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Monday, January 22, 2007 11:46 PM

Gold, M3, and Willingness to Lend

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Let's start with a quick look at the expansion of the monetary base in comparison to the expansion of broad money supply as measured by M3.

Monetary Base


The above chart is from a discussion on Money Supply and Recessions. For this article, pay attention to the green line, ignoring the others. M3 started exploding in 1971 and it was not happenstance either. Here is a snip from The Last Great Bubble - Counterfeiting the Dollar.

1971 - Aug 15 - President Nixon closes the international gold window. U.S. Dollars are no longer redeemable in gold for international settlements. This marked the beginning of the current, anchorless floating currency regime, an not coincidentally, a decade of inflation.
The previous link is an interesting read from 2002 predicting the demise of the dollar even as it was still rising at the time. However, the article fails to point out that it was not just the US abandoning all ties to the gold standard, it was every country in the world.

This was the biggest experiment in fiscal madness the world has ever seen. Unleashed from the "burden" of gold redemptions, credit has soared far faster than base money supply. This in turn fueled asset bubble after asset bubble, but most notably in the global equity markets and housing.

Do those charts represent inflation? Absolutely, what else can they represent? Inflation is the expansion of money and credit and both money and credit went on a tear. But although the chart patterns are similar, the scale is enormously different. M3 dwarfs monetary base expansion.

There is without a doubt a bubble in credit. Money is being "swept" out of checking accounts and lent out. Bank reserves are non-existent. Fannie Mae and Freddie Mac have been creating debt out of thin air. That is what happens when money is no longer backed by anything. But the question is not "What happened?", as the charts clearly show that. The pertinent question is "What happens next?" As long as asset prices keep rising the bubble can keep expanding. Consumers can then keep borrowing against the rising value of their houses and stocks which in turn supports current consumption.

Is the ability to expand that credit bubble infinite?

I think not. Therein lies the problem. Every bubble sows the seeds of its own demise. Wages are not keeping up with ability to service debt. Global wage arbitrage and outsourcing ensures that trend will continue. Housing is not affordable and has risen several standard deviations beyond wage growth and rental costs. People purchased homes they could not afford just because someone was dumb enough to lend them money. The result is rising bankruptcies and foreclosures at a massive annual rate of growth.

Can the Fed keep expanding the bubble?
Once again the answer is no. Debt bubbles end when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and /or speculation no longer makes any economic sense.

Here is an alternative reason: Debt bubbles implode when the ability to service the debt can no longer be maintained. Bankruptcies and foreclosures are two ways to measure inability to service debt.


Foreclosures are actually at a fairly low rate. It is the rate of change however that is alarming. Foreclosures increase 51 percent nationwide.
Foreclosures increased 94 percent last year to 157,417 homes in California, as homeowners struggle with fast-rising home payments and a slow-selling market, according to a Fair Oaks real estate investment advisory firm on Monday. California had the most foreclosures filed nationwide, while Nevada had the largest percentage increase at 175 percent last year compared to 2005, according to Foreclosures.com. Nationwide, almost 971,000 foreclosure filings were reported last year, 51 percent more than the 641,000 in 2005, according to the annual report.
Faith In The Fed

Right now there is enormous faith in the ability of the Fed to keep the bubble inflated. Inflationists fail to see that much of that credit borrowed into existence can never be paid back.

Yet somehow everyone thinks the Fed will expand money enough to matter if a credit bust happens. It has never worked that way in history. Take a good hard look at monetary base vs. M3. Interest rate policy at the Fed can not fuel that expansion forever.

The Treasury Department has massive ability to print money but it can not force banks to lend. It is important to understand the difference. Credit lending standards can only go far so far before bankruptcies and foreclosures force a change. That change is finally upon us and a huge secular reversal is now underway.

The Fed itself simply does not have the power to deposit money into consumer accounts so that bills can be paid. They probably would not do so even if they could because it would be to the detriment of banks and creditors. Will the Fed react to a debt implosion by cutting interest rates? Absolutely. The Fed is will likely attempt anything they can to help consumers service debt. History proves it and history proves gold will benefit as well. But the Fed can not create jobs or revive housing and neither can the Treasury.

Willingness To Lend

The Mortgage Lender Implode-O-Meter is reporting “Twelve lenders have now gone caput since December 2006”. This number has has been increasing at a rate of 1-2 a week since December. Two of those lenders were among the top twenty subprime lenders. One of them was Ownit Mortgage, the other was Mortgage Lender Network. Ownit Mortgage and MLN both went bankrupt.

Following is a partial list of lenders unable (via bankruptcy) or unwilling (because of huge losses) to make subprime loans.

2007-01-19: EquiBanc
Wachovia recently conducted an intensive strategic review of its mortgage business which has altered the company's approach to the origination of non-conforming loans. As a result, Wachovia has elected to close EquiBanc Mortgage - Wachovia's only business dedicated solely to non-conforming loans.
2007-01-19: FundingAmerica
Due to current market conditions in the mortgage industry, Funding America has decided to discontinue accepting any new business.
2007-01-08: Clear Choice Financial/Bay Capital
Clear Choice Financial, Inc. a Nevada corporation, announced that it is insolvent and in default on numerous obligations. Clear Choice has officially closed the mortgage lending offices of its wholly owned subsidiary, Bay Capital, located in Owings Mills, Maryland and Irvine, California.
2007-01-05: SecuredFunding
Based upon market conditions and limited product availability, we are ceasing wholesale operations. We have stopped accepting new applications, and will have until the 12th of January to fund out the pipeline. We appreciate your patience as we undergo this transition.
2006-12-29: MLN
Hundreds of workers in Rocky Hill left the office of a billion-dollar national company with boxes in hand and tears in their eyes. Mortgage Lender's Network, headquartered in Middletown, recently stopped funding new loans. "We're not going to get paid. We keep our benefits for two weeks, and we're not going to have a severance package." said MLN employee Melissa Goyette. The company is closing after losing a large financial backer and the failure of a last-minute bid to raise cash. The company was in the middle of building a new location in Wallingford that was to open later in the year.
2006-12-20: Harbourton Mortgage Investment Corporation
Harbourton Capital Group, Inc. announced that effective December 20, 2006, Harbourton Mortgage Investment Corporation (“HMIC”), its wholly owned mortgage-banking subsidiary, ceased funding new mortgage loans and initiated a process to wind down its operations. HMIC was forced to take these actions when it was unable to satisfactorily resolve mortgage repurchase claims asserted by selected investors that had purchased mortgage loans from HMIC. As a result of this action, HCG will likely write off its full investment in HMIC. HMIC’s recent ignificant losses and requirements for new capital negatively impacted HCG during 2006.
Eligible Buyer Pool

The pool of eligible buyers is now shrinking. Consider the article For credit risks, home loans harder to get. Here are some excerpts regarding changes in lending standards:
  • Down Payments: New guidelines require 10 percent down according to Gary Akright, a mortgage broker at Dominion Mortgage Corp. The previous guidelines required 5 percent down.
  • Credit scores: Previously, borrowers with a FICO credit score as low as 570 (out of 850) could qualify for a single loan financing 100 percent of their home purchase, Mr. Carmona of Homewood Mortgage in Carrollton said. "Now, across the board, it's jumped up to a 600 FICO score for an 80/20 loan".
  • Subprime Rates: Rates on subprime mortgages have risen about a full percentage point since September, Mr. Carmona said, while regular mortgage rates have been relatively steady.
  • Savings requirements: "They want to see borrowers have at least three months of reserves in their account in case of an emergency," Mr. Carmona said. "They want to see it in your bank account saved for at least 60 days. Usually, subprime lenders didn't ask for that."
Current Conditions vs. 70's and 80's

Conditions now are radically different than conditions in the 70's and 80's. A couple decades ago households went from one wage earner to two wage earners which increased purchasing power; wages and benefits were rising and not just for those at the top end; mortgage rates were set to decline nine full points; credit lending standards had plenty of room to drop; debt levels were low; the savings rate was high, and ability to take on debt was huge. Virtually none of those conditions exist today, not a single one. Yet many think that because commodity prices are rising that this is some sort of 70's and 80's replay. It simply can not be. The conditions are vastly different.

Willingness to Lend / Willingness to Borrow
  • Credit standards are tightening
  • The pool of willing lenders is clearly shrinking
  • The pool of eligible home buyers is now shrinking with the tightening of credit standards
  • The pool of willing buyers is shrinking along with a decrease in the willingness to speculate on housing
The psychology of both lenders and borrowers has now changed at the margin (subprime lending). This is how cascades start. When defaults continue it will progress further and further up the chains of credit worthiness. It is a mistake to think this will be confined to housing. It won't. If and when another huge hedge fund blowup, and/or there is a huge junk bond default, the leveraged buyout and merger mania markets will be hit hard. This is all poised to feed on itself once the ball gets rolling. A major credit bust is coming and it is only a matter of time.

There is massive belief in the Fed to be able to do something about that bust when it happens. That faith is totally unwarranted. Note again the huge difference between M3 and Base money. Also note that the Fed can not create jobs or put money directly into consumer accounts. Even if the Fed could deposit money into consumers pockets (the helicopter drop theory), to do so would be at the expense of banks and creditors. That makes the helicopter drop scenario implausible. However, the Fed will undoubtedly be willing to slash rates. But will banks be able and willing to lend? Will consumers be able and willing to borrow? A history of credit bubble collapses suggests otherwise as does the data presented above.

Mike Shedlock / Mish

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