Forced to justify the Federal Reserve’s great monetary leap forward known as Quantitative Easing (or QE2), Fed Chairman Bernanke in a Washington Post editorial fell back on textbook Keynesianism that monetary stimulus would result in lower interest rates and greater availability of funding for firms to generate spending on plant and equipment. But from there he took a leap in suggesting that the Fed’s actions would result in higher stock prices, which would be expected to have a wealth effect on spending and create jobs (not mentioned in Keynesianism). Well, let’s give him credit for one out of three: Stock prices have been reinvigorated, though interest rates have increased due to inflation expectations (see: Not since Jimmy Carter), and business lending via the banking system is still 25 percent below 2007 levels.
Having been a Fed watcher for many decades, I was more than surprised when the Fed ventured into justifying monetary expansion as an intentional attempt to stimulate the stock market. Not since the backlash to Chairman Greenspan’s Irrational Exuberance Speech of 1996, which was intended to throw cold water on the tech stock bubble, did the Fed tip-toe into rendering opinion on the stock market, let alone suggesting it was the intent of policy to crank it up. Most surprising of all, on the face of it, cranking up financial markets is counter to the Fed’s new responsibly of being the systemic meltdown cop. That is, the Fed is now in charge of identifying financial bubbles and preventing their meltdowns rather than causing one.
Aside from the policy conflict in stock market stimulus, the more intriguing question is the efficacy of the Fed moving the stock market. That is, by what transmission mechanism does the Fed’s purchase of Treasuries raise stock prices when the U.S. commercial banking system is still certifiably on life support? Despite an increase in the monetary base of more than 150 percent since the onset of the financial crises, the assets of FDIC Insured banks have increased about 8% from 2007 levels. The net effect is that new credit is not being made available to the U.S. banking-dependent borrowers to make a recovery happen via the commercial banks, despite Fed liquidity injections.
Yet the Fed’s QE2 has had positive effects. So the question is: how? This requires an understanding of the new monetary transmission mechanism; that is, the mechanism or linkages of how new money affects asset prices and spending. To understand this, one must be able to see into the shadows of the unregulated, unreported, unaccounted-for mechanism that has been built as a financial transmission device — generally known as the shadow banking system.
The way QE2 produces asset buoyancy (except bonds due to inflation fears) is quite simple on the transaction level but complex as a system. The first link of the chain is when the Fed purchases Treasuries with a check it issues (a claim on cash) from some very conservative institutions such as a pension fund, a commercial bank, an insurance company or an endowment fund, etc. The conservative institutional seller of the Treasury now sits with a cash deposit in their bank but has a need for a replacement interest-bearing asset in its portfolio to replace the Treasury it sold to the Fed. Given the absurdly low-yielding Treasury environment of about 10 basis points, these institutions’ portfolios are in need of greater interest earnings in their portfolio allocation to the high-quality, liquid-asset category.
A bump in short rates is obtainable from participating in the asset-backed lending market, better known as the repo market. Here is how it works: The conservative institution is now holding a cash deposit generated from the Treasury bonds sold to the Fed and goes to its favorite market maker in what is known as the repo market. The market maker, typically one of the surviving investment banks, arranges for the institution to lend to counterparty on what appears to be very conservative terms. The loan terms require that the loan is over-collateralized by some market-traded asset and the loan has a maturity of one day. The next day, the conservative lender can renew the loan if they please, but if they believe that the market value of the collateral has become riskier, they could either allow the loan to mature or refinance and require a high level of overcollateralization in order to extend the loan. This asset-based lending yields about 15 basis points more than an overnight Treasury.
As a result of the transaction, the conservative institution has become a shadow lender on an unreported basis (to bank regulators or to the SEC or the public) to an unknown borrower (the counterparty). Generally, the counterparty borrowers are financial entrepreneurs such as hedge funds, private equity firms or “Special Purpose Vehicles” (SPVs) of investment banks investing in their own account with borrowed funds. The shadow borrower’s motivation is to earn a spread on the higher yielding assets or the appreciation of those assets that are funded by a relatively low cost of funding. These assets are also purchased and held on an overnight basis as the arrangement for the asset resale the next day is made by the market maker in advance.
Making money on other people’s money or leverage is an enticing adventure and as a result is often taken to extremes. How much leverage there is in shadow banking transactions depends on how much capital the borrower must put up to purchase the asset. This is analogous to the down payment made when a consumer purchases a house: the more the down payment, the lower the leverage. In the terminology of the repo market, the borrower’s capital in the transaction is called the “haircut”.
As can be seen from the graph of borrowers’ haircuts in the overnight asset purchasing market (thanks to Haircuts by Gary Gorton and Andrew Metrick of Yale University), the down payments by the borrower is generally very, very low — approximately 1 percent or less as it was prior to the financial crises that began in the summer of 2007.
From these data we can see that the shadow lender’s evaluation of the riskiness of its loan to the financial entrepreneur is biased on the low side in that the loan is due in one day. To the lender the risk then becomes not the long-term ability of the underlying collateral to perform from the successful execution of a business plan or the success of the Irish government to repay its debt due in 5 years, but whether or not the collateral will depreciate overnight. Given this evaluation of risk, some very flakey paper — such as structured products like sub-prime residential mortgage-backed securities, as shown in the graph — is financed on a highly leveraged basis. Other flakey collateral that looks good on an overnight basis would include stocks and commodities, distressed European government bonds and some might include long term US Treasury bonds.
Given the thinness of the over-collateralization, it is quite possible for the price of the collateral to fall overnight such that the collateral falls below the loan outstanding. To the extent the collateral is worth less than the loan, it digs into the capital of the hedge fund borrower. Generally the borrower is put in the position of selling other unpledged good assets to cover the loan losses and hence a contagion asset meltdown begins and prices fall across the board.
Not that this process is sinister or unavailable to us mere mortals if we have a stock brokerage account. But in the regulated market, the Fed controls margin lending in our brokerage account, and if we feel bullish on stocks we can margin up to 50 percent of our capital. Hence for you and me in the regulated market, financial leverage is confined to 1.5 times per dollar of our own capital; whereas in the shadow banking system, where there is no reporting and regulation other than the animal spirits of those involved with borrowers’ capital or haircuts of 1 percent or less, the leverage available has been in the neighborhood of 100 to 1 on a given transaction. This is how hedge funds and investment banks were so leveraged when the financial crises hit in 2007.
We can also see that if the market changes its mind as to the overnight risks, it can raise the haircut — as it did in steps in 2007 through 2008, as shown in the graph. As a result, the leverage available for structured products such as residential mortgage-backed securities by late 2008 declined from almost 100 to 1 down to 2 to 1. The mad scramble to sell assets to accommodate that level of deleveraging was better known as the Lehman Brothers weekend.
All of this occurs in the shadows, as recently revealed in the Financial Crises Inquiry Commission Report last week. In the latest probes by the Fed to gain an insight into the shadow markets (as they are now in charge of preventing asset bubbles), the Fed only can meekly inquire into the flow of overnight leverage into financial markets (on a voluntary basis using the Federal Reserve’s Senior Credit Officer Opinion Survey). Not surprisingly, the first such survey found the greatest demand for overnight credit is for U.S. equity purchases. The Fed has no force of law to require reporting. That is, they are the regulatory cop without a search warrant and are not sure the extent of the asset bubble they are creating. Fed Vice Chair Janet Yellen has indicated:
“A reasonable fear is that this process could go too far, encouraging potential borrowers to employ excessive leverage to take advantage of low financing costs and leading investors to accept less compensation for bearing risks as they seek to enhance their rates of return in an environment of very low yields”. (See: The Federal Reserve’s Asset Purchase Program, p.5)
So there is reason for the Fed to claim they have run up stock prices. Despite the lack of transparency into the shadow banking system, there are enough clues that the Fed’s purchases have provided the funding to put the shadow banking system back into high gear. The asset acquisition by hedge fund types is in turn financing businesses on extraordinarily moderate terms. Haircuts are back down to 2007 levels, and corporate debt containing Covenant Lite and Payment in Kind (PIKs) are back – and some of the funding is filtering into corporate spending on plant and equipment — but only for firms that are able to reach the public capital markets.
Hence, the Fed is pumping up an asset bubble and is creating spending in an end run around the moribund U.S. commercial banking system. We must hope the bubble doesn’t succumb to a Black Swan event such as a Muni or Euro sovereign default or a Middle East blockage of trade and energy through the canal. These events can create a quick reversal of the buildup of financial buying when haircut down payments rise and extreme deleveraging sets in. The Lehman Brothers weekend was just two short years ago. My oh my, how short the memories of the shadow lenders and borrowers — and for that matter, the Fed.