Proposal for Fed to Become the Next AIG

You thought the Fed had a lot of freedom? You ain't seen nothing yet. According to two MIT economists, Ricardo Caballero and Pablo Kurlat, the Fed should directly get into the credit default swap business to "prevent the next crisis." Says the WSJ:

Their proposal will be debated today at the Fed’s annual Jackson Hole, Wyo., symposium by the world’s leading central bankers and economists. Harvard’s Kenneth Rogoff, former chief International Monetary Fund economist, will present a critique.

Just in case you missed what destroyed AIG, and what, contrary to the current CEO's desire, will be the reason why AIG will be subsidized by taxpayers for centuries, is selling gluts of CDS on virtually anything that had any risk in it. But the MIT guys think next time around AIG should actually be the Fed:

The two professors say the underlying idea — selling insurance against extreme financial risk — should be in the Fed’s arsenal to manage financial crises.

“Insurance is an effective and cheap tool during a panic,” they say in their Jackson Hole paper. The Fed did provide an ad-hoc form of insurance during the crisis -– guarantees to Citigroup Inc. and Bank of America Corp. on the value of more than $400 billion in assets they held. More broadly, the Fed provided insurance to the whole financial system when officials there vowed to do “whatever it takes” to stabilize markets last fall and extended their safety net beyond banks to AIG. The professors say the bank guarantee program should be formalized in instruments called tradable insurance credits which could be triggered by banks and even hedge funds if another crisis erupts.

Alas, some red lights ahead of this proposal are imminent:

There are some practical problems with the idea. The Fed was able to offer these guarantees to Bank of America and Citigroup using legal authority only allowed during “unusual and exigent” emergencies. To make ‘TICs’ a formal part of its toolkit, it would likely need congressional approval. That would likely be a tough sell with Congress now populated by many restive lawmakers who complain the Fed used its power too expansively during the crisis.

This may be a tough nut to crack as lately over 280 members of Congress have been pushing for limited the Fed's powers, not expanding it.

Yet most interesting, is that the Fed may have well already entered the CDS arena. Recent TIC data (not Tradable Insurance Credits, but the Treasury International Capital variety) indicate that beginning in March the Fed started getting involved in derivatives classified as "Other Contracts By Risk Type", to the tune of over $1.3 trillion dollars!

Perhaps before the Fed decides to wholeheartedly dominate CDS trading in addition to every other component of the financial system, they can clarify what exactly is the nature of these various "other" derivatives.

Granted, while trillion is the new million, US taxpayers may be quite curious to know why since the start of QE the Fed has been involved with not only Credit, but Equity and All Other types of this new form of derivative contract.

hat tip Dan

Comments

[Leftfield:]

LTCM, then Wall St., now they want the Fed to implode. Keep handing these children bigger toys and it's always the same result. And they keep dragging the rest of us in deeper. I don't recall agreeing to selling my children and beyond to serve Wall St. in the first place.

Aug 21 03:29 PM

[PainfullyAware:]

I would like to know if the Fed has purchased any "Interest Rate Derivatives" used to hedge against rises in interest rate.

If they have, then will they really go against their "Holdings" and raise interest rates when they should?

The More Stuff "Put Behind The Curtain" The More Potential Conflict Of Interest.

Aug 21 03:33 PM

[doubleguns:]

If congress has not approved any of this and the FED has entered the CDS arena I say let the FED pay for any losses. They are a private entity with profits. They can lose some of their profits.

No more taxpayer bailouts for anyone including the FED.

WHERE DOES THIS FU@KING END!!!!!

Aug 21 03:44 PM

[Pat C:]

Insanity, defined.

Aug 21 03:52 PM

[Living4Divi...:]

1.3 T in CDS EXPOSURE + derivatives exposure by holding AIG's portfolio. The new "bad bank" is the FED

Aug 21 04:49 PM

[LKofEnglish:]

seems pretty simple to me. either you believe in free markets and are willing to let them go down once in a decade or something or you don't. everything else is, well, the government. you weren't actually expecting the truth were you? of course there is the pesky problem of the 800,000 employees of the united states postal service which will be out of money (according to the Post Office) "within a few months."

Aug 21 05:08 PM

[doubleguns:]

Maybe its time to go postal!!!!!!


On Aug 21 05:08 PM LKofEnglish wrote:

> seems pretty simple to me. either you believe in free markets and
> are willing to let them go down once in a decade or something or
> you don't. everything else is, well, the government. you weren't
> actually expecting the truth were you? of course there is the pesky
> problem of the 800,000 employees of the united states postal service
> which will be out of money (according to the Post Office) "within
> a few months."

Aug 21 05:56 PM

[whidbey:]

I like the idea, no risk is too great for our economy even if we don't understand the odds or see a pay point. Trifles.

The truth is CDS are profitable until they must be paid to the counter-party and become liabilities. They must be matched on quantity risk v.s. quantity rewards, so presumably there are serious limits on any institution's capacity to deal with CDS adversity.

Do they imagine that in the long run the premiums offset the possible pay-outs? If so, is the the period infinite? Are we talking about AIG again? I know, white horses are different than brown horses, or something like that, when it comes to risk.

Aug 21 06:49 PM

[yellowhoard:]

Daddy, I can't kill that squirrel with this 22 caliber rifle.

I need a 30/30.
I need a BAR.
I need a handgrenade.
I need a Howitzer.
I need a napalm strike.
I need daisy cutters/
I need a low yield thermonuclear weapon.
I need a hydogen bomb.
I need a syncronized launch of 2,000 MIRVed nuclear missiles directed at that f#cking squirrel!

Son, maybe you weren't born to be a hunter.

Aug 21 07:34 PM

[Swashbuckler:]

YH---If it takes all that, that is one squirrel I don't want to fu#k with.

Aug 21 08:39 PM

[Moon Kil Woong:]

Essentiall the fed's tens of trillions in backstops are derivative insurance not unlike AIG except the Fed gets no money for it, placing the onus on default squarely and completely in the hands of taxpayers and giving banks and financial institutions all the benefits. If financial institutions can't afford the risk in writing the loan why on god's green earth should the taxpayer cover it?

Thus the Fed's dabbling in derivatives is just a drop in the bucket. I suspect those other assets are the Fed's bailing out another almost bankrupt friend without Congressional approval that they certainly would not ever get. The Federal Reserve needs to be reigned in!

Aug 22 01:09 AM

[sethmcs:]

I guess most do not understand credit default swaps. Its nothing more than insurance. The problem is its not regulated like insurance. Every so many years a financial hurricane will strike and claims will be paid. If CDS were regulated than there would be suffient reserves to pay claims. Should the fed be doing this? Absolutely not. Panic buying is as bad as panic selling.

Aug 22 01:20 AM

[Philman:]

Why do you believe that the referenced document reflects Federal Reserve holdings? The guide to these numbers describes them as follows:

"The Treasury International Capital (TIC) reporting system collects data for the United States on cross-border portfolio investment flows and positions between U.S. residents (including U.S.-based branches of firms headquartered in other countries) and foreign residents (including offshore branches of U.S. firms)."

How does that convert to the Federal Reserve creating derivatives? If I am not seeing something here, please advise.

Aug 22 11:04 AM

[Jonathan Rose:]

Great have the US government underwrite all business risk. Anyone who has dealt with the government will have experienced that they don't hire the brightest of people and because they are coddled in the feather blanket of a job for life they have no understanding of the real world.

In my recent dealing with the real world the government employee did get that by not returning my lawyers calls or leaving answer phone messages stating said employee was away it cost me thousands of dollars in legal fees. They don't have the foggiest about anything in the real world, how can they evaluate risk and determine how much they need to insure that risk.......

In the UK the socialized medicine and everything else has resulted in taxes around 51% - the US seems to be at that figure as well now and yet has non of the costs - where is the money being spent - defense - wait till you add a health service on which will cost you double what your defense budget does.....
Clinton did damage that will last a generation and with the current administration I have never been so scared in my life

Aug 22 12:00 PM

[Jimbo:]

We need to demand that Congress authorize an audit of the FED NOW!

Aug 22 12:26 PM

[Stimpy:]

I noticed that as well, Phil.

It doesn't mean what is being suggested, at least on the surface.

What it DOES show is an explosion of derivative activity (equity and credit) starting in Sept of 2007 concentrated almost entirely among US and foreign depository institutions (see columns 19 and 21).

While this is not a "smoking gun" in the sense Tyler is suggesting (the data specifically excludes direct Gov't and FED holdings which are accounted for elsewhere at the Dept of Commerce filings), it is not out of the realm of possibility that it is happening anyway--though less transparently.

First of all, FED intervention at this point in the crisis makes TOTAL SENSE.

If things were as bad as we have been led to believe, why would ANY form of emergency (13-3type ) intervention be left off the table as a stabilization tool?

Is there a more effective/effcient "lever" of public confidence in the sytem than strategic credit spreads when Quantitative Easing becomes the last line of defense and the Mongols are at the door?

(hint: only the Dow Jones)

What the data does seem to suggest is that, during a period of massive de-risking in the derivatives markets (when counterparty risk created a global seize-up) depository institutions (who deal with the FED) managed to ramp up hedges using synthetics to offload balance sheet risk to SOMEONE.

Who would be taking the other side of these trades when credit became a one-way street in the winter of 2007?

If it was the FED or the Treasury, how would a synthetic long position (insurance sold) be accounted for? Would it even need to be?

Remember AIG didn't need to show any positions either until their own counterparty risk forced a mark.

If the Government was the seller, would any one question the counterparty risk?

PS: Anyone who doubts FOR ONE SECOND that the Government could hide market inetrvention for years should spend 5 minutes on the Treasury TIC website.

Jackson Pollack couldn't have done better.








On Aug 22 11:04 AM Philman wrote:

> Why do you believe that the referenced document reflects Federal
> Reserve holdings? The guide to these numbers describes them as follows:
>
>
> "The Treasury International Capital (seekingalpha.com/symbo...)
> reporting system collects data for the United States on cross-border
> portfolio investment flows and positions between U.S. residents (including
> U.S.-based branches of firms headquartered in other countries) and
> foreign residents (including offshore branches of U.S. firms)."<br/>
>
> How does that convert to the Federal Reserve creating derivatives?
> If I am not seeing something here, please advise.

Aug 22 12:47 PM

[Gary A:]

Perhaps they are involved in the fraud swaps still threatening. No one else can be the counterparty to the banks since the banks raped the mortgage insurers and they are running out of money. Word has it that the banks purchased multiple swap products on one property. Markopolos is about to break this and hinted at it in a speech: bank-abuse.com/bankste...

This could be the greatest ponzi in the world without counterparties, except of course, the taxpayer.

Aug 22 06:54 PM

[BrentB:]

In the chart, column 11 is the sum of 12, 13, and 14. It shows the total (column 11) as actually lower on 09/03 than in 08/12, although it shows no breakout numbers in columns 12, 13, 14.

Is this just a flop in thei rdata collection? Does the table make sense?

Aug 23 01:38 AM

[Faisal Humayun:]

While the private sector is deleveraging...the government sector is leveraging...So for sure there is a big bubble building up and that should ideally end with the demise of the Fed....

Aug 23 04:30 AM

[TeresaE:]

But it won't.

My bet is it ends with the demise of the non-government, non-paid off, middle class.

They are betting our jobs and our futures.

We lose no matter how it ends.


On Aug 23 04:30 AM Faisal Humayun wrote:

> While the private sector is deleveraging...the government sector
> is leveraging...So for sure there is a big bubble building up and
> that should ideally end with the demise of the Fed....

Aug 23 09:04 PM

[Andrew Butter:]

The problem with that strategy is that it failed with the "To Big To Fail", they were private sector "gamblers" who were responsible for their own losses, and then they gobbled up so far $4 trillion to cover their losses from the Fed (some of which they say they will pay back), because they were too big to fail.

I suspect that if push comes to shove the Fed will take that option too.


On Aug 21 03:44 PM doubleguns wrote:

> If congress has not approved any of this and the FED has entered
> the CDS arena I say let the FED pay for any losses. They are a private
> entity with profits. They can lose some of their profits.
>
> No more taxpayer bailouts for anyone including the FED.
>
> WHERE DOES THIS FU@KING END!!!!!

Oct 06 05:29 AM

[Andrew Butter:]

Or alternatively the yield on the 30-Year which is one thing they can't control (long term, although I suspect they are manipulating it now) will climb up to 7.5%

So the next bubble to pop is Treasuries!


On Aug 23 04:30 AM Faisal Humayun wrote:

> While the private sector is deleveraging...the government sector
> is leveraging...So for sure there is a big bubble building up and
> that should ideally end with the demise of the Fed....

Oct 06 05:32 AM