President Bush called for an immediate stimulus package today in the order of $140 to $150 billion dollars. According to one of his aides, Bush wants to give individuals and households tax rebates of $800 and $1,600 respectively, among other things. Of course, he tried to remain optimistic that the American economy is in good shape, but he was not at all convincing. I think the following two sentences perhaps best summarize the sentiment of his speech: “Yet there are also times when swift and temporary actions can help insure that inevitable market adjustments do not undermine the health of the broader economy. This is such a moment.”

So what are these “inevitable adjustments” that threaten to “undermine the health of the broader economy”?

Before I give you my take on it, I want to impress on you that we are in a very precarious financial environment. It is rare for the President to come out and say that there is a real and present danger that threatens the economy and drastic action is needed immediately. Now, with that in mind, read what Frank Veneroso wrote to his clients on Wednesday.

Unusual Behavior from the Current Fed and Past Fed Chairman
by Frank Veneroso
January 16, 2007

Last week Chairman Ben Bernanke and Fed Governor Fredrick Mishkin made two striking public speeches.  Let me reiterate the key statements in both.

Fed Chairman Ben Bernanke: “...the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced..... The financial situation remains fragile, and many funding markets remain impaired.  Adverse economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses.”

Fed Governor Mishkin: “By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop....timely action is crucial when an episode of financial instability becomes sufficiently severe to threaten the core macroeconomic objectives of the central bank. In such circumstances, waiting too long to ease policy could result in further deterioration of the macroeconomy...(and further)...an economic downturn tends to generate even greater uncertainty about asset values, which could initiate an adverse feedback loop in which the financial disruption increases financial disruption, causing a further deterioration in macroeconomic activity, and so on.”

In essence these two Fed spokesmen are telling the marketplace that, owing to extreme financial “fragility” and “turmoil”, the economy and the markets are on the edge of a downward spiral.  Fed heads don’t speak this way. They don’t deliver alarmists signals, and then do nothing.

Yesterday (Tuesday) former Fed Chairman Alan Greenspan indicated the economy may have already entered into a recession.

The symptons are clearly there,” Greenspan said.  “Recessions don’t happen smoothly.  They are usually signaled by a discontinuity in the market place, and the data of recent weeks could very well be characterized in that manner.”

Today (Wednesday) Former Fed Chairman Paul Volcker said on CNBC, “The Fed has lost control”.

Former Fed Chairmen do not make statements like this. They don’t second guess the Fed on a super crucial issue like Greenspan, or disparage the Fed like Volcker.  It is especially weird that they are making such statements given the distress signals sent out by Bernanke and Mishkin last week.

Look at it this way, Greenspan and Volcker know that congress and everyone else are going to take note of their statements.  They were Mr. Federal Reserve for almost three decades and were perhaps the two most prominent central bankers in history.  They know their words carry great weight. With the unemployment rate up 0.6% they know that congress will be grilling Bernanke and company about what they are doing to prevent higher unemployment and recession.  They know that their statements can readily be used by Congress to argue that Bernanke & Co are asleep at the switch.

Given the remarkable statements of Bernanke and Mishkin about downside risks last week, Congress can throw at Bernanke & Co their own words as well as those of Greenspan and Volcker. We must presume that Greenspan and Volcker delivered these messages to the Fed privately before they went public.  Why have they since gone public, creating the opportunity for Congress to embarrass and pressure the Fed?

I have only one explanation.  They recognize the gravity of the current problem.  They have conveyed the need to Bernanke and Kohn for very dramatic policy action and are frustrated that it is not forthcoming.

Given the remarkably candid and almost alarmist assessments of Bernanke and Mishkin late last week, it would seem that they have been getting the message of Greenspan and Volcker.  Perhaps Bernanke is getting opposition from inflation hawks that do not have the awareness of systemic financial risk that he and Mishkin do as a result of their studies of the 1930’s and the lost decade of Japan.  Perhaps this FOMC opposition is fretting that dramatic policy action will “scare the children” or lead to more moral hazard and won’t go along. Perhaps the statements of Bernanke and Mishkin, as well as the statements of Greenspan and Volcker, are aimed at pushing the FOMC into unanimous support of “shock and awe” policies.

Frank Veneroso

As Frank said, former Fed Chairmen do not make statements like these, and Presidents don’t make speeches like Bush did today. These people are supposed to remain calm, so what is going on?

Imagine that your neighbor bought a house and took out a mortgage. The bank wrote the mortgage, gave him the money, and promptly sold the mortgage to a mortgage broker, who packaged it together with other mortgages into a mortgage backed security and sold the whole package to a pension fund, hedge fund, or some other investor.

The investor who bought this package of mortgages then went to a bond insurance company and entered into a credit default swap arrangement (a derivative product). Basically, the bond insurance company insured the package of mortgages against default and for this insurance the investor pays a quarterly fee. Now the investor doesn’t really worry about the actual credit quality of the mortgages he bought because he was able to offset the risk of default onto the bond insurer for a small fee. The investor feels so good about this piece of business that he goes to a bank and borrows ten times more money that what he has in capital to buy more such mortgages, and offsets the risk by entering into more credit default swaps.

The bond insurance company also likes this business because it believes the risk of default is small, and so it enters into credit default swaps with as many investors as it can find, and not only for residential mortgages, but commercial mortgages, corporate debt, consumer debt and all sorts of other debt -- the sky is the limit.

Now comes the fun part: the “insurance” company that assumed all this default risk doesn’t really have any money to cover any unanticipated defaults. But the credit rating agencies looked at this and said, well, they are making so much money in fees that we’ll give them a credit rating of A, or better, and the investors said, oh, well, if the insurance company has an A credit rating we won’t require them to put up any collateral for all the credit default swaps we are doing with them.

Now, because such packages of mortgages were supposedly “insured” against default the bond rating agencies assigned very high credit ratings to the debt, AAA in most cases. This allowed the original investors to sell them onto other investors for hefty gains since these AAA structured investment vehicles had a much higher yield than comparable government bonds, for instance.

There was huge demand for these assets and a seemingly limitless amount of debt could be issued to anyone, regardless of whether they could ever repay said debt, since the “investors” were able to “insure” it with credit default swaps. Before the real estate bubble popped people were able to get a mortgage with no money down and no proof of income or assets, or any indication whatsoever that they could pay back the money they were borrowing.

Then, one fine summer day last year, someone tried to sell one of these mortgage backed assets and a totally irresponsible and inconsiderate buyer questioned the price, or I should say value, of what he was buying. You have to understand, there is no real market for these things and the “investors”, predominantly highly leveraged hedge funds and less leveraged pension funds, basically just valued them at whatever price they felt like. But when someone asked what one of these things was really worth, and didn’t want to pay top dollar for a bag of debt that was perhaps never going to get paid back, the whole market froze up. If they couldn’t sell all this packaged up debt for the same price as they had valued them on their balance sheets they would be forced to write-down the values on their balance sheets, and no-one wanted to admit to such losses. The solution was just to not trade them, which is why the market froze up and they all resorted to staring each other in the eye.

It became evident that the actual default rate on some of this packaged-up debt was going to be higher than the complex financial models being employed were predicting. But, who cares, there are credit default swaps to take care of this problem, no?

Take ACA Financial Guarantee Corp., a company that was actively engaged in “insuring” such products through credit default swaps. ACA had $425 million in capital and assumed the default risk on $69 billion of debt. Because ACA had an A credit rating nobody asked them to put up collateral for the credit default swaps they wrote. Then when people started fretting about the actual value of all this debt that was created the credit rating agencies started taking a harder look at some of the bond insurers, such as ACA, and soon realized that they had no way of making good on all the contracts they had entered into. So ACA’s credit rating was slashed to CCC -- junk status.

All of a sudden all those investors who had relied on the credit default swaps that ACA had provided them realized that, in reality, they had no protection whatsoever. ACA’s shares fell from $15 to $0.50 and were then de-listed. Merrill Lynch wrote down $3.1 billion on assets it had insured through ACA. CIBC wrote down $2 billion and Calyon about $1.7 billion -- and these losses are just a smidgen of the total losses, and they are all just with respect to assets for which ACA provided credit default swaps.

This whole business of credit default swaps was so much fun that it didn’t stop with investors who actually bought collateralized debt obligations. Hedge funds got into the game big time: typically they would buy $10 million chunks of credit default swaps without owning any of the underlying debt, and trade them as risk premiums change. They also did this employing huge leverage, often 10 to 100 times their capital. So the insurers were under capitalized and the speculators were under capitalized -- precisely the sort of scenario that could collapse into a pile of dust and cause a ripple of systemic default through the entire financial structure, since one guy’s loss is no longer someone else’s gain: when one counter-party goes bankrupt there is no offsetting gain.

The estimated size of the credit default swap market is around $46 trillion dollars and credit default swaps are only one part of the much larger Over the Counter (OTC) derivative market, which is estimated at around $500 trillion.

Humor me, let’s put that number in perspective: if you deposited one million dollars into a bank account two thousand years ago, on Day 1 of Year 0001, and you added one million dollars to that account every single day you would not even have one trillion dollars today. If you added one million dollars to this account every day for a million years you would still not have $500 trillion dollars. I don’t think many people can actually comprehend how large a number 500 trillion really is.

Could we have a $1 trillion loss in debt and derivatives on our hands? I think so. In fact, I think that could be a conservative number and I think it is the prospect of financial losses of that magnitude that have Bush, Bernanke, Greenspan, Volcker and Mishkin so scared. And I don’t believe for a minute that Bush’s $140 to $150 billion stimulus plan is enough if there is systemic risk in the financial sector, which I now believe there is.