It was certainly a wild one; a truly extraordinary week in the equity market that saw stocks and indices get whipped around in historical volatility extremes. The Philadelphia Semiconductor index, for example, began the week at 1182, traded to a low of 965 Tuesday and closed today at 1223, up 27% from Tuesdays lows and 4% for the week. The Semis have gained 74% for the year. The NASDAQ100 began the week at 4398, traded as low as 3525 on Tuesday and closed today at 4292, 22% off Tuesday’s lows and down just about 2% for the week. The NASDAQ100 has a year-to-date gain of 16% and a 52-week gain of 96%. It was a strong week for the blue-chips, as the Dow gained 2% and the S&P500 added about 1%. The Transports, Morgan Stanley Cyclical index and the Utilities gained 2%, while the Morgan Stanley Consumer index rose 3%. The small caps, after taking a drubbing earlier in the week, rallied with the NASDAQ to close with a gain of 1%. The AMEX Biotech index surged 9% and the Morgan Stanley Technology index gained almost 2%. The weakest performers were The Street.com Internet index that declined 5%, and the NASDAQ Telecommunications index that sank 4%, this despite strong advances today. Interestingly, the financial stocks traded poorly today. For the week, the S&P Bank index and the Bloomberg Wall Street index dropped 2%.
Despite generally higher stock prices, the financial backdrop is becoming more ominous by the day. Today, the spread between Fannie Mae’s current coupon mortgage-backs and the 10-year Treasury note widened 9 to a record 200 basis points. This spread was 155 one month ago and 124 on January 26th. Spreads on Fannie Mae and Freddie Mac benchmark 10-year notes widened about 3 basis points today and 5 for the week. Fannie’s 10-year spread ended today at 118, 36 basis points higher than last month and almost double earlier in the year. Freddie’s 10-year spread closed today at 122, 37-basis points higher than last month. The 10-year dollar swap spread widened two basis points to 128 this week, rising 26 basis points during the past month. The spread on 10-year Federal Home Loan System notes also widened two basis points, ending the week at 114, this compared to 83 one month ago and 56 on January 26th. There is absolutely no doubt that some players have been hurt badly and that a major dislocation has developed in the massive interest rate derivative market.
We very much like the work of Northern Trust’s Paul Kasriel and will highlight his recent writing, "Do Government Sponsored Enterprises Create Credit? No, Alan Does." http://www.ntrs.com/rd/rd35/rd35fr.html , as it does a nice job explaining the consensus view, although we obviously disagree. In past commentaries we have, of course, strongly argued that the GSEs not only create credit, but they have become "runaway credit creators, directly or indirectly pumping up the economy and asset prices." On another front, we have also stated firmly our view that the nature and role of "money" and money creation remains critical to our financial system and economy. Both of these views run strongly against conventional thinking and today’s analysis will try to integrate these views.
The thrust of our argument is that that GSE’s, money market funds, and capital markets generally have come together to develop into critical instigators of money and credit excess. While some would like to believe that the GSE’s and other non-banks do not create money or credit, that they only provide a beneficial function as "intermediary" between savings and investment, this belies reality. Instead, these often-aggressive institutions are pivotal players in an historic bubble that has virtually nothing to do with efficiently allocating savings, but everything to do with money and credit excess. Indeed, through the capital markets, unprecedented money and credit growth has fueled an unprecedented financial and economic bubble. Today’s commentary will rehash some old "stuff", while also hopefully shedding some new insight.
Conventional thinking has it that the GSEs are simply intermediaries, middlemen between those saving and those wanting to borrow money. As the thinking goes, the GSEs operate similarly to an insurance company; they simply "intermediate" without creating additional credit, or buying power. As logical as this analysis is on the surface, it is nonetheless flawed. Importantly, when a person purchases insurance, she exchanges her money for an insurance policy. And while the insurance company will take your funds and use them to purchase securities, such as government or corporate bonds, the saver is left with only an insurance policy. This policy certainly does not possess the important qualities of money, such as serving as a "medium of exchange," or providing at least the perception of a "store of value." After all, you can call your broker but your insurance policy will not function as a medium of exchange to buy stocks. Thinking of it this way, the insurance company does function simply as an intermediary, taking money from a "saver" and giving it to a borrower, but it doesn’t create additional purchasing power.
Let’s now look at a bank’s role as intermediary. When you place your money into a bank deposit, the bank will take your funds and make loans. The borrower, now with "money" in his account, will have access to your funds, hence acquiring purchasing power. At the same time, you, as holder of a bank deposit, maintain your purchasing power. In this example it should be clear that bank lending creates credit and additional money supply. This, of course, is the traditional mechanism for money creation, or the "money multiplier." The key difference between the intermediation performed by an insurance company and that of a bank is that a bank deposit is "money," functioning both as a medium of exchange and a perceived store of value. As opposed to insurance premiums, bank deposits afford its holder the means to buy goods, jump on a hot stock or use as a down payment on a new home. Banks, having the ability to create money out of thin air, have at times throughout history lent excessively and recklessly, creating too much additional purchasing power only to fuel manic booms that end with the inevitable devastating busts. To guard against such occurrences, governments have for some time closely regulated bank lending, using such measures such as reserve and capital requirements. Or at least they used to.
Let’s now look at the nature of intermediation performed by money market funds. Let’s say someone places money into a money market fund account. The money market fund then performs its function as an intermediary, lending these funds into the financial markets. Does this lending create additional money - additional purchasing power? To help answer this question, let’s ponder the following: Is the intermediation function of a money market fund similar to that of our insurance company example, or is it more like a bank? Importantly, it is the nature of the financial liability created by the initial deposit into the intermediary that is a critical factor to be considered. So, with this in mind, does a deposit into a money market fund create a liability to the depositor similar to an insurance policy - an instrument that does not function as a medium of exchange? If this were the case, additional money and purchasing power would not be created through the intermediation process.
On the other hand, does the deposit into the money market fund instead create a financial asset with "money" characteristics similar to a bank deposit? Or, said another way, does the depositor maintain a financial asset that functions as money, securing purchasing power? Well, it should be obvious that money market fund deposits have the economic functionality of bank deposits and, thus, should today be considered "money." Clearly, when a person makes a deposit into a money market fund, purchasing power is maintained in the form of fund deposit, while additional purchasing power is created for the borrower when these funds are subsequently lent by the money fund, just like bank lending. The Federal Reserve agrees that money market fund assets are money, as it includes retail money market fund assets in M2 money supply and institutional money funds in M3. And in an effort to develop the most meaningful measure of money supply after momentous changes within the financial system, William Poole, president of the St. Louis Federal Reserve Bank, developed MZM, "Money at Zero Maturity" that specifically includes money market fund assets.
Undeniably, money market funds provide "intermediation" similar to banks, creating additional purchasing power and "money" through the act of taking deposits and lending these funds into the marketplace. At the same time, money market funds have some striking and powerful advantages in this process not traditionally available to banks. For one, they are not burdened by either reserve or capital requirements. This is precisely why we make the argument that the mechanism of money market funds taking deposits and lending into the capital markets provides an "infinite multiplier" for money and credit creation. Unlimited additional money market liabilities can be created as long as deposits are made into money market funds and these deposits are lent and re-circulated back into additional money market deposits.
To clarify how this can work, let’s briefly look at an example. Let’s say Jim Smith deposits $100,000 into a money market fund. The fund then immediately lends this $100,000 to Fannie Mae, which immediately funds a new $100,000 home equity loan. The home equity borrower, planning on using this $100,000 to eventually buy stock, immediately deposits these funds into a money market fund. This fund, now with $100,000 of additional deposits, then lends to Fannie Mae, which again immediately funds another mortgage loan, and so on. Although it is not easy to conceptualize, this original $100,000 can circulate through the capital markets creating additional money market fund deposits/liabilities, unfettered by reserve requirements. Importantly, when financial institutions, such as the GSEs and Wall Street firms, borrow from the money market funds and then lend to finance the acquisition of a financial asset, in the case of the GSEs, a new mortgage, or in the case of a securities firm, a margin loan, credit is created. And if GSE borrowings and Wall Street balance sheet expansion are behind an increase in money fund assets, one must also accept that GSE and non-bank lending is creating additional money supply. Moreover, with more than $1.7 trillion of assets, largely mortgage loans, it should be patently clear that the GSEs not only create credit, they are in fact egregious credit providers.
To better appreciate the credit bubble, it is useful to recognize the evolution of financial intermediation concomitant with the transformation of our financial system into a wildcat operation of reckless lending and speculating. And like much of our economics coursework, things today function much differently than we were taught. No longer is the primary role of financial intermediaries to allocate funds between "savings" and "investment." That may sound enticing in theory. But, let’s face it; our depleted savings was long ago woefully inadequate to satisfy ever-growing demands for borrowings. Instead, the role of the financial sector has evolved into fostering and accommodating massive credit expansion, and the function of "intermediation" has become largely to convert mountains of risky mortgage, credit card, auto and corporate debt into a form acceptable to sell into the marketplace. Granted, this "intermediation," or conversion process, has worked swimmingly as unprecedented credit creation has found what has been seemingly insatiable demand in the capital markets. This has occurred despite a few scares and the near market meltdown in the fall of 1998.
Indeed, the US financial sector has demonstrated an amazing ability to adapt to changing environments. No adaptation, however, was more momentous than that during 1998. In the midst of global crisis and near financial collapse, investor appetite for risk vanished. And with the US bubble being increasingly fueled by an extension of risky credits, especially unprecedented mortgage debt growth emanating from an accelerating real estate bubble, this newfound aversion to risk had great potential to stop the US boom in its tracks. Yet, the always creative and malleable US financial sector responded quickly and aggressively. To keep the game going would necessitate an acceleration of credit growth, and to accomplish this, the "intermediation" function took on momentous importance. What was really needed was a mechanism to convert $100’s of billions of risky loans into securities that even the most risk-averse would be willing to hold. What developed was one of history’s great alchemies, the "conversion" of loads of risky securities into something people love: money. This was quite an accomplishment and for this magic, Wall Street teamed with the GSEs.
You see, with their special status as government-sponsored enterprises and the perception that the US government would stand behind these institutions’ debt in case of crisis, Fannie Mae, Freddie Mac and the Federal Home Loan Bank System have been granted virtually unlimited access to the capital markets. No matter how leveraged these institutions become, they maintain AAA ratings and have unlimited access to money market borrowings. Indeed, during times of heightened stress and market dislocation, the perception of safety has always provided these institutions the opportunity to borrow aggressively - ballooning their balance sheets - effectively converting risky loans into seemingly risk-free securities held by the money funds. As we have explained previously, the GSEs purchased huge amounts of securities in the fall of 1998 from the leveraged speculators, borrowing aggressively in the money market. In fact, during a tumultuous 1998 Fannie and Freddie increased short-term liabilities by $139 billion, or 53%.
But one may point out that additional short-term debt borrowings by Fannie and Freddie in 1998 were only about one-half of the $302 billion total money market fund asset growth (compared to growth of $165 billion in 1997). Here we will make what we believe is an important point. It is our belief that the leveraged speculating community, often financed with borrowings from money market funds, actively purchase agency securities. Indeed, the largest money fund from one of the major Wall Street firms recently had 53% of fund assets invested in short-term securities of the GSEs and the other 47% of assets in "repos," or lending arrangements that likely financed agency securities. In this way, a Wall Street firm borrows from a money market fund and uses these proceeds to fund the purchase of notes from Fannie Mae, Freddie Mac and the Federal Home Loan Bank System. We see this transaction as a critical aspect of the "financial alchemy" that has surreptitiously fueled the US bubble. Indeed, it is our view that this mechanism of borrowing from the money funds "multiplies" money market liabilities – creating additional money. At the same time, this mechanism also works indirectly to "convert" risky securities into perceived "safe" ones that people are willing to hold – it transforms them into money.
Think of this process: a brokerage firm borrows from the money market, then lends to a GSE (by purchasing agency debt), and the GSE then funds more risky mortgages that it holds on its expanding balance sheet. Here, mortgages are again converted, although indirectly, into money fund assets, as the GSEs borrows from the speculators who themselves borrow from the money funds. Thus, it is with the combination of GSE borrowing directly from the money markets as well as the leveraged speculators borrowing in the money markets to fund purchases of agency debt securities that provides an explanation as to why there is such a close correlation between GSE and money market fund asset growth (see today’s chart).
So, one might ask, why do we have a problem with this arrangement of converting risky debt into money? Well, we actually have a list of concerns, but for this discussion there is a key aspect of this seemingly wonderful alchemy that needs to be highlighted: derivatives. But first, one more point needs to be made about money. We mentioned earlier that one of the key characteristics of money is the perception that it is a "store of value". This is critical. You see, the reason that individuals are comfortable holding bank and money market deposits, while they would not consider investing in mortgage-backs and other risky securities, is because they believe that there is virtually no risk of loss – that these accounts are indeed a "store of value". But these accounts can only remain free of risk from the underlying debt that actually backs this money – in particular the risk of changes in interest rates and defaults - as long as the intermediaries assume all risk. The highly leveraged intermediaries, however, with huge short-term borrowings and only a sliver of equity, must look elsewhere to obtain what is perceived to be an adequate risk buffer. This "elsewhere" has become the derivatives marketplace. In many ways, it is the derivatives market, particularly interest rate derivatives, that stand as the buffer between the volatile value of mortgage debt and the perceived stability of money. As such, we strongly argue that only with the proliferation of derivatives has the conversion of a mountain of risky debt into wonderful money been possible.
So hopefully this helps to explain our focus on derivatives, especially the interest rate swaps market that has been used so aggressively by the GSEs and other intermediaries to hedge against interest rate risk. Derivatives are clearly the weak link in the chain. In particular, the 10-year dollar swap is a derivative instrument used extensively for hedging interest rate exposure. So when we discuss the 10-year dollar swap spread, this is the difference in yield between this hedging instrument and the 10-year Treasury yield. When this spread widens sharply, as it has done the past few months, this is an indication of heightened stress in the derivatives marketplace and financial system generally. Certainly, it is our contention that the interest rate derivative marketplace is now in dislocation and that this will prove a seminal event for the US credit bubble. Going back to our earlier analysis, we believe that derivatives are a key factor in the "financial alchemy" that is at the heart of our system’s credit creation mechanism – the intermediation that has been so efficiently converting risky loans into "safe" money. At the same time, as we attempted to explain last week, it should be recognized that a proliferation of derivatives, like flood insurance, actually only increases risk taking leading to much greater systemic risk. In the end, derivatives markets falter exactly when they are needed the most because it is simply impossible to attract sufficient parties with adequate capital to accept the enormous risk exposure created, especially in an escalating market risk environment. And, in fact, that is exactly where we see the derivative marketplace today, faltering as the leveraged speculating community scurries to offload risk now that the market is dislocating.
In conclusion, it is critical to recognize how fragile and vulnerable a system becomes when the capital markets take the lead as instigators of money and credit excess. If for any reason market confidence wanes, the credit creation mechanism that had been fueling booming asset markets and the economy can come to an abrupt halt. Today, we see clearly the initial signs of waning confidence. Moreover, the unfolding dislocation in interest rate derivatives is a harbinger of a serious breakdown in this market-based money and credit creation process – a faltering of the key "intermediation" of risky loans into "safe" money. Indeed, we see the extraordinary inversion in the yield curve, panic buying of Treasuries, extreme widening in spreads for mortgage-backs, agencies and swap rates, and faltering liquidity as indicative of severe developing financial market trouble. We also believe that financial historians will not be kind when they look back at the proliferation of derivatives and the unprecedented credit and speculative excess fueled by the GSEs, money market funds, banks, hedge funds, Wall Street firms, and the aggressive US financial sector generally. Not only have they fostered major distortions and imbalances to both the financial system and economy, they have also poisoned our money supply. How this all plays out is today uncertain but, unfortunately, such egregious excesses only end badly.