8 January 2008 – The Aleph Blog

Why Do I Follow M3?

Posted on 8 January 2008 by David Merkel

I like the no-nonsense attitudes of some bloggers. Dr. Jeff would be one of them. In response to my piece Looking Beyond the Three Percent Horizon he posed the following question:

David –
I understand that the Fed discontinued M3 and that you have a good proxy. My question is, ?Why??

In my research on money supply measures, I have been asking economists what they are trying to measure and why. So far, none has had any reason to track M3. I?ll get around to my reasons for this in a future post, but before doing so, I am curious about why you think this is important. The same question might be asked of MZM.

Thanks,

Jeff

I do have a reason to track M3, so maybe this will help Dr. Jeff.? At RealMoney, as M3 was eliminated, I made the following post:

		David Merkel
		Taking a Substitute for Vitamin M3
		3/14/2006 3:26 PM EST

If you’re not into monetary policy, you can skip this. Within the month, the Federal Reserve will stop publishing M3. Now, I think M3 is quite useful as a gauge of how much banks are levering themselves up in terms of credit creation, versus the Fed expanding its monetary base. I have good news for those anticipating withdrawal symptoms when M3 goes away: The Federal Reserve’s H.8 report contains a series (line 16 on page 2 – NSA) for total assets of all of the banks in the US. The correlation between that and M3 is higher than 95%, and the relative percentage moves are very similar. And, from a theoretical standpoint, it measures the same thing, except that it is an asset measure, and that M3 incorporated repos and eurodollars, which I think are off the balance sheet for accounting purposes, but should be considered for economic purposes.

But it’s a good substitute… unless Rep. Ron Paul’s bill to require the calculation of M3 passes, this series will do.

Position: none

My reason for wanting an M3 measure is that the process of intermediated credit creation is important.? As we go down the monetary aggregates, from cash, to the monetary base,? to M1, M2, and MZM, we get further away from cash, and closer to credit.? At one point in time, the Fed had a measure called L for total liquidity, which was broader than M3.? In a credit-driven economy like ours, measuring the differences between various types of credit creation can give signals as to how the banks are faring, and how well aggregate demand will do in the intermediate term.? That’s why I look at M3; it helps me to see how much the banks are stretching their balance sheets compared to how much the Fed is stretching its balance sheet.? There are limits to how much independent stretching the banks can do, in the absence of aid from the Fed.

Perhaps I’m just a wonk here, but the willingness of banks to extend credit in our economy is important, and M3 was better correlated with that than most other monetary measures.? That’s why I went in search of an M3 proxy.

Fifteen Points on Credit Where Credit Ain’t Due

Posted on 8 January 20088 January 2008 by David Merkel

I’ve wanted to do a post on credit for a while, but I’ve just had too many things to think about. Well, here goes:

1) From the “We Keep Him in a Bubble” file there is James Glassman with his prediction that Spring 2008 would bring the end of the housing troubles. Why does this guy still get air time? Why wasn’t Dow 36,000 enough? There are too many vacant homes to reconcile, there is no way for Spring 2008 to be it….

2) For an excellent summary of where we are in housing, Calculated Risk has this review piece.

3) Not all defaults are subprime. They are happening with Option ARMs, and even prime loans where they had to get Private Mortgage Insurance.

4) Is the subprime mortgage bust bigger or smaller, or similar to the size of the the S&L crisis? I’ll go with bigger. I don’t buy DeKaser’s smaller argument because securitization has provided more credit to small and medium sized businesses. I do think Portfolio.com is on the right track by looking at the amount of the housing price rise that has happened.

5) Personally, I find it delicious that the banks get stuck footing the bill in particularly bad foreclosure situations. So much for structural complexity in lending.

6) Americans are the most overhoused people in the world. No one else gets as much space, or stores as much stuff, broadly speaking. This book review of “House Lust,” will take you through the whole matter, in probably too much detail. (And yes, my house is large also, but I have ten people here… Americans can be unusual in other ways too; as a culture, we are more optimistic about children.)
7) From Calculated Risk, a tale of why lenders tend to forbear with marginal borrowers that are having difficulties with their current loans. One thing they don’t mention, the Residential MBS market does not have special servicers like the Commercial MBS does. When a loan gets into trouble, the CMBS special servicer gets paid adequately, but the ordinary RMBS servicer does not, particularly when lots of loans are in trouble. It is a weakness in the RMBS system.

8 ) As the TED spread declines, market players begin to relax about liquidity. But what of solvency? As losses are realized by banks, some will have to shore up their capital positions, and to do that, they will have to ratchet back lending.

9) How similar is the US today to Japan back in the early ’90s? There are some similarities, given the property bubbles in both places, and the interest rates that get lower and lower, but there are differences — a healthier banking system in the US, and a more market-oriented economy here as well. A depression is possible in the US, but I would not assume it at present.

10) Is the US consumer spent-up? Could be. Consider this article on auto loans as well. Personally, I am surprised at the degree to which lenders will make consumer loans with inadequate security, but that is just a normal aspect of American life today. For now.

11) What of corporate bonds? It certainly seems like junk bonds will be seeing more defaults in 2008. (Here also.) This shouldn’t surprise us, because the credit quality was low and the volume of high yield bond issues was high 2004-2006. It takes a little while for bad debt to season, and we should see the results in 2008.

12) When I did my “Fed model” I used BBB corporate yields as my comparison to earnings yields on equities. Given the backup in credit spreads, my Fed model is not nearly as favorable as those using Treasuries. But those looking only at credit spreads get the wrong result also. With Treasury yields so low, most high quality bonds are not attractive now.

13) On the bleak side, I tend to agree with Naked Capitalism and the FT that there is a transfer of power going on in the world, away from the US, and toward China and the Middle East. Power follows capital flows, and they are funding the US at present. They will own more and more of US businesses over time. They increasingly won’t be satisfied by owning our debts.

14) I found this piece from Credit Slips to be educational. There are certain types of income that can’t be garnished; nonetheless, garnishing happens. The only way to protect yourself is to fight back, and that article highlights how it is done.

15) Finally, credit at its most basic level. Credit is trust; trust that repayment plus interest will occur. Who do you trust? Personally, I found the discussion following Barry’s post to be depressing, because so many commenters were cynical. here was my comment:

Capitalism is based on trust. Without trust, capitalism will slowly cease to exist. Yes, there will be barter-type transactions, but any complex long-term transaction or relationship is based on trust. Any multi-party transaction requires trust, because multiple parties can gang up on the weak one.

Even representative government requires trust. Now, that trust is often abused, but who wants to get rid of representative government?

There is a lot more trust within our society than most of us imagine. Woe betide us if trust drops to a minimum level.

Estragon (thank you) agreed with me at the end, but it is fascinating to consider the implications of a society where trust is declining. Ultimately, it means that credit will be declining.

Make Money While You Sleep

Posted on 8 January 2008 by David Merkel

Eddy Elfenbein often comes up with cute ideas on how the market works, and this article is no exception.? Someone holding the stock market overnight, at least over the past decade, does better than someone owning stocks during the day.? (I assume that? Eddy has made the proper corrections for dividends, and things like that.)? Now, why might this be?? This is my theory: though daytraders are a part of this, it is not that we are all a bunch of daytraders, but that enough players in the market view the daylight hours as less risky than the night, because they can’t trade then.? Newsflow happens more often while the market is closed.? Thus, there is a tendency to clear out positions before the session closes.? (Now, no net position clearing occurs.? Someone has to hold the stock overnight; they receive a slight discount in the price to do it.)

Another way to think about it is that people get paid to take risk, and there is risk in holding stock overnight.? Now, if we wanted to test this hypothesis, there is even more risk holding stock over the weekend.? How do the overnight returns vary overnight, versus over multiple nights?? Perhaps Mr. Elfenbein can run that calculation as well.