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STIGUM'S MONEY MARKET
By MARCIA STIGUM, ANTHONY CRESCENZI The McGraw-Hill Companies, Inc.
Copyright © 2007 McGraw-Hill
All rights reserved.
ISBN: 978-0-07-150882-7
Excerpt
CHAPTER 1
Introduction
The U.S. money market is a huge and significant part of the nation's financial system in which banks and other participants trade more than a trillion dollars every working day. Where those dollars go and the prices at which they are traded affect how the U.S. government finances its debt, how business finances its expansion, and how consumers choose to spend or save. Yet we read and hear little about this market, with most focusing on the intrigue of the stock market and fluctuations in the bond market. The conspiratorially minded might consider the money market's existence intentionally obscured. The reason most people are unaware of the money market is that it is a market that few businesspeople encounter in their daily activities and in which the general public turns to meet its ever-rising expectations on investment returns. Moreover, in an age in which attention spans have shrunk, there seems to be too little glamour in the money market to keep people tuned in to it.
The money market is a wholesale market for low-risk, highly liquid, short-term IOUs. It is a market for various sorts of debt securities rather than equities. The stock in trade of the market includes a large chunk of the U.S. Treasury's debt and federal agency securities, commercial paper, corporate securities, mortgage-backed securities, municipal securities, negotiable bank certificates of deposit, bank deposit notes, bankers' acceptances, and short-term participations in bank loans. Within the confines of the money market each day, banks—domestic and foreign—actively trade huge blocks and billions of dollars of federal funds and Eurodollars, the two main sources of overnight funds and the tools by which the Fed transmits its monetary policies. In addition, banks and nonbank dealers are each day the recipients of billions of dollars of secured loans through what is called the "repo market," which is now several trillion dollars in size. Today, a major feature of the money market is the derivatives market, where market participants go to hedge their risks and place bets associated with the gyrations in interest rates.
The heart of the activity in the money market occurs in the trading rooms of dealers and brokers of money market instruments, although increasingly the activity is occurring in cyberspace, over the Internet. During the time the market is open, these trading rooms are characterized by a frenzy of activity. Each trader or broker sits in front of a battery of direct phone lines that are linked to other dealers, brokers, and customers. Few phones ever ring, they just blink at a pace that makes, especially in the brokers' market, for some of the shortest phone calls ever recorded. The Internet has reduced the need to transact over the phone, but with trading volume having increased dramatically, trading rooms seem as frenetic as ever, and dealing rooms are anything but quiet. Dealers and brokers know only one way to hang up on a direct-line phone; they BANG the off button. And the more hectic things get, the harder they bang. Banging phones like drums in a band beat the rhythm of the noise generated in a trading room. Almost drowning that banging out at times is the constant shouting of quotes and tidbits of information.
Unless one spends a lot of time in trading rooms, it's hard to get a feel for what is going on amid all this hectic activity. Even listening in on phones is not very enlightening. One learns quickly that dealers and brokers often swear (it's said to lessen the tension), but the rest of their conversation is unintelligible to the uninitiated. Money market people have their own jargon, and until one learns it, it is not easy to understand them. Luckily, this divide has crumbled a bit over the years, thanks to the information age and increases in market transparency and accessibility, even to the smallest of investors.
Once adjusted to their jargon and the speed at which traders converse, one observes that they are making huge trades—$20 million, $200 million, $1 billion—at the snap of a finger. Moreover, nobody seems to be particularly awed or even impressed by the size of the figures. A fed funds broker asked to obtain $100 million in overnight money for a bank might—nonchalant about the size of the trade—reply, "The buck's yours from the San Fran Home Loan Bank," slam down the phone, and take another call. Fed funds brokers earn less than $1 per $1 million on overnight funds, so it takes a lot of trades to pay the overhead and let everyone in the shop make some money. Luckily for these brokers the volume of brokered transactions is between $60 billion and $80 billion per day.
Despite its frenzied and seemingly incoherent appearance to the outsider, the money market efficiently accomplishes vital functions every day. One is shifting vast sums of money between banks and other financial institutions. For banks, this shifting is required because many large banks, domestic and foreign, with the exception of very few, all need more funds than they obtain in deposits, whereas many smaller banks have more money deposited with them than they can profitably use internally.
The money market also provides a means by which the surplus funds of cash-rich corporations and other institutions can be funneled to banks, corporations, and other institutions that need short-term money. In addition, in the money market, the U.S. Treasury can fund huge quantities of debt with ease. And the market provides the Fed with an arena in which to implement its monetary policy. This is where the money market gets the most attention, with investors throughout the world focused almost obsessively with what the Fed might do next. New instruments such as fed funds futures now make it possible to pinpoint precisely what the money market expects of the Fed. The varied activities of money market participants also determine the structure of short-term interest rates, for example, what the yields on Treasury bills of different maturities are and how much commercial paper issuers have to pay to borrow. The latter rate is an important cost to many corporations, and it influences in particular the interest rate that a consumer who buys a car on time will have to pay on his loan. The commercial paper market is also one that tends to be overlooked, despite the fact that it is twice the size of the Treasury bill market. Finally, one might mention that the U.S. money market is increasingly becoming an international short-term capital market. In it oil imports, semiconductor purchases, aircraft, and a lot of other non-U.S. trade are financed.
Anyone who observes the money market soon picks out a number of salient features. First and most obvious, it is not one market but a collection of markets for several distinct and different instruments. What makes it possible to talk about the money market is the close interrelationships that link all these markets. A second salient feature is the numerous and varied cast of participants. Borrowers in the market include foreign and domestic banks, the U.S. Treasury, corporations of all types, the federal agencies such as Fannie Mae and Freddie Mac, Federal Home Loan Banks and other federal agencies, the financial arms of industrial corporations such as General Electric, dealers in money market instruments, and many states and municipalities. The lenders include almost all of the above plus insurance companies, pension funds—public and private—and various other financial institutions, including the mutual fund industry. And, often, standing between borrower and lender is one or more of a varied collection of brokers and dealers.
Another key characteristic of the money market is that it is a wholesale market. Trades are big, and the people who make them are almost always dealing for the account of some substantial institution. Because of the sums involved, skill is of the utmost importance, and money market participants are skilled at what they do. In effect, the market is made up of extremely talented specialists in very narrow professional areas. A bill trader extraordinaire may have only vague notions of what the Eurodollar market is all about, and the Eurodollar specialist may be equally vague on other sectors of the market. Increasingly, however, more of today's trading desks are staffed with generalists, who deal in a wider variety of securities on a daily basis.
Another principal characteristic of the money market is honor. Every day traders, brokers, investors, and borrowers do billions of dollars' worth of business over the phone, and however a trade may appear in retrospect, people do not renege. It can be said that a motto of the money market, as in the fixed-income and foreign-exchange market, more generally is: My word is my bond. Of course, because of the pace of the markets, mistakes do occur, but no one ever assumes that they are intentional, and mistakes are always ironed out in what seems like the fairest way for all concerned.
One of the most appealing characteristics of the money market is innovation. Compared with our other financial markets, the money market is lightly regulated. If someone wants to launch a new instrument or to try brokering or dealing in existing instruments in a new way, he does it. And when the idea is good, which it often is, a new facet of the market is born. Moreover, the market is always changing. In the very final stages of the writing of this book, for example, the Chicago Mercantile Exchange was announcing its intention to buy the Chicago Board of Trade, merging two futures exchanges where the money market is prominently featured. Many more innovative changes undoubtedly lie ahead for the money market.
The focus of this book is threefold. First, attention is paid to the major players—who are they, why are they in the market, and what are they attempting to do? A second point of attention is on the individual markets—who is in each market, how and why do they participate in that market, what is the role of brokers and dealers in that market, and how are prices there determined? The final focus is on the relationships that exist among the different sectors of the market, for example, the relationship of Eurodollar rates to U.S. rates, of Treasury bill rates to the fed funds rate, of the repo rate to the fed funds rate, and so on.
This book is organized in a manner to enable readers with different backgrounds to read about and understand the money market. Part One contains introductory material for readers who know relatively little about the market. It is preface and prologue to Parts Two and Three, which are the heart of the book. Thus, readers may skim or skip Part One depending on their background and interests. They are, however, warned that they do so at their own peril, since an understanding of its contents is essential for grasping subtleties presented later in the book. Readers needing to gain a quick sense of particular subject matter will find the charts, supporting text, and end-of-chapter reviews useful tools. The footnotes serve as a useful reference to readers wishing to delve into topics more deeply.
CHAPTER 2
Funds Flows, Banks, and Money Creation
As preface to a discussion of banking, a few words should be said about the U.S. capital market, how banks create money, and the Fed's role in controlling money creation. This will provide background for Chapters 6 and 7, which cover domestic and Eurobanking, and Chapter 9, where we examine in greater detail the Fed's role.
Roughly defined, the U.S. capital market is composed of three major parts: the stock market, the bond market, and the money market. The money market, as opposed to the bond market, is a wholesale market for high-quality, short-term debt instruments, or IOUs.
FUNDS FLOWS IN THE U.S. CAPITAL MARKET
Every spending unit in the economy—business firm, household, or government body—is constantly receiving and using funds. In particular, a business firm receives funds from the sale of output and uses funds to cover its costs of production (excluding depreciation) and its current investment in plant, equipment, and inventory. Historically, for most firms, gross saving from current operations (i.e., retained earnings plus depreciation allowances) has fallen far short of covering current capital expenditures; that is, net funds obtained from current operations are inadequate to pay capital expenditures. As a result, each year most nonfinancial business firms and the nonfinancial business sector as a whole have tended to run a large funds deficit. In the early 2000s, this pattern was upended, with most nonfinancial firms running large funds surpluses.
The actual figures rung up by nonfinancial business firms in 2005 are given in column 2 of Table 2.1. They show that business firms had retained earnings of $383.5 billion (profits before tax of $887.7 billion minus $254.1 billion of taxes on corporate income and net dividends of $250.1 billion) and their capital consumption allowances totaled $636.0 billion, giving them (after a few other relatively small adjustments) a grand total of $1.020 trillion of gross saving with which to finance capital expenditures. This amount, however, totaled $926.9 billion, so the business sector as a whole incurred a $93 billion funds surplus.
The surplus that nonfinancial businesses rang up in 2005 is highly unusual from a historical perspective, as the business sector tends to have a chronic funds deficit. The deficit is commonly known as the corporate financing gap, and it tends to run at close to 2% of the U.S. gross domestic product (GDP). This means that in 2005, with GDP at roughly $13 trillion, a deficit of $260 billion would have been considered normal. The funds surplus of 2005 was the second in a row for nonfinancial firms, which ran a surplus of $78.9 billion the previous year. This is in stark contrast to 2000 when these firms ran a large deficit, owing largely to spending by entities earning little or no profits, particularly those that had used the capital that they had raised during the run-up in stock prices in the late 1990s. For example, there were many dot-com companies that were spending money that they would never earn, utilizing the proceeds from their initial public offerings.
Figure 2.1 shows the financing gap for all sectors. The chart indicates big swings between 2000 and 2006, moving from a large deficit to a large surplus.
There are many reasons why the nonfinancial sector moved to a funds surplus in the early 2000s, some of which are debatable. For example, some cite the large tax cuts enacted during those years, although there are many who would disagree. Another major influence was the bursting of the financial bubble in 2000. It instilled cautiousness among corporations, which became slower to hire and more restrained in their capital outlays. Such was the case until 2004 when both hiring and capital spending accelerated. Yet another reason relates to the secular trend begun in the early 1990s toward restructuring. Since that time, companies have been particularly keen to run themselves as leanly and efficiently as possible in order to boost profitability. Advances in technology, which contributed to the productivity boom that began in the mid-1990s, gave added momentum to the restructuring trend, boosting profitability and spurring funding surpluses in the process.
Whatever the causes of the funding surpluses, the surpluses reduced the nonfinancial sector's need to draw capital from other sectors. In other words, the business sector did not need to sell stocks, bonds, and money market instruments in order to fund its capital expenditures. That is why in 2005 the net amount of funds the business sector raised in the markets was a negative $78.4 billion, resulting largely from a $264.3 billion decrease in the amount of net new equity issues. Nonfinancial businesses nonetheless saw a net increase of $280.3 billion in credit market instruments, including $60.7 billion of corporate bonds.
Chronic deficits are more the norm for the business sector, which is to be expected, since every year the business sector receives a relatively small portion of total national income but yet has to finance a major share of national capital expenditures. Established business firms typically obtain relatively little new financing from the sale of new shares; the bulk of the funds they obtain to cover their deficits comes through the sale of bonds and money market instruments.
In contrast to the business sector, the consumer sector presents a quite different picture. As Table 2.1 shows, households in 2005 had gross savings of $1.186 trillion yet made capital expenditures of $1.712 trillion, leaving the sector with a funds deficit of $526 billion. This funds deficit has been a persistent phenomenon in the early 2000s. Every year consumers as a group have been saving less than they have been investing in housing and other capital goods. Consumers have been financing their investments mostly through home mortgages; household mortgage debt doubled between 2000 and the first quarter of 2006, increasing from $4.4 trillion to $8.9 trillion. With consumers running large funding deficits, it could be said that the business sector has been lucky that it hasn't had to depend upon the household sector to finance its capital expenditures. In past years, the consumer sector was a major supplier of funds to the business sector, which is to be expected in any developed economy in which the bulk of its investing is carried on outside the government sector. Households are, after all, the major income recipients, and business firms are the major investors.
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Excerpted from STIGUM'S MONEY MARKET by MARCIA STIGUM. Copyright © 2007 by McGraw-Hill. Excerpted by permission of The McGraw-Hill Companies, Inc..
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