Frankly, we are delighted to read this. It is high time the Fed woke up and took stock of the excesses taking place in virtually every asset class. Not only do we have very high liquidity, asset bubbles, and profligate lending, but we also have signs of inadequate risk management.
We have said before that people have taken false comfort from the relatively happy resolution of the pinnacle of the problems created by the Russia default, namely, the collapse of a very large hedge fund, Long Term Capital Management, that nearly took down the financial system.
To give a thumbnail sketch of a much more complicated situation (see here for fuller recounting), LTCM’s signature trade was “short vol” (volatility) meaning they would enter into trades where derivatives prices reflected that volatility was higher than historical norms. They would bet that volatility would revert to its regular level.
LTCM made this bet in many markets and assumed they were uncorrelated. But in a panic, which is what the Russia default produced, the trader’s cliche is “all correlations move to one.” All assets with any risk behave the same. They tank. And volatility increases enormously. LTCM was getting killed on its volatility bets, and it was such a big player, that it couldn’t get out of them while the markets were moving against them. Yet because they were highly leveraged, their losses meant their margins loans and repos were undercollateralized. So they had to start liquidating, which pushed their remaining positions even further under water, calling on them to sell more….
Get the picture? Now this didn’t happen overnight. LTCM bled over weeks before things hit a breaking point and the Fed called in 24 large counterparties, basically everyone who was anyone on Wall Street, to force a bailout.
We have argued that the situation is worse, not better, by having so many hedge funds and other levered players taking lots of bets. If there were a Russia style, multi-market crisis that produced a massive rush for the exits, there would be many players who could not get out of their positions fast enough due to lack of buyers, yet were required to sell because the no longer had enough collateral for their loans. LTCM redux, except spread among dozens of players. And this time, you can’t get them together into a room to sort things out. There are too many parties involved. The 20 to 30 financial institutions that are severely exposed won’t have the bandwidth (legal, operations, risk management, senior management) to handle that many time pressed negotiations in parallel.
Nine years ago a default by the Russian government on part of its debt caused financial markets around the world to seize up as investors rushed to shed risk. Today, Federal Reserve officials are concerned something similar may happen.
The anxiety isn’t centered on Russia or any other particular country. It’s that good times have been rolling for so long in markets everywhere that investors and institutions are behaving as if they have forgotten that there are always risks, that there’s always something that can go wrong.
The good times have been fueled by a flood of liquidity supplied from the huge pool of savings in China, some other Asian nations and oil exporting countries. Meanwhile, market volatility has largely disappeared in the wake of the successful efforts to tame global inflation.
That combination of liquidity, low inflation and low volatility has reduced interest rates around the globe and sent investors scurrying to find higher yields almost regardless of risk.
“There has been a marked improvement in global economic performance, with strong growth, relatively low inflation, and less volatility in both growth and inflation,” Timothy Geithner, president of the New York Federal Reserve Bank, said in a May 15 speech.
“This seems to have reduced concern about future fundamental risk, in terms of the potential damage of future shocks and in the ability of governments and central banks to both avoid the policy errors of the past and to competently manage some daunting longer-term policy challenges,” he said.
`Seeds’ of Undoing
And on May 31, Terrence Checki, an executive vice president at the New York Fed who has spent years dealing with financial crises, especially in emerging market countries, warned at a conference in Athens, “The recent long period of stability may contain the seeds of its own undoing.”
“Abundant global liquidity has been a powerful wind in the back of economic and policy progress and has brought substantial benefits,” Checki said. “In addition, as we all know, liquidity is ephemeral: it disappears at the most inconvenient times.”
Perhaps what worries Fed officials the most is that monetary policy can’t do much to reduce the risks in this situation.
The liquidity hasn’t been created by monetary policy decisions in the industrial world, and the Fed and its counterparts can’t sop it up. And now some of the countries sporting foreign currency reserves totaling in the trillions of dollars are beginning to search for higher yields too.
“The growing interest in earning better returns on reserve assets may signal reduced caution going forward,” Checki said.
In this largely benign investment climate, it’s impossible to pinpoint what might go wrong — what might trigger a sudden massive move to shed risk, such as occurred after the Russian default in August 1998. In that case, liquidity simply evaporated from markets everywhere, even in those for U.S. Treasury securities.
In a Feb. 28 speech, Malcolm Knight, general manager of the Bank for International Settlements — an organization of central banks — likened the 1998 episode to “an old fashioned bank run.”
“Indeed, it has transpired that markets, like institutions, are vulnerable to such runs,” Knight said, adding that some of the fundamental changes in the financial system since 1998 “have arguably made it more, not less, dependent on continuous access to funding liquidity.”
“On the one hand, there is now a much greater ability to trade assets and risks in markets of increasing breadth and depth,” he said. “On the other hand, it is critical for agents to be able to trade even under stressful market conditions.”
In recent years, Knight said, a vast array of new financial products has been created, allowing risks to spread and leverage to soar while increasing the complexity of investment positions. At the time, new players such as hedge funds and private-equity firms have entered markets, adding to “the unprecedented surge in the volume of transactions,” he said.
One result of these changes, Knight said, is “system-wide exposures have become more opaque due to the growing complexity of risk profiles, to the interconnections across different market segments and to the scarcer information about the exposures of some of the new key players.”
In other words, should an event trigger a rush to get out the door among investors in some market, it could prove to be very difficult to know one’s own position, much less to know that of a counterparty. If everyone were to go into a defensive crouch, it could be the fall of 1998 all over again.
The Fed, with Geithner’s bank in New York taking the lead, has been working with banking supervisors in other countries to push global financial institutions to improve their risk- management efforts.
“This approach to supervision is designed to look ahead to try to ensure the adequacy of capital and liquidity, and the sophistication of risk management discipline relative to risk, over time and at all points in the cycle,” Geithner said.
However, he pointedly cautioned that neither monetary policy nor such efforts at supervision can guarantee something won’t go wrong.
One major casualty of the 1998 crisis was Long Term Capital Management, a major hedge fund that failed. In order to prevent a disorderly closing out of LTCM’s complex book of derivatives and other investments that could have done significant damage, the New York Fed encouraged creditors to put up enough cash to unwind those positions slowly.
It’s not at all clear that such an effort would succeed in today’s far more complex markets. That’s one reason for the worry at the Fed.