Conor's Weekly Roundup - Lessons from the Past, and How Much 'Money' is Out There?

Conor Sen works in the investment industry and is researcher and coauthor for 'How Markets Really Work'. Conor developed a passion for studying the financial markets as a teenager and has degrees in economics and computer science. His opinions are solely his own and do not represent those of this website or his employers.

"The Federal Reserve Board has degenerated into a political appenage of this Administration." -Charles Hamlin, Federal Reserve Board member, June 13, 1926

One of my favorite books is entitled "Understanding the Dollar Crisis" by Percy Greaves, published in 1973. I bought it off eBay a few years ago for $8 or so, and it's a series of lectures that the author gave in South America in 1969. What makes this book worth more than its weight in gold is a 60-page chapter on the causes and policy failures of the Great Depression. I can assure you that Ben Bernanke has never read this book. In light of the Fed's unprecedented actions of the past week, which I will talk about, I thought it'd be useful to cite some excerpts from the book.

"As some of you may know, we had a land boom in Florida in the mid 1920s. People from all forty-eight states were eager to buy almost any kind of real estate in that sunny state, supposedly ideal for vacations or retirement...Banks that had lent money on the boom prices of Florida real estate were in trouble when the high land prices broke early in 1926. We learn from Mr. Hamlin's diary that a man from the Federal Reserve Bank of Atlanta appeared before the Board in Washington on April 21, 1926. He told them the 'collapse of the Florida real estate boom would probably involve 50 banks in failure.'"

Sound a bit like our housing bubble and the ongoing collapse of mortgage originators and investors in mortgage-backed securities and CDOs?

"That spring, 1926, there was also a corrective break in the stock market. Prices dropped about 10 percent. On April 22, the Reserve Board approved a lowering of the discount rate from 4 to 3 1/2 percent, for the Reserve Bank of New York only. The cheaper credit helped to send stock prices soaring again."

Back in the 1920s, the different branches of the Federal Reserve were pretty independent. Targeting just the NY Fed was a fairly blatant attempt at supporting stock prices.

Last Friday the Fed lowered the discount rate only, from 6.25% to 5.75%. This was after they permitted banks to access the discount window using large quantities of mortgage-backed securities as collateral. The policy change got the speculative juices of the bulls flowing again, as stocks rallied strongly. Stocks continued higher this week on the back of Dubai's investment in MGM and Bank of America taking a stake in Countrywide.
The big news of the week happened on Friday, though, when the Fed announced it had loosened restrictions on using asset-backed commercial paper (ABCP) as collateral for borrowing from the Fed. The funny thing is this big news happened underneath the radar. You might be asking yourself, "what is asset-backed commercial paper?" I hadn't heard of it until a week ago. There's no entry for it on wikipedia. The easiest way I can explain it is it's a tool to allow institutions to borrow short-term money using (sometimes) illiquid assets as collateral. As an analogy, it'd be like giving consumers the ability to borrow money cheaply for 30 days using one's comic book collection as collateral.

The problem for the markets was a lot of the collateral for ABCP was mortgage-backed securities and derivatives tied to the mortgage market. All of a sudden the short-term default probabilities for companies such as Coventree and Countrywide skyrocketed, and people decided they didn't want to lend for ABCP anymore. In addition there were concerns about money market funds investing in securities at risk for major losses. Fears of a Countrywide bankruptcy led to an old school run on the bank as customers rushed to Countrywide banks to withdraw money. The impact of all this was pushing short-term treasury rates dramatically lower, under 2% in the case of 1-month treasury bills. Loosening restrictions on investment-grade ABCP now allows banks to invest in ABCP yielding say 6.25% and finance it by borrowing from the Fed at 5.75%. Free money. Good deal if you can get it.

We've now seen the Bernanke Fed intervene in the markets three different ways:

1) Accept unprecedented levels of MBS as collateral
2) Cut the discount rate from 6.25% to 5.75%
3) Accept all investment-grade ABCP as collateral

What they haven't done is cut the Fed Funds target rate. In addition, for a Fed that claims to want to improve transparency, there's no press release on federalreserve.gov about the ABCP policy change. So if you're a financial institution stuck with illiquid assets, the Fed's got your back. If you're a homeowner, not so much. Ultimately, these stopgap measures aren't likely to avert a credit crunch -- the canary in the coal mine was the wobbly housing market and none of these policy changes have addressed housing, which continues to deteriorate. Still, it's eerily disturbing to see Bernanke implement policy from his 2002 and 2004 speeches on deflation and the Great Depression. If you're really curious on what policies we're likely to see in a recession I highly recommend you read them -- the one thing I'm becoming convinced of is the Fed won't cut the target rate until it absolutely has to -- it'll wait to see a drop off in employment, inflation, production, or a plunge in the stock market. Betting against a September rate cut is a good risk/reward bet in my opinion.

http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm

Bernanke thinks the Fed exacerbated the Depression by not providing enough liquidity, but that the Fed has the ability to fix a Depression were it to happen again: "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." Here are a couple more excerpts from someone who implemented policy during the Depression:

"We had something of an obsession for easy money in the system, a feeling that it makes the atmosphere of business, that it can stop a recession of business and turn a period of depression into one of recovery." -Adolph Miller, Federal Reserve Board member, 1931

"Up to this day it has never yet been demonstrated that any agency can be invented to which power to govern the currency could be entrusted without ultimately disastrous consequences." -Miller, 1935

(I am not predicting a Depression. All I know is our current system is unsustainable, and that "bad stuff" is likely to happen in the next few years as the credit bubble deflates. Its severity and duration will depend on external factors such as crowd psychology, government intervention, as well as technological and geopolitical factors. As for the stock market, I have nothing intelligent to say. If you think the government will make it all right you buy 'em; if you think we're going to get the inevitable unwind you stay far away.)
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How much money do you have in your wallet right now? $20? $100? Maybe you just got back Vegas and you've got a few hundred? The mean net worth in the US is well over $100,000, so there has to be a lot of money in a vault or something, right? Before I deliver the punchline, let's think about this for a minute. Several thousand years ago, money didn't exist. Barter was the only form of commerce. Money emerged in the forms of gold and silver because they were valuable, scarce, durable, easily divisible, and portable. Paper money emerged because people didn't want to lug gold and silver around, so banks would issue receipts entitling the bearer to a given amount of gold or silver. Paper money was "as good as gold." The amount of money in circulation had to equal the amount of gold and silver in bank vaults -- perpetual inflation was impossible without an increase in the issuance of receipts or newfound sources of gold and silver. When prices got too high people became suspicious of banks, and would redeem their gold to quell their fears. The banks that had issued too many receipts would be exposed and would collapse. Some people would unfortunately lose money, but afterwards prices came down and the stability of the system was restored. Credit issuance never spiraled out of control for long.

After the Panic of 1907 some people got fed up with periodic bank runs. Without getting into too much detail, the proposal to remedy the situation was the Federal Reserve. After Theodore Roosevelt entered the 1912 presidential election as an independent, assuring the Democrat Woodrow Wilson of victory, the Federal Reserve was pushed through and incepted in 1913. The combination of the Federal Reserve, fractional reserve banking, the financing of World War I, and FDR led to the practical dissolution of the gold standard -- for transactions paper money had replaced gold as currency. Since FDR outlawed private ownership of gold markets we've had perpetual inflation, with the steady erosion in the value of the dollar. A dollar today is worth less than 5% of what it was worth in 1913. For many of you with whom I've spoken, none of this is new information.

So what does this have to do with cash? For hard money advocates like myself, it's bad enough that the dollar is no longer a reliable store of value, as the quantity of dollars in circulation is an uncertainty going forward and subject to the whim of politicians. But this excerpt from a Washington Post article got me thinking even more, "The $100 bill represents more than 70 percent of the $776 billion in currency in circulation, two-thirds of which is held overseas." $776bn in actual greenbacks in circulation. 2/3 held overseas. So there is $256bn in greenbacks residing in the US. There are 300 million Americans today. This means that if we were to give each American an equal amount of all paper dollars in circulation in the US, there would only be about $830 for each of us to go around.

In day to day "Mediocristan" as Taleb might put it, this is not a problem. We can pay for things with credit cards, debit cards, checks, PayPal, etc. But say the unthinkable happened and people rushed to banks to liquidate their checkings and savings accounts, as happened with Countrywide a week ago ( http://www.ajc.com/business/content/business/stories/2007/08/17/countrywidebank0817.html ). There isn't nearly enough cash to go around. So we're off the gold standard and on the fiat dollar standard. But when you do the math you realize that if the average (mean) American is worth over $100,000 and yet there's less than $830 to go around for each of them, you come to the inescapable that we're not really on the paper dollar standard either. We think that we can sell our house, stocks, cars, and jewelry for cash at the end of the day, but in reality we can't. Are we as Americans all a bunch of roadrunners who have gone off the cliff but are still spinning our legs, oblivious to the 1000 foot drop below because the force of gravity hasn't been felt in decades? It troubles me, I must admit.

Conor

Good trading and great risk management to all.

Educational use only. Never intended as investment advice.