Monday, April 25, 2011

Is It 1994 Again?

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(, 2009)

There are several similarities between current trends and those in 1994, a year when many institutions were left destitute. Historical analogies can help us imagine what might happen, but identification of differences should be noted too.

The greatest dissimilarity is probably the structure of markets. There was some official (government-sponsored) interference in 1994, the most obvious being the Federal Reserve's authorized pegging of interest rates. There was, however, no comparison to the government's merrymaking in 2011.

Official policy to boost the stock market is well known. See, for instance
The Fed Underwrites Asset Explosion. Rumblings that the Federal Reserve is writing put options on U.S. Treasury securities circulate, the particulars of which can be read on various websites and in the Financial Times (see: "More on the Literal Bernanke Put," April 18, 2011.) The result of such interference is, or, would be, (depending on your inclination), to relieve fears of bondholders. The risk of falling prices is transferred to the party that has written the put. The Fed is (would be) absorbing losses if Treasury bond yields continue to rise and prices fall. (The latter is often forgotten but is important since balance sheets suffer losses and collateral falls: leading to calls for additional collateral.)

All government interference in security markets fails. The Fed's monopolized control and underpricing of short-term interest rates failed when the Internet and mortgage bubbles burst. Today, whether or not the Fed is writing put options to attract buyers of Treasuries is not as important as the knowledge that there are few interested buyers of an unhedged, 2-year Treasury note (0.70% yield) or a 10-year Treasury bond (3.5%). The Fed-sponsored put option is the logical next step to dampen the yield curve.

The analogy to 1994 is to an earlier time when the government could no longer control interest rates. Yields were too low and bond prices too high. Once rates did rise, there were several consequences. Many were related to untested and overmarketed derivative products. Institutions failed, some of high reputation, because they did not understand the derivatives that were making their clients rich (and suddenly poor). As we've seen time and again, "stress tests" of derivatives (and of banks) are paper exercises that cannot account for unforeseen divergences or convergences of markets that have been mangled. Many institutional and retail investors were caught in the grinder. An autopsy of 1994 may help today's investors avoid similar mistakes.

Then and now, the Fed had reduced interest rates to a microscopic level (from 9-3/4% to 3%), which had chased investors out of money markets and into the stock market. Net cash flows into stock mutual funds rose from $13 billion in 1990 to $79 billion in 1992 and to $127 billion in 1993. In 1992 and 1993, money market funds suffered net outflows.

Then and now, the banking system needed a bailout. Then and now, the Federal Reserve assisted financial gimmickry to boost a floundering economy. Commercial real estate was the greatest offender in the early 1990s. Citicorp and others had stopped lending. Banks borrowed Treasury bills at 3% and bought Treasury bonds that paid 6% yields.

This was the carry trade. Federal Reserve Chairman Alan Greenspan launched the carry trade in the early 1990s, for which he claimed a patent at the September 2004 FOMC meeting (See "
The 2004 Fed Transcripts: A Methodical, Diabolical Destruction of America's "Wealth." Several iterations later (of raising and cutting rates), have shown not only that superficial finance suffocates the real economy, not only that deeper and deeper cuts are less stimulative, but also that each new fix in finance must be more intrusive and crippling to markets.

In 1994, unhealthy securities were fashionable. More importantly, novice securities produced wholly unanticipated results when markets collided. Seemingly sophisticated investors learned they had not appreciated the risks they were bearing. Unanticipated correlations were imbedded in highly marketable derivative products. Today, derivatives are far more complex and the magnitude is incomprehensible. J.P. Morgan, a single bank, holds $78 trillion of derivative contracts. About 84% of all U.S. commercial banking derivative contracts ($231 trillion in total - all told, over a quadrillion dollars of contracts exist in the world) are interest-rate related at a point when interest rates can only go in one direction. A failed Treasury auction could boost interest rates by 4% in seconds. The banks say "We're hedged." Well, maybe this will turn out swell, but it is hard to grasp how the twists and turns of a commercial-bank, derivative book almost 15 times the size of the United States' GDP (around $15 trillion) can be anticipated when markets devour unmodeled deviations.

Then and now, derivative protection against rising rates is selling. From The Credit Bubble Bulletin, April 8, 2011: "The biggest year since 2003 for the packaging of U.S. government-backed mortgage bonds into new securities has extended into 2011, bolstered by banks seeking investments protecting against rising interest rates. Issuance of so-called agency collateralized mortgage obligations, or CMOs, reached $99 billion last quarter, following $451 billion in 2010..."

Then and now, the Federal Reserve - specifically, the FOMC - was too slow to raise rates. Discussions at current FOMC meetings will not be released to the public until 2016, but debate in late 1993 may have generated a similar edge. Larry Lindsey was the Federal Reserve governor who upset the applecart, or at least, the chairman, Alan Greenspan.

In September 1993, FOMC members David Mullins and Lawrence Lindsey expressed concern of a 'speculative bubble' in the stock and bond markets. Mutual fund flows from the U.S. had recently driven stock markets to all-time highs in Hong Kong, Bombay, and Botswana.

In November, Boston Chicken's shares appreciated 243% on the first day of trading. The stock sold at over 100 times sales - not earnings. This was the beginning of the public's consciousness of an acronym - IPO - that previously had been a Wall Street insiders' term. Federal Reserve Governor Lindsey stated at the December 1993 meeting: "[W]e all agree that the 3 percent [funds] rate is unsustainable. We all know it is too late." That is, the FOMC should have raised rates earlier to forestall a certain degree of speculation.

Lindsey noted a rush into $1 million home mortgages since, at current interest rates and forthcoming tax rates (which were going up for the well-to-do); this was "like borrowing money free for 30 years." Lindsey expected "asset rediversification, a flow of funds into real estate and... out of dividend-paying stocks into OTC stocks." "OTC stocks" would soon be rechristened "the Nasdaq" which rose from 760 to over 5,000 in about six years.

After Lindsay warned about "asset rediversification" in 1993, he raised the Boston Chicken IPO as a sign of speculation, then suggested the Fed cook up its own fast-food IPO, asking: "What do you think, Al?" Nobody at the FOMC ever call Greenspan "Al" and very rarely "Alan." First names were generally not used when FOMC members addressed each other. Transcripts are only words, but if a playwright's annotations were called for, "scowl" is the impression when Larry spoke to Al.

On January 31, 1994, Greenspan warned that "[m]onetary policy must not overstay accommodation." The Fed chairman went on to say the FOMC would decide "when is the appropriate time to move to a somewhat less accommodative level of short-term interest rates... Short-term interest rates are abnormally low in real terms..." By early 1994, banks were liquid and lending. This, too, should have warned the carry-trade was coming to an end. This is in contrast to 2011, when large banks' are not lending and owe their parasitic solvency to the Financial Accounting Standards Board.

The Fed raised the funds rate to 3.25% on February 4. This one-quarter of one percentage point increase caused more financial destruction than any event since the 1987 crash. Margin calls drove prices lower and yields higher. This prompted more margin calls and more selling. Long-term Treasury yields rose from 6.3% in January to 8.0% in December 1994.

February was just the beginning. The Fed continued to raise the funds rate to a peak of 6.00% in 1995. Greenspan probably did not anticipate the carnage. Nor, may he have anticipated how derivatives destabilized the financial system. The leverage in these contracts had contributed mightily to the recovery of the U.S. economy. The deleveraging could not have been a complete surprise.

A comparison between Greenspan in 1994 to Ben Bernanke in 2011 is probably an empty exercise. It is unlikely that Simple Ben will ever raise rates. He is, after all, simple. Either the market or a successor will do so. That is my opinion though, so Greenspan's reaction to rising rates in 1994 is presented as a case study that might shed some light on what the 2011 FOMC could think and do.

It does not appear the flowering of imaginative finance was appreciated even after the Fed raised rates on February 4. Frank Partnoy's book, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets is an invaluable guide to the unraveling. Quoting Partnoy: "The New York Times took note of the panic among financial specialists on February 5...saying the Fed's action sent an arctic blast through Wall Street."

On February 28, Chairman Greenspan told the FOMC: "I think we broke the back of an emerging speculation in equities. We pricked that bubble [in the bond market] as well....We have also created a degree of uncertainty; if we were looking at the emergence of speculative forces, which clearly were evident in very early stages, then I think we had a desirable effect." The Fed would raise the funds rate to 3.50% on March 22 and to 3.75% on April 18, 1994.

Askin Capital lost all of its money by April 7 - two months after the first rate hike. David Askin "was one of the largest and most sophisticated investors in mortgage securities. Askin was a respected trader...and was among the most active traders of complex mortgage securities. Often, Askin was the market." (Partnoy)

David Askin had marketed his fund as containing the "highest quality" securities. These would be hedged "so as to maintain a relatively constant portfolio value, even through large interest rate swings." He may have believed this, yet two 0.25% increases in a short-term rate sank the $600 million fund. The fund advertised its "proprietary analytic models" which discovered mispricings among complex mortgage derivatives, such as Collateralized-Mortgage Obligations (CMOs). Askin and his models misunderstood the complexities and compounded the error with a high dose of leverage. He also made the common mistake of ignoring the markets (after the February 4 rate hike) and believing his models - which told him they were right and the markets were wrong.

In hindsight it is easy to find fault with investors who lose money in a slingshot fund. Yet, it is also easy to understand why investors would trust Askin, given his experience, his reputation, and his domination of the market in which he invested. This is a warning to investors, in 2011: that it is worth the effort to understand the types of securities being managed in an account. Bond ratings are often camouflage for devious accounting tricks. ETFs are being launched so fast today, they cannot possibly be thoroughly vetted beforehand. More flash crashes should be expected. Standard asset allocation (as seen in the glossies and newspapers) is not the way to think about one's assets when imbalances are bound to topple. Collateral behind derivative arrangements (such as ETFs) is obscure.

At the April 18 FOMC meeting, Greenspan ventured: "[T]he sharp declines in stock and bond prices since our last meeting, I think, have defused a significant part of the bubble which had previously built up. We let a lot of air out of the tire, so to speak..." Possibly, but cascading losses had a long way to go. This was the date of the third rate hike, to 3.75%.

Askin's failure prompted an earthquake through the CMO market. Piper, Jaffrey, an old-line Minneapolis investment firm advertised the Piper Jaffrey Government Income Portfolio Fund as safe and secure. CMOs include mortgages that are backed by the U.S. government, so the fund remained within its mandates when the derivative securities rose to 93% of his holdings. As government-backed securities, they carried AAA-ratings. (There was no memory of unwarranted, AAA, U.S. government-sanctioned ratings in 2007. Why none of the regulators, rating-agency analysts, portfolio managers, CEOs were not arraigned...) The fund yielded over 13% - double the average of other government short-term bond funds. Something is mispriced here, but not the CMOs: more sophisticated traders called the securities "nuclear waste."

With the fig leaf of a AAA-rating, Piper, Jaffrey bought "inverse IO" CMOs, the payments from which correspond to the inverse of interest-rate payments of homeowners. Piper relied on Askin's models to price its own securities. When Askin's apparatus failed; Piper, Jaffrey could no longer value the portfolio. The fund manager resorted to calling brokers around the country and then released a weekly price. (Piper, Jaffrey was legally required to publish a daily Net Asset Value.) This garbage-in, garbage out methodology calculated the 1994 principal loss at 28%.

The lesson for investors in 2011 is to look beyond a brand name. Piper, Jaffrey had a good reputation. The Piper Jaffrey Government Income Portfolio had some flaws. It was managed by a celebrity: Worth Bruntjen. The "Wizard of Mortgages" appeared on the December 6, 1993 front cover of Business Week. He dressed as General Patton at sales meetings. Unbeknownst to the human resources department, he had not graduated from college. The most prominent red flags were the Piper, Jaffrey ads: "THIRTEEN PERCENT RETURNS! Legislation was passed permitting municipalities to buy shares in the fund. About 60 did so.

On May 17, 1994, the Fed raised the funds rate by 0.50% to 4.25%. On May 24, Greenspan told the FOMC members that "ever since the 1987 peaks after the stock market crash" uncertainty was diminishing and there was an element of euphoria that gripped the markets...we have taken a very significant amount of air out of the bubble...I think there's still a lot of bubble around.... [W]e have the capability, I would say at this stage, to move more strongly than we usually do without the risk of cracking the system." It is interesting that he estimated the damage done by raising rates had not and would not "crack the system," probably meaning the credit system along with the stock and bond markets. This is in contrast to 1999 when Greenspan claimed the Fed could not identify a bubble and even if it could the Fed would do nothing other than sweep up the debris. Looking at 1994 now, Greenspan had (in his words) identified a bubble, was letting air out of it [sic], and The System was in fine shape. Yet, it was cracking. The deified investment bank at 85 Broad Street was bailed out.

The largest publicly acknowledged casualty of all was Orange County, California, which lost $1.7 billion in derivative trades and was forced into bankruptcy. It had fallen prey to the pathetic County Treasurer, Robert Citron. (When asked how he knew interest rates would not rise: "I am one of the largest investors in America. I know these things"). To make a long story short, he bought AAA-rated issues of the Federal Home Loan Bank. The credit was sound but the bonds had been diced into inverse-floating rate structured notes. These were well beyond Citron's comprehension. As such, his decision to leverage $7.4 billion worth of inverse-floaters with $13 billion lent by Merrill Lynch threw kerosene on the fire.

It might be asked why a respected Wall Street firm did not observe more prudence when the borrower was so obviously untutored. Merrill was making too much money to care. Between 1990 and 1993, Merrill Lynch earned more than $3.1 billion, topping the total profits of its previous 18 years as a public company. Over $100 million of the profits were wired from the Orange County treasurer. Corporations were easy prey for investment banks. Merrill Lynch sold Preferred Redeemable Increased Dividend Equity Securities (PRIDES), Goldman Sachs marketed Automatically Convertible Enhanced Securities (ACES), Lehman unleashed Yield Enhanced Equity Linked Securities (YEELDS) and Bear Stearns created Common Higher Income Participation Securities (CHIPS).

Other big losers include Air Products and Chemicals (which lost $113 million), Dell Computer ($35 million), Caterpillar Financial Services, Eastman Kodak, Gibson Greetings, Mead, Procter & Gamble, Cuyahoga County (Ohio), National Fisheries (South Korea), Postipankki Bank (Finland), Federal Paper Board, Wimpey Group, Silverado Banking Savings and Loan, City Colleges of Chicago ($96 million - almost its entire portfolio), the Eastern Shoshon Tribe, the Sarasota-Manatee Airport Authority, Lewis & Clark County (Montana), eighteen Ohio municipalities (the reader may note an implied, potential vaporization of municipal balance sheets - they are easy prey), and Sears. Firms in the money business also paid a heavy price. Investment managers NationsBank, Fidelity Investments, the Vanguard Group, First Boston, Cargill Investor Services, Metallgesellschaft, Yamaichi Securities, Shanghai International Securities, and Soros Fund Management suffered unexpected losses.

Bankers Trust was hired by Gibson Greetings to hedge its interest-rate risk. At first the derivatives were simple. The strategies evolved into bizarre interest-rate swaps. For instance, Gibson Greetings received a fixed-rate, 5.5% interest coupon from its counterparty (Bankers) which received a floating-rate coupon equal to the London Interbank Offered Rate (LIBOR) squared by itself and then divided by six. This was more fun than scriptwriting The Daily Show. A Bankers Trust managing director recalled: "Guys started making jokes on the trading floor about how they were hammering customers." Gibson Greetings paid over $13 million in fees to Bankers over a 3-year period. The chairman of Bankers, Charlie Sanford, awarded the salesman a substantial bonus and sent an enthusiastic memorandum to the company when he announced the elevation.

Bankers Trust honed its skills to a remarkable degree. Bankers earned $7.6 million from one interest-rate swap it sold to Procter & Gamble. The security was so complex that the company misunderstood its exposure to a change of interest rates by a factor of 17. What appeared to be an exposure of $200 million was actually a $3.4 billion bet that rates would remain low. More interesting than the trade (on which P&G lost $200 million) were the taped phone calls that cut to the heart of the derivative sales boom. Following is a conversation between Kevin Hudson, who sold the deal, and Alison Bernhard, a colleague:

BERNHARD: "Oh, my ever-loving God. Do they understand... what they did?"

HUDSON: "No. They understand what they did, but they don't understand the leverage."

BERNHARD: "They would never know...."

HUDSON: "Never. No way, No way. That's the beauty of working at Bankers Trust."

These gimmicks were gathering headlines by the fall of 1994. It may have been fate, then, that entwined Bernhard and Hudson on November 5, 1994. The New York Times devoted a story to the managing director and the vice president of Bankers Trust. We read, under a lovely photograph of the pair: "Alison Ann Bernhard, a daughter of Dr. and Mrs. Robert Bernhard Jr. of New Orleans, was married yesterday to Kevin Walter Hudson, a son of Dr. Barbara W. Hudson and Walter Hudson of Baltimore. The Reverend Jeffrey H. Walker performed the ceremony at Christ Episcopal Church in Greenwich, Connecticut." The happy pair were headed to London where they would ply their trade for Bankers Trust.

It was misguided economists who sold the world on their efficient market hypothesis. It was the EMH on which the premises of the derivative models are constructed. Simple Ben worships at the altar. The models still do not address such pricing abnormalities as greed, pride, criminality and the most basic of motivations that led Bernhard & Hudson to the altar of Christ Episcopal Church.