Andy Kessler writes on the opinion page of the Wall Street Journal about Fed policy, collateral and the shadow banking system. This is definitely an inside baseball type story. But this is a case where the detail work makes a big difference to the big picture. The quick version is that banks use high quality collateral, i.e., government and mortgage debt, to create credit. They do this by re-hypothecation in the repo (repurchase agreement market). His point is to criticize Fed policy, presumably with the idea of “correcting” it. If he is correct, and I think that he is at least partially correct, then the immediate implications are far more interesting than a critique of Fed policy.

First, here is a bit of background. A repo is nothing more than a collateralized loan. For example, I purchase a 10 year note and want to finance it. The cheapest way to do so is in the repo market where I post the note as collateral. It is called a repurchase agreement because rather than create a loan, I simultaneously sell the note to the bank and negotiate a forward “repurchase” of it. Voila. The bank is happy because it has a liquid asset backing its loan (not like a house) and it has a very good handle on its value. Plus it demands the loan be over-collateralized. I’m happy because I’m getting an extremely good rate due to the safety of the loan.

The bank now has a 10 year note on its balance sheet. Banks don’t like to waste balance sheet; they get measured on their efficient use of it. So the bank does a repo with the 10 year note from me. Now they have the cash, minus the overcollateralization amounts. Bam! Money created. That process is called re-hypothecation (simply because the original loan is called hypothecation. Fortunately, the next transaction is still called re-hypothecation and not re-re-hypothecation.).

Before anyone lays down judgment on how this shows how banks shouldn’t be able to create out of control fiat credit, please realize I’m reporting what happens. I’m not interested right now in whether it is a good idea or not.

The first question is whether he is correct. There is no doubt that the Fed is buying truckloads of bonds. This article from Bloomberg in December estimates that the Fed will be the buyer of 90% of new dollar denominated assets. The Fed focuses on the highest quality (most credit worthy and liquid) issues, i.e., government and mortgage debt. So there clearly is a critically small amount of issuance available. Further, this IMF paper documents the re-hypothecation in the banking system.

To review: 1) The Fed’s QE policy is reducing the amount of usable collateral for hypothecation, 2) this collateral is critical for the “shadow” banking sector, and 3) the “shadow” banking sector is a larger credit creation mechanism than the Fed’s QE. The Fed has stated that its goal is to keep QE going until economic growth gains momentum. Based on this analysis, the clear conclusion is that right as the Fed wants to unwind QE to take the pedal off of the gas, collateral will become available and the credit creation from the shadow banking system will kick in. The implication is that the Fed will have trouble keeping credit creation under control and that inflation will become a real risk.