BUSINESS | NOVEMBER 24, 2008

Anatomy of the Morgan Stanley Panic

Trading Records Tell Tale of How Rivals’ Bearish Bets Pounded Stock in September

By SUSAN PULLIAM, LIZ RAPPAPORT, AARON LUCCHETTI, JENNY STRASBURG and TOM MCGINTY

Two days after Lehman Brothers Holdings Inc. sought bankruptcy protection, an explosive rumor spread that another big Wall Street firm, Morgan Stanley, was on the brink of failure. The chatter on trading desks that Sept. 17 was that Deutsche Bank AG had yanked a $25 billion credit line to the firm.

John Mack

That wasn’t true, but it helped trigger a cascade of bearish bets against Morgan Stanley. Chief Executive Officer John Mack complained bitterly that profit-hungry traders were sowing panic. Yet he lacked a critical piece of information: Who exactly was behind those damaging trades?

Trading records reviewed by The Wall Street Journal now provide a partial answer. It turns out that some of the biggest names on Wall Street — Merrill Lynch & Co., Citigroup Inc., Deutsche Bank and UBS AG — were placing large bets against Morgan Stanley, the records indicate. They did so using complicated financial instruments called credit-default swaps, a form of insurance against losses on loans and bonds.

A close examination by the Journal of that trading also reveals that the swaps played a critical role in magnifying bearish sentiment about Morgan Stanley, in turn prompting traders to bet against the firm’s stock by selling it short. The interplay between swaps trading and short selling accelerated the firm’s downward spiral.

This account was pieced together from the trading documents and more than six dozen interviews with Wall Street executives, traders, brokers, hedge-fund managers, regulators and investigators.

For years, sales of credit-default swaps were a profit gold mine for Wall Street. But ironically, during those tumultuous few days in mid-September, the swaps market turned on Morgan Stanley like a financial Frankenstein. The market became a highly visible barometer of the Panic of 2008, fueling the crisis that ultimately prompted the government to intervene.

Other firms also were trading Morgan Stanley swaps on Sept. 17: Royal Bank of Canada, Swiss Re, and hedge funds including King Street Capital Management LLC and Owl Creek Asset Management LP.

Pressure also mounted on another front. There was a surge in "short sales" — bets against the price of Morgan Stanley’s stock — by large hedge funds including Third Point LLC. By day’s end, Morgan Stanley’s shares were down 24%, fanning fears among regulators that predatory investors were targeting investment banks.

That pattern of trading, which previously had battered securities firms Bear Stearns Cos. and Lehman, now is dogging Citigroup, whose stock fell 60% last week to a 16-year low.

Andrew Cuomo

Investigators are attempting to unravel what produced the market mayhem in mid-September, and whether Morgan Stanley swaps or shares were traded improperly. New York Attorney General Andrew Cuomo, the U.S. Attorney’s office in Manhattan and the Securities and Exchange Commission are looking into whether traders manipulated markets by intentionally disseminating false rumors in order to profit on their bets. The investigations also are examining whether traders bought swaps at high prices to spark fear about Morgan Stanley’s stability in order to profit on other trading positions, and whether trading involved bogus price quotes and sham trades, people familiar with the probes say.

No evidence has emerged publicly that any firm trading in Morgan Stanley stock or credit-default swaps did anything wrong. Most of the firms say they purchased the credit-default swaps simply to protect themselves against potential losses on various types of business they were doing with Morgan Stanley. Some say their swap wagers were small, relative to all such trading that was done that day.

Proving that prices of any security have been manipulated is extraordinarily difficult. The swaps market is opaque: Trading is done by phone and email between dealers, without public price quotes.

Erik Sirri

Erik Sirri, the SEC’s director of trading and markets, contends that the swaps market is vulnerable to manipulation. "Very small trades in a relatively thin market can be used to … suggest that a credit is viewed by the market as weak," he said in congressional testimony last month. He said the SEC was concerned that swaps trading was triggering bearish bets against stocks.

Morgan Stanley had entered September in pretty good shape. It made money during its first two fiscal quarters, which ended May 31. It didn’t have as much exposure to bad residential-mortgage assets as Lehman did, although it was exposed to commercial-real-estate and leveraged-loan markets. Mr. Mack knew that third-quarter earnings were going to be stronger than expected.

On Sept. 14, as Lehman was preparing to file for bankruptcy protection, Mr. Mack told employees in an internal memo that Morgan Stanley was "uniquely positioned to succeed in this challenging environment." The following day, the firm picked up some new hedge-fund clients who had fled Lehman.

But rumors were flying as traders worried which Wall Street firm could fall next. The chatter among hedge funds was that Morgan Stanley had $200 billion at risk as a trading partner with American International Group Inc., the big insurer on the brink of a bankruptcy filing, according to traders. That wasn’t true. Morgan reported in an SEC filing that its exposure to AIG was "immaterial."

Some brokers at rival J.P. Morgan Chase & Co. were suggesting to Morgan Stanley clients it was risky to keep accounts at that firm, people familiar with the matter say. Mr. Mack complained to J.P. Morgan Chief Executive James Dimon, who put an end to the talk, these people say. Deutsche Bank, UBS and Credit Suisse also marketed to Morgan Stanley’s hedge-fund clients, people familiar with the pitches say.

On Sept. 16, Morgan Stanley’s stock fell sharply during the day, although it rebounded late. Some hedge funds yanked assets from the firm, worried that Morgan might follow Lehman into bankruptcy court, potentially tying up client assets. In an effort to quell concerns, Morgan Stanley released its earnings that afternoon at 4:10 p.m., one day early.

Colm Kelleher

"It’s very important to get some sanity back into the market," said Colm Kelleher, Morgan’s chief financial officer, in a conference call with investors. "Things are frankly getting out of hand, and ridiculous rumors are being repeated."

UBS analyst Glenn Schorr asked Mr. Kelleher about the soaring cost of buying insurance in the swaps market against a Morgan Stanley debt default. Protection for $10 million of Morgan Stanley debt had risen to $727,900 a year, from $221,000 on September 10, according to CMA DataVision, a pricing service.

"Certain people are focusing on CDS as an excuse to look at the equity," Mr. Kelleher responded, implying that traders betting on swaps were also shorting Morgan Stanley shares, betting that the stock price would fall.

It’s impossible to know for sure what was motivating buyers of Morgan Stanley credit-default swaps. The swap buyers stood to receive payments if Morgan Stanley defaulted on bonds and loans. Some buyers, no doubt, owned the firm’s debt and were simply trying to protect themselves against defaults.

But swaps were also a good way to speculate for traders who didn’t own the debt. Swap values rise on the fear of default. So traders who believed that fears about Morgan Stanley were likely to intensify could use swaps to try to turn a fast profit.

Amid the uncertainty that Sept. 16, Millennium Partners LP, a hedge fund with $13.5 billion in assets, asked to pull out $800 million of the more than $1 billion of assets it kept at Morgan Stanley, according to people familiar with the withdrawals. Separately, Millennium had also shorted Morgan Stanley’s stock, part of a series of bearish bets on financial firms, said one of these people. In addition, the hedge fund bought "puts," which gave it the right to sell Morgan shares at a set price in the future.

"Listen, we have to protect our assets," Israel Englander, Millennium’s head, told a Morgan Stanley executive, according to one person familiar with the conversation. "This is not a personal thing."

Those bearish bets, small compared to Millennium’s overall size, rose in value as Morgan Stanley shares fell.

That same day, Sept. 16, Third Point LLC, a $5 billion hedge-fund firm run by Daniel Loeb, began to move $500 million in assets out of Morgan Stanley. The following day, Sept. 17, Third Point, after seeing the surge in swaps prices, made a substantial bearish bet, selling short about 100,000 Morgan Stanley shares, trading records indicate. Third Point quickly closed out that position for a profit of less than $10 million, says one person familiar with the trading.

Around the same time, hedge fund Owl Creek began asking to withdraw its assets, and ultimately took out more than $1 billion.

On the morning of Sept. 17, David "Tiger" Williams, head of Williams Trading LLC, which offers trading services to hedge funds, heard from one of his traders that a fund had moved an $800 million trading account from Morgan Stanley to a rival. His trader, who was on the phone with the fund manager who moved the money, asked why. Morgan Stanley was going bankrupt, his client responded.

Pressed for details, the fund manager repeated the rumor about Deutsche Bank yanking a $25 billion credit line. Mr. Williams hit the phones. His market sources told him they thought the rumor false.

But damage already was being done. By 7:10 that morning, a Deutsche Bank trader was quoting a price of $750,000 to buy protection on $10 million of Morgan Stanley debt. At 10 a.m., Citigroup and other dealers were quoting prices of $890,000.

As the rumor about Deutsche spread, Morgan shares fell sharply, from about $26 at 10 a.m. to near $16 at 11:30 a.m.

Before noon, swaps dealers began quoting the cost of insurance on Morgan in "points upfront" — Wall Street lingo for transactions where buyers must pay at least $1 million upfront, plus an annual premium, to insure $10 million of debt. In Morgan Stanley’s case, some dealers were demanding more than $2 million upfront.

During the day, Merrill bought swaps covering $106.2 million in Morgan Stanley debt, according to the trading documents. King Street bought swaps covering $79.3 million; Deutsche Bank, $50.6 million; Swiss Re, $40 million; Owl Creek, $35.5 million; UBS and Citigroup, $35 million each; Royal Bank of Canada, $33 million; and ACM Global Credit, an investment fund operated by AllianceBernstein Holding, $28 million, according to the documents.

The following day, Sept. 18, some of those same names were back in the market. Merrill bought protection on another $43 million of Morgan Stanley debt; Royal Bank of Canada, $36 million; King Street, $30.7 million; and Citigroup, $20.7 million, the trading records indicate.

None of the firms will comment on how much they paid for the swaps, or whether they profited on the trades.

"The protection we bought was a simple hedge, not based on any negative view of Morgan Stanley," says John Meyers, a spokesman for AllianceBernstein. A Royal Bank of Canada spokesman says the bank bought the swaps to manage its Morgan Stanley "credit risk," and was not "betting against Morgan Stanley and conducted no bearish trades on its stock."

King Street, a $16.5 billion hedge fund, bought the swaps to hedge its exposure to Morgan Stanley, which included bond holdings, according to a person familiar with the fund. The fund didn’t hold a short position in the stock, this person says.

Spokespeople for Deutsche Bank and Citigroup say their trading was relatively small and meant to protect against losses on other investments with Morgan, and to handle client orders. An Owl Creek spokesman says it bought the swaps "to insure collateral we had at Morgan Stanley at the time," and that it continues to do business with the firm.

Merrill, UBS and Swiss Re declined to comment on the trading.

As Morgan Stanley’s stock tumbled, the number of shares sold short by bearish investors soared to 39 million on Sept. 17, nine times the daily average this year, adding to the 31 million shares shorted in the prior two days, according to trading records.

Mr. Mack sent a memo to employees on Sept. 17. "I know all of you are watching our stock price today, and so am I.… We’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down."

The stock and swaps trading were feeding on each other. That afternoon, Mr. Schorr, the UBS analyst, wrote: "Stop the insanity — we need a time out." In an interview that day, he said "the negative feedback loop of stocks and CDS making each other crazy shouldn’t be able to destroy the value of companies."

Scrambling to stop the crisis of confidence, Mr. Mack phoned Paul Calello, investment-banking chief at Credit Suisse, and asked whether he knew what was driving the cost of the swaps up so quickly, say people familiar with the call. Mr. Calello said he didn’t.

Morgan Stanley’s chief legal officer, Gary Lynch, once the SEC’s enforcement chief, called New York Stock Exchange regulatory head Richard Ketchum. He said he was suspicious about manipulation of Morgan Stanley securities, and asked whether the NYSE would support a temporary ban on short selling, according to people familiar with the call.

Mr. Mack called SEC Chairman Christopher Cox, Treasury Secretary Henry Paulson and others. Trading in Morgan Stanley securities, he groused, was irrational and "outrageous," and "there’s nothing to warrant this kind of reaction," says a person familiar with the calls. The steps already taken by the SEC to prevent certain types of abusive short selling, he argued, didn’t go far enough.

In his memo to employees that day, Mr. Mack had made it clear that he intended to press regulators to rein in short sellers. When word about that got out, hedge-fund managers were up in arms. Some yanked business from Morgan Stanley, moving it to rivals including Credit Suisse, Deutsche Bank and J.P. Morgan. They said the trading represented legitimate protection and speculation.

James Chanos

Hedge-fund veteran Julian Robertson Jr. and James Chanos, a well-known short seller, both longtime Morgan Stanley clients, were both angry. Mr. Chanos says he "hit the roof" when he heard about Mr. Mack’s memo.

After the stock market closed that day, Mr. Chanos decided that his hedge fund, Kynikos Associates, would pull more than $1 billion of its money from a Morgan Stanley account.

"It’s one thing to complain, but another to put out a memo blaming your clients," says Mr. Chanos, who adds that the development all but ended a more-than-20-year relationship with Morgan Stanley. He says his fund hadn’t bought any Morgan Stanley swaps or sold short its stock.

Other Wall Street executives, concerned about their stocks, were also calling regulators. At about 8:15 that night, the SEC said it would require more disclosure of short selling. Late the following day, Sept. 18, the SEC moved to temporarily ban short selling in financial stocks.

Mr. Mack contacted hedge-fund clients to tell them he hadn’t single-handedly brought on the ban, and that he was primarily interested in giving the market a temporary "time out" from the volatile mix of rumors and trading.

But within days, more than three-quarters of Morgan Stanley’s roughly 1,100 hedge-fund clients had put in requests to pull some or all of their assets from the firm, according to a person familiar with the operation. Even though most kept some money at the firm, Morgan Stanley couldn’t process all the withdrawal requests at once, adding to market fear.

Morgan Stanley was in a precarious position. During the Sept. 17 trading frenzy, Mr. Mack had begun merger talks with Wachovia Corp. Four days later, Morgan Stanley shifted course, becoming a bank-holding company and gaining wider access to government funds. Last month, after raising $9 billion from a Japanese bank, it received a $10 billion capital injection from the federal government.

Morgan Stanley must now revise its business strategy to contend with a more risk-averse environment and the more stringent government oversight that comes with being a bank-holding company. Earlier this month, it announced it would fire about 2,300, or 5%, of its employees.

The cost of insuring its debt has come back down from its peak, but its stock remains in the doldrums. On Friday, it was trading at $10.05 a share in 4 p.m. composite trading on the New York Stock Exchange — less than half of the $21.75 close on Sept. 17.

A month after the mayhem, Mr. Mack said in an interview that he had all but given up trying to get to the bottom of what was driving the trading in his firm’s securities during those chaotic days in mid-September. "It’s difficult to say what’s rumor and what’s fact," he said.

Write to Susan Pulliam at susan.pulliam@wsj.com, Liz Rappaport at liz.rappaport@wsj.com, Aaron Lucchetti at aaron.lucchetti@wsj.com and Jenny Strasburg at jenny.strasburg@wsj.com

FT.com on house prices.

FT: Is America’s house price crash at last bottoming out ?
(Link: http://www.ft.com/cms/s/0/91dd4430-7ea0-11dd-b1af-000077b07658.html)

For Leon Belenky, the low came at the beginning of summer. "Everybody was sitting on the sidelines," says the Florida real estate broker. "They were waiting to see what was going to happen and no one was buying."

But Mr Belenky, a former software consultant who moved from New York in the mid-1990s to deal in beachfront condominiums and other high-end homes, says he recently detected an improvement. That came even before the cautious optimism generated by the government takeover at the weekend of Fannie Mae and Freddie Mac, the two mortgage giants.

He says American buyers seem ready to move back into the market, whereas previously interest was confined to foreigners trying to take advantage of the weak dollar. At Jade Beach, a luxury high-rise development just north of Miami, clients are following through on commitments to buy several units. Mr Belenky had been nervous they might back out. "Although we are still seeing some turbulence on Wall Street, I think the worst is already behind us," he says.

Property professionals are famously optimistic. But there are very tentative signs that the US housing slump could be in the first stages of moderating, after battering the global banking industry and dragging the US economy to its knees. The pace of decline is no longer growing worse and may indeed be decelerating.

Across the global financial system, the search for a floor in US housing is being followed closely. Even if prices continued to decline for a while at a declining pace, reduced uncertainty as to where they would end up stabilising would allow banks to put a firmer price tag on their losses and start generating credit again. In turn, that could help bolster other troubled housing markets, notably in the UK.

Across metropolitan America, the drop in house prices has eased from a monthly rate of 2.2 per cent six months ago to 0.5 per cent in June, according to the latest Standard & Poor’s Case-Shiller index. Over the same period in Miami, Mr Belenky’s market, the pace of house price declines slowed from 4.5 per cent to 1.7 per cent.

Meanwhile, the volume of new and existing home sales has stabilised – at a low level – across the US, after dropping considerably in the first half-year or so of the credit crisis. According to the most optimistic predictions, these trends could be mutually reinforcing this autumn, paving the way for a recovery early next year. But there are a lot of time- lags in the housebuying process. Some analysts fear that the problems at Fannie and Freddie between June and August – which pushed up mortgage rates over that period – will soon show up in weaker home sales.

That is not the only problem, as Gerard Cassidy, analyst at RBC Capital Markets, points out. "The expected stabilisation in the mortgage markets resulting from the US government’s action will help bring down mortgage rates," he says. "But they do not solve the problem of rising foreclosures and falling house prices."

Still, the government rescue of the twin mortgage funders should guarantee the supply of affordable home loans in the coming months. That could ensure that any weak patch in sales is relatively short-lived, locking in one necessary condition for any recovery: stable turnover.

If sales remain at present levels – a big "if" – inventories of unsold new homes could decline rapidly in the final months of this year and early next year, as the effect of past drops in home starts finally feeds through to home completions. That would still leave a large inventory of existing homes available for sale.

Frank Blake, chief executive of Home Depot, the second largest US retailer, was nonetheless seeing light at the end of the tunnel even before the Fannie-Freddie move. "We don’t think we’re at the bottom yet – but we think you can see it from here," he says. Investors also seem keener than before to wager on a recovery. Shares in Regions Financial, Alabama’s biggest bank, rose more than 15 per cent last week after it took over the branches of Georgia-based Integrity, which collapsed at the end of August because of the mortgage crisis and was seized by regulators.

But for all the glimmers of hope, a rapid turnround in America’s housing market looks unlikely. For many economists, its return to vigour will be long and agonising – and they warn that any progress could quickly unravel. It is hard to believe we are at the bottom. Several indicators of the health of the housing market are still troubling. According to RealtyTrac, a property website, one out of every 464 households received a foreclosure filing in July, compared with one in 557 in February. Foreclosures are not likely to peak until the first quarter of 2009, according to analysts at Lehman Brothers.

Last week, Fitch Ratings sounded another alarm bell, saying as much as $96bn (£54bn, €68bn) in home loans sold with initial flexible payments will switch to more stringent terms, probably forcing even more borrowers into foreclosures. Delinquency rates on prime loans, as well as subprime and other exotic mortgages, are climbing.

Rising foreclosures prevent a reduction in the inventories of unsold homes and raise the danger of local foreclosure "spirals" as fire sales depress prices of other homes in the neighbourhood. As of July, the National Association of Realtors says, it would take a record 11.2 months to work through the supply of previously owned homes.

The mortgage crisis has repeatedly disappointed policymakers since it began 18 months ago. House prices remain elevated on some measures, such as price-to-rent ratios. Moreover, efforts to arrange economically efficient restructurings of mortgage debts – and thereby minimise unnecessary foreclosures – remain an uphill struggle. That is due in large part to the fragmented investor base, with numerous institutions owning a slice of a securitised mortgage.

Looking ahead, one main concern is the interplay between housing and the wider US economy, in particular the jobs market. Unemployment has jumped from 4.9 per cent of the workforce in January to 6.1 per cent, amid eight consecutive months of job losses. As more Americans struggle to keep their jobs, it will be harder for them to buy property, no matter how cheap it looks.

This year’s jump in the price of petrol could also damp the potential for a housing recovery. Many of the neighbourhoods with the biggest oversupply of homes are on the distant fringes of US cities. These areas have been made less attractive by the much higher costs of commuting by car. Furthermore, with the mortgage markets under strain, lenders have raised the bar for prospective buyers, which is making sales harder to clinch and putting further downward pressure on prices.

"Risk-averse lenders are requiring buyers to bring more equity and higher [credit] scores. Even those who qualify are finding it tough to get properties to appraise" – in other words, to have the proposed purchase price endorsed by the lender’s valuer – "or to obtain mortgage insurance, as the entire industry has become more cautious", says Paul Miller, analyst at Friedman Billings Ramsey, a property investment group.

With the subprime sector all but evaporated and the jumbo market (for loans into the millions of dollars) barely alive, about three-quarters of mortgage loans are now guaranteed by Fannie Mae and Freddie Mac. Prior to their takeover, risk spreads on their debt and on their mortgage-backed securities were at near record levels, while the companies were tightening underwriting standards and raising fees to preserve their own capital. That helped keep mortgage rates higher than they were a year ago, in spite of 325 basis points of interest rate cuts by the Federal Reserve.

Now, as risk-spreads on Fannie and Freddie paper narrow again and the fees they charge are under downward pressure, a significant decline in mortgage rates finally comes into prospect. That would improve affordability and should at least result in house prices falling less than they otherwise would have done. Over time, the move could also entice buyers away from the sidelines, because the guarantee of an ongoing supply of affordable home loans reduces the risk of a truly catastrophic decline in house prices.

The problem is that employment and incomes could push the other way – resulting in a more traditional housing downturn driven by recessionary conditions in the broad economy rather than overvaluation and a credit shock.

"We are keeping a watchful eye on residential real estate, to be sure – especially the inventory-to-sales ratio and home prices and the impact of this latest policy intervention," says David Rosenberg, chief US economist at Merrill Lynch, referring to the federal rescue of Fannie and Freddie. But even if the market begins to bottom soon, "the lead time to the end of the consumer recession is likely a year away at a minimum".

That in itself would limit the number of Florida home hunters arriving at Mr Belenky’s door.

Quaint

Posted on Wednesday, August 13th, 2008 by bsetser

The Economist – in the course of its analysis of the Fed’s response to the credit crisis — noted that only a few years ago the Fed got rid of its Agency holdings because it didn’t want its asset purchases to distort the allocation of credit in the US economy.

“Politicians have asked the Fed to favour certain industries or keep interest rates low almost from its birth. In 1921 the Fed rejected requests from Congress to buy long-term agricultural debt. In the 1940s and again in the 1960s, under pressure from the Treasury, it bought bonds to hold down long-term interest rates. In the 1970s, at the behest of Congress, it bought the debt of federal agencies such as Fannie Mae and Freddie Mac.

A 2002 staff study pointed out the risks of favouring particular assets or borrowers: it could result in too much investment in preferred sectors and too little in others, drag the Fed into arguments about fiscal policy and compromise its monetary policy. In recent decades the Fed largely extracted itself from anything resembling credit allocation. The last of its Fannie bonds matured in 2003.”

Obviously, the Fed has shed its inhibitions here over the past year — though helping the banks avoid forced sales of their existing assets into an illiquid market arguably has less impact on the allocation of future credit than buying securities other than Treasuries when times are good. still, there are concerns that the Fed is now shaping the allocation of credit in the US economy. The Economist writes:

“The central bank is lending to private companies on an unprecedented scale and is thus making decisions it long sought to avoid about the allocation of credit. It is also acquiring new powers of oversight. Politicians could chafe at the Fed’s power: why, they might ask, should unelected officials choose who benefits from taxpayers’ money? And they might press the central bank to pursue political ends—such as propping up favoured borrowers—that interfere with monetary policy ….

That brings up an interesting question: If Americans are uncomfortable having the Fed shape the allocation of credit in the US economy, shouldn’t they be equally uncomfortable when foreign central banks — notable China’s central bank — shape the allocation of credit in the US economy through their asset purchases?

The PBoC now has a larger dollar balance sheet (on the asset size) than the Fed. It holds around a trillion dollars of Treasuries and Agencies (over $950b can be identified using the TIC data, and the TIC data understates China’s holdings … ). The Fed has around $900 billion in assets — $940 billion, to be precise.

Moreover, the PBoC’s dollar balance sheet is growing far faster than the Fed’s dollar balance sheet. The Fed has responded to the credit crisis by changing the composition of the assets it holds, not by increasing its holdings. The PBoC by contrast is adding to its foreign assets at an extraordinary rate.

Back when the Fed was getting out of the Agency market in 2003, China was getting into the Agency market. In a really big way. China has bought close $100 billion of Agency debt a year now for several years – and likely bought far more over the past year, though accurate data isn’t yet available. As the US stood down, China stood up — so to speak.

There is an argument, popular at the Fed, that claims central bank intervention in the market has little impact. If a central bank buys Treasuries and pulls rates below their “true” rate, private investors will sell Treasuries until they return to their natural equilibrium. Consequently, central bank demand doesn’t have a big impact on Treasury yields. If central banks buy a ton of Agencies, lowering the yield for mortgage backed securities, private investors will shift their funds toward sectors that central banks are ignoring and push yields back up. There won’t necessarily be more funds available to finance housing.

If this argument holds for the actions of foreign central banks, it presumably also holds for the actions of the Fed — and there wasn’t much need to worry that the Fed’s purchase of assets other than Treasuries might influence the cost of credit in the US. And well, if the Fed’s small purchases could favor one sector over another, wouldn’t far larger purchases from foreign central banks have a similar effect?

That possibility though raises a host of difficult issues that the United States has preferred to ignore. Among other things, it implies that China’s government already plays a significant role in determining the allocation of credit inside the US economy, not just the allocation of credit inside China’s economy.

This entry was posted on Wednesday, August 13th, 2008 at 10:21 pm and is filed under Monetary policy, central bank reserves. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

The June US trade data

Posted on Tuesday, August 12th, 2008 by bsetser

In July, China posted rather impressive export growth — all things considered. US imports from China in July aren’t known, but US imports from China were only up 2.9% y/y in June. During the first half of the year, US imports from China are only up 4.2%. The US hasn’t been driving Chinese export growth — Europe has.

And in June, US exports were up 21.1% y.y ($164.4b v $135.7b). Non-petrol good exports were up 17.7% y/y — so it wasn’t all driven by higher prices on the United States (small) petroleum exports. Real goods exports were up 11% in June, and 9.6% for the first half of the year. And real non-oil goods imports aren’t growing. Real non-petrol goods imports in June 2008 were 2.7% lower than in June 2007 — and for h1, real non-petrol goods imports are down by a bit less than 1%.

Exports of corn, beans (and other oilseeds) and wheat are up 90% in nominal terms, rising from $13.6b in the first half of 2007 to $25.9b in the first half of 2008. It isn’t all just higher prices — real exports of foods, feeds and beverages are up 10%. The United States’ financial capital should be grateful it is linked in a currency union to the agricultural Midwest; think where the dollar would be if the US only exported repackaged residential mortgages. Quips about flyover country should stop …

Not so long ago, important voices often argued that exchange rates had little effect on trade — and particularly no effect on US-Chinese trade. I though would challenge anyone to explain — credibly explain — how both China and the United States experienced strong export growth in the first half of this year without mentioning exchange rates. Dollar depreciation is having the expected effect on US exports. And the RMB’s depreciation against the euro has had the expected effect on China’s exports to Europe.

There is only one problem with this story. Bringing the US deficit down, it now is clear, required dollar depreciation, stronger demand growth outside the US than inside the US and stable oil prices. Strong global growth in particular cuts both ways — as it pushes up the price of oil and thus the US oil import bill even as it pushes US exports up. Falls in the dollar also cut both ways, at least to the extent that dollar weakness pushed oil up. I personally find the argument that high oil pushes the dollar down a bit more compelling, but there is a big debate on this.

In the first half of the year, the US non-petroleum goods deficit fell by $51 billion. But the petroleum deficit increased by $69 billion, pushing the goods deficit up. The services surplus improved by $25b — bringing the overall deficit down a bit, but only a bit.

The good news here is that the current future price of oil is now below the June import price ($112 v $117 a barrel), which suggests that the deterioration in the oil balance may almost have peaked. July will be painful — and maybe August too. But a fall in the monthly import bill is now in sight. The bad news is that the current market price is still higher than the average price of imported crude in the first half of 2008 ($96.4 a barrel), so there is still a bit of bad news to come. If petrol imports stay at their June level for the rest of the year ($45b), the US energy import bill would rise from $319b in 2007 to $495b in 2008 — a $175b deterioration. That could be too high if oil continues to fall — it is likely an upper not a lower bound. But it indicates that it is a bit too soon to project a huge improvement in the 2008 trade balance.

Remember, the same factor that has pulled oil down — a slowing global economy — should also pull US export growth down.

A few other interesting tidbits:

In June, real imports of industrial supplies — a category that includes oil — are down 9.2% relative to June 2007. Real imports of autos are down 6.6%. That hurts Japan (and Canada) more than most countries. Real imports of consumer goods are only up 1% — which isn’t great for China. Real exports of capital goods (airplines, turbines and the like) are up by 10% — less than real exports of industrial supplies. Real exports of industrial supplies are up an impressive 17.4%. The US still has a decent sized economy based around the extraction of natural resources.

Real petrol imports are down 8.3% in June (v June 07) — while real petrol exports are up by 65%! Net petrol imports in June were down an amazing 17.4%. For the the first half of 2008, real (net) petrol imports are down 11.1%. Prices up, demand down.

For the first half of the year, nominal exports to the Eurozone are up 15%. Nominal exports to China are up 20%. But in dollar terms in the increase in exports to the eurozone ($12.6b) significantly exceeds the increase to China ($6.1b). The big driver of US export growth though has been Latin America. Exports to South and Central America are up $17.7b (h1 08 v h1 07), or 36%.

Thank the populist governments in Latin America than the US financial sector doesn’t exactly like: Exports to Argentina are up 49% in the first half of the year and exports to Venezuela are up 41%. Exports to Brazil are up a more modest 33%. On current trends, total exports to South America should soon top exports to Mexico.

No doubt there are more nuggets that can be found in the details of the trade data …

UPDATE: Calculated Risk has a nice chart showing the petroleum and non-petroleum deficits over time. The contrast between the source of improvement in the deficit during the last recession and the current source of improvement are instructive. Last time around, the dollar was strong and almost all the improvement came from a fall in oil prices (when IT spending fell, it also cut into both US imports and exports — producing a more symmetrical fall in non-oil imports and exports). This time around, the dollar is weak (at least against Europe, not so much v Japan and China) and the improvement in the non-oil balance accounts for all of the improvement.

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Ben Bernanke: Jackson Hole Symposium Speech

Chairman Ben S. Bernanke
At the Federal Reserve Bank of Kansas City’s Annual Economic Symposium, Jackson Hole, Wyoming
August 22, 2008
Reducing Systemic Risk

In choosing the topic for this year’s symposium–maintaining stability in a changing financial system–the Federal Reserve Bank of Kansas City staff is, once again, right on target. Although we have seen improved functioning in some markets, the financial storm that reached gale force some weeks before our last meeting here in Jackson Hole has not yet subsided, and its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment. Add to this mix a jump in inflation, in part the product of a global commodity boom, and the result has been one of the most challenging economic and policy environments in memory.

The Federal Reserve’s response to this crisis has consisted of three key elements. First, we eased monetary policy substantially, particularly after indications of economic weakness proliferated around the turn of the year. In easing rapidly and proactively, we sought to offset, at least in part, the tightening of credit conditions associated with the crisis and thus to mitigate the effects on the broader economy. By cushioning the first-round economic impact of the financial stress, we hoped also to minimize the risks of a so-called adverse feedback loop in which economic weakness exacerbates financial stress, which, in turn, further damages economic prospects.

In view of the weakening outlook and the downside risks to growth, the Federal Open Market Committee (FOMC) has maintained a relatively low target for the federal funds rate despite an increase in inflationary pressures. This strategy has been conditioned on our expectation that the prices of oil and other commodities would ultimately stabilize, in part as the result of slowing global growth, and that this outcome, together with well-anchored inflation expectations and increased slack in resource utilization, would foster a return to price stability in the medium run. In this regard, the recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year. Nevertheless, the inflation outlook remains highly uncertain, not least because of the difficulty of predicting the future course of commodity prices, and we will continue to monitor inflation and inflation expectations closely. The FOMC is committed to achieving medium-term price stability and will act as necessary to attain that objective.

The second element of our response has been to offer liquidity support to the financial markets through a variety of collateralized lending programs. I have discussed these lending facilities and their rationale in some detail on other occasions.¹ Briefly, these programs are intended to mitigate what have been, at times, very severe strains in short-term funding markets and, by providing an additional source of financing, to allow banks and other financial institutions to deleverage in a more orderly manner. We have recently extended our special programs for primary dealers beyond the end of the year, based on our assessment that financial conditions remain unusual and exigent. We will continue to review all of our liquidity facilities to determine if they are having their intended effects or require modification.

The third element of our strategy encompasses a range of activities and initiatives undertaken in our role as financial regulator and supervisor, some of which I will describe in more detail later in my remarks. Briefly, these activities include cooperating with other regulators to monitor the health of individual financial institutions; working with the private sector to reduce risks in some key markets; developing new regulations, including new rules to govern mortgage and credit card lending; taking an active part in domestic and international efforts to draw out the lessons of the recent experience; and applying those lessons in our supervisory practices.

Closely related to this third group of activities is a critical question that we as a country now face: how to strengthen our financial system, including our system of financial regulation and supervision, to reduce the frequency and severity of bouts of financial instability in the future. In this regard, some particularly thorny issues are raised by the existence of financial institutions that may be perceived as "too big to fail" and the moral hazard issues that may arise when governments intervene in a financial crisis. As you know, in March the Federal Reserve acted to prevent the default of the investment bank Bear Stearns. For reasons that I will discuss shortly, those actions were necessary and justified under the circumstances that prevailed at that time. However, those events also have consequences that must be addressed. In particular, if no countervailing actions are taken, what would be perceived as an implicit expansion of the safety net could exacerbate the problem of "too big to fail," possibly resulting in excessive risk-taking and yet greater systemic risk in the future. Mitigating that problem is one of the design challenges that we face as we consider the future evolution of our system.

As both the nation’s central bank and a financial regulator, the Federal Reserve must be well prepared to make constructive contributions to the coming national debate on the future of the financial system and financial regulation. Accordingly, we have set up a number of internal working groups, consisting of governors, Reserve Bank presidents, and staff, to study these and related issues. That work is ongoing, and I do not want to prejudge the outcomes. However, in the remainder of my remarks today I will raise, in a preliminary way, what I see as some promising approaches for reducing systemic risk. I will begin by discussing steps that are already under way to strengthen the financial infrastructure in a manner that should increase the resilience of our financial system. I will then turn to a discussion of regulatory and supervisory practice, with particular attention to whether a more comprehensive, systemwide perspective in financial supervision is warranted. For the most part, I will leave for another occasion the issues of broader structural and statutory change, such as those raised by the Treasury’s blueprint for regulatory reform.²

Strengthening the Financial Infrastructure
An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe "financial infrastructure" very broadly, to include not only the "hardware" components of that infrastructure–the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions–but also the associated "software," including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction. Of course, a robust financial infrastructure has many benefits even in normal times, including lower transactions costs and greater market liquidity. In periods of extreme stress, however, the quality of the financial infrastructure may prove critical. For example, it greatly affects the ability of market participants to quickly determine their own positions and exposures, including exposures to key counterparties, and to adjust their positions as necessary. When positions and exposures cannot be determined rapidly–as was the case, for example, when program trades overwhelmed the system during the 1987 stock market crash–potential outcomes include highly risk-averse behavior by market participants, sharp declines in market liquidity, and high volatility in asset prices. The financial infrastructure also has important effects on how market participants respond to perceived changes in counterparty risk. For example, during a period of heightened stress, participants may be willing to provide liquidity to a market if a strong central counterparty is present but not otherwise.

Considerations of this type were very much in our minds during the Bear Stearns episode in March. The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns’s borrowings were largely secured–that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Many short-term lenders declined to renew their loans, driving Bear to the brink of default.

Although not an extraordinarily large company by many metrics, Bear Stearns was deeply involved in a number of critical markets, including (as I have noted) markets for short-term secured funding as well as those for over-the-counter (OTC) derivatives. One of our concerns was that the infrastructures of those markets and the risk- and liquidity-management practices of market participants would not be adequate to deal in an orderly way with the collapse of a major counterparty. With financial conditions already quite fragile, the sudden, unanticipated failure of Bear Stearns would have led to a sharp unwinding of positions in those markets that could have severely shaken the confidence of market participants. The company’s failure could also have cast doubt on the financial conditions of some of Bear Stearns’s many counterparties or of companies with similar businesses and funding practices, impairing the ability of those firms to meet their funding needs or to carry out normal transactions. As more firms lost access to funding, the vicious circle of forced selling, increased volatility, and higher haircuts and margin calls that was already well advanced at the time would likely have intensified. The broader economy could hardly have remained immune from such severe financial disruptions. Largely because of these concerns, the Federal Reserve took actions that facilitated the purchase of Bear Stearns and the assumption of Bear’s financial obligations by JPMorgan Chase & Co.

This experience has led me to believe that one of the best ways to protect the financial system against future systemic shocks, including the possible failure of a major counterparty, is by strengthening the financial infrastructure, including both the "hardware" and the "software" components. The Federal Reserve, in collaboration with the private sector and other regulators, is intensively engaged in such efforts. For example, since September 2005, the Federal Reserve Bank of New York has been leading a joint public-private initiative to improve arrangements for clearing and settling trades in credit default swaps and other OTC derivatives. These efforts include gaining commitments from private-sector participants to automate and standardize the clearing and settlement process, encouraging improved netting and cash settlement arrangements, and supporting the development of a central counterparty for credit default swaps. More generally, although customized derivatives contracts between sophisticated counterparties will continue to be appropriate in many situations, on the margin it appears that a migration of derivatives trading toward more-standardized instruments and the increased use of well-managed central counterparties, either linked to or independent of exchanges, could have a systemic benefit.

The Federal Reserve and other authorities also are focusing on enhancing the resilience of the markets for triparty repurchase agreements (repos). In the triparty repo market, primary dealers and other large banks and broker-dealers obtain very large amounts of secured financing from money funds and other short-term, risk-averse investors. We are encouraging firms to improve their management of liquidity risk and to reduce over time their reliance on triparty repos for overnight financing of less-liquid forms of collateral. In the longer term, we need to ensure that there are robust contingency plans for managing, in an orderly manner, the default of a major participant. We should also explore possible means of reducing this market’s dependence on large amounts of intraday credit from the banks that facilitate the settlement of triparty repos. The attainment of these objectives might be facilitated by the introduction of a central counterparty but may also be achievable under the current framework for clearing and settlement.

Of course, like other central banks, the Federal Reserve continues to monitor systemically important payment and settlement systems and to compare their performance with international standards for reliability, efficiency, and safety. Unlike most other central banks, however, the Federal Reserve does not have general statutory authority to oversee these systems. Instead, we rely on a patchwork of authorities, largely derived from our role as a banking supervisor, as well as on moral suasion, to help ensure that the various payment and settlement systems have the necessary procedures and controls in place to manage the risks they face. As part of any larger reform, the Congress should consider granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.

Yet another key component of the software of the financial infrastructure is the set of rules and procedures used to resolve claims on a market participant that has defaulted on its obligations. In the overwhelming majority of cases, the bankruptcy laws and contractual agreements serve this function well. However, in the rare circumstances in which the impending or actual failure of an institution imposes substantial systemic risks, the standard procedures for resolving institutions may be inadequate. In the Bear Stearns case, the government’s response was severely complicated by the lack of a clear statutory framework for dealing with such a situation. As I have suggested on other occasions, the Congress may wish to consider whether such a framework should be set up for a defined set of nonbank institutions.³ A possible approach would be to give an agency–the Treasury seems an appropriate choice–the responsibility and the resources, under carefully specified conditions and in consultation with the appropriate supervisors, to intervene in cases in which an impending default by a major nonbank financial institution is judged to carry significant systemic risks. The implementation of such a resolution scheme does raise a number of complex issues, however, and further study will be needed to develop specific, workable proposals.

A stronger infrastructure would help to reduce systemic risk. Importantly, as my FOMC colleague Gary Stern has pointed out, it would also mitigate moral hazard and the problem of "too big to fail" by reducing the range of circumstances in which systemic stability concerns might be expected by markets to prompt government intervention.⁴ A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.

A Systemwide Approach to Supervisory Oversight
The regulation and supervisory oversight of financial institutions is another critical tool for limiting systemic risk. In general, effective government oversight of individual institutions increases financial resilience and reduces moral hazard by attempting to ensure that all financial firms with access to some sort of federal safety net–including those that creditors may believe are too big to fail–maintain adequate buffers of capital and liquidity and develop comprehensive approaches to risk and liquidity management. Importantly, a well-designed supervisory regime complements rather than supplants market discipline. Indeed, regulation can serve to strengthen market discipline, for example, by mandating a transparent disclosure regime for financial firms.

Going forward, a critical question for regulators and supervisors is what their appropriate "field of vision" should be. Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well.

At least informally, financial regulation and supervision in the United States already include some macroprudential elements. As one illustration, many of the supervisory guidances issued by federal bank regulators have been motivated, at least in part, by concerns that a particular industry trend posed risks to the stability of the banking system as a whole, not just to individual institutions. For example, following lengthy comment periods, in 2006, the federal banking supervisors issued formal guidance on underwriting and managing the risks of nontraditional mortgages, such as interest-only and negative amortization mortgages, as well as guidance warning banks against excessive concentrations in commercial real estate lending. These guidances likely would not have been issued if the federal regulators had viewed the issues they addressed as being isolated to a few banks. The regulators were concerned not only about individual banks but also about the systemic risks associated with excessive industry-wide concentrations (of commercial real estate or nontraditional mortgages) or an industry-wide pattern of certain practices (for example, in underwriting exotic mortgages). Note that, in warning against excessive concentrations or common exposures across the banking system, regulators need not make a judgment about whether a particular asset class is mispriced–although rapid changes in asset prices or risk premiums may increase the level of concern. Rather, their task is to determine the risks imposed on the system as a whole if common exposures significantly increase the correlation of returns across institutions.

The development of supervisory guidances is a process which often involves soliciting comments from the industry and the public and, where applicable, developing a consensus among the banking regulators. In that respect, the process is not always as nimble as we might like. For that reason, less-formal processes may sometimes be more effective and timely. As a case in point, the Federal Reserve–in close cooperation with other domestic and foreign regulators–regularly conducts so-called horizontal reviews of large financial institutions, focused on specific issues and practices. Recent reviews have considered topics such as leveraged loans, enterprise-wide risk management, and liquidity practices. The lessons learned from these reviews are shared with both the institutions participating in these reviews as well as other institutions for which the information might be beneficial. Like supervisory guidance, these reviews help increase the safety and soundness of individual institutions but they may also identify common weaknesses and risks that may have implications for broader systemic stability. In my view, making the systemic risk rationale for guidances and reviews more explicit is certainly feasible and would be a useful step toward a more systemic orientation for financial regulation and supervision.

A systemwide focus for financial regulation would also increase attention to how the incentives and constraints created by regulations affect behavior, especially risk-taking, through the credit cycle. During a period of economic weakness, for example, a prudential supervisor concerned only with the safety and soundness of a particular institution will tend to push for very conservative lending policies. In contrast, the macroprudential supervisor would recognize that, for the system as a whole, excessively conservative lending policies could prove counterproductive if they contribute to a weaker economic and credit environment. Similarly, risk concentrations that might be acceptable at a single institution in a period of economic expansion could be dangerous if they existed at a large number of institutions simultaneously. I do not have the time today to do justice to the question of the procyclicality of, say, capital regulations and accounting rules. This topic has received a great deal of attention elsewhere and has also engaged the attention of regulators; in particular, the framers of the Basel II capital accord have made significant efforts to measure regulatory capital needs "through the cycle" to mitigate procyclicality. However, as we consider ways to strengthen the system for the future in light of what we have learned over the past year, we should critically examine capital regulations, provisioning policies, and other rules applied to financial institutions to determine whether, collectively, they increase the procyclicality of credit extension beyond the point that is best for the system as a whole.

A yet more ambitious approach to macroprudential regulation would involve an attempt by regulators to develop a more fully integrated overview of the entire financial system. In principle, such an approach would appear well justified, as our financial system has become less bank-centered and because activities or risk-taking not permitted to regulated institutions have a way of migrating to other financial firms or markets. Some caution is in order, however, as this more comprehensive approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise. It would likely require at least periodic surveillance and information-gathering from a wide range of nonbank institutions. Increased coordination would be required among the private- and public-sector supervisors of exchanges and other financial markets to keep up to date with evolving practices and products and to try to identify those which may pose risks outside the purview of each individual regulator. International regulatory coordination, already quite extensive, would need to be expanded further.

One might imagine also conducting formal stress tests, not at the firm level as occurs now, but for a range of firms and markets simultaneously. Doing so might reveal important interactions that are missed by stress tests at the level of the individual firm. For example, such an exercise might suggest that a sharp change in asset prices would not only affect the value of a particular firm’s holdings but also impair liquidity in key markets, with adverse consequences for the ability of the firm to adjust its risk positions or obtain funding. Systemwide stress tests might also highlight common exposures and "crowded trades" that would not be visible in tests confined to one firm. Again, however, we should not underestimate the technical and information requirements of conducting such exercises effectively. Financial markets move swiftly, firms’ holdings and exposures change every day, and financial transactions do not respect national boundaries. Thus, the information requirements for conducting truly comprehensive macroprudential surveillance could be daunting indeed.

Macroprudential supervision also presents communication issues. For example, the expectations of the public and of financial market participants would have to be managed carefully, as such an approach would never eliminate financial crises entirely. Indeed, an expectation by financial market participants that financial crises will never occur would create its own form of moral hazard and encourage behavior that would make financial crises more, rather than less, likely.

With all these caveats, I believe that an increased focus on systemwide risks by regulators and supervisors is inevitable and desirable. However, as we proceed in that direction, we would be wise to maintain a realistic appreciation of the difficulties of comprehensive oversight in a financial system as large, diverse, and globalized as ours.

Conclusion
Although we at the Federal Reserve remain focused on addressing the current risks to economic and financial stability, we have also begun thinking about the lessons for the future. I have discussed today two strategies for reducing systemic risk: strengthening the financial infrastructure, broadly construed, and increasing the systemwide focus of financial regulation and supervision. Work on the financial infrastructure is already well under way, and I expect further progress as the public and private sectors cooperate to address common concerns. The adoption of a regulatory and supervisory approach with a heavier macroprudential focus has a strong rationale, but we should be careful about over-promising, as we are still rather far from having the capacity to implement such an approach in a thoroughgoing way. The Federal Reserve will continue to work with the Congress, other regulators, and the private sector to explore this and other strategies to increase financial stability.

When we last met here in Jackson Hole, the nature of the financial crisis and its implications for the economy were just coming into view. A year later, many challenges remain. I look forward to the insights into this experience that will be provided by the papers at this conference.

Footnotes

1. See, for example, Ben S. Bernanke (2008), "Liquidity Provision by the Federal Reserve," speech delivered (via satellite) at the Federal Reserve Bank of Atlanta Financial Markets Conference, Sea Island, Ga., May 13. Return to text

2. See Department of the Treasury (March 2008), Blueprint for a Modernized Financial Regulatory Structure. Return to text

3. Ben S. Bernanke (2008), "Financial Regulation and Financial Stability," speech delivered at the Federal Deposit Insurance Corporation’s Forum on Mortgage Lending for Low and Moderate Income Households, Arlington, Va., July 8. Return to text

4. See, for example, Gary H. Stern and Ron J. Feldman (2004), Too Big to Fail: The Hazards of Bank Bailouts (Washington: Brookings Institution Press). Return to text

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