Credit Markets

I have heard commentators (Larry Kudlow) making the argument that the credit markets are working OK because bank loans are up by some pretty high numbers. That got me wondering, so I looked at the percentage change in total bank credit plus asset-backed commercial paper from end of September to end of September the following year. The data include Loans and Leases in Bank Credit based on Statistical Release H.8 from the Federal Reserve (the "Fed") and asset-backed commercial paper outstanding from the Fed's Data Download Program. (In 2006 I had to use the October ABCP outstanding due to a gap in the data.) The first graph shows the results.

(Loans and Leases in Bank Credit plus ABCP)

As illustrated by the graph, total credit growth is actually quite meager. The true situation is, however, much worse. I illustrated this by taking out of total credit in 2008 outstanding loans made by the Fed and securities lent to dealers*. In other words, I am trying to isolate the private banking system itself as if the Fed's loans were to be repaid (of course, they cannot be). The second graph shows the result.

(Less Fed credit)

Credit coming from the private system is down - a lot - not up. Without the Fed's interventions we could be bartering by now. Now, there are a lot of other pieces to the puzzle, but this is certainly a more troubling view of the credit markets. Granted Mr. Kudlow was referring to the most recent 13 weeks, but if you calculate credit the way I have I still do not see any increases in credit coming from the private banking system.

* This includes the net Repo position of the Fed, the TAF, the PDCF, the Bear Stearns loan, loans to AIG, the TSLF, and the new asset-backed commercial paper financing. It does not include the new facilities announced by the Fed that are scheduled to begin Monday for the purchase of commercial paper and, as of the other day, other assets by the Fed.

Sphere: Related Content

More From The Federal Reserve

The Federal Reserve announced today that it will form a special purpose vehicle (the Commercial Paper Funding Facility or CPFF) that will purchase commercial paper in the marketplace from qualified issuers. This raises many questions, such as whether the Fed is now rationing credit to US companies without oversight.

The Federal Reserve is already in effect purchasing asset-backed commercial paper through its Asset-Backed Commercial Paper Money Market Liquidity Facility (ABCPMMLF) where it is lending money to banks to purchase commercial paper that is then pledged to the Federal Reserve. The twist here is that the loans to the banks are non-recourse, so if the commercial paper defaults the Federal Reserve is stuck, not the bank that borrowed the funds – same risk as ownership if you ask me. This action was authorized pursuant to section 13(3) of the Federal Reserve Act (see below). The commercial paper that banks are purchasing and pledging to the Federal Reserve under the ABCPMMLF is secured by the assets backing the asset-backed commercial paper.

The Federal Reserve is now expanding its use of this authority to purchase commercial paper directly from issuers that may be non-bank companies raising the prospect that the Federal Reserve will be rationing credit to US businesses. There is also an issue of authorization, and it seems definitions are malleable in times of crisis. From today’s announcement:

The CPFF will be structured as a credit facility to a special purpose vehicle (SPV) authorized under section 13(3) of the Federal Reserve Act. The SPV will serve as a funding backstop to facilitate the issuance of term commercial paper by eligible issuers.

According to section 13(3) of the Federal Reserve Act:

3. Discounts for Individuals, Partnerships, and Corporations In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank (emphasis added): Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

According to the highlighted section of the Act the commercial paper purchased by the Fed must be SECURED. My understanding of security in lending transactions is that there is a guaranty or some form of asset available to the lender that can be sold in the event of a default, the proceeds of which would be likely to repay the debt. According to the Federal Reserve's release:

Commercial paper that is not ABCP must be secured to the satisfaction of the Federal Reserve. The commercial paper may be secured in one of the following ways: (i) The issuer pays the SPV an upfront fee based on the commercial paper initially sold to the SPV and a further fee based on subsequent commercial paper sales above that amount (emphasis added); or (ii) The issuer obtains an indorsement or guarantee of the issuer’s obligations on the commercial paper sold to the SPV that is satisfactory to the Federal Reserve; or (iii) The issuer provides collateral arrangements that are satisfactory to the Federal Reserve; or (iv) The issuer otherwise provides security satisfactory to the Federal Reserve. The Federal Reserve will consult with market participants about other methods for issuers of non-ABCP commercial paper to provide satisfactory security to the Federal Reserve.

I wonder how being paid a fee for purchasing commercial paper meets the definition of SECURED under the Federal Reserve Act quoted above. It sounds more like creation of an insurance pool to me. Shouldn't the Federal Reserve obtain Congressional approval to purchase commercial paper from issuers in this manner? The authority is not clear to me.

I do not object to the Federal Reserve taking whatever action is within its authority that could help avert a financial disaster. What I do object to is when institutions bend the meaning of laws to accomplish what they want but then speak about the rule of law and the need to police the actions of those who seek to avoid compliance. Isn't this exactly how we got into this mess in the first place? I am also troubled by the fact that the Federal Reserve can now be seen as rationing credit to US corporations and that this situation is ripe for abuse through influence. There should, in my opinion, be oversight.

Sphere: Related Content

Trickle Up or Trickle Down?

Now that I got the details of the GSE takeovers out of the way with my last post, I wanted to write a more controversial opinion piece about this socialization of the mortgage market. As with many opinion pieces the topic is overly simplified in order to get the opinion across, but that's where all the fun is!

First let me note that although it is socialization now, the plan is to wind down the GSEs to approximately one quarter of their current size so ultimately this is a mortgage market privatization plan as much as it is a socialization plan. What has caused all of this turmoil? How did we get to this point? Here is one perspective for your consideration.

First, lets put a few factors into play. The divide between rich and poor has gotten very wide – the GINI coefficient has risen from under 40 in 1967 to 47 in 2006 (from Wikipedia.org). Second, we have seen falling or flat real wages as globalization has put pressure on labor’s ability to negotiate increases at the same time labor has become more productive by leaps and bounds. Third, corporate profits have been excellent over the past several years prior to the “credit crunch”. Finally, we have witnessed a huge increase in the level of debt owed by the average American household. Are all of these things related? I think they are, and my conclusion may not sit well with free marketeers.

At the heart of a capitalist system is the drive for profits. This drive, in an environment of free market competition, should result in innovation and, in turn, a rising standard of living. I agree with this concept and believe that there should be competition in markets. But does this system always work without unacceptable excesses? Of course not, and the current fallout is just one example. I believe that the imbalance of power between capital and labor has had a lot to do with our current situation, and if that sounds Marxist so be it.

Capital seeks profit. This is what drives a capitalist system. It gets profits by taking some of the value created by labor and keeping it for the owners of capital rather than sharing it with the producers – labor. Whether you believe this is good or bad is irrelevant for my purposes, so I will dispense with value judgment here. In order to maximize profits owners of capital seek to compensate labor at lower levels, and modern globalization together with governmental trade policies have enabled owners to take the upper hand in labor/wage negotiations. This is clearly evident in the fall of unionization and falling real wages, and is currently playing out at Boeing as labor seeks to limit management’s ability to outsource production. By successfully seeking lower labor costs owners created increased profits (lower labor costs net of increased transportation expenses). The higher levels of profit meant more new capital seeking profit. That means more investment in productive capacity. If the system gets out of balance, there is too much capital seeking profit and we get over-production. The problem is, who will purchase the surplus production, especially when real wages are falling? In theory this would result in declining prices and capital would be allocated away from production because profits would fall. So what got in the way of this process? Where is the invisible hand?

Enter leverage, the elixir. All of the excess capital was turned into even more excess capital through leverage in the financial industry. This leverage is evident in all of our financial institutions, from the failure of Bear Stearns to the liquidity crisis to the socialization of the GSEs. Leverage was enabled by our government through regulatory steps that opened the door for massive levels of debt relative to the existing pool of capital. This partnership between Wall Street and Congress is, I believe, bi-partisan and well entrenched. The result – consumers had the capacity to borrow and purchase even though they did not have the income to support the ongoing cost of ownership. Therein lies the imbalance between capital and labor that has resulted in our current situation. Too much capital allocated to production and lending for consumption, not enough wages to support ownership. The signs are there – rising inequality between rich and poor, outstanding corporate profits (until recently), consumption exceeding production, and stagnant or falling real wages. Now, as losses mount in the capital and money markets from all of the foolish extensions of credit (capital seeking profit), the process goes into reverse. Credit is difficult to come by and only allocated to the most worthy of borrowers. Consumers can no longer consume above their incomes and the price adjustment process that should have occurred a long time ago arrives with ferocity. Welcome to the credit crunch! What was the cause? Unrestrained and under-regulated capital.

As we de-leverage business profits will suffer from falling demand, asset prices will fall, and unemployment will rise. For the less well off there is the struggle to maintain the household, obtain food, and keep up with payments. For those with capital there is the struggle to preserve and grow it in an environment where prices are unstable. The current struggle is also playing out in the context of the political contest for President. Whether both parties are actually shills for the wealthy interests is a matter for debate and many believe this to be the case. Taking the candidates at face value, however, the Democratic party is calling for a redistribution from wealth to wage, while the Republican party is calling for a reduction of social benefits for wage earners to pay for ongoing tax cuts that benefit high income earners and owners of capital. Trickle up or trickle down. That is the question.

Sphere: Related Content