how did we get here and does the financial crisis suggest the need for structural reforms?

©Copyright 2012 Cumberland Advisors

®. Further distribution prohibited without prior permission.

How Did We Get Here and Does the

Financial Crisis Suggest the Need for

Structural Reforms

Dr. Robert A Eisenbeis

Fourth Annual Rocky Mountain Economic

Summit and Retreat

Friday, July 27, 2012

Jackson Hole, WY

Florida Office New Jersey Office (800) 257-7013 One Sarasota Tower 614 E. Landis Avenue 2 N. Tamiami Trail, Suite 303 Vineland, NJ 08360 Sarasota, FL 34236




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• Questions have arisen about the effectiveness

and efficacy of low interest rates policies,

unconventional monetary policy interventions

and efforts to affect the slope of the yield curve.

• How did we get to this point?

• What if any role has financial structure played in

affecting the efficacy of policy?

Problems Exposed



Large complex financial institutions relied heavily upon short term funding to

carry longer term assets. The decline in housing prices set off

severe financial distress in early 2007 resulted in spreads widening that

accelerated in the fall of 2007

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The asset-backed CP Market Declined 50% from

$1.2 Trillion to $700 B in Fall 2008



Financial CP Declined at Start of Phase II and

Non-Financial Declined at Start of Phase III



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Phase I. Was Treated from a Policy Perspective as a Traditional Liquidity Problem



Phase 1. Phase 2.

The Fed Creates a Number of Programs to Provide Funds to Primary Dealers




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Fed Switched Mode From Supporting Individual Institutions to Supporting Markets and Providing Liquidity




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• That lack of access over the period of 2007-2009,

combined with losses, resulted in the failures or

disappearance of several primary dealers including

• Countrywide

• Bear Sterns-acquired by JPMorgan Chase

• Lehman Brothers - failed

• Merrill-Lynch-acquired by Merrill-Lynch

• Freddie and Fannie went into conservatorship,

Wamu was merged into JPMorgan Chase and AIG

was rescued

The Cause Was Housing Price Decline



Rates and Spreads Settled Down in 2009




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Bank Lending Declined and Excess Reserves Increased-

Did Financial Structure Play a Role in Blunting the Effectiveness of Monetary Policy




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• Real GDP Averaged 1.5% Q1-2009

• 1.8% Last 6 quarters

• Unemployment has come down but still stands

at 8.2%

• Despite the huge injection of liquidity and

reserves, bank lending hasn’t picked up to

support the expansion

But Real GDP Growth Has Been Dismal




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• When the primary dealers experience financial distress monetary policy can be frustrated

• When the critical tri-party repo market freezes up and creates a bottleneck, then policy too can be frustrated - that market is critical to the implementation of open market operations. It is the main market through which the desk and primary dealers interact with each other. – This market evolved in an ad hoc way and instead of being an

organized exchange it is a private sector duopoly run by JPMorgan Chase and Bank of NY Mellon who extend trillions of dollars in daylight overdrafts. These firms are the operational hub and are interlinked to all the world’s major financial institutions

– The market lacks transparency, has no federal oversight, raises the specter of conflicts of interest because of the two firms’ access to information on counterparty transactions and ability to meet collateral requirements, and poses systemic risk should either or both experience financial distress

The crisis exposed two critical and as yet unresolved

problems




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• Primary dealer system evolved when daily bids were transmitted by runner in NY to the Desk

• Bids are now submitted and accepted electronically, but bids are still limited to the primary dealers

• Given current technology, there is no reason that daily participation needs to be limited to primary dealers and could be opened up to all member institutions that meet predefined prudential standards

• In essence, the primary dealer system should be eliminated and the Fed should emulate the ECB that deals with approximately 500 counter parties – Technology is such that the entire bid process could be easily

automated and securities and/or reserves allocated accordingly

– Additionally, funding stress could also be limited by having the desk stand ready to buy and sell securities continuously at the target funds rate

What Can Be Done? Primary Dealers




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• Move to a centralized clearing platform

– Be it stand alone

– Government operated – eg. The Fed or

– Separately operated affiliate or subsidiary

What Can Be Done? Tri-party Repo Market




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Move to a Centralized Clearing Platform




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• Limits risk transfers

• Reduces systemic risk

• Controls liquidity problems

• Other needed reforms – Asset substitution rules

– Loss sharing arrangements

– Increased supervision and monitoring

– Limit daylight overdrafts or eliminate them

– Possibly impose margin requirements like futures exchanges

– Modify rules so that repos are structured without recourse to limit unwinding problems

Advantage of Centralized Clearing Platform




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• We have experienced a series of shocks to the financial system and have been forced to engage in new and untried policy remedies

• Whether they are working or will ultimately get us out of the present situation remains to be seen

• But it seems clear that market structure is a problem and it doesn’t seem that Dodd-Frank has helped us to address the critical problems exposed by the crisis.

Conclusion

how did we get here and does the financial crisis suggest the need for structural reforms?

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