Bubble Blower
The Daily Reckoning
London, England
Thursday, July 01, 2004
The Daily Reckoning PRESENTS: Following yesterday's much-
anticipated FOMC meeting, Chris Mayer inspects America's
money machine and concludes that the driver may not wield
as much power as you might think.
BUBBLE BLOWER
by Chris Mayer
Despite all its position of power, prestige and privilege,
the economy lies still beyond the grasp of the central
bank. The bank can influence, but it cannot control. It can
turn on the hose, but it can't aim it. While this was true
in its earliest days, it is even more so today.
Central banking was created during times when the banks
were at the heart of borrowing and lending, and hence at
the heart of money and credit creation, and yet today -
that situation is no longer true.
As Martin Mayer [no relation to your editor] has observed
in his book "The Fed", the Fed's control over the money
supply has diminished because non-bank financial
institutions realize so much credit creation and "credit
could be substituted for money at the margin in many
guises." The new reality of our credit-soaked economy is
that control of the money supply is virtually impossible.
The capital and money markets now dominate finance, with
banks only a subset.
The distinction between money and credit is sometimes a
blurred one in today's world. We won't get into the finer
distinctions here. For us, it is enough to know that
credit, like money, represents ready purchasing power.
Purchasing power that is increasingly being manufactured
outside of the sphere of banking and used to finance the
purchase of assets such as stocks and real estate. Non-bank
financial institutions, notably the GSEs Fannie Mae and
Freddie Mac, but also others non-bank finance companies,
have driven the creation of a seemingly bottomless and
borderless money market.
This is a point that Doug Noland at PrudentBear has been
hammering away at for years, which is mainly to get people
to appreciate the contemporary financial system's
extraordinary ability to create credit unrestrained by the
traditional reserve requirements that bind banks. Fannie
Mae, for example, can create instruments (its notes) that
can be held as money market fund holdings. It has the
ability to facilitate the creation of additional purchasing
power through money market fund intermediation. Banks do
not have to be involved at all. An initial deposit made at
a money market fund can create additional deposits at a
greater rate than traditional bank deposits, again, because
the money markets are not part of the reserve requirements
of banks.
In fact, as Grant notes in the Interest Rate Observer, less
than 3.6% of today's broadly defined money stock is subject
to reserve requirements, as opposed to 38% in 1959. This is
important because the Fed's primary means of influencing
the money supply is to create (or restrict) additional bank
reserves through its open market purchases (or sales) of
government securities held by banks. It is through these
open market operations that the Fed tries to maintain its
Fed funds rate target. It does not even control that with
certainty; we are not talking about a rate that is set. The
Fed strongly influences that rate so that it may appear to
be set, but it does not set it in a formal sense.
Through open market purchases, the Fed can create
additional reserves that can then be used for lending
activities that, the Fed hopes, will stimulate the economy.
This is the standard playbook of any central bank. Increase
bank reserves and it's like adding a little booze to the
party; tighten up the reserves (open market sales) and they
are, to use the old phrase, taking away the punch bowl.
Bank reserves facilitate lending, constrained by reserve
requirements, which creates a multiplier effect on the
reserves. If banks can lend out 90% of their deposits, then
a $10 million initial purchase by the Fed leads to $9
million in lendable funds, which (assuming the loaned funds
stay in the banking system) then create $8.1 million in
lendable funds for another bank and on and on it goes. The
money markets can create additional money market fund
deposits (readily available funds that can be used to
settle transactions) without the inhibition of bank reserve
requirements.
Even though the Fed can create bank reserves, it cannot
force lenders to lend or borrowers to borrow, though there
are very strong incentives for both to do. But the modern
money markets no longer need the banks or their reserves to
finance incredible amounts of financial assets (stocks,
mortgages, etc.). There is a seemingly insatiable demand
for money market funds that are continually plowed back
into the credit creation process and lead to higher asset
prices. It is just such a process that has fueled the
housing bubble.
No credible future historian of our era will neglect the
GSEs, Fannie and Freddie, whose tremendous contribution to
the credit creation process will stand out like the
Petronas Towers in Kuala Lampur's skyline.
It appears to be open season on the twin GSE giants of
finance, Fannie and Freddie. Everyone, it seems, is taking
shots at remaking or modifying various aspects of these
monstrous credit creations. In a May 6 speech, William
Poole, President of the Federal Reserve Bank of St. Louis
laid out a devastating criticism of risks in Fannie and
Freddie's operations (let's call them FF for short, as
Poole does). While many of us have undoubtedly heard these
arguments before, it is noteworthy when it comes from the
mouth of a Federal bureaucrat - there is definitely a shift
in the wind against the mortgage behemoths.
Poole's comments focus on FF's propensity to borrow at
short-term rates and lend at long-term rates. FF magically
performs these feats of courage with a thin capital base.
This combination has led to the production of healthy
profits and returns on equity in the vicinity of 30
percent, not to mention the adulation of many investors.
According to Poole, about 34% of FF's total assets are
financed with short-term debt. The obvious risk is that
these debts re-price faster than FF's assets. If you
finance a 30-year mortgage at 6.0% with a short-term (say,
one-year) loan at 2.0%, you make a healthy spread on your
money. But, at the end of one-year, that 2.0% loan re-
prices at market rates. If interest rates rise, say to
3.0%, then your profit margin is cut by about 25% and you
still have 28-years of risk left. A situation can easily be
envisioned where FF is way under water on these assets.
FF claims to have hedges in place protecting it against
interest-rate risk. First, I would note that hedging simply
transfers that risk to another party. This is an important
point because that interest-rate risk, though it may be
hedged by FF, is still borne somewhere in the financial
system - perhaps by banks, hedge funds or other
institutions. Secondly, the quality of FF's hedge book has
been called into question. The usefulness of FF's stress
testing has been doubted.
Poole noted that FF's hedge is far from perfect. A
reversion to spreads available only as recently as 2001
could cost Fannie about 20% of their reported net income
for 2003. While such a turn would likely crush the stock
price, it would not likely cause immediate problems for
Fannie's solvency. However, if the market should come to
distrust the creditworthiness of Fannie's paper it could
create larger problems. FF rolls over some $30 billion in
short-term obligations every week. In the event of a
crisis, the market may be unwilling to soak up so much
paper at least not without a significant adjustment in
pricing. As Poole says, "The fact is that FF depend
critically on continuous market access, and with their
minimal capital positions that access could be denied
without warning." FF maintain capital positions of only
about 3.5% on their assets - not including off-balance
sheet items, which would likely balloon that leverage even
further.
I have the distinct feeling that when the GSEs are finally
stricken by crisis, it will be written as if it were
obvious all along. Just as the history of LTCM - where one
is prone to shake one's head and say "my goodness what were
they thinking?" - so too, future readers will just shake
their head, as it will all seem so obvious by then.
When the post mortem of this great credit bubble era is
written historians will focus on money and credit. They are
not going to consult the CPI or PPI. They are not going to
look at productivity figures, or job reports or
manufacturing utilization rates. They are not going to pay
much attention to the comings and goings of political hacks
- no, they are going to write about the massive growth of
money and credit as the seed of the monetary meltdown of
western civilization. They are going to write about what
happened to our money.
Regards,
Christopher Mayer,
for The Daily Reckoning
Editor's Note: Christopher W. Mayer is a veteran of the
banking industry, specifically in the area of corporate
lending. A financial writer since 1998, Christopher's
essays have appeared in a wide variety of publications,
from the Mises.org Daily Article series to here in The
Daily Reckoning. He is also the author of "Capital and
Crisis," a recently launched investment advisory for
contrarian-minded financial observers. For details, see:
Capital and Crisis
[
www.capitalandcrisis.net]