Money Was Ignored, and the Global Economy Is Ill
The world of the eurodollar system exists primarily in the footnotes. The accounting conventions in place today are tailored for a time that has long since been passed over; more than once. Balance sheets are some good measure of a company doing business in the real economy, though they are practically worthless when applied to the high monetary finance of the late 20th and early 21st centuries. The term "off-balance sheet" may have entered the public consciousness with Enron, but it was just the first visible emblem of eurodollar era fuzziness.
To this day, people still have great difficulty understanding why the Federal Reserve went to so much trouble with AIG. The bailout of the business wasn't really a bailout at all, and coming in the middle of September 2008 it was already curious that monetary policy specifically singled out an insurance company by which to enter the credit default swap business. On September 16, 2008, FRBNY was authorized to lend $85 billion to AIG in a two-year revolver at the seemingly punitive rate of 3-month LIBOR + 850 bps, with a 350 bps floor for the 3-month rate. In exchange, however, FRBNY was granted equity participation notes which were really warrants giving the Federal Reserve 79.9% effective equity control.
That was only the initial rescue, as the government ended up adding on a lot more before it was all over. It is a sharp contrast to what had occurred with regard to Lehman Brothers. And we must not lose sight of the fact that one followed the other and both just over a week after the GSE's were placed into conservatorship, as all these elements are tangled together, often impenetrable as well as inseparable. Lehman, AIG, or any of the others were just what broke above the surface.
A bank run people understand even today even though it is more relic than real. There was Northern Rock in September 2007, but by and large no threats to physical dollar supplies emerged - ATM's remained fully stocked and free of the "queues" which felled the UK bank. But to find Fannie and Freddie being nationalized, then Lehman, Merrill Lynch, AIG, etc., all careening toward some kind of gruesome outcome and all the same time, there was obviously too much going on where nobody could make much sense of it.
The answers start in the footnotes. In AIG's 2007 Annual Report filing, the company reported on Page 33 deep within the recesses of so much mind-numbing but relevant minutiae that it had written $527 billion, more than half a trillion, gross notional exposure into its AIGFP subsidiary super senior credit default swap portfolio. While that should have been enough of a wake up on its own, it was the disposition of the portfolio that truly starts to explain the hidden panic of 2008. Of that $527 billion gross notional, AIG detailed that $379 billion "were written to facilitate regulatory capital relief for financial institutions primarily in Europe."
The key words in that one sentence, "regulatory capital relief", coupled with the staggering balances related to them and the "primarily" European nature start to illuminate the real monetary issues. I don't want to get caught up in the inordinate complexities related to either super senior mortgage structure mechanics nor those of "regulatory capital relief", rather the general, overall point of the endeavor was to make European bank balance sheets more efficient in capital terms by changing the risk-weightings on assets to which any of AIG's written CDS would be applied. In broad terms, AIG was helping European banks' assets appear to be less risky so that they could be specified as such in the regulatory framework of Basel II, leading them to be able to hold (vastly) more assets for a given amount of "capital."
In many ways especially in hindsight it all sounds like a farce, a con. There was, however, far be it for me to defend the practice, legitimacy to it in terms of intent but also history. The practice on Wall Street (as representative of this kind of behavior that occurred well beyond strictly American banking, indeed often pioneered by European banking as AIG helpfully points out in its downfall) was to take innovations that were in isolation good ideas and develop them to dangerous extremes. Such was the case with securitization itself, which gave us super senior tranches of often subprime mortgages to be converted into less risky perceptions in the first place.
The reason that this could ever develop in taking on massive, truly impractical proportions was itself a product of the eurodollar system that qualitatively expanded the boundaries of money and finance. The real monetary limits were pushed into the footnotes by a rigid regulatory structure that from monetary policy on down remained incurious as an intentional act. The Fed had its federal funds rate lever which is all the FOMC ever wanted, so whatever else was occurring in the great beyond was believed to be still within the reach of Greenspan's quarter-point moves. If there is farce to the monetary story, that is it; the true con of the Great "Moderation."
AIG was highly rated. Therefore, in the math of Wall Street and London "dollars" that was enough. Highly regarded ratings agencies had done their own math and come to those conclusions because everything ran on statistical probability models of losses and prospective losses derived from expected volatility spectrums. In a world where the math assumes a highly rational and "accommodative" central bank possessing great power and flexible authority there is little expectation for volatility. The real world proved much different.
In just this one specific instance of AIG's activities up to 2007 and 2008 we can trace the general outline of the hidden monetary collapse. As AIG's exposures to mortgage products of all kinds were questioned, not in actual losses but increasing modeled probabilities of them (ironically created by the prices of super senior tranches that were tied to credit default swap spreads written on various ABX-type indices), the company faced liquidity problems and then ratings downgrades (and often just threats of downgrades). When nobody questioned AIG's credentials in writing CDS for "regulatory capital relief" it was all a smooth almost automatic (which was the problem, it was so easy and plain habitual nobody ever thought about it) process of balance sheet expansion. Once their contracts were doubted, again without any need for actual losses, balance sheet capacities among AIG's counterparties, Europe and everywhere else, became much more murky.
Misgivings about bank balance sheets are doubts about modern money itself. Why did the GSE's fall into conservatorship? Why did Lehman go? What about Wachovia or Merrill? There were no bank runs in any of them, but there was systemic balance sheet contraction due to factors that are still misunderstood today. Why did the Fed appear to be bailing out the world, though "primarily in Europe", with unlimited dollar swaps by October 2008? Global "dollar" balance sheet capacity was and so far remains the true global reserve currency. And, it needs to be repeated, those dollar swaps didn't work; the system experienced another liquidation in early 2009 even after they were active monetary policy along with by then ZIRP.
Whereas Greenspan's quarter-point federal funds moves were the great farce of the eurodollar buildup, central bank balance sheet expansion is more than its equal on this side of the systemic divide. Because private balance sheets are shrinking around the world, it does not follow that the Fed's expansion of its own is a substitute. Even if it was, there are still great and dire uncertainties surrounding the "right" quantity especially since so much of the contraction was done and continues to be done in the footnotes. Despite the name "quantitative easing" it is abundantly clear by now the monetary models just picked some round numbers; there was nothing truly quantitatively intentional about them.
The real matter at hand, though, is the "easing" part. To even arrive at that term we must simply assume that central bank balance sheets in expansion are near perfect substitutes to private bank balance sheets in contraction. They are not; not even close. As the example above illustrates, there are far more functions to be had in global "dollar" money dealing than straight "cash" (quotation marks deserved) liabilities created through the narrow channel of purchasing bonds from primary dealer banks. And though the Fed essentially absorbed a good part of AIG's troubled portfolios through the Maiden Lane funds, it was not at all the same as taking on AIG's continuing capacity to provide "regulatory capital relief."
Global bank balance sheets have to adjust to a world where capital efficiency is no longer so automatically favorable in its pliability. We can argue whether or not that is a good thing, and I believe wholeheartedly that it is, but that is not the issue facing us today. That would be Step 2 in the process, where Step 1 is making sure there is a suitable alternative in place. In other words, it is only a half measure because the capacity for money growth in lieu of the old ways was never conceived of beyond generic central bank balance sheet expansion. To be successful, monetary policy had to be right about both the quantities of its money offsets as well as just how much of a substitute they would be.
The fact that central bankers gathered last week at Jackson Hole largely to talk about developing new monetary tools is rather startling proof that even central bankers realize, to some relative degree, they were wrong on both counts.
The damage has already been done, however. It's not just that a more developed monetary sense would have perhaps provided a better platform to respond to the events of 2008, but more so that realizing the full range of the eurodollar (geography as well as qualitative expansion in these footnote-type functions) could have been the starting point to replace it with a truly stable format where good ideas can flourish while constrained enough never to stray so far into the hidden and nonsensical. Instead, we are left with nearly a decade of lost economic opportunity that is increasingly problematic all over the world; Brazil recently providing the great service in its hosting of the Olympics of being a visible example of such "dollar" depression.
The Brazilian economy is perhaps the perfect example of this monetary strangulation taken to its (so far) most extreme case. In broad terms, it began to suddenly and "unexpectedly" collapse in early 2014 and despite two and half years of ample time for any usual, cyclical turnaround to develop the economy has instead continued to sink month after month in a slow churn of confusion and increasing chaos.
Brazilian industrial production, which includes activity in its vast resource and export sector, absolutely surged starting in the middle of 2003. From June 2003 to June 2008, IP jumped 35% in just five years. By comparison, industrial production expanded 34% total in the eleven years prior to that month from the trough after the country's chronic monetary issues of the 1980's. It was believed to be yet another emerging market economic miracle, not unlike or even unrelated to China's.
Such wealth creation was supposed to act as a permanent buffer against the kind of retrenchment now taking place there. Since the summer of 2013 and the dramatic selloff of taper drama that included currency systems around the "dollar" world, Brazilian industrial production has declined by an unthinkable 22%, falling to a level equivalent to early 2003 before its "miracle" truly got started.
In the world of central bank balance sheet expansion, this makes no sense. The most economists will come up with is that Brazil has its own problems and a history of them. In the reality of the eurodollar system, however, there is no need for such non-specific fuzziness; as Brazil's economy was rising rapidly, so was AIG's credit default swap portfolio. Indeed, it was far more than AIG and thus far more than "primarily in Europe." Bank balance sheets were expanded throughout the eurodollar world in visible size but also through the footnotes obscuring various multi-dimensional functions, and one result of such balance sheet expansion was the economic "miracle" in Brazil.
It was also during this period that Mr. Greenspan was undertaking his final act of futility as Chairman of the Federal Reserve. While continuously raising the federal funds rate for two years, intending to "tighten" monetary policy, this runaway expansion in eurodollar system behavior took absolutely no notice. The Office of the Comptroller of the Currency reports that in Q1 2002 there were about $400 billion in gross credit default swap notionals throughout US banks (but primarily concentrated in just four). That was actually the first quarter they reported on CDS, suggesting there wasn't even much interest in them or market for them prior to that point. By the middle of 2003, that total had doubled to $800 billion.
From there on, CDS exploded to Europe as well as all over the world. While Alan Greenspan thought he was tightening monetary policy, global bank balance sheets were being inundated with hedging capacity and some unquantifiable plethora of "regulatory capital relief" in so many forms. OCC figures show that by the time Bear Stearns had "failed" toward the end of Q1 2008 the total gross notional reported by US banks was $16.4 trillion. The BIS estimates similar proportions in its global breakdown in more than just dollars: rising from $6.4 trillion in December 2004 (the first time CDS was included in the derivatives report) to a peak of $58.2 trillion at the end of 2007, just three years (and how many "rate hikes"?) later.
Greenspan and Ben Bernanke tried to reconcile this disparity by assuming some "global savings glut" when in reality they were just proving and demonstrating their own monetary ignorance and criminally rigid ideology for posterity's sake. The initial panic and monetary collapse during 2007 and really 2008 was not as eurodollar "things" like CDS collapsed, rather the great panic that mimicked the properties of bank runs came about because of the sudden and shocking lack of continued growth in them.
Knowing now that global bank balance sheet factors are not nearly so kind as to permit wild and unbridled expansion, Brazil's economic chaos isn't so much of a mystery, particularly as it relates to its currency. The falling real is not some devaluation tactic to restart its contracting export engine, it is indicative of the wholesale, eurodollar reality of an increasing and actually tightening "dollar" shortage (Brazil must "pay up" to attract what it needs of the dwindling "dollar" balance sheet). The lack of global balance sheet capacity is on display almost anywhere you care to look, meaning that unlike economists you have to set aside QE and central bank balance sheet expansion as nothing more than the inverse farce to Greenspan's similarly ineffective "tightening."
From negative interest rate swap spreads to negative cross currency basis swap premiums, especially with Japan and yen (a big clue), these are all indications of hidden balance sheet constraints that are serious in their own right but cumulatively add up to more than suggest global money problems. With such massive imbalances offered at each, they are essentially a leveraged invitation to "free money" in anyone wishing to take on the trade. I wrote in mid-March as the yen basis swap acted up (and, not coincidentally, dollar repo markets went crazy with a surge and level in repo fails not seen since 2009):
"The negative yen basis swap acts like leverage where even yields on the interim ‘investment' are negative. Any speculator or bank with spare ‘dollars' could lend them in a yen basis swap meaning an exchange into yen. Because you end up with yen you are forced into some really bad investment choices such as slightly negative 5-year government bonds, but that is just part of the cost of keeping risk on your yen side low. Instead, the real money is made in the basis swap itself since it now trades so highly negative. The very fact of that basis swap spread means a huge premium on spare dollars; which is another way of saying there is a ‘dollar' shortage. Because of the shortage and its premium, you can swap into yen and invest in negative yielding JGB's in size and still make out handsomely. There has been, in fact, a rush of foreign ‘money' into Japan to take advantage of this dollar shortage; the fact that there has been such enthusiasm and it still has not alleviated the imbalance proves scale and intractability."
In the nearly six months since I wrote that, yen basis swaps pushed even more negative, hitting new records toward the end of July. Where are all the banks that should be arbitraging this trade down to normal again? There are those who have been doing so, of course, as JGB yields had declined sharply (meaning more negative) as basis swap premiums became even more negative. The yield on the Japanese 10-year government bond was nearly -30 bps during the worst of it, three times the NIRP "penalty" rate, thus further demonstrating that "dollars" are the determining factor not Bank of Japan yen policy.
The end of the Japanese record negative basis swap (to this point, anyway) came about, ironically, as the Bank of Japan disappointed so many economists and "investors" betting on something like the monetary helicopter. Rumors throughout July had circulated that Kuroda's central bank was going to push balance sheet expansion to a whole new level (since, it is usually left out of mainstream commentary, prior balance sheet expansion accomplished next to nothing). Instead, at the end of July BoJ dashed any such hopes choosing to carry out little noticed (and, as usual, greatly misunderstood) dollar changes. The Wall Street Journal, for example, was not amused.
"The Bank of Japan was reaching deep when it decided to double its U.S. dollar lending facility. If only the program was more meaningful."
In terms of the record negative basis swaps, and thus the record negative JGB yields, it worked. The Monday after the program was announced the basis swap jumped 7 bps away from the record negative, a huge one-day move. Perhaps more instructive, the 10-year JGB yield which had been -29.7 bps and -27.9 bps in the two days before the BoJ policy announcement spiked dramatically to just -6 bps by Tuesday, August 2. It is at this point I usually remind people that oil prices which had peaked on June 8 in tandem with this renewed indication of "dollar" shortage vis a vis Japan stopped falling on August 2.
Even economists can tell something is wrong, but the world is looking only for the possibility of recession because it still follows the rules of traditional money and accounting that seek only cyclical conditions. Because this monetary problem is hidden not just in footnotes but more so in the misunderstood manner of actual function and through what is and should be carried out in real places like Brazil, the lack of recession right now is used as proof there will not be one as if that is the end of the matter. And thus every positive economic result is relayed into the further message of Janet Yellen's recovery; except, if you hadn't noticed, the global economy is "somehow" today further from it than it was just a few months ago. And from the perspective of late 2014 (let alone 2009) in what was supposed to happen, the current economy is unrecognizable at all, with a highly unique propensity toward contraction especially in goods and the global trade of goods.
It is, of course, trade where monetary availability most applies. The economy seems a mystery because mistaken views about central bank balance sheets continue to dominate. If you think QE was money printing, then Brazil makes no sense except as some vague possible tendency to always risk third world-type instability.
If, however, you see QE as the intellectual descendant of Greenspan's "tightening", then the similarities between Brazil's economy, China's economy, and that in the United States or Europe become perfectly clear and make perfect sense. AIG informed us of what to expect on both sides. There is no shortage of evidence of a systemic eurodollar money shortage that includes factors beyond just "cash." Trade goes first in monetary decay and gets hit the hardest, but nobody is spared. The only variable in money-born depression is the ultimate extent of spreading damage to which each will experience. The global economy is chronically and inexplicably ill because money was forced into the footnotes.