02/18/2000 Dr. Paul and Dr. Greenspan on Money *

It was another wild option expiration week - one that ended ominously. The strange divergence between the blue-chips and the more speculative sectors continued as the small cap Russell 2000 increased 2%, the Semiconductors jumped 3% and the AMEX Biotech index surged 23%. Bear market action, however, continues elsewhere. For the week, the Dow dropped 2% and the S&P500 declined 3%. The Utilities sank 3% and the Morgan Stanley Cyclical index dropped 4%, although the Transports were unchanged and the Morgan Stanley Cyclical index actually rose 2%. With today’s selling, the NASDAQ100 and the Morgan Stanley Technology indices were largely unchanged. The Internet stocks under performed, dropping 5%, while the NASDAQ Telecommunications index declined 1%. The financial stocks were clobbered with the S&P Bank and Bloomberg Wall Street indices sinking 6%.

It was another perilous week for the credit market. In fact, we see the unfolding crisis as having taken a decided “turn for the worst” this week, as our conviction now grows that the mighty credit bubble is in its most serious jeopardy since the failure of Long Term Capital Management. Remember, during the late summer and early fall in 1998, spreads widened sharply, with, for example, the 10-year dollar swap spread widening from about 70 basis points to 95. This week, the 10-year dollar swap, apparently having developed into a key market benchmark, widened 9 basis points to 100. This spread was 70 on January 26th, before the commencement of the current explosive move.

It appears that the mortgage security marketplace is a key source of current systemic stress. The spread between generic Fannie Mae mortgage-backed securities and 10-year Treasury notes widened 11 basis points to 161, this after trading at 124 on January 26th. Heightened pressure is also apparent in the important market for GSE Agency securities, as spreads widened about 8 basis points this week. These spreads have widened almost 30 basis points during the past three weeks, a very painful move for those that had borrowed to speculate in Agency securities. Elsewhere, speculators that had bet on a steeper yield curve have been severely bloodied. Today, the spread between 5-year T-notes and 30-year T-bonds widened 9 basis points to a negative 53, this after trading at a positive 12 in mid-January. An even greater trading debacle, however, has developed for those speculators financing or hedging mortgages with the government long bond. This spread widened 11 more basis points this week to 194. This spread has widened 34 basis points so far this month and almost 60 basis points since mid-January.

The harsh reality remains that our highly leveraged financial system functions poorly with any widening of spreads. As was the case during the LTCM fiasco, any sudden widening abruptly leads to illiquid markets as the leveraged players are forced to dump securities and frenetically move to hedge risk. If this hedging involves derivative, as appears increasingly the case, the writers of these products then sell securities as they dynamically hedge their exposure. We have, of course, stated before our view that the US financial sector has developed (or - regressed) into one massive interest rate arbitrate, with hundreds of billions of dollars of leveraged trades and trillions of interest rate derivatives. Over the years, interest rate speculation has grown to become endemic to our financial system. Included in the long list of speculators are the banks, the government-sponsored enterprises, a proliferation of non-bank lenders including mortgage brokers and aggressive credit card providers, Wall Street brokerage firms, mutual funds, hedge funds and others through the derivatives markets. In fact, maybe it is because this has been going on for so long that it is difficult for most to accept that borrowing in the money markets, either directly or indirectly, to finance a balance sheet or portfolio of mortgages and other higher yielding securities is a risky proposition.

We have believed for some time that crisis would be the unavoidable consequence of truly unprecedented credit market leverage and speculation. Eventually, markets always punish egregious excess – always. Actually, this unhealthy bubble was in the process of being pierced back in the autumn of 1998. It should be recognized today that it would have been much better for the system to have taken the medicine back then. Instead, the Federal Reserve cuts rates sharply, while Fannie Mae, Freddie Mac and the Federal Home Loan Bank System moved aggressively as buyers of last resort for the leveraged speculators. In the process, hundreds of billions of new credit was created by the GSEs that gave a dangerously maladjusted credit system another lease on life – and what a life it became. For sure, this bailout created huge moral hazard for the credit and stock markets. It incited truly unprecedented credit and speculative excess.

It is also our view that historians will look back on the fall of 1998 and see it as the critical point where the Federal Reserve truly lost control of the financial system. Since the bailout, the corporate sector has likely added over $700 billion in debt, while mortgage debt has probably expanded by $750 billion. The GSE’s have added more than $500 billion in debt and contracted for hundreds of billions of interest rate derivative protection. And with money and credit creation running unchecked, money market fund assets have increased by nearly $700 billion and broad money supply (M3) has surged almost $1 trillion. It has been out of control. Such unprecedented money creation has fueled a precarious economic boom and the greatest stock market bubble of all time. Truly egregious money and credit creation has led to a myriad of imbalances and distortions, both financial and economic. For our highly leveraged credit system, this has now created a most serious dilemma. With a desperately overheated economy and stock market bubble stoking immense borrowing demands, hundreds of billions in new debt securities have been created even as interest rates have surged. On the other hand, the booming economy and stock market have fueled extraordinary tax receipts and government debt pay downs.

Importantly, this confluence of factors now works to impair the massive interest rate arbitrage that has come to dominate the financial sector. Instead of a steady stream of new private sector debt instruments that could be financed/hedged by shorting government debt securities, now a flood of private sector debt is matched against a declining pool of government securities. Naturally, the relative prices of the shrinking supply of government debt dramatically outperform the prices associated with a mushrooming supply of private debt. This has increasingly fostered unexpected pricing relationships throughout the highly leveraged credit system, leading to dislocation for the massive interest rate arbitrage. Sophisticated trading models incorporating past pricing relationships that were in the past extraordinarily profitable, are particularly unsuited for the today’s very unusual environment. Indeed, this important phenomenon was captured clearly in a Bloomberg News story that caught our eye Wednesday evening. Quoting a senior mortgage analyst at Paine Webber: “Now more than any time in recent history, people are questioning their models. That’s the unexpected downside of a budget surplus.”

We do not think one can overstate the potential momentous importance of this development for the financial system or the economy. When models no longer work as expected, our acutely vulnerable system is in serious trouble. If models are breaking down, the leveraged speculators will be forced to deleverage and the credit bubble will be pierced. Importantly, the stock market and economic bubbles are manifestations of this massive credit bubble. When the credit bubble is pierced, the liquidity spigot that has fueled the booming stock market and economy will be closed. And with egregious leverage and speculation having come to dominate the stock market as well, it is destined to be a most difficult period for the stock market and, inevitably, the economy.

Hats off to Texas Congressman Dr. Ron Paul. In yesterday’s Humphrey-Hawkins testimony, Dr. Paul asked Dr. Greenspan for some clarification on the Federal Reserve’s policy regarding what has been inarguably massive excess money supply growth. We found the exchange very interesting. We commend Dr. Paul for his commitment to sound money, although he is seemingly the only individual in Washington with this view.

Dr. Ron Paul: “We have concentrated here a lot today on prices, and you talk a lot about the price of labor, labor costs. And yet that is not the inflation according to sound money economics. The concern a sound money economist has is for the supply of money. If you increase the supply of money, you have inflation.

Just because you are able to maintain a price level, (a) certain level that because of technology or for whatever, this should not be reassurance because we still could have our malinvestment, we can still have our excessive debt and borrowing. And it might contribute even to the margin debt and these various things.

So I think we should concentrate, especially since we’re dealing with monetary policy, more on monetary policy and what we’re doing with the money. It was suggested here that maybe you’re running a policy that’s too tight. Well, that – I’d have to take exception to that, because it’s been far from tight. I think that we have had a tremendous growth in money. The last three months of last year might be historic highs for the increase of Federal Reserve credit. In the last three months the Federal Reserve credit was increasing at a rate of 74%. It is true, a lot of that has been withdrawn already. But this credit that was created at the time also influenced M3, and M3 during that period of time grew significantly, not quite as fast as the credit itself. But M3 was rising at a 17% rate.

Now, since that time, of course, a lot of the credit has been withdrawn, but I have not seen any significant decrease in M3. And I wanted to just refer to this chart that the Federal Reserve prepared on M3 for the past three years. And it sets the targets. And for three years you’ve never been once in the target range.

You know, if I set my targets and I perform like that as a physician, my patient would die. I mean, this would be big trouble in medicine. But here it doesn’t seem to bother anybody. And if you extrapolate and looked at the targets set in 1997 and carried that set of targets all the way out, you only missed M3 by $690 billion. I mean, that’s just a small amount of extra money that came into circulation. But I think it’s harmful. I know Wall Street likes it, and the economy likes it when the bubble’s getting bigger. But my concern is, what’s going to happen when this bursts? And I think it will unless you can reassure me.

But the one specific question I have is will M3 shrink? Is that a goal of yours, to shrink M3? Or is it only to withdraw some of that credit that you injected for the non-crisis of Y2K?”

Mr. Greenspan: “Let me suggest to you that the monetary aggregates as we measure them are getting increasingly complex and difficult to integrate into a set of forecasts. The problem that we have is not that money is unimportant, but how we define it.

By definition, all prices are indeed the “ratio of an exchange of a good for money.” And what we seek is what that is. Our problem is we used M-1 at one point as the proxy of money, and it turned out to be a very difficult indicator of any financial state. We then went to M-2 and had the similar problem. We have never done M-3 per se because it largely reflects the extent of expansion of the banking industry. And when in effect banks expand, in and of itself, it doesn’t tell you terribly much about what the real money is.

So our problem is not that we do not believe in sound money. We do. We very much believe that, if you have a debased currency, that you will have a debased economy. The difficulty is in defining what part of our liquidity structure is truly money. We have had trouble ferreting out proxies for that for a number of years. And the standard we employed is whether it gives us a good forward indicator of the direction of finance and the economy.

Regrettably, none of those which have been able to develop, including MZM – has not done that. That does not mean that we think that money is irrelevant. It means that we think our measures of money have been inadequate. And, as a consequence of that, we, as I have mentioned previously, have downgraded the use of the monetary aggregates for monetary policy purposes, until we are able to find a more stable proxy for what we believe is the underlying money in the economy.”

Dr. Paul: “So it’s hard to manage something you can’t define?”

Mr. Greenspan: “It is not possible to manage something you can’t define.”

All we can say is that Greenspan should be ashamed.