Amplified Losses-----The Fed Painted Itself Into A Corner And Now Comes The Carnage

by MN Gordon at Economic Prism

Federal Open Market Committee meetings are always a spectacle.  The forthcoming FOMC meeting, scheduled for September 16 and 17, should be particularly endearing.  For despite the Fed’s claim to provide transparency the upcoming policy announcement is cloudier than pollywog stew.

All year the Fed has hinted they’d finally lift the federal funds rate from near zero.  Yet with each FOMC meeting the Fed has pushed back the decision.  Until three weeks ago, the September FOMC meeting was to be the historic date of a small, incremental rate increase.

But that was before the stock market shuttered and rapidly dropped 12 percent.  In late August, at the moment of maximum panic, New York Federal Reserve Bank President, William Dudley, backed off on the prospect of a September rate increase.  The markets greeted Dudley’s remarks as if they were manna from heaven.

However, after the stock market settled down, it wasn’t clear if the September rate increase was still on or not.  No one seems to know.  This includes the Fed too.

Nonetheless, delaying a rate increase – again – will cause the Fed to lose what little credibility they have left.  Clearly, they’re winging it.  They are making things up…making gut feel policy decisions as they go.

Stand Still

When it comes down to it, the Fed has painted itself into an extraordinarily tight corner.  After six plus years of zero interest rate policy, and a 400 percent increase in the money base, the Fed is trapped.  There is absolutely no way they can exit the radical policy path they took us down without triggering a major market disruption.

Now, with less than a week before the FOMC meeting, the intelligentsia is coming out against the planned rate hike.  The New York Times is against it.  Moreover, in a most comedic plot twist, Larry Summers, the man Janet Yellen beat out for the job, is now publicly offering advice.

“Two weeks ago I argued that a Federal Reserve decision to raise rates in September would be a serious mistake,” blogged Summers on Wednesday.  “As I wrote my column, the market was assigning a 50 percent chance to a rate hike.  The current chance is 34 percent.  Having followed the debate among economists, Fed governors and bank presidents I believe the case against a rate increase has become somewhat more compelling even than it looked two weeks ago.”

Then, after tediously describing his five salient points, Summers concludes, “Now is the time for the Fed to do what is often hardest for policymakers.  Stand still.”

Maybe so, but hasn’t the Fed stood still for nearly 7 years?

Not that we know any better than Summers or Yellen.  But we don’t pretend to.  Our position is that willing lenders and borrowers can agree on a fair rate of interest on an individual basis much better than unelected bureaucrats.

The critical fact is that stemming from the Fed’s key interest rate are trillions of dollars in big bets.  What’s more, these aren’t just high risk hedge funds engaging in these big bets.  They’re pension fund managers…and even your county municipal treasurer.

Amplified Losses

Take Robert Citron, for instance.  In 1994, the 69-year old treasurer for Orange County, a position he’d held for 25 years, oversaw a $1.64 billion dollar loss of public funds.  At the time this resulted in the largest municipal bankruptcy in U.S. history.  The fuse for Citron’s ticking time bomb was Alan Greenspan’s federal funds rate increase.

“As treasurer of Orange County, Robert Citron was considered to be somewhat of an investing whiz,” explains Andrew Beattie at Investopedia.  He consistently beat neighboring investment pools by at least 2 percent and, as a result, a steady flow of cash came his way.  Unfortunately, of the schools, cities and districts that rushed to invest with him, very few looked into how Citron was able to produce such amazing returns.

“In the simplest terms, Citron counted on interest rates remaining low.  From this view, the difference in yield on a short-term yield and a long-term yield offered an opportunity for arbitrage, so Citron used structured notes to take advantage of this.  Although this increased the risk as well as the potential profit, it was a viable strategy.  However, Citron leveraged the entire portfolio to further magnify the gains.  And, therein, lied the problem.

“Citron did a series of reverse repurchase agreements that allowed him to use his securities as collateral for loans to buy yet more securities.  Through this method, he turned the sizable $7 billion portfolio into a $20 billion dollar position.  The massive leveraging amplified his gains while interest rates followed his predicted course.  In February 1994, however, the Feds began to raise interest rates and Citron’s amplified gains turned into amplified losses.  As the rate hikes continued, the losses became too much to control.  The county was forced into bankruptcy.”

At the moment, the timing of the next Fed rate increase is uncertain.  Obviously, the Fed must raise rates at some point.  When they do, it’s almost guaranteed there’ll be some big bets that will go bad.  However, the frequency of these financial blowups happening has been dramatically increased by the Fed’s muddled guidance.

In Orange County’s experience, the grand jury investigation found that Citron “relied upon a mail-order astrologer and psychic for interest rate predictions.”

Perhaps Yellen does too.

Source: Amplified Losses | Economic Prism

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