Page 1 of 3 CREDIT BUBBLE BULLETIN
The Volcker Rule
Commentary and weekly watch by Doug Noland
When Paul Volcker's term as chairman of the Federal Reserve ended, total US
credit market debt outstanding tallied around US$10 trillion. Broker/dealer
assets ended 1986 at $185 billion. Funding corporations stood at $146 billion.
Government-sponsored enterprise (GSE) assets were at $364 billion, with $352
billion of outstanding GSE-guaranteed mortgage-backed securities (MBS). The
asset-backed securities (ABS) market, at $75 billion, was hardly a force.
Real-estate investment trusts (REITs) were only $15 billion. The Federal
Reserve’s balance sheet ended 1986 at $275 billion. There were $1.80 trillion
of outstanding Treasury securities and $808 billion of agency
securities. Total commercial bank assets stood at $2.621 trillion, with
miscellaneous bank assets of $741 billion. Total US mortgage debt was just
under $2.70 trillion.
Fast-forward to last year's third quarter. Total credit market debt outstanding
had ballooned more than five-fold to $52.617 trillion. Broker/dealer assets
ended September at $2.062 trillion (after surpassing $3.0 trillion in 2008).
Funding corporations stood at $1.338 trillion. GSE assets had ballooned to
$3.126 trillion, with outstanding GSE-guaranteed mortgage-backed securities
(MBS) at $5.30 trillion. The asset-backed securities (ABS) market ended the
third quarter at $3.650 trillion. REITs were $266 billion. The Federal
Reserve’s balance sheet had swollen to $2.180 trillion. There were $7.520
trillion of outstanding Treasury securities and $8.123 trillion of agency
securities. Total commercial bank assets stood at $14.2 trillion, with
miscellaneous bank assets of $4.027 trillion. Total US mortgage debt ended the
quarter at $14.42 trillion.
The Washington Post last week went with the headline "Volcker Rule Shifts Power
from Geithner". Secretary Geithner is perceived as more of a New Era Wall
Street-type - a tenuous position to find oneself these days. Paul Volcker is
the consummate tough, no nonsense old-school financial regulator. Volcker is an
anachronism from a different era - or so the markets had thought until last
week. The general perception was that he had lost touch - and was basically out
of touch with the White House. Yet the great American statesman has made a
dramatic return to the center stage.
As much as the new Administration had been badgering and threatening the "Wall
Street fat cats", the marketplace had assumed that this was mostly political
bluster. At the end of the day, Washington needs Wall Street to ensure strong
markets and a sustainable economic recovery. After unprecedented fiscal and
monetary stimulus - not to mention scores of bailouts - the street can't be
faulted for assuming it was back to business as usual. That was before last
week.
While certainly not without faults, the financial system back in the Volcker
era was more stable. The ABS market barely existed. The Wall Street firms and
their marketable debt instruments were not major factors in system credit
creation. The banking system dominated the extension of private-sector credit.
Derivatives markets were in their infancy - and certainly didn't dominate the
financial world. Outside of some GSE MBS, mortgage credit was in the form of
bank loans. There were only a handful of hedge funds - not thousands.
Leveraging marketable debt instruments wasn't The Game.
I have over the years discussed ramifications associated with the
transformation of contemporary finance from bank loan dominated to marketable
security dominated. I have contrasted the "staid" bank loan with the advent of
the dynamic marketable debt instrument. The bank loan sat unassumingly on the
bank's balance sheet until it was repaid - all under the watchful eye of the
traditionally conservative bank loan officer. The marketable security, on the
other hand, could be created by virtually anyone (the aggressive mortgage
banker cold-calling from the rented office suite!) and held on the books of a
Wall Street proprietary trading desk, a hedge fund, or exist as part of a
collateralized debt obligation.
The marketable security could be "marked to model" - for some nice profits
and/or bonuses - and, importantly, leveraged. And the more marketable debt
securities that were created, the higher their market value (and the larger
speculative profits and bonuses).
These marketable debt securities provided leveraged players an almost
guaranteed spread to short-term interest rates or Treasuries. Even better, its
value would be expected to go up in the event the Federal Reserve responded to
systemic stress by aggressively slashing rates. And for years, GSEs Fannie Mae
and Freddie Mac would be gluttonous buyers of these securities in the event of
a marketplace liquidity problem - providing the leveraged speculators a
wonderful "backstop bid". The Federal Reserve had never enjoyed such a powerful
monetary tool. These potent credit dynamics were at the heart of the US credit
bubble.
But the Wall Street/mortgage finance bubble eventually burst and almost brought
down the entire credit system and economy. This, of course, woke up the
regulators. But serious financial reform was put on hold, as policymakers
waited anxiously for a sustainable recovery to take hold.
Political considerations notwithstanding, it is difficult to argue against the
premise that it's now time to begin addressing serious financial reform. Moves
to rein in bank proprietary trading, hedge fund investments, and private equity
are all reasonable. Focus on protecting the Federal Deposit Insurance
Corporation/taxpayer is vitally important. And the moral hazard and "too big to
fail" issues are about as important to our nation's economic future as any. If
we could just go back to the old days of chairman Volcker and the sedate bank
loan.
I have hypothesized that the underlying structure of the US bubble economy
requires in the neighborhood of $3 trillion annual non-financial credit growth.
An especially protracted period of financial excess inflated asset prices,
incomes, corporate cash flows, government receipts and expenditures, trade and
current account deficits, the general price level, and spending patterns
throughout the entire economy. Since after the crisis's onset, the massive
expansion of federal government finance (primarily Treasury and agency
securities and the Fed's balance sheet) has been sufficient to stabilize the
system.
I remain skeptical that the private sector credit mechanism can recover
sufficiently to allow the Federal government to back away from massive deficits
and guarantees. With Wall Street trading profits and hedge fund returns
bouncing back so quickly, market optimism for the emergence of a
self-reinforcing credit cycle has been seemingly justified. Bolstered by near
zero short-term rates and the Fed's "quantitative ease," security issuance -
federal, agency, state, and corporate - has been massive. Meanwhile, though,
bank lending has remained stagnant.
The Fed needs to commence its exit strategy - and private sector credit is
going to have to take up some of the slack. The uncertainty that has erupted
with the introduction of the "Volcker rule" and the prospect for more stringent
financial reform would not seem to support the rejuvenation of private sector
lending. Uncertainties related to the futures of Fed chairman Ben Bernanke,
Fannie and Freddie don't help market confidence either. The administration's
solution would be for the banks to step up and lend money more aggressively.
It's just been a long while since that was their main focus. Financial reform
is not without huge obstacles and risks.
The markets have been much too complacent when it comes to the vulnerability of
this credit recovery. I wish we could simply go back to simpler financial times
- back to when the bank loan was king; back to when the economy wasn't so
dependent on massive ongoing credit creation; back to when financial
speculation wasn't such a commanding force for global markets and economies. In
the past two decades the entire financial apparatus was transformed.
One of the big problems today is that there are tens of trillions of marketable
securities out there - and their value depends greatly on the ongoing creation
of trillions more. Our system needs major financial reform - no doubt about it.
From last Friday's Wall Street Journal: "The White House's relationship with
Wall Street is close to the breaking point." A war on Wall Street would put
credit growth, asset markets and economic recovery all at risk.
WEEKLY WATCH
For the week, the S&P500 sank 4.3% (down 2.1% y-t-d), and the Dow lost 4.1%
(down 2.1% y-t-d). The broader market did a little better. The S&P 400
Mid-Caps declined 3.0% (down 0.7%), and the small cap Russell 2000 fell 3.4%
(down 1.3%). The Banks slipped 0.8% (up 8.5%), and the Broker/Dealers declined
2.8% (down .3%). The Morgan Stanley Cyclicals were hit for 6.9% (down 1.7%),
and Transports were down 4.4% (down 2.3%). The Morgan Stanley Consumer index
dropped 2.1% (down 1.0%), and the Utilities declined 1.4% (down 3.9%). The
Nasdaq100 sank 3.9% (down 3.5%), and the Morgan Stanley High Tech index fell
4.5% (down 4.6%). The Semiconductors sank 4.6% (down 8.5%). The InteractiveWeek
Internet index dropped 4.2% (down 4.2%). The Biotechs declined 2.2% (up 1.9%).
With bullion sinking $36, the HUI gold index was hammered for 8.6% (down 6.1%).
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