The Fed And Credit Bubbles

Includes: FMCC, FNMA
by: Shareholders Unite

For many, the Fed has been responsible for the big credit bubble that ultimately led to the financial crisis. There are two versions of this idea, pointing to two possible constraints on credit supply. Each of these has its own problems.

Base Money

The traditional view centers around the "money multiplier." Banks hold a certain part of the money they lend in reserves (a fraction in vaults and the rest in accounts at the Fed). These bank reserves (or "base money") are the central point of leverage for monetary policy.

Banks are supposedly reserve-constrained. As long as they can get more bank reserves, they will provide more credit to businesses and households. Now, there are two sources of bank reserves: borrowing from the Fed or borrowing from other banks (and big financial institutions) on the money market.

But borrowing from other banks just redistributes the amount of reserves, and the only source is the Fed. By increasing and decreasing the availability (and/or price) of bank reserves, the Fed can steer the supply of credit and thereby influence the business cycle. According to many, the Fed has been too lax in doing this; that is, it provided too many and too cheap reserves, leading to the credit bubble. Some want to constrain the Fed and prevent this from happening again by moving to a gold standard (the timing of this couldn't be worse), while others want to abolish the Fed altogether.

That the relation between bank reserves and the credit market is a good deal less straightforward has become clear lately. Since the financial crisis, the Fed has flooded the banking system with reserves, without this leading to much of an uptick in credit provision by banks. Apparently they are not so reserve-constrained as many thought.

Banks are sitting on large amounts of "excess" reserves; they could lend out much more, but they don't (the famous "pushing on a string" comment by John Keynes referred to this situation). Perhaps despite record low interest rates, credit demand isn't sufficient. Or there is something else going on.

But looking back at the credit bubble before the financial crisis, consider the following piece of data from Sing and Stella:

Total credit market assets held by US financial institutions (excluding the monetary authorities) rose by $32.3 trillion from 1981 to 2006 (744%). Commercial bank reserves held as deposits at the Federal Reserve fell by $6.5 billion during the same period. In fact, total commercial bank reserves at the Federal Reserve amounted to only $18.7 billion in 2006, less than the corresponding amount, in nominal terms, held by banks in 1951. So from the first angle it is fairly clear that not only have financial institutions not relied on an increase in reserves held at the Fed to expand credit, they have expanded credit by 744% while reserves fell.

The authors go on to show that there is no relation between the growth rate in bank reserves and inflation (supposedly the consequence of excess credit creation). What happened is that the influence of base money and the Fed to steer credit creation has been compromised by the emergence of non-bank financial institutions (or "shadow banks") that don't have access to base money, but engage in credit creation nevertheless.

These non-bank financial institutions rely on ownership of highly liquid collateral, as a basis for credit creation, and this is simply beyond the control of the Fed. Which is why open-market purchases only create money if they swap a monetary base for assets that are no longer accepted at full value as collateral in the market. So only when the Fed was buying mortgage-backed securities was it engaging in "money creation."

Implicit Guarantees

So if it's the market that determines the amount of credit creation financial institutions might be willing to engage in on the basis of their access to collateral, then credit creation basically becomes a function of risk management. This is where an article by Seeking Alpha contributor Martin Lowy, called "The Future Of Global Finance," comes in.

In the article, he blames the excessive credit creation leading up to the bursting of the bubble in 2008 to "implicit guarantees" by the government:

For several decades, the European, Chinese, Japanese-and even American-governments have effectively guaranteed the debts of their banking institutions. Not surprisingly, such guarantees have enabled the banks to bloat themselves, unchecked by market forces.

Things even got worse when authorities loosened capital requirements through the Basel II agreement, but now they are finally onto the case and tightening capital requirements. We have a number of questions and objections to this monocausal explanation of the boom and bust.

One issue is timing. When did governments start to "implicitly" guarantee the debt of their banking institutions? Since the guarantee is implicit, this is a harder question to answer than it might seem at first sight. But since this, in essence, is a binary event, there should be a clear identifiable break visible, a "before" and "after," when banks got tacit understanding that they could greatly expand.

We would have preferred if Lowy would have been a little more specific here, as without data this hypothesis is, well, near impossible to test, as plausible as it might seem at first hand. But we have a bigger problem with this. Lowy specifically mentions four areas (Europe, China, Japan, and the U.S.) where these implicit guarantees became operative (all roughly at the same time? we don't know). However, let's take Europe. Credit bubbles were by no means a universal feature in the European landscape. For every Spain and Ireland, there is a Greece, Germany, and Italy where there were no big excesses in private credit.

Since financial institutions are still largely regulated on a national basis in Europe, this isn't at all surprising, but points to another culprit that fits the timing and country differences much better, in our view: financial deregulation. For instance, financial deregulation made it much easier for other financial institutions to engage in what was effectively money creation, and we would refer to the first part of this article where it is explained how the monetary base has lost much of its explanatory power for credit (and hence money) creation as a result of the rise of shadow banks.

Lowy's solution is also too simple. Tighten up capital requirements, and all will be well. What happened the last decade was that even banks (that is, those institutions that are under at least some control of the Fed) moved a whole lot of dodgy stuff off their balance sheets, escaping any limits in capital they might have had if they kept them on their books.

This ability to do so has much to do with market failures and deregulation. The market failure in question here is what economist call information asymmetries; in other words, the ability to opportunistically exploit information advantages. Financial markets in particular are absolutely rife with information asymmetries (if you doubt this, the next time you buy a stock ask yourself who is likely to know more about that particular company, you or the seller).

The mortgage market is a textbook example. Mortgages were shoved down the throats of people who couldn't afford them, exactly because banks knew they could shift the risks involved through repackaging these mortgages into devilishly complex products and sell them to unsuspecting investors (fooled by the triple-A credit ratings these products generally attained).

The "smartest" banks (or, really, the most opportunistic ones) even bet against these instruments after shifting them, or let clients do so, or let preferred clients make these products up. This process has little to do with any government guarantee, implicit or otherwise -- it's simply the result of a plain market imperfection. Nor is it the case, as Lowy suggests, that Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA) were mostly responsible. That is simply not in accordance with the facts, as both were latecomers to the subprime market and relatively minor players.

While we do not deny that implicit government guarantees made life easier for banks, the result of which was that they took on more risk than they otherwise would have, this is by no means the only explanation for the credit crisis. Implicit in this view is also the idea that if only the government wouldn't mess in financial markets, all would be well.

We think there is so much evidence of market failures in financial markets and irrational behavior (any treatise on behavioral finance would do here), proper regulation of financial markets is key. After all, look at those financial markets where regulation is clearly insufficient, like those of mortgage-backed securities (any rational "price discovery" going on there?) or the pink sheets, a shark-infested place where penny stock pumpers prey on the gullible and greedy (or, in economic terms, "opportunistically exploit information asymmetries").

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.