Page 2 of 5 THE FOLLY OF INTERVENTION, Part 1 The zero interest rate trap
By Henry C K Liu
its member nations, passed a rule allowing the European counterpart of the US
SEC to liberalize management of risk both for broker dealers and their
investment banking holding parents. In response, the SEC instituted a matching
voluntary program for broker-dealers with capital of at least $5 billion,
enabling the SEC to oversee both the broker-dealers and the holding parents.
Deregulation was being driven by financial nationalism.
Ever since the Great Depression, the US government has tried to limit the
leverage available to investors in the US stock market by maintaining margin
requirements. But regulators, led by former chairman of the Federal Reserve
Alan Greenspan, thought financial innovation would be hampered and financial
activity driven to unregulated markets overseas if there were any attempts to
impose limits on leverage in the unregulated credit and capital markets. After
all, innovation was viewed as the driving force in US prosperity. The global
financial system embarked on a race to assume more risk under a mentality of
"if I don't smoke, somebody else will".
This brave new approach, which all five qualifying broker-dealers - Bear
Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley -
voluntarily adopted, altered the way the SEC measured their capital. The five
big firms led the charge for the net capital rule change to promote financial
innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two
years later, would leave Goldman to become the Treasury Secretary and until the
departure of the George W Bush administration this month had to deal with the
global mess after failing to secure government aid. Bear Sterns and Merrill
Lynch had been sold to big commercial banks and Goldman and Morgan Stanley have
turned themselves into regulated bank-holding companies. The age of independent
investment banks came to an end in the US.
Growth of structured finance
Structured finance, the structuring of financial needs for larger markets to
generate greater financial value, emerged at first as a means to profit from
unlocking latent value of conventional debt through unbundling of risk through
securitization, and to gain from eliminating market inefficiency through
arbitrage. It creates financial value by facilitating the transfer unit risk to
the credit system through complex legal entities that shift liabilities off
balance sheet. Risk transfer through debt securitization leads to degradation
in underwriting standards, as liability is transferred to counterparties or to
market participants systemically.
Advances in computerized trading enable the handling of large amounts of market
information at electronic speed to conduct profitable trades to exploit market
inefficiency to restore fundamental equilibrium. The intellectual energy of
structured finance came through spillovers from advances in risk management in
nuclear arms control during the Cold War. Before long, with financial
deregulation, quantitative trading groups, known as quant shops, and hedge
funds, hoping to profit from capitalizing on eliminating market inefficiency,
were springing up like mushrooms after a spring rain.
Also, risk management needs by all institutions that have exposure to financial
risk create massive market demand for derivative instruments of all varieties
and complexities to transfer unit risk to systemic risk. This leads to
securitization of financial obligations to manipulate risk levels in order to
attract investors of varying risk appetite. With increasingly sophisticated
hedging against risk, investors begin to assume higher tolerance for risk
through hedging. Hedging then transforms from a method of protection by
reducing risk, to one of achieving higher profit by assuming more risk. Risk is
no longer merely an index of danger; it becomes an index to command
compensatory returns. Risk changes from something to be avoided to something
that should be sought for those seeking higher returns. Finance capitalism is
built on a structure of risk.
Hedging only transfers risk to other parties; it does not eliminate risk from
the system. Systemic risk rises as more unit risks are hedged. But while unit
risk is managed by resident risk managers, deregulation reduced the role of
systemic risk managers, traditionally market regulators, which in the US are
the Federal Reserve for banking institutions and the Security Exchange
Commission for equity markets.
Former Fed chairman 0Greenspan's argument in support for deregulation is that
innovation should not be inhibited and that self interest of financial
institutions would be sufficient to assure self regulation. The logic is akin
to the argument that if foxes were given free run of chicken coops, self
interest of the foxes would regulate consumption of chickens to ensure a steady
food supply. He has since admitted that he had put too much faith in the
self-correcting power of free markets.
Seduced by fantasy profit targets
The entire structured finance sector has been seduced by fantasy profit targets
driven by excess liquidity of cheap money released by the central bank. These
fantasy profit targets are pushed even unrealistically higher by the
under-pricing of risk due to the ease with which entity risk has been passed
onto counterparties in the global credit system to get liabilities off the
balance sheets of funding intermediaries and underwriters.
Instead of acting as responsible intermediaries between investors, securitizing
intermediaries and borrowers, investment banks while acting as securitizing
intermediaries, also became investors in structured finance instruments they
themselves invented and whose risk has been under-priced and whose safety is
dependent on the performance of borrowers of poor credit ratings and record.
Fantasy profit targets have permeated the entire credit market because risk has
been pushed unrealistically low by spreading it to a great number of
counterparties in a daisy chain. When a few counterparties in the daisy chain
defaulted, it impacted the credit ratings of all parties in the global daisy
chain, requiring additional compensatory collateral, placing the entire daisy
chain in an unenviable position of undercapitalization. The opaqueness of the
daisy chain makes it impossible to locate and strengthen the weak links and the
whole system comes crashing down from undercapitalization.
The fear factor
A fantasy profit target cannot be justified merely by low risk, particularly if
the alleged low-risk assessment itself is a fantasy. There is no mileage in
risking even one penny for an impossible dream. Pricing of risk is a judgment
call based on confidence on likelihood of gain, the reverse of which is fear of
loss. The fear factor usually faces a rising threshold in a bull market and
declining bar in a bear market in reverse direction to a required risk-reward
ratio. The greater the fear, the higher would the risk-reward ratio be
required. At some point, the fear factor can push the required risk-reward
ratio to infinity when risk aversion overrides any and all reasonable profit
targets. That is the point when markets seize.
Historical data suggest that a 100 basis point (1%) increase in federal 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 were raised by
the Fed in late winter 2003 can be explained by the expectation theory of the
term structure that links market expectation of the future path of short-term
rates to changes in long-term rates, as St Louis Fed president William Poole
pointed out in a speech to the Money Marketeers in New York on June 14, 2005.
The market simply did not expect the Fed to keep the short-term rate high for
extended periods under then current bullish conditions. The upward trend of
short-term rates was expected by the market to moderate or reverse direction as
soon as the economy slowed.
The failure of long-term rates to fall as short-term rates were cut by the Fed
to near zero in December 2008 can be explained by the fear factor and by the
uncertain direction of the purchasing power of the dollar in the future.
Zero short-term rate can raise systemic risk
A liquidity trap can also raise the risk premium as market appetite for risk
wanes and investors flee towards safety. But a zero short-term interest rate
trap set by the central bank can distort the historical term structure by
abnormally widening the gap between short-term and long-term rates as long-term
rates fail to fall with the short-term rate because of a rising spread in risk
premiums.
This distortion can increase systemic risk by tempting investors to engage in
term interest arbitrage, by borrowing at a near-zero short term rate to invest
in higher-yielding long-term instruments with even normal risk premiums.
The re-pricing of short-term risk was a root cause of the 1997 Asian financial
crisis and it was again a root cause of the 2007 credit crisis a decade later.
Monetarism had not banished the business cycle; it merely extended the length
of the boom phase by making the eventual bust more painful.
A liquidity trap, together with a zero interest rate trap, can combine to lead
to a structural under-pricing of risk, followed by a subsequent overshoot of
the risk premium from a rising fear factor, and lead to a systemic failure of
the short-term credit market. In August 2008, all debts that matured in 30, 90
or 120 days could not be rolled over at previous rates, or as the fear factor
escalated, at any interest rate.
Risk is inherently dangerous even if it is priced appropriately to reflect
realistic market conditions. A healthy does of risk aversion is indispensable
for the survival of financial capitalism, which thrives only on prudent
risk-taking, not suicidal heroic risk abuse. Yet under-pricing of risk driven
by excess liquidity released by the central bank over long periods to stimulate
economic activities, the basic strategy of monetarism, will implode as a
systemic crisis at the end of the day as surely as the sun will set.
Central banking, democracy and monetary policy
The Federal Reserve Act of 1913 gave the Federal Reserve authority and
responsibility for setting monetary policy, which guides central bank actions
to influence the availability and cost of money and credit to help promote
national economic goals. Since the founding of the country, full employment has
never been part of the US national economic goal. From the nation's beginning,
during the pioneering days, the US faced a persistent labor shortage. In the
agricultural South, the labor shortage problem was solved by the institution of
slavery. During the age of capitalist industrialization, the industrial North
solved the labor shortage problem with immigration after 1830 from the laboring
class in Europe. Until then, the US did not have a working class, or an
unemployment problem.
The winning of independence by the US from Britain in 1782 was accompanied by
gloomy predictions that the new nation would not succeed in creating a stable
central authority to replace the
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