05/16/2002 Food for Thought *

The acutely unstable U.S. stock market made a run higher this week, with the Dow jumping 4% and the S&P500 gaining 5%. Economically sensitive issues shined, with the Transports adding 6% and the Morgan Stanley Cyclical index 4%. The Morgan Stanley Consumer index increased 1%. In ominous portents for the vulnerable U.S. bond market, the Utility index was hammered for a 5% loss this week. The broader market enjoyed a strong rally, as the small cap Russell 2000 gained 3% and the S&P400 Mid-Cap index rose 4%. The wild technology sector caught fire, with the NASDAQ100 surging 12%, the Morgan Stanley High Tech index 11%, and the Semiconductors 13%. The Street.com Internet index jumped 15%, and the NASDAQ Telecommunications index gained 8%. The Biotech index surged 10%. Financial stocks were strong as well, with the AMEX Securities broker/dealer index jumping 9%, and the Bank index increasing 5%. While bullion slipped 40 cents, the HUI gold index added 2%.

The Credit market was also quite unsettled. The implied yield for December eurodollar futures jumped 23 basis points this week, rising eight basis points Monday and 17 Tuesday, then declining six basis points Wednesday and seven Thursday, only then to jump 11 Friday. The two-year Treasury note saw yields jump 21 basis points this week to 3.37%, while 5-year yields increased 15 basis points to 4.60%. The key 10-year Treasury yield rose 14 basis points to 5.26%. The long-bond saw its yield rise 15 basis points to 5.75%, the highest level since April 2nd. Benchmark mortgage-backs performed relatively well, with yields rising 8 basis points. Implied yields on agency futures increased 10 basis points. The spread on Fannie Mae’s 5 3/8% 2011 note narrowed 2 to 54. The benchmark 10-year dollar swap spread declined 2 to 53. The dollar suffered through another rough week, with the index declining about 1%. The dollar is now at 8-month lows against the Swiss franc, 7-month lows against the euro, and 5-month lows against the Japanese yen. Interestingly, the British pound has dropped to 8-month lows against the euro.

May 15 Bloomberg – “New York legislative leaders said they agreed on a state budget plan that will seize unclaimed bank deposits, tap reserve funds and offer government employees early retirement to help close a revenue gap that has grown to $6.9 billion from $5.7 billion.”

May 14 Bloomberg – “California Governor Gray Davis said the state’s projected deficit grew to $23.6 billion and he plans to eliminate 4,000 state jobs in an effort to balance the budget. The cuts would reduce the state’s workforce of 319,000 by about 1.3 percent. The state already has cut 6,600 jobs since 1999, the governor said. The state’s deficit for the coming fiscal year was expected to be $20 billion before today’s announcement. California is the world’s fifth-largest economy based on a gross domestic product of $1.36 trillion in 2000. Last year, the state experienced its worst one-year decline in tax revenue since World War II as the U.S. economy slowed and a falling stock market slashed capital-gains tax revenue.”

April “advanced” retail sales came in at a much stronger than expected rise of 1.2%, the strongest performance since November. Year-over year, sales were up 4.5%, compared to March’s 2.7% y-o-y increase. The strength was notably broad-based, with ex-auto sales up 3.8% y-o-y. Vehicle and parts sales were up 6.7%, furniture 4.3%, electronic stores (led by strong home appliance sales) 9.5%, and building materials 9.7%. “Health store” sales were up 9.2%, “sporting and books” jumped 9.1%, and “eating and drinking” establishments saw sales rise 7.1%. General merchandise sales were up 4.1% y-o-y, with “food and beverage” sales flat, clothing sales declining slightly, and gas station sales down 6.3%.

U.S. automobile dealers’ optimism has improved significantly, with a second quarter index reading of 153 up 17 points from the first quarter, to the highest level since March 2000. The Association of Home Appliance dealers reported April sales up 7% y-o-y to 5.455 million units. For comparison, April sales were 5.24 million during 2000, 5.43 million during 1999, 4.48 million during 1998, and 4.191 million during April 1997. April’s gains were led by an 11.7% increase in dishwasher sales, a 9.8% y-o-y increase in refrigerator sales, and 6.2% increase in sales of cooking appliances.

Today’s release of the University of Michigan’s preliminary May index had consumer confidence jumping to the highest level in 18 months. Both economic conditions and outlook increased from April, with current conditions rising to the highest level since March 2001. March’s trade deficit came in at a miserable but slightly less-than-expected $31.6 billion. Imports increased 0.3%, while export growth surprised at up 0.6%. Year-over-year, imports are down 9.2% and exports are down 12.9%.

The National Association of Realtors (NAR) this week reported that first quarter existing home sales were the strongest in its 20 years of tracking data. At an annualized rate of 6.54 million units, first quarter sales jumped 9.3% above the previous record established during last year’s first quarter. Sales increased in 46 states and were up double-digits in 26. All four regions reported strong gains. Up 10.8%, the West enjoyed the strongest y-o-y increase, with sales up 27.7% in New Mexico, 19.6% in California, and 16.9% in Montana. Sales were up 10.7% in the Midwest, with sales up 20.5% in Kansas, 19.6% in South Dakota, 18.5% in Michigan, and 17.7% in Iowa. The Northeast saw sales increase 9.3%, with Maine up 23%, Vermont up 21.4%, Massachusetts up 20.5%, and Connecticut up 15.8%. Sales increased 7.3% in the South, up 29.4% in Mississippi, 28.4% in Oklahoma, 22% in Louisiana, and 15.3% in Arkansas.

The NAR also reported that the national median priced was up 8% from last year’ first quarter, an acceleration from the 4th quarter’s 6.2% and the 3rd quarter’s 5.7% y-o-y increases. Quoting the NAR president: “The lean supply of homes on the market, against a backdrop of record sales activity, means we are once again seeing a situation of multiple bids on desirable properties. This strong demand is the primary factor in sharper home price increases. In some areas there is almost no inventory in the higher prices ranges, which is causing an artificial dip in the median price for those markets.” All regions enjoyed solid price gains. In the East, prices rose 26.5% in Nassau-Suffolk, N.Y., 25.2% in Worcester, Massachusetts 25.2%, and 21.8% in Atlantic City, New Jersey. In the South, prices were up 21.9% in Mobile, Alabama, and 19.8% in Washington D.C. In the West, Los Angeles-Long Beach saw prices jump 17.7% and Tucson, Arizona 17.4%. In the Midwest, median prices were up 18.5% in Topeka, Kansas, and 14.6% in Minneapolis-St. Paul.

Money supply declined significantly (M1 down $14.7 billion), rose significantly (M2 up $19.3 billion), or increased moderately (M3 up $7.3 billion). Analysis today must look to broad money supply, as flows between categories make for wild swings in the various Ms. For the week, demand deposits declined $12.4 billion, savings deposits increased $25 billion, retail money funds gained $9 billion, large time deposits added $10.9 billion, and institutional money funds declined $24.6 billion.

The Bank of International Settlements (BIS) this week released its semiannual derivative statistics for year-end 2001. Total outstanding over-the-counter (OTC) derivative positions surged $11.4 trillion (23% annualized) to $111 trillion. Interestingly, foreign exchange and “equity linked” derivative positions actually declined slightly during the second-half (up 7% and down 1% for 2001), while interest rate contracts ballooned. Total interest rate derivatives increased at a 30% annualized rate to $77.5 trillion during the second half, and grew 20% for all of 2001. Interest rate swaps grew at a 29% rate to almost $59 trillion. Outstanding swap positions have now doubled since June 1998, while total interest rate derivatives are up 83%.

Fannie Mae’s total book of business expanded by $20 billion during April, an annualized growth rate of 15.8%. While this is below February and March’s 20% pace, year-to-date growth remains at a strong 17% ($252 billion annualized). Fannie’s retained portfolio expanded at a 10.7% rate, up from March’s unusually slow 2.4%, while average investments increased at a 16% annualized rate (up from March’s 6% and February’s 8%). Curiously, Fannie’s average “liquid investments” increased $7.4 billion during April to $66 billion. The average yield on April mortgage purchases declined to 6.15%

While it receives little of the attention bestowed upon its publicly traded GSE cousins, the Federal Home Loan Bank System (FHLB) remains a key Credit Bubble player. And in this most unstable environment, any highly leveraged financial institution with $703 billion of assets deserves close monitoring. The FHLB recently reported first-quarter earnings of $449 million, down 16% y-o-y; this despite total assets increasing 4% and interest-rates in steep decline. It is not easy to see how this bodes well for when rates move higher. It is worth noting that the FHLB earned $1.2 billion back during 1991 (for the entire year), when total assets ended the year at $155 billion. As is demonstrated by miniscule returns (first-quarter return on assets of 0.26%!), this GSE, created by Congress in 1932, is largely a non-profit cooperative. Its Triple-A debt rating allows it to borrow aggressively in the markets, in the process providing cheap finance and easy lending terms to its member institutions. In an unstable financial environment, this is a recipe for trouble.

The FHLB has accumulated retained earnings of less than $1 billion, although it reports “Capital Stock” of $34 billion. But with this “capital” provided by the same institutions that borrow aggressively from the FHLB, it is a rather strange breed of equity to say the least. One can think in terms of a private bank that would like to attract public equity to provide greater capacity to expand its lending business. To raise this “equity” it lends to other highly leveraged banks on very favorable terms. The borrowing banks then use a portion of these funds to purchase stock in their lender’s initial public offering. Strange “equity,” indeed!

While FHLB growth has slowed markedly over the past year, total assets have doubled since the end of 1997. Their 25% growth in 1998 and 32% expansion during 1999 played a key role in that period’s reliquefication. Their 34% growth during 1994 was previously instrumental in providing liquidity during that bout of acute financial stress. Of late, asset growth slowed to 14% during 2000 and 7% during 2001. Total assets increased $5.5 billion, or 3.1% annualized, during this year’s first quarter. Although growth has tempered, the composition of assets is going through rather notable changes. For the quarter, FHLB’s core assets - outstanding advances/loans to member institutions - declined $10.7 billion (9.1% annualized) to $462 billion (member advances ended 1992 at $80 billion). “Advances activity has been affected by improvements in members’ liquidity positions due to strong deposit flows.” In other words, with money supply booming last year, member banks have of late had little need to tap cheap FHLB borrowings.

Meanwhile, other asset classes and associated risks have been expanding rapidly. Fed funds sold increased $6.8 billion (56% annualized) to $55 billion during the first quarter. Mortgage loans increased $4.0 billion (57.6% annualized) to $31.6 billion, and held-to-maturity securities increased $5.0 billion (20.6% annualized) to $102.3 billion. “As of March 31, 2002, the FHLBanks’ unsecured credit exposure to counterparties other than U.S. Government or U.S. agencies and instrumentalities was $81.2 billion, much which was Federal funds sold and commercial paper.” This was up 14% y-o-y. Interestingly, of this exposure, 39% was overnight maturity, 23% 2-30 days, 29% 31-90 days and only 9% beyond 91 days. I have in the past highlighted Wall Street derivative strategies that incorporate FHLB financings for leveraged security speculations.

Something caught our eye from the company’s earnings release. The FHLB invests “in U.S. agency obligations, primarily structured debt issued by other GSEs. The FHLBanks use interest-rate exchange agreements to hedge the interest-rate risk associated with investments in structured debt.” Agency obligations jumped $4.5 billion during the first quarter (119% annualized rate) to $19.6 billion, and were up $8.1 billion (70%) y-o-y.

The mention of structured debt recalls memories of the GSEs creating and Wall Street marketing such instruments as part of the agencies’ interest-rate hedging operations back during 1993. The infamous case was selling, in staggering quantities, sophisticated structured notes yielding above market rates to Orange County’s less than competent treasurer Robert Citron. These securities were essentially leveraged bets against rising rates (many with yields that declined – and sometimes exponentially – with increasing market rates), which were sold to Citron using leverage from the repurchase agreement market. When the Fed increased rates throughout 1994, the over-leveraged and speculation-saturated U.S. bond market dislocated, interest-rates shot higher, and seemingly benign structured notes were rather abruptly transmuted into toxic waste. Orange County’s portfolio began to implode, the Wall Street firms moved aggressively to take control of their collateral (the securities sold on “repo” to Citron), and losses spiraled to $1.7 billion. Merrill Lynch, the leading seller of securities to Citron, later settled claims related to the county’s bankruptcy for $400 million. Interestingly, I don’t remember the agencies coming under any criticism for creating such potentially lethal securities to be sold in the public domain.

Perhaps there is little to the FHLB’s aggressive purchases of structured agency debt over the past year, but we don’t like the smell of it. The FHLB’s vulnerable capital structure simply leaves no room for error. Besides, why would the FHLB acquire such securities only to then use derivatives to “hedge the interest-rate risk associated with investments in structured debt”?

Surely, Fannie and Freddie are hard at work today creating instruments to hedge their enormous risk to imminent Fed rate increases. We doubt that there are many Robert Citrons in positions to unknowingly act as risk repositories at the hands of the sophisticated GSEs and smooth securities salesmen. Furthermore, as we have tried to explain previously, we suspect that the traditional derivative players today are increasingly impaired from credit, equity and other losses, and have no appetite to shoulder additional interest rate risk. The agencies and Wall Street will be forced to be quite “creative” in their hedging operations this time around. We are thus intrigued, although not necessarily surprised, that the old FHLB, out of the public spotlight, shows up as an aggressive buyer of GSE structured debt.

Over the years, the FHLB has developed into a major derivative player. The company reported outstanding derivative positions of $612 billion at March 31, 2002, up 12% year-over-year. Derivatives are now an instrumental aspect of the FHLB’s business, as its “cooperative” structure apparently impels it to provide exceptional terms to its member borrowers. For example, looking at 2001’s first quarter we see that average member advances yielded 6.04%. At the same time, average “consolidated obligations” (marketplace borrowings) cost 6.0%. Such largess to borrowers does not, however, leave much lender cushion for unfavorable interest rate fluctuations (not to mention Credit losses). The past year’s collapse in short-term interest-rates occasioned a 358 basis point drop in yields received from member advancements, to the first-quarter 2002’s 2.46%. And with the FHLB ending 3/31/01 with outstanding long-term bonds of $415 billion, only successful derivative hedging could have saved the FHLB from significant losses. Well, the average yield paid on consolidated obligations declined 320 basis points and the company remained in the black.

The FHLB must essentially keep its funding costs short-term and floating to match the variable nature of its yielding assets (member loans). But this leaves both the FHLB and its member institutions at considerable risk to rising market rates. There is also the issue of liquidity risk for such an enormous and highly leveraged borrower. Especially in today’s unstable environment, the FHLB must protect its liquidity by borrowing longer-term. In this regard, it is worth noting that over the past year the FHLB has reduced short-term note issuance from $185 billion to $128 billion, with an $11 billion reduction during 2002’s first quarter (another GSE liability management activity that helps to explain the first quarter’s money supply stagnation!). So the FHLB borrows in the bond market and immediately swaps to floating rate with the use of derivative contracts. Effectively, the FHLB is borrowing short-term but transferring liquidity risk to the derivatives marketplace. Such a strategy has been an overwhelming success for the FHLB and others, solidifying the perception of the tremendous benefits of the derivatives market. Are such perceptions misplaced?

Let’s use the FHLB to construct an example of how a derivative strategy might have functioned over the past year. Say that the company’s entire $598 billion of “consolidated obligations” at 3/31/01 were long-term bonds issued with 6.0% coupons. In our static example, total 12-month interest expense would have been about $35.8 billion. But the FHLB, at risk to declining yields on its short-term member loans/advances, uses the derivatives market to swap its fixed-rate debt service to short-term borrowing rates. In our example, we will assume that short rates immediately collapsed to 2.80%, with the FHLB then reducing the cost of funds charged to its members. In our example, the FHLB’s swap strategy was a huge winner. Hedge-adjusted borrowing costs decreased by $19.1 billion to $16.7 billion (2.8%X$598B). While the FHLB must continue to pay the 6% coupon to its bondholders, its swap arrangement calls for receiving the 6% fixed and paying floating short rates (now 2.8%). Thus, FHLB counterparties are on hook for the cash flows for the difference between the 6.0% and the 2.8%, or $19.1 billion (3.2%X$598B).

Maybe derivatives do create miracles. Just how on earth do the swap counterparties come up with such enormous sums of cash to make payment against contracts written in the event of a substantial decline in interest rates? Well, it’s actually a case of establishing positions in the marketplace that will generate the necessary cash flows – they must acquire securities with fixed yields and finance these holdings with short-term variable rate borrowings. Then, if rates decline, their spreads widen and cash flows increase.

Enter the repurchase agreement market. Let’s say that the FHLB would like to issue bonds and swap them back to floating (securing long-term finance but at low and variable short-term borrowing rates). A derivative counterparty – let’s say a Wall Street primary dealer - acquires FHLB bonds by financing them in the repo market. Over the following year, the Wall Street dealer then receives the 6% coupon and pays the overnight (or “term”) “repo” borrowing rate. As short-term rates collapsed over the past year, the reduced cost of financing in the repurchase market provides the necessary cash flows (widening spread between fixed 6% coupon and overnight borrowing rates) for the swap counterparty to pay its swaps obligation to the FHLB. This mechanism has worked almost like magic, providing the FHLB with the security of long-term funding at what amounts to a small spread above overnight borrowing rates. So what’s the catch? To simplify the bookkeeping, why not have the Wall Street dealer community acquire all of the FHLB bonds - financed in the repo market - and just have the FHLB make payment directly to Wall Street at a small spread above repo rates? The FHLB, having issued bonds, is protected on the liability side, pays close to overnight rates, and Wall Street enjoys a small spread on a humungous trade. Everyone’s happy.

Beyond the FHLB, there are many major players that have been forced to aggressively hedge against declining rates. The entire mortgage arena is a case in point, with American homeowners enjoying the benefits of an imbedded option to refinance their mortgages in the event of declining rates. This extraordinary benefit has only become considerably more valuable in an environment of minimal cost refinancings and extraordinary home price inflation. As we saw in 1998, 2000, and again with WTC, any financial shock that causes declining interest rates has today great potential to incite a self-feeding refinancing boom and immediately lower borrowing costs for American homeowners. Fannie Mae, for example, has seen the average yield on its entire investment portfolio (mortgages and other investments) decline from January 2001’s 7.19% to last month’s 6.45%. And with a booming housing market and the popularity of refinancing for equity extraction and/or lower rates, the average life of a mortgage is today about 3 years. Fannie, Freddie, and the speculators that hold mortgage securities have had to adjust their borrowings/hedges accordingly. Also keep in mind that over the past four years total mortgage debt has increased $2.45 trillion, or 47%. How will derivative players now generate cash flows to hedge against rising rate on ballooning mortgage debt? What would be the consequences to hedging strategies and the Credit market in the event of sharply higher rates and the average life of household mortgage debt increasing to, say, 10 years?

The repurchase agreement market (a contemporary version of the age-old strategy of borrowing short and lending long) has been instrumental and quite successful in “hedging” against declining rates during this long cycle. It is no coincidence that growth in the repo market has paralleled interest rate derivatives that has followed mortgage debt growth. Surpassing $500 billion for the first time during 1992, primary dealer repurchase agreement positions have since expanded four-fold. These positions have increased 80% since the beginning of 1998. After ending year 2000 at about $1.4 trillion, positions increased to almost $1.8 trillion by the conclusion of 2001. Recent growth has been tremendous, with outstanding repos recently surpassing $2.1 trillion. With short-term rates collapsing to 40-year lows, there has been unprecedented demand for securities – for both hedging and speculating - to be financed at low repo market rates. Players have understandably moved aggressively to capture the extraordinary spreads the Fed has lavished on the marketplace between overnight funding costs and longer-term market yields.

This demand goes a long way toward explaining the recent collapse in agency, mortgage-back, and dollar swap spreads. Although it garners little media attention, we are in the midst of an historic bull market in repo finance, with the recent period of wild excess demonstrating all the troubling characteristics of a speculative blow-off, or perhaps covert market dislocation. But let’s not confuse the success of borrowing short and lending long in an environment with generally low and declining interest rates, with the general capacity for derivative markets to ameliorate market risk.

I certainly cannot claim knowledge as to intricacies of the repurchase agreement marketplace, but there is no doubt in my mind it has become the key market for financing positions for both the speculators and derivative players – the key liquidity mechanism. To what extent foreign players are active and to what extent the dollar could be vulnerable to any future tumult in this crucial market is unclear. Yet it is clear that there have been repeated scares in the repo area, with acute stress developing during 1998, 1999, 2000, and post-WTC. When the repo market is expanding rapidly (participants borrowing to finance securities holdings), the Credit market remains highly liquid and agency and swaps spreads tighten accordingly. We have noted, as well, that when repo growth stagnates, spreads widen and liquidity wanes. The repo market came under acute stress (widening spreads) during the second-half of 1999. Conventional thinking had it that this was related to Y2K worries, but the issue was very clouded by the fact that this period also coincided with the Fed raising rates (taking back 1998’s 75 basis point cuts). When the Fed raised rates another 75 basis points in early 2000, spreads were rocketing to historic highs. Since May of 2000 Fed funds have sunk from 6.50% to 1.75%. Outstanding repurchase agreements have exploded, and the key dollar swap spread has collapsed from almost 140 to today’s 53. Calm before the storm?

The repo market was in total disarray post-WTC, with a cascade of failed trades. Many lenders of securities faced difficulties having their securities returned. Since then, there has been a general shortage of “collateral” (Treasury and agency securities in particular), with the Fed, Treasury, and GSEs all responding by providing the dealer community with additional issues. Even today, heightened demand for some Treasury issues continues. But is this evidence of a sound market or one under stress? Is this environment sustainable or a market Bubble? To what extent the Fed’s aggressive rate cuts (and artificially steep yield curve) distorted the repo and interest rate derivatives marketplaces, only time will tell.

Certainly, derivative players positioned to hedge against the possibility of rising interest rates (counterparties to Fannie Mae and Freddie Mac, for example) have not had an easy time. They would have been forced to cover their short positions in the Credit market; positions established to provide the necessary cash flows in the event of a rising rate environment. We pose this issue today as we consider the possibility that part of the recent extraordinary expansion in the repo market (and collapse in spreads) could have been related to protective buying by derivative players caught (short) exposed. The bond market in August through October 1993 demonstrated similar characteristics, with near panic buying developing as rates declined precipitously, only to reverse to panic selling in February 1994 as yields rapidly shot higher.

Another historic example of such a market environment was NASDAQ during the first quarter of 2000. Enormous market risk had developed associated with a speculative technology Bubble coupled with rapidly deteriorating industry fundamentals. Accordingly, significant derivative and hedging positions (especially short sales and put options) had been established in the stock market. These positions then contributed to market dislocation, with a virtual melt-up of panic short covering and derivative-related buying that culminated in March of 2000. The dislocated market effectively destroyed significant hedges put in place to protect against an imminent fall, leaving the marketplace especially vulnerable when the decline eventually began in earnest. Importantly, when this dislocation/blow off subsided, the market’s liquidity position abruptly changed. Technology stocks began sinking and the derivative players became aggressive sellers only weeks after they had been panic buyers. As buyers, they contributed to the bull market perception of endless liquidity; as aggressive sellers they soon faced the harsh reality of illiquidity. There is no doubt that the derivative market played an instrumental and direct role in the melt-up and later collapse. One could similarly argue that the Dollar’s surge this January was a derivative-related market dislocation/“blow off” prior to the commencement of a bear market.

We recount market history only to remind readers of how contemporary markets tend to demonstrate highly unstable and unpredictable behavior near key inflection points. Market environments do change abruptly, and seemingly endless liquidity may disappear almost overnight. The U.S. Credit market today appears nearing an important crossroads, and certainly has all the characteristics of an acutely vulnerable market. The Fed is maintaining artificially low short-term borrowing costs to accommodate a fragile financial sector, as well as understandably fearing the market’s reaction to any move toward higher rates. In the process, outstanding repurchase agreement volume is growing at a frenetic pace with possible “blow off”/dislocation characteristics. But it is also clear that the Fed must eventually reverse course from extreme accommodation. Foreign central banks have already begun to move, global pricing pressures are strengthening, the dollar is under pressure, the U.S. economy is showing signs of serious maladjustment, and a dangerous U.S. housing Bubble is running in full force. Fundamentals beckon for the Fed to move away from such extreme accommodation, but the Fed fears piercing the great Credit Bubble.

New York Federal Reserve President William McDonough gave a talk this week at Chicago Mercantile Exchange commemorating the 30th anniversary of the International Monetary Market, “the first futures exchange created explicitly for trading financial instruments.” His topic was derivatives and, as a strong proponent, the general message was “with improvements in disclosure and increased transparency, we may do a great deal to dispel some pubic misperceptions about how derivatives function and their usefulness in today’s financial markets.”

While additional disclosure and some transparency are fine suggestions, I wish someone would explain how today’s derivatives market is going to function properly in a rising rate environment. I have no problem recognizing how aggressive leveraged purchases financed in the repo market - in an environment of low short-term interest rates and a steep yield curve - easily create cash flows to pay on hedging contracts. It is also clear in our minds how such operations work (seductively) to create liquidity throughout the financial system. What we are not so sure about is how these dynamics will function in reverse? In theory, derivative players are to establish short positions in the bond market to generate the necessary cash flows in a rising rate environment (as bond prices decline). But the nub of the issue is that such shorting (as opposed to buying) destroys market liquidity (as opposed to creating it). But what really perplexes me is how a market that has been so geared to hedging and speculating for low and declining interest rates smoothly reverses – changing course to protect against rising rates. It is not the nature of markets to be so accommodative.

As we have discussed previously, the 1994 experience offers about the only example of the predicament today facing the Fed. During the second-half of 1993, extreme interest rate speculation, especially in the mortgage arena, had the derivative players as aggressive buyers of fixed-income securities. There were aggressive hedging activities to protect against declining interest rates and mortgage prepayment risk. When the Fed raised rates in February 1994, not only did these hedges need to be reversed, new hedges were needed to protect against rising rates. Buyers of call options on the bond market needed to sell and become put buyers. The leverage players needed to liquidate, and market dislocation was assured. On the one hand there was the need to unwind the enormous leverage that had developed with speculating and hedging in one rate environment, while on the other there was necessary selling to establish hedges for the new rising rate environment. The market was simply overwhelmed with sellers and liquidity disappeared. Ten-year government yields surged about 140 basis points in three months. Two-year yields surged almost 225 basis points in four months.

The amount of system debt, along with unprecedented systemic asset-liability mismatch, endemic leveraged speculation, and derivative trading, are today on an entirely different level than 1994. We also seriously doubt that the GSEs will be in a position to come to the market’s liquidity rescue as they did quietly back in 1994. The GSEs have been running at full throttle since 1998, and we would expect them to be more of a problem than a solution in regard to future derivative and systemic liquidity issues. We are also concerned how a vulnerable dollar will play in the liquidity equation. We are actually rather convinced that the Fed is staring eye-to-eye at one major dilemma. And while the Fed bides time, the problem only festers. The amount of mortgage debt, the size of GSE balance sheets, interest rate derivative positions, and the repurchase agreement market only grow by the month. The dollar weakens and perceptions change.

Above I mentioned that the FHLB had effectively transferred liquidity risk to the derivatives/repurchase agreement market. I believe it is accurate to appreciate that this has been done on a systemic basis, with the repo market surpassing $2 trillion. The “catch” is that liquidity has become the critical systemic issue. Throughout the financial sector, companies have issued bonds and swapped from fixed to floating rates, with derivative players financing in the repo market apparently on the other end of many of these issues. This is dangerous finance and seemingly asking for an inevitable liquidity crisis. A tree cannot grow to the sky. At the same time, Fannie Mae and Freddie Mac have apparently transferred systemic interest rate risk to the derivatives market, with their balance sheets surpassing $1.45 trillion. How this risk transfer is supposed to function in a rising rate environment, I have absolutely no idea. Yet, it is clear that the proliferation of derivatives has created a rather concentrated market for the “bundling” of market risk.

Also from Mr. McDonough’s speech: “The Federal Reserve’s use of options on repurchase contracts to stabilize the financing markets in the months leading up to the Y2K century-date change is another example of the positive use of derivatives. Signs of an aversion to funding risk surrounding Y2K were apparent throughout the spring and summer of 1999. To help ensure that market liquidity in the fixed-income markets remained at reasonable levels, the Federal Reserve held auctions of options on repurchase agreements that could be exercised in the period around year-end. These options enabled market participants to establish predictable funding arrangements for their year-end positions. In so doing, the options encouraged marketmaking and the maintenance of liquid financing markets in the period surrounding the century-date change. A sign of the effectiveness of these repo options was the behavior of year-end funding premiums. These premiums declined substantially at key times during the options program, such as when the options were first announced, after the early auction results were reported, and later on when the number of auctions was extended.”

I highlight these comments only because the Fed must today be anxiously developing a strategy for dealing with likely market disruptions in response to its inevitable move away from extreme accommodation. We see today that the Fed is proposing revisions to discount window operations to make it easier to provide liquidity. Considering the structure and dynamics of the derivatives marketplace and the egregiously distorted U.S. Credit system, it appears that the Fed will likely have little alternative other than to become actively involved in both the repo and interest rate derivative marketplaces. The nature and extent of any future Fed activities is pure conjecture at this point, but I can see how an anxious Fed would today want to draw encouragement from its experience with options for Y2K. Could the Fed resort to writing options against higher rates, hoping to forestall any self-feeding market dislocation? How about more put options ensuring liquidity in the repo market? I cringe at the thought. But one thing about the system’s “bundling” of risk in derivatives: it does afford the Fed a convenient mechanism for extracting such risk from the marketplace. It may be silly today to ponder the ramifications of such conjecture, but it is a fascinating issue. And while we can see how such operations might temporarily alleviate domestic liquidity concerns, we seriously doubt they would be well received in the currency markets. Anyway, just a little Food For Thought. These are exceedingly interesting times...