Federal Reserve & Interest Rates

While in some ways the current global recession began with the collapse of the U.S. housing market and the subprime mortgage meltdown, much of the ensuing damage was amplified because of the explosive growth of the over-the-counter(OTC) derivatives market.  It will also be exceedingly difficult for the Federal Reserve to develop a regulatory structure for this complex and unwieldy market that many observers have called a ticking time bomb for the financial system.

The government has been holding hearings recently on revamping the entire regulatory structure of the entire financial system in order to prevent the kind of shocks that nearly brought it to it’s knees over the past year.  A major concern for the Fed is the currently unregulated OTC derivatives market and some of it’s members gave their views before Capitol Hill today, on ways to finally regulate a market that is pretty much a festering wound waiting to happen.

The events of the last two years have demonstrated the potential for difficulties in one part of the financial system to create problems in other sectors and in the macroeconomy more broadly. OTC derivatives appear to have amplified or transmitted shocks. An important objective of regulatory initiatives related to OTC derivatives is to ensure that improvements to the infrastructure supporting these products reduce the likelihood of such transmissions and make the financial system as a whole more resilient to future shocks.

The key goal of any of the changes to the financial regulatory structure will be to dampen systemic risk and the derivatives market as it currently stands poses a grave threat to future global financial stability.  Unfortunately the task ahead at this point may be akin to closing the barn door after all the animals have already left.

Because the market has grown so large in such a short time, it will take a global effort from central banks around the world to realize any significant changes in the short term for it to be effective.  At this point acting on it’s own, the Fed’s can only realistically try to mitigate any possible shocks to the financial system as opposed to attempting to prevent them entirely.

In exchange for a 80% equity stake in American International Group, the Federal Reserve has agreed to lend up to $85 billion so that it can avoid a disorderly collapse that could adversely effect global financial markets.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.  

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy. 

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

This is far from a government handout, with the current Libor rate, AIG is on the hook for over 11% interest rate for the 2 year loan.  The loan is in place for the sole reason so that there can be an orderly sale of the company’s assets.

While AIG was in talks with Morgan Stanley and J.P. Morgan Chase in order to secure a $75 billion lifeline, apparently those talks broke down leaving the company no choice but to accept the government’s offer.  The world’s largest insurer has been brought low by losses stemming from credit derivatives it sold on Collateralized Debt Obligations most notably Mortgage Backed Securities.

These credit default swaps are basically insurance policies that investors purchase to protect themselves from losses.  In case of default, the seller of the swaps makes payment to the purchaser for the principal or face value in exchange for the underlying security.

When the housing market was booming this was pretty much free money as they never had to make any payments.  Now, with defaults and foreclosures at record levels, the payments have flowed out like a torrent which has pulled AIG under.

AIG’s former CEO, Hank Greenberg, who is also one of it’s largest shareholders has come out in criticism of the plan stating the company merely needed a temporary loan not a government takeover and breakup.  There is a good chance that stockholders could be wiped out after the dust settles, though frankly management has done a good job of that themselves as the stock has lost over 90% of it’s value over the past year.

In a speech today, Treasury Secretary Henry Paulson called for new regulations to help liquidate failing firms without it affecting overall market stability.

“For market discipline to constrain risk effectively, financial institutions must be allowed to fail,” Paulson said in excerpts of a speech he will deliver in London.

“It is clear that some institutions, if they fail, can have a systemic impact, so we must give regulators the authorities to limit that impact and facilitate an orderly failure,” Paulson said.

Why are these regulatory changes needed?  Well back in March, the Fed intervened when it looked like Bear Stearns was in danger of failing, financing a buyout from JP Morgan and putting to risk potentially $30 billion in taxpayer dollars.

Through it’s excessive risk taking in the residential mortgage market, Bear Stearns deserved to fail but it couldn’t be allowed to due to the impact it would have on other financial firms.  Financial firms are tightly interconnected these days through counterparty risk in the credit derivatives market, a largely unregulated market that has had explosive growth in the past decade. 

It is a massively leveraged market that has the potential of causing financial Armageddon according to some well known industry leaders.  Although firms are slowly de-leveraging, there will still be the potential of a failure cascade as the credit crisis is far from over. 

Over the past few weeks speculation has run wild on Wall Street that Lehman Brothers would meet the same fate as Bear Stearns and need to be sold at a discount, although those rumors have abated somewhat recently.  While this is one potential trigger that has been avoided, the danger will likely exist as long as home prices keep falling and firms face the prospect of more writedowns.