Greenspan - the Wizard of Bubbleland
By
Henry C.K. Liu
Part I: Greenspan - the Wizard of Bubbleland
Part 2: The Repo Time Bomb
This article appeared in AToL
on September 29, 2005
The
repo market is the biggest financial market today. Domestic
and international repo markets have grown dramatically over the last
few years due to 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, the borrowed assets will be returned 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 participant
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 which
have funds to invest short-term. Or they may be parties who wish to
briefly obtain the use of a particular security by doing a reverse
repo. For example, a party may want to sell the security short, or
they 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; and
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 essentially 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 are for unsecured loans based on the credit worthiness
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 that 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 its 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 that 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 financed 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 interest rate spread
positive for the borrower, the market value of the security will fall
as 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 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 Fannie Mae and Freddie Mac,
so-called GSEs (government sponsored enterprices, or agencies) which
were founded with government help decades ago to make home ownership
easier by purchasing loans that commercial lenders make, then either
hold them 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 [secondary credit] market
source their funds in the repo market.
In this [secondary credit] mortgage market, investors, rather than banks, set mortgage rates by setting the repo rate. Whenever the economy is expanding faster than the money supply growth, investors demand higher yields from mortgage lenders. However, the Fed is a key participant in the 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 long-term
rates to increase as short-term rates has 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, 2005.
The market simply does not expect the Fed to keep short-term rate
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 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 leads to inflation which discourages bond
investment. Lower interest rates also lower the exchange value of the
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 also 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 collateralized 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, 2005 that a “global savings glut” has depressed
US interest rates since 2000. Greenspan testified before
Congress on July 20 that this glut is one of the factors behind the
so-called interest rate conundrum, i.e., declining long-term rates
despite rising short-term rates. Bernanke noted that in 2004,
US external deficit stood at $666 billion, or about 5.75% of US 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 needs 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.
Beranke observed that US 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, essentially 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%. Yet 18% of 1985 GDP of $4.22 trillion
is $757 billion and 14% of 2004 GDP of $11.71 trillion is $1.64
trillion. Norminaslly, the US saved $883 billion more in 2004
than in 1985, more than double. Common sense suggests that as a
person's income increases, the need for saving as a percentage of
income can safely decrease. 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
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 neoclassical macroeconomics.
For total investment to be equal to total savings, the demand for
loanable funds must equal the supply for loanable funds and this is
only possible if the rate of interest is appropriately
defined. If the interest rate was such that the demand for loanable
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 under-investment in the economy.
Foreign
countries with dollar trade surpluses from the US increase 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
emerging-market 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
increase 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 which 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 that
can hardly be viewed as national savings.
The exporting
economies ship real wealth to the US in exchange for fiat dollars
which 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 when 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 US has become the world's
biggest debtor nation. Japan and China have become the world's
biggest creditor nations. The US owes Japan over US$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, 2005, over 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 have 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
generates returns that not only can comfortably carry the cost of
debt service but also to conflate asset values with astronomical p/e
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 further utilize sovereign credit to back the
investment needs of its private sector. As a result, Japan
looks to international capital (mostly from the US), money (over $2
trillion) that really belongs to Japan. The moves towards zero
interest rates temporarily helped the Tokyo equity market but whether
it represents a sustainable recovery is still very much in doubt.
US
investors and lenders require a US-style transparency and a degree of
control that is 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 American 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.
Grass-root 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.
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 US 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 asset not to capture high interest or
dividend payments, but to hope for continuing price appreciation. But
increasingly-hollowed, non-performing assets will eventually require
sky-rocketing 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, even when key market participants such as Bill
Gross of Pimco, the nation’s largest bond dealer, has
repeatedly warned.
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 everyday to
keep the Ponzi scheme going, to the tune of over $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 President
Carter found out from the Fed’s reckless easing under Arthur
Burns during the Nixon/Ford years. The Carter stagflation will be
merely a minor storm involving billions compared to the coming
financial tsunami where the stakes have been exponentially inflated
to trillions. Just like little naïve 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 1970's, the repo
market has grown into the largest financial market in the world,
surpassing stocks, bonds, and even foreign-exchange.
At a time
around 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 in 1998 became the place where bond firms and investors
raise cash to buy securities, and where corporations and money market
funds park trillions of electronic dollars daily to lock in risk-free
attractive returns. That market has since grown to over $5 trillion a
day, almost 50% of 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 to finance 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 command average trading volume of
about $5 trillion per day in 2004, up from $2 trillion in 1998, and
the European one now passed 5 trillion euros in outstandings. Both
have been growing at double-digit 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 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 notes that the stock of Treasury debt
currently held by foreigners is just over 50%, and that “with
higher short rates would come greater risks of chronic or intractable
fails if foreign participation in repo markets was not assured.”
The St Louis Fed reports that as of June 30, 2005, Federal debt held
by foreigner amounted to over $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 introduces
the term "full employment" as a policy goal, although the
content of the bill had been watered down before passage by snake-oil
economics to consider 4% unemployment as structural. Unemployment
near or below the structural level is deemed structurally
inconsistent due to its impact on inflation (causing wages to rise! -
a big no-no for die-hard monetarists), thus only increasing
unemployment down the road. Structural unemployment is now
theoretically set at 6%.
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 is it 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 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 a money creation venue, can be 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 two
to three. In 2005, ten dollars in the money supply (M3 – $10
trillion) yields twelve dollars of GDP ($12 trillion), a ratio of
two-and-a-half to three. 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 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 that “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,
auto 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 for having said that systemic risk is a
good trade-off 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
by-pass 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 circle 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 repos 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 to 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 repos market is
not opened to small investors. The largest
users of repos and reverses are primary dealers in government
securities. As of August 2005, there are 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 one-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, 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 3-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 re-lending 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-the-run 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
counter-party 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 around 20% since 1990. Of the $33 trillion outstanding
at year-end 1998, only $4 trillion were exchange-traded derivatives;
the remainder were off-exchange or over-the-counter (OTC)
derivatives. Most of the funds came from the exploding repo
market.
The 1987 crash was a stock market bubble burst. The
newly appointed Greenspan as Fed Chairman, merely nine weeks in the
powerful post, flooded the banking system with new reserves by having
the FOMC (Fed Open Market Committee) 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 US$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 ease 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 Corporation (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.
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 1 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 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. Despite the Lourve Accord of 1987 to slow the
Plaza-Accord-induced fall of the dollar, which fell to 94 yen and
1.43 marks by 1995. The low dollar laid the ground for the Asian
finance 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 towards 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. And nobody
imagined that so many traders could be long in such huge size.
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 2-year-bond prices, he decided to be long 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 2-year notes outstanding. In 1992,
value-at-risk analysis which, based by 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 to
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,
or gilts at LIFFE or do structured products with pay-offs based on
the difference between Spanish and German rates. The whole world
essentially 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 sophisticate command on the virtual
world of financial values and relationships, but were unwittingly
naïve 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 factors why 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. 1994 was a year 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 effectively 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 to lose 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 becomes 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 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 melt down 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 it 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 5th 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 over-designed 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 un-calculable
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 statisitical 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 in 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
long-term instruments which returns its principle 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 like that the Fed expects that
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,
together with the Treasury Department, have evolved from
traditionally quiet functions of insuring the long-term value and
credibility of the nation’s currency, to activist promotions of
speculative boom fueled by run-away debt, replacing the Keynesian
approach of fiscal spending to manage demand by sustaining
board-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 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. This
amounted to less than 6 percent of banks’ total assets. Still,
these credit exposures have been growing rapidly, more or less in
line with the growth of the notional amounts... ... 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, U.S. 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 eighteen 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.”
Whole speech:
http://www.bog.frb.fed.us/BoardDocs/Speeches/Current/19990319.htm
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 percent 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.”
Whole
testimony:http://www.bog.frb.fed.us/boarddocs/testimony/1998/19981001.htm
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. Gree