The Smallest Errors Produce the Most Carnage

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It is hard to say how much of an effect it had in the overall transactions that conspired to doom the prior financial arrangements of the last great "dollar" era, but as so often is the case in fragile, complex systems it is the smallest "errors" that produce the most carnage. Even in the events of March 2008, forgetting how Brutus told Caesar in Shakespeare's play to "beware the ides of March", the history of Thornburg Mortgage is all but forgotten except by those with a deep interest (too deep by some estimation). Bear Stearns remains with all the attention, but Thornburg might have been the real spark.

The problem for us now is not so much that it lit the fuse toward eventual, and likely inevitable, panic, but as to how that was ultimately unwound and re-secured. For its part, Thornburg was unique in a period replete with specialist financial firms doing all sorts of unusual things with unusual arrangements. Contrary to what might be conventional wisdom about the affairs of that age, the company had absolutely nothing to do with subprime mortgages and toxic assets.

Thornburg was certainly within the mortgage space, but its focus was on high-end borrowers and property with all the best credentials and vitals. Because these were mostly if not all jumbo non-conforming, there were better (a very relative observation) premiums to pocket in heading up a space uncovered by the giant reach of the GSE's.

Based in Santa Fe, the lender wasn't really a lender or even a bank; it was a REIT. It was further a special case of one, a mortgage REIT, which had nothing to do with building, owning and running properties. Instead, it would situation itself somewhere in the stream of mortgage finance and pocket pure spreads. Since these were often narrow by result of competition (and how the housing bubble had turned everyone toward "yield enhancing" practices) the basic business model here did not suggest high leverage, it required it for survival.

Fortunately, or unfortunately depending on how you view the ultimate outcome, the repo market had been developing steadily for decades as the traditional ideas about banking fell away just as the traditional idea of the dollar had. Funding no longer was tied exclusively to money, currency nor even deposits themselves. Operating as a wholesale franchise, Thornburg's proficiency depended so much upon its Rolodex - a network of correspondent banks that supplied exactly the kinds of high-end loans the firm made its reputation on. On the other side, the firm utterly depended on close relationships with banks offering lines of credit and most especially bespoke repo arrangements (specifically reverse repo from Thornburg's perspective). From those two sides, assets and liabilities, the company would perform securitization functions upon various pools and obtain that profit spread from the wholesale process.

The problem of just such a funding model becomes obvious in the context of repo difficulties that intensified after August 2007. No matter that there were no subprime loans anywhere near the mortgage pools they operated, the whole of MBS repo collateral was being redefined under more realistic (and less rate repressive idealism) terms, meaning that haircuts (effectively margin calls) were being cascaded upon them simply by "market" mechanisms finally awakening from recency bias. With spreads so slim and leverage so immense, the firm had not margin to meet the margins.

Not for lack of trying, however, as they did survive all the way into 2008 when so many SIV's, hedge funds and truly subprime vehicles were already unwound. Thornburg renegotiated lending constraints and tried to raise equity capital, which may have only marked the firm for further problems as doing so painted an obvious target upon their stock and financial standing (if you wanted to know who was in deep liquidity trouble back then, only look to who was hurriedly filing shelf registrations).

But it wasn't just these manic funding actions undertaken, as management believing in its own righteousness took to the dark side. As is so often the case in finance, good trades are no security against insolvency. So when Thornburg's management studied their own products and pools and saw nothing but "cash good" assets without much potential for losses, they rejected market determinations and took their own course.

According to SEC charges from March 2012, three executives at the firm allegedly "schemed to fraudulently overstate the company's income by $400 million and falsely report a profit rather than an actual loss for the fourth quarter in its 2007 annual report." The annual report was due to be filed on February 28, 2008, and there were already severe liquidity strains of haircuts and margin calls. The SEC quotes three emails in its fraud charges, the first from February 25 in which the CEO tells other C-suite executives that they have not even informed their auditors about the margin calls. Instead, as noted in an earlier email, "we don't want to disclose our current circumstances until it is resolved."

The intent was, as the SEC notes in that third email, "to keep the current situation quiet while we deal with it." The company filed what the SEC maintains was a fraudulent account of its condition, but that still wasn't enough as further liquidity problems forced another filing on March 5, 2008. The 8-K, a notice of a "material event", disclosed that JP Morgan had declared a default event and was taking control of $320 million in collateral under its amended Master Repurchase Agreement (JP Morgan is at the center of all these major events as the main tri-party repo dealer).

That move triggered downstream defaults under other reverse-repo arrangements and secured lending lines (rehypothecation). As what would become standard operating deficiency in the 2008 crisis, the company was not so much out of cash or currency but collateral in which to balance its book of assets vs. liabilities. The 21st century bank run had claimed its first major American victim.

While it wasn't a bank, it was a bank in the wholesale view of finance and its rather sordid final days had an immediate impact. Again, since Thornburg wasn't anywhere near the subprime business and failed on liquidity problems anyway, it became open season on similar situations of all sizes as realizations dawned that "irregularities" were nowhere near contained but rather endemic and systemic. The next (or rather parallel) target was Carlyle, followed closely by Bear Stearns.

In the emergency conference call of March 10, 2008, the FOMC members noted the widespread distress all over the world. Bear Stearns wasn't much discussed even though it would fail only days later. All that was mentioned about Bear was an offhand comment by FRBNY President Bill Dudley that, "there were rumors today that Bear Stearns was having funding difficulties"; an understatement of perhaps all-time stature.

That sentiment was apparently lost upon the FOMC, as only eight days later Bill Dudley dryly (as far as I can tell from the context) noted,

"The fact that to the extent that there is stigma, they are not going to want to come, and that is going to reinforce the deleveraging process that is clearly under way, as is the fact that they just saw Bear Stearns go from a troubled but viable firm to a nonviable firm in three days. The lesson from that for a lot of firms is going to be, oh, I need more liquidity, I need to be less leveraged, and that lesson, from what happened to Bear Stearns, isn't going to go away."

Indeed it wasn't. Unfortunately, the tangled mess of repo and wholesale funding under bankruptcy only made uncertainty worse, especially as it gave "undue" power to those at the center of the liquidity universe, most especially JP Morgan. Thornburg lingered on until May 2008 when it finally declared bankruptcy, but its estate saw fit to file a $2.2 billion lawsuit against Citigroup, RBS, Credit Suisse, UBS and, of course, JP Morgan, charging that the banks ran a "collusive scheme" on their margin calls. A judge in September 2014 dismissed 22 of the 31 counts in the suit, but several of the defendants have since settled to various amounts.

But at the time of March 2008, such was the high degree of uncertainty about not just "markets" but all counterparties to these markets, as knowable conditions to engaging in otherwise normal trades were broken along all fronts. It wasn't just that JP Morgan didn't trust Thornburg's collateral even though there was nothing even remotely subprime about any of it, Thornburg didn't trust even JP Morgan or anyone else's motives (which is why, from what I can gather, they engaged in the alleged fraud and cover up). In no uncertain terms, honest trade had been obliterated.

Under such conditions, you can understand (only a little) the situation that policymakers found of themselves (with any sympathy rapidly evaporating when factoring how wholesale funding got so out of alignment in the first place). The March 10, 2008, conference call was ostensibly about taking the "next" step in crisis management. The initial moves, the rate cuts of late 2007 and then TAF, had done so very little to stem the growing end of honest trading.

The ECB and Swiss National Bank wanted to reopen "dollar" auctions at about double the volume as prior. In addition, the FRBNY wanted to expand the collateral pool surrounding its new "window" of the TSLF, capped up to a then-huge sounding $200 billion. In outward appearance to the uninitiated, it all looked like a major step in the right direction, especially given the collateral-focus of illiquidity as represented by Thornburg and Carlyle which were well-known by that point. However, even with consistency among targets, even Charles Plosser pointed out, "I am not terribly confident that this will have the effect we desire. I thought I heard Governor Kohn saying that the ECB actually does take this sort of risk and collateral and it's not working particularly well."

Indeed, at that moment the FOMC was totally unaware of the full implications of what was taking place, though they moused around the contours of it almost incessantly. As Governor Kohn said earlier on March 10,

"One emerging market economist- this is in my CGFS, my global financial system group-reported that locally owned banks in his market were refusing to advance funds through their New York affiliates and their London affiliates to U.S. and European banks. I think I will pause there for the irony to sink in for a second. Those economies that had multinational banks operating in them said that the multinational banks with headquarters in Europe or the United States were definitely selling assets in emerging market economies, not only their portfolios in order to raise funds and hoard liquidity but also subsidiaries were being shopped around in order to conserve their capital."

It was total "dollar" failure of a global scale, and the most the FOMC was willing to offer was a semi-monthly $15 billion swap to the ECB and monthly $6 billion to Switzerland? (for frame of reference, by the end of November 2008, FRBNY was engaged in almost $600 billion in swap lines with foreign central banks). I suppose that is expected under the still-reigning theory of the "global savings glut" that works hard to ignore the true eurodollar standard as it developed throughout the late 1990's and 2000's. By its very nature, the Fed is a cautious and conservative institution in at least its operative functions. While its offerings that day seven years ago were totally underwhelming, it represented an actual break with all prior arrangements and internal thoughts about how far it might go.

One such step was tied to collateral and credit risk under the new and expanded schedule. With AAA-rated private-label MBS now acceptable at the new TSLF, the FOMC debated the legal language to in essence decide, if it should so desire, to send a bank into illiquid insolvency. The committee even openly debated whether or not they had the "capacity", in President Fisher's words, to exclude Bear Stearns from the TSLF.

Bill Dudley answered in the affirmative, going so far as to emphasize to the rest of the committee that such power was not going be disclosed, ever:

"Well, the first thing is that almost all of these primary dealers have the SEC as their primary consolidated supervisor. So it is important to understand that it is not as though there isn't an entity looking at the financial strength and stability of these institutions. We have the right not to accept collateral from any of the primary dealers, should we decide to do that. It is not going to be public. We are not going to be making a statement. This is just going to be a bilateral arrangement between us and the given primary dealer."

As we would soon find out only five months later, the FOMC would exercise this exact "discretion" to exclude Lehman Brothers and leave that firm to the mercy of JP Morgan's collateral haircuts and heightened claims. The implications of this power establishes far more than singular non-market determinations about financial regularity in specific firms, it sets about the precedence to make decisions about market prices and even markets themselves.

Richmond Fed President Jeffrey Lacker explained this quite well, though it would fall unanswered even to the present day (which is the problem, as I'll get to):

"I have yet to see a plausible case for market failure that would warrant such intervention by a central bank here. In this case, I don't think the concerns raised by the New York staff memo really come close, and it strikes me that they could equally well rationalize buying tech stocks in late 2000. More broadly, our efforts to ameliorate credit market conditions appear to be motivated by the notion that exogenous malfunctions internal to credit markets endanger the real economy. But it seems much more plausible to me now that the credit market phenomena we have been seeing over the past year are driven entirely by the evolution of expectations regarding the fundamental real return on mortgages and other primitives."

In other words, It may not be so certain who gets to decide what prices are "true" or "real" and which are to be discarded by subjectively, and often politically, determined exigent circumstances. Can the Fed simply vote that it doesn't like the price of a stock or an entire class of fixed income "products" and thus act as if it has the only form of true knowledge? This opens the debate as to what market prices are and are for. If there is only to be "allowed" "normal" function, what happens when that mission becomes unto itself?

You can honestly see the great possibility where failure of policy is the very engine whereby the rough outline of just mission creep becomes the actual mission instead. In the specific case of March 2008, as Plosser expected in parallel to the ECB's inability to stem the tide, the failure of the swap lines and the TSLF simply became the excuse for the next level of abiding intervention - markets were increasingly supplanted all in the name of "normal" functioning as determined by the very same people whose primary problem was that they could not for the life of them actually describe normality in anything resembling current terms. In that case, they were not actually solving problems so much as blindly attempting to end obvious disarray through any and all means.

The relevance of this problem is that it remains totally unanswered even in 2015. In a bit of overlooked prescience, again of March 10, 2008, Governor Kevin Warsh rationalized:

"I am trying to figure out what our objective function is here, and I think it is principally to help provide liquidity for high-quality assets held by a class of highly leveraged financial institutions so that we can do three things: buy time to facilitate price discovery, improve market functioning, and improve the efficacy of open market operations. We are not trying to establish asset values. We're not trying to buy assets. Those aren't our goals, and it strikes me that they shouldn't be."

It may have not been the explicit and direct intent to influence or establish market prices or even to "buy" assets at that very moment, but the philosophical grounding of doing so was established then and there. Indeed, before that very same calendar year had ended, the very same FOMC gathered to approve, as they did, exactly that "buying of assets" and "establishing asset values" in the name of QE. Once through the looking glass, the Federal Reserve has never come back, and that philosophy dominates the current economic landscape.

If the financial system is one captured of tremendous imbalance, rendered operable for so many years by belief in the infallibility of policy and the math that sustains it, then the natural course of counteracting that imbalance is not "improper" no matter what it may do to short-term and normal function. As Lacker explained without enough apparent forcefulness, who is the FOMC to decide that the breakdown in March 2008 wasn't a necessary breach against the longer-term financial tide that had been devolving banking for decades? By virtue of nothing but government approval, the Fed undertook a total rewriting of capitalism. It wasn't really all at once, as what they did at that last step then was codify what had been creeping gradually all during what they still term the Great "Moderation" - markets weren't approved unless they served the political purpose of engineering nothing but GDP.

Using that perspective, the path that was opened by the alteration of policy limitations was not so much to seek a path back to normalcy but in the larger and more important sense to define bubble imbalances as normal. If the Fed sanctions great financial imbalance as a condition of its political view of how the world should work, then all things engaged to that end are thus deemed proper including the total overriding of all market determinations. Indeed, we know that without question by the Fed itself and its actions under QE and ZIRP; to re-establish and rebuild the economy as it was in 2005 as if that were anything like a good idea. What was established was the totalitarian-like framework where the FOMC deemed itself infallible and not subject to any falsification of any kind; a precarious self-appointment given that asset "markets" continually want to crash or revert to a less-chaotic or imbalanced state.

The enduring problem of this "recovery", as it is still somehow debatable pushing on toward the sixth anniversary of the end of the Great Recession, is how wages have never recovered. The Establishment Survey suggests an economy that doesn't exist anywhere else, a fact of divergence that is actually being recognized more widely under the terms of the "rising dollar" (unapproved "tightening" again as in the pre-crisis state), the related collapse in oil prices, and the highly bearish yield curve. The simplified count of payrolls (which is not what the Establishment Survey actually measures, as it only defines stochastic variability surrounding a presupposed benchmark advance or trend) purportedly is expanding at a pace not seen since the late 1990's.

This is highly unusual to say the least:

"If Federal Reserve policymakers were to look solely at headline labor market indicators, they might be tempted to conclude that the U.S. economy had finally reached cruising altitude. The unemployment rate has fallen from a peak of 10 percent in 2009 to 5.5 percent, within the range considered to be full employment. Nonfarm payroll growth has averaged 275,000 a month over the last year, a pace last seen in the roaring '90s.

"Yet nothing else has that '90s feel: not the pace of economic growth, not capital investment, not productivity growth, not even Nasdaq 5000. The juxtaposition of solid job growth and tepid economic growth describes what the current expansion lacks: dynamism and innovation. These are the forces that drive productivity growth, allowing companies to produce more with less and provide a higher real wage to workers."

It's not just wages, either. Even the BLS's broader labor utilization measures show an economy that has shrunk in absolute terms since the late 1990's. In terms of "total hours worked", an estimate of total labor output, the current level is not only slightly below the prior peak (Q2 2007) it remains below even the cyclical peak before that (Q2 2000). This all despite the fact that the population of the total potential labor force in the US has grown by 37.4 million, or 18%! In other words, total aggregate labor output is slightly less now than fifteen years ago even though the potential in just labor population expanded by almost a fifth. Productivity problems are only an expression of larger disarray in true economic function. In any basic sense of a true economy, properly defined not by GDP or the "dollar" value of goods and services but by labor specialization, the US economy in 2015 is significantly smaller than it was at the turn of the century.

To economists it is just coincidence that the same period of this labor and wage issue happens to be the same as obvious financial dislocations. We are supposed to believe that great long-term erosion in the true economy has nothing to do with the fact that the stock market has crashed twice now (and is looking frothy once again) and housing once, all on orders of magnitude matched only by the early 1930's. In one sense, as I described above, that may actually be true, as imbalance itself isn't the direct cause but the symptom. The overriding feature of this century, and the last part of the 20th century, is the mission creep of financial "management" and central planning.

The March 2008 episode demonstrates well the flaw in such powerful attainment. How can we expect the economy to produce efficiently for long-term success when it is dominated more and more by bureaucratic inanities that don't even come close to comprehending that which they dominate? They so inefficiently manage the close nature of even their own operations to the point that it can so damagingly fail, yet the economy is supposed to, on its own, do what it had always done prior. The very act of injecting centralized monetary policy to socialize economic function has the effect of undoing market efficiency in the first place; therefore markets are no longer "markets", properly defined and properly serving resource allocation functions.

It might be too much to ask at this juncture for orthodox acceptance of some causation in that artificial chaos, totally opposite the beneficial chaos that true capitalism produces in the form of dynamic achievement, as I would accept instead just admission of the correlations. The two biggest problems of the current age are asset bubbles and labor problems, so it really should not be so hard to accept their relation especially since the intent of keeping the bubbles is a matter of badly constructed, operated and delivered monetary theory.


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

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