Central Banks Have Run Out of Excuses
My own interest in the monetary system began in earnest about twenty years ago. I remember clearly reading through JP Morgan’s 1997 Annual Report and being teased into pulling on a loose thread. Of course, the bank was known then as Chase Manhattan, and my interest in it was at first researching its stock. I expected to find a bank, to be perfectly honest. Maybe that was just naiveté on my part, because what was in that book (they were printed back then) didn’t seem to qualify as one; at least not in full.
The audited financial statements were familiar enough, though there were several pieces that intrigued. On Page 26 deep within the notes to those statements, Chase reported its segment income and operations results for its Trust, Custody, and Investment Management division. It had done well here in 1997, with fees rising 11% from 1996.
On its own, that didn’t seem out of line with the environment of the time. After all, it was the dot-com era and this particular part of Chase included investment management services (trust) that were derived strictly from the duties of a custodian. Asset management was a booming business.
But that wasn’t what drove the bank’s fees in this area, at least not in 1997. Almost all the growth came from its institutional trust business, particularly “expanded securities lending activity.” It was this that caught my attention and the world has never really been the same for me since.
The reason I paid it so much notice was simple: I had never really heard of “securities lending.” There was, of course, that kind of activity in simple stock trading whenever anyone shorts a particular stock. But this wasn’t that, it was so much more.
That pursuit started with what was immediately in front of me: the rest of Chase’s 1997 Annual Report. I combed through all its pages looking for other references to, and mentions of, securities lending. On Page 43, in the section on “Accounting and Reporting Developments” the footnotes referenced SFAS 125 and SFAS 127. The latter was issued in order to defer some requirements of the former. And all Chase’s document said with regard to SFAS 125 was that it, “relat[ed] to repurchase agreements, securities lending and other secured financing transactions.”
Here I have to depart from memory because in those days there was no internet, or at least not as we know it today. Right now I can google SFAS 125 and within microseconds the full text is at my fingertips. Not so back then. I had to go on with what material I had available, scouring research reports and other official (print) filings in order to just tease out pieces of what all this was.
That was no easy task and not just from the standpoint of what limited information was readily available, more so because all this stuff was so far over my head. The more I investigated securities lending and repurchase agreements related and unrelated to SFAS 125 the less I felt I knew. I’ve been told many, many times by people first introduced to these things (often by what I write) that they feel as if they are drowning or have been hit with a firehose of foreign concepts. I can sympathize completely, because I have been there.
Accounting rule 125 wasn’t really that big of deal in and of itself. What was, and what stuck with me all these years since, is why it was being delayed. It was issued by the Financial Accounting Standards Board (FASB) in December 1996 to help clear up inconsistencies surrounding how banks accounted for things they owned, or might not own. As the Chase Manhattan report noted, it would not become effective until calendar year 1998.
To most people, clarifying ownership is an almost ridiculous proposition, as it seemed to me at the time. Capitalism is at its core about property, and a bank as a bank is supposed to be under the constraints of property at least starting in a constructive bailment. I give it my money and the institution custodies it on my behalf. What it does in that custody on its own behalf is this stuff of footnotes and unclear conventions.
That’s not the really weird part, though. When you dig further into it, and what it took me a long while to finally figure out, is that all these things needed to be addressed because there was this whole other world taking place. What the accounting conventions were trying to do was keep up, but only with the tip of the iceberg.
The FASB was not rewriting accounting, merely trying to adapt along with banks to account for as much and as best as possible. In truth, traditional accounting statements were not made for securities lending and dollar rolls. Accounting standards weren’t really falling behind, they were inappropriate.
The problem with implementation of SFAS 125, according to the banks, was that it required assessing too much all at once. That’s why it was delayed with SFAS 127. Think about that for a moment. The point of the rule was to make clear ownership and to account for it.
“This Statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a financial-components approach that focuses on control. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished."
It is nearly absurd. I give you money and you as a bank create a liability. You give me back that money and the liability is extinguished. But in a world where repurchase agreements dominate and securities lending is an important part of that domination, who really owns what, and how?
As I said, what really captured my attention was that these transactions were no niche effort, some small out-of-the-way corner of Wall Street that had come to be a minor nuisance. Here’s what SFAS 127 declared as its reasons for delaying 125’s rules for ownership:
“The Board was made aware that the volume and variety of certain transactions and the related changes to information systems and accounting processes that are necessary to comply with the requirements of Statement 125 would make it extremely difficult, if not impossible, for some affected enterprises to apply the transfer and collateral provisions of Statement 125 to those transactions as soon as January 1, 1997. As a result, this Statement defers for one year the effective date (a) of paragraph 15 of Statement 125 and (b) for repurchase agreement, dollar-roll, securities lending, and similar transactions, of paragraphs 9-12 and 237(b) of Statement 125.”
If there was this hidden monetary world the FASB was trying to help illuminate, it was an enormous one. Using what limited tools I had available to me at the time, it was a frustrating and slow learning process.
Because of that, I tried on several occasions to enlist the aid of some people who were sure to know what I couldn’t figure out. One of those was in 1998 or 1999, I can’t remember exactly as my specific memory isn’t as crisp as a google search.
Working in Buffalo at the time for a small RIA, and being still relatively new to the business, I belonged (as a junior member or alternate or whatever kind of secondary membership they had) to the local CFA society. For one of their meetings they had invited the head or chief economist from one of the big wirehouse firms (I won’t say which) to make the trip upstate from NYC.
Given a chance to speak briefly with him, I asked about these repurchase agreements and securities lending deals (didn’t get into dollar rolls because I remember thinking that was too far beyond my limited capabilities at the time to even make it worth asking and hoping for an answer I was sure to misunderstand). As I was describing my findings, I could tell by his demeanor that he didn’t have any idea what I was talking about. The more I questioned him, which wasn’t all that much, the more he inched and nudged himself away from me toward someone else in the room; anyone else in the room.
Finally, to be done with me, he blurted out some variation of, “that’s Alan Greenspan’s concern.”
The really sad part is that I actually believed him. We all did in those days. Greenspan was the Maestro, the master of money and coin. The people working in the financial services industry, myself included, really felt for a very long time that we didn’t need to know a single thing about securities lending, SFAS 125, dollar rolls or whatever else because surely he did. He would take care of that part so that we could focus on analyzing the balance sheet numbers of the next big dot-com thing.
That wasn’t really true, however. It wasn’t ever true. And if we had been paying more attention, we would have known that it wasn’t. It is easy now in hindsight, though not so easy because even today many if not most people still don’t realize it. Greenspan himself expressed on many occasions grave doubts about his ability on behalf of the Fed’s capabilities to be able to accomplish anything so consequential.
I’ve recalled in this space many times those fragments of speeches and discussions when placed in this kind of context leaves you with no other interpretation. And I’ll keep doing so because it matters just that much.
“The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition.”
Not only was money changing, it was in a sense disappearing into these footnotes. That is what shadow banking really was; not shadows but lengthy and incomplete details all mixed together with no governing principles or properties and recorded haphazardly off to the side in the parts nobody ever really read. The FASB was fighting not a losing battle, but a war with evolution that it could never win. The term “off-balance sheet” doesn’t even begin to describe it all.
What Alan Greenspan said quoted above from the June 2000 FOMC policy discussion (about, quite appropriately, Humphrey-Hawkins and its requirement of the Fed to produce money targets) wasn’t quite true, either. He claimed without any noted objection that the US central bank didn’t believe it could define or measure this vital economic tool. But they could have found money in June 2000 if they ever bothered to really try. They only needed some small affinity for the annotations and appendices to break out of their ideological bubble.
A lot has happened in the seventeen years since that statement, almost all of which relates to that statement. There was first the global asset bubbles built on credit of (to economists) some unknown origin (called the “global savings glut” if only to further disguise Greenspan’s various prior doubts and contemporary conundrums), and now a global economy that appears otherwise as if to have forgotten how to grow. In the middle, an interbank panic that ten years after it authorities still don’t seem to have quite understood much about it.
That isn’t as uniformly true anymore. Though the world’s central bankers have tried often desperately to take the money explanation off the table, the pitiful state of the global economy demands no such constraints on investigation. Federal Reserve officials in particular can claim that they did all in their power to create and nurture healthy liquidity in dollars (QE’s and more), but even Fed staff in 2017 are under less of an obligation to simply take their bosses at their word – especially considering all the evidence continues to point to monetary “tightness” of some kind as the (repeated) answer.
To that end, other official outlets have removed themselves from these philosophical limitations. The BIS in its Quarterly Review for September 2017, just released (and a serious thank you to M. Simmons for flagging this), makes at the outset of one article the following admission:
“Every day, trillions of dollars are borrowed and lent in various currencies. Many deals take place in the cash market, through loans and securities. But foreign exchange (FX) derivatives, mainly FX swaps, currency swaps and the closely related forwards, also create debt-like obligations. For the US dollar alone, contracts worth tens of trillions of dollars stand open and trillions change hands daily. And yet one cannot find these amounts on balance sheets. This debt is, in effect, missing.”
It’s not debt that is missing; it is money in the purest sense of the word. I call it eurodollars because what was off in the footnotes of the 1990’s era bank reports wasn’t limited to US banks conducting these kinds of transactions with other US banks, or even US banks with foreign banks. What I found out was that in most cases these dollars or really “dollars” were changing hands without any tangible connection to the United States whatsoever.
The initial eurodollar was an actual deposit of actual dollar bills of some unknown origin in an offshore location, primarily Europe as the name suggested. By the nineties it had become so much more than that that there were no dollar bills, less of deposits, and not even so much just Europe. It was a global system of monetary exchange that didn’t fit on any accounting statement because the money it used was whatever form of bank liability one bank could dream up another bank would accept.
What all these institutions were doing was trading liabilities back and forth of all kinds to shape and mold their balance sheets in whatever fashion they could get away with. It sounds ludicrous, where any bank’s balance sheet is governed to some huge proportion by what isn’t on it. The balance sheet was created in the first place so that everything any business could ever do would be included. Whoever developed the first one would never have dreamed of the eurodollar system.
For the record, the BIS calculates perhaps $13 to $14 trillion of this “missing debt” exists outside the US, hidden off in the shadows of global footnotes. That’s on top of the $10.7 trillion in offshore debt that is recorded. What supports all that? Where does it come from? The footnotes.
It’s surely far more than that, too, given that this particular study is limited in its scope to just FX and derivative transactions like it. How does one calculate, for instance, the effects of negative securities lending parameters on global collateral flow? Or, the VaR effects on capital or risk budgets for any bank’s balance sheet deriving from interest rate swaps, or more so changes in their price and availability? The net result of all that might make the difference between $14 trillion hidden and a pitiful global economy, and $20 trillion and actual recovery; or $5 trillion and a repeat of something like 2008. It’s not missing debt so much as monetary math that no balance sheet was designed to catalog.
The most important statement the BIS report makes is in many ways a simple one that requires no special knowledge to intuitively accept. It is the same as my own journey of investigation where for a very long time I was told repeatedly that this wasn’t money or even important, but I could see that it was on both counts by what followed from it.
“These transactions are functionally equivalent to borrowing and lending in the cash market.”
Two banks that exchange a basis swap, for example, report only the value of the basis swap on their accounting statements. Functionally, however, you can see that there is so much more to it than that limited expression. A monetary result happens at both ends. Tradition requires that we focus only on the ends, or really parts of those ends, rather than the swap itself that puts those ends together. It is that piece of balance sheet capacity, not the balance sheet itself, that matters in the modern eurodollar system.
The biggest objection I always get in claiming that the monetary system is to blame for, well, almost everything is this idea that there is no possible way that authorities weren’t on top of all this from Day 1. It’s the Greenspan fallacy whose legend dies hard. I admit that on first experience it sounds insane, making the charge that there is and was this whole other monetary system, and more than that for half a century it was what really mattered. It strains all sense of propriety and the notions embedded within us for institutional control; it is directly contrary to what we have been told by all the right people starting with every economics professor teaching. It was a great impediment to me, too, because I doubted myself all those years with, “this can’t possibly be real, can it?”
Yet, here we are with central banks run out of excuses and the more people look into the matter the more they suspect the shadows, too. And why wouldn’t they? The word itself understates the size and more so the scope of what has gone on, and what is still going on. Janet Yellen as Ben Bernanke says there is no reason to suspect the monetary system for what ails the world. She does so from the position of what is on the accounting statements.
The idea of “missing money” was first raised in 1976 by economist Stephen Goldfeld. The money wasn’t ever missing, though; it was only missing from the official calculations and statements for economists who at the time didn’t consider these new things like repurchase agreements as money. And though they have come to accept repos as such, that one evolution in monetary arrangements wasn’t the last; not even close. For economists and Fed policymakers, the missing money wasn’t ever found; they just decided instead that it wasn’t really that important to go looking for it.
How about now?
