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John G. Gurley and Edward S. Shaw on Financial Intermediaries

The surprise rate cut by the Federal Reserve worked wonders for equity prices, and the more speculative the stock, the better it generally performed. For the week, the NASDAQ100 and Morgan Stanley High Tech indices surged 13%, Semiconductors 12%, The Street.com 11%, and the NASDAQ Telecommunications index 9%. The Biotech stocks added 5%. Blue chips caught fire as well, with the Dow and S&P500 jumping almost 5%. The Transports added 3%, and the Morgan Stanley Cyclical index increased 4%. Defensive issues underperformed, with the Morgan Stanley Consumer index increasing just 1% and the Utilities adding 3%. The broader market performed well, with the small cap Russell 2000 adding 3% and the S&P400 Mid-Cap index increasing 4%. The Securities Broker/Dealer index jumped 5%, while the S&P Bank index was unimpressive with its 2% gain. The HUI gold index was unchanged.

Importantly, the surprise rate cut by the Federal Reserve did anything but work wonders for the credit market. While fixed income did muster gains with Wednesday's cut, Thursday was the worst day of trading in the credit market in several months. For the week, 2-year yields were relatively unchanged. However, it was another poor week for the "belly" of the yield curve. Five-year Treasury yields increased 5 basis points, the key 10-year Treasury yield jumped 13 basis points and the long-bond saw its yield surge 20 basis points. For the week, benchmark Fannie Mae mortgage-back yields added 2 basis points and agency yields generally increased 6 basis points. The 10-year dollar swap spread narrowed 6 basis points to 84. Over the past two weeks, 5 year Treasury yields have surged 33 basis points, 10-year 30 basis points, 30-year 34 basis points, mortgage-backs yields 28 basis points, and agency yields 32 basis points. Over the past two weeks, 5 year Treasury yields have surged 33 basis points,10-year 30 basis points, 30-year 34 basis points, mortgage-backs yields 28 basis points, and agency yields 32 basis points. Rising yields are very much a global phenomenon. European bond yields moved to two-month highs this week, while emerging bond markets came under considerable pressure. Increasing fears of default led Argentina bond yields to 26-month highs. Bond markets were also hammered in Brazil, Turkey, and Russia. The dollar weakened noticeably after the Fed's surprise move, with the dollar index declining more than 1% for the week. Gold jumped $4.50.

Well, there are certainly diverse ways of looking at things. From listening to the punditry on a number of U.S. business programs, one would be left with the belief that with the Fed having finally "wised up" we are now at the precipice of another major leg in the perpetual bull market. They will be stupendously disappointed. Whether the pundits or Greenspan recognize it or not, the Fed Chairman is now locked in what will be an increasingly desperate struggle to hold together one massive and increasingly fragile financial regime/scheme. I have in the past referred to this situation as the "Great Experiment," encompassing unprecedented leveraging by the likes of the government-sponsored enterprises, Wall Street firms, hedge funds and the "leveraged speculating community" generally; this incredible edifice is synthesized with "sophisticated risk management" vehicles including unfathomable amounts of (equity, interest rate, currency, credit, gold, energy, etc.) derivatives, credit insurance, debt guarantees, liquidity agreements, sophisticated "structured finance" deals, vehicles, asset-backed securities and such; all this then underpinned by an unwritten promise that the Federal Reserve and their GSE Washington D.C. neighbors would ensure uninterrupted market liquidity.

This, either by design or necessity, has developed into an incredibly complex "managed liquidity" monetary regime, based on a daisy chain of gross speculation, leverage, and a vast array of financial promises all wrapped in a quagmire of some very dubious premises and serious analytical flaws. Although such a system makes no common sense, its multitude of complexities and sophistication provide neat cover. Intellectually, it has been an astounding drift away from rationality, good judgment, and sound economics. From a historical perspective, this is simply quite extraordinary. I have several times in the past compared this endeavor to John Law's early 18th century experiment with a managed paper "money" regime that unleashed the fateful Mississippi Bubble in France. The more daring the experiment, the greater the danger of it running amok and sprinting completely out of control.

Not unlike Law when his dysfunctional bubble began to falter, the Fed is clearly scared and increasingly desperate. They have every reason to be. Importantly, interest rates began to move sharply higher last week, especially in the vulnerable agency and mortgage-back area. Rising rates would be the kiss of death to an incredibly overleveraged system already buckling under the stress of a faltering equity bubble and enormous and mounting credit losses. Credit market liquidity did begin to falter abruptly when a serious liquidation appeared to have commenced. Having few options, the Fed was forced to respond the only way it knew how. For the Greenspan Fed, it has come down to one simple (John Law-style) objective: at all costs, entice the speculative "Hot Money" to remain in "The Game," while attempting to encourage enough additional financial sector leveraging to maintain general systemic liquidity. The truth of the matter is that a system of "managed liquidity" functions with all the appearances of a miracle throughout the credit-induced bubble expansions, while instilling great (albeit, false) and increasingly entrenched confidence in both the system and monetary authority (as well as silly notions of New Paradigms). The menace of illiquidity, however, is always lurking around the bend as the downside brings the harsh reality of faltering asset markets, collapsing leverage, unavoidable illiquidity, and a wrecking ball process of shattering confidence. The specter of illiquidity, as we have seen repeatedly, can be postponed through aggressive monetary management, but at the escalating cost associated with greater general credit excess, more dangerous financial system leveraging, and a bubble economy. There should be a fundamental understanding that leveraging in the asset markets creates its own liquidity during the boom, only to collapse in illiquidity come the inevitable liquidation. That's the unassailable bottom line. Speculative leveraging is an unavoidable dangerous nightmare on the downside, and this is precisely why monetary authorities must be prepared to guard against it with considerable cost, if necessary.

So, we are left today with the terrible reality that the Great Credit Bubble Monster has now firmly taken control of the entire process. Importantly, the unfolding crisis has at this point reached the critical stage where monetary policy has lost all flexibility. That such a point has been reached should not be understated. From this perspective, it is not surprising that credit markets have responded unenthusiastically to Wednesday's rate cut. We can now throw out the "playbook" of how central banking should operate. Disregard any thought that the Fed is now focused on the economy. And please discard the notion that inflation risk any longer even enters into the picture. It clearly does not. Definitely rid yourself of any blind faith that the Fed is intent on protecting the long-term purchasing power of our currency. Indeed, monetary policy has now clearly embarked on a new, perilous path.

A sadly appropriate analogy would be the profligate and highly overindebted consumer who has finally reached the end of his rope. He is forced desperately to seek out new credit cards and plead for higher borrowing limits to obtain the wherewithal to remain current with his long and increasingly anxious list of creditors. He's buried, but will go to great lengths to maintain the appearance of solvency, while scurrying to postpone the day of reckoning (what's to lose in trying, anyway?). But it is a sorry game that will be lost, with two unknowns. First, how long can the scheme can be held together - when will the final lender at last say, "no mas!"? Second, to what extent does the amount of outstanding debt mushroom before the inevitable default? Today's $64,000 question: How long does the marketplace - the domestic and offshore speculators, foreign and U.S. investors - play along? One thing is certain, the Fed is now playing a very weak hand, and markets have an unobliging way of exposing and punishing weak hands. It is simply difficult for me to believe the sophisticated players won't be moving to pull some chips off the table. But they've surprised me before…

Yesterday from Dow Jones News: "Mortgage-Back Market will 'Carry' on Nicely after Rate Cut - It may not get much better than this for the mortgage-backed securities market, which enjoyed an unexpected boost Wednesday from the federal Reserve's inter-meeting rate cut. For MBS investors, the rate cut improves their carry, or the difference between the yield on the MBS investors own and the cost of funding that they have to pay out, said Jeff Ho, an MBS analyst at UBS Warburg. Patrick McMahon, a principal of MKP Capital Management LLC, a hedge fund in New York, agreed. "It's gonna be positive for the overall spread sector,' he said. 'It improves funding for everybody.' Many MBS investors fund themselves at the shorter-end of the Treasury curve, which closely follows the Fed fund rate. Therefore, the rate cut means the borrowing cost suddenly dropped by 50 basis points for many, making their investment so much more attractive."

Also from Dow Jones: "Convertible Arbitrage Rides Volatility To Further Gain - Global convertible arbitrage funds have made a lot of money from market volatility lately. And while stormy markets will calm, history says the returns from these funds won't disappear. Convertible arbitrage funds continue to outperform other types of hedge funds, according to March data from CSFB/Tremont as turbulent markets have gifted the convertible funds with the volatility they use to prize apart the differing valuations within a convertible's equity and bond elements. 'The bottom line is convertible arbitrage is doing fantastically yet again, and it is hard to see a sudden collapse,' said Katalin Tischhauser, head of global convertible research at Goldman Sachs…Since CSFB/Tremont started charting the strategy in 1994, convertible arbitrage has seen an average monthly return of more than 1.2%. Most months have rode in a positive 1%-2% band. Is there any downside for this strategy? Only that few expect last year's boom to be repeated in 2001…Arbitrage funds have also benefited from an increase in value of the bonds in their portfolios. Increased demand for the asset class has pushed convertiblebond prices higher throughout the year."

Geez, it's as good as "free money."

I have in past commentaries used the terminology "history's most crowded trade" when discussing the proliferation of leveraged speculations betting on a Fed-orchestrated interest rate collapse. There is no doubt that there are positions of unprecedented enormity utilizing sophisticated models and leverage. These systems operate under the great assumption of liquidity. For individual speculators that's fine, but for an aggressive mass of speculation, no way. This is the leap of faith that will come back to haunt the marketplace. Again, the focal point going forward will be maintaining market liquidity in such a distorted and acutely fragile financial environment. There has undoubtedly been a flood of "Hot Money" into agency, mortgage-back, and convertible securities. When these players move to exit, there will be a systemic liquidity crisis.

The following are quotes going back to the late 1950's/early '60's from noted Stanford monetary economists John G. Gurley and Edward S. Shaw:

"Turning to another matter, it has seemed to be a distinctive, even magic, characteristic of the monetary system that it can create money, erecting a "multiple expansion" of debt in the form of deposits and currency on a limited base of reserves. Other financial institutions, conventions doctrine tells us, are denied this creative or multiplicative faculty. They are merely middlemen or brokers, not manufactures of credit. Our own view is different… There is no denying, of course, that the monetary system creates debt in the special form of money: the monetary system can borrow by issue of instruments that are means of payment…However, each kind of non-monetary intermediary can borrow, go into debt, issue it own characteristic obligations - in short, it can create credit, though not in monetary form. Moreover, the non-monetary intermediaries are less inhibited in their own style of credit creation than are the banks in creating money."

"The 'multiple of expansion' is a remarkable phenomenon not because of its inflationary implications, but because it means that bank expansion is anchored, as other financial expansion is not, to a regulated base. If credit creation by banks is miraculous, creation of credit by other financial institutions is still more a cause of exclamation."

"The group of non-monetary (nonbank) intermediaries purchased 15 percent of total issues in 1898-1900. The share rose very slowly to 17 percent just before war, and then fell to 11 percent in the face of heavy issues of the war period. After that, the activity of these intermediaries was phenomenal. During 1922-24, their share jumped to 40 percent, remained at about this level in the following sub period, and then hit 50 percent during the final three years of the period. The high indirect finance ratio during most of the 1920's, therefore, was due principally to the growth of non-monetary intermediation." Financial Intermediaries and the Saving-Investment Process, John G. Gurley and Edward S. Shaw, American Economic Review, September 1960.

Arguably, the most interesting facet of the above quotations is that one apparently has to go back 40 years to find such insightful and pertinent analysis as to the key importance of financial intermediaries. How can this be? It is my view, of course, that completely unfettered money and credit growth has created an historic and now acutely vulnerable credit bubble, and that the explosive credit creation by a myriad of nonbank financial intermediaries (that runs unabated to this day) has played a most critical role fueling a momentous asset inflation and bubble economy. It is, furthermore, quite apparent that current monetary thinking/theory is poorly equipped to recognize and appreciate credit system dynamics, dynamics that have come to create such a dire predicament. Just as there was woefully little understanding of the financial dynamics fostering the boom, there is today alarmingly oblivion to the unfolding bust.

In my rummages through the stacks in the money and banking section of the University of New South Wales Library, I have come across several interesting compilations of articles on money and credit theory. Included was an article, The Radcliffe Report and Evidence, by John G. Gurley of Stanford University.

In 1957 Britain's Chancellor of the Exchequer appointed The Committee on the Working of the Monetary System (known as the Radcliffe Committee) "to inquire into the working of [Britain's] monetary and credit system, and to make recommendations." There were 59 days of hearings where "evidence was obtained from the Treasury, the Bank of England, clearing banks and other financial institutions, dozens of trade associations, business leaders, and many economists." The committee's report was issued in four volumes ("upwards of 3 ½ million words") in 1959.

While the report apparently came under heavy criticism, Gurley surmised that some of the report's weaknesses came from "a desire to escape the conventional." We certainly will not hold that against the committee! From Gurley: "In this idealized form, the Report presents a pioneering analysis of Britain's financial system, in which the monetary system and money are considered as only part of a complex, but integrated structure of financial institutions, assets, and markets, and in which monetary policy, debt management, and fiscal policy are treated as coordinating techniques of a general financial policy aimed at regulating spending through this financial structure. In the underlying theme of the Report, all issuers of financial assets are relevant to financial policy; the Treasury issuing various forms of government securities; the monetary system creating money and other claims; and the nonbank intermediaries creating liquid claims. The idealized Report sees the level and structure of interest rates, which are the immediate targets of financial policy, determined partly by the whole range of financial assets - the level by the relation of liquid assets, including money, to holdings of financial and physical assets, and the structure to the composition of financial assets and demand for these components, with expectations playing their role in both cases. It sees money as only one asset among many, banks as only one type of institution among many, and the control of money as only one aspect of an over-all financial policy."

Interesting and quite pertinent "stuff." Certainly, reading carefully through this paper only reinforces my view that money and credit theory has made little if any headway over the past 50 years. In fact, a very strong case could be made that analysis regarding some key aspects of monetary economics has actually been backsliding. The Radcliffe Report's recognition of the importance of a "whole range of financial assets" and the liquidity creating ability and impact on interest rates by the "nonbank intermediaries" provides clearly superior analysis to the current view that basically holds that one need only focus on the banking sector. I just don't fathom the current bizarre notion that "only banks create credit."

For his article, Gurley identifies seven points that "appear to qualify as the Committee's dominant views on monetary theory and policy, including "#4. While spending is not directly affected by interest rates, it is affected by liquidity, which is composed of the money supply and the money people can get hold of. The private sector's liquidity is increased by the lending of commercial banks and other financial intermediaries, because such lending increases the supply of loanable funds ('money people can get hold of'), and the growth of liquidity stimulates spending. The important thing about financial institutions is not the liquid liabilities (monetary or otherwise) they create but the lending they do - the assets they purchase."

The Committee clearly grappled with the difficult issue of the ramifications of large purchases of financial assets and resulting liability increases by nonbank intermediaries. Under the heading "Liquidity and Financial Institutions," Gurley writes: "But while money is shoved out the house through the front door, for all to see, it does make its reappearance surreptitiously through the back as a part of general liquidity: and the most important source of liquidity is the large group of financial institutions. This is the reason the Committee devotes much space in its Report not only to the monetary system but also to the large number of nonbank financial intermediaries."

"It is no simple matter to discover in the Report by what process the intermediaries alter liquidity…but its principal view seems to be that the public's liquidity is composed not only of the money supply but of the amount of money it can get hold of….Put somewhat differently, the notion is that the proliferation and growth of financial intermediaries increase the demand for 'bonds,' which 'makes money more available' and stimulates spending for current output, even though the banking system is tightly controlled. With one possible exception, nowhere in the Report is there a statement as explicit as that, and nowhere does the Committee attempt to explain the process just described. The reader is simply left with the thought that if a new intermediary comes along, or if an old one grows, the aggregate demand for 'bonds' is somehow increased - there is an increase in the supply of loanable funds, and more money is made available to potential spenders."

"It follows that the extent to which the growth of nonbank intermediaries will increase the supply of loanable funds (or 'liquidity' in the Committee's terms, i.e., the excess stock of liquid assets) depends on the degree of substitutability between savings deposits and money, so that an answer to this question requires an analysis of the types of claims issued by the intermediaries. By concentrating on the asset side of the intermediaries' balance sheet, and neglecting the liability side, the Committee fails to come to grips with the problem. Its failure to compare what is being withdrawn from the market with what is being issued to the market - or, put another way, its failure to consider the demand for liquid assets as well as the supply of them - is as the heart of the difficulty."

"There were of course many dissenters…torn between two opposing views: that nonbank intermediaries when borrowing funds from the public, have no effect on monetary equilibrium; and that such intermediaries, when creating money substitutes, do upset monetary equilibrium…M.W. Holtrop, president of The Netherlands Bank…stated that, inasmuch as nonbank intermediaries simply redistributed the community's savings, there was no reason to believe that they would create a monetary disturbance…"

From Gurley's conclusion: "But at the same time, in its analysis of this wide, wide world there seems to be confusion everywhere - in the role of the money supply, in the concept of liquidity, in the analysis of nonbank intermediaries, in the discussion of interest rate determination, in the exalted role assigned to debt managers, and so on."

"Confusion everywhere," yes, these can be quite difficult issues to conceptualize. However, at least there was recognition that discussions were in order and a there existed a will to search for a clearer and more comprehensive understanding. Today? Nothing. Nada. Zip.

In my work, I draw extensively from some brilliant analysis of the "Roaring '20s" boom. This is done specifically because the current U.S. financial and economic bubble shares some key characteristics to the 1920's, one being the spectacular growth of financial intermediaries (as addressed in the excellent work as quoted above from Gurley and Shaw) and the profound financial and economic distortions ("bubble economy") fostered by the resulting explosion of financial credit (credit created to finance the holdings of financial assets). If one has embarked on a quest for understanding the intricacies of today's Great Credit Bubble, the focal point should be specifically with the financial intermediaries. And, ironically, if there is one area that completely lacks a sound analytical framework, it lies clearly with the role played in the money and credit creation process (liquidity creation) by financial intermediaries. This is no mere coincidence. We must assume that if policymakers understood the destabilizing consequences (monetary disequilibrium) of wildly excessive credit expansion by nonbank financial institutions, they would have moved to nip this process in the bud some years ago. They were, however, caught in the age-old trap that intermediaries "simply redistributed the community's savings;" that "they are merely middlemen or brokers, not manufactures of credit," that they simply transfer money from savers to borrowers. This complete lack of understanding by U.S. policymakers and the economic community has left me more than baffled.

Through my readings, increasingly I am coming to appreciate the backdrop for this momentous analytical shortcoming. Simplistically, the U.S. economic community has for some time been basically split down the middle. Half have believed that money just doesn't much matter, and this group could hardly care less about financial system developments. The other half has believed that money matters tremendously, but at the same time sees (erroneously) money as virtually under the direct control of the Federal Reserve. Interestingly, with the Federal Reserve as the Master of Money Supply, financial system developments really haven't concerned this "school" either. Besides, this group has generally been ardent supports of deregulation for the economy and financial system, with research and curriculum catering to this agenda; "leave the markets to their own devices." And in the bipolar world that developed, to practice economics as a profession seemingly necessitated strict adherence to respective doctrines, with great cost to sound, independent analysis of money, credit, financial system developments, and monetary processes. Most unfortunately, those that believed that money mattered (coming to possess profound influence on economic thinking, policy making and curriculums) erroneously pinned blame for the Great Depression directly on the Federal Reserve for ineptly not expanding money supply as the downturn took hold. Having found its villain, there was no reason to "turn over rocks" or search for a better understanding/appreciation of potential systemic weaknesses or mechanisms that inherently foster economic distortions, financial fragility, and dangerous boom/bust dynamics. Amazingly, this approach even went so far as to create a revisionist illusion that the "Roaring 20's" was a pinnacle of sound prosperity devoid of serious financial imbalances and systemic maladjustments. Thus ended any pursuit of the actual underlying financial and economic dynamics that led to the disastrous 1920's boom/bust and Great Depression.

Unfortunately, the seeds of a similar ideologically based misadventure are already sprouting. Not only does placing sole responsibility for this prodigious fiasco on the Fed and "government" provide easily salable dogma, it furthermore provides a cover for what should be some recognition of the need for shared responsibility within many diverse constituencies. But, then again, who wants to do that? Sure, pinning responsibility on "the government" conveniently allows a tidy and rapid conclusion intellectually. Emotionally appealing yes, but at the cost of another absolute failure in the pursuit of true understanding. I urge everyone to not fall prey to such pursuits.

For those who believe I fixate on the GSEs, I am providing you additional ammunition. First quarter numbers are in! We see that Fannie Mae expanded its mortgage portfolio by $33 billion for the quarter, at an annualized rate of almost 24%. This compares to an 11% rate during last year's first quarter. Fannie ended the quarter with total assets of $701 billion, an increase of 19% during the past year. During the past four quarters, Fannie's mortgage portfolio expanded by $104 billion to $642 billion, while its allowance for losses increased three million to $810 million. Fannie Mae's total book of business - its mortgage portfolio held on its own balance sheet as well as the mortgage-back securities owned in the marketplace for which it provided guarantees - has expanded to $1.37 trillion, with Shareholder's Equity of about $21 billion. In one of history's greatest and most reckless credit expansions, Fannie Mae has ballooned its balance sheet (total assets) by an astounding $297 billion during the past three years, a 74% increase.

In light of the explosion GSE liabilities and the resulting surge in money market fund asset, as well as increasing systemic instability, I am going to make another attempt at explaining the concept of an "infinite multiplier," the ability of some key financial intermediaries to create "money" and credit basically in enormous quantities and without constraint. It is this process that has been at the epicenter of the Great Credit Bubble, and will prove its "Great Achilles Heel" going forward.

Looking at a simple example: let's say we have Mr. Miller seeking to borrow $200,000 to buy Mr. Smith's home down at the end of the block (owned "free and clear"/no mortgage). For purposes of our example, we will assume that our little community has only one money market fund. Mr. Miller applies for his loan and Fannie Mae immediately contacts Community Money Market Fund (CMM) to borrow $200,000. Fannie Mae issues commercial paper - Fannie presents the money market fund an "IOU" for $200,000 and instructs CMM to transfer "funds" to the account of Mr. Smith.

In reality, what we refer to as "funds" are better recognized as simply electronic journal entries. When Fannie creates "IOUs"/borrows commercial paper from the money market fund to finance new mortgages, both the assets and the liabilities of the money market fund are increased by $200,000. Best to think of these as what they actually are: electronic journal entries. CMM fund assets - "Commercial Paper Borrowings - owed by Fannie Mae" - are debited/increased $200,000, while liabilities - "Fund Deposits Owed to Mr. Smith" - are credited/increased $200,000. Again, the fund simply creates journal entries, increasing the amount owed to Mr. Smith (CMM liability) and the amount to be received in the future from Fannie Mae (CMM asset) by $200,000. The community's "money supply" is increased with the expansion of money market fund assets, through the creation of additional Fannie Mae liabilities - the issuance of Fannie Mae "IOUs" that back the creation of fund liabilities - "Fund Deposits Owed to Mr. Smith".

Referring back to the opening quote, this process sure does seem "to be a distinctive, even magic, characteristic of the monetary system that it can create money, erecting a "multiple expansion" of debt in the form of deposits… Unlike Mr. Gurley's example of bank money expansion limited by a base of "reserves," money market fund deposits are devoid of reserve (or capital) requirements. No reserve requirements means that this process of journal entries can go on indefinitely, with great inherent risk of an inflationary spiral of monetary claims. Amazingly, this is precisely what we have witnessed in real life over the last few years as money market fund assets have multiplied by an incredible $1 trillion during just the past 40 months to $2.1 trillion. It is clearly anything but coincidence that total GSE assets increased by about $1 trillion over this same period to surpass $2 trillion during the first quarter. It has been one historic massive monetization of real estate inflation that has developed into a precarious self-reinforcing asset and credit bubble: credit excess begets higher asset prices that provide additional collateral to borrow against, fostering only more inflationary money and credit creation, and so on…

But there is more to the story. The GSEs have issued $100s of billions of bonds. It is my contention that a significant part of this issuance has been acquired by the "leveraged speculating community." Let's look at another somewhat more complex transaction.

For this example, Mr. Jones seeks to borrow $200,000 to purchase Mrs. Anderson's home (owned "free and clear"/no mortgage). Once again, the community only has one money market fund. Mr. Jones applies for his loan and Fannie Mae immediately contacts Goldman Sachs to issue $200,000 of bonds. In this example, Goldman's proprietary trading department (requiring borrowings to consummate the purchase) then immediately contacts Community Money Market Fund to borrow $200,000 through the issuance of a Repurchase Agreement ("repo" loan) using Fannie Mae "Benchmark" bonds as collateral. Goldman instructs CMM to use the loan proceeds to credit Fannie Mae's account for $200,000, and Fannie Mae instructs CMM to use bond issue proceeds to credit Mrs. Anderson's account $200,000. Here, "funds" are borrowed by Goldman, "transferred" to Fannie, then "transferred" to the account of Mrs. Anderson. This example demonstrates the mechanics and monetary consequences of Fannie issuing a bond that is purchased directly by a "leveraged speculator" who funds the purchase through money market borrowings. Unconstrained "Financial Credit" creation in its purest form.

Again, what we refer to as "funds" are better recognized as simply electronic journal entries. When Goldman borrows in the money market ("repos") to fund holdings of new Fannie bond issues, both the assets and the liabilities of the money market fund are increased, in this case by $200,000. Money fund assets - "Repurchase Agreements - Owed by Goldman Sachs" - are debited $200,000, while fund liabilities - "Fund Deposits Owed to Mrs. Anderson" - are credited $200,000. Again, the fund simply creates journal entries, increasing the amount owed to Mrs. Anderson (CMM liability) and the amount to be received in the future from Goldman Sachs (CMM asset) by $200,000. The community's "money supply" expands with the "multiplication" of money fund deposits by the creation of financial sector liabilities - the issuance of Goldman Sachs IOUs/"repos" that back the creation of new money market fund liabilities - "Fund Deposits Owed to Mrs. Anderson". The community's unwavering confidence that money fund deposits are liquid and safe from loss ("store of value") is the key facet allowing various financial intermediaries to convert risky loans into "money."

A slightly more complicated (realistic?) example illuminates the process by which a hedge fund takes a speculative position in Fannie Mae "Benchmark" bonds. Upon Mr. Jones' request to borrow $200,000 to buy Mrs. Anderson's home, Fannie Mae immediately contacts J.P. Morgan to issue $200,000 of bonds. Morgan's sales staff immediately contacts their "Hedge Fund" client who readily agrees to "Repo" Fannie Bonds (intending to pocket spread between borrowing at short-term money market rates and lending at long-term agency yields). Morgan's next call is to Community Money Market Fund to arrange $200,000 of financing through the issuance of "Commercial Paper." In this example, Morgan is borrowing "funds" from CMM to "transfer" to "Hedge Fund" to "transfer" to Fannie Mae to "transfer" to Mrs. Anderson's account at CMM. In reality, Morgan simply instructs CMM to credit Fannie Mae's account with the $200,000, and Fannie Mae instructs CMM to credit Mrs. Anderson the $200,000. For CMM, both assets and liabilities are increased $200,000, but in this case we'll say the transaction occurs in two steps. First, to fund the issuance of Fannie Mae Benchmark Bonds, CMM makes the following journal entries for the loan transaction with Morgan: The CMM asset "Commercial Paper Borrowings - owed from J.P Morgan" is debited $200,000, while the fund liability "Owed to Fannie Mae" is credited $200,000. Step two involves Fannie Mae funding the mortgage, where the CMM liability "Owed to Fannie Mae" is debited/decreased $200,000 and the liability "Deposit - Owed to Mrs. Anderson" is credited/increased $200,000. Looking at the two sets of entries in combination, the $200,000 debit and the $200,000 credit "Owed to Fannie Mae" cancel each other out, leaving a $200,000 increase in CMM assets "Commercial Paper Borrowings - Owed by J.P. Morgan and a $200,000 increase in CMM liabilities "Deposit Owed to Mrs. Anderson." (In this example, it is also worth noting that J.P. Morgan's balance sheet expanded by $200,000, with the $200,000 increase in the liability "Commercial Paper Borrowings" and $200,000 increase in assets "Reverse Repurchase Agreement - Owed from "Hedge Fund." Fannie Mae's balance sheet also expands $200,000, with the asset "Mortgage Loan Due From Mr. Jones" increasing $200,000 and the liability "Bonds Outstanding" increasing $200,000.).

It is at this point worth noting that there were a stunning $1.15 trillion of outstanding financial sector commercial paper borrowings as of Wednesday. I would argue that this is unmistakable evidence of systemic leveraged speculation - one massive and precarious interest rate arbitrage. A financial accident could be precipitated from several potential sources. For one, there could be a flight out of uninsured money market fund deposits (increasingly risk averse Mr. Smith or Mrs. Anderson from the above examples shifting to insured bank deposits). Second, the speculators could move (voluntarily as interest rate expectations change, or by necessity to mitigate market losses) to liquidate leveraged positions (Goldman Sachs or "Hedge Fund" selling Fannie Mae bonds). There is also certainly the potential for a flight by foreign-based investors/speculators out of money market fund deposits and leveraged security positions (due to interest rate, currency, and systemic liquidity concerns). In any of these cases, a significant liquidation would prove quite problematic for a highly leveraged and vulnerable financial system.

Over the past few years we have witnessed some pretty crazy things: the Russian debacle, the rise and fall of LTCM, and more recently the Internet fiasco, the telecommunications "arms race" debt bubble, and the Silicon Valley real estate bubble (to mention just a few), all of which now pose significant systemic danger. Why there was not some recognition of these conspicuous threats to the stability of the financial system and economy when they were developing is a clear indication of a critical weakness in both our financial system and in oversight generally. And where is the oversight today as this massive and unrelenting GSE/money market fund bubble creates a clear and present danger of financial catastrophe? This is not exaggeration. It is this bubble that leaves me fearful of what is looking increasingly like an unavoidable financial accident, and I say this with both earnestness and deep frustration. This is clearly a process of reckless monetary inflation that has gone from being out of control to one that has now taken a decided turn for the worst. Perhaps CEO Franklin Raines actually believes his own ridiculous propaganda when he states "Fannie Mae's critical role in providing liquidity during the current period of mortgage refinancings has been extremely beneficial to homeowners and lenders, and also to our shareholders." "Beneficial" will, in our view, ultimately prove to be a most inappropriate choice of words. And how economists and policymakers can continue to look the other way to such an obvious calamity in the making is simply beyond me. The fact that Wall Street is very much the cheerleader and leading instigator of this financial time bomb is absolutely inexcusable. But, as they say, "par for the course."

In today's parlous environment of acute financial instability, it is critical to recognize that this process of expanding leverage on top of leverage is so clearly a financial accident in the making. It should be accepted as unsustainable, and it clearly will not function in reverse. Any significant move out of this complex pyramid of money market fund financial leveraging will lead to an abrupt systemic liquidity crisis. It's always been a case of unsustainable credit expansion, that's been recklessly allowed to grow to the point of unmanageability. Importantly, it has been the unprecedented expansion of financial sector liabilities (predominantly "nonbank") that has been the major source of "liquidity" for the economy and asset markets - providing the "supply" behind what has been basically an unlimited availability of "loanable funds." This boundless availability of credit created by a seemingly insatiable appetite for securities from the leveraged speculating community has for some time provided the main source of fuel underpinning this aged boom. Certainly, a surge of liquidity from an enormous mortgage-refinancing boom has of late proved a critical factor in sustaining systemic liquidity (and consumer spending) in the face of collapsing technology shares and telecom debt. Specifically, the massive and unrelenting expansion of GSE holdings has played an unparalleled role, not only by providing liquidity directly, but also more surreptitiously by reinforcing the notion (moral hazard) that there would always be liquidity for the speculators in case of financial crisis or when it came time to book profits.

This openly displayed but never quite spoken assurances of liquidity even in the midst of severe market disruption has obviously played a profound role in nurturing endemic leveraged speculation throughout the mortgage-backed arena. It has, furthermore, played a major role underpinning what should be increasingly nervous markets in credit card, home equity, and equipment leasing asset-backed securities. Not only have these key markets greatly benefited from the indirect liquidity effects of massive mortgage purchases by the GSEs, the consumer debt sector in particular has been further buttressed by the recognition of the GSE's ability and willingness to inflate mortgage credit (incite mortgage refinancing booms) to sustain liquidity for the heavily overborrowed household through the monetization of real estate gains. This is really an incredible set of interrelations, a truly historic edifice of financial credit and speculative excess. Unfortunately, at every point along the daisy chain there is the assumption of liquidity, hence the current priority of maintaining the regime of "managed liquidity." However, today's momentous dilemma rests with the fact that the liquidity for the leveraged speculators is provided not by the Fed, but by the leveraged speculators.

I will end with a final piece of excellent analysis from John G. Gurley: "Financial intermediaries become potentially more dangerous to the stability of the economy the more illiquid their assets are relative to their liabilities, given the rate and pattern of their growth." Give that sentence some thought. Today, there is the perception of absolute liquidity for "money," which has become mainly the liabilities of financial intermediaries, while there is little marketplace liquidity for any meaningful liquidation of intermediary assets. Viewing the current environment through Gurley's perspective, the enormous GSEs, money market funds and the "leveraged speculating community" are quite dangerous indeed!"

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