Shadow Banking

Ray Dalio, founder and co-chief investment officer of Bridgewater Associates, L.P. and one of the most successful hedge fund managers of all time told Maria Bartiromo last week that he owns gold and that he sees no “sensible reason not to own gold”. The interview was part of the Council on Foreign Relations (CFR) Corporate Program's CEO Speaker Series, which provides a forum for leading global CEOs to share their priorities and insights before a high-level audience of wealthy and influential CFR members.  The respected hedge fund manager suggested that a depression and not a recession was likely and warned of social unrest and the risk of radical politics as was seen with Hitler and the Nazis in the Depression of the 1930’s. Dalio spoke about how “gold is a currency” and when asked by Bartiromo “do you own gold?”, he smiled and said “Oh yeah, I do.” The admission elicited a laugh from the CFR audience. Dalio’s interview is important as it again indicates how slowly but surely gold is moving from a fringe asset of a few hard money advocates and risk averse individuals to a mainstream asset. Wealthier people and some of the wealthiest and most influential people in the world are slowly realising the importance of gold as financial insurance in an investment portfolio and as money. This will result in sizeable flows into the gold market in the coming months which should push prices above the inflation adjusted high of 1980 - $2,500/oz. The interview section where Dalio is asked about gold by an audience member begins in the 43rd minute and can be seen here.

Some wonder why we have been so convinced that no matter what happens, that the Fed will have no choice but to continue pushing the monetary easing pedal to the metal. It is actually no secret: we explained the logic for the first time back in March of this year with "Here Is Why The Fed Will Have To Do At Least Another $3.6 Trillion In Quantitative Easing." The logic, in a nutshell, is simple: everyone who looks at modern monetary practice (as opposed to theory) through the prism of a 1980s textbook is woefully unprepared for the modern capital markets reality for one simple reason: shadow banking; and when accounting for the ongoing melt of shadow banking credit intermediates, which continues to accelerate, the Fed has a Herculean task ahead of it in restoring consolidated credit growth. Shadow banking, as we have explained many times most recently here, is merely an unregulated, inflationary-buffer (as it has no matched deposits) which provides the conventional banking credit transformations such as maturity, credit and liquidity, in the process generating term liabilities. In yet other words, shadow banking creates credit money which can then flow into monetary conduits such as economic "growth" or capital markets, however without creating the threat of inflation - if anything shadow banks are the biggest systemic deflationary threat, as due to the relatively short-term nature of their duration exposure, they tend to lock up at the first sing of trouble (see Money Markets breaking the buck within hours of the Lehman failure) and lead to utter economic mayhem unless preempted. Well, preempting the collapse in the shadow banking system is precisely what the Fed's primary role has so far been, even more so than pushing the S&P to new all time highs. The problem, however, as we will show today, is that even with the Fed's balance sheet at $2.8 trillion and set to rise to $5 trillion in 2 years, it will not be enough.

Moments ago, the Fed released its latest Z.1, aka the Flow of Funds, which is the primary source of information of that one component of modern finance which all modern economists continue resolutely to ignore because it blows all their anachronistic theories on monetary theory out of the water: shadow banking data. But more on that later. for now, here is the graphic summary of that most important of conventional data points updated every quarter: the US household balance sheet, and specifically the net worth of the US consumer, which in Q2 declined from a 4 year high of $63 trillion to $62.7 trillion, on a $900 billion drop in financial assets, offset by a $400 billion hike in real estate assets. Most importantly, and the reason why to the CTRL-P operator the only thing that matters is the stock market, of a total of $76.1 trillion in assets, only $24.2 trillion are tangible: i.e., real estate and durable goods. The remainder, $51.9 trillion or 68.2% of total, is Financial assets. It is this number that is the sole target of Bernanke's "monetary policy" and which must be inflated at any and all cost.

One of the key stories of 2011 was the revelation, courtesy of MF Global, that no asset in the financial system is "as is", and instead is merely a copy of a copy of a copy- rehypothecated up to an infinite number of times (if domiciled in the UK) for one simple reason: there are not enough money-good, credible assets in existence, even if there are more than enough 'secured' liabilities that claim said assets as collateral. And while the status quo is marching on, the Ponzi is rising, and new liabilities are created, all is well; however, the second the system experiences a violent deleveraging and the liabilities have to be matched to their respective assets as they are unwound, all hell breaks loose once the reality sets in that each asset has been diluted exponentially. Naturally, among such assets are not only paper representations of securities, mostly stock and bond certificates held by the DTC's Cede & Co., but physical assets, such as bars of gold held by paper ETFs such as GLD and SLV. In fact, the speculation that the physical precious metals in circulation have been massively diluted has been a major topic of debate among the precious metal communities, and is the reason for the success of such physical-based gold and silver investment vehicles as those of Eric Sprott. Of course, the "other side" has been quite adamant that this is in no way realistic and every ounce of precious metals is accounted for. While that remains to be disproven in the next, and final, central-planner driven market crash, we now know that it is not only precious metals that are on the vaporization chopping block: when it comes to China, such simple assets as simple steel held in inventories, apparently do not exist.

Feel like every day Europe is juggling hot potatoes? You are not alone. As the following graphic summary from Citi's Matt King (whose insight into Europe, liquidity conduits, shadow banking and a comprehensive picture of modern financial "innovation" has rapidly become second to none) shows, the hot potatoes are getting hotter by the minute, and are flying ever faster and higher. But the kicker: King has the best punchline on Europe we have yet encountered: "Losses are unquantifiable" Q.E.D.

There is a frequent tendency to over state the importance of the Fed and its policies and ignore the primary fundamentals driving the gold market which are what we have long termed the ‘MSGM’ fundamentals. As long as the MSGM fundamentals remain sound than there is little risk of gold and silver’s bull markets ending. What we term MSGM stands for macroeconomic, systemic, geopolitical and monetary risks. The precious metals medium and long term fundamentals remain bullish due to still significant macroeconomic, systemic, monetary and geopolitical risks. We caution that gold could see another sharp selloff and again test the support at €1,200/oz and $1,550/oz. If we get a sharp selloff in stock markets in the traditionally weak ‘Fall’ period, gold could also fall in the short term as speculators, hedge funds etc . liquidate positions en masse. To conclude, always keep an eye on the MSGM and fade the day to day noise in the markets.

Gold’s remonetisation in the international financial and monetary system continues.  LCH.Clearnet, the world's leading independent clearing house, said yesterday that it will accept gold as collateral for margin cover purposes starting in just one week - next Tuesday August 28th. LCH.Clearnet is a clearing house for major international exchanges and platforms, as well as a range of OTC markets. As recently as 9 months ago, figures showed that they clear approximately 50% of the $348 trillion global interest rate swap market and are the second largest clearer of bonds and repos in the world. In addition, they clear a broad range of asset classes including commodities, securities, exchange traded derivatives, CDS, energy and freight. The development follows the same significant policy change from CME Clearing Europe, the London-based clearinghouse of CME Group Inc. (CME), announced last Friday that it planned to accept gold bullion as collateral for margin requirements on over-the-counter commodities derivatives.  It is interesting that both CME and now LCH.Clearnet Group have both decided to allow use of gold as collateral next Tuesday - August 28th. It suggests that there were high level discussions between the world’s leading clearing houses and they both decided to enact the measures next Tuesday.  It is likely that they are concerned about ‘event’ risk, systemic and monetary risk and about a Lehman Brothers style crisis enveloping the massive, opaque and unregulated shadow banking system.

When China started tightening policy to fight inflation, almost no one thought that it would slow the economy to what China is in right now. When China started imposing ever more aggressive real estate prices curb, some people believed that that it would not make home prices drop (because there are many people in China, and urbanisation, etc), and even less believed that it would slow the economy to what China is in right now. When China started to slow down more than most thought, almost no one thought that it could be a big problem, while some thought that the slowdown was “engineered” to fight inflation.  Because it was an intentional slowdown, not many people believed that it could get much worse. Digging deeper, we have not found much good reasoning behind those who insist on the uber-optimistic case, and most bullish arguments can be boiled down: "This is China.  China is different.  Don’t ask, just buy."

Over two years ago, the US Clearing house of the CME, the world's largest derivatives marketplace, had no choice but to allow gold as collateral. Why: because as we showed some days ago, while in Europe bank deposits are expansive, in the US, financial system funding relies primarily on mythical assets as liabilities, i.e., those that exist primarily due to faith in the system, something which has been in short supply, as a result of which the $15 trillion (down from a peak of $23 trillion) shadow banking system long used to fund regular operations, has been imploding.  Couple that with a scarcity of other (re)pledgeable assets which in the US do not, unlike the UK, have an infinite rehypothecation chain, and one can see why back in October 2009 the CME had no choice but to accept gold as eligible collateral for clearing purposes. As of minutes ago, the European arm of CME Clearing has folded too, and has released a press release stating that it to0 "has extended the range of eligible collateral types to include gold bullion." Of course, this is the same gold bullion that Germany will be seeking to "repo" in exchange for sovereign bail outs as Europe's periphery continues to run out of endogenous money and has to increasingly rely on the benevolence of the Bundesbank. For now all we need to know is that another exchange just threw in the towel and admitted that contrary to Bernanke's stern position, gold is, indeed money.

Yes, we all know that Europe is in deep, deep, trouble, and we all know that Europe has a major fiscal deficit issue which is why well over half of the Eurozone is effectively locked out of the capital markets, and only has funding courtesy of various back door Ponzi schemes funded by the ECB, and we also all know that on a consolidated basis Europe's debt/GDP is very high. But the truth is that at least Europe is taking small steps to rectify its historic profligacy and is at least pretending to be implementing austerity (in some cases actually truly doing so). How about the US. Well, the chart below should answer that particular question. Because while the consolidated GDP of the US and Europe are nearly identical, they differ very materially in terms of both fiscal deficit, and total Debt/GDP. The chart below shows precisely where the differences lie between the United States of Europe and the United States of America.

Previously we explained on at least two occasions (here and here) why the upcoming death of the US money market industry is not greatly exaggerated: quite simply, as we wrote back in 2010, the Group of 30, or the shadow group that truly runs the world (see latest members) decided some time ago that it would rather take the "inert" $2.6 trillion held in money markets, and not used to boost the fractional reserve multiplier, and instead have it allocated to such more interesting markets as bonds and stocks. As a reminder, Europe already achieved this last month when it cut its deposit rate to zero leading to a sequential shuttering of money market funds. The Fed, however, has to be far more careful to not impair the overnight General Collateral repo market which as everyone who understands the nuances of Shadow Banking knows is where all the bodies are buried, and as such has been far more careful in implementing such a shotgun approach. Instead, Ben, the SEC, and the Group of 30 have adopted a far more surgical approach to destroying money markets: they want investors themselves to pull their money by implementing such terminally destructive measures as floating NAV, redemption restrictions and capital requirements, which will achieve one thing - get the end user to pull their money from MM and put the cash either into either deposits, where it can then proceed to be "fractionally reserved" into the banking system, or to boost AMZN's 250+ P/E. After all the number under observation is not modest: at $2.6 trillion, this is almost 20% of the market cap of the US stock market. So it was only a matter of time before major money market institutions, in this case Federated first, but soon everyone else, starts screaming and warning that money markets are about to die (which they are). 

The easing of credit conditions (in other words, the enhancement of banks’ ability to create credit and thus enhance their own purchasing power) following the breakdown of Bretton Woods — as opposed to monetary base expansion — seems to have driven the growth in credit and financialisation. It has not (at least previous to 2008) been a case of central banks printing money and handing it to the financial sector; it has been a case of the financial sector being set free from credit constraints. Monetary policy in the post-Bretton Woods era has taken a number of forms; interest rate policy, monetary base policy, and regulatory policy. The association between growth in the financial sector, credit growth and interest rate policy shows that monetary growth (whether that is in the form of base money, credit or nontraditional credit instruments) enriches the recipients of new money as anticipated by Cantillon. This underscores the need for a monetary and credit system that distributes money in a way that does not favour any particular sector — especially not the endemically corrupt financial sector.

While endless jawboning and threats of more free (and even paid for those close to the discount window) money can do miracles for markets, if only for a day or two, by spooking every new incremental layer of shorts into covering, there is one problem with this strategy: the "flow" pathway is about to run out of purchasing power. Recall that Goldman finally admitted that when it comes to monetary policy, it really is all about the flow, just as we have been claiming for years. What does this mean - simple: the Fed needs to constantly infuse the financial system with new, unsterilized reserves in order to provide bank traders with the dry powder needed to ramp risk higher. Logically, this makes intuitive sense: if talking the market up was all that was needed, Ben would simply say he would like to see the Dow at 36,000 and leave it at that. That's great, but unless the Fed is the one doing the actual buying, those who wish to take advantage of the Fed's jawboning need to have access to reserves, which via Shadow banking conduits, i.e., repos, can be converted to fungible cash, which can then be used to ramp up ES, SPY and other risk aggregates (just like JPM was doing by selling IG9 and becoming the market in that axe). As it turns out, today we may have just hit the limit on how much banks can do without an actual injection of new reserves by the Fed. Read: a new unsterilized QE program.

Any contrition on the part of Weill for his role in repealing Glass-Steagall might as well be an attempt to close the stable door after the horse has bolted. It’s like trying to uninvent the atom bomb after Hiroshima. Weill was the guy who — above anyone else — was responsible for the damage done. Coming out and claiming that reimposing Glass-Steagall would fix the problem is inadequate. If he wants to be taken seriously he should match every dollar he spent trying to get Glass-Steagall repealed with new lobbying funds to reimpose a separation between banks that accept deposits and the shadow banking and derivatives casinos.

Europe is once again scrambling by clutching at broken straws and juggling dead ends.  To wit: instead of actually proposing a realistic solution to its massive debt overhang, the ECB's Ewald Nowotny "said there are arguments in favor of giving Europe’s rescue fund a banking license, reviving the debate on bolstering its firepower as leaders face the prospect of a full-scale Spanish bailout." As a reminder, this is an absolute dead end that Germany and the ECB have both repeatedly rejected as implementation would confirm just how hollow the European gutted shadow banking market (you can't have shadow banking without credible collateral). Further slamming the Nowotny comment was Daiwa which called the Nowotny statetment a Red Herring and that "remarks that ECB council member sees arguments for giving bailout fund banking license "look to be just noise," Grant Lewis, head of research at Daiwa Capital Markets Europe, says in client note. Comments appear to have been off the cuff and purely personal opinion; such a move remains “highly improbable,” as Germany and ECB “implacably opposed” to this. Finally Daiwa adds that markets will soon focus again on fact that if ESM can’t be activated in early autumn, there’s no money available to bail out Spain, “let alone Italy."