Drastic Fed Moves Reveal Policy Gone Awry

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As part of its newly conceived Operation Twist update, in September 2011 the Federal Reserve decided that it would reinvest proceeds from maturing MBS holdings in its SOMA portfolio in newly created MBS. In the vernacular of the MBS market, the Open Market Desk at the New York Branch (FRBNY) would concentrate its purchases in the TBA market.

It's pretty common knowledge that mortgages take time to matriculate between the date of application and the ultimate release of funding. There is paperwork, surveys, title searches, etc., which create a lag between the first opening of a mortgage product and the actual cash. Banks call this their pipeline, and it is a dance of creative finance to manage one's pipeline with efficiency and proficiency.

Part of that process is this TBA market (too be announced), which is essentially a forward market. The rules of the marketplace are governed by SIFMA, including predetermined settlement dates and contract specifications, owing to established rules dating back to 1981 and SIFMA's predecessor, the Public Securities Association. The creation of pass-through securities in the early 1970's as a means of financing new government "responsibilities" in mortgage housing led to these kinds of rules. The intent was to facilitate trading in residential mortgage backed securities (RMBS) issued by these new government-sponsored enterprises (GSE). That way there would develop a government/private finance partnership that could enhance the goals of home ownership as it was described then.

The counterparties in the TBA market are originators and investors. Banks or wholesalers enter into a forward contract to deliver at a future date RMBS securities to investors. The actual securities are not specified in advance, only the price and the quantity. The reason for this seeming quirk is that there is no predictability in the dropout rate for the originator. No matter what the financial conditions, some people intent on borrowing from a financial concern via a mortgage will change their mind. The number of people doing so is highly variable, causing a good deal of headaches for those dulcet pipeline managers.

When the Open Market Desk of FRBNY began its "Twist" operations and reinvestments, it did so by trading these forward contracts in MBS securities with its primary dealers (and only its primary dealers). The primary dealers acted as the originator, and thus took on the pipeline risk, while the Desk acted as the "investor."

As timing would have it, one primary dealer had been added to the list earlier in 2011. MF Global had begun its quest to become a primary dealer several years before it received final clearance in January 2011. The bank had submitted its formal application the preceding January, but had been delayed well past the original contact of December 2008. In January 2009, MF Global's COO sent a formal letter requesting FRBNY consider the firm for inclusion on the primary dealer list. There were several problems with this process, even though MF Global had already begun testing its systems, participating in Treasury auctions and even submitting mock FR2004 reports.

The first hurdle was MF Global's parent company's domicile of Bermuda. Beyond that, FRBNY was informed by the Commodities Futures Trading Commission, the regulator overseeing MF Global's brokerage unit, that there were "several significant control issues." The CFTC ordered MF Global to rebuild its control systems, with the assistance of outside counsel, and then be subject to further review. FRBNY decided that it would await the CFTC review before assessing the application for inclusion as a primary dealer.

In May 2009, MF Global was informed that it would have to wait six months because of these CFTC problems. In the interim period, MF Global advised the Fed it had become the subject of a further CFTC inquiry into trading irregularities. At the same time, the Fed had begun to revise its primary dealer guidelines to institute a one-year waiting period for any institution subject to litigation or regulatory action. FRBNY deemed the latest MF Global proceedings as such and informed the bank it would impose the one-year restriction once the guidelines were finalized.

On December 17, 2009, the CFTC settled with MF Global that included a Consent Order forcing the bank to impose remedial sanctions for a clear violation of the Commodities Exchange Act. In early January 2010, the Fed finished its primary dealer guidelines and was forwarded, almost immediately, Part 1 of MF Global's formal application; followed closely by information in Part 2. That was all well and good, but FRBNY staff replied that the one-year waiting period would still be imposed dated to the CFTC Consent Order.

That unleashed a surge of legal wrangling and argument where MF Global contended that the CFTC action was not material to its primary dealer application; FRBNY of course believed the opposite. Lawyers exchanged communications, had meetings and phone calls were made between executives on both sides, but ultimately FRBNY stuck by its original assessment. MF Global even removed (he was allowed to resign) its CEO in March 2010, replacing him with former New Jersey Senator Jon Corzine.

The installation of Mr. Corzine had allowed the bank to raise additional equity as well as expand the scope of the business. The application to become a primary dealer was relevant to that expansion and was thus communicated as a very important step in MF Global's business. The formal application process had been allowed to proceed despite the one-year waiting period, likely as a "courtesy" towards MF Global's aspirations.

Finally on January 21, 2011, Richard Dzina, a senior VP at the New York Fed's Markets Group, circulated a memo that essentially cleared MF Global in terms of meeting all the FRBNY standards for inclusion as a primary dealer. Specifically, the bank had achieved activity levels in Treasury repo and cash markets that assured the staff MF Global could meet its obligations. No other department reviews at FRBNY objected to the application, and on February 2, 2011, MF Global was designated officially as a primary dealer.

That meant that when the FOMC switched from a runoff of its balance sheet after the expiration of QE2 in this new Operation Twist, MF Global would be one of the mortgage originators the Open Market Desk would conduct forward transactions with in the TBA marketplace. The timing couldn't have been more coincident, as the first transactions carried out, TBA, occurred in late September 2011, with more that followed in early October.

Specifically, the Desk had transacted seven times with MF Global, creating forward contracts for the delivery of MBS. Toward the end of October, MF Global, of course, had run into severe difficulties. On October 24, Moody's downgraded both the brokerage firm and parent company as a result of liquidity issues tied to repo-to-maturity trades in PIIGS sovereign holdings. For FRBNY, that created credit risk should MF Global fail to meet its obligations toward the TBA MBS deliveries.

Less than nine months after receiving its primary dealer designation, FRBNY excluded the bank from further transactions. Further, FRBNY demanded MF Global execute an Annex to the Master Securities Forward Transaction Agreement that required the firm to post margin with the Open Market desk. It was a highly unusual step for FRBNY to take, and it coincided with margin and collateral demands from JP Morgan operating as MF Global's triparty repo custodian. Under the annex, MF Global posted initial margin on October 28, but was made to post further margin later that same day. Finally, by 6 pm on Friday the 28th, FRBNY suspended MF Global fully as a primary dealer.

The following Monday, MF Global was again hit with a margin call by the Desk, only to rebuff the request as the firm had run out of customer assets to transfer to its London subsidiary and rehypothecate for its own account. The Fed declared an event of default, used the collected margin and executed replacement trades. As a result, FRBNY sent MF Global a bill expecting the bank to repay the Open Market Desk for the loss incurred on having to re-enter the market.

There has yet to be a full accounting on this behavior and whether it contributed to the firm's ultimate failure. In fact, despite testimony and written action reports, there is little specific information available at all. There is no doubt that JP Morgan's retaining of collateral and margin requests were of a much larger problem for MF Global, as failure to make JP Morgan happy would have resulted in complete exclusion from the repo market - a power only JP Morgan and Bank of New York Mellon hold as the two custodians and operators of triparty repo.

Of course, that represents a systemic weakness, a bottleneck in the liquidity system where the Open Market Desk itself relies on the triparty repo market to conduct monetary policy. That would give these banks elevated discourse and situation in any considerations of policy, though the Fed denies as such. In the MF Global affair, the Fed argues that it was simply safeguarding the taxpayer from loss due to stupidity (my words). Unfortunately, the trades that ruined the bank were on the books when the application for primary dealer inclusion was approved; an application that passed through FRBNY's legal, compliance and credit areas.

I suppose at this point it is worthwhile to point out that the last thing we would want the Fed to engage in is effectively approving or denying banks on the basis of how they choose to invest their funds. If Goldman Sachs and JP Morgan choose to be risky hedge funds and expand their balance sheets in the exact same manner as the SIV's that preceded the panic of 2008, that is not for the Fed to deny. This is true not only of any bank's operations as it relates to its obligations as a primary dealer, but in the Federal Reserve's regulatory responsibilities over banks in general.

In the "old days", bank supervisors, largely under state banking agencies, were allowed to use their own trained judgment and opinions (gasp!) when reviewing bank soundness. In fact, it was this kind of system which led to many closures during the run period of the Great Depression. The mathematics of modeling and market "inputs" as ultimate arbiters of solvency came later with the Basel regime and the re-orientation of banking to the asset side, away from deposits and liabilities that had always governed the system.

It is quite curious, in that light and how FRBNY acted in the MF Global case, that there was an obvious and definitive shift in QE operations at the Open Market Desk occurring the week of November 20, 2013. Prior to that week, the Fed had been engaging in very minimal purchase activity in the 10-year treasury space (which I am defining here as treasury bonds maturing in 2023 and 2024). After November 20, suddenly the Open Market Desk was using from a quarter to a third of all its POMO buying activity on bonds in just those two maturities.

Where this all gets really interesting is that there was an obvious anomaly in the swaps market on the date of November 20. The yield curve itself had been rapidly steepening between the 5-year and 10-year space up to that date, and 10-year swap spreads that had been consistently trading in the 10 to 11 bps range suddenly dropped to 3 bps on November 19; and then minus 7 bps on November 20.

After November 20, the curve shape between the 5-year and 10-year reversed - from rapidly steepening to rapidly flattening. Swap spreads resumed their previous behavior. Was there a credit market event that required Open Market Desk operations to "bail out" the 10-year treasury range?

We know how much the 10-year treasury gets reflected in mortgage rates, and the utter collapse in mortgage applications since the bond selloff and dollar tightening of May/June must have had an impact on FOMC discussions. It may have been a significant (if not the most important) factor in delaying taper past September 2013 to December. What's intriguing here, and just speculation at this point, is how this may all tie back to the TBA market. We don't have specific information on pipeline conditions and dropout rates at the major banks, but we do know that overall pipeline levels have been decimated at every major mortgage institution.

If an originator was unable to meet its obligations under a TBA agreement, it would have to supply a replacement RMBS security to the investor. If there was a sudden shift in pipeline activity across the mortgage spectrum, as there clearly has been, that might lead to more than one originator party running into delivery issues. That would further mean market pressure on dollar rolls (don't ask, essentially a separate repo-type market where investors fund the difference in maturities between forward maturity dates in TBA). We know that insurance companies, for example, use TBA dollar rolls to hedge interest rate exposure.

Ultimately what I am inferring here is that there may have been some kind of hidden repo run in the TBA market that spilled into other credit places. Normally counterparty risk is not high in TBA's, but if pipelines have been suppressed so badly in the past few months it may have led some parties to become overextended toward their ability to actually deliver securities on forward contracts. That would cause some reassessment of collateral systems and perhaps margin and collateral calls and demands.

Of course, again, this is all speculation on my part given the almost complete darkness in which these markets operate. But the truly compelling factor here, in my opinion, is the obvious shift in open market operations into the 10-year maturities. Since it occurred at exactly the same time as these other dramatic indications in credit markets it seems that there is enough circumstantial evidence to at least float a theory about it. That there is a logical consistency in putting these indications together only strengthens that theory.

The implications are more about the bigger picture than any burgeoning repo panic or run. In fact, I doubt very much there is any direct artifact of that episode left inside the system now, except that the Open Market Desk is still heavily weighting POMO to the 2023 and 2024 maturities. In terms of the big picture, I think it goes back to my earlier article about losing control of the yield curve. The credit markets, as I have tried to describe here, are exceedingly complex; utterly frustrating in that manner. The bond selloff and dollar tightening initiated largely in May may be having profound effects on the wider system, certainly in ways that central bankers will never be able to anticipate.

The point here is that paradigm shifts are never orderly, and certainly nothing close to predictable. That the Fed had to adjust its POMO program so drastically shows that, perhaps, the system is running a bit away from intentions. As the MF Global sage shows, the central bank is ultimately a creature of pseudo-certainty and precision, but it lacks the foundation for meaningful exertions of policy that are consistent with the real world. Complex systems in a state of criticality tend to do that, and it argues exactly against ultimately feeble attempts at control and manipulation. The complexity of the wider marketplace makes this kind of drama a near-certainty regardless of the carefully crafted illusion that is maintained by regulatory actions. That seems to be the final lesson of 2008; keep doing the same things, but redouble the efforts to make it look like it's all under control.


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

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