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July 09, 2004

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 W. Mayer

Editor's Note: Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer'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 the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.

Copyright © 2004-2007 Christopher W. Mayer

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