by Doug Noland
When Paul Volcker's term as Chairman of the Federal Reserve ended, total U.S. Credit market debt outstanding tallied around $10 TN. Broker/Dealer assets ended 1986 at $185bn. Funding Corporations stood at $146bn. GSE assets were at $364bn, with $352bn of outstanding GSE-guaranteed mortgage-backed securities (MBS). The asset-backed Securities (ABS) market, at $75bn, was hardly a force. REITs were only $15bn. The Federal Reserve's balance sheet ended 1986 at $275bn. There were $1.80 TN of outstanding Treasury Securities and $808bn of Agency Securities. Total Commercial Bank assets stood at $2.621 TN, with miscellaneous bank assets of $741bn. Total U.S. Mortgage Debt was just under $2.70 TN.
Fast-forward to Q3 2009. Total Credit Market Debt Outstanding had ballooned more than 5-fold to $52.617 TN. Broker/Dealer assets ended September at $2.062 TN (after surpassing $3.0 TN in 2008). Funding Corporations stood at $1.338 TN. GSE assets had ballooned to $3.126 TN, with outstanding GSE-guaranteed mortgage-backed securities (MBS) at $5.30 TN. The asset-backed Securities (ABS) market ended the third quarter at $3.650 TN. REITs were $266bn. The Federal Reserve's balance sheet had swelled to $2.180 TN. There were $7.520 TN of outstanding Treasury Securities and $8.123 TN of Agency Securities. Total Commercial Bank assets stood at $14.2 TN, with miscellaneous bank assets of $4.027 TN. Total U.S. Mortgage Debt ended the quarter at $14.42 TN.
The Washington Post 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. Mr. Volcker is an anachronism from a different era - or so the markets had thought until yesterday. 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 yesterday.
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 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 by 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 created the higher their market values.
This marketable debt security 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 Reserved responded to systemic stress by aggressively slashing rates. And for years, Fannie and Freddie 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 had such a powerful monetary tool. These potent Credit dynamics were at the heart of the U.S. 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 reasonable. Focus on protecting the FDIC/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 U.S. Bubble economy requires in the neighborhood of $3.0 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) 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 Dr. 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.
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 today'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.
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