<blockquote>"When Paul Volcker's term as Chairman of the Federal Reserve ended, total U.S. Credit market debt outstanding tallied around $10 TN. Broker/Dealer assets ended 1986 at $185bn. Funding Corporations stood at $146bn. GSE assets were at $364bn, with $352bn of outstanding GSE-guaranteed mortgage-backed securities (MBS). The asset-backed Securities (ABS) market, at $75bn, was hardly a force. REITs were only $15bn. The Federal Reserve’s balance sheet ended 1986 at $275bn. There were $1.80 TN of outstanding Treasury Securities and $808bn of Agency Securities. Total Commercial Bank assets stood at $2.621 TN, with miscellaneous bank assets of $741bn. Total U.S. Mortgage Debt was just under $2.70 TN.
Fast-forward to Q3 2009. Total Credit Market Debt Outstanding had ballooned more than 5-fold to $52.617 TN. Broker/Dealer assets ended September at $2.062 TN (after surpassing $3.0 TN in 2008). Funding Corporations stood at $1.338 TN. GSE assets had ballooned to $3.126 TN, with outstanding GSE-guaranteed mortgage-backed securities (MBS) at $5.30 TN. The asset-backed Securities (ABS) market ended the third quarter at $3.650 TN. REITs were $266bn. The Federal Reserve’s balance sheet had swelled to $2.180 TN. There were $7.520 TN of outstanding Treasury Securities and $8.123 TN of Agency Securities. Total Commercial Bank assets stood at $14.2 TN, with miscellaneous bank assets of $4.027 TN. Total U.S. Mortgage Debt ended the quarter at $14.42 TN.
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While certainly not without faults, the financial system back in the Volcker era was more stable. The ABS market barely existed. The Wall Street firms and their marketable debt instruments were not major factors in system Credit creation. The banking system dominated the extension of private-sector Credit. Derivatives markets were in their infancy – and certainly didn’t dominate the financial world. Outside of some GSE MBS, mortgage Credit was in the form of bank loans. There were only a handful of hedge funds – not thousands. Leveraging marketable debt instruments wasn’t The Game.
I have over the years discussed ramifications associated with the transformation of contemporary finance from bank loan dominated to marketable security dominated. I have contrasted the “staid” bank loan with the advent of the dynamic marketable debt instrument. The bank loan sat unassumingly on the bank’s balance sheet until it was repaid – all under the watchful eye of the traditionally conservative bank loan officer. The marketable security, on the other hand, could be created by virtually anyone (the aggressive mortgage banker cold-calling from the rented office suite!) and held on the books of a Wall Street proprietary trading desk, a hedge fund, or exist as part of a collateralized debt obligation. The marketable security could be “marked to model” – for some nice profits and/or bonuses – and, importantly, leveraged. And the more marketable debt securities that were created the higher their market value (and the larger speculative profits and bonuses).
These marketable debt securities provided leveraged players an almost guaranteed spread to short-term interest rates or Treasuries. Even better, its value would be expected to go up in the event the Federal Reserved responded to systemic stress by aggressively slashing rates. And for years, Fannie and Freddie would be gluttonous buyers of these securities in the event of a marketplace liquidity problem – providing the leveraged speculators a wonderful “backstop bid.” The Federal Reserve had never enjoyed such a powerful monetary tool. These potent Credit dynamics were at the heart of the U.S. Credit Bubble."
- Doug Noland,
The Volcker Rule, January 22, 2010</blockquote>