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Disorderly Collapse - The Endgame Of The Fed's Artificial Suppression Of Defaults
Submitted by Jeffrey Snider via Alhambra Investment Partners,
The Federal Reserve under Alan Greenspan and then Ben Bernanke has escaped, largely, responsibility for the panic in 2008 mostly because there is no direct link between monetary policy and the housing bubble. The most stinging criticism that comes out of the era is Greenspan’s “ultra-low” interest rate setting for federal funds, but there is no smoking gun in the form of the “printing press” or bank “reserves.” In fact, bank reserves remain, somehow, the central focus of monetary policy even today when they should be taken for how big a mess the Fed created of the prior bubbles.
There is no printing press in the basement of the Marriner Eccles building or even at the Open Market Desk of FRBNY in NYC. That does not mean, however, that monetary policy is absolved from the center of the biblical expansion of “dollar” reach and debasement (in both definition and scale). When you look at bank reserves, the immediate reaction, often more visceral than cerebral, is that there should be an enormous bout of inflation by now; that was, in fact, the first public and expressed criticisms of the QE’s.
That view of “reserves” conflates what they actually represent. In the operational format alone, reserves are only what the Open Market Desk is doing of monetary policy at that time. In terms of the serial asset bubbles, they represent the onboarding of immense “money dealing” that took place in the latter 1990’s and early and middle 2000’s under the implicit but never-tested promises of monetary policy. In other words, the rise in reserves now was only to make explicit, in arrears, what was expected from bank balance sheets during the bubbles themselves.
In that respect, the increase in reserves post-crisis was not to unleash new inflation, consumer or asset, but rather to enumerate, and only partially, what it took to get past inflation going and maintaining. The Fed was only, through the QE’s, taking belated ownership of that which it implicitly aided of past “dollar” existence. Linking monetary policy to that inflation was not just the federal funds rate, but how that “communication” (as Janet Yellen tells it) was used in actual “money supply” circumstances.
In March 2007, Richard Claiden, CFO of Primus Guaranty, delivered a presentation at the Richmond Fed’s Credit Markets Symposium that showed this monetary linkage in unequivocal detail. Credit spreads on the Dow Jones OTR 5-year CDX had fallen from near 80 bps in early 2003, at the bottom of the dot-com “cycle”, to almost 30 bps by early 2007.
The reason for that massive compression was what is familiar to any financial observer of the post-QE3 environment. Not only did Mr. Claiden refer to a “reach for yield” in March 2007 he also quantified what is perhaps the least appreciated aspect of wholesale monetary influence: clustering defaults.
In the attempt to diminish the influence of the business cycle, the Fed uses monetary policy to influence bank and bond investors with regard to liquidity and risk. One of the major expressions of that is to artificially induce default clusters; there was a massive default wave in the nascent wholesale finance industry out of the dot-coms but then a serious absence of persisting defaults despite a relatively weak recovery thereafter. That disparity is covered by monetary policy influence which, in addition to “reach for yield” via rate repression, keeps many weaker businesses afloat long past the point at which they “should” fail. That isn’t, however, a permanent reduction of what orthodox economics perceives of a negative factor (when in fact it might rather be recognized, rightfully, as necessary creative destruction) only a temporary assuagement of defaults that instead cluster into the next cycle – which happened to be, not by coincidence, much, much bigger.
Mr. Claiden and Primus were no outside observers to this problem, and his firm was expecting an uptick in spreads as mortgage problems grew somewhat more acute. The founder of Primus was the man who practically invented the swap, or at least the standardized version of it that became the bedrock of the entire derivatives industry. In May 2007, Tom Jasper, the CEO who in 1985 launched and became the first co-chairman of ISDA, was “toasting” to wider credit spreads and a much fatter return for Primus. The mortgage problems, he figured, would be grand for Primus’ main business which was writing credit protection.
Because spreads were so thin and had grown thinner throughout Greenspan’s “conundrum”, Primus was forced (in their profit models) to lever up significantly. At the end of 2005, the company, which was a publicly-traded and listed stock, reported a total swaps portfolio of single name entities of $13.4 billion, a 28% increase over the end of 2004. That $13.4 billion came upon a base of just $69 million in cash and $560 million in available-for-sale securities. That was 21x leverage.
By the time Bear Stearns had failed, Primus had $24.3 billion in swaps and just $774 million in cash and assets; or 31x leverage. Since Primus only sold protection on “high quality” companies, in other words those with the highest ratings, there was little perceived risk even with spreads thought to be rising in 2007. In fact, a good proportion of the protection was written against financial firms, meaning the largest banks including Lehman. As you would expect, the firm nearly went bankrupt by October 2008 and the panic, but survived long enough to be finally and fully unwound last year (again, models and math that were no match for reality). Mr. Jasper left the firm in 2010.
While the current state of Primus’ liquidation gives us another anecdote about the eurodollar decay post-crisis, it was its buildup that turned monetary policy into actual money supply as it is/was understood and used in the eurodollar/wholesale model. Those credit default swaps that Primus was supplying at dirt cheap spreads allowed, artificially and mistakenly, other financial firms and banks to reduce risk in their credit portfolios – at least that was the way it was calculated in their models which translated directly into real financial power or what passes for money these days. That meant those firms, through the “supply” of risk absorption provided by Primus and others, could invest, warehouse and hold much more in terms of par and notional credit for a given “capital” base – the math became the means by which credit expanded so precipitously, traded as exchanged liabilities often in the form of derivative contracts.
Without that supply, including and especially during the panic, the Fed has been forced to take over money dealing more directly, turning out numerical bank reserves in place of what was before just unspecified and held off-balance sheet, but very real, balance sheet capacity. The more the Fed suppressed via its interest rate measure, the more leverage firms like Primus had to supply to be profitable (or as profitable as their models demanded) – at the end of 2005, that 28% increase in the swap portfolio was how the firm increased ROE to 15%. If spreads had been more in line with actual economic reality, Primus may not have “needed” to use as much leverage and the “supply” of risk absorption capacity may have instead been itself reduced, halting even somewhat the massive expansion of subprime and others (since Primus was offering a great deal of swaps on financial firms, especially the bigger banks, those CDS were likely used as hedges against credit structures, including subprime, that were offered/sponsored by those very same firms; in other words, there is a great likelihood that Primus risk capacity was directly related to the subprime mortgage blowout, both up and then down).
Nobody apparently learned much from the whole bubble-bust affair as banks and financial firms are at it again, this time in corporate debt. The artificial suppression of default, in no small part to perceptions of those bank reserves under QE (just like perceptions of balance sheet capacity pre-crisis), has turned junk debt into the vehicle of choice for yet another cycle of “reach for yield.” The supply, this time, is far less of the eurodollar variety and more through mutual funds – less banking, more personal sector. That may sound somewhat more comforting except that it is the weakened, perhaps fatally, eurodollar state that is, in the end, expected to support the whole corporate morass when the default cycle inevitably runs its course and the artificial cluster reappears. As retail investors might likely flee against expectations they never apparently conceived but should have given recent history, there won’t be much, if any, balance sheet capacity to boost appetites toward an orderly transition.
In the past two bubble cycles, we see how monetary policy creates the conditions for them but also in parallel for their disorderly closure. It isn’t money that the FOMC directs but rather unrealistic, to the extreme, expectations and extrapolations. Once those become encoded in financial equations, the illusion becomes real supply. In that way, it appears as if central banks hold great power but little responsibility. The pathology, however, is there and apparent to any and all inquiry. All that is required is a contemporary frame of reference, including what and where the printing press is and resides.
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did you not hear a single word i just said? just buy the fucking dip!
https://www.youtube.com/watch?v=0akBdQa55b4
Almost as funny as "And...it's gone!"
The next bubble will be the financialization of the poor ... serf bonds ... where one can invest and speculate on the future earnings of the unemployable.
To the moon Alice!
Regards,
Cooter
HAHA we are already there bro! i gotz muh everest college diploma on the wall dawg! wanna buy a used car on a 30year arm? we can make it happen. yes we can! yes we can!
Direxion is going to open a 3X Bear Serf ETF for exactly that purpose.
You really can make money whether the market goes up or down.
th only question should be asked is, how will markets respond with the next round of QE? because these monetary crack fiends dont seem to mind that its all an illusion. and you can pretty much count on joe the plumber not giving a fuck about shot other than the big game this weekend. im not very hopeful for this carnage, lehman, 1929 mad max, collapse, or any other click bait synonym we speak of each day. no matter how much i want it to happen...
"there should be an enormous bout of inflation by now" What the fuck does this guy eat? Beef is up 30% in one year. That isn't inflation?
Beeflation?
It's all in the terminology for these guys.
They will never get it, but at some point inflation is going to kick in. All those investors buying all those dips, they can't all be rich and live happily ever after. Someone has to lose in this game, the taxpayer. Inflation is going to "spiral out of control", "oh lawdy we couldn't possibly see this one coming, now we have to stick together as a country, as a people, during these times of hardship" and that's going to be that. Recession, depression, death. Blame the weather or something.
Only with zimbabwe dollars everyone can be a millionaire.
Fuck it, I'm pulling for hyper inflation at this point. Ive worked my ass off to tread water and keep my head above the surface but Im not going anywhere. Id rather the fed lose control of inflation now and wipe out everything.
Heres the catch: itll wipe out the > $1,000,000 of debt per taxpayer in the US that the boomers tried so hard to leave for their children and grandchildren. I dont know about you guys but I dont have a million dollars of financial assets. Lose control of the system and lose everything, assets and debt alike. Who is hurt the most? The folks who are old enough to have that kind of money stuffed away (the same folks who borrowed on our backs in the first place). Seems like the most just solution to me.
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Looked at the website. Great idea except Texas alone will not be able to go it alone against the pschopaths in D.C. If you really want to make a difference, learn about, and encourage your state legislators to join in the convention of states movement to reign in, or dissolve D.C. thru an Article V amendment process. However, it is still good to have a backup plan in case the Fe ds refuse to accept changes to the Constitution that are ratified by the states. In that case, it should be much easier to gain the acceptance of at least the 38, or more, ratifying states that they have to use much more radical means to do what is necessary to restore the rule of law.
On the contrary, bankers learned that they can get away with massive leverage and fraud and that they would not be prosecuted, could walk away with huge sums of money and that in many cases their losses would be paid for by the government.
My guess, is that gave them an incentive to just do it again.
"Only this time paid with interest."
All in the name of "Fighting the Taliban" I might add.
Sorry but both Wall Street and the Federal Government look like they're on a suicide mission here...like that plane crash today.
We'll see if Greece turns out to be a big winner. Sure looks nice and sunny there...
Technically, their losses are paid for by the people, collected by the government, then transferred to the ziogangbangkster cabal.
Disorderly Collapse = CARNAGE
Winston Smith, we need new words.
Doubleplus Good.
The Fed saw the crisis as one of solvency where "mere money printing" would not do.
So the monetized the debt (illegally) to the tune of TRILLIONS.
Great news if you're a Bknd investor or Wall Street...
End of World if you're trying...and still trying...to run a State or Municipal Government.
Unlike Europe the various 50 States cannot print their own money.
Detroit has gone bankrupt, Stockton CA, now would seem Puerto Rico.
Some part of "the Big Picture" I ain't getting here?
ANYBODY????
profits are private---losses are public---Municipalities can't mark to fantasy but banks can. Its the banks balance sheet that shows assets against liabilities where liabilities are counted as assets because they are hedged or have cds supporting them. This allows more borrowing due to "exceptionally high ratings". Banks invest in HY vehicles to infinity because a hedged HY vehicle is an asset--any hedge of course is a derivitive of the other hedges in the chain. ------just my take on the thingy
Greenspan and Bernanke escaped so far but bankster huntin season hain't even opened yet.
a good example of the scheme might be the Independent Life insurance coverage of south Fl before Andrew-- lots of on the book insurance but no real insurance. Ditto for Travelers. Travelers paid off at 5 cent on the dollar in Miss. and La. but the banks loaned to new construction almost at once.
Mr. Snider is most definitely on to something with his insights. Otherwise, the guillotines would have been dusted off long ago and people like Greenspan, Bernanke, Yellen, Draghi, Kuroda, Carney and King brought to justice for all the pain and suffering they have caused to the 99.99%'ers. Yep, the banks do the printing, not Marriner Eccles, until the banks stop printing, forcing direct debt monetization via quantitative easing. Now, as with Primus and leveraged CDS in the lead up to 2008, the explosion in derivatives written 95% by the TBTF banks since the crash to somewhere around a quadrillion dollars is going to be a real whopper by the time the Debt Piper finally demands his due.
Good piece. Fed suppression of rates always encourages risk-taking, leverage and improper asset allocation. That is why it should be reserved as an emergency measure of very temporary duration.
7 years of ZIRP to be followed by years more of close to ZIRP and is a cock-up of monumental stupidity.
Most folks kinda understand there is something VERY wrong with all the abbra kadabbra since 2008. Most, I should say that are not on the gubbamint dime. I don't know when the S will HTF but it will be the most anticipated meltdown in history.