Beware of the Fed's Next "Conundrum"; Revisiting Alan Greenspan's 2005 Interest Rate Conundrum

Since TBTF banks and interest rate managers seem to be just gambling on the future direction of yields, inflation, and the economy like it's a game on Zynga, with the Federal Reserve distorting the whole market. Let's revisit February 16, 2005, a better time, when former Federal Reserve Chairman Alan Greenspan had a serious interest rate "conundrum" on his hands. This conundrum would end up destroying the financial system three years later.

Source: St. Louis Fed

During a congressional hearing on February 16, 2005, Alan Greenspan said that he didn't understand why longer-term Treasury yields weren't rising with the federal funds rate. Look at the charts and you'll see that the 10-year Treasury yield always moved in tandem with the federal funds rate up until 2004.

1980-2012, Fed Funds Rate vs. 10Y Treasury Yield (St. Louis Fed)

But after the Federal Reserve lowered the fed funds rate to a record low of 1% in early 2003 to 2004, which was a tool used backstop the tech bubble aftermath, 2001-2 recession, and negative sentiment after the 9/11 terrorist attacks, he fueled the biggest credit bubble in history. This credit bubble was backed by mispriced assets and asymmetric information (credit market fraud) via the opaque, illiquid credit markets (the OTC Zynga casino that is still in place today) and zero regulation. Both Alan Greenspan and Ben Bernanke (then Fed governor) thought that the global saving glut was responsible for this peculiar interest rate conundrum.

In a 2005 speech, Bernanke said the global saving glut was the reason why long-term rates were moving down via the trade deficit. But Stanford Economics Professor John B. Taylor said this wasn't the case in a November 2008 research report. Even the St. Louis Fed's research department brought this up recently (see below). Either way, it just shows how confused the Federal Reserve was at that time even with all the data in the world in front of them.

St. Louis Fed, September 2012:

"Bernanke’s (2005) advanced the global saving glut hypothesis to explain the conundrum. Bernanke (2005) suggested that the significant increase in the supply of saving globally could account for the “relatively low level of long-term interest rates.” Smith and Taylor (2009) reject this hypothesis, noting that “world saving as a share of world GDP had actually fallen during this period.”8

Bernanke’s (2005) hypothesis also is problematic in that it implies that foreign investors had a strong preference for the long end of the yield curve. The 3-month T bill rate rose in lockstep with the funds rate and the yield curve inverted by July 2006."

Ben Bernanke's speech on March 10, 2009:

"The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy. Its fundamental causes remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.

The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances. However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States. The details of the story are complex, but, broadly speaking, the risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets."

Stanford Economics Professor John B. Taylor, November 2008:

"This alternative explanation focuses on global saving. It argues that there was an excess of world saving—a global saving glut—which pushed interest rates down in the United States and other countries. The main problem with this explanation is that there is actually no evidence for a global saving glut. On the contrary, as Figure 3 shows in very simple terms, there seems to be a saving shortage. This figure, which was produced by staff at the International Monetary Fund in 2005, shows that the global saving rate—world saving as a fraction of world GDP—was very low in the 2002-2004 period especially when compared with the 1970s and 1980s. So this alternative explanation does not stand up to empirical testing using data that have long been available

To be sure, there was a gap of saving over investment in the world outside the United States during 2002-2004, and this may be the source of the term “saving glut.” But the United States was saving less than it was investing during this period; it was running a current account deficit which implies that saving was less then investment. Thus the positive saving gap outside the United States was offset by an equal sized negative saving gap in the United States. No extra impact on world interest rates would be expected. As implied by simple global accounting, there is no global gap between saving and investment."

So is the Fed going to repeat 2005-2007 again, but on a much larger scale? All we've done is mask the original problem with more debt and printed money, which has made everyone in the finance and investment industry geniuses again. Total Credit Market Debt/GDP is still near the historic high.

source: St. Louis Fed

Below are quotes from Greenspan and Bernanke's 2005 speeches/congressional testimonies. You can see that they 100% failed to foresee and manage the biggest credit bubble in history. And they even knew the risks.

Testimony of Chairman Alan Greenspan The economic outlook Before the Joint Economic Committee, U.S. Congress June 9, 2005:

"Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates on U.S. Treasury securities despite a 2-percentage-point increase in the federal funds rate. This is clearly without recent precedent. The yield on ten-year Treasury notes, currently at about 4 percent, is 80 basis points less than its level of a year ago. Moreover, even after the recent backup in credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period.

The unusual behavior of long-term interest rates first became apparent almost a year ago. In May and June of last year, market participants were behaving as expected. With a firming of monetary policy by the Federal Reserve widely expected, they built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with a rising federal funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, market participants once again bid up long-term rates, but as occurred last year, forces came into play to make those increases short lived. There remains considerable conjecture among analysts as to the nature of those market forces.

That said, there can be little doubt that exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding and home turnover, and especially in the steep climb in home prices. Although a "bubble" in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels."

"The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace."

Let's not forget that opaque and illiquid OTC derivatives, which are still managed and backed by the too-big-to-fail banks, leveraged the conundrum of mass destruction 1000x1.

Remarks by Chairman Alan Greenspan
Risk Transfer and Financial Stability
To the Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank Structure, Chicago, Illinois 
(via satellite)May 5, 2005:

"Use of Credit Derivatives to Transfer Risk outside the Banking System
Perhaps the most significant development in financial markets over the past ten years has been the rapid development of credit derivatives. Although the first credit derivatives transactions occurred in the early 1990s, a liquid market did not emerge until the International Swaps and Derivatives Association succeeded in standardizing documentation of these transactions in 1999. According to the BIS, the notional value of credit derivatives outstanding increased sixfold between 2001 and 2004, reaching $4.5 trillion in June of last year. Moreover, this growth has been accompanied by significant product innovation, notably the development of synthetic collateralized debt obligations (CDOs), which allow the credit risk of a portfolio of underlying exposures to be divided or "tranched" into different segments, each with different risk and return characteristics. Recent growth of credit derivatives has been concentrated in these more-complex structured products.

As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively. In particular, the largest banks have found single-name credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books while allowing them to meet the needs of their largest corporate customers. But some observers argue that what is good for the banking system may not be good for the financial system as a whole. They are concerned that banks' efforts to lay off risk using credit derivatives may be creating concentrations of risk outside the banking system that could prove a threat to financial stability. A particular concern has been that, as credit spreads widen appreciably at some point from the extraordinarily low levels that have prevailed in recent years, losses to nonbank risk-takers could force them to liquidate their positions in credit markets and thereby magnify and accelerate the widening of credit spreads.2

A definitive evaluation of these concerns about nonbank risk-takers would require information on the extent of credit risk transfer outside the banking system and on the identities and risk-management capabilities of the entities to which the risk has been transferred. Unfortunately, available data do not provide this information. Data on the size of the credit derivatives markets are limited largely to the notional principal amounts of transactions. As discussed earlier, notional amounts often are misleading indicators of risk, and this problem is acute regarding credit derivatives. Critical to any evaluation of the CDO markets is an understanding that, per dollar of notional value, the risk (and risk transfer) associated with various CDO tranches varies enormously. The risk per dollar of notional amount of the "first loss," or equity, tranche can be thirty or forty times the risk per dollar of the senior tranche, which would be required to absorb losses only after the protection provided by the equity tranche and other more-junior tranches had been exhausted.

While available data cannot resolve these issues, a study conducted last year by the Joint Forum, which was based on interviews with market participants, does shed some light.3 The study concluded that notional values had significantly overstated the amount of credit risk that had been transferred outside the banking system to that point and that the amount of risk transfer was quite modest relative to the total amount of credit risk that exists in the financial system. The study found no evidence of "hidden concentrations" of credit risk. Risk-takers outside the banking system included monoline insurers and other insurance companies; private asset managers acting on behalf of pension funds, mutual funds, and other institutional investors; and hedge funds. As to the risk-management capabilities of these nonbank entities, the study found that they seem largely aware of the risks associated with credit derivatives.

The study did note that understanding the credit risk profile of CDO tranches poses challenges to even the most-sophisticated market participants. An especially difficult issue is the assessment of default correlation across different reference entities. In general, the valuation of CDO tranches is model dependent, and market participants need to carefully evaluate the models that they use and the model parameter assumptions that they make, notably the assumptions regarding default correlations. To limit legal and reputational risks, dealers should seek to foster a complete understanding of transactions among the investors to which they sell CDO products. The report cautioned investors in CDO tranches not to rely solely on rating-agency assessments of credit risk, in part because a CDO rating cannot possibly reflect all the dimensions of the risk of these complex products. The report also called attention to significant operational risks that have emerged as market participants' back offices have struggled to keep pace with growing transactions volumes and more complex products. Despite recent automation initiatives, the lack of timely documentation of new transactions and assignments of existing transactions remains a significant problem.

Some other concerns about the transfer of credit risk outside the banking system seem to be based on questionable assumptions. Some observers believe that credit risks will be managed more effectively by banks because they generally are more heavily regulated than the entities to which they are transferring credit risk. But those unregulated and less heavily regulated entities generally are subject to more-effective market discipline than banks. Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities. Such private prudential regulation can be impaired--indeed, even displaced--if some counterparties assume that government regulations obviate private prudence. We regulators are often perceived as constraining excessive risk-taking more effectively than is demonstrably possible in practice. Except where market discipline is undermined by moral hazard, for example, because of federal guarantees of private debt, private regulation generally has proved far better at constraining excessive risk-taking than has government regulation.

In fact, while many focus on the dangers of risk transfer to highly leveraged entities that might be vulnerable to a sharp widening of credit spreads, a significant portion of the risks that are being transferred outside the banking system are being transferred through private asset managers to institutional investors that have much lower leverage than banks. Indeed, the increasing transfer of systematic risks from banks to entities with lower leverage and longer time horizons may, other things equal, push credit spreads lower. Such investors may naturally have a greater tolerance for risk than banks."

Here is Ben Bernanke's speech from April 2005 on the global saving glut's effect on long-term rates.

Remarks by Governor Ben S. Bernanke
At the Homer Jones Lecture, St. Louis, Missouri
Updates speech given on March 10, 2005, at the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia
April 14, 2005
The Global Saving Glut and the U.S. Current Account Deficit

"On most dimensions the U.S. economy appears to be performing well. Output growth has returned to healthy levels, the labor market is firming, and inflation appears to be well controlled. However, one aspect of U.S. economic performance still evokes concern among economists and policymakers: the nation's large and growing current account deficit. In 2004, the U.S. external deficit stood at $666 billion, or about 5-3/4 percent of the U.S. gross domestic product (GDP). Corresponding to that deficit, U.S. citizens, businesses, and governments on net had to raise $666 billion on international capital markets.1 The current account deficit has been on a steep upward trajectory in recent years, rising from a relatively modest $120 billion (1.5 percent of GDP) in 1996 to $414 billion (4.2 percent of GDP) in 2000 on its way to its current level. Most forecasters expect the nation's current account imbalance to decline slowly at best, implying a continued need for foreign credit and a concomitant decline in the U.S. net foreign asset position.

Why is the United States, with the world's largest economy, borrowing heavily on international capital markets--rather than lending, as would seem more natural? What implications do the U.S. current account deficit and our consequent reliance on foreign credit have for economic performance in the United States and in our trading partners? What policies, if any, should be used to address this situation? In my remarks today I will offer some tentative answers to these questions. My answers will be somewhat unconventional in that I will take issue with the common view that the recent deterioration in the U.S. current account primarily reflects economic policies and other economic developments within the United States itself. Although domestic developments have certainly played a role, I will argue that a satisfying explanation of the recent upward climb of the U.S. current account deficit requires a global perspective that more fully takes into account events outside the United States. To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today. The prospect of dramatic increases in the ratio of retirees to workers in a number of major industrial economies is one important reason for the high level of global saving. However, as I will discuss, an important source of the global saving glut has been a remarkable reversal in the flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders.

To be clear, in locating the principal causes of the U.S. current account deficit outside the country's borders, I am not making a value judgment about the behavior of either U.S. or foreign residents or their governments. Rather, I believe that understanding the influence of global factors on the U.S. current account deficit is essential for understanding the effects of the deficit and for devising policies to address it. Of course, as always, the views I express today are not necessarily shared by my colleagues at the Federal Reserve.2"

And finally, here is Greenspan's testimony on the interest rate conundrum. I think at this point he realized something was amiss with his ideology. As noted previously, he still argues that the crisis was caused by the global saving glut (Greenspan & Associates Report, 2010). But many people, including Peter Schiff and former hedge fund manager Michael Burry (who predicted the crisis and shorted mortgage-backed securities via credit default swaps), put most of the blame on the Federal Reserve's policies. So beware of the next "conundrum" at the Fed!

Testimony of Chairman Alan Greenspan
Federal Reserve Board's semiannual Monetary Policy Report to the Congress
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
February 16, 2005

"In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.

In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6-1/2 percent last June, is now at about 5-1/4 percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations.

Some analysts have worried that the dip in forward real interest rates since last June may indicate that market participants have marked down their view of economic growth going forward, perhaps because of the rise in oil prices. But this interpretation does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads observed over the same interval. Others have emphasized the subdued overall business demand for credit in the United States and the apparent eagerness of lenders, including foreign investors, to provide financing. In particular, heavy purchases of longer-term Treasury securities by foreign central banks have often been cited as a factor boosting bond prices and pulling down longer-term yields. Thirty-year fixed-rate mortgage rates have dropped to a level only a little higher than the record lows touched in 2003 and, as a consequence, the estimated average duration of outstanding mortgage-backed securities has shortened appreciably over recent months. Attempts by mortgage investors to offset this decline in duration by purchasing longer-term securities may be yet another contributor to the recent downward pressure on longer-term yields.

But we should be careful in endeavoring to account for the decline in long-term interest rates by adverting to technical factors in the United States alone because yields and risk spreads have narrowed globally. The German ten-year Bund rate, for example, has declined from 4-1/4 percent last June to current levels of 3-1/2 percent. And spreads of yields on bonds issued by emerging-market nations over U.S. Treasury yields have declined to very low levels.

There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.

This is but one of many uncertainties that will confront world policymakers. Over the past two decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past twenty years exhibited declines in GDP, and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward.

Yet history cautions that people experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead.

Prominent among these challenges in the United States is the pressing need to maintain the flexibility of our economic and financial system. This will be essential if we are to address our current account deficit without significant disruption. Besides market pressures, which appear poised to stabilize and over the longer run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. Central to that adjustment must be an increase in net national saving. This serves to underscore the imperative to restore fiscal discipline.

Beyond the near term, benefits promised to a burgeoning retirement-age population under mandatory entitlement programs, most notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead. Real progress on these issues will unavoidably entail many difficult choices. But the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008. This is especially the case because longer-term problems, if not addressed, could begin to affect longer-dated debt issues, the value of which is based partly on expectations of developments many years in the future."

More articles and videos (2005-2009):

Peter Schiff vs. Ben Bernanke, Economists and the Media (2005-2009 Epic Fail Videos) (CNBC, Fox, CNN Videos) *previous post

Peter Schiff on March 12, 2006 on the Low Saving Rate, Federal Reserve, Debt ceiling, Housing and Gold, "If Things Were So Great We Wouldn't Be Raising Debt Ceiling" (CNBC and Bloomberg Videos)

The Fed Did It, and Greenspan Should Admit It (, March 2009)

Greenspan's Mysterious Conundrum (, July 2005)

Greenspan wrestling with rate 'conundrum' (MSNBC, June 2005)
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