Dear Steve Liesman: Here Is How The US Financial System Really Works
Earlier today, Bill Frezza of the Competitive Enterprise Institute and CNBC's Steve Liesman got into a heated exchange over a recent Frezza article, based on some of the key points we made in a prior post "A Record $2 Trillion In Deposits Over Loans - The Fed's Indirect Market Propping Pathway Exposed" in which, as the title implies, we showed how it was that the Fed was indirectly intervening in the stock market by way of banks using excess deposits to chase risky returns and generally push the market higher. We urge readers to spend the few minutes of this clip to familiarize themselves with Frezza's point which is essentially what Zero Hedge suggested, and Liesman's objection that "this is something the banks don't do and can't do."
Liesman's naive view, as is to be expected for anyone who does not understand money creation under a fractional reserve system, was simple: the Fed does not create reserves to boost bank profits, and thus shareholder returns, and certainly is not using the fungible cash, which at the end of the day is what reserves amount to once dispersed among the US banks, to gun risk assets higher.
Alas, Steve is very much wrong. And as a tangent, it is truly deplorable how many "experts" have zero understanding of just what the interplay of the Fed and commercial banks is in money creation.
The biggest stumbling block that Steve seems to have is the dramatic shift in the historic interplay in money creation pre and post-Lehman. As we showed previously, where in the Old Normal, whereas every dollar of deposits (or low powered money, or however one wants to define them), was derived from an almost 1-to-1 correlation between new loan underwriting by commercial banks (seen here), something snapped the day Lehman filed. This can be seen in the chart below.
What happened after September 2008 is very obvious, and very dramatic: there was a major disonnect between deposits sitting in bank vaults, which continued to rise dramatically, and loans underwritten by commercial banks, which tumbled until early 2011, and have since attempt to stage a very weak and modest comeback. What is undeniable, however, and what once can check easily with the weekly H.8 statement - the Weekly update of Assets and Liabilities of US Commercial Banks, is that in the latest week, there was a $2.1 trillion difference between deposits ($9.317 trillion), and bank loans ($7.237 trillion) in the US banking system.
That much is undisputed.
Incidentally, there are less loans outstanding currently than there were the week after Lehman filed ($7.275 trillion). What is irrelevant here is why loan creation has lagged as much as it has: whether it is due to more stringent lending standards (supply), or due to far lower interest in debt-funded enterprise for loans (demand). That is a policy discussion (and one, by the way, that proves undisputedly that the US economy is much weaker now than it is purported to be as end consumers and business have far less desire to risk becoming indebted even in a zero interest rate environment) and not relevant to the subject discussed in this article.
Where things get tricky for most, certainly for Mr. Liesman, is grasping the genesis of the surge in deposits over loans.
For that answer, we go to the Fed, specifically the Chicago Fed, and its 1961 booklet, Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion, which incidentally is still the best reference for everyone who is desperately confused about money creation under fractional reserve banking (although, for obvious temporal reasons, it excludes all discussion of that critical subset of credit money created under Shadow Banking, which peaked at nearly $23 trillion in 2008 - luckily, that too is not relevant in this discussion).
And while we sincerely urge anyone with even a passing interest in fractional reserve banking, especially those who break down monetary theory to three letter acronyms that spell out "socialism" to read the entire booklet, there is one line that is absolutely critical. To wit:
Changes in the quantity of money may originate with actions of the Federal Reserve System (the central bank), depository institutions (principally commercial banks), or the public. The major control, however, rests with the central bank. The actual process of money creation takes place primarily in banks.
The punchline is bolded because that simple sentence is so very misunderstood by most. It is also why historically, deposits matched loans created by commercial banks on a dollar for dollar basis. Yet as can be seen in the chart above, this historic truth broke down to the right of the blue arrow, at which point money creation was no longer the purvey of the (commercial) banks.
So who created money? Why the Fed of course, courtesy of the $2+ trillion in excess reserves injected into the financial system since the week of September 15, 2008.
This should come as no surprise: after all the Fed has "purchased" some $2.2 trillion in assets over the same time period, which have been necessarily matched by an expansion in the two main Fed liabilities: currency in circulation and reserves, as the whole point of the Fed's ongoing purchases of US Treasurys, in addition to monetizing the US deficit and allowing the US government to operate without fear of a surge in bond rates (and a bond auction failure via the Primary Dealer-facilitated close loop that is the name for each and every Treasury auction as there will always be a buyer of last resort), is to provide the necessary and sufficient "collateral" to ever expanding reserves.
And while the amount of currency in circulation has risen by a very modest amount in the past 4 years, it is the amount of excess reserves that has soared by a massive amount - virtually the entire asset expansion on the left side of the Fed's balance sheet has gone to creating reserves parked with banks.
And as expected, mapping out a chart between the expansion in commercial bank deposits since the day of Lehman's failure and the amount of assets purchases by the Fed (which is explicitly almost a 100% identity to reserves created by the Fed) explains just where the incremental $2 trillion in money creation - i.e., bank deposits by reverse identity, has come from.
Naturally, if one were to account for the money that has gone into currency (i.e. M1) instead of reserve creation, the two lines would virtually overlap. Furthermore, for those purists confused by the peculiar slump in the black (deposits over loans) line around March 2010, the explanation is simple, and once again comes courtesy of the Fed (via the G.19):
Upward revisions to revolving consumer credit are due mainly to nonfinancial business. Prior to March 2010, securitized pools contribute positively to the revisions, while corresponding declines in finance company estimates somewhat damp their effect. After March 2010, finance companies contribute positively, while offsetting declines of securitized pools estimates somewhat damp their effect. The average revision from January 2006 through March 2012 is slightly less than 3 1/4 percent of its former value, with most revisions about $27 billion above the old estimates. In March 2010, the gap widens somewhat because of adjustments for the accounting rule changes, Statements of Financial Accounting Standards (FAS) Nos. 166 and 167, which cause finance company estimates to jump by more than the offsetting decline of securitized pools.
In other words, if it weren't for the securitized pool adjustment in March 2010, the black line would have been a straight horizontal one from January until September 2010, precisely as the total Fed asset expansion would suggest it should be.
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The point of the above explanation is to demonstrate, simply and visually, that whereas deposit creation in the days before Lehman came primarily courtesy of banks, the days since Lehman have seen the Fed in the driving seat when it comes to deposit (money) creation.
At this point a tangential discussion might be required on the difference between high powered and lower powered money, or M1 and M2, but that would require a much broader dive into the mechanics of fractional reserve banking (one which will be satisfied by the Chicago Fed's booklet), but suffice to say, deposits are the fungible equivalent of money when being transacted from one low powered investment option (deposits in banks) to another (purchases of risk assets).
And, once again, like one week ago, we would have ended this conversation here because suggesting that banks abuse excess deposits for risky pursuits would be considered absolutely preposterous... if it wasn't for the stunning confirmation courtesy of that epic blunder by none other than Jamie Dimon's JP Morgan, and his Chief Investment Office (conveniently once again located in that mecca of underregulation London) implosion, just what it is that banks do with the excess between deposits over loans.
Allow us to paraphrase what we wrote last week:
Presenting Exhibit A, which comes directly from page 24 of JP Morgan's June 13 Financial Results appendix, in which the firm laid out, for all to see, just how it is that the Firm generated over $5 billion in prop trading losses in its Chief Investment Office unit - a department which had previously been tasked with "hedging" trades but as it turned out, was nothing but a glorified, and blessed from the very top, internal hedge fund, one with $323 billion in Assets Under Management! To wit:
The chart above shows the snapshot - from the horse's mouth - of how a major "legacy" bank, one engaged in both deposits and lending, decided to use the "deposit to loan gap" which had swelled to $423 billion at just JPM (blue box in middle), and led to $323 billion in CIO "Available For Sale securities."
What happened next is well-known to all: JPM's Bruno Iksil, together with Ina Drew and the rest of the CIO group (all of whom have since been dismisses), decided to put on a massive bet amounting to over $100 billion (and potentially much greater - sadly there still has been no full disclosure by either the bank nor regulators just what JPM was invested excess deposits in) in notional across the credit spectrum (the one place where a position of this size could be established without becoming the entire market, although by the time it imploded Bruno Iksil was the market in IG9 and various other indices and tranches). The loss was just as staggering, and amounts to what is one of the largest prop bets gone horribly wrong in history.
Now the JPM spin is well-known: the CIO was merely there to "hedge" exposure, as a direct prop bet would be illegal as per the Volcker Rule, not to mention the avalanche of lawsuits and the regulatory nightmare that would ensue if it became clear that the firm was risking what amount to deposit capital to fund massive, highly risky prop trading bets. Which, when one cuts out the noise, is precisely what JPM did of course, especially since the "hedge" trade blew up just as the market tumbled in the spring of 2012, a time when it should have otherwise hedged the balance of the firm's otherwise bullish posture. That it did not do this refutes the logic that this was a hedge, and confirms that what JPM was doing was nothing short of using an internal, heavily shielded hedge fund, which had $323 billion in collateral as investible equity, to trade away, knowing very well no regulator would dare touch JPM.
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Now, the conventional wisdom has always been that banks would lend out deposits: obviously something they have not done since the Lehman failure as we have been shown previously and in this post, and hence the "deposit to loan gap", and failing that, the deposits would be invested in only the safest securities - Treasurys and the like (sorry, not Italian or Spanish bonds).
Now it is possible that JPM did purchase "safe" securities, quite possibly hundreds of billions worth of bonds, or MBS, or agencies.
Did JPM transform its treasury purchases via repo into free cash, or did
it simply rehypothecate them in the bowels of the London financial netherworld where anything goes (something we know for a fact happened extensively with that other Primary Dealer
failure, MF Global) repeatedly off the books for even more free cash, is also unknown, and unclear. But that too, is irrelevant for the topic at hand. What we do know for a fact is that the firm, ultimately ended up with free, uncumbered fungible capital of some $423 billion to trade and risk at will as it saw fit.
That much is now also undisputed, and has been confirmed by page 24 of JPM's June 13 Financial Results appendix.
And none of this would have been public knowledge had it not been for the epic trade blunder at JPM's CIO. Or rather, any allegations that JPM was abusing excess deposits to trade on its own prop account would be simply dismissed as further ramblings of deranged fringe bloggers.
* * *
So to summarize what we know:
- We know that historically banks have created money (both low and high powered) and specifically, deposits, via loan creation. This process broke down in September 2008 when loan creation by commercial banks effectively ceased.
- We know that in the aftermath of Lehman, the Fed's reserves were the source of the money used by banks to boost their deposits, either by traditional or shadow bank transformation pathways, even as loans remained stagnant, and are now, nearly 4 years after Lehman, at a lower level than they were in late September 2008.
- We know that, as JPM has explicitly admitted, at least one bank has used the excess deposits over loans to engage in risky activity, and to trade on its own prop account, on at least one occasion, with a loss potential as large as $5 billion, and potentially far greater.
What We don't know how many other banks are using excess deposits to engage in risky activity, which may range from selling credit CDS (single name or index), to buying equity ETFs and REITs (like the Bank of Japan openly does), to buying outright stocks, to even buying real estate, or any other activity which obviously continues to be unsupervised by the Fed, especially in offshore jurisdictions (London).
So, dear Steve Liesman, now that you too know just who is funding the surge in deposits, and now that you too know, that bank(s) are directly taking advantage of this excess deposit pool to trade for their own account, perhaps you can ask the Chairman during his next press conference, what happens to internal bank hedge funds when the Fed starts unwinding its QE and by implications, results in a drop of at least $2 trillion in excess deposits over loans (a number which will likely rise to $3 trillion by the end of 2013, then $4 trillion by the end of 2014 and so on). But certainly ask him what would happen if instead of using excess deposits to invest in the S&P 500 (or Russell 2000 as the case may be), the banks were to lend said money out, and how far would the stock market plunge as a result.
Because, oddly enough, there are some people who are misguided and believe that the Fed still has some capacity to tighten, or even stop expanding its balance sheet, without destroying that house of cards - the S&P500/Russell 2000/DJIA - it has so carefully and lovingly created over the past 4 years.