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Federal Reserve Capital Management

Is the Federal Reserve essentially a giant hedge fund?

Economics

Do central banks stabilize or destabilize financial systems? The answer is: “both.”

Perhaps one popular notion is that a central bank, such as the Federal Reserve (the Fed), the Bank of England (BoE), the Bank of Japan (BoJ), the European Central Bank (ECB), etc., is the ‘Big Bank’ that can step in and provide funding in a monetary or liquidity crisis, seeking to relieve selling pressure in markets and to get credit-money to flow again, in essence, to act as a lender of last resort. Another popular notion (and one that is more common historically) is that a central bank exists to finance sovereign national government debt, to issue fiat paper currency, and to set interest rate policy based on any number of perceived macroeconomic factors. Yet another popular notion is that a central bank acts as a cartel monopoly, and because it can print fiat money and set interest rates, it is a central planner possessing exogenous powers to manipulate capital markets.

The thesis of this work is to convince the reader that a central bank, such as our own Federal Reserve, is for all intents and purposes a giant hedge fund, nominally drafted and chartered by the sovereign to keep sovereign borrowing costs low, among other hedging and financing aims, and that it can incur risks of failure.

A hedge fund is defined as “a private investment fund that participates in a range of assets and a variety of investment strategies intended to protect the fund’s investors from downturns in the market while maximizing returns on market upswings.” In rudimentary analogy, the Fed is a private institution chartered by Congress, employing “monetary tools” to finance and manage Treasury assets/liabilities, and exercising hedging strategies to protect the Fed’s “constituents” from capital market downturns (e.g. the “Greenspan or Bernanke put”) while maximizing the growth of the “national wealth.” The monetary tools and hedging strategies include the Fed’s many “asset swap programs” and “open market operations.” A generalized example is the process through which the Fed accumulates Treasury or Agency [1] debt securities in exchange for some other “asset,” such as fiat money (dollars), or debt securities existing on its balance sheet. In executing this process, the Fed affects the money supply and the interest rate structure of the Treasury yield curve, which in part drives the market for interest rates on other debt securities. The Fed also lends money at a discount to its constituents through its “discount window,” and will lower its Federal Funds target rate to reduce this discount in the event of market turmoil, in effect providing a put option. (A dated table of published Fed programs can be found HERE

.)

On the face of it, the hedge fund analogy might provide an inspiring view of the role of a central bank, particularly if one buys into the “national wealth benefactor” belief. In reality, hedge funds can fail, and fund investors can lose everything.

The skeptical reader is probably asking how a central bank can fail, especially if it retains the power to print fiat money and set interest rates and reserve ratios. Let me answer this by saying that a central bank, such as the Fed, is not the exogenous hand of God, but essentially another endogenous player in the financial system. If the Fed were the exogenous hand of God, as some claim, we’d not see the evidence of financial instability that central bank monetary policies create or exacerbate, or at the very least, fail to fix. Those instabilities are twofold: (a) they exist because the financial system can be thrown out of equilibrium, and most neoclassical monetary measures that the Fed and other central banks employ assume an inherently equilibrium system and response; and (b) fiat money is multiply leveraged by the Fed and other central banks in attempts to restore stability and provide relief to markets and constituents, and such compounded leverage is linked to the growth of endogenous credit-money and the increases in risk of financial instability, market dislocations or shocks.

The Fed’s regulation of interest rates, which have included repeated interest rate cuts and sharp reversals (Fig. 1) has coincided significantly with the growth of financial markets, and with the rise of risk, volatility and financial instability. The Fed’s justification for controlling target interest rates is to regulate price inflation when markets heat up and to provide credit ease to markets in a disinflationary turmoil. In practice, this tool has had significant unintended consequences, distorting what the market perceives as price based on supply and demand. The “Greenspan put” came to be the market hedge bailout that provided protection to market bulls, and particularly those selling leveraged derivative contracts as portfolio insurance or as a bet against spiking volatility. With the Fed standing ready to provide liquidity in the form of interest rate cuts, open market operations or discount loans, market constituents were given a green light to take on greater risks than they would if there had been no hedging backstop. The 2008 financial crisis that started as a severe dislocation in the credit and mortgage debt securities markets in 2007 formed a culmination of risk-driven mania induced by easy credit and the implied Greenspan-Bernanke put option hedge.

Fig. 1: Historical target Federal Funds interest rate and Discount Window rate to primary borrowers

Fig. 1: Historical target Federal Funds interest rate and Discount Window rate to primary borrowers

Fig. 2: Money supply metrics vs. original (pre-1983) Consumer Price Index (CPI)

Fig. 2: Money supply metrics vs. original (pre-1983) Consumer Price Index (CPI)

Since early 2009, after the Fed reduced the target Federal Funds rate to a pinioned range of 0%-0.25%, the Fed has resorted to outright quantitative easing or debt monetization measures in large scale to prop up flailing markets, buying up Treasuries and other debt securities, namely Agency debt obligations and mortgage-backed securities, with fiat dollars. (A list of these large-scale asset purchases can be found HERE

.) Money supply metrics have swelled to record levels, as has the consumer price index, a measure of price inflation (Fig. 2).

Most recently (Aug/Sept. 2011), the Fed has announced an indefinite continuance of its zero interest rate policy, and a large-scale “maturity extension program” (a.k.a. “Operation Twist”), whereby shorter-term maturity Treasuries on the Fed’s balance sheet are sold and the proceeds used to buy longer-term maturity Treasuries, with the intention to keep long-term interest rates, and most notably long-term government borrowing costs, low. As of the writing of this essay, the Fed’s published balance sheet (Fig. 3) has swelled to ~$2.9T, with >91% of it (~$2.7T) composed of Treasury and Agency securities. (The Fed’s published, simplified balance sheet can be tracked HERE

, with debt securities acquired via open market operations tracked HERE .)

Fig. 3: Historical Fed balance sheet (assets) and components (securities held, loans, etc.)

Fig. 3: Historical Fed balance sheet (assets) and components (securities held, loans, etc.)

Fig. 4: Holders of U.S. Treasury securities

Fig. 4: Holders of U.S. Treasury securities

It is important to point out that the Fed doesn’t follow standards of accounting that apply to (most) of the rest of the world. Capital, which it does not hold should its portfolio lose significant value, can simply be declared. It is useful to ask the following question: when the securities (namely Treasuries) that the Fed holds come due, who pays whom? For what? That’s where a program such as Operation Twist comes in – it is a scheme to refinance that debt. Likewise, if the Fed starts to unwind its balance sheet by selling off Treasury and Agency debt securities, who will buy them? The Fed already had a failed auction this summer when it tried to sell mortgage-backed securities it held [2], and recently it has only stepped up the purchase of Agency MBSs

. The Fed increasingly looks like a buyer of last resort, with fiat money multiply leveraged to monetize the debt securities it purchases. In the event that foreign and domestic holders of Treasuries (Fig. 4) decide to sell their holdings, causing an increase of selling pressure and triggering a sharp decline of Treasury prices (and a commensurate sharp increase in interest rates), can the Fed declare enough capital to buy up all that sinking Treasury debt?

The ultimate questions that everyone should be asking are these: How sustainable are the Fed’s various hedging strategies described, can it fail and what are the risks of failure?

The leveraging of the dollar to monetize debt and keep interest rates stable and low has limits – the Fed cannot simply declare capital indefinitely to maintain stability. An instructive analogy is a company that decides to issue too much equity or debt – in doing so it dilutes its capital standing, and loses market value, sometimes sharply. Another analogy is that of a private hedge fund – those that thought they could hedge away risks through complex arbitrage trades, especially involving high leverage and little capital as a cushion, failed spectacularly. A prime example is that of Long Term Capital Management [3]. LTCM was able to move interest rates and ‘invent money’ with its highly leveraged swap book.

If the Fed can fail, who will be its lender of last resort? Who is its regulator?

A solution is to let markets freely determine interest rates and attendant price levels based on supply and demand instead of artificially driven, leading to exogenous seeds and shocks, and ultimately, financial instability. Sound money and a defendable, honest monetary standard that cannot be gamed or cheated remain the alternative to fiat money that can be declared at will, violating the property rights of those who have earned their money and who cannot simply declare capital at will. The Fed (or any similar central bank) as an independent [4] lender of last resort constrained to these principles would be a far safer entity, at less risk of failure, and less of a danger to capital markets and economies.

Author’s Note: I provide two primers below for the reader interested in understanding some of the concepts referred to in this essay. The first primer is on endogenous money, and the second primer is on chaos theory and how it may apply to financial markets in cases where mainstream neoclassical models break down.

References:

[1] “Agency” refers to housing-related government-sponsored enterprises (GSEs) Fannie Mae, Freddie Mac and the Federal Home Loan Banks.
[2] “Failed Fed Auction an Early Warning?” Susanne Lomatch, June 12, 2011.

[3] “Vintage Greenspan and the Lessons of LTCM,” Susanne Lomatch, August 13, 2011.
[4] An independent Fed would be decoupled from its government-sponsored charter.

Primer on Endogenous Money

Endogenous money refers to the theory that money comes into existence driven by the requirements of the real economy and financial market participants, and that banking system reserves are enlarged or drained as needed to accommodate the demand for lending at the prevailing interest rates.

One can immediately see from this simple definition why endogenous money is an important concept when we try to gauge the effect of ‘exogenous’ measures enacted by a central bank, such as the Fed, in the form of fiat lowering of target interest rates and injecting fiat money into the money supply or into bank reserves via its various open market operations. Further, one can also envisage the unintended consequences if such exogenous measures lead to geometric growth (or volatility) of endogenous money, and a commensurate rise of risk through the increase of leverage and fractional reserve lending. The geometric and power law growth of the debt securities markets [1] and derivatives markets [2] corroborate the growth of endogenous credit-money and the attendant risks that market participants find compelled to hedge.

If history is a guide, the central bank (the Fed) becomes in reality just another endogenous player in the system, as its future actions are dependent on the progression or play-out of the endogenous mechanics of system, including the instabilities that result. In short, the central bank is part of the ‘feedback loop,’ and may impose negative side effects in the attempt to restore stability to an inherently endogenous system. The Fed is known to use neoclassical monetary models to estimate quantity of broad money and to set its monetary policies accordingly, while these models may underestimate the effect of its exogenous measures.

The endogenous money theory is based on three main insights: [3]

1. ‘Loans create deposits’: at the level of the banking system as a whole, the drawing down of a bank loan by a non-bank necessarily creates new deposits (and the repayment of a bank loan necessarily destroys deposits). So while the total quantity of bank loans and the quantity of deposits may not equal each other in an economy, a deposit is a logical concomitant of a loan – it should not be seen as that which a bank needs to raise prior to extending a loan.

2. Whilst banks can be capital-constrained, a solvent bank is not usually reserve-constrained or funding-constrained: they can usually obtain reserves or funding if required either from the interbank market or from the central bank.

3. Banks will therefore pursue any profitable lending opportunities that they can identify up to the level consistent with their level of capital, treating reserve requirements and funding issues as matters to be addressed ex post – or rather, at an aggregate level.

These insights imply that the quantity of broad money in an economy is determined endogenously within an economy: in other words, the quantity of deposits held by the non-bank sector ‘flexes’ up or down according to the aggregate preferences of non-banks. Significantly, the theory states that if the non-bank sector’s deposit holdings are augmented by a policy-driven exogenous shock (such as quantitative easing), the sector should be expected to find ways to ‘shed’ most or all of the excess deposit balances by making payments to banks (comprising repayments of bank loans, or purchases of securities).

This account runs entirely counter to the mainstream economic theory of money creation, which states that the quantity of broad money is a function of (a) the quantity of “high-powered money” or “government money” (notes, coins and bank reserves), and (b) the money multiplier. Endogenous money concludes that the money multiplier as a concept has no bearing on how lending and bank reserves interact in practice.

[1] “Global Debt Watch,” Susanne Lomatch, September 15, 2011

. See also detailed data for U.S. debt markets HERE .
[2] “Global Derivatives Watch: Netting, Collateral and Capital Cushions Matter,” Susanne Lomatch, September 15, 2011 .
[3] The italicized portion was adapted from a Wikipedia entry for Endogenous Money .

Primer on Chaos Theory vs. Neoclassical Models in Quantitative Finance

This primer is a very brief introduction to how chaos theories may apply to financial systems and markets when standard neoclassical models (based on normal random probability distributions and the assumption of equilibrium behavior) break down.

In a financial crisis, instabilities become manifested in the form of outcomes that would occur with incredibly miniscule probabilities when standard equilibrium theories are applied that assume a normal Gaussian probability distribution. This fact has emerged from the numerous historical examples we have on record, e.g. the 1987 Black Monday stock market crash, which exhibited price changes that would have occurred with a normally distributed probability of 10^(-160) [1,2], or the 10-sigma (10 standard deviation) failure of Long Term Capital Management (discussed in the essay text above) [3], or most recently, the 2008 financial crisis, which began with a massive dislocation and seizure in the credit markets in August 2007 when the LIBOR-OIS spread jumped a whopping 17x its usual standard deviation (17-sigma) [4]. As [2] asks, “The close calls of 1987 and 1998 had made quantitative risk models that had emerged from rational market finance look bad. Would they have looked much, much worse if the Fed hadn’t bailed markets out? On the other hand, if the Fed can be relied upon to save the world’s financial markets whenever they threatened to freeze up, what was the problem?

While markets do at times exhibit a normal random walk whereby price movements can be predicted with models assuming a normal distribution, there are times of turmoil when those models break down spectacularly, and market hedgers or policy estimators that use these models to make complex trades (e.g. with derivatives or a leveraged arbitrage) or to enact monetary measures (e.g. fiat interest rate cuts or fiat money injections) may find failure or unintended consequences a real possibility.

Two assumptions of neoclassical models are independence between events and linearity. When events develop an interdependence (e.g., future events depend on past outcomes) and nonlinearity enters as a dynamic, unpredictable outcomes can occur, sometimes involving great volatility and erratic behavior.

Chaos theory concerns the study of systems where a small input can lead to a disproportionate (nonlinear) response. Stated another way, small occurrences significantly affect the outcomes of seemingly unrelated events. Though “standard” chaos theory applies to deterministic systems, it is where seemingly random systems become chaotic that is of great interest, and has possible application to understanding the behavior of markets, financial systems, and the deleterious effects of participants, including central banks. As quoted from a pioneer of chaos theory, fractal mathematics and their application to finance: “We need to understand, in much closer fidelity to reality, how different kinds of prices move, how risk is measured, and how money is made and lost. Without that knowledge, we are doomed to crashes, again and again [5].”

[1] “Recovering Probability Distributions from Equity Prices,” J.C. Jackwerth and M. Rubenstein, Journal of Finance, Dec 1996.
[2] “The Myth of the Rational Market,” J. Fox, HarperCollins Publishers, 2009.
[3] “Fooled by Randomness,” N. N. Taleb, Random House, 2004.
[4] “Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis,” J.B. Taylor, Hoover Institution Press, Stanford University, 2009. See also “A Black Swan in the Money Market,” J.B. Taylor and J.C. Williams, Hoover Institution and FRBSF, April 2008.

[5] “The (Mis)Behavior of Markets: A Fractal View of Financial Turbulence,” B. Mandelbrot and R.L. Hudson, Perseus Books, 2008.

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