STIGUM'S MONEY MARKETBy MARCIA STIGUM, ANTHONY CRESCENZI
The McGraw-Hill Companies, Inc.Copyright © 2007 McGraw-Hill
All rights reserved.
ContentsPREFACEACKNOWLEDGMENTSChapter 1 IntroductionPART 1 SOME FUNDAMENTALSChapter 2 Funds Flows, Banks, and Money CreationChapter 3 The Instruments in BriefChapter 4 Bond ValuationChapter 5 Duration and ConvexityPART 2 THE MAJOR PLAYERSChapter 6 The Banks: Domestic OperationsChapter 7 The Banks: Eurodollar OperationsChapter 8 The Treasury and the Federal AgenciesChapter 9 Don't Fight the Fed! The Powerful Role of the Federal ReserveChapter 10 The Market Makers: Dealers and OthersChapter 11 The Investors: Running a Short-Term PortfolioPART 3 THE MARKETSChapter 12 The Federal Funds MarketChapter 13 The Repo and Reverse MarketsChapter 14 Treasury and Federal Agency SecuritiesChapter 15 Financial Futures: Bills, Eurodollars, and Fed FundsChapter 16 Treasury Futures 745Chapter 17 Financial OptionsChapter 18 Eurodollars: Cash Time Deposits and FRAsChapter 19 Interest-Rate SwapsChapter 20 Certificates of DepositChapter 21 Bankers' AcceptancesChapter 22 The Commercial Paper MarketChapter 23 Bank Sales of Loan ParticipationsChapter 24 Medium-Term NotesChapter 25 Municipal NotesChapter 26 Money Market FundsGLOSSARYINDEX
The U.S. money market is a huge and significant part of the nation's financialsystem in which banks and other participants trade more than a trillion dollarsevery working day. Where those dollars go and the prices at which they aretraded affect how the U.S. government finances its debt, how business financesits expansion, and how consumers choose to spend or save. Yet we read and hearlittle about this market, with most focusing on the intrigue of the stock marketand fluctuations in the bond market. The conspiratorially minded might considerthe money market's existence intentionally obscured. The reason most people areunaware of the money market is that it is a market that few businesspeopleencounter in their daily activities and in which the general public turns tomeet its ever-rising expectations on investment returns. Moreover, in an age inwhich attention spans have shrunk, there seems to be too little glamour in themoney market to keep people tuned in to it.
The money market is a wholesale market for low-risk, highly liquid, short-termIOUs. It is a market for various sorts of debt securities rather thanequities. The stock in trade of the market includes a large chunk of the U.S.Treasury's debt and federal agency securities, commercial paper, corporatesecurities, mortgage-backed securities, municipal securities, negotiable bankcertificates of deposit, bank deposit notes, bankers' acceptances, and short-termparticipations in bank loans. Within the confines of the money market eachday, banks—domestic and foreign—actively trade huge blocks andbillions of dollars of federal funds and Eurodollars, the two main sources ofovernight funds and the tools by which the Fed transmits its monetary policies.In addition, banks and nonbank dealers are each day the recipients of billionsof dollars of secured loans through what is called the "repo market," which isnow several trillion dollars in size. Today, a major feature of the money marketis the derivatives market, where market participants go to hedge their risks andplace bets associated with the gyrations in interest rates.
The heart of the activity in the money market occurs in the trading rooms ofdealers and brokers of money market instruments, although increasingly theactivity is occurring in cyberspace, over the Internet. During the time themarket 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 arelinked to other dealers, brokers, and customers. Few phones ever ring, they justblink at a pace that makes, especially in the brokers' market, for some of theshortest phone calls ever recorded. The Internet has reduced the need totransact over the phone, but with trading volume having increased dramatically,trading rooms seem as frenetic as ever, and dealing rooms are anything butquiet. 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 atrading room. Almost drowning that banging out at times is the constant shoutingof quotes and tidbits of information.
Unless one spends a lot of time in trading rooms, it's hard to get a feel forwhat is going on amid all this hectic activity. Even listening in on phones isnot very enlightening. One learns quickly that dealers and brokers often swear(it's said to lessen the tension), but the rest of their conversation isunintelligible to the uninitiated. Money market people have their own jargon,and until one learns it, it is not easy to understand them. Luckily, this dividehas crumbled a bit over the years, thanks to the information age and increasesin market transparency and accessibility, even to the smallest of investors.
Once adjusted to their jargon and the speed at which traders converse, oneobserves that they are making huge trades—$20 million, $200 million, $1billion—at the snap of a finger. Moreover, nobody seems to be particularlyawed or even impressed by the size of the figures. A fed funds broker asked toobtain $100 million in overnight money for a bank might—nonchalant aboutthe size of the trade—reply, "The buck's yours from the San Fran Home LoanBank," slam down the phone, and take another call. Fed funds brokers earn lessthan $1 per $1 million on overnight funds, so it takes a lot of trades to paythe overhead and let everyone in the shop make some money. Luckily for thesebrokers the volume of brokered transactions is between $60 billion and $80billion per day.
Despite its frenzied and seemingly incoherent appearance to the outsider, themoney market efficiently accomplishes vital functions every day. One is shiftingvast sums of money between banks and other financial institutions. For banks,this shifting is required because many large banks, domestic and foreign, withthe 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 canprofitably use internally.
The money market also provides a means by which the surplus funds of cash-richcorporations and other institutions can be funneled to banks, corporations, andother 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 marketprovides the Fed with an arena in which to implement its monetary policy. Thisis where the money market gets the most attention, with investors throughout theworld focused almost obsessively with what the Fed might do next. Newinstruments such as fed funds futures now make it possible to pinpoint preciselywhat the money market expects of the Fed. The varied activities of money marketparticipants also determine the structure of short-term interest rates, forexample, what the yields on Treasury bills of different maturities are and howmuch commercial paper issuers have to pay to borrow. The latter rate is animportant cost to many corporations, and it influences in particular theinterest rate that a consumer who buys a car on time will have to pay on hisloan. 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 aninternational short-term capital market. In it oil imports, semiconductorpurchases, aircraft, and a lot of other non-U.S. trade are financed.
Anyone who observes the money market soon picks out a number of salientfeatures. First and most obvious, it is not one market but a collection ofmarkets for several distinct and different instruments. What makes it possibleto talk about the money market is the close interrelationships that linkall these markets. A second salient feature is the numerous and varied cast ofparticipants. Borrowers in the market include foreign and domestic banks, theU.S. Treasury, corporations of all types, the federal agencies such as FannieMae and Freddie Mac, Federal Home Loan Banks and other federal agencies, thefinancial arms of industrial corporations such as General Electric, dealers inmoney market instruments, and many states and municipalities. The lendersinclude almost all of the above plus insurance companies, pensionfunds—public and private—and various other financial institutions,including the mutual fund industry. And, often, standing between borrower andlender 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 theaccount of some substantial institution. Because of the sums involved, skill isof the utmost importance, and money market participants are skilled at what theydo. In effect, the market is made up of extremely talented specialists in verynarrow professional areas. A bill trader extraordinaire may have only vaguenotions of what the Eurodollar market is all about, and the Eurodollarspecialist may be equally vague on other sectors of the market. Increasingly,however, more of today's trading desks are staffed with generalists, who deal ina wider variety of securities on a daily basis.
Another principal characteristic of the money market is honor. Every daytraders, brokers, investors, and borrowers do billions of dollars' worth ofbusiness over the phone, and however a trade may appear in retrospect, people donot renege. It can be said that a motto of the money market, as in thefixed-income and foreign-exchange market, more generally is: My word is mybond. Of course, because of the pace of the markets, mistakes do occur, butno one ever assumes that they are intentional, and mistakes are always ironedout 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 lightlyregulated. If someone wants to launch a new instrument or to try brokering ordealing in existing instruments in a new way, he does it. And when the idea isgood, which it often is, a new facet of the market is born. Moreover, the marketis always changing. In the very final stages of the writing of this book, forexample, the Chicago Mercantile Exchange was announcing its intention to buy theChicago Board of Trade, merging two futures exchanges where the money market isprominently featured. Many more innovative changes undoubtedly lie ahead for themoney market.
The focus of this book is threefold. First, attention is paid to the majorplayers—who are they, why are they in the market, and what are theyattempting to do? A second point of attention is on the individualmarkets—who is in each market, how and why do they participate in thatmarket, what is the role of brokers and dealers in that market, and how areprices there determined? The final focus is on the relationships that existamong the different sectors of the market, for example, the relationship ofEurodollar rates to U.S. rates, of Treasury bill rates to the fed funds rate, ofthe repo rate to the fed funds rate, and so on.
This book is organized in a manner to enable readers with different backgroundsto read about and understand the money market. Part One contains introductorymaterial for readers who know relatively little about the market. It is prefaceand 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 anunderstanding of its contents is essential for grasping subtleties presentedlater in the book. Readers needing to gain a quick sense of particular subjectmatter will find the charts, supporting text, and end-of-chapter reviews usefultools. The footnotes serve as a useful reference to readers wishing to delveinto topics more deeply.
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 moneycreation. This will provide background for Chapters 6 and 7,which cover domestic and Eurobanking, and Chapter 9, where we examine ingreater 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. Themoney market, as opposed to the bond market, is a wholesale market forhigh-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 governmentbody—is constantly receiving and using funds. In particular, a businessfirm receives funds from the sale of output and uses funds to cover its costs ofproduction (excluding depreciation) and its current investment in plant,equipment, and inventory. Historically, for most firms, gross savingfrom current operations (i.e., retained earnings plus depreciationallowances) has fallen far short of covering current capital expenditures;that is, net funds obtained from current operations are inadequate to paycapital expenditures. As a result, each year most nonfinancial business firmsand the nonfinancial business sector as a whole have tended to run a largefunds deficit. In the early 2000s, this pattern was upended, with mostnonfinancial firms running large funds surpluses.
The actual figures rung up by nonfinancial business firms in 2005 are given incolumn 2 of Table 2.1. They show that business firms had retainedearnings of $383.5 billion (profits before tax of $887.7 billion minus $254.1billion of taxes on corporate income and net dividends of $250.1 billion) andtheir capital consumption allowances totaled $636.0 billion, giving them (aftera few other relatively small adjustments) a grand total of $1.020 trillion ofgross saving with which to finance capital expenditures. This amount, however,totaled $926.9 billion, so the business sector as a whole incurred a $93 billionfunds surplus.
The surplus that nonfinancial businesses rang up in 2005 is highly unusual froma historical perspective, as the business sector tends to have a chronic fundsdeficit. 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 $260billion would have been considered normal. The funds surplus of 2005 was thesecond in a row for nonfinancial firms, which ran a surplus of $78.9 billion theprevious year. This is in stark contrast to 2000 when these firms ran a largedeficit, owing largely to spending by entities earning little or no profits,particularly those that had used the capital that they had raised during therun-up in stock prices in the late 1990s. For example, there were many dot-comcompanies that were spending money that they would never earn, utilizing theproceeds from their initial public offerings.
Figure 2.1 shows the financing gap for all sectors. The chart indicatesbig swings between 2000 and 2006, moving from a large deficit to a largesurplus.
There are many reasons why the nonfinancial sector moved to a funds surplus inthe early 2000s, some of which are debatable. For example, some cite the largetax cuts enacted during those years, although there are many who would disagree.Another major influence was the bursting of the financial bubble in 2000. Itinstilled cautiousness among corporations, which became slower to hire and morerestrained in their capital outlays. Such was the case until 2004 when bothhiring and capital spending accelerated. Yet another reason relates to thesecular trend begun in the early 1990s toward restructuring. Since that time,companies have been particularly keen to run themselves as leanly andefficiently as possible in order to boost profitability. Advances in technology,which contributed to the productivity boom that began in the mid-1990s, gaveadded momentum to the restructuring trend, boosting profitability and spurringfunding surpluses in the process.
Whatever the causes of the funding surpluses, the surpluses reduced thenonfinancial sector's need to draw capital from other sectors. In other words,the business sector did not need to sell stocks, bonds, and money marketinstruments in order to fund its capital expenditures. That is why in 2005 thenet 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 ofnet new equity issues. Nonfinancial businesses nonetheless saw a net increase of$280.3 billion in credit market instruments, including $60.7 billion ofcorporate bonds.
Chronic deficits are more the norm for the business sector, which is to beexpected, since every year the business sector receives a relatively smallportion of total national income but yet has to finance a major share ofnational capital expenditures. Established business firms typically obtainrelatively little new financing from the sale of new shares; the bulk of thefunds they obtain to cover their deficits comes through the sale of bonds andmoney market instruments.
In contrast to the business sector, the consumer sector presents a quitedifferent picture. As Table 2.1 shows, households in 2005 had grosssavings of $1.186 trillion yet made capital expenditures of $1.712 trillion,leaving the sector with a funds deficit of $526 billion. This fundsdeficit has been a persistent phenomenon in the early 2000s. Every yearconsumers as a group have been saving less than they have been investing inhousing and other capital goods. Consumers have been financing their investmentsmostly through home mortgages; household mortgage debt doubled between 2000 andthe first quarter of 2006, increasing from $4.4 trillion to $8.9 trillion. Withconsumers running large funding deficits, it could be said that the businesssector has been lucky that it hasn't had to depend upon the household sector tofinance its capital expenditures. In past years, the consumer sector was a majorsupplier of funds to the business sector, which is to be expected in anydeveloped economy in which the bulk of its investing is carried on outside thegovernment sector. Households are, after all, the major income recipients, andbusiness firms are the major investors.
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