By Jonathan Yates (May 2011)
Back offices are notoriously the weaknesses in financial institutions for a variety of factors. The most obvious is that the back office is not a revenue producer. It does not bring in the earnings that a trader or investment banker does. As a result, it will never receive neither the attention nor the resources of a trading desk or an arbitrage group. With all the money earned at financial institutions, however, all back operations could obviously be made extremely efficient at little extra cost. But there are many advantages, particularly for a market make, so this does not happen. With almost $3 trillion in assets, over $2 trillion more than in 2007, the Federal Reserve Board now finds itself in the position of a market maker like that never witnessed before in financial history with a need to dispose of hundreds of billions, possibly trillions, of assets, with the value not known for many until the actual sale due to the shortcomings of back offices in the private sector.
From back office inefficiencies flow many benefits for the organization. If an inefficiency exists in money management, there is generally a reason for it that benefits the institution. The longer it takes for a trade to be cleared and settled, as an example, the more the financial intermediary profits. This is the basic time value of money element, i.e., “the float.” The longer the brokerage, bank or insurance company has the money, the more interest or investment income they earn. This has always been a huge revenue source for the financial establishment.
Inefficiency also allows for the market maker to manipulate the time and price of the trade to their benefit. For markets other than the New York Stock Exchange, this is a tremendous source of free money for the market maker. Bernie Madoff, unsurprisingly, was notorious for abusing this aspect of the clearing and settling process for NASDAQ trades, stretching the time allowed to book it to make more money by marking the buy and sell at the prices most to his advantage. It is also endemic in foreign bourses, bond trading and other exchanges where the transparency of The Big Board does not exist.
Another benefit of inefficient back offices is that assets can be marked to meet the needs of the financial institution. If a credit instrument is not traded over an exchange, it can be carried on the books at the price needed to meet regulatory standards or reporting needs. Level III assets fall into this category. Back office accounting for these assets did not turn out well in The Great Recession, to say the least.
As a result of these inefficiencies, trillions of assets have been mispriced and misstated. A recent report from Citigroup Global Markets, “CDS Liquidity Drying Up,” stated that the level of toxic assets had been overstated by a factor of ten. Rather than there being $60 trillion in toxic assets in 2007, there were only $6 trillion.
The reason for the discrepancy is that participating institutions did not net each contract against offsetting contracts. As a result, the volume of the trades accumulated with no marking against inventory for buying and selling. John Dizard, a columnist for the Financial Times, commented that, “It was as if every time someone bought or sold a share, of, say IBM, that trade was counted as if it were an addition to a pile of assets. The market statistics were counting flows as if they were stocks.”
About $1 trillion of these toxic assets are now owned by the United States Federal Reserve. Just as QE2 has brought about a rise in asset classes due to a cheap money policy, so too have the value of toxic assets increased. On April 19, 2011, Citigroup announced that it had sold $12.7 billion in toxic assets (subprime loans, mortgage backed securities and corporate debt) to comply with Basel III capital requirements. In those sold, three quarters of the toxic assets went at a price equal to or greater than that recorded on the books.
Others have benefitted from the rise in value of these toxic assets. In a recent letter to investors in the $9 billion Credit Opportunities Fund of John Paulson & Co., these assets were credited with its strong performance. Up 7.8 percent for the year, Paulson wrote, “…we have shifted our focus to equity linked credit investments such as defaulted debt, convertible bonds, and post reorganization equity securities.” Fortress Investment Group LLC reported its credit hedge funds as being up five to six percent for the same financial conditions. “The credit markets are on fire,” observes Peter Briger, who manages that business for Fortress.
These credit instruments now “on fire” constitute about half of the balance sheet of the Federal Reserve, with Treasury securities the remainder. Against this asset structure backdrop, there have been two seemingly contradictory positions assumed by the Federal Reserve recently. The first is that QE2 will terminate in June, taking the Federal Reserve out of its present role in financing the US budget deficit. The second, as articulated by Federal Reserve Chair Ben Bernanke at his April news conference, is that the commitment to a low interest rate environment will continue. The market has so far reacted by raising the price of Treasuries and lowering the yields, evincing its firm belief in the Chairman.
As the Federal Reserve has been the buyer of about 70 percent of Treasury bonds issued during the span of QE2, interest rates would seem to be destined to rise, however, despite recent market activity. Basic supply and demand would naturally dictate that higher interest rates would be the only way to attract alternative investors into Treasuries once the Federal Reserve retreated to the sidelines. Bill Gross and George Soros have both made major moves in anticipation of interest rates rising. Gross has dumped his Treasury holdings and has gone short in a big way, while Soros has sold commodities such as silver in anticipation of rates rising and the dollar being strengthened as a result.
On the balance sheet of the Federal Reserve now is over about $2.7 trillion in assets. In 2007, there was about $700 billion. By the end of QE2, the Federal Reserve will have about $1.8 trillion in extra long term assets on its books. Disposing of these assets will have a profound impact upon financial markets, particularly if many are worth more than currently being marked.
The reversal of QE2 has been created in less than a year by Federal Reserve policy. Now it is will be the Federal Reserve’s actions in selling securities that will have the greatest impact on interest rates, rather than its purchases. Under QE2, it was the Federal Reserve buying Treasuries that maintained low interest rates.
An operating standard at the Federal Reserve is that buying an extra $200 billion in assets takes 25 basis points off the funds rate. As QE2 entailed $600 billion in Treasury buys since last November, current interest rates are, in effect, about minus two points. With more than $1.8 trillion to move in Federal Reserve assets to return back to its previous position in 2007, the impact on interest rates will be huge, particularly in a presidential election year.
The basic scenario supported by some at the Federal Reserve first required abandoning the low interest rate policy. Then, next in order was to drain the excess reserves from the banking system and raise short term rates. After this was accomplished, asset sales were to be initiated. This approach was seemingly dismissed by Bernanke last month at his press conference. The market has reacted in solidarity with the Federal Reserve Chairman, bringing interest rates down.
At his press conference, Bernanke said the Federal Reserve would keep interest rates extraordinarily low for “an extended period” as, “It is a relatively slow recovery. The combination of high unemployment, high gas prices, and high foreclosure rates is a terrible combination. A lot of people are having a tough time.” Rather than being the last action taken by the Federal Reserve, asset sales could now by the first in order to keep interest rates low.
This was witnessed with the Federal Reserve’s involvement in the AIG bailout, then initial public offering; and could set the pattern for toxic asset sales. Cash proceeds from the initial public offering of AIA Group Limited were used to repay the credit extended by the Federal Reserve Bank of New York. The remaining FRBNY preferred interests in ALICO Holdings LLC and AIA Aurora LLC, valued at approximately $20 billion, were purchased by AIG through a draw on the Treasury’s Series F preferred stock commitment and then transferred by AIG to the Treasury as consideration for the draw on the available Series F funds.
This removed about $35 billion from the banking system over the 13-week period and about $22 billion in the past 4-week period. The toxic assets on the books of the Federal Reserve dwarf these figures. If the Federal Reserve were to offset the reduction in bank reserves from its asset sales with the open-market purchase of Treasury securities, any adverse impact on interest rates would be negated. In the AIG transaction, this brought down the “net” QE2 injections of reserves into the banking system.
QE2 required about $75 billion in monthly Treasury purchases from the Federal Reserve. This amount could easily be financed by the sale of the $1.8 trillion in assets. If the sales were to be made to foreign investors, the impact on US financial markets would be minimal. Were the funds to be withdrawn from the US banking system, the concomitant purchase of US Treasuries with the proceeds would negate any interest rate alterations, as happened with the AIG securities
At this juncture, the Federal Reserve is a market maker on steroids, unrivaled in economic history. Not only does it control the largest position, probably about $2 trillion in excess assets, it is dealing the cards in its unparralled capability to influence the direction of interest rates, which directly affects the value of its holdings (about one fifth the US GDP). Letting interest rates rise would not only degrade the value of its $2.8 trillion portfolio, but also enervate the accomplishments of its actions since 2007. Job growth, financial markets and the housing sector in the United States would also be destroyed, as would Obama’s reelection hopes.
The circle is now complete for toxic assets. When the Federal Reserve took toxic assets off the books of financial institutions in the midst of The Great Recession, there were no other interested parties; truly the buyer of last resort. Now many sales are going for more than book, evidence of strong demand in a yield hungry world. How the toxic assets are disposed of in the months ahead by the Federal Reserve will dictate political and economic fates well in the future, as happened in 2007 and 2008.