SP Long Term Charts and the Reckless Adventurism of the Greenspan Federal Reserve

This chart shows the extreme effects of the Greenspan Federal Reserve on the stock market as a representation of its profound impact on the US economy, if not that of the world. Reckless adventurism may be too kind a description.

Two asset bubbles, back to back, were caused by the irresponsible expansion of credit and the lack of regulatory oversight of the banking system. This fostered malinvestment and a terrific destruction and reallocation of wealth.

This is what happens when the Fed takes its eye off the growth of money supply and credit, and instead focuses on exotic metrics and statistical rubbish, to the cacaphony and flourishes of pseudo-scientific oratory that confounds common sense.

There will be significant human dislocation and misery to come as the economy readjusts to more sustainable growth patterns and capital allocation.

Near term support levels are more obvious when looking at this chart below.

What we have are two neatly nested Head and Shoulders tops, at least.

Lehman Auction Sets up Largest CDS Settlement of $270 Billion

Bloomberg
Lehman Credit-Swap Auction Sets Payout of 91.38 Cents
By Shannon D. Harrington and Neil Unmack

Oct. 10 -- Sellers of credit-default protection on bankrupt Lehman Brothers Holdings Inc. will have to pay holders 91.375 cents on the dollar, setting up the biggest-ever payout in the $55 trillion market.

An auction to determine the size of the settlement on Lehman credit-default swaps set a value of 8.625 cents on the dollar for the debt, according to Creditfixings.com, a Web site run by auction administrators Creditex Group Inc. and Markit Group Ltd. The auction may lead to payments of more than $270 billion, BNP Paribas SA strategist Andrea Cicione in London said.

While the potential payout is higher than 87 cents on the dollar suggested by trading in Lehman's bonds yesterday, sellers of protection have probably written down their positions and put up most of the collateral required, said Robert Pickel, head of the International Swaps and Derivatives Association. More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. No one knows exactly who has what at stake because there's no central exchange or system for reporting trades.

``I don't think it buries anybody,'' said Brian Yelvington, a strategist at CreditSights Inc., a bond research firm in New York.

Sellers are required to post collateral, or pledge assets, to the buyer of protection, known as the counterparty, on the other side of the trade if the value of their positions declines. Because Lehman's bonds had already fallen, that collateral has probably been posted, Yelvington said.

Pimco, Citadel

The list of participants in the auction includes Newport Beach, California-based Pacific Investment Management Co., manager of the world's largest bond fund, Chicago-based hedge fund manager Citadel Investment Group LLC and American International Group Inc., the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.

Hedge funds, insurance companies and banks typically buy and sell credit protection, which is used either to insure a bond against default or as a bet against the company's ability to pay its debt.

The payments ``are insignificant when put into the context of the trillions of dollars of payments that are made through settlement systems each and every day,'' Pickel said on a conference call with reporters today.

Fears `Overblown'

Some funds may be forced to dump assets to meet the payment demands if they haven't hedged, BNP Paribas's Cicione said.

``Banks can go to the Federal Reserve, or use the commercial paper market where it is still functioning'' to meet protection payments, said Cicione, who said a 9.75 cent recovery rate would lead to payments of about $270 billion. ``But fund managers or hedge funds, once they've used their cash, have only one option: to sell assets.....''

Stand and Deliver - Significant Fails in the US Treasury Market

This is the worst 'failure to deliver' Treasuries that we've seen since we started tracking this on a weekly basis in 2003.

An explanation of the Settlement Failures from the Federal Reserve is listed below.

There was no corresponding spike in Agencies, MBS, or Corporates in the data.

Fails data reflect cumulative "fails to receive" and "fails to deliver" over the course of a week for the primary dealer community only. The cumulative weekly totals are calculated by summing the fails outstanding on each business day of the reporting week.1 These totals include both fails that started during the reporting week as well as fails that started in prior weeks and have not yet been resolved. The aggregate fails data include fails associated with both outright transactions and financing transactions.

Fails data are reported for four distinct categories: Treasury Securities, Agency Securities, Mortgage-Backed Securities and Corporate Securities. Mortgage-backed securities include those issued and insured by government sponsored enterprises. Privately issued mortgage-backed securities are categorized as corporate securities. The FRBNY has collected aggregated fails data in this form since July 1990 for Treasury, Agency and Mortgage-Backed securities, and since July 2001 for Corporate securities.

Reported fails numbers sometimes can reach elevated levels due to so-called "daisy chains" and "round robins" in which an initial delivery failure causes a chain of subsequent fails as the party expecting to receive the security in the initial transaction fails to deliver to its counterpart in the second transaction, and so on. Daisy chains and round robins are ultimately not the cause of fails. Fails, at root, are caused by the core short positions of cash and repo market participants.

As described in the primer below, there are many factors that can create an initial delivery failure. Once a significant volume of fails occurs, lenders of collateral sometimes also withhold collateral because they are concerned that existing fails diminish the likelihood of that collateral being returned to them. Such withholding can be self-fulfilling because withholding scarce collateral can increase the incidence of fails in and of itself.

The importance of delivery chains and the potential for feedback effects from changes in the withholding behavior of collateral lenders also imply that relatively small amounts of collateral can settle a larger volume of failed transactions: an increase in collateral can be delivered from one party to the next to clear up a chain of failed trades and the resolution of failed trades may, in turn, make collateral lenders more willing to lend securities that had been in short supply.

Reasons for Settlement Fails

Fails occur for a variety of reasons. One source of fails is miscommunication. Despite their best efforts to agree on terms, a buyer and seller may sometimes not identify to their respective operations departments the same details for a given transaction. On the settlement date the seller may deliver what it believes is the correct quantity of the correct security and claim what it believes is the correct payment, but the buyer will reject the delivery if it has a different understanding of the transaction. If the rejection occurs late in the day there may not be enough time for the parties to resolve the misunderstanding.

In some cases a seller or a seller’s custodian may be unable to deliver securities because of operational problems. An extreme example is the September 11 catastrophe that destroyed broker offices and records, impaired telecommunications links between market participants, and damaged other critical infrastructure. Less extreme operational problems can also precipitate settlement fails, and are not uncommon.

Finally, a seller may be unable to deliver a security because of a failure to receive the same security in settlement of an unrelated purchase. This can lead to a “daisy chain” of fails; where A’s failure to deliver bonds to B causes B to fail on a sale of the same bonds to C, causing C to fail on a similar sale to D, and so on. A daisy chain becomes a “round robin” if the last participant in the chain is itself failing to the first participant.

Fails also occur “naturally” when special collateral repo rates approach or reach zero. In general, a market participant would be better off borrowing securities to avoid a fail even if the interest on the money lent in the specials market is below the general collateral repo rate, because (as explained below) the alternative is forgoing interest altogether.3 However, this incentive becomes less compelling as a specials rate approaches zero. A specials rate will approach zero if there is unusually strong demand to borrow a security, e.g. following heavy short selling by hedgers, or if holders are unusually reluctant to lend the security.

Source: Federal Reserve Bank

Is This a 'Deflationary Moment?'

In short, no.

This is what is called a short term liquidity crunch, where traders, in this case most likely hedge funds and small speculators, go into panic selling to address margin calls and short term cash obligations. It is the unwinding of leveraged positions under extreme short term duress. There is some talk that the CDS situation is causing this, and rumours that the banks are forcing the selling by raising short term margin and issuing margin calls, perhaps to an excess.

It is possible to turn this into a deflation, given time and a tightening of the money supply relative to economic growth. The word 'moment' is the tipoff here. There are no 'moments' in a real inflation or a real deflation. They are trends of weeks and months and sometimes years. Short term events, whether due to a storm, the collapse of a company, a panic, are just that: events.

What we are seeing today, almost across the board, is hedge funds selling almost everything to raise cash to meet their obligations. We suspect that the Lehman CDS settlement today may be a precipitant. We are also seeing banks continuing to tighten their lending even to the funds.

It will reach a climax and then things will begin to normalize. VIX is at crash levels today.

For this to become a true 'deflation' would require the world's central banks to start tightening credit, raising interest rates, tightening government budgets. Lets see if they do that. Merely doing nothing would probably not even be enough, since the market would just find a level at which it could clear and then normalize. It takes serious government meddling to create problems like a hyperinflation or a true deflation.

Its important to keep these things square in our minds. Cooler heads prevail, given a little time, and panicking is never a wise strategy, unless you panic first. We're probably beyond that point..


Gold Falls as Dollar Gains, Investors Sell Metal to Raise Cash
By Pham-Duy Nguyen
October 10, 2008 13:09 EDT

Oct. 10 (Bloomberg) -- Gold tumbled from the highest since July as the dollar strengthened and investors sold the metal to cover losses in equity markets. Silver plunged 11 percent.

The dollar headed for the second consecutive weekly gain against a weighted basket of six major currencies. Earlier, gold reached $936.30 an ounce, the highest since July 29, on demand for a haven amid plunging global equity markets.

``Investors are selling gold to raise dollars,'' said Frank McGhee, the head dealer at Integrated Brokerage Services LLC in Chicago. ``It's fear versus dollar strength, and dollar strength is winning...''