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Tuesday, June 26th, 2012

Interesting ZH article

On The Verge Of A Historic Inversion In Shadow Banking

This is an interesting article which details something I’ve been curious about – a correlation between what I’d term the shadow money supply and FED action. I’m wondering if this analysis is correct – the FED buys up what I’d term a hard asset, say for example a mortgage backed security (a mortgage basically) from a bank or investment firm. Now normally if this type of transaction were occurring entirely in the private sector, when a bank purchases an asset like this, they would then go out and buy an insurance policy on the asset (a CDS?). The company (say AIG?) that sells the policy doesn’t need collateral (deposits) to cover a loss on the policy. So in effect, money is printed – the bank owns an asset with little risk of loss, meaning they can continue to invest (risk) the value of the asset in other areas, and AIG simply sits back and preys nothing goes wrong.

Looking back at the FED scenario, if the FED buys the asset no insurance policy will be issued so the value of the asset will not be reinvested back into the markets. Within the private sector this set of transactions creates money, but when the FED gets involved net new money creation is ~zero.

If this is all basically correct, then for every dollar the FED prints to buy assets like MBS, an equal amount of money is removed from the money supply – resulting in a net zero change. Hence, no inflation.

One thing in the article isn’t clear to me -

Said inflation buffer, however, is getting smaller and smaller every quarter, and at this rate, shadow banking as a transformational conduit will completely disappear in a few short years, at which point everything will be in the hands of fickle depositors.

Why is this assumption made? Once things begin to calm down, wouldn’t the investment banks of the world, and the AIGs, go risk-on again? Has something changed that prevents them from doing so? The SBN graph in the ZH article appears to reflect a bottoming process is taking place, so at some point an increase in money printing through non-deposit backed credit will resume. But maybe I’m missing something that will prevent that.

Overall what this seems to indicate is that the FED’s QE initiatives were doomed to fail from the start.

One other thought, due to the inherent money printing in these types of transaction isn’t there an inflationary risk tied to the FED unwinding its portfolio by selling assets back into the private sector? If the FED really wants to create inflation, shouldn’t it start selling assets now while we are still experiencing deflationary headwinds, or does the FED want to keep all that money printing potential out of the markets? Also, wouldn’t waiting to unwind ultimately exacerbate future inflationary forces? Overall current FED policy seems rather flawed to me.

addendum: In thinking about this a bit more, if the bank sells the asset to the FED, it receives newly minted money in return, which it can then invest. So maybe the insurance portion isn’t needed to print and the net creation of money is still positive?