Today the Fed released the full set of transcripts from its eight 2011 meetings, a year which was particularly tumultuous due to the end of QE2, the downgrade of the US AAA rating by S&P, and the peak of the European debt crisis. It was also the first year in which the Fed's hope of hiking rates "soon" was crushed as global deflation returned, eventually forcing the Fed to launch Project Twist and QE3.
As has become a tradition, instead of breaking down the specific transcripts - readers can do so at their leisure here - we summarize the prevailing mood at each meeting based on the number of instances of "laughter" revealed in the transcript. As shown in the chart below, 2011 was decidedly more funny than 2010, if only to the FOMC, which laughed on average 39.4 times every meeting, up 43% from the 27.4 times per meeting in 2010.
Furthermore, as some have suggested, the Fed's forced laughter was an indication of underlying tension, which means that while August was the most uneventful meeting, the November meeting was by far the most tense, as FOMC members laughed at least 57 times, which would make intuitive sense: this is the meeting that preceded the global Fed bailout of the European financial system with the launch of trillions in currency swaps.
Which is why we decided to focus particularly on this specific meeting, and while much of the discussion involved, as one would expect, the collapsing European financial situation and US monetary conditions - a rather interesting debate on the use of negative rates in the US can be found in the September transcript - what we found most interesting was the Fed's real-time analysis and "hot takes" of the MF Global bankruptcy which took place on October 31, 2011 and combined a variety of issues: from being a Primary Dealer, to its holdings of Italian bonds which plunged in value, to its flawed capital structure, to the "hubris" of its principals.
The first mention of MF Global in the November 1-2 meeting, or just days after the bankruptcy took place, was in Brian Sack's summary of recent events, in which he explains how the Fed, despite having substantial exposure to the failed primary dealer, managed to avoid losses, as follows:
As you know, MF Global experienced a rapid deterioration that led the firm, and the U.S. broker–dealer subsidiary that is a primary dealer, into bankruptcy. In short, investors became skeptical about the viability of the firm given the size of its exposures to European sovereign debt markets, its weak earnings for the third quarter, and the associated downgrades of the firm by several rating agencies. With these events, the firm found itself unable to sustain sufficient financing, even as it attempted to rapidly sell parts of its business and shed assets.
The path of MF Global serves as an example of the vulnerability of firms that are heavily reliant on short-term wholesale funding. As shown in the bottom-right panel, the firm had a narrow equity buffer, and its liability structure was relatively unstable. Indeed, the firm had little longer-term unsecured debt and, since it was not a bank, no retail deposits. Instead, the firm had 61 percent of its liabilities in the form of repo transactions and other trading liabilities.
This structure left the firm very susceptible to a liquidity run in response to any emerging questions about its capital adequacy. Of course, this is the same issue that I noted earlier in the discussion of investor concerns about Morgan Stanley and Goldman Sachs. However, as can be seen in the table, Morgan Stanley has a much larger share of long-term debt as well as some retail deposits. The table also shows the figures for JP Morgan to offer a comparison to an institution with a larger banking operation.
The problems experienced by MF Global raised risks to the Federal Reserve through our counterparty relationship with the firm. Our potential exposures were associated with MF Global’s participation in our securities lending operations, in our operations in Treasury securities, and in our operations in agency mortgage-backed securities. The Desk began to exclude MF Global from some operations last Wednesday and from all operations last Thursday. Yesterday, the Federal Reserve Bank of New York announced that it had terminated its primary dealer relationship with MF Global.
Heading into the market open yesterday, our only exposure to the firm was from seven unsettled MBS purchase transactions. These transactions, which totaled about $950 million, were due to settle as far out as mid-January. To limit the risk to the Federal Reserve from these transactions, on Friday we established a special arrangement for the firm to post collateral to us on a daily basis. Based on yesterday’s events, we exercised our legal authority to terminate the seven trades, and we conducted trades with other counterparties to reestablish the same positions, using the collateral that had been posted by MF Global to cover the additional expense of those replacement trades. Given these steps, we do not expect to realize any losses from our counterparty exposures to MF Global.
This then led to an informal discussion between the FOMC members on MF Globa, starting with Richard Fisher, where the topic of customer account commingling and rehypothecation first emerges. As Brian Sack admits, "if there were problems in that regard, you could see a loss in confidence in other types of custodial arrangements or intermediaries."
MR. FISHER. First, I want to congratulate you on handling MF Global the way you handled it. I have a question about that, and I have two other questions. But on this front, any other trip bars that might ensue from MF’s failure that you’re monitoring in terms of its impact on the system—not the Federal Reserve System, but on the fixed-income markets and on financial stability?
MR. SACK. Yes, there are several areas we’re monitoring. MF Global, of course, had essentially a large brokerage unit into futures markets. One area we’re watching is whether their customers will experience any period of disruption and confusion about their ability to change positions. There could potentially be odd short-term dynamics for futures markets.
The second area is questions about whether the customers’ assets are truly fully there at the institution, and if there were problems in that regard, you could see a loss in confidence in other types of custodial arrangements or intermediaries.
And the third area is whether there would be any consequences for repo financing, not necessarily direct consequences associated with the unwinding of MF Global’s positions, but broader concerns about whether repo funding for less liquid assets is as stable as the market had assumed.
I’m sure there are others, but those are three areas that we’re watching. Not having the benefit of seeing markets today, but through yesterday, it looked like the markets were not overly concerned with any of those systemic consequences, but that’s what we’ll continue to monitor
Next, its was NY Fed president and former Goldmanite (and therefore subordinate of former Goldman head and then-MF Global CEO Jon Corzine) Bill Dudley's turn to chime in.
VICE CHAIRMAN DUDLEY. Yes, just a few things. This is the first significantly sized FCM, futures commission merchant, that’s failed in a way that they didn’t actually port the customer accounts off smoothly to some other entity. There’s a little bit more uncertainty here because it has never happened like this before. In the past, there has always been a smooth transfer of accounts.
The second thing I would say is that it underscores how fast liquidity can dry up for a firm. This is another firm that, while I wouldn’t say they were fine a week ago, they didn’t look like they were headed to collapse, and a week later they’re dead. That is going to reinforce people’s anxiety about firms that are wholesale funded without any obvious lender-of-last-resort support from the central bank. I think as long as other firms stay out of trouble, it’s not an issue, but if they get into trouble, people may actually pull back faster as a consequence.
And the third thing, of course, is that this was triggered in part by, as Brian mentioned, European sovereign debt exposure. To the extent that things in Europe deteriorate, other firms are viewed as having exposure to Europe, and that’s another aspect of this. But so far we would say, and I think Brian and I would both agree, that the selloff in the market today really has very little to do with MF Global.
Former FOMC staffer Elizabeth Duke then touched on the issue what would happen to MF Global's derivative counterparties:
MS. DUKE. My question goes back to the impact on customers of MF Global, and this question may not make sense because I wasn’t sure I understood the article I read just before I came in here. But it was something about either clearinghouses or exchanges freezing customer transactions, customers of MF. And then, I was remembering how some of the people who came through here were really unhappy in the Lehman bankruptcy about their collateral getting tied up in pieces. Is there anything in moving derivatives to central counterparties that we should be aware of in connection with this?
MR. SACK. That is related to one of the three broad concerns I talked about: Would there be uncertainty about the client’s ability to change positions? Would there be confusion about what the status of their assets was or not? And as Vice Chairman Dudley mentioned, without the quick transfer of the client accounts, it leaves this uncertainty. I don’t know enough about the legal arrangements to answer the questions you raise. But how long that will take and how transparent it will be in terms of when the customers will be able to reaccess their positions is one of the big areas of uncertainty here.
Outgoing Fed president Dennis Lockhart then asked Brian Sack what the MF Global bankruptcy means for financial instability, in light of recent bank "runs" at Morgan Stanley and Goldman Sachs:
MR. LOCKHART. Thank you, Mr. Chairman. Just to continue on the question of MF Global, a couple of weeks ago, as you see on chart 12, there was—and I hesitate to call it a “run” —but certainly a lot of pressure on Morgan Stanley and Goldman Sachs, which has eased. Then, we get the first casualty with MF Global. My broad question, Brian, is: Are you more or less concerned about financial instability now than two weeks ago? How is that trending?
MR. SACK. At best slightly more comfortable, but actually probably about the same. As I noted, what happened a few weeks ago with Morgan Stanley and Goldman Sachs was the same dynamic. Taking Morgan Stanley as an example, based on their discussions about the firm’s exposures, I think market participants weren’t convinced that the firm actually had problematic exposures, but what they were convinced about was the fact that if the market got too concerned, they could put Morgan Stanley out of business because of their reliance on short-term funding markets. I think that contributed a lot to the jitters that emerged in early October, and it is the same dynamic that ultimately brought down MF Global. But I do want to emphasize that MF Global is a very different case than a Morgan Stanley, in terms of the aggressiveness—relative to its size—of how MF Global was positioned.
Dudley then chimed in with am ominous warning: "The MF Global experience showed you that whatever liquidity cushion you have can run off a lot faster than you expect."
VICE CHAIRMAN DUDLEY. Morgan Stanley, we believe, has a very large liquidity cushion. The MF Global experience showed you that whatever liquidity cushion you have can run off a lot faster than you expect. Morgan Stanley is starting with a much better balance sheet than MF Global was, and they have been actually earning money. One of the precipitating events for MF Global was that they took a very large loss in the most recent quarter. That was really what started this thing spinning last Tuesday.
Lesson learned: never take large losses. That said, Lockhart had some follow up questions, namely whether MF Global was taken down by "predatory market players" to which the former head of the Fed's trading desk said "No."
MR. LOCKHART. Do you see any dynamic of predatory market players essentially gaining any victory with this one and moving on to the next most vulnerable?
MR. SACK. No.
MR. LOCKHART. No, we don’t see anything like that?
VICE CHAIRMAN DUDLEY. I don’t think this was about people shorting the CDS and driving down the stock price. This is all about the fundamentals of the company; that would be my opinion.
Some, like Jim Bullard was confused why a primary dealer imploded in such spectacular fashion. The answer: "They passed the credit review. But that doesn’t guarantee that they can’t go downhill. As we see in the market price and everything, they went downhill very quickly and very unexpectedly."
MR. BULLARD. Thank you, Mr. Chairman. On MF Global—it became a primary dealer this year, is that correct?
MR. BULLARD. Are we happy with our expanded criteria for primary dealers? And does this give you any pause about that new, more expansive definition?
MR. SACK. The new primary dealer policy just increases the transparency about the requirements. There was no reduction in the requirements to be a primary dealer. When we look at the primary dealers as candidates, there is an extensive review. It covers quality of management, the quality of their systems, their financial health, and so on. But we are at a disadvantage. We are not a supervisor of this firm. There is a credit review. They passed the credit review. But that doesn’t guarantee that they can’t go downhill. As we see in the market price and everything, they went downhill very quickly and very unexpectedly.
Jeff Lacker also had a question whether and just MF GLobal was insolvent:
MR. LACKER. Yes, a question about MF Global, and then I want to follow up on a question from President Fisher. MF Global is insolvent, I take it? Is that our best information?
VICE CHAIRMAN DUDLEY. I don’t think we know whether they are insolvent or not. We know they can’t meet their obligations, but that doesn’t mean when they are all liquidated that the value of the assets couldn’t be a lot greater than the value of the liabilities. We don’t know that. The fact is that their long-term debt, which they have a small piece of, is trading at about, last time I saw, in the 35 to 45 percent per dollar range, which suggests that the market thinks that they are most likely to be insolvent. But we are not going to know for a while.
MR. LACKER. Okay. Do you view how it has played out as inefficient ex post?
VICE CHAIRMAN DUDLEY. It was inefficient in the sense that there was not an orderly bankruptcy process. It would be much better if there had been a way to move the customer accounts to new firms, so that they didn’t get trapped. It was messier than optimal. Is it systemic or not? Fingers crossed, we hope not.
Yes, that's the Fed expressing hope that "fingers crossed" the "messier than optimal" collapse of MF Global is not systemic.
Finally, we go back to Richard Fisher who chimed in, and slammed Dudley's former boss saying the MF Global "principals involved here were extremely arrogant, taking the positions that they had, and were imbalanced in terms of their judiciousness of risks, and I think the markets are well aware of that."
MR. FISHER. I would add a fourth factor, which is humility versus arrogance and balanced risk. The principals involved here were extremely arrogant, taking the positions that they had, and were imbalanced in terms of their judiciousness of risks, and I think the markets are well aware of that.
As to why Jon Corzine would be "extremely arrogant"? We have an idea...
Source: Federal Reserve