Quantitative Unease: The Treasury Assists the Fed in Conducting Monetary Policy

Yesterday the Treasury announced that it would begin auctioning, starting today, $200 billion of Treasury bills in eight weekly auctions.  The proceeds are to be put in a special account at the Fed, the Supplementary Financing Account.  This is a signal, in addition to the recent discount rate increase, that the Fed is beginning to tighten.  What is unusual is that the signal came in the form of a low key Treasury press release.

The Treasury bills being issued pursuant to this program add to the supply of an outstanding issue, that is, the bills being sold at these special auctions have a maturity date that is the same as an outstanding bill issue and will consequently have the same CUSIP number as the outstanding bill issue.  Once issued, there is no way to distinguish this addition to the supply of the outstanding bill to that which was previously issued.

The Treasury had let the supplementary financing account run down to $5 billion because of the debt limit.  It says it is restoring it to the level it was at during much of last year.

The more important point is, as I have written before, the Treasury is undertaking these sales to help the Fed drain reserves from the banking system.   In essence, rather than the Fed selling Treasury securities from its portfolio and thus draining reserves, the Treasury sells newly created securities and the proceeds are taken out of the banking system.  The result on reserves is the same in either case.

Chairman Bernanke said last July that “although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.”  The operational benefits of a little more reliance seems to outweigh for the time being the need to protect independence.

According to a Bloomberg News article today (not yet available online), the Fed is trying to downplay the significance of the Treasury announcement.  The article by Rebecca Christie quotes the Fed: “‘The SFP is not a necessary element in the Federal Reserve’s set of tools to achieve an appropriate monetary policystance in the future,’ the Fed said.  ‘Still, any amount outstanding under the SFP will result in a corresponding decrease in the quantity of reserves in the banking system,which could be helpful in the Federal Reserve's conduct of policy.’”

As I have commented in previous posts, there are policy and legal questions one can raise about the Supplementary Financing Program.  The Treasury could also be criticized for paying interest for borrowing money it does not need.  Fortunately for Treasury, short-term interest rates are quite low; the interest rate on the 56-day bill auctioned today was 0.1%.  One can also explain that Fed alternatives would also cost the Treasury money.  If the Fed sold securities from its portfolio, the Fed would receive less interest income and therefore would have less earnings to turn over to the Treasury.  Alternatively, if the Fed raised the interest it pays on excess reserves held by banks pursuant to the authority it received in the TARP legislation, in order to encourage banks to hold idle balances, this would also reduce Fed earnings.

The Treasury also appears to be helping out the Fed in its cash management practices.  It used to be that the Treasury would target a relatively small balance at the Fed, perhaps $5 billion or so, and keep the rest of its cash in commercial banks in what are called Treasury Tax and Loan Accounts (“TT&L”).  A quick glance at Monday’s Daily Treasury Statement indicates that this is not the practice.  On Monday, Treasury held $32.6 billion at its operating account at the Fed, $5 billion in the Supplementary Financing Program account, and $1.9 billion in TT&L accounts.

AIG, FRBNY, Maiden Lane III, and Goldman Sachs

The attempt to figure out what happened in the AIG bailout continues.  Bloomberg News has posted an article today on the subject -- "Secret AIG Document Shows Goldman Sachs Minted Most Toxic CDOs."  This article is based on a document that the Federal Reserve Bank of New York ("FRBNY") did  not want made public in unredacted form but was inserted into the record by Representative Darrell Issa (R, CA.), the ranking member of the U.S. House Committee on Oversight and Government Reform.  The document, called "Schedule A," lists the credit default swaps ("CDS's") on collateralized debt obligations ("CDOs") that were put into an investment vehicle created by the FRBNY called Maiden Lane III (named after one of the streets bordering the FRBNY building in the Wall Street area).

Schedule A lists each underlying CDO by CUSIP number along with the tranche name, the associated AIG counterparty for the CDS on each CDO, the notional value (principle value of each CDO), the amount of collateral AIG had posted  for each CDS, and the negative mark to market (difference between the market and notional value).

As explained in the written statement of Tom Baxter, the FRBNY's General Counsel, for a January 27 hearing of the House Oversight Committee, Maiden Lane III was funded by a $24.3 billion loan from the FRBNY, which is secured by CDOs AIG had insured with CDS contracts and a $5 billion equity investment from AIG.  The purpose of Maiden Lane III was to terminate, or tear up, the CDS's sold to 16 AIG counterparties.  In return for agreeing to tear up the contracts, the AIG counterparties were allowed to retain $35 billion in collateral which AIG had posted with them and to sell the underlying CDOs to Maiden Lane III.  The $29.3 billion of funding was used to purchase the CDOs, which had a principal value of $62 billion.  Mr. Baxter states that the fair market value of the CDOs was approximately $29.6 billion, and that therefore the counterparties essentially received "par" for the securities in return for tearing up the contracts.

Baxter's statement is somewhat vague about the exact amount the counterparties received from Maiden Lane III for the CDOs.  According to a November 2009 report of the Special Inspector General for the Troubled Asset Relief Program ("SIGTARP"), Maiden Lane III paid the counterparties $27.1 billion and AIG Financial Products $2.5 billion as "an adjustment payment to reflect overcollateralization."  (Page 5 of the report.)  This adds up to $29.6 billion, the deemed fair value of the CDOs.  Left unexplained is how Maiden Lane III was able to make payments of $29.6 billion, when its initial funding amounted to $29.3 billion.

Baxter also states that AIG's $5 billion equity investment is subordinated to the FRBNY's $24.3 billion loan and that the FRBNY, in addition to this downside protection, will get two-thirds of any profits Maiden Lane III makes.  Maiden Lane III can hold the CDOs to maturity.

This seems like a pretty sweet deal for the counterparties for getting out of their exposures to both the CDOs they held and  to AIG if the CDOs were to suffer a credit event that triggered a payment on the CDS (which I am distinguishing from collateral posting).  In defense of the arrangement, Baxter states "...if AIG defaulted, and even filed for bankruptcy protection, the counterparties would have kept both the collateral and the underlying CDOs (and would have been made whole if they had sold the CDOs for fair value." [Emphasis in original.]  However, this particular argument does not square with some of the Fed's justification for this transaction.  If AIG had filed for bankruptcy, the "fair value" of the underlying CDOs would have  gone down, perhaps substantially.

There will likely be more revelations about this matter as the press and official groups, such as the Financial Crisis Inquiry Commission and various Congressional committees, continue to investigate.  In addition, as mentioned in a previous post, Goldman is a focus.  This additional evidence that it was such a large counterparty to AIG, backed by some hard numbers, guarantees additional public scrutiny of the firm.

The Wages of Hubris (II) – Goldman Sachs(?)

Currently, Goldman Sachs is under intense scrutiny. Matt Taibbi’s article for the July 2 Rolling Stone, “Inside the Great American Bubble Machine,” in which he blames Goldman for market bubbles since the 1920s, is an extreme version of the criticism, which Goldman no doubt could effectively rebut if it felt it had to, but, depending on the facts which are not all known, more recent criticism involving AIG and now Greece might be harder to shake off.

During the 1980s, two of the most important investment banks had similar names but apparently quite different corporate cultures.  They were, of course, Salomon Brothers and Goldman Sachs.  Salomon was especially an important firm in the government securities market and I would note that its research department produced interesting papers, some of which, such as those having to do with the pricing of zero-coupon securities, I found very useful in my work for Treasury at the time.  But Salomon's sense of its importance and invulnerability caught up with it when some of its officers thought they could get away with lying to the Treasury on the tender forms the firm submitted at auctions of Treasury securities.  In 1991, they got caught, and the resulting scandal eventually led to the firm being merged with Smith Barney, and its name disappearing as part of Citigroup.

Goldman has never been as brazen in dealing with the government as Salomon.  The firm makes great efforts to have good relationships with the government.  As evidence of their success at this, the SEC has in the past directed other government agencies to Goldman for explanations of their state of the art compliance programs.  It has also not hurt the firm’s reputation that many of its partners do a stint of government service  and, whatever else one might want to say about these Goldman alumni, they are smart.

Goldman’s record is not unblemished, though.  For example, on October 31, 2001, Goldman received word that Treasury had just announced that it would stop issuing 30-year bonds before the embargo on the news ended and traded on that information before it became generally know in the market.  Goldman’s CEO, Henry M. Paulson, claimed that the firm had not violated SEC rules (“Goldman Chief Denies Firm Violated Any SEC Rule,” New York Times, April 6, 2002).  However, the firm ended up settling with the SEC, disgorging $3.8 million in profits and $500,000 in interest and paying an additional $5 million penalty. Also, a Goldman employee was sentenced to almost three years in prison for his role in the affair.

This embarrassing history was, however, not mentioned when Paulson was later nominated and confirmed as Secretary of the Treasury.  Everyone seemed relieved that a man with a successful Wall Street career was taking over Treasury after being headed by two Secretaries who had received generally bad reviews and had been viewed as ineffective.  And however one might evaluate Secretary Paulson’s actions during the financial crisis, no one doubted his level of knowledge nor his influence in making policy.

Currently, as I have mentioned in a previous post, there are questions about Goldman’s relationship with AIG.  The New York Times  published an article about this a week ago, "Testy Conflict with Goldman Helped Push AIG to Edge."  However justified Goldman’s demands for collateral were from a weakening AIG, Goldman had to know at some point that its demands were increasing the risk of an AIG bankruptcy, in the wake of which the entire market, including Goldman, would suffer.  It appears we do not know the whole story here, and, as long as we do not, Goldman can expect there to be some suspicion directed its way.

Now it turns out that Goldman was helping out Greece in hiding its true fiscal situation through transactions Goldman arranged.  Simon Johnson, a former chief economist of the IMF, has been especially critical of Goldman on this. 

Given the threat to the euro of the Greek situation and what that means to the global monetary system, this affair could prove a challenge to Goldman.  It is quite possible that Europe will be able to muddle through this problem and any future ones (Portugal, Ireland, Italy, Spain?), but the dangers are real.  Of course, they are not Goldman’s fault; a reasonable argument is that Europe got too far ahead of itself in creating a single currency and that the UK was right to stay out.  But Goldman’s facilitating hiding fiscal problems will be examined.

The people who run Goldman are smart, and they may be able to ride out their current problems.  The facts, of course, may be more benign than one might now suspect.  But their actions and their success in making huge profits are getting unprecedented scrutiny.  They have much greater name recognition than they have ever had; for them, that is not a good thing.

The Wages of Hubris (I) – Fannie Mae and Freddie Mac

Scandals and crises are periodic occurrence in financial markets.  Sometimes the arrogance of those involved is breathtaking.  For example, who can fail to remember Enron or the accounting scandals of Fannie Mae and Freddie Mac?

With respect to the latter, Fannie and Freddie had successfully fought off Treasury’s attempts to rein them in over the years.  The Treasury has had an institutional bias against Government Sponsored Enterprises (“GSEs”), of which Fannie and Freddie are the largest.  The reason for this was once succinctly summarized to me by a senior career Treasury official – “They pay themselves private sector salaries but do not take private sector risks.”

At Treasury, we knew that no matter how loudly we proclaimed that the Treasury did not guarantee Fannie and Freddie securities, which was technically accurate, no one would believe us.  Consequently, GSE securities, with somewhat higher yields than Treasuries, competed with Treasury securities.  Treasury’s debt managers did not appreciate this.

When the firms were approaching failure and were put into conservatorship, market participants’ assessment of the value of the “implicit” guarantee proved accurate.  The government had little choice.  Even if it had been willing to make private investors in Fannie and Freddie debt suffer financial losses, it could not afford to do this to foreign central banks which had invested in Fannie and Freddie debt.    

The creation of a new safety and soundness regulator in 1992 at Treasury’s urging, the Office of Federal Housing Enterprise (“OFHEO,” which was merged into the Federal Housing Finance Agency in 2008), did not faze these firms.  In fact, the two mortgage giants took on more interest rate risk while under OFHEO’s supervision.  For both GSEs at the time of OFHEO’s creation, the income from guarantee fees on their mortgage backed securities (“MBS”) was greater than the income from the interest rate spread on their portfolio holdings.  During the years of OFHEO supervision, this relationship between the two types of income reversed, meaning that Fannie and Freddie were taking on interest rate risk as well as credit risk in order to increase their profits.  (Ultimately, of course, the interest rate risk did not matter.  Their recent fate was due to growing defaults.)

But in the late 90s and subsequent years, Fannie and Freddie apparently did not realize that the political landscape was changing.  They had most of Wall Street intimidated by their size, but the relaxation of Glass-Steagall rules and then its repeal in 1999 allowed the big banks to get even larger.  In 1999, some of these banks created an organization called “FM Watch.”  They were concerned that Fannie and Freddie, in their attempt to maintain their historical returns on equity, which at times was around 30%, would continue to broaden their activities in direct competition with the banks.  The market for conforming mortgages might not grow fast enough to suit the GSEs, and the banks wanted at a minimum to limit what Fannie and Freddie could do.

Both firms decided to adopt aggressive accounting policies which crossed the line of what was permissible. In Fannie’s case, the arrogance was remarkable; right up to the end in 2004, Frank Raines was testifying before a Congressional committee that he thought the accounting rules were complex but did not believe that Fannie had done anything wrong.  (I was following this at Treasury, and, though I have forgotten the details, I remember thinking at the time that it was hardly a close question of whether Fannie had crossed over the line in its accounting.)

Mr. Raines insisted that the SEC review the conclusions of the more aggressive OFHEO he was then facing. One has to wonder what he was thinking.  The SEC also thought Fannie had broken the rules, and by the end of 2004, Frank Raines had left Fannie Mae.

Currently, the knives seem to be out for yet another firm Goldman Sachs, though not, at least not yet, from the regulators.  Goldman is the subject of the next post.

AIG Questions

As the financial market crisis of 2008 has receded, there is considerable controversy about its causes and the actions the government took in response.

A slew of books have been hurried to print on the subject. That they have been written in a hurry shows. For example, Andrew Ross Sorkin, in his interesting book, Too Big to Fail, makes mistakes, such as incorrectly describing Washington, DC geography, stating that fiscal policy is decided in the Fed Board room, and confusing the relationship between the yields and prices of Treasury securities. The book also contains numerous typos, but still researchers for years will find the book interesting for the story it tells.

While Sorkin's book has been called too big to read by some, it is interesting. It is, though, true that it is nearly impossible to read all the books that have been produced. But as the attention and controversy has currently centered on AIG, I would like to suggest some questions and issues which could very usefully be addressed in one place.

● Some of AIG's counterparties were purchasing credit default swaps (CDS) in order to minimize their capital requirements. Because AIG had a AAA rating, banks could apparently reduce the capital needed to support their holding of collateralized debt obligations (CDOs). What proportion of AIGs derivatives business was for the purpose of minimizing its counterparties capital requirements? How much did AIG's activities in this area enable banks to increase their leverage?

● Were the federal banking regulators and the SEC aware of the concentration of risk at AIG, caused at least in part by incentives in capital rules? How much sharing of information concerning this was there within regulatory agencies, for example among bank examiners responsible for specific banks? Was this issue discussed among the various regulatory agencies?

● What was the motive for Goldman Sachs to enter into CDS’s with AIG? Was it capital, hedging, or something else?

● Goldman claims that the direct effect of a AIG failure would have been negligible on the firm. Apparently, it had offset it positions with AIG with other counterparties. (Of course, Goldman's hedges of its AIG positions may not have worked if its counterparties had been financially weakened in the fallout of an AIG bankruptcy.) How and with whom did Goldman hedge its credit exposure to AIG?

● Why was Goldman pushing as hard as it was for additional collateral from AIG, since this could push AIG into bankruptcy and cause systemic problems in the market and resulting financial pressure on Goldman itself? Was Goldman betting that some solution would be found by the Fed or the Treasury?

● Goldman reportedly told AIG that it should accept Goldman’s valuations of the CDO’s that AIG had effectively insured with CDS’s, because Goldman and AIG shared the same auditor, PricewaterhouseCoopers. How did PwC manage its role in this affair? What are the implications for auditing firms that get caught in valuation disputes among their clients?

● Were there any significant tax motivations underlying AIG’s derivatives transactions?

● What percentage of the securities that AIG effectively insured by selling CDS’s have defaulted?