In February 2012, a number of hedge fund traders noted one
particular index--CDX IG 9--that seemed to be underpriced. It
seemed to be cheaper to buy credit default protection on the 125
companies that made the index by buying the index than by buying
protection on the 125 companies one by one. This was an obvious
short-term moneymaking opportunity: Buy the index, sell its
component short, in short order either the index will rise or the
components will fall in value, and then you will be able to quickly
close out your position with a large profit.
But February passed, and March passed, and April rolled in, and
the gap between the price of CDX IG 9 and what the hedge fund
traders thought it should be grew. And their bosses asked them
questions, like: "Shouldn't this trade have converged by now?"
"Have you missed something?" "How much longer do you want to tie up
our risk-bearing capacity here?" "Isn't it time to
liquidate--albeit at a loss?"
So the hedge fund traders began asking who their counterparty
was. It seemed that they all had the same counterparty. And so they
began calling their counterparty "the London Whale". They kept
buying. And the London Whale kept selling. And so they had no
opportunity to even begin to liquidate their positions and their
mark-to-market losses grew, and the risk they had exposed their
firms to grew.
So they got annoyed.
And they went public, hoping that they could induce the bosses
of the London Whale to force him to unwind his possession, in which
case they would profit immensely not just when the value of CDX IG
9 returned to its fundamental but by price pressure as the London
Whale had to find people to transact with. And so we had
'London Whale' Rattles Debt Market
, and similar stories.
The London Whale was Bruno Iksil. He had been losing, and
rolling double or nothing, and losing again for months. His boss,
Ina Drew, took a look at his positions. They found they had a
choice: they could hold the portfolio and thus go all-in, or they
could fold. They could hold CDX IG 9 until maturity--make a fortune
if a fewer-than-expected number of its 125 companies went bankrupt,
and lose JPMorgan Chase (
) entirely to bankruptcy if more did. Or they could take their $6
billion loss and go home. They could either take their losses, or
sing "Luck, Be a Lady Tonight!" and bet JPMorgan Chase on a single
crapshoot. After all, what could they do if the bet went wrong and
they had to eat losses at maturity? JPMorgan Chase couldn't print
money. So Drew stood Iksil down, and the hedge fund traders had
their happy ending.
In late 2008, the Treasury bond went haywire. The interest rate
on the Ten Year Nominal Treasury bond fell to 2.1% in the
panic--clearly overpriced. In the late 1990s, with the
debt-to-annual-GDP ratio on the decline, the Treasury bond had
traded between 5% and 7%. In the 2000s, with a weak economy, the
Treasury bond had traded between 4% and 5%. With the Federal debt
exploding even faster than it had around 1990, it seemed to hedge
fund traders very clear that the long-term fundamental value of the
Ten-Year Treasury bond probably carried an interest rate of 7%, or
more--and was at the very least more than 5%. So smart hedge fund
traders shorted Treasuries, and waited for the Treasury Bond to
return to its fundamental value.
And they ran into the widowmaker.
So they scrambled around, wondering: "Why did the interest rate
on the Ten-Year Treasury peak at 4%? And why has it gone down since
then? And why won't it go back to its 5%-7% fundamental." And they
looked around. And they found Ben Bernanke:
The Washington Super-Whale.
He had printed-up reserve deposits, and used them to buy
Treasury Bonds, and in so doing, they thought, had pushed the price
of Treasuries up well beyond their fundamentals. Yet rather than
easing off, taking his lumps, and letting the market "clear", he
kept buying and buying and buying and buying, leaving the hedge
fund traders with larger and larger and larger short positions in
Treasuries that had to be carried at a loss. And every year that
they carry those positions is a -2% times the size of the long leg
negative entry in their cash flow.
Bruno Iksil, they thought, had been pulled up short by his boss
Ina Drew's unwillingness to bet the firm and risk bankruptcy. Ben
Bernanke, they thought, ought to have been pulled up short by his
regard for financial stability--by his promise to keep inflation at
its target, for the counterpart to JPMorgan Chase's bankruptcy and
liquidation would be the national bankruptcy that is another
episode of inflation like the 1970s. But Ben Bernanke wasn't pulled
up short by the risk of inflation. He had no supervising CEO. And
he dominated the Federal Open Market Committee.
But what Bernanke was doing, they thought, was as unprofessional
as it would have been for Ina Drew to tell Bruno Iksil: "You turn
out to have made a large directional bet that we can sell unhedged
protection and profit? Let's see if you are right: let it
And so they went public with the Washington Super-Whale, as they
had gone public with the London Whale. Perhaps somewhere out there
was an equivalent of Jamie Dimon who could tell Bernanke that it
was time to unwind the Federal Reserve's balance sheet now? Jeremy
From my perspective, of course, the hedge fundies' analogy
between the London Whale and the Washington Super-Whale is all
wrong--the hedge fundies are thinking partial-equilibrium when they
should be thinking general equilibrium. CDX IG 9 has a well-defined
fundamental value: the payouts should each of the 125 companies go
bankrupt times the chance that they will. What Bruno Iksil does
does not affect that fundamental value. He can bet, and drive the
price, but he cannot change the fundamental.
But the Washington Super-Whale is different.
In a healthy economy, the Ten-Year Treasury Bond does have a
well-defined fundamental. When the economy is healthy enough that
pricing power reverts to workers and keeping inflation from rising
is job #1 for the Federal Reserve, the level of the Federal Funds
rate now and in the future is pinned down by the requirement to hit
the inflation target. And the fundamental of the Ten-Year Treasury
Bond is then the expected value over the bond's lifetime of the
future Federal Funds rate plus the appropriate ex-ante duration
But when the economy is depressed, like now? When market
appetite for short-term cash at a zero interest rate is unlimited,
like now? When workers have no pricing power, and so wage inflation
is subdued, like now? The Federal Reserve is not JPMorgan Chase. It
is not a highly-leveraged financial institution that must worry
about holding too much duration risk. As Glenn Rudebusch once
Our business model here at the Fed is simple: (i) print
reserve deposits that cost us 0 (OK. 0.25%/yer), (2) invest them
in interest-paying bonds that we then hold to maturity, (3)
And the more quantitative easing the Fed undertakes and the
larger is its balance sheet, the larger is the amount of money the
Federal Reserve makes on its portfolio, without running any
risks--as long as the economy remains depressed.
The Federal Reserve, you see, is unlike JPMorgan Chase: the
But, the hedge fundies say: "What if the economy recovers and
starts to boom? What if inflation shoots up? The Fed could lose
$500 billion on its portfolio as it moves to control inflation! Why
doesn't that fear that?"
The Fed does not fear that. That is what it is aiming for. The
Fed is charged
with "promot[ing] effectively the goals of maximum employment,
stable prices, and moderate long-term interest rates". A
full-employment economy is not something to be feared but something
to be welcomed. And a $500 billion mark-to-market loss on its
current portfolio? The Fed has given $500 billion to the Treasury,
as a present, over the past decade.
It is not a profit-making private bank. It is a central bank
charged with "promot[ing] effectively the goals of maximum
employment, stable prices, and moderate long term interest
"But," the hedgies say, "George Soros! The Bank of England held
the pound sterling away from fundamentals in 1992, and George Soros
bet against them and they could not maintain the parity and George
Soros took them for $2 billion! Why aren't we doing the same?" Ah.
But George Soros took $2 billion from the Bank of England because
its political masters told it to stand down: "We will not," they
said, "defend the ERM pound parity at the price of bringing on a
deep recession and mass unemployment." Who do the hedgies imagine
are the Fed's political masters who will tell it to shift and adopt
policies that will bring on even more massive unemployment? Rand
There is a reason that the trade of shorting the bonds of a
sovereign issuer of a global reserve currency in a depressed
economy is called "the widowmaker".
A Foolproof Approach To Monetary Policy For Both
Fiscalists And Monetarists