With Fed’s 2008 Minutes, It’s What Wasn’t Discussed That Matters

With Fed’s 2008 Minutes, It’s What Wasn’t Discussed That Matters
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After US Federal Reserve (Fed) watchers and the media poured over the recently released 2008 meeting transcripts, discussing ad nauseam what was said and the inner meaning of such statements, can the real story be found in what wasn’t discussed?

As the housing market was collapsing all around it, the Fed, a semi-private institution whose majority shareholders are said to include the largest US banks, was making decisions to purchase mortgage-backed securities.  The large banks had recently engaged in a highly profitable escapade where they packaged toxic assets into opaque mortgage-backed securities that were advertised as being among the highest quality bond products.  Underneath the surface, as is now known, another truth existed.

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No discussion of toxic nature of opaque mortgage-backed securities

The mortgage-backed securities that were being sold contained highly risky sub-prime loans where the borrower was less than qualified.  Borrowers with shaky credit were more likely than not to default on their loans, particularly once the loan re-set to a higher interest rate. Even if just a small percentage defaulted, it would contaminate the entire pool of investments and trigger credit default SWAPs designed to protect against just such an event.

Although this was widely discussed in e-mails around Wall Street, the Federal Reserve, in discussions for purchasing such toxic assets, never fully flushed out the true risk – or even showed any interest in understanding  one core of the problem, based on the lack of such discussion.  One core reason for the default of Lehman and Bear Stearns was the fact that these mislabeled “prime” assets had a very different real value than what was placed on the books.

Perhaps the closest anyone came to getting to the heart of this issue occurred when a joke was made by now Federal Reserve Chairwoman Janet Yellen.  “An accounting joke concerning the balance sheets of many financial institutions is now making the rounds,” she said, about to point to the core of the problem with opaque toxic assets.  “On the left-hand side, nothing is right.  On the right hand side nothing is left.”

This joke belied a serious problem at the core of the financial crisis, yet the Federal Reserve, the regulator of the large banks issuing these over the counter (OTC) traded derivatives didn’t discuss the root meaning of that joke or clearly identify the core of the problem.

But that’s not all.  There were several high profile warnings given about the toxic nature of the mortgage-backed securities and the housing crisis that the Fed should have been discussing, but wasn’t.

Fed: Warnings given regarding crisis not discussed

The Fed was engaged in serious discussions with US Treasury Secretary Hank Paulson about the financial crisis.  Didn’t they discuss Paulson’s 2006 warning to the Bush Administration that the market was on the verge of collapse?  But that wasn’t the only un-discussed warning. In 2007 the Fed was given a warning from a leading financial consultant regarding the housing market that would lead to the collapse of the unregulated derivatives that would ultimately implode on the world economy.

While the Fed is being analyzed up and down for what was said, perhaps it is worth considering what was not discussed?

Mark Melin is an alternative investment practitioner whose specialty is recognizing a trading program’s strategy and mapping it to a market environment and performance driver. He provides analysis of managed futures investment performance and commentary regarding related managed futures market environment. A portfolio and industry consultant, he was an adjunct instructor in managed futures at Northwestern University / Chicago and has written or edited three books, including High Performance Managed Futures (Wiley 2010) and The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill 2008). Mark was director of the managed futures division at Alaron Trading until they were acquired by Peregrine Financial Group in 2009, where he was a registered associated person (National Futures Association NFA ID#: 0348336). Mark has also worked as a Commodity Trading Advisor himself, trading a short volatility options portfolio across the yield curve, and was an independent consultant to various broker dealers and futures exchanges, including OneChicago, the single stock futures exchange, and the Chicago Board of Trade. He is also Editor, Opalesque Futures Intelligence and Editor, Opalesque Futures Strategies. - Contact: Mmelin(at)www.valuewalk.com
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