Thursday, August 19, 2010

Bernanke Sets Up a Clog the Leak Play

What happens if banks start using the trillion dollars in assets they have tucked away as excess reserves? Fed Chairman Ben Bernanke is going to have to drain those reserves from the system very fast, or we are going to be talking about a major inflationary money leak that is going to make the BP Gulf Oil leak look like a kid pissing in his bathing suit.

How do you drain a trillion dollars from the system quickly?

Bernanke thinks he is going to be able to do it with the help of money market mutual funds. I think he is out of his mind.

The New York Federal Reserve Bank just named 26 MMMFs that will be part of its emergency plan. The combined assets of these funds were approximately $900 billion at the end of July, according to Crane Data LLC.

The problem with Bernanke's plan is that you aren't going to be able to drain over a trillion dollars out of the system with a group of MMMFs that don't have a trillion. Bernanke understands this and is likely relying on other tools as well. But how helpful can the money market fund industry really be?

They funds aren't keeping $900 billion on the sidelines. They have it in commercial paper and other short term assets. If the Fed calls on the money markets for anything over chump change of 5% of assets, i.e., anything over $45 billion, the money markets will have to start liquidating their paper to buy the Fed supplied Treasury paper. The planet hasn't seen such a separation and shift in assets since North America separated from South America. Liquidation of anything over $45 billion by MMMFs means huge disruptions in the financial markets, especially the commercial paper market. Further, plus $45 billion is a long way from a trillion.

The Fed can use the MMMFs for small operations, but I'm thinking anything significant is beyond the capability of the MMMFs, without it resulting in major instability in the financial system.

In short, as far as I can determine, the Fed has no plan that will drain reserves fast enough with size, if banks began to rapidly deploy their excess reserves into the system. In addition to the normal problems the Federal Reserve has in dealing with the business cycle as a result of Fed money manipulations, Bernanke has built on top, a layer of new tools that are untested in crisis, many of which are unlikely to act as expected by the Fed. Bottom line: Bernanke has taken over a rickety ship, and through the introduction of new tools has increased the instability of the system by at least a multiple of 5.

For the record, here are the 26 MMMFs Bernanke is counting on:

 BofA Cash Reserves

 BlackRock Liquidity Funds: TempFund

 Schwab Cash Reserves

Schwab Value Advantage Money Fund

Deutsche Cash Management Master Portfolio

Dreyfus Cash Management Fund

Dreyfus Government Cash Management Fund

Dreyfus Institutional Cash Advantage Fund

Federated Government Obligations Fund

Federated Prime Obligations Fund

Fidelity Cash Reserves

Fidelity Institutional Prime Money Market Portfolio

Fidelity Institutional Money Market Portfolio

Fidelity Institutional Government Portfolio

First American Prime Obligations Fund

Goldman Sachs Financial Square Government Fund

Goldman Sachs Financial Square Money Market Fund

Goldman Sachs Financial Square Prime Obligations Fund

AIM STIT Liquid Assets Portfolio

JPMorgan Prime Money Market Fund

JPMorgan US Government Money Market Fund

Western Asset/Liquid Reserves Portfolio

Vanguard Market Liquidity Fund

Vanguard Prime Money Market Fund

Wells Fargo Advantage Government Money Market Fund

Wells Fargo Advantage Heritage Money Market Fund


  1. Did corp CEOs get a whiff of this way back when and moved to raise cash as a result or is this Bernanke trying to use that development in an opportunistic manner?

    Maybe they didn't scent this specific CB threat but it does seem like they all decided not to get burned by a frozen CP market again.

  2. Not gonna happen Robert, but it would be a great problem to have versus what we may get. At least with Inflation, the Fed has a monster it knows how to fight.

    With heavily impaired asset prices, reduced debt appetite and consumer trends toward frugality, we are at a minimum stuck in first gear for years to come.

    Worse, is getting stuck in reverse. We are one cycle away from rising real interest rates in the form of deflation. If a deflation occurs, monetary policy won't be able to move the gears. Banks won't lend and the most productive use of capital will become debt service. It's counterintuitive, but you should provide an equal share of your blog to the possibility of debt deflation. The CPI and PPI trends are now showing an increasing likelihood of deflation in spite of everything the Fed has thrown at the problem. Monetary policy is broken.

    For those that are interested in the flip side, Irving Fisher's essay "The Debt Deflation Theory of Great Depressions" is available @ It proposes reflation as a remedy, but so far, we don't have a model for how to get a modern economy out of this morass.

  3. LOL Irving Fisher had no f-ing clue.

    Just before the 1929 crash, he said "Stock prices have reached what looks like a permanently high plateau."

    He stated on October 21 that the market was "only shaking out of the lunatic fringe" and went on to explain why he felt the prices still had not caught up with their real value and should go much higher.

    On Wednesday, October 23, he announced in a banker’s meeting “security values in most instances were not inflated.” For months after the Crash, he continued to assure investors that a recovery was just around the corner.\

    He turned out to be the lunatic.

  4. Debt deflation spiral (as defined by Fisher) is just a hypothesys. It has not happen in real life. And there has been several ocasions where mainstream economist said it would happen and never happened.

    In reality debt deflation spiral can only happen if the government imposes stupid and strong price restrictions. Otherwise it will never happen.

    But the keynesians use this debt deflation spiral that has never happened to scare people about deflation and use it as excuse to inflate, inflate and inflate.

  5. @Summers/Anonymous: you just don't give up, do you?

    @RW: Following are some thoughts that I did not have time to organize into a post...hope to next week with some more information. For now, think about this:

    If, you'll recall, in late 2009, the Fed conducted some test triparty reverse repos with MM's as lenders and the PD's as intermediaries--they failed miserably. So it's no surprise the Fed is now going to trade bilaterally with the MM's. As you point out, MM's are major players in the CP market, but they are also instrumental in the repo market. In May, FRBNY commissioned a white paper and solicited comments on the tri-party repo market. Results and comments are here:

    It looks to me, esp. based on the last comment (7) re: establishment of a central counterparty, that the Fed is muscling it's way into the middle of the repo market--perhaps it wants to be the central couterparty. Not surprising, as it's getting in the middle of everything. If the Fed recognizes it cannot drain money from MM's without disrupting the CP/repo markets, why not get micromanage the CP/repo markets as well--what could go wrong?

    Also, there's the Term Deposit Facility (Fed Bills) that the Fed tested out in July. That would ostensibly lock up excess reserves for fixed periods.

  6. My understanding is that the reserves are a result of the massive monetary base pumping from the summer of 2008-spring 2009. At best the reserves can be bottled up for a little while longer, but at some point they're going to get out unless something is done. Leaving the reserves in brings in the possibility of large scale inflation at some point, so they must be drained.

    But as I understand it, the reserves are what is supporting the currently mis-aligned, mal-invested economy. To take them out would be problematic because there be another crash. Do I have this wrong?

    And what's with all these exotic (read: new, untested, and foolhardy) tools that they're trying to use now? Why go through all these new tricks, which are more likely to not work?

  7. I believe a liquidity crisis will emerge, where there will not be enough buyers for sellers of stocks as well as bonds. I believe that the Fed’s engagement of the top 26 MMMFs should be seen as a new Federal Reserve Facility that will have the same result of the Fed’s QE TARP Facility, that of being an integration of the financial institutions into Government.

    I believe that when liquidity evaporates, these MMMFs and other money market accounts will be used as a policy tool to seize and stabilize the financial system as a systemic risk event unfolds.

    I also believe that Financial Regulator will be announced who will oversee lending and credit, as well as money market and brokerage accounts. He will be what I call a credit boss or credit seignior who funds economic operations with an emphasis on seeing that the strategic needs of the country are met and that monies for food stamps keeps flowing. I believe the government will become the first, last and only provider of liquidity and money.

  8. @ First Anon:
    Maybe the drivel you've been taught in school, that deflation is bad, has corroded your brain. Deflation does not destroy the real capital in society, real capital means earth movers, computers, factories, etc. It only causes real capital to change hands, from the insolvent to the solvent.

    Asset prices have nothing to do with creating economic prosperity, rather they are a reflection of economic prosperity.

    An economy is a circular rotation of resources, not money. Clowns who fail to understand this are the only ones who believe inflation is a good thing and it will cure all depressions. If that were the case, why hasn't it worked for Zimbabwe. And why didn't it work for us as we've had years of moderate positive inflation?