12/29/2000 Crisis Management Reliquefication *

As is only fitting for a year of historic volatility, the final week of year-2000 was another wild one with extraordinary divergences. The bluechips had a positive finish, with the Dow and S&P500 gaining 1%. The Transports and Morgan Stanley Cyclical index added 3%, while the Morgan Stanley Consumer index jumped 5%. The small caps rallied strongly, gaining almost 5% and cutting year-to-date losses to 4%. The Utilities gained 1%. The S&P400 Mid-Cap index rose 3%, increasing year-2000 gains to 16%. The financial stocks were mixed, with the S&P Bank index unchanged and the AMEX Broker/Dealer index jumping 4%. The New York Stock Exchange Financial index ended with a year-2000 gain of 25%, with yesterday’s close a record high. The Biotechs declined 1% this week. Tech stocks were sold heavily into today’s close, with the NASDAQ100 dropping 4% this week. The Morgan Stanley High Tech index declined 1% this week, while the Semiconductors dropped 2%. The Street.com Internet index declined 6%, while the NASDAQ Telecommunications index actually added 1%. Gold stocks declined 2%.

The credit market ended the year with a negative tone. For the week, 2-year Treasury yields increased 8 basis points, 5-year 9 basis points, 10-year 10 basis points, and the long-bond 6 basis points. The yield on the benchmark Fannie Mae Mortgage-back jumped 9 basis points to 6.90%. Agency securities under performed, as yields generally increased 11 basis points. With the dollar faltering and perceptions seemingly backing away from the economy “falling off a cliff,” the credit market appears quite vulnerable. The 10-year dollar swap widened 1 basis point to 102. Junk bond and corporate debt securities generally outperformed, with spreads narrowing between 2 to 10 basis points. The dollar continues to trade poorly, dropping about 1% this week.

When pondering the possible emotions experienced by Wall Street executives after closing out another tumultuous year, I couldn’t help but remember a Saturday Night Live skit that aired shortly after the completion of impeachment proceedings. A particularly smug looking President Clinton (played superbly by Darrell Hammond) came to the podium for a news conference, spoke the words “I am Bulletproof” and then left the stage.

Indeed, Wall Street has good reason to feel “bulletproof” as another year comes to an end. The Street has not only survived, but it has prospered mightily through the early 1990’s financial crisis, the credit market and Mexican collapse in 1994/95, SE Asia in 1997, the Russia and LTCM debacle in 1998, more credit market dislocation and the Y2K scare last year, and, just completed, NASDAQ’s largest decline in history and a virtual collapse in the junk bond market. Over this long boom cycle, there has been recurring amazement as to the resiliency of the great U.S. “supertanker” economy and the diversity and vigor of its phenomenal financial system. This year is no exception, although the true source of this resiliency has become as conspicuous as it is enormous.

We see that M3 money supply increased a stunning $56 billion last week to more than $7 trillion. Over the past four weeks, broad money supply has expanded by $105 billion. This is a continuation of what has been a truly historic monetary expansion over the past three years, with broad money supply (M3) increasing an unfathomable $1.64 trillion, or 30%. During this period, money market fund assets have surged $800 billion, or 75%, to an astounding $1.9 trillion. Outstanding Asset-backed Commercial Paper (held by the money market funds) has more than doubled to surpass $620 billion, expanding by 21% this year. Curiously, after growing only moderately during the first-half, money market fund assets exploded $205 billion during the past six months. The Federal Reserve publishes data for both retail and institutional funds. With two week remaining, institutional money fund assets have increased $155 billion this year, or 25%, to $780 billion.

Earlier in the year I wrote a commentary where I attempted to illustrate, using “journal entries”, the process of monetary expansion through the increase in money market fund assets (Mar.10, 2000-Commercial Paper). I will take another spin at this type of analysis, using a hopefully realistic example of a mechanism that I believe has played a critical role in recent monetary expansion. Here, the analytical focus is on the concept of electronic money, and the notion that contemporary money is simply journal entries on the “Big Electronic Ledger.” Electronic entries comprise our current financial system. Admittedly, it takes thinking like an accountant to makes sense of this line of analysis – my apologies. We suggest that “T Accounts” may be helpful in following these entries.

Let’s say we have a system comprised of five entities, Fannie Mae, Goldman Sachs, Microsoft Insiders, the Household Sector, and a Money Market Fund. Attempting to make this “simple” example more realistic, for our purposes Fannie Mae begins with a balance sheet that includes Total Assets of $500 billion, consisting entirely of Holdings of Mortgage Receivables from the Household Sector. On the “right side of the balance sheet,” Fannie has total liabilities of $500 billion, consisting of $200 billion in “Commercial Paper Borrowings Owed to Money Market Fund” and $300 billion of Long-Term Debt ($200 billion held by Goldman Sachs and $100 billion held by the Household Sector). Money Market Fund has Total Assets of $400 billion, consisting of $200 billion of “Holdings of Fannie Mae (IOUs) Commercial Paper” and $200 billion “Holdings of Goldman Sachs (Repurchase agreements with Fannie Mae Long-Term Debt as Collateral) Commercial Paper.” Money Market Fund, of course, also has $400 billion of liabilities - “Deposits Owed to The Household Sector.” Goldman Sachs has Assets of $200 billion - “Holdings of Fannie Mae Long-Term Debt” – as well as $200 billion of Liabilities - “Short-Term Borrowings from Money Market Fund (“Repo”).” Goldman Sachs’ derivative desk also has an “Off Balance Sheet Liability,” a Put Option Contract written to Microsoft Insiders insuring them against a decline in their $100 billion holdings of Microsoft stock (insurance that kept these insiders from liquidating positions).

The Household Sector has Total Assets of $1.1 trillion, $400 billion of Deposits at Money Market Funds, $100 billion of Fannie Mae Long-Term Debt Securities (held on account at Goldman Sachs) and $600 billion market value of Residences (with real estate inflation increasing housing values by $50 billion during the year). On the Liability side, the Household Sector has $500 billion of Mortgage Debt Owed to Fannie Mae, while enjoying a $600 billion bonanza of “Net Worth.” Microsoft Insiders have $100 billion of Microsoft Stock and rights as the holder of the Goldman Sachs Put Option Contract.

Now assume that the technology bubble has burst, with Microsoft’s stock in the midst of a severe decline. Marketplace liquidity rapidly falters (margin calls, etc.!). This is a particularly problematic development for the Goldman Sachs derivative desk, on the hook for the downside on $100 billion of Microsoft shares. Goldman is forced to “dynamically hedge” (sell short the stock as it declines) to mitigate its exposure to collapsing stock prices. With systemic liquidity disappearing as a sinking technology sector feeds a self-reinforcing “deleveraging” (margin calls and hedging-related selling), the alarm bells ring. The financial sector goes into “Crisis Management Reliquefication Mode (CMRM).”

CMRM entails immediate and aggressive action, with the old stalwart Goldman Sachs leading the charge. The firm takes a major leveraged position in Fannie Mae Long-Term Debt Securities to the tune of $50 billion. Since these are top-rated securities, this transaction is easily consummated by Goldman borrowing $50 billion in the money market (from the Money Market Fund using Fannie Mae Securities as collateral – a “repurchase agreement”). These “funds” are used to purchase $50 billion of the Household Sector’s Fannie Mae Long-Term Debt Securities, held on account at Goldman Sachs. The $50 billion of proceeds are instantly deposited (electronic journal entry!) into the Money Market Funds on behalf of the client, the (now much more “liquid”) Household Sector. In this case, Goldman’s balance sheet increases by $50 billion to $250 billion, with Holdings of Long-Term Fannie Mae Securities increasing $50 billion (to $250 billion) and Borrowings from Money Market Fund (“Repo”) also increasing $50 billion (to $250 billion). Total Household Sector Assets remain the same at $1.1 trillion. While Holdings of Fannie Mae Long-Term Debt Securities were reduced by $50 billion (to $50 billion), Money Market Fund Deposits increased $50 billion (to $450 billion). Through this leveraged transaction (an increase in financial sector liabilities/an expansion of financial credit!), Money Market Fund assets (broad money supply!) actually increased by $50 billion to $450 billion, with $250 billion of Holdings of Goldman Sach’s Commercial Paper (“Repo”) and $200 billion of Fannie Mae Commercial Paper. Money Market Fund liabilities “Deposits Owed to Household Sector” increased by $50 billion to $450 billion. Hopefully, this illustrates how financial sector leveraging increases so-called “liquidity,” or the money supply.

Goldman’s aggressive purchases, as presumed (because it’s worked so many times in the past!), lead to surging bond prices and a collapse in market interest rates. Sharply lower mortgage borrowing costs, as expected, incite the Household Sector to move quickly to refinance home mortgages. This is a particularly powerful mechanism for credit creation, as the Household Sector continues to benefit from extraordinary housing price inflation (fueled by continued lending excess by Fannie Mae!). Conditioned by steady housing gains and a the perception of enormous “Net Worth,” the Household Sector chooses to extract (“monetize”) $50 billion of housing gains during this round of refinancings with Fannie Mae. For this transaction (Household Sector extracting $50 billion of home equity), Fannie Mae Borrows $50 billion from the Money Market fund, which is “transferred” to the Money Market accounts of the refinancing Homeowners (again, through electronic journal entries). In this transaction, Fannie Mae’s balance sheet expands by $50 billion (to $550 billion), with Mortgage Loans Receivable from Household Sector increasing $50 billion (to $550 billion). Liabilities increase by $50 billion, as Short-Term Borrowings from Money Market Fund increasing to $250 billion, while Long-Term Borrowings remain the same at $300 billion. Money Market Fund assets - “Holdings of Fannie Mae (IOUs) Commercial Paper” – increase $50 billion, while the liability - Deposits Owed to the Household Sector – also increases $50 billion to $500 billion. The Household Sector’s balance sheet expands by $50 billion, as it takes on $50 billion of additional debt (Mortgage Debt Owed to Fannie Mae), while the asset - Deposits at Money Market Funds - increases $50 billion to $500 billion.

The Household Sector, now with $100 billion additional “liquidity” (Deposits at Money Market!) - $50 billion of proceeds from the earlier sale of Fannie Mae Long-Term Debt Security sales to Goldman, and $50 billion from “monetizing” home equity - has now been “liquefied,” providing ample means to continue its annual pension plan contributions (held, of course, at Goldman Sachs). With Goldman’s popular strategist calling for a sharply higher share price and constant propaganda that stocks always increase in value over the long-term, the Household Sector uses its newfound (after the Household Sector savings rate going negative!) “liquidity” to purchase $100 billion of Microsoft stock. This is “Plan Well Executed,” as it lets the Goldman Sachs derivative trading operation “off the hook,” providing desperately needed buyers for the Microsoft stock that they had to sell short to hedge the Put Option they wrote. Immediately upon receipt of the proceeds from sale, these “funds” are deposited into Money Market Fund accounts, to be paid at maturity for settlement of the Put Option Contract to the Microsoft Insiders. Looking at the outcome of this transaction, Household Sector assets are unchanged, with Holdings of Microsoft Stock increasing $100 billion and Deposits at Money Market Fund decreasing $100 billion to $400 billion. Money Market Fund assets are unchanged at $500 billion, with Household Deposits decreasing $100 billion and Goldman’s account to be paid to Microsoft Insiders increasing $100 billion.

No doubt about it, “Crisis Management Reliquefication Mode” works like magic, creating perceived wealth and “buying power” with the ease of entries on the “Big Electronic Ledger.” And the more acute the systemic stress, the greater must be these efforts to create the additional “liquidity” necessary to keep this game going. All this massive leveraging and financial sector liability creation does create enormous revenues for the government, as well as delusions of multi-trillion dollar surpluses. But make no mistake, this game does require continued confidence in the U.S. financial markets.

I have written how this “experiment” in electronic money has ominous parallels to John Law’s fateful foray into paper money. Interestingly, when confidence ebbed and Law’s scheme of “managed money” began to falter, he also took rather draconian actions to sustain his financial bubble. Importantly, he used note issuance (credit creation) from the Royal Bank to support (“liquefy”) the faltering Mississippi Bubble. Further, (from Antoin E. Murphy’s excellent book, John Law - Economic Theorist and Policy-Maker), “Law used the domestic exchange-rate changes produced through devaluations and revaluations of the money of account (not unlike today’s money market balances!), not for fiscal reasons, but to increase the attractiveness of banknotes vis-à-vis specie and to achieve his long-term objective, the demonetization of specie (gold and silver). There were three distinct stages in his use of domestic exchange-rate changes to achieve his monetary objective…The third phase of Law’s operations started (when the Mississippi Bubble began to falter) in the summer of 1719 and gathered pace during the early months of 1720. In the initial stages it involved an attempt to reduce the value of gold and silver relative to banknotes, ultimately followed by a policy announcing the complete demonetization of gold and a phased series of reductions in silver. From May 1719 the price of gold had been progressively reduced…this policy was aimed at making banknotes more attractive than specie for the public.” Law understood clearly that any mass exodus from shares would be catastrophic to his entire system, so strong measures were taken to keep the crowd in the market (like we see today).

While it ended in catastrophe, this period provided some great and pertinent economic thinking. We again would like to highlight a few timeless quotes from Richard Cantillon, a contemporary of John Law’s who profited handsomely from the Mississippi Bubble and went on to write his brilliant “Essai,” one of the great early works in economics.

“It is then undoubted that a bank with the complicity of a Minister is able to raise and support the price of public stock and to lower the rate of interest in the state at the pleasure of this Minister when the steps are taken discreetly, and thus pay off the state debt…but these refinements which open the door to making large fortunes are rarely carried out for the sole advantage of the state, and those who take part in them are generally corrupted.”

“An abundance of fictitious and imaginary money causes the same disadvantages as an increase of real money in circulation, by raising the price of land and labour, or by making works and manufacturers more expensive at the risk of subsequent loss. But this furtive abundance vanishes at the first gust of discredit and precipitates disorder.

“The excess banknotes, made and issued on these occasions, do not upset the circulation, because being used for the buying and selling of stock that do not serve for household expenses and are not changed into silver. But if some panic or unforeseen crisis drove holders to demand silver from the Bank, the bomb would burst and it would be seen that these are dangerous operations.”

This last quote resonates particularly clearly in our minds. Back in 1998, when the financial sector went into Crisis Management Reliquefication Mode, most of the new money created did “not upset the circulation, because being used for the buying and selling of stock that did not serve for household expenses.” And while it goes unappreciated, we believe it is critical to appreciate that this past year saw a significantly larger percentage of additional money creation feed directly into ballooning trade deficits. This is structural, as years of credit excess have impacted wages while also fostering economic distortions, including the “gutting” of our industrial base. We certainly expect this situation to only worsen, with the current refinancing boom perpetuating the over consumption of imports. This will only exacerbate stubborn trade deficits, and create what will be a key issue for the upcoming year

Wall Street and the Fed have one key advantage not enjoyed by John Law. Most alternative vehicles (gold, foreign currencies, other stores of value) outside of the Great U.S. Financial Bubble remain in general disrepute, so Law’s efforts to devalue alternative vehicles are seemingly not as critical. Today, the “alternative” to stocks is, most conveniently for Wall Street, the money market fund they manage. One cannot overstate how the money market has developed into a central mechanism for the Great Financial Bubble. However, this is not sound money, but a “New Age” monetary scheme. This precarious monetary regime is backed by inflated asset values and is acutely dependent on constant and massive liquidity creation to sustain levitated asset prices. The asset bubble requires enormous money creation, while money creation in this scheme requires rising asset prices. An accident waiting to happen…

We constantly waver between believing that Greenspan understands the severity of this great bubble, and the alternative view that he is rather “clueless.” We certainly take issue with his past comments addressing bubble dynamics. It is our view that the piercing of the great U.S. bubble will be the key issue for 2000 (and years to come), so we would like to highlight Greenspan’s thinking on this issue:

“One of the important issues for the FOMC as it has made such judgments in recent years has been the weight to place on asset prices. As I have already noted, history suggests that owing to the growing optimism that may develop with extended periods of economic expansion, asset price values can climb to unsustainable levels even if product prices are relatively stable.

The 1990s have witnessed one of the great bull stock markets in American history. Whether that means an unstable bubble has developed in its wake is difficult to assess. A large number of analysts have judged the level of equity prices to be excessive, even taking into account the rise in "fair value" resulting from the acceleration of productivity and the associated long-term corporate earnings outlook.

But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best. While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy.

The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan's current economic problems. Likewise, while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy. And certainly the crash of October 1987 left little lasting imprint on the American economy.

This all leads to the conclusion that monetary policy is best primarily focused on stability of the general level of prices of goods and services as the most credible means to achieve sustainable economic growth. Should volatile asset prices cause problems, policy is probably best positioned to address the consequences when the economy is working from a base of stable product prices. Monetary policy and the economic outlook, Before the Joint Economic Committee, U.S. Congress June 17, 1999

We strongly disagree that “the subsequent failure to address the damage to the financial system in a timely manner caused Japan's current economic problems,” and this entire analysis will keep economists busy for years to come. Japan’s protracted financial and economic difficulties are primarily the unavoidable consequences of wild boom-time financial excess. Still, through it all, the Japanese economy has run large trade surpluses while enjoying significant household savings. These two factors have been critical in allowing Japan the “luxury” of dropping interest rates to near zero with little concern for the yen. This is one heck of an advantage when an economy suffers from a collapsing bubble, one that has proved elusive to other countries forced to raise interest rates dramatically to stem capital outflows. A question for 2001: will the dollar’s status as the “world’s reserve currency” provide the “luxury” of Japanese-style interest-rate flexibility, as Wall Street and Greenspan assume? If not, there is one big problem brewing.

I believe that the general growth in large institutions have occurred in the context of an underlying structure of market in which many of the larger risks are dramatically – or, I should say, fully hedged. That is not to say that I have no concerns that at some point we’re going to run into institutional failures. We will. We always have. There’s no conceivable scenario of which I am aware which says that we will not have those type of problems. I think the crucial issue is, one, how do we keep the probability that they will occur to a minimum; and secondarily, to be certain that when and if they occur we have mechanisms in place which effectively either insulate or significantly diminish the impact of such failure on the rest of the economy. Alan Greenspan, hearing before the House Banking And Financial Services Committee, July 25, 2000

If Greenspan truly believes that the explosion in financial sector liabilities is mitigated - “many of the larger risks are dramatically – or, I should say, fully hedged” - by sophisticated derivatives and hedging strategies, lord help us all. Interestingly, but not surprisingly, the collapse of the technology bubble and the faltering junk bond market has led Wall Street to “circle the wagons.” Almost without exception, the key players in the Wall Street Credit Machine have experienced strong stock prices. We see that the AMEX Securities Broker/Dealer index gained 26% this year. Fannie Mae jumped 40% and Freddie Mac 46%. Credit insurer MBIA gained 40% and Ambac surged 67%. Aggressive consumer lenders Providian gained 26% and Capital One 37%. Investment management companies Alliance Capital gained 69% and Franklin Resources 19%. With Wall Street at the helm of this dysfunctional system, lavish rewards continue to fall to those perpetuating credit bubble excess.

For 2001, we don’t see the predominant risk being a failure of an individual institution, as much as the potential for the entire credit mechanism to come under intense scrutiny. The risk going forward is systemic, with a relatively small group of powerful players and an unprecedented concentration of financial power. Granted, such an arrangement does function impressively in keeping the system functioning with the appearance of soundness, despite acute underlying stress. But, this goes bring to mind the proverbial “bursting of the dam” analogy, come the day confidence wanes for the fragile U.S. financial system. For the next year, we certainly expect that the entire logic of derivatives and credit insurance will come to be questioned. We also expect that the bullish perception of money market funds as “risk free” investments/”stores of value” is a (major) potential casualty of the unfolding crisis. Wall Street has abused this vehicle, and through this abuse poisoned our nation’s money. And if the marketplace begins to question egregious financial leveraging, derivatives, credit insurance, and the soundness of money market funds, the GSE bubble will find itself in jeopardy, and I will leave it at that. Further, the current path of reckless financial sector leveraging, consumer credit excess, and the unrelenting accumulation of foreign liabilities guarantee a crisis in confidence for the dollar, and we do take note of how poorly the dollar traded as the year came to an end.

At the same time, we don’t believe the worst is over for the global financial system. Trouble could come from overseas, with financial systems throughout Asia an accident waiting to happen. One of these days there will be a major derivative accident, perhaps out of Japan, Taiwan or South Korea.

And finally, it is worth noting that as this historic year draws to its conclusion, severe distortions to the real economy are becoming increasingly conspicuous. The unfolding energy debacle in California is an example of how quickly such a crisis can develop and, importantly, how difficult it can be to rectify. But, then again, that is the nature of structural economic distortions. There are no easy solutions to such problems, and they certainly are not solved by lower interest rates and greater credit creation. As should have been expected after years of money and credit abuse, the list of problem areas is as long as it is diverse.