Fin/Inv

We have now reached a point when a Senator has to write a well-intentioned letter to the very administration he serves, (whose sworn duty is to preserve the wealth of all of its constituents, not just Goldman Sachs), with a cautionary tale that continued lying to the general population combined with a culture of opacity and persistent fraud, will lead to a disastrous effect to the economy and to the very fabric of American society. Alas, in a society in which those being lied to extract a satisfaction as great, if not greater, from this process, than those doing the actual lying, this is not too surprising. Sticking our collective heads in the sand has traditionally worked miracles for resolving the bulk of this nation's problems. And with the public sector now demonstrating a preferential treatment for the financial space, at the expense of 99% of the remaining population, it has become obvious US citizens can no longer rely on the US government for procuring the truth. Furthermore, with China now a vassal owner of America via its undisputed creditor status, we may soon lose the protection the government is entrusted with affording its citizens in other realms, from enemies certainly domestic (mostly located in south Manhattan), and very possibly foreign. Yet, another voice of caution that has recently emerged, and whose message is critical to all, is that of Pimco's Mohamed El-Erian. The Pimco executive has written another very relevant Op-Ed in the Financial Times, "How to handle the sovereign debt explosion" which does not so much disclose new things, as capture the essence of the groundbreaking transformation that is currently occurring within the entire "developed" world, and more specifically, the denial that the vast majority of "experts" are exhibiting when faced with a previously unseen process of unprecedented significance.

While we recommend reading the entire article, the following section is of particular note:

We should expect (rather than be surprised by) damaging recognition lags in both the public and private sectors. Playbooks are not readily available when it comes to new systemic themes. This leads many to revert to backward-looking analytical models, the thrust of which is essentially to assume away the relevance of the new systemic phenomena.

There is a further complication. Timely recognition is necessary but not sufficient. It must be followed by the correct response. Here, history suggests that it is not easy for companies and governments to overcome the tyranny of backward-looking internal commitments.

Where does all this leave us? Our sense is that the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood. Yet, with time, it will prove to be highly consequential. The sooner this is recognised, the greater the probability of being able to stay ahead of the disruptions rather than be hurt by them.

Precisely the same argument can be brought against Ben Bernanke who in numerous public appearances saw no threat of the bubble bursting in 2005-6, and who, unfathomably, sees no threat of a massive-liquidity bubble explosion currently.

The question we need to ask is shy are we getting this critical insight from a member of the private sector? Why is nobody in government addressing this critical issue and bringing the population's attention to this most material of systemic patterns. Instead we bicker over the end of civilization as we know it should Goldman collapse (it won't: it will simply mean that Goldman's 23,500 staffers will finally have to do an honest day's work for once in their lives if they want to get paid), or how many quadrillion it will cost for the government to nationalize healthcare, and every other industry. Yes- we should be getting this warning from the Federal Reserve, and from those who hope to become the Fed's new members - a position which once upon a time was considered an admirable accomplishment yet now puts you roughly in line with the lepers, hookers, wifebeaters and prison rats in the social hierarchy. We should but we don't - all we get from this government is silence. Instead we get a daily barrage from government bought cheerleaders who preach that all is well, and that precisely the warnings of El-Erian and so many others are to be ignored. And the crowning glory of how far our society has fallen is that the vast majority among us chose to believe these lies, and gladly hand over money to buy another share of Lehman brothers which is in liquidation yet still trades.

And somehow Bernie Madoff is in jail for doing just what the government does to us every single day.

In a letter to Larry Summers and Tim Geithner, Senator Sherrod Brown warns the administration to not simply place more Wall Street cronies in filling the three vacancies at the Federal Reserve, which will open up once Fed vice chairman Donald Kohn leaves this coming June. Instead of mere" maximum liquidity" automatons, Brown wants the new Fed members to be "committed to transparency, consumer protection and lowering the unemployment rate." Furthermore, Brown demands that "we need economic policy makers who possess the foresight to identify harmful economic trends, the courage to speak out about the necessity of addressing these practices before they inflict lasting damage to our economy, and the wisdom to listen even if their views are challenged." Alas, as transparency and rationa thought, coupled with proactive defensive actions means game over for the Fed, these conditions are an immediate deal killer, with the result being that the only affirmative criteria for new Fed membership is the endorsement of Lloyd Blankfein and current Fed Director Jamie Dimon. With the yield curve merely at record wides, there is certainly enough room for the current 2s10s spread of 282 to at least double as the American middle class still has a little money that can be stolen, in space or time, by Wall Street, with the Fed's endless blessings. Everything else is smoke and mirrors.

Full letter from Senator Brown, via Huffington Post:

March 10, 2010

The Honorable Timothy Geithner
Secretary
United States Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

The Honorable Lawrence Summers
Director
National Economic Council
The White House
1600 Pennsylvania Avenue, NW
Washington, D.C. 20500

Dear Secretary Geithner and Director Summers,

I write to you today to express my concern about the vacancies at the Federal Reserve, both on the Federal Open Market Committee (FOMC) and soon in the Vice Chairman's office. This is the financial equivalent of leaving open vacancies on the United States Supreme Court, and it is essential that we fill these positions.

As Chairman of the Senate Banking Committee's Subcommittee on Economic Policy, with jurisdiction over the Federal Reserve System's monetary policy functions, I am acutely aware of the importance of monetary policy at the Fed. Both the full Banking Committee and the Economic Policy Subcommittee have examined the causes of the financial crisis and the resulting effects on lending, access to credit, and employment. The evidence presented to the Committee about the role that Fed policy decisions played in the financial crisis and the economic downturn has led me to conclude that the Fed's monetary policy has focused almost entirely on controlling inflation rather than maximizing employment and that the Fed has too often put banks' soundness ahead of its other responsibilities. In light of this experience, there are several other important qualifications that I would urge you to consider in selecting the new Vice Chairman and new members of the FOMC:

1. Recognition of the causes of the financial crisis before it occurred.

Many economic experts, including some at the Federal Reserve, failed to anticipate the impending economic crisis. However, there were exceptional people who sounded alarms about the rapidly inflating housing bubble, the proliferation of subprime lending, and the packaging, selling, and investing in toxic financial products by Wall Street. Unfortunately, regulators, including the Fed, ignored or attempted to discredit many of these courageous individuals, rather than heeding their warnings. We need economic policy makers who possess the foresight to identify harmful economic trends, the courage to speak out about the necessity of addressing these practices before they inflict lasting damage to our economy, and the wisdom to listen even if their views are challenged.

2. Demonstrated dedication to protecting consumers and maximizing employment.

For years, the Federal Reserve's monetary policy has maintained an almost single-minded focus on inflation. This has been detrimental to the Fed's other core missions, particularly maximizing employment and protecting consumers. The results of this fixation speak for themselves. The national unemployment rate is more than double the Fed's statutorily mandated 4 percent unemployment target. The Fed also failed to act on repeated warnings about predatory mortgage lending and credit card abuses. Consumer protection experience is particularly important if the new consumer protection entity were to be housed at the Fed. Our economy will benefit from renewed attention to all of the Fed's priorities.

3. Commitment to releasing e-mails related to the Fed's involvement in the AIG bailout.

A growing number of experts - including economists, academics, and former regulators - have called upon the Federal Reserve to release all e-mails, internal accounting documents, and financial models related to AIG's collapse. The American taxpayers now hold the majority of AIG shares, and they have a right to know how their money is being spent. Providing greater detail about the AIG bailout is particularly important because that episode continues to taint the Fed's reputation. Focusing on candidates committed to full transparency related to this particular economic event would help to restore the Fed's stature and credibility in the eyes of many Americans.

The American public has lost a great deal of confidence in the Federal Reserve. Selecting a Vice Chair and FOMC members with the above qualifications will send the message that the Federal Reserve has learned from the financial crisis, and that the Fed's weaknesses are being addressed with more than just cosmetic changes.

I would be happy to discuss specific candidates with you at your convenience. Thank you for considering my views, and I look forward to working with you to address these vacancies at the Fed.

Sincerely,

Sherrod Brown
United States Senator

What is wrong with this picture: the MTS just announced that the February budget deficit was $220.9 billion, after receipts of just $107.5 billion with vastly surpassed by outlays of $328.4 billion. This is a record. Yet the interest on the public debt was a mere $16.9 billion (page 13 of the MTS report). The reason for this is because as TreasuryDirect points out, in February the interest on public marketable debt (actual cash outlays), which as of Monday stood at $8.061 trillion, hit an all time low of 2.548%. How is it possible that unprecedented debt accumulation can result in ever declining interest rates, and Treasury auctions, such as today's 10 Year reopening, in which the Bid To Cover hit an all time high? One answer: The Federal Reserve, which through complete domination of the entire capital market courtesy of ZIRP and QE has now turned market logic upside down by 180 degrees. In a normal world, the more money you borrow, the greater the associated risk, and the greater the interest payments on this debt. Not in America though. So can we assume that the Fed can forever keep rates on debt at record low levels? No. Which begs the question: what happens when interest rates do finally start going up?

Here is the relevant page highlighting the deficit. In a word: the US collects enough money organically (via taxes) to cover less than a third of its outlays.

A look at the distribution of receipt components should lead to questions about the sanity of anyone who claims that the budget trajectory is sustainable - in a word, tax revenues are plunging. Of course, this has to be evaluated in parallel with the observation that tax refunds in January and February of 2010 have actually surpassed those of 2009 as Zero Hedge discussed previously, explaining why consumers have shown abnormal resilience so far in 2010.

So even as the income side of the Federal ledger has rarely if ever been quite as bad, the expenditure side has exploded, and not as a function of debt funding: the bulk of outlays have to do with entitlement programs which came in over $160 billion, and which still could not have been covered organically.

Here is where debt comes in. We know that recently the debt ceiling was raised to $14.3 trillion which is expected to be hit in less than a year. Observant readers will recall that the previous ceiling of $12.4 trillion was supposed to last the US until the end of March - well, not only was this number passed over a week ago, it is now, less than half way into March at $12.5 trillion, which would have broken the debt ceiling far in advance of expectations. This leads us to believe that the $14.3 trillion ceiling will likely have to be raised once again and at a very critical time for the administration: around mid-term election time.

Yet if one were looking just at the interest rate paid by the government on the marketable debt portion of the public debt (which was $8.06 trillion as of most recently), it would appear that America's economy was cranking on all cylinders. Of course, this is not the case, and the rate is merely an indication of the Fed's direct intervention in all possible markets.

The chart below shows the absolute level of the interest on marketable debt, and the MoM % change. In February the rate came in at a record low 2.548%, a 1.8% decline from the 2.595% in March.

To be sure, this is expected with the Fed running a Zero Interest Rate Policy, and QE adding direct purchases by the Fed.

Yet what is notable is that even with the effective Fed Funds rate at zero for over a year, the rate on marketable debt has bottomed out, and the spread from FF to the Interest Rate has held constant at about 2.5%.

The primary reason for this is the duration distribution of US debt. The short-term portion has already reaped the benefits of issuance at or near 0%, while the longer-dated side of the curve is keeping rates higher. If indeed the Treasury is serious about extending the average maturity on public debt from 4 to 6 years, the new baseline for this spread will eventually be at about 3%, where it was earlier in the decade. 

Yet the logical next question is what happens when rates start going up? It was as recently as September 2007 that we had a interest rate on marketable debt of nearly 5%. The plunge to 2.5% took just over a year. Even the mere mention of actual tightening will spring rates right back to 5%. What does that mean for actual outlays. Well: if indeed we are correct that total debt will hit $14.3 trillion in less than a year, it means the marketable debt will be about $10 trillion, and the incremental 250 bps of interest will mean about $250 billion of additional interest outlays a year, or half a trillion annually. That comes to about $42 billion a month. In January this amount would have been double the net withheld income taxes.

It becomes obvious why the Fed simply can not allow rates to go up. It has nothing to do with excess liquidity, which of course is a major concern as America goes from one excess-liquidity bubble to another. The problem is that the surging budget, which will need ridiculous amounts of debt for funding, will truly explode if rates were to go up merely to 5%. What happens if rates hit 7.5%... or 10%? At that point it is game over. And that sad ending will occur once the Fed and the administration realize that all ongoing efforts to kick start a consumption driven economy will fail. In the meantime, the economy will slowly grind to a halt as the servicing of public debt takes over a greater and greater portion of all tax receipts, until all taxpayer money is used merely to cover the interest expense. At that point buying CDS on the US denominated in euros, dollars, gold, .556, watermelons, or what have you, will be completely pointless as the bankruptcy of the US will be entirely priced in.

Via UBS Financial Services

As Told To….. – I was at an all-day, offsite seminar yesterday so this is not the usual eye-witness account but is based on input from friends. The stock market opened marginally weak but quickly changed to the upside in reaction to a sharp downside move in the dollar.

Some upbeat talk from some airlines about the “return of the passenger” combined with strength in the railroads to take the Transport Index to a new 52 week high. Since the Industrials have not made a new high that sets up a Dow Theory “confirmation” challenge. If the Industrials fail to make a new 52 week high that would set up a negative divergence, hinting a meaningful pullback in stocks.

For much of the early going the Industrials looked like they might have a go at a run toward new highs. Part of the thrust came from a series of rumors that spurred trading in the likes of Fannie, Freddie, AIG and Citi. The rumor that seemed to help them all was a zany thesis that the U.S. might ban shorting of the companies that it had a large stake in. While the rumor seemed whacky and unfounded, a rumor is not responsible for who believes in it. That became evident as buyers surged into the above-named stocks, probably on the theory that a shorting ban could cause a massive short covering rally.

Citi benefitted from a couple of other rumors. Charlie Gasparino reported on Fox that the U.S. government was looking to sell its Citi stake. That might free the company up. The stock spiked 7%. Also helping was the strong demand for some preferred shares the company was issuing.

The rumor driven frenzy in those stocks swelled the volume sharply. Monday looked like the slowest day of year, followed by the highest volume in a month. All thanks to a couple of rumors.

Shortly after 1:00, the rally in the averages seemed to sputter. The initial pull back was small. They regrouped and tried to rally again shortly after 2:00. They failed to get past the earlier high and things started to turn ugly, quickly. Bids evaporated and stocks plunged in a trapdoor selloff. They shot into negative territory.

In the final hour, they circled the wagons and regained plus territory but marginally. Unfortunately, the general volume (away from the four rumor beneficiaries) accelerated on the selloff.

What caused the sudden selloff? They were several theories. First was simply technical. The failure of the S&P to surmount its earlier intra-day high, presented a double top and a failed attempt to break through Januaries highs. That, said the napkin readers, spooked the bulls.

Some friends had another theory. Shortly after 1:00, a Wall Street Journal blog run a story on a speech by a Fed official. Here’s a bit:

For some time now, Federal Reserve officials have been hesitant to put a precise time frame on when they will begin to tighten policy, except to note the action lies well into the future.

But on Monday, one of their chief lieutenants, the man charged with implementing Fed policy, offered a pretty clear take on the likely timing of a move up in interest rates. The official, New York Fed Markets Group chief Brian Sack, has no formal role in setting monetary policy. But his position elevates his importance, and he suggested in a speech some sort of rate tightening will occur by late year.

“The current configuration of yields and asset prices incorporates expectations that short-term interest rates will begin to rise around the end of this year,” Sack told a group of economists in Virginia. “The markets seem prepared for the risks toward tighter policy,” he said, adding a “decent-sized term premium” on longer-dated yields suggests low chances of a “sizable upward shift in yields’ when that tightening comes.
Why is this observation important? Sack’s speech was entitled “Preparing for a Smooth (Eventual) Exit” from the current state of very stimulative monetary policy. If the Fed wants a tranquil exit from its current stance of 0% interest rates and if it thinks market are priced for the move, then it’s reasonable to believe a late-year increase in rates is what policy makers have penciled in.

Sack’s speech also laid out a path for the unwind. He sees the Fed draining reserves on a temporary basis, then raising rates, all the while allowing the $1.7 trillion in mortgage and Treasury assets it will have purchased by end-March to mature. Any active sales will come much later. Importantly, he said the tools to drain reserves temporarily will be in place by midyear, lending additional heft to the idea the Fed can start easing rates up off 0% by year end.

That hinted tightening could come sooner than expected. Some friends claim it caused a lot of buzz and may have contributed to the selloff.

We’ll investigate more today.

Spotty Performance – My ham radio pal passed along the latest sunspot data. For the period from February 25th through March 3rd, the numbers were 30, 26, 26, 13, 36, 39, and 39. Longtime readers will recognize that for the first three days, we had basically two spots per day. Then, we dropped to one spot followed by three days of approximately three spots per day. It’s nice to see the action but we’re still below normal. Despite the recent thaw, remember where you put that sweater.

Consensus – Assaulting January highs. Stay Nimble.

Trivia Corner

Answer - If you spell "Tennis" backward, you find the last three letters spell "Net" - a piece of equipment used in Tennis.

Today's Question - Tomorrow, today will be yesterday and yesterday, today was tomorrow. When tomorrow is yesterday, today will be as close to Sunday as today was when yesterday was tomorrow. What day is it?

And here is why fixing healthcare, whether today or in the middle ages, never works when the government gets involved:

History

On this day in 1349, in the midst of the infamous Black Plague epidemic, the forces of government, science and academia came together with a plan to save the people. As you recall from earlier episodes, the Black Plague had spread from the eastern Mediterranean throughout most of Europe killing millions over the preceding three years. People searched everywhere for the source of the plague…..a heavenly curse; a burden of immigrants; the result of spices in the food. It was tough to figure however, since whenever they held a conference either the host area caught the plague or the visitors did…..so…..not too many conferences.

Then in the six months preceding this date the death rate leveled off…..or seemed to. So in castles and universities and town halls across Europe, great minds pondered the cause of the plague. And they came pretty close. The collective governmental/academic wisdom was that the source of the Black Plague was fleas - (absolutely correct). So the word went out from town to town across Europe - to stop the plague - kill the fleas -by killing all the dogs. And immediately the slaughter of all dogs began.

But like lots of well-intentioned governmental/academic ideas it was somewhat wide of the mark...and had unexpected consequences. The cause was fleas alright but not dog fleas…..it was rat fleas. And in the 1300's what was the most effective way to hold down the rat population…..you guessed it - dogs. So by suggesting that townsfolk kill their dogs, the wise authorities had unwittingly allowed the rat population to flourish and thus a new vicious rash of Black Plague began. Before it was over, three years later, nearly 1 out of 3 people in the world had died of the plague.

To mark this eventful period, take time to review your public servant’s plans for your welfare. Whether taxes or healthcare, they'll work night and day for a solution. It may not be as efficient as the way that they handled social security but - what is? Just remember that these public servants have your best interests at heart. Don't dwell on the DARK AGES. Back in those days the seat of government often was filled with rats, vermin and leeches. Thank goodness those days are over.

(Historic footnote…..Published sources say that with so many people dying, millions of estates had to be settled - result…..the fallout of the plague was a huge growth in....the number of lawyers.)

There were no carts on Wall Street with guys crying "bring out your dead" yesterday. But in mid-afternoon, the stock market looked like it needed a doctor.

I’ve seldom seen so much rubbish written by people who ought to know better in a single day. Many able people have heaped the scorn and incredulity on three articles, one a piece on Rahm Emanuel slotted to run in the Sunday New York Times Magazine, another an artfully packed laudatory piece on Timothy Geithner by John Cassidy in the New Yorker and a more even handed looking one (I stress “looking”) in the Atlantic.

Ed Harrison has skillfully shredded parsed the Geithner pieces . Simon Johnson thrashed the New Yorker story. A key paragraph below:

The main feature of the plan, of course, was – following the stress tests – to communicate effectively that there was a government guarantee behind every major bank or quasi-bank in the United States. Of course this works in the short-term – investors like such guarantees. But there’s a good reason we usually don’t guarantee all financial institutions – or act happy when other countries do the same. Unconditional bailouts lead to trouble, encouraging reckless risk-taking and undermining responsible governance. You can’t run any form of reasonable market system when some big players hold “get out of bankruptcy free” cards.

Banking expert Chris Whalen was so disturbed by the numerous distortions in the New Yorker piece that he had already fired off a long letter to the editor by the time I pinged him, with these starting paragraphs:

Jack Cassidy tells us that “Timothy Geithner’s financial plan is working—and making him very unpopular.” Unfortunately this is completely wrong. Cassidy’s comment just illustrates why the New Yorker has fallen into such obscurity, namely because it is more Vanity Fair than its vivacious sibling and unable to perform critical journalism.

In fact, the banking system is continuing to sink under bad loans and even worse securities losses. Telling the public that the banks are “fixed” is irresponsible. Unfortunately this false perception is widespread, including among major media such as CNBC and also with a number of my clients in the hedge fund world.

And from Marshall Auerback, who had a ringside view of the aftermath of the Japanese bubble:

Cassidy’s article brings to mind a retort by Chou En Lai when he was asked about the success of the French Revolution. He said, “It’s too early to tell”. Yet here we have John Cassidy from the New Yorker and Joshua Green from The Atlantic both making the assumption that the Geithner plan “worked”. This whole line about “taxpayers to recover bailout money” is based on an accounting fraud, because accounting abuses are the primary means by which TARP recipients have repaid bailout money — putting us at greater risk. That may seem paradoxical, but the rush to repay is driven by a desire to have unrestrained executive bonuses (a very bad thing associated with far greater accounting fraud and failures — requiring future, larger taxpayer bailouts) and accounting abuses produce the (fictional) ability to repay the United States (primarily by failing to recognize existing losses). The TARP recipients weakened their financial condition, and increased moral hazard, when they rushed to repay the TARP funds. Both factors increase the risk of making more expensive future bailouts more likely.

Yves here. The reason that people who can discern clearly what is afoot are so deeply disturbed is simple, and all the comments touch on it. The campaign to defend Geithner and Emanuel, both architects of the administration’s finance friendly policies has gone beyond what most people would see as spin into such an aggressive effort to manipulate popular perceptions that it is not a stretch to call it propaganda.

This strategy, of relying on propaganda to mask their true intent, has become inevitable, given the strategic corner the Obama Adminstration has painted itself in. And this campaign has become increasingly desperate as the inconsistency between the Adminsitration’s “product positioning” and observable reality become increasingly evident.

Recall how we got here. Early in 2009, the banking industry was on the ropes. Both the stock and the credit default swaps markets said that many of the big players were at serious risk of failure. Commentators debated whether to nationalize Citibank, Bank of America, and other large, floundering institutions.

The case for bold action was sound. The history of financial crises showed that the least costly approach is to resolve mortally wounded organizations, install new management, set strict guidelines, and separate out the bad loans and investments in order to restructure and sell them. An IMF study of 124 banking crises concluded that regulatory forbearance, the term of art for letting impaired banks soldier on, found:

The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred…

Shuttering sick banks is hardly a radical idea; the FDIC does it on a routine basis. So the difference here was not in the nature of the exercise, but its operational complexity.

This juncture was a crucial window of opportunity. The financial services industry had become systematically predatory. Its victims now extended well beyond precarious, clueless, and sometimes undisciplined consumers who took on too much debt via credit cards with gotcha features that successfully enticed into a treadmill of chronic debt, or now infamous subprime and option-ARM mortgages.

Over twenty years of malfeasance, from the savings and loan crisis (where fraud was a leading cause of bank failures) to a catastrophic set of blow-ups in over the counter derivatives in 1994, which produced total losses of $1.5 trillion, the biggest wipeout since the 1929 crash, through a 1990s subprime meltdown, dot com chicanery, Enron and other accounting scandals, and now the global financial crisis, the industry each time had been able to beat neuter meaningful reform. But this time, the scale of the damage was so great that it extended beyond investors to hapless bystanders, ordinary citizens who were also paying via their taxes and job losses. And unlike the past, where news of financial blow-ups was largely confined to the business section, the public could not miss the scale of the damage and how it came about, and was outraged.

The widespread, vocal opposition to the TARP was evidence that a once complacent populace had been roused. Reform, if proposed with energy and confidence, wasn’t a risk; not only was it badly needed, it was just what voters wanted.

But incoming president Obama failed to act. Whether he failed to see the opportunity, didn’t understand it, or was simply not interested is moot. Rather than bring vested banking interests to heel, the Obama administration instead chose to reconstitute, as much as possible, the very same industry whose reckless pursuit of profit had thrown the world economy off the cliff. There would be no Nixon goes to China moment from the architects of the policies that created the crisis, namely Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke, and Director of the National Economic Council Larry Summers.

Defenders of the administration no doubt will content that the public was not ready for measures like the putting large banks like Citigroup into receivership. Even if that were true (and the current widespread outrage against banks says otherwise), that view assumes that the executive branch is a mere spectator, when it has the most powerful bully pulpit in the nation. Other leaders have taken unpopular moves and still maintained public support.

Obama’s repudiation of his campaign promise of change, by turning his back on meaningful reform of the financial services industry, in turn locked his Administration into a course of action. The new administration would have no choice other that working fist in glove with the banksters, supporting and amplifying their own, well established, propaganda efforts.

Thus Obama’s incentives are to come up with “solutions” that paper over problems, avoid meaningful conflict with the industry, minimize complaints, and restore the old practice of using leverage and investment gains to cover up stagnation in worker incomes. Potemkin reforms dovetail with the financial service industry’s goal of forestalling any measures that would interfere with its looting. So the only problem with this picture was how to fool the now-impoverished public into thinking a program of Mussolini-style corporatism represented progress.

How did the Administration and financial services message control teams work together?

The first was the refusal to consider investigations of any kind. Obama is widely reported to have studied the early days of Franklin Delano Roosevelt’s administration for inspiration; it would be impossible for him to miss the dramatic steps FDR took, including supporting the continuation of a Senate Banking Committee investigation into the misdeeds of the Roaring Twenties, the Pecora Commission. The Pecora Commission not only kept the bankers on the defensive, but it also did the forensic work into the abuses. It was critical to bring the nefarious practices to light to devise durable and lasting reforms.

Why were there no inquiries into how the firms that needed bailouts got themselves into a mess? This was an obvious and comparatively easy avenue of inquiry which would make a great deal of useful background accessible and identified issues for further examination. For instance, after the rescue of UBS, the Swiss Federal Banking Commission required UBS to provide an extensive report of what went wrong, and also had the bank make considerable portions of that information public, via a special report to its shareholders. Yet no US firm has been asked to make any explanation of how it managed its affairs so badly as to require extensive public support to keep from failing.

The choice here was obvious. A refusal to investigate was tantamount to a refusal to reform. A good understanding of what had happened was essential, not merely to develop sound new rules, but also to keep the industry from muddying the waters, which would be easy to do, given how complex and opaque many of the products are

More compelling evidence of the Administration’s lack of interest in reining in the money-changers came via Treasury Secretary Timothy Geithner’s first presentation on his reform plan, which was more accurately a plan to have a plan. It was widely criticized for its sketchiness, but most observers missed the true significance. Had the Obama transition team done any serious thinking about the financial crisis? Obviously not, because you don’t need to think too hard if the game plan is to go back to business as usual to the extent possible. Geither’s presentation came nearly three weeks after Obama was sworn in, and all its initiatives were Bush/Paulson wine in new bottles: a new go at the failed idea of having the government overpay for bad bank assets; “stress tests” to put more discipline around the process of handing out TARP funds to the needy; and a mortgage modification program which pretended to be able to square the circle of saving borrowers without taking on investors in mortgage securitizations.

Geithner’s not-much-of-a-plan exemplified the second tool in the Obama campaign to sell doing as little as possible to the financiers: the Theory of Positive Thinking.
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That notion has a proud tradition in America and was much in evidence in the run-up to the crisis. It promises that the economy will be fine as long as everyone thinks happy thoughts about it. For instance, I noted in a March 2007 blog post that while the tone of the Financial Times as of March 2007 had become generally grim, the US had become a Tinkerbell market, where valuations are held aloft by faith, and participants conspire to stoke true belief. And as the crisis wore on, other magical personages intervened. As a hedge fund manager who writes as Augustus Melmotte noted,

The market responded with enthusiasm to reports that the Tooth Fairy has agreed to acquire Lehman. The purchase price has not yet been determined and will be set by Dick Fuld wishing upon a star, clicking his heels three times, and being transported back to that magical place where Lehman still sells for over $70 per share….. Meanwhile, the SEC has announced an investigation of mean, evil, bad short-seller David Einhorn. …. Einhorn reportedly suggested that the Tooth Fairy does not exist and that wishing upon a star is not a wholly reliable price discovery mechanism. Christopher Cox, chairman of the SEC, said, “Vicious rumors attacking the Tooth Fairy will not be tolerated. Our entire financial system and indeed the American way of life depend on the Tooth Fairy and wishing upon a star…” The SEC is reportedly planning to set up re-education camps for short-sellers.

Remember that the US has an entire cable channel devoted to the Theory of Positive Thinking, namely CNBC, and a goodly portion of the financial media falls into CNBC-style cheerleading with more than occasional abandon.

Now it is true that this idea has a kernel of truth. John Maynard Keynes attributed the Depression to a change in investor “liquidity preferences,” which meant they had suddenly become very risk averse and preferred to hold cash until they felt conditions had improved, with devastating consequences for economic activity. Uncertainty can morph into a self-reinforcing downcycle. But it is one thing to use confidence boosting as a tool, quite another to regard it as a magic bullet. Merely clapping our hands all together will not cure the long-standing ailments in the economy.

Moreover, the Theory of Positive Thinking has been used, upon occasion, to suggest that conditions will only deteriorate if the public examines the financial services industry critically. It isn’t hard to see whose interests benefit from that posture.

Now it is hard to prove in a tidy way that the tone of financial press coverage had shifted suddenly, and decisively, to optimism as of early March. But many professional investors in my circle started regularly talking of cheerleading. Two Wall Street veterans, Sandy Lewis and William Cohan, weighed in on this pattern at the New York Times:

Whether at a fund-raising dinner for wealthy supporters in Beverly Hills, or at an Air Force base in Nevada, or at Charlie Rose’s table in New York City, President Obama is conducting an all-out campaign to try to make us feel a whole lot better about the economy as quickly as possible… We’re concerned that nothing has really been fixed. We’re doubly concerned that people appear to feel the worst of the storm is over — and in this, they are aided and abetted by a hugely popular and charismatic president and by the fact that the Dow has increased by 35 percent or so since Mr. Obama started to lay out his economic plans in March.

This result relied on more than mere dint of personality. A Pew Research Center study found that roughly government and businesses originated over half the economics-related news after the crisis. Obama himself “dominated” the key images and ideas. The reporting had a clear arc. The early coverage focused on the struggles over the stimulus plan and the banking industry plans, and as those faded, so did coverage of the crisis in any form. The tacit assumption was that the crisis was over, and the performance of the supposedly forward looking stock market was proof. But as anyone with a modicum of detachment could see, the market was a false positive, treating an aversion of utter disaster as an imminent return to normalcy.

The stock market has rallied over 60% from its early March lows, enabling the wounded banks to sell new equity to the public and avoid further contentious taxpayer-funded rescue measures. But the justification for the soft glove treatment of the banking classes, that what was good for them would prove to be good for everyone else, has proven to be wildly false. When the Dow levitated over 10,000, mainstream news outlets celebrated the event, with nary a mention of the continued train wreck in the real economy. As Matt Taibbi observed, “the dichotomy between the economic health of ordinary people and the traditional ‘market indicators’ is not merely a non-story, it is a sort of taboo — unmentionable in major news coverage.”

But banking boosterism has succeeded all too well, allowing Team Obama to fantasize that it can get away with creating Potemkin prosperity in lieu of waging the pitched battles needed to lay the groundwork for the real thing.

Indeed, the adoption of the Theory of Positive Thinking has virtually guaranteed that nothing will change, unless there is sufficient deterioration in the real economy or the financial markets to provide compelling counter-evidence. One example is the “paying back the TARP” charade. As the banks continued to post improved earnings, no matter how phony they were, they argued that they were now healthy and should be allowed to pay back the TARP funding that had been crucial to their survival. The reason they were so keenly motivated to do should have been reason enough to deny their request: namely, that they wanted to escape restraints on executive compensation, virtually the only demand that the government had made. But overpaying staff and keeping too little in the way of risk reserves was precisely the behavior that led to the near collapse of the financial system. Going back to business as usual would virtually guarantee more looting of major financial firm and another series of collapses.

But the Obama administration miscalculated badly. First, it bought the financiers’ false promise that massive subsidies to them would kick start a economy. But economists are now estimating that it is likely to take five years to return to pre-crisis levels of unemployment. Obama took his eye off the ball. A Democratic President’s most important responsibility is job creation. It is simply unacceptable to most Americans for Wall Street to be reaping record profits and bonuses while the rest of the country is suffering. Second, it assumed finance was too complicated to hold the attention of most citizens, and so the (non) initiatives under way now would attract comparatively little scrutiny. But as public ire remains high, the press coverage has become almost schizophrenic. Obvious public relations plants, like Ben Bernanke designation as Time Magazine’s Man of the Year (precisely when his confirmation is running into unexpected opposition) and stories in the New York Times that incorrectly reported some Goldman executive bonus cosmetics as meaningful concessions have co-existed with reports on the abject failure of Geithner’s mortgage modification program. While mainstream press coverage is still largely flattering, the desperation of the recent PR moves versus the continued public ire and recognition of where the Adminsitrations’s priorities truly lie means the fissures are becoming a gaping chasm.

So with Obama’s popularity falling sharply, it should be no surprise that the Administration is resorting to more concerted propaganda efforts. It may have no choice. Having ceded so much ground to the financiers, it has lost control of the battlefield. The banking lobbyists have perfected their tactics for blocking reform over the last two decades. Team Obama naively cast its lot with an industry that is vastly more skilled in the the dark art of the manufacture of consent than it is.

Two weeks after the indirect hit ratio in the 4 week auction came at a record 100%, today it was once again at almost at the all time possible high, with Indirect Bids of just $6.744 billion taking down $6.683 billion, resulting in a 99.1% hit ratio. The chart of the recent Indirect hit ratio in recent 4 week bill auctions is attached.

Here is the actual auction result:

• 4 week prices at 0.11% (nearly double the 0.056% from two weeks ago)
• 75.56% allotted at high; Median rate of 0.1%, low of 0.05%;
• Bid to Cover 3.90, compared to 4.34 last week
• Indirects take down $6.68 billion of competitives, or 21.8%;
• Indirect hit rate comes in at 99.1%

We provided the following explanation two weeks ago as to why this will likely be an ongoing theme, especially when coupled with aggressive roll offs of Bills by key investors such as China:

The implications from this result: the Indirect bidders put the greatest amount of 0.000% or as close to preliminary bids as possible (remember, this means bidding at the highest actual bond price), followed by directs and primary dealers as we approached the 0.055% stop out to fill the $31 billion reverse dutch auction. Yet the hit ratio has never been 100% before (or at least not according to our data). This means that indirects are not price fishing, trying to jigger the auction with low ball bids: they are simply reducing their absolute nominal exposure to the Bill space, further confirming the TIC data which showed China is now happy to let its Bills expire without rolling . We expect an increasing amount of 100% hit ratio Indirect bids in Bill auctions in the future, as the full amount of Bills tendered progressively declines, forcing Primary dealers to take down 80% or more of all future Bill auctions.

And in other news, now that we can stop all pretense about fiscal responsibility courtesy of the just increased debt ceiling, the Treasury just announced that it is increasing the balance of its Supplmentary Financial Program to $200 billion, which will be promptly filled by 8 sales of $25 billion 56-day Bills over the next 8 weeks. The SFP program, which was previously unwound to a mere $5 billion, will now be used to raise an incremental $195 billion in debt to fund the burgeoning deficit. A Treasury official was quoted as saying: "We're committed to working with the Federal Reserve to ensure they have the flexibility to manage their balance sheet." Since the Fed has the printer, we are committed to believing that whatever the Fed does will be in the dollar's best interest. The beatings to increase morale, as well as the 8 SFP sales, will commence promptly tomorrow and continue until mid-April.

This SFP news is relevant because today's Indirect Hit Ratio demonstrates that the "sales" of $195 billion in new SFP bills will merely go to Primary Dealers and whoever the increasingly less mysterious Direct Bidder is, as Indirects phase out all Bill interest altogether.

The $26 billion 52-week auction also closed today, with a 4.00 BTC, compared to 3.65 previously.

There are a handful of good ideas in some of the latest proposals floating around: Consolidate all of the banking oversight into one super regulator to prevent forum shopping. Then give that regulator teeth. (I suggest the FDIC is the best office to do this in).

Here are some of the proposals under discussion:

“Strip the Federal Reserve of regulatory powers over all but the very largest banks, those with more than $100 billion in assets, people briefed on the negotiations said on Monday night.

The plan would remove Fed oversight from all but 23 of the 4,974 bank holding companies, which have a collective $16.7 trillion in assets, and from 874 state-chartered member banks that are members of the Fed system and that have a total of $1.7 trillion in assets.

The vast majority of the bank holding companies would be overseen by a regulatory agency formed from a merger of the Office of the Comptroller of the Currency, which oversees national banks, and the Office of Thrift Supervision, which regulates savings and loans, the individuals said. Regulation of the state banks would go to the Federal Deposit Insurance Corporation, which already oversees about 5,000 banks that are not part of the Fed system.”

Perhaps the rationale for the big banks staying under the jurisdiction of the Fed is that it somehow effects monetary policy through their primary dealers of US Treasuries.

But I don’t see why we want or need to keep the Fed overseeing even those 23 banks . . .

>

Source:
Fed’s Reach May Be Curbed Under Plan
SEWELL CHAN
NYT: March 8, 2010
http://www.nytimes.com/2010/03/09/business/economy/09regulate.html

With Geoffrey Batt

The ongoing troubles at the GSEs are no secret: it is public knowledge that Fannie had a 5.38% delinquency rate at December, while Freddie just passed the 4% threshold in January; both continue to rise rapidly each month. The fact that the mortgage-bond spread has just hit a record tight is merely an ongoing artifact of the Fed's endless meddling in the mortgage market, with the sole purpose of keeping rates artificially low, and preventing banks from being forced to take massive writedowns on their entire loan book. This is all well known. What, however, seems to have escaped public attention is what the impact of these delinquencies is on the one largest holder of Mortgage Backed Securities, the Federal Reserve. What also seems to have escaped the public is that the Fed is now the world's largest bank, with total assets near $2.3 trillion. We provide a weekly update of the Fed's balance sheet and while we briefly note the liability side, our, and everyone else's, attention, is traditionally focused on the asset side. Yet a more detailed look at the liability side reveals something very troubling, specifically that the Fed's capital, i.e. equity buffer, which as of most recently was $53.3 billion (a comparable metric for plain vanilla banks is their equity buffer, or Tier 1 Capital, or however the FASB wants to define it on any given day when it is covering up massive capital shortfalls) is in fact negligible and could well be substantially negative, if the Fed were to account for the rapidly rising level of delinquencies in its one largest asset holdings: the $1.027 trillion in settled MBS. And while there is no possibility of a run on the Fed, the reality is that the Fed now likely runs with a negative real capital balance, meaning that the US Federal Reserve is now essentially insolvent.

First, we present the Fed's assets broken down by key segments. The chart below shows the most recently disclosed asset holdings as per the H.4.1 statement. Of the $2.3 trillion in assets, the vast majority, or $1 trillion is held in MBS. As pointed out previously, this is only the settled amount - in reality the Fed has already purchased $1.22 trillion in MBS, which will settle over time. In practice, this merely means that the potential for asset impairment at the Fed is even greater by about 20%.The chart also shows what happens to MBS holdings if haircuts of 5%, 10% and 15% are applied.

Like any balance sheet, where there are assets, there are liabilities, and some version of capital/equity. The Fed's liabilities are two principal components: currency in circulation, which has been at about $900 billion for an extended period of time, and the much more relevant recently line item called "Bank Deposits", which has been popularized as Reserves with Federal Reserve Banks (or excess reserves). The Reserve line has increased from essentially nothing to nearly $1.3 trillion in the span of a few months. Furthermore, as more and more MBS purchased are settled, the excess reserve line will soon reach at least $1.6 trillion, if not more, if indeed Q.E. 2 is launched at some point in the future. The persistent discussions of potential inflation center precisely on the interplay between the green and blue blocks in the chart below: as long as the Currency in Circulation is flat, and Bank Deposits keep rising, the probability of inflation is slim to none. In essence, excess reserves exist only due to the Taylor rule implied negative Fed Funds rate. Should there be a material shift from green to blue, or from excess reserves to currency in circulation, that is when the hyperinflationary threat becomes all too real, as suddenly far too much money will chase a fixed amount of assets. This is also where the discussion about all the various mechanisms that the Fed has at its disposal to moderate tightening comes into play, whether it involves selling of assets, increase of the rate on reserves, or some combination inbetween (we point readers to yesterday's paper from the Minneapolis Fed which discusses these options, and the caveats associated with each). While the asset reallocation debate is very interesting, it is not the topic of this discussion.

The one item on the balance sheet that is often ignored, is the Fed's "Equity", or as it is defined, "Capital." As previously pointed out, this line item is currently $53.3 billion. It is shown graphically in the leftmost column of the chart below, which depicts actual Fed liabilities. Where the interesting part comes in, is when one analyzes what happens to the Fed's capital when the abovementioned MBS haircuts are applied.

A 5% realized haircut on MBS alone would result in a complete elimination of the Fed's capital balance. Applying a 10% or even 15% haircut, results in a capital deficiency of $50 billion and $100 billion respectively. This deficiency will grow as more and more MBS are settled, and as the serious delinquency rate on MBS keeps increasing (no danger in this moderating any time soon). 

Now in an environment, such as the one we live in today, when mark-to-myth is the new normal, and when banks are encouraged to come up with creative ways to indicate that their Residential and Commercial Loan portfolios are worth par (despite recent disclosures by the FDIC), to assume that the Fed would do something that lowly depositor banks are told not to do, would be folly. Yet, for those who prefer to live away from Never Never land, and brave this thing called reality, just what will happen if and when the Fed finally does disclose that it is, for all intents and purposes, insolvent?

The pragmatics among you will say: this is irrelevant, the Fed can just print more money and fill in any capital hole. Well, yes and no. As an increase in cash would have to be offset by a comparable increase in some asset, it is not that simple. For a refined analysis of what would happen in that moment of clarity when the world realizes the world's biggest bank is broke, we turn to a presentation by Chris Sims, given before Princeton University, titled "Fiscal/Monetary Coordination When The Anchor Cable Has Snapped." We encourage all readers to read this powerpoint cover to cover, as it discusses precisely the issues were are faced with today: namely a monetary policy that has run amok, seignorage, exploding excess reserves, the impact of these on "power money", and, in general, a Fed balance sheet that is increasingly reminiscent of a drunk, rapid and schizophrenic bull in a China store.

Among other relevant things we note that as the author points-out that "Interest bearing deposits at the Fed do not (yet) count against the Federal debt ceiling" and "if substantial interest is paid on reserves, they could constitute a major leak in the US system for legislative control of debt creation or they are not backed by the full faith and credit of the US government, which has implications for inflation control" - the consequences here are material - with a $1 trillion plus in vacuum interest-collecting paper which in all other world would be counted toward the debt ceiling, the US debt subject to limit would increase from the $12.5 trillion currently to about $13.7 trillion. Add in $6 trillion from the GSEs and America is already at the dreaded $20 trillion threshold. And furthermore, what happens to the interest payments by the Fed should rates go up to 100 bps, 200 bps? On $1.6 trillion in excess reserves this is a material amount that would reinforce inflation in a circular loop, further justifying why the Fed is mortally worried about a rise in rates.

As for the topic at hand, we turn to pp 23-24 of the presentation:

• Central bank operations generate fluctuating levels of net earnings (seigniorage), most of which are turned over to the Treasury as revenue
• Central bank balance sheets sometimes go into the red. The Treasury may then recapitalize it by creating, and giving to the central bank, new government debt
• [The Fed's] Independence meant that the legislature and the Treasury did not complain [much] about seignorage fluctuations or about the effect of interest rate changes on the Treasury's interest expense
• Fed can always "print money" to pay its bills.
• There is no possibility of a run on the Fed, since its liabilities make no conversion promise.
• A commitment to a path for inflation or the price level makes the balance sheet matter.
• Without Treasury backing, the Fed must rely on seigniorage to raise revenues, and that can conflict with inflation-control goals.

So here is the crux of the issue: the only way to deal with a mark-to-market of the Fed currently is to embrace monetization. It is no longer a question of semantics, of who promised what: it is the only mechanical way by which the Fed can dig itself out of a capital deficiency. With GSE delinquencies exploding, and with the Fed (and Congress) singlehandedly facilitating imprudent lender policy by allowing ever more borrowers to become deliquent without consequences, the MBS delinquency rate will likely hit 10% over the next 6-12 months. At that moment, someone will ask the Fed: "what is the true basis of your capital account?" And when the Fed is forced to justify a valid response, is when monetizaton will begin.

Since the market deals in expectation absolutes, all it would take for rates to breach the inflection point black swan and commence going up, is the mere possibility of open monetization.

What we hope to show with this exercise is that no course of action, even the one currently employed by the Fed, can continue in perpetuity: you can't have infinitely low housing rates in an environment of exploding delinquencies, as even more MBS are onboarded on the taxpayer's balance sheet. The reality is that inflationary conerns will come to a fore, and have a material impact on rates, the second all these speculations are voiced in a more reputable arena. At that point the game will be up; the Fed's attempt to continue the status quo will be over, and the relentless rise up in rates will begin, culminating with the long-awaited Minsky moment.

As for the timing of this development? We will join the Bob Janjuah camp on this one. While few have the guts to take the money printer head on, doing so early is certainly suicidal. Yet with each passing day, all those who are fully aware that the Fed's course is one of self-destruction, grow bolder, until finally one day a new class of investors - the Fed vigilantes will emerge, looking for cheap opportunities to make a killing (think ABX) on the other side of the "Fed trade", which ultimately will lead to a systemic catharsis of unprecedented proportions.

At that point neither gold, nor lead will be in any way useful. Beta and gamma radiation will make sure of that.

From Brian P. Sack, Executive Vice President. Recall that Brian is the de-facto head of the Fed's "markets group" operation located on the 9th Floor of Liberty 33. If there is indeed a Plunge Protection Team, Brian is likely the PM who runs it.

Remarks at the National Association for Business Economics Policy Conference, Arlington, Virginia

Thank you for inviting me to speak today. In my remarks, I will provide an update on the progress that the Federal Reserve is making toward preparing for a smooth exit from the extraordinary policy actions that were taken in response to the financial crisis.¹

I should note up front that I will not be providing any information about the likely timing of policy tightening; those decisions will be made and communicated by the Federal Open Market Committee (FOMC). Instead, I will focus my comments on the policy tools and strategy that are likely to be used whenever that exit becomes appropriate. I will also discuss the preparedness of financial markets for the Fed's exit, in order to assess how financial conditions may evolve as the exit approaches and gets under way.

When the time comes to tighten monetary policy, the Federal Reserve will be embarking on a tightening cycle like no other in its history. First, this tightening cycle will have two policy dimensions, in that the FOMC will have to decide on the path of its asset holdings in addition to the path of the short-term interest rate. Second, we will be using tools to drain reserves that are new and that will have to be implemented on a scale that the Fed has never before tried. And third, we will be operating in a framework of interest on reserves that has not been fully tested in U.S. markets.

All of that may sound risky. However, I believe the Federal Reserve is positioned to minimize any risks involved. Most important, we have worked hard to ensure that we have all of the tools needed to exit, and FOMC members have begun to describe a strategy for using them that is cautious along several dimensions. In addition, if we communicate effectively, the markets should be clearly informed and well prepared ahead of the exit. These are the points that I will emphasize in more detail.

Liquidity Facilities: A Success Story
When discussing the Federal Reserve's exit strategy, it is important to separate liquidity facilities from the stance of monetary policy. While the exit from the accommodative monetary policy stance has yet to begin, the exit from liquidity facilities is nearly complete. Let me begin with some comments on recent developments regarding the liquidity facilities, and then I will move on to monetary policy.

As is well known, the Federal Reserve launched a number of liquidity facilities to provide short-term funding to the financial markets during the crisis, in order to meet the extraordinary demand for liquidity at that time. Here I am referring to those facilities that provided funding at maturities of up to three months to particular sets of firms, such as the primary dealers, money market mutual funds, commercial paper issuers, and depository institutions.² Just today, we conducted the last operation associated with those facilities, meaning that all of the short-term liquidity facilities that were introduced during the crisis have now effectively been retired. The only special liquidity program that remains active is the Term Asset-Backed Securities Loan Facility, which I consider to differ from the short-term liquidity programs because it provides funding for up to five years.

With the wind-down of these short-term liquidity facilities, it is a good time to look back and assess their performance. The bottom line here is simple: These programs were an unquestionable success. We have witnessed a remarkable improvement in the functioning of short-term credit markets and an impressive recovery in the stability of large financial firms. While a whole range of government actions contributed to this recovery, giving financial institutions greater confidence about their access to funding, and that of their counterparties, was most likely a crucial step toward achieving stability.

Moreover, the exit from these facilities has been quite smooth. At their peak, these facilities provided more than $1.5 trillion of credit to the economy. Today, the remaining balance across them is around $20 billion. It is impressive that the Fed was able to remove itself from such a large amount of credit extension without creating any significant problems for financial markets or institutions. That success largely reflects the effective design of those programs, as most were structured to provide credit under terms that would be less and less appealing as markets renormalized. This design worked incredibly well, as activity in most of the facilities gradually declined to near zero, allowing the Fed to simply turn them off with no market disruption.

The success of these facilities should be judged by the outcomes they produced for financial market functioning, and not by the financial returns they generated on the Federal Reserve's books. However, there are several reasons why the Fed might be expected to profit from this type of lending under most circumstances. First, the Fed is providing funds in response to an extreme move in the price of liquidity—that is, it is in effect buying a cheap asset. Second, the programs themselves, if successful at returning market functioning, would help the performance of the Fed's loans to be sound. And third, the lending under these facilities has to be adequately secured.

Asset Holdings: A Policy Lever
While the exit from the liquidity facilities has been successful, the exit from the accommodative stance of monetary policy involves a different set of challenges. Many of these challenges arise from the Federal Reserve's outright holdings of Treasury debt, agency debt and agency mortgage-backed securities (MBS), which together represent the overwhelming share of the Fed's balance sheet today. Indeed, as a result of our large-scale asset purchase programs, these asset holdings now account for $2.0 trillion of the Fed's $2.3 trillion balance sheet.

The Federal Reserve is approaching the scheduled end of its large-scale asset purchases. We have bought $169 billion of agency debt to date, nearly fulfilling our plan to purchase "about $175 billion." For MBS, we have only about $30 billion of purchases remaining to reach our $1.25 trillion target. In addition, we completed $300 billion of purchases of Treasury securities late last year. Looking across these programs, we have now purchased $1.69 trillion of assets, bringing us 98 percent of the way through our scheduled purchases. To get to this point, the Trading Desk at the New York Fed has so far conducted 126 discrete operations to purchase Treasury and agency debt, and has managed 292 trading days on which either it or its investment managers have acquired MBS.

My view is that the purchase programs have helped to hold down longer-term interest rates, thereby supporting economic activity. With the conclusion of the programs approaching, the Desk has been tapering the pace of its purchases of agency debt and MBS. However, even as the pace of our purchases has slowed, longer-term interest rates have remained low, and MBS spreads over Treasury yields have remained tight. This pattern suggests that the effects of the purchases have been primarily associated with the stock of the Fed's holdings rather than with the flow of its purchases. In that case, the market effects of the purchase program will only slowly unwind as the balance sheet shrinks gradually over time.³

In my previous speech back in December, I discussed in detail the channels through which these market effects may arise. By removing large amounts of duration and prepayment risk from the market, the Fed's asset purchases reduced the volume of risk that the market had to hold, which lowered the risk premia on those assets. Put differently, the purchases bid up the prices of those assets and hence lowered their yields. The lower levels of yields would be expected to boost other asset prices as investors substitute into alternative asset classes. These patterns describe what researchers often refer to as portfolio balance effects.

Such effects are important to consider, because they have implications for monetary policy. If the Fed's holdings of assets have produced lower long-term interest rates, the FOMC has to carefully take into consideration how it will manage the size of its balance sheet going forward. In particular, a rapid and substantial reduction in our holdings of assets would likely push up long-term interest rates that is, it would put upward pressure on those rates by unwinding the portfolio balance effect. That increase in long rates would, in turn, weigh on other asset prices, reversing the positive effects that had been associated with the expansion of the Fed's balance sheet.

Under this view, the size of the Fed's asset holdings becomes a relevant policy lever. Accordingly, this will be the first tightening cycle for which there are two broad policy decisions in play, as the FOMC will have to set out not only the path of the short-term interest rate, but also the path of its asset holdings. The decisions on these two variables will have to be made in conjunction with one another to produce the desired outcome for economic activity and inflation.

These considerations leave open a range of outcomes for how the two instruments will be used. In his February 10 testimony, Chairman Bernanke described a possible approach for managing the size of the balance sheet. In particular, he indicated that he does not currently anticipate that the Fed will sell any of its asset holdings until the economic recovery is more firmly established and policy tightening has gotten underway. Until that time, the portfolio would shrink only through asset redemptions. Chairman Bernanke noted that the Fed's holdings of agency debt and MBS are being allowed to roll off the balance sheet, without reinvestment, as those securities mature or are prepaid, and that the FOMC may choose to redeem some of its holdings of Treasury securities in the future, as well.

With this approach, the FOMC would be shrinking its balance sheet in a gradual and passive manner. That, in my view, is a crucial message for the markets. It should limit any reversal of the portfolio balance effects described earlier, effectively putting reductions in asset holdings in the background for now as a policy instrument. As long as this approach is maintained, it would leave the adjustment of short-term interest rates as the more active policy instrument—the one that would carry the bulk of the work in tightening financial conditions when appropriate.

This approach is cautious in several dimensions. First, a decision to shrink the balance sheet more aggressively could be disruptive to market functioning. Second, a more aggressive approach would risk an immediate and substantial rise in longer-term yields that, at this time, would be counterproductive for achieving the FOMC's objectives. Third, the effects of swings in the balance sheet on the economy are difficult to calibrate and subject to considerable uncertainty, given our limited history with this policy tool. And fourth, policymakers do not need to use this tool to tighten financial conditions. They can tighten financial conditions as much as needed by raising short-term interest rates, offsetting any lingering portfolio balance effects arising from the still-elevated portfolio.

Even under this cautious strategy of relying only on redemptions, the Federal Reserve could achieve a considerable decline in the size of its balance sheet over time. From now to the end of 2011, we project that more than $200 billion of the agency debt and MBS held by the Federal Reserve will mature or be prepaid, though the actual total will depend on the path of long-term interest rates and the prepayment behavior of mortgage holders. Thus, the Fed's asset holdings would shrink meaningfully if the FOMC maintains its current strategy of not reinvesting those proceeds. In addition, about $140 billion of Treasury securities mature between now and the end of 2011, giving the FOMC scope to reduce its asset holdings even further if it chooses to not replace some of those maturing securities.

While the passive strategy of relying on redemptions may be appropriate for now, it might not be sufficient over the longer-term. One problem is that relying only on redemptions would still leave some MBS holdings on our balance sheet for several decades. As indicated in the minutes from the January meeting, the FOMC intends to return to a Treasuries-only portfolio over time. This consideration could motivate the FOMC to sell its agency debt and mortgage-backed securities at some point, once the economic recovery has progressed sufficiently.

Draining Tools: Control of Short-Term Rates
Under the strategies just described, the Fed's asset holdings are likely to still be elevated at the time that the FOMC wants to raise short-term interest rates. That creates a challenge for controlling those rates, because of the large amounts of reserves that were created from the Fed's purchases of those assets. It is therefore important for the Fed to determine the way in which it will raise short-term interest rates in an environment with so much
liquidity—a topic that I will now cover.

The primary vehicle for making adjustments to short-term interest rates in that environment is the ability to pay interest on reserves. We would expect changes in the interest rate on reserves to have a significant influence on other short-term interest rates. However, in order to ensure our ability to influence those other short-term interest rates, we have been developing two tools that can be used to reduce the large amount of excess reserves in the banking system—term deposits with banks and reverse repurchase agreements (reverse repos) with a broader universe of financial institutions. Let me first provide an update on the progress we have made in developing these tools.

On term deposits, the Federal Reserve has received public comments on the proposed structure of the facility that was published in December, and we are working toward its final form. As described in the recent Monetary Policy Report, the Federal Reserve expects to be able to conduct test transactions in the spring and to have the facility fully ready, shortly thereafter, to conduct transactions when needed.

On reverse repos, we have already successfully run small-scale operations using Treasury and agency debt as collateral with primary dealers. However, that leaves two significant steps still to take in preparing the tool. One is developing the capacity to use our MBS holdings as collateral. Work in that area is nearly complete, and we will likely conduct some small-scale operations with MBS collateral in a month or so to exercise that capability. The other step is expanding the set of counterparties that we use for such operations. Earlier today, we published criteria for money market mutual funds to become eligible to participate in reverse repo operations, which was a first and important step in that direction. We are currently working with other types of firms to assess their potential participation in the program, as well. Our expectation is to have arrangements in place and to be ready to transact with some non-dealer firms by the end of the second quarter. This expansion of counterparties is important for boosting the capacity of the program.

The bottom line is that the preparation of both facilities is advancing very effectively. Looking across the two programs, we will have established the capacity to drain a significant portion of excess reserves by the second half of the year. Of course, achieving this capacity does not say anything about how and when the FOMC will decide to actually drain reserves.

The actual timing and size of draining operations, and their relation to changes in the interest rate paid on reserves, will depend on how market and economic conditions evolve. Chairman Bernanke discussed one possible sequence in his February 10 testimony. He suggested that operations to drain reserves could be run on a limited basis well ahead of policy tightening, in order to give market participants time to become familiar with them, and then could be scaled up to more significant volume as we approach the time for policy tightening.

Removing a portion of the excess reserves from the system ahead of increasing the rate paid on reserves is a cautious approach, as it should improve the Fed's control of short-term interest rates when it comes time to tighten monetary policy.⁴ To be sure, even at today's reserve levels, we would expect the interest rate paid on excess reserves to exert considerable pull on other short-term interest rates such as the federal funds rate or repo rates. However, we are unsure of the exact relationship between these rates and believe that it is likely to be tighter when the banking system is not as saturated with liquidity as it is today. Thus, it may be prudent to remove some portion of excess reserves before raising the interest rate on reserves.

Note that the policy tightening in this scenario will still likely be taking place in an environment of large excess reserve balances, and the main workhorse of the tightening cycle will still be the interest paid on reserves. However, the draining tools can be used to best ensure the success of that framework.

Market Conditions: At Risk on Exit?
Finally, let me turn to conditions in financial markets and discuss whether there may be vulnerabilities related to the Fed's exit from the current monetary policy stance. I think there are two potential areas of concern.

The first potential concern is that the exit strategy could simply cause confusion among market participants, prompting volatility in asset prices. As noted earlier, this tightening cycle, when it arrives, will be more complicated than past cycles, as there will be more decision points facing policymakers. With more decision points come more opportunities for the markets to be confused by our actions. The recent changes to the discount rate and the Treasury's Supplementary Financing Program balances highlight this concern, as the amount of attention that those actions received was outsized relative to their significance for the economy or for the path of short-term interest rates.

The burden is on the Fed to mitigate this risk by communicating clearly about its policy intentions and the purpose of any operational moves it might take. In this regard, the forward-looking policy language that the FOMC is currently using in its statement is important. I would argue that this language contains much more direct and valuable information about the likely path of the short-term interest rate target than does any decision about draining reserves. Indeed, it will be difficult for market participants to make precise inferences about the timing of increases in the target interest rate from the patterns of reserve draining alone, in part because the FOMC has not specified the path of reserves it intends to achieve before raising interest rates.

The second potential concern that some may have is whether the markets have adequately priced in the exit strategy. However, a few considerations should limit this concern. Most important, the current configuration of yields and asset prices incorporates expectations that short-term interest rates will begin to rise around the end of this year. Thus, the markets seem prepared for the risks toward tighter policy. Moreover, looking out to longer maturities, the shape of the Treasury yield curve appears to incorporate not only expectations of policy tightening, but a decent-sized term premium on longer-term securities. Indeed, the term premium is well above the levels observed over most of the past several years, even though inflation is likely to be low and upside inflation risks are limited. This should help to diminish the chances of a sizable upward shift in yields.

A related issue is whether the current levels of risky asset prices will prove robust in a rising rate environment. This may be a particular concern among those who argue that the current low policy rate environment has fueled an unsustainable rise in asset prices beyond their fundamental values. However, this is not clearly the case on a broad basis. Obviously, risky asset prices have undergone a historic rise from their trough in early 2009. But this rise began from an extreme starting point, one in which asset prices were being depressed by the baseline forecast of a deep recession, by the prospect of further downside risks to the economy, and by very elevated risk premiums.

As the economy stabilized, asset prices benefitted from both the improving economic outlook and a significant renormalization of risk premiums—a pattern that was a desired outcome from the stance of monetary policy. Moreover, we do not see definitive signs that risk premiums have broadly become too low at this point. To be sure, a number of significant risks remain in the economic outlook, and those translate into financial market risks. Eventually, though, we expect to reach a period of sustained, above-trend growth to absorb the substantial slack in place, which is an environment that should be quite supportive of risky asset prices. Policy tightening will presumably occur as that happens, limiting the downside risk to markets associated with policy actions.

Conclusion
In conclusion, the exit from the various liquidity facilities that the Federal Reserve implemented has been very successful, as the up-front design of those facilities reduced the need to actively manage the end of those programs. However, the exit from the current stance of monetary policy is quite different, in that it will have to be actively managed to ensure a smooth exit.

I began the speech by noting that we face an extraordinary challenge with this exit, given the historic steps that have been taken with the Fed's balance sheet. This challenge, which involves operating in uncharted territory along several dimensions, will inherently involve some uncertainties and risks. However, as I hope is clear from my remarks, the Federal Reserve's efforts to date should minimize those risks. Indeed, I believe the Fed's efforts have been prudent along a number of dimensions.

As a first step, we have been careful to make sure we have an adequate set of tools. To that end, we have developed multiple tools that can be used for draining reserves, in order to ensure our capability to do so. Moreover, we have been testing those tools and will continue to take steps to ensure that we and the markets are prepared to use them in more significant volumes when needed. Developing the tools is not enough, though. As a second step, policymakers will need to formulate a strategy for using them in an appropriate manner to avoid any undesired outcomes for financial markets and the economy.

The FOMC is actively engaged in determining that strategy, as indicated in the FOMC minutes from the January meeting. The strategy to be employed has not been fully decided, but recent speeches by FOMC members and the recent FOMC minutes have begun to convey some of the possibilities. Many of the potential steps described seem to guard against the risks involved. For example, reducing the size of the Fed's balance sheet through redemptions for now will produce a gradual adjustment that will be easier for the markets to digest. In addition, steps taken to drain reserves ahead of policy tightening may best ensure the success of interest on reserves at influencing other short-term interest rates.

Overall, an approach along these lines should help to ensure a smooth exit from the current accommodative stance of monetary policy. Moreover, if the Fed's intentions are well communicated to the financial market participants, they too should be fully prepared and in the best possible shape for navigating this exit.

^{______________________________________________________
1} The views expressed here are not necessarily shared by the Federal Open Market Committee or by other members of the staff of the Federal Reserve Bank of New York.
² In discussing these facilities, I am not including any provision of credit intended to support specific institutions, including those associated with the Maiden Lane LLCs. I include the Term Securities Lending Facility in with short-term lending facilities, even though it provided the market with Treasury securities rather than reserves, because it was often used to find funding for positions in less liquid securities.
³ An alternative explanation is that the large-scale asset purchases have had no effect and that the low levels of rates and spreads simply reflect other factors. However, I believe the evidence indicates that the asset purchases have contributed to the low level of longer-term rates.
⁴ Some have discussed whether the draining of excess reserves has effects on the economy beyond the implications for short-term interest rates. In my view, it would be surprising if there were significant effects on the real economy or inflation associated with substituting one short-term, liquid, risk-free asset (reverse repos or term deposits with the Fed) for another (reserves), except for the degree to which that substitution affects the Fed's control of overnight interest rates.

In a letter to the CFTC's Chairman, Gary Gensler, GATA Chairman William Murphy shares the following bombshell:

"GATA has evidence that there are enormous physical short positions in the gold and silver markets that cannot be covered."

Even as the CFTC is meeting later this month to establish position limits in the gold, silver, and other precious metals' markets, it could be none other than the CFTC's core banks, and Mr. Gensler's former Goldman bosses, that form the very core of the biggest market manipulation collusion syndicate in the history of the commodity markets.

Because of the decades-long interference with the gold market, we estimate that the free-market price of gold is multiples of the current price. Growing stress caused by burgeoning physical bullion demand is threatening to lead to a price explosion, which will restore to the market the balance that regulation has failed to maintain. In our view, the Comex paper market will become dysfunctional, with "force majeure" having to be declared as the concentrated shorts are unable to deliver on their obligations."

If GATA is not bluffing and indeed has evidence of massively uncoverable physical positions, and should this evidence be made public, the repercussions for the price of gold will be unprecedented.

Full GATA letter to ex-Goldmanite, and Brooklandville, MD resident, Gary Gensler:

March 8, 2010

Gary Gensler, Chairman
U.S. Commodity Futures Trading Commission
3 Lafayette Centre
1155 21st St. NW
Washington, DC 20581

Dear Chairman Gensler:

The Gold Anti-Trust Action Committee (GATA) was formed in January 1999 to expose and oppose the manipulation and suppression of the price of gold. What we have learned over the past 11 years is of great importance in regard to the CFTC’s forthcoming hearings regarding position limits in the precious metals futures markets. Our efforts to expose manipulation in the gold market parallel those of Harry Markopolos to expose the Madoff Ponzi scheme to the Securities and Exchange Commission.

Initially we thought that the manipulation of the gold market was undertaken as a coordinated profit scheme by certain bullion banks, like JPMorgan, Chase Bank, and Goldman Sachs, and that it violated federal and state anti-trust laws. But we soon discerned that the bullion banks were working closely with the U.S. Treasury Department and Federal Reserve in a gold cartel, part of a broad scheme of manipulation of the currency, precious metals, and bond markets.

As an executive at Goldman Sachs in London, Robert Rubin developed an idea to borrow gold from central banks at minimal interest rates (around 1 percent), sell the bullion for cash, and use the cash to fund Goldman Sachs' operations. Rubin was confident that central banks would control the gold price with ever-more leasing or outright sales of their gold reserves and that consequently the borrowed gold could be bought back without difficulty. This was the beginning of the gold carry trade.

When Rubin became U.S. treasury secretary, he made it government policy to surreptitiously operate an identical gold carry trade but on a much larger scale. This became the principal mechanism of what was called the "strong-dollar policy." Subsequent treasury secretaries have repeated a commitment to a "strong dollar," suggesting that they were continuing to feed official gold into the market more or less clandestinely to support the dollar and suppress interest rates and precious metals prices.

Lawrence Summers, who followed Rubin as treasury secretary, was an expert in gold's influence on financial markets. Previously, as a professor at Harvard University, Summers co-authored an academic study titled "Gibson's Paradox and the Gold Standard," (see Footnote 1 below) which concluded that in a free market gold prices move inversely to real interest rates, and, conversely, if gold prices are "fixed," then interest rates can be maintained at lower levels than would be the case in a free market. This was the economic theory behind the "strong dollar policy."

Federal Reserve Chairman Alan Greenspan understood Summers' research when he remarked at a 1993 meeting of the Federal Open Market Committee:

"I was raising the question on the side with Governor Mullins of what would happen if the Treasury sold a little gold in this market. There's an interesting question here because if the gold price broke in that context, the thermometer would not be just a measuring tool. It would basically affect the underlying psychology." (See Footnote 2 below.)

GATA has collected reams of evidence that Western central bank gold has long been mobilized and surreptitiously dishoarded to rig the gold market and influence related markets and that this rigging has drawn upon the U.S. gold reserves.

President Obama has called for greater transparency in both the federal government and the financial markets. In pursuit of such transparency GATA has made Freedom of Information Act requests to the Federal Reserve and Treasury Department for a candid accounting of their involvement in the gold market, particularly in regard to gold swaps. In a reply to GATA's lawyers dated September 17, 2009, Fed Governor Kevin M. Warsh acknowledged that the Federal Reserve has gold swap agreements with foreign banks but insisted that such documents remain secret. (See Footnote 3 below.)

As a result, last December GATA sued the Federal Reserve in U.S. District Court for the District of Columbia, seeking access to the Federal Reserve's withheld records of gold swaps.

Understanding that the manipulation of the price of gold is profoundly important to all markets and the American public, on January 31, 2008, GATA placed a full-page color advertisement in The Wall Street Journal at a cost of $264,000. (See Footnote 4 below.) GATA's ad warned, "This manipulation has been a primary cause of the catastrophic excesses in the markets that now threaten the whole world." What GATA warned against has come to pass.

GATA has long implicated the New York Commodities Exchange (Comex) as being a mechanism by which gold and silver price suppression is implemented. The smoking gun is the excessive concentration of bullion bank positions in the gold and silver futures markets. This concentration enables market manipulation -- just as market concentration was the justification offered by the CFTC in 1980 when it acted against the Hunt Brothers in the silver market.

The weekly commitment of traders report documents the total net short position of commercial traders in the commodity markets. The monthly bank participation reports disclose the holdings of U.S. banks in various markets. In a letter to GATA dated February 19, 2009, Laura Gardy, a CFTC legal assistant, wrote, "The commission determined that where the number of banks in each reporting category is particularly small, fewer than four banks, there exists the potential to extrapolate both the identity of individual banks and the banks' positions. As a result, as of December 2009 the CFTC no longer names the number of banks when it is less than four."

The CFTC has been investigating possible manipulation of the silver market for more than a year, so this reporting change is disturbing to us, as it reduces transparency and the ability to uncover market manipulation.

The CFTC's own reports of November 2009 show that just two U.S. banks held 43 percent of the commercial net short position in gold and 68 percent of the commercial net short position in silver. In gold, these two banks were short 123,331 contracts but long only 523 contracts, and in silver they were short 41,318 contracts and long only 1,426 contracts. How improbable is it that these two banks attract most of the investors who want only to sell short? (See Footnote 5 below.)

It has been possible to extrapolate that the two banks that hold these large manipulative short positions on the Comex are JPMorgan Chase and HSBC because of their huge positions in the OTC derivatives market, whose regulator, the U.S. Office of the Comptroller of the Currency, does not provide anonymity when it publishes market data. 6 In the first quarter 2009 OCC derivatives report, JPMorgan Chase and HSBC held more than 95 percent of the gold and precious metals derivatives of all U.S. banks, with a combined notional value of $120 billion. This concentration dwarfs the concentration in the gold and silver futures markets and should raise great concern about the lack of position limits on the Comex.

It is also disturbing to us that HSBC is the custodian for the major gold exchange-traded fund, GLD, and that JPMorgan Chase is the custodian for the major silver exchange-traded fund, SLV. It is a significant material omission to fail to disclose to GLD and SLV investors that the custodian banks of the two exchange-traded funds have an interest in falling prices in the futures and derivatives markets.

Detailed daily monitoring of gold trading reveals these patterns:

1. In recent years gold price suppression has been apparent from the near-complete failure of the gold price to rise more than 2 percent per day on the Comex (what GATA calls the 2 Percent Rule) while there is no corresponding restriction on days when the gold price is falling.

2. At option expiry gold almost always falls to a point where a large number of call options have been written, nullifying the value of the options. Typically, the price rallies immediately after option expiration.

3. The gold price consistently falls at 3 a.m. New York time when the gold cartel’s traders report to work in London, and again following the PM gold price fix, when physical market pricing has concluded for the day, and in the access market following the Comex close.

No other market trades so repetitively.

GATA has evidence that there are enormous physical short positions in the gold and silver markets that cannot be covered. Because of the decades-long interference with the gold market, we estimate that the free-market price of gold is multiples of the current price. Growing stress caused by burgeoning physical bullion demand is threatening to lead to a price explosion, which will restore to the market the balance that regulation has failed to maintain. In our view, the Comex paper market will become dysfunctional, with "force majeure" having to be declared as the concentrated shorts are unable to deliver on their obligations.

We urge the CFTC to report fully and candidly on these markets and take appropriate action.

Sincerely,

WILLIAM J. MUPRHY III, Chairman
Gold Anti-Trust Action Committee Inc.

... Footnotes:

1. "Gibson's Paradox Revisited: Professor Summers Analyzes Gold Prices" by Reginald H. Howe. http://www.goldensextant.com/

2. http://www.federalreserve.gov/monetarypolicy/files/FOMC19930518meeting.p...

3. http://www.gata.org/files/GATAFedResponse-09-17-2009.pdf

4. http://www.gata.org/node/wallstreetjournal

5. http://www.cftc.gov/dea/bank/deanov09f.htm

6. http://www.gata.org/node/7307

h/t Jeff

One of the big puzzles over the past several months has been the apparent plateau in the unemployment rate, even despite a double dip in initial claims and an overall sentiment that the economy is ready to take a second, post-stimulus, leg down. Aside from the traditional allegations of data fudging by the BLS, one concept often presented has been the unprecedented surge in labor productivity, which despite overall declines in hours per worker and a deterioration in the labor force, has allowed GDP to not only regain its losses from the recent lows, but to stage a dramatic improvement. Today, in a must read paper, the San Francisco Fed tackles precisely this topic, and comes to the unpleasant conclusion that unemployment rate forecasts may well be too rosy for 2010 and beyond, especially if companies continue to sacrifice workers at the expense of ever increasing "worker productivity" which in itself is about as "credible" as any other data series presented by the government over the past year.

The core of the article revolves around a recently observed record variation from the expected Okun Law distribution of the Output Gap and Unemployment, which as can be seen in the chart below, has never been as dramatic as in Q4, 2009.

Here is a brief observation on what the chart above details:

The figure plots the relationship between deviations from trend of real GDP and the unemployment rate from the first quarter of 1949 through the fourth quarter of 2009. Trends are taken from the Congressional Budget Office’s (2010) most recent estimates. The dotted line plots a statistical relationship between the output and unemployment gap from the first quarter of 1949 through the first quarter of 2007. As the plot shows, the empirical association that Okun noted generally describes the  data well. This is true across different points in the business cycle and across a long span of time.

Indeed, early in the 2007 recession there was little evidence of divergence from Okun’s law. In the second quarter of 2009, however, things went off track and a wedge began to emerge between changes in output and changes in unemployment. As shown by the red squares appearing above the line in Figure 1, the familiar two-for-one pattern broke down and unemployment went up by substantially more than expected. By the fourth quarter of 2009, the deviations in output to unemployment were the largest observed over the span of the data. The divergence of the current data from the typical pattern wreaks havoc with forecasters, but also leaves a puzzle: Why did unemployment rise so rapidly in 2009?

The FRBSF then goes on to detail the key variables that go into determining the output gap and overall unemployment: the labor market participation rate, the hours worked per worker, and, most notably the GDP per nonfarm hour:

The first point to consider is whether changes in worker behavior have boosted the unemployment rate and disrupted the Okun’s law relationship. As the first panel of Figure 2 suggests, labor force participation, or the fraction of the working-age population reporting that it is working or looking for work, has bounced around during this downturn. Typically, labor force participation will fall in a downturn as potential workers realize their prospects are weak and withdraw from the labor force to pursue other goals or because they are discouraged. In the first year of the recession, this normal pattern failed as individuals remained in the labor force despite the weakening economy (Daly, Hobijn, and Kwok 2009). However, by 2009, this pattern had reversed and labor force participation dropped precipitously. Currently, the trend in the labor force participation rate is helping reduce, rather than boost, measured unemployment.

Another factor that might be contributing to the breakdown in Okun’s law is hours worked per employee. In recessions, the number of hours worked generally falls as firms cut back on overtime or regular hours in response to declines in demand. By reducing worker hours instead of reducing the workforce, firms lay off fewer workers. If this recession were different and firms laid off more workers and then worked the remaining ones longer, then we would expect some deviation in the normal GDP/unemployment relationship. However, the second panel of Figure 2 does not support this hypothesis. The hours worked per employee is roughly in line with previous periods and, if anything, is working to reduce, rather than increase, the wedge in Okun’s law.

The final panel of Figure 2 points to the factor that turns out to be the main driver of the recent departure from Okun’s law—average labor productivity, measured as GDP per nonfarm hour worked. The deviation in average labor productivity relative to the GDP gap is far outside the range plotted over time and is consistent with the rapid productivity growth recorded in 2009. The surge in labor productivity allowed employers to keep output steady while shedding workers and reducing hours of work in the economy. As such, it allowed unemployment to rise much more than expected given the change in GDP, breaking the normal pattern between the two measures observed over the past 60 years.

A longitudinal time-course analysis presents these finding in a more digestible way: the only reason why GDP has not collapsed, and why the output gap is not double where it is presented to be, is exclusively due to workers who are currently employed playing far less Solitaire and just happy to have their jobs, even though average wages have continued to be at cycle lows.

The authors' conclusion is a troubling one, not just because it comes from the Federal Reserve itself, which is always conflicted and has a propensity to demonstrate data in the rosiest picture possible, but because they are in fact, very much correct in their interpretation.

The data presented here consistently point to unusually strong productivity growth as the main driver of the departure from Okun’s law in 2009. A key question that remains unanswered by this analysis is whether this pattern will continue in 2010. Most forecasters assume that the economy will return to its historical path this year, following Okun’s two-to-one ratio of changes in GDP and changes in unemployment. Under this scenario, unemployment would begin to edge down this year as the economy recovers and gains momentum. But there are clearly risks to this view. Some of the surge in productivity growth in 2009 was likely due to such cyclical factors as layoffs of least productive workers, greater intensity of work effort, and shifts away from producing intangible capital, which is not measured in output statistics. Anecdotal evidence suggests that efforts to contain costs and remain nimble in the face of uncertainty have become a fixture in business strategy. If productivity keeps on growing at an above-average pace, then unemployment forecasts based on Okun’s law could continue to be overly optimistic.

While it would have been easier to buy the premise that Americans are suddenly far more productive because our civilization suddenly discovered the Internet, this is patently not true. The last secular boost to productivity came ten years ago with the advent of information commoditization courtesy of the interwebs. Since then the only major discovery has been the iPhone and Twitter, which one could argue detract from productivity, not add to it. Indeed, it is very hard to swallow that our economy has not collapsed merely because those who are employed have been cranking out widgets at a record pace.

Michael Pento does an astute, if somewhat perfectly cynical, analysis of this quandary.

I went through the last 20 years of productivity data and couldn't find anything close to those three consecutive quarterly booms in output per hour of work. It sort of like saying at the start of Q2 2009 we invented the internet and the wheel on the same day.

What makes the claim of surging productivity even more amazing is that the U.S. economy is comprised of nearly 90% services. That means waitresses must be kicking people out of restaurants before they are finished eating or people have learned to eat much faster. Then again maybe doctors have learned to truncate their exams of patients or perhaps they have somehow found away to eliminated the second waiting room you have to sit it once you get past the reception area.

I guess productivity gains can come by magic just through the process of firing workers. Somehow we were are able to increase the output of goods and services as a nation even though 8.4 million people have lost their jobs and hours worked are down. What a relief it must be for businesses to shed themselves of all that dead wood. If we are to believe these productivity numbers we also must believe those formerly employed individuals were doing nothing at all but standing around with their thumbs up their bum. Call me skeptical.

Skeptical indeed. And since there is a direct causal chain in the variables that ultimately lead to GDP, productivity is the one intangible where the conflicting data of rising GDP and declining workforce collide. The question is whether this is a cause or effect: is the Census bureau spinning (and spewing) data that has no bearing in the real world (i.e., GDP), with the weakest link being this unprecedented worker productivity? We leave it up to readers to decide whether they believe the productivity boost thesis is credible, although with even the San Fred Fed questioning it outright, we expect to see some major declines in GDP once productivity recedes to historic levels, if it is not accompanied by an increase in the work force. And based on contemporaneous data, even with massive BLS fudging, this is not going to happen any time soon, once again leaving us with the sad conclusion that all rumors of V- or U-shaped recovery are greatly exaggerated.

Full San Fran Fed paper.

While we are not sure how Betty Liu feels about Rogers' invitation to come eat some Wienerschnitzel, what is certain is that Greek PM Papandreou is not too happy with the commodities pundit right about now. When asked should Europe bail out Greece, Jim says: "No, of course not, they should let Greece go bankrupt. It would be good for the euro, it would be good for Greece, it would be good for everybody." Alas, more true words have rarely been spoken. And with every financial professional already on the same side of the boat as Rogers, politicians are now left on their own to do what they know best: i.e., the wrong thing... over and over again, and if someone can be blamed (evil, evil CDS speculators come to mind), so much the better. Also, should anyone wish to take a brave foray into the political arena (which appears is now the best paying job in the world, incidentally, just after Goldman CDS traders, hehe) on the crest of the anti CDS bashing, now is the time. It appears quite a few have risen to the challenge.  As on the topic du jour that speculators are behind the euro's fall, Rogers is painfully logical:

No, of course, not, if you think that speculators and hedge funds went out and run up a deficit of 12% of the GDP, of course not. The Greeks did it and the Greek politicans did it. Then other people see the problems and started selling. The main people who are selling in Greece are Europeans who are selling, cause they see the problems. It's just like in America. When Fannie Mae got into trouble, people sold Fannie Mae. Speculators got in too, as people call then, but speculators did not cause Fannie Mae to run up gigantic debts and get into trouble, management did. And then that attracted investors who tried to take advantage of the situation.

Not to mention that if speculators are truly to blame, all they do is create a terrific buying opportunity for everyone else on the other side of the trade. Can this "speculators are guilty for everything" meme please die out already? Of course, when the shift away from equilibrium pricing is performed with the constant, very visible hand of the one endless money printer, the Federal Reserve (more on this later), it is a different story altogether.

In his column titled An Irish Mirror, Paul Krugman notes “the most striking similarity between Ireland and America was “regulatory imprudence”: the people charged with keeping banks safe didn’t do their jobs.”  (emphasis mine)

The phrase “regulatory imprudence” is far to imprecise — and wimpy — to describe what took place. Imprudent, as defined by Merriam Webster, is “lacking discretion, wisdom, or good judgment.” (Imprudence is the “state of being imprudent”).

If the Fed was only guilty of bad judgment or lack of wisdom, we could live with that. After all, people are fallible and judgment can go awry.

But that was not what occurred; rather, under Alan Greenspan, the Fed was guilty of Nonfeasance.

According to West’s Encyclopedia of Law, the definition of nonfeasance is far harsher:   It is the intentional failure to perform a required duty or obligation.

When Greenspan made the decision to not regulate or oversee non-bank lenders, his choice was nonfeasance. He chose not to do something that he was bound to do as part of his official duty. (In common law, this was punishable by fines or imprisonment or both).

Over the weekend we posted a very critical paper by the Minneapolis Fed discussing the potential weakness with the various liquidity extraction mechanisms (in the absence of a Fed Funds rate hike). Today, the Fed goes one step further, after noting increasing pressure by its own members to commence a tightening policy, and has announced the expansion of its reverse repo program with Primary Dealers, by adding additional counterparties. And guess who the first expansion wave focuses on - why Money Market mutual funds of course. Let's just do all we can to drain the money market system asap, shall we.

Statement Regarding Counterparties for Reverse Repurchase Agreements

The Federal Reserve Bank of New York today announced the beginning of a program to expand its counterparties for conducting reverse repurchase agreement transactions ("reverse repos"). This expansion is intended to enhance the capacity of such operations to drain reserves beyond what could likely be conducted through the New York Fed's traditional counterparties, the Primary Dealers. This announcement is pursuant to the October 19, 2009, Statement Regarding Reverse Repurchase Agreements, which announced that the New York Fed was studying the possibility of expanding its counterparties for these operations. The additional counterparties will not be eligible to participate in transactions conducted by the New York Fed other than reverse repos. This expansion of counterparties for the reverse repo program is a matter of prudent advance planning, and no inference should be drawn about the timing of any prospective monetary policy operation.

The initial efforts of the New York Fed will be aimed at firms that typically provide large amounts of short-term funding to the financial markets. This approach will ensure that the Federal Reserve quickly achieves significant capacity for conducting reverse repo operations while allowing the Trading Desk at the New York Fed to utilize its current infrastructure for conducting and settling such operations. Over time, the New York Fed expects it will modify the counterparty criteria to include a broader set of counterparties.

In this context, the New York Fed also published today eligibility criteria for the first set of expanded counterparties, domestic money market mutual funds. The eligibility criteria are intended to identify funds that conduct sizable transactions in the tri-party repo market and that the New York Fed anticipates would participate meaningfully in any reverse repo program it may be directed to implement. (See the Reverse Repo Counterparty Eligibility Criteria for Money Funds document for more details on the criteria.) In the coming months, the New York Fed anticipates that it will publish criteria for additional types of firms and for expanded eligibility within previously identified types of firms. Moreover, it anticipates publishing a New York Fed Master Repo (legal) agreement for money market mutual funds in approximately one
month.

The ultimate size and terms of reverse repo operations will depend on the directive from the Federal Open Market Committee to conduct such operations. In terms of operational details, the New York Fed
anticipates that any transactions would be:

• offered to primary dealers and the broader set of counterparties,
• conducted at auction for a fixed (not floating) rate, 
• settled through the tri-party repo system, and
• held against all major types of collateral in the System Open Market Account (SOMA), including Treasury securities, agency debt securities, and agency MBS securities.

Further program parameters will be decided and announced at future dates.

As noted earlier this month (Geithner, Summers Lead FOMC Vacancy), there are 3 vacancies on the Federal Reserve — two Governors and a Vice-Chairman. Fed Governors are appointed by the President, and require Senate confirmation. They serve 14-year terms.

I placed a significant amount of blame on the Federal Reserve for the financial crisis. The ultra low rates pushed by Greenspan in response to the dotcom collapse was aimed at bailing out traders and speculators, not the country as a whole. 1% Fed rates jump-started an upwards spiral of prices in houses, food, oil, and gold, along with excess speculation across all asset classes.

That aspect is well understood. What people seem to understand less is how else the Fed failed. The Federal Reserve states its responsibilities are:

1. Conducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices;

2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers

3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

4. Providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation’s payments systems

How’d they do?

Not very well.

Recent history shows us the Fed was nearly exclusively focused on #1 — monetary policy. They did a terrible job at #2 — regulating banking institutions. Their failure as bank regulators led to #3 — total instability of the financial system (although I credit Bernanke’s out of the box thinking with pulling the system back from the abyss). As to #4, the Fed (and especially, the NY Fed) seems to forget about their disclosure duties.

One way to prod the Fed to perform its own duties and responsibilities is to make sure that any new Fed Governor or FOMC Vice-Chair has a firm commitment to these responsibilities. Greenspan’s Randian ideology prevented him discharging nos 2, 3 and 4.

Thus, I suggest a litmus test for any nominee to the FOMC board. Senators should ask each participant the following questions:

-Are you willing to put all of the AIG emails into the public domain?
-Did you warn about the housing bust and credit crisis BEFORE it happened?
-Do you believe that the Federal Reserve  should address bubbles in real time, or merely clean up after they pop?
-Do you believe the government should protect consumers, investors, and savers?
-Is that a proper role of the Federal Reserve, or another agency?

These are just a few questions I would hope to see answered satisfactorily before we approve any nominee for the Federal Reserve Board of Governors . . .

>

courtesy of Gallup Polls

Previously:
Do-Nothing Fed Regulator = Huge Bank Victory (March 3, 2010)
http://www.ritholtz.com/blog/2010/03/do-nothing-fed-regulator-huge-bank-victory/

Sources:
Frequently Asked Questions: Federal Reserve System
http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm#3

The Federal Reserve System: Purposes and Functions
Board of Governors of the Federal Reserve System
June 2005
http://www.federalreserve.gov/pf/pdf/pf_complete.pdf

See also:
Kohn exit could herald several years of easy money (Reuters)
The Fed’s stuck in the penalty box (Fortune)
Dissent and Disagreements at Future FOMC Meetings? (Northern Trust)
Fed appointments hold key to exit strategy (FT)

The Financial Times give us yet another sorry update in the bankster vs. the general public saga, and the banksters continue to gain ground. Their latest about-to-be-cinched victory is beating back a pro-reform idea sponsored by Senator Dodd (yes, even he can have the occasional “Nixon Goes to China” moment). Dodd had wanted bank regulation to be stripped from the Fed and housed in a new agency.

While that model can be argued to have led to some fumbled passes in the UK during the early stages of the crisis (most notably, the Northern Rock run), many observers contend that the flaw was the failure to hash out certain operational details, rather than the structure being inherently unworkable (in general, any organization structure is going to have particular shortcomings; you therefore need to have other mechanisms in place to compensate for them).

Perhaps most important in the case of the US, the Fed is far and away the most captured, the most asleep at the switch of the banking regulators. Keeping them in charge of bank regulation is like reappointing a fire commissioner who let half the town burn down.

And the “compromise” settled upon is to allow the banks most in need of tough supervision, ones with more than $100 billion in assets (which amounts to the biggest 23, and thus includes all the 19 TARP recipients) to remain the wards of the supine Fed. Yet these are the ones that pose the biggest systemic risks. Heck of a job, Brownie.

The notion that makes this guaranteed-to-continue-to-be-weak oversight OK is that the big banks will be permitted to fail. While that may be credible for some of the really big banks (Fifth Third, for instance, is large but not systemically important) any large capital markets player is an integral part of crucial debt market operations. Those large firms in turn are deeply enmeshed via counterparty relationships, most notably repos and credit default swaps. How, pray tell, do you shut down a trading firm in an orderly fashion? You can’t freeze positions, which is what you need to do in an unwind, and not create pain and inconvenience for the counterparties. Are we going to have a firm in default (presumably with emergency credit lines) continue trading? I haven’t heard a credible solution to this rather major conundrum from the officialdom.

Ex starting a serious program to reduce the connectedness of these firms, I see only one of two likely outcomes: either a Lehman 2.0 (a firm will be allowed to fail because it will be politically necessary to have one fail, it will prove to be a mess, and then the officials, in a panic, will start bailing out the ones impacted by the unforeseen blowback) or a successor Administration will not trust the resolution procedures and will go directly to bailout (not doubt with a few punitive measures, like some forced divestitures of non-core businesses, to allow them to claim that it was not a bailout, but a new version of resolution lite).

Andy Xie reminds us that regulatory reform is a key precondition to a sustained recovery. His piece takes up one of our favorite themes: how the story of Japan’s colossal lost decades has been airbrushed here, to argue that the big Japanese mistake was insufficiently aggressive fiscal and monetary stimulus. By contrast, it is seldom reported here that the Japanese themselves believe that their big failure was not reforming their financial system in the initial years after the implosion. No one here wants to admit that we are following the failed Japanese playbook, and for the very same reasons: politicians are unwilling to take on powerful, entrenched financiers. From Xie (hat tip Crocodile Chuck):

Last year, in a moment of panic over the global financial crisis, central banks and governments poured monetary and fiscal stimulus into the global economy. The side effects of these misguided policies are already showing up….Despite the visible need for tightening, the consensus is demanding a slow and delayed exit. Japan’s “early withdrawal” is touted as an example of what could happen otherwise.

Japan has experienced two decades of economic stagnation since the collapse of the infamous bubble it suffered in the 1980s. The most popular explanations are that Tokyo wasn’t aggressive enough in stimulating the economy after the bubble burst, or that it withdrew its stimulus too early – or both. This line of thinking is popular among elite economists in the US, where it is rarely challenged. But few Japanese analysts buy it.

The Americans liken an economy in a slide to a car with a dead battery: it can be jump-started with a forceful enough push. But there’s no sound logic behind such thinking. After a big bubble bursts, an economy suffers a terrible misalignment between supply and demand. Through high prices, a bubble diverts investment and labor to unneeded activities. It takes time for an economy to normalize. The bigger the bubble, the longer it takes to heal.

The argument to “stimulate until prosperity returns” is popular because it doesn’t hurt anyone in the short term….. Japan’s tale is just a nice story that seems to support the argument.

At the peak of Japan’s bubble, the biggest in history, the excess value of its property and stock markets was more than five times its gross domestic product – more than the entire world’s gross domestic product at that time. In comparison, the excess asset value in the US bubble was less than twice its GDP, or half the global GDP. So how is it possible to just stimulate an economy back to health after such a massive correction?

Japan has run up the national debt equal to 200% of GDP — the greatest Keynesian stimulus program in history — all in the name of stimulating the economy back to health. It has failed miserably. Japan’s nominal GDP is about the same as when the stimulus began. Those who advocated the policy blame Japan’s failure on either the stimulus being too small or not being sustained for long enough – that is, the dosage, not the medicine itself, was at fault.

The bankruptcy of Japan Airlines is a sobering reminder of what is still wrong with Japan….Zombie companies that have first claims to resources have trapped the Japanese economy in stagnation for decades. The lack of shareholder rights has given the moribund companies the luxury of being able to disregard capital efficiency….

What ails Japan is a lack of reforms, not stimulus….

The crisis happened because financial professionals had incentives to bet other people’s money in a game they could not lose. With so many getting in on the act, the liquidity they threw into the trades made them effective, turning bankers into heroes, but only for a while.

The crisis showed that their behavior was indeed rational: while the losses to shareholders and taxpayers surpassed all the accounting profits that Wall Street reported during the bubble, those who made the trades are still rich, because they paid themselves bonuses in cash, not derivatives.

Obama has not been well-advised. His so-called accomplishment — stabilizing the financial system — comes from throwing trillions of taxpayers’ dollars at financial firms. He has behaved like a Wall Street trader: spending other people’s money with no thought of consequences. Anyone can do that…

Reform, not stimulus, is the solution. Only by limiting financial speculation can the foundations be laid for a healthy recovery, and to prevent another crisis.

Looks like Tom Hoenig's dissension at the recent FOMC vote is starting to generate some serious traction. A paper just released by V.V. Chari of the Minneapolis Fed, "Thoughts on the Federal Reserve's exit strategy" goes so far as blasting the Fed for demonstrating Goldman Sachs-like "hubris" courtesy of the persistent lowest common denominator resolution to every crisis, namely Bernanke's redux of MLK "I have a dream" speech for the 21st century, in the Chairman's "we have a printing press" thesis.

The money line from the paper, which Chairman Shalom would be all too wise to re-re-re-read over and over until his delusion of grandeur curve flattens by at least by 1 basis point.

"...The Fed differs from private firms and emerging markets in that it can “create” money to finance its debts. And indeed, that ability may well lead to hubris on the part of policymakers—similar to that seen among financial managers in the current crisis who were clearly overconfident in their ability to obtain financing. Regardless of such self-assurance on the part of policymakers, if market participants lose confidence in the Fed’s ability to obtain funds from lenders, the Fed would have to pay very high interest rates to obtain short-term debt. A self-fulfilling, high-inflation equilibrium in which expectations that the Fed will pursue lax monetary policy because banks demand a high-inflation premium will lead banks to demand that high-inflation premium."

This is, in a nutshell, the encapsulation of the downside risk to the entire recovery: the entire ephemeral bear market rally is based on confidence in the Fed, which in turn is based on confidence that there will be no "paradigm shift" (yes, we hate the phrase as much as you do) in perceptions vis-a-vis the Fed's ability to print without any inherent checks and balances. Downside analysis must always start (and end) with precisely a view on how and why this concept should be taken for granted. Because if even the Fed is starting to question its soundness, the capital markets can not be far behind.

As to the paper itself, Chari performs a very relevant analysis of the three alternatives to Fed liquidity reduction (in the absence of an actual Fed Fund rate hike), which are as follows: Strategy 1: Raising interest rates on overnight reserves, Strategy 2: Offering banks higher interest rates on short-term deposits, and Strategy 3: Gradual sales of financial assets. In surprisingly lucid fashion Chari demonstrates just what the key weaknesses of Strategy 1 and 2 are, which in a nutshell boils down to Interest Rate and Rollover Risk associated with the ambiguity of Fed actions as pertains to the general interest rate environment.

And while Chari describes the asset sale alternative as the most feasible one (this is true, and hammered home previously by other Fed presidents), his logic as to why concerns about the spike in Mortgage rates (and a depression of all other asset classes) are overblown, is flawed. He says:

The extent to which asset prices would be depressed depends on how segmented financial markets are—that is, how difficult it would be for investors to shift assets from one market to another over a reasonable time frame. Bear in mind that the volume of traded financial assets of all kinds in world markets is on the order of $200 trillion. Given this extremely large financial market, if the Fed were to sell $1 trillion in assets over a period of time, the odds are small that such sales would have a big effect on global financial markets, assuming assets can be shifted among markets with relative ease.

Chari tries to neutralize the impact of asset transfer by saying that in the long run, portfolio shifts will normalize. Well, on a long enough timeline...

How much segmentation truly exists among such markets? If you look at them minute by minute, it’s clear that markets are highly segmented; but over longer time horizons, such as two or three years, people clearly have time to shift their portfolios. The question ultimately is, where is that break point where market segmentation ceases to be quantitatively and materially important? While there is little empirical research on this question with regard to mortgage-backed securities, for instance, it is my judgment that over a reasonable time frame, market participants would be able to absorb the sale of the Fed’s security holdings without significant price impact.

This is patently flawed. Assuming that asset flows and yields will normalize on a long-enough timeline, is of course correct in a Chicago-esque perfectly efficient market. Yet the author himself earlier ridicules Chicago economics when he says "Because markets are not complete and since frictions do exist, each strategy can have a significant effect on both the economy and the conduct of future policy." So while the withdrawal of liquidity in 2050 will certainly have been priced in, what happens in the near-term, courtesy of a market which is jaggedly volatile on materially declining liquidity, not just in equities, but in cash bonds and certainly in CDS will be a massive (over)reaction the second selling overtures are initiated.

Furthermore, using BIS data about total financial asset traded annually and comparing that to Fed MBS holdings is extremely juvenile from an actual trading perspective. It is like saying that the entire capital structure of various risk assets is one homogeneous pool, with equal liquidity and in which returns up- and down-shift gradually and gracefully, without regard for "speculators" (oh wait, just ask Greece about that one). Having the very bottom of the balance sheet propped up provide massive leverage to dabble in higher yielding (and risky) assets as it removes the risk to the sub-5% yielding asset class, and allows material leveraging of positions in assets in the IG (6-7%), HY (8-10%) and equities (12%+) return classes. If the MBS bid is gone, the bottom of the market would literally fall out. Which is why we believe that while Chari is implicitly correct in principle about the Fed's options, he is extremely wrong about the ramifications to not downward price pressure on not just MBS, but all asset classes.

Then again, the Fed can merely continue on its path of unmitigated hubris until “some ‘kids’ in New York and elsewhere sitting in front of a computer" decide it is time to put an end to the Fed's stupidity. Which is why the Fed and Europe must put an end to all CDS and naked (or any other kind) of equity shorting optionality, and also make outright selling of securities illegal, coupled with mandatory participation by every US citizen in UST retirement accounts, before such time as these "kids" finally wake up and smell the manipulated market coffee.

Full Minneapolis Fed paper.

There are few people as qualified to discuss the stresses of (and on) the financial system over the past several years as Yale and Wharton Professor Gary Gorton, who just incidentally has held positions at the Bank Of England, the Federal Reserve and the FDIC. In a submission to Zero Hedge, Professor Gorton provides some unique perspectives into what we have long claimed was the immediate catalyst for the near collapse of the banking system: the bank run, not so much on depository institutions, but on the much more critical shadow banking system. And when one considers the parallels between the two, whose existence in any case is merely contingent on the persistence of trust in the workings of the broader financial system, Gorton observes that the Great Panic which commenced really in August 2007 (with the first salvo fired by none other than the HFT quant community, on August 6, discussed extensively here previously and in Barron's today most recently), is really no different from the Panics of 1907 or 1893, except that in 2007 "most people had never heard of the markets that were involved, didn't know how they worked, or what their purposes were. Terms like subprime mortgage, asset-backed commercial paper conduit, structured investment vehicle, credit derivative, securitization, or repo market were meaningless." And just like deposit bank runs earlier, the securitized banking system, which is in essence a real banking system, "allowing institutional investors and firms to make enormous, short-term deposits" was vulnerable to a panic. What should be more troubling is that the event commencing with the August 2007 waterfall, were not a retail panic involving individuals, but a wholesale panic involving institutions, where large financial firms "ran" on other financial firms, making the system insolvent. As some other witty writer once put it best, "banks opened up their books to each other, and hated what they saw."

The scariest thing is that we have still done nothing to address the propensity for institutional panic to come back, which courtesy of money now being electronic 1's and 0's, will certainly take an even faster time to hit its plateau when it appears next. Keep in mind that post the Lehman crisis, it only took 3 days before the money markets locked up and were in need of governmental guarantees, while the broader repo market was shut down within 48 hours. As retail investors tend to enjoy obtaining physical delivery of their asset (read FRNs), for institutions, the wave can turn at a heartbeat, and next time around the administration will likely not even have 12 hours before a complete financial, systemic, and irrevocable lock-down is in place. The only backstop to this risk- the Federal Reserve. Yet the question remains: how long before nobody in the world dares to take the Fed head on. It is no secret that the entire investment community now realizes that the Fed's experiment is doomed. The US is no longer a viable going concern: when the CBO notifies the public that the debt/GDP in a decade will be 90% and that total marketable debt will double to $20 trillion, the game is over. And just like in any good old game theory construct, the first defector is the one to benefit the most. The Fed can not, be definition "defect"; so when one of the whale account does, and the avalanche of enjoinders jumps on board, the proverbial "you don't get in front of the Fed" will be a memory. What we know is that we now have a t-10 years timer before the US economy is certainly finished. But the real question is when the defections against Bernanke et al will begin in earnest.

Back to the repo system: As Gorton points out - "Times change. Now, banking has changed again. In the last 25 years or so, there has been another significant change: a change in the form and quantity of bank liabilities that has resulted in a panic. This change involves the combination of securitization with the repo market. At root this change has to do with traditional banking system becoming unprofitable in the 1980s. During that decade, traditional banks lost market share to money market mutual funds (which replaced demand deposits) and junk bonds (which took market share from lending), to name the two most important changes" [incidentally, this is precisely the reason why Paul Volcker has historically been so adamantly against money markets, and for a dramatic, and some say terminal, overhaul in the MM system, whose mere ongoing existence is a substantial destabilization of the financial status quo as investors funnel trillions of dollars to and fro MM's whenever the Fed plays around with the Fed Funds rate, adding massive instability to capital markets]"Keeping passive cash flows on the balance sheet from loans, when the credit decision was already made, became unprofitable. This led to securitization, which is the process by which such cash flows are sold."

Gorton goes on to demonstrate just how the traditional and parallel (shadow) banking systems are intertwined:

As the above Gordian Knot chart indicates, there is much as stake here, and much reason for the authorities to distract the general populace with such silly concepts as a Consumer Protection Agency and Healthcare Reform. Indeed, shadow economy investors stand to lose over $70 trillion dollars should the traditional-shadow banking linkage be broken and the cash flow transfer process be disrupted. The bigger question: how much longer will such cash flows sustain in the current day and age when real demand has collapse courtesy of record domestic unemployment. The biggest question: what happens when there is a secular change to the prevalent level of capital flows into shadow banking. One of the primary reasons for the massive expansion in the money system (via the credit pyramid), has been precisely the shadow banking system, which is second only to the credit and interest rate derivative market (incidentally we were fascinated by the race to the currency bottom, and the technical associated short squeezes in the Dollar and Euro, in May 2009, long before anyone even considered such now daily discussion pieces).

Yet should shadow baning disappear, the tranche above it (or below it by seniority) would disappear as well. And with 90%+ of global liquidity gone, and no additional source of "credit" money to fill the Fed's infinite demand for monetary supply, asset prices will explode (forget about gold - one apple will be $6,000 an ounce). Deflationists are right that ceteris paribus asset prices will decline, and that the Fed is powerless to stop this. Yet deflationists take one huge variable for granted: that the existing liquidity pyramid will persist. It is obvious that should another systemic stress episode emerge and money contract by a massive amount, the end consumer will matter little when total global credit collapses from $600 trillion to mid double digits, thereby decimating the real shadow monetary base, and realligning global assets with a liability side in flux. After all, the key offset to CPI going stratospheric over the past 30, 50 and even 100 years has been precisely the emergence of the alternative banking system, with its influx of tens if not hundreds of trillions of "shadow" dollars, which almost ceased to exist in the 2007-2009 crisis. The netting of intangible money to tangible currency in circulation would be a forced explosion in the money multiplier by the same amount as the shadow economy has sucked out in a vacuum of expiring credibility overnight.

For this, and much more we recommend a read of the attached "Q&A about the Financial Crisis" in which Gary Gorton discusses before the US Financial Crisis Inquiry Commission, in very clear language, the big dangers still facing shadow banking.

Should readers demand for additional information, Gary Gorton has recently written a book, "Slapped by the Invisible Hand, The Panic of 2007" (you know it's good because it is not available on the Kindle), which discusses more of the same fascinating topics (and to which a just as interesting intro written by Gorton can be found here).

By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives

A question of values…

Derivative contracts are valued on a mark-to-market (”MtM”) basis. This requires valuation of the contracts based on the current market price.

OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models.

In current accounting argot, most derivatives are Level 2 assets (Mark-to-Model). In practice, this means that they cannot be priced based on quoted trade prices (Level 1) but are valued using observable inputs; for example, comparable assets or instruments or using interest rates, volatility, correlation, credit spreads etc that can be put through an accepted model to establish values.

There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.

Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or “bootstrapped” from available data. In certain products, the limited number of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider.

Model variations and small differences in input can frequently result in large changes in values for some products.

The models make numerous assumptions including the ability to borrow at market rates for (theoretically) infinite amounts, unrestricted ability to enter into transactions and abundant trading liquidity. These assumptions are difficult to satisfy in practice.

For example, a key assumption of derivative valuation is that a transaction can be hedged with a counterparty or through other means at all times. In late 2008, in the aftermath of the collapse of Lehman Brothers and problems at AIG, market liquidity dried up and made it impossible to source market prices or transact in many instruments.

Model based valuations drive pricing of transactions and dealer hedging. They also are used to calculate the risk of the transactions and ultimately to derive the capital required to be held for regulatory and internal purposes. The model-based valuations are also used to determine earnings and ultimately bonus payments for dealer staff.

Non-professional dealers rarely have the required sophisticated pricing and valuation systems. They are dependent upon valuation date (predominantly) supplied by dealers or (less frequently) rely on pay-as-you-go pricing services.

Investors use the model-based prices to generate values for their fund units. Investors transact at these model-based prices when they invest or redeem investments

The accuracy and tractability of derivative valuation, especially for complex products, is questionable.

MtM prices may be also prone to manipulation. Recent disclosures about events leading up the government bailout of AIG highlight potential problems.

There is limited internal or external (auditors and regulators) oversight of the models. This reflects, in part, the complexity of the models and the scarcity of experienced professionals capable of undertaking such reviews.

Widespread reliance on models and MtM methodology is perhaps surprisingly an unquestioned article of faith in financial markets. It allows immediate recognition of gains and losses that will accrue over many years immediately.

Interestingly, MtM accounting is generally not available outside of financial instruments. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the U.S. Securities and Exchange Commission (”SEC’) to allow MtM accounting to be used in the natural gas industry. This allowed the company to record current earnings based on the future value of long term contracts.

Current regulatory proposals do not attempt to deal with the pricing, valuation and model issues. As Daniel C. Gelman observed: “Where secrecy reigns, carelessness and ignorance delight to hide.”

Stand by Me …

In derivative contracts, each party takes the credit risk of the other side in terms of performing their obligations. This is known as counterparty risk. The failure of Lehman Brothers and a number of banks during the Global Financial Crisis (”GFC”) highlighted the problems of counterparty risk in derivatives.

Counterparty risk in derivatives is different from credit risk generally. In a loan, the lender is exposed to the risk of the borrower failing to pay interest or repay the known face value of the loan. In contrast, in most derivative contracts (other than options), the risk is mutual with both parties being exposed to the risk of non-payment by the other.

Counterparty risk is complex because the payment obligations as between the parties are contingent. The quantum and the direction of payments depend on market price movements. The potential counterparty risk is not known in advance and is apparent only when actual price movements occur. In practice, this requires parties to estimate the potential exposure using mathematical models based on the expected evolution of the relevant market prices.

In the 1980s when the derivative markets developed, counterparties were generally of high credit quality. This had the effect of reducing, though not eliminating, counterparty risk.

Over the last two decades, the derivatives market has becoming more democratic. Entities with lower credit ratings have become active users of derivatives. This includes highly leveraged investors, such as hedge funds and private equity funds. Participation of these riskier entities has entailed reliance on credit enhancement techniques.

The primary form of credit enhancement was the use of bilateral collateral. This entailed counterparties posting collateral in the form of cash or high quality securities to secure the current value of the contract. The collateral acted as surety against non-performance under the contract. Collateral arrangements were highly customised. For example, AIG’s collateral arrangements required the firm to post collateral only where the exposure under the contracts increased above an agreed level or AIG’s credit rating was reduced below a specified quality.

Other credit enhancement techniques used include a right to break that allows either party to terminate the contract under certain credit-related circumstances. Any such termination would be at market values triggering an obligation of one party to pay the other party the current value of the contract.

Counterparty risk and credit enhancement techniques are predicated on the same models used for pricing and valuation. Use of bilateral collateral relies on the accuracy of valuations and risk models. It also relies on certain and enforceable legal rights in respect of collateral and proper management of the cash and security lodged.

The GFC, especially the bankruptcy filing of Lehman Brothers, provided a test of counterparty risk in derivatives. The quantification and management of such risk proved problematic. The quantum of credit risk from derivatives was higher than model based estimates as market volatility increased and correlations between risk factors moved erratically. Legal enforceability, control and management of collateral also experienced problems.

Current regulatory proposals have focused heavily on counterparty risk issues. The central legislative reform proposed is a central clearinghouse – the central counterparty (”CCP”). The BIS also proposed changes in capital requirements against counterparty risk in the light of recent experience.

Under the CCP arrangements, (so far unspecified) “standardised” derivative transactions must be transferred to an entity that will guarantee performance. In a curious circularity, standardised means anything that is eligible for and can be “cleared”. Interesting inclusions and exclusions – both in terms of products and parties that must trade through the CCP – are to be found. The arrangement centralises contracts in a single entity, the ultimate case of “too big to fail”.

The CCP will implement risk management systems to manage its exposure under derivative contracts.

The CCP will be reliant on risk models and the ability to value contracts. As noted above, there are significant issues in pricing and valuing contracts and, for some products, reliance on complex models.

The CCP proposal relies heavily on “self-confidence”, which as Samuel Johnson observed is “the first requisite to great undertakings.” In relation to the CCP, legislators and regulators are basing their approach on Lillian Hellman’s helpful advise: “It is best to act with confidence, no matter how little right you have to it.”

One (Not Very Nice) World…

The GFC, in line with previous derivative crises including the collapse of Long Term Capital Management (”LTCM”), revealed deep fault lines in financial markets.

Derivative markets entail complex chains of risk that link market participants. This is similar to the re-insurance chains that proved problematic in the case of Lloyd’s Insurance market problems. In both markets, the risks are both potentially significant and “long tail”, that is, they do not emerge immediately and may take some time to be fully quantified.

As in the re-insurance market, the long chain of derivative contracts can create unknown concentration risks. This is exacerbated by the highly concentrated structure of derivatives trading. It is likely that for each product or asset class a few dealers (less than 10-12 and sometimes as few as 4-6) account for the bulk of trading. This means that financial problems or uncertainty about any major dealer could cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

Current regulatory proposals have not focused on the issue on inter-connected trading and concentration risk. The CCP proposal affects these issues. It is widely believed that the CCP will improve the market structure. In reality, the CCP becomes a node of concentration. In addition, to the extent that products are not routed or counterparties are not obligated to trade through the CCP, the problems remain and may increase.

A central problem of the current derivative markets is potential liquidity (cash or funding) risks. Ironically, the problems derive, in substantial part, from the desire to reduce counterparty risk through credit enhancement procedures, such as bilateral collateral.

Where derivative contracts are marked-to-market daily and any gain or loss covered by collateral to minimise performance risk, movements in market rates can trigger large cash requirements. These requirements may be unanticipated. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. This may leave the parties unhedged against underlying risks or on offsetting positions creating the risk of additional losses.

For example, ACA Financial Guaranty sold protection totalling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement.

AIG’s CDS contracts were subject to the provision that if the firm was downgraded below AA- then the firm would have to post collateral. In October 2008, when AIG was downgraded below the nominated threshold, this triggered a collateral call rumoured to be around US$14 billion. AIG did not have the cash to meet this call and ultimately required government support. The problems at ACA and AIG are not unique.

Current regulatory proposals do not address liquidity risks in derivative markets. Interestingly, the CCP may inadvertently increase liquidity risk as more participants may be subject to margining and unexpected demands on cash resources. The BIS has proposed an extensive regime of liquidity risk management controls that would, in part, cover some liquidity risks.

Failed Plumbing…

The GFC has exposed some long standing and significant problems with the infrastructure of derivatives markets.

In 2006, Alan Greenspan expressed shock and horror at the state of settlements in the credit derivative market. He expressed surprise that banks trading CDS seemed to document trades on scraps of paper. The ex-Chairman, perhaps unfamiliar with the reality of financial markets, had difficulty reconciling a technologically advanced business with this “appalling” operational environment.

Derivative systems and trade processing are generally inadequate, with infrastructure lagging well behind innovation. Delays in documenting contracts forced regulators to step in requiring banks to confirm trades more promptly. The accuracy of the mark-to-market values of contracts, particularly of less liquid and infrequently traded reference entities, is not unimpeachable. Where collateral is used, as noted above, monitoring and management of collateral poses significant risks.

Current regulatory proposals seek welcome improvements processes and systems for derivative trading.

Derivative contracts are documented under the International Swap and Derivatives Association (”ISDA”) Master Agreement. The ISDA Agreement has been remarkably successful in standardising documentation of trading.

The contract has not been tested under stressful conditions such as those of the GFC. A number of issues have emerged. The bankruptcy of Lehman Brothers and resulting unwinding of complex derivative arrangements has exposed problems of derivative and bankruptcy law, especially in cross-border, multi-jurisdictional transactions.

The GFC exposed issues relating to the documentation of specific derivative contracts, such as CDS contracts, and the impact on bankruptcy and resolution of financial distressed firms.

Current regulatory proposals do not address any of these documentary issues.

Bank regulatory capital has long distinguished between banking (loans or hold-to-maturity assets) and trading books (trading or available-for-sale assets). Differing capital rules between the banking and trading books encouraged regulatory arbitrage, generally using derivative structures to reduce the required level of capital. The BIS has addressed some regulatory anomalies, increasing the capital required against derivative positions.

Regulatory initiatives continue to emphasise improved disclosure of derivative contract. There is already significant disclosure, although much of it is incomprehensible and lacks utility. Additional disclosure will not significantly reduce systemic risks of derivatives.

On 25 September 2002, speaking at the U.K. Society of Business Economist while in London to collect an honorary knighthood for contribution to economic stability, Alan Greenspan outlined the case for less transparency: “…paradoxically, the full disclosure of what some participants know can undermine incentives to take risk, a precondition to economic growth….to require disclosure of the innovative product either before or after its introduction would eliminate the quasi-monopoly return and discourage future endeavours to innovate….market imperfections would remain unaddressed and the allocation of capital to its most productive uses would be thwarted.

Greenspan argued that even “disclosure on a confidential basis solely to regulatory authorities may well inhibit…risk taking.” Dealers will undoubtedly resist meaningful disclosure prejudicial to their economic interests.

Regulatory initiatives do little to address the quality of regulators and the acuity of oversight. The absence of suitably expert and experienced regulators will undermine regulatory and legislative initiatives. Given the shortage of talent in derivatives generally and the pay grades of regulators, it will be difficult for regulatory agencies to properly supervise dealers and derivative activity. In terms of an old Spanish proverb “Laws, like the spider’s web, catch the fly and let the hawk go free.”

Regulatory Tango…

Debate over regulation of financial services has taken on a frenzied tone. Regulators and think tanks are producing voluminous, overlapping and (sometimes) contradictory proposals. Regulatory agencies are jockeying for position, sometimes forming unlikely coalitions to preserve or expand territory. In the U.S. Congress, multiple bills and several committees are jostling to make sense and harmonise complex and irreconcilable draft legislation. Activity and achievement are confused.

Banks and their lobbyists do not believe that there is a case for regulation. In William Davenant’s words: “Had laws not been, we never had been blam’d; For not to know we sinn’d is innocence.”Banks argue that the complex nature of derivative trading dictates that self-regulation is the only feasible approach. If that fails, then banks seek to minimise scrutiny of major issues, such as the size of the market, speculative activity, pricing issues, complexity and mis-selling of derivatives to unsuitable clients. They argue that existing regulations already adequately cover some issues. Proposed regulations will be masterfully narrowed to minimise impediments to profitable activities.

There will be a familiar threat. Lack of international agreement and regulatory uniformity makes compliance impractical. Banks and derivative activity will relocate with losses of jobs and taxes to the host country. Familiar arguments will be heard regarding the loss of competitive advantage, diminished financial innovation, slower capital formation and higher cost of capital. Each is a well-known step in the familiar “regulatory tango”.The complexity of the issues means that ultimately no laws may be truly effective. As one famous law maker, Adlai Stevenson, observed “Laws are never as effective as habits.”Groucho Marx observed that “[government] is the art of looking for trouble, finding it, misdiagnosing it and then misapplying the wrong remedies.” Legislators and regulators are likely to discover the truth of that proposition in their attempts to regulate the derivative market.

Today, the market spiked in the last hour of trading after it was announced that total consumer credit increased for the first time in a year (not all credit, mind you, just car loans; consumers are still eagerly paying down their credit cards). And who was the source for this generosity you may ask? Why, the US Government of course. Not only that, but Non-Seasonally Adjusted Consumer credit was actually down by $4 billion. But let the government have its smoothing fun. On a non-seasonally adjusted basis, consumer credit has declined by $108 billion in the past 12 months. What may be surprising, is that were one to strip away the contribution from the Federal Government of $78 billion, the decline would have been almost double, or $187 billion. Furthermore, in January, NSA consumer credit would have declined by $14 billion had it not been for the... wait for it... Federal Government, which sourced $10.4 billion in new consumer credit. So here is what happens in case you haven't figured it out already: the government takes taxpayer money, and lends it out to all sorts of destitutes at zero % interest, who have to keep up with the Joneses at all costs, and even though can not afford to put down any equity, must buy a new car every 6 months (even though they have likely not made a mortgage payment in about a year... not to worry, Uncle Sam is footing that too via the Federal Reserve and Fannie and Freddie), and when the news of the government's generosity hits the market, and the spin is that Americans are again confident enough to borrow, the few SPARC machines left trading do whatever Liberty 33 tells them to, and bump up the total capitalization of the market by about $20 billion, putting money straight into the pockets of Goldman Sachs and other recent bailoutees, who without doubt deserved a $70 billion bonus season in 2009. And now you know where your money goes to.

Via UBS Financial Services

Final Hour Float Up In Front Of Payroll Data – Surprising strength in retail data and a couple of analyst upgrades helped the stock market fend off currency influences.

The early session was somewhat uncertain. Stocks opened better on a drop in Initial Claims and that retail strength. At
10:00, a surprise drop in pending home sales drove the bids off the floor.

The selloff was brief but sharp. By about 10:40, the S&P had plunged from 1122 to 1116. That number corresponded to Wednesday’s afternoon lows which provided an excuse to circle the wagons.

Prices came back, regaining about half the area lost in the selloff.

For the next four hours, stocks churned sideways in a rather narrow band, warily watching the dollar and the Euro.
About 3:15, stocks began to tick slowly, but steadily higher.

The hypothesis was that the “snowstorm excuse” had taken hold. The thinking was that even if this morning’s payroll
data was dreadful, it would be shrugged off as weather related. Thus, good news could help but bad news couldn’t hurt.
So, buying began since the news probably couldn’t hurt you.

The net result was a low volume levitation that let the averages close near the highs of the day. The lack of volume,
however, kept the action from being conclusive.

Cocktail Napkin Charting – Thursday’s low volume levitation turned the Dow positive for the year. The S&P turned
positive earlier in the week.

Yesterday’s high in the S&P was just shy of 1124. We suggested yesterday that you might need a close of 1125 or higher to point to a possible retest of the January highs.

For today, the napkins hint resistance may sit around 1127/1130 and support around 1113/1116. Again, it’s a close above 1125 we’d like to see, and especially on higher volume.

More Pressure On The “Dollar Carry Trade”? – Up till now the primary pressure on the dollar carry trade has been the flight to safety buying of the greenback in the face of the Greek crisis or some geo-political event. Now another sign of pressure is showing up.

Here’s a bit from Bloomberg:

March 4 (Bloomberg) -- The cost of borrowing in yen for three months between banks fell below the dollar rate for the first time since August, reducing the appeal of the greenback as a funding currency for leveraged purchases of assets.

The London interbank offered rate, or Libor, for three- month yen loans fell to 0.251 percent, compared with 0.252 percent for dollar loans, according to data from the British Bankers’ Association. The dollar Libor rate had moved below its yen counterpart last year for the first time after the Federal Reserve held interest rates at a record low.

Investors borrowing greenbacks at record low interest rates and buying assets in countries offering yields higher than U.S. deposit rates had helped to push the Dollar Index to a more than one-year low in November. The dollar has gained about 9 percent since then as the U.S. economy showed signs of strengthening faster than in Europe and Japan and the Fed began to wind down emergency lending programs.

“This not only closes the gap with yen Libor but makes the dollar no longer the most attractively priced currency for these carry trades,” said Ashraf Laidi, chief market strategist at CMC Markets in London. “This is already giving support to the dollar, which will continue.”

Our friend, Kevin Ferry has correctly been pointing toward Libor for some time. It will tell us a lot as inter-bank lending begins to normalize. It will bear careful attention in coming weeks.

Is China Harboring Scores Of “Californias”? – There are concerns growing about municipal and provincial debt in
China. Professor Victor Shih has recently warned that –

Borrowing by local-government entities, not counted in official estimates of China’s debt ratios, may push up the country’s borrowing to 96 percent of GDP ……

Shih’s comments follow somewhat the warnings from folks like Rogoff and even Jim Chanos. Here’s what Bloomberg
wrote recently:

Surging borrowing by local-government entities, uncounted in official estimates of China’s debt-to-GDP ratio, is the key reason for Shih’s concern. Harvard University Professor Kenneth Rogoff said Feb. 23 that a debt-fueled Bubble in China may trigger a regional recession within a decade, while hedge-fund manager James Chanos has predicted a Chinese slump after excessive property investment.

It is a little talked about issue that bears close attention.

Consensus – Payrolls and the dollar likely set the tone. Athens’ streets may also influence. Stay very nimble.

Trivia Corner

Answer - Al is 6, Mike is 9 and Jack is 20.
Today's Question - Give me a sporting chance - spell the name of a popular sport backwards and the last 3 letters give you the name of a piece of equipment needed in that sport. What is the sport? What is the equipment?

History:

On this day in 1806, one of the best examples of American capitalism took place. It had it all. A product that could be produced very cheaply. A group of people who could use the product. A clever but inexpensive means to transport the product from where it was made to where people needed it.

On this day in 1806, Fred Tudor arrived in the Caribbean port of Martinique. Tudor had sailed from Boston with a shipload of ice that had been harvested in the dead of winter from his dad's pond. Despite the claims of critics, Tudor made the ice last by insulating it with sawdust and hay (which were naturally to be washed off when the ice was sold).
The first day of Tudor's arrival was a smashing success. People paid high prices for the product he offered. But the next day...that was a problem. They had unloaded all the ice and, the boys at the dock, trying to be helpful, had washed off the insulation. Net result...night two...puddle of water….lots of screaming people offering to pay any price for the ice they now missed. Thus Tudor's ice idea was a failure...but he had learned two key parts of marketing....keeping a product fresh (storage) and how once you create demand people will pay up in scarcity. He returned to Boston, poorer but wiser.

There he raised new capital and bought the rights to harvest ice from several local ponds. But travel got risky as the War of 1812 broke out. After the war, however, Tudor sent a ship to Havana...not with ice but with thick cedar planking and sawdust...he was going to build an ice-house in Havana to keep the ice fresh. Then he sent some ice to see if the ice-house worked. It did.

He then asked for a ten year exclusive contract to be the sole supplier of ice to Cuba and Martinique. No one thought it was a big deal since folks were not used to having ice in those locales. Then he started giving the ice away, especially to bartenders (along with exotic frosty drink recipes). The "free ice" created a demand, so then Tudor began charging higher and higher prices (remember the exclusive). This ingenious marketing concept was later adopted by King Gillette and is commonly called the razor/razorblade theory. (You practically give the razor away and when they need new blades only your blades fit that razor....Op. Cit. "Barbie & Ken dolls.") Tudor went back to New England bought up the ice rights of hundreds of ponds, commissioned the manufacture of huge ice saws to cut the blocks of ice from the ponds. He compounded the strategy all through the South (one source says he invented the mint julep just to sell more ice). For 80 years, Tudor and his heirs were the "Ice Kings" of America. All from a product nature supplies for free. And he became a multi-millionaire in the process.

Thursday, the market shook off the late session chill it had experienced earlier in the week. That levitation gave the bulls some welcome breathing room.

The Fed, having performed abysmally in recognizing the growth of a global debt bubble, and then having botched the early-stage reactions (after each of the first three acute phases, it went into Mission Accomplished mode), now is pushing not simply to hold its turf, but expand its sphere of influence. From the New York Times:

In a speech Wednesday to the Council on Foreign Relations in Manhattan, Richard W. Fisher, president of the Federal Reserve Bank of Dallas, compared the financial crisis to a near-fatal heart attack.

He warned that stripping the Fed of its supervision powers “would be the equivalent of ripping out the patient’s heart.”

Mr. Fisher added: “That would surely prevent another heart attack but would likely have serious consequences for the patient.

The amazing bit is that the Fed keeps shamelessly harping on the “we stopped the crisis” message, trying to drown out anyone who points out inconvenient facts, like its abject failures before and during the crisis, and even worse, its apparent lack of recognition that its performance left a great deal to be desired. For instance, why was the Fed caught utterly flat footed by the failure of Lehman and the risk posed by AIG? The big reason for not letting Bear go was concern over credit default swaps counterparty failures. Lehman, Merrill, and UBS were all known to be wobbly when Bear failed. The first order of business should have been to understand the CDS market much better, to map the nature and extent of exposures. The Fed, in concert with the ECB and the Bank of England, should have gone on full bore data gathering mission to understand the issues and problem involved with the CDS market. Even a superficial inquiry would have led them straight to AIG.

If the Fed exhibited some humility and had engaged in some post-mortems to understand what it needed to do better next time, I’d have far more respect for it as an organization. But it bears all the hallmarks of being arrogant, insular, jealous of its authority, and resentful of legitimate criticism.

The Fed refuses to recognize the fact that it failed abysmally as a regulator and it wants a bigger regulatory role. Or more accurately, it wants oversight responsibility, but is likely to continue to rely heavily on self-regulation. Willem Buiter, a former central banker and now chief economist of Citigroup, once said that regulation is to self regulation as regard is to self-regard.

And if you think I am exaggerating, consider: the Fed, in Congressional testimony, said it intended to rely on and improve on the stress test approach used in 2009 (and the improvements, needless to say, were on the macro data side). Yet the stress tests greatly understated the true capital needs of banks. Josh Rosner at the Roosevelt Institute Let Markets Be Markets symposium, pointed out that the stress tests had grossly underestimated losses from second mortgages, and allowing for that alone would reveal that many banks needed to go back to the TARP trough. But no one involved can possibly admit failure, so the charade that the stress tests were a good idea is not simply being kept alive as a necessary bit of propaganda, but are actually going to be hard coded into continuing practice.

So who does this arrangement serve? Aside from the Fed, the industry, of course. Simon Johnson, in his talk at the same conference, made an aside that if the IMF found a governance structure like that of the Fed, it would deem it to be unacceptable. Even though it came at the end of the article, the New York Times deigned to mention the Fed’s problematic structure and Congressional concern over it, which says the issue is still a live one:

Critics of the Fed say the district presidents are often too cozy with the banks they regulate. The 12 banks have their own boards, which choose the presidents, in consultation with Fed headquarters.

Member banks elect two-thirds of each board (half are bankers and half are other members of the public), and the Fed’s board of governors names the remaining third.

“I always thought that the reserve banks, the way they appoint the presidents, was a conflict of interest,” said Senator Richard C. Shelby, the senior Republican on the Banking Committee. He said of the member banks, “They appoint their own regulator, and I’d like to knock that out.”

Damon A. Silvers, policy director at the A.F.L.-C.I.O., agreed. “If the Federal Reserve is going to have additional regulatory responsibility, it should be clear that it’s a public body, and not a self-regulating body or an arm of the banks,” he said.

I am told that the fight over Bernanke’s reappointment did penetrate the Fed’s reality distortion sphere, but its response, like Team Obama, is that it needs to conduct a PR campaign rather than take the critics’ case seriously. That means that even more pressure needs to be applied.

The Federal Reserve's assets were at $2.26 trillion as of March 3, flat sequentially. 

• Securities held outright: $1,971 billion (an increase of $60 billion MoM, resulting from $57 billion increase in MBS and $3 billion in Agency Debt), or a $6 billion decrease sequentially. 
• The fed has completed $169.1 billion of $175 billion in the agency MBS program: there is just 3% of Agency dry powder remaining (no new purchases in the week ending March 3). The Fed has completed $1.22 trillion of its $1.25 trillion MBS debt purchase program, or 98%, through March 3 (including the $10 billion announced today). There is now just $35 billion left in Quantitative Easing capacity.
• Net borrowings: unchanged at $103 billion from the prior fortnight.
• Float, liquidity swaps, Maiden Lane and other assets: a $1 billion decline sequentially to $190 billion. The CPFF program was at $7.7 billion. FX liquidity swaps are now at zero. Maiden Lane I and Maiden Lane II increased and were $27.2 and $15.6 billion, while Maiden Lane III came flat at $22.4 billion.

Custody foreign securities holdings increased by $4.4 billion sequentially to $2,969 billion.

The maturity distribution change of Fed assets from the prior week is shown below. Some $6 billion in sub 15 days USTs and Reverse Repos matured, offset by some Agency rolls into this dated category. Other assets maturing up to a year increased by about $8 billion, consisting mostly of Bills rolling closer. The net decline in assets across the entire curve was $6 billion.

The roll off of Quantitative Easing for MBS/Agencies can be seen below. The Fed's ability to artificially keep mortgage rates low is almost over.

And since everyone is concerned about the impact of the end of QE, here is Goldman Sachs to soothe everyone's nerves, by hoping readers believe that as a result of the artifical floow in the MBS market being lifted, the impact will be at most 10 basis point (that's right 10 bps. At least Goldman doesn't see a tightening in rates as a result).

In this Daily Comment we present a statistical analysis suggesting that the impact of the Fed’s asset purchase on mortgage rates has come mostly via the stock of announced MBS purchases rather than the flow of actual purchases. Our estimates suggest a total effect of around 80 basis points (bp), of which 70bp is due to the announced stock of purchases and 10bp to the week-to-week flow of purchases. Taken at face value, our results imply that mortgage rates should only rise by around 10bp when the Fed stops buying MBS over the next few weeks, although the uncertainty remains significant

Many market participants worry that the end of the Federal Reserve’s purchases of mortgage-backed securities (MBS) purchases in March will push up mortgage rates substantially.  One popular approach for gauging the likely effect is to estimate the impact of the Fed’s purchase program via the deviation of the 30-year fixed mortgage rate from its normal relationship with the 10-year Treasury yield.  As shown in the chart below, mortgage rates are currently about 70bp lower than would be expected based on the current 10-year Treasury yield.  (The 30-year mortgage rate is typically compared with the 10-year rather than 30-year Treasury yield because the embedded prepayment option reduces the duration of mortgages compared with Treasuries of equal maturity.)  Thus, some analysts have argued that mortgage rates could rise by 70bp once the Fed stops buying MBS.

 

This approach, however, ignores the distinction between the announced stock of Fed purchases and the flow of actual Fed purchases. If markets are forward-looking and therefore discount the Fed’s eventual demand for assets, rates should depend on the announced stock of purchases. This implies that the entire effect of the Fed’s purchase program should have occurred when it was announced in November 2008 and expanded in mid-March 2009. Only to the extent that markets are imperfect should the mortgage rate respond to actual Fed purchases. The distinction between stocks and flows becomes critical when the Fed stops purchasing MBS but does not change its announced MBS holdings – i.e. what we expect to happen in March.

 
To asses the outlook for mortgage rates after the Fed stops buying, we construct simple models to estimate the effect of the Fed program on the mortgage rate. It is important to note that it is difficult to be confident in the results of this exercise, as we have few observations and many other factors have affected mortgage rates at the same time. Still, we believe that our results provide a useful benchmark for what might happen to mortgage rates in coming months.

 

Our model explains the 30-year Freddie Mac primary market fixed mortgage rate (or its spread over 10-year Treasuries) using the stock of announced purchases, the weekly flow of actual MBS purchases, and a number of macroeconomic control variables. The stock of announced MBS purchaseswas initially set at $500bn on November 25, 2008 and then raised to $1.25tr on March 18, 2009. The Fed started purchasing MBS in January 2009; the purchase rate peaked in March 2009 at $33bn per week and has slowed to $11bn per week since then, averaging about $20bn per week during this period. We also include a measure of the corporate Baa yield because we want to allow for changes in overall attitudes to risk that may or may not be related to the Fed’s purchases. Furthermore, we include cyclical indicators such as the ISM manufacturing index, changes in nonfarm payrolls and the unemployment rate. Using a weekly sample from 2007 to the present, we arrive at the following results (see table below):

* First, we consider the effect of the purchase program on the spread between 30-year fixed rate mortgages and 10-year Treasuries, controlling for overall credit spreads as measured by the Baa spread over Treasuries. We estimate that the total effect of the purchase program on the current mortgage/Treasury spread is 70bp; of this, 58bp is due to the announced stock of purchases while 12bp is due to the flow of purchases (see column 1).

* Second, we consider the effect on the level of the mortgage rate, while again controlling for credit conditions by including the Baa yield. We find a total effect of 82bps on the mortgage rate; again most of the effect due to the announced stock (72bp) with the remainder (10bp) due to the flow of purchases (see column 2).

Table: Estimated Effect of the Fed MBS Purchase Program

 

The magnitude of the total effect we uncover is broadly consistent with a December 2009 speech given by Brian Sack, the head of the New York Fed’s markets group, which implies that Fed purchases have reduced the mortgage rate by about 100bp (see “The Fed’s Expanded Balance Sheet”, 2 December 2009, Remarks at the Money Marketeers of New York University). The magnitudes Sack refers to are broadly consistent with our own previous work. We have argued that Fed asset purchases of $1tr are roughly equivalent to a cut in the federal funds rate of about 100bp or, equivalently, 35bp in financial conditions (see “The Ps and Qs of Unconventional Easing”, Daily Comment, March 18, 2009). Using the weight of the long-term interest rate in the financial conditions index (55%) this effect is equivalent to roughly a 65bp drop in long-term interest (e.g. mortgage) rates for a $1tr purchase program, broadly consistent with the estimates presented above.

While we believe that the Fed’s ultimate objective is to reduce the borrowing rate that consumers actually face – i.e. the level of the primary mortgage rate used in the foregoing analysis – we test the robustness of our findings by considering two alternative measures: (1) a secondary market mortgage rate, and (2) a mortgage rate that is adjusted for the value of the prepayment option (i.e. the fact that borrowers may refinance prior to the maturity of their mortgage). For both of these measures the above conclusion – that the announced stock is the key in pushing down the mortgage rate – continues to hold and the flow effect of the purchases weakens further (not shown in the table).

One key caveat in our analysis is that we only consider the effect of the Fed MBS purchase program on the mortgage rate. We were not able to identify separately the effects of the Fed’s agency debt and Treasury purchase programs on the mortgage rate – essentially because they were announced at the same time and, in the statistical jargon, are hence highly “collinear” with the MBS purchase program. However, to the extent that the agency debt and Treasury purchase programs – which are much smaller in magnitude – had an impact on the mortgage rate, we believe that our approach should implicitly include this effect. In other words, we view our 70-80bp estimate as a reasonable gauge of the total effect of all Fed programs on the mortgage rate. The fact that we find a larger effect on the mortgage rate than on its spread over Treasuries is consistent with a modest impact of Fed purchases not just on mortgage spreads but also on Treasury yields.

In sum, we find that the stock of announced Fed purchases has been more important in pushing down mortgage rates than the flow of actual purchases. Thus, our analysis only points to a modest rise in mortgage rates of around 10bp when the Fed stops buying MBS in a few weeks. Together with the subdued outlook for MBS origination volumes in a weak housing market environment (see “The GSE at a Crossroads”, Fixed Income Monthly, February 2010), this suggests that nominal mortgage rates will remain low. However, an announcement to sell MBS – which we believe will not occur for some time to come – would likely result in a much bigger rise in mortgage rates of up to 80bp. Again, however, we emphasize that it is difficult to have a great deal of confidence in our regression results given the inherent difficulty of estimating the impact of an unprecedented policy in an environment of nearly unparalleled swings in the mortgage and broader asset markets.

Sven Jari Stehn

With Erik Hane

Zero Hedge has previously discussed the bifurcation in market performance when comparing regular hour trading with that of the afterhours session, noting that in the September through December 2009 period, the market would have been flat if one were to strip away the benefit of gains after the market closed. Today, we take a look at a different set of data, namely observing a very peculiar market phenomenon associated with the term coined as Mutual Fund Mondays, especially over the past 6 months. Whereas on a long-enough timeline, the market performance on any given Monday (or, more specifically on any given first day of the business week), has averaged to about a 50% win/loss ratio, this is certainly not the case in the September 2009 - March 2010 period. In fact, during this time period, when the broader market has risen by only 10%, the positive contribution from Mondays has been 20%, implying that on all other days of the week the market has, on average, lost 10% in the past 6 months. Furthermore, the win/loss ratio for the first trading day in the last 26 weeks has been 85%: a nearly 3 standard deviations from the norm outlier. Let's dig in.

To analyze this particular data set, we have split up the SPY performance from the past 52 weeks, and have primarily focused on the market performance (as captured by the broad SPDR ETD) on first day of any particular week. We notice two distinct regimes: one from March 1 2009 through the end of August, and a much more aggressive one beginning in September 2009 and continuing through today.

First, below we present is a price/volume chart of the SPY performance in the two periods under consideration.

While market volume is not a topic in this particular discussion, the secular decline as the market has kept going higher has only been interrupted by the brief correction in early February when the market was forced to undergo a breif 10% correction, which forced volume to spike up substantially. Now volume is back to normal.

Yet what we would like to bring your attention to are the following to charts, which scatterplot the performance of any given first week day mapped over time.

First - the period from March through September 2009:

And next, the period beginning September 2009 and continuing through today:

Here are the notable observations:

Between March and September 2009 the broader market increased by just under 50%, between September and March 2010 the market returned just one-fifth, or about 10%. This is well-known to everyone. Yet what may not be well known is that while historically, the win/loss ratio of the first day of any given week averages to 50%, and this is precisely the win/loss ratio for the period March-September 2009 (13 out of 26 weeks positive), the win loss ratio in the September-March interval is 85%, or higher on 22 of 26 Mondays (in some cases Tuesdays when the Monday is a holiday). In fact, the average daily return for "Mondays" in the first interval is a mere 0.09%, while in the second interval it is a stunning 0.75%! In fact, since early December, or 12/7/2009 to be specific, there has been just one "Monday" in which the SPY has closed down. In addition, the bullish performance on 1/19/2010, 1/25/2010 and 2/1/2010 are in stark opposition with the broader bearish downdrift that was taking place in the market during the period from January 15 and February 5. These three days account for 3 of the 5 green days in the this broader trading period.

Looking at this data in aggregate, in the second interval period, the cumulative return of just Monday has been 20%, or double the broader market return of 10%.

This data indicates that traders should buy the market (SPY) just before the open on Monday in the afterhours session (or just before the Friday close for those who have no access to AH trading) and to sell just before market close on Monday. If the trend discussed above persists, two months of this kind of repetitive activity will generate a 20% return all else equal.

And while this observation indicates that due to the high statistically significant nature of this outlier phenomenon the market is possible being nudged between the weekly close and the close of the first day of the following week from September 2009 through today, as there is nobody in regulatory capacity who either cares about this event, or would be willing to take any action against it, the best possible outcome would be for everyone to jump on board with the algo or outright mutual fund buying that is taking place at this time, and simply ride its coattails to power and riches. Then again, as with all technically trending patterns, that have no validation in reality or fundamentals, the persistence of this pattern will only continue until enough market participants spot it, and there is no greater fool to take advantage of on the other side of the trade (except for gullible taxpayers of course, represented in this, and every case, by the Federal Reserve).

As more and more details of the actual Volcker Rule implementation continue to trickle in, we present the following excerpts from proposed additions to the Bank Holding Company Act, first noted in iMarketNews. For a proposal that has been written off by pretty much everyone, Volcker's proposal sure seems to refuse to give up the ghost.

The Bank Holding Company Act is amended by adding the following new sections:

PROHIBITION ON PROPRIETARY TRADING.

Notwithstanding any other provision of law, the appropriate Federal banking agencies shall jointly prohibit proprietary trading by an insured depository institution or by a company that controls an insured depository institution or is treated as a bank holding company for purposes of this Act.

EXCEPTION FOR UNITED STATES AND OTHER GOVERNMENT AND RELATED OBLIGATIONS.

Any prohibition imposed pursuant to this subsection shall not apply to trading in obligations of the United States or any agency thereof, obligations, participations, or other instruments of or issued by the Government National Mortgage Association, the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation, and obligations of any State or of any political subdivision thereof.

PROHIBITION ON SPONSORING AND INVESTING IN HEDGE FUNDS AND PRIVATE EQUITY FUNDS.

The appropriate Federal banking agencies shall jointly prohibit sponsoring and investing in hedge funds and private equity funds by an insured depository institution or by a company that controls an insured depository institution or is treated as a bank holding company for purposes of the Bank Holding Company Act.

EXCEPTION FOR INVESTMENTS IN SMALL BUSINESS INVESTMENT COMPANIES AND INVESTMENTS DESIGNED PRIMARILY TO PROMOTE THE PUBLIC WELFARE.

Any prohibition imposed pursuant to this subsection shall not apply to investments in small business investment companies and investments designed primarily to promote the public welfare as provided in

LIMITATIONS ON RELATIONSHIP WITH HEDGE FUNDS AND PRIVATE EQUITY FUNDS.

No insured depository institution and no company that controls an insured depository institution or that is treated as a bank holding company for purposes of this Act that serves, directly or indirectly, as the investment manager or investment adviser to a company described in subsection may enter into a covered transaction as defined in section 23A of the Federal Reserve Act with, or provide custody, securities lending and other prime brokerage services to, such company.

RULEMAKING AUTHORITY.

The appropriate Federal banking agencies shall jointly issue regulations and guidance to carry out this section including appropriate additional capital requirements giving full effect to the prudential intent of the Congress regarding this section.

EFFECTIVE DATE AND TRANSITION.

The provisions of this section shall take effect after the end of the 180-day period beginning on the date of enactment of this title.

TRANSITION.

Any insured depository institution, any company which owns or controls an insured depository institution and any company which is treated as a bank holding company for purposes of the Bank Holding Company Act, shall not, after two years from the effective date of this Act, retain any investment prohibited by this section. The appropriate Federal banking agency is authorized, upon application of any such company, to extend the two-year period as to such company for not more than one year at a time, if in its judgment, such an extension would not be detrimental to the public interest, but no such extension shall in the aggregate exceed three years.

CAPITAL AND QUANTITATIVE LIMITATIONS FOR CERTAIN NONBANK FINANCIAL COMPANIES.

The Board shall adopt rules imposing additional capital requirements and specifying additional quantitative limits for nonbank financial companies under its supervision that engage in proprietary trading and sponsoring and investing in hedge funds and private equity funds.

CONCENTRATION LIMIT ON LARGE FINANCIAL FIRMS.

A financial company may not merge or consolidate with, acquire all or substantially all of the assets of, or otherwise acquire control of, another company if the acquiring financial companys total consolidated liabilities upon consummation of the transaction would exceed 10 percent of the aggregate consolidated liabilities of all financial companies at the end of the prior calendar.

RULEMAKING AND GUIDANCE.

The Board shall issue regulations implementing this section, including the definition of terms as necessary. The Board may issue interpretations or guidance regarding the application of this section to an individual company or in general.

A week ago Ron Paul asked Ben Bernanke a series of questions, which the Chairman and pundits immediately dismissed as "bizarre" and an indication that the potential presidential candidate has finally lost it (among these was a very nuanced question whether or not the Fed is buying sovereign debt, something which Bernanke disclosed in 2002 is a distinct possibility and an action the Fed is permitted to do). Chief among these were queries arising from the work of U of T professor Robert Auerbach, and specifically his book "Deception and Abuse at the Fed" (not available on Kindle), which seek information on whether the Fed was involved in the Watergate scandal and, subsequently, in Iraqi weapons purchases. 

Well, Paul may not be as kooky as people are trying to make him out to be. None other than "consumer protection advocate" Barney Frank has demanded that Bernanke do a full probe based on these allegations.

Bloomberg reports:

Representative Ron Paul asked questions about “inappropriate political interference” and “hidden transfers of resources” during a Feb. 24 hearing with Bernanke, and the allegations “must be fully investigated,” Frank said in a letter today to Bernanke and obtained by Bloomberg News.

Frank, 69, said the Fed must address the charges because “continued concern about political interference” with the Fed and “allegations about a lack of transparency.” Bernanke and other Fed officials are trying to fend off a measure offered by Paul, which passed the House in December, that would open the Fed to audits of interest-rate decisions.

“These specific allegations you’ve made I think are absolutely bizarre, and I have absolutely no knowledge of anything remotely like what you just described,” Bernanke told Paul, a Texas Republican who wrote the 2009 book “End the Fed,” during last week’s hearing.

Some more on Professor Auerbach's background, which lends substantial credibility to his allegations:

Auerbach worked for Henry Gonzalez, a former chairman of the House committee who died in 2000 and investigated the sale of U.S. arms to Iraq in the 1980s, before the Gulf War. Gonzalez said the Fed and other agencies initially tried to block his probe, according to a 1992 New York Times article.

Fed bank examiners in Atlanta failed to note $5.5 billion being funneled to Iraq from a local branch of an Italian bank, Auerbach, a critic of the central bank and former congressional economist, said in his book.

“The Federal Reserve’s ability to manage monetary policy in an effective manner depends, in large part, on its reputation for independence and integrity,” Frank, a Massachusetts Democrat, said in the letter. “A complete investigation of these charges is necessary to maintain both.”

We can't wait just how deep this particular rabbit hole ends up going, although we will be extremely shocked if the Fed ends up finding absolutely nothing implicating it in any new illegal (and treasonous) activity. Luckily, the Fed is perfectly transparent, so the general population can do a parallel query on its own. Oh wait...

Yet another much needed reminder that the topic of High Frequency Trading is far from resolved. On Tuesday, Senator Ted Kaufman reminded that increasingly more regulators and market participants remain divided over HFT, even as concern about possible improprieties associated with market structure grows. Kaufman's most recent topic of focus - order cancellations. He said the SEC should address the "burgeoning" number of order cancellations involved in high frequency trading, which, he added, are "clearly excessive" and virtually a "prima facia" case that battles between competing algorithms have become "all too commonplace, overloading the system and regulators alike."

Kaufman's five priorities for the SEC have been as follows:

1. Provide timely guidance on new market practices, like co-location and naked access — before they become too widespread.
2. Use its ‘large trader’ authority to require the tagging and disclosure of high frequency trading, then mask it and release it to the marketplace so there can be independent analysis by academics and others on the effects of high frequency trading on long-term investors.
3. Better define ‘manipulative’ market activity and provide clear guidance for traders to follow, just as the UK has declared “spoofing” to be a deceitful trading strategy.
4. Continue to make the reduction of systemic and operational risk a top priority.
5. Address the growing number of order cancellations.

Lastly, the Senator has called on the high frequency trading industry to “come to the table” and play a meaningful role addressing current market issues.

Congratulations to our friends from Themis Trading for being referenced in the Senator's speech.

Full Kauman speech:

Mr. President, I have spoken on the Senate floor many times about the importance of transparency in our markets.  Without transparency, there is little hope for effective regulation.  And without effective regulation, the very credibility of our markets is threatened.
 
But I am concerned recent changes in our markets have outpaced regulatory understanding and, accordingly, pose a threat to the stability and credibility of our equities markets.  Chief among these is high frequency trading. 
 
Over the past few years, the daily volume of stocks trading in microseconds — the hallmark of high frequency trading — has exploded from 30 to 70 percent of the U.S. market.  Money and talent are surging into a high frequency trading industry that is red hot, expanding daily into other financial markets not just in the United States but in global capital markets as well.
 
High frequency trading strategies are pervasive on today's Wall Street, which is fixated on short-term trading profits.  Thus far, our regulators have been unable to shed much light on these opaque and dark markets, in part because of their limited understanding of the various types of high frequency trading strategies. Needless to say, I’m very worried about that.
 
Last year, I felt a little lonely raising these concerns. 
 
But this year, I’m starting to have plenty of company.
 
On January 13th, the Securities and Exchange Commission issued a 74-page Concept Release to solicit comments on a wide-range of market structure issues.  The document raised a number of important questions about the current state of our equities markets, including “Does implementation of a specific [high frequency trading] strategy benefit or harm market structure performance and the interests of long-term investors?” and, “Do commenters believe that the overall use of harmful strategies by proprietary firms is sufficiently widespread that the Commission should consider a regulatory initiative to address the problem?”
 
Among other potential sources of unfairness, the Commission noted that “short-term price volatility may harm individual investors if they are persistently unable to react to changing prices as fast as high frequency traders.”  
 
Finally, the SEC called attention to trading strategies that are potentially manipulative, including momentum ignition strategies in which “the proprietary firm may initiate a series of orders and trades (along with perhaps spreading false rumors in the marketplace) in an attempt to ignite a rapid price move either up or down.  For example, the trader may intend that the rapid submission and cancellation of many orders, along with the execution of some trades, will ‘spoof’ the algorithms of other traders into action and cause them to buy ([or] sell) more aggressively.” 
 
The SEC went on to ask, “Does…the speed of trading and ability to generate a large amount of orders across multiple trading centers render this type of strategy more of a problem today?”
 
Mr. President, the SEC raised many critical questions in its concept release, and I appreciate that the SEC is trying to undertake a baseline review.
 
As its comment period moves forward, I am pleased to report that other regulators and market participants, both at home and abroad, have taken notice of the global equity markets' recent changes, including the rise in high frequency trading.
 
In the United States, the Federal Reserve Bank of Chicago, in the March 2010 issue of its Chicago Fed Letter, argued that the rise of high frequency trading constitutes a systemic risk, asserting “The high frequency trading environment has the potential to generate errors and losses at a speed and magnitude far greater than that in a floor or screen-based trading environment.”   In other words, high frequency trading firms are currently locked into a technological arms race that may result in some big disasters.
 
Citing a number of instances in which trading errors have occurred, the Chicago Fed stated that “a major issue for regulators and policymakers is the extent to which high frequency trading, unfiltered sponsored access and co-location amplify risks, including systemic risk, by increasing the speed at which trading errors or fraudulent trades can occur.”
 
Moreover, the letter cautions us about the potential for future high frequency trading errors, arguing, “Although algorithmic trading errors have occurred, we likely have not yet seen the full breadth, magnitude, and speed with which they can be generated.  Furthermore, many such errors may be hidden from public view because a large number of high frequency trading firms are privately held, rely on proprietary technology, and have no customers.”
 
There is action internationally as well.  On February 4th, Great Britain's Financial Services Secretary, Paul Myners, announced that British regulators were also conducting an ongoing examination of high frequency trading practices, stating, “People are coming to me, both market users and intermediaries, saying that they have concerns about high frequency trading…High frequency trading is a very new development.  Does that have consequences that regulators need to be focusing on?”
 
This development comes on the heels of another British effort targeting so-called “spoofing” or “layering” strategies in which traders feign interest in buying or selling a stock in order to manipulate its price. In order to deter such trading practices, the Financial Services Authority (FSA) announced that it would fine or suspend participants who engage in market manipulation.  The revamped enforcement effort is partly intended to more clearly define manipulative activity.  Noting that some market participants may not be sure that spoofing or layering is wrong, an FSA spokeswoman said, "This is to clarify that it is.”   
 
In Australia, market participants are also requesting clearer definitions of market manipulation, particularly with regard to momentum strategies like spoofing.  In a review of algorithmic trading published February 8th, the Australian Securities Exchange called on the Australian Securities and Investments Commission to, “Ensure that…market manipulation provisions…are adequately drafted to capture contemporary forms of trading and provide a more granular definition of market manipulation.” 
 
Mr. President, high frequency trading poses two risks:  systemic risk to the market and the risk of manipulation.  As the Chicago Fed stated, it is high time that we weigh the risk of major high frequency trading errors against the supposed “efficiency” benefits of cutting down trading speeds by several milliseconds. 
 
The risk of an algorithmic trading error wreaking havoc on our equities markets is only magnified by so-called “naked,” or unfiltered sponsored access arrangements, which allow traders to interact on markets directly — without being subject to standard pre-trade filters or risk controls. 
 
Robert Colby, the former deputy director of the SEC’s Division of Trading and Markets, warned last September that naked access leaves the marketplace vulnerable to faulty algorithms.  In a speech given at a forum on the future of high frequency trading, which was cited by the Chicago Federal Reserve’s recent letter, Mr. Colby stated that hundreds of thousands of trades representing billions of dollars could occur in the two minutes it could take for a broker-dealer to cancel an erroneous order executed through naked access.
 
According to a report released December 14th by the research firm Aite Group, naked access now accounts for a staggering 38% of the market’s average daily volume compared to 9% only four years ago. 
 
Let me reiterate that: almost FORTY percent of the market’s volume is executed by high frequency traders interacting directly on exchanges without being subject to any pre-trade risk monitoring.  
 
In January, the SEC acted to address this ominous trend by proposing mandatory pre-trade risk checks for those participating in sponsored access arrangements.  This move would essentially eliminate naked access, and I applaud the SEC for its proposal.   
 
While I am pleased that the SEC has taken on naked access and has issued a concept release on market structure issues, there is much work that still needs to be done in order to gain a better understanding of high frequency trading strategies and the risks of frontrunning and manipulation they may create.  In the last few months, several industry studies aimed at defining the benefits and drawbacks of high frequency trading have emerged.  While these studies may not be the equivalent of peer-reviewed academic studies, they do have the credibility of real-world market experts.  And they begin to shed light on the opaque and largely unregulated high frequency trading strategies that dominate today’s marketplace.  
 
In addition to the Aite Group study, reports by the research firm, Quantitative Services Group (QSG), the investment banking firm, Jefferies Company, the dark pool operator, Investment Technology Group (ITG), and the institutional brokerage firm, Themis Trading, all raise troubling concerns about the costs of high frequency trading to investors and reinforce the need for enhanced regulatory oversight of these trading practices.
 
Last November, QSG analyzed the degree to which orders placed by institutional investors are vulnerable to high frequency trading strategies.  Large investors typically seek to break up their orders into a series of smaller ones in order to hide their trading interest and avoid price swings. 
 
Despite this tactic, QSG found that institutional order flow is very susceptible to high frequency predators who sniff out such order flow and trade ahead of it. 
 
Specifically, the study concluded that splitting large orders into several smaller ones not only enhances the risk of unfavorable changes in price, but also increases, “the chances of leaving a statistical footprint that can be exploited by the ‘tape reading’ HFT algorithms.”   While traders have long tried to trade ahead of large institutional orders, they now have the technology and models to make an exact science out of it.   
 
A second QSG study released on February 11th analyzed changes in price that occur minutes after a large order is filled.  According to the study, institutional investors routinely experience unfavorable price movements while attempting to make a transaction only to see prices move 25 percent in a more favorable direction once the sale is completed.  This outcome is evidence of high frequency strategies that act "as a motivated competitor for liquidity, not a supplier," the study’s press release says. 
 
In a study put forth on November 3rd, the Jefferies Company examined the advantages high frequency traders gain by co-locating their computer servers next to exchanges and subscribing directly to market data feeds.
 
Jefferies estimates that these advantages afford high frequency traders a 100 to 200 millisecond advantage over those relying on standard data providers.
 
Under such conditions, Jefferies concludes, high frequency traders enjoy “(almost) risk-free arbitrage opportunities.”
 
A Themis Trading white paper released in December elaborated on Jefferies’ conclusion, noting that the combination of speed and informational advantages allow high frequency traders to “know with near certainty what the market will be milliseconds ahead of everybody else.”
 
Themis estimates this ability to essentially predict the future and trade ahead of unsuspecting investors translates into $6 to $12 million a day for high frequency traders employing these predatory strategies, or roughly $1.5 to $3 billion a year in “profit generated from traditional institutional and retail investor assets under management.”
 
ITG, which runs the block trading dark pool POSIT, also conducted a study last November on predatory high frequency trading in dark pools.
 
ITG’s study warns that, “due to the overwhelming participation level of high frequency trading firms in dark pools, adverse selection is occurring much more frequently to the detriment of buyside participants,” who represent institutional investors, including pension and mutual funds. 
 
Regulators need to determine whether institutional investors’ pockets are being picked in the dark pool, pennies at a time.  The evidence shows that high frequency traders have models that effectively allow them to trade at the most optimal time, exploiting institutional investors with less sophisticated trade execution strategies.  In the past, these dark pools were never accessible to high frequency traders, but now they appear to have virtually risk-free money-making opportunities there for the taking.  
 
Equally troubling, ITG notes that the current market structure, conflicts of interest among some broker-dealers, and the lack of adequate quantitative methods and relevant data mean that poor executions are “often invisible” to buyside traders.
 
These findings demonstrate that some institutional investors, including those managing the pension and mutual funds of average Americans, may be failing not only to obtain best executions for their clients when trading in dark pools with high frequency traders, but are also unaware of this reality.
 
While concerns expressed by regulators and members of the industry have mounted, high frequency trading firms continue to enter and expand their presence in the marketplace.  Recently, GETCO, a high frequency trading firm that already serves as a registered market-maker for NASDAQ and BATS Exchange, and represents as much as 10 to 20% of average daily trading volume according to various estimates, announced that it would become one of the New York Stock Exchange’s “designated market makers.” 
 
 As high frequency traders carve out an increasingly dominant role in the market, the lack of transparency into their trading practices looms as a reminder of the troubling gaps in our regulatory framework. 
 
Mr. President, the studies and papers I have mentioned underscore the need for the SEC to implement stricter reporting and disclosure requirements for high frequency traders under its “large trader” authority, as Chairman Mary Schapiro promised she would in a letter to me on December 3rd. We need tagging of high frequency trading orders and next day disclosure to the regulators, and we need it now.
 
Mr. President, for investors to have confidence in the credibility of our markets, regulators must vigorously pursue a robust framework that maintains strong, fair and transparent markets.  The regulators owe it to investors and the American public to actively address these problems.  I would make five points.
 
First, the regulators must get back in the business of providing guidance to market participants on acceptable trading practices and strategies.  While the formal rule-making process is a critical component of any robust regulatory framework, so too are timely guidelines that bring clarity and stability to the marketplace.  Co-location, flash orders and naked access are just a few practices that seem to have entered the market and become fairly widespread before being subject to proper regulatory scrutiny.  For our markets to be credible, it is vital that regulators be pro-active, rather than reactive, when future developments arise.
 
Second, the SEC must gain a better understanding of current trading strategies by using its “large trader” authority to gather data on high frequency trading activity.  Just as importantly, this data – once masked – should be made available to the public for others to analyze. 
 
I am concerned that academics and other independent market analysts do not have access to the data they need to conduct empirical studies on the questions raised by the SEC in its concept release.  Absent such data, the ongoing market structure review predictably will receive mainly self-serving comments from high frequency traders themselves and from other market participants who compete for high frequency volume and market share.
 
Evidence-based rule-making should not be a one-way ratchet because all the "evidence" is provided by those whom the SEC is charged with regulating. We need the SEC to require tagging and disclosure of high frequency trades so that objective and independent analysts — at FINRA, in academia or elsewhere — are given the opportunity to study and discern what effects high frequency trading strategies have on long-term investors; they can also help determine which strategies should be considered manipulative.  
 
Third, regulators must better define manipulative activity and provide clear guidance for traders to follow, just as Britain’s regulators have done in the area of spoofing.  By providing “rules of the road,” regulators can create a system better able to prevent and prosecute manipulative activity.
 
Fourth, the SEC must continue to make reducing systemic and operational risk a top regulatory priority.  The SEC’s proposal on naked access is a good first step, but exchanges must also be directed to impose universal pre-trade risk checks.  If left solely in the hands of individual broker-dealers, a race to the bottom might ensue.  We simply must have a level playing field when it comes to risk management that protects our equities markets from fat fingers or faulty algorithms.  Regulators must therefore ensure that firms have appropriate operational risk controls to minimize the incidence and magnitude of such errors while also preventing a tidal wave of copycat strategies from potentially wreaking havoc in our equities markets.
 
Fifth, the SEC should act to address the burgeoning number of order cancellations in the equities markets.  While cancellations are not inherently bad – potentially enhancing liquidity by affording automated traders greater flexibility when posting quotes – their use in today’s marketplace is clearly excessive and virtually a prima facie case that battles between competing algorithms, which use cancelled orders as feints and indications of misdirection, have become all-too-commonplace, overloading the system and regulators alike.
 
According to the high frequency trading firm T3Live, on a recent trading day only 1.247 billion of the 89.704 billion orders on Nasdaq’s book were executed – meaning a whopping 98.6% of the total bids and offers were not filled. Cancellations by high frequency traders, according to T3Live, were responsible for the bulk of these unfilled orders. 
 
The high frequency traders that create such massive cancellation rates might cause market data costs for investors to rise, make the price discovery process less efficient and complicate the regulators’ understanding of continuously evolving trading strategies.  What’s more, some manipulative strategies, including layering, rely on the ability to rapidly cancel orders in order to profit from changes in price.  
 
Perhaps excessive cancellation rates should carry a charge.  If traders exceed a specified ratio of cancellations to orders, it’s only fair that they pay a fee.  The ratio could be set high enough so that it would not affect long-term investors (even day traders), and should apply to all trading platforms, including dark pools and ATSs as well as exchanges.  
 
The high-frequency traders who rely on massive cancellations are using up more bandwidth and putting more stress on the data centers.  Attempts to reign in cancellations or impose charges are not without precedent. In fact they have already been implemented in derivatives markets where overall volume is a small fraction of the volume in cash market for stocks.  The Chicago Mercantile Exchange’s volume ratio test and the London International Financial Futures and Options Exchange’s bandwidth usage policy both represent attempts to reign in excessive cancellations and might provide a helpful model for regulators wishing to do the same.   
 
Finally, the high frequency trading industry must come to the table and play a constructive role in resolving current issues in the marketplace, including preventing manipulation and managing risk.  In order to maintain fair and transparent markets and avoid unintended consequences, market participants from across the industry must contribute to the regulatory process.  I am pleased that a number of responsible firms are stepping forward in a constructive way, both in educating the SEC and me and my staff.  I look forward to continue to working with these industry players.
 
Mr. President, we all must work together, in the interests of liquidity, efficiency, transparency and fairness to ensure our markets are the strongest and best-regulated in the world.  But we cannot have one without the other – for markets to be strong, they must be well-regulated.  So with this reality in mind, I look forward to working with my colleagues, regulatory agencies, and people from across the financial industry to ensure our markets are free, credible and the envy of the world.
 
Mr. President, I ask that links to some of the studies and reports I have mentioned be included in the record.

• www.qsg.com
  • “Liquidity Charge® & Price Reversals: Is High Frequency Trading Adding Insult to Injury?” February 11, 2010
  • “Beware of the VWAP Trap,” November 11, 2009
• http://www.themistrading.com/article_files/0000/0519/THEMIS_TRADING_White_Paper_--_Latency_Arbitrage_--_December_4__2009.pdf
• http://www.itg.com/news_events/papers/AdverseSelectionDarkPools_113009F.pdf
• http://www.aitegroup.com/reports/200912141.php
• http://www.asx.com.au/about/pdf/20100211_review_algorithmic_trading_and_market_access.pdf
• http://www.chicagofed.org/digital_assets/publications/chicago_fed_letter/2010/cflmarch2010_272.pdf

Mr. President, I yield the floor.
 

FOMC's Beige Book indicates that things could not be better... if you ignore the record unemployment of course and the tens of trillions in rollover debt, and the quadrillions in 2100 deficits, and that damn snowfall which came at a very sensitive time for the economy. So yes, aside from that, all is great.

March 3 Beige Book

Prepared at the Federal Reserve Bank of Kansas City and based on information collected on or before February 22, 2010. This document summarizes comments received from businesses and other contacts outside the Federal Reserve and is not a commentary on the views of Federal Reserve officials.

Reports from the twelve Federal Reserve Districts indicated that economic conditions continued to expand since the last report, although severe snowstorms in early February held back activity in several Districts. Nine Districts reported that economic activity improved, but in most cases the increases were modest. Overall conditions were described as mixed in the Atlanta and St. Louis Districts, though St. Louis noted further signs of improvement in some areas. Richmond reported that economic activity slackened or remained soft across most sectors, due importantly to especially severe February weather in that region.

Consumer spending improved slightly in many Districts since the last survey, but severe snowstorms in early February limited activity in some Districts. Tourist activity was reported as increased or mixed, with some improvement in hotel occupancies. The demand for services was generally positive across Districts, most notably for health-care and information technology firms. Of the five Districts reporting on transportation, three characterized activity as improved over the previous survey. Manufacturing activity strengthened in most regions, particularly in the high-tech equipment, automobile, and metal industries. Residential real estate markets improved in a number of Districts, although several Districts noted that activity softened or remained weak partly due to extreme winter weather. Most Districts characterized commercial real estate and construction activity as weak or having declined further, but some Districts noted slight stabilization and a few signs of modest improvement. Loan demand remained weak, and lending standards remained tight across the country. Harsh weather continued to negatively affect agricultural activity, although some Districts reported favorable crop conditions. Districts reporting on energy activity said it continued to strengthen, particularly drilling for natural gas.

Price pressures were mostly limited, with the exception of some increases in raw materials prices. Even with input costs rising, selling prices remained stable due to competitive pressures and limited pricing power. Although some Districts reported an uptick in hiring or a slowdown in layoffs, labor markets generally remained soft throughout the nation, which resulted in minimal wage pressures.

Consumer Spending and Tourism
Consumer spending showed signs of improvement in many Districts since the last report but was hampered in several regions by severe weather conditions in early February. Retail sales improved in the Chicago, Minneapolis, Dallas, and San Francisco Districts, and New York said sales were well above year-ago levels in January and met expectations in February despite inclement weather. Philadelphia also reported that sales were moving up slowly until snowstorms hit in February. Boston and Cleveland characterized sales as mixed but slightly higher overall than year ago levels. Sales were lower than expected in the Atlanta and Kansas City Districts and were down from year-ago levels in the St. Louis District. Several Districts reported that sales were strongest for lower-priced items, while sales of luxury and big ticket items remained sluggish. However, San Francisco noted scattered reports of increased discretionary spending, and Cleveland said some retailers noted a broader, if still slight, increase in demand across a variety of products. Inventories were being managed carefully and held at fairly low levels in most Districts, but Chicago said rising sales were leading retailers to begin rebuilding inventories from low levels.

Auto sales were generally reported as flat or down, with a few Districts again noting that some of the sluggishness was likely due to poor weather conditions. New York, Cleveland, and San Francisco all noted some softening in new auto sales, though New York cited brisk sales of used vehicles. Chicago and Kansas City also reported declining auto sales, while Dallas noted some seasonal softness and Atlanta said sales remained weak. Some Districts reported modest improvement in auto credit conditions. Cleveland noted that many consumers remain reliant on manufacturers' incentives, and auto dealers in the Chicago District blamed part of their recent sales decline on reduced factory incentives.

Districts reporting on tourism said that activity was either rising or mixed since the last survey period. Ski resorts in the Richmond and Kansas City Districts reported at least modest rebounds in activity from year-ago levels, while Minneapolis characterized skier visits to a Montana resort as flat. New York said hotel occupancies in Manhattan were up considerably from a year ago in January and Broadway theatre activity was robust before falling off due to weather in February. Atlanta also reported rising tourism activity related to several successful major sporting events and a well-attended Mardi Gras in New Orleans. San Francisco noted increases in visitors to Hawaii and Las Vegas and said hotel occupancies stabilized in some other areas.

Nonfinancial Services
Nonfinancial services activity was reported as steady or improved by the majority of Districts. Boston, St. Louis, Minneapolis, and San Francisco reported generally solid demand in health-care services, although Minneapolis noted continued weakness in elective procedures. New York indicated that a growing number of service firms planned to increase capital spending in the months ahead, but investment expectations diminished among high-tech companies in the Kansas City District. Richmond reported that service revenues fell due to the record snowstorms, but a few contacts saw a slight pickup in demand, particularly architectural firms, hospitals, and financial service professionals.

In transportation services, Cleveland, Atlanta, and Kansas City reported an improvement in activity since the last survey, while Dallas said activity was mixed and St. Louis noted large job cuts in the industry. Regional rail loadings were above year-ago levels in the Atlanta District, especially for autos, chemicals, metals, and some construction-related equipment. Intermodal firms in the Dallas District reported no change in cargo volumes, with a rise in exports being offset by a decline in imports. Although shipping volumes increased, Cleveland noted that margins remained depressed due to over-capacity issues, limiting investment in new trucks.

Manufacturing
Manufacturing activity increased further in most Districts, although Minneapolis, Dallas, and San Francisco characterized overall activity as flat or mixed. Philadelphia reported widespread production increases across most industries, and manufacturers in the Cleveland District reported a general rise in capacity utilization. Many Districts reported strong production in metals, and the Boston, Dallas, and San Francisco Districts noted strength in high-tech equipment, particularly semiconductors. Cleveland, Chicago, St. Louis, and Dallas noted solid improvements in auto-related manufacturing. A consumer goods company in the Boston District said European sales were at healthier levels. Contacts in the Chicago District reported strong growth in Asian exports but remained concerned about China's underlying economic strength. Dallas reported that exports for natural-gas based products remained strong, but weak demand for refined products has trimmed margins and cut capacity utilization further. Construction-related activity remained weak in the Chicago and Dallas Districts, and new orders for commercial aircraft and parts were sluggish in the San Francisco District. Philadelphia and Richmond noted productions delays due to the winter snowstorms in February, but some factories were able to make up the losses with longer work hours and extended shifts. Several manufacturers in the Philadelphia District said production gains could be limited due to continued tightening in credit markets and adverse developments in taxes and regulations. Plant managers in a few Districts reported that a large number of customers were simply restocking inventories, leading to concerns about the sustainability of the increase. However, contacts in most Districts remained optimistic for future months, with several reports of planned increases in capital spending.

Real Estate and Construction
Residential real estate markets improved in a number of Districts, remained weak or softened further in the New York, Atlanta, and Chicago Districts, was little changed in the San Francisco District, and characterized as mixed in the St. Louis District. Richmond also reported overall housing activity as mixed, but one contact noted that absent the harsh weather, market conditions might have improved. Adverse weather conditions also hampered home sales and construction in the New York, Philadelphia, and Atlanta Districts. Most Districts attributed stronger home sales to the home-buyer tax credit, with several contacts apprehensive about future sales once the credit expires on April 30. Philadelphia, Cleveland, Kansas City, and Dallas reported that sales were strongest for low-priced and starter homes, while Dallas cited financing difficulties for high-end homes. Home construction was down or stagnant in most Districts, with the exception of the Minneapolis, Kansas City, and Dallas Districts. Atlanta said the most pronounced weakness was among Georgia homebuilders, and San Francisco attributed weak construction activity to elevated home inventory levels. Home prices mostly remained flat or declined slightly, but signs of improvement were noted in the Boston and San Francisco Districts. A real estate agent in a relatively upscale area of the New York District said prices have continued to drift downward but that short sales were relatively rare and most transactions were still above the mortgage balance.

Commercial real estate conditions remained weak or declined further in most Districts, although some Districts noted slight stabilization or modest signs of improvement. Commercial real estate activity weakened in the Richmond, Minneapolis, Kansas City, Dallas, and San Francisco Districts, though Dallas noted that leasing fell at a slower rate and San Francisco cited increased leasing in some segments. Boston and Philadelphia said conditions remain weak, but both noted some improvement in sales of commercial space. New York reported softer activity in the New York City area but some steadying in vacancies and rents elsewhere, while St. Louis said activity remained weak throughout the District. Several Districts also noted that many tenants were pushing for, and in some cases receiving, concessions on rents. All Districts reporting on commercial construction said that activity remained weak or slow, except for some moderate boost from federal stimulus projects and other public construction. Credit for commercial development and transactions was still very difficult to obtain in several Districts, though San Francisco noted a slight improvement in financing availability.

Banking and Finance
Loan demand remained weak across the country. New York, Cleveland, and Kansas City reported decreased demand for most types of loans. Other Districts said loan demand was unchanged but soft. Richmond and Chicago noted that the weak economic outlook was holding back loan demand, and San Francisco said caution about hiring and spending plans was keeping businesses from seeking credit. However, Philadelphia and Richmond reported banks were receiving more inquiries from businesses about loans, and Dallas said contacts were hopeful that loan demand would pick up by the end of the year.

Most Districts indicated that banks remained cautious about lending. New York, St. Louis, and Kansas City reported somewhat tighter credit standards on commercial real estate loans, and New York noted tighter standards for commercial and industrial loans. In other Districts, credit standards were little changed but remained tight. Atlanta reported that banks had ample liquidity but were reluctant to reduce cash reserves. Chicago said a leveling in asset quality was causing large banks to become more interested in lending to prime borrowers, but strained balance sheets were holding back lending by mid-size banks. In the Dallas District, smaller banks reported that regulatory requirements were limiting their ability to expand real estate lending. Loan quality remained a concern but showed signs of stabilizing in some Districts. New York, Dallas, and San Francisco cited further declines in loan quality. In addition, banks in the Philadelphia and Kansas City Districts were reported to be slightly less pessimistic about future loan quality than in the previous survey.

Agriculture and Natural Resources
Harsh winter weather continued to dampen overall agricultural activity, although crop conditions were still generally favorable in most Districts. Minneapolis, Kansas City, and Dallas reported that livestock were stressed by severe weather and that producers provided supplemental feed due to poor grazing conditions. Atlanta commented that cold temperatures caused minor freeze damage to vegetable and citrus crops. Despite below-average temperatures, Kansas City reported the winter wheat crop was in generally good condition. Dallas and San Francisco said that heavy rains and snowfall improved soil moisture for this year's crop production, though some contacts were concerned that spring planting could be delayed if fields remain too wet. Crop prices edged down following the bumper fall harvest, but Chicago noted that high-quality grain was selling at a premium, due in part to strong export demand. Hog and cattle prices strengthened and dairy prices were flat. Kansas City noted stronger farm incomes from crop production, while agricultural lenders in the Minneapolis District expected farm income and spending to decrease.

Energy activity generally strengthened since the last survey period. Kansas City and Dallas reported increased drilling activity, especially for natural gas, and Cleveland noted increased natural gas-related investment. However, producers in the Kansas City District were concerned that a boost in supply from shale gas production could lower natural gas prices later in the year. Minneapolis reported that oil exploration expanded in February, while oil production was stable in the Atlanta and San Francisco Districts. Coal production in the Cleveland and Kansas City Districts remained below year-ago levels. Minneapolis reported brisk activity in metal mining and continued energy construction.

Employment, Wages, and Prices
The pace of layoffs slowed in most Districts, but hiring plans still remained generally soft. New York cited a slowdown in layoffs at a securities firm and noted a pickup in hiring in what was still characterized as an exceptionally weak legal industry. Staffing firms in the Boston District also saw a strengthening in demand, particularly from the financial and manufacturing sectors. Several manufacturing and construction firms in the Cleveland District began recalling workers, and temporary staffing accelerated in the Richmond, Atlanta, and Chicago Districts. However, Chicago said demand for permanent workers was low, and a manufacturing contact in the Richmond District held back employment due to productivity improvements. Layoffs were also reported at several retail and manufacturing firms in the Dallas District, and Minneapolis said companies in the medical insurance and financial services industries reduced employment. Wage pressures were minimal, but Boston and Cleveland noted a lift in salary freezes and Richmond said wages rose at service and retail businesses.

The majority of Districts reported limited price pressures, although several noted rising input costs due to higher commodities prices. Boston, Cleveland, Chicago, and Dallas noted an increase in metals prices, particularly steel, and Chicago and Kansas City said the upward pressure on some raw materials prices was likely to continue. Lumber prices rose in the Cleveland and Richmond Districts due in large part to weather-related supply issues. On the other hand, San Francisco reported commodity prices were stable or down, with declines in natural gas, copper, and aluminum prices. Some contacts in the Boston District said customers sought fewer price concessions from vendors in order to better ensure reliable deliveries. But nearly all Districts reported limited pricing power, with many firms unable to increase selling prices due to competitive pressure. Retail prices were stable in most Districts, although San Francisco noted heavy discounting. Districts generally expected stable prices overall heading forward.

The following just released video from the Cleveland Fed, in which the Fed explains the workings of the Fed, does not need much commentary, suffice to say that it likely came to you courtesy of the production and direction talents of Goldman's PR group. It appears the video is supposed to be some form of user friendly PR approach created by the same people that gave you Enron. Alas, some of the biggest roles of the Fed are sadly unaccounted for. We leave it up to you, dear readers, to uncover just what these are but here are some suggestions: buying everything in perpetuity, keeping Goldman solvent in perpetuity, keeping the Fed's shady dealings with other Central banks and primary dealers hidden from the public's eye in perpetuity, keeping fed funds rate at (or below?) zero or below in perpetuity, etc, you get the picture.