Making Money Out of Thin Air

Every once in a while you read an article that makes you say "aha!" The information imparted satisfies a gnawing question lurking deep in your mind that you couldn't even put words to. I felt just that way after reading The Global Money Machine, an Op Ed piece in Friday's Wall Street Journal by David Roche, President of Independent Strategy, a London-based investment consultancy. Now I have the question and the answer.

The question is....Why do I have this feeling that the US sub prime debacle is just part of a larger breakdown of underwriting standards that goes farther than most in the mainstream media have really given voice to, and won't the sudden tightening of lending standards, driven by the sub prime mess initially, have a significant negative impact to the economy beyond just low income borrowers and speculators in residential real estate?

The answer is yes, there will be wide ranging ramifications of this "increase in risk premiums", as there always is. The unwinding of what some people have called the debt bubble (which I think is overly sensational, but not so far off the mark as to be ignored) will have a wide reaching impact globally and it's not just because of tighter underwriting standards. The squeeze is coming from a significant shrinkage in money available to lend, well beyond the traditional bank lending downturns that have historically taken place. This is because of the partial unwinding of a new source of financing that has taken control of the money supply out of the hands of banks and government central banks. I want to use this piece to elaborate on the Op Ed piece, and its implications and why I think its so important to the outlook for the markets and ultimately New York City real estate.

Back in the early 1980s, when inflation was the driving force in financial markets, Wall Street economists used to follow the "money supply", as many "monetarists" believed that inflation was strictly a monetary phenomenon - a result of central banks making credit too easily available. At that time even the Fed paid a lot of attention to money supply and at times even targeted its policies to manage the supply of money. For a variety of reasons, which Fed governors discussed in later years, traditional measures of money supply M1, M2 and M3 seemed to become less accurate. Check this link for a great primer on money. The reason the M's became less accurate was financial innovations that allowed the creation of money that couldn't be captured in even the widest basket called M3.

I am getting to a point here. One of the ways that money is created is by the leverage of lending. Central banks make money available to banks. Banks can borrow from the central bank and lend the money out, but they must keep a "reserve" level of funds (equity or capital) in case any of their depositors want their money back on a given day. Old bank collapses happened when all depositors wanted their money the same day...a so called "run on the bank" - I digress. As long as the bank kept its reserve levels high enough it could lend as much as it wanted....but these reserve requirements ultimately limited the amount by which the bank could multiply the money created by the central bank. The central bank had several ways of controlling money supply. They could change the rates they lent at, which made it more or less profitable for banks to borrow from the central bank and lend (thus multiplying money); they could change reserve requirements (the amount the banks could multiply the money by) or they could tighten bank inspection standards and pressure banks to lend only to the best borrowers, thereby rationing money based on credit worthiness. This last method was also called "moral suasion" or "jawboning", where the fed effectively just tells banks to lend more or less - but this only works to a point - which we will talk about later.

David Roche points out that Wall Street's financial innovation circumvented the reserve requirement system temporarily. This allowed money supply worldwide to grow faster than central banks could measure. A recent Barron's article called Wall Street "a place where people who shouldn't lend are introduced to people who shouldn't borrow"...HA. I love it, but it's exactly true. By allowing banks to "securitize" debt and sell it off of their balance sheets, reserve requirements were effectively circumvented as new lenders beyond the Fed's ken were introduced into the system. (There was another fancy way of keeping loans from impacting reserve requirements called synthetic securitization, where banks eliminated credit risk through default swaps and interest rate risk through interest-rate swaps). Banks could multiply money as many times as they wanted as long as they could find new sources of capital. New lenders who traditionally lent by buying bonds, not by making bank loans, became sources of such funds. These included money market funds, bond funds, insurance companies and hedge funds, foreign sovereign funds etc. The latest innovations like SIVs and CDOs allowed the bank loan products to be packaged into bond-like pieces that accommodated the investment restrictions on these varied lender types. Now many of these funds have their own ability to leverage...or in my parlance....multiply money. These funding sources are not new - though some have grown exponentially in recent years like hedge funds and sovereign funds - and their ability to leverage and lend was expanded significantly by packaging innovations.

PUNCH LINE - We are now going back to basics. The game is temporarily over. Because of the failure of some of these packaging techniques to deliver the risk levels expected and because of the lack of transparency about who owns what paper and how toxic it is. Transparency was much better when banks owned all the debt and bank regulators had the last word on lending standards. Think of it as many small banks going under. These new lenders are all pulling back from lending and likely won't ever be able to come back with the leverage levels or appetites they once had. All those dollars that were created out of thin air and central bank control are going away. Now central banks can lend to banks and keep them lending to each other, they can lower the cost of money and boost bank profits, but they can't (and shouldn't) force banks to lend or lower their lending standards using moral suasion alone. Additionally, the real banks are having to take assets back on their balance sheets and write them down to market value, which is shrinking their capital bases significantly. In order to meet reserve requirements they must pull back on lending volumes. Perhaps most importantly, the central banks can't bring back the non-bank lenders with their added multiplier effects. As a result central banks are trying....in new creative ways.... to offset the destruction of money that is taking place...but they can't un-pop the bubble. This chart shows what the fed has been doing with the printing presses.

Independent Strategy noticed that asset prices and financial sector balance sheets were growing at multiples of GDP in recent years while measurable money supply wasn't. This set them on their objective to identify the missing money. Well, that extra un-measured money supply is shrinking and it will have an impact on the other parts of the equation: asset prices, GDPs and financial sector balance sheets generally. So there you have it. This conclusion puts me at odds with the "Great Maestro" Greenspan, who is worried about inflation....if your a monetarist, money supply is contracting and the Fed needs to address it, it follows that inflation will be coming down with just about everything else.

From the Blogosphere

Bernanke Goes to Statue of Liberty Play - Bank System Scores

The Collapse of the Modern Day banking System

Monetary Policy Using the Asset Side of the Fed's Balance Sheet

Five Things You Need To Know About Stagflation

No Way Back - the Horrible US Economic Morass

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