Naked Capitalism: Marshall Auerback: Bankers Gone Wild in Ireland AND Germany

Marshall Auerback: Bankers Gone Wild in Ireland AND Germany

By Marshall Auerback, a hedge fund manager and portfolio strategist who writes for New Deal 2.0.

Despite a blame-a-thon on Ireleand, Germans banks are really at the core of the eurozone catastrophe.

Much ink has been spilled in the press over the Irish problem and the laxity of the country’s southern Mediterranean counterparts in contrast to the highly “disciplined” Germans. But perhaps we have to revisit that caricature. Not only has the Irish crisis blown apart the myth of the virtues of fiscal austerity during rapidly declining economic activity, but it has also illustrated that Germany’s bankers were every bit as culpable as their Irish counterparts in helping to stoke the credit bubble.

One of the traditional rationales for the creation of the euro was that a single currency and strict Maastricht criteria would keep the profligate Mediterraneans and their Celtic equivalents in line. Instead, critics, particularly in Germany, increasingly see the European Monetary Union as a means for freeloading nations to offload their liabilities onto fitter neighbors.

Not surprisingly, this has engendered much discussion that perhaps it would serve Germany’s interests to leave the euro, rather than booting one of the Mediterranean “scroungers” out. But as Simon Johnson has pointed out, this comforting narrative of German prudence matched up against Irish profligacy doesn’t really stack up:

German banks in particular lost their composure with regard to lending to Ireland — although British, American, French and Belgian banks were not so far behind. Hypo Real Estate — now taken over by the German government — has what is likely to be the highest exposure to Irish debt.

But look at loans outstanding relative to the size of their domestic economies (using the BIS data on what they call an “ultimate risk basis”).

German banks are owed $139 billion, which is 4.2 percent of German G.D.P. [my emphasis]

Where were the German regulators? As my colleague Bill Black has noted:

They seem to have believed that ‘What happens in Vegas (Dublin) stays in Vegas (Dublin).’ Instead, their German banks came back from their riotous holidays in the PIIGS with BTDs (bank transmitted diseases). The German banks’ regulators continue to let them hide the embarrassing losses they picked up on holiday, but that cover up will collapse if any of the PIIGS default. The PIIGS will default if the EU does not bail them out, so there will be a bail out even though the German taxpayers hate to fund bailouts.

German banks’ relatively high exposure to Ireland does pose the question as to whether there is some wild, Weimar-style hyperinflationista lurking deep in the heart of every German, only able to express itself fully when away from the prying eyes of fellow citizens.

All of the rescue plans that have been introduced in Ireland or Greece thus far rest on the assumption that, with more time, the eurozone’s problem children could get their fiscal houses in order — and Europe could somehow grow its way out of trouble. But the fiscal austerity being offered as the “medicine” is turning out to be worse than the disease. It has exacerbated the downturn and unleashed a horrible debt deflation dynamic in all of the areas where it was reluctantly implemented.

But here’s the thing: these fiscal straitjackets obscure the history of how we came to today’s horrible impasse and, more specifically, the German banks’ role in helping to fuel the credit binge. Also lost is the reason why this has metastasized into a far greater crisis: as part of the eurozone, Ireland does not have the fiscal freedom to come up with a sufficiently robust government response. The UK had a comparable real estate bubble in the late 1980s, which culminated with the Soros attack on the pound in 1992 and the ejection of sterling from Exchange Rate Mechanism (the precursor to the EMU). This was a blessing in disguise. Withdrawal from the ERM saved the UK because it allowed the country sufficient latitude to reflate. Yes, the country had a major recession (in many ways a consequence of the surrender of fiscal freedom as a result of joining the ERM in the first place), but there was never a systemic risk that posed a threat to the country’s overall solvency as is the case in Ireland today. And this is exacerbating the problem in Ireland because it persists in chasing its tail repeatedly with futile fiscal austerity measures.

The truth of the matter is this: the eurozone seems rotten to the core, literally. Germany represents that core. The Germans might occupy the penthouse suite, but it is the suite of a roach motel. And we know what happens to those who enter such “establishments.”

Yes, longer term the problems currently afflicting the eurozone could be sorted via the creation of a supranational fiscal authority — a “United States of Europe”. But with each crisis (Ireland today; Portugal and Spain tomorrow; Italy and then France next?), the political forces are coalescing in a radically different direction. The Germans are becoming increasingly resentful as they perceive their country as the bailout mechanism of last resort (even though the Irish experience suggests that their bankers are also guilty of many of the same excesses as the “Celtic Tiger”). The PIIGS themselves are seeing that the benefits of euro membership have been vastly overstated and in fact now act as a cancerous influence through the Germanic embrace of austerity. (Paradoxically, it has been the “profligate” behavior of those so-called lazy Mediterraneans that has enabled Germany to retain its export-driven model, as well as allowing it to run lower budget deficits than most other countries.)

The eurozone could ultimately end up like Yugoslavia writ large. Prior to the break up of that country, the relatively rich republics, Slovenia and Croatia, resented policies that transferred wealth to the poorer republics like Serbia, Macedonia, Montenegro, or the autonomous region of Kosovo. Once Tito’s organizing genius disappeared, the links stitching the country together became frayed and eventually snapped as old grievances manifested themselves in newer forms. The same could happen to the Europe Union if it underwent a supranational fiscal union — the beginnings of which are already in evidence. I think the Germans are beginning to recognize that, which is why there is discussion about leaving the euro.

But let’s first be clear: German Chancellor Angela Merkel has persistently argued that it is essential that private investors, notably the bond holders, begin to suffer losses so that they will have the proper incentives to provide effective “private market discipline” going forward. She has further argued that it is fair that they suffer losses, given the premium yields they received and their lack of due diligence. That’s an honorable policy. But it’s like the old Irish joke of the driver who gets lost, asks for directions, and is told, “Well, I wouldn’t be starting from here.” By the same token, Ireland clearly illustrates that German banks, as well as their Mediterranean counterparts, would be big losers under the Merkel proposal. Ironically, German financial institutions could find themselves subject to the same kinds of bailouts that Chancellor Merkel and many of her counterparts in Berlin are urging on the Irish and Greeks.

As always, leave it to the Irish to come up with the most poetic response to the crisis. True, W.B. Yeats did not live to see this disaster, but his passionate “September 1913” does evoke the tragedy of today’s Ireland and the futility of the current policy responses for their people (and beyond):

Was it for this the wild geese spread
The grey wing upon every tide;
For this that all that blood was shed,
For this Edward Fitzgerald died,
And Robert Emmet and Wolfe Tone,
All that delirium of the brave?
Romantic Ireland’s dead and gone,
It’s with O’Leary in the grave.

Graves that might soon include not only the O’Learys, but also the Garcias, Texeiras, Moreaus, and Schmidts if a more rational course of action throughout the euro zone is not adopted soon.

Why QE2 and reserves dont matter.

Auerback: Amateur Hour at the Federal Reserve

By Marshall Auerback, a portfolio strategist and Roosevelt Institute Fellow

As any student of Economics 101 realises, you can control the price of something, or the quantity, but not both simultaneously. In announcing its decision to purchase an additional $600bn of treasuries last week, the Federal Reserve presumably intended to create additional stimulus to an economy, since tepid growth has failed to make a dent in unemployment. Even Friday’s “good” unemployment numbers, where the US economy added 151,000 jobs, were not enough to reduce the current jobless rate of 9.6%.

So is a new round of “QE2” going to do the trick? It would be interesting to figure out how the Fed came to the magic number of $600 billion. Why not a trillion? Why not $250bn? Why $75bn a month? There’s an element of sticking one’s finger in the air and hoping for the best. The Bernanke Fed is slowly reaching Greenspan-like levels of incompetence.

Let’s go back to first principles: Quantitative easing involves the central bank buying financial assets from the private sector – government bonds and maybe high quality corporate debt. In this particular instance, the Fed has announced it will buy $75bn of treasuries a month. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserve balances. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

Central bank demand for “long maturity” assets held in the private sector reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds are likely to drop. But on the other hand, the low rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

Essentially, then, you have a supply side response to a problem of aggregate demand. The cost of investment funds might well drop, although that’s not 100 percent clear. Consider the following example: Let’s say the Fed simply targeted the 10 year treasury at 2.25%. The central bank would have a bid at that level and buy all the securities the market didn’t want to buy at that level. They may in fact buy a lot or a very few, and possibly none at all, depending on Treasury issuance, investor demand, and market expectations.

But the FOMC has announced a limit to the Fed purchase program, both in terms of the monthly amounts and the total quantity. How high will 10 year notes trade with the billions free to trade at market levels?

It could be at much higher yields, which presumably defeats the whole purpose of the program. Of course, if the Fed bought every single 10 year treasury, then for sure they could maintain that rate indefinitely; but then they would have to preclude announcing a specific amount that they wished to purchase. Of course, if the Fed did this, people would undoubtedly squawk about “printing money” and “creating inflation” but again, QE does not actually create new net financial assets.

In fact, the Fed has done nothing but TALK about its plans over the past several months, but has yet to initiate the program. There has been no widespread “money printing” or “currency debasement”. The Federal Reserve announced an INTENTION to do something and private portfolio investors took their cue from that. But as any Asian central banker can tell you, private portfolio preference shifts are notoriously fickle, with conflicting motives. The term structure of rates in Japan would imply a comparable intent to make holding yen unattractive, yet 10 year government bonds in Japan yield less than one percent and the yen remains resolutely strong against the dollar.

Is there another method by which the Fed could influence the long term structure of interest rates? Why not just stop issuing 10 year government paper? If the Treasury had announced they were eliminating everything longer than 2 year notes for new issues there would hardly be any screams of “money printing”?

And how low would the 10 year go?

If the objective is to allow the banks to earn their way out of insolvency, then QE2 is also an ineffective means of doing this, since it flattens the yield curve, but still engenders interest rate risk on the part of the banks which persist in “playing the yield curve”, especially via leverage. There is a more effective means of doing promoting bank profitability in a comparatively risk free way, as my colleague, Randy Wray, has noted:

[T]here is nothing wrong with offering longer-maturity CDs to replace overnight reserve deposits held by banks at the Fed. Banks are content to hold deposits at the Fed—safe assets that earn a little interest. They are hoping to play the yield curve to get some positive earnings in order to rebuild capital. If they can issue liabilities at an even lower interest rate so that earnings on deposits at the Fed cover interest and other costs of financing their positions in assets, this strategy might work. That is what they did in the early 1990s, allowing banks that were insolvent to work their way back to profitability. The Fed could even lend to banks at 25 basis points (0.25% interest) so that they could buy the CDs, then pay them, say, 100 or 200 basis points (1% or 2% interest) on their longer maturity CDs. The net interest earned could tide them over until it becomes appropriate for them to resume lending to households and firms.

To be clear, we are not necessarily advocating banks play the yield curve to restore profitability (far better to have a payroll tax cut for that), or that they get such an arbitrage from the Fed, only that it would work with less risk both to the bank and the financial system than what will result from QE. Ultimately, if the objective is to allow banks to restore profitability via traditional lending activities, then there are far more obvious ways to do so. Let’s first recall that BANKS DO NOT LEND THEIR RESERVES, as is always depicted in the economics textbooks via so-called “fractional reserve lending”. The Federal Reserve Bank is a bank, just like Citibank or Wells Fargo. The Treasury has an account at the bank, just as you or I have a checking account at our local bank. Other banks, like BofA and Wells Fargo have accounts at the Fed as well, and they are called reserve accounts (for more see here).

Reserve accounts are not made up of money held in reserve in case a loan goes bad, they are money held at the Federal Reserve for payment settlement. The reserves of money held in case loans go bad are capital. They are not lent out. The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share. But that’s a function of credit analysis (or the lack of it, as the cycle matures), NOT the bank’s reserve positions.

These loans are made independent of their reserve positions. At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the bank’s marginal cost of funds is sufficient, the bank will lend

So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend (for more explanation, see here).

Consequently, the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is ultimately dictated by the presence of creditworthy borrowers, which is a function of FISCAL POLICY. Instead of expending political capital on pointless accounting shuffles and financial guarantees, or programs such as TALF, TARP, Term Auction Credit, or the Commercial Paper Lending Facility, one could simply implement a $2 trillion tax cut (or spend it via the government, or do revenue sharing with the states), thereby generating increased spending power in the economy, providing significantly higher multiplier effects and ultimately shifting the economy back to self-sustaining growth. This would be far more effective than continuing an endless array of silly Fed programs, which do nothing but diminish the central bank’s credibility and have had minimal impact in terms of economic growth.

In many respects, the markets are already implicitly conceding the ineffectiveness of “QE2”. Within hours of the program being announced, there were stories of “QE3”. Instead of having a situation where the markets “buy the rumor, sell on the news”, it appears to have been more a case of buy the rumor and then double up on the news.

We’ve truly hit amateur hour at the Fed. We’re inciting speculation and the Federal Reserve is acting like the kid in his car seat who keeps turning his toy steering wheel as much as it takes to turn the car. Toy cars, however, won’t get you very far if you plan a long journey, and likewise QE2 is a pretty ineffective vehicle if one wishes to engender genuine economic growth. Eventually, investors will realize they’ve been conned (yet again) by the Fed and the end result won’t be pretty.

Don’t Fear the Rise in the Fed’s Reserve Balances

By Scott Fullwiler

Many in the financial press have noted the rise since September 2008 in the Fed's reserve balances from about $20 billion to more than $800 billion today. A number of well-known economists have expressed concern that this will be inflationary.

However, fears that these are inflationary are misplaced, even inapplicable, as they apply only to a monetary system operating under a gold standard, currency board, or similar arrangement, not the flexible exchange rate system of the U. S.

Under a gold standard, for instance, banks must be careful when creating loans that they have sufficient gold or central bank reserves to meet depositor outflows or legal reserve requirements. This is the fractional banking, money multiplier system standard in the economics textbooks. If there is an inflow of gold, then bank deposit creation can increase and prices can rise. The same can occur if the central bank raises the quantity of reserves circulating relative to its own gold reserves.

But that's not the case under modern monetary systems with flexible exchange rates.

In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed's stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.

The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank's ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.

In other words, there is no loan officer at any bank that checks with the bank's liquidity officer to see if the bank has reserves before it makes a loan.

What constrains a bank in the creation of new loans and deposits, then? First, there is the fact that there must be a willing borrower . . . one whom the bank deems to be creditworthy. Second, the loan must be perceived as profitable . . . in this case, the bank's ability to raise deposits does matter, since it probably expects the borrower to withdraw the deposit it will create, and finding new deposits is much cheaper for the bank than borrowing from other banks or from the Fed. Third, the loan must be on the regulator's approved list of assets, and if the loan results in an expansion of the bank's balance sheet, the bank must be aware of the impact on its capital requirements and other financial ratios with which the regulator is concerned.

But, how many reserve balances the bank is holding does NOT affect its operational ability to make the loan.

Most fears expressed by economists, policymakers, and the financial press regarding the rise in reserve balances since September presume—like the inapplicable money multiplier model—this will necessarily lead to excessive creation of loans and deposits by banks and thus rising inflation.

But this cannot possibly be true. Banks have the same ability to create loans with $800 billion in reserve balances that they had with $20 billion. The difference now is mostly that they do not see as many creditworthy borrowers coming through their doors, given the deep recession, which has led them to create fewer loans.

Admonishments of banks by members of Congress for "not lending out the TARP funds" make the same mistake. Banks don't lend out TARP funds or any other funds. They create loans and deposits out of thin air, then use reserve balances to settle payments or meet reserve requirements.

For further evidence, consider two recent extreme cases:

In Canada, reserve balances have been effectively zero for over a decade now, and bank lending continues as it does anywhere else. Canada's inflation also has been similar to that of the U. S.

In Japan, under the so-called quantitative easing regime of 2001-2005, reserve balances reached around 15% of GDP, and the monetary base (reserve balances plus currency in circulation . . . often termed "high powered money") reached 23% of GDP. But Japan has, if anything, experienced deflation during and since this period, which is not surprising, since—again—the rising quantity of reserve balances did not enhance Japanese banks' abilities to create loans.

In the U. S., by comparison, reserve balances have reached about 6% of GDP, with the monetary base rising from about 6% to about 12% of GDP since September 2008. Those fearing rising Fed reserve balances apparently haven't noticed that an increase in reserve balances about three times the size in terms of GDP already happened in Japan, with none of the effects that have been predicted for the U. S.

In short, don't fear the rise in the Fed's reserve balances. It is not inflationary because the money multiplier view, found in the textbooks, doesn't apply to the flexible exchange rate monetary system of the U. S. The U. S. may indeed experience rising inflation in the future (or it may not), but it won't have anything to do with the quantity of reserve balances banks are holding.

Data sets for dissertation

Fed state level data

http://fraser.stlouisfed.org/publications/allbkstat/

Mason and Calomiris:

http://research.stlouisfed.org/publications/review/98/05/9805jm.pdf

FDIC member bank data:

Brief explanation of housing in NIPA:

http://www.michaelcarliner.com/HE0110-Hous-GDP.pdf

Naked Capitalism: Japan’s Experience Suggests Quantitative Easing Helps Financial Institutions, Not Real Economy

Japan’s Experience Suggests Quantitative Easing Helps Financial Institutions, Not Real Economy

A few days ago, we noted:

When an economy is very slack, cheaper money is not going to induce much in the way of real economy activity.

Unless you are a financial firm, the level of interest rates is a secondary or tertiary consideration in your decision to borrow. You will be interested in borrowing only if you first, perceive a business need (usually an opportunity). The next question is whether it can be addressed profitably, and the cost of funds is almost always not a significant % of total project costs (although availability of funding can be a big constraint)…..

So cheaper money will operate primarily via their impact on asset values. That of course helps financial firms, and perhaps the Fed hopes the wealth effect will induce more spending. But that’s been the movie of the last 20+ years, and Japan pre its crisis, of having the officialdom rely on asset price inflation to induce more consumer spending, and we know how both ended.

Tyler Cowen points to a Bank of Japan paper by Hiroshi Ugai, which looks at Japan’s experience with quantitative easing from 2001 to 2006. Key findings:

….these macroeconomic analyses verify that because of the QEP, the premiums on market funds raised by financial institutions carrying substantial non-performing loans (NPLs) shrank to the extent that they no longer reflected credit rating differentials. This observation implies that the QEP was effective in maintaining financial system stability and an accommodative monetary environment by removing financial institutions’ funding uncertainties, and by averting further deterioration of economic and price developments resulting from corporations’ uncertainty about future funding.

Granted the positive above effects of preventing further deterioration of the economy reviewed above, many of the macroeconomic analyses conclude that the QEP’s effects in raising aggregate demand and prices were limited. In particular, when verified empirically taking into account the fact that the monetary policy regime changed under the zero bound constraint of interest rates, the effects from increasing the monetary base were not detected or smaller, if anything, than during periods when there was no zero bound constraint.

Yves here This is an important conclusion, and is consistent with the warnings the Japanese gave to the US during the financial crisis, which were uncharacteristically blunt. Conventional wisdom here is that Japan’s fiscal and monetary stimulus during the bust was too slow in coming and not sufficiently large. The Japanese instead believe, strongly, that their policy mistake was not cleaning up the banks. As we’ve noted, that’s also consistent with an IMF study of 124 banking crises:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.5 Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.

But (to put it charitably) the Fed sees the world through a bank-centric lens, so surely what is good for its charges must be good for the rest of us, right? So if the economy continues to weaken, the odds that the Fed will resort to it as a remedy will rise, despite the evidence that it at best treats symptoms rather than the underlying pathology.

ProPublica: Banks’ Self-Dealing Super-Charged Financial Crisis

Banks’ Self-Dealing Super-Charged Financial Crisis

Short/no reading version of the story:
Planet Money

Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.

Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:

They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks -- primarily Merrill Lynch, but also Citigroup, UBS and others -- bought their own products and cranked up an assembly line that otherwise should have flagged.

The products they were buying and selling were at the heart of the 2008 meltdown -- collections of mortgage bonds known as collateralized debt obligations, or CDOs.

As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created -- and ultimately provided most of the money for -- new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain [1] that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.

Economist's View: Questions and Answers about the Financial Crisis

Questions and Answers about the Financial Crisis>
Gary Gorton

Link to full pdf (the full article is required reading for History of Intl Business and Finance)

Here is the beginning and end of a (much longer) Q&A with Gary Gorton discussing the financial crisis. He explains how the crisis was generated by a bank run much like past bank runs, but in a different type of asset and in a different segment of the banking system.

Rather than a run by individual depositors on demand deposits held in traditional banks (or, further in the past, private bank notes), this run involved firms and institutional investors and it was on repo held in the shadow banking system:

Questions and Answers about the Financial Crisis, Prepared for the U.S. Financial Crisis Inquiry Commission, by Gary Gorton[open link]: 1. Introduction ... Yes, we have been through this before, tragically many times. U.S. financial history is replete with banking crises and the predictable political responses. Most people are unaware of this history, which we are repeating. A basic point of this note is that there is a fundamental, structural, feature of banking, which if not guarded against leads to such crises. Banks create money, which allows the holder to withdraw cash on demand. The problem is not that we have banking; we need banks and banking. And we need this type of bank product. But, as the world grows and changes, this money feature of banking reappears in different forms. The current crisis, far from being unique, is another manifestation of this problem. The problem then is structural.

In this note, I pose and try to answer what I think are the most relevant questions about the crisis. I focus on the systemic crisis, not other attendant issues. I do not have all the answers by any means. But, I know enough to see that the level of public discourse is politically motivated and based on a lack of understanding, as it has been in the past, as the opening quotations indicate. The goal of this note is to help raise the level of discourse.

2. Questions and Answers

Q. What happened?

A. This question, though the most basic and fundamental of all, seems very difficult for most people to answer. They can point to the effects of the crisis, namely the failures of some large firms and the rescues of others. People can point to the amounts of money invested by the government in keeping some firms running. But they can’t explain what actually happened, what caused these firms to get into trouble. Where and how were losses actually realized? What actually happened? The remainder of this short note will address these questions. I start with an overview.

There was a banking panic, starting August 9, 2007. In a banking panic, depositors rush en masse to their banks and demand their money back. The banking system cannot possibly honor these demands because they have lent the money out or they are holding long-term bonds. To honor the demands of depositors, banks must sell assets. But only the Federal Reserve is large enough to be a significant buyer of assets.

Banking means creating short-term trading or transaction securities backed by longer term assets. Checking accounts (demand deposits) are the leading example of such securities. The fundamental business of banking creates a vulnerability to panic because the banks’ trading securities are short term and need not be renewed; depositors can withdraw their money. But, panic can be prevented with intelligent policies. What happened in August 2007 involved a different form of bank liability, one unfamiliar to regulators. Regulators and academics were not aware of the size or vulnerability of the new bank liabilities.

In fact, the bank liabilities that we will focus on are actually very old, but have not been quantitatively important historically. The liabilities of interest are sale and repurchase agreements, called the “repo” market. Before the crisis trillions of dollars were traded in the repo market. The market was a very liquid market like another very liquid market, the one where goods are exchanged for checks (demand deposits). Repo and checks are both forms of money. (This is not a controversial statement.) There have always been difficulties creating private money (like demand deposits) and this time around was no different.

The panic in 2007 was not observed by anyone other than those trading or otherwise involved in the capital markets because the repo market does not involve regular people, but firms and institutional investors. So, the panic in 2007 was not like the previous panics in American history (like the Panic of 1907, shown below, or that of 1837, 1857, 1873 and so on) in that it was not a mass run on banks by individual depositors, but instead was a run by firms and institutional investors on financial firms. The fact that the run was not observed by regulators, politicians, the media, or ordinary Americans has made the events particularly hard to understand. It has opened the door to spurious, superficial, and politically expedient “explanations” and demagoguery. ...

3. Summary

The important points are:

• As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.

• The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short-term, safe, interest-earning, transaction account like demand deposits: repo. Repo also grew enormously, and came to use securitization as an important source of collateral.

• Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately-created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.

• In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.

• The crisis was not a one-time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.

Update: See also What Really Went Wrong?, BY Steve Landsburg.

DIY Stress Test 3: A New Fed Stress Test and Size-Versus-Losses

From Rortybomb: DIY Stress Test 3: A New Fed Stress Test and Size-Versus-Losses
by Mike on June 12, 2009

Yesterday we went through the Fed’s Stress Test documents and created a toy model to see projected losses under some U3 numbers. I want to talk about a few observations from both the model and the Fed data itself.

A New Fed Stress Test

Elizabeth Warren is calling for a new round of stress tests. This seems like a political non-starter. Can our model make it more appealing?

Let’s say that U3 goes to 12.2% in the DIY Stress Test Model. The Financial Sector, which needed to raise $76bn under the adverse scenario, now needs to raise an additional $272bn. How is that distributed? Here’s a graph (Updated, and fixed):



Four firms – BoA, Citi, JP Morgan Chase and Wells Fargo – account for 75% of the new losses. Morgan Stanley is 5%. Everything else is less than 4%, with some still at zero.

I believe we should have another official Stress Test of the largest 5-8 firms at the end of the summer. There is no reason to drag in all the firms all over again. To whatever extent American Express and other small players had unknowns going into the crisis we have a handle that their capital reserves can take a shock and if they need to raise $1-$3bn the market should be able to handle it. If BoA needs another $75bn, that will have to come from the government.

We still have a lot of uncertainty with the largest 5 firms, and since we, regardless of how they are paying their TARP, have a liability in them we should demand accountability. In an additional 3 months it will be much clearer what both the books and the economic outlook will be. As a bonus we’ll have them already committed to a set of models and techniques. To whatever extent they could cherry-pick their data and their models the first time around, we can force them to stay consistent the second time around and extrapolate confidence intervals from there.

A “5 firm Stress Test Checkup” will also be as an easier sell. Instead of dragging what felt like the entire financial sector in front of the jury we look at the specific firms we know have a problem. That strikes me as fair and appropriate and also more politically reasonable.

What about Size versus Losses?

There was a bit of a blogosphere debate a few months ago about the optimal size of a bank. There was an argument from the big-is-better crowd that larger banks may have more losses net, but as a percent of total assets it will be smaller. A bank that is size $100 might lose $10 for a 10% loss, and a size $50 bank might lose $7 for a 14% loss. So even though the big banks were losing more total dollars – $10 versus $7 – they were probably doing better as a percent than the smaller banks – 10% versus 14% – because they were more ‘innovative.’

The argument was that larger banks would have smaller expected losses overall as a percent (or, alternatively, that smaller banks would have a larger expected loss percent) because there was some sort of return to risk management with size. Larger banks can hire the smartest MBAs with giant salaries to have them ‘innovate’ risk-management techniques that your local bank can’t afford. Your local bank can’t lend to CRE developments in Japan while handling credit cards in Hong Kong while also giving out subprime mortgages in the LA suburbs. Your Giant Bank can. By having access to more lines of business they would be able to diversify their lending in a way that takes advantage risk management techniques not available to smaller banks.

How’d that work out? I want to show you a really interesting chart. Let’s look at risk weighted-assets plotted against total losses for all the firms (kicking out American Express as a non-appropriate outlier). From the Fed’s SCAP Document, specifically the summary chart I put here, so no toy model:



This chart should feel like someone just kicked you in the stomach. The biggest banks, using their own models they chose to report to the Fed, did terrible compared to a basket of small banks.
At a base level, in a crisis all correlations go to 1. So whatever diversification benefits the largest banks had by being able to hold on to all asset types is out the window. To whatever extent their being big allowed them to have larger and smarter capital buffers, that is gone as well. Instead of being lower, or even random or having no pattern, it is clear that the bigger banks do worse with handling losses and risk than small banks do even as a percentage.

I really want to see this replicated large scale in a more controlled fashion, but intuitively this makes sense to me. The bigger you are the more internal noise there is in your corporation. It is easier to make a clever 10% return with $100m than with $1bn; alpha does not scale well, and the bigger you are the more competition is watching you. The obvious thing to do to get larger profits than your smaller competition is to keep a smaller capital buffer. There is a separate argument that bigger banks can handle larger losses better; beyond having a kind of financial nihilism to it, it has turned out to be completely untrue. So here we are. Looking at the data for a while, being big is a big liability. For those banks. But mostly for you, me and everybody else.