MarketSkeptics has published incredible information detailing what is not only fraud by the Federal Reserve, but something that has the very real potential of blowing up the entire financial system on a scale previously unimagined. The information comes almost exclusively from a June 24-25, 2003 Federal Reserve meeting, where it was explained in very clear terms, that the Federal Reserve had actually seriously contemplated using derivative products, specifically put options on US Treasuries, as a means of pushing down long-term rates:
The alternatives that could be adopted while changing only the composition of the balance sheet are listed in the top panel. These include (1) extending the average maturity of the outright holdings in the SOMA, (2) setting explicit ceilings on longer-term Treasury yields, and (3) using derivative instruments.
Let me explain, first, why this may have been more than a theoretical proposition, and second, why it is even important to begin with.
The above excerpt from the 2003 transcript quotes System Open Market Account (SOMA) manager Dino Kos, who was in the process of proposing a series of policy tools that the Federal Open Market Committee (FOMC) could use in order to drive down long-term interest rates. Traditionally, the Federal Reserve only targets the short end of the yield curve, and we are actually taught in economics that central banks are incapable of affecting 10, 20 or 30 year interest rates (no need to go into why right now). I never bought into this argument, and anyone who watched the yield curve flatten, and subsequently invert during the late Greenspan era will find plenty of reason to exercise similar skepticism on the subject.
Now, in reference to Kos’ specific suggestions, points (1) and (2) have already been implemented. “Extending the average maturity of the outright holdings in SOMA” simply means buying a greater share of long-term treasury debt. The Fed has already been doing this for some time. Meanwhile, “setting explicit ceilings on longer-term Treasury yields” simply means that the fed won’t allow interest payments on newly issued US government debt to exceed a specific target, presumably by stepping in as a buyer to fill the demand gap in the treasury market that would otherwise drive rates higher. This is pretty much what the Fed does in the short-term money markets by setting the artificial federal funds rate target. To put this another way, points (1) and (2) are both influenced by the Federal Reserve monetizing the long-term debt obligations of the United States, which is what QE1 and QE2 were all about.
Figure 1 – short-term US government debt is replaced with long-term debt
The chart above shows how the Federal Reserve began to unwind its position in short-term government paper in the beginning of 2008, only to expand dramatically its purchase of long-term paper at the start of 2009. The reason for the lull in buying by the Fed that you see during the last three quarters of 2008 is probably a result of natural market pressures driving up prices for US government securities as people were rushing out of riskier assets into the “safer” short-term US treasury market. This would have freed up the Federal Reserve from having to make the type of large-scale asset purchases in treasuries that have subsequently characterized QE1 and QE2. This “freedom” is also reflected in the giant spike that you see for other “credit programs.” The buying of long-term US debt has subsequently taken up an increasing amount of room on the Fed’s balance sheet.
In other words, people were losing interest in holding US treasuries at prevailing market prices. When this happens, the natural effect is for prices to drop, signaling to the government that it needs to raise rates (the yield on its newly issued bonds) in order to compel buyers to purchase more treasuries. In order to prevent this natural rise in rates, the Fed rushed in to make up the difference, serving as a buyer and thus creating artificially high demand for treasuries. This put a floor on prices and worked as a cap for long-term rates. This is what QE1 and QE2 were meant to accomplish.
Ok, so now we have established that points (1) and (2) have already been implemented. This is important to recognize because it makes it all the more likely that point (3) would have, at the very least, been seriously considered as well. Now, we will turn to why the implementation of point number 3 (the use of derivative products) is such a scary prospect.
When Dino Kos proposed the use of derivative products in this 2003 fed meeting, he specifically made reference to the use of treasury put options. Without going into great detail, a put option is basically a derivative product used as a means of selling-short a particular asset. If you buy a put option on wheat, it means that you are expecting the price of wheat to decline, and so you are entering into a bet to that effect. Of course, every trade has a counter party, and so, if you are buying a put option on something, it means that there is someone else on the other side of that trade who is writing the option. This other party, in a free market at least, would be writing the option because he/she expects the price of the underlying asset to rise above the strike-price.
Buying put options on US government debt is essentially a way of selling-short the treasury market. You are basically betting that the price of government debt is going to drop and that yields are going to rise. If the demand for put options on US treasuries is growing, then pressure begins to build on yields. In short, the market for treasury put options is just another way for bond traders to provide an up or down vote on the US credit rating, and thus on benchmark interest rates in the economy.
As we already mentioned, the Federal Reserve can influence interest rates by buying up US bonds, thus driving up prices and pushing down yields. This is what quantitative easing means. However, the policy becomes increasingly ineffective with every purchase. It stands to reason that if the Fed wants to continue to keep rates artificially low in the face of market sentiment to the contrary, it must find new ways to influence prices. One such way would be through the derivatives markets, specifically using treasury puts. According to Dino Kos:
Alternatively, we could sell put options on longer-term Treasury securities at strike prices associated with desired longer-term yields…[The] ultimate success would hinge on the quantity of options sold—that is, how big a bet the Federal Reserve were willing to make. The more options sold, the greater the chance they would have the desired effect on longer-term rates even if not associated with any policy commitment, either by raising the costs to the Fed associated with options being exercised, or by lowering risk premiums on longer-term rates.
What Kos is saying here is plain as day: issue put options on long-term debt at artificial strike prices that are likely to produce the sort of yields that the Fed is looking for. This is just another way of manipulating the interest rates in the economy. However, Kos recognizes that, in order to have the desired effect, the Fed would need to issue an increasingly high number of these put options. Here is the kicker:
[O]f course the risks to the portfolio, to reserve levels, and of capital losses would rise in equal measure. And an exit strategy for options may not be as straightforward as it seems, even apart from the possibility of their being exercised. Of course, the Desk could stop auctioning new options at any time. But a decision to stop selling more options or not to issue new contracts with later expiration dates as time passes likely would be interpreted in the market as a statement about future policy intentions. The resulting rush to unwind market positions would likely be very disruptive and send yields sharply higher.
So, unlike traditional policies of buying and selling the underlying asset (as is the case when the Fed buys or sells treasuries in order to add or extract liquidity and thus raise or lower the Federal Funds Rate), a strategy of issuing put options to counter parties interested in hedging against an environment of rising rates puts the Fed in a dangerous trap of having to supply ever more derivative contracts in order to suppress the price of long-term yields – the very yields that they are issuing insurance against.
First of all, this is fraud. The Fed is effectively issuing credit protection against itself. That’s like me taking out a $1 million loan and then issuing another $1 million in credit protection against my own default. This is absurd. If I default on my debt, then this means that I won’t be able to make good on the insurance contract either. This is just a fraudulent means by which to borrow more money.
Second, and more importantly, this has the potential to blow up the entire financial system, and I will explain why in as simple terms as I can. If the Federal Reserve is issuing more and more insurance contracts, effectively betting against a rise in long-term yields, this means that it is also increasing its exposure to a fat tail event that would drive rates suddenly higher. In order to prevent a rise in the rates, the Fed can only do one thing and this is to continue issuing more and more put options (insurance contracts against default). However, just like with bond purchases, there is a point at which the issuance of ever more insurance through put options will prove ineffective.
At this point, the Fed would be left with two options. 1) it could start to buy up all the options it has outstanding, which would probably cause hyperinflation and thus a break down in the economy or 2) it could default, in which case the entire financial system would blow up. In either case, the outcome would be a total catastrophe the likes of which none of us can comprehend.
It all comes down to just how involved the Fed is in the derivatives market for treasuries, and if this activity is large enough to scale back without blowing up the entire system. I am not a bond trader and do not monitor this market, so I don’t have any idea if the Fed is actually doing what MarketSkeptics is implying. The guys at ZeroHedge seem to give this scenario a great deal of credibility, and as traders they are in a better position to express an opinion on the matter either way. Still, no one really knows, and the prospect is so apocalyptic in its consequences that even if I had an answer I wouldn’t know what to do with it.