Tonight's Noland is a must read.
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The Evolving Nature of the Financial System: Financial Crises and the Role of the Central Bank:
May 19 – Bloomberg (Hamish Risk): “The global derivatives market expanded to a record $298 trillion in the second half of 2005, led by a 34 percent increase in contracts to insure debt payments, the Bank for International Settlements said… Credit-default swaps rose to $13.7 trillion…”
May 19 – Financial Times (Gillian Tett ): “The recent sharp falls in stock markets appear to have been exacerbated by an unusual wave of derivatives activity on the part of hedge funds and big banks, traders yesterday indicated. In particular, some banks and big investors appear to have been forced into selling large amounts of equity futures because they have been acting as counter-parties to large, leveraged bets on the direction of stock market volatility in recent months - and these bets are now unravelling because volatility has increased sharply. This forced selling has hurt equity futures index prices on markets such as the London International Futures Exchange - and depressed the value of cash equities as well, some observers suggest. ‘This is an incredibly sensitive topic but it looks as if some big investors are being forced into big moves because they need to hedge these [derivatives] positions,’ one senior trader said yesterday. It is impossible to track this type of derivatives trading with accuracy, since the investors and banks engaged in these markets are extremely anxious to keep their positions private.”
May 19 – Bloomberg (Kevin Carmichael and Carlos Torres): “Former Federal Reserve Chairman Alan Greenspan comments on the regulation of hedge funds, market efficiency and productivity… Greenspan said he opposed stronger regulations for hedge funds because that would hinder their ability to do what they do well -- make the financial system more efficient. Hedge funds all are looking for profits above the average rate of return, he said. Hedge funds find those returns because of ‘market inefficiency.’ Therefore, hedge funds ‘increase the efficiency of the financial system.’ That’s part of the reason the U.S. has been able to boost productivity rates even with low savings rates, he said. ‘We use our savings in a very effective way.’”
Thursday evening (at The Conference on New Directions for Understanding Systemic Risk) Fed Governor (and new Vice-Chairman) Donald Kohn, gave an interesting talk, “The Evolving Nature of the Financial System: Financial Crises and the Role of the Central Bank.” Considering the environment, Mr. Kohn’s comments are worthy of highlighting and discussing:
Dr. Kohn: “Maintaining the stability of the financial system and containing the systemic risk that may arise in financial markets has been central to the Federal Reserve’s mission for as long as there has been a Federal Reserve. Indeed, Congress passed the Federal Reserve Act in 1913 to provide the nation with a safer and more stable monetary and financial system… At the beginning of the twentieth century, banks were virtually the only financial intermediary available. Periodically, these highly leveraged institutions lost the confidence of depositors, fell into crisis, and reduced their lending to creditworthy borrowers, thereby accentuating economic downturns. The tools that were developed to prevent and to manage financial crises--lender-of-last-resort facilities, supervision and regulation aimed at bank safety and soundness, deposit insurance, and the provision of payment system services--were geared toward a bank-denominated system.”
“Today, multiple avenues of financial intermediation are available, and the financial system has become much more market-dominated. This evolution of financial institutions and markets probably has made the financial system more resilient. Financial innovations, such as the development of derivatives markets and the securitization of assets, have enabled intermediaries to diversify and manage risk better. Moreover, as markets have become more important, ultimate borrowers have acquired more avenues to tailor their risk profiles and are less dependent on particular lenders, and savers have become better able to diversify and to manage their portfolios. Consequently, the economy has become less vulnerable to problems at individual types of institutions.”
My comment: As expected, the Bernanke Fed is content to follow the Greenspan ideology that derivatives, hedge funds and “contemporary finance,” generally, are highly beneficial to financial and economic system stability. The focal point of the Fed’s rationalization is the capacity for today’s systems to isolate, disperse and mitigate risk. There is, however, no denying the prominent role derivatives and leveraged speculation play in promoting Credit availability and system leveraging. As always, it is the innate nature of “highly leveraged institutions” to create fragility and the risk of crisis. A very strong case can be made that the U.S. economy is today extraordinarily vulnerable to any interruption in system Credit creation or marketplace disruption.
Dr. Kohn: “The 1987 stock market crash may have been the first modern financial crisis in the United States. Unlike previous financial crises, the 1987 stock market decline was not associated with a deposit run or any other problem in the banking sector. Instead, the 20 percent decline on October 19, 1987… was driven by investor decisions to reduce equity exposures and by the resulting chaotic trading in the stock markets…”
“The liquidity crisis in the fall of 1998 was triggered by the Russian debt default in August and then aggravated by the problems at the hedge fund Long-Term Capital Management. During the 1998 crisis, risk spreads widened sharply, stock prices fell, and liquidity became so highly valued that the spread between on- and off-the-run Treasury securities widened substantially. Of even more concern, the capital markets virtually seized up as market participants retreated from risk taking, and, for a time, credit was simply unavailable to many private borrowers at any price.”
“The events of 1987 and 1998 had several common elements. First, they began with sharp movements in asset prices. Second, these price movements were exacerbated by market participants trying to protect themselves--with portfolio insurance in 1987 and by closing out positions in 1998. Third, market participants became highly uncertain about the dynamics of the market, the “true” value of assets, and the future movement of asset prices. As a consequence, with their standard risk-management systems seemingly inapplicable, they pulled back from making markets and taking positions and further exacerbated the price action. Fourth, the large and rapid price movements called into doubt the creditworthiness of counterparties, which could no longer be judged by now obsolete financial statements; credit decisions were further complicated by uncertainty about the value of collateral. In turn, the defensive behavior of market participants escalated and reinforced adverse market dynamics. Finally, the decline in asset prices reduced wealth and raised the cost of capital, which seemed likely to reduce both consumption and investment.”
My comment: It is definitely well-timed for the Fed to refresh their analyses of the ’87 and ’98 financial market dislocations. Unfortunately, the Fed’s view of both episodes offers Important Lessons Not Learned. The 1987 stock market crash was precipitated by a confluence of highly speculative trading, along with the aggressive use of a new market hedging vehicle – “portfolio insurance.” Importantly, the dynamic-trading nature of the hedging strategy – that writers of the market insurance were to sell S&P futures contracts into a declining market to establish short positions that would generate the positive cash flow to make payment on the contract – led to precipitous and self-reinforcing selling in the futures market. “Computer-generated” sell programs culminated in marketplace dislocation and collapse.
Immediately after the crash there were fears that the markets were discounting a severe economic downturn (even depression), although this financial crisis was largely contained to the equities markets. Importantly, uncertainty and tumult were only somewhat of a setback for the Credit system. It was not long before Fed liquidity injections and sharply lower market rates bolstered a Credit apparatus that was already well on its way to financing a boom. Late-eighties excesses, including the junk bond, LBO, coastal real estate, and national commercial real estate booms, may seem rather picayune these days, but virtually pushed the banking system over the edge by the early nineties.
From the 1987 stock market crash, the Fed understood that it may very well be necessary to intervene in the marketplace to cushion the influence of some of the new financial “innovations.” This certainly included interventions to forestall marketplace bouts of trend-following derivative-related selling and other forced liquidations. This policy insight served them well during the LTCM crisis. When the disintegration of a highly leveraged portfolio of international bond bets risked precipitating a global financial market dislocation, Greenspan hastily intervened. The Fed shielded the insolvent LTCM from liquidation, aggressively cut rates, added liquidity and, importantly, assured the markets that the U.S. government – the Greenspan, Rubin and Summers “Committee to Save the World” –– were ready and willing to employ unprecedented measures to guarantee liquid and continuous markets. I have in the past written extensively regarding the momentous moral hazard implications of this endeavor and will not delve further into this issue this evening.
With regard to policy implications, the Greenspan Fed emerged from the LTCM crisis resolution with an intrepid appreciation for the unparalleled power and control they now exercised over marketplace liquidity. Virtually on demand, Greenspan could incite risk-taking and leveraged speculation, both activities that would immediately add to marketplace liquidity, stimulate borrowing and risk-taking, boost asset prices, and only somewhat later stimulate economic activity.
The instantaneous actions of today’s leveraged speculators can be compared to the influence adding reserves and tinkering with interest-rates – the Fed’s old toolkit - previously had nudging along bank loan officers and businesspersons. I have always believed that the primary impetus for Greenspan’s championing of derivatives, hedge funds and Wall Street finance was that they afforded him the most powerful policy device in the history of central banking. Besides, in post-LTCM analysis, the Fed could rationalize their intervention with the notion that their encroachment stemmed the forced liquidation of high-quality debt instruments held by Credit-worthy borrowers.
The next major financial crisis will be of much broader scope than 1998, just as LTCM was to 1987. I believe the probability for such a crisis during the next year is high, and I wouldn’t be surprised if recent market turbulence is a precursor to trouble ahead. With this in mind, I will briefly share some thoughts I have as to why the next crisis will be significantly more problematic for the Fed.
First of all, I cannot write enough times that the key to the so-called “resiliency” of the U.S. markets and economy has been due to the capacity for uninterrupted Credit growth and marketplace liquidity creation. While there have been a few instances where the flow of new finance was at risk, in each case the Credit wheels were greased with lower rates and assurances of a hospitable environment for risk-taking. The Fed enjoyed great flexibility during the LTCM crisis. The global backdrop (post-Mexico, SE Asia and Russian collapses) was quite disinflationary, especially in the energy and commodities markets. Oil was heading to $10, gold to $250, and the CRB index to multi-decade lows. And, importantly, while the dollar did weaken around the time of the worst of the LTCM scare, it had rallied 25% over the preceding three-year period (on its way to King Dollar highs). The Fed enjoyed the incredible luxury of inciting massive Credit inflation with confidence that dollar liquidity would readily find a home in U.S. securities markets (where the nature of its inflationary impact was largely contained).
The genesis of the problem for the market during 1998 was one of illiquidity and the forced unwind of various Credit spreads, derivatives, and interest-rate arbitrages. The potential collapse and liquidation of LTCM (and copycats) was hanging over the marketplace; players were either hastily liquidating positions or completely backing away from the market in anticipation of a marketplace dislocation. But this predicament was certainly amenable to lower rates, additional liquidity, and concerted Fed and Treasury assurances that a marketplace disruption would be avoided at all costs.
The next financial crisis will be much less agreeable. For one, I believe the general nature of leveraged speculating is different today. The type of the underlying assets being financed (distorted and inflating global assets) is altogether different, and the general inflationary/liquidity backdrop is unrecognizable from 1998. Whereas LTCM speculations were primarily Credit spreads and various rate-arbitrages, I fear the prominent trades today are more of the global carry trade variety. These involve borrowing in low-yielding currencies to finance speculations in instruments of higher-yielding currencies. This recalls SE Asia, Russia and Argentina.
Objectively surveying the global environment, one can surmise that today’s leveraged speculations are financing gross and unsustainable distortions (including U.S. over-consumption and global asset inflation). This implies especially weak underlying Credit instrument fundamentals, basically a non-issue back in 1998. To what degree leveraged speculations have been financing our Current Account Deficit is unknown, but this could prove to be a huge issue in the event of a currency market disruption. One can envisage a scenario where the Fed’s best intention of supporting the marketplace in providing Credit to “worthy borrowers,” is undermined by the deteriorating view of U.S. creditworthiness. There is a huge risk associated with financing serial current account deficits and asset inflation with market-based leveraged speculations. To be sure, U.S. imbalances and policymaking are certainly held in much less regard these days.
I will suggest this evening that acute dollar vulnerability is poised to significantly curtail the Bernanke Fed’s flexibility. The ramifications for a policy approach that pushes the Credit system into overdrive to counter financial disruption are different going forward - perhaps much different. The greatest problem for the global financial system currently is enormous and relentless dollar liquidity excess. Inciting Credit growth and risk-taking may very well prove counter-productive, and it is likely that aggressive (1998-style) Fed actions would exacerbate a flight out of dollar securities. A flight from the dollar would only then worsen the deteriorating inflation backdrop. Not only is it possible that the Fed loses the luxury of lowering rates during the next crisis, it may very well be forced at some point to do what other countries are forced to do - raise rates to mitigate a run on its currency.
Perhaps we’ve already been somewhat privy to the backdrop for the next crisis: a sinking dollar, spiking metals prices, surging crude, and rising global bond yields. A scenario where marketplace dislocation manifests first in the currency markets (with a faltering dollar) is as reasonable as it would be problematic. Here, one would assume that the Fed’s proven modus operandi of adding liquidity, cutting rates, and inciting more Credit and liquidity would be only counter-productive. And, as we have witnessed, the nature and consequence of current leveraged speculation are more unsettling than those preceding 1998. Today’s inflationary backdrop nurtures destabilizing speculative leveraging in all the “un-dollar” markets – certainly including the emerging markets and commodities. This creates a highly unstable situation prone to myriad and recurring Bubbles, volatility and busts. Accordingly, the characteristics of the underlying debt instruments are problematic and increasingly susceptible to wild price gyrations.
I read a lot about Bubbles these days: The “energy Bubble”, the “metals Bubble”, the “commodities Bubble”, the “emerging market Bubble”, the “hedge fund Bubble”, and so on. But most of the analysis misses the more salient points. What we’re dealing with – the overriding issue is - The Dollar Liquidity Bubble. The combination of massive Current Account Deficits and outbound (investor and speculator) finance is inundating the financial world, and there is no way short of a major U.S. crisis to rein it in. This liquidity is fueling myriad dramatic global marketplace price inflations – as well as the occasional hiccup - along the way. I don’t view recent pull-backs in these markets as bursting Bubbles because I don’t yet see any change to the nature of underlying dollar liquidity excess.
In conclusion:
May 19 - Dow Jones: “Former Federal Reserve Chairman Alan Greenspan said Thursday that the U.S. is ‘fortunate’ in being able to run large current account deficits, a result of increasingly globalized economies and capital markets. Greenspan said that there has been a ‘large dispersion’ of current account deficits and surpluses across the global economy as developing nations with higher savings rates have begun to catch up economically with their developed-world counterparts. This has created a flow of savings from these developing countries which has allowed the U.S. to comfortably finance the ‘large deficits’ that it has run in recent years.” |
