This is one “freakish” stock market, and there is much more to the story than “Old” versus “New” economy stocks. Today, for example, the S&P Bank index declined more than 1%, but the AMEX Security Broker/Dealer index at one point sported a gain of almost 6%. Wild short squeezes continue throughout, while the blue chips struggle in what appears an unfolding bear market. For the week, the Semiconductors surged 10%, The Street.com Internet index 8% and the NASDAQ Telecommunications index 3%. The respective year-to-date gains for these indices are 89%, 14% and 21%. The NASDAQ100 gained 3% and the Morgan Stanley High Tech index 2%, increasing year-to-date gains to 24% and 19%. Heated speculation continues in the small caps as the Russell 2000 gained 1% this week, increasing its 2000 gain to 20%. Some of the moves this week in the small cap area were simply breathtaking. Some air, however, did come out of the Biotech bubble this week, with the AMEX Biotech index dropping 9%. The S&P500 declined 1%, while the Dow suffered a drop of 4%. The Morgan Stanley Cyclical index dropped 2%, Transports 3%, Morgan Stanley Consumer index and Utilities 5%. The financial stocks were mixed with the S&P Bank index declining 2% while the AMEX Securities Broker/Dealer index gained 2%.
Despite the strength in the stocks of the Wall Street firms, it was another ominous week in the credit market. The benchmark 10-year dollar swap spread widened 7 basis points to an alarming 105. Some key spreads between mortgage-backed securities and Treasuries widened as much as 12 basis points, moving to levels not seen since last September. We continue to view the credit market as acutely vulnerable to both higher interest rates and wider spreads, which would prove a precarious mix. Although there is absolutely no transparency, we fully expect dislocations to develop in the massive market for interest rate derivatives. The highly leveraged market for mortgage securities also looks particularly vulnerable. With what we view as an unfolding crisis in the US credit system combined with historic stock market speculation, we will simply state that the US financial system now travels in “uncharted waters.”
Again this week, our attention is focused on money. We will begin with several quotes from around 1700.
“The use of banks has been the best method yet practiced for the increase of money.” John Law
“So far as they lend they add to the money, which brings a profit to the country by imploying more people, and extending trade; they add to the money to be lent, whereby it is easier borrowed, and at less use; and the bank has a benefit. But the bank is less sure, and though none suffer by it, or are apprehensive of danger, it credit being good; yet if the whole demand were made, or demands greater than the remaining money, they could not all be satisfied, till the bank had called in what sums were lent.” John Law
“The advantages of a National Bank, and the good effects it will have…will plainly appear, when it is considered that one hundred pounds borrowed, will circulate two besides itself, and thereby reduce the interest… John Law
“If a banker upon receipt of a 1000 pound give his note, and that note circulate as money, and he imploy the 1000 pound received, which it is probable he will, though the banker have only the particular gains that may be made by imploying the 1000 pound in money, yet the nation may reach some advantage by having the 1000 pound thus doubled as to use: The note may pass and do service as to 1000 pounds and the money as another…” John Pollexfen 1697
“The good bank is the bank that does not pay. The banks that did not pay were ‘good,’ it was thought, because, not giving credits, they always retained the funds deposited with them, and thus the depositors ran no risk.” Charles Rist on monetary theory during the era preceding John Law
Slightly adapting the first quote above from John Law, it is our contention that “the use of commercial paper has been the best method yet practiced for the increase of money.” In the past, bank deposits ruled the money and credit creation process. Yet today, in what has degenerated into a “wildcat” financial system, brokerages, non-bank lenders and money market fund deposits are at least as powerful as banks in money creation. Indeed, a key to what has been unprecedented money excess lies specifically with the money markets - the predominant source of short-term financing for the leveraged speculating community. As such, we adamantly disagree with both the view that the Federal Reserve is the creator of our nation’s money supply, and the notion that only banks create money and credit. After all, with additional money created through the lending process, it should be recognized that non-banks have clearly evolved to be dominant players in the lending business. Just look at Fannie Mae, Freddie Mac, GE Capital, GMAC and Merrill Lynch, to name just a few. And, importantly, the money market has developed into the leading source of borrowings by these aggressive non-banks.
In the past, when banks were the predominant intermediaries for saving and lending, the Federal Reserve had considerable control over money expansion. Importantly, money growth was restrained by both reserve and capital requirements, not to mention prudent lending. Banks were required to withhold at portion of deposits as reserves, and lending was furthermore limited as to not allow total loans held on a bank’s balance sheet to exceed a certain ratio to the bank’s underlying capital. Economic textbooks taught the “money multiplier,” whereby a bank receives a deposit and a portion of this is held back for reserve. Funds remaining after the reserve hold-back were then lent, hence creating additional money supply. This was the “multiplication of bank deposits.”
The old textbook example, however, will need to be rewritten to be applicable to the contemporary financial system. You see, short-term borrowings, largely commercial paper, are the major source of funding for the enormous growth in the US financial sector. While bank deposits and the expansion of bank balance sheets were the essence of money creation in the “old economy,” money market deposits, securitizations and the balance sheet for the entire financial sector are the rocket fuel for the “new economy.” Keep in mind that financial sector debt absolutely exploded during the 1990’s. Beginning the decade at $2.4 trillion, total financial sector borrowings ended 1999 near $7.6 trillion. As we have stated before, this should be viewed as one massive and precarious interest rate arbitrage. During the decade, total outstanding commercial paper (CP) borrowings grew from $526 billion to $1.4 trillion, or 166%. Interestingly, the most dramatic CP growth is apparent in the category “Asset-Backed Commercial Paper.” This category began 1993 at $47 billion and ended 1999 at $521 billion, growing more than 1,000% in seven years. “Asset-backed Commercial Paper” is the financing vehicle for the “funding corporations” banks have developed to “off load” loans from their balance sheets, thus circumventing both reserve and capital requirements. Moreover, during periods of heightened financial stress, there has been a noteworthy increase in asset-backed commercial paper. During the four-month crisis back in 1998, asset-backed CP increased $70 billion, or at a 67% annualized rate. Then, during last year’s second half, over a five-month period asset-backed CP expanded by $97 billion, a rate of 55%.
As difficult as this notion is to comprehend, it is our view that the contemporary financial system does in fact have ability to create its own “liquidity.” Literally, “money” and credit have been created out of thin air, basically providing unlimited demand for the loans and securities created through continued unprecedented credit excess. And when our over-leveraged and fragile financial sector has come under acute systemic stress, it has to this point had the ability to create ever-greater money and credit to perpetuate the bubble. Primarily through the money and capital markets, conveniently unrestrained by reserve and capital requirements, the financial sector has engaged in unfettered money and credit creation with an “infinite multipier effect.” With contemporary “money” predominantly just entries on an electronic ledger, it has become a money creation “free for all,” as well as a complete breakdown in the key relationship between savings and borrowings. With additional money created simply with electronic journal entries, borrowings create their own demand as the financial sector takes on additional leverage. Attempting to make some sense out of this perplexing subject, we have constructed three examples of how money is created in our contemporary financial system.
Let’s say we have a community with three entities, Fannie Mae, Hedge Fund and Money Market Fund. For purposes of our example, Fannie Mae has a balance sheet with Total Assets consisting of $1 million of “Holdings of Mortgages” and liabilities of $1 million in “Commercial Paper Borrowings Owed to Money Market Fund.” Hedge Fund has Total Assets of $2 million, $1 million of “Holdings of Mortgage-Backed Securities” and $1 million “Cash/Deposit in Money Market Fund.” Money Market Fund has Total Assets of $1 million – “Holdings of Fannie Mae Commercial Paper” and $1 million of Liabilities -“Deposit Owed to Hedge Fund.” In our example, broad money supply (M3) begins at $1 million, entirely the $1 million in Money Market Fund assets.
Now, however, a financial crisis develops and Hedge Fund is losing on its $1 million bet on mortgage-backed securities. Hedge Fund manager immediately calls Fannie Mae, faithful buyer of last resort for the mortgage security marketplace. Fannie Mae agrees to the purchase and states that $1 million will be deposited in Hedge Fund’s account at Money Market Fund. Fannie then immediately calls Money Market Fund with two requests. First, Fannie Mae needs to issue and sell to Money Market Fund $1 million of commercial paper in order to fund the purchase of the mortgage-backed securities from Hedge Fund. Second, Fannie Mae directs Money Market Fund to deposit the “proceeds” into the account of Hedge Fund at the Money Market Fund. Money Market Fund agrees, the deal is transacted and Hedge Fund sends over its mortgage-backed securities to Fannie Mae.
So what has actually transpired and how has this impacted the financial position of our three entities? First, Fannie Mae’s balance sheet now totals $2 million, having increased by $1 million. On the asset side, “Holdings in Mortgage-Backed Securities” were debited/increased $1 million. On the liability side, “Commercial Paper Borrowings from Money Market Fund” were credited/increased $1 million. For Hedge Fund, Total Assets were unchanged at $2 million. However, the composition of assets changed, as “cash/Deposit in Money Market Fund” was debited/increased $1 million, and “Holdings of Mortgage-Backed Securities” was credited/reduced by the $1 million sold to Fannie Mae. The interesting question then becomes: what were the consequences of this transaction for assets of Money Market Fund? Well, Total Assets increased $1 million, with the asset “Holdings of Fannie Mae Commercial Paper” debited/increased by the $1 million lent to Fannie Mae. Money Market Fund liabilities increased $1 million as well, with “Deposit owed to Hedge Fund” credited/increased by $1 million. What happened to money supply? Money supply equals total Money Market Fund asset, $2 million, having increased by the additional $1 million commercial paper borrowings by Fannie Mae.
Our community has four entities, Brokerage Firm, Old Wealthy Client, Young Silicon Valley Client, and Money Market Fund. For purposes of our example, Brokerage firm begins with $1 million of assets - holdings of corporate bonds - and $1 million of liabilities - commercial paper borrowings from Money Market Fund. Old Wealthy client has total assets of $2 million, a $1 million home and $1 million deposited in Money Market Fund. Young Silicon Valley Client has assets consisting entirely of $1 million worth of Cisco Stock. Money Market Fund has assets of $1 million – “Holdings of Brokerage Firm Commercial Paper”, and liabilities - “Deposit Owed to Old Wealthy Client” of $1 million. In our example, broad money supply (M3) begins at $1 million, entirely the $1 million in total Money Market Fund assets.
Now, however, a financial boom develops with both the stock market and home prices rising sharply. Brokerage Firm advises Wealthy Client, a CNBC fanatic, to borrow $1 million against increased home equity to purchase a sure thing “new economy” stock, Cisco Systems. Brokerage Firm happily agrees to fund Wealthy Client’s $1 million home equity loan, providing the “cash” for the purchase. Young Silicon Valley Client, having received Cisco stock as compensation for services performed, is a happy seller. To consummate the transaction, Brokerage Firm immediately notifies Money Market Fund of its intention to borrow $1 million through the issuance of commercial paper. Brokerage firm also directs Money Market Fund to deposits the $1 million of “proceeds” into the account of Young Silicon Valley Client at Money Market Fund for payment of his Cisco shares. Money Market Fund agrees, the deal is completed, and Young Silicon Valley Client sends over the stock certificates to Old Wealthy Client.
So what has transpired in this example? First, Old Wealthy Client’s balance sheet now totals $2 million, having increased by $1 million. On the asset side, “Stock Holdings in Cisco” were debited/increased $1 million. On the liability side, “Mortgage Payable to Brokerage Firm” was credited/increased $1 million. For Brokerage Firm, Total Assets are now $2 million, having increased by $1 million. The asset, “Corporate Bonds”, was left unchanged, while the asset “Mortgage Receivable from Wealthy Client” was debited/increased by $1 million. Brokerage Firm liabilities – “Commercial Paper Borrowings from Money Market Fund,” increased to $2 billion. Total Assets of Young Silicon Valley Investor were unchanged, although the composition changed. “Cash/Deposit in Money Market Fund” was debited/increased $1 million, and the asset “Stock Holdings in Cisco” was credited/reduced by the $1 million sold to Old Wealthy Client. Again, the interesting question becomes: what did this transaction do to the balance sheet of Money Market Fund? Well, Total Assets increased $1 million, with “Holdings of Brokerage Firm Commercial Paper” debited/increased by the $1 million - the amount borrowed by Brokerage Firm to fund Old Wealthy Client’s home equity loan. Money Market Fund liabilities increased $1 million as well, with “Deposit Owed to Young Silicon Valley Client” being credited/increased by $1 million. What happened to money supply? Money supply increased by $1 million, as total Money Market Fund assets increased to $2 million.
Our community has three entities, Brokerage Firm, Corporate Insider, and Money Market Fund. For purposes of our example, Brokerage Firm has a balance sheet with Total Assets of $1 million – “Corporate Bonds”, and liabilities of $1 million - “Commercial Paper Borrowings from Money Market Fund.” Corporate Insider has Total Assets of $3 million, $2 million of “Holdings in Company Stock” from a recent exercise of stock options, and $1 million “Cash/Deposit in Money Market Fund.” Money Market Fund has Total Assets of $1 million – “Holdings of Brokerage Firm Commercial Paper,” and liabilities - “Deposit Owed to Corporate Insider” of $1 million. In our example, broad money supply (M3) begins at $1 million, entirely the $1 million in Money Market Fund assets.
Now, however, Corporate Insider would like to monetize part of his a financial windfall after a spectacular stock market boom, but would prefer not to recognize the actual sale of her shares. In such circumstances, Brokerage Firm regularly incorporates sophisticated strategies including shorting stock and/or using derivatives that often allow clients to almost fully monetize capital gains. But for our simple example, Corporate Insider is advised to use margin borrowing to extract 50%, or $1 million. Brokerage Firm is happy to fund Corporate Insider’s $1 million margin loan, charging a few hundred basis points above commercial paper rates. Brokerage Firm immediately directs Money Market Fund of its plans to borrow $1 million by issuing commercial paper. Brokerage firm also instructs Money Market Fund to deposits the $1 million “proceeds” into the account of Corporate Insider at Money Market Fund.
So what has occurred? First, Corporate Insider’s balance sheet now totals $3 million, having increased by $1 million. On the asset side, “Cash/Deposit in Money Market Fund” were debited/increased $1 million, while the other assets – “Holdings in Company Stock” were unchanged at $2 million. On the liability side, “Margin Debt Payable to Brokerage Firm” was credited/increased $1 million. For Brokerage Firm, total assets increased by $1 million, to $2 million. “Holdings in Corporate Bonds” were unchanged, while the asset “Margin Receivable from Corporate Insider” was debited/increased by $1 million. Brokerage Firm Total Liabilities – “Commercial Paper Borrowings from Money Fund” – now total $2 million, having increased by the additional $1 million. Again, the interesting question becomes: what did this transaction do to the balance sheet of Money Market Fund? Well, assets now total $2 million, with “Holdings of Brokerage Firm Commercial Paper” debited/increased by the $1 million borrowed by Brokerage Firm. Money Market Fund liabilities increased $1 million as well, with “Deposit Owed to Corporate Insider” credited/increased by $1 million. What happened to money supply? Money supply increased by $1 million, as total Money Market Fund assets increased to $2 million.
Hopefully these tedious examples are helpful in illuminating the nuances of money creation in the age of truly electronic money and, importantly, banks, bank deposits or the Federal Reserve need not be involved. In fact, these examples should make it clear that today money is created with dangerous ease. With commercial paper and other money market financing vehicles operating completely outside of reserve and capital requirements, the “infinite multiplication” of money is at work. The Federal Reserve has completely lost control and the ever-opportunistic Wall Street has grabbed the reins. Truly unprecedented quantities of money and credit are being created, which appear as wealth in the midst of the greatest financial and economic bubble in the history of man. Unfortunately, Wall Street is much better at creating financial claims than it is real economic wealth. Sure, in the above examples money is created, but there is absolutely no increase in real economic wealth, only an increase in debt. What passes as wealth are merely entries on an electronic ledger. As long as confidence holds that all these securities and electronic entries function as a store of value, this game will play on. But make no mistake, this is one momentous confidence game that will end ugly.