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.
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.
GSEs: Manufactured Away from Banking
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.
GSEs: No Reserve Requirements
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.
GSEs: The Problem with Hedges
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.
for The Daily Reckoning
July 1, 2004
Yesterday, the world ended, not with a bang but with a whimpering little rate increase of 0.25%.
The news fell upon the world like an aging Congressman down the capital steps. No one cared or thought it would make any difference. But the Fed’s move marked the end of a trend that has lasted for 25 years.
"A new era for rates," says today’s International Herald Tribune’s front-page story. The Fed’s goal, the paper tells us, is a ‘soft landing.’
For the last quarter of a century, the entire world economy has been flying – higher and higher – on the Fed’s jet fuel of easy credit. But there are limits to everything. The higher you go, the thinner the atmosphere. Eventually, you get so high you begin to hallucinate and gasp for air.
We listen to the wheezing every day. There are things we know now, and things we will not know until tomorrow or the next day. What we know now is that this ‘new era’ is an era of ‘flation – but we don’t know yet whether this heavy breathing is inhaling or exhaling. Are prices going up…or down? So far this week, like the last one, the evidence was mixed. Gold plunged on Tuesday. Oil and commodities seemed to be heading down too, with Brent crude hitting $33, also on Tuesday. Bonds went up on Wednesday. And China’s outlet store, Wal-Mart, cut its sales forecast in half. Meanwhile, Freddie Mac, one of America’s leading mortgage debt enablers, reported a 53% drop in profits for 2003.
On the other hand, India said its GDP grew more than 8% in the first quarter – it’s fastest growth in 15 years. And the government expects the economy to grow at 7% to 8% a year for the next decade. "A strong pickup in industrial activity also appeared to increase demand for the services sector, which grew 13.8 percent in the last quarter of 2003-2004," said AP. [Ed. Note: Just as James Boric reported on his return from Mumbai, India is growing fast. This is great news, especially for the two Indian small-caps he unearthed. Follow the link for James’ exclusive India research…
And Japan? The widely reported rise in consumer spending in Japan is hardly a ‘done deal.’ Sales for May came in 2.5% lower than the same period a year ago. The Avis of world economies may be a good investment…but its recovery from a 14-year-long slump may or may not come without complications.
China, meanwhile, is trying for its own ‘soft landing.’ It too was launched into space by the Great Enabler, Alan "Bubbles" Greenspan. The Fed chairman gave Americans money to spend that they had not earned. The Chinese rushed to help them get rid of it. Thus did the old era establish a convenient symmetry: excessive consumer spending by Americans led to excessive capital spending by the Chinese. Both economies are now far above the earth, hoping to get back on the ground without injury.
The metaphor is nice enough. Cut back on the fuel – by raising the key Fed rate 0.25% – and the great airplane will gradually fly lower…and then come to a soft, safe landing.
Which only goes to show the trouble with metaphors. The world economy has come to depend on credit from the Fed at give-away rates. Households, companies and speculators have built their lives, businesses, and portfolios around them – and left themselves with less margin for error than any generation in history. A man who now spends all his income and has a 6% mortgage cannot painlessly adjust to a 7% rate. Something has to go. When it does, a whole swarm of bright, buzzing business strategies, carry trades, and hopes for the future begin to crash and burn. Pretty soon, the ground is littered with them.
Neither the U.S. economy nor the Chinese one is a mechanical device, after all. And neither engineers nor economists can hope to understand it…or control it.
That job falls to us: moral philosophers, humorists, kibitzers and agents provocateurs. Only we appreciate the heights of madness to which the world has risen. Only we will get a chuckle when the conceits of the Greenspan era smash to ground. And only we have our own non-resident genius, the Great Mogambo, who always has the ‘mot juste’ for any occasion.
What would Mogambo say?
More news from our New World team:
Eric Fry, our man on Wall Street…
– Mr. Greenspan raised rates. Mr. Market yawned…the Dow Jones Industrial Average added 22 points to 10,435.48, while the Nasdaq gained 13 points to 2,048.
– The Federal Open Market Committee hiked short-term interest rates by a quarter-point yesterday, just as expected…and the pinstriped pooh-bahs also promised to continue raising rates at a "measured" pace, just as expected. Thus, the Fed funds rate now stands at 1.25%, just as expected. But yesterday’s quarter-point hike barely begins to fulfill the lumpeninvestoriat’s lengthy list of expectations for Mr. Greenspan’s monetary machinations.
– The lumps expect Greenspan to adjust the Fed funds rate as needed to maintain the value of the dollar and to foster economic growth and to dampen inflationary pressures and to facilitate employment growth and to perpetuate the bull market in stocks and to nurture the steady appreciation of home prices and, if possible, to reduce geopolitical tensions, urban crime and teen pregnancy.
– Although the Fed funds rate stands only 125 basis points tall, most investors see it as a financial Colossus of Rhodes. But maybe this itty-bitty interest rate can’t really do what so many believe it can do. And maybe the guy who pushes this rate around doesn’t really possess the wisdom and omnipotence that we ascribe to him. Maybe – and now we are merely speculating – Greenspan is a mortal, capable of error. Indeed, he could be erring as we write.
– The FOMC’s well crafted press releases do not change the fact that Greenspan is holding short-term rates well below the inflation rate – a condition that bond fund manager Bill Gross terms, "atrociously speculative." Even after yesterday’s rate hike, the U.S. inflation rate is nearly triple the Fed funds rate. In other words, Greenspan is still gunning the U.S. economy with easy money. Under the guise of a "moderate" and "measured" monetary policy, he is joyriding in an $11 trillion economy.
– A 1.25% Fed funds rate in a land of 3% to 4% inflation encourages the kind of speculation that leads to dislocations known as bubbles. A "neutral" rate of, say, 3.5% would tend to discourage most of the most reckless forms of speculation. Why then does this speculative rate persist?
– "The 1% federal funds rate is an emergency rate without an evident emergency," wrote James Grant in advance of yesterday’s rate hike, "and it has to go up – at a ‘measured’ pace if possible, faster if necessary. Such is the new word from the Federal Reserve Board."
– To the delight of Wall Street pundits, yesterday’s FOMC press release contained the "new word." Said the FOMC: "With underlying inflation still expected to be relatively low, the committee believes that policy accommodation can be removed at a pace that is likely to be measured."
– The financial media have latched on to the Fed’s new favorite word like a newborn to its mother’s breast. Yesterday’s Wall Street Journal featured the following poorly edited line: "As the Federal Reserve embarks today on its project to moderately raise interest rates a measured amount that is moderate and measured, the consumer picture is distinctly odd."
– Should the inclusion, or exclusion, of a specific adjective in an FOMC press release, carry such weight in the financial markets? Should it dictate the destination of trillions of investment dollars? We, here at the Daily Reckoning, value semantic nuance as much as anyone. After all, word selection and sentence structure are the tools of our trade. But should these linguistic apparatuses also be the tools of American finance?
– By according such an outsized significance to the word "measured," investors are engaging in a kind of mock-heroic farce – not unlike a music historian crediting Beethoven’s quill with creating his 5th Symphony.
– Mr. Market does whatever he wishes, no matter which words the Fed chooses to describe its activities. Is measured such an important word after all? What if the Fed’s release instead contained the word, "gradual" or "incremental" or "step-by-step?" Would the world be such a different place?
– Or let’s imagine that the Fed admitted its limitations by replacing the word "measured" with a word like "whimsical" or "capricious" or "haphazard." Sure, the Dow would fall 100 points or so initially, but the financial world, where real money is made and lost, would not have changed one iota…and within 48 hours, every journalist in America would begin emphasizing the wisdom of the Fed’s promise to raise interest rates in a "capricious" manner.
– Enough already! Enough of the tortured linguistic analysis. Here’s an idea: Let’s try to buy good stocks and to sell bad ones.
"But man, proud man,
Drest in a little brief authority…
Plays such fantastic tricks before high heaven
As make the angels weep."
– Shakespeare’s "Measure for Measure"
Bill Bonner, back in London:
*** 1980-2004…Bush-Reagan…could two periods be any less similar? U.S. consumer debt hit a new record, came the news yesterday, at $9.185 trillion, or 110% of take-home pay. As a percentage of earnings, it is nearly twice was it was in the early ’80s. In 1980, Americans prepared for a long bust – and a boom followed. Twenty-four years later they prepare for a long boom, while a bust is surely on its way.
*** Poor David Beckham. The metro-masculine half of the ‘Posh and Becks’ celebrity team seems to be in disgrace in London. At least, that was the implication of the TIMES cover from yesterday. A photo shows a poster of the soccer star after the English team lost a critical match. An illiterate fan had written ‘Looser’ over Beckham’s face.
*** We have been thinking more about the ‘transit of Venus.’ You’ll recall, dear reader, that the fault lies not in ourselves, but in our stars. Venus does what she does. Somehow, someway – science spends its time trying to clarify how these things work – we do what we do. We pretend to think our way forward. We pretend we know what we are doing and have a good reason for everything. But why do we think what we think? Venus. Mars. The heavens…God, the devil…and the deep blue sea. Thoughts arise, we know not wherefrom.
"I’m sometimes amazed by what comes out of my own mouth," said a friend at dinner last night. "Where did that idea come from, I wonder. I didn’t know I thought that."
We offer no explication here this morning. We merely pause to listen to the angels weep and appreciate the triste elegance of it all.
What set off this minor reflection? An article in the Daily Mail, in which Amanda Platell regrets the ‘selfish singletons’ among her 40-something friends. They believed they could do a better job of designing their lives than nature or tradition. Instead of marrying and having children, as generations had done before them, these people created a new era of their own. Rather than suffering the stresses and strains of family life, they built careers and friendships…furnished their apartments from Ikea…and voted for Tony Blair.
Now, Tony Blair’s favorite think tank is worried about them. It calls them the Lonely Generation. "Two million people face a future alone…" a report concludes.
"By the end of the next decade," Platell explains, "the children of the Sixties will be in their ’70s and many of them will be paying a price…
"They were the ones who placed sexual satisfaction above enduring love and self-fulfillment above self-sacrifice.
"Of course there are those among them who say that so long as you have friendships, families don’t matter. They claim the old and lonely will socialize with – and care for – each other.
"It’s a neat idea, but one that owes more to hope than reality. Ask yourself this question: how many of your friendships have lasted longer than a decade? And how many of your current friends could you reasonably expect to look after you if you had Alzheimer’s, or cancer…?
"No I’m afraid that kind of unconditional love only usually comes from family…"
At least your family would put you in a nursing home where you could drool without the neighbors noticing.
*** Pittsburgh correspondent, Byron King, on the housing bubble on the banks of the Monongahela:
I was riding the street railway into downtown Pittsburgh this morning. I noticed a billboard in the trolley car, advertising units in an apartment complex. I happen to know that this apartment complex is real estate of significant quality. This particular rental property has architectural merit, and was recently rebuilt from the inside out, up to a very good specification. It is, in short, a very nice place to live.
It is even nicer now, because the ad said: "$99 Deposit – Two Months FREE Rent."