naked capitalism

I’ve seen some eye-poppin’, credulity-stretchin’ accounts in my time. The report “The Budgetary Impact and Subsidy Costs of the Federal Reserve’s Actions During the Financial Crisis,” just released by the Congressional Budget Office, ranks with the most extreme. It claims that the budgetary cost (which corresponds roughly to expected losses) of the Fed rescue facilities launched during the financial crisis is approximately $21 billion. Moreover, its peculiar formulation (“fair value subsidies”) conveys the misleading impression that this was the extent of the central bank’s support to the financial services industry.

In a (weak) defense to the CBO, my understanding (and readers are welcome to correct me) is that the office is tasked to execute analyses as they are framed. In other words, if the CBO is asked to opine on a particular matter, it has to deal with only the questions posed to it. It is not permitted to tweak the inquiry or broaden the focus to provide more insight.

The closest thing to a statement of scope and objectives comes in the Preface and it is remarkably thin. The most important remark:

The report also presents estimates of the risk-adjusted (or fair-value) subsidies that the Federal Reserve provided to financial institutions through its emergency programs.

Yves here. The report thus purports to answer the criticism made most forcefully by former central banker Willem Buiter before he became Citigroup’s chief economist: not only were the Fed’s numerous bailout vehicles a clear violation of Constitutionally-stipulated budget processes, but they expose taxpayers to the risk of eventual costs, since if the Fed takes big enough losses, the Treasury will have to recapitalize the monetary authority (the Fed can simply “print” its way out of a certain level of losses, but if that activity were to stoke inflation, the Fed would need instead to seek funds from the Treasury).

However, note the framing of the report. It conflates the discussion of budgetary costs and financial services industry subsidies, when explicit costs to taxpayers are only the tip of the iceberg of the bennies that banks received from Fed. While the other forms of support are arguably outside the CBO’s purview, the failure to state those omissions means that defenders of the Fed and the banksters can use this report to obscure the true extent of welfare for financiers.

A partial list of the subsidies the report chose to ignore:

1. Far and away the biggest, near zero short-term interest rates. As we pointed out recently, this is the biggest source of real cash earnings at financial firms these days, since banks can earn easy, risk-free profits simply by borrowing from the Fed and parking the proceeds in longer-dated Treasuries (even though the biggest financial firms are also reporting embarrassing trading profits, those are due in part to low interest rates, both their impact on funding costs and by boosting asset values). These low interest rates are a large tax on savers. Not only do they make investing in comparatively safe and liquid investments unattractive, but they compress risk spreads by enticing investors to go into riskier assets to chase yield, which props up prices of investments generally.

2. Gross underpricing of the rescue facilities. Bagehot’s rule for a distressed financial firm is to lend freely against good collateral at a penalty rate. But the Fed instead lent against virtually any and all collateral and at attractive, often artificially low rates.

The CBO’s “fair market” value seeks to argue that the facilities were priced correctly using an NPV analysis, but that’s bogus. First, as we will see in due course, a mere eyeballing of the results strains credulity. But second, the idea of the Bagehot rule is both to provide for good incentives (you don’t want to make it attractive to use emergency facilities) and to allow for an ample margin for error. A characteristic of panics is they follow bubbles, and what looked to be a decent valuation for collateral might prove to be more than a tad exaggerated. For instance, AAA CDOs were acceptable collateral at the Fed pre-crisis, and if memory serves me correctly, the haircut was 30%. That seemed hugely generous, but the record shows that real-estate related CDOs would have needed a haircut of 80% to 100%.

Although my favorite example comes from the TARP, which is also discussed in the CBO report, it illustrates the general principle. This discussion comes from former derivatives trader Roger Ehrenberg:

The US taxpayer has been systematically looted out of hundreds of billions of dollars… Whether anyone will admit it or not, without the AIG (read: Wall Street and European bank) bail-out and the FDIC issuance guarantees, neither Goldman nor any other bulge bracket firm lacking stable base of core deposits would be alive and breathing today…

It stood with the rest of Wall Street as a firm with longer-dated, less liquid assets funded with extremely short-dated liabilities….In exchange for giving the firm life (TARP, FDIC guarantees, synthetic bail-out via AIG, etc.), the US Treasury (and the US taxpayer by extension) got some warrants on $10 billion of TARP capital injected into the firm. While JP Morgan Chase CEO Jamie Dimon prefers to poke a stick in the eye of the Treasury, seeking to negotiate down the payment to buy back the TARP warrants, Lloyd Blankfein smartly paid the full $1.1 billion requested. He looked like a hero for doing so, a true US patriot repaying the US Government in full for its lifeline, thanking the US taxpayer in the process. $1.1 billion… $1.1 billion…Hmm…something doesn’t seem right. You know why it doesn’t seem right? BECAUSE THE US TREASURY MIS-PRICED THE FREAKING OPTION.

There is not a Wall Street derivatives trader on the planet that would have done the US Government deal on an arms-length basis. Nothing remotely close. Goldman’s equity could have done a digital, dis-continuous move towards zero if it couldn’t finance its balance sheet overnight. Remember Bear Stearns? Lehman Brothers? These things happened. Goldman, though clearly a stronger institution, was facing a crisis of confidence that pervaded the market. Lenders weren’t discriminating back in November 2008. If you didn’t have term credit, you certainly weren’t getting any new lines or getting any rolls, either. So what is the cost of an option to insure a $1 trillion balance sheet and hundreds of billions in off-balance sheet liabilities teetering on the brink? Let’s just say that it is a tad north of $1.1 billion in premium. And the $10 billion TARP figure? It’s a joke. Take into account the AIG payments, the FDIC guarantees and the value of the markets knowing that the US Government won’t let you go down under any circumstances. $1.1 billion in option premium? How about 20x that, perhaps more. But no, this is not the way it went down….

Yves here. So let’s do a little comparison. Ehrenberg argues that the subsidy embodied in the underpriced TARP warrants for Goldman alone (the strongest firm of the bunch) was $21 billion, if not more. The CBO would have us believe that the subsidies provided to all financial players across ALL Fed facilities was a mere $21 billion. Tell me how credible that sounds.

3. The Fed has allowed Wall Street to skim more from its rescue operations, like its over $1 trillion purchase of mortgage backed securities. From the Financial Times in 2009:

Wall Street banks are reaping outsized profits by trading with the Federal Reserve, raising questions about whether the central bank is driving hard enough bargains in its dealings with private sector counterparties, officials and industry executives say…

However, the Fed is not a typical market player. In the interests of transparency, it often announces its intention to buy particular securities in advance. A former Fed official said this strategy enables banks to sell these securities to the Fed at an inflated price.

The resulting profits represent a relatively hidden form of support for banks, and Wall Street has geared up to take advantage. Barclays, for example, e-mails clients with news on the Fed’s balance sheet, detailing the share of the market in particular securities held by the Fed.

“You can make big money trading with the government,” said an executive at one leading investment management firm. “The government is a huge buyer and seller and Wall Street has all the pricing power.”

A former official of the US Treasury and the Fed said the situation had reached the point that “everyone games them. Their transparency hurts them. Everyone picks their pocket.”…another official familiar with the matter said the central bank “has heard that dealers load up on securities to sell to the Fed. There is concern, but policy goals override other considerations.”

Yves here. Let me translate. “Policy goals” means the extra margin the Street nicked from the Fed was a feature, not a bug.

Now to the report itself. It is unabashedly Fed and financial services industry friendly. Start from the top: “The financial system plays a vital role in the U.S.
economy.” You can tell this is a preamble to “the Fed had to rescue the banks” which it predictably recites later:

In CBO’s judgment, if the Federal Reserve had not strategically provided credit and enhanced liquidity, the financial crisis probably would have been deeper and more protracted and the damages to the rest of the economy more severe.

Yves here. This anodyne statement is intellectually dishonest. The report discusses ONLY the Fed’s rescue programs. Thus, the CBO posits bi-modal choice (acting v. not acting) when the officialdom had a huge menu of possible actions. This “the Fed had to Do Something, ergo its programs were warranted” misses the massive moral hazard of what was put in place: the continuation of super-low interest rates and the Greenspan/Bernanke puts, the failure to remove the managements and boards of seriously troubled organizations.

Then we get to the piece de resistance (click to enlarge):

Yves here. Regular readers of this blog know we have done extensive analysis on Maiden Lane III, one of the rescue facilities for AIG’s toxic exposures (see here and here for a few of the examples). The idea that it will show no losses is utter hokum. Similarly, the Fed’s massive purchase of MBS are also likely to result in red ink. The central bank entered into them explicitly to tighten risk spreads at a time when Treasury yields were at low levels, thanks both to heightened appetite for safe assets and active efforts by the Fed to lower interest rates.

The old saw among traders is that it is easy to move markets, but hard to do so profitably. Whether the Fed seeks to sell these MBS later to mop up liquidity, or holds them to maturity, it is very likely to show losses relative to its purchase price.

So how, exactly, does the CBO come up with such a miraculous result? Go look at how they built the model. It’s sufficiently vague and technical-sounding to deter most readers:

To estimate such subsidies, the Congressional Budget Office (CBO) developed a stochastic simulation model for each major program. In general, under that approach, CBO projected probability distributions of future cash flows associated with each program and then discounted the cash flows to their present value using rates that reflected the risk associated with the particular
flows.1 The probability distribution of a program’s cash flows depended on several factors: the program’s rules and structure; the probability distributions of interest rates, default rates, and recovery rates on defaults; and how the demand for a program was affected by those variables.

Yves here. First, this is a hold-to-maturity approach. Second, there is no indication as to how they derived their default and recovery rates. We’ve seen from the famed stress tests that the officialdom has a weakness for estimates that are too optimistic. An article today from the Dow Jones Equity Analyst (hat tip reader Scott, no online source) describes hedge fund Fortress Group predicting “the great liquidation”:

If you think the opportunity for distressed debt investors has come and gone, think again, says Peter Briger Jr., principal and head of distressed debt operations at Fortress Investment Group LLC (FIG).

“In the next five years we’re going to see more financial asset liquidation out of the shadow banking system and the regulated banking system than we’ve
seen over the past 100 years,” Briger said during a keynote address at the 2010
SuperReturn U.S. conference in Boston.

Briger predicted that financial institutions will offload between $5 trillion and $10 trillion in assets in the coming years. He pointed to some $1.6 trillion in asset dispositions that have already been announced by 13 financial institutions, including AIG, Fortis Bank, Royal Bank of Scotland and Lehman Brothers.

Briger said believes that it will take years for those assets to unwind, in part because of the complexity associated with financial assets in today’s market, as well as their sheer volume.

Yves here. How does this “great liquidation” impact the CBO’s valuation? All this paper hitting the market over the next few years will suppress recovery rates, big time.

The report is silent on how it arrived at its assumptions, particularly its loss and recovery estimates. But it is hard to take an analysis that has egregious errors like this in it seriously:

At the end of 2009, the amount of reserves that banks held with the Federal Reserve was the central bank’s largest liability. Such reserves have grown from about $6 billion at the end of July 2007 to more than $1,022 billion at the end of 2009; those reserves greatly exceed the amount that banks are required to hold.3 In effect, the Federal Reserve financed its activities during the crisis primarily by creating bank reserves rather than by issuing more currency or
increasing its other liabilities.4

I was disturbed by the last sentence, and a financial analyst who has expertise in central bank operations concurred:

It’s complete nonsense. All that happened was that the Fed took the shadow banking system on its balance sheet. The Fed doesn’t “finance” any of its activities per se.

Scott Fullwiler, who has considerable knowledge of Fed operations, agreed and added:

The quote suggesting reserve balances were $6 billion in July 2007 was quite wrong, but typical. That was the size of required reserve balances. But required clearing balances were about the same size, so that brings the total to double that, then you have to add another $2 billion for excess balances. So, it was about $14-16 billion total. People who don’t understand the Fed’s operations don’t know that they have to add a few things into the Fed’s balance sheet quote of reserve balances. This can be seen in charts 2 and 3 here

This paper unwittingly suggests that any Audit the Fed initiatives that have the CBO as an important actor will be ineffective, perhaps even counterproductive. If the CBO is as easily led by the nose as this report indicates, it’s likely to be another garbage in, garbage out exercise in modeling that serves to tart up Fed propaganda. The government official who called this exercise to my attention labeled it a “disgrace”, and I agree fully with his assessment.