If anyone in the Congressional committees that oversee the Fed had an operating brain cell, they should flay the Fed for its indefensible posture of ignorance and powerlessness. I have to confess to being too annoyed to read the underlying document, its semi-annual report on financial stability and am so instead relying on what I take to be a fair-minded recap in the Financial Times, Fed warns of hidden leverage lurking in financial system.
What I find most disturbing is the rank dishonesty of the Fed, in what looks to be deliberate mischaracterization of the Archegos implosion, made worse by the central bank’s “And how can you expect us to know what’s going on?” anticipatory blame avoidance. To put this another way, the Fed is trying to pre-sell a “whocoulddanode?” defense when that sort of guilty faced, foot-shuffling act is unacceptable after the Fed was caught out being way behind the curve in the runup to the global financial crisis.
Archegos was not a systematic event. Not even close. One hedge fund with so few investors that it ran on a “friends and family” basis (tarted up as “family office”) blew up. It did not bring down any other players. It did briefly roil markets in the stocks Archegos held. Banks collectively lost about $10 billion. By comparison, Paribas paid $8.9 billion in economic sanctions fines to the Department of Justice in 2014, which in current dollar terms is $10.0 billion. No one suggested the Paribas fine was systemic or even a health-threatening blow.
The troubling issue was how did this one hedge fund get to be so leveraged? Here is where the Fed misdirects Congress and the general public:
The US Federal Reserve has warned that existing measures of hedge fund leverage “may not be capturing important risks”, pointing to the collapse of Archegos Capital as an example of hidden vulnerabilities in the global financial system….
Hwang’s high-wire act was hard to monitor because family offices face limited disclosure requirements and because he used derivatives known as equity total return swaps. These instruments enabled Archegos to profit from rises in individual stocks with payments equal to only a fraction of the size of the underlying positions.
First, the hand-wringing about Archegos being a hedge fund able to do sneaky things in dark alleys is all wet. Do you seriously think regulators have all that much visibility into the much bigger (but also known to be tightly run) Citadel? How about the personal portfolios of very large investors? And what about multinational corporations that run their Treasury operations as profit centers, or Apple, which runs an internal hedge fund out of Nevada?
In other words, if the Fed thinks the problem is particular player, “hedge funds” is far too narrow a frame. “Leveraged financial speculators” is closer to the mark.
And they are secretive about their holdings. Any large trader will spread his business among multiple execution firms because the firms can and will trade against him if they know his positions.
Second, the problem is not the opaqueness of the hedge fund’s activity, even though if you read the Financial Times’ account, you would think that that is the the Fed’s big worry. It’s the ability to achieve high levels of leverage. And that’s the fault of the regulatory regime.
In passing, in the section excerpted above, the report mentions total return swaps. A short definition from Wikipedia:
Hedge funds use Total Return Swaps to obtain leverage on the Reference Assets: they can receive the return of the asset, typically from a bank (which has a funding cost advantage), without having to put out the cash to buy the Asset. They usually post a smaller amount of collateral upfront, thus obtaining leverage.
Due to the hour and the state of Google, I can’t find data on the size of the total return swap market, but at the time Archegos blow, it was under $300 billion, which means too small to wreck the financial system (well, unless perhaps they blew up Deutsche Bank).
Perhaps more important, regulators had decided they didn’t like them but from what I can infer, have also been slow to shut down the market. That’s a mistake since it’s clear the purpose of total returns swaps is pure speculation, and any additional price discovery benefit is too marginal to allow the use of so much leverage.
More generally, the Fed and financial regulators seem unwilling to do two essential things. The first is to say “no” to certain activities. Andrew Haldane, in a paper I have mentioned repeatedly, explained that the only answer to the level of societal harm posed by financial crises is prohibition, as in not allowing certain activities. From his seminal speech, The $100 Billion Question, cited in a 2010 post:
More support comes from Andrew Haldane of the Bank of England, who in a March 2010 paper compared the banking industry to the auto industry, in that they both produced pollutants: for cars, exhaust fumes; for bank, systemic risk. While economists were claiming that the losses to the US government on various rescues would be $100 billion (ahem, must have left out Freddie and Fannie in that tally), it ignores the broader costs (unemployment, business failures, reduced government services, particularly at the state and municipal level). His calculation of the world wide costs:
….these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.
It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.
Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. Even though we have described its activities as looting (as in paying themselves so much that they bankrupt the business), the wider consequences are vastly worse than in textbook looting.
Back to the current post. The original sin of the Fed, at least with respect to crises in the modern era, is the decision by Alan Greenspan to do nothing about derivatives. I recall in the mid 1900s gasping out loud when I read that he intended to take a “let a thousand flowers bloom” approach. By then, I had had one of the top derivatives firms as a client and had an appreciation as to how dangerous they could be.
There is a role for derivatives in highly liquid markets for hedging. Banks generally have the underlying volumes of cash transactions to manage FX futures and options on an OTC basis. But all things being equal, it’s preferable to have a central exchange (more stable market structure) or else highly distributed position-taking. Anything in the middle is more prone to meltdowns.
But an even bigger issue is aside from well-established categories of pretty simple derivatives, there’s no justification for allowing financial intermediaries to offer much in the way of OTC derivatives. The overwhelming uses of high margin OTC derivatives are for accounting gimmickry, tax avoidance, or achieving high levels of leverage on the cheap (which means having the bank or lender as bagholder). None of these are positive from a societal standpoint.
So all of the Fed’s mealy-mouthing about hidden leverage is utter rubbish. Yes, asset valuations are strained due to super cheap money and too much speculative froth. But as we saw in the collapse of the monster dot-com bubble, the mere collapse of speculative bubbles, even really big ones, does not do systemic damage (although they can set off recessions as the speculators lick their wounds and the folks with bezzle-based revenues take hits). What does systemic damage is high levels of leverage, particularly leverage on leverage, which was what turned the housing crash from an S&L crisis x 1.5X level event to a global financial crisis.
For the Fed at this juncture to profess to be so stupid about the fundamental problem as cover for their unwillingness to take on Big Finance is depressing, although in another way, not exactly surprising.
I see your point but on the opaqueness of hedge funds, there has been quite some progress since 2007.
Private Funds have to report info to the SEC which is then aggregated and published on their website:
The problem with Archegos was that (i) it was not registered as Private Fund and hence did not have to report data to the SEC and (ii) rules around TRS have not been finalized. For example, it is unclear to me if TRS have to be reported to swap repositories (supervised by CFTC/SEC) or not at the current juncture. If TRSs were to be reported then a supervisor could have seen that by analyzing the data.
While I appreciate your point, a Form ADV is filed only annually and a Form PF, quarterly. The Form ADV deadline for filing the Dec 31 report is March 31. Forms PF are due within 60 days of the quarter end. Then the SEC has to compile the data.
This is too far in arrears to be useful in identifying regulatory risks.
It would also not capture a risk the SEC might legitimately be concerned about, which is size of position relative to typical trading volumes. That is what brought down LTCM and later Amaranth Capital. LTCM took a monster position in of all things interest rate swaps, a classic “short vol”. But then the swap spreads widened and some traders figured out there was a whale in trouble and sold into the short, increasing LTCM’s distress.
The SEC is in the liquid markets business. I doubt it has any basis for judging liquidity risk in OTC markets. So even if it had the info on an LTCM-type situation, it would be very unlikely to recognize it, even assuming it was timely (60 days in arrears might as well be a year stale from a trading risk perspective).
“But an even bigger issue is aside from well-established categories of pretty simple derivatives, there’s no justification for allowing financial intermediaries to offer much in the way of OTC derivatives. The overwhelming uses of high margin OTC derivatives are for accounting gimmickry, tax avoidance, or achieving high levels of leverage on the cheap (which means having the bank or lender as bagholder). None of these are positive from a societal standpoint.”
TRS is for regulatory arbitrage or leverage. Margins on TRS are tiny. Its a loss leader of a product, designed to keep you in the frame for higher value deals. It does have the advantage that you might see when “a whale” is exiting a big position, but clearly thats not foolproof, eh CS?
We are witnessing the slow moral bankruptcy of the nation.
I have no doubt that the Fed corruption of money will be identified as the main culprit by future historians.
How did the Fed manage to become such a powerful monster in our society?
By the systematic unraveling of sensible and necessary regulations?
Look no further than the Congress.
If they can impeach a President in one week, they could impeach the entire FOMC before lunch (i.e., pass a veto-proof law to abolish it or redefine so-called mandate)
But, why would they? They are all multi-millionaires and direct beneficiaries of the monetary policy.
How do banks really work?
Our knowledge of banking has been going backwards since 1856.
Credit creation theory -> fractional reserve theory -> financial intermediation theory
“A lost century in economics: Three theories of banking and the conclusive evidence” Richard A. Werner
Nearly all today’s policymakers think banks are financial intermediaries.
The financial system looks a lot safer than it is when you think banks are financial intermediaries.
Bankers get to create money out of nothing, through bank loans, and get to charge interest on it.
What could possibly go wrong?
Bankers do need to ensure this money gets paid back, and this is where they get into serious trouble.
Banking requires prudent lending.
Credit Suisse pumped loads of money into Archegos, but they couldn’t get it back again and the loss crystallised.
Banks can pump out a lot of loans in the good times as the money comes out of nothing.
When the bad times come, the losses crystallise in the system.
Why did the US financial system to collapse in 1929?
If someone can’t repay a loan, they need to repossess that asset and sell it to recoup that money. If they use bank loans to inflate asset prices they get into a world of trouble when those asset prices collapse.
As the real estate and stock market collapsed the banks became insolvent as their assets didn’t cover their liabilities.
They could no longer repossess and sell those assets to cover the outstanding loans and they do need to get most of the money they lend out back again to balance their books.
The banks become insolvent and collapsed, along with the US economy.
When banks have been lending to inflate asset prices the financial system is in a precarious state and can easily collapse.
What was the ponzi scheme of inflated asset prices that collapsed in Japan in 1991?
Japanese real estate.
They avoided a Great Depression by saving the banks.
They killed growth for the next 30 years by leaving the debt in place.
What was the ponzi scheme of inflated asset prices that collapsed in 2008?
“It’s nearly $14 trillion pyramid of super leveraged toxic assets was built on the back of $1.4 trillion of US sub-prime loans, and dispersed throughout the world” All the Presidents Bankers, Nomi Prins.
They avoided a Great Depression by saving the banks.
They left Western economies struggling by leaving the debt in place, just like Japan.
It’s not as bad as Japan as we didn’t let asset prices crash in the West, but it is this problem has made our economies so sluggish since 2008.
The last lamb to the slaughter, India
They had created a ponzi scheme of inflated asset prices in real estate, but it collapsed.
Now they need to recapitalize their banks.
Their financial system is in a bad way, recovery isn’t going to be easy.
“The Great Crash 1929” John Kenneth Galbraith
“By early 1929, loans from these non-banking sources were approximately equal to those from the banks. Later they became much greater. The Federal Reserve Authorities took it for granted that they had no influence over these funds”
He’s talking about “shadow banking”.
They couldn’t control the lending from shadow banks in the 1920s either.
Japan ventured into shadow banking in the 1980s.
Jusen were nonbank institutions formed in the 1970s by consortia of banks to make household mortgages since banks had mortgage limitations. The shadow banks were just an intermediary put in place to get around regulations.
This is how shadow banks pose a threat to the financial system.
They are just intermediaries put in place to get around regulations.
The banks need to get the money they loan out back again, and whether they use shadow banks as an intermediary or not, doesn’t make a lot of difference.
The dangers are the same.
I just remembered something else from “The Great Crash 1929” John Kenneth Galbraith
They thought leverage was great before 1929; they saw what happened when it worked in reverse after 1929.
Leverage acts like a multiplier.
It multiplies profits on the way up.
It multiplies losses on the way down.
“Our knowledge of banking has been going backwards since 1856.”
Well, yeah, or is it being driven in reverse gear? Just asking.
I mean Ricardo, Mills, Marx, Minsky, Keynes and many others all seem to understand banking in particular, and economics in general, very well, but they have gone into the memory hole alone with large portions of Adam Smith’s mangled, Bowdlerized, expurgated work.
Taking introductory courses in economics is like studying fantasy. Not because of the lies as such as all the blasted omissions that have been created since the early twentieth century.
You are quite right.
It’s surprising what they used to know in the past.
The Ricardo “Pick and Mix”
We got some stuff from Ricardo, like the law of comparative advantage.
What’s gone missing?
Ricardo was part of the new capitalist class, and the old landowning class were a huge problem with their rents that had to be paid both directly and through wages.
“The interest of the landlords is always opposed to the interest of every other class in the community” Ricardo 1815 / Classical Economist
What does our man on free trade, Ricardo, mean?
Disposable income = wages – (taxes + the cost of living)
Employees get their money from wages and the employers pay the cost of living through wages, reducing profit.
Employees get less disposable income after the landlords rent has gone.
Employers have to cover the landlord’s rents in wages reducing profit.
Ricardo is just talking about housing costs, employees all rented in those days.
Low housing costs work best for employers and employees.
Veblen spoke pretty clearly about the parasitical, predatory nature of finance.
Yves, pieces like this are one of the reasons I come to NC daily. I want to post a longer response on this subject of deliberate opacity as I have been mulling this over for nearly 20 years – since Enron’s SPE abuse and then Lehman’s Repo 105 fraud. But for now I’ll content myself with a big thank you and a hearty vote for more of your stringent analysis and (a)stringent prose. I hope your health issues permit your writing and tormenting the Davos/FIRE set of neoliberal Vandals who’ve destroyed our stability while enriching themselves as never before.
Hear hear. I agree heartily with P, above. Enron comes to mind regularly these days. Seems like we’ve seen this untethered derivatives movie before, too, and it’s a horror show. Yves, I feel like a dufus when it comes to global and national economics, but I certainly learn it here. (Which why I love this site.)
Banking requires prudent lending. SoS
Borrowing short to lend long is inherently risky and government should in no way privilege or bear that risk.
Yet government does so since we have only a SINGLE payment system (besides mere physical currency, coins and paper CB or Treasury Notes) that must work through private banks or not at all. So the banks hold the economy hostage.
We could fix that by providing an ADDITIONAL, inherently risk-free payment system via debit accounts for all at the Central Bank (or Treasury) and by abolishing all other privileges, explicit and implicit, for private depository institutions.
Then whether the banks were “prudent” or not would be irrelevant to the general welfare.
The alternative to genuine reform is merely to kick-the-can down the road a bit further via regulation and/or even more privileges for private banks to make them more stable – as if systematic injustice should or even can be truly stable.
“The Fed and financial regulators seem unwilling to do two essential things. The first is to say “no” to certain activities.” paragraphs go on to support this point.
I need to apologize for my lack of reading comprehension but I’m not understanding what the second thing (that the regulators are unwilling to do) is?
Is it about the OTC derivatives or tamping down on leverage in general?
And it never gets old:
FRONTLINE: The Warning
Brooksley Born warns of the dangers of opaque derivative markets; Greenspan and Summers, et al, crush her, and pave the way to further crises.
they’re the ones forcing grandma into speculative markets by squeezing returns.
Can you even call them returns when they’ve been negative for multiple years?
Real chutzpah is expecting a positive return on risk-free assets (such as government insured bank deposits) since this constitutes welfare proportional to account balance.
Not that we should be opposed to welfare but it should be according to need or at least in a manner that does not violate equal protection under the law.
New markets for debt must be found. And if that means fraud (or too much risk) so be it. Usually, the Federal Reserve waits for the muppets to show up en masse before taking the punch bowl away. Problem is, the muppets have been gun shy since they got burned back in the Global financial crisis. So what’s a poor Federal Reserve to do but to keep the party going?
By the way, that’s why I think there’s all the gnashing of teeth over the risk of inflation. It’s not because the talking heads are worried about the consequences to main street. It’s because they’re worried it will bring the party to an end after all the muppets start becoming playahs again.