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The Banking System Is Both Too Big and Not Big Enough

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It's too big in the sense that the capacity to make loans far outweighs the demand for credit, yet it's not big enough to accommodate the demand for liquid savings.

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The 10-year shorts could either be due to outright MBS extension hedging or by the swap desks which sell the hedge to the MBS holders. Either way considering we only had a 50bps move in rates tells you something about the sensitivity of price and duration with these low negatively convex coupons vs. what it was like in 2009 200bps higher.

Let's examine a scenario that may have led to the repo squeeze. Since the financial crisis total bank credit and bank deposits have continued to expand to all-time highs at $9.97 and $9.23 trillion respectively. Yet in an environment with no loan demand securities have supplemented the growth in total credit. One of the largest allocations in a bank's securities portfolio are MBS representing roughly 50% of the $2.7 trillion currently sitting on bank balance sheets. In September when the Fed launched QE III targeting MBS in amounts that some estimate could absorb the total supply of new production, spreads on MBS collapsed 100bps in a short period of time.

MBS 30-Year CC Vs. 10-Year



Levered investors such as hedge funds and REITs (and some large banks) were forced to hedge prepayment risk by buying duration. This was all happening against the backdrop of a radical regime change in Japan that was intent on increasing inflationary monetary policy which saw a precipitous drop in the USDJPY. This reversed the rally and put upward pressure on long-term interest rates, which pushed MBS spreads wider, driving hedgers to reverse longs to go short in order to hedge extension risk. As a consequence of the rapid reversal in yields there was tremendous short position built up in a short period of time, which is leading to a squeeze in the repo market.

The consumption bubble led to $2.5 trillion in liquidity on corporate balance sheets. This liquidity now represents institutional cash pools looking for liquid assets. At the same time following back-to-back investment and consumption bubble collapses right in front of baby boomer retirement we are seeing a shift in household investing behavior back towards liquid deposit savings at a level that now exceeds $9 trillion. This double whammy is now stressing the system's capacity to meet this demand for short term safe liquid investments.

With this week's FOMC meeting the headlines will focus on the QE exit strategy and what that means for higher interest rates. However with deposit yields already at zero and the cycle of savings just underway there is also risk if interest rates fall. As the reflexive process evolves, the lower they go the more you need to save, and the more you need to save, the lower interest rates will fall. This will provide banks with more funds to invest and lend which will force more capital into an already saturated system, which will only generate more stress.

Liquid savings demand continues to represent a rising share of household net worth at a time when the banking system's capacity to accommodate this demand is getting maxed out. This is the evolution in household behavior following investment and consumption cycles, but it's not clear how the imbalance gets reconciled. What is clear is that the slightest uptick in volatility can make a seemingly very liquid banking system suddenly very illiquid.

Twitter: @exantefactor
No positions in stocks mentioned.
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