Ghosts of Lehman And a Budding Bank Crisis

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A quirk of the 21st century banking system is that runs are now largely unobservable, hidden from the sight of the vast majority of financial participants through amazing complexity. This was entirely true of August and September 2008, as that panic was not fully unmasked for the larger population until that October when stocks finally crashed.

The disturbance in equities earlier in August 2011 was a similar notification that there is much amiss amongst the interconnected, intercontinental monetary system. It is a run on fractional money in a manner very similar to the historical, conventional notion of bank runs. But the object of the panic is not at all recognizable as what people currently conceive of as money. This change in comprehensions of money is essentially the most basic representation of all that is wrong with this still woeful financial age.

A bank run is typically believed to be a mass movement of the larger public to redeem a derivative monetary instrument for "real" money. In the 19th century version, this meant a panicked conversion of bank-issued deposit notes (paper dollars) for gold (real money). Since deposits were issued well in excess of actual gold on hand (fractional reserves) these paper instruments in times of distress would lose value in relation to that of real money. The deposit bills would trade at steeper discounts as a panic worsened and the public desperately searched for a more stable store of value. The evolving threat of potentially large withdrawals of gold from any individual institution simply meant that there was a growing probability that not enough gold would be left at that particular bank (or country) to satisfy all outstanding paper claims, leaving a large number of paper holders with nothing of "value".

In the 20th century, panics took on a distinctly different format that highlights the changing perceptions of money. Since 1913 with the advent of the Federal Reserve System, paper dollars were uniformly changed to the current dollar form that we know today. No longer would deposit dollars be plagued by panic-driven discounts; instead, with currency intentionally shifted to the responsibility of a national private banking corporation (the Fed), money would be controlled by the center. Banks would not be limited to multiplying gold reserves on hand. Instead they were capitalized (in conceptual terms) by these new national dollars - backed by the full faith and credit of the taxing authority of the national government.

Panic at the outset of the Great Depression, while still a search for a stable store of value, did not involve public demand for gold. Instead, it was the national currency that was in desperately short supply. Deposit balances at banks were wiped out with each successive banking failure, so deposit claims began to exhibit the same discounting that paper currency featured in the previous century. True money was now regarded as national, Fed-issued paper dollars.

By controlling the stock of national dollars, the Fed believed it had solved the liquidity end of panics. Whenever the public desire for paper dollars increased, or, to put it another way, whenever the discounting of deposit claims became severe enough, the Fed could simply issue more paper dollars. This amplification of dollar liquidity, known as monetary elasticity, was believed to be a barrier to wider contagion of the real economy.

This plan for liquidity was never meant to be a cure for solvency, however. Liquidity is simply the first step in a multi-pronged approach to save the banking system's capacity for credit creation. With enough liquidity from the central bank, defined in the 20th century manner of national dollars, solvency can be addressed through equity capital. Persistently low or zero interest cost of money combined with a range of policy tools to isolate problem or non-performing assets (such as the Resolution Trust Corporation formed as a "bad bank" to "resolve" the savings and loan crisis of the late 1980's and early 1990's) supply necessary first-loss equity buffers to protect the larger capital structure of the banking system, including depositors. In short, the banking system, it is believed, can be saved from itself, despite itself, by an extension of itself.

An ill-functioning banking system that leads to an ill-functioning economy is largely unable to maintain the status quo of the pre-existing monetary and credit environment. After all, the general population stirs from apathy once real economic damage is visited to the larger cohort. Isolating banks from the economy is simply the self-realization of self-preservation. And the status quo of the monetary period since 1980 has been one of maximization (to the point of domination) of the financial economy over the real economy.

In 2008, however, the cross currents of banking evolution in the wake of both Basel rules and Federal Reserve policies fundamentally altered the state of real money again. This time the Fed was unprepared for this modification as it still believed in national currency as the ultimate definition of true money and the methodology of the liquidity buffer. This was not anything that policymakers had anticipated or understood, leading to the breakdown of the liquidity firewall that nearly a century of centralized planning had enacted (especially through the careful and voluminous study of the Great Depression). The story of 2008 is still unfolding, however, much to our collective vexation.

Freed from the physical constraints of actually holding cash, Basel essentially moved reserve requirements from the asset side of the banking system's balance sheet to the liability side. Banks were no longer limited to multiplying credit from their reserves of national currency on hand. They could now produce credit and deposits from their store of equity capital. And a large segment of equity capital is retained earnings, meaning banks could multiply their own ability to create credit and leverage through using leverage on their own profitability. The status quo of the banking system has become one in which banks themselves control the levers of money creation - it is the wildest fantasies of the banking system come true.

But in depending so much on leverage, the banking system has become overly dependent on collateral. Collateral provides the lowest cost short-term operational funds while at the same time, depending on the particulars of each class of collateral, affords a reduction in the equity capital charge via regulatory definitions of "safety". A repo transaction for a bank is a collateralized loan where a bank can fund assets at that lowest cost. In terms of the overall quantity of those assets a bank can ultimately hold and turn into profits, the securities that adhere to regulatory definitions of safety lead to the lowest capital reserve charges, and therefore provide both regulatory and funding leverage.

This accounting trick of regulatory safety meant financial innovation was needed to not only transform risky assets, but to mass-produce them as "safe". Securitization of mortgage debt was one innovation widely used to create AAA-rated securities that were readily accepted as low haircut repo collateral, while at the same time using up as little equity capital as possible. The interest rate paid by the underlying mortgages and the traditional concept of risk/reward were secondary and tertiary considerations to how much leverage could be obtained and applied. Quality of assets was hardly considered in the pursuit for ultimate quantity.

The derivatives markets were also products of financial innovation designed to enhance the leveraged prospects of monetary returns, with only a loose subscription to the real economy. The ultimate goal for all of this innovation was/is to provide maximum returns through maximum leverage.

With leverage now the vital currency of banking credit creation, the key to it all is collateral. An interest rate swap or a repo transaction both require posted collateral, so to keep the leverage currency lubricated and flowing means to keep up the stock of collateral. In this important way, financial collateral is now the real money that physical national notes were in the 20th century, and gold was in the 19th. The fractional nature of leveraged lending today is predicated on the stock of collateral available to facilitate and backstop the exchange of that leverage within the global banking system.

It bears repeating that leverage has supplanted interest rates and risk/reward as the key drivers of financial profitability. In the context of this change in the ultimate goals of intermediation, it has all led to the surreal applications of what would otherwise be breathtaking innovation and genius - and to risks that have yet to be fully accounted for or even understood. Yet there has been no contrary trend to the still growing desire to "evolve" the banking system still further down the path of innovation and "progress". That is, except for the panic of 2008, which was itself an attempt at self-correction against the grain of all this risky, unquestioned modernization.

As it turns out, the fractional multiplication of collateral into leverage has taken a turn into the obscene in the absence of fulfilled self-correction. In accepting collateral from counterparties to lend out interbank and wholesale money, money-lending banks have been re-using the same collateral for their own funding needs. This process of rehypothecation is essentially another pyramid upon the derivative currency of collateral stock, itself a derivative of actual physical dollars (which are themselves derivatives of the ultimate utility of actual goods and services - a breathtaking complexity all to what end?).

A simplified example of rehypothecation is when Bank A accepts collateral from Hedge Fund B to engage in a derivative or repo transaction, exchanging future cash flows in the former or upfront cash in the latter. Now in physical possession of the collateral security, but while Hedge Fund B consistently maintains legal ownership, Bank A can re-use the same security to collateralize its own operations. The counterparty at the other end of Bank A's funding transaction is now in possession of a security that is owned by an entity other than Bank A, that has now been pledged twice.

It does not stop there. The now rehypothecated security can be further pledged (especially under British and European rules) for another collateralized transaction on down the line, including untold numbers of short sales. Just like hard money and fractional lending, this works well until enough legal owners want their actual collateral back. The IMF estimates that at the height of the credit bubble as much as $4 trillion in interbank funding was created by this absurdity of financial derivations. Even today, after some self-correction was short-circuited by the monetary policy desire to maintain the status quo, as much as $2 trillion in shadow lending is still predicated on this pyramid of illusory stability.

However, one of the prime lessons the financial system learned from the Lehman Brothers episode was that pledged collateral can often become intertwined in a counterparty's bankruptcy proceedings, especially those securities that have been rehypothecated. To this day, nearly three years after its failure, an estimated $12 billion in previously posted then rehypothecated collateral is still encumbered by multiple claims, meaning several firms have yet to see the return of financial assets that they have continuously and legally owned outright. As with every fractional reserve system, there is a pin that will prick that illusion of stability to begin the cascade of doubt that eventually leads to that destructive historical pattern of money discounting.

In the wake of Lehman, counterparties that post collateral are now more discerning about the ability to rehypothecate (Dodd-Frank is also playing a role here, but that is a lengthy discussion for another day). Any idiosyncratic or systemic variability that may make a bank more susceptible to bankruptcy will trigger a general and growing disdain for rehypothecation at the bank in question. As the ability to rehypothecate and freely transmit unowned collateral becomes limited, the operational ability to obtain and maintain vital leverage sinks.

It is operationally no different than a 1930's bank experiencing a run on its stock of national currency. The lower that level of real money gets, the shakier the perception of the bank becomes, the more counterparties continue the cycle of real money removal - physical dollars in 1930, rehypothecated collateral in 2011. The perception of risk becomes reality, and this may be exactly what is playing out today as banks with questionable exposures to PIIGS have seen their abilities to operate in wholesale money markets dwindle into this current crisis.

While the stock market finally felt the ripples of imbalance in early and mid-August, the behavior of Treasury bill rates showed signs of distress as early as February 2011. In the framework of leverage and the currency of collateral, U.S. treasury bills are the prime, most "valued" form of U.S. dollar-denominated financial collateral. If, as I propose here, banks have been limited in their abilities to rehypothecate treasury bills, that means the demand for unencumbered bills should rise noticeably since they will have to replace their use of phantom, rehypothecated securities with real bills.

Four-week bill yields began to fall in early February 2011, before recovering somewhat later in the month. By early March, right around the time the Greek-fiasco was back on the front pages, four-week bill yields had dropped to about four basis points. Bill rates had similarly fallen during the rolling PIIGS crises of 2010, but had not persisted at low levels beyond relatively brief periods.

In 2011, however, bill rates have not only stayed low, they fell to zero and even negative rates, remaining at these low levels since early June. Worse still, rates on three-month bills joined their four-week brethren at and around that zero level. At times in July and August, even six-month bills had declined to as low as four or five basis points, while one-year bills have seen rates below ten basis points. In other words, the premium on the true interbank currency has risen just like the premium real money exhibited during banking panics of centuries past.

The implications of this situation are far more profound than is currently understood. For nearly six months, the banking system has been in a chronic state of desperate malady, largely hidden from the unsuspecting public. Even economists and experts at the Federal Reserve are ignorant to the turmoil, completely unprepared for the wider consequences (confusing headwinds). In fact, as I have argued previously, quantitative easing has made the situation much worse by removing treasury collateral from the banking system and replacing it with the wrong definition of money - the Fed is fighting a battle against a 20th century bank panic.

Without a functioning collateral system, those newly created reserves can never move beyond the primary dealer network, confounding the mathematical expectations of policymakers. The Fed mistakenly assumes that liquidity is uniform in both definition and execution. Yet, if we properly define modern bank currency as financial collateral, then QE has been a monumental failure that both explains the unsolved nature of continual crises and the larger failure of all that liquidity to supply the buffer/firewall for the real economy.

The system that has evolved in the face of leverage desires and Basel rules is one that is largely unconcerned with that state of the real economy. The intersection of the banking system with the real economy is no longer about properly allocating monetary resources within the economic system's creation of productive endeavors and the use of scarce real resources. The banking system now utilizes the real economy as a template for the rehypothecation and synthesization of financial products in the overall attempt to maximize leverage within the profitable chase for ever-increasing dollar piles.

Banks do not care about the overall health of southern European governments, only whether the debt of those governments can provide the maximum amount of funding and regulatory leverage. Add to that moral hazard, and the end result is a constantly imbalanced system that has no sense of itself or its relation to the rest of the physical, tangible world.

Should we continually prop up a system that so execrates both the real economy and the economic ideal of basic credit intermediation? Is this chronically distraught banking system worth saving if its health is predicated on the continual (mis)usage of financial property that belongs to not just someone else, but more than a few someone elses? Imagine the uncertainty and fear that would reign should we see several Lehman-type failures, due to nothing more than the legal and accounting mess of untangling all these interconnected, derivative illusions. Nobody would have any idea of who really owned or was owed what.

The status quo of rehypothecation is not worth the multi-trillion dollar effort. If a banking system cannot exist without unfettered and opaque access to security collateral that it does not rightfully own (including gold and silver leasing), then the current design and framework needs to be replaced with one more suited to the far more important job of allocating scarce capital about an economic system that values productive potential - like the boring old depository institutions that have been largely forgotten by monetary policy and designs. Instead of continually forcing our collective focus toward the unproductive happenstance of securities banks, we would be better off utilizing these considerable energies toward the resolution of the far greater problems of flow in the real economy.

Capitalism is supposed to be an arrangement where monetary flow enhances the exchange of real goods and services (does anything I have discussed here even remotely center on the ability of someone, somewhere to purchase real good or services?). This current level of monetarism is the opposite of capitalism, where the desire to transact in the real economy is simply a methodology or model for acquiring and reacquiring money within the game of finance. One has to wonder how many banking panics need to be endured before a larger desire for the re-acquaintance of money banks to true intermediation is demanded. If banks cannot function operationally without rehypothecation, synthesization and the entire array of financial innovation, perhaps the real economy might be far better off if those banks did not function at all.

In my opinion, we are about to find out just how many jobs in the real economy need to be sacrificed to maintain the status quo of the financial economy and all its innovative, arranged evolutions and contortions. And it will all be very surprising to the professional class of economists and experts - perhaps the one true constant amongst historical and contemporary banking panics.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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