Excess Liquidity Eviscerated Our Economy

Friday, 27 Sep 2013 08:15 AM

By Barry Elias

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Accommodative monetary policy enabled excess market liquidity that eviscerated our economy.

Following the Clinton financial deregulation, an extraordinary amount of credit was provided to banks using high-risk mortgage-related debt as collateral. In 2008, the prices of these collateralized instruments plummeted, resulting in the financial crisis.

The short term financing mechanism for our entire banking system is the repurchase (repo) market. Following the severe financial deregulation under President Clinton, the daily outstanding collateral volume of the repo market grew 2 ½ times, from $3 trillion in 2001 to $7.4 trillion by 2008, according to the Federal Reserve Bank. This growth led to the demise of Bear Stearns and Lehman Brothers and a severe global recession. The world economies are still reverberating from the shock that occurred more than five years ago.

High-risk mortgage-related debt was the largest category in the repo market, composing nearly one-third of the total and larger than that for U.S. Treasurys, the most stable form of debt. Due to carefully camouflaged risk, these financial derivatives ultimately suffered substantial capital losses, ranging from 8 to 40 percent, in a very short period of time, reports the Federal Reserve Bank of New York.

This debt was overrated by rating agencies, such as Moody's, Standard & Poor's and Fitch, to ensure a stable relationship with their clients. This conflict of interest arose when the agencies received fees for advising clients while rating their securities at the same time.

'"It was a very unstable form of funding during the crisis and it is still a problem," said Sheila Bair, former head of the FDIC, and chairwoman of the Systemic Risk Council, a nonpartisan group that advocates financial reforms, according to The New York Times. "The repo market is also highly interconnected because the trades are done between financial institutions."

Fortunately, the repo market has been getting smaller.

The recent Federal Reserve purchases of mortgage-related debt and U.S. Treasurys have caused the repo market to fall in volume, with the central bank owning roughly 17 percent of the market, Bloomberg reported. In addition, the turnover in U.S. Treasurys as a multiple of total outstanding debt has declined from 20 in 2008 to approximately 12, based on the Treasury Borrowing Advisory Committee's report to the U.S. Treasury cited by Bloomberg. As a result, the spread differential to buy and sell Treasury future contracts by dealers has doubled in the past five years following Lehman's bankruptcy.

"We are seeing financial institutions rely on more stable [long-] term sources of capital, such as debt and equity, rather than repo [overnight] financing. In fact, the vast majority of remaining risk in the repo market is against United States Treasurys, the most liquid instruments in the market today," Brian Ruane, executive vice president for tri-party rep services at Bank of New York Mellon, wrote in a letter to the editor of The New York Times.

Bank of New York Mellon is the largest repo clearing institution. "Repo is the last over-the-counter market that's not headed toward central clearing and the Fed should mandate a change. Should a large dealer have a problem or the clearing banks have an issue, the repo market could shut down," Peter Norwicki, the former head of several large bank rep desks, told The Times.

Despite these positive signs, the repo market remains 50 percent larger than it was in 2001 when Clinton deregulated the financial industry, based on data provided by the Federal Reserve Bank.

The malfunctioning repo mechanism developed over several decades — a rather stunning, irresponsible undertaking that had a devastating economic impact, which continues to this day. While risk has been reduced, as seen with wider spreads, the process of deleveraging has further to go.

Over the past three or four decades, the economic focus relied on financial asset turnover instead of long-term investment in real products and education. We now experience a shortage of skilled labor in a sea of underutilized capacity. It may take several decades for our economy to develop the labor force and entrepreneurial architecture to produce cost-effective products that add value to society.

Increasing the quantity of cost-effective goods and services would permit sustainable income and economic growth that protect purchase power parity.

Ironically, less readily available credit would permit a more prudent lending landscape that benefits the entire society in the near-, medium- and long-term.

© 2014 Moneynews. All rights reserved.

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