The chaotic global breakdown of March 2020 did a lot of things, including adding more unnecessary pressure to an already-reeling pandemic-shocked world. Authorities have spent the balance of the more than two years since doing two things: puzzling over Treasury market function while yet congratulating themselves for what they say was its timely “rescue.”
Such clash between Treasuries as money and baffled Fed officials was nothing new. It’s not so much laissez faire as it is intellectual laziness, the attitude that any non-fatal end can justify their lack of means. If the whole thing doesn’t completely crash, we must’ve done good!
On May 20, 1982, the FOMC pulled together all its otherwise previously-engaged membership to discuss the “Drysdale problem.” No transcript of this emergency conference call apparently survives, or at least hasn’t been made public. Instead, we can only access a staff memorandum summarizing the discussion.
Were these details too sordid, or mere laziness over record keeping? The conversation centered on, here we go, securities lending.
“As to the System's role, it was understood that the Desk would stand ready to lend securities to assist in the efficient functioning of the government securities market in accordance with the broadened terms and conditions for such lending approved by the FOMC in a vote conducted late yesterday and today.”
Drysdale Government Securities, as it turned out, was a tiny bit player, capital and performance a rounding error when standing next to the Big Guys of its day. Having equity somewhere between $5 and $30 million (depending upon sources), the “bond dealer” had amassed a short portfolio of about $4.5 billion at one point against $2.5 billion long USTs, like LTCM a generation later “somehow” plying enormous leverage.
In mid-May 1982, Drysdale was paid interest on what securities it held. Conventions at the time were much looser and less standardized, therefore interest was paid to whomever possessed the instruments, with ultimate responsibility falling on the possessor to forward accrued payments to title owners.
Who were the owners?
At first, you might have thought Chase Manhattan Bank. When the government issued $270 million in funds to Drysdale for interest on “its” relevant bonds, Drysdale management immediately notified Chase that it was keeping the cash because otherwise it was out of funds.
This, obviously, led to all kinds of panic at Chase and then further on down the line. Unnamed “market participants” told the Wall Street Journal at the time, “We’re all in uncharted waters on this one.” Another said, “No one really knows what’s going to happen.”
When Chase initially balked over making up the payments, another repo person remarked, “This thing is going to blow a hole in somebody.” Meetings were convened in NYC, DC, probably other places like London, too.
As it turned out, the bonds delivered to Drysdale from Chase weren’t Chase’s, either. On the contrary, Chase’s securities lending desk had obtained them from a catalog of thirty different dealers then operating with Chase in this opaque, totally misunderstood yet fast-growing thing called repo.
A contemporary account published by The New York Times mere days after Drysdale’s notification adequately summed the level of awareness then, and the misconceptions that have been permitted to stand to this very day.
“For banks, the use of Treasury securities as collateral to arrange loans from businesses and others with spare cash to invest has been the fastest-growing source of funds in recent years. Combining those borrowings with other overnight loans, large banks now roll over more than $100 billion of debt a day, up from less than $28 billion eight years ago.”
This repo stuff all sounds pretty straightforward enough when you put it that way, therefore the problem otherwise seemed to be that it maybe got too big and suffered from a simple lack of oversight by the presumed monetary experts. The same conclusion was, in general, reached at the FOMC conference call, where “It was also agreed that the question of whether to seek regulatory authority to deal with such problems should be studied and that at some future time…”
The Washington Post actually went straight to the heart of the matter:
“The [30] brokers say Chase is responsible for making good the $160 million [later clarified as $270 million] they are due. They say they lent the government bonds and notes to Chase, not Drysdale. Chase, they say, without their knowledge, re-lent the securities to Drysdale.” [emphasis added]
That seems an especially crucial nugget, yet, as per usual, government officials then set busily about fixing what wasn’t really the problem. They focused all their efforts on…the interest payment process.
Drysdale had improperly been paid on bonds it didn’t own, bonds the actual owners didn’t know it possessed. Rather than question much about the latter and really how widespread the practice, new regulations and directives were quickly written and issued which required better track of accruing interest payments.
Most, nearly all, really, regulatory and official focus centered on explaining the specifics of Drysdale. In July 1982, for example, the FOMC – at its regular meeting, fully transcribed – policymakers recounted this affair mainly in the context of what Drysdale’s specific mistake which had led to held up coupons, rather than the full implications of these systemic collateral practices being used for massive expansion (therefore even more massive future expansion) in repo.
They all appeared to agree that any all the fuss had been limited to bad execution of a widely-followed matched-book strategy and therefore some losses over those interest payments; basically, operating long-short in USTs to pocket spreads arising from short-run fluctuations liberally employing repos and reverse repos alike. This required the fluid, steady exchange of borrowed collateral as well as cash.
But, should something go awry or a market price moves in some unanticipated way, these highly leveraged and interconnected issues can simply implode to where not every part of it might be as adequately covered as had been thought at first by everyone involved. Simple though aggressive matched-book strategies wouldn’t lead to, “This thing is going to blow a hole in somebody.”
From a policy perspective, the Fed’s very own securities lending window had done its job. The May 1982 conference call vote had increased the Open Market Desk’s authority by tenfold, reassuring the entire repo market, officials believed, that any short-sellers out there would be able to rent Treasuries from FRBNY.
Chase would eventually agree to cover most of the lost coupon payments, after a while everyone moved on.
No one seems to have considered the re-using of collateral for more than hedge fund-like short selling, for funding entire portfolios or even firms – the real potential hole to be blown in somebody. And not just the tiny specks like Drysdale, which, though mid-level at best it still nearly caused a serious market disruption anyway, perhaps someday bigger funds like LTCM, maybe even bulge bracket types from the old-boys-club, a Bear Stearns, a Lehman, possibly a GSE or two?
In fact, the main focus of the FOMC by July 1982 remained with bank reserves, not collateral. Despite having just witnessed the possibilities of a collateral cascade from the relatively innocuous holdup of interest payments, most of those under Paul Volcker at the time believed their best course of action was to make bank reserves more available even if doing so, or even promising to do so, would mean very public abandonment of prior “tight money” policies.
From the July ’82 transcript:
“MR. MORRIS. While I sympathize with Governor Partee's general point of view, I think it would be a big mistake for us to announce that we were willing to peg interest rates again…To begin, even in a little way, to back away from that would be a serious mistake strategically.”
Frank Morris’s concern would not prevail. Officials were grappling with several problems simultaneously, with potentially devastating (in their views) consequences which the Drysdale (and Comark, which I’m not going to get into here) episode only added more to what was already a massive downturn.
Remember, July 1982 was near the depths of what would stand until 2007 as the worst economic contraction since the Great Depression. Federal Reserve members couldn’t make heads or tails from the monetary statistics, then all of a sudden chaos in the repo market regarding something or other about lost interest payments on bonds at least twice re-lent.
J. Charles Partee, an FRB Governor, spoke for the majority when he foresaw trouble:
“MR. PARTEE. Yes. Because I agree there is going to be a recovery, but my concern is much, much deeper than that. I believe the recovery may be very wishy-washy and that it may be followed by a collapse. And I think we ought to have a point at which we say: This is it for the time being and we're not going to tolerate--tolerate is too strong--but we would not expect the funds rate to trade consistently above 15 percent.”
Chairman Volcker, as usual, was unsure and so as was his habit he erred on the side of caution while urging others to do the same.
“CHAIRMAN VOLCKER. I'm not sure that the way to handle this isn't to keep the same [funds rate] range we have now, without changing its statement in the actual directive, but to include to a limited degree the discussion in the policy record, against the background that I myself would be very hesitant, unless there were overpowering reasons, to see the federal funds rate go above 15 percent. I would want to think twice, three times, four times, or whatever, before condoning that for any period of time.”
Flying (monetarily) blind, beset by heavy recession and financial irregularities on all sides (not just Drysdale), Volcker and his crew agreed to what was a nascent targeting scheme by which they pledged to keep the federal funds rate within a range specified by the Committee. They would not allow it to go about 15% (again), supplying bank reserves as necessary via open market operations.
This accidental, singular focus on solely fed funds became the entire operating dogma of the Fed from that point onward – though it would take some time before it coalesced into a more coherent framework trying to reason why this had happened without admitting the monetary truth.
From this, the “modern” Federal Reserve’s origin story was birthed. The overly simplified correlation between what the fed funds rate did and what eventually happened in the real economy: Volcker restricted reserves (first in ’79, then giving up before trying again later) and, ignoring all the bank/money/credit particulars in between, the economy fell into recession.
Twice.
Correlation has since been claimed as causation without any of those messy money details filled in to justify this conclusion.
And then, near the trough of the worst 1982 contraction, policy was changed to more “accommodative” in the sense that should the fed funds effective rate flirt with 15% (it wouldn’t, by the way), the Fed would abandon its “tight” approach and pledge unlimited reserves to keep the effective rate below that level.
Recovery followed about five months later, and the US economy did not, in fact, collapse nor was it, as Governor Partee worried, “wishy-washy.” The upturn would end up being one of the most robust periods in US history.
Was that because of this new fed funds targeting thing-y? According to later convention, sure, let’s say interest rate targeting was the reason.
The Fed and its cultish proponents have since proposed some non-specific relationship between it choosing a range then a single target for only federal funds (bank reserves) and the rest of the economy simply falling in line of those policy intentions, without anyone at the Fed knowing much or any of the increasingly global, increasingly misunderstood, increasingly evolving monetary, banking, or credit details in this increasingly complex monetary system.
Or just how important collateral had already become to all those things in between the Fed and the real economy.
It was all just laid out on…faith. Don’t take my word for it; here’s Alan Greenspan summing up this, frankly, absurd transition in its operating dogma in a 1997 speech given at Stanford University (apparently no one in the audience thought to heckle or just question him about how much this differed from what a true central bank actually must do):
“Increasingly since 1982 we have been setting the funds rate directly in response to a wide variety of factors and forecasts. We recognize that, in fixing the short-term rate, we lose much of the information on the balance of money supply and demand that changing market rates afford, but for the moment we see no alternative. In the current state of our knowledge, money demand has become too difficult to predict.”
What might the world have looked like had anyone tugged on the collateral thread tantalizingly sitting there, just hanging off the haggard Drysdale sweater begging to be followed all the way into what would later become subprime mortgage bonds as good as repo “gold?”
We’ll never know, costing us 2008. The Fed still doesn’t, therefore September 2019 before March 2020. As Greenspan said in 1997, it’s all a lie, one pegged to loose correlations that no longer even plausibly hold (why does QE have to be repeated?).
They would seem plausible only so long as collateral in real money, the eurodollar system, continued to do the actual monetary work for everyone. The supremacy of securities lending, the constant need for a steady stream of reusing, repledging, even rehypothecating just to keep us from “is going to blow a hole in somebody.”
Holes showed up this year again everywhere in global markets especially since June 14. As those were being witnessed in everything from commodities to curves, repo fails – an indirect proxy for collateral conditions including reuse rates – skyrocketed to extreme levels equal with those experienced during…March 2020.
The Volcker Myth needs to die and quick, lest the rest of the market meaning the actual monetary system be proved correct yet again. The eurodollar futures curve, for example, is now inverted in a way we haven’t seen since September 2007, a pretty keen and alarming picture of deflationary money potential.
Global money participants, those who have gone way, way beyond Drysdale’s rather simple match-booking are clearly worried about something. About real money something and not about fed funds rate targets. Maybe the actual thing about March 2020 (or September 2008) wasn’t ever fixed.
These Fed persons really only fix the federal funds rate. Since when does that have to do with anything?
