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     Dec 16, '13


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CREDIT BUBBLE BULLETIN
Q3 2013 Flow of Funds
Commentary and weekly watch by Doug Noland

The latest US Federal Reserve Flow of Funds report shows a record Total Market Credit, while Total Non-Financial Debt has set new highs as a percentage of gross domestic product.

Total (Non-Financial and Financial) Market Credit jumped $406 billion (nominal) during Q3 2013 to a record $58.082 trillion. On a seasonally adjusted and annualized (SAAR) basis, Total Credit expanded $1.571 trillion, up from Q2ís $1.478 trillion and compared to SAAR $1.155 trillion in Q3 2012. As a percentage of GDP, Total Market Credit was little changed year-over-year at 344%.

Total Non-Financial Debt (NFD) jumped $377 billion during the quarter to a record $41.384 trillion. NFD was up $1.745 trillion over the past year, or 4.4%. NFD jumped $6.860 trillion in four years.



In five years, NFD as a percentage of GDP has increased to 245% from 227%. So much for "deleveraging".

On a percentage basis, Nonfinancial Debt expanded at a 3.5% pace during the quarter, up from Q2ís 3.4% and compared to Q3 2012ís 3.0%. Federal borrowings slowed to a rate of 1.5%, the weakest level since Q2 2007. Corporate borrowings expanded at a 9.2% rate, up from Q2ís 8.7% and Q3 2012ís 6.8%. Household (non-mortgage) Credit increased at a 6.0% pace, up from Q2ís 5.9%. Household Mortgage debt growth turned positive (0.9%) for the first time since Q1 2009. Total Household borrowings are on pace for the strongest annual growth since 2007. Interestingly, State & Local borrowings contracted at a 3.9% annual rate, down from Q2ís 1.1% growth.

On an annualized basis, NFD increased SAAR $1.431 trillion during the quarter, up from Q2ís $1.372 trillion and compared to SAAR $1.197 trillion during Q3 2012. The change in the composition of credit growth is noteworthy. Treasury borrowings slowed to SAAR $174 billion during Q3, down from Q2ís $299 billion and Q3 2012ís $788 billion. State & Local government borrowings contracted SAAR $117 billion.

Meanwhile, Corporate credit growth is the strongest since 2007. Nonfinancial Business borrowing jumped to SAAR $981 billion, up from Q2ís $934 billion and Q3 2012ís $619 billion. For comparison, Nonfinancial Business debt increased a record $1.317 trillion in boom-time 2007, before turning negative in 2009 ($256 billion). Nonfinancial Business debt increased $170 billion in 2010, $543 billion in 2011 and $718 billion in 2012. Household debt expanded SAAR $393 billion during the quarter, up from Q2ís SAAR $105 billion and compared to Q3 2012ís $203 billion contraction.

In 21 quarters, GDP increased 17% ($2.393 trillion) to $16.891 trillion. Over this period, Treasury debt jumped 128% ($6.706 trillion) to $11.957 trillion. Federal Liabilities have increased 135% ($9.012 trillion) to $15.710 trillion. In 21 quarters, Federal Liabilities surged from 46% to 93% of GDP. Over this period, State & Local Liabilities jumped 76% ($2.127 trillion) to $4.940 trillion. Combined Federal and State & Local Liabilities have increased from 66% of GDP to 122% in 21 quarters. Over this period, Federal Reserve Assets have expanded $2.835 trillion, or 298%, to $3.787 trillion.

Government-Sponsored Enterprises (GSE) Agency Securities (debt and MBS) increased $52.9 billion during Q3 to a four-year high $7.714 trillion. Agency Securities were up $170 billion y-o-y, or 2.2%. Outstanding Asset-Backed Securities (ABS), which include "private-label" MBS, declined $35 billion during Q3 and fell $173 billion y-o-y (to $1.629 trillion). Interestingly, Home Mortgage ABS was down $150 billion y-o-y, or 15.4%, to a multi-year low $819 billion. Home Mortgage ABS is now about half the level compared to the end of 2009, as "private-label" MBS either default or are refinanced into lower-rate conventional mortgages.

Rest of World (ROW) holdings of US assets jumped $419 billion during Q3 to a record $21.996 trillion, with over half of the increase explained by the increase in Equities holdings. Total ROW holdings were up $1.502 trillion, or 7.3%, year-over-year. Total ROW Official (central bank) Treasury holdings jumped $1.153 trillion, or 40%, between the end of 2008 to 2012 (to $4.032 trillion). It is worth noting that ROW Official Treasury holdings declined $7.5 billion during 2013ís first three quarters. Over the past year, Official holdings of Agency Securities declined $65 billion, or 11.8%, to a multi-year low $484 billion. Total ROW holdings of Agency Securities declined $145 billion, or 14.1%, to a multi-year low $883 billion.

Even in the face of booming equities and corporate credit, the real economy struggles to gain momentum. National Income expanded at a 3.7% pace during the quarter (to $14.597 trillion), with year-over-year growth of $635 billion, or 4.5%. Compensation expanded at a 2.4% rate during Q3 (to $8.889 trillion), with y-o-y growth of $298 billion, or 3.5%.

Q3 federal Receipts were up 11.9% year-over-year to SAAR $2.972 trillion, while Federal Spending increased just 1.3% y-o-y to SAAR $3.825 trillion. Payments from the GSEs and other special items have made fiscal improvement appear better than reality. It is worth noting that Q3 State & Local receipts were up only 3.2% y-o-y, with spending rising 1.6%.

Not much notable action within the miscellaneous financials. Credit Union Assets were up 5.7% y-o-y to $1.005 trillion. Finance Company Assets were down 1.7% from a year ago to $1.488 trillion. Benefiting from strong securities markets, Life Insurance Assets were up 5.3% y-o-y to $5.866. The REITs were down 3.8% in four quarters to $764 billion. Security Credit expanded at a 7% pace during the quarter to a near-record $1.536 trillion. Securities Broker/Dealer Assets were little changed year-over-year at $2.060 trillion. Funding Corp Assets were up 7.3% ($146 billion) y-o-y to a two-year high $2.149 trillion.

While the Corporate Balance Sheet is now expanding rapidly, the key bubble Dynamic remains the interplay between the Fedís Balance Sheet and the Household Balance Sheet. In one of historyís incredible "wealth" creations, a trillion dollar expansion of Federal Reserve Liabilities - and corresponding injection of this "money" into the financial markets - saw an extraordinary one-year $7.854 trillion surge in Household Net Worth.

To be sure, the Household Balance Sheet is something to behold. Household Net Worth was up another $2.122 trillion (nominal!) during Q3 to a record $77.459 trillion. Household Net Worth is today more than triple the level from 1994. At 459% of GDP, Household Net Worth is also not far from the year-end 2007 level (484%). In just the past two years, Household Net Worth inflated $18.631 trillion, or 31.7%. It is worth noting that Household Net Worth jumped $23.807 trillion during the historic four-year bubble period 2003-2007. For further perspective, Household Net Worth increased an annual averaged $1.862 trillion for the 13 years 1989 to 2002, a period notable for a historic securities bull market.

For Q3, Household Financial Assets holdings were up $1.496 trillion, or 9.1% annualized, to a record $63.894 trillion. Financial Asset holdings jumped $5.356 trillion, or 9.1%, over the past year. Combined Equities and Mutual Fund holdings increased $917 billion during the quarter to $18.299 trillion, while Credit Market Instruments declined $103 billion during the quarter (to $5.500 trillion) and fell $41 billion year-over-year. Household Deposits increased $437 billion, or 4.9%, y-o-y to $9.275 trillion. Since the end of 2008, combined Equities and Mutual Fund holdings were up 98% ($9.061 trillion), while Credit Market Instruments increased only 6.6% ($341 billion). Deposits have expanded 15.3% ($1.231 trillion) since the end of 2008.

It is not only Financial Asset prices that are inflating these days. Household Real Estate holdings increased $502 billion, or 9.5% annualized, during Q3 to a record $21.611 trillion. Over the past year, Real Estate holdings were up $2.332 trillion, or 12.1%.

The Fedís Balance Sheet (assets) ended 1995 at $472 billion, 1998 at $567 billion, 2000 at $636 billion, 2002 at $753 billion, 2004 at $841 billion, 2006 at $908 billion and closed 2007 at $951 billion. Fed Assets then surged to $2.271 trillion in 2008 - and then ended 2009 little changed at $2.267 trillion. Total Fed Assets closed 2010 at $2.453 trillion, jumped to $2.947 trillion in 2011 and were little changed in 2012 at $2.955 trillion.

Federal Reserve Assets this week surpassed $4.0 trillion. The vast majority of the Fedís Assets are securities. After liquidating its T-bill portfolio, the Fed currently holds $2.178 trillion of Treasury notes and other federal securities, up about $500 billion over the past year. The Fed also holds about $1.70 trillion of MBS, up more than $500 billion from a year ago.

On the Liability side of the Fedí s Balance Sheet, Currency in Circulation was up $72.8 billion over the past year to $1.230 trillion. There are a few miscellaneous Liabilities (ie reverse "repos" $113 billion, Deposits $62 billion), but the vast majority of Fed Liabilities are now "Reserve Balances with Federal Reserve Banks." Reserves were $2.541 trillion this week, an increase of over $1.0 trillion from a year ago.

This additional trillion of "Reserves" is the (electronic) "money" the Fed has injected into the securities markets over the past year. These are digital/electronic "credit" entries in the general ledger balances between the Federal Reserve Banks and its member banks and financial institutions. These electronic IOUs are created in the process of the Fed expanding its balance sheet holdings (purchasing securities in the marketplace with newly created "money").

Thereís great confusion regarding these "Reserves." It is a popular misconception that, since these balances sit benignly as "Excess Reserves" (surplus "cash") on bank balance sheets, this "money" is having no impact on transactions or prices. Thereís discussion at the Fed to now use the interest-rate paid on these balances as a policy tool. Former Fed vice chair Alan Blinder would like the Fed to charge banks to hold these reserves, thus incentivizing the banks to lend these "reserves" rather than to do nothing with them.

I am these days reminded of when the expansion of short-term GSE liabilities (electronic IOUs) became a powerful marketplace liquidity-creation mechanism back during the '90s - yet it for years remained virtually unrecognized (was it ever recognized?). Importantly, the massive increase in the Fedís Liability "Reserves" is a direct "money"-creation mechanism with profound effects on securities market prices (and speculative dynamics). Moreover, these "Reserves" must remain banking system Assets until the Fed sells Assets (securities) and uses the proceeds to partially extinguish its Liabilities. Said differently, Fed "Reserves" IOUs will remain in existence until the Fed extracts liquidity from the marketplace - ie collapses some of the liquidity it created - and reduces the quantity of its Liabilities.

To claim the Fedís "Reserves" are large because banks are failing to lend is factually incorrect. Reserves are gigantic for only one reason: the Fed has created enormous quantities of "money" in its misguided quantitative easing program. If these $2.4 trillion of "Reserves" are just sitting there innocuously, why then doesnít the Fed commence the process of "normalizing" its balance sheet? Why is it continuing to add $85 billion a month? Because once monetary inflation takes root it is extremely difficult to stop.

WEEKLY WATCH
The S&P500 dropped 1.7% (up 24.5% y-t-d), and the Dow fell 1.7% (up 20.2%). The broader market was under pressure. The S&P 400 Midcaps dropped 1.6% (up 26.4%), and the small cap Russell 2000 was hit for 2.2% (up 30.3%). The Utilities sank 2.5% (up 4.6%). The Banks declined 1.2% (up 29.9%), and the Broker/Dealers slipped 0.6% (up 62.5%). The Morgan Stanley Cyclicals dipped 0.5% (up 33.9%), and the Transports fell 1.6% (up 33.5%). The Nasdaq100 declined 1.4% (up 29.9%), and the Morgan Stanley High Tech index dropped 2.0% (up 24.9%). The Semiconductors fell 2.0% (up 31.6%). The Biotechs sank 2.8% (up 43.6%). With bullion up $10, the HUI gold index recovered 1.5% (down 56%).

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