With the US financial system at the brink following the collapse of Long Term Capital Management and the severe impairment of the reckless leveraged speculator community - largely hedge funds and Wall Street firms - the Greenspan Federal Reserve now embarks on yet another round of financial crisis management. And reminiscent of the bank and S&L bailout in the early 1990's, and the Mexican bailout in 1995, the singular remedy is but ever-greater credit excess. And, of course, each crisis sets the stage for the next even larger debacle necessitating another bailout only more arduous and precarious than the one before.

In the final analysis, today's bailout of Wall Street is little more than another round of financial system monetization. Today, truly massive credit creation encompassing the banking system and the government sponsored entities, Fannie Mae, Freddie Mac and the Federal Home Loan Bank system, rescues the leverage speculators and, hence, the US financial system. We have, however, a difficult time celebrating this largess, recognizing all to well it only defers the inevitable devastating day of reckoning for the unsuspecting American investor and taxpayer.

The Money and Credit Explosion

Today, a virtual explosion of money and credit accompanies the Fed's stance of heightened accommodation. And while exorbitant credit growth has been carelessly disregarded for some time now, recent data is so striking as to garner concern from sagacious observers and even brief media attention. Indeed, October was much an historic month for the US credit system as money supply expanded at the strongest rate since the economy emerged, in June of 1982, from a deep and protracted recessionary period. In obvious contrast, however, record credit growth today largely feeds financial and asset markets.

It is simply unprecedented for a central bank to move frenetically toward ease in the face of such exponential money and credit expansion. But admittedly, these are anything but normal circumstances as the Fed is inarguably now held captive to a highly leveraged credit system and phenomenal stock market speculation. Witnessing the suddenness of the US financial system's lurch to near collapse this past summer, a desperate Greenspan set course to perpetuate the great American bubble. With acute systemic risk posed by the impairment of the highly leveraged speculators, most notably the hedge funds and Wall Street firms, he moved aggressively to reliquify the credit markets. So far, Greenspan's pursuit is certainly being advanced by a financial system with an extraordinary proclivity towards excess.

For the month of October, total bank credit expanded at a stunning annual rate of 22%. Importantly, almost half of this growth was in security purchases as banks became aggressive buyers. Holdings of non-US government securities surged $37 billion, or at an annual rate surpassing 100%. Taking up the slack from faltering security markets, banks were also aggressive lenders as commercial and industrial loans grew at an annual rate of 27% and loans for securities exploded at 125%. Interestingly, as bank credit exploded by almost $100 billion during October, bank deposits increased but $23 billion leaving the funding source for the majority of security purchases and loan growth to "Borrowings" from banks and others. For those schooled in financial history, this is much reminiscent of the unbridled credit creation within the banking system curing the late 1920's referred to by the Austrian economists as the "roundabout" process.

The Fountainhead: Money Markets

And while some note is taken of this flood of new bank credit, we see a complete lack of recognition and understanding as to the key credit creation role played today by the money markets. Indeed, we see the money markets as much the great but unappreciated fountainhead for the US financial and economic bubble. According to the Investment Company Institute, money market fund assets now approach $1.4 trillion, having grown $300 billion, or almost 30%, during the past year. In fact, the explosion of money market assets largely explains the excessive growth in the monetary aggregates, especially over the past several months as M3 money supply has grown at an annual rate of more than 13%.

For the recent three-month period, August through October, astonishing record M3 money growth reached $200 billion (fully 60% greater than the same three month period in 1997!), almost 70% of which can be traced directly to an explosion of money market fund assets. To clarify, during this period currency in circulation grew by $14 billion, total checkable deposits actually declined by $400 million, savings deposits increased $53 billion, large time deposits grew $6 billion and money fund assets ballooned $137 billion. Remarkably, and what should be setting off deafening alarm bells throughout the Federal Reserve System, this three month money fund growth compares to $50 billion during the similar period in 1997, or fully 270% the level of the previous year. Clearly, if anyone is searching for an explanation for the parabolic move in the money aggregates, it lies patently with the money markets.

In this regard, we must again admit to being dumbfounded by the level of understanding that permeates the American economic and financial community with respect to the mechanisms of money and credit creation. To this day, dogmatic and fallacious assertions are made that only banks create money and credit. This is a bogus claim and should be accepted as nonsense by any serious analyst especially considering the evolution of the US financial system and, particularly, recognizing an asset-backed security market having grown to $3.7 trillion, the absolute proliferation of non-bank financial institutions as well as the profound role now played by Wall Street and the security markets. This misconception is certainly perpetuated by the monetarists.

This school of thought holds to the doctrine that money and credit are created almost exclusively through the "multiplier effect" of bank deposits recirculating through the banking system with reserve requirements and Federal Reserve governance controlling bank credit expansion. However, and critically, this school views non-bank participants in this process as merely financial intermediaries, transferring bank created money from saver to borrower. With this in mind, such analysis focuses overwhelmingly on bank reserves and the narrow definition of money, M1. And with M1 actually contracting marginally over the past six months and bank reserves with a year-over-year decline, it is completely lost among these adherents as to how it is possible that the broader money aggregates explode in an unprecedented and historic expansion.

Greenspan's Vigorous Partners - Fannie and Freddie

Let us provide an explanation. For our discussion we will focus on Fannie Mae and Freddie Mac, companies whose balance sheets have ballooned to almost $750 billion from about $170 billion at the end of 1990. Fannie and Freddie rely extensively on the money markets for financing truly staggering balance sheet growth, having accumulated short-term liabilities approaching $400 billion. Indeed, as we wrote last month, Freddie actually financed its entire record third quarter asset growth with $37 billion of additional short-term debt. Basically, Freddie and Fannie tap the money markets for funds used to acquire long-maturity financial assets, mortgages. They borrow, creating money market liabilities, and use proceeds ("money") to fund the purchase of mortgages originated throughout the financial system.

Importantly, when Fannie and Freddie purchase mortgages this "money" stays within the financial system where it largely recirculates back to money market funds. This works much like the banking system "multiplier effect" accept for one very significant exception: Money market funds are not restrained by reserve requirements, hence providing a completely unbridled credit creation mechanism. In regard to money funds and their propensity of fostering uncontrolled credit growth, we note the traditional caution of the Bundesbank, clearly recognizing the considerable risk associated with credit creation extraneous to the banking system. Indeed, with today's highly sophisticated financial infrastructure functioning largely unsupervised and outside the banking industry, money instantaneously "spins" through the system providing unlimited credit creation.

Continuing our discussion of Fannie and Freddie, we see absolutely no mystery as to the explosion of money market fund assets. Indeed, it is part and parcel to the explosion in Fannie and Freddie balance sheets. First, it is instructive to compare growth rates for money market assets to the expansion of Fannie and Freddie assets going back to the beginning of 1995, really the commencement of rapid expansion within the broader money aggregates. Since this time, money funds have grown almost 100% compared to 90% for Fannie and Freddie balance sheet assets.

Now comparing annualized growth rates for money funds to Fannie and Freddie assets on a quarterly basis for the past four periods, we see during the fourth quarter of 1997, 13% vs. 14%; 1998's first quarter, 22% vs. 26%; the second quarter, 27% vs. 25%; and the third quarter, 27% vs. 32%. The most glaring correlation, however, was during October where Fannie and Freddie purchased, for their own balance sheets, a shocking $26 billion of mortgages, by far an all-time record and fully 400% the level of October 1997 purchases. Indeed, Fannie and Freddie expanded assets at an astonishing 50% annualized rate in October and, not surprisingly, money fund assets also experienced a momentous month, expanding at a 60% annualized rate.

This is definitely no coincidence!

So clearly the explosion in money market assets and the money stock is not the enigma many claim. It is just ever larger doses of what has so intoxicated the US financial system for many years now, out of control credit creation largely directed at financial assets. While the highly leveraged US financial system came to the brink over the summer, massive credit expansion by the banking sector and Fannie and Freddie have come to the rescue, for now.

In a key development, despite dramatically wider credit spreads and considerable tumult throughout the mortgage-backed securities marketplace, Fannie and Freddie, nonetheless, sharply lowered consumer mortgage rates to as low as 6.49% in early October, the lowest rate in decades. This quickly incited record mortgage refinancings, providing Freddie and Fannie a huge pool of new mortgages for which to balloon their balance sheets. Importantly, this effort by Freddie and Fannie played a powerful role in reliquifying the credit markets.

Borrowing aggressively from the money markets to absorb the flood of mortgage refinancings, this operation was a godsend as much needed cash was directed to previous holders of mortgage-backed securities who could use this liquidity to reduce leverage or purchase other credit market instruments. Moreover, Fannie and Freddie also forcefully expanded purchases of loans and securities financing commercial real estate, multifamily, home-equity, sub prime and manufactured housing, much explaining the celebrated contraction in credit spreads throughout. It must be said, Greenspan has found vigorous partners in Fannie and Freddie.

In effect, we see Greenspan's rate reductions as an extraordinary crisis management effort, desperately lowering borrowing costs for leveraged players as well as conveying to market participants both the Fed's willingness and ability to support markets. Apparently adopting as the overriding objective the reliquification of the credit markets, the Fed now foments truly unprecedented credit excess and financial system leverage, not to mention egregious stock market speculation.

Supplanting the reckless hedge fund and brokerage community as the leading purveyor of the American credit bubble, today this baton has been handed, on one hand, to the domestic banking sector backed by deposit insurance and, on the other, to Fannie and Freddie with their implied debt guarantee from the American taxpayer. Appallingly, after turning a blind eye to years of massive hedge fund and Wall Street leveraged speculating, allowing such to grow to both dominate and debase the entire financial system, the Fed now acts forcefully to perpetuate this hopelessly parlous financial bubble. And, admittedly, so far with much success, although this only raises the stakes for the inevitable day of reckoning.

Doug Noland
Le Metropole
30 November 1998
http://www.lemetropolecafe.com