Thursday, October 9, 2008

the Fed's shrinking lever


the more I watch our response to the ongoing credit meltdown, the more I question the judgments and assumptions of our financial leaders. as a mere journalist equipped with nothing but the Fed's own Flow of Funds report (Z.1) and microsoft excel, I have discovered some startling realities that may in the long run prevent Ben Bernanke from successfully navigating this crisis.

the basic argument: THE FED IS A LOT LESS IMPORTANT THAN WE THINK. the Fed controls the economy via the banks... but, banks have significantly lost relevance in the US economy over the last 35 years. this could leave central bankers much less powerful than we believe.

some numbers:

in 1974, checking, savings and "time deposits" (certificates of deposit) represented 46% of the total credit-market debt in the US economy. this mass of deposits was the bedrock of the financial system and provided the basis for all other lending. for instance, total mortgages represented just 65% of the deposits in US banks in 1974. and commercial bank loans were 22% of U.S. credit market debt.

fast forward to 2007: checking, savings accounts and CDs are now just 18% of total credit market debt. and now, mortgages represent 160% of all deposits. commerical bank loans fell to 14% of total credit-market debt.


these numbers show bank deposits and bank loans declining relative to the overall system, while mortgages break out on their own program.




traditional banking did, of course, grow over those years. but during the same period, banks increased their reliance on capital markets for funding. furthmore, many other kinds of non-bank borrowing and lending developed -- basically asset-backed entities that functioned like banks, but without the rules.

in 1974, corporate bonds were mainly used by railroads and utilities to finance long-term assets like tracks and transmission lines. this is the traditional use of bonds, and dates back by centuries. in 1974, these non-financial companies accounted for 77% of all corporate bonds. banks and finance companies were just 16%.

fast forward to 2007, and non-financial companies had shrunk to 32% of the market, while financials grew to 52%. (foreign companies and governments account for the remaing issuance.)

again, the financial sector develops its own source of money, independent of deposits...


corporate bonds have gotten bigger over the years, reflecting the growth of the non-bank financial system.

in 1974, corporates were 12% of total credit market debt.

by 2007, they were 22% of credit market debt.


also, in 2007, issuers of asset-backed securities represented 35% of the corporate-bond market. that almost doubled from just 18% in 2000. an increase like this, reflecting debt growth of more than $3 trillion in seven years, is staggering by itself.
keeping the comparison with 1974, ABS issuers were a whopping 0% of the corporate bond market.

in other words, a huge, unregulated sector grew apart from the balance sheets of banks and securities firms. it ran up vast amounts of debt, most of which was funneled into reckless mortgage lending. wall street wunderkind transformed a class of securities dedicated to long-term productive assets into a cheap and easy way to plow money into home mortgages and consumer debt. (with huge fees along the way.) and, a sector of lending previously dominated by the banks, under the watchful eye of the Fed and other regulators, was thrown to the law of the jungle.

THE GROWTH OF CAPITAL MARKETS ALLOWED THE FINANCIAL INDUSTRY TO BYPASS THE BANKS. IN THE CURRENT CRISIS, THE PROBLEMS ARE STILL OUTSIDE THE BANKS. THEY ARE IN THE CAPITAL MARKET-- THE CREDIT MARKET.




this leads to two major conclusions:

1-the basic principles of monetary economics and central banking need to be questioned. the idea that you can control liquidity by manipulating interbank rates looks increasingly incorrect. the Fed has actually been losing this control for years... they raised rates in 2004-7 and liquidity continued to expand and inflate the credit bubble. why? because the liquidity was coming from the capital market, which was awash in money. (I know because I covered corporate bonds deal by deal as it happened.)


NOW THE ILLIQUIDITY IS ALSO COMING FROM THE CAPITAL MARKET. prompted by the collapse of Lehman Brothers, the demand for corporate bonds and commercial paper has collapsed. that's what killed credit. it's not like the great depression, when bank runs pushed the system over the edge. TODAY, THE RUN IS IN THE CAPITAL MARKET. when bond investors refuse to rollover the debt of financial institutions, it's the same thing as when depositors pulled money out of the banks in 1932.




for years, the experts at Pimco have spoken about the "shadow banking system". for years, greenspan spoke about the "conundrum" of how interest rates defied the Fed's rising overnight rate. it's time we recognize the tools of monetarism have lost much of their power. banks matter less, capital markets matter more.


2-solutions to this problem must be found in the capital market. that's why I am promoting the idea of the government stepping in and creating "official" prices for bonds. this will revive the issuance of these securities and allow debt to be refinanced. without refinancing debt, companies will drop like flies.

3-banks need the credit market now more than ever because they rely more increasingly on debt capital markets for their money. in 1974, commerical banks had less than $11bln of corporate bonds outstanding. that was just 1.3% of their total liabilities.

by 2007, that proportion had almost quadrupled to 6.3%.

one of the dirty secrets now is that banks and financial companies have 100s of billions of dollars in debt maturing in the next year. now that the corporate bond market is effectively shut down, so now they are getting all the money they need from the Fed's slew of liquidity facilities.

in other words, the public sector is already helping banks pay their debt. we might as well just get above board with this and let the government buy the corporate bonds outright.

it's time to rethink our rescue efforts. trying to fix the problem in the interbank market misses the mark. our age is dominated by capital markets, not banks. our policies need to catch up with the times.

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