ECON120: Monetary History

When Interbank Trust Failed

Long Term Capital Management (LTCM) was a hedge fund launched in 1994 with tremendous fanfare. Its partners painted a picture of perfection with their track record. They hailed from the mighty Salomon Brothers investment bank, the Federal Reserve, and included a pair of Nobel Prize winning economists. Their art was arbitrage, much like the first bill discounters of sixteenth century Antwerp upon which the money markets were built. LTCM's competitive advantage combined interest rate arbitrage, enormous amount of leverage, and carte blanche from the world's leading investment banks. However, it all ended in ruin after the fund spectacularly failed after only four years in existence. American financial journalist Robert Lowenstein titled his book about LTCM's ultimate collapse in 1998 When Genius Failed in perfect summation. That a hedge fund took oversized risk and went insolvent wasn't anything new, rather a typical cycle of boom, hype, and bust. The riveting revelation from LTCM's collapse was also the smoking gun that indicated the events of 2007 and beyond were inevitable. Shortly after the Federal Reserve bailed out LTCM's investment bank counterparties and the unwind of the infamous hedge fund itself, Federal Reserve chairman Alan Greenspan characterized the bailout as of necessity due to the prospect of a systemic collapse of the entire financial system in a testimony to U.S. Congress:

Only with the passage of time and subsequent Federal Reserve emergency actions does the gravity of Greenspan's admission begin to sink in. He confessed that the system might have collapsed had it not been for a measly $3.6 billion bailout. Why?

The answer lies in derivatives. Derivatives are financial contracts not considered securities. (Securities describe stocks and bonds for example, and derivatives describe stock options, futures contracts, and interest rate swaps). Derivatives blossomed in the 1990s as a way to synthetically expose a portfolio to an array of outcomes, most commonly the fluctuation of interest rates. They were bank liabilities in a new form, one that was difficult for financial regulators or even the banking system as a whole to fully comprehend. Most illustratively though, derivatives existed as a tangled web of financial obligations within the banking system, concentrating risk in the relationships between a handful of banks in the United States and Europe. An enormous margin call from the investment bank and major LTCM counterparty Bear Stearns in September 1998 triggered a collective realization that derivatives held by the hedge fund had the power to bring down the entire house of flimsy interbank risk.

At the time of the LTCM bailout, the total market value of all the world's derivatives including interest rate swaps, credit default swaps, and foreign exchange currency swaps was $3 trillion. To compare, the total supply of U.S. Treasuries was also about $3 trillion. By 2007, the total supply of U.S. Treasuries increased to $4 trillion but the market value of derivatives outstanding increased to $11 trillion. While the $4 trillion in Treasuries stood upon a bicentennial tradition of creditworthiness, conversely, the $11 trillion unsustainably teetered on the thin and fraying wires of interbank trust.

Falling into Disrepair

Despite cracks in the dollar pyramid's foundation that surfaced after the LTCM bailout, money market interest rates portrayed a sturdier facade. U.S. Treasury Bills, Fed Funds, Eurodollar LIBOR, and Treasury Repo GC rates all closely tracked each other for years. Small divergences would occur but were always characterized as the result of seasonal or idiosyncratic factors. That would all change starting on August 9, 2007. On that day, LIBOR rose by what might seem like a paltry 0.12% relative to the rest of the family of money market rates, but it was the start of something dramatic. The night before, French bank BNP Paribas was unwilling to value certain derivatives and froze all cash withdrawals for funds holding financial instruments related to risky American home borrowers. A sudden jolt of distrust electrocuted the interbank funding market in the weeks to follow. Banks were afraid to lend money to each other in any capacity because they weren't sure which banks might not open back up the next day. The era of unlimited, almost care-free interbank exposure had ended, replaced by extreme caution and nervousness. The ascent up the dollar pyramid had begun.

On December 12, 2007, the Federal Reserve was finally forced to address the gargantuan elephant in the room, which was that European interbank trust and the "bookkeeper's pen" Eurodollar funding mechanisms had broken down. A con- traction in European interbank trust, expressed by a rising LIBOR, was causing the whole dollar pyramid to rattle like an earthquake. The Fed instituted foreign exchange swap lines to the European Central Bank and Swiss National Bank in order to provide liquidity to the off shore banking system, having to turn a blind eye to the practice of creating dollar liabilities outside the Fed's purview. The Fed's role as lender of last resort had expanded beyond its borders because of the complicated evolution of the international monetary system, not because its mandate all of a sudden switched from domestic to global monetary policy. This conundrum was neither escapable nor up for discussion considering that the international monetary system was unabashedly dependent upon the Federal Reserve as the lender of only resort.

These foreign exchange swaps created yet another type of second-layer money made available by the Federal Reserve exclusively to other select central banks.

Amidst a wave of American mortgage defaults in 2008, the intricate web of failing mortgage derivatives started causing lower layers of the dollar pyramid to crumble with dramatic and permanent consequences. When the prestigious investment bank Lehman Brothers failed on September 15, 2008, a money market fund called Reserve Primary Fund famousl "broke the buck" when it posted a share price of $0.97 because it owned a fair amount of newly defaulted Lehman Brothers commercial paper. This drop of a mere three cents from par triggered an all-out financial panic that elicited unprecedented emergency actions from central banks and governments around the world. The reason for the panic wasn't necessarily the three-cent drop, but the fear that if Lehman Brothers commercial paper could fail, and Reserve Primary Fund's shares weren't worth a whole dollar, nothing could be trusted. All forms of bank liabilities lost liquidity, and the financial system froze. Time stood still, as nobody knew if banks would open the following day.

The Fed fulfilled its role as lender of only resort by launching a slew of consecutive rescues to stave off systemic collapse. The insurance giant American International Group (AIG) received a Fed lifeline on September 16th because it had underwritten insurance on risky mortgage securities that were suddenly defaulting. The entire Money Market Fund complex received a guarantee from the Fed on September 19th that its share prices would be supported to prevent withdrawal panic. Goldman Sachs and Morgan Stanley received their lifeline on September 22nd after being allowed to convert from investment banks into bank holding companies which gave them direct access to Fed lending. Concurrently, the Fed was increasing liquidity capacity for major central banks across the world on a daily basis. It was an all-out capitulation from the Fed to avoid systemic collapse.

Despite the Fed backstopping each and every form of cash it could, the ongoing liquidation of inferior assets and ascent up the dollar pyramid persisted. The original intent of the Federal Reserve System was to provide a second layer of money elastic enough to withstand shocks to the system exactly like this one. On November 25th, the Federal Reserve had no other choice than to flood the system with reserves by purchasing U.S. Treasuries, many of which had been newly issued in order to finance enormous deficits resulting from economic recession, tax shortfalls, and corporate bailouts. Large-scale expansion of second-layer money by the Fed was a response to contraction elsewhere in the system; it had to meet the collapse in interbank trust and liquidity with its own reliable liquidity. The Fed called it Quantitative Easing (QE), but we can refer to it as second-layer money creation.

Interbank trust only decayed in the years after the financial crisis of 2007–2009. Banks started dialing back their exposure to each other during the fourth quarter of each year to prepare for year-end regulatory snapshots. Divergences in key money market interest rate spreads - like when LIBOR split from Fed Funds and others in August 2007 - occurred more often, especially around calendar events such as the end of each quarter and United States tax deadlines. Complete dis- locations would occur, indicating that money needed at certain times during the year wasn't necessarily available to those who needed it most. Liquidity was haphazard, to say the least. The Fed had slashed the price of money and targeted interest rates of 0%, backstopped the unknown quality Eurodollar market, and created trillions of dollars of reserves to bolster the American banking system, but for what? When the Fed eventually tried to unwind its emergency actions years later, it was unable to raise interest rates above 2% without financial panic briefly rearing its ugly head again. The Fed quickly reversed course upon becoming reacquainted with the dollar system's fragility. A return to peaceful money markets was unattainable, as the Fed had removed price discovery from the system by disallowing so many third-layer money-types from realizing their ultimate fate.

Lender of Only Resort

Much like several of the money market dislocations of the 2010s, the initial blame for the Treasury Repo crisis in September 2019 was ascribed to the United States corporate tax deadline. The financial media's narrative was: MMF shares were sold by corporations so they could pay their tax obligations which in turn depleted the Treasury Repo lending base, but that Treasury Repo liquidity would return quickly much like in the days after other calendar events. On September 16th, the spread of General Collateral to Fed Funds increased by 0.10%, but nobody blinked an eye. Moves of this size had  become quite standard in the years since the notorious day in August 2007 when LIBOR became disjointed from the rest of the money market.

The next day, however, would live in Treasury Repo infamy. By late morning, the Treasury Repo GC rate registered at an alarming 8% higher than Fed Funds, indicating that at least one bank holding U.S. Treasuries could not find a counterparty to lend money against its Treasury collateral. The Federal Reserve responded with an emergency Treasury Repo funding operation later that day, effectively backstopping the entire market for Treasury-collateralized lending. The measures were supposed to be temporary as seasonal factors were surely to blame, but it didn't play out as such. The Fed increased its commitment to a smoothly functioning Treasury Repo market by cementing its willingness to lend freely against Treasury collateral so that what happened on September 17, 2019 would never happen again. After saving the Eurodollar in December 2007, the Fed had liberated yet another dollar-type in Treasury Repo and made a trend out of institutionalizing dollar-types gone astray. The Fed continued to find new ways to create wholesale second- layer money in order to counter instability.

During the pandemic-induced global financial panic of March 2020, the Federal Reserve announced several additional lending facilities to further backstop the Treasury Repo market, Money Market Funds, and fifteen additional foreign central banks. To protect the system against foreign liquidation of U.S. Treasuries, the Fed instituted a facility to lend money in the Treasury Repo market to approved foreign entities so that these governments and central banks didn't disrupt the Treasury market if they ever needed cash: they could post their Treasuries as collateral directly at the Fed's pawn shop. Even though Treasury prices soared in the first few days of pandemic panic as unlimited demand emerged for the world's safest asset amidst collapsing prices of stocks and corporate bonds, they didn't remain impervious. U.S. Treasuries with longer maturities (ten to thirty years) suddenly lost a bid despite their typical safe-haven status because of all the chaos in the markets. Members of the Fed panicked: a malfunctioning Treasury market was a recipe for disaster. What followed was a wave of U.S. Treasury purchases and reserve creation by the Fed that made the 2008– 2010 Quantitative Easing programs look like a practice run. The Fed convened over the weekend and announced a new, unlimited QE program of Treasury purchases without any defined maximum in order to mollify all concerns that the Fed might let the world's most important security market experience any sustained disturbance.

Money-types around the world were losing their ability to survive independent of the Federal Reserve. While it never lost its position atop the dollar money pyramid, the Fed has with some degree of success managed to claw back power over sections previously outside of its purview, mostly due to the fact that as each money-type almost failed, the Fed stepped in to save the day. The whole system has become entirely beholden to its support. Yet despite the dollar system's fragility that has been exposed over the past dozen years, the dollar is more deeply entrenched as the international monetary system's fulcrum than ever. The world is seemingly trapped inside a dollar denomination and is hankering for a monetary renaissance. Each crisis seems to be unraveling more quickly than the previous one as the system becomes dramatically more fragile.

Taking a step back, we have to understand why the Fed is creating all this second-layer money in the form of reserves, Treasury Repo lending, foreign exchange swap lending, and other bailout mechanisms. It does this because the Fed is a wholesale money safety net. Unless it flies a fleet of helicopters over American cities and unloads crates of second- layer retail money (Fed notes or cash), it does not have a way to provide money in a retail setting to individuals. The only way the Fed can provide monetary stimulus is to provide wholesale money where it is needed most within the financial system. The Federal Reserve is meant to provide reserves, and currently it possesses no political authority to issue retail monetary stimulus.

Tales of the dollar's demise are premature. While their arguments have mathematical merit given just how much money the Fed has created, they lack cohesiveness when considering the alternatives. The dollar is still the undisputed world reserve currency. Half of all international invoices are denominated in USD even though the American economy comprises only 15% of the global economy. Despite all the worthy criticisms about the Federal Reserve's seemingly infinite dollar creation, the dollar's stature as an accounting denomination, preferred method of payment for inter- national commerce, and capital market funding currency is nothing short of dominant. Its dominance is unlikely to fade away over the next several years. U.S. Treasuries remain the only asset that has the proven market liquidity and depth required to don the title of risk-free asset. The dollar has become so ephemeral in nature that the only way to truly store dollars over time is to own a portfolio of U.S Treasuries. That is why dollars travel around on the second and third layer of money, but only U.S. Treasuries can call themselves first- layer money in the dollar pyramid. The depth and liquidity of the U.S. Treasury market doesn't preempt the decision to store capital in the dollar denomination, it's actually the only thing holding it together because of the uncertainty that stems from owning bank-issued third-layer money.

Source: Nik Bhatia: Layered Money
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