The Federal Reserve’s century-long affair with repos

Latest update: August 4, 2013

The Federal Reserve and the repurchase market are intimate partners in the financial system that delivers credit throughout the U.S. economy.

For almost 100 years, they have relied on each other to help reach their goals of a strong economy and profitable banking.

From “Instruments of the Money Market” by the Federal Reserve Bank of Richmond in 1993:

In addition to its use as a short-term market for investing and lending funds, the repo market is the primary medium through which the Federal Reserve Bank of New York’s Domestic Trading Desk (the Desk) conducts open market operations on behalf of the Federal Reserve System.

Although the Fed has recently stopped doing repo transactions and is using a strategy known as “quantitative easing” instead, it has made clear that the repurchase market continues to be a key arrow in its monetary policy quiver.

The interdependence of the Fed and the repurchase market is an awkward entanglement for a central bank that wears several hats, including: It executes monetary policy, it regulates the country’s biggest financial institutions, and it is the lender of last resort to the financial markets.

In these roles, the Fed is supposed to trade on the repo market to keep the U.S. economy strong, discipline its repo trading partners when their activities might endanger the financial markets, and flood its repo trading partners with cash and securities if they get into financial trouble so acute it threatens the economy.

Juggling these roles, the Fed has emerged as a timid repo reformer, even as other bankers, regulators and analysts have called for substantial changes to the repurchase market, which was revealed in 2008 to be one of the weakest links in the chain that delivers credit from Wall Street to Main Street. 

From “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market” by Viral V. Acharya and T. Sabri Öncü, New York University, March 23, 2012:

… we note that the current financial legislation proposals are completely silent on how to reform the repo market …. We believe this omission is a mistake in light of the systemic nature of the repo market and its structural weaknesses. … Unless this systemic liquidity risk of repo market is resolved, the risk of a run on the repo market will remain.

The relationship between the Fed, other central banks, and the repurchase market has been building for decades.

Over time the Fed has chosen repos as one of its main tools for carrying out monetary policy: In general, it tries to slow an economy that is overheating by getting repo loans from selected securities dealers and making interest rates go up.  Or it tries to revive an economy that is faltering by giving repo loans to those same securities dealers and making interest rates go down. Or it does both,  as needed.

In 2006 the Federal Reserve reported that it got an average of $565 billion in repo loans from the dealers each month and gave an average of $177 billion.

In 2007 the Federal Reserve reported that it got an average of $723 billion in repo loans from the dealers each month and gave an average of $216 billion.

In 2011, the Federal Reserve did not do any repos with securities dealers, because it was using quantitative easing instead. (It did, however, get an average of $1.5 trillion in repo loans from foreign central banks and other international government groups. In part, this was possibly European organizations investing their cash at the Federal Reserve during times of turmoil at home.)

For repo transactions to flow readily into the economy, the Federal Reserve needs securities dealers who are thriving in a vibrant repurchase market. The Fed’s selected dealers do about 90 percent of all U.S. repo borrowing and 88 percent of the lending, according to a report by four New York Fed analysts.

At times the Fed has taken dramatic steps to keep the repo process hearty, as it did when a run on the giant Long-Term Capital Management hedge fund roiled the markets in 1998; after the terrorist attacks of 9/11; and during the financial crisis of 2008. Some experts expect such interventions to continue, because so much is at stake.

Economies throughout the world depend on the Fed being able to operate efficiently and effectively.

As then-Federal Reserve Chairman Alan Greenspan said in a June 14, 2000, speech, referring to 1998 when Russia defaulted on its debt and the Fed had to intervene to protect the credit markets from the near-collapse of Long Term Capital Management:

There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. 

The U.S. Treasury also relies on a vital repo market, in at least two ways. Repos help finance the national debt, because Wall Street’s appetite for Treasuries depends in part on well-functioning  repurchase financing, and since 2006 the U.S. Treasury has been making repo loans with its excess cash, as part of its investment program.

(Editor’s note: See below for a chronology of key steps in the Fed’s entanglement with the repurchase market. Also see below for excerpts from Martin Mayer’s 2001 book, “The Fed,” that explore the relationship between the Fed and the financial markets.)

Paul Volcker valued repo

Thirty years ago Paul Volcker, then chairman of the Federal Reserve Board, understood the critical role repos play in the financial markets and in Fed and Treasury operations: In 1982 he urged Senator Bob Dole to protect repos. From a Volcker letter to Dole:

Repos are used by a wide range of entities in addition to government securities dealers, including states, municipalities and other public bodies, financial institutions, and pension funds, to employ funds on a secure basis through temporary acquisitions of various kinds of securities, including U.S. government and agency securities, bankers’ acceptances and CDs.

In adition, repos are a very important tool used in Federal Reserve open market operations and in financing the national debt. Therefore, because of this widespread use in very large amounts, it is important that the repo market be protected from unnecessary disruption.

Ironically, a law that Volcker proposed in response to the 2008 financial crisis has stimulated a new debate on whether repos are dangerous and should be limited. 

The Volcker Rule says deposit-taking banks can’t trade or speculate on their own behalf.  But the rule exempts repos, securities lending, and transactions involving U.S. government and agency instruments, like Treasuries and Freddie Mac or Fannie Mae mortgage securities.

Occupy the SEC objected to the repo exemption in a December 15, 2011, statement:

Paul Volcker had a simple idea: get the government out of the hedge fund business. From his simple idea was born a simple proposal: ban proprietary trading and investments in hedge funds at government-backstopped banks. Congress agreed, to a point, and passed the “Volcker Rule” as section 619 of the Dodd-Frank Act.

The draft of the Volcker Rule, which grew from a three-page proposal to a 300+ page behemoth, was released by the regulatory agencies this October. The draft rule grants a number of exemptions from the proprietary trading restrictions. One of our major concerns is the blanket exemption for repurchase agreements (“repos”). The exemption isn’t mentioned in the statute, and for reasons discussed below it seems to defy the intent of the rule. In our eyes, the presence of such an overbroad exemption is profoundly disappointing. Whose interests are the regulators serving?

One could reply that they’re serving the interests of Paul Volcker and the Federal Reserve.

Repos make a good tool for central bankers for several reasons, according to a 1999 report by the Bank for International Settlements in Basel, Switzerland, which was founded in 1930 to help central banks worldwide and to be their banker.  From the report:

Repos are useful to central banks both as a monetary policy instrument and as a source of information on market expectations.

By both giving and receiving cash and securities, repos give central banks some precision over the flow of each, according to the report. Repos are considered low risk, because they’re collateralized. Repos can be precisely structured to meet the central bank’s goals, because terms like amount, maturity, and interest rate are flexible. And repos reach a market that has been broad and deep for decades. 

According to the Richmond Fed in 1993:  

As a result of the continued growth in the types and volume of arrangements, the repurchase market has become by most accounts one of the largest and most liquid financial markets in the world.

The 1999 report by the Bank for International Settlements noted, though, that repo markets can contribute to systemic risk. Foreshadowing the future, it said:

Shocks originating in securities markets can be transmitted through repo markets and give rise to systemic risk. Large price shocks in securities markets can result in an under-collateralisation of exposures in the repo market. The need to meet margin calls to cover such exposures may lead to financial distress at an institution using repos as a source of financing. Failure in securities settlement systems is another securities market shock that may be transmitted through the repo market.

Finally, leveraging through repo markets can contribute to systemic risk by allowing market participants to take bigger positions in markets. Excessive leverage resulting from inadequate risk management and inadequate counterparty discipline can also add to systemic risk by increasing the probability of failure of a large institution.

Fed tiptoes around reform

Although these warnings came true in 2008, the Fed has tiptoed around repo reform. For example:

-In 2009 the Fed handed reform of the vital tri-party repo market, where the Fed conducts its repurchase transactions, to a committee of Wall Street bankers and dealers, possibly to benefit from their expertise, insure their cooperation, and keep the market flowing through any changes.  The result: Earlier this year the committee adjourned without installing the reforms the Fed wanted, and four years after the crisis tri-party repo is still of deep concern to the Fed and other top regulators.  The Fed has told participants to draw up plans that show how they will operate more safely, and use tri-party repo less, in the future.  It will review the plans this fall.

-In 2010 the Obama Administration proposed to levy a “Financial Crisis Responsibility Fee” on some of the debt of financial firms with at least $50 billion in assets, to repay taxpayers for “the extraordinary assistance they provided to Wall Street.” Within two weeks the administration said it would exempt repo debt because some bankers and economists had warned that the fee could hurt the important repurchase market and impair Federal Reserve operations. (Not yet approved, the proposed fee with the repo exemption is included in the Obama Administration’s fiscal 2013 budget. Meanwhile, FDIC-insured banks have had to pay a fee on repos since the FDIC began charging one in 2011.)

-Some economists have made concrete proposals for ways to make the repurchase market more secure. But the Fed, which has the power to implement these suggestions, has done little – even though this period, when the Fed is not using repos, would seem to be a convenient time to make changes.

The close relationship between the Fed and the repurchase market entangles the Fed in conflicts of interest and conundrums. Some examples:

-In its final days last October, securities dealer MF Global appealed to the Fed for help in responding to a run, as worried clients and trading partners clamored to get their money back. But the Fed was one of the trading partners doing the clamoring, to protect deals it had outstanding with MF Global. 

(RepoWatch editor’s note: This run could not have surprised MF Global or the Fed, as MF Global’s CEO Jon Corzine was deeply involved in the 1994-1998 rise and fall of Long-Term Capital Management and saw the runs that nearly destroyed it, and the Fed engineered the deal that rescued the fund.)

-Both MF Global and Lehman Brothers complained that JP Morgan Chase, acting as their tri-party repo clearing bank, held onto cash or securities they desperately needed in their final days. At MF Global, Corzine tried to fix the problem by picking up the phone and calling William Dudley, president of the Federal Reserve Bank of New York, to complain.

But Dudley’s first concern would not have been for MF Global. It would have been for preserving the integrity of JP Morgan and tri-party repo.

International Monetary Fund economist Manmohan Singh explains this concern in his “Puts” in the Shadow of September 2012. The Fed is so reliant on tri-party repo – and tri-party’s two clearing banks, JP Morgan Chase and Bank of New York Mellon – for implementing monetary policy that it must protect them, he said.

The Fed‘s involvement with the two clearers … allows substantial use of their systems for its operations to the extent it could not tolerate their failure. … the Fed needs to keep tri-party repo clearers in business to meet the needs of its own operations, particularly in light of the large liquidity draining operations that will eventually be needed when monetary policy is again tightened. The dealers are used to the subsidy and do not want to change the status quo. Not surprisingly, the recent whitepaper of the Fed did little to change the existing tri-party repo system.

– At times, repos, derivatives and government securities get special treatment under the bankruptcy code. For example, a repo lender holding a U.S. government-guaranteed security as collateral can immediately sell that security if the borrower files bankruptcy, without having to share it with other creditors. Critics claim this special treatment encourages repo lenders to make loans to risky borrowers they might not otherwise lend to, and the critics want the provision repealed. But efforts to undo it have met resistance in part from those who fear such a change would make repos less popular and interfere with the Fed’s ability to implement monetary policy.

The Fed and moral hazard

Some observers believe the Fed’s dramatic intervention in the financial markets from 2007 to 2010 succeeded in preventing another Great Depression. The Fed has said that one of its key goals was to keep the repurchase market operable, with emergency programs like the Primary Dealer Credit Facility and the Term Securities Lending Facility, both in effect from March 2008 to February 2010. But critics claim these crisis actions by the Fed also encouraged risk taking, by once again proving to repo bankers that the Fed will ride to their rescue:

From “Wall Street aristocracy got $1.2 trillion in secret loans” by Bradley Keoun and Phil Kuntz, Bloomberg News, August 22, 2011:

The Fed’s liquidity lifelines may increase the chances that banks engage in excessive risk-taking with borrowed money, (Harvard economics professor Kenneth) Rogoff said. Such a phenomenon, known as moral hazard, occurs if banks assume the Fed will be there when they need it, he said.

From “Will the Central Bank Bail-Outs Ever End?” by L. Randall Wray, EconoMonitor, February 23, 2012:

My worry is this: the “too big to fail” (or as my colleague Bill Black calls them “systemically dangerous”) institutions have learned that no matter what they do, they will be saved and their top management will never be punished.

From Greenspan’s June 14, 2000, speech:

Clearly, to choose the distribution of risk-bearing between private finance and government is to choose the degree of moral hazard. I believe we recognize and accept it. Indeed, making that choice may be the essence of central banking.

Three Federal Reserve economists reviewing the Primary Dealer Credit Facility agreed that the Fed’s actions to save the repo market could create moral hazard. But they saw a silver lining. From “The Federal Reserve’s Primary Dealer Credit Facility” by Tobias Adrian, Christopher R. Burke, and James J. McAndrews, Federal Reserve Bank of New York, August 2009:

To be sure, concerns have been raised that access to this type of backstop funding source could discourage dealers from managing their funding positions carefully. Yet the risk of such perverse incentives is offset by the protections the PDCF affords more prudent firms against the market stresses created by their highly leveraged counterparts.

The solution to the moral hazard problem is better regulation, the three economists said.

To the extent that backstop lending facilities like the PDCF might create conditions conducive to moral hazard, it is important to have regulation in place that helps enforce the prudent management of funding positions.

Absent repo reform, this means Americans must rely on the Fed to rein in its repo dealers, something the Fed in the past has not been able to do.

Further reading

RepoWatch recommends the following reports on the Federal Reserve:
-”The Federal Reserve System – Purposes and Functions“ by the Board of Governors, Federal Reserve System, June 2005.
-”The Fed” by Martin Mayer, Free Press, 2001. This books shows that the dangers exposed by the financial crisis were well known in advance. (See excerpts below.)
-”In Fed We Trust” by David Wessel, Three Rivers Press, 2010. This book describes the Fed’s role in responding to the financial crisis.
-“At the Fed,” the last chapter in Roger Lowenstein’s book about the fall of Long-Term Capital Management, “When Genius Failed,” 2001.                                                -The Fed’s Annual Reports describe the Fed’s operations. In the “Statistical Tables” section are data for each year going back to 1918.
-The Fed’s Open Market Operations reports are prepared by the Markets Group of the Federal Open Market Committee, Federal Reserve Bank of New York.

Some milestones

Following are some milestones in the Federal Reserve’s century-long affair with repos:

1917: The Federal Reserve begins using repos to provide temporary funds to member banks.  This will continue for a few years and then be discontinued until 1975.

1920s: The Fed begins using repos to extend credit to securities dealers.

1940s: The Fed stops using repos entirely.

1949: The Fed resumes intermittent use of repos for monetary policy.

1950: J.P. Morgan develops the overnight repurchase  agreement. In its overnight repurchase agreements, Morgan gets repo loans from its large depositors, thus replacing deposits with loans. This is (1) a way for Morgan to pay its large depositors interest, at a time when the law forbids banks to pay interest on deposits, and (2) it’s a way for Morgan to reduce deposits, thereby reducing the reserves that it has to keep with the Fed.

1951: Congress enacts the Treasury-Federal Reserve Accord, which establishes the independence of the Fed and its control of monetary policy and brings repos back into favor.

1953: Canada’s central bank begins using repos as an instrument of monetary policy. 

1969: Short-term interest rates reach new heights, and that spurs investor interest in making more repo loans.

1974: Rising rates and ballooning U.S. debt fuel the repo market. From “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market” by Viral V. Acharya and T. Sabri Öncü, New York University, March 23-24, 2012:

During the period of high inflation in the 1970s and early 1980s, rising short-term interest rates made repos a highly attractive short-term investment to holders of large amounts of idle cash. Increasing numbers of corporations, local and state governments, and at the encouragement of securities dealers, even school districts and other small creditors started depositing their idle cash in “repo banks” to earn interest rather than depositing money in commercial banks that did not pay interest on demand deposits.

Furthermore, the U.S.Treasury started borrowing heavily after 1974, eventually changing the status of the U.S. from a creditor to a debtor nation and increasing the volume of marketable Treasury debt significantly. This led to a parallel growth in government securities dealers’ positions and financing, and the repo market grew by leaps and bounds.

The flow of credit through the financial markets becomes increasingly dependent on U.S. Treasuries, because they make safe repo collateral.

1975: The Fed resumes repo transactions with member banks.

1982: The failure of a securities dealer active in the repo market causes panic. From a New York Fed report:

The prospect of a chain of failures was particularly worrisome: “There are hundreds of [repo] transactions out there that look safe until one participant goes under.” … Faced with an impending crisis, the Federal Reserve Bank of New York reminded market participants that it stood ready to act as a “lender of last resort” to assist the commercial banks in meeting “unusual credit demands related to market problems.”

The panic forces the industry, prodded by the New York Fed, to make important improvements in its repo contracts, and that increases the popularity of the market. 

1983: From “Retail Repurchase Agreements: Overcoming Insecurity within the Securities Laws” by Gabrielle Sigel, 1983:

Since 1969 bank issues of wholesale repos have blossomed, sustaining a 24 percent average annual growth rate. This growth is attributed to the higher interest rates of the past 15 years, the continued prohibition against interest payments on corporate demand deposits, and technological advancements which facilitate cost-efficient, short-term transfers of commercial paper.

1984: Federal Reserve officials and securities dealers get Congress to pass a law that exempts repos from a repo borrower’s bankruptcy if they are collateralized by Treasuries, securities issued by federal agencies like Fannie Mae, bank certificates of deposit and bankers’ acceptances. In other words, repo lenders who hold these types of collateral will be repaid before other creditors when a repo borrower files bankruptcy. This law increases the popularity of repos with lenders. Volcker wrote his 1982 letter, mentioned above, to support this legislation.  

1985: The Federal Reserve encourages the development of today’s tri-party repo market, which has become popular as an efficient way to repo, with a clearing bank handling the mechanics of the transactions for borrowers and lenders.

1986: Commercial banks increasingly embrace the repurchase market. From “The Behavior of the Bank Repurchase Agreement Market: 1981-1983” in the Journal of Applied Business Research, Winter 1986-1987, by George W. Kutner:

The repurchase agreement (repo) market is one of the most important markets to the banking industry. It acts as a major source of short-term funds for banks as well as a vehicle for managing their liability positions and obtaining liquidity. Use of this market has increased. Outstanding repos of all commercial banks has grown approimately 20 percent annually since 1969 with over $50 billion of commercial bank repos outstanding today.

1991: One-fourth of overnight borrowings by large traditional banks is done on the repurchase market, according to the Federal Reserve Bank of Richmond.

1993: The Federal Reserve Bank of Richmond publishes a book about money market instruments and says repo, which it pictures as a busy and thriving area of finance,  is one of the most important instruments of the money markets.

The same report tracks the growth in U.S. repo volume for the Fed’s securities dealers from $65 million in 1981 to $629 million in 1992. (RepoWatch editor’s note: These dealers’ repo volume will peak in 2008 at $4.6 trillion. Today it stands at $2.64 trillion.)

1997: Japan and the UK begin using repos as an instrument of monetary policy

1998: Tri-party repo begins offering a new service called GCF (General Collateral Finance) Repo, which adds another element of efficiency because it accepts any kind of qualified security as collateral, including Fannie Mae- and Freddie Mac-guaranteed mortgage securities, rather than requiring a certain security.

1998: This is the year of the Russian debt default and the collapse of the giant Long Term Capital Management hedge fund. The repurchase market plays a key role in the turmoil. The Federal Reserve arranges for a consortium of banks to rescue the fund.

1998-1999: The Federal Reserve formalizes its policy of not using its authority to restrict mortgage lending by companies it regulates. Fannie, Freddie and others nearly double their  issuance of mortgage-related securities. 

1999: The European Monetary Union is founded, with repos as a fundamental instrument of monetary policy. 

1999: The Federal Reserve begins using tri-party arrangements for its repos.

1999: The Bank for International Settlements publishes an in-depth look at central-bank use of repos, “Implications of repo markets for central banks.” The largely supportive study nevertheless identifies important risks.

1999: The Gramm-Leach-Bliley Financial Services Modernization Act makes the Federal Reserve the primary regulator for U.S. bank holding companies, which under this law can engage in a variety of financial businesses. Subsidiaries and affiliates of these holding companies conduct most U.S. repo transactions. 

2000-2001: The Federal Reserve dramatically drops short-term interest rates after the dot.com and telecom busts in 2000, thereby spurring more repo borrowing. After the terrorist attacks of 9/11/2001, it takes historic steps to keep the stricken repurchase market alive.  

November 26, 2001: Fannie Mae introduces its Benchmark Repo Facility, to stimulate the repo market for its mortgage securities by lending them overnight. The low rates and surge of collateral are boosts for the repo market and the Fed’s securities dealers.

2005: Congress passes a law that exempts repos collateralized with mortgage-related securities from a repo borrower’s bankruptcy. This extends the scope of the bankruptcy exemption that Congress granted to repos in 1984, with support from Paul Volcker. It gooses both the repo market and the housing market, by making lenders eager to make repo loans collateralized with mortgage-backed securities. Mortgage-backed securities join U.S. Treasuries as some of the most valued collateral for repo loans.

2007-2010: The housing bubble bursts. The Federal Reserve, the FDIC and the U.S. Treasury temporarily put a safety net in place for shadow banks, to halt multiple runs. They insure money market fund deposits, and they pour money into the financial markets through two dozen emergency programs, including the Primary Dealer Credit Facility and the Term Securities Lending Facility which specifically target the repurchase market.  They say they will do whatever it takes to keep credit flowing. Fed Chairman Ben Bernanke and Timothy Geithner, then president of the Federal Reserve Bank of New York, say their biggest fear is for tri-party repo.

2012:  Financial firms borrow $2.6 trillion on the U.S. repo market every day.  Roughly two-thirds of the loans are collateralized by U.S. Treasuries and one-third by mortgage securities insured by agencies like Fannie Mae and Freddie Mac. Congressional efforts to reduce U.S. debt and eliminate Fannie and Freddie would shrink the supply of safe collateral for repos, and that would have implications for the flow of credit in the U.S. and the Fed’s conduct of monetary policy.

From “The Fed” by Martin Mayer

In 2001, seven years before the 2008 panic, financial writer Martin Mayer took a critical look at “the inside story of how the world’s most powerful financial institution drives the markets” in his book “The Fed.” Following are some insightful passages:

To say that central banks must now seek their objectives through the market rather than through the banks masks the essential change. Securitization, derivatives, worldwide markets, and the vastly increased liquidity of once non-marketable assets … have made the idea of the ‘quantity’ of money a historical curiosity, like belief in a flat Earth. Credit may be amorphous, but credit risk is specific, and leverage – the fraction of the money at risk that the lender or investor or speculator must repay to his creditors – continues to rise. Henry Kaufman worries that securitization and derivatives will act as rubber bands allowing the sytem to keep stretching as the central bank pulls at it; an equal worry is that the chaos theoreticians may be right, and that a system where receipts and payments are tightly bound together may shatter beyond easy repair if a minor event far away – the Indonesian butterfly’s wings feared by the chaos maven – leads with awesome inevitability to systemic disaster.

As the Asian crisis of 1997 demonstrated, much of this risk remains with the banks.

*****

It was while the European central banks were in retreat that the Federal Reserve in fall 1999 sought and gained new powers and new responsibilities, winning a war with the Office of the Comptroller of the Currency that had been fought in the battlefields of Congress for more than 60 years.

*****

What central banks do for a living is, they prevent systemic failure. … Among the oddities of the 1990s has been the rise of a school of thought holding that there is no systemic risk in finance – that the markets will rebalance quickly if only governments will permit the foxes of economic growth to eat the lame ducks of unwisely sunk costs.

*****

The lesson from (the failure of Franklin National Bank in New York in 1974) was that in the modern world the big losers from a bank failure were likely to be the borrowers. One way or another, the creditors get taken care of, but the builder who has arranged a loan from the failed bank finds that no other bank will pick it up….

*****

In the United States, the deposit insurer is now the lender of last resort to the banks, and the central bank is the lender of last resort to the markets. …

Politically and economically, this is an enormously important phenomenon. Both the fixed-income markets and the stock markets have come to rely to an unprecedented degree on a safety net from the Federal Reserve.

*****

In 1981-1982, as a member of the finance committee of Ronald Reagan’s National Commission on Housing, I became one of the authors of the plan by which housing could be financed with real estate mortgage investment conduits, permitting pension funds and mutual funds to get in and out of housing investments, and permitting Wall Street houses to slice and dice mortgage paper that carried an implicit government guarantee. The bankers created innumerable “tranches” that could be sold separately to risk-averse investors and risk-seeking speculators, hedged to reduce the dangers of changes in interest rates, or rolled over in repurchase agreements to multiply both risks and rewards. It is by no means clear that the future will regard this system of home finance as a good idea.

*****

The health of the economy in the 1990s, and Chairman Alan Greenspan’s ability to change Fed policies at the margin to match the incremental changes in the economy, have masked the great truth that conceptually – looking ahead as central banks are supposed to look ahead – we no longer understand what we are doing.

*****

In the end, then, seeking risk reduction, the Fed and the Bank for International Settlements recommended an emphasis on bilateral netting between participants in the markets rather than multilateral netting through the clearinghouses. … It felt safer, because the raw numbers of monies passing through the clearinghouse were lower, but in real life two-party netting and the reduction of flows through the clearinghouse would eventually become a threat to the system.

*****

In 1994, mathematically inclined analysts were selling large foundations and hedge funds on the proposition that their computers could promise a return on investment in different “tranches” of collateralized mortgage obligations whether the market for such instruments went up or down. …

The mathematicians and strategists had not expected the Fed to raise rates in February 1994. Some large houses with heavy CMO portfolios took immense losses.

*****

How to regulate and supervise such “Large Complex Banking Organizations” is one of the great practical questions of our time.

*****

The belief here is that the reason why the Federal Reserve Bank of New York engineered the rescue of the Long Term Capital Management hedge fund in September 1998 was fear that the collapse of the fund would have exposed to public view the sloppy performance of the world’s great financial institutions – and the careless, trusting supervision that had permitted this overconfident crowd of Ph.D. economists, mathematicians, and gamblers to carry positions in excess of $100 billion, and derivative contracts with nominal values over $1 trillion on a capital base of less than $2 billion. …

Only a few days before the New York Fed felt it had to intervene to save (John Meriwether, chairman of Long-Term Capital Management) from losing his hedge fund, Alan Greenspan had testified to the House Banking Committee that “hedge funds were strongly regulated by those who lend the money. …”

*****

(Ed Furash, a bank consultant) likes to contrast the examinations done by the different federal agencies. “The Fed as a regulator,” he said, “adores ambiguity. The Office of the Comptroller of the Currency will say, seeing a bank that is buying collateralized mortgage obligations then putting them out for repurchase and using the cash to buy more collateralized mortgage obligations, ‘The level at which you are doing dollar rolls into CMOs is not justified by your capital.’ The Fed will say, ‘You should look and see whether your dollar rolls are compatible with safety and soundness.’

“Some bankers love it because they get more wiggle room. Others say, ‘Furash, will you tell me what the hell these guys really want.'”

And then, of course, there are the others that just don’t care. William Isaac noted that it is “very tough to do – to go into a major bank before it has obvious problems and say, you guys are making a lot of real estate loans and we are really worried about it and we think you ought to slow down. I’ve seen it, I was in Security Pacific on behalf of that board of directors, looking at what happened and why. The Comptroller of the Currency actually was calling the thing at Security Pacific five or six years before it happened, before it blew up. They kept on saying, you’re doing this, you’re doing that, and Security Pacific would write back and say – we appreciate your kind note, but frankly, we are Security Pacific – you don’t seem to understand that – and please keep in touch. That was the end of that. What are you going to do about it?”

*****

… when banks were in trouble in the early 1990s, they loaded up with mortgage paper. With loans to strong companies and loans to weak companies carrying equal capital allocations, banks were tempted to lend to weaker companies, who would pay more for the money. And banks became adept at setting up “special purpose vehicles” financed by people who would otherwise buy loan packages from them, which could originate loans with guarantees from the banks, and greatly reduce the required capital allocation against credit risk.

*****

To the extent that the (bank) examination does have an adversarial component it rests on the fact that the examiner’s task is to form a view of whether in fact the bank can carry out its plans as presented. Who are the counterparties for the “credit derivatives” which save the bank from defaulting borrowers? How much funding will be lost with a decline of value in the bonds temporarily owned by those with whom the bank has “repurchase agreements?” What protection does the bank have against severe fluctuations in the value of long-dated currency options? Will the models work?

*****

One comes back to the simple truth that leverage is dangerous, whether it is excessive margin in the stock market or inadequate capital in banks or daisy chains of repurchase agreements that monstrously enlarge the structures that can be raised on small foundations.

*****

The fact is that large American banks keep four sets of books: one for the internal management information system, which hopes to keep the bosses informed of what’s happening; one for the regulators; one for the Internal Revenue Service; and one for the stock holders.

Peter Fisher, who runs the desk that makes flesh of the Federal Open Market Committee words says that “Every time somebody publishes a period-end balance sheet, required by the SEC, it’s a lie.”

*****

Greenspan, who was a fierce defender of bank secrecy in his first years at the Federal Reserve, has become a public proponent of greater transparency. … But the fact is that in the area where the activities of banks are the most opaque – over-the-counter two-party derivatives trading – the Fed has stood with the industry to fight off meaningful disclosure. Even disclosure to the examiners has been curtailed, as banks are permitted to determine the riskiness of their own portfolios for purposes of measuring capital adequacy.

A major reason why the banking system has become increasingly opaque is the regulators’ encouragement of bilateral “netting” arrangements, by which two parties that have several derivatives deals with each other can simply compare their winning and losing positions and establish a net number for that moment in time.

*****

We live in a time when the Pandora’s box of capitalism, so feared for so long, releases mostly good things, and people will, as David Frost suggested, think well of the Fed.

Yet it can blow up. … The tragedy for all of us would be if the Fed’s and the Treasury’s and the Congress’s reverence for people who make a lot of money left us unprotected against some sudden revelation of the truth that becomes obvious only in hindsight, that a lot of them don’t know what they’re doing.