Central Bankers Cry Wolf

This post will take a look at the Brave New World of derivatives, what the Fed and central bankers are saying about that world, and what the world believes they both can do. Let’s start off with a look at the GSEs.

Sallie Mae

Bloomberg reported, “Sallie Mae 4th-Quarter Net Falls on Derivatives Losses”:

“SLM Corp., the nation’s largest provider of college-student loans, said fourth-quarter profit tumbled 96% because of a decline in the value of financial contracts it uses to protect against swings in interest rates.

“Net income fell to $18.1 million, or 2 cents a share, from $431 million, or 96 cents, a year earlier, the Reston, Va.-based company said today in a statement. Earnings excluding the derivatives rose 15%, less than analysts expected. Sallie Mae had a loss of $244.5 million related to derivatives and hedges, compared with a gain of $70.2 million in the prior year.”

GSEs: Where Do We Stand?

On Jan, 17, 2007, William Poole, president of the Federal Reserve Bank of St. Louis, gave a speech on the topic “The GSEs: Where Do We Stand?”:

“Not long after coming to the St. Louis Fed in 1998, I became interested in government-sponsored enterprises, or GSEs. My interest arose when I began digging into aggregate data on the financial markets and discovered how large these firms are. The bulk of all GSE assets are in the housing GSEs — Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks. Using information as of Sept. 30, 2006 — the latest available as of this writing — these 14 firms have total assets of $2.67 trillion; given their thin capital positions, their total liabilities are only a little smaller. Just two firms — Fannie Mae and Freddie Mac — account for $1.65 trillion of the assets, or 62% of all housing GSE assets. Moreover, Fannie Mae and Freddie Mac have guaranteed mortgage-backed securities outstanding of $2.82 trillion. Thus, the housing GSE liabilities on their balance sheets and guaranteed obligations off their balance sheets are about $4.47 trillion, which may be compared with U.S. government debt in the hands of the public of $4.83 trillion…

“My initial curiosity about the GSEs was stoked simply by the size of these firms. As I investigated further, I became concerned about their thin capital positions and the realization that if any of them got into financial trouble, the markets and the federal government would look to the Federal Reserve to deal with the problem…

“I continue to believe that the nation would be well served by turning the GSEs into genuinely private firms, without government backing implied or explicit. If they bolster their capital, they can function perfectly well as purely private firms…

“Financial firms throughout the economy ought to have an intense interest in reforming the GSEs. One reason is simply that banks and other financial firms, and many nonfinancial firms, hold large amounts of GSE obligations and GSE-guaranteed mortgage-backed securities. I believe that many risk managers simply accept that GSEs are effectively backstopped by the Federal Reserve and the federal government without ever thinking through how such implicit guarantees would actually work in a crisis. The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the ‘someone’ be identified and the ‘somehow’ be specified. I have emphasized before that if you are thinking about the Federal Reserve as the ‘someone,’ you should understand that the Fed can provide liquidity support, but not capital. As for the ‘somehow,’ I urge you to be sure you understand the extent of the president’s powers to provide emergency aid, the likely speed of congressional action and the possibility that political disputes would slow resolution of the situation…

“At present, there is no process and no one knows what would happen if a GSE is unable to meet its obligations.

“Freddie Mac and Fannie Mae both got into trouble with accounting irregularities in part because of the complexities under GAAP rules of accounting for derivatives positions and rules determining which assets should be reported at market and which should be reported at amortized historical cost. Sound risk management practices require that GSE managements base decisions on market values, or estimates as close to market as financial theory and practice permit. The reason is simple: Fannie Mae and Freddie Mac pursue policies that inherently expose the firms to an extreme asset/liability duration mismatch. They hold long-term mortgages and mortgage-backed securities financed by short-term liabilities. Given this strategy, they must engage in extensive operations in derivatives markets to create synthetically a duration match on the two sides of the balance sheet. These operations expose the firm to a huge amount of risk unless the positions are measured at market value…

“Since the GSE accounting scandals emerged in mid-2003, one thing has remained rock-solid: The GSEs have continued to borrow at yields only slightly higher than those of the U.S. government, and noticeably lower than those available to any other AAA-rated private company or entity. In other words, despite the vast recent accumulation of knowledge about the significant risks run by the GSEs, as well as their inability (or unwillingness) to manage these risks, investors in GSE debt securities appear unmoved. Upon reflection, the lack of market discipline evident during this crisis period is striking — like a dog that did not bark. This fact indicates to me that there still is a significant problem with the GSEs that needs to be fixed.

“The obvious answer to why the dog did not bark is that the so-called ‘implicit guarantee’ — that is, the belief by investors that the U.S. government would not allow the GSEs to default on their debt obligations — has not been removed…

“I began this speech noting that the Federal Reserve has a responsibility to maintain financial stability. That responsibility includes increasing awareness of threats to stability and formation of recommendations for structural reform. I do not believe that a GSE crisis is imminent. However, for those who believe that a GSE crisis is unthinkable in the future, I suggest a course in economic history.”

Key GSE Points

  • Size and leverage of Fannie Mae and Freddie Mac is enormous
  • The Fed does not want to be responsible for a blowup at either company
  • Both pursue policies that inherently expose the firms to an extreme asset/liability duration mismatch
  • Both hold long-term mortgages and mortgage-backed securities financed by short-term liabilities forcing them to synthetically create a duration match via massive amounts of derivatives
  • The stocks act as if there are implicit government guarantees. There are no such guarantees
  • The lack of market discipline is striking
  • The Fed can provide liquidity, not capital
  • A crisis is not unthinkable. Those who think so need a course in economic history.

Liquidity Support

Let’s review one key excerpt: “The Fed can provide liquidity support, but not capital.” For all this talk of “helicopter drops,” Poole seems to be calling Bernanke’s bluff. I have pointed out many times before that the Fed has no authority to do “a drop,” and probably would not even if it could. No doubt it would act to slash interest rates in a crisis, but depending on the exact nature of Fannie Mae’s hedges, it is conceivable that the opposite play might be needed. Is this what has the Fed spooked over Fannie Mae?

Federal Reserve Emergency Powers

In the panel on government-sponsored enterprises, Poole spoke on the emergency powers of the Fed:

“I am acutely aware that should there be a market crisis, the Federal Reserve will have the responsibility to manage the problem. Just as many market participants apparently believe that GSE obligations have the implicit backing of the federal government, they may also believe that the Federal Reserve has all the powers necessary to manage a crisis. The Fed’s successful efforts to handle the stock market crash in 1987, the near-insolvency of Long Term Capital Management in 1998, and the financial effects of the Sept. 11 tragedy all justifiably increase market confidence in the Federal Reserve. In the interest of a full understanding of the Federal Reserve’s powers in the event of a crisis in the market for GSE obligations, I’ll outline the Fed’s powers as provided by the Federal Reserve Act…

“The Federal Reserve has ample power to deal with a liquidity problem, by making collateralized loans as authorized by the Federal Reserve Act. The Fed does not have power to deal with a solvency problem. Should a solvency problem arise with any of the GSEs, the solution will have to be found elsewhere than through the Federal Reserve.”

Because of all the past Fed interventions, no one believes the Fed. Is this the case of the boy who cried wolf one time too many? Is the Fed finally issuing a legitimate warning that no one believes? Let’s go across the Atlantic and check out things in Europe.

A Warning From Trichet

The Financial Times is reporting, “Prepare for Asset Repricing, Warns Trichet”:

“Current conditions in global financial markets look potentially ‘unstable,’ suggesting that investors need to prepare themselves for a significant ‘repricing’ of some assets, Jean-Claude Trichet, president of the European Central Bank, warned at the weekend in Davos.

“The recent explosion of structured financial products and derivatives had made it more difficult for regulators and investors to judge the current risks in the financial system, Mr. Trichet said.

“‘We are currently seeing elements in global financial markets which are not necessarily stable,’ he said, pointing to the ‘low level of rates, spreads, and risk premiums’ as factors that could trigger a repricing.”

Did anyone care about Trichet’s warning? I think not. The following news headline says it all: “Davos Elite Rebuffs Risk Warnings From Policymakers”:

“Bankers, investors, and executives last week arrived at the Swiss resort of Davos giddy about record profits and bonuses. After five days of hectoring by policymakers that they are too complacent, they left just as happy.

“‘The mood has been totally upbeat,’ Sunil Mittal, the billionaire chairman of Bharti Airtel Ltd., India’s largest mobile phone operator, said of the 37th annual meeting of the World Economic Forum. ‘I’ve never seen a mood like this.’

“Warnings by central bankers such as Jean-Claude Trichet were batted away by dealmakers like Michael Klein, co-president of Citigroup Inc.’s investment banking unit, and David Rubenstein, managing director at the Carlyle Group Inc. buyout firm. They were confident in their ability to cope with the inevitable slowdown of the world’s strongest economic growth in three decades.

“‘The consensus here in Davos is everybody’s thinking it’ll be another booming year,’ Morgan Stanley chief global economist Stephen Roach said.”

On Jan. 26, Bloomberg reported, “ECB’s Weber Says Markets Shouldn’t Expect Central Bank Bailouts”:

“European Central Bank council member Axel Weber said investors shouldn’t expect central banks to bail them out in the event of an ‘abrupt’ drop in financial markets.

“‘If you misprice risk, don’t come looking to us for liquidity assistance,’ Weber said in an interview in Davos, Switzerland, at the annual meeting of the World Economic Forum. ‘The longer this goes on and the more risky positions are built up over time, the more luck you need’…

“‘It is time for financial market to move back to more adequate risk pricing and maybe forego a deal even if it looks tempting,’ said Weber. There’s a danger of a ‘rush to the exit’ if investors wait too long, he said…

“The catalyst may come in Japan, as the central bank there raises benchmark borrowing costs from the current 0.25%, he said.”

Are Central Bankers Crying Wolf?

Is this the case of the Fed that cried wolf one time too many? Oddly enough, I do not believe Trichet or Weber, or Poole, either. Like everyone else, I think the Fed will be there and willing to lend a hand to attempt to bail out the speculators. But unlike everyone else, I think that credit expansion and risk taking have reached such astronomical proportions that when it all implodes, the central bankers will be powerless to stop it.

As for the catalyst…there seems to be too much consensus on the catalyst. “The catalyst may come in Japan, as the central bank there raises benchmark borrowing costs from the current 0.25%,” Weber said.

I am not sure what will pop this global credit bubble, but I suspect it will not be higher U.S. interest rates or a rising yen. More than likely, it will be either pure exhaustion, something totally off everyone’s radar, or simply the reverse of some scenario that everyone expects.

In 1980, it took $1 of new debt to create $1 of GDP; in 2000, it took $4; and today, it takes $7. All of that extra credit is serving no productive means. It is pure speculation and it will be unwound. Nonetheless, the sheep are still grazing.

There is a lot of unjustified faith in this Fed for what little power it has relative to where things stand in the current credit expansion cycle. Whether or not the central bankers are purposely crying wolf is now irrelevant.

Mike Shedlock ~ “Mish”

February 1, 2007

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