September 30, 2017

 The expression “Shadow Banking” was popularized in 2007 by Bill McCulley of PIMCO. While the term seems to imply something sinister and covert the shadow banking system exists in response to regulation of the banking system. In essence it moves the risks of the formal banking system to entities which are not banks.

In a traditional bank, depositors put money into accounts getting it back on demand with interest and the bank loans out that money to people and businesses charging them interest. If the bank is well run, its shareholders can share the profits. What are the risks? There are at least three:

1) Liquidity risk: the bank's liabilities are to the depositors. These are short term. Depositors can ask for their money back whenever they want. The bank’s assets are the loans it made. If the depositors, for whatever reason, all want their money back at the same time the bank cannot get the money back from the people it made loans to just because the depositors want their money. This is liquidity risk and this problem is solved by the Federal Reserve. It a bank needs cash, it can get it from the Federal Reserve by pledging some of those long-term assets. This discourages bank runs. In addition the FDIC insures the accounts of depositors so that they have no need to ask for their money if there is a rumor about the bank. The Basel banking accords require banks to keep reserves at a certain percentage of their of their deposit liabilities.

2) Solvency risk. If too many of the banks loans go bad the bank will become insolvent having little or negative net worth. In this case the bank will be taken over by FDIC. Usually the liabilities (the checking and saving accounts) are sold to one bank and the assets (the loans) are sold to another. This almost always happens after close of business on a Friday so that, to a customer wanting to make a withdrawal, the effect is minimal. You go there on Monday and all you notice is that the name of the bank changed. The stockholders were wiped out but the depositors and anyone holding a check written by those depositors are protected. This last point about banks being the heart of our payment system is too easily glossed over.

3) Duration mismatch risk: the third type of risk is slower and less obvious. If banks make and hold fixed rate 30-year mortgage loans the interest rate on the asset side is locked in for years but the depositors will, if inflation picks up, move their money to a bank offering higher savings rates. The problem is that the durations of the bank's assets and liabilities are mismatched. Because interest rates can change substantially with time entities such as FNMA and FHLMC were created to buy mortgage loans from banks and sell them to investors who took the long term rate risk.

Stop right here and realize that what is described above is the traditional banking system and the some of the regulatory structure which goes with it.

The shadow banking system exists to a large extent to move those risks outside the traditional banking system.

The shadow banking system consists of hedge funds, money market funds, structured investment vehicles (SIV), credit investment funds, exchange-traded funds, credit hedge funds, private equity funds, securities broker dealers, credit insurance providers, securitization and finance companies. From time to time the relative size of these components of the shadow banking system change.

Commercial Paper is essentially short term, unsecured (<270 day) loans to companies and local governments.  Most commercial paper is provided by money market funds.  The fact that the commercial paper market seized after the Lehman bankruptcy was one of the most significant causes of the recession. Deprived of the ability to borrow, businesses had to downsize.  Replacement for normal commercial paper came from the Federal Reserve in the form of the Commercial Paper Funding Facility.

The Rest of the Shadow banking system

In 1999 the Gramm–Leach–Bliley (GLB) Act was passed. The allowed for big banks to combine banking, securities and insurance companies under one corporate umbrella. The reasoning was that when times are good customers invest in equities and when times get tough they sell equities and keep their assets in cash (checking and savings accounts.) While some folks place the blame for the effects of the mortgage mess on GLB, I do not think that is accurate. Two points: 1) Wall Street was already well in control of non-GSE mortgage securitization long before that and 2) some of the big Wall Street investment banks did not merge with banks before the mortgage mess forced them to do so.

The problem with banks vis-à-vis the mortgage mess stemmed not from GLB but rather from something less apparent. The best explanation comes from the late economist Fisher Black. (Black was one of the creators of the Black–Scholes equation for calculating the correct price of derivatives. Since the Nobel Prize is not awarded posthumously Black did not share on the fruit of his work when Myron Scholes received the Nobel in 1995.) This paragraph is from the “Fundamentals of Liquidity” (1970):

"Thus a long term corporate bond [same is true for mortgages] could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the risk of default. The last two would not have to put up any capital for the bond, though they might have to post some sort of collateral."

Black was spot on long before this actually transpired. The buyers of Mortgage Backed Securities supply the money. Interest rate swaps bear the rate risk. Credit default swaps (CDS) bear the default risk. What happened was that commercial banks and investment banks joined forces to get both the rate risk and the default risk off the balance sheets of banks. Banks generated mortgages and sold all three parts - the money flow, the rate risk and the default risk to other entities. The risks were relocated from the banking sector to the shadow banking sector. To suggest that the shadow banking system was responsible here is only partially accurate. This was done with the knowledge and encouragement of banking regulators. Regulators wanted risk off the balance sheets of the banks they regulated and with the same risk in a less regulated segment of the shadow banking system. Risk was not eliminated but rather relocated.  The shadow banking system is where much of the risks associated with traditional banking are now located.

The problem with the mortgage mess/liquidity crisis was that too many bad mortgage loans were made. This inflated home prices by expanding the demand to people who would not be able to make the payments. The system for separating rate and default risk while it did not create the demand for bad mortgages certainly made the process of generating them easier. The fault was with 1) HUD for mandating that FNMA and FHLMC do subprime 2) banking entities such as Countrywide which plunged headfirst into non-GSE subprime and 3) the debt rating firms for providing bogus ratings for the debt. More accurately perhaps was that the debt rating firms treated mortgage default risk as static paying too little attention to the fatal combination of diminished underwriting guidelines and the housing bubble.

The whole thing blew up only when it was apparent that one of the entities which provided the credit default swaps - AIG - had not sufficiently hedged its positions. It sold CDS but never purchased them. It was not until the week of the Lehman Bankruptcy that Moody's announced that it was less confident that AIG could actually pay all of the CDS’s which it was holding for mortgage debt. That meant that not only AIG was in trouble but that anyone who thought that AIG was going to deliver if the mortgages defaulted had to go out and buy a back-up policy just at a time when the cost was increasing dramatically. The Federal Reserve and the Treasury Department moved in to mitigate the damage created by the collapse of AIG.

The problem was not that there were CDS’s but that AIG did not hedge its risk. AIG was the whale at the table with all its chips on "pass" when the economy rolled craps. Worse yet, the whale could not cover its markers.

We may be seeing something even further away from the traditional commercial banking and investment banking businesses with crypto-currencies and Initial Coin Offerings. Crypto-currency is a challenge to the sole ability of central banks to issue money and banks accounts as store of wealth. ICO’s (Initial Coin Offerings) have become a new way of raising capital for startup companies while circumventing investment banks and the regulations which go with capital raising.

The crypto-currency, block-chain, ICO industries are starting to become an ever greater challenge to the banking system including the central banks. These are responses to regulations involving capital raising and the tradition that money is created only by central banks. These can be the genesis of significant economic activity and create jobs, spending and wealth in a manner unrestrained by regulations.  This is a point usually missed by commentary about cryptocurrency.

September 9, 2017

I believe that one of the most important metrics of the health and, in fact, survivability of the economy is the ratio of National Debt/GDP. Consequently we should pay attention to GDP growth of which has been anaemic of late. Debt/GDP at the end of 1stQ2017 was 14.13%.This is not accurate. Note that when we measure debt/GDP we use nominal dollars (not inflation adjusted) rather than real (inflation adjusted) because debt is, of necessity, measured in nominal dollars. Also not that since Congress has not increased the ceiling on the National Debt we do not have an accurate measure of the National Debt at present. Treasury does funny business with accounting at times like this. In November 2015 after the debt ceiling was raised the National Debt shot up $339.1 billion in one day. In 2013 we had a $328.2 billion increase in one day. In 2011 we had a $238.3 billion increase in one day.

Economist Lacy Hunt makes the case that once debt/GDP is above 90% government deficit spending has a negative multiplier. Why? Because money borrowed by the government is money that is not being deployed either as capital to business or as loans to businesses and individuals thus reducing investments and spending. If Hunt's thesis is correct we are in serious trouble.

The GDP report is the metric of the state of the economy. One point is that as much attention should be paid to one number in the report as the overall GDP. That is the number called "Real Final Sales of Domestic Goods."

Average GDP growth for the past 22 quarters has been 2.05%. This despite near-zero interest rates and enormous expansion on money supply. Making believe that the economy is doing well because Initial jobless Claims, the unemployment rate, and inflation are low is foolish. Whatever the problem may be it is not monetary.

Despite more than 5 years of dismal GDP growth and massive increases in debt be it government, corporate of individual we continue to see asset inflation in equities and real estate and most any sort of financial investment. This is a symptom of the financialization of the economy. People are not investing in capital improvements but rather financial assets having little or no correlation with capital investments intended to produce future growth. This is dysfunctional capitalism.

I want to make four points about the sources of domestic economic malaise: 1) we are hurting a bit because of other nations' problems 2) we are hurting because of too much debt 3) we are hurting because the economy has become too financialzed. Capital is not being deployed to create things. Instead leverage is being deployed to make corporate balance sheets look better through stock buy-backs and money is being deployed in speculating in commodities and derivatives 4) we are hurting because of too much government (federal, state, and local) regulation.

We should target GDP growth at 4%. There is a tendency to set the goal lower at 3% but the fact is that what we really should be looking at is the National Debt/GDP ratio. We should be trying to get it under 95%. Take a look at this historic debt/GDP graph.. 

September 4, 2017

 Inside the BLS Employment Situation Report

For several years we have been writing this numerically detailed analysis of the BLS Employment Situation Report. In the early 90's;  everyone was preaching that this report was the most significant each month both as an economic indicator and a driver of interest rates.  At that time this was accurate. In recent years assumptions about how the jobs market affects things have not been correct. Last week we wrote about inflation and noted that that the usual assumption that the low unemployment rate we have had should be causing inflation because it should be driving up wages. But that is not happening. I remain massively frustrated at the absolutely poor mainstream reporting of the jobs report. It takes a lot more than quotes of headline jobs and unemployment rate to gauge the health of the jobs market. The jobs market has not been contributing to economic growth for years. The headline numbers are touted but they fail to account for three things: 1) we need a monthly gain of approximately 120,000 jobs to keep pace with population growth 2) the jobs we added for 10 years were almost entirely something other than full-time W2 jobs 3) Headline BLS counts jobs not people working. We can have a gain in jobs with fewer people working when there are more people holding multiple jobs.

This is my monthly look inside the BLS Employment Situation Report. There are two BLS Surveys: the Establishment and the Household. Establishment surveys about 141,000 businesses and government agencies, representing approximately 486,000 individual worksites. It is taken each month during the week which includes the 12th of the month. Household is a survey of 60,000 households taken each month during the week which includes the 12th of the month.

Each item below is suffixed with (H) if it is from the Household Survey, (E) if it is from the Establishment Survey, and (B) if it is from both.