THE WIZARD OF BUBBLELAND
PART II: The repo time bomb
By Henry C K Liu 

(Click here for previous parts)

The repo market is the biggest financial market today. Domestic and international repo markets have grown dramatically over the past few years because of increasing need by market participants to take and hedge short positions in the capital and derivatives markets; a growing concern over counterparty credit risk; and the favorable capital-adequacy treatment given to repos by the market. Most important of all is a growing awareness among market participants of the flexibility of repos and the wide range of markets and circumstances in which they can benefit from using repos. The use of repos in financing and leveraging market positions and short-selling, as well as in enhancing returns and mitigating risk, is indispensable for full participation in today's financial markets.

A repurchase agreement (repo) is a loan, often for as short as overnight, typically backed by top-rated US Treasury, agency, or



mortgage-backed securities. Repos are contracts for the sale and future repurchase of a top-rated financial asset. On termination date, the seller must repurchase the asset at the same price at which he sold it, pay interest for the use of the funds and, if the asset was borrowed, return the borrowed assets to the lending owner, who also receives a fee for lending. If the repoed security pays a dividend, coupon or partial redemptions during the repo, this is returned to the original owner. Institutions with excess assets routinely avoid holding unproductive idle assets by lending them for a fee to institutions in need of more assets. A well-defined legal framework has developed to facilitate repo transactions.

A key distinguishing feature of repos is that they can be used either to obtain funds or to obtain securities. The former feature is useful to market participants who wish to acquire other assets that provide arbitrage opportunities against the collateralized assets. The latter feature is useful to market participants because it allows them to obtain the securities they need to meet other contractual obligations, such as to make delivery for a futures contract. In addition, repos can be used for leverage, to fund long positions in securities and to fund short positions for hedging interest rate risks. As repos are short-maturity collateralized instruments, repo markets have strong linkages with securities markets, derivatives markets and other short-term markets such as interbank and money markets. Securities dealers use repos to finance their securities inventories. Counterparties may be institutions, such as money-market funds that have money to invest short-term. Or they may be parties who wish to obtain the use of a particular security briefly by doing a reverse repo. For example, a party may want to sell the security short, or it may need to deliver the security to settle a trade with a third party. Accordingly, there are two possible motives for entering into a reverse repo:

1) Short-term investment of funds, or GC (general collateral) repos.
2) To obtain temporary use of a particular security, or special repos.

Interest rates on special repos tend to be lower than those on GC repos. This is because a party doing a reverse repo on a special security will accept a reduced interest rate on its funds in exchange for receiving the special security it requires. Economically, the transaction is no different from cash collateralized security lending. Pricing of either type of contract depends upon demand for the desired security.

Because repos are in essence secured loans, their interest rates do not depend upon the respective counterparties' credit ratings. For GC repos, the same rates apply for all counterparties. Accordingly, GC repo rates, or simply repo rates, are benchmark short-term interest rates that are widely quoted in the marketplace. They differ from LIBOR (London interbank offered rate) in that repo rates are for secured loans whereas LIBOR is for unsecured loans based on the creditworthiness of the borrower.

Dealers sell securities short to profit from, or hedge against, rising interest rates. If interest rates rise, the price of a fixed-rate security falls correspondingly to reflect prevalent market rate. A dealer who sells a security whose value he expects to fall stands to profit by purchasing the security later at a lower price. If that dealer has holdings that will lose value when interest rates rise, the move to sell short and buy later will offset this exposure. By countering potential losses with potential gains, the dealer hedges his balance sheet against any changes in interest rates. Dealers use the repo market to finance their cash market positions. The key advantage of the repo market as a funding mechanism is its flexibility: dealers who are uncertain how long they will need to maintain a position or a hedge can borrow securities for a short period or, if necessary, extend the loan indefinitely at a relatively low cost.

Unless the repo market is disrupted by seizure, repos can be rolled over easily and indefinitely. What changes is the repo rate, not the availability of funds. If the repo rate rises above the rate of return of the security finance by a repo, the interest-rate spread will turn negative against the borrower, producing a cash-flow loss. Even if the long-term rate rises to keep the interest-rate spread positive for the borrower, the market value of the security will fall as the long-term rate rises, producing a capital loss. Because of the interconnectivity of repo contracts, a systemic crisis can quickly surface from a break in any of the weak links within the market.

Repos are useful to central banks both as a monetary-policy instrument and as a source of information on market expectations. Repos are attractive as a monetary-policy instrument because they carry a low credit risk while serving as a flexible instrument for liquidity management. In addition, they can serve as an effective mechanism for signaling the stance of monetary policy. Repos have also been widely used as a monetary-policy instrument among European central banks, and with the start of the EMU (European Monetary Union) in January 1999, the Eurosystem adopted repos as a key instrument. Repo markets can also provide central banks with information on very short-term interest-rate expectations that is relatively accurate since the credit risk premium in repo rates is typically small. In this respect, they complement information on expectations over a longer horizon derived from securities with longer maturities.

The secondary credit market is where the US Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corp (Freddie Mac), so-called GSEs (government sponsored enterprises, or agencies) that were founded with government help decades ago to make home ownership easier by purchasing loans that commercial lenders make, then either hold loans in their portfolios or bundle them with other loans into mortgage-backed securities for sale in the credit market. Mortgage-backed securities are sold to mutual funds, pension funds, Wall Street firms and other financial investors who trade them the same way they trade Treasury securities and other bonds. Many participants in this market source their funds in the repo market.

In this mortgage market, investors, rather than banks, set mortgage rates by setting the repo rate. Whenever the economy is expanding faster than the money supply, investors demand higher yields from mortgage lenders. However, the Federal Reserve is a key participant in the US repo market as it has unlimited funds with which to buy repo or reverse repo agreements to set the repo rate. Investors will be reluctant to buy low-yield bonds if the Fed is expected to raise short-term rates higher. Conversely, prices of high-yield bonds will rise (therefore lowering yields) if the Fed is expected to lower short-term rates. In a rising-rate environment, usually when the economy is viewed by the Fed as overheating, securitized loans can only be sold in the credit market if yields also rise. The reverse happens when the economy slows. But since the Fed can only affect the repo rate directly, the long-term rate does not always follow the short-term rate because of a range of factors, such as a time lag, market expectation of future Fed monetary policy and other macro events. This divergence from historical correlation creates profit opportunities for hedge funds.

The "term structure" of interest rates defines the relationship between short-term and long-term interest rates. Historical data suggest that a 100-basis-point increase in Fed funds rate has been associated with 32-basis-point change in the 10-year bond rate in the same direction. Many convergence trading models based on this ratio are used by hedge funds. The failure of long-term rates to increase as short-term rates have risen since late winter 2003 can be explained by the expectation theory of the term structure, which links market expectation of the future path of short-term rates to changes in long-term rates, as St Louis Fed president William Poole said in a speech to the Money Marketeers in New York on June 14. The US market simply does not expect the Fed to keep short-term rates high for extended periods under current conditions. The upward trend of short-term rates is expected by the market to moderate or reverse direction as soon as the US economy slows.

Investors buy bonds to lock in high yields if they expect the Fed to cut short-term rates in the future to stimulate the economy. When bond investor demand is strong, mortgage lenders can offer lower mortgage rates for consumers because high bond prices lead to lower bond yields. But lower interest rates lead to inflation, which discourages bond investment. Lower interest rates also lower the exchange value of the US dollar, allowing non-dollar investors to bid up dollar-asset prices. Non-dollar investors are not necessarily foreigners. They are anyone with non-dollar revenue, such as US transnational companies that sell overseas or mutual funds that invest in non-dollar economies. Unlike investors, hedge funds do not buy bonds to hold, but to speculate on the effect of interest-rate trends on bond prices by going long or short on bonds of different maturity, financed by repos.

As with other financial markets, repo markets are subject to credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on repos from that associated with uncollateralized instruments is that repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralization of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets will force liquidation of collateral at a discount in the event of a counterparty default, or even a fire sale in the event of systemic panic. Leverage that is built up using repos can exponentially increase these risks when the market turns. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels.

In general, the art of risk management has been trailing the decline of risk aversion. Up to a point, repo markets have offsetting effects on systemic risk. They can be more resilient than uncollateralized markets to shocks that increase uncertainty about the credit standing of counterparties, limiting the transmission of shocks. However, this benefit can be neutralized by the fact that the use of collateral in repos withdraws securities from the pool of assets that would otherwise be available to unsecured creditors in the event of a bankruptcy. Another concern is that the close linkage of repo markets to securities markets means they can transmit shocks originating from this source. Finally, repos allow institutions to use leverage to take larger positions in financial markets, which adds to systemic risk.

Global savings glut caused by dollar hegemony
Fed governor Ben Bernanke argued in a speech on March 29 that a "global savings glut" has depressed US interest rates since 2000. Fed chairman Alan Greenspan testified before Congress on July 20 that this glut is one of the factors behind the so-called interest-rate conundrum, ie, declining long-term rates despite rising short-term rates.

Bernanke noted that in 2004, the US external deficit stood at US$666 billion, or about 5.75% of gross domestic product (GDP). Corresponding to that deficit, US citizens, businesses, and governments on net had to raise $666 billion from international capital markets. As US capital outflows in 2004 totaled $818 billion, gross financing needed exceeded $1.4 trillion. He argued that over the past decade a combination of diverse forces has created a significant increase in the global supply of savings, in fact a global savings glut, which helps to explain both the increase in the US current account deficit and the relatively low level of long-term real interest rates in the world today. He asserted that an important source of the global savings glut has been a remarkable reversal in the previous flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders.

In the United States, national saving is currently dangerously low and falls considerably short of US capital investment. Of necessity, this shortfall is made up by net borrowing from foreign sources, in essence by making use of foreigners' savings to finance part of domestic investment. The current account deficit equals the net amount that the US borrows abroad, and US net foreign borrowing equals the excess of US capital investment over US national saving. Bernanke reasoned that the country's current account deficit equals the excess of its investment over saving. In 1985, US gross national saving was 18% of GDP; in 1995, 16%; and in 2004, less than 14%. It seems obvious that despite Bernanke's predisposed observation, the current account deficit equals the excess of US consumption, not investment, over savings.

Theoretically, investment cannot, as a matter of definition, exceed savings, a concept aptly expressed by the formula I = S (total investment equals total savings) framed by economist Irving Fischer (Nature of Capital and Income, 1906) that every economist learns in the first day of class in neo-classical macroeconomics. For total investment to be equal to total savings, the demand for lendable funds must equal the supply for lendable funds and this is only possible if the rate of interest is appropriately defined. If the interest rate were such that the demand for lendable funds was not equal to the supply of it, then we would also not have investment equal to savings. Thus the Fed interest-rate policy is responsible for over- or underinvestment in the US economy.

Foreign countries with dollar trade surpluses from the United States increased reserves by issuing local currency debts to withdraw the trade-surplus dollars held by their citizens, thereby, according to Bernanke, mobilizing domestic saving, and then using the dollar proceeds to buy US Treasury securities and other assets. In effect, foreign governments have acted as financial intermediaries, channeling domestic saving away from local uses and into international capital markets. A related strategy has focused on reducing the burden of external debt by attempting to pay down those obligations, with the funds coming from a combination of reduced fiscal deficits and increased domestic debt issuance. Of necessity, this strategy also pushed emerging-market economies toward current account surpluses. Again, the shifts in current accounts in East Asia and Latin America are evident in the data for the regions and for individual countries.

Bernanke also asserted that the sharp rise in oil prices has contributed to the swing toward current-account surplus among the non-industrialized nations in the past few years. The current account surpluses of oil exporters, notably in the Middle East but also in countries such as Russia, Nigeria and Venezuela, have risen as oil revenues have surged. The aggregate current account surplus of the Middle East and Africa rose more than $115 billion between 1996 and 2004. In short, events since the mid-1990s have led to a large change in the aggregate current account position of the developing world, implying that many developing and emerging-market countries are now large net lenders rather than net borrowers on international financial markets. In practice, these countries increased foreign-exchange reserves through the expedient of issuing debt to their citizens, thereby mobilizing domestic saving, and then using the dollar proceeds to buy US Treasury securities and other dollar assets.

While Bernanke accurately describes the conditions, he obscures the causal dynamics. The so-called global savings glut is hardly the result of voluntary behavior on the part of foreign central banks. It is the coercive effect of dollar hegemony that has left the trading partners of the US without a choice. The US trade deficit is denominated in dollars, which can only be recycled into dollar assets. Local-currency debts are issued by foreign treasuries to soak up the current account surplus dollars so that foreign central banks end up holding larger dollar reserves, which can hardly be viewed as national savings.

The exporting economies ship real wealth to the United States in exchange for fiat dollars that cannot be spend in their own economies without first being converted into local currencies. If the local central banks exchange the trade-surplus dollars with local currencies, local inflation will result from an expansion of the money supply while the wealth behind the new money has been shipped to the US. Thus most foreign governments issue sovereign debts in local currencies to soak up the dollars and turn them over to their central banks as foreign-exchange reserves. The local sovereign debt is equal to the loss of real wealth from export to the US.

A dollar glut that impoverishes
The glut is only a dollar glut that in fact impoverishes the exporting economies. There is no global savings glut at all. While the exporting economies continue to suffer from shortage of capital, having shipped real wealth to the US in exchange for paper that cannot be used at home, their central banks are creditors holding huge amounts of dollar debt instruments. It is not a global savings glut. It is a global dollar glut caused by the Fed printing money to feed the gargantuan US appetite for debt.

The United States has become the world's biggest debtor nation. Japan and China have become the world's biggest creditor nations. The US owes Japan more than $2 trillion. At the end of third-quarter 1998, 33% of US Treasury securities were held by foreigners, up from just 10% in 1991. Some 30% of foreign-held assets were US government bonds ($1.5 trillion), and 12% corporate bonds. By June 30 this year, more than 50% of outstanding US Treasuries ($2 trillion) were held by foreigners. Total US federal debt exceeds $7.6 trillion. Yet Japan needs US investment and credit. The US economy has been booming for more than a decade with only two brief recessions, each bailed out by the Fed injecting massive liquidity into the banking system, while during the same time the Japanese economy has been sliding downhill and its sovereign debt receiving junk ratings.
While there are many well-known factors behind this strange inversion of basic economic logic, one factor that seems to have escaped the attention of neo-liberal economists is the US private sector's ability to use debt to generate returns that not only can comfortably carry the cost of debt service but also conflate asset values with astronomical p/e (price-earning) ratios. Japan has been cursed with an opposite problem. Japan's long-term national debt exceeded its GDP in 2004, and the ratio of its long-term national debt to GDP was double that of the US. It has been unable to utilize sovereign credit further to back the investment needs of its private sector. As a result, Japan looks to international capital (mostly from the US), money (more than $2 trillion) that really belongs to Japan. The moves toward zero interest rates temporarily helped the Tokyo equity market, but whether the recovery is sustainable is still very much in doubt.

US investors and lenders require US-style transparency and a degree of control that are incompatible with Japanese traditional social norms. US-managed "Japanese" funds want only to make investments based on financial rationale rather than on Japan's keiretsu relationships. The intrusion of US-managed capital would cause the very social chaos that Japanese politicians badly want to avoid.

This problem holds true throughout much of Asia, including China. Asia is unable to attract sufficient global capital to sustain its growth/recovery targets, unable to restructure its economies away from export to generate that capital domestically, and unwilling to allow an uncontrolled influx of US-managed global capital on US terms. Politically, Asian leaders are trapped between the economic demands of a neo-liberal global system and indigenous social traditions. They face a policy paralysis resulting from conflicting pressures. Inefficiencies continue, recovery aborted by externally imposed economic realities, and social tensions reach boiling points.

An Asian solution will come from creating Asian institutions to supplant the unresponsive global institutions within which Asian economies are increasingly put at a competitive disadvantage even as they pile up trade surpluses. Grassroots resistance to US demands for trade liberalization will force Asian leaders to seek Asian regional solutions, perhaps an Asian common market with its own currency regime supported by an Asian Monetary Fund to free itself from dollar hegemony.

The dollar a non-convertible currency
Under dollar hegemony, the dollar has become a de facto non-convertible currency in a deregulated global financial free market. What pushes long-term dollar interest rates down is the inflationary effect on dollar assets caused by too many dollars chasing increasingly hollow dollar assets of dwindling productive content.

Global trade is now a game in which the United States produces dollars and the rest of the world produces real goods dollars can buy. This game hollows out the real value of dollar assets as they appreciate in nominal value with thinning substance or declining yields. When prices of dollar assets are bid up by speculation, their real yields fall. Foreign-held dollars are invested in dollar assets not to capture high interest or dividend payments, but to hope for continuing price appreciation. But increasingly hollowed, non-performing assets will eventually require skyrocketing yields to attract or hold investors. There will come a time when the gap between speculative price appreciation and high yield becomes too wide to be reconcilable, as companies in the New Economy discovered in 2000. Bernanke, a very astute economist, no doubt is familiar with the iron law governing the inverse relationship between rising bond prices and falling bond yields, yet on the need to keep yields high to attract bond buyers, he remains curiously silent.

This is the inescapable trap in which Greenspan finds himself when he attempts to deflate a debt bubble approaching bursting point with his measured-paced interest-rate policy. The Fed cannot raise short-term interest rates above long-term rates because an inverted rate curve will lead to a recession. Yet he must raise short-term rates to hold down inflation, this time not wage-pushed (because outsourcing has kept wages low), but from a speculative frenzy fueled by debt recycling. Yet long-term rates remain low because of the coerced global capital-flow effects of dollar hegemony. As Bernanke accurately observes, foreign central banks have been reduced to playing the role of funding intermediaries to permit the US to finance its capital account surplus with its current account deficit. It is a game of financing US consumer debt with US capital debt, with the Fed printing more money every day to keep the Ponzi scheme going, to the tune of more than $1.4 trillion a year in 2004 or $5.4 billion every trading day.

But the outcome of this game is stagflation - recession with inflation - as US president Jimmy Carter found out from the Fed's reckless easing under Arthur Burns during the Nixon/Ford years. The Carter stagflation will be viewed as merely a minor storm involving billions compared with the coming financial tsunami where the stakes have been exponentially inflated to trillions. Just as little naive Dorothy finally drew the curtain open to expose the trickery of the Wizard of Oz, the foreign exporting economies will soon catch on to the monetary smoke and mirrors of the Wizard of Bubbleland in support of neo-liberal trade.

The repo market now big and dangerous
Created to raise funds to pay for the flood of securities sold by the US government to finance growing budget deficits in the 1970s, the repo market has grown into the largest financial market in the world, surpassing stocks, bonds, and even foreign exchange.

in 1998, when the world's biggest government-bond market was shrinking because of a temporary US fiscal surplus, the market where investors financed their long bond purchases with short-term loans continued to grow by leaps and bounds. The $2 trillion daily repo market became the place where bond firms and investors raised cash to buy securities, and where corporations and money market funds parked trillions of electronic dollars daily to lock in risk-free attractive returns. That market has since grown past $5 trillion a day, almost 50% of US GDP.

The repo market grew exponentially as it came to be used to raise short-term money at lower rates for financing long-term investments such as bonds and equities with higher returns. The derivatives markets also require a thriving financing market, and repos are an easy way to raise low-interest funds to pay for securities needed for arbitrage plays. It used to be that the purchase of securities could not be financed by repos, but those restrictions have long been relaxed along with finance deregulation. Repos were used first to raise money to finance only government bonds, then corporate bonds, and later equities. The risk of such financing plays lies in the unexpected sudden rise in short-term rates above the fixed returns of long-term assets. For equities, rising short-term rates can directly push equity prices drastically down, reflecting the effect of interest rates on corporate profits.

Hard figures on the size of the repo market in the US or Europe are not easy to come by. The Bond Market Association, a trade group representing US bond dealers, provides estimates of US market size based on surveys taken by the New York Federal Reserve Bank on daily financing transactions made by its primary dealers that do business directly with the Fed. By Fed statistics, the US repo market commanded average trading volume of about $5 trillion per day in 2004, up from $2 trillion in 1998, and the European one has now passed 5 trillion euros ($6.1 trillion) in outstandings. Both have been growing at a double-digit pace. That jump occurred even as the face value of US government bonds outstanding declined to $3.3 trillion from $3.5 trillion between 1999 and 1997 - the first drop since the Treasury began selling 30-year bonds regularly in 1977.

Total US federal government debt outstanding at the end of 2004 was $7.6 trillion, nearly 70% of GDP. In its February 2, 2005, Report to the Secretary of the Treasury, the Bond Market Association Treasury Borrowing Advisory Committee noted that the stock of Treasury debt held by foreigners was just over 50%, and that with higher short rates would come greater risks of chronic or intractable failures if foreign participation in repo markets was not assured. The St Louis Fed reports that as of June 30, federal debt held by foreigners exceeded $2 trillion.

The runaway repo market is another indication that the Fed is increasingly operating to support a speculative money market rather than following a monetary policy ordained by the Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act. Under the Federal Reserve Act as amended by Humphrey-Hawkins, the Federal Reserve and the Fed Open Market Committee (FOMC) are charged with the job of seeking "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates". Humphrey-Hawkins mandates that, in the pursuit of these goals, the Federal Reserve and the FOMC establish annual objectives for growth in money and credit, taking account of past and prospective economic developments to support full employment. The act introduced the term "full employment" as a policy goal, although the content of the bill had been watered down by snake-oil economics before passage to consider 4% unemployment as structural. Unemployment near or below the structural level is deemed structurally inconsistent because of its impact on inflation (causing wages to rise - a big no-no for diehard monetarists), thus only increasing unemployment down the road. Structural unemployment is now theoretically set at 6%.

Unfortunately, aside from being morally offensive, this definition of full employment is not even good economics. It distorts real deflation as nominal low inflation and widens the gap between nominal interest rate and real interest rate, allowing demand constantly to fall behind supply. Humphrey-Hawkins has been described as the last legislative gasp of Keynesianism's doomed effort by liberal senator Hubert Humphrey to refocus on an official policy against unemployment. Alas, most of the progressive content of the law had been thoroughly vacated even before passage. Full employment has not been a national policy for the US since the New Deal. Yet few have bothered to ask what kind of economic system demands that the richest country in the world cannot afford employment for all its citizens.

The one substantive reform provision: requiring the Fed to make public its annual target range for growth in the three monetary aggregates, the three Ms, namely M1 = currency in circulation, commercial bank demand deposits, NOW (negotiable order of withdrawal), and ATS (auto-transfer from savings), credit-union share drafts, mutual-savings-bank demand deposits, non-bank traveler's checks; M2 = M1 plus overnight repurchase agreements issued by commercial banks, overnight Eurodollars, savings accounts, time deposits under $100,000, money market mutual shares; and M3 = M2 plus time deposits over $100,000 and term repo agreements. A fourth category, known a L, measures M3 plus all other liquid assets such as Treasury bills, savings bonds, commercial paper, bankers' acceptances and Eurodollar holdings of US residents (non-bank).

Changes in the financial system, particularly since the deregulation of US banking and financial markets in the 1980s, have contributed to controversy among economists about the precise definition of the money supply. M1, M2 and M3 now measure money and near-money while L measures long-term liquid funds. There is no agreement on the amount of L. The controversy is further complicated by the financing of long-term instruments with short-term repos which while being is a money creation venue are mercuric in outstanding volume.

The persistent expansion in the money supply has been accompanied by a decline in the efficiency of money to generate GDP. In 1981, two dollars in the money supply (M3 - $2 trillion) yielded three dollars of GDP ($3 trillion), a ratio of 2:3. In 2005, 10 dollars in the money supply (M3 - $10 trillion) yields 12 dollars of GDP ($12 trillion), a ratio of 2.5:3. It now takes 25% more money to produce the same GDP than 25 years ago. That 25% is the unproductiveness of debt that has infested the US economy, not even counting the unknown quantity of virtual money that structured finance creates.

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money-supply growth expired, the Fed announced that it was no longer setting such targets, because it no longer considered money-supply growth as providing a useful benchmark for the conduct of monetary policy. It is a reasonable position since no one knows what the money supply and its growth rate really are. However, the Fed said, "The FOMC believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions. Moreover, M2, adjusted for changes in the price level, remains a component of the Index of Leading Indicators, which some market analysts use to forecast economic recessions and recoveries." Non-useful data yield non-useful forecasts.

Commercial banks profit from using low-interest-rate repo proceeds to finance high-interest-rate "sub-prime" lending - credit cards, home equity loans, automobile loans etc - to borrowers of high credit risks at double-digit interest rates compounded monthly. To reduce their capital requirement, banks then remove their loans from their balance sheets by selling the CMOs (collateralized mortgage obligations) with unbundled risks to a wide range of investors seeking higher returns commensurate with higher risk. In another era, such high-risk/high-interest loan activities were known as loan-sharking. Yet Greenspan is on record as having said that systemic risk is a good tradeoff for unprecedented economic expansion.

Repos are now one of the largest and most active sectors in the US money market. More specifically, banks appear to be actively managing their inventories, to respond to changes in customer demand and the opportunity costs of holding cash, using innovative ways to bypass reserve requirements. Rising customer demand for new loans is fueled by and in turn drives further down falling credit standards and widens interest-rate spread in a vicious cycle of unrestrained credit expansion.

Repos are widely used for investing surplus funds short-term, or for borrowing short-term against quality collateral. When the FOMC sells government securities to withdraw cash from the banking system, the banks can take the same securities to the repo market to get the cash back, neutralizing the Fed attempt to tighten the money supply in the banking system, even as the total money supply in the economy is theoretically tightened. And this tightening can also be neutralized by an increase of money velocity.

Although legally a sequential pair of transactions, in effect a repo is a short-term interest-bearing loan against solid collateral. The annualized rate of interest paid on the loan is known as the repo rate. Repos can be of any duration but most commonly are overnight loans. Repos for longer than overnight are known as term repos. There are also open repos that can be terminated by either side on a day's notice. In trade parlance, the seller of securities does a repo and the lender of funds does a reverse. Because cash is the most liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market value, usually by 2-5% depending on maturity. It is improbable that top-rated securities can have a drop in market value of more than 5% overnight, but not impossible.

The repo interest rate is usually slightly lower than the Fed funds rate, which banks charge each other for overnight loans. This is because a repo transaction is a secured loan, whereas the issuing of Fed funds is the release of sovereign credit into the money supply. Also, only the Fed can issue Fed funds, while anyone with surplus cash can lend money through a repo collateralized by top-rated security.

Even though the return is modest, overnight lending in the repo market offers several advantages to investors. By rolling overnight repos, investors can keep surplus funds invested without losing liquidity or incurring price risk. They also incur very little credit risk because the collateral is always highest-grade paper. The repo market is not open to small investors. The largest users of repos and reverses are primary dealers in government securities. As of August, there were 23 primary dealers recognized by the Fed, authorized to bid on newly issued Treasury securities for resale in the market. Primary dealers must be well capitalized, and often deal in hundred-million-dollar chunks. In addition, there are several hundred dealers who buy and sell Treasury securities in the secondary market and do repos and reverses in at least million-dollar chunks. The balance sheet of a government securities dealer is highly leveraged, with assets typically 50 to 100 times its own capital. To finance the inventory, there is a need to obtain repo money in large amounts on a continuing basis. Big suppliers of repo money are money funds, large corporations, state and local governments, and foreign central banks. Generally the alternative of investing in securities that mature in a few months is not attractive by comparison. Even three-month Treasury bills normally yield less than overnight repos.

A dealer who holds a large position in securities takes a risk in the value of his portfolio from changes in interest rates. Position plays are where the largest profits can be made. However, conservative dealers run a nearly matched book to minimize market risk. This involves creating offsetting positions in repos and reverses by "reversing in" securities and at the same time "hanging out" identical securities with repos. The dealer earns a profit from the bid-ask spread. Profits can be improved by mismatching maturities between the asset and liability side, but at increasing risk. As dealers move from simply using repos to finance their positions to using them in running matched books, they become de facto financial intermediaries. By borrowing funds at one rate and relending them at a higher rate, a dealer is operating like a finance company, doing for-profit intermediation. This form of carry trade in massive amounts can hit with unmanageably destructive force should interest-rate spreads turn against it.

Dealers hedging activities create a link between the repo market and the auction cycle for newly issued (on-the-run) Treasury securities. In particular, there is a close relation between the liquidity premium for an on-the-run security and the expected future overnight repo spreads for that security (the spread between the general collateral rate and the repo rate specific to the on-the-run security). Dealers sell short on-the-run Treasuries in order to hedge the interest rate risk in other securities. Having sold short, the dealers must acquire the securities via reverse repurchase agreements and deliver them to the purchasers. Thus an increase in hedging demand by dealers translates into an increase in the demand to acquire the on-the-run security (that is, specific collateral) in the repo market.

The supply of specific collateral to the repo market is not perfectly elastic; consequently, as the demand for the collateral increases, the repo rate falls to induce additional supply and equilibrate the market. The lower repo rate constitutes a rent (in the form of lower financing costs), which is capitalized into the value of the on-the-run security. The price of the on-the-run security increases so that the equilibrium return is unchanged. The rent can be captured by reinvesting the borrowed funds at the higher general collateral repo rate, thereby earning a repo dividend.

When an on-the-run security is first issued, all of the expected earnings from repo dividends are capitalized into the security's price, producing the liquidity premium. Over the course of the auction cycle, the repo dividends are "paid" and the liquidity premium declines; by the end of the cycle, when the security goes off-the-run (and the potential for additional repo dividend earnings is substantially reduced), the premium has largely disappeared.

A repo squeeze occurs when the holder of a substantial position in a bond finances a portion directly in the repo market and the remainder with "unfriendly financing" such as in a tri-party repo. Such squeezes can be highly destabilizing to the credit market.

The direct dependence of derivatives financing on the repo market is worth serious focus. According to Greenspan, "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives."

The Office of the Controller of Currency (OCC) Bank Derivative Report (First Quarter 2005) on bank derivatives activities and trading revenues is based on call report information provided by US insured commercial banks. During the first quarter, the notional amount of derivatives in insured commercial bank portfolios increased by $3.2 trillion to $91.1 trillion. The notional amount of interest-rate contracts increased (by $2.5 trillion) to $78 trillion. The notional value of foreign-exchange contracts decreased (by $94 billion) to $8.5 trillion. This figure excludes spot foreign-exchange contracts, which increased (by $319 billion) to $738 billion. Credit derivatives increased (by $777 billion) to $3.1 trillion. Equity, commodity and other contracts increased (by $87 billion) to $1.5 trillion. The number of commercial banks holding derivatives increased (by 18) to 695. Eighty-six percent of the notional amount of derivative positions consists of interest-rate contracts, with foreign-exchange accounting for an additional 9%. Equity, commodity and credit derivatives accounted for the remaining 5% of the total notional amount. Holdings of derivatives continue to be concentrated in the largest banks. Five commercial banks account for 96% of the total notional amount of derivatives in the commercial banking system, with more than 99% held by the largest 25 banks.

Over-the-counter (OTC) contracts comprised 91% and exchange-traded contracts comprised 9% of the notional holdings as of first quarter of 2005. An OTC instrument is traded not on organized exchanges (like futures contracts), but by dealers (typically banks) trading directly with one another or with their counterparties (hedge funds) using electronic means that link counterparties. OTC contracts tend to be more popular with banks and bank customers because they can be tailored to meet firm-specific risk-management needs. However, OTC contracts expose participants to greater credit risk, particularly counter-party risk, and tend to be less liquid than exchange-traded contracts, which are standardized and fungible.

At year-end 1998, US commercial banks reported outstanding derivatives contracts with a notional value of only $33 trillion, less than a third of today's value, a measure that had been growing at a compound annual rate of about 20% since 1990. Of the $33 trillion outstanding at year-end 1998, only $4 trillion was exchange-traded derivatives; the remainder was off-exchange or over-the-counter (OTC) derivatives. Most of the funds came from the exploding repo market.

The 1987 crash was a stock-market bubble burst. Greenspan, merely nine weeks into the powerful post of Fed chairman, flooded the banking system with new reserves by having the FOMC buy massive quantities of government securities from the market, and announced the next day that the Fed would "serve as liquidity to support the economic and financial system". He created $12 billion of new bank reserves by buying up government securities. The $12 billion injection of high-power money in one day caused the Fed funds rate to fall by three-quarters of a point and halted the financial panic. The abrupt monetary easing led to a subsequent real-property bubble burst that in turn caused the savings and loan (S&L) crisis two years later. The Financial Institutions Reform Recovery and Enforcement Act (FIRREA) was enacted by the US Congress in August 1989 to bail out the thrift industry in the S&L crisis by creating the Resolution Trust Corp (RTC) to take over failed savings banks and dispose of their distressed assets. The Federal Reserve reacted to the S&L crisis with a further massive injection of liquidity into the commercial banking system, lowering the Fed funds rate target from its high of 10.75% reached on April 19, 1989, to below the 3% inflation rate, making the real rate near zero until January 31, 1994.

Since there were few assets worth investing in a down market, most of the Fed's newly created money went into bonds. This resulted in a bond bubble by 1993, which then burst with a bang in February 1994 when the Fed started raising rates, going further and faster than market participants had expected: seven hikes in 12 months, doubling the Fed funds rate target to 6%. As short-term rates caught up with long, the yield curve flattened out. Liquidity evaporated, punishing "carry traders" who had borrowed short-term at low rates to invest longer-term in higher-yield assets, such as long-dated bonds and more adventurous higher-yielding emerging-market bonds. The rate increases set off a bond-market crash that bankrupted Wall Street giant Kidder Peabody & Co, California's Orange County and the Mexican economy, all casualties of wrong interest-rate bets. In the case of Orange County, a triple-legged repo strategy brought it extraordinary returns for a few years, but the risk of the portfolio was such that over time, it could lose as much as $1.6 billion in excess of value at risk estimates in one case out of 20. And it did in 1994.

By 1994, Greenspan was already riding on the back of the debt tiger from which he could not dismount without being devoured by it. The Dow was below 4,000 in 1994 and rose steadily to a bubble of near 12,000, while Greenspan raised the Fed funds rate target seven times from 3% to 6% between February 4, 1994, and February 1, 1995, to try to curb "irrational exuberance". Greenspan kept the Fed funds rate target above 5% until October 15, 1998, when he was forced to ease it after contagion from the 1997 Asian financial crisis hit US markets. The rise in Fed funds rate target in 1994 did not stop the equity bubble, but it punctured the bond bubble and brought down many hedge funds. The dollar fell to 94 yen and 1.43 marks by 1995. The low dollar laid the ground for the Asian financial crisis of 1997 by fueling financial bubbles in the Asian economies that pegged their currencies to the dollar.

Stan Jonas, a minor legend on Wall Street in the early 1990s, explained the hedge funds/derivative world in an interview by DerivativeStrategy.com in November 1995. The low-interest-rate policy of the Fed in 1993 turned the market into a speculative free-for-all. With the banking system in precarious shape, the Fed kept the yield curve very steep, meaning a wide spread between short-term and long-term rates, and kept short-term rates low in order to give banks a chance to rebuild their capital. Bankers, acting on the signal that the Fed was going to hand out a free put, bought two-year notes and profited on the capital gain as well as the profitable carry trade, lending the low-cost funds to borrowers at higher rates. All through 1993, and particularly toward the end, there was a huge bond rally. When bonds broke at the end of 1993, most market participants were long on bonds. As the Fed tightened, the market recognized how closely concentrated liquidity had been. Everybody was on the same side of the trade, long on US bonds, German bunds etc.

Jonas detailed how it worked. In 1992, a hedge-fund manager with $3 billion in stocks, hearing the Fed signal to the banking system, decided to go long on bonds, meaning to bet on bond prices rising. Quantitative analysis suggested that bonds were one-third as volatile as stocks. The manager went long on $10 billion of 10-year bonds. When the yield curve steepened, meaning 10-year-bond prices were rising slower than two-year-bond prices, he decided to be long on two-year notes. On a duration weighted basis, quant analysis told him he should be long about seven times as much, or $70 billion in two-year notes, which exceeded the amount of two-year notes outstanding. In 1992, value-at-risk analysis that, based on probabilities and correlations and volatility, told a trader how much he could lose in his entire portfolio with a particular trading plan, looking at past correlations and volatilities, concluded that French bonds and two-year notes were a comparable exposure to his current US fixed-income positions. The manager went to the European market, where the easing cycle had not yet caught up to that in the US. Many of the hedge funds made the same kind of decision with electronic speed. All the equity managers jumped into fixed income with leverage of 100:1, and made a lot of money. The Fed eased 24 times and kept on easing. The traders became real-life versions of Sherman McCoy, master-of-the-universe bond trader in Tom Wolfe's Bonfire of the Vanities.

When the Fed began to ease aggressively in 1992, the financial world was opening up by deregulation. With derivatives, a trader could make bets that were impossible to make three or four years earlier. One could buy French bonds at the MATIF (Marche A Terme International de France), or gilts at LIFFE (London International Financial Futures Exchange), or do structured products with pay-offs based on the difference between Spanish and German rates. The whole world in essence became a futures market grouped under the benign name of structured finance. Many of these hedge-fund managers and traders were interrelated by blood, by background, by tastes, by lifestyle and by education. It was a very small elite group, fearless and confident, competing with and checking on what the others were doing. They had a firm, sophisticated command on the virtual world of financial values and relationships, but were unwittingly naive about the complexity of the real world. In all, a few thousand young Turks ran the whole market and spoke a language that their supervisors could hardly follow and were embarrassed to admit they were clueless. That was one of the reasons all the bets tended to be on the same side. And when it came time to unwind, there was hardly anyone to sell to. All of the statistical notions of diversification failed because there was no wide divergence of views in a broad market. The year 1994 was when all global bond markets moved in the same direction. When it came time to liquidate, the market froze for lack of buyers. Most model builders assume reality to be rational and orderly. In fact, life is full of misinformation, errors of judgment, miscalculations, communication breakdowns, ill-will, legalized fraud, unwarranted optimism, prematurely throwing in the towel, etc. One view of the business world is that it is a snake pit. Very few economic/financial models reflect that perspective.

Most hedge funds make money as trend followers. The key to trend-following is that if the market goes up you keep buying more. There was a built-in tendency for a herd instinct that quickly turned into a stampede. Those who turned out right ended up as superstars. Normally, if a trader makes money, he is supposed to take profits when the going is still good because everyone knows pigs lose money. Gamblers who overstay at the tables in Las Vegas will end up as losers. But the 1990s were the age of unabashed greed. When managers got on a track that made money, they developed a sense of invincibility and in effect doubled up on their positions, so on any big move down, they faced big losses that would wipe out all their previous gains.

Many of the biggest hedge funds promised their investors that they would never lose serious amounts of money because of brute-force stop-loss breaks, so that no matter what happened they would never lose more than say 3-5% of their capital in any one month in trading strategies that could yield average returns of up to 70%. But the stop-loss strategy unwittingly destroyed their hedge. As a fund experienced losses in one marketplace, it started shrinking its positions in every marketplace to prevent its portfolios losing more than 5%. So after the Fed tightened in the US market, the funds sold in the European market. When the European market fell, they sold in the Latin American markets to shrink their overall position. It became a "global triage". The position was pared of the most liquid securities first, leaving the fund with the most difficult positions, the "toxic waste", to the detriment of their shareholders. The global market was hit by contagion when good markets were sold down to save bad markets. Strange corollaries appeared. One day the market was down in Germany and the next day it spilled over to Mexico and the Turkish markets in rhythms tied to investor preferences and risk aversion, not to macroeconomic events in the economies. The fundamentals were good but the markets kept falling. This asset was cheap relative to that asset; Mexico was cheap relative to Spain, and so on. This shrinkage quickly became self-exacerbating and a global meltdown took place. The lesson from the banking side was that static notions of risk and implied volatility were meaningless. Infinite liquidity in the marketplace might work on theoretical models, but the mathematics was valid only a very controlled scale. In the real world, the complexity always overwhelms the model. The big hedge funds knew that every time they bought more, it set off signals for others to buy more. Assets became Giffen goods, the demand for which increases when the price goes up. It's a positive feedback loop. The big funds could control the market trend to make other participants buy more because they knew the participants' recipe for replicating the options. As Nassim Taleb, celebrated author of Dynamic Hedging and Fooled by Randomness, formulates his fifth rule on risk management, "The market will follow the path to thwart the highest number of possible hedgers." Taleb cautions that financial models, unlike engineering models, are based more on assumptions that are not verifiable. "In finance, you are not as confident about the parameters. The more you expand your model by adding parameters, the more you become trapped in an inextricable apparatus of relationships. It is called overfitting," he said in an interview by DerivativeStrategy.com.

The market is difficult to model because there are vast arrays of variables that are indeterminate and the externalities are not isolatable. Still, even engineering models have similar characteristics. Engineers overcome such problems by legally requiring a safety factor of 3 in most building codes and strength-of-materials standards. In other words, every engineered structure is over-designed by a factor of at least three. The problem with financial models is that profitability is derived from shaving the safety factor to near zero. Financial models are designed to allow the user to skate on the thinnest ice possible, rather than the safest ice necessary. Risk management has been misused to allow traders to take more risk rather than to protect him from the dangers of incalculable risk.

Dealers provide hedge funds with the opportunity to track a new type of risk embedded in the marketplace: correlation risk. The pricing is based on relative movements of previously stable historical relationships. All the hedging technologies based on those ideas would break down in a crisis. The most vulnerable weakness of a value-at-risk (VaR) or any statistical model is its assumed stable correlation matrix. Taleb warns that when potential loss distributions are fat-tailed (a term implying a more than nominal probability of losses at the far end of the distribution - that is, high degree of probability of several defaults in the pool), simulation based critical value estimates show significant biases and have standard errors of substantial magnitude. This is particularly significant when a portfolio's positions contain options. These distributions are a mixture of different distributions, and it becomes virtually impossible to verify with any accuracy the potential losses associated with extremely rare events.

Updated assumptions are irrelevant because history progresses at a disjointed pace. By definition, if every market participant trades with the same assumptions, historical correlation will be inoperative. If large numbers of market participants are trying to exit at the same time, the market turns finite and the historical parallels becomes so dynamic that risks becomes unquantifiable. Ironically, it's the worst sort of empiricism. Jonas thinks the worst sort of technical trading is typified by the refrain of the lazy technician, and it's been carried forward by many risk modelers, "I don't have to know anything about the fundamentals, the charts tell me all I need to know."

What gives the market a false sense of safety now is that more asset positions are getting "marked to market" at the end of every trading day, moving the marketplace dramatically toward risk management as the savior, rather than book value of long-term instruments that returns its principal at maturity, making intermediate risk irrelevant. This actually increases overall risk since temporary losses are the basis of longer-term gains.

Greenspan opposed regulation for derivatives
Most of the time, if the words "interest rates" do not appear in Greenspan's utterances, little attention is paid to them. Yet in detached language and calm tone, Greenspan has been saying that he does not intend to exercise his responsibility as Fed Board chairman to regulate OTC financial derivatives intermediated by banks, even though he recognizes such instruments as being certain to produce unpredictable but highly damaging systemic risks. The justification for no-regulation is: if we don't smoke at home, someone else offshore will. Moreover, risk is a price we must accept for a growth economy. It sounds as if the Fed expects each market participant or even non-participant individually to take measures of self-protection: either miss out on the boom, or risk being wiped out by the bust. It is unpatriotic, not to mention dumb, not to participate in the great American game of downhill-racing risk-taking.

With the rise of monetarism, the Fed and the US Treasury Department have evolved from traditionally quiet functions of ensuring the long-term value and credibility of the nation's currency, to activist promotions of speculative boom fueled by run-away debt, replacing the Keynesian approach of fiscal spending to manage demand by sustaining broad-based income to moderate the downside of the business cycle. Never before, until Greenspan, has any central banker advocated and celebrated to such a degree the institutionalization and socialization of risk as an economic policy. As Anthony Giddens, director of the London School of Economics, explains in his The Third Way that so influenced Bill Clinton, the New Economy president, and British Prime Minister Tony Blair, the self-proclaimed neo-liberal market socialist: "Nothing is more dissolving of tradition than the permanent revolution of market forces." What the Third Way revolution did in reality was to restore financial feudalism in the name of progress. Debt has enslaved a whole generation of mindless risk-takers, with the encouragement of the Wizard of Bubbleland.

In a speech on financial derivatives before the Futures Industry Association in Boca Raton, Florida, on March 19, 1999, Greenspan said:

By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives ... the fact that the OTC markets function quite effectively without the benefits of the Commodity Exchange Act provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives. On a loan equivalent basis, a reasonably good measure of such credit exposures, US banks' counterparty exposures on such contracts are estimated to have totaled about $325 billion last December [1998]. This amounted to less than 6% of banks' total assets. Still, these credit exposures have been growing rapidly, more or less in line with the growth of the notional amounts ...

A Bank of International Settlements survey for last June ... estimated the size of the global OTC market at an aggregate notional value of $70 trillion, a figure that doubtless is closer to $80 trillion today. Once allowance is made for the double-counting of transactions between dealers, US commercial banks' share of this global market was about 25%, and US investment banks accounted for another 15%. While US firms' 40% share exceeded that of dealers from any other country, the OTC markets are truly global markets, with significant market shares held by dealers in Canada, France, Germany, Japan, Switzerland, and the United Kingdom.

Despite the world financial trauma of the past 18 months, there is as yet no evidence of an overall slowdown in the pre-crisis derivative growth rates, either on or off exchanges. Indeed, the notional value of derivatives contracts outstanding at US commercial banks grew more than 30% last year, the most rapid annual growth since 1994 ... during panic periods the usual assumption that potential future exposures are uncorrelated with default probabilities becomes invalid. For example, the collapse of emerging-market currencies can greatly increase the probability of defaults by residents of those countries at the same time that exposures on swaps in which those residents are obligated to pay foreign currency are increasing dramatically.

While their financial clout may be large, hedge funds' physical presence is small. Given the amazing communication capabilities available virtually around the globe, trades can be initiated from almost any location. Indeed, most hedge funds are only a short step from cyberspace. Any direct US regulations restricting their flexibility will doubtless induce the more aggressive funds to emigrate from under our jurisdiction. The best we can do in my judgment is what we do today: Regulate them indirectly through the regulation of the sources of their funds. We are thus able to monitor far better hedge funds' activity, especially as they influence US financial markets. If the funds move abroad, our oversight will diminish. We have nonetheless built up significant capabilities in evaluating the complex lending practices in OTC derivatives markets and hedge funds. If, somehow, hedge funds were barred worldwide, the American financial system would lose the benefits conveyed by their efforts, including arbitraging price differentials away. The resulting loss in efficiency and contribution to financial value added and the nation's standard of living would be a high price to pay - to my mind, too high a price ...

We should note that were banks required by the market, or their regulator, to hold 40% capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidedly lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs.

Interstate banking restrictions have been lifted and the barriers between commercial and investment banking are starting to fall; US banks are consolidating in record numbers and the size and complexity of our largest banks are growing. While this consolidation and growth may not, in and of itself, be bad, one thing is clear: The loss of just one of these banks will pose an even greater systemic risk than before ...

The moral-hazard problem is particularly severe in banking because of the lack of deductibles. Governments often provide 100% depositor protection, especially at large banks where a loss could have industrywide repercussions (a practice known as too-big-to-fail - TBTF) ... In 1991, the US Congress created an explicit and more stringent TBTF policy [Federal Deposit Insurance Corp Improvement Act - FDICIA]. Prior to 1991, there was an unwritten TBTF policy, and the government was much freer to rescue large banks and protect uninsured depositors. Under FDICIA, uninsured depositors cannot receive protection if it raises costs to the FDIC. There is an exception, however, if the failure of the bank poses a systemic risk. The emergency bailout can go forward with the approval of the secretary of the Treasury (who must consult with the president), the Federal Reserve Board of Governors and the FDIC's board of directors. Therein lies the problem: FDICIA still leaves the door open for moral hazard in the extreme. Uninsured depositors at the very largest US banks still know they are likely to be fully protected and have little reason to monitor how their deposits are invested. And, as a result, large banks have an incentive to take on more risk than they would otherwise.