Fed's Folly: Fooled by Flawed Futures?

Was it a misunderstanding of their mandate, inexperience, or just plain hubris?

Regardless, it took only 2 days to learn just how ill-considered the Fed's emergency market rescue plan was: To wit, a fraudulent series of losses led to a major European bank unwinding a huge trade: Societe Generale Reports EU4.9 Billion Trading Loss.

SG's $7.1Billion dollar unwinding led to panicked futures selling on Monday and Tuesday.

Hence, we quickly learn what sheer folly and utter irresponsibility it is for the Fed to use its limited ammunition to intervene in equity prices. Their panicky rate cute were not to insure the smooth functioning of the markets, but rather, to guarantee prices.

As we have been saying for the past two days, this is not the Fed's charge. They are supposed to be maintaining price stability (fighting inflation) and maximizing employment (supporting growth) -- NOT guaranteeing stock prices.

I guess the European Central Bank has it easier: Their only charge is to fight inflation: "maintain price stability, safeguarding the value of the euro."

Tuesday's panicked 75 basis cut will prove to be an historical embarrassment, a blot on the Fed for all its days. Failing to understand what their responsibilities are is bad enough; allowing themselves to be bossed around by Futures traders is inexcusable.

And, having been rewarded for their past tantrums, the market will now be screaming for another 75 bps next week. As Rick Santelli appropriately observed, the Pavlonian training is now complete.

~~~

Too bad we didn't know this during yesterday's Fed debate . . .

Fed to the Rescue (11:20am )

~~~
One last point: I still think the Bernanke Fed inherited this mess from Greenspan, and are boxed in trying to resolve it...

Sources:

Societe Generale Reports EU4.9 Billion Trading Loss
Gregory Viscusi
Bloomberg, Jan. 24 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=a8GBEB7UuuXc&

Societe Generale Hit By Fraud, Write-Downs
NICOLAS PARASIE
WSJ, January 24, 2008 9:40 a.m.
http://online.wsj.com/article/SB120115814649013033.html

Related:

Equity Derivatives House of the Year - Société Générale
RISK, January 2008 | Volume21/No1
http://www.risk.net/public/showPage.html?page=685494

Juicing the economy will come at a cost
Jeanne Sahadi
CNNMoney.com, January 23 2008: 4:51 PM EST

http://money.cnn.com/2008/01/23/news/economy/cost_of_stimulus/?postversion=200

Comments

[Chungst:]

This is simply jejune logic -- I failed to see how a small amount like $7.1 Billion in trades (fradulent trades that was created over a number of months) in the capital markets consisting of trillions of dollars could the sole cause of the market meltdown. Any student of financial history can compared this amount to Long Term Capital Management (LTCM) and discern the amount involved at LTCM was much greater and never resulted in a 75 basis point cut in the Fed Fund rate. Barry Ritholtz needs to work on basic logic and employ the simple techique of cause and effect.

For example, I strongly believed Mr. Ritholtz neglected the fact that two of America's greatest wealth creation engines are showing double digit declines -- the decline in the housing market (as measured by housing prices) and the decline in US equity values (for example, the Russell 2000 index, was down about 15% when measured from 12/26/07 at 797.03 to 673.18 on 1/18/08, which is impressive in light of the so called January effect). When you have this much wealth being destroyed in America, one of the richest economies in the world, at such speed -- it is a problem for the US economy and for the global economy as well.

Separately, I am not a fan of Bernanke's actions and I consider his 75 basis point cut to be "bush league" akin to wetting his pants. However, I still believe the rate cut was INDEPENDENT of the so-called fraud.

Cheers.

2008 Jan 25 04:55 AM

[Phil G.:]

It should be easy enough to find this out - how would a trade like this affect European markets/futures. If we're talking futures, which can be less liquid, I don't think it's that far fetched.

2008 Jan 25 05:55 AM

[Chris White:]

It seems to me that Barry is pointing productively to one of the international features of what is going on, namely, the unwinding of the leverage geared up through derivative contracts. Quantifying losses, and estimating effects of losses, is difficult because the leverage ratios are not known, and because the assets which are leveraged, and re-leveraged, and re-releveraged are neither identified, nor can they be valued accurately. Therefore timescales and discount rates are black-holes. After all ground rent is included with interest in the pricing of assets as part of the 'cost' of 'producing' the asset. Where will US housing prices end up? When? How will the totality of mortgages and agreements related to mortgages be affected by the continuing slide in housing prices? How does this affect taxes and government debt.

Soc Gen's loss must be some fraction of what was in the black-hole.
Was it stock, commodity, mortgage or whatever-based? Who knows, probably no one will ever know. However until more attention is given to the matter of leverage unwinding as an inter-market, international process discussion about amounts and largeness or smallness of problems will miss the target. It's the barn door the target was pinned to which has disappeared. We all need to know how big the barn was and what was inside when the door disappeared to make judgements about size and evaluate effects.

2008 Jan 25 08:07 AM

[flow5:]

Which came first...the chicken or the egg? Coincidental? The financial markets are hip. I'm happy to take your money.

The ECB's mandate is correct. The FRB's mandate is impossible.

Bernanke is smart as hell. Second guessing is fruitless. He was just scalping commodity prices during their seasonal strength (directly or indirectly).

In hindsight I would have pulled the trigger earlier (Dec), but now I believe the Fed's timing was correct (more productive).

There's nothing independent about the FRB. It is now & has always been, run by COMMERCIAL BANKING interests as opposed to the financial intermediaries.

2008 Jan 25 10:52 AM

[flow5:]

It seems to me that the economic "recession" is just alot of media hype.

2008 Jan 25 11:26 AM

[Tristan Yates:]

When over $1T of S&P 500 wealth is wiped out in two weeks and another $1T is on the way given the overseas losses and the futures, that's an economic reality you can't ignore. The Fed has a mandate to provide stability to the system, and the way it was going on tuesday, trading probably would have been halted multiple times that day. BB didn't know about SocGen, and regardless, I don't think a single market participant could have triggered the panic we saw.

2008 Jan 25 01:37 PM

[Reinko:]

It might be that the futures were a bit flawed because of the big unwinding Societe Generale had to do. But would that be the reason for a 75 basis point cut?

Unseen in many many years and even intra policy making meetings from the FED.

No, the real reason is far more simple to understand and is found in the inner workings of the FED:

On the day Bernanke did his 75 point thing, also the combined reserves of the US commercial banks could go negative.

Here is the 17 Jan 2008 so called H3 release (look for the 'non borrowed column where the real reserves are) and see that in just six weeks time the reserves declined from over 43 billion to just 200 million US$:

www.federalreserve.gov.../

Here is the 24 Jan release and remark that they haven't updated (should be done yesterday but now almost 24 hours later it is still not updated!):

www.federalreserve.gov.../

This likely means that combined real reserves from the US commercial banks is in the negative zone and we have to conclude:

At least one US commercial bank is in the red with her reserves...

2008 Jan 25 03:01 PM

[Johnny Bitc...:]

Mr. Ritholtz tends to view all world economic events as being some kind of proof of his prior predictions or postures - this one is no different.

He usually has some form of argument that has validity - such as the Fed move looks panicky and ill-advised - but then over-reaches in some kind of childish told ya so fashion.

I believe the level of work put into logical arrangement of his arguments and beliefs is much smaller than his need to be right and claim rightness in terms of economic analysis.

Bernanke's 75 point cut was nothing more than 50 which was already priced into the market and then a 25 point statement akin to a confidence game. I do believe that vocal market participants crying for his head probably caused the additional 25, and there is even some argument that SocGen selling might have made things look worse than they appear and played some role, but certainly not any reasonable theory that the entire 75 cut was caused this way.

jbd.

2008 Jan 25 06:07 PM

[Al Capital:]

The Fed lowered the rate, and will be forced to lower again, to take pressure off of deteriorating bond insurers. All the other stuff is noise.

mnrtrading.blogspot.co...

2008 Jan 25 08:36 PM

[TA:]

Well said Johnny Bitchdog

Hands up who things Barry is heavily shorting the market and writes this articles to push them for maximum profit?

Personally I think we are in a bear market and Fiday on help confirm it. I just get so sick of the 'I'm so smart, I predicted all of it' rap that always comes about this part of the cycle

I know it's a bear market, can you go do some trading and stop telling me the obvious? Please?

2008 Jan 26 11:42 PM