The Fed Subsidizes The Wrong Behavior

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On May 18, 2007, Fitch Ratings affirmed its ratings regime for Merrill Lynch's Bernoulli High Grade CDO I, Ltd. Fitch assigned AAA ratings using its proprietary VECTOR model to all the class A tranches, amounting to about $1.37 billion in par value, and investment grades all the way down to the D class or "equity" tranche. The structure was initiated in March 2006, with a total par of about $1.5 billion, as a static hybrid cash and synthetic CDO.

There was nothing particularly revolutionary or unusual about Bernoulli I. At the time, this was pretty much standard fare for structured finance, even with its hybrid model. That referred to the way in which the structure gained exposure to the reference security pool which consisted of about 68% RMBS (residential mortgage-backed securities) and 32% other CDO's. Obtaining exposure to those asset classes was done by a mix of 76% cash bonds and 24% synthetic exposures on securities through credit default swaps.

Entering 2007, Merrill Lynch was heavily involved in the hybrid CDO space, underwriting a second structure with the name, the Bernoulli High Grade CDO II, Ltd., in August, as well as 29 others that year. The March 2007, Norma CDO I Ltd., like those that followed, demonstrated the compressed evolution of structured finance. Norma was classified as the same type of security, a hybrid CDO, but the balance and proportions of its $1.5 billion par value were far different. Unlike Bernoulli I, Norma was very heavily weighted toward synthetic exposures. Only 6% of Norma's reference assets were "cash" bonds.

This new proportionality toward synthetics offered distinct advantages to underwriters (as opposed to investors). Actual cash securities were difficult to obtain and often messy toward the primary purpose of putting together a CDO - harmonization toward a mathematical precision in estimating risk/return and other financial parameters. Synthetic exposure was an easy, off-the-shelf substitute that could be assembled in a very short period of time. Second, synthetic exposures offered leverage and, more importantly when selling these things, liquidity. Liquidity meant pricing, which meant a wider audience and deeper market penetrations.

The growth in hybrid synthetics and liquid default swap markets meant that these investment bank underwriters were creating ostensibly "credit" products without having to use actual credit. The amount of exposure derived from synthetic "fillers" may have been as much as three or four times the level of actual reference obligations. Before trouble hit in August 2007, there were about $70 billion in hybrid CDO's packaged - but unfortunately not all of them were sold.

Implicit in this synthetic component is a heavily element of cross-selling. The Bernoulli I CDO, for example, was referenced in credit default swaps written by AIG's Financial Products group. To create this element of liquidity, and thus pricing, required active trading, so cross-referencing filled a dual need of topping up available synthetic filler, so to speak, at the same time appearing to create a liquid and stable marketplace. In the stock market this is known as a pump and dump.

The problem came from the dump part. As I mentioned, not all of the CDO's that were planned on being sold made it out the door. The investment banks got caught in warehouse financing these unsold issues. In other issues, the banks were on the hook as liquidity died in the asset-backed commercial paper market since a lot of the largest tranches were sold out the door on leverage (the commercial paper served as the vehicle to obtain borrowed funds to reduce "capital" needed to obtain these larger tranches). With commercial paper investors, mainly money market funds, getting wise to the liquidity scheme, investment banks were forced to "stand behind" these already sold products, and thus derived exposure and a good deal of investment loss from CDO's and products that had already been sold.

Much of this, in 2012, is pretty well known. The issue I have with all of this is the moment of sale. Under "gain on sale" accounting rules, the investment bank underwriter and the mortgage originators booked all the expected profits from these deals at the time of the sale, upfront. For underwriters, fees could be anywhere from 1% to 2% of par, and much higher for originators. Again, as is well known now, that gave underwriters and originators the incentive to overlook prudent intermediation in favor of pure volume - thus the growing demand for filler synthetics.

Whenever Merrill Lynch, Countrywide or any of the other financial perpetrators of the housing bubble period finished one of these deals they booked their fees, which, in the accounting of financial institutions, actually increased their bank capital. The largest part of Tier 1 "capital" is retained earnings, so more fees meant more profits, and thus more bank "capital".

As I referenced a few weeks back, the FOMC took note of this structured finance trend as early as June 2003, in their roundtable discussion of what they termed as the only credit conduit flowing. In the context of their fear of deflation in the economy as a result of the dot-com bust, they were well relieved by the potential for a positive economic response.

In the Basel system of equity-driven bank reserves, more structured finance profits would beget more structured finance conduits since growing equity capital increased the ability of banks to expand their own balance sheets (including warehouse funding and liquidity guarantees). As far as the FOMC was concerned, all this structuring was increasing the level of credit in the wider economy, which they believed, unequivocally, was a good and positive trend.

Banks themselves, however, were changing in character and content. They were transforming from intermediaries to volume dealers, tied most directly to liquidity and pricing. Part of the process meant deliberately trashing their own product, as in the cases of Abacus and Magnetar, because volume and liquidity meant a necessary need for both longs and shorts. The severing of the link between intermediation and marginal credit flow meant a palpable decrease in the efficiency of both bank capital and money itself. That distinguishes "capital" accumulated in this manner from traditional notions of capital since volume overcomes all other considerations, especially efficiency.

In the context of orthodox monetary theory, there is no distinction to be made. The quantity of credit, and thus the quantity of real economic activity, is all that is considered by central banks. But even central banks would notice the severing link of actual credit advanced through structured finance and the growing use of hybrids proportioned heavily toward synthetics. A synthetic default swap does not in any way create economic activity in the real economy (outside of pay for bankers and investment managers). In fact, the more synthetic filler in the system, the less economic activity created by this volume process. It would be difficult to prove, but I have a good hunch that the changing character of structured finance toward synthetics played a significant role in ending the housing bubble. It could not withstand a mass exodus of "funds" and "capital" deployed increasingly away from actual, real borrowers in 2005 & 2006, and right on until August 2007.

We know for a fact that that changing trend, again a volume consideration, increased systemic risks at the same time the economy was losing credit access. Not that long after AIG became entangled with Bernoulli I, for example, those default swap positions had to be transferred in November 2008, to Maiden Lane III as a ward of the Federal Reserve. Bernoulli I, as well as Bernoulli II and Norma, were put into various stages of defaults and liquidations. Modern bank capital was impaired because sales and volume were the primary drivers of "capital" accumulation - the severing of money efficiency from marginal credit enabled all these kinds of speculative excesses. Any system that incentivizes one set of "values" over another will end up turning into a system that eventually only recognizes that artificial distortion.

That brings us, of course, to QE 3 and this week's QE 4. Conceptually, to me, there isn't a whole lot of difference between what Merrill Lynch was doing in the Bernoullis and Norma and what the FOMC is doing with quantitative easing. QE's, after all, are volume programs, complete with available synthetic fillers (interest rate swaps, in this case).

These programs do absolutely nothing to enhance the productivity of the credit system. Again, the Fed and all of modern economics make no distinction between one kind of activity and another, in both the real economy and credit production systems. But as neutral as that sounds, it is actually a net negative since they incentivize exactly the wrong type of behavior and activity. The Fed, by virtue of its oversized presence now in both MBS and US treasuries, is distorting the prices of financial risk and reducing the threshold for speculation, just as volume in structured finance attracted more and more participants, funds and "capital" pre-2008. Some of that is certainly intentional displacement (the Fed wants to push financial firms and investors into other "risky" asset classes, to what avail?) but there is more to it than that.

For QE 3, clearly the Fed is hoping that by acting as marginal buyer in GSE MBS, more financial institutions will rush to issue mortgages to take advantage of this pricing "floor" that was established well above "market" prices. But that isn't necessarily the case. Banks can just as easily pocket arbitrage spreads while speculating in synthetic credit, financed, in large part, by the cheapened cost of collateral for synthetic credit products (US treasuries, in this case) and the distortion in interest rates. Low interest rates that appear as a result of the heavy hand of volume pull funds and "capital" in all sorts of financial spaces that have little or nothing to do with advancing credit in the real economy. Volume encourages speculation, not investment, and certainly not intermediation.

Furthermore, this rewarmed speculative capital accumulation is not risk-free. In fact, the asymmetric risks remain, and may have actually grown. As firms continue to speculate on the pace and seemingly unending nature of volume expansion, they begin to accumulate positions and cross-positions that are based on nothing more than that same speculative volume. The increase in hybrid CDO's stuffed with synthetic filler was a byproduct of speculation on volume growth being near-limitless or infinite. The expansion of volume becomes both self-reinforcing and self-limiting at the same time, but participants only see the former and ignore, or are ignorant of, the latter.

In terms of interest rate swaps, for example, the preponderance of positions appears to be heavily favoring QE-forever. That makes a reverse proposition devastating to not just individual firms, but the entire system. Such an imbalance favoring floating rate payers would, in a QE-exit, amount to a massive margin call on collateral obligations. Again, risks are asymmetric here since margin calls and diminished valuations of contract values directly impact accounting "capital" levels. In other words, the system cannot be maintained without a permanent expansion of volume because the system distorts to that volume, which is why QE in Japan is unending and Chairman Bernanke is on his fourth explicit attempt. The FOMC recognized this danger in 2003, but it has been apparently discarded in favor of doubling down on academic experimentation.

We see this in inflation breakevens and even corporate spreads - every time there is a QE program in the US and Japan, inflation expectations rise. But the moment QE ends, they revert to deflation (in Japan) or reduced expectations (in the US). This was once called the zombification of the financial system, since these firms are alive and in operation, but provide little or no direct value to the real system (the actual, real economy). They don't seem to leave any permanent impact where it might actually be needed. In the parlance of Keynesianism, the multiplier must be far less than 1 (if not less than zero at some points, particularly looking at real disposable personal income).

In the financial system, however, the results are the continued distortions in the character of finance and financial interactions. Not only does this volume desire change the incentive structure for banks, it pushes banking into cartelization. Since volume distortions purposefully favor scale, smaller institutions are immediately disadvantaged. That is no more obvious than the primary dealer system in US treasury bonds. QE 4 flow will fall first and foremost among the primary dealers who have the unique capacity to flip auctioned bonds back directly to the Fed by virtue of the nature of the monetary system's design. They get to capture the best of the volume speculation system since inflation and financial volume do not affect the system uniformly; they start at the point of origin and benefit most those closest before decaying into the rest of the system. By the time that process reaches the real economy, in this speculative system, it is actually deleterious (again, real disposable personal income).

Despite the trauma of 2008 and the lip service paid to "too big to fail", credit production rests in even fewer hands now than the CDO heyday. And it's not even close. Some of that is delayed recognition of those asymmetric risks - it is assumed they can be better absorbed through scale (that is why Merrill Lynch was eventually pushed, as a consequence of "successful" selling and volume capture of CDO's, into Bank of America's capital structure). But it really is just the nature of the beast. Volume is synonymous with size, as the two go hand in hand.

The Fed continues to believe, or at least continues to think that enough others believe, QE's are a net benefit and that volume-type inflation will eventually break through and create a real recovery at some point. I tend to believe that this continuation of rigidity and asymmetric risks are nothing more than the uninterrupted devolution of banking away from actual intermediation. QE's are no better monetary propositions than those hybrid Bernoulli CDO's. Money and credit get less and less productive, while accumulated "capital" still embeds more and more artificial risk. Does any of this volume expansion "buy" actual economic progress?

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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