How Debt Gets Monetized

The real turmoil in the credit markets stems from shadow banking...

PEOPLE create credit and money, not central banks. A central bank sets the price of money and credit. Individuals or businesses create money by borrowing it into existence, writes Greg Canavan for the Daily Reckoning Australia.

Take the example of a (rare) first home buyer borrowing $250k to build a home. The money didn't exist previously but, using their credit and good standing, the bank agrees to create the money and credit their account.

The first home buyer then pays for the various services required to build the house, and the money flows through the economy. The loan therefore increases the amount of money flowing through the economy, which winds up back in various different bank accounts, which go on to fund other loans etc.

So the person now has a house as their asset, and a $250k debt to the bank as a liability. But 6 months later they lose their job, and can't make their loan repayments. The loan turns bad and the bank has to write down the value of it.

Imagine, for a moment, that this happens on a large scale. If the bank was to write the loan down in value it would wipe out shareholder equity and render it insolvent. It doesn't want to do that so it turns to the central bank for help. It says the situation is just temporary. It has a liquidity problem, not a solvency problem.

The central bank buys the loans off the bank for 100 cents in the Dollar, even though they might be worth only 50 cents. In doing this, the central bank is monetizing previously created credit that has turned 'bad'.

This is how central banks try to avoid deflation. If inflation is just growth in the creation of credit money, deflation is the destruction of this money via loans turning bad.

This is a very basic example of how central banks operate in the normal banking system.

But the real action happens in what is known as the 'shadow banking' system. This is truly a wonder of modern finance. It's a system that creates more 'money' than central banks could ever dream of.

And therein lays the problem. Shadow banking is an out of control beast. Its fuel is hope...hope provided by central banks that they won't let speculators go under.

What is shadow banking? It's a system of banking for very large organizations (money market funds, pension funds, insurers, hedge funds etc.) that is largely unregulated.

Put simply, the shadow banking sector monetizes the debt created in the traditional banking sector and uses this money to speculate in the asset and derivative markets. In other words, it transforms long dated, illiquid debt instruments into 'money'.

If you have a 10-year US government bond, you can go to an investment bank or broker and leave it as security (collateral) for an overnight cash loan. You then have 'money' to play with, and can keep rolling your loan over as long as you don't do something stupid.

Even if you don't have good collateral in the form of treasury securities, the shadow banking system has a solution for you. Through various relationships with the players involved (brokers, clearinghouses etc) you can swap a junk bond for a treasury note and then go elsewhere with your treasury note and obtain cash.

The shadow banking system is a place where you can turn sewage water into a double malt whiskey.

This all works amazingly well when participants are 'hopeful' that nothing will go wrong. There is faith in even the poorest form of collateral, like junk bonds, and when sentiment is so bullish, the system turns nearly all forms of market debt into 'money'.

But last week, a little known Fed member, Governor Jeremy Stein, gave a speech titled 'Overheating in Credit Markets: Origins, Measurement, and Policy Responses'. It's a bit dense, but well worth the read.

He basically shines a light on the largely unregulated shadow banking system, and ponders how the Fed should respond to the excesses that are beginning to emerge. He doubts that regulation can have a meaningful effect on curbing excesses, and wonders whether monetary policy should play a greater role.

Such a 'solution' may sound completely rational to a person with common sense. But coming from a Fed governor, it's a big deal. If Bernanke had made these comments, markets would have plunged.

The Fed knows the real turmoil in the credit crisis had its origins in shadow banking. It was where the double malt whiskey went back to being sewage water.

That it will happen again is assured. It always does. That the Fed is wondering aloud how it might prevent it is also another obvious sign of the inherent fragility of the system.

So, keep one eye on the exit, because the Fed is getting nervous.

Time to Buy Gold?...