have come to light recently: 1) records prior to 1871 (yes, they do exist) indicate that the degree of outperformance is less consistent than thought, and 2) the figures are for US assets only, and therefore do not necessarily apply to the rest of the world.

The revised results are compelling to anyone with an interest in how to view long term performance — it’s not as simple as it seems! More on this next week.

I wish you all a happy holiday season!

Brett Friedman