There's a Very Real, and Growing, Dollar Funding Problem

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It may be an artifact of evolutionary biology, or it may just be that the human animal is a unique species, but there is no discounting just how complex human systems can become. Logic and reason do not always apply, though they are applied in trying to understand the billions of interactions that occur with both regular and irregular frequency. From understanding it is hoped, and then abused, that control can be established as a mechanism to "humanize" seemingly impersonal forces.

On April 15, 1954, for example, the community of Bellingham, Washington, was increasingly gripped by puzzled fear. As one newspaper headline declared, "Mystery Windshield Damage Spreads In Seattle And County." The same day in another Seattle-area paper, an article transcribed the curious case of two King County Sheriff's officials. Deputies Bill Randecker and Bill Forbes were dispatched to investigate windshield anomalies in a pie truck driven by Robert Nobel. Mr. Nobel had reported the appearance of windshield pits after visiting a restaurant at South 115th St. While there, the deputies claimed to observe new pits appear while they were watching.

Shortly thereafter, they radioed back to Capt. Bert Kersh that pits had then appeared on their patrol car's windshield.

There were numerous stories and rumors to that effect, complete with police reports and "verifications." After only a few days (nobody knows exactly when it started) there were some 3,000 reports of windshield damage. Over on Whidbey Island, Sheriff Tom Clark publicly theorized a connection to recent H-bomb tests. It was also speculated that the Navy's million-watt radio transmitter might be the culprit, or perhaps cosmic rays. There was a lot of attention paid to magnetism and a mysterious substance.

Orvall Jones of Bothell, Washington, reported finding carbon-like particles in the glass of his car windshield, before noting that, "I touched the hole with a tooth-pick and nothing happened. But when I touched it with a lead pencil, the particles around the pockmark jumped away." The police chief in Olympia called out the department's reserves to investigate after 150 reports. Roadblocks were set up in various towns, and even 75 Marines at the Navy station on Oak Island were mobilized.

Eventually Washington Governor Arthur Langlie telegraphed President Eisenhower, as well as enlisting scientific help from the University of Washington.

At some point, a police officer noted that damage to car windshields on lots at dealerships were limited to cars that had already seen road duty. New cars that had been idle were completely unaffected. Sergeant Max Allison of the Seattle department dryly explained that the windshield problem was, "5 per cent hoodlumism, and 95 per cent public hysteria." The perceived authority of the newspapers and police departments had given this "mystery" enough plausibility that the residents of the Seattle area were driven far outside Occam's razor to simply notice old pits in their windshields for the first time. Assigning mysterious blame was just the illusion of understanding and control, the rationalizing of hysteria under the appeal to authority.

When a large conglomerate Wall Street bank analyzed the mortgage market in 2003 or 2004, it did so with the same false premise. Investing in residential mortgages at then-record low interest rates made absolutely no sense from a conventional risk standpoint. There was simply not enough spread, even with borrowed short-term funds at then-record lows thanks to Greenspan's FOMC "stimulus." However, changing the reserve calculation a bit to obtain regulatory leverage plus repo market availability for funding leverage made it far more appetizing, even preferable.

The whole of the explosion in mortgage origination was not due to opening up the subprime class, that was a symptom, but rather stretching the boundaries of bank finance. Banks make money, in the traditional sense, on the spread between lending longer-term and borrowing shorter-term. The advent of wholesale money and the application through repo brought that potential maturity spread to its apex or extreme - short-term borrowing could be overnight, and thus the cheapest cost of funds.

The evolution that made such a spread possible was the wholesale money market. What began as a method for banks to meet required reserves in the 1920's had become a full-fledged funding mode, an acceptable alternative to traditional deposits. Adding collateral to the mix made perfect sense, since repo-ready securities were the end result of securitizations. It added another source of even cheaper funding, accompanied by complexity that was, and still remains, not well understood.

Wholesale money as it evolved after the end of the gold standard was not fully smooth itself. There were lumpy evolutions, but none greater than the transition of monetary policy from targeting broader "money supply" aggregates to interest rate targeting. Once the monetary mechanics of the Federal Reserve System adjusted fully by the late 1980's, the federal funds market, and its very close links to eurodollars, opened the door to shadow banking.

Under interest rate targeting, the Federal Reserve pledges to meet any and all demand for short-term funding to keep the rate target stable. From the perspective of a global bank, that is the illusion of control as the Fed is promising a liquidity backstop against any and all funding disruptions. There is no overstating how important that is to developing through to the mania that was prevalent by the mid-2000's. Banks were certain, under the illusion of understanding and control, that the Fed would meet the needs of the wholesale "markets" no matter what might happen. Models were invented and incorporated into risk management based on exactly that.

It never would have worked without that liquidity promise. It gave the wholesale markets the veneer of implicit promises that were needed to take on such massive risk. By the time LTCM failed in 1998, what was implicit was becoming very explicit, but hushed. The wholesale system had been run through real world testing, exhaustive it was mistakenly believed, and had come through largely unscathed. That gave banks and policymakers false confidence that the liquidity promises were real and fully durable.

While the Federal Reserve operates exclusively in the federal funds market, through its New York Branch Open Market Desk, the accounting conventions had allowed fully seamless operation through to eurodollars. Wall Street banks are fully connected to their London subs, and thus dollars were arbitraged between New York and London, tightening the links between fed funds and eurodollars. Thus what liquidity promises were made or understood in New York were believed to be fully applicable, through Wall Street, to eurodollar markets.

For a European mega-bank, then, the enticement into US dollar denominated spread-scalping was also reachable. The European bank could gain full regulatory and funding leverage in almost exactly the same way as US-domiciled banks. Global banks want to get into dollar markets simply because of that illusion of understanding and control, usually denoted by words like "depth" and "most liquid". What the banks are really saying is that they are more comfortable stretching the limits of their balance sheet capacity in US dollars than other currencies, somewhat due to the dollar's history, but very much because of that liquidity promise drilled right into the bedrock of basic monetary operation.

The European bank, however, required(s) an intermediate step that is not present at the Wall Street end. Buying US dollar assets, including mortgage securities, requires conversion of local currencies into US dollars. Fortunately, derivative markets developed right alongside wholesale money and there was also a seamless transition among currencies as well. The concept of dollar swaps was nothing new in post-gold finance, having been practiced by central banks and governments long before the gold window actually closed.

The Swiss banking system cumulatively by early 2007 had obtained a dollar imbalance of slightly more than 5% of its total asset base. That was a huge skew amounting to hundreds of billions of dollars. The Swiss banks, almost exclusively the Big 3 in those days (UBS, Credit Suisse and Swiss Bank Corp), accumulated US dollar credit assets that were funded by short-term rollovers in eurodollar markets paired with derivatives trades. It was a complex and tangled web of modeled financial "risk" and tolerances, imbalanced intentionally because there was "certainty" in the wholesale system.

What that meant in practical terms was the entire Swiss banking system, tied together by the Swiss National Bank, was running a huge and synthetic dollar short position. Being short US dollars, even to that degree, did not seem a huge risk because the Fed had promised unlimited liquidity against its rate target.

It is not the currency denomination that creates the synthetic dollar short, however. In reality, even US banks run a synthetic dollar short simply by stretching their balance sheet capacity (the modern concept of fractional lending). Rollover risk in dollar markets is simply another expression for being short US dollars; the entire modern banking system runs on it. That has been true as long as fractional reserve lending has been around, but the manner in which it has manifested is hidden in complexity as an aspect of the fiat system where true money is absent. What is short is not dollars, but the means and mechanism of flow of ledger dollars, the digital, modern concept that passes for "money".

By August and September 2007, however, this dollar hysteria and evolution was finally being revealed. Liquidity was just an empty promise since even Fed officials were totally unaware of both the scale of what was happening and even that it existed in the first place. The veneer of understanding and control melted in the complexity of evolved finance; central banks clearly did not comprehend the collateral shortage nor did they really grasp the dollar shortage as either a concept or operational reality. They appealed to a minor dollar swap line implementation in December 2007, but it was wholly inadequate, amounting to little more than a token. Monetary focus was where it always was, wrongly tied to interest rates as a panacea.

By March 2008, as Bear Stearns failed, the wholesale dollar market split apart, fragmenting New York-based federal funds from eurodollars (LIBOR began trading at premium, small at first, to federal funds target and effective). At that point, the liquidity promise was effectively ended, proving to be a durable dollar problem that is yet to be fully resolved. By September 2008, the fragmentation was so large that it resulted in a massive US dollar asset dump; banks across the globe were forced by margin and collateral calls to sell US dollar assets to obtain ledger balances of "currency" or "reserves". That snowballed into more and more asset sales, expressed as a panic, something thought fully and completely impossible.

Combined in October and November 2008, foreign investors (including banks) sold $92.7 billion in US assets, net of purchases. Considering that foreign inflows and purchases of US assets had averaged $79.6 billion per month in 2008, and $83.2 billion from 2003 to mid-2007, it was a huge reversal. And it was due to the collapse in plausibility of the Fed's targeting scheme as it related to US dollar liquidity across the globe.

As long as credit production globally had been leaking into US GDP calculations through the housing bubble, economists at the Fed were conspicuously incurious about these evolutions. There were just as fooled by the hysteria as the authorities in Seattle in 1954. And because they believed they had actually created the Great "Moderation", they were consumed with recency bias and hubris, and thus incapable of looking outside their carefully-crafted intellectual bubble. What they should have seen was this transition of finance for what it was: building leverage upon policy rather than fundamental economy or even traditional notions of finance (like risk and reward).

Now, in the age of QE, we are again experiencing leverage built on policy. Dollar funding globally is again fully and completely connected to Federal Reserve promises, though no longer through interest rate targeting. QE is the promise of "visible" liquidity, a flood of "reserves" that actually exist in a computer in Washington, though intentionally idled. The assumption apparently is that markets will find this more appealing than the previous implicit promises of liquidity that proved false.

As it has throughout the "recovery" period, post-2008 liquidity is far more complex, visible or not. There have been further instances of both collateral and dollar shortages (2011), as well as continued fragmentation. But for the most part, dollar leverage has been reborn under renewed understanding and the illusion of control - QE would be a long-term process.

The talk of tapering that emerged first from hints at the March 2013 FOMC meeting, then with seemingly full official embrace in May, runs counter to market perceptions of the policy promise that the Fed painstakingly built over the past years. Thus leverage built on policy expectations are now threatened. There have been repo collateral issues, strange occurrences even, as well as the gold selloff. Dollar liquidity has been boiling and roiling just beneath the surface, but because it is so opaque and esoteric it is largely unobservable directly.

The dollar problem finally broke into the sunlight with June's TIC data. Where $92 billion in US securities were sold in October and November 2008 combined, foreign investors sold $77.8 billion in June 2013 alone. It was the largest dollar outflow for a single month in the series going back to 1978. Adjusting for unrecorded principal payments and other processes, actual outflows amounted to an estimated $85.4 billion for the month. Even accounting for the reduction in US dollar asset acquisitions post-2008 (since mid-2009 monthly inflows only averaged $59.2 billion) as global trade has not fully recovered, including the US economy's demand for imported goods as consumer spending is still a shell of its bubble levels, June's outflow was still the largest dollar reversal in history.

This is not some idle academic issue to be sorted out by the economists at the Fed. This is a very real and growing dollar funding problem as the leverage piled onto policy expectations falls apart, slowly at first. The synthetic dollar short may no longer reside in the Swiss banking system (they learned their lesson and took some brutal measures in 2008), but it still exists globally. This used to be known as Triffin's Paradox, where in a world of half-fiat, half-gold, the reserve currency would necessarily be weak and subject to runs.

In this 21st century system, Triffin's Paradox seems to apply to leverage and the synthetic dollar short. For the global system to avoid full and complete failure, there must exist this aggregate short position, extending beyond wholesale money into derivatives. The global financial system cannot function without it; therefore policy must be slanted toward fostering that dollar short with "liquidity" measures and promises (both visible and implicit). The problem now is what it was in 2007; that the liquidity promises are only as good as financial actors make them.

Mania is largely built on recency bias and the logical fallacies of both the appeal to authority and the wisdom of crowds. Humans are susceptible to cocooning inside that comfortable position where such hysteria just seems so normal and commonplace; rationalizing is far more appealing, the anesthesia of imagined stability. That false sense of security extends into human systems, particularly finance and economics. That authorities believe it too is just the power of the illusion. The massive dollar reversal in June, desperate trouble in that synthetic short, is an immense warning that the illusion is breaking down again. Hopefully some policymakers actually attempt to understand the implications this time, though I doubt at this point whether orthodox economics is even capable of the task.


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

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