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THE WIZARD OF BUBBLELAND
PART II: The repo time bomb
By Henry C K Liu 29/09/05
The repo market is the biggest financial market today. Domestic and international repo markets have grown dramatically over
the past few years because of increasing need by market participants to take and hedge short positions in the capital and
derivatives markets; a growing concern over counterparty credit risk; and the favorable capital-adequacy treatment given to
repos by the market. Most important of all is a growing awareness among market participants of the flexibility of repos and the
wide range of markets and circumstances in which they can benefit from using repos. The use of repos in financing and
leveraging market positions and short-selling, as well as in enhancing returns and mitigating risk, is indispensable for full
participation in today's financial markets.
A repurchase agreement (repo) is a loan, often for as short as overnight, typically backed by top-rated US Treasury, agency, or
mortgage-backed securities. Repos are contracts for the sale and future repurchase of a top-rated financial asset. On
termination date, the seller must repurchase the asset at the same price at which he sold it, pay interest for the use of the funds
and, if the asset was borrowed, return the borrowed assets to the lending owner, who also receives a fee for lending. If the
repoed security pays a dividend, coupon or partial redemptions during the repo, this is returned to the original owner. Institutions
with excess assets routinely avoid holding unproductive idle assets by lending them for a fee to institutions in need of more
assets. A well-defined legal framework has developed to facilitate repo transactions.
A key distinguishing feature of repos is that they can be used either to obtain funds or to obtain securities. The former feature is
useful to market participants who wish to acquire other assets that provide arbitrage opportunities against the collateralized
assets. The latter feature is useful to market participants because it allows them to obtain the securities they need to meet other
contractual obligations, such as to make delivery for a futures contract. In addition, repos can be used for leverage, to fund long
positions in securities and to fund short positions for hedging interest rate risks. As repos are short-maturity collateralized
instruments, repo markets have strong linkages with securities markets, derivatives markets and other short-term markets such
as interbank and money markets. Securities dealers use repos to finance their securities inventories. Counterparties may be
institutions, such as money-market funds that have money to invest short-term. Or they may be parties who wish to obtain the
use of a particular security briefly by doing a reverse repo. For example, a party may want to sell the security short, or it may
need to deliver the security to settle a trade with a third party. Accordingly, there are two possible motives for entering into a
reverse repo:
1) Short-term investment of funds, or GC (general collateral) repos.
2) To obtain temporary use of a particular security, or special repos.
Interest rates on special repos tend to be lower than those on GC repos. This is because a party doing a reverse repo on a
special security will accept a reduced interest rate on its funds in exchange for receiving the special security it requires.
Economically, the transaction is no different from cash collateralized security lending. Pricing of either type of contract depends
upon demand for the desired security.
Because repos are in essence secured loans, their interest rates do not depend upon the respective counterparties' credit
ratings. For GC repos, the same rates apply for all counterparties. Accordingly, GC repo rates, or simply repo rates, are
benchmark short-term interest rates that are widely quoted in the marketplace. They differ from LIBOR (London interbank
offered rate) in that repo rates are for secured loans whereas LIBOR is for unsecured loans based on the creditworthiness of the
borrower.
Dealers sell securities short to profit from, or hedge against, rising interest rates. If interest rates rise, the price of a fixed-rate
security falls correspondingly to reflect prevalent market rate. A dealer who sells a security whose value he expects to fall
stands to profit by purchasing the security later at a lower price. If that dealer has holdings that will lose value when interest
rates rise, the move to sell short and buy later will offset this exposure. By countering potential losses with potential gains, the
dealer hedges his balance sheet against any changes in interest rates. Dealers use the repo market to finance their cash market
positions. The key advantage of the repo market as a funding mechanism is its flexibility: dealers who are uncertain how long
they will need to maintain a position or a hedge can borrow securities for a short period or, if necessary, extend the loan
indefinitely at a relatively low cost.
Unless the repo market is disrupted by seizure, repos can be rolled over easily and indefinitely. What changes is the repo rate,
not the availability of funds. If the repo rate rises above the rate of return of the security finance by a repo, the interest-rate
spread will turn negative against the borrower, producing a cash-flow loss. Even if the long-term rate rises to keep the interestrate spread positive for the borrower, the market value of the security will fall as the long-term rate rises, producing a capital
loss. Because of the interconnectivity of repo contracts, a systemic crisis can quickly surface from a break in any of the weak
links within the market.
Repos are useful to central banks both as a monetary-policy instrument and as a source of information on market expectations.
Repos are attractive as a monetary-policy instrument because they carry a low credit risk while serving as a flexible instrument
for liquidity management. In addition, they can serve as an effective mechanism for signaling the stance of monetary policy.
Repos have also been widely used as a monetary-policy instrument among European central banks, and with the start of the
EMU (European Monetary Union) in January 1999, the Eurosystem adopted repos as a key instrument. Repo markets can also
provide central banks with information on very short-term interest-rate expectations that is relatively accurate since the credit
risk premium in repo rates is typically small. In this respect, they complement information on expectations over a longer horizon
derived from securities with longer maturities.
The secondary credit market is where the US Federal National Mortgage Association (Fannie Mae) and Federal Home Loan
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Mortgage Corp (Freddie Mac), so-called GSEs (government sponsored enterprises, or agencies) that were founded with
government help decades ago to make home ownership easier by purchasing loans that commercial lenders make, then either
hold loans in their portfolios or bundle them with other loans into mortgage-backed securities for sale in the credit market.
Mortgage-backed securities are sold to mutual funds, pension funds, Wall Street firms and other financial investors who trade
them the same way they trade Treasury securities and other bonds. Many participants in this market source their funds in the
repo market.
In this mortgage market, investors, rather than banks, set mortgage rates by setting the repo rate. Whenever the economy is
expanding faster than the money supply, investors demand higher yields from mortgage lenders. However, the Federal Reserve
is a key participant in the US repo market as it has unlimited funds with which to buy repo or reverse repo agreements to set the
repo rate. Investors will be reluctant to buy low-yield bonds if the Fed is expected to raise short-term rates higher. Conversely,
prices of high-yield bonds will rise (therefore lowering yields) if the Fed is expected to lower short-term rates. In a rising-rate
environment, usually when the economy is viewed by the Fed as overheating, securitized loans can only be sold in the credit
market if yields also rise. The reverse happens when the economy slows. But since the Fed can only affect the repo rate
directly, the long-term rate does not always follow the short-term rate because of a range of factors, such as a time lag, market
expectation of future Fed monetary policy and other macro events. This divergence from historical correlation creates profit
opportunities for hedge funds.
The "term structure" of interest rates defines the relationship between short-term and long-term interest rates. Historical data
suggest that a 100-basis-point increase in Fed funds rate has been associated with 32-basis-point change in the 10-year bond
rate in the same direction. Many convergence trading models based on this ratio are used by hedge funds. The failure of longterm rates to increase as short-term rates have risen since late winter 2003 can be explained by the expectation theory of the
term structure, which links market expectation of the future path of short-term rates to changes in long-term rates, as St Louis
Fed president William Poole said in a speech to the Money Marketeers in New York on June 14. The US market simply does not
expect the Fed to keep short-term rates high for extended periods under current conditions. The upward trend of short-term
rates is expected by the market to moderate or reverse direction as soon as the US economy slows.
Investors buy bonds to lock in high yields if they expect the Fed to cut short-term rates in the future to stimulate the economy.
When bond investor demand is strong, mortgage lenders can offer lower mortgage rates for consumers because high bond
prices lead to lower bond yields. But lower interest rates lead to inflation, which discourages bond investment. Lower interest
rates also lower the exchange value of the US dollar, allowing non-dollar investors to bid up dollar-asset prices. Non-dollar
investors are not necessarily foreigners. They are anyone with non-dollar revenue, such as US transnational companies that sell
overseas or mutual funds that invest in non-dollar economies. Unlike investors, hedge funds do not buy bonds to hold, but to
speculate on the effect of interest-rate trends on bond prices by going long or short on bonds of different maturity, financed by
repos.
As with other financial markets, repo markets are subject to credit risk, operational risk and liquidity risk. However, what
distinguishes the credit risk on repos from that associated with uncollateralized instruments is that repo credit exposures arise
from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can
result in an under-collateralization of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets
will force liquidation of collateral at a discount in the event of a counterparty default, or even a fire sale in the event of systemic
panic. Leverage that is built up using repos can exponentially increase these risks when the market turns. While leverage
facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is
important to maintain these risks at prudent levels.
In general, the art of risk management has been trailing the decline of risk aversion. Up to a point, repo markets have offsetting
effects on systemic risk. They can be more resilient than uncollateralized markets to shocks that increase uncertainty about the
credit standing of counterparties, limiting the transmission of shocks. However, this benefit can be neutralized by the fact that
the use of collateral in repos withdraws securities from the pool of assets that would otherwise be available to unsecured
creditors in the event of a bankruptcy. Another concern is that the close linkage of repo markets to securities markets means
they can transmit shocks originating from this source. Finally, repos allow institutions to use leverage to take larger positions in
financial markets, which adds to systemic risk.
Global savings glut caused by dollar hegemony
Fed governor Ben Bernanke argued in a speech on March 29 that a "global savings glut" has depressed US interest rates since
2000. Fed chairman Alan Greenspan testified before Congress on July 20 that this glut is one of the factors behind the so-called
interest-rate conundrum, ie, declining long-term rates despite rising short-term rates.
Bernanke noted that in 2004, the US external deficit stood at US$666 billion, or about 5.75% of gross domestic product (GDP).
Corresponding to that deficit, US citizens, businesses, and governments on net had to raise $666 billion from international
capital markets. As US capital outflows in 2004 totaled $818 billion, gross financing needed exceeded $1.4 trillion. He argued
that over the past decade a combination of diverse forces has created a significant increase in the global supply of savings, in
fact a global savings glut, which helps to explain both the increase in the US current account deficit and the relatively low level
of long-term real interest rates in the world today. He asserted that an important source of the global savings glut has been a
remarkable reversal in the previous flows of credit to developing and emerging-market economies, a shift that has transformed
those economies from borrowers on international capital markets to large net lenders.
In the United States, national saving is currently dangerously low and falls considerably short of US capital investment. Of
necessity, this shortfall is made up by net borrowing from foreign sources, in essence by making use of foreigners' savings to
finance part of domestic investment. The current account deficit equals the net amount that the US borrows abroad, and US net
foreign borrowing equals the excess of US capital investment over US national saving. Bernanke reasoned that the country's
current account deficit equals the excess of its investment over saving. In 1985, US gross national saving was 18% of GDP; in
1995, 16%; and in 2004, less than 14%. It seems obvious that despite Bernanke's predisposed observation, the current account
deficit equals the excess of US consumption, not investment, over savings.
Theoretically, investment cannot, as a matter of definition, exceed savings, a concept aptly expressed by the formula I = S (total
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investment equals total savings) framed by economist Irving Fischer (Nature of Capital and Income, 1906) that every economist
learns in the first day of class in neo-classical macroeconomics. For total investment to be equal to total savings, the demand for
lendable funds must equal the supply for lendable funds and this is only possible if the rate of interest is appropriately defined. If
the interest rate were such that the demand for lendable funds was not equal to the supply of it, then we would also not have
investment equal to savings. Thus the Fed interest-rate policy is responsible for over- or underinvestment in the US economy.
Foreign countries with dollar trade surpluses from the United States increased reserves by issuing local currency debts to
withdraw the trade-surplus dollars held by their citizens, thereby, according to Bernanke, mobilizing domestic saving, and then
using the dollar proceeds to buy US Treasury securities and other assets. In effect, foreign governments have acted as financial
intermediaries, channeling domestic saving away from local uses and into international capital markets. A related strategy has
focused on reducing the burden of external debt by attempting to pay down those obligations, with the funds coming from a
combination of reduced fiscal deficits and increased domestic debt issuance. Of necessity, this strategy also pushed emergingmarket economies toward current account surpluses. Again, the shifts in current accounts in East Asia and Latin America are
evident in the data for the regions and for individual countries.
Bernanke also asserted that the sharp rise in oil prices has contributed to the swing toward current-account surplus among the
non-industrialized nations in the past few years. The current account surpluses of oil exporters, notably in the Middle East but
also in countries such as Russia, Nigeria and Venezuela, have risen as oil revenues have surged. The aggregate current
account surplus of the Middle East and Africa rose more than $115 billion between 1996 and 2004. In short, events since the
mid-1990s have led to a large change in the aggregate current account position of the developing world, implying that many
developing and emerging-market countries are now large net lenders rather than net borrowers on international financial
markets. In practice, these countries increased foreign-exchange reserves through the expedient of issuing debt to their citizens,
thereby mobilizing domestic saving, and then using the dollar proceeds to buy US Treasury securities and other dollar assets.
While Bernanke accurately describes the conditions, he obscures the causal dynamics. The so-called global savings glut is
hardly the result of voluntary behavior on the part of foreign central banks. It is the coercive effect of dollar hegemony that has
left the trading partners of the US without a choice. The US trade deficit is denominated in dollars, which can only be recycled
into dollar assets. Local-currency debts are issued by foreign treasuries to soak up the current account surplus dollars so that
foreign central banks end up holding larger dollar reserves, which can hardly be viewed as national savings.
The exporting economies ship real wealth to the United States in exchange for fiat dollars that cannot be spend in their own
economies without first being converted into local currencies. If the local central banks exchange the trade-surplus dollars with
local currencies, local inflation will result from an expansion of the money supply while the wealth behind the new money has
been shipped to the US. Thus most foreign governments issue sovereign debts in local currencies to soak up the dollars and
turn them over to their central banks as foreign-exchange reserves. The local sovereign debt is equal to the loss of real wealth
from export to the US.
A dollar glut that impoverishes
The glut is only a dollar glut that in fact impoverishes the exporting economies. There is no global savings glut at all. While the
exporting economies continue to suffer from shortage of capital, having shipped real wealth to the US in exchange for paper that
cannot be used at home, their central banks are creditors holding huge amounts of dollar debt instruments. It is not a global
savings glut. It is a global dollar glut caused by the Fed printing money to feed the gargantuan US appetite for debt.
The United States has become the world's biggest debtor nation. Japan and China have become the world's biggest creditor
nations. The US owes Japan more than $2 trillion. At the end of third-quarter 1998, 33% of US Treasury securities were held by
foreigners, up from just 10% in 1991. Some 30% of foreign-held assets were US government bonds ($1.5 trillion), and 12%
corporate bonds. By June 30 this year, more than 50% of outstanding US Treasuries ($2 trillion) were held by foreigners. Total
US federal debt exceeds $7.6 trillion. Yet Japan needs US investment and credit. The US economy has been booming for more
than a decade with only two brief recessions, each bailed out by the Fed injecting massive liquidity into the banking system,
while during the same time the Japanese economy has been sliding downhill and its sovereign debt receiving junk ratings.
While there are many well-known factors behind this strange inversion of basic economic logic, one factor that seems to have
escaped the attention of neo-liberal economists is the US private sector's ability to use debt to generate returns that not only can
comfortably carry the cost of debt service but also conflate asset values with astronomical p/e (profit-earning) ratios. Japan has
been cursed with an opposite problem. Japan's long-term national debt exceeded its GDP in 2004, and the ratio of its long-term
national debt to GDP was double that of the US. It has been unable to utilize sovereign credit further to back the investment
needs of its private sector. As a result, Japan looks to international capital (mostly from the US), money (more than $2 trillion)
that really belongs to Japan. The moves toward zero interest rates temporarily helped the Tokyo equity market, but whether the
recovery is sustainable is still very much in doubt.
US investors and lenders require US-style transparency and a degree of control that are incompatible with Japanese traditional
social norms. US-managed "Japanese" funds want only to make investments based on financial rationale rather than on
Japan's keiretsu relationships. The intrusion of US-managed capital would cause the very social chaos that Japanese politicians
badly want to avoid.
This problem holds true throughout much of Asia, including China. Asia is unable to attract sufficient global capital to sustain its
growth/recovery targets, unable to restructure its economies away from export to generate that capital domestically, and
unwilling to allow an uncontrolled influx of US-managed global capital on US terms. Politically, Asian leaders are trapped
between the economic demands of a neo-liberal global system and indigenous social traditions. They face a policy paralysis
resulting from conflicting pressures. Inefficiencies continue, recovery aborted by externally imposed economic realities, and
social tensions reach boiling points.
An Asian solution will come from creating Asian institutions to supplant the unresponsive global institutions within which Asian
economies are increasingly put at a competitive disadvantage even as they pile up trade surpluses. Grassroots resistance to US
demands for trade liberalization will force Asian leaders to seek Asian regional solutions, perhaps an Asian common market with
its own currency regime supported by an Asian Monetary Fund to free itself from dollar hegemony.
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The dollar a non-convertible currency
Under dollar hegemony, the dollar has become a de facto non-convertible currency in a deregulated global financial free market.
What pushes long-term dollar interest rates down is the inflationary effect on dollar assets caused by too many dollars chasing
increasingly hollow dollar assets of dwindling productive content.
Global trade is now a game in which the United States produces dollars and the rest of the world produces real goods dollars
can buy. This game hollows out the real value of dollar assets as they appreciate in nominal value with thinning substance or
declining yields. When prices of dollar assets are bid up by speculation, their real yields fall. Foreign-held dollars are invested in
dollar assets not to capture high interest or dividend payments, but to hope for continuing price appreciation. But increasingly
hollowed, non-performing assets will eventually require skyrocketing yields to attract or hold investors. There will come a time
when the gap between speculative price appreciation and high yield becomes too wide to be reconcilable, as companies in the
New Economy discovered in 2000. Bernanke, a very astute economist, no doubt is familiar with the iron law governing the
inverse relationship between rising bond prices and falling bond yields, yet on the need to keep yields high to attract bond
buyers, he remains curiously silent.
This is the inescapable trap in which Greenspan finds himself when he attempts to deflate a debt bubble approaching bursting
point with his measured-paced interest-rate policy. The Fed cannot raise short-term interest rates above long-term rates
because an inverted rate curve will lead to a recession. Yet he must raise short-term rates to hold down inflation, this time not
wage-pushed (because outsourcing has kept wages low), but from a speculative frenzy fueled by debt recycling. Yet long-term
rates remain low because of the coerced global capital-flow effects of dollar hegemony. As Bernanke accurately observes,
foreign central banks have been reduced to playing the role of funding intermediaries to permit the US to finance its capital
account surplus with its current account deficit. It is a game of financing US consumer debt with US capital debt, with the Fed
printing more money every day to keep the Ponzi scheme going, to the tune of more than $1.4 trillion a year in 2004 or $5.4
billion every trading day.
But the outcome of this game is stagflation - recession with inflation - as US president Jimmy Carter found out from the Fed's
reckless easing under Arthur Burns during the Nixon/Ford years. The Carter stagflation will be viewed as merely a minor storm
involving billions compared with the coming financial tsunami where the stakes have been exponentially inflated to trillions. Just
as little naive Dorothy finally drew the curtain open to expose the trickery of the Wizard of Oz, the foreign exporting economies
will soon catch on to the monetary smoke and mirrors of the Wizard of Bubbleland in support of neo-liberal trade.
The repo market now big and dangerous
Created to raise funds to pay for the flood of securities sold by the US government to finance growing budget deficits in the
1970s, the repo market has grown into the largest financial market in the world, surpassing stocks, bonds, and even foreign
exchange.
in 1998, when the world's biggest government-bond market was shrinking because of a temporary US fiscal surplus, the market
where investors financed their long bond purchases with short-term loans continued to grow by leaps and bounds. The $2 trillion
daily repo market became the place where bond firms and investors raised cash to buy securities, and where corporations and
money market funds parked trillions of electronic dollars daily to lock in risk-free attractive returns. That market has since grown
past $5 trillion a day, almost 50% of US GDP.
The repo market grew exponentially as it came to be used to raise short-term money at lower rates for financing long-term
investments such as bonds and equities with higher returns. The derivatives markets also require a thriving financing market,
and repos are an easy way to raise low-interest funds to pay for securities needed for arbitrage plays. It used to be that the
purchase of securities could not be financed by repos, but those restrictions have long been relaxed along with finance
deregulation. Repos were used first to raise money to finance only government bonds, then corporate bonds, and later equities.
The risk of such financing plays lies in the unexpected sudden rise in short-term rates above the fixed returns of long-term
assets. For equities, rising short-term rates can directly push equity prices drastically down, reflecting the effect of interest rates
on corporate profits.
Hard figures on the size of the repo market in the US or Europe are not easy to come by. The Bond Market Association, a trade
group representing US bond dealers, provides estimates of US market size based on surveys taken by the New York Federal
Reserve Bank on daily financing transactions made by its primary dealers that do business directly with the Fed. By Fed
statistics, the US repo market commanded average trading volume of about $5 trillion per day in 2004, up from $2 trillion in
1998, and the European one has now passed 5 trillion euros ($6.1 trillion) in outstandings. Both have been growing at a doubledigit pace. That jump occurred even as the face value of US government bonds outstanding declined to $3.3 trillion from $3.5
trillion between 1999 and 1997 - the first drop since the Treasury began selling 30-year bonds regularly in 1977.
Total US federal government debt outstanding at the end of 2004 was $7.6 trillion, nearly 70% of GDP. In its February 2, 2005,
Report to the Secretary of the Treasury, the Bond Market Association Treasury Borrowing Advisory Committee noted that the
stock of Treasury debt held by foreigners was just over 50%, and that with higher short rates would come greater risks of
chronic or intractable failures if foreign participation in repo markets was not assured. The St Louis Fed reports that as of June
30, federal debt held by foreigners exceeded $2 trillion.
The runaway repo market is another indication that the Fed is increasingly operating to support a speculative money market
rather than following a monetary policy ordained by the Full Employment and Balanced Growth Act of 1978, known as the
Humphrey-Hawkins Act. Under the Federal Reserve Act as amended by Humphrey-Hawkins, the Federal Reserve and the Fed
Open Market Committee (FOMC) are charged with the job of seeking "to promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates". Humphrey-Hawkins mandates that, in the pursuit of these
goals, the Federal Reserve and the FOMC establish annual objectives for growth in money and credit, taking account of past
and prospective economic developments to support full employment. The act introduced the term "full employment" as a policy
goal, although the content of the bill had been watered down by snake-oil economics before passage to consider 4%
unemployment as structural. Unemployment near or below the structural level is deemed structurally inconsistent because of its
impact on inflation (causing wages to rise - a big no-no for diehard monetarists), thus only increasing unemployment down the
road. Structural unemployment is now theoretically set at 6%.
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Unfortunately, aside from being morally offensive, this definition of full employment is not even good economics. It distorts real
deflation as nominal low inflation and widens the gap between nominal interest rate and real interest rate, allowing demand
constantly to fall behind supply. Humphrey-Hawkins has been described as the last legislative gasp of Keynesianism's doomed
effort by liberal senator Hubert Humphrey to refocus on an official policy against unemployment. Alas, most of the progressive
content of the law had been thoroughly vacated even before passage. Full employment has not been a national policy for the
US since the New Deal. Yet few have bothered to ask what kind of economic system demands that the richest country in the
world cannot afford employment for all its citizens.
The one substantive reform provision: requiring the Fed to make public its annual target range for growth in the three monetary
aggregates, the three Ms, namely M1 = currency in circulation, commercial bank demand deposits, NOW (negotiable order of
withdrawal), and ATS (auto-transfer from savings), credit-union share drafts, mutual-savings-bank demand deposits, non-bank
traveler's checks; M2 = M1 plus overnight repurchase agreements issued by commercial banks, overnight Eurodollars, savings
accounts, time deposits under $100,000, money market mutual shares; and M3 = M2 plus time deposits over $100,000 and
term repo agreements. A fourth category, known a L, measures M3 plus all other liquid assets such as Treasury bills, savings
bonds, commercial paper, bankers' acceptances and Eurodollar holdings of US residents (non-bank).
Changes in the financial system, particularly since the deregulation of US banking and financial markets in the 1980s, have
contributed to controversy among economists about the precise definition of the money supply. M1, M2 and M3 now measure
money and near-money while L measures long-term liquid funds. There is no agreement on the amount of L. The controversy is
further complicated by the financing of long-term instruments with short-term repos which while being is a money creation venue
are mercuric in outstanding volume.
The persistent expansion in the money supply has been accompanied by a decline in the efficiency of money to generate GDP.
In 1981, two dollars in the money supply (M3 - $2 trillion) yielded three dollars of GDP ($3 trillion), a ratio of 2:3. In 2005, 10
dollars in the money supply (M3 - $10 trillion) yields 12 dollars of GDP ($12 trillion), a ratio of 2.5:3. It now takes 25% more
money to produce the same GDP than 25 years ago. That 25% is the unproductiveness of debt that has infested the US
economy, not even counting the unknown quantity of virtual money that structured finance creates.
In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money-supply growth expired, the
Fed announced that it was no longer setting such targets, because it no longer considered money-supply growth as providing a
useful benchmark for the conduct of monetary policy. It is a reasonable position since no one knows what the money supply and
its growth rate really are. However, the Fed said, "The FOMC believes that the behavior of money and credit will continue to
have value for gauging economic and financial conditions. Moreover, M2, adjusted for changes in the price level, remains a
component of the Index of Leading Indicators, which some market analysts use to forecast economic recessions and
recoveries." Non-useful data yield non-useful forecasts.
Commercial banks profit from using low-interest-rate repo proceeds to finance high-interest-rate "sub-prime" lending - credit
cards, home equity loans, automobile loans etc - to borrowers of high credit risks at double-digit interest rates compounded
monthly. To reduce their capital requirement, banks then remove their loans from their balance sheets by selling the CMOs
(collateralized mortgage obligations) with unbundled risks to a wide range of investors seeking higher returns commensurate
with higher risk. In another era, such high-risk/high-interest loan activities were known as loan-sharking. Yet Greenspan is on
record as having said that systemic risk is a good tradeoff for unprecedented economic expansion.
Repos are now one of the largest and most active sectors in the US money market. More specifically, banks appear to be
actively managing their inventories, to respond to changes in customer demand and the opportunity costs of holding cash, using
innovative ways to bypass reserve requirements. Rising customer demand for new loans is fueled by and in turn drives further
down falling credit standards and widens interest-rate spread in a vicious cycle of unrestrained credit expansion.
Repos are widely used for investing surplus funds short-term, or for borrowing short-term against quality collateral. When the
FOMC sells government securities to withdraw cash from the banking system, the banks can take the same securities to the
repo market to get the cash back, neutralizing the Fed attempt to tighten the money supply in the banking system, even as the
total money supply in the economy is theoretically tightened. And this tightening can also be neutralized by an increase of
money velocity.
Although legally a sequential pair of transactions, in effect a repo is a short-term interest-bearing loan against solid collateral.
The annualized rate of interest paid on the loan is known as the repo rate. Repos can be of any duration but most commonly are
overnight loans. Repos for longer than overnight are known as term repos. There are also open repos that can be terminated by
either side on a day's notice. In trade parlance, the seller of securities does a repo and the lender of funds does a reverse.
Because cash is the most liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market
value, usually by 2-5% depending on maturity. It is improbable that top-rated securities can have a drop in market value of more
than 5% overnight, but not impossible.
The repo interest rate is usually slightly lower than the Fed funds rate, which banks charge each other for overnight loans. This
is because a repo transaction is a secured loan, whereas the issuing of Fed funds is the release of sovereign credit into the
money supply. Also, only the Fed can issue Fed funds, while anyone with surplus cash can lend money through a repo
collateralized by top-rated security.
Even though the return is modest, overnight lending in the repo market offers several advantages to investors. By rolling
overnight repos, investors can keep surplus funds invested without losing liquidity or incurring price risk. They also incur very
little credit risk because the collateral is always highest-grade paper. The repo market is not open to small investors. The largest
users of repos and reverses are primary dealers in government securities. As of August, there were 23 primary dealers
recognized by the Fed, authorized to bid on newly issued Treasury securities for resale in the market. Primary dealers must be
well capitalized, and often deal in hundred-million-dollar chunks. In addition, there are several hundred dealers who buy and sell
Treasury securities in the secondary market and do repos and reverses in at least million-dollar chunks. The balance sheet of a
government securities dealer is highly leveraged, with assets typically 50 to 100 times its own capital. To finance the inventory,
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there is a need to obtain repo money in large amounts on a continuing basis. Big suppliers of repo money are money funds,
large corporations, state and local governments, and foreign central banks. Generally the alternative of investing in securities
that mature in a few months is not attractive by comparison. Even three-month Treasury bills normally yield less than overnight
repos.
A dealer who holds a large position in securities takes a risk in the value of his portfolio from changes in interest rates. Position
plays are where the largest profits can be made. However, conservative dealers run a nearly matched book to minimize market
risk. This involves creating offsetting positions in repos and reverses by "reversing in" securities and at the same time "hanging
out" identical securities with repos. The dealer earns a profit from the bid-ask spread. Profits can be improved by mismatching
maturities between the asset and liability side, but at increasing risk. As dealers move from simply using repos to finance their
positions to using them in running matched books, they become de facto financial intermediaries. By borrowing funds at one
rate and relending them at a higher rate, a dealer is operating like a finance company, doing for-profit intermediation. This form
of carry trade in massive amounts can hit with unmanageably destructive force should interest-rate spreads turn against it.
Dealers hedging activities create a link between the repo market and the auction cycle for newly issued (on-the-run) Treasury
securities. In particular, there is a close relation between the liquidity premium for an on-the-run security and the expected future
overnight repo spreads for that security (the spread between the general collateral rate and the repo rate specific to the on-therun security). Dealers sell short on-the-run Treasuries in order to hedge the interest rate risk in other securities. Having sold
short, the dealers must acquire the securities via reverse repurchase agreements and deliver them to the purchasers. Thus an
increase in hedging demand by dealers translates into an increase in the demand to acquire the on-the-run security (that is,
specific collateral) in the repo market.
The supply of specific collateral to the repo market is not perfectly elastic; consequently, as the demand for the collateral
increases, the repo rate falls to induce additional supply and equilibrate the market. The lower repo rate constitutes a rent (in the
form of lower financing costs), which is capitalized into the value of the on-the-run security. The price of the on-the-run security
increases so that the equilibrium return is unchanged. The rent can be captured by reinvesting the borrowed funds at the higher
general collateral repo rate, thereby earning a repo dividend.
When an on-the-run security is first issued, all of the expected earnings from repo dividends are capitalized into the security's
price, producing the liquidity premium. Over the course of the auction cycle, the repo dividends are "paid" and the liquidity
premium declines; by the end of the cycle, when the security goes off-the-run (and the potential for additional repo dividend
earnings is substantially reduced), the premium has largely disappeared.
A repo squeeze occurs when the holder of a substantial position in a bond finances a portion directly in the repo market and the
remainder with "unfriendly financing" such as in a tri-party repo. Such squeezes can be highly destabilizing to the credit market.
The direct dependence of derivatives financing on the repo market is worth serious focus. According to Greenspan, "By far the
most significant event in finance during the past decade has been the extraordinary development and expansion of financial
derivatives."
The Office of the Controller of Currency (OCC) Bank Derivative Report (First Quarter 2005) on bank derivatives activities and
trading revenues is based on call report information provided by US insured commercial banks. During the first quarter, the
notional amount of derivatives in insured commercial bank portfolios increased by $3.2 trillion to $91.1 trillion. The notional
amount of interest-rate contracts increased (by $2.5 trillion) to $78 trillion. The notional value of foreign-exchange contracts
decreased (by $94 billion) to $8.5 trillion. This figure excludes spot foreign-exchange contracts, which increased (by $319 billion)
to $738 billion. Credit derivatives increased (by $777 billion) to $3.1 trillion. Equity, commodity and other contracts increased (by
$87 billion) to $1.5 trillion. The number of commercial banks holding derivatives increased (by 18) to 695. Eighty-six percent of
the notional amount of derivative positions consists of interest-rate contracts, with foreign-exchange accounting for an additional
9%. Equity, commodity and credit derivatives accounted for the remaining 5% of the total notional amount. Holdings of
derivatives continue to be concentrated in the largest banks. Five commercial banks account for 96% of the total notional
amount of derivatives in the commercial banking system, with more than 99% held by the largest 25 banks.
Over-the-counter (OTC) contracts comprised 91% and exchange-traded contracts comprised 9% of the notional holdings as of
first quarter of 2005. An OTC instrument is traded not on organized exchanges (like futures contracts), but by dealers (typically
banks) trading directly with one another or with their counterparties (hedge funds) using electronic means that link
counterparties. OTC contracts tend to be more popular with banks and bank customers because they can be tailored to meet
firm-specific risk-management needs. However, OTC contracts expose participants to greater credit risk, particularly counterparty risk, and tend to be less liquid than exchange-traded contracts, which are standardized and fungible.
At year-end 1998, US commercial banks reported outstanding derivatives contracts with a notional value of only $33 trillion, less
than a third of today's value, a measure that had been growing at a compound annual rate of about 20% since 1990. Of the $33
trillion outstanding at year-end 1998, only $4 trillion was exchange-traded derivatives; the remainder was off-exchange or overthe-counter (OTC) derivatives. Most of the funds came from the exploding repo market.
The 1987 crash was a stock-market bubble burst. Greenspan, merely nine weeks into the powerful post of Fed chairman,
flooded the banking system with new reserves by having the FOMC buy massive quantities of government securities from the
market, and announced the next day that the Fed would "serve as liquidity to support the economic and financial system". He
created $12 billion of new bank reserves by buying up government securities. The $12 billion injection of high-power money in
one day caused the Fed funds rate to fall by three-quarters of a point and halted the financial panic. The abrupt monetary
easing led to a subsequent real-property bubble burst that in turn caused the savings and loan (S&L) crisis two years later. The
Financial Institutions Reform Recovery and Enforcement Act (FIRREA) was enacted by the US Congress in August 1989 to bail
out the thrift industry in the S&L crisis by creating the Resolution Trust Corp (RTC) to take over failed savings banks and
dispose of their distressed assets. The Federal Reserve reacted to the S&L crisis with a further massive injection of liquidity into
the commercial banking system, lowering the Fed funds rate target from its high of 10.75% reached on April 19, 1989, to below
the 3% inflation rate, making the real rate near zero until January 31, 1994.
6
Since there were few assets worth investing in a down market, most of the Fed's newly created money went into bonds. This
resulted in a bond bubble by 1993, which then burst with a bang in February 1994 when the Fed started raising rates, going
further and faster than market participants had expected: seven hikes in 12 months, doubling the Fed funds rate target to 6%.
As short-term rates caught up with long, the yield curve flattened out. Liquidity evaporated, punishing "carry traders" who had
borrowed short-term at low rates to invest longer-term in higher-yield assets, such as long-dated bonds and more adventurous
higher-yielding emerging-market bonds. The rate increases set off a bond-market crash that bankrupted Wall Street giant Kidder
Peabody & Co, California's Orange County and the Mexican economy, all casualties of wrong interest-rate bets. In the case of
Orange County, a triple-legged repo strategy brought it extraordinary returns for a few years, but the risk of the portfolio was
such that over time, it could lose as much as $1.6 billion in excess of value at risk estimates in one case out of 20. And it did in
1994.
By 1994, Greenspan was already riding on the back of the debt tiger from which he could not dismount without being devoured
by it. The Dow was below 4,000 in 1994 and rose steadily to a bubble of near 12,000, while Greenspan raised the Fed funds
rate target seven times from 3% to 6% between February 4, 1994, and February 1, 1995, to try to curb "irrational exuberance".
Greenspan kept the Fed funds rate target above 5% until October 15, 1998, when he was forced to ease it after contagion from
the 1997 Asian financial crisis hit US markets. The rise in Fed funds rate target in 1994 did not stop the equity bubble, but it
punctured the bond bubble and brought down many hedge funds. The dollar fell to 94 yen and 1.43 marks by 1995. The low
dollar laid the ground for the Asian financial crisis of 1997 by fueling financial bubbles in the Asian economies that pegged their
currencies to the dollar.
Stan Jonas, a minor legend on Wall Street in the early 1990s, explained the hedge funds/derivative world in an interview by
DerivativeStrategy.com in November 1995. The low-interest-rate policy of the Fed in 1993 turned the market into a speculative
free-for-all. With the banking system in precarious shape, the Fed kept the yield curve very steep, meaning a wide spread
between short-term and long-term rates, and kept short-term rates low in order to give banks a chance to rebuild their capital.
Bankers, acting on the signal that the Fed was going to hand out a free put, bought two-year notes and profited on the capital
gain as well as the profitable carry trade, lending the low-cost funds to borrowers at higher rates. All through 1993, and
particularly toward the end, there was a huge bond rally. When bonds broke at the end of 1993, most market participants were
long on bonds. As the Fed tightened, the market recognized how closely concentrated liquidity had been. Everybody was on the
same side of the trade, long on US bonds, German bunds etc.
Jonas detailed how it worked. In 1992, a hedge-fund manager with $3 billion in stocks, hearing the Fed signal to the banking
system, decided to go long on bonds, meaning to bet on bond prices rising. Quantitative analysis suggested that bonds were
one-third as volatile as stocks. The manager went long on $10 billion of 10-year bonds. When the yield curve steepened,
meaning 10-year-bond prices were rising slower than two-year-bond prices, he decided to be long on two-year notes. On a
duration weighted basis, quant analysis told him he should be long about seven times as much, or $70 billion in two-year notes,
which exceeded the amount of two-year notes outstanding. In 1992, value-at-risk analysis that, based on probabilities and
correlations and volatility, told a trader how much he could lose in his entire portfolio with a particular trading plan, looking at
past correlations and volatilities, concluded that French bonds and two-year notes were a comparable exposure to his current
US fixed-income positions. The manager went to the European market, where the easing cycle had not yet caught up to that in
the US. Many of the hedge funds made the same kind of decision with electronic speed. All the equity managers jumped into
fixed income with leverage of 100:1, and made a lot of money. The Fed eased 24 times and kept on easing. The traders
became real-life versions of Sherman McCoy, master-of-the-universe bond trader in Tom Wolfe's Bonfire of the Vanities.
When the Fed began to ease aggressively in 1992, the financial world was opening up by deregulation. With derivatives, a
trader could make bets that were impossible to make three or four years earlier. One could buy French bonds at the MATIF
(Marche A Terme International de France), or gilts at LIFFE (London International Financial Futures Exchange), or do structured
products with pay-offs based on the difference between Spanish and German rates. The whole world in essence became a
futures market grouped under the benign name of structured finance. Many of these hedge-fund managers and traders were
interrelated by blood, by background, by tastes, by lifestyle and by education. It was a very small elite group, fearless and
confident, competing with and checking on what the others were doing. They had a firm, sophisticated command on the virtual
world of financial values and relationships, but were unwittingly naive about the complexity of the real world. In all, a few
thousand young Turks ran the whole market and spoke a language that their supervisors could hardly follow and were
embarrassed to admit they were clueless. That was one of the reasons all the bets tended to be on the same side. And when it
came time to unwind, there was hardly anyone to sell to. All of the statistical notions of diversification failed because there was
no wide divergence of views in a broad market. The year 1994 was when all global bond markets moved in the same direction.
When it came time to liquidate, the market froze for lack of buyers. Most model builders assume reality to be rational and
orderly. In fact, life is full of misinformation, errors of judgment, miscalculations, communication breakdowns, ill-will, legalized
fraud, unwarranted optimism, prematurely throwing in the towel, etc. One view of the business world is that it is a snake pit. Very
few economic/financial models reflect that perspective.
Most hedge funds make money as trend followers. The key to trend-following is that if the market goes up you keep buying
more. There was a built-in tendency for a herd instinct that quickly turned into a stampede. Those who turned out right ended up
as superstars. Normally, if a trader makes money, he is supposed to take profits when the going is still good because everyone
knows pigs lose money. Gamblers who overstay at the tables in Las Vegas will end up as losers. But the 1990s were the age of
unabashed greed. When managers got on a track that made money, they developed a sense of invincibility and in effect
doubled up on their positions, so on any big move down, they faced big losses that would wipe out all their previous gains.
Many of the biggest hedge funds promised their investors that they would never lose serious amounts of money because of
brute-force stop-loss breaks, so that no matter what happened they would never lose more than say 3-5% of their capital in any
one month in trading strategies that could yield average returns of up to 70%. But the stop-loss strategy unwittingly destroyed
their hedge. As a fund experienced losses in one marketplace, it started shrinking its positions in every marketplace to prevent
its portfolios losing more than 5%. So after the Fed tightened in the US market, the funds sold in the European market. When
the European market fell, they sold in the Latin American markets to shrink their overall position. It became a "global triage". The
position was pared of the most liquid securities first, leaving the fund with the most difficult positions, the "toxic waste", to the
detriment of their shareholders. The global market was hit by contagion when good markets were sold down to save bad
markets. Strange corollaries appeared. One day the market was down in Germany and the next day it spilled over to Mexico
7
and the Turkish markets in rhythms tied to investor preferences and risk aversion, not to macroeconomic events in the
economies. The fundamentals were good but the markets kept falling. This asset was cheap relative to that asset; Mexico was
cheap relative to Spain, and so on. This shrinkage quickly became self-exacerbating and a global meltdown took place. The
lesson from the banking side was that static notions of risk and implied volatility were meaningless. Infinite liquidity in the
marketplace might work on theoretical models, but the mathematics was valid only a very controlled scale. In the real world, the
complexity always overwhelms the model. The big hedge funds knew that every time they bought more, it set off signals for
others to buy more. Assets became Giffen goods, the demand for which increases when the price goes up. It's a positive
feedback loop. The big funds could control the market trend to make other participants buy more because they knew the
participants' recipe for replicating the options. As Nassim Taleb, celebrated author of Dynamic Hedging and Fooled by
Randomness, formulates his fifth rule on risk management, "The market will follow the path to thwart the highest number of
possible hedgers." Taleb cautions that financial models, unlike engineering models, are based more on assumptions that are
not verifiable. "In finance, you are not as confident about the parameters. The more you expand your model by adding
parameters, the more you become trapped in an inextricable apparatus of relationships. It is called overfitting," he said in an
interview by DerivativeStrategy.com.
The market is difficult to model because there are vast arrays of variables that are indeterminate and the externalities are not
isolatable. Still, even engineering models have similar characteristics. Engineers overcome such problems by legally requiring a
safety factor of 3 in most building codes and strength-of-materials standards. In other words, every engineered structure is overdesigned by a factor of at least three. The problem with financial models is that profitability is derived from shaving the safety
factor to near zero. Financial models are designed to allow the user to skate on the thinnest ice possible, rather than the safest
ice necessary. Risk management has been misused to allow traders to take more risk rather than to protect him from the
dangers of incalculable risk.
Dealers provide hedge funds with the opportunity to track a new type of risk embedded in the marketplace: correlation risk. The
pricing is based on relative movements of previously stable historical relationships. All the hedging technologies based on those
ideas would break down in a crisis. The most vulnerable weakness of a value-at-risk (VaR) or any statistical model is its
assumed stable correlation matrix. Taleb warns that when potential loss distributions are fat-tailed (a term implying a more than
nominal probability of losses at the far end of the distribution - that is, high degree of probability of several defaults in the pool),
simulation based critical value estimates show significant biases and have standard errors of substantial magnitude. This is
particularly significant when a portfolio's positions contain options. These distributions are a mixture of different distributions,
and it becomes virtually impossible to verify with any accuracy the potential losses associated with extremely rare events.
Updated assumptions are irrelevant because history progresses at a disjointed pace. By definition, if every market participant
trades with the same assumptions, historical correlation will be inoperative. If large numbers of market participants are trying to
exit at the same time, the market turns finite and the historical parallels becomes so dynamic that risks becomes unquantifiable.
Ironically, it's the worst sort of empiricism. Jonas thinks the worst sort of technical trading is typified by the refrain of the lazy
technician, and it's been carried forward by many risk modelers, "I don't have to know anything about the fundamentals, the
charts tell me all I need to know."
What gives the market a false sense of safety now is that more asset positions are getting "marked to market" at the end of
every trading day, moving the marketplace dramatically toward risk management as the savior, rather than book value of longterm instruments that returns its principal at maturity, making intermediate risk irrelevant. This actually increases overall risk
since temporary losses are the basis of longer-term gains.
Greenspan opposed regulation for derivatives
Most of the time, if the words "interest rates" do not appear in Greenspan's utterances, little attention is paid to them. Yet in
detached language and calm tone, Greenspan has been saying that he does not intend to exercise his responsibility as Fed
Board chairman to regulate OTC financial derivatives intermediated by banks, even though he recognizes such instruments as
being certain to produce unpredictable but highly damaging systemic risks. The justification for no-regulation is: if we don't
smoke at home, someone else offshore will. Moreover, risk is a price we must accept for a growth economy. It sounds as if the
Fed expects each market participant or even non-participant individually to take measures of self-protection: either miss out on
the boom, or risk being wiped out by the bust. It is unpatriotic, not to mention dumb, not to participate in the great American
game of downhill-racing risk-taking.
With the rise of monetarism, the Fed and the US Treasury Department have evolved from traditionally quiet functions of
ensuring the long-term value and credibility of the nation's currency, to activist promotions of speculative boom fueled by runaway debt, replacing the Keynesian approach of fiscal spending to manage demand by sustaining broad-based income to
moderate the downside of the business cycle. Never before, until Greenspan, has any central banker advocated and celebrated
to such a degree the institutionalization and socialization of risk as an economic policy. As Anthony Giddens, director of the
London School of Economics, explains in his The Third Way that so influenced Bill Clinton, the New Economy president, and
British Prime Minister Tony Blair, the self-proclaimed neo-liberal market socialist: "Nothing is more dissolving of tradition than
the permanent revolution of market forces." What the Third Way revolution did in reality was to restore financial feudalism in the
name of progress. Debt has enslaved a whole generation of mindless risk-takers, with the encouragement of the Wizard of
Bubbleland.
In a speech on financial derivatives before the Futures Industry Association in Boca Raton, Florida, on March 19, 1999,
Greenspan said:
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of
financial derivatives ... the fact that the OTC markets function quite effectively without the benefits of the Commodity Exchange
Act provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives. On a
loan equivalent basis, a reasonably good measure of such credit exposures, US banks' counterparty exposures on such
contracts are estimated to have totaled about $325 billion last December [1998]. This amounted to less than 6% of banks' total
assets. Still, these credit exposures have been growing rapidly, more or less in line with the growth of the notional amounts ...
8
A Bank of International Settlements survey for last June ... estimated the size of the global OTC market at an aggregate notional
value of $70 trillion, a figure that doubtless is closer to $80 trillion today. Once allowance is made for the double-counting of
transactions between dealers, US commercial banks' share of this global market was about 25%, and US investment banks
accounted for another 15%. While US firms' 40% share exceeded that of dealers from any other country, the OTC markets are
truly global markets, with significant market shares held by dealers in Canada, France, Germany, Japan, Switzerland, and the
United Kingdom.
Despite the world financial trauma of the past 18 months, there is as yet no evidence of an overall slowdown in the pre-crisis
derivative growth rates, either on or off exchanges. Indeed, the notional value of derivatives contracts outstanding at US
commercial banks grew more than 30% last year, the most rapid annual growth since 1994 ... during panic periods the usual
assumption that potential future exposures are uncorrelated with default probabilities becomes invalid. For example, the
collapse of emerging-market currencies can greatly increase the probability of defaults by residents of those countries at the
same time that exposures on swaps in which those residents are obligated to pay foreign currency are increasing dramatically.
Greenspan testified on the collapse of Long Term Capital Management (LTCM) before the Committee on Banking and Financial
Services, US House of Representatives on October 1, 1998, a month after the collapse of the huge hedge fund:
While their financial clout may be large, hedge funds' physical presence is small. Given the amazing communication capabilities
available virtually around the globe, trades can be initiated from almost any location. Indeed, most hedge funds are only a short
step from cyberspace. Any direct US regulations restricting their flexibility will doubtless induce the more aggressive funds to
emigrate from under our jurisdiction. The best we can do in my judgment is what we do today: Regulate them indirectly through
the regulation of the sources of their funds. We are thus able to monitor far better hedge funds' activity, especially as they
influence US financial markets. If the funds move abroad, our oversight will diminish. We have nonetheless built up significant
capabilities in evaluating the complex lending practices in OTC derivatives markets and hedge funds. If, somehow, hedge funds
were barred worldwide, the American financial system would lose the benefits conveyed by their efforts, including arbitraging
price differentials away. The resulting loss in efficiency and contribution to financial value added and the nation's standard of
living would be a high price to pay - to my mind, too high a price ...
We should note that were banks required by the market, or their regulator, to hold 40% capital against assets as they did after
the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the
same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the
level of output and standards of living decidedly lower. Our current economy, with its wide financial safety net, fiat money, and
highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have
the choice of accepting the benefits of the current system without its costs.
Central banks in desperate times would look to hyper-inflation to "provide what essentially amounts to catastrophic financial
insurance coverage", as Greenspan suggested in a November 19, 2002, address on "International Financial Risk Management"
to the Council on Foreign Relations (CFR) in Washington. Greenspan noted that since February 2000, the draining impact of a
loss of $8 trillion of stock-market wealth (80% of GDP), and of the financial losses associated with September 11, 2001, has had
a highly destabilizing effect on the aggregate debt-equity ratio in the US financial system, and has pushed the ratio below levels
conventionally required for sound finance. This private debt in 2000 of $22 trillion was backed by $8 trillion less equity, an
amount in excess of one-third of the debt. Greenspan attributed the system's ability to sustain such a sudden rise of debt-toequity ratio to debt securitization and the hedging effect of financial derivatives, which transfer risk throughout the entire system.
"Obviously, this market is still too new to have been tested in a widespread down-cycle for credit," Greenspan allowed.
Total debt in the US economy now runs to $40 trillion as of March 2005, of which $31 trillion is private-sector debt, 66% ($21
trillion) of which has been added since 1990 under Greenspan's watch. That is 20% of 2004 GDP. This figure is consistent with
the fact that it now takes 25% more money in the money supply to support a given GDP than 25 years ago.
In recent years, the rapidly growing use of more complex and less transparent instruments such as credit-default swaps,
collateralized debt obligations, and credit-linked notes has had a net effect of transferring individual risks to systemic risk. The
impact of the costs of Hurricane Katrina to the credit market is yet to be fully felt, but nervousness about sudden changes in the
systemic risk profile is mounting across the market. Structured finance is a two-sided blade. It spreads the risk throughout the
system to create resilience; but as structured finance un-bundles risk to maximize returns, it concentrates distress on the highrisk takers, such as hedge funds which are the leading players in the credit market.
Securitization seeks to substitute capital-market-based finance for credit finance by sponsoring financial relationships without
the lending and deposit-taking capabilities of banks (disintermediation). Generally, securitization represents a structured finance
transaction, where receivables from a designated asset portfolio are sold as contingent claims on cash flows from repayment in
the bid to increase the issuer's liquidity position and to support a broadening of lending business (refinancing) without increasing
the capital base (funding motive). Aside from being a funding instrument, securitization also serves to reduce both economic
cost of capital and regulatory minimum capital requirements as a balance-sheet restructuring tool (regulatory and economic
motive) and to diversify asset exposures (especially interest-rate and currency risk) as issuers repackage receivables into
securitizable asset pools (collateral) underlying the so-called asset-backed securitization (ABS) transactions (hedging motive).
Also the generation of securitized cash flows from a diversified asset portfolio represents an effective method of redistributing
credit risks to investors and broader capital markets.
These issuer incentives correspond to a certain investment appetites in ABS. As opposed to ordinary creditor claims in lending
relationships, the liquidity of a securitized contingent claim on a promised portfolio performance in a structured transaction
affords investors at low transaction costs to adjust their investment holdings quickly because of changes in personal risk
sensitivity, market sentiment and/or consumption preferences.
Asset-backed securitization represents a growing segment of structured finance. Efficient risk and asset allocation through
seasoned trading in this relatively young fixed-income market requires both investors and issuers to understand thoroughly the
longitudinal properties of spread prices (over benchmark risk-free market interest rate) of traded securities, which reflect various
risk factors of a transaction. Spreads are closely watched by investors and issuers alike, and by doing so, they create an
efficient primary and secondary markets of informed investment.
9
The flexible security design of asset-backed securitization allows for a variety of asset types to be used in securitized reference
portfolios. Mortgage-backed securities (MBS), real estate and non-real estate asset-backed securities and collateralized debt
obligations (CDO) represent the three main strands of asset-backed securitization in a broader sense. All ABS structures
engross different criteria of legal and economic considerations, which all converge upon a basic distinction of security design:
traditional vs synthetic securitization.
Traditional securitization involves the legal transfer of assets or obligations to a third party that issues bonds as ABS to investors
via private placement or public offering. This transfer of title can take various forms (novation - substitute of a new legal
obligation for an old one, assignment, declaration of trust or sub-participation), which ensures that the securitization process
involves a "clean break" (true sale, bankruptcy remoteness or "credit delinkage" in loan securitization) between the sponsoring
bank (which originated the securitized assets) and the securitization transaction itself. In most cases, however, the sponsor
retains the servicing function of the securitized assets. Traditional securitization mitigates regulatory bank capital requirements
by trimming the balance-sheet volume. In synthetic securitization only asset risk (eg credit-default risk, trading risk, operational
risk) is transferred to a third party by means of derivatives without change of legal ownership, ie no legal transfer of the
designated reference portfolio of assets. Hence any resulting regulatory capital relief does not stem from the actual transfer of
assets off the balance sheet but the acquisition of credit protection against the default of the underlying assets through asset
diversification and hedging. Commonly, sponsors of synthetic securitization issue debt securities supported by credit derivative
structures, such as credit-linked notes (CLNs), whose default tolerance amounts to total expected loan losses in the underlying
reference portfolio. Hence investors in credit-linked obligations (CLOs) are exposed not only to inherent credit risk of the
reference portfolio but also to operational risk of the issuer. Systemic stability cannot be enhanced when the system is
decapitated, as exemplified by the 1998 collapse of Long Term Capital Management (LTCM), which required Fed intervention to
prevent systemic instability. With world financial markets already suffering from heightened risk aversion and illiquidity from the
1997 Asian financial crisis, officials of the Federal Reserve Bank of New York judged that the precipitous unwinding of LTCM's
portfolio that would follow the firm's default would significantly add to market problems, would distort market prices, and could
impose large losses, not just on LTCM's creditors and counterparties, but also on other market participants not directly involved
with LTCM. In an effort to avoid these difficulties, the Federal Reserve Bank of New York (FRBNY) intervened with the major
creditors and counterparties of LTCM to seek an alternative to forcing LTCM into bankruptcy. The hedge-fund industry has since
grown with an increased number of funds, which will make the dispersed risk crisis more complex for future Fed intervention by
virtue of the large number of interested parties that need to be satisfied.
Greenspan acknowledged that derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an
oversized Achilles' heel. It appeared that the benefit had been reaped in the past decade, leading to a wishful declaration of the
end of the business cycle. Now we are faced with the oversized Achilles' heel, with "the possibility of a chain reaction, a
cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked". According to Greenspan,
"only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it
becomes destructive. Hence central banks have, of necessity, been drawn into becoming lenders of last resort."
Greenspan asserted that such "catastrophic financial insurance coverage" by the central bank should be reserved for only the
rarest of occasions to avoid moral hazard. He observed correctly that in competitive financial markets, the greater the leverage,
the higher must be the rate of return on the invested capital before adjustment for higher risk. Yet there is no evidence that
higher risk in financial manipulation leads to higher return for investment in the real economy, as recent defaults by Enron,
Global Crossing, WorldCom, Tyco and Conseco have shown. Higher risks in finance engineering merely provide higher returns
from speculation temporarily, until the day of reckoning, at which point the high returns can suddenly turn in equally high losses.
The politics of upward redistribution
With the support of the supposedly independent Fed under Greenspan, the Bush administration's economic policy is consistent
with its "war on terrorism".
Taking care of business is the core of the supply-side ideology of market fundamentalism. It is consistent with the strategic
thrust of the Bush administration's geopolitical war on global terrorism through an international coalition of state power,
notwithstanding that terrorists of all different stripes generally identify social injustice with failed state power, both domestically
and internationally. Radical or extremist Islamic fundamentalism considers both the secular Islamic states and the theocratic
Islamic states part of the regime of nation-states that has given birth to the political and socio-economic-cultural imperialism that
acts as the midwife of insurgent political terrorism. In this respect, Islamic fundamentalism is not much different from other forms
of religious fundamentalism.
The Church of Rome went through the conflict between church and state with much blood and violence, finally reaching a
compromise of separating the two conflicting institutions in the spiritual and the political spheres. Religious fundamentalism has
yet to accept this separation completely, even in the United States, where the intrusion of religion into state-supported education
remains active. God is omnipresent in the US political system. Printed on all its money are the words "In God we trust."
Fundamentalist Christians in the US are aggressively working to recapture the state and its foreign policy through renewed
alignments of the national interest with Christian values. Islamic fundamentalism, insulated from Western liberalism, also
continues to reject secularism in politics and culture.
A key part of the US "war on terrorism" is the protection of the governments of "moderate" oil states from grassroots Islamic
fundamentalism. A new network of neo-colonialism made necessary by the existence of alleged "failed" states is at the center of
America's geopolitical "war". On the economic front, the administration's strategy of sustaining normalcy and domestic security
is built on keeping big business from failing, either from terrorist disruptions or from market excesses. Selective government
intervention into markets to relieve business of external costs will be the cornerstone of the new normalcy. "Too big to fail"
becomes a dogma for believers of the free market. Corporate strategy quickly adjusts to this game by getting bigger through
mergers and acquisitions to secure the added protection from government based on size. Would the government allow Citigroup
to fail? No one expects Fannie Mae to fail.
Eight weeks into the 1997 Asian financial crisis, Gary H Stern, president of the Minneapolis Fed, wrote about "The Too-Big-toFail Problem", in which he warned:
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Interstate banking restrictions have been lifted and the barriers between commercial and investment banking are starting to fall;
US banks are consolidating in record numbers and the size and complexity of our largest banks are growing. While this
consolidation and growth may not, in and of itself, be bad, one thing is clear: The loss of just one of these banks will pose an
even greater systemic risk than before ...
The moral-hazard problem is particularly severe in banking because of the lack of deductibles. Governments often provide
100% depositor protection, especially at large banks where a loss could have industrywide repercussions (a practice known as
too-big-to-fail - TBTF) ... In 1991, the US Congress created an explicit and more stringent TBTF policy [Federal Deposit
Insurance Corp Improvement Act - FDICIA]. Prior to 1991, there was an unwritten TBTF policy, and the government was much
freer to rescue large banks and protect uninsured depositors. Under FDICIA, uninsured depositors cannot receive protection if it
raises costs to the FDIC. There is an exception, however, if the failure of the bank poses a systemic risk. The emergency bailout
can go forward with the approval of the secretary of the Treasury (who must consult with the president), the Federal Reserve
Board of Governors and the FDIC's board of directors. Therein lies the problem: FDICIA still leaves the door open for moral
hazard in the extreme. Uninsured depositors at the very largest US banks still know they are likely to be fully protected and have
little reason to monitor how their deposits are invested. And, as a result, large banks have an incentive to take on more risk than
they would otherwise.
There is also the "too-important-to-fail" dogma. The selection of Lockheed over Boeing as contractor of the new $200 billion JSF
(Joint Strike Fighter) program was reportedly based on the consideration that Lockheed could not survive a disappointment,
while Boeing could. Thus the sustenance of two military suppliers is not based on issues of merit or competition, but on the need
for security redundancy - a standby defense manufacturer.
Enron lost 80% of its market capitalization value in 12 months, wiping out $50 billion of wealth (share prices dropped from
$89.63 on September18, 2000, to $15.4 on October 26, 2001), finally and suddenly attracting much attention in the media. It
faced serious cash-flow problems not from the fall of energy prices alone, but from its role as a major trader of energy futures,
leading to a $618 million third-quarter loss, not to mention a Securities and Exchange Commission investigation on creative
accounting and financial reporting that resulted in a $1.2 billion equity dilution.
If Enron were to go under, and all the smart money was betting on it if market forces were allowed to govern, the counterparty
risk fallout threatened to dwarf the LTCM crisis. Enron received $250 million from Congress's stimulative package that failed to
save it from its multibillion-dollar debt exposure and trading losses. Enron then bought back $2 billion of its commercial papers,
depleting its $3.3 billion bank credit, because commercial papers were traded in the open credit market and Enron might not
have been able to roll them over. Its bank loans were only tradable in the private debt market. Corporate credit lines were
generally not expected to be drawn down without signaling to the market that the borrower was in serious trouble. The higher
resultant cost of higher interest payments from this desperate move only added to Enron's cash-flow problem. The press
reported that the company was negotiating with its banks for $2 billion in new credit. Enron's connection to Texas and the Bush
political network was well known. Enron was hoping to be bailed out by the "too big to fail" principle, until criminal indictments
foreclosed the option. No doubt there was criminality in the Enron affair, but whether the criminality was the cause of its collapse
or merely convenient cover for a flawed market is another question (see Capitalism's bad apples: It's the barrel that's rotten,
August 1, '02).
The equity markets since the September 11 terrorist attacks are no longer free markets. They are now a scam operated in the
name of patriotism to transfer through managed volatility by the Plunge Prevention Team, of which the Fed is a charter member,
the losses that have already occurred but are yet hidden to unsuspecting small investors who were too patriotic to sell
immediately. The new financial normalcy is a totally new system. The United States has entered a new phase of state
capitalism, with the government deciding who survives and who fails. The US system is being attacked by both terrorism and
the "war on terrorism".
The individual management of risk, however sophisticated, does not eliminate risk in the system. It merely passes on the risk to
other parties for a fee. In any risk play, the winners must match the losers by definition. The fact that a systemic payment-default
catastrophe has not yet surfaced only means that the probability of its occurrence will increase with every passing day. It is an
iron law of an accident waiting to happen understood by every risk manager. By socializing their risks and privatizing their
speculative profits, risk speculators hold hostage the general public, whose welfare the Fed now uses as a pretext to justify
printing money to perpetuate these speculators' reckless joyride.
What kind of logic supports the Fed's acceptance of a 6% natural rate of unemployment to combat phantom inflation while it
prints money without reserve, thus creating systemic inflation to bail out reckless private speculators to fight deflation created by
a speculative crash?
Next: How the US money market really works
Henry C K Liu is chairman of a New York-based private investment group.
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