More helpless Fed hypothesis

Ilargi: Recently, strictly for entertainment purposes, I wrote a little hypothesis about the Fed’s powers, Just how powerless is the Fed, hypothetically?, based on the following, excellent article by Henry Liu.

I thought I'd allow myself to hypothesize a bit more, strictly for entertainment purposes, as you undoubtedly understand. You see, I was thinking that while Liu is right in his assessment below that the Fed is by no means the only issuer of money and debt, he omits a few important facts nonetheless.

The Fed does have considerable power over money created by banks and other issuers. It can, and does, set reserve requirements for banks, for one thing, which can potentially have a huge impact on the amounts that can be loaned out and created. The Fed also sets the interest rates that dictate how expensive it is to borrow money. And that is not some arbitrary issue; it’s obvious that more people will borrow at 1% than they will at 10%. In the early 1980’s, then Fed Chairman Paul Volcker raised interest rates well into double digits, with the clear intention to stop too much money from being created. And it worked, too, causing a recession in the process.

It was, and is, clear to anyone at the Fed, and beyond, that the opposite would work as well. So when Greenspan lowered US interest rates to 1% from 6.5% in 2001-’03, he knew, and everyone knew, what would happen. People would apply for more credit. And even with the low rates, there was still the potential for constraint through reserve requirements set by the Fed. If anything, they were loosened, not tightened.

Simply imagine what the credit situation would be like today if the Greenspan Fed had followed Volcker’s example... Would mortgages have been handed out to "everyone who could fog a mirror" with interest rates at 10% or higher? Would there have been a $700+ trillion derivatives market without overly cheap and overly abundant credit?

Now I know that there’s people out there, armed with graphs, who postulate that the Fed, when it comes to interest rates, does nothing more than follow the -bond- markets, but that doesn’t satisfy me. If only because the Fed has no obligation to do so. And if they do anyway, we need to ask why.

Coming back to Liu: the advent of the non—bank financial system may have, and certainly has, meant even more money was being created by entities other than the Fed, specifically through the mushrooming derivatives trade, but the Fed didn’t exactly try to stop that process. On the contrary, there are lots of quotes from Greenspan singing the praise of the derivatives market, which according to him almost annihilated all risk in finance:

• May 2003: “Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management… As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”
  
• May 2005: "The use of a growing array of derivatives and the related application of more sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions."

Not that the oracle didn’t cover his derrière:

• Also May 2005: "The sheer complexity of derivatives instruments, in particular, coupled with the consolidation in the financial industry, made it increasingly hard for regulators and bankers to assess levels of risk."
  "The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress."

So he knew something was amiss, as early as 3 years ago at the latest, but decided not to do anything, claiming he 'believed' markets would solve any and all problems.

To get back again to Liu, yes, it’s true that the Fed is not the sole issuer of money and debt. But no story about that issue is complete if these means of control, which the Fed very much does have, are omitted. It’s a necessary element too for understanding the intention of this week’s rate cut, namely the creation of still more debt and money, something the markets are already drowning in.

The problem these days, however, is that all kinds of parties would like to borrow, and get more liquidity, but lack the collateral, the solvency, to qualify for loans. And that is something that the Fed can indeed not solve: providing liquidity, yes to an extent, but providing solvency, no. They can throw lots of good money after bad, but, starting in 2008, money will disappear faster than they can create it, or push others to do so. Assuming they would want to.

The only effect of all the money-throwing capital infusions we're about to see, and have seen, is to put the American people ever deeper into debt. Ideas about rising inflation can be discarded by now: there's no way the Fed, or any other party, can pump up/in money and debt as fast as it's vanishing through asset devaluation.

And I, for one, find it hypothetically hard to keep on believing that the Fed plays, and has played, an innocent and helpless role in all of this. As I said in a comment yesterday:
"If [you are the owner of the house and] you have all the tools in the house at your disposal, including the cards, the chips, the tables, the bank, the croupiers and the waitresses, and you are the only player in the entire house, and then with all that going for you, you still manage to lose money [to yourself!!] at the end of the day, that's nothing less than redefining incompetence."

And that I find hard to stomach. Hypothetically. The American people have been conned, and all these stimulus packages and bail-outs only serve the purpose of conning them even more, and longer. Yes, for entertainment purposes only.

Here's the part of the article I was commenting on:

Fed helpless in its own crisis

As economist Hyman Minsky (1919-1996) observed insightfully, money is created whenever credit is issued. The corollary is that money is destroyed when debts are not paid back. That is why home mortgage defaults create liquidity crises. This simple insight demolishes the myth that the central bank is the sole controller of a nation’s money supply. While the Federal Reserve commands a monopoly on the issuance of the nation's currency in the form of Federal Reserve notes, which are "legal tender for all debts public and private", it does not command a monopoly on the creation of money in the economy.

The Fed does, however, control the supply of "high power money" in the regulated partial reserve banking system. By adjusting the required level of reserves and by injecting high power money directly into the banking system, the Fed can increase or decrease the ability of banks to create money by lending the same money to customers multiple times, less the amount of reserves each time, relaying liquidity to the market in multiple amounts because of the mathematics of partial reserve. Thus with a 10% reserve requirement, a $1,000 initial deposit can be loaned out 45 times less 10% reserve withheld each time to create $7,395 of loans and an equal amount of deposits from borrowers.

But money can be and is created by all debt issuers, public and private, in the money markets, many of which are not strictly regulated by government. While a predominant amount of global debt is denominated in dollars, on which the Fed has monopolistic authority, the notional value used in structured finance denominated in dollars, which reached a record $681 trillion in third quarter 2007, is totally outside the control of the Fed. Virtual money is largely unregulated, with the dollar acting merely as an accounting unit. When US homeowners default on their mortgages en mass, they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth.

As the debt securitization market collapses, banks cannot roll over their off-balance sheet liabilities by selling new securities and are forced to put the liabilities back on their own balance sheets. This puts stress on bank capital requirements. Since the volume of debt securitization is geometrically larger than bank deposits, a widespread inability to roll over short term debt securities will threaten banks with insolvency.

Now, even though I’ve been poking at Liu a little with regards to the 'helpless' Fed, I hope it’s still clear that he is, as I’ve said before, one of my favorite finance writers. So here’s a few more gems from the same article:

On a Stimulus Package:

... the Republican proposal favors a tax rebate, meaning that only those who actually paid taxes would get a refund. That means a family of four with an annual income of $24,000 would receive nothing and only those with annual income of over $100,000 would get the full $800 rebate per taxpayer, or $1,600 for joint return households.

Further, against a total US consumer debt (which includes installment debt, but not home mortgage debt) of $2.46 trillion in June 2007, which came to $19,220 per tax payer, the Bush rebate of $800 would not be much relief even in the short term. In 2007, US households owed an average of $112,043 for mortgages, car loans, credit cards and all other debt combined. Outstanding credit default swaps is around $45 trillion, which is three times larger than US GDP of $15 trillion and 3,000 times larger than the Bush relief plan of $150 billion.

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On Bond Insurers and Credit Default Swaps:

For the insurers to maintain the necessary triple-A rating, their capital reserve would have to be repeatedly increased along with the premium they charge. There will soon come a time when insurance premium will be so high as to deter bond investors. Already, the annual cost of insuring $10 million of debt against Bear Stern defaulting has risen from $40,000 in January 2007 to $234,000 by January of 2008. To buy credit default insurance on $10 million of debt issued by Countrywide, the big subprime mortgage lender, an investor must as of January 11, 2008 pay $3 million up front and $500,000 annually. A month ago, the same protection could be bought at $776,000 annually with no upfront payment.

Credit-default swaps tied to MBIA's bonds soared 10 percentage points to 26% upfront and 5% a year, according to CMA Datavision in New York. The price implies that traders are pricing in a 71% chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co valuation model. Contracts on Ambac Financial, the second-biggest insurer, rose 12 percentage points to 27% upfront and 5% a year. Ambac's implied chance of default is 73%.

[..]

The triple-A credit rating of the bigger bond insurers is crucial because any demotion could lead to downgrades of the $2.4 trillion of municipal and structured bonds they guarantee. This could force banks to increase the amount of capital held against bonds and hedges with bond insurers - a worrying prospect at a time when lenders such as Citigroup and Merrill are scrambling to raise capital. Significant changes in counterparty strengths of bond insurers could lead to systemic issues.[..]

If credit insurers turn out to have inadequate reserves, the credit default swap (CDS) market may well seize up the same way the commercial paper market did in August 2007. The $45 trillion of outstanding CDS is about five times the $9 trillion US national debt.

The swaps are structured to cancel each other out, but only if every counterparty meets its obligations. Any number of counterparty defaults could start a chain reaction of credit crisis.

The Financial Times reported that Jamie Dimon, chief executive of JPMorgan, said when asked about bond insurers: "What [worries me] is if one of these entities doesn't make it ...? The secondary effect ...? I think could be pretty terrible."

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On Corporate Bonds and Commercial Real Estate:

As big as the residential subprime mortgage market is, the corporate bond market is vastly larger. There are a lot of shaky outstanding corporate loans made during the liquidity boom that probably could not be refinanced even in a normal credit market, let alone a distressed crisis. A large number of these walking-dead companies held up by easy credit of previous years are expected to default soon to cause the CLO valuations to plummet and CDS to fail.

Commercial real estate is another sector with disaster looming in highly leveraged debts. Speculative deals fueled by easy cheap money have overpaid massive acquisitions with the false expectation that the liquidity boom would continue forever. As the economy slows, empty office and retail spaces would lead to commercial mortgage defaults.