Doug Noland 
Refco and Delphi No Surprises

More Trials and Tribulations of Wall Street Finance

I do not argue that Wall Street Finance is necessarily inherently corrupt.  Instead, I propose that a highly energized, market-based Credit system offering enormous and easily attained financial rewards openly invites abuse and corruption.  What’s more, the combination of Federal Reserve easy “money” policies and overly abundant marketplace liquidity virtually guarantees a gold rush mentality of wealth-seeking endeavors – legal, legitimate and otherwise (Why did Willie Sutton rob banks?).   

This week’s news of fraud and deception at futures powerhouse Refco should come as no major surprise.  After all, the Wall Street Finance infrastructure that had coddled and financed the likes of Enron and Worldcom is these days more powerful and commanding than ever.  Sure, there were some hefty fines to pay – but their relevance was readily diminished by a few years of historic windfall profits courtesy of the Fed’s ultra-easy monetary accommodation.  Those pushing the (risk or statutory) envelope were emboldened and windfall fortunes only more handily procured.     

I contend that the defining feature of Wall Street Finance is the propagation of excess and self-reinforcing risk (excessive speculation, leveraging, asset inflation/Bubbles, unsound lending, and malfeasance).  The past few years have witnessed a veritable (blow-off) explosion of derivative trading and securitizations, areas particularly ripe for abuse and fraud.  Nonetheless, my view is in stark contrast to chairman Greenspan’s and the consensus view that contemporary finance provides an unparalleled capacity to recognize, isolate and manage risk.  For now, Mr. Greenspan’s sanguine view receives ongoing support from the potent elixir of abundant marketplace liquidity and rising asset prices.  There are indications, however, that the environment is in the process of changing.  As Warren Buffett has commented, “You don’t know who’s swimming naked until the tide goes out.” 

With hedge fund returns lagging, recent revelations of improprieties (Bayou Group and Wood River) are likely the proverbial tip of the iceberg (there are, after all, 8,000 funds!).  And to what extent market fluctuations (currencies, interest-rates, energy, oil, equities…) played a role in this week’s collapse at Refco, only time will tell.  For now, we should expect the wrecking ball of destabilizing volatility across the spectrum of securities markets to continue to chip away at marketplace confidence and liquidity.  In textbook fashion, the strength of U.S. equity markets has narrowed over time, and we see of late that the few favored groups have a proclivity for abrupt and painful downturns.  Clearly, the market environment is becoming increasingly challenging for the leveraged speculating community.  There will be ongoing pressure to rein in risk, counterbalanced by the necessity of posting positive returns. 

While the end-of-week focus was on Refco and inflation data, Delphi’s bankruptcy was a decisive blow to the tottering auto sector.  Auto and auto-related bonds were hit hard, while GM and Ford Credit default swap prices surged to levels not seen since last spring’s marketplace tumult.  Yet - and a curious departure from that period’s market response - Treasury yields this week rose sharply instead of their typical precipitous decline at the first inkling of heightened systemic stress.  It is very tempting to view this as a major marketplace development. 

Confidence that the Fed would cut rates in the event of a bout of marketplace angst has for sometime underpinned not only the U.S. bond market but the stock and “risk” markets as well.  A player speculating in the higher risk sectors (say, auto bonds, Credit default swaps, junk, emerging markets, homebuilding stocks, CDOs, energy, etc.) could at least partially hedge market exposure with (leveraged?) positions in Treasuries.  And while the various risk markets have tended to become more highly correlated over time, faith has held strong that bond prices would spike concurrently with any turbulence that might encompass the “risk” markets.  I would furthermore propose that the predictability of bond market rallies in response to tumult in the “risk” markets has played a major role in stabilizing leveraged speculator performance.  Diversification among various asset classes (large bond exposure?) has been a fundamental feature of relatively stable positive hedge fund returns and, hence, a crucial element fostering the hedge fund boom and systemic leveraging generally.  A less accommodative and predictable Treasury market would mark a major development with respect to speculator returns and, importantly, market and liquidity dynamics. 

Returning to our ongoing question: Why can’t booms last forever? Well, we can continue to focus on Financial Sphere inflation and the resulting strong inflationary bias that that has engulfed the global oil and energy sector.  This development has now significantly altered the likely possibilities of Fed policy actions.  The probability of a scenario of much higher rates has increased significantly, while the likelihood that the Fed would be quick to ease policy has largely diminished.  And while market rates are adjusting to this new reality, I believe that market players have not yet adjusted risk portfolios to this much less hospitable backdrop.  Keep in mind that up until recently the market perceived that the Fed was in the “eighth inning” and that cuts would likely commence in earnest early next year.   

There is a prominent dichotomy with respect to Wall Street Finance:  unprecedented Credit and speculative excesses have fomented asset Bubbles, economic booms, myriad distortions and untold corruption, right along with an historic speculative Bubble in Credit insurance/protection.  This is a huge systemic issue that I expect will become much more of a factor in the unfolding environment.  In the first place, I don’t believe Credit is an insurable risk.  Credit losses are not random, independent or quantifiable events, such as auto accidents, house fires, health issues or death.  Credit, by its nature, is very cyclical and non-random.   

The problem lies in the reality that the Credit insurance “business” will always appear extraordinarily profitable during the boom cycle (today in mortgages), with losses coming out of the woodwork on the downside (today in airlines and auto parts).  Importantly, cheap and abundant Credit insurance incites greater lending, debt issuance and speculative excesses, fomenting problematic aged financial and economic Bubbles.  Protracted Bubbles, then, guarantee commensurate down-cycles that prove devastating to the inflated Credit insurance marketplace.  It’s the nature of the beast. 

Fed “reflationary policies” incited aggressive risk-taking behavior throughout the markets (including speculating in GM, Ford, Delphi and other auto-supplier Credit default swaps); Dallas Fed president Robert McTeer led the cheer for consumers to all “hold hands and buy SUVs;” and booming ABS and mortgage finance ensured sufficient liquidity to create a global energy shock our system is today ill-structured to handle.  The inflationary backdrop (including energy, healthcare, and pension liabilities) has thus far largely destroyed the old-line U.S. airline and auto-parts industries.  And while the prognosis for General Motors and other industrials is not encouraging, the changing environment has me peering further out into the future.  

The rampant inflation in asset markets (homes and securities, in particular) has set the stage for Credit “insurance” disaster – including Credit default swaps, GSE guarantees, mortgage insurance, bond insurance, financial risk arbitrage and myriad federal guarantees.  Perhaps even more than leveraging, this Credit Insurance Bubble is the System’s Achilles heel.  Inflated home prices, reckless lending and corruption are today sowing the seeds for enormous Credit losses throughout ABS, MBS and the mortgage arena.  But that is jumping ahead… a bit. 

In some respects, the market environment has returned to where I thought it was earlier in the year.  I believed that “risk markets” had reached a critical juncture in the early spring.  Market rates were moving higher, stocks were in retreat and then near debacle struck in auto Credit default swaps.  I expected the leveraged players would be forced to shed risk, ushering in the end of the Credit boom cycle.  Well, I was wrong.  I today believe I was wrong because of the liquidity-creating power of a final unanticipated (for me, at least) bond market rally and decline in mortgage rates.  What transpired was a classic final melee, replete with negligent mortgage lending, wild Wall Street excesses, a Credit default swap boom, an emerging market boom, and a Global Liquidity Glut sufficient for $70 crude.  Those having hedged against higher rates were forced to unwind and dreams of a 3% 10-year yield filled giddy traders’ imaginations.  For good reason, events have unnerved the Fed, and I suspect it will be some time before they are again so eager to pander to an imperious Wall Street.   

If I am correct, pieces are falling into place for the unavoidable adjustment to highly leveraged and speculative U.S. asset markets.   I would expect stress in auto-related risk markets to be contagious.  Higher market yields from this point are also problematic.  The highly leveraged MBS marketplace is vulnerable to rising rates, wider Credit spreads and self-reinforcing hedging-related selling.  The entire financial sector is vulnerable to the unfolding environment, and this reality should begin to manifest in widening sector Credit spreads.  Further negative Refco revelations would likely push this process forward.  Because of the complex nature of the expansive speculative Bubble, we are forced to analyze subtleties in various markets for indications of heightened risk aversion, de-leveraging and waning liquidity.   

One would generally expect such speculative dynamics to ebb and flow depending on the prevailing sentiment of greed or fear.  Yet this week Refco did remind us how prone fragile underpinnings are to sudden collapse.  And, let there be no doubt, the shallow underpinnings of Wall Street Finance are - from here on out - highly susceptible to any slowdown in Credit expansion, any serious bout of risk aversion, or any meaningful move by the speculator community to de-leverage.  

Excerpted with permission from the Credit Bubble Bulletin, Oct. 14, 2005, copyright, PrudentBear.com

Timothy F. Geithner
Challenges In Risk Management
NY Fed Tells Banks To Beware Of Credit Derivatives

Today, I’d like to concentrate on some of the risk management challenges that are at the heart of prudential supervision—in particular, the financial health of the core intermediaries and the major wholesale markets for finance and risk mitigation.

While these topics are always at the center of our agenda, they are worthy of special attention today for two reasons.

The first relates to the overall economic and financial context in which financial institutions operate today. We have been through a period of relatively favorable overall macroeconomic conditions in the United States, low realized credit losses, lower volatility in output growth and relatively low and stable, long-term inflation expectations. This has been accompanied by a reduction in many different types of risk premia and in expectations of future volatility. This change in market perception of future risk has occurred in the context, however, of a substantial increase in leverage in the balance sheets of the United States, the federal government and the U.S. household sector. These developments are a potential source of greater macroeconomic uncertainty.

The second reason for greater attention to prudential concerns is that we are in the midst of substantial changes in the structure of the U.S. financial system.
The largest financial institutions in our markets are substantially larger than even a decade ago in the scope and complexity of their operations and in terms of their importance in the markets in which they operate. Hedge funds and other financial institutions that operate outside the scope of regulation or consolidated supervision now play a more important role in our financial markets. And we have seen a new way of financial innovation in credit risk transfer techniques and many new derivative instruments that have allowed risk to be measured and managed more effectively and distributed more broadly.

These developments have contributed to what seems to be a significant improvement in the overall stability and resilience of the U.S. financial system, by reducing the vulnerability of individual institutions to a broader range of potential shocks. They may also, however, add to uncertainty about how well the system might function in the context of a major systemic shock. And in this sense, they create some exacting challenges for risk management.

Let me focus on three areas where this is the case: counterparty risk management with respect to hedge funds and other unregulated entities; risk management and market infrastructure issues in credit derivatives and other instruments; and stress testing and scenario analysis.

First, the greater role of hedge funds and other unregulated entities in our financial system today requires more attention by the major banks and investment banks to counterparty risk management. The greater diversity of participants in risk intermediation is probably on balance a positive thing for our financial system.

Hedge funds, private equity funds and other kinds of investment vehicles help to disperse risk and add liquidity. Their greater prominence in our markets, however, means that banks and investment banks face a heightened challenge in managing the risks involved in their exposure to these firms and in understanding the firms’ ability to weather conditions of stress and their impact on market conditions in those circumstances. The degree of the systemic risk presented by the growth in the leveraged, unregulated financial institutions depends in part on how well the major dealers manage these challenges. Market practice in these areas has improved significantly since 1998, but progress has been uneven across the dealer community, and competitive pressures have caused some erosion in counterparty discipline relative to the risks in exposures.

We believe it is important that internal information systems are capable of capturing the full range of exposures to individual counterparties across the firm; that potential future credit exposure is measured realistically, including through stress tests at the counterparty level and across the firm’s portfolio, and managed to prudent limits relative to capital; that credit limits and terms reflect the quality of information provided by the counterparty about its risk profile and risk management systems and are not eroded by competitive pressures; and that the risk management process tries to capture the risk to the firm that could result from the rapid unwinding of positions by leveraged counterparties.

A second challenge relates to the growth in volume and complexity of new instruments for risk transfer, which has advanced, as it typically does, ahead of improvements in the trade processing infrastructure and risk management and control practices. Although these innovations seem likely to reduce overall risk in the financial system, shortfalls in the infrastructure leave the market more vulnerable than it needs to be to adverse dynamics in conditions of stress.

These gaps are evident in the degree of manual processing required for trade capture and settlement; the substantial backlog of undocumented or unconfirmed trades; the prevalence of assignments of trades without the consent of counterparties; and in the slow adoption of market services for automated processing. Shortfalls are also evident in the limits of models and other techniques for measuring potential exposures in conditions of stress.

Some of these shortfalls are the result of limited investments in resources and technology and the limited ability of individual firms to improve market practice without a commensurate effort by other dealers. Some are a reflection of the complexity of the products and the limited experience firms have had with how these exposures trade in more adverse market conditions. Both require a greater investment of resources and attention by senior managers.

We are encouraged by the initial commitments outlined by the major dealers earlier this month to resolve a number of these problems. In cooperation with the other principal supervisors, we will be monitoring progress closely.

The third area I’d like to discuss concerns the need to improve stress testing and scenario analyses, which are among the most difficult and consequential parts of the risk management process.

What is important, as always, is to bring a forward-looking view to evaluating a firm’s potential exposure across a broad range of economic and market conditions and to capture the risk in the tail of the distribution of possible outcomes.

Among the challenges we see today, even at the most sophisticated institutions, are the following:

• bringing more integration to the assessment of market and credit risk and the interactions between them,
• capturing, measuring and aggregating credit exposures stemming from activities across all of a firm’s business lines,
• assessing the value of positions in portfolios of more complex and less liquid products,
• capturing the potential implications on market liquidity and price movements of the unwinding of common positions across market participants, and
• assessing the implications of the exit of a major counterparty, particularly in the more concentrated segments of the market, and the limitations imposed by the size of the institution itself in responding to adverse market conditions.

Together, the three areas I’ve discussed—challenges in counterparty risk management with respect to hedge funds, developments in the credit derivatives market and infrastructure and ongoing work to improve stress testing and scenario analysis–represent areas where uncertainty is necessarily high. And assessing the probability of various outcomes and the potential losses associated with those outcomes is very complicated and hard to do well. Doing so requires care, judgment and a portfolio of different approaches. This is particularly important to do well in a context when we have had such a sustained period of relatively low credit losses and low volatility.

Across all these areas, these judgments have to be translated into appropriate limits, an appropriate capital cushion above the regulatory minimum and a robust liquidity management strategy. These thresholds need to be calibrated to withstand more adverse conditions than we’ve seen in the recent past.

The major institutions seem in general to be managed so that they are in a stronger position to withstand the shocks of the nature and magnitude of the last few decades of experience. The apparent increase in the strength and resilience of the U.S. financial system has contributed significantly to the improvement in the overall performance of the U.S. economy of the past 20 years.
As the challenges of risk management become more demanding, it is important that supervisors and those charged with managing the major financial institutions make the investments necessary to stay abreast of the changing frontier of risk management challenges and a potentially more uncertain future.

Excerpted from a lunch speech Mr. Greithner, the president and CEO of the Federal Reserve delivered Oct. 18, 2005 to an Institute of International Bankers meeting in New York City.