The 2011 Banking Crack-Up Began In 2008

It is fashionable at year's end to engage in reflection on the calendar just past, but a year's worth of contemplation is just not enough for today's circumstances. That is not to say that 2011 was uneventful, far from it. However, if we review the evolution of the banking system, especially in the past three years, I believe its trajectory becomes quite clear.

For over a year, beginning in March 2009, the financial system looked to be on its way to full recovery. Bank profits had returned, debt charge-offs and delinquencies mercifully peaked, and the wholesale money markets began to trickle funding into the illiquid desert that the global banking system had become. A lot of that profitability was illusory, particularly since the FASB had changed the mark-to-market accounting rules, but so much of the big banks' losses in 2008 were just as illusory. Investment bank assets, especially the voluminous super senior tranches of "warehoused" or backstopped CDO's, were being priced by panic in credit default swaps so prices, and therefore losses, were not based on real estimates of cash flows. In some ways, and this will bring me a lot of grief from those that believe all mortgage bonds were "toxic" - especially from those unfamiliar with correlation trading, the banking panic of 2008 was overdone due to FAS 157.

So the accounting mess of mark-to-market began to sort itself out, and the phantom losses were somewhat reversed so the accounting calculation of the equity base of the banking system could begin to heal. In many ways that is a perfect way to encapsulate the start of this recovery period since the preceding period was just as ephemeral. It wasn't just that banks were creating debt, synthesizing it from nothing and pledging it as gold-plated collateral for funding their own operations, they were also actively engaged in accounting mischief as they booked massive profits in advance through the wonders of gain-on-sale accounting (created and sized through the complex math of modeled expectations). It is not just figurative license to say that banks were printing money, both as a tool for the Fed's designs in managing the economy and for their own profit maximization.

So much understanding has been lost by the emotion of the panic period, but it should be pointed out that October 2008 was also a euro-centric crisis. The front page, headline-grabbing aspect of that panic was the rocket-like action in LIBOR rates. LIBOR measures the willingness of the big banks to lend eurodollars to each other. The eurodollar market has been the epicenter of crisis ever since. As much as conventional wisdom has pegged 2011's travails on Greece and Italy, those are just symptoms of the eurodollar plague since they never would have been so deeply indebted without wholesale, collateralized finance and interest rate targeting.

Eurodollars are probably the most misunderstood aspect of modern finance and banking. They are not really dollars, and are not really tethered to Europe by anything other than happenstance. The eurodollar market is simply the Wild West of the banking system, a regulatory black hole where regulation is sparse and lax. London is its capital because "the city" and British regulators have placed little to no restrictions on banks doing foreign lending. So the eurodollar market is, again both figuratively and literally, an accounting creation (Milton Friedman published a great paper in 1969 about how eurodollars work, and why they are nothing more than figments of imaginative balance sheets).

The reason all this lending is denominated in dollars is simply convenience. With the dollar as the world's reserve currency, it offers depth and liquidity that no other currency can match. But the primary driver of eurodollar size is (or was) the perceived stability of the U.S. and its currency. The capture of this vital wholesale market by dollar denomination was one of the biggest motivating factors for creating the euro currency - it was believed that by fashioning a dollar-alternative more created credit would actually flow into European markets as opposed to letting the US keep it all. As it is, the eurodollar market created dollar-denominated liabilities that were more often than not matched by dollar-denominated assets. In other words, global banks were funding themselves with phantom, accounting dollars and then giving out dollar loans to real obligors primarily in the U.S. Europe simply wanted a greater share of the debt party.

The advent of securitization, after the mass adoption and replication of the Gaussian copula correlation shortcut in the early 2000's, tipped the marginal balance of power toward the investment bank/hedge fund model of credit. In other words, the eurodollar market was the operational lynchpin of the housing bubble (and made European banks into behemoths that dwarf their home country's GDP, maxed out on US real estate assets). Instead of the traditional sense of lending where a bank has to acquire physical cash in its vault before looking to multiply that money as loans, wholesale banks simply create loans first then obtain funding through the phantom, accounting creations of the wholesale money markets (either eurodollars or Fed funds). Since the Federal Reserve has been committed to interest rate targeting, it actually commits to meeting any and all demand for wholesale money at whatever interest rate it has set as its target.

Accessing the eurodollar or Fed funds markets is not like buying stocks or trading bonds, however. These markets operate through the primary dealer network, the biggest global banks directly plugged into the Federal Reserve via U.S. treasury bonds. So in actuality, unlimited dollar supplies were reliant on the willingness of the primary dealers to turn those dollars they acquired directly from the Fed around to the wider banking system. The wholesale money markets are interbank markets, wholly dependent on those more directly connected to disperse any newly created funds. It has also given the big primary dealer banks an unusual concentration of power and sway, perhaps even too big to fail from the perspective of the monetary authority.

To accomplish this wider distribution of wholesale dollar dispersal often requires a second step, the posting of some form of collateral by the financial firm seeking dollars. A non-primary dealer bank will typically post a US treasury bond or AAA-rated mortgage bond as collateral to obtain dollar funding at the lowest imaginable cost (a repo transaction). Sometimes, and this was very common, that non-primary dealer bank would post the same bond, even if it was a bond held in custody on behalf of a client, as collateral for several different funding arrangements (this is called rehypothecation, and was virtually unlimited at eurodollar subsidiaries).

So the primary dealer network would obtain unlimited dollar funding directly from the Federal Reserve and disperse those dollars since there was plentiful "safe" collateral. It was thought to be a highly efficient model of mathematical precision, supposedly immune to the emotional vagaries that had plagued the physically limited systems since this would all be governed by the mathematical prowess of first the Fed, and second the primary dealers and their complex estimations and predictions.

Essentially the ongoing crisis since really 2007 has been about nothing more than a dearth of quality collateral, a development that was completely unforeseen by bank operators and monetary authorities. They were unprepared for the first, most obvious shrinkage in the collateral pool during the emotional elimination of mortgage bonds. By October 2008, banks were not only unable to secure dollar funding on favorable terms because they had little non-mortgage "quality" collateral to post, they were actively walking away from the collateral they did post! Instead of seeing the repo transaction all the way to the second leg, the borrowing bank simply kept the cash and stuck the lender with an illiquid mortgage bond that was devaluing rapidly. That the entire wholesale money markets froze completely is not really surprising since nobody knew what anyone else would do, or who would get stuck with what (or, in the case of rehypothecation in the Lehman bankruptcy, who actually owned what).

The Federal Reserve belatedly (as in after the panic) came in through its various lending programs and began accepting almost anything as collateral for short-term lending arrangements, initiating a workaround of the eurodollar and Fed funds markets. Part of that workaround was dollar swap arrangements with other central banks (at the height of panic the Fed was funding nearly $600 billion for foreign banks desperate for dollars they normally obtained from the eurodollar market). With dollars now in the hands of foreign central banks, those overseas central banks created similar workarounds by accepting all sorts of collateral from banks in their domicile.

When the Fed finally started quantitative easing to "buy up" these illiquid mortgage bond collateral assets it thought it had solved the liquidity problem, essentially buying the system time to ride the mark-to-market, zero interest rate conditions all the way back to full profitability and health. So the "normalization" of the banking system was really just the Fed acting as dollar lender of last resort, not through the Discount Window that would have proved fatal to any bank desperate enough to go there, but as wholesale money alternative that was none too picky about collateral. However, the Fed knew that the panic uncertainty would last as long as it was stuck in that role of collateral catcher of last resort, so it, with the other central banks, actively encouraged the global banking system to obtain and accept additions to the pool of "quality" collateral. Enter sovereign debt.

Nobody was terribly concerned about Greece or Ireland in 2009. With TARP and QE still fresh, the ability to repay never really mattered because bailouts were the order of the day - until someone in early 2010 finally did the math and saw that the size of that potential bailout would dwarf 2008 by an order of magnitude. Suddenly, the newly ordained "quality" collateral pool of PIIGS sovereign debt was rethought, and once again the eurodollar market was short of dollars despite trillions in liquidity created out of thin air by the Fed's balance sheet accounting. Again, the Federal Reserve never anticipated that the primary dealer network, its pet and primary tool, would refuse to diffuse money into the wider system.

This time, though, the Europeans handled it themselves by guaranteeing sovereign debt, all in the attempt to put PIIGS back in the "quality" collateral pool. It worked for awhile, especially when the Fed went all-out to devalue the dollar with QE 2.0 and in doing so boosting the failing euro, but again the math and reality intruded. Guarantees are only worth the faith investors have in them. Since every single pronouncement out of Europe has proven false (Greece, Ireland, Portugal would never need a bailout, Greek debt would never need to be restructured, Italy was safe, there is no such thing as contagion, etc.) and nobody is really willing to put up serious money and take ownership of this eurodollar overgrowth, the collateral pool has again contracted - sharply.

This year, 2011, has seen this lack of interbank currency progress far further than anyone imagined possible. Those past European guarantees are a distant memory, as interbank lending has essentially broken down completely - again. This has created a crazy dance of accounting tricks to guarantee debt without really guaranteeing debt. The EFSF was supposed to be the successful end of the crisis, as it would take a pool of "money" from various European countries and leverage it into a kind of old-school CDO. But there is something discomfiting about a guarantee where the guarantors are very much unwilling to directly participate in it, and where a sizable portion of those guarantees come directly from those needing the bailout in the first place. As the EFSF finally fell apart, and European talks changed to outright treaty changes, suddenly euros became short in supply right along with dollars.

Now we have the situation where the European Central Bank has essentially assumed the role of intermediary to the intermediaries. Banks refuse to lend to each other without sufficient quality collateral, so those with excess funds park extra euros with the ECB (a half trillion and counting). The ECB then lends out euros to those that post "eligible" collateral. This has taken a more concerning turn recently as the ECB engaged in a three-year funding program in direct contrast to the stated goals of a reluctant, passive central bank.

But even here, the collateral shortage has taken a turn for the absurd. Some of the large Italian banks, unable, apparently, to obtain eligible bond collateral on their own, simply issued their own debt, had that debt guaranteed by the Italian government, and then posted it as eligible, quasi-sovereign collateral with the ECB. Who needs markets or common sense anymore?

I think the trajectory here is quite clear. The collateral problem is not going away no matter how authorities on either side of the Atlantic try to dress up fake guarantees. The system of wholesale lending through repo is terminally broken, since both quality reputations as well as quality collateral are in short supply. In other words, the inside participants of the global banking scheme know all too well that the system pyramided far too much paper on top of far too little actual cash flow. Liquidity is not the real problem since all the worthless collateral still stuck inside the system is likely worthless because the mathematical predictions of 2005 and 2009 proved utterly inept. Those accounting notions of equity during the credit bubbles were just as phantom as the valuations of the assets that were created from it. This coming year will be just a dance or game of musical chairs to determine who gets stuck with the bill.

The problem does not just stay with Europe, though, as the shortage of quality collateral is dire in the U.S. too. U.S. t-bill rates are persistently zero or negative, indicating just how desperate banks are for dollar funding. A bank that willingly accepts negative t-bill rates just to capture some dollars in a repo is a bank that is in desperate trouble. This kind of intentional capital destruction is a sign of extreme stress, and it has been ongoing since at least April (it should be noted here that wholesale lenders like money market funds require liquid collateral since they may be forced to sell it quickly, so accepted collateral in terms of t-bills applies only to those issues that are "on-the-run", or just out of auction).

In the age of drowning central bank liquidity it should be more than a little troubling to see such a lack of it. Within this trajectory of constant illiquidity lies the dirty secret of the modern banking system. There was and is no counter-cyclical restraint for credit creation. The accounting notion of equity capital buffers is simply too easy to circumvent through complexity and complicity. So much of the financial innovation of the last few decades was focused on figuring out how to game the system, allowing the investment banks, their security-based lending system and Wall Street or its global cousins to dominate intermediation. It was all intentionally coincident with central banks' goals of artificially inflating the global economy - from Florida condos to Greek pensioners to Irish banks.

Instead of a proactive enforcement against too much credit into inefficient and unsustainable sectors, the banking system ironically is only constrained by the mess it created as it cast aside the theoretical accounting limitations. In practice, the supply (or lack) of quality collateral is the only real measure that actually serves to limit the banking system's aspirations (and why traditional, credit-driven inflation is impossible under these circumstances - inflation pressures these past two years have instead been a direct function of the devalued dollar). The amount of junk paper that was created in the good ole bubble days is now a millstone around the neck of that previously reckless system and no amount of direct intervention by any central bank can actually change that outside of hyperinflation. The shortage of collateral is too immense - especially when so much was re-used in rehypothecation schemes.

But this practical restraint is ex post facto, too late to do us much good. We would have been far better served if there were some form of restraint on lending and money creation before it all got out of hand. The modern Basel system was supposed to be a superior method, a positive evolution in monetary efficiency and progress. Instead it was a one-sided system that tilted the playing field, with a huge assist from central bank interest rate targeting, toward Wall Street and London. Just how, exactly, is this mess better than the physical restraint of actual vault cash? Or, gasp, the gold standard?

The truth of the matter, as the collateral saga amply demonstrates, is that the Basel system was nothing more than PR for disguising unlimited fractional lending. There was never meant to be any exogenous restraint on the monetary system. The Federal Reserve, in its self-appointed role of economic philosopher king, believed its own press about its acumen in controlling and managing the economy through Wall Street. What really evolved was a shift, a transfer of power from the people to the Fed. A physical system or some kind of gold standard meant that the uneducated population held the trump card, the ability to restrain banks by removing physical cash or gold. The equity standard and its digital creations that are called dollars, including those phantom, accounting eurodollars, completely obliterated the people's power in the name of forestalling those same pesky bank panics. Bankers' ages old dream of true money elasticity was finally realized by, as strange as it seems, accounting and computers.

The collateral problem was never foreseen by the mathematical "prowess" of the Fed managers or the economics profession - sadly, most of the economics profession is completely unaware of equity-based lending and the Basel system. Again, I ask just how is this system better? The only answer the elite can come up with is the Great Moderation. But just how moderate was a period that included two of the largest asset bubbles in human history? That begs the further question of just how much economic "success" of the Great Moderation was real and how much was just unrestrained credit creation?

For impartial observers the answers to those questions are obvious, in light of both the European farce and the 2008 panic that preceded and presaged it. As the progression of crisis has moved from paper asset to paper asset, from banks to countries and back to banks again, the trajectory is entirely clear. Some form of actual, exogenous restraint on credit creation will be imposed, either by someone currently in power that finally "gets it", or by a free market shaking free from the shackles of the over-enlarged financial economy and its hell-bent attempts toward unlimited money. Collateral is king in this banking world, and the rapid decay of "quality" is a testament to the intentional imbalance of finance over economy, to the hubris of modern economics and monetary "science". Unfortunately for the dreamers of true money elasticity, and too late for the rest of us, this was never supposed to happen.