Neither the Crisis Nor Its Timing Is Random

Neither the Crisis Nor Its Timing Is Random
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This isn’t random. Neither the crisis nor its timing. If it feels a lot like 2008 right now that’s because, in large part, nothing was learned from the first Global Financial Crisis (hereafter GFC1). That’s why everything that’s being done in response to the latest one (hereafter GFC2) had already been tried during the last one.

Because it all worked out so well in 2008, let’s do it all over again?

QE’s and ZIRP’s sounded fantastically new when they were introduced, but today they’re just a normal part of the landscape (that’s how effective they’ve been). Dollar swaps and commercial paper facilities. Been there. Done that. Liquidity auctions everywhere. A Primary Dealer Credit Facility. Revolutionary in GFC1, now making its reappearance for GFC2.

Only that last one begins to take a stab, and only a half-hearted thrust, at the main immediate problem. Collateral.

How fitting the stock market’s worst day since 1987 showed up right at the twelfth anniversary of Bear Stearns. It is worth yet another look at how it came to be this way, and why there would be more to the first crisis following that specific failure. The same damn lessons still to be learned the hard way.

On Friday, March 14, 2008, the ancient Wall Street broker once synonymous with the Street itself announced that it had secured 28-day funding from JP Morgan and the Federal Reserve Bank of New York (through its Discount Window). By Monday, March 17, it was owned by JP Morgan for a pittance, $2 a share with considerable further and direct assistance from FRBNY.

Subprime mortgages didn’t have much to do with it by that point.

Before the middle of June 2007, two hedge funds sponsored – not owned - by Bear Stearns had been dabbling in subprime mortgages. That’s the part everyone wants to focus on, even today the whole thing is attributed to this “toxic waste.”

No. Even the hedge funds could’ve weathered the storm, taken losses, and not inflicted any lasting systemic damage except for how and where they were funding their positions. Repo.

These two “shadow” investment vehicles were taking full advantage of modern, wholesale shadow money. They owned CDO’s (collateralized debt obligations) and pledged them into the repo market as collateral for the borrowed funds required to finance their transactions. The subprime mortgage loans pooled within them were merely the catalyst to begin questioning the whole process, not just the specific transactions that took place inside of that process.

On June 19, 2007, Merrill Lynch seized $850 million worth of CDO’s after the hedge funds rejected repeated requests to post more collateral. As the housing bubble began to collapse, questions were legitimately raised about the value of assets created during it. Especially the riskiest ones. If the funds had any sizable collateral stock in reserve, it wouldn’t have been the trigger for the biggest financial crisis since the Great Depression.

But they didn’t; nor had the repo market asked the same of anyone. At the time, you posted collateral on the basis it was accepted by the cash lender. If the lender was OK with the collateral, why have any in reserve? Thinking about what could happen tomorrow was the epitome of boring and this was an age of nothing but exciting.

The margins were that thin. Just the thought of revaluing those CDO’s left these funds exposed regardless of any credit losses they might have incurred. Who cares what those might be if you can’t stay afloat long enough to find out? And if Bear’s funds couldn’t, and they didn’t, it wasn’t a signal about subprime loans so much as confirmation the repo markets were desperately short of spare collateral.

After having been refused, Merrill moved in…and then regretted ever getting tangled up in this mess. Taking possession of the $850 million, as was its legal right, it tried to auction the CDO’s as standard repo practice. This is the whole point of taking collateral; so that if the counterparty borrowing cash from you defaults in any way on its obligations, including provisions about being undercollateralized, you can take ownership of the collateral and dispose of it as you see fit in order to get your cash back.

All your cash. This was the bedrock assumption of the repo market, the very thing that made it the central monetary pivot for an exhaustive and expansive global dollar marketplace. Repo is safe because the security of securities.

Except, Merrill could only find buyers for $100 million of the $850 it had taken. Suddenly, a cash lender was on the hook for unknown possibly large-scale losses due to a collateralized funding operation.

From that point forward, the whole system began demanding more collateral from counterparties who didn’t have it; the latter being the whole problem. That was the inelasticity.

Merrill’s dilemma demonstrated the system’s primary weakness; repo only works so long as the collateral remains fluid and liquid itself. That’s the whole point; the funding only flows when the collateral does. No cash lender is ever supposed to wonder about the security they’re taking for lending that cash. If they’re not absolutely sure they can sell it tomorrow, and on what terms, the whole thing is off.

Since repo is the real backbone and backstop, the cascade of collateral paralysis becomes an unstoppable tidal wave of effective currency inelasticity in multiple dimensions all at once.

What Bear Stearns’ sponsored hedge funds were doing Bear Stearns was also doing as a parent company. Its brokerage subsidiary was financing about $85 billion in assets, primarily MBS, and notsubprime, mind you, in overnight repo.

Just a few days after the debacle, on March 20, 2008, SEC Chairman Christopher Cox wrote to the Chairman of the Basel Committee on Banking Supervision, Dr. Nout Wellink, to inform him of the details behind Bear’s demise. The firm was sound by every major regulatory measure, having fallen within and under all proscribed banking guidelines for being well-capitalized. The SEC estimated that its holding company capital ratio was a stout 13.5% at the end of February 2008.

The very model of a modern major money dealer.

The trouble, Cox relayed, was that the repo market rejected any secured funding for Bear.

“Notwithstanding that Bear Stearns continued to have high quality collateral to provide as security for borrowings, market counterparties became less willing to enter into collateralized funding arrangements with Bear Stearns.”

The collateral was stamped high-quality by all prior standards but the repo market was no longer accepting it in that way. Even prime MBS collateral was marked down, just not to the level of subprime, meaning it was given a much larger haircut requiring Bear to post more of it just to maintain the same amount of funding.

The reason for this? MBS markets were increasingly uncertain and therefore illiquid. It didn’t matter that this was “high quality” collateral, repo cash lenders only cared what the thing might be worth tomorrow if they had to seize and sell. They just weren’t going to take any chance of getting stuck in the same situation as Merrill had been right at the outset of the crisis.

You don’t lose money lending cash on a secured, overnight basis. You just don’t.

Dealers pulled back in secured funding and then sat on the sidelines in repo and everywhere else. Bear could never have posted enough collateral because the repo market was rejecting all of the collateral it had. If only Bear had maintained a large stock of US Treasuries besides.

The firm had instead bolstered its parent company liquidity pool to $21 billion by March 6 (from $8.4 billion on January 31). But collateral calls and refused rollovers (from Fidelity and Federated) stripped that down to just $2 billion on March 13. The old boy thought its high-quality collateral had bought it a successful future, but it instead had run the company out of business.

The quality of the collateral didn’t matter, its liquidity profile did.

Like the cavalry that comes dramatically charging in far too late long after the battle is already lost, the Federal Reserve came up with the Primary Dealer Credit Facility (PDCF). It was announced March 16, 2008, the Sunday in between, and was up and ready when business opened Monday with Bear Stearns already stricken from the ranks of the living dealers.

Its purpose was straightforward: to accept lesser collateral than the repo market was at the time. FRBNY would take investment grade securities of all kinds, even MBS, at terms that wouldn’t change overnight. Had it been open, or so the theory went, Bear could’ve accessed the facility and might still be around.

But, again, the problem wasn’t subprime mortgages nor Bear; it was systemic meaning the lack of spare or meaningful collateral reserves. Which is exactly what everyone would find out just a few months later.

When Lehman, AIG, Wachovia, etc., all met their reckoning in September 2008, once more repo and the lack of collateral was at the forefront of wrecking everything. The whole time the global system was melting down collateral-first, through it all sat this PDCF. It had been open and operational during the entire panic.

Back in mid-March 2008, though, officials were very proud of their creation. They had shepherded Bear Stearns into a merger while using that as an exercise to radically alter the way in which American central banking was conducted. As Bill Dudley, Manager of the System Open Market Account declared at March 18’s FOMC meeting

Even before the Primary Dealer Credit Facility was implemented this weekend, we were inthe middle of a historic transformation in the Federal Reserve System’s balance sheet. 

Fat lot of good that “historic transformation” did for anyone except the academic historians of the central bank cult. In a paper written and presented at a 2012 Federal Reserve Conference looking back at the crisis, even those authors had admitted:

After Bear Stearns collapsed in March 2008, the Fed introduced its most radical change in monetary policy since the Great Depression by extending its lender of last resort support to the systemically important primary dealers through the new Primary Dealer Credit Facility (PDCF). However, even this extension of the lender of last resort facility did not prevent the run on Lehman Brothers, as investors realized that this support was not unconditional and unlimited.”

It is impossible to understate the importance as well as incongruence of this one passage; the Fed really stepped up with its most radical idea ever…but it didn’t matter one bit for the one firm, Lehman, let alone the whole damn system. If changing the entire way the US central bank did its crisis business couldn’t even save a single player, then what are we really saying here?

Something’s obviously missing, folks, and it’s not a small thing, either. You can’t reconcile how the central bank could be so powerful and go so big, and then come up so small without asking a lot of uncomfortable questions; starting with, what do central banks actually do?

One thing they don’t do is understand the repo market. And that can only mean they don’t understand their job. This was one key takeaway from GFC1 – that few were willing to admit. It exposed the Fed as a monetary fraud, and the system much more complex than what’s stated in every Economics textbook.

This past Monday, after yet another massive market meltdown, the Federal Reserve made its announcement.

Credit extended to primary dealers under this facility may be collateralized by a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities.

Yes, the PDCF was brought back. Nearly twelve years to the day Bear Stearns met its end, marking the same for the eurodollar system, here was another unwelcome trip down memory lane.

The reason why was the same as before: collateral, only the geniuses at the Fed don’t really know what that means. All they know is that there is something wrong, again, though they didn’t bother to figure out exactly what went wrong the first time. Even after last September’s repo rumble, or at any point over the last couple years since May 29, 2018, when the yield curve began screaming at them about all this “strong worldwide demand for safe assets.”

All officials know is that there is a collateral problem and all officials have at their fingertips is what had long ago been exposed as still another policy scam. Inspires tremendous confidence, doesn’t it?

If coming up with a PDCF during GFC1 was a huge step in Fed history, watching it fail spectacularly as we did the first time around what are we supposed to make of the PDCF making its comeback this week during GFC2?  

Jay Powell thinks you’re stupid. Or he genuinely is.

What should be undebatable is collateral. Not only can we see its effects in the yield curve, especially at the front as T-bill rates found themselves more frequently underneath zero this week, but just in the manner of these waves of global liquidations.

Time and again it happens the same way: early morning hours repo books from the prior day are being closed and collateral is being rejected, which leads to some parties trying to use gold, some herded into T-bills at any price, while the unfortunate rest are left to fire sale anything they can. Gold down, T-bills way up, and equities liquidated into the open.

Rinse. Repeat.

Once the repo books are closed, these markets may even bounce back – if they can. Gold tends to rise, bill yields go back up, and even share prices are somewhat higher into the middle of these dreadful days (which tends not to last).

Jay Powell has fired bazooka after bazooka, and nothing has worked. Illiquid markets have sprung up all over the world, the other big lesson of GFC1. Sure, these are unprecedented times but the central bank’s entire job is currency elasticity for times exactly like these – to make sure that a crisis like this doesn’t become a catastrophe.

Again, we were all warned about the global dollar shortage and systemic frailty long before there was a COVID-19. Market participants know the Fed is no backstop at all, even when it goes “big.”

That’s why just as in GFC1 the Fed and all its global counterparts have failed miserably in GFC2. Just when they were and are needed the most, they come up short in the most predictable fashion. The dollar screams upward declaring inelasticity for the whole world to see, and policymakers actually choose to replay 2008 as their response!

They are repeating the crisis playbook and unsurprisingly the results are already much the same.

It’s still a collateral problem, by and large. It may not be subprime mortgages or MBS of any kind this time around, but it doesn’t matter because the form is not the issue. It never was.

During GFC2, corporate junk is the new “toxic waste” clogging repo channels and sucking liquidity out of every possible corner. CLO’s instead of CDO’s, leveraged loan tranches instead of MBS, and most of all, I believe, Eurobond junk – corporate and sometimes governments who have issued bonds in offshore US$ markets where those bonds then get used as collateral to fund the dollar positions they raised.

Take a peek at corporate spreads lately; in many places they’re even worse than subprime spreads had been at their most monetarily destructive (gamma). As those markets for corporate junk and not-junk become increasingly illiquid, repo dealers are fleeing out of repo and every money market, moving straight to the sidelines because Merrill Lynch in June 2007 and Bear Stearns in March 2008 are never far from their memories.

Officials finally proved they have a vague notion that there’s a(nother) systemic collateral problem, therefore reinstating the PDCF. But by doing so, they’ve also proved they have no idea what they are doing after having squandered the last dozen years not coming up with any legitimate answers. Yeah, subprime mortgages. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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