The Money Supply And The Credit Crisis

I have been reading about monetarism around the web lately and find the topic interesting. Most of the writings I have seen look to money supply measures as an indicator of whether we should expect inflation and discuss the monetary aggregates, M1 and M2. Some commentators are stressing that M3 and MZM are better indicators of the true money supply as they include institutional money market funds ("IMMFs"). I agree with this position, but I think it misses some issues of the current economic situation. I think of it this way: Under the traditional model of monetary expansion the Federal Reserve injects reserves into the banking system which then uses the reserves to make a loan. The proceeds of the loan are then deposited into a bank and this is new money! The bank receiving the deposit can use a portion of this new deposit to make a loan, and the proceeds of that loan will be deposited into another bank – more new money. This process continues expanding the money supply and debt, limited by the portion of each new deposit that must be kept in reserve rather than loaned out and the fact that in order to make a new loan, banks need capital. But what if debt could expand without expansion of the money supply or bank capital? There would be a decoupling of the relationship between the money supply and debt creation. This decoupling has happened as debt that is originated by banks is often removed from the balance sheets of the banks through securitization, and this process converts the money supply from M2 to M3 or even out of M3 completely. To see how this happens requires a rather lengthy diversion into an example, so here goes:


To see how an everyday transaction ends up converting M2 to M3, I have drawn the diagram above. Beginning with the asterisk in Bank Reserves and assuming the Fed has injected $100 in new reserves, the Bank would want to make a loan for $100. Assume the Bank makes a loan of $100 to Home Buyer to purchase a house from Home Builder. Home Buyer takes out the loan and the cash goes to Home Builder. Home Builder now takes the cash and deposits it into the Bank. (These transactions are the black lines.) This is a new deposit and it represents growth in all the monetary aggregates. But in today’s financial markets (at least before the current meltdown) the Bank is likely to sell the loan to remove it from its balance sheet. If it does so by selling the loan (either directly or through a securitization first) to a commercial paper conduit, then the blue lines would represent the transfer of the loan in exchange for cash. But where did this cash come from? Let’s assume Investor took $100 out of its account at the Bank to purchase a share in IMMF (institutional money market fund) (the red lines). IMMF used this new cash to purchase commercial paper from the Conduit, which is where the Conduit got the cash to purchase the loan (the green lines). At the end of this series of transactions, there has been no net change in bank deposits because $100 went in from Home Builder and $100 came out from Investor (no change in M1 or M2). The original $100 of reserves injected into the bank by the Fed has been replaced by the proceeds from the $100 loan purchase by the Conduit. The money supply has grown, but it is what used to be M3 that increased through an increase in IMMF balances. The Bank is now free to lend the entire $100 again, effectively eliminating the reserve requirement and bank capital as a limitation on money supply (M3) growth from the initial reserves. Because of this off-balance sheet financing of loans by banks it can be M3 that increases as loans are made and sold rather than M1 or M2. Also note that this financing structure is speculative, funding long-term assets with short-term debt. Since the funding source (commercial paper) is not generally guaranteed (as are bank deposits) it is prone to a run. If the bank simply securitized the loans and sold them directly to investors without a commercial paper conduit we could diagram the same result with respect to M2 without an increase in M3 or MZM, but it would not necessarily be speculative. In any event, we have already created the money underlying the loan, but we have converted it to something that is not measured by M2 and sometimes not measured by M3. Because of these conversions of money from one form to another the traditional concepts of money supply and monetary expansion have been altered. As debt creation escapes the bounds of the monetary system around which traditional debt expansion occurred we should monitor debt outside banks as well as M2 or M3.


To see the change in the relationship between deposit expansion and debt creation I compared M2 to non-federal-government debt (“NFGD”) using the first graph above. (NFGD is all debt less federal government debt.) NFGD has increased from a multiple of approximately two times M2 in 1980 to over 3.2 times in 2007. Historically, as debt increased through the banking system there would be a concurrent increase in M2 as the fractional reserve system of banking would multiply the monetary base through deposit expansion. Today, however, deposit expansion and debt expansion have become decoupled as banks sell loans to third parties. In addition to decoupling deposit expansion from debt expansion, the latter is no longer constrained by bank capital since the banks are no longer accumulating loans that require capital. This can create a monetary base outside of the traditional measures of money.


We have also seen a decoupling of the relationship between incomes and debt creation. In its simplest form this is the relationship between debt and GDP. The second graph shows NFGD as a percent of GDP and M2 as a percent of GDP. The divergence is striking, and I think gets to the heart of our economic crisis – the breakdown of the relationships between money supply and debt and between debt and income. With debt ballooning to new highs relative to income, the cash flow implication for consumers is less consumption and more saving – a recession. But what supports this balloon of debt in the first place? In part it is like any other bubble - the rising prices of the assets being financed by the debt provides collateral for more debt. The difference with this bubble, however, is that we have gone from a game where the ultimate size of the monetary bubble is regulated by the Fed through banking reserves, deposit multipliers, and bank capital to a system where any bubble can create its own monetary supply to support itself using securitization to multiply bank reserves in a virtually unlimited manner. At the same time we should be monitoring broader measures of monetary expansion because of financial innovation the Fed has stopped publishing M3 in the belief that it adds nothing to what M2 tells us.

So, other than restructuring how we monitor the financial system for the future, what should be done? Lets start by recognizing that doing nothing is unacceptable as the risk of a deflationary spiral is too great and the results too dire to chance. Once consumers are overburdened with debt service we should expect a recession because not only will consumers save to pay down debt, they will stop borrowing while they do so which will further reduce consumption. Reduced consumption could lead to falling incomes and prices, in which case relative debt burden increases making things worse. Assuming savings also decline through falling asset prices (stocks, home values, etc.) there would be no reason to expect an increase in consumption (save the increase in the value of cash net of the value of liquidity, if any, in such circumstances) or investment, and we could get stuck in a long-term underemployment of great proportions. If the true driver of the current financial crisis is the creation of too much consumer debt, then the only way we exit the crisis is by reducing the burden of the debt on consumers through some proactive means. There are several ways to go about reducing the burden of debt-service on consumers (other than simply using public funds to repay private debt). (1) We can try to inflate our way out of the impending cycle of deflation and recession by adding reserves to the banking system, but this assumes more reserves will result in more borrowing, investment, and consumption. Will companies borrow to invest when the economic outlook is dreadful because consumers are overburdened with debt? Will consumers borrow to consume when they are already overburdened with debt? In short, will traditional efforts to expand the money supply expand the money supply? The evidence is not in yet on this front. (2) We can make every effort to lower interest rates thereby supporting asset prices and reducing debt service payments. This would help to reduce the debt-service in the debt-service/income ratio and provide more income for consumption. The Fed’s efforts to reduce both short and long term interest rates should have some positive impact on reducing the debt burden by lowering rates and, therefore, debt-service payments and should, in turn, support asset prices. Note this is related to the inflation scenario in that monetary policy easing means lowering interest rates on the short end. The Fed has now gone to purchasing long-term securities in an effort to reduce long-term rates that have not responded to the short-term rate reductions. We can also attempt to restructure debt obligations so as to reduce the current payment obligations of consumers by, for example, extending the term of a loan. (3) We can have a major fiscal stimulus that creates employment to increase incomes relative to legacy debt-service. By increasing incomes the debt-service/income ratio would decline. The stimulus would, in effect, replace private debt with public debt, freeing up income for consumption. Based on recent reports, a major fiscal stimulus plan is probably in the works by the new administration.

While we wait to see if our efforts are successful, we can utilize the Fed and Treasury to (i) pump public money into bank capital so the banks have enough capital to make new loans when they hold excess reserves, and (ii) lend to ever increasing elements of the financial system to prevent major systemic collapse as speculative financing evaporates. None of this is news.

Sphere: Related Content

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

The Plan for GSEs

The Federal Housing Finance Agency (FHFA), the regulator of the GSEs (Fannie Mae and Freddie Mac) announced today that it is putting these two behemoths into conservatorship. I have read through the announcement from Treasury Secretary Paulson and the statement made by James Lockhart, both of which are available at the Treasury Press Room online. (Please note that any quotes in this article not otherwise noted refer to this release.) There are some interesting aspects to this plan, as well as interesting questions.

The first question is why. Why put these entities into conservatorship now? According to today’s statements, the root cause of the problem is the inherent conflict within these organizations of being run for profit but with a purpose of serving a public interest. Of course, these institutions have existed in this form for quite some time (1968 for Fannie Mae and 1970 for Freddie Mac), so this would not be why they are being put into conservatorship now. They are being put into conservatorship now because they are no longer able to accomplish their mission of helping to provide liquidity to the mortgage market and “respond appropriately to the private capital market,” (see the legislation that created Freddie Mac here) and they are at risk of failure which could have devastating ripple effects in the financial industry and the broader economy. Mismanagement, excessive lobbying success, and the rapid decline in home prices have left them inadequately capitalized to carry out their missions.

Because they are undercapitalized investors have not been snapping up GSE liabilities. The poor demand for their debt results in the GSEs paying higher interest on borrowings, and this translates into more expensive mortgages for borrowers. So, even though the Federal Reserve has the target Federal Funds rate down to 2%, a negative real rate, interest rates in the mortgage markets are going up. Some believe this situation goes well beyond the GSEs and is a reflection of the entire financial system in the United States, but don’t expect to hear any politician or regulator tell you that in public. A Heard On The Street Column in The Wall Street Journal Online Edition makes that point this morning.

In order to provide liquidity to the mortgage market (which means demand for mortgage backed securities and debt issued by the GSEs), the Federal Government has decided to step in with a four-point plan. The hope is that if this plan is successful, mortgage interest rates will decline causing increased housing demand softening the housing price declines we are seeing. In turn, this should speed a recovery in the overall economy as falling home prices represent a huge drag on consumer spending. In addition, the systemic risk from a failure of the GSEs goes away (is transferred to the United States taxpayer).

One point I want to mention before getting into the details of how the plan works is that according to the statement released by James Lockhart, “all political activities – including all lobbying – will be halted immediately.” I find this ironic, and I would like to know when this rule would be applied to Wall Street.

That’s the why, now to the how. Step one is placing the GSEs into conservatorship, meaning they will now be run by FHFA. Investors who own stock lose all of their rights although they can keep the stock in the hope that at the end of all of this there will be some value in it. There will be no dividends paid to common or preferred shareholders. There is a ripple effect to this part of the plan, as any financial institution that holds a large amount of stock in the GSEs will likely realize a sudden and dramatic loss. The agencies involved in the financial system

encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares … are likely to reduce their regulatory capital below ‘well capitalized.’ The banking agencies are prepared to work with the affected institutions….

In any event, the largest players in the mortgage markets are now in the hands of regulators.

Treasury announced an additional three steps it will take to shore up confidence in the GSEs so their debt costs will come down and to provide liquidity to the mortgage market. These are (i) taxpayer guarantees of GSE debt backed by taxpayer purchases of Senior Preferred Stock of the GSEs as required (initially up to $100 billion for each GSE), (ii) “market” purchases of GSE mortgage backed securities (MBS) in an unspecified amount, and (iii) a taxpayer credit line of an unspecified amount for loans to the GSEs and the Federal Home Loan Banks secured by GSE MBS (or, in the case of the Federal Home Loan Banks, advances). These steps are all in addition to the $400 billion of liquidity provided by the Federal Reserve, the recent $300 billion taxpayer guaranteed FHA refinance plan, and the $250 billion of taxpayer guaranteed debt issued by the Federal Home Loan Banks since this “contained” “subprime” mortgage crisis began.

First, the Treasury (that would be the taxpayers) has guaranteed the solvency of the GSEs. So, if these entities lose money and become insolvent, the United States taxpayer will purchase up to $100 billion of Senior Preferred Stock in each entity that will be senior to existing preferred stock and common stock outstanding. This amount is not necessarily a limit on what taxpayers will invest – rather it is an amount chosen by Treasury as an initial facility size. Just to put this amount into perspective, the current common equity of Freddie Mac is approximately $12 billion. This taxpayer investment program is aimed at shoring up demand for GSE debt in the hope it will reduce the cost of debt and, in turn, bring down mortgage interest rates. In order to protect taxpayers, Treasury also gets warrants to purchase, at a “nominal” cost, up to 79.9% of each GSE. Senior and subordinated debt issued by the GSEs and the MBS they issue and guarantee remain senior to taxpayers and are, in fact, guaranteed by taxpayers because if the GSE can’t pay them taxpayers purchase more Senior Preferred Stock to provide the funds. The total amount of this debt is massive, but these are backed by mortgages and so losses are what we should be focused on. Even so, we are talking about a total principal exposure of over $5 trillion dollars.

As part of the agreement between Treasury and the GSEs, each GSE must shrink its on-balance sheet mortgage assets by 10% per year from $850 billion (a little more than what they are today) on December 31, 2009 to $250 billion. The impact of such a reduction in size on the GSEs’ ability to act as a conduit between lenders and the secondary market is likely to be substantial. According to FHFA this should address the systemic risk posed by the size of these institutions. It seems a shame, however, that publicly assisted housing finance that had worked so well until a few years ago is being forced to all but disappear. The ultimate losers would be the general public and the ultimate winners – well – whoever will satisfy all the mortgage demand when the GSEs are too small. Hopefully Congress will figure out a way to preserve the public benefit (Representative Frank?).

The second step Treasury is taking is initiating a program of purchasing GSE MBS that are credit guaranteed by the GSEs. Now remember that pursuant to the step just discussed these guarantees are now guarantees of the Treasury. Yes, the taxpayers will be purchasing taxpayer guaranteed debt with taxpayer funds. This part of the plan hopes to provide additional liquidity to the market for mortgage backed securities – something that the $400 billion or so that the Federal Reserve has provided, plus the $250 billion or so the Federal Home Loan Banks have provided, plus the $300 billion FHA plan, have not accomplished. Treasury will designate “independent asset managers as financial agents” to make purchases of mortgage backed securities on behalf of Treasury. Of course, none of these people know one another so we can rest assured that there will be no favoritism regarding who Treasury purchases the GSE MBS from (hummm). Two glaring mysteries in this part of the plan – how much will taxpayers purchase and from who?

Finally, Treasury is providing a collateralized loan facility to the GSEs AND the Federal Home Loan Banks. So, if the market for GSE debt is unfavorable even after all of the other steps, taxpayers will lend the money to the GSEs taking MBS as collateral, and if the Federal Home Loan Banks run into problems issuing their taxpayer guaranteed debt they too can borrow from the taxpayers directly (this type of borrowing would fund advances at these banks that are collateralized by mortgage assets of financial institutions). These lines of credit are available until December 31, 2009, as authorized by the recent legislation passed by Congress. There is no stated limit on the overall size of this facility.

If you are interested in following your money Treasury will be releasing information on borrowing by the GSEs and Federal Home Loan Banks in the Daily Treasury Statement. Purchases of MBS will be reported monthly in the Monthly Treasury Statement.

All of this raises some very interesting questions about our overall economic system. If time permits I will publish a perspective on possible root causes of all of these deviations from our “free market” system.

Sphere: Related Content

What Caused The Credit Crisis?

I have been following and writing about the credit crises for some time. Watching the stock prices of the financial companies plummet over the past few months has been painful if you own any of them. As I wrote in March I have been expecting this decline, but its acceleration in recent weeks has been breathtaking.

I have been reading a lot of commentary about what caused the credit crisis. Most recently I read the first section of “The First Global Financial Crisis of the 21st Century” published by VoxEU.org. This is a collection of articles written by renowned economists addressing the credit crisis, and part one deals with the causes. Unless otherwise noted my references in this article to other writers refers to their article in this collection. There is a rather long list of suspects, but in my opinion the cause of the credit crisis was a failure of the regulators of the financial system to adequately protect it from systemic risks that they should have seen at the time. Determining why they failed under such circumstances should be the primary path of inquiry. This involves uncovering the reasons why, in the face of compelling evidence of a major financial storm in the making, financial regulators did nothing. The same can be said for Congress.

I believe there is plenty of blame to go around and there were many bad actors involved in generating loans that should never have been made. In one of my early articles I pointed the finger at many of these actors. But it is the job of regulators to monitor the financial system and prevent excessive, systemic credit problems and they failed to do so. When banks are lending people 100% of the value of a home, waiving income verification, and basing the borrowers ability to pay on a loan payment that is based on a temporary teaser rate there is abject foolishness in the market. This condition existed for at least two years while bank regulators and Congress looked on and did nothing. As if this wasn’t enough, at the same time there was obvious chicanery in the credit markets relating to housing we experienced a housing bubble of massive proportions. Regulators and Congress still did nothing, except that Congress and the President began to brag about home ownership rates.

Some commentators (see Tito Boeri and Luigi Guiso, pg 37) (see also Theodore Forstmann, “The Credit Crisis Is Going To Get Worse”, The Wall Street Journal Online Edition, July 5 2008) argue it was classic supply-push in the credit markets caused by excessive monetary easing from 2001 – 2004 that caused the stupidity that led to this crisis. I tend to agree that monetary policy has been too accommodative and is one of the root causes of the current crisis. However, we have always known that monetary policy easing increases risk taking so to blame this as the cause of the crisis misses the point.

Some argue that new innovations, such as CDOs, where not fully understood (see Guido Tabellini, pg 45). I find humor in this though I am not happy with the result. If we take a lot of crappy assets and put them together, will the resulting “diversified” pool of crappy assets have less risk? Well, when all the assets are correlated to the housing market and are the most sensitive to any price changes (subprime) then obviously all you have done is made a bigger pool of crap. Add to this the fact that history exists in the subprime lending world and it is not good. Where the assumptions came from underlying the ratings on CDOs is a mystery to anyone who has seen subprime lenders crash and burn. To say this was a failure of the statistical models is a nice way of saying the assumptions were wrong and upon further inspection this should have been obvious. Statistical complexity aside, what happened to common sense? Isn’t this where the regulators are supposed to come in? When the market is doing things that are clearly high risk and in large magnitude? Where were they?

Some argue it was the rating agency conflicts that enabled this debacle to occur. I agree this was a contributing factor, but Congress and the regulators knew this problem existed since, at the latest, 2002 when it was presented to Congress in testimony relating to the Enron bankruptcy by Frank Partnoy (see part II. D). There were very clear and explicit warnings that this type of crisis was waiting to happen yet Congress and the regulators turned a blind eye.

Some argue that it is the over reliance on statistical modeling that led to this crisis (see Jon Danielsson pg. 13). The lack of backtesting data for those once in 100 years events meant that the science was flawed. In addition, the correlations are all wrong when everyone acts the same way at the same time (the heard). I buy this argument, but what I don’t buy is the argument that the regulators were fooled by all of this. This was clearly a movement to allow financial institutions to self regulate using their own internally developed models. Whether this was politically driven or truly a belief among regulators that this was a better way I do not know, but it takes a lot of the burden off regulators to monitor and regulate! Now regulators are calling for additional powers. I ask, where were they when this crisis developed?


I actually know part of the answer to my last question. One thing the regulators were working on was providing the financial system with large amounts of leverage that would ultimately be at the root of the liquidity part of this crisis. In 2004 regulators codified banks’ use of off balance sheet entities, those SIVs and asset-backed commercial paper conduits that leapt onto the front pages last Fall, with minimal regulatory capital requirements. At the same time there were regulatory changes for the investment banks that have been referred to as the “Bear Stearns Future Insolvency Act of 2004”. With respect to the banks, the result is easily discernible from the graph above. Asset-backed commercial paper outstanding skyrocketed as banks utilized their newly codified leverage structure to take on the CDOs and other securities where the true risk of all this absurd lending was being hidden. Especially notable here is the absence of the SEC. These securities that were being rated and issued were, apparently, not understood by anyone. By extension, they were not understood by the SEC – isn’t that part of its job? Unfortunately, when investors discovered that there was excessive risk in these vehicles they stopped purchasing the commercial paper that funded them. The result was a severe liquidity crisis as the banks had to honor lines of credit they provided to these entities securing the repayment of commercial paper under just these circumstances. The Federal Reserve has received great admiration for its creative tonics when this crisis broke out, but I believe that is like honoring a firefighter for extinguishing a very dangerous fire that the firefighter ignited in the first place. I can’t finish this part of my rant without pointing out a couple of issues here. First, a crisis in the commercial paper market would certainly present a systemic risk to the financial system if all the banks had credit lines backing their $1.2 trillion in asset-backed commercial paper. Given this fact, together with the knowledge from Enron that off balance sheet treatment does not eliminate risk but increases risk taking, how did the bank regulators determine that is was 10 times safer to fund assets this way than the traditional method of holding them on a bank’s balance sheet? This seems like an extraordinary conclusion, extraordinarily wrong headed.

Of course the current crisis is well beyond a mere liquidity event. The off balance sheet leverage combined with excessive monetary easing provided much too much liquidity to the markets, and the resulting stupidity in the credit world will ultimately cost institutions their solvency. As of this writing Bear Stearns no longer exists (although the taxpayers now own $29 billion (and falling) of mortgage-backed securities that Chase didn’t want while the shareholders walked with cash) and the FDIC has seized IndyMac, a large bank with extensive mortgage operations. I don’t believe this will be the last, and taxpayers will be paying for this debacle for years to come.

So what caused this crisis? Those responsible for ensuring a sound financial system failed, plain and simple. Regulators and Congress are to blame as they were well aware of the risks of rating agency conflicts, off balance sheet financing and excessive leverage yet they turned a blind eye when it came to the financial sector. The fact that rating agency conflicts and other abuses by Wall Street and others played a role does not change the fact that those responsible for regulating these activities failed. In fact, these issues should have made the regulators even more watchful in light of the fact that they were warned of rating agency conflicts that go to the heart of the regulatory system they set up.

In hindsight all of this looks obvious, and what is obvious in hindsight is not always so clear at the time. Perhaps it was not so obvious to regulators or Congress at the time. But why didn’t they figure it out? These are the best and brightest in the field and it is their job to figure this out and monitor and protect the financial system. What forces were at play such that this set of events could be set in motion and play out without any reaction from the Fed or Congress? Perhaps there is something structurally wrong with having the Fed involved in bank regulation at the same time it is responsible for monetary policy. Perhaps there is an issue with the appointment of regulators such that a given administration’s policies become too pervasive. Perhaps too many key people in the regulatory authorities come from the very institutions they are there to regulate or get jobs at those institutions when they leave. Perhaps the financial industry has too much influence in Congress and it is the broken political system where money buys influence that caused the credit crisis. In my opinion these are the fundamental issues raised by the credit crisis and I believe they should get more attention than they are getting now. I also believe that these very same regulators should not be setting the agenda for the new regulatory regime that will follow this crisis, but as of now they are.

Sphere: Related Content

Sheriff John Green

I was reading this article in today’s Wall Street Journal, Online Edition and was struck by some of the conflicting messages it highlights for many. I am a student of financial markets and to some extend the Federal Reserve (the “Fed”), so I have a certain perspective on the whole subprime mortgage debacle that is no secret to anyone reading my column. I object to bailouts, whether it be for homeowners or Wall Street, and I have been writing that opinion since last October when I first started publishing my blog. But this article got me thinking about these Philadelphia residents who are being evicted from their homes because they can’t pay their mortgages. Circumstances have now changed, and they have changed because the Fed, no doubt with the blessing of Treasury, has bailed out Wall Street. (For more on this there is another article in today’s Wall Street Journal Online expressing one Federal Reserve Bank President’s concerns about the Fed’s recent actions and the market distortions that can be expected as a result.)

Admittedly bailing out Wall Street is good, in some ways, for everyone as it lessens the risk of a major economic blowup. But tell that to a resident in Philadelphia being evicted from their home who can understandably be thinking “they can bail out those Wall Street executives and their customers but they can’t help me?” Enter the Sheriff, John Green:

Sheriff John Green has spent 37 years in law enforcement. But these days he's best known around town for the law he won't enforce.

With the economy soft and thousands of Philadelphians delinquent on their mortgages, Sheriff Green this spring refused to hold a court-ordered foreclosure auction. His move raised eyebrows on the bench and dropped jaws among lenders and their attorneys, who accuse him of shirking his duty to enforce legal contracts….

Mortgage lenders, servicers and their attorneys thought Mr. Green was acting more Robin Hood than sheriff. "It's not his job to postpone things in favor of certain people," says Michael VanBuskirk, a Philadelphia attorney, who describes the city as a "legal free-fire zone." The city, he says, is "less attractive to business if you can't be certain that the sheriff won't invalidate a contract."

Fed policies to help rescue Wall Street firms have created distortions that have hurt many innocent bystanders in this debacle as savings rates plummet and inflation increases. In fact, the inflation in food and energy prices caused in large measure by negative real interest rates is likely a direct cause of many of the foreclosures as those consumers most at risk can no longer afford to pay all of their bills. So in keeping real interest rates negative to rescue the financial industry Fed policies are hurting many of those who would be hurt in a larger financial collapse anyway and the impact is falling disproportionately to the most vulnerable among us. To hear mortgage lenders now object to the Sheriff’s actions because they favor one group over another is, in my opinion, entertaining at best. In my view, looking to the public policy issues behind this story presents a very different picture than a simple issue of contract law.

I believe we are witnessing the spread of the bailout mentality that has been established by the Fed (and sanctioned by the Administration) in favor of Wall Street. Regardless of the ultimate consequences of allowing major Wall Street firms to fail, the general public will understandably view these actions as favoring those on Wall Street as opposed to them. Let’s do a thought experiment. The first part is to ask: “Why is it good for the Fed to bail out these Wall Street firms by providing credit at taxpayer risk?” The answer, of course, is that to do so will help avoid an economic collapse that would hurt everyone. The second part is to ask: “Why should the Sheriff refuse to sell foreclosed homes at auction?” The answer, of course, is that doing so helps avoid an economic collapse of the neighborhoods involved that would hurt everyone. So, is the Sheriff acting like Robin Hood or following the example set by the Fed? In the eyes of those on the ground I think taking the latter view is easily comprehensible.

The distortions caused by the Fed’s bailout of years of negligent lending activities by Wall Street and all of its subsidiary tentacles has set the stage for redistribution fights such as this one, and I don’t know how you put this genie back in the bottle. So at the end of this piece I have an unanswered question: Is the creativity demonstrated by Mr. Bernanke, with the certain blessings of Mr. Paulson, good for our society in the long run or just another example of how being too creative (ever heard of a CDO squared?) can really mess things up?

Sphere: Related Content

Some Hidden Costs of the Credit Crisis

The Federal Reserve (the Fed) is likely causing dramatic distortions in the markets by lowering interest rates below the level of inflation and the impact may only be evident in retrospect. One side effect of the Fed's actions is a massive shift of the costs associated with the credit crisis from borrowers to savers. While negative real interest rates are helping some homeowners keep their payments down they are also fueling inflation resulting in a tremendous loss in value to those who have saved for retirement. Artificially low interest rates are also causing pain for those living on a fixed income through both inflation and loss of investment earnings. Here are a couple of hypothetical situations based on real stories I am hearing from friends and relatives to illustrate these distortions I am referring to.

The first story is about a hard working middle-class family headed by Dick and Jane. Dick and Jane grew up in the 1950s and 1960s. They have worked full time for almost 40 years, raised a family, a dog and several cats, and have been preparing to retire. They have contributed to Social Security from every paycheck they have ever received, and have been frugal and lucky enough to put aside some money for retirement. They purchased their home 30 years ago and have paid off the mortgage through 360 consecutive monthly payments of principal plus interest. Everything was going along according to plan until, suddenly and without warning, the earnings on their investments began to plummet.

They couldn’t understand what was happening at first. Because they were getting close to retirement they had allocated much of their portfolio to fixed income investments, and some of those were falling in value at the same time they could not get more than a 3% return on CDs and Treasury securities. They went to their bank to get advise and were told that because the Federal Reserve had lowered interest rates safe investments were yielding very low returns. They took out their calculator and figured that if inflation is around 4% and the real interest rate is 2.5%, they should be earning 6.5% on a risk free investment. Instead they are being offered 2.5% on a CD, so the cost to them is 4%. Based on their retirement portfolio of $750,000 they are losing $30,000 per year! Even if they can get a 3.5% return the cost is still $22,500 per year. But that’s not all. If we believe that these low interest rates are also causing inflation in basic goods such as energy and food, the value of their retirement savings is declining. Where $750,000 may have been enough based on all reasonable forecasts just a year or so ago, now it is not enough because of the cost of living increases.

Confused and angry, Dick and Jane reconcile to the fact that they will likely not be retiring as planned unless they cut back dramatically and save as much as possible. They will delay any major expenditure until absolutely necessary, and because of inflation they have less to save. The $1,100 fuel oil bill drove this point home last week. A portion of their retirement has disappeared through no fault of theirs, and they wonder why. Why is it that with inflation getting worse interest rates are going down? Shouldn’t it be the other way around?

The second story is about Cathleen, a neighbor of Dick and Jane. She retired from her clerical position ten years ago. Her husband passed away several years back and she now lives on Social Security and the income from the $250,000 portfolio of treasury securities, money market accounts, and CDs left from their lifetime savings and her husband’s live insurance. She can’t understand what is happening, but for the first time since retirement she must liquidate some of her retirement portfolio to pay all of her bills. Her Social Security income of $1,500 per month doesn’t come close to covering all of her expenses so she has relied on the interest from her portfolio for the rest. Last year her interest income was $13,750, giving her total income with social security of $31,750. This year her interest income was $8,750 giving her total income of only $26,750. Adding the rising costs of her medications, property taxes, food and energy she is for the first time concerned that she could run out of money. She wonders why, and she has decided she must cut back to only the necessary expenditures.

While lower interest rates are helping some homeowners with adjustable rate mortgages they are hurting savers and those living on a fixed income. Inflation also harms savers but benefits borrowers. At the same time, as between the average savers and the average adjustable rate mortgage borrowers it is the latter who have more culpability for the crisis in the first place. It is clear that the American people are paying the price of this credit crisis one way or another, and the question at hand is whether the distortions resulting from the remedy are making things better or worse as the burden is shifted from borrowers to savers?

There are at least three reasons for the Fed to be lowering rates right now. Let’s take a look at each of the primary reasons for the Fed to be lowering interest rates.

The first reason to lower interest rates when the economy is soft is referred to as the wealth effect. When interest rates are lower asset values tend to be higher. If mortgage payments are lower house prices can be higher because it is more affordable based on the payments. This applies to financial assets as well. As interest rates fall, in general, the value of financial assets rise. In practice, this effect makes people feel better off because their assets are worth more and this is good for the economy because when people feel wealthier they tend to spend more. This sounds great, but there is dark side.

When inflation becomes a problem rising asset values tend to be offset by rising costs. While keeping interest rates depressed may help support the value of certain assets it is also fueling inflation, and the inflation is countering the wealth effect. Low interest rates don’t always spark inflation, but in the current global economic situation commodity prices are rising dramatically and inflation is becoming a real issue. Lower interest rates in the US hurts the value of the dollar and sparks price increases in dollar denominated commodity prices. Anyone who goes to the grocery store or drives a car or heats a home knows that inflation is a rising problem today. So assuming low interest rates are in fact supporting asset prices the resulting inflation could be countering the impact because real values (adjusted for inflation) are not changing or are, perhaps, even falling. Is the wealth effect of lower interest rates working this time? I question its efficacy under current conditions when real interest rates are negative AND we have supply shocks in energy, food, and metals all at the same time.

The second intended effect of lowering interest rates is to spur business investment by making it less expensive for businesses to borrow and invest. This should also lead to increased employment as businesses hire more workers. Before businesses invest, however, they must believe that consumers will consume. Helping to keep mortgage payments down for a portion of the population will certainly help consumer sentiment, as will the resulting benefit of slower price depreciation in housing. But there is also a downside to consumers of low interest rates and the inflation we are now seeing. The retirement savings of the baby boom population are losing value to inflation, while at the same time low interest rates are cutting into the income of those living on their savings. The loss of real savings and real income (from both depressed interest rates and the impact of inflation) to the population of savers and spenders is likely to have a negative impact on consumption, especially as those close to retirement increase savings and those in retirement are forced to cut back on spending. This, in turn, could offset the positive impact of low interest rates on consumer sentiment. Consumers also have more debt as a percent of their personal income now than at any time in the past several decades and probably need time to pay it down rather than consume more. So will lower interest rates spur investment under these circumstances or simply prolong the reckoning while causing a very troubling inflationary spiral? There is certainly room to question the efficacy of further rate cuts on business investment in the current economic climate.

The third reason for lowering interest rates right now is to help rescue the financial industry in the US and prevent a collapse of the financial system. A major meltdown of the financial industry would certainly be a problem that would have a negative impact on all of us because it could result in a severe recession or even a depression. If the banking system becomes insolvent (meaning the banks do not have capital and cannot make loans) then anything people purchase on credit could suddenly experience dramatic reductions in demand, while at the same time businesses would find it very difficult to obtain funds for investment. When things get really bad you get deflation because there is simply not enough demand for anything to keep prices from falling. This may sound OK at first but in fact it is worse than inflation in many ways. Who will lend you money to buy a house if the value of the house is expected to decline next year? The same logic holds for a car or any other major purchase. Imagine your mortgage payment staying the same while your home value and wages drop – that’s deflation and it can spiral down the same way inflation can spiral up. At the same time unemployment would rise dramatically because businesses facing falling demand and lack of funds for investment would be laying off workers. This is certainly a situation to be avoided. So how does lowering interest rates help us lower the risk of this happening? Aside from the wealth effect and business investment helping the economy stay afloat, the lower interest rates help to support the value of assets on banks’ balance sheets (remember these are interest bearing financial assets). That means fewer write downs and, in turn, lower losses and more capital. The low interest rates also reflect banks’ cost of obtaining funds to lend, and when their costs go way down their profits can go up. More profit means more capital and more incentive to lend. So lowering interest rates helps the banks to preserve and add to their capital helping to lower the risk of financial system insolvency. Of course, if this is truly the reason for lowering interest rates right now one must wonder why banks continue to pay dividends to investors. If they are under-capitalized that should be the first place they go for capital preservation, not to the policies of the Fed. This is especially true when the Fed policies are creating distortions in the market and may not be helping to support the economy for reasons discussed above. If the financial system is in fact under-capitalized perhaps the Fed should be reaching back into its bag of tricks and figuring out another way to add capital to the banking system.

Sphere: Related Content

A Long Article about the Credit Markets

OK, here is my take on the current goings on in the financial markets. I want to preface this with the fact that this is not investment advise and it is my opinion. I do not have the time to provide backup for all of the numbers but they are readily available from current news sources. Where I don’t know the exact number I tried to be conservative. It is very difficult to try to boil this down to any reasonable length so a lot is left unsaid and what is said is meant to stress the risks we currently face. Many if not most professional economists believe we will have a mild recession and return to growth in the second half of 2008. That said, here goes:

1. The US has relied on foreign capital to support a large and long-term trade deficit. As we consume more than we produce, the net difference is imported from overseas. At the same time we export dollars to pay for these things we import. Those dollars often find their way back here in the form of investors looking for return. With all of these dollars looking for investments added to the normal amount of available investment capital, the markets work their way down the food chain. First they make good investments until those run out, then they make mediocre investments until they run out, then they make bad investments until the cracks begin to show as with the subprime mortgage meltdown. While this is going on the economy is booming because people are buying things, in fact, spending even more than they are making. Once investors realize they have made some very bad investments, however, they do exactly the opposite and run from these investments. Foreign investors take their money out of the US and bring it home or invest it elsewhere. This causes the value of the dollar to fall as everyone is trying to sell it in exchange for their own currency, and it reduces the amount of financing available to support asset prices and economic activity in the US.

2. As foreign investors pull their money out of the US and domestic investors run from financial assets prices of financial assets in the US fall because there is less demand for them. This is especially true when investors realize that the assets they invested in are not of the quality they expected. Mortgage backed securities, private equity buyout loans, and so on are all worth less than they were last year, not just because of defaults but because there is just less money around looking to buy these assets. This is referred to as re-pricing of risk. This flight to quality is seen in the dramatically low interest rates on Treasury securities that fall as demand for these safe investments increases – investors are selling riskier assets and purchasing safer ones. They are also purchasing hard assets as seen in the recent explosion of commodity prices.

3. As asset prices fall and capital flows out of the country and out of certain financial assets, banks begin to feel pressure. They need to raise funds to meet the demands of deposit withdrawals and to fund loans to customers who can no longer raise money in other markets such as the commercial paper market (again because the flow of money has reversed from in to out). Normally banks will borrow from other banks or depositors, and/or sell assets to raise the liquidity necessary to meet these demands. Today, however, they cannot do enough of either because they are all in the same boat and because there is a lack of demand for their assets – remember the capital is going out, not coming in. In order to sell assets and raise liquid funds the banks would be forced to take big losses on their assets, and that would reduce bank capital. The more they have to sell the lower the price they will get and the more bank capital is reduced. This could ultimately lead to insolvency of the banks, which is worse than illiquidity because it means that even if the banks had liquidity, they could not make any loans. No loans, investment plummets and employment follows. Of course, if this happens the loans on the banks’ balance sheets get even worse because as employment falls loan defaults increase in this downward spiral.

4. The Fed is using all kinds of tools, new and old, to prevent the system from collapsing under the weight of this de-leveraging (the term for when investors who provide capital leave the markets). First, it is lowering interest rates rapidly, with the federal funds target rate down from 5.25% in September to 3.0% now and another cut expected on Tuesday. Lowering interest rates is targeted at two things: lower rates in general means the rates on investments should go down and the re-pricing of assets should be less severe; and lower rates should support additional investment and consumption assuming those rates make it to the borrowers. The problem is that the lower rates are not making it to the borrowers and so the intended effect is not yet being felt. One reason this is happening could be that the banks are, in fact, insolvent based on current asset prices so they cannot make loans even if they have the liquidity. The other reason this could be happening is that the liquidity crisis is so severe that the banks are simply keeping up with their own balance sheet changes without making many new loans. Either way this is very troubling.

5. In addition to lowering interest rates, the Fed normally acts as lender of last resort to commercial banks. If a bank has a liquidity problem it can pledge collateral to the Fed and the Fed will then make a short-term loan to the bank through the discount window. This has also run into to trouble, however, because none of the banks want to borrow from the Fed this way. They are worried that if they do it will signal a problem and everyone will withdraw their funds from the bank – a classic run-on-the-bank scenario. To deal with this, the Fed created a new program called the Term Auction Facility, or TAF. Under this $100 billion facility the banks bid for loans from the Fed, and if they win they pledge collateral and get a loan for 28 days. The Fed has opened up the collateral pool to include basically anything the banks have to pledge (they can pledge anything they could have pledged for a discount window loan). The names of borrowing banks are not made public, and there is no schedule of the collateral the Fed takes to secure these loans released to the public.

6. The TAF was a very good idea, except it did not provide liquidity directly to the investment banks because they cannot borrow from the Fed without drastic action. In order to address this issue, last week the Fed announced a new $200 billion swap facility called the Term Securities Lending Facility. Under this facility an investment bank can give the Fed mortgage backed securities and other collateral and the Fed will give the bank Treasury securities from its own portfolio. The investment bank can then sell the Treasury securities for cash to get liquidity, and 28 days later it reverses the transaction by returning the Treasury securities for the collateral. Unfortunately this facility is not yet operational so it was too late for Bear Stearns. Bear experienced a run-on-the-bank Thursday and Friday of last week, and the Fed took that drastic action to lend directly to Bear Stearns through JP Morgan Chase. The Fed has not done this since the Great Depression.

So between lowering interest rates (the cost of funds to banks) and providing a source of liquidity (the loans and swaps) for the banks’ assets that are re-pricing, the Fed is hoping to avoid a major collapse of the system that could include runs on many institutions such as the one experienced by Bear Stearns last week. If the banks cannot raise liquid funds then they cannot meet the demands of depositors and borrowers and once this is known, there is a run on the bank. All told, the Fed has announced at least $400 billion in new facilities to provide liquidity to the banking system, which is about 44% of its entire balance sheet. Unfortunately interest rates to borrowers are still not declining signaling an even deeper liquidity crisis or an insolvency crisis. The falling dollar confirms the exodus of capital from the US markets and no one knows how far this will go. In the interim, the economy looks worse as banks do not extend credit for investment or consumption in large enough quantities to support economic growth. The very interesting and as yet unanswered question is what happens if the banks cannot repay the loans from the Fed and the pledged collateral ends up being worth less than the loan?

7. The Fed has a dilemma on its hands and there may be no solution available to it. On the one hand interest rates must be low to stimulate the economy by promoting borrowing and investment/consumption. If interest rates are high businesses will not invest and consumers will postpone purchases, so low rates traditionally help spur the economy. This is the standard policy response to a declining economy, and we are in a declining economy. On the other hand, however, low rates drive more capital out of the markets as it seeks better returns elsewhere. Witness the current boom in commodities, surely the next asset class to bubble over, and the continuing decline in the dollar. These trends are also leading to higher inflation as witnessed at the pump. So lower rates help to spur the economy and hopefully place some floor under the assets being re-priced, but at the same time chase away much needed capital (perhaps worsening the re-pricing because of lack of purchasers) and create a higher inflation risk. If the capital stays away because of the lower rates banks will not lend and we could have a severe economic downturn. Raising rates may help attract the much-needed capital, but it will slow the economy at a time when it is already vulnerable possibly resulting in a severe economic downturn. Therein lies the dilemma. It is very possible the Fed does not have a solution to the current problems.

8. Remember from number 1 above that this cycle of asset pricing and re-pricing was at least in part created by the unsustainable trade deficit of the US. The trade deficit reflects the fact that we have been consuming more than we have been producing, and paying for the difference by borrowing (and, in some cases, selling our assets). We have simply blown our credit beginning with the subprime mortgage meltdown, and it is now time to pay down some of the debt because our lenders are cutting off the flow of funds. That means a combination of selling our assets (as in Citigroup equity sold to foreign sovereign wealth funds) and saving. Saving is the opposite of consuming, so the more we need to save the less we can consume. The less we consume the lower the GDP, unless of course we cut all spending only on imports which is impossible, especially with our dependence on foreign oil. So I predict a fairly substantial slowdown in our immediate future as all of this works its way through the economy. If the flight of liquidity is severe enough we could also witness even more stress in our financial system, without which our economy comes to a halt. Because of this don’t be surprised if there is a large Federal bailout of the banking system on the horizon, regardless of what noise comes out of the White House about free markets and the like. If Bear Stearns is too big to fail so are all of the other major banks, both commercial and investment.

9. A taxpayer bailout of any magnitude is the last thing we need right now, especially with rising budget deficits, two wars, and ever increasing health care commitments. Tax increases may be unavoidable, even if they do further depress economic activity (though there is debate over whether this would be the case under these circumstances). The flight to commodities and resulting price pressure may or may not be sustained, depending in part on how long and how deep the economic downturn turns out to be. If the economy falls into a very deep recession, and especially if the global economy follows, we could see a reversal of the commodity price boom and, potentially, a period of deflation as all asset prices fall (this would be a worst case scenario).

10. How big of a crisis do we have on our hands? We can look at what the Fed and the Federal Government have done so far. At least $400 billion of liquidity facilities have been announced beginning in December and this does not include whatever loans have been made to Bear Stearns. Approximately $200 billion of mortgages have been funded by The Federal Home Loan Banks, an extraordinary increase on a historical basis. The FHA is in the process of refinancing defaulted subprime loans, and there are proposals in Congress to increase the total amount they can refinance to $300 billion. Congress and The President have passed an economic stimulus package estimated to cost approximately $160 billion. All the foregoing is taxpayer backed in one form or another. On the private side, banks have so far written off approximately $150 billion in losses on their assets and many expect another $135 billion to follow. Are we over $1.3 trillion yet? I think so. This sounds like a big problem.

Sphere: Related Content