Fed Continues to Treat Symptoms, Not Disease (TAF/Derivatives Edition)

In a bit of synchronicity, two items, focusing on different aspects of our continuing credit woes, illustrate how the Fed is acting like the drunk looking under a streetlamp for his keys, because the light is good there, rather than where he lost them. The central bank’s version of this behavior is to continue to focus on the most superficial aspects of the crisis, even though those measures have not produced any lasting success (indeed, some have backfired) rather than go after root causes. In the initial phases, this response would be reasonable; you need to stabilize the patient before you operate, but at this juncture, the Fed’s disinclination to address obvious causes of instability is mystifying.

Let’s look at the two faces of this coin. The first is market commentary, “TAF results are disconcerting,” from David Kotok of Cumberland Advisors. Note that Kotok by predisposition is more optimistic about the future than yours truly, and is well plugged into the Fed, so a note of this sort signals real concern:

The Term Auction Facility (TAF) results were not encouraging. Neither were they substantially discouraging but, at the margin, they actually worsened. It is clear that the demand for liquidity in the banking system is still intense….

The minimum bid in the most recent auction (April 21) was 2.05%. In the previous auction (April 7) the minimum bid was 2.11%. In the most recent auction the stop out rate which was awarded to all bidders was 2.87%. In the previous auction the awarded rate was 2.82%. So the minimum bid went down while the award rate went up. The spread widened by 11 basis points. That is not suggestive of a market returning to normalcy….

We should also note that the TAF auction rate was very close to LIBOR. And LIBOR has been the subject of much negative press recently as followers of money markets know.

Our conclusion is that credit markets are still dysfunctional and the process of normalcy restoration has a long way to go….

This latest auction cannot give any comfort to the Fed. In the reaction over LIBOR, the Fed watched market driven interest rates rise. LIBOR is the world’s most important commercial interest rate reference. It went up even as the Fed tried to ease rates down. Our central bank sees market driven interest rates moving in the opposite direction of the path that the central bank desires. This is a message that the Fed’s policy is failing.

We expect the Fed to cut interest again at the meeting at the end of this month. We also believe that the Fed will have to enlarge the TAF auction and also add more extended terms to the facility. The sooner the Fed implements those changes the sooner the credit markets will start to heal and return to more normal spreads.

We offer this final note. Various measure of spread based risk premiums have been at extraordinary levels since last June when the turmoil started. These widened spreads are taking an economic toll. We expect that the Fed will persist until it gets them to narrow.

If the Fed fails, we will have a difficult and protracted deflationary recession. If the Fed succeeds, the slowdown will be shorter and shallower….But we must admit that when we see a TAF auction result like we just saw, we become just a little more worried.

Now this is by all accounts a very savvy individual, yet what does he recommend? Persisting in, nay redoubling, a failed strategy. That is not a sign of intelligence. And his thinking may well reflect Fed input.

Consider the alternative view, which is more persuasive, and fits the fact set of the broader problem better, but also makes clear that the path to resolution is full of pitfalls and complications.

John Dizard, in “The jerry-built derivative structure will have to go,” argues that thing will not get better until OTC credit derivatives are dismantled. Lets’ face it, banks are unwilling to lend to each other for perfectly good reason. They know how sizeable and prone to mishap their own exposures are. Its’ a no-brainer that a significant proportion of their counterparties are in at least as bad shape as they are.

The very fact that the Fed orchestrated a rescue of Bear, who should otherwise have been too small to fail save for the size of its credit default swaps book indicates that the Fed on some level recognizes that this is a major problem. Yet there seems to be no institutional will to confront it. Admittedly, this is hugely hairy problem, but I suspect the real impediment is that confronting the industry requires considerable tough-mindedness, a quality notably lacking at the US central bank.

But further injections of liquidity in lieu of addressing the fundamental issue is akin to adminsitering more morphine to treat the pain of intestinal blockage. It not only fails to address a the real ailment, but the higher doses are every bit as dangerous as the untreated disease.

From the Financial Times:

Credit market people and their regulators have been so preoccupied with defusing the more visible unexploded bombs in Wall Street that the more serious, long-term structural problems have been put off for later attention. Much later attention, in the case of those structural problems that could cause career or biography damage for senior policy people.

The epicentre of all the problems is the financial system’s dependence on over-the-counter derivative contracts, which made possible all the other bubbles that have been revealed and will be revealed soon. I believe that it will be necessary to dismantle carefully most of this jerry-built structure, and replace the bank-to-bank-to-dealer-to-dealer contract structure with central clearing houses for risk instruments.

Given that these are international markets of unimaginable size, this will take multilateral official co-operation to put into effect. The US government’s involvement in the Bear Stearns work-out, far from marking the end of the credit crisis, shows how any resolution to the larger systemic issues will need to have official backing.

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.

The character and integrity of the participants in these exchanges – the speculators, hedgers and intermediaries – is no better than you would find in the over-the-counter markets. But the scope for wrongdoing is far less, since every day, every hour, these people’s assets and liabilities are more or less accurately marked, and any deficiencies in their accounts have to be made up, or the accounts liquidated.

There were advantages of the over-the-counter markets for credit default swaps, interest rate swaps, and equity derivatives. OTC derivatives required less market-making capital than exchange-traded instruments, and the conserved capital could support more real economic activity.

OTC derivatives are more flexible than exchange-traded instruments, so they can be written for the exact requirements of the counterparties. That in turn made further capital savings possible, since (apparently) precisely hedged positions did not need the same level of reserves.

But it all got too big. The model did not take sufficient account of financial markets invariably taking any sensible innovation to senseless extremes.

I’ve been reading the Massachusetts state government’s administrative complaint against Bear Stearns Asset Management, and its administration of the now bankrupt High Grade Structured Credit Strategies Fund, and the Enhanced Leverage Fund. The complaint has been filed in order to commence court proceedings against Bear Stearns.

No one can believe that Bear Stearns Asset Management was uniquely self-serving and careless; in fact, it may have been better than many of its counterparts on the Street. It’s just that the poor behaviour of the Bear management is now a matter of public record….

For example, according to the Massachusetts complaint, related party transactions were poorly administered. “The result of this poor conflict management was that hundreds of transactions did not obtain the approvals required by federal law and promised in the offering documents,” the complaint claims.

Also, mis-priced derivatives instruments were allegedly transferred, or “novated” in the legal jargon, on the investors by Bear management. The transfers of value took place at cost rather than market value, the complaint claims, not to the advantage of the investors in the funds.

Referring to just two sets of transactions, the complaint says, “on information and belief, the net decrease in value to the funds as a result of the May 3 novation of credit default swaps . . . was $6,199,587 [and] . . . as a result of the May 8 novation of credit default swaps was $10,9111,290”.

Multiply this sort of behaviour across the thousands of funds, vehicles, accounts and so on, around the world, and you see the scale of the problem. Exchange-traded and centrally cleared instruments may be less flexible and more capital intensive, but at least everyone sees the same prices.

How did this come to pass? Christopher Whalen of Institutional Risk Analytics blames the Federal Reserve and other regulators. “The Fed knows that banking is a commodity business, and by allowing the banks to migrate off the exchanges they allowed them to enhance their profitability. The Fed people knew risk management was a problem, but they thought they could deal with all the risks created by the over-the-counter model through the Basel 2 rules.”

I guess not.

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  1. Anonymous

    Although I agree with the author’s premise that America is in decline, and the dollar is in free-fall, his contention that long-term rates are rising is fallacious. Has he looked at a chart of TNX or TYX lately? The bond market doesn’t seem to be pricing in all this inflation people keep talking about.

    By the way the Fed is NOT printing our way out of this recession. M1 is actually flat. Read Mish’s site for good analysis of what inflation and deflation really are.

  2. Francois

    “The bond market doesn’t seem to be pricing in all this inflation people keep talking about.”

    Remember that Mish use (correctly IMO) the Austrian School of Economics definition of inflation.

    “the definition I use when I speak of inflation is a net increase in money supply and credit.”

    It looks like the bond market agree with that.

    Now, the 62 Trillion (devaluating) dollars question: Where does that leaves us?

  3. Ingolf

    Yves, first let me say how much I enjoy and appreciate your blog. It seems to me a model of genuinely intelligent, informed and inquisitive commentary.

    I have no argument with the general point being made in this post. The structural problems are breathtaking and there’s no doubt OTC derivatives are at the core of them. In this comment, however, I want to take up a narrower issue and would be most interested in your thoughts.

    As Anonymous notes above, for all the excitement and “innovation”, the monetary base is hardly growing at all and hasn’t been for quite some time (by my records, 1.47% over the last 12 months). The great changes, as of course you know, have instead been to the composition of the base. It seems surprising to me how little of the commentary one reads seems to take account of this fact.

    As an aside, it’s my understanding that central banks, in simplistic terms, have the choice of either setting base rates or the size of the monetary base, but not both. More often than not, it seems to me that the Fed tends to lead the market from behind, promoting the illusion they’re setting rates when in fact they’re more often than not simply validating what the market would do in any case.

    Unless the Fed is willing to go in for some serious monetisation (a course of action full of its own dangers but one which I suspect they’ll be forced into sooner rather than later), it’s hard to see how they can expect to have much of an effect. Surely all they’re really doing so far is relieving some of the spread pressure. And, of course (for however long the belief in their powers persists) providing some comfort through the appearance of providing a backstop, the feeling that somebody is still in control. Quite how long this illusion will last would seem one of the more vital questions.

    Anyway, enough for a first post. Look forward to any thoughts you may wish to share.

  4. Anonymous

    “There were advantages of the over-the-counter markets for credit default swaps, interest rate swaps, and equity derivatives. OTC derivatives required less market-making capital than exchange-traded instruments, and the conserved capital could support more real economic activity.”

    I hear, in this, echoes of the argument that proceeds from casino profits will fund public education – therefore, gambling is good. But this stupid comment pushes the envelop even further.

    The problem is that almost ALL the money got caught up in a whorl of incestuous, unregulated whoring about. To pin the appendix of an argument that the leverage could be higher and that the residual capital could be put to “productive” use is hilarious.

    Dizard has the brain of a lizard at least in this case. To make the case that the real advantage of highly risky overleveraging was so that more capital could be put to productive use is the whining of an apologist.

    The real case is that OTC simply allows the filthy rich to get even richer via more leverage. Nothing to do with productive use of capital.

  5. Mac

    I think Dizard has over egged the pudding a bit with this observation:

    “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.

  6. Andrew Teasdale

    The problem is all these issues were self evident, even before they started to hit the fan.

    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

  7. J. Powers

    “Now this is by all accounts a very savvy individual, yet what does he recommend? Persisting in, nay redoubling, a failed strategy. That is not a sign of intelligence. And his thinking may well reflect Fed input.”

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

  8. NC Jim

    For years the Fed was/is led by a Chairman whose opinion of regulation was the same as a pimp’s opinion of undercover vice officers. Free markets will always optimize the system and automatically solve any imbalances. If nothing else comes of this era, I hope this ideology is forever discredited.

    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]


  9. Anonymous

    Free markets *will* resolve this imbalance. The question is, are the costs of the *adjustment* acceptable? It apparently is not given people’s expectation for quick & easy fixes at someone else’s expense.

  10. David Pearson


    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.

  11. minka

    Thanks for this post. It is exactly what I’ve been worried about, expressed much more clearly than I could manage.

  12. Richard Kline

    So Ingolf, I’m in agreement with you that the Fed has not ‘led’ for the last twenty years (really for the last thirty) but trimmed it’s sails to whatever breeze the bond markets were blowing, with a little ballast shifting out of view with regard to the equity market. This is one reason why the Powers That Be presently seem to lack resolution faced with a crisis, they have been conditioned to be reactive rather than proactive for a generation.

    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.

  13. Anonymous

    Think I’ll do as Ayn Rand has John, Dagney et. al. do. Take my brain power and go live in a valley. Larry

  14. pato

    I have issue with comments and thinking like this.

    “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.

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