“OTC derivatives required less market-making capital than exchange-traded instruments, and the conserved capital could support more real economic activity.”

You can’t create more real capital or more real economic activity by moving numbers around on paper. Sometimes people on Wall St are so far up in the clouds they forget what the real economy is.

The finance industry doesn’t create more real capital or real economic activity. The best it can hope to do is improve the allocation of capital to allow more efficient economic activity.

I fully expect that the Fed and Treasury will at some point, likely in the Fall, resort to monetization/’quantitative easing’ because this is something that they _can_ do without having to go before the public and ask whereas more realistic long-term interventions will have major, immediate, and obvious impacts on public consumption and revenues. If a certain amount of monetization takes place a) with international coordination and b) after significant price discovery in the actual present value of deflating asset classes, it may do only limited harm although it won’t do much good in the mid-term either. If monetization occurs unilaterally and while inflated assets are still being carried at illusory prices, those assets will simply soak up the monetization while our currency and debt are savaged on the international market. I expect the latter result, unfortunately. Considering that we now hear voices from China announcing, “We think we are being cheated by crypto-depreciation,” further cuts in the Fed Funds would be simple madness at this juncture, to me.

And further cuts if and when they are applied—and I also believe they will be applied—will have no impact on spreads. The issue with banks’ failure to lend does not seem to me to show primarily a concern with counterparty risk, real those these are; the lack of intra-bank lending seems more to show concern with massive shortfalls of internal reserves against exposure the banks already have on their own books. _Additional_ counterparty risks are real but something of a red herring: it’s existing unreserved risks that are the ticking timebomb’s in the vault. Leave aside the very real issue of whether bets on MBS have already wiped the reserves and capitals of most major banks (I think they have); the Fed has said kinda-sorta that it will let no major bank fail due to MBS positions by offering to swap them out at inflated values for the mid-term. The banks cannot depend upon the kindness of regulators further as the Fed has not, and practically speaking cannot, said the same about CDS exposure, that’s the rub.

The idea that CDSs could be used without setting aside real and liquid reserves against losses is one of those innovative acts of madness which will be historically famous. No matter how many swaps are done, at some point somewhere somebody has to pay off realized losses. If the risk is spread systemically, the potential for mismatches to occur increases—but no one in the system has set aside significant reserves against mismatch liquidity squeezes. The most that was done was to line up Tier 2 MBS and other securitized assets to doorstop Tier 3 counterparty claims until institutions could collect on their own swaps and pay off those derivative claims. However, those Tier 2 ‘mini-reserves’ have collapsed in value, are totally illiquid, and have themselves burned holes in institutions’ Tier 1 capital. If the Fed has poured Treasuries and pipe gunk into the Tier 1 gap, this still means that intitution’s Tier 3 exposure now remains _nakedly_ unreserved. The Carlyle Capital and Bear Stears debacles have shown that institutions in fact need massive and highly liquid reserves against their prodigious CDS obligations or else they can run out of ammo in days from Tier 1 and get eaten by zombies. The present market couldn’t possibly be worse for raising capital to resrve against this Tier 3 risk that banks are now beginning to ‘price realistically’ in their own back offices if not to the public. Furthermore, if there are even rumors that a bank or fund is ’setting aside capital against derivative exposure’ they would face the high probability of an immediate run. Thus, to me banks look like they are ‘hoarding’ capital or ‘resisting lending’ when in fact they are piling bales of bonds a-top the ticking bombs down in the Tier 3 crypt in hope that such revetments will permit the house to survive a ‘controlled explosion’ when it comes. You can’t get bankers to lend when they are desperate for capital to offset known or expected losses, and the spreads on the auction bids say that banks are very desperate indeed.

. . . I sure wish that the Powers That Be would quit fiddling around with interest rates. Except that their likely next courses of action are either to ‘guarantee’ derivative positions, buy up MBSs en masse, or flood cheesy Treasuries into the system. We won’t like the outcome of any of those choices. Bernanke and Paulson can do their damnedest to try to prevent an asset deflation, but they will be shocked and awed at their inability to drag the rest of the world along for the ride: they will fail. To me, we need to _stop_ with these unilateral actions and get an international plan together. That would include for starters a more or less negotiated re-valuation of currencies for US-EU-CHN, and an _increase_ in US Fed Funds to back up the new rate. We may very well need new people in the chairs Bernanke, Paulson, and Dubya are occupying to effect anything like that, or any of the rest of the interventions we really need.

My sense is that the Fed’s ultimate goal is to have the monetary base grow again. I base this on Bernanke’s own criticisms of the 1930’s Fed and (more recently) the BOJ — both committed the “cardinal sin” of allowing the base to stagnate or fall.

Bernanke likely believed that the TAF-induced spread tightening might lead to more demand for Fed Funds. Unfortunately, this demand never materialized. He now has two choices: abandon the goal of monetary base growth; or resort, as you predict, to quantitative easing.

Bernanke must know full well that he is influencing inflation expectations at a global level. Maybe he’ll try to cool that fire by skipping the next rate cut. Regardless, this is a man who’s life work is based on the idea Central Banks must avoid credit-induced deflation at all cost. I think he’ll resort to quantitative easing as long as the bond market (aka China) lets him by keeping bond yields low. Its all down to whether China revalues in response, which of course depends on the price of rice in China.

If you will allow a partisan opinion, we have had a period with the worst President and the worst Fed Chairman in history following a false ideology.

Is there any surprise that the result was disaster? [/rant]

Jim

Alcoholics Anonymous definition of insanity: doing the same thing over and over, and each time expecting a different result.

I think we need to redefine intelligence from the current interpretation regarding speed and comprehension of basic linear processing to one encompassing structural, spatial, non linear reasoning.

Most brains are no more than computers able to process according to the programming they have received. Rubbish in, rubbish out.

In other words human beings are a low intelligence life form.

Andrew Teasdale

The TAMRIS Consultancy

“You will notice that through all the perturbations of the financial markets over the past nine months, there have been no problems with the operations of the centrally cleared futures and options exchanges.”

Obviously he has not heard about various grain futures (corn, wheat, soybean) consistently closing above the cash price at settlement, reported by Yves yesterday (http://www.nakedcapitalism.com/2008/04/commodity-volatility-creates-problems.html).

The news from somebody in the thick of commodity trading yesterday it seems as though the futures market is, in his veteran experience, in meltdown.

So much for a stable exchange traded situation, with OTC contracts now being traded in place of going to the CBOT.