A Money View of the FCIC Report: Part Two


Saving the (International) Dollar

Financial Times articles being discussed: NY Fed to Expand Reverse Repo Requirements (Feb 1), Fed passes China in Treasury holdings (Feb 2)

The dissenters to the FCIC Report quite rightly emphasize the global character of the crisis, but they draw the wrong conclusions. What they miss is the global character of the shadow banking system, the collapse of which caused the crisis. (Chapter 7 is clear on this; “an ocean of money” was invested in commercial paper and repo, used to fund purchase of mortgage-backed securities.

The Report is replete with references to actions taken in order to support money market funds, starting from the very earliest stages of the crisis. (See pp. 253-54 for example.) But it never asks why those actions were taken. The answer, from a money view perspective, is that those actions were fundamentally about defending par between the international dollar and the domestic dollar, between shares of money market mutual funds held by foreigners, and domestic dollar deposits.

The origin of the ultimate assets held by the shadow banking system was of course mortgage borrowing by US citizens, but all the other dimensions of the system could be and often were located outside the US. That global dimension needs special attention. Two pieces of the system in particular were important.

First, credit risk. While China built its massive dollar reserve, invested mainly in Treasury and GSE securities , Europe accumulated the more risky mortgage-backed securities and their derivatives. The China dimension of the crisis therefore had most to do with Fannie and Freddie (the public shadow banking system, if you will), while the European dimension had to do with the fate of the shadow banking system (the private counterpart).

Second, liquidity risk. The ultimate funders of those mortgage-backed securities preferred more money-like dollar claims, and that preference was met by the expansion of offshore money market funds, which provided short term funding for the offshore shadow banking system that held the mortgage-backed securities.

It is important to emphasize that the offshoring of both of these risks was apparently approved, even endorsed, by US regulatory authorities. Risk borne by foreigners was that much less risk faced by (FDIC-insured) depositors in the regulated domestic banking system. And quasi-money supply held by foreigners was that much less money supply backed by the discount window at the Fed.

In the early stages of the crisis, the support for this offshore shadow banking system was private and the motive was profit. Money market funds investing in asset-backed commercial paper, or lending in the repo market against mortgage-backed collateral, faced potential losses if they continued to roll over their funding. And so the sponsors of those money funds took over the funding, borrowing on their own account from the money funds and lending on to the holders of the mortgage collateral, or taking that collateral onto their own balance sheets.

After the collapse of Bear Stearns in March 2008, this private lender of last resort support was backed up by aggressive public lender of last resort support through the Primary Dealer Credit Facility (PDCF) and the Term Security Lending Facility (TSLF). But after September 2008 that wasn’t enough. The Fed, in cooperation with the Treasury, took over the funding directly. The money funds got Treasury bill assets (plus an FDIC-like liability guarantee, and a discount window-like liquidity facility). The Treasury got deposits at the Fed, and the Fed lent on the proceeds to the holders of the mortgage collateral. This was the period of so-called dollar shortage.

Eventually, in 2009, the Treasury stepped out of the picture, leaving private banks to do the intermediation. Meanwhile, the Fed stepped even more into the picture by taking the collateral onto its own balance sheet, in so-called QE1 purchase of $1.25 trillion of mortgage backed securities.

This is the context, and the frame, needed to understand the most recent developments reported in the FT. Apparently the world demand for money-like dollar claims continues unabated, and if the private sector cannot meet that demand then the Fed will. That is what the QE2 program is about, at bottom; it will increase the most money-like dollar claims by $600 billion, albeit by reducing supply of the already fairly money-like Treasury securities by the same amount.

From this point of view, the reverse repo program is not so much about draining reserves lest they cause inflation. Note well that the anticipated counterparty on the other side of those repos is the money market mutual funds. The reverse repo program is therefore about letting private banks (and domestic dollar money expansion) step out of the picture in order to allow money funds (and international dollar money expansion) to take their place.

So we are apparently putting back together the international dollar system that existed before the crisis, or trying to do so anyway. The vital question of the relationship between that international dollar system and our domestic banking system going forward remains unaddressed, indeed not even asked.

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