The Fed Is Serving the Wall Street Banks Not the Republic

In times such as these we like to look past the bought and paid for house economists and over-eager-for-an-Undersecretary-of-the-Treasury-appointment academics for serious, seasoned, and meaningful commentary from those who have been in and actually understand the markets.

14 April 2008
The Fed Has Power, but No Will
By MARTIN MAYER
Barron's Online

THERE'S SOMETHING STRANGE ABOUT THE TREASURY DEPARTMENT'S suggestions for the reform of banking regulation and about the cascade of commentary on it. From one end to the other, there's an assumption that the Federal Reserve has somehow lacked the information and authority it could have used to prevent the insanity that has engulfed the credit markets.

The Fed, we are told, had access through its examiners to what the commercial banks were doing, but not to what the investment banks were doing. Yet the investment banks that mattered, including Bear Stearns (and Morgan Stanley, Merrill, Lehman and Goldman, not to mention the mortgage lender Countrywide), were all among the 20-odd primary dealers who help the Fed distribute Treasury bills in the weekly auctions that fund the federal government.

All participants in those auctions were supposed to keep the Fed informed of any significant changes in their balance sheets-on a continuous basis. When Joe Jett's purchase of strips and reconstitution of Treasury bonds led to a weakening of Kidder Peabody's financial position in 1994, there was all hell to pay at the Federal Reserve Bank of New York, because its government-securities division was not promptly informed.

Our present regulatory structure goes back not to the Great Depression, but only to 1999 and the Gramm-Leach-Bliley Act, which undid the Depression-era Glass-Steagall Act.

The great controversy as the repeal bill moved to passage was about responsibility for supervising the banks in their exercise of new powers. If nationally chartered banks were permitted to be brokers and dealers and underwriters and mutual-fund managers, their work would be supervised by the Comptroller of the Currency, whose examiners inspected these banks. But if the law gave the new powers only to the holding companies that owned the banks, everything would be controlled by the Fed, which was to be the umbrella regulator for the new financial-services institutions.

THAT'S WHAT THE FED WANTED. Rep. Jim Leach, who was chairman of the House Banking Committee, was a great admirer of Alan Greenspan and the Federal Reserve, so that's what the Fed got.

Most commentators on the current credit crisis have argued that the banking regulators and supervisors played no role in its inception, because the bad mortgages were written and sold and packaged by unregulated mortgage brokers and mortgage bankers. But all the bank-holding companies had subsidiaries that were active in the mortgage market, and virtually all the mortgages packaged for sale by private entities passed through some subsidiary of some bank-holding company or some bank-controlled investment vehicle at some time between the inking of the contract and its disappearance into a collateralized security.

There was plenty of opportunity for bank examiners checking out the holding companies to notice that some of the paper in the vaults had inadequate or dishonest documentation, and to "classify" it. When the examiner classifies an asset, he forces the bank to reduce its reported profits and discourages further investment in similar assets.

Of course, Fed examiners don't look at individual loans any more; they just ask banks whether they are living up to their own standards of due diligence, and if it's OK with the bank it's OK with the Fed.

MEANWHILE, THE FINANCIAL SECTOR under the Fed's umbrella regulation was building a highly unsafe structure that abandoned many private-sector security features that had been created in the 1970s. With the systems developed then and perfected more recently, the buyers and sellers of stocks or exchange-traded futures or options have no contact with each other once the trade is confirmed by both sides later that day. At that moment of confirmation, the entire market, in the form of the clearinghouse, becomes the counterparty -- the guarantor that the buyer will get his stock or option or future and the seller will get his cash.

Among the useful attributes of this arrangement for the options and futures markets is that most contracts are extinguished by the purchase of an opposing contract: A previous seller buys, or a previous buyer sells, and the contract with the clearinghouse disappears. At the end of every day, the clearinghouse reports trades and "open interest."

But as banks honed the profitability of derivatives trading, they made more and more individual over-the-counter trades that involved payment from buyer to seller, delivery from seller to buyer, no clearinghouse, and a continuing relationship of the two counterparties. This was presented as innovation, and the Fed was committed not to discourage innovation. Now it can be seen as the retrograde development it really was. Like the stock market of the 1960s, this over-the-counter system has blown up, leaving behind gaseous waves of mistrust.

In the OTC derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It's an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit.

The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps.

BEAR STEARNS APPARENTLY had created trillions of dollars of positions this way, which is why it had to be kept in business. Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don't know who will wind up with obligations they thought they had insured against and they can't meet. Suddenly, all counterparties for all sorts of trade become suspect. We should note in passing that the big beneficiaries of the Fed's action on Bear Stearns were the sellers of credit derivatives insuring Bear's obligations. The counterparties' paper had been worth very little on Thursday night and quite a lot on Sunday afternoon.

The Fed could easily have prevented this ruinous expansion of OTC credit-default swaps by requiring banks to keep extra reserves against such holdings, larger than the margin requirements of the exchanges where derivatives were traded, cleared in a clearinghouse, properly settled and extinguished. Instead, the Fed promoted the false idea that the banks in their own interest would police the gambling of the mortgage bankers and the credit-gobbling quantitative traders and the leveraged-buyout fakirs -- and that the hidden trading of non-standard, bilaterally settled, opaque derivative instruments would improve the stability of markets. Such ridiculous claims are still being made.

Quite apart, then, from the philosophical question of whether bank examination and control of monetary policy fit well together (they don't), the Fed has done nothing to deserve Treasury Secretary Henry Paulson's recommendation that its role in supervising the markets should be expanded by new laws.

The truth is that the Fed had plenty of authority to take the steps that would have avoided today's dangers and its own embarrassments. The problem was that the Fed lacked the will to supervise. Before we can restore the self-confidence of the market, we will need to create a Federal Reserve that believes in its own regulatory mission more than it believes in prudence at the banks.

MARTIN MAYER is a guest scholar at the Brookings Institution and author of numerous books about banking and finance. "If anyone knows more about money, banking, and investments, that individual is keeping the information to himself," wrote James Grant of Grant's Interest Rate Observer in reviewing Martin Mayer's 1991 book Stealing the Market. In 1993, Publisher's Weekly described Mayer's Nightmare on Wall Street as "A landmark treatment of the money world." Martin Mayer has been writing about business and financial subjects for forty years. Mayer's latest book, The Bankers: The Next Generation, was published in January 1997.

Speculation Nation

We have been taking a look at some volume figures with colleagues, and discussing the remarkably low NYSE volumes over the past few days. We were comparing volumes across various exchanges, and wondering about the dark pools of trading that are cleared in off exchange venues. Some wondered if the NYSE volume was primarily the 'retail trade.'

We're not sure just what we think of that yet. But in the course of discussion one of our trader friends brought up the volume of option trades. (Hat tip to George Slezak).

As you know, options are a derivative trade on the future course of a stock or index in a given period of time. Investors normally do not trade in options, unless they are selling covered calls to incrementally increase return, or buying puts to safeguard against downside.

Below are two charts of CBOE volume going back into the 1990's. We were interested to see the spike in volumes of calls in particular around periods of high speculation and important tops.

Another Peak in Speculative Activity?

Are we there again? We're not so sure. But with the data at hand, the overall derivatives volumes including options, and the relative volumes of stocks on transparent exchanges at least, we are concluding that stocks are once again in a speculative bubble, and are "trading like commodities" with less price discovery and only a tenuous connection to the financial fundamentals of individual stocks and the equity markets.

This makes sense. Companies have been spending an inordinate amount of their profits on buybacks of their own stock. This has the putative effect of 'returning value to shareholders' but we suspect it has more to do with washing out the dilution of share floats as management grants themselves enormous amounts of stock options.

However it goes, the current environment is not what might be called 'healthy' by a level-headed economist, especially not one on the pad to a major trading house.

We might add that buying stock option 'calls' is one way to beat the margin requirements and take highly leveraged positions in stocks for periods of time. Despite the recent financial slump we still have roughly 8000 hedge funds out there, in addition to a wave a new retail financial speculation, and 'banks' increasingly dependent on their trading volumes for profits.

This type of wild speculative environment is generally fostered by a loose regulatory environment and even looser credit, and often is the prelude to a serious reversion to the mean of price discovery, aka a stock market crash.

This is the market that has been fostered by the Republican Administration and the Fed. This is hardly what might be called a 'productive economy.' Its an easy money economy. Let's see what happens.

If you have not already done so, please take the time to read The Trillion Dollar Meltdown" which is a couple blog entries below this one. Its worth it.

US Stocks Expected to Fall an Additional 15 percent Near Term - Goldman

Goldman Sachs and Wells Fargo warn 'delusional' investors on stocks
By Ambrose Evans-Pritchard,
International Business Editor
UK Telegraph
Last Updated: 1:58am BST 15/04/2008

Wall Street faces the growing risk of an equities bloodbath in coming months as the credit crunch spreads to the wider economy and earnings crumble, according to a pair of grim reports issued by Goldman Sachs and Wells Fargo.

Goldman Sachs said the key for equities will be the full-year guidance offered by companies.

David Kostin, the chief US investment guru for Goldman Sachs, expects the S&P 500 index of Wall Street equities to plummet a further 15 per cent over the "near term" as companies scramble to lower their outlook for this year.

"Although only a few firms have reported first quarter results, early signs are awful. We expect a swath of lowered profit guidance," he said in a research note published today, entitled 'Fasten Seatbelts'.

Mr Kostin, who replaced the ever-bullish Abby Cohen as chief strategist in December, expects the S&P index to reach 1,160, which would amount to a fall of 27pc from the bull market peak of 1,576 in September and enter the annals as a relatively severe bear market.

Goldman Sachs was the only major investment bank on Wall Street to turn a profit from the credit crunch, taking out huge "short" positions on sub-prime mortgage bonds before they went into a tailspin.

The firm's daily trading notes are one of the most closely watched sources in global finance.

Scott Anderson, chief economist at Wells Fargo, is equally pessimistic, describing the bullish views of some market players as "bordering on delusional".

"The equity markets have not yet priced in a prolonged downturn in economic growth in my opinion. We are still in the early stages of the credit crunch. Earnings estimates for the second half of the year are likely still far too high," he said.

Mr Anderson said investors should pay attention when the International Monetary Fund cuts its global growth forecast for 2008 three times in less than five months. The Fund has put the odds of a world recession at 25pc and predicted $945bn in losses from the credit debacle spread across banks, hedge funds, pension funds, and insurers.

"Even more alarming, the IMF estimates that only a quarter of these potential losses have been recognized," he said.

"Rarely do we ever see such uncertainty surrounding the economic and financial outlook. The forecasts for GDP growth in the second quarter of 2008 are currently all over the map. If you feel you must wade into equities at the present time, I would suggest spreading your bets widely," he said.

Goldman Sachs said the key for equities will be the full-year guidance offered by companies rather than first quarter profits. It cited the example of Bed Bath & Beyond, where the stock fell sharply last week after the firm said the earnings prospects for 2008 would be around 16pc below consensus estimates.

Mr Kostin said investors often "look through" downturns, preparing for the sunny uplands that lie on the other side as the cycle recovers. But the pattern in this bear market has been a series of earnings shocks precipitating sudden share price falls.

The implication is that investment funds have been caught badly off guard by the severity of the economic slump and are scrambling to catch up with reality.

Goldman Sachs and Wells Fargo warn 'delusional' investors on stocks

The Trillion Dollar Meltdown

We have not read the book yet, but are reasonably informed that it is on the way via(we'll pay for it with what's left of the stimulus check after buying Silver eagles).

In the meanwhile, here is a brief synopsis of the author's hypothesis as it appeared online recently at Foreign Policy.

8 Steps to a Trillion-Dollar Meltdown
By Charles R. Morris
April 2008

How did the U.S. financial crisis happen? A review of the road to ruin reveals a course littered with more villains than heroes.

No, it’s not the Great Depression, but the United States is facing a nasty economy-wide retrenchment following the excesses of the 2000s, with no easy way to dance through it. Think 1979 to 1982, when then U.S. Federal Reserve Chairman Paul Volcker exorcised consumer price inflation from the economy. The difference today is that the inflationary explosion has been absorbed by prices of assets—houses, stocks and bonds, office buildings—rather than by the prices of things you buy at the store. Here’s how it happened.

1. The Fed spikes the punch bowl. In the wake of the dot-com bust and 9/11, the Fed lowers interest rates to 1 percent, the lowest since 1958. For more than 2½ years, long after the economy has resumed growing, the Fed funds rate remains lower than the rate of inflation. For banks, in effect, money is free.

2. Leverage soars. Financial sector debt, household debt, and home prices all double. Big banks shift their business models away from executing transactions for customers to “principal trading”— or gambling from their own accounts with borrowed money. In 2007, the principal-trading accounts at Citigroup, JPMorgan Chase, Goldman Sachs, and Merrill Lynch balloon to $1.3 trillion.

3. Consumers throw a toga party. Soaring home prices convert houses into ATMs. In the 2000s, consumers extract more than $4 trillion from their homes in net free cash (excluding financing costs and housing investment). From 2004 through 2006, such extractions exceed 7 percent of disposable personal income. Personal consumption surges from its traditional 66 to 67 percent of GDP to 72 percent by 2007, the highest rate on record.

4. A dollar tsunami. The United States’ current-account deficits exceed $4.9 trillion from 2000 through 2007, almost all for oil or consumer goods. (The current account is the most complete measure of U.S. trade, as it encompasses goods, services, and capital and financial flows.) Economists, including one Ben S. Bernanke, argue that a “global savings glut” will force the world to absorb dollars for another 10 or 20 years. They’re wrong.

5. Yields plummet. The cash flood sweeps across all risky assets. With so many people taking advantage of cheap loans, the most risky mortgage-backed securities carry only slightly higher interest rates than ultra-safe government bonds. The leverage, or level of borrowing, on private-equity company buyout deals jumps by 50 percent. Takeover funds load even more debt onto their portfolio companies to finance big cash dividends for themselves.

6. Hedge funds peddle crystal meth. Aggressive investors pour money into hedge funds generating artificially high returns by betting with borrowed money. To maximize yields, hedge funds also gravitate to the riskiest mortgages, like subprime, and to the riskiest bonds, which absorb losses on complex pools of lower-quality mortgages known as collateralized debt obligations or CDOs. The profits from selling bonds based on very risky underlying securities override bankers’ traditional risk aversion. By 2006, high-risk lending becomes the norm in the home-mortgage industry.

7. A ratings antigravity machine. Pension funds cannot generally invest in very risky paper as a mainstream asset class. So, banks and investment banks, with the acquiescence of the ratings agencies, create “structured” bonds with an illusion of safety. Eighty million dollars of “senior” CDO bonds backed by a $100 million pool of subprime mortgages will not incur losses until the defaults in the pool exceed 20 percent. The ratings agencies confer triple-A ratings on such bonds; investors assume they are equivalent to default-proof U.S. Treasury bonds or blue-chip corporates. To their shock, investors around the world discover that as pool defaults start rising, their senior CDO bonds rapidly lose trading value long before they suffer actual defaults.

8. The Wile E. Coyote moment arrives. Suddenly last summer, all the pretenses start to come undone, and the market is caught frantically spinning its legs in vacant space. The federal government responds with more than $1 trillion in new mortgage lending and lending authorizations in multiple guises from Fannie Mae, Freddie Mac, the Federal Housing Finance Board, and the Federal Reserve. Home prices still drop relentlessly; signs of recession proliferate; risky assets plummet.

What now?

The collapse of Wall Street investment bank Bear Stearns may be a watershed moment. Participant reports suggest that JPMorgan Chase came into weekend negotiations last month prepared to do a deal without Fed support. But after examining Bear’s balance sheet, which looks completely conventional, except for $46 billion of hard-to-value mortgage assets, Morgan apparently said, “Hell no!”

The $30 billion backup line of credit Morgan got from the Fed implies that they expect mortgage portfolio losses of some 70 cents on the dollar. Had Morgan recognized those losses, they could have forced comparable write-downs on a string of other banks. Bear’s default, in addition, could have triggered huge cash liabilities by thinly capitalized “bond insurers” and hedge funds that had guaranteed Bear’s debt. Many of the guarantors might have failed to have made good their guarantees. The Fed chose to pay up.

Analysts at Goldman Sachs recently estimated the total losses from this mess at $1.2 trillion, including nearly $500 billion at the banks. The cleanest solution would be for regulators to force banks to revalue their assets down to realistic levels in one fell swoop. (If the Fed and the Securities and Exchange Commission drive such a process, it might be accomplished within a single quarter.) The revaluations would almost certainly wipe out all or most equity capital at a number of the larger banks. Since it is unlikely that new private, nongovernmental capital could supply the entire shortfall, the federal government would have to act as the equity supplier of last resort.

But what about the homeowners who are stuck with mortgages they can no longer pay? Helping them will be simpler once their problems are untangled from the banks’ goal of protecting overpriced assets. A change in the bankruptcy laws, for example, could empower judges to convert excessive mortgages into market-rate rentals, which are usually much cheaper.

All current rescue proposals being floated in the U.S. Congress have the taxpayer buying up the loans the banks no longer want, absorbing the losses just as taxpayers did in the savings and loan crisis of the late 1980s. As an equity investor, however, the U.S. government would get the same terms as other private investors, leaving the losses to fall on the shareholders and executives who either caused the debacle or allowed it to happen. Concerns about the government’s holding bank stock directly could be allayed by depositing the shares in the Social Security trust funds. As the banks return to normal operations, they would become quite valuable securities and probably greatly improve the system’s returns.

Bank shareholders and executives made extraordinary financial gains during the 2000s. Now that their Ponzi scheme has been exposed, they are demanding that the public absorb much of their losses, and the Federal government has been responding with huge showers of money.

The Bear Stearns rescue demonstrates the need to draw a line. From now on, the banks, their shareholders, and their executives should eat their own losses. If that wipes out the capital of essential depositary institutions, the federal government should step in. Save the banks and help struggling homeowners, yes. But no more largesse for bank executives and shareholders.

Charles R. Morris, a lawyer and former banker, is the author of The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash (New York: PublicAffairs, 2008).