Yesterday, the Pragmatic Capitalist (ht ZH) questioned who the mysterious large buyer of eMini S&P 500 futures (ES) was, when there has not been a corresponding large buyer of SPY ETF shares over the same short periods.  We decided this warranted a further investigation to assess, in the larger context, whether it is SPY or the ES that has historically had the greatest impact on the S&P 500 cash index, and the results were surprising. 

Methodology and Notes:  After normalizing the volume for both the ES and SPY over one minute periods going back to June, 2001 (when suitable data begins),  the relative difference in volume was multiplied by the change in one minute price of the Cash S&P 500, with a running total kept for the ES and SPY (similar to Effective Volume and Larry Williams A/D calculation).  The first minute of each trading day was not used so as to eliminate the effect of opening gaps.  Only SPY trading hours were used for the ES (9:30 am to 4:00 pm EDT).  The gap opening phenomenon associated with the ES futures is important, but a subject for another post.  A further caveat–S&P 500 pit futures exceeded the ES futures in total dollar amount traded until a few years ago and were more significant in influencing the cash S&P 500; however, we don’t have minute volume data for it, and it was not considered.  This preliminary study does not attempt to weigh the effects of the actual stocks that comprise the S&P 500 and implicitly assumes it is possible to lead the cash S&P with ES futures and/or SPY. 

Relative effect of ES and SPY volume on Cash S&P 500

The weekly chart, above, demonstrates that SPY volume (scaled left) has been basically on permabid since the beginning of 2002, with the ES only aiding the bulls (at least during the day session that we are measuring) from mid-2005.  The ES was showing chinks in the rally’s armor in Q4 2007 and led nearly the entire bear leg, with SPY relenting and sharing the lead down only during February 2009.  It may be worth remembering this when we get another down leg. 

In the daily chart, we’ve highlighted some interesting inflection points.  After the ES led most of the early rally from the March 2009 low, it led the June correction, after which SPY took the reins into the end of August.  Curiously, since then it’s been nearly flat, while the ES has led most of the down ward legs.  This is due to the fact that SPY’s upward and downward contributions have been netting more intraday, which suggests that either (1) the bullish firepower has been temporarily directed to the ES (though the fact that the ES’ net contribution is trending down is ominous), or (2) that there is institutional selling in SPY that is counteracting the upside firepower. 

Fortunately, there may be some trading insight to be gained here.  In future posts (free registration), we will attempt to determine if interim bottoms and tops in the S&P 500 can be anticipated and confirmed by these measures and their derivatives, especially when taking into consideration divergences between the two and by delving intraday.  Until then, it looks like SPY has picked up the slack today where the ES left off, so we should be safe until tomorrow.

This morning, Treasury released the quarterly Minutes of the Meeting of the Treasury Borrowing Advisory Committee Of the Securities Industry and Financial Markets Association, which is

[A]n advisory committee governed by federal statute that meets quarterly with the Treasury Department. The Borrowing Committee’s membership is comprised of senior representatives from investment funds and banks. The Borrowing Committee presents their observations to the Treasury Department on the overall strength of the U.S. economy as well as providing recommendations on a variety of technical debt management issues. The Securities Industry and Financial Markets Association does not participate in the deliberations of the Borrowing Committee.

Though the Committee had some interesting things to say about 30 Year TIPS and inflation expectations, we will focus on the statements of one member’s presentation regarding the Federal Reserve’s exit strategy (with respect to the >$1 trillion in excess reserves held by banks on its balance sheet).  We are not told just who the presenter is, but the Committee members comprise the most highly influential firms on Wall Street, including representatives from JP Morgan (Chairman), Goldman Sachs (Vice Chairman), Soros Fund Management, and Pimco. From the minutes:

The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve’s exit strategy and the implications for the Treasury’s borrowing program resulting from that strategy.

The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities.  It was noted that the near-zero interest rates driven by current Federal Reserve policy was pushing many financial entities such as pension funds, insurance companies, and endowments further out on the yield curve into longer-dated, riskier asset classes to earn incremental yield.  Treasury securities have benefitted from the resultant increase in demand, but riskier assets have benefitted even more.  According to the member, the greater decline in the indices for investment grade and high-yield corporate debt relative to 10-year Treasuries and current coupon mortgages displays this reach for yield.  A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero.  [This is a shot off the bow to HY and, especially, CRE—more on this in another post.]

Here’s where it gets interesting:

The presenting member then looked at the likely sequence of the Federal Reserve’s exit strategy.  The member acknowledged that the central bank must address the uncertainty and fragility of the economic recovery and the dependence of the housing market on low rates.  It was suggested that the most likely sequence would be the [1] draining of excess reserves from the banking system, [2] the cessation of the mortgage-backed securities purchase program, and [3] only then raising the Fed funds target rate.

Several members at this point asked why draining reserves before ending the MBS program made sense. The presenting member noted that the program was already set to expire, and other measures, such as a revival of the Supplementary Financing Program, could be utilized by the Federal Reserve at the same time.

The Fed’s $1.25 trillion Agency MBS buyback program is set to expire at the end of March, 2010, according to the last FOMC Announcement from September 23, 2009.  The point of the “several members” is valid, because why would the Fed drain reserves, only to continue adding them as a result of MBS purchases?  The presenting member points out that the Fed can avoid adding reserves after they are first drained through a revival of Treasury’s Supplementary Financing Program (SFP).

By way of background, the SFP is a special account maintained by Treasury at the Fed and is financed by cash management bills.  Says Treasury on September 17, 2008, “Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.”  Once the Fed gained the ability to pay interest on excess reserves in October 2008, Treasury announced that SFP would be gradually wound down as it was no longer necessary to sterilize the Fed’s balance sheet.  [As an aside, no where does the presenter mention the ability of the Fed to pay interest on excess reserves, a fact of which it is highly unlikely he would be ignorant.  Given the Fed’s recent statements regarding the use of other tools to manage excess reserves, we infer that the Fed does not view this as a viable option for managing excess reserves–perhaps because it is too costly, or too impotent a strategy.]

The big picture point, however, is that at least according to the presenting member (that we presume to be Fed-connected), the Fed currently envisions draining the >$1 trillion in excess reserves currently on its balance sheet by next March.  While it is possible the member means that the draining will only have begun by the end of March, his focus on the use of the SFP to drain any additional reserves generated by existing MBS purchases up to the end of March would have to be a non sequitur (and we assume rational actors here).

If the Fed drains in this fashion, it is close to criminally insane, as it has been deflationary with respect to M2 money supply since April 2009 and draining reserves would only further deflate the general economy.  If credit is hard to come by now, it will be immensely more so should these actions come to pass.

The mechanics of the draining are then discussed as follows:

The presenting member then addressed the options for draining reserves from the banking system.  The problem of excess reserves could persist through the end of 2011 with up to one trillion in excess reserves remaining after liquidity facilities and on balance sheet securities have rolled off.  One approach, raising the Fed funds rate to increase the opportunity costs of banks using their reserves, carries the attendant problems of increasing interest rates too soon in the economic recovery.  A second option, taking in term deposits, lacks a clear mechanism for rate setting and bank use.  Selling assets may run into difficulties if the public appetite for debt at that time is sated, especially considering the impact on the housing market and the major role the Federal Reserve currently plays in the market.  [Keeping up the public’s appetite for debt is the Fed’s de facto third mandate.]

According to the presenting member, these less than optimal solutions leaves the Federal Reserve the option of reverse repurchase agreements (reverse repos) as the most likely option although the potential of the mechanism for draining reserves is unclear.  If it is to undertake these reverse repos, the selection of counterparty is important.  Depending on how the program is designed, whether it is made to work with dealers or money market funds or to pursue a TALF model with banks as agents, there will be different impacts on the scope of the program, the ease with which it can be set up, and the term of the contracts.  In all cases, the program will compete with other short-term investments and put upward pressure on Treasury bill rates according to the presenting member.  Moreover, draining excess reserves may dampen the demand for Treasury securities by banks given that banks are investing in securities – particularly Treasuries – in the absence of loan demand. [Whether it’s the “absence of loan demand” or absence of banks willing to loan is a point for another post.]

Several members noted the graph discussing net fixed income supply in 2009 and 2010, and how issuance will ramp up dramatically in 2010. Federal Reserve purchases have taken an enormous amount of supply out of the market this past year across fixed income markets, but next year, financial markets should expect even greater issuance with no support. Such an outcome could pressure rates.

At this point, we must consider the possibility that the presenter is acting on behalf of the primary dealers and issuing a thinly veiled threat against the Fed and its deflationary policies.  QE has certainly been a profitable endeavor for them and the (recent) cessation of Treasury QE puts the primary dealers on the hook for any extra supply.  We hope we’ve simply read too much into this or that the presenting member at the TBAC minutes simply does not know what he’s talking about.  However, if the Fed is truly contemplating a drain of all excess reserves in such a short period of time, with the view of tightening shortly thereafter, we implore it to reconsider.

With the Fed’s $300 billion gift card to PD’s Treasure Island maxed out, one wonders who will support the vendors chomping at the bit to offload Uncle Timmy’s 3 to 7 year wares (much less the 30 year, being so two-thousand-and-late).  But with the sun setting, the Japanese tourists trickling out, and the kids tired from a hard day of play on the S&P 500 Coaster and the SPY IOI Whack-a-Mole, it would be easy to settle into a semi-euphoric complacency, thinking ahead to a frolic-filled night on Pleasure Island. 

This is the season when retailers typically look ahead with glee and patriotic investors hit the buy button on their stock accounts, not to return to their screens until January.  With equities awash in the greatest liquidity bath since Emperor Claudius built up Aquae Sulis from a Celtic mud pit, one hopes the proverbial plug has not been pulled here because, without the foundation of a stable and growing money supply, equities need the spigots set to max.

True, we still have QE in the form of Agency and Agency MBS, the latter of which could be considered a $1.25 trillion fire hose astride the puny Treasury QE faucet.  Then, there’s always the odd SFP wind-down.  But the sun rises and falls with the 2s10s and, should they get out of hand, already-difficult-to-secure business funding costs will rise along with mortgage rates.  This, ahead of record CRE resets, cannot be had.  Worry, not–Uncle Ben has a plan (aside from backstopping E-Trade in exchange for removing the sell button from their platforms), and all will be revealed soon.  Not at the next FOMC meeting, mind you, but surreptitiously, through the back channels of the Fed’s PR page. 

Will it be QE 2.0, usurpation of the money markets, or will the lamb of choice be the Primary Dealer Credit Facility?  We’re on pins and needles here, so please don’t disappoint us. 

————————

Update:  Ironically, a crashing stock market relieves the yield bloat.  Perhaps the Fed is content to watch the carnage for a while.

Reprinted from our weekly Chart Junkie submission at Wall St. Cheat Sheet.

The anchored VWAP line in blue provided good support over the years, including the 2002 low after the tech bubble crash (8).  However, price clearly broke through the line at times, most recently in March 2009 (9).  The lower panel plots the percentage deviation of price from the VWAP line, beginning from the July 1932 low.  Interestingly, the % deviation to the down side has never exceeded the -16% to -24% support area, the lower end of which was precisely hit this March (-22%).  This support level also caught the major low in 1974 (5) as well as some early lows in the 1930’s (1, 2 & 3). 

Just as the yellow horizontal lines can act as support or resistance, so can the green trendlines.  The 1966 top came after a break through major trendline support (4) and retest of the 110% level.  On the 2000 top (7), there was no upward retest and this did mark the high.  Eventually, the current rally will peter a bit, and we would expect a long period of sideways action until the far right green downward trendline is finally broken.  Unfortunately, this could take years (points 5 to 6 span eight years). 

What will be the high of this rally?  We would expect it to come on a test of one of the two far right green trend lines.  If price were to continue up at the same pace, this would be at Dow 10,700 or 12,500.  However, if the trend slows or stops altogether, these figures will be less of course.  We will definitely be keeping an eye on this indicator for some time.  For background on the powerful support that anchored VWAP can provide (a component of the Paul Levine MIDAS method), please see our Free Resources page (includes free TradeStation indicator).

The following interview by Damien Hoffman is reprinted with permission from WallStCheatStreet.com.  We are a long time follower of Chris Whalen, who is a highly connected banking analysts that pulls no punches.

———————-

One of Superman’s greatest powers is his x-ray vision. Independent banking analyst Chris Whalen has similar skills when it comes to seeing through banks’ vaults and financial books.

You can hardly find anyone as well respected on Wall Street as Chris Whalen — and Chris has earned that reputation.  In addition to his accurate and incredibly thorough analysis, Whalen follows Groucho Marx’s valuable advice “Before I speak, I have something important to say.”

Therefore, you won’t see or hear Whalen babbling crap or echoing the lemmings as they follow one another over a cliff.

I had the pleasure of catching up with Chris to talk about his adventurous career in finance, the folly of Wall Street’s over-simplified ratings systems, why covering banks is like calculating the location of a particle in physics, and how a Groucho Marx quote guides his rigor.

Sit back, relax, and learn why Chris Whalen is our second Medal of Honor recipient in Wall St. Cheat Sheet history …

 Damien Hoffman: Chris, you’ve had a very adventurous career in finance. Tell me about your adventure.

Chris: I was brought up in a different household from most because my father, Richard Whalen, was a journalist.  My mother corrected his spelling.  He worked at Time Inc.  and briefly at the Wall St. Journal with a guy named Robert Novack — who we just lost.  So I had the good fortune of following his career.  That included moving to Washington DC and writing speeches for Richard Nixon.

I grew up in D.C., so my world was national politics and the Fed.  People like Paul Volker, Alan Greenspan, and Arthur Burns would be at our house drinking bourbon, dining, and talking — doing what people did in the 60s and 70s.  So that was my context.

I came out of Villanova in 1981 and worked on Capital Hill.  Then I worked for the Heritage Foundation and Jack Kemp on the Hill — the Republican Conference Committee. That’s where I started to learn how write for two great editors, Karl Pflock and Terri Hauser, who both also were hardcore libertarian conservatives.

Then I got a chance to go up to New York and work at the Federal Reserve in the management training program.  That was my jumping point from DC to Wall St.  After that program I went to work for Bear Stearns as a sales trader.  I had a lot of fun there.

After Bear I worked with my father’s consulting firm, WIRES Ltd., that focused on trade and investments.  We had a lot of big clients in the Far East.  Then I started doing my own thing down under in Mexico because we were working on things related to NAFTA and Free Trade.  Among other things, I published a newsletter called the Mexico Report until ‘97.

In ‘97 I moved from DC back to New York and did tech-industrial banking at Bear Stearns.  I focused mostly on the financial buyer private equity community, but also got to try to make some big picture ideas work with Alan Schwartz, who is a tremendous banker. He didn’t deserve the way he got treated at the end of the Bear Stearns mess.  I’m very hopeful that he’s going to come back.  He can work as a banker in half a dozen industries and it’s really a talent to have that kind of flexibility.

Skipping ahead a bit, in 2003 I got a phone call from my current partner Dennis Santiago, who I met as a banker at PruVolpe.  He’s a great technologist and has built half a dozen major platforms on Wall Street for analyzing and displaying data.  He had bended my ear about his latest project called Audit Integrity.  I took a look at it – actually worked as a consultant on it for a few months.  It was a good methodology but, unfortunately, you can’t boil down a fundamentals-based analysis because it’s going to be wrong very often.  You’re going to have many false positives that will make the tool ineffective.

For example, when the flag is raised in the system, the question is, “What does the flag mean?”  If you go through that iteration, which is what we go through for things such as our Bank Monitor sample, we are able to then approximate a score — but it’s still a very complex score.  It is not a “yes/no” which is what Wall Street wants.

Damien: There are too many conditional variables to come up with one number in a snapshot and say, “This is it.”

Chris: That’s right.  On the other hand, having the ability to crunch tons of variables in the platform is great.  We get some interesting preliminary results.

I like to look at the context of the numbers, step back and say, “Where is this bank’s business model compared to the other banks?”  Take Hudson City Savings Bank (HCBK) for example.  They are very different than the other banks — even the banks in their peer group and size range.  They’re much less risky in a lot of ways that are very significant.

We said we’d stay positive on this name because they’re going to outperform everyone else. That’s the insight investors and risk managers want from analytics.  You want the analytics to help you get there, but it’s never going to give you a 100% black or white answer.  You have to understand what the numbers mean and the context.  But there is also a judgmental factor you can’t teach to a computer.  It’s moving.  It’s dynamic.  You can’t teach a computer that the last five years were crazy.  You can say, “Yes, these are all anomalies and now we’re going into some more anomalies in the opposite direction.”  But all the machine sees is the numbers and assesses them at face value.

So there is a judgmental part at interpreting all of these pretty analytics to try and finally come down to a judgement that offers something.  We have a range for retail products.  We have our index give a very objective view:  “How did you do this quarter?”  Basically, we look at five discreet factors that are all weighted equally.  Then we get more subjective as we try to synthesize a CAMEL Rating — the framework regulators use for evaluating banks.  We’ve got to decide which ones are important.  The bottom line is you’re going to be much better off so long as you can remember the difference between objectivity and subjectivity in analysis.

What we see a lot of on TV and the news is just a general movement of prices — it’s not evidence of rational behavior.  It is so funny when economists posit rational behavior in the financial market.  I think for 50 years we’ve been moving away from rationality in the markets because we don’t focus on cash flow and the fundamentals of values.  Instead, we look at stuff like, “To who can I sell this asset for more than I paid?”  So, by definition we live in a speculative environment.

When you try to use fundamental analysis, you’ve always got to be aware of that speculative context.  Look at financials.  From March of this year until now we’ve had a 100+ percent rally in financials.  Does that make any sense given the fundamentals?  Absolutely not.  You see this in other sectors as well.  The momentum factor in markets today is fascinating.  It’s much bigger than it’s ever been before.

Damien: Speaking about understanding the difference between types of analysis, does your diverse skill set play a role in keeping you cross-disciplinary in your approach?

Chris: A broader sampling of life’s experience is always a good thing.  For example, I wasn’t a particularly good banker when I went back to Bear Stearns.  I worked on fixed income and was also a bit older than most associates.  But, fortunately, they gave me good tips and I worked on several deals. I also did a few at PruVolpe. That’s how you learn:  the hands-on experience of diligence, talking to people, and researching financials. Those are all skills that take time to develop and to gain the confidence to use properly.

For example, if you’re an analyst, you learn how to tell little white lies if you can’t get access to the information you need.  Some people stretch things too far.  But working as an investigator in banking deals and as a channel researcher gave me forensic skills that I wouldn’t have learned about otherwise.

I’ve done a fair amount of work in consulting and litigation.  So. I’ve developed a niche of specialization with certain types of research, working with the public disclosure system, and tracking data that way.  It helps.

Now, include my partner Dennis.  He is a scientist and systems developer who knows how to query Edgar in amazing ways.  That skill allows us to harvest data kids coming out of school just don’t know how to do.  So there is a value to accumulating knowledge and skills you can’t get in formal settings.

It’s funny how people are skilled with technology when coming out of school, yet unskilled in the basics.  They can use all the tools and program in different languages, but if you sit them in front of a terminal with a command prompt and ask them to build something from scratch, they can’t do it.  Not all of them, but most.

Damien: As an researcher, how do you deal with barriers to disclosure?

Chris: Disclosure presents a lot of challenges outside the US because we are the only country in the world silly enough to believe in disclosure.  Disclosure is not a universal thing.  We can get hold of some data in some countries, but the quality level is iffy and the providence on the data is almost unknown.  So, we end up working with private vendors.  We have a friend in Vietnam of all places who gathers public and private company data throughout Asia.  It’s a private service bureau model.  There is no public mandate for disclosure in any of these countries.

Damien: How do your partners get the data if it isn’t mandated or disclosed?

Chris: Bilaterally with other banks.  If they have business relations with the bank, they will exchange data confidentially.

It doesn’t help the analyst or the investor.  As an analyst we are left with market price data.  It’s all anybody really has. Then we have the US economic data which is a horror show — but everybody pretends it’s biblical text. This is why the data industry has focused on tools driven by market data instead of fundamentals. Issuers have no interest in transparency, but rather selling stocks and bonds.

That’s what you’ve got in most of the world:  anecdotal news reporting. Y ou don’t have the rigger of disclosure you have in the US. Even in Europe.  Think about it:  where do you go for bank data in Europe?  There ain’t no place to go.  I’ve been told there’s a not-so-secret secret — a non-public source for all the regulators.  I’ve got to see if we can get them to give us some disclosure.

Damien: This leads to an interesting point. Your personal website has a very interesting quote from Groucho Marx, “Before I speak I have something important to say.” How do you know when you’ve done enough research to speak?

Chris: That’s a very good question. The first thing I do is assume the posture of the student. So long as you pay tribute to your sources and admit when you don’t know something, you’re all right.

I cringe when people describe me as an expert because it is very hard to be an expert in all of these banks — even the ones I actively cover. You can read everything, listen to all the calls, think deeply about them, and they can still surprise you!

I have to be qualified in my opinions. There’s no “absolute” anything. There isn’t an absolute distribution of possibilities  on which you can run Monte Carlo situations and be confident because your possibilities are variables floating through space. You don’t quite know what they are, but you sort of do.

It’s like a classic physics problem. Where is the particle in space? The answer is I don’t know, but I think I kind of know where it’s going and how fast it’s going there … but I don’t quite know where it is in space right now. We don’t want to get into a trap of generalizing — which we all do because we want to say all companies are like, for example, this one is better than that one. That’s a narrative comparison. That’s dangerous.

Working with Dennis I’ve learned to use statistics very broadly the first time I look at a bank. I compare the bank to all banks because I want to know where it falls into possible ranges of business models. But when you’re a sell-side analyst — or especially investment banking — you tend to group banking peers very closely. In other words, they don’t look at the entire industry. They look only at a few peers and comps. That analysis is prejudiced because they are looking at only part of the industry group. However, if you keep those sources of distinction in mind, you can keep out of trouble.

Damien: Chris, you’ve clearly done better than keep out of trouble with your excellent analysis leading up to and through the financial crisis. We are proud to give you our Medal of Honor for Excellent Service and look forward to your future work.

Chris: Thank you, Damien. I am flattered. I look forward to staying in touch.

Please click her to learn more about Chris and Dennis’s company Institutional Risk Analytics.

Be heard! Click here to nominate someone for a Medal of Honor.

Chief executive officer and president of the Federal Reserve Bank of New York (and ex-Goldmanite), William Dudley,  delivered a speech Tuesday afternoon that contains, with supreme gall and irony, a subsection called “Transparency.”  The title of the speech was thoughtfully crafted to allow a redirect.  So here we go…

[To] Dudley:  Some Lessons [for the Fed] from the Crisis.”

Transparency

In some critical segments of our financial markets, both before and during the crisis, limited or ineffective disclosure undermined market discipline and this contributed to the accumulation of risk.

Does this limited or ineffective disclosure undermine market discipline when it is carried out by the Federal Reserve, or do market participants turn forever a blind eye to the accumulated risk on the Fed’s balance sheet?  For how long will foreign CB’s snap up 30 year T-bonds at 4.0%?

In the years leading up to the crisis, the lack of transparency contributed to increased risk and leverage in off-balance sheet vehicles, structured credit products and in over-the-counter securities such as asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) and their associated derivatives.

These would be the same Agency MBS being created from no-doc loans issued by the FHLA for the sole purpose of reigniting the housing bubble—to the tune of $1.25 trillion–correct?  The same CMBS that will eventually be refinanced by TALF 3.0—correct?  Good thing they’re AAA rated by a group of cherry-picked ratings agencies.

Once the crisis was underway, the opacity of many of these vehicles, structures and securities contributed to the concerns about counterparty credit risk. This uncertainty exacerbated the erosion in market liquidity conditions and further intensified the crisis.

Fortunately, the counterparty risk to the Fed for this and other programs is now gone as it has been assumed by a combination of Treasury, FDIC and, of course, the Fed itself.  Note: counterparty credit risk cannot be removed by a tautology.

This lack of transparency was present in a number of different places:

Valuation. CDOs and other securitized obligations were complex and difficult to value. This reduced liquidity, pushed down prices and increased uncertainty about the solvency of institutions holding these assets.

Prices. The lack of pricing information led to a loss of confidence about accounting marks. Sometimes identical securities were valued differently at different financial institutions.

Fortunately, the Fed’s assets are reported at par—no need to value anything here—as long as they were taken in under the AAA stamp of approval.  With that out of the way, any question of insolvency cannot be addressed.  So, who needs an audit?

Concentration of risk. Because there was no detailed reporting of exposures, market participants did not know much about the concentration of risk. This led to a reluctance to engage with counterparties, which, in turn, pushed up spreads and reduced liquidity further.

Well, we know where all the risk is concentrated now…in the world’s largest central bank cum hedge fund. 

Thanks for the lesson on transparency, Mr. Dudley.

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This article was originally posted on Zero Hedge.

A rather prescient piece in the NYT the other day highlighted the problems in the debt securitization markets, which banks rely on to make room on their books for new lending:

To be sure, certain corners of the securitization market are percolating again, thanks to the government’s Term Asset-Backed Securities Loan Facility, or TALF, which provides attractive financing for investors who buy the securities.

Bonds backed by consumer debt — credit card debt, auto loans and some student loans — are being issued at costs close to those before the financial crisis, an indication that the market is functioning again.

But the program applies only to borrowers with stellar credit. It does not cover credit card debt or auto loans for people with blemished credit histories.

“The market is coming back, but a lot of it is because of TALF,” said Hyun Song Shin, a Princeton economist who studies securitization. “The big question is, Will the private issuance market stand on its own two feet without TALF, or has there been a fundamental change in the market that it is somehow hobbled permanently?”

The latest Consumer Credit data provided by the Fed today underscore this point, revealing that revolving credit decreased by an astonishing 13.5% in August (on an annualized, seasonally adjusted basis), accelerating an already existing downward trend.

Delving into the numbers a bit further in the second table (note these are non-seasonally adjusted numbers here), commercial banks, finance companies and the like actual increased slightly their revolving lending in August.  The culprit is the pools of securitized assets, down to $432.3 billion from $465.6 billion in Q2 2008.

As Zero Hedge noted, TALF was recently altered to an end that encourages shopping amongst ratings providers.  The big question, from our perspective, is how long into an anemic holiday shopping season will it be before TALF 3.0 is released, replete with overt accommodation for subprime consumer credit assets?

Veteran gold traders can attest that piling onto breakouts, especially in highly leveraged futures, can quickly become a losing proposition on a reversal.  While yesterday’s surge in gold was confirmed with gold priced in other currencies (especially impressive with the confirming moves in the commodity currencies of the CAD and AUD):

…there is a slight seasonal negative at work here until the end of October:

Traders should recall that the second week of October 2008 began a painful slide after a strong September.  The forced deleveraging from all instruments on margin call mania exacerbated the move last year, to be sure.  But it seems prudent to wait for a move back to the 1025 to 1031 area (basis Dec 09 contract), which is the 61.8% to 50% retracement box from the breakout of last week’s highs at the 1011 area.   Gold could even retrace to the 1010 (61.8% off 985.50 low) with the medium term bullish trend in tact.

In our opinion, better to be careful and potentially miss a move than to get caught up in the euphoria of a market that has burned many short term leveraged traders.

The Financial Times recently reported on the Fed’s latest exit strategy to eventually contain the inflation zombie:

During the crisis, the Fed created roughly $800bn of additional bank reserves to finance asset purchases and loans. This total is likely to rise in the coming months as the central bank completes its asset purchases and the Treasury unwinds financing it provided to the Fed. Fed officials think they could raise interest rates even with this excess supply of reserves by offering to pay banks to deposit their surplus funds with it rather than lend them out. However, they also want to use reverse repos in tandem to soak up some of the excess reserves. Policymakers call this a “belt and braces approach”. [The latter, clearly a nod to the great Gekko.] 

Tyler Durdan touched on this last Thursday, and we will expand upon it here as it is particularly relevant to our ongoing theory that it is the proceeds from permanent open market operations (POMOs) and their close cousins that are driving equities.  Though this may be received wisdom to ZH readers, the Fed has done us the favor of providing additional evidence through the FT story.  A bit of background, as we are new contributors to this forum:

Money Supply:  Based on our previous research on the effects of swings in M2 non-seasonally adjusted money supply (M2) on the stock market, we were a bit surprised in July 09 by the resiliency of the rally, which continued in the face of such a dramatic contraction in M2.  The dismal Durable Goods report from last Friday confirms that the capital goods sector is still under significant pressure as a result of a lack of money in the general economy.  With banks not lending to normal businesses and consumer credit contracting equally as violently, what is the basis for this rally and from where does the never-ending flow of equities juice flow? 

Bank Non-Borrowed Excess Reserves:  The Fed statistic that most closely correlates with the 2009 equities run-up appears to be bank non-borrowed excess reserves (bank NBER), which is a component of the monetary base (M0).  As explained by the Fed, bank NBER is simply total bank excess reserves minus bank borrowed excess reserves (bank BER).  This resulted in bank NBER going negative throughout much of 2008 because banks acquired most of their excess reserves through participation in Fed lending programs.  As the Fed has wound down these programs in 2009, bank BER has steadily declined and has been a drag on M0.  Concurrently, though, bank NBER has advanced since late March 09 with only one brief material pause in June, and reflects those excess reserves that need not be repaid as part of any Fed lending program.  The Fed purchases of MBS, Agency and Treasury securities netted $990 billion trillion since March 09.  The distinction between borrowed and non-borrowed excess reserves is critical because the latter would be ideally suited for leveraging and lending out to hedge funds and the like to “invest” in the high beta stocks that have led the rally.

The primary conclusion is simple—the stock juice flows from steadily increasing Bank NBER, which is hidden to even astute observers that focus on only M0 or M2.  Though we previously found no historical correlation between M0 (or its constituent components) and the stock market, we have witnessed an historically unprecedented set of circumstances.  Now that the Fed has become the world’s largest hedge fund, we are prepared to accept unorthodox conclusions.

So why not inflate both equities and the general economy simultaneously?  It was most likely a race against time.  The administration and Fed needed to replace the incredible evaporation of wealth that occurred in late 2008/early 2009 to quell the voting and investing masses.  They could not reflate the entire economy this quickly without jeopardizing their ability to borrow cheaply and restart the housing bubble.  To keep long term yields low, they reflated the stock market only, with the hope that the general economy would eventually catch up in 2010 and be able to sustain the stock market gains.  The problem with rising yields has not been solved, but was postponed. 

As we noted in previous research, we are toward the end of a seasonal drain on M2.  Once over the October hump, it should be easier for the holiday season to carry the market into March 2010, especially with the help of another $634834 billion in MBS and Agency POMO into next March (not to mention the possible Treasury SFP wind-down effect to the tune of $114 to 185 billion).  The Fed must be perfect, however, as any new panic will quickly feed on itself and likely lead to another mass exodus from equities.  This is quite simply because currently, there is absolutely nothing else to back up this rally in the general economy if the Fed funny money cannot do its trick.

Back to Money Market Funds:  If bank NBER is materially tied up in equities, then the Fed cannot drain from this source to mitigate inflation, or it risks the resulting cascade of sell orders that accompany the typical panic.  According to the FT article:

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets.  By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure [at gunpoint] from regulators and investors to stick to low-risk liquid investments. 

The Fed Helps Build Our Case:  As of September 17 09, bank NBER had increased by $563 billion since the March 09 rally began.  With M2 net flat during this period, the $563 billion has not made its way into the general economy by any stretch.  Perhaps it is sitting idle; however, the Fed says only $100 billion would be available from primary dealers in the future?  As the vast bulk of bank NBER is concentrated in primary dealers, this begs the obvious question of what will be tying up the remaining $463 billion (and we are not including the expected increases in bank NBER into next March, which could double this amount)?  Given a conservative lending leverage ratio of 10 to 1, there is potentially $4.63 trillion already sloshing around.  Even if we are much more conservative, given the roughly $2 trillion increase in the US stock market since Mar 09, it is not only easily conceivable, but probable, that a substantial portion was courtesy of the Fed ATM machine.

As Gekko closed his famous speech in Wall Street, “Greed – you mark my words – will save Teldar, and that other malfunctioning corporation, the U.S.A.”  While we have focused here only on coercive greed, it will be interesting nonetheless to see how this works out.

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This article was originally posted here on zerohedge.com.

Update:  A reference to “trillion” above was revised to “billion” and is marked.

This just in from the Fed:

Credit Quality Declines in Annual Shared National Credits Review

 Credit quality declined sharply for loan commitments of $20 million or more held by multiple federally supervised institutions, according to the 32nd annual review of Shared National Credits (SNC).

The credit risk of these large loan commitments was shared among U.S. bank organizations, foreign bank organizations (FBO), and nonbanks such as securitization pools, hedge funds, insurance companies, and pension funds. Credit quality deteriorated across all entities, but nonbanks held 47 percent of classified assets in the SNC portfolio, despite making up only 21.2 percent of the SNC portfolio. U.S. bank organizations held 30.2 percent of the classified assets and made up 40.8 percent of the SNC portfolio.

So, it looks like the large financial institutions have effectively offloaded nearly half of their bottom of the barrel commercial real estate and other garbage loans to the likes of AIG, CalPERS and the Norwegian Government Pension Fund.

The 2009 review covered 8,955 credits totaling $2.9 trillion extended to approximately 5,900 borrowers. Loans were reviewed and categorized by the severity of their risk–special mention, substandard, doubtful, or loss–in order of increasing severity. The lowest risk loans, special mention, had potential weaknesses that deserve management attention to prevent further deterioration at the time of review. The most severe category of loans, loss, includes loans that were considered uncollectible.

Key findings were:

• Criticized assets, which included SNCs classified as special mention, substandard, doubtful, or loss, reached $642 billion, up from $373 billion last year, and represented 22.3 percent of the SNC portfolio compared with 13.4 percent in 2008.
• SNC commitment volume increased $92 billion, or 3.3 percent, while the number of credits remained virtually unchanged.

• Classified assets, which included SNCs classified as substandard, doubtful, or loss, rose to $447 billion from $163 billion and represented 15.5 percent of the SNC portfolio, compared with 5.8 percent in 2008. Classified dollar volume increased 174 percent from a year ago.
• Special mention assets, which exhibited potential weakness and could result in further deterioration if uncorrected, declined to $195 billion from $210 billion and represented 6.8 percent of the SNC portfolio, compared with 7.5 percent in 2008.

The decline is because they are now in the bottom category.

• The severity of criticism increased with the volume of SNCs classified as doubtful and loss rising to $110 billion, up from $8 billion in 2008. Loans in nonaccrual status also increased nearly eight times to $172 billion from $22 billion. Nonaccrual loans included $32 billion in credits classified as loss and $56 billion classified doubtful.
• The distribution of credits across U.S. bank organizations, foreign bank organizations, and nonbanks remained relatively unchanged. U.S. bank organizations held 40.8 percent, while FBOs and nonbanks held 38 percent and 21.2 percent, respectively. Nonbanks continued to hold a disproportionate share of classified assets. Nonbanks held 47 percent of classified assets and 52 percent of nonaccrual loans. Federal Deposit Insurance Corporation-insured institutions held 24.2 percent of classified assets and 22.7 percent of nonaccrual loans.

Good luck, CalPERS.

• Criticized volume was led by the Media and Telecom industry group with $112 billion, Finance and Insurance with $76 billion, and Real Estate and Construction with $72 billion. These three groups also represented the highest shares of criticized credits with 17.3 percent, 11.7 percent, and 11.2 percent of criticized credits in the SNC portfolio, respectively.

Watch out CNBC.

• The review identified significant deterioration in credit quality of leveraged finance credits, with these loans representing more than 40 percent of the dollar volume of total criticized assets. About 72 percent of the dollar volume of the 50 largest leveraged finance SNCs were criticized, which represents one-third of all criticized assets.

Good thing for follow on offerings.

• Underwriting standards in 2008 improved from prior years, with examiners identifying fewer loans with structurally weak underwriting characteristics compared to credits written in 2007 and 2006. However, the SNC portfolio contained loans with structurally weak underwriting characteristics that were committed before mid-2007 that contributed significantly to the increase in criticized assets.

The SNC program was established in 1977 to provide an efficient and consistent review and classification of SNC, which includes any loan and or/formal loan commitment, and any asset such as real estate, stocks, notes, bonds, and debentures taken as debts previously contracted, extended to borrowers by a federally supervised institution, its subsidiaries, and affiliates that aggregates to $20 million or more and is shared by three or more unaffiliated supervised institutions. Many of these large loan commitments are also shared with foreign banking organizations and nonbanks, including securitization pools, hedge funds, insurance companies, and pension funds.

In conducting the 2009 SNC review, agencies reviewed $1.2 trillion of the $2.9 trillion credit commitments in the SNC portfolio, or 41 percent of the credits by dollar volume. The 2009 SNC sample was heavily weighted toward non-investment grade and criticized credits. The results of the review are based on analyses prepared in the second quarter of 2009 using credit-related data provided by federally supervised institutions as of December 31, 2008, and March 31, 2009.

Do you think the loans are performing better or worse since March 31, 2009?

Full PDF is here.  Nice chart illustrates the parabolic rise in low quality loans.

Sector analysis is here: