Attending The Exits, Part 3

by: Alhambra Investment Partners

By Jeffrey P. Snider

Very much in line with the stubborn and creative effort to convince you that the economy has healed, policymakers have taken to the notion of "resiliency" as they seek to exit the QE business once again. Janet Yellen seems to work that adjective into every speech she gives, as if the power of her voice were enough to simply make it so. While that is somewhat hyperbolic, under a regime of rational expectations theory self-fulfilling prophecies and undying faith in economic control, you would expect such attempts at reinforcement despite whatever may demonstrate otherwise.

Part of the problem stems from what appears to be an intentional misunderstanding of modern finance. Econometrics has taken hold of economics, in the orthodox persuasion more so than anywhere else, very much like the baculovirus turns gypsy moths to zombies. In decrying of nothing but regressions, all function and form of the economy and even the financial system are relegated to generic fashions. While Janet Yellen recently claimed to be in search of nuance in the labor market, that is seemingly the first such foray outside of generalization (and really doesn't amount to much at all) in perhaps decades.

The orthodox economist is a slave to generic "aggregate demand" as if there is no difference at all between engaging in wasteful, bubble behavior and producing actual wealth. At the same time the economist will refer to the "money supply" as if it were some monolithic pile stored close at hand in a gargantuan vault under NYC. The M's still hold sway at the FOMC, despite the fact that they were problematic to begin with (and even the FOMC in the 1970's began to note a breakdown in correlations). When speaking of "inflation", another overly generic allusion, the economist undoubtedly refers to increasing the "money supply" in order to achieve it as if one follows directly from the other.

That is a problem not just in understanding the concept of price changes, but also basic systemic function and liquidity. One hundred billion dollars in the hands of an insurance company is not the same as $100 billion in a ledger of an ABS issuer in 2004. The same goes for interbank internals too - $100 billion in the "reserve" account of JP Morgan at FRBNY is not the same as $100 billion at JP Morgan on account for a triparty repo counterparty. In fact, there are vast differences between all of these though they often constitute the same bland money supply concepts. What counts in not the count, but moving deeper into motivations and flexible designs.

Where and how "money" arrives and in whose hands it ultimately resides is far, far more important than how much exists. People still look at M1 or M2 as if that holds some kind of hold on financial function - yet "velocity" drops to zero because there remains today so little correlation among the M's and economic and financial assertion.

This is as much a systems approach to finance as economics, and rightfully so. The fragmentation that nearly ruined all of it beginning in 2007 was about exactly this problem - that singular and generic notions of money supply were completely unimportant; instead it was about flow, or how "dollars" go from A to B and then C and D. The pathways for liquidity, financial plumbing, largely sealed the fate of the financial system, especially as regulators and central bankers were as much dumbfounded as most commentators and economists. The very people charged with understanding how things worked got an abrupt and impromptu (and very costly) lesson in how things worked.

From that we are led to believe an extrapolation whereby central bankers have learned those lessons and "next time" will be different. I have taken recently to describing, as noted above, just how that is not the case (it will be different; don't get me wrong as that is almost a fixture of history, but you can pretty much be guaranteed that policymakers not only won't know it's happening, they will have very little idea of "why" and "how" even in the immediate aftermath). The fact of narrowing exits even just in the past eighteen months in repo and eurodollars is, unfortunately, only the beginning.

By outward appearance, the financial system looks if not fully rebuilt something very much close to it. For that the Fed is taking a deep and extended bow to distract from very real deficiencies on the economic side. In fact, that is the great incongruity of the QE age, where financial liabilities have seemingly reconstituted without much by way of "leakage" this time into the economy.

The chart immediately above shows the "hole" in the financial system that marks the Great Financial Crisis. If you take the monetary approach, the depth of the Great Recession is the lack of liability expansion from the middle of 2007 to the middle of 2010 (in reality it has been lack of wealth, but for the monetarist this conforms). Thus, QE2 seems to have "worked" in that liability creation (a generic "money supply") lurched forward from that point. In fact, nearly $14 trillion in financial liabilities have appeared in those nearly four years.

But to what avail? The economy since 2012 has seen a marked deceleration, and that after already underperforming historical comparisons and violating any expectations for symmetry. To distract from that reality, the Fed refers constantly to "resiliency" in the financial system, to which the increase in liabilities almost looks evidentiary.

The financial system as it exists now, though, is almost unrecognizable to what came before (for both good and ill). The marginal sources of credit expansion in the decades before 2007 have suffered through the downturn and have yet to recovery (good). What has taken their place removes a great deal of flexibility (ill) as it relates to defining potential systemic liquidity.

Starting with the pieces experienced of liability destruction, it is as you would expect after a massive bubble imploded in real estate: GSEs, ABS, MMFs and securities brokers. In other words, the shadow financial system that built the housing bubble, acting as Greenspan's seemingly "fruitful" means for "filling in the troughs without shaving off the peaks", is still ground zero. In 1990, just as the era of shadow banking debasement began to take off, the total proportion of "money supply" devoted to these vehicles was a seemingly insignificant $3 trillion, or just 4% of total financial firms' liabilities.

By the time of panic in 2008, there were liabilities of $22.3 trillion, amounting to more than a third of all financialism (34% of outstanding financial-held liabilities). After the panic, nearly $6 trillion in liabilities have run off, or have been written off. That is a gigantic hole in the "money supply" that explains a lot about "clogged monetary transmission."

In its place, however, we see an entire character change in financial constitution at the margins:

The first three categories (monetary authority, foreign bank offices in the US, and Holding Companies) all relate to policy changes and monetary intrusions that have occurred post-panic. The last two are where my focus lies.

The buildup of liabilities in ETFs and Mutual Funds amounts to a significant reorientation of financialism, especially as it relates to liquidity and the scale of potential exits. It also goes a long way toward explaining the inefficiency of monetarism in this "cycle" vs. the last, but that is beyond the scope here, as I want to retain attention on "attending the exits."

Part of this can be seen by what is not shown in either group above - depository institutions, insurance companies and pension funds. These are the backbone of the financial system, offering more than just a repository for assets. These are among the most flexible of the potential vehicles to contain liabilities, particularly as it relates to crowded trades becoming overturned (the herd turning). This is not to say that banks and pension funds are perfect, or even satisfactory, in performing what is really a vital function of absorbing such liquidity needs or shocks. We know their inherent deficiencies all too well given recent history, and even developments since the panic, though the reasons for those paucities are as much about "evolution" as intrinsic problems.

With that in mind, there is more than a trivial distinction with liabilities carried in a bank versus that carried in a mutual fund. In the former, if you and enough people like you remove your claims on the vehicle (likely a deposit amount) the bank has recourse to other sources of funding before having to resort to asset sales of increasing intensity. Again, 2007-08 showed that can be very problematic, particularly when internal systems are not aligned or even functioning, but the flexibility of the design at least permits such absorption. The bank can raise funds in the repo market or the Discount Window, even sell debt and raise equity capital (if they personally know Warren Buffet); there are options in the mythical and problematic currency elasticity regime - even pension funds and insurance companies as alternates have a variety liquidity options before appealing to the dark side of fire sales.

Transferring that claim from a bank as a vehicle to hold assets to a mutual fund removes all flexibility. A rush of withdrawals on mutual funds can only end with asset sales, unless the funds are holding enough cash on hand, which we know is not the case currently with cash balances at record lows. In the case of the crowded trade, there will be no option but asset sales. This as true in credit as stocks, particularly since mutual funds have added a staggering $2.25 trillion in credit instruments since ($1.1 trillion in corporate bonds alone) to go with an additional $4 trillion in stocks at current prices (all dated to Q1 2014 - these levels have obviously gained since then). In fact, mutual funds were among the earliest buyers into the wave of corporate issuance that began in 2009.

In historical context, some of the panic and intensity makes perfect sense given the vast changes over the past 40 years. While in the chart above depository institutions, insurance companies and pension funds all have seen growing nominal liabilities (and thus assets), the financial system (which includes stock prices) has far outpaced these more measured gains.

In terms of overall proportion, these more "flexible" vehicles of "money supply" were once almost exhaustive of the entire system. Before the 1970's, almost 85% of financial liabilities remained locked into this traditional setup. Then, in the years following Bretton Woods' final demise in 1971, the eurodollar standard took over and began the revolution of financial evolution. Banks sought to increase their place in the rising churn, and doing so by moving outside this traditional framework. In evolution came rigidity, but that was the "price" financial firms accepted in the name of capital and funding "efficiency."

A full part of that was government-driven, as the GSEs played a central role in the formation of securitization and even the early part and adoption of the repo market itself. By the time of the housing bubble in the late 1990's, the proportion here was less than half. In their place was, again, GSEs, ABS issuers and MMFs that proved to be very brittle in terms of liquidity, impacting systemically in ways never imagined (and still not fully appreciated by the generic understanding of "money supply" economists). No one really accepted that rigidity, proclaiming instead brilliance, enhanced safety and, yes, "resilience" right up until it showed up in fragmentation and flow problems on August 9, 2007.

Despite the recreation of financial liabilities post-QE2, it is still the same stripped down version that had so much trouble in 2007-08. Maybe it is just coincidence that there were no waves of bank failures when the system was dominated by sound money and narrowed outlets for liabilities, and that bubbles and crashes are much more the norm since then, but I sincerely doubt it. In a systems approach, there is much less flexibility, even understanding, in the evolutionary financialism. In overly simple terms, that translates to potential liquidity "gating", or narrow exits - the simple lack of capacity to absorb rapid changes or inflections.

The Fed wants to claim the mantle of resiliency, yet nothing about this suggests that. In fact, both the short-term and long-term show that such feebleness is a feature of an age of fiat instability rather than a one-time deficiency. The financial system has been rebuilt alright, with all of the leftover weaknesses remaining and now enhanced and repriced.