For all the computerized financial engineering that preceded the meltdown, he thinks it resembled a classic 19th-century bank panic

TO BE NOTED: From the WaPo:

"Quiet Tiger at the Fed

By David Ignatius
Thursday, May 28, 2009

Sometime this summer, President Obama will have to start thinking about one of the big decisions of his presidency -- whether to reappoint Ben Bernanke as chairman of the Federal Reserve when his term expires next January. What complicates the choice is that the other obvious candidate is Lawrence Summers, the White House economic czar.

Bernanke has emerged as one of the few heroes of the financial crisis, widely praised for his innovative stewardship of the Fed. He's still something of a sleeper in Washington, so low-key that the frequent descriptions of his "soft-spoken" manner don't do justice to just how quiet he is. But in fixing the financial breakdown, he has been a veritable tiger. The Bernanke Fed is so much more powerful than its predecessors that it's almost a different institution.

Bernanke agreed to sit down for a luncheon interview last week to talk about lessons learned. Behind him through the picture window of his private dining room was a majestic view of the Mall, but the Fed chairman was as reserved and fastidious as ever -- even as he described his battle to contain the greatest financial crisis of the past half-century.

I asked him what message he might leave for his successor to explain what these two tumultuous years have taught him. Bernanke offered a surprising answer: For all the computerized financial engineering that preceded the meltdown, he thinks it resembled a classic 19th-century bank panic. Investors thought their money was parked in securities that were as safe as bank deposits. When these securitized assets proved to be riskier than expected, investors panicked.

"We were seeing variants of classic panic behavior," Bernanke said, remembering the wild days of 2007 and 2008, when supposedly safe markets suddenly locked up as frightened investors rushed to get their money out.

Bernanke recommended studies by Gary Gorton, a Yale economist who has analyzed the ways the recent panic resembled those of the late 19th century. In his latest paper, "Slapped in the Face by the Invisible Hand," Gorton explains that the long-ago panics typically came at the height of the business cycle and involved new information that frightened depositors into withdrawing their money. Such bank panics disappeared for nearly 75 years after the enactment of federal deposit insurance in 1934.

The panic psychology returned with stunning force in 2007, when Wall Street suddenly lost confidence in new instruments created by the shadow banking system, such as mortgage-backed securities. It's hard to imagine now, but these exotic instruments were embraced by risk-averse investors such as money-market funds, pension funds and corporate treasuries. When that safety proved illusory, people rushed for the exits.

As Fed chairman, Bernanke scrambled for innovative ways to pump money and confidence back into these markets. If one tactic didn't work, he quickly tried another. When the panic first hit in August 2007, Bernanke took the unusual step of sharply cutting the discount rate for lending directly to banks. Banks proved wary of using the discount window, so Bernanke created a less-stigmatizing "Term Auction Facility."

Next came special Fed facilities to bolster money-market funds, the commercial-paper market, mortgage-backed securities and asset-backed securities -- all with complicated names and strategies. But the mission was consistent: to lend into the panic, and to reassure the markets that the Fed was really, truly committed to maintaining liquidity, no matter what. Gradually, the panic eased.

More jury-rigged rescue programs may be on the way. Barney Frank, chairman of the House banking committee, is drafting a bill to provide federal insurance for the municipal bond market, which could add hundreds of billions of dollars in new federal obligations. The Fed hasn't objected, saying this is a fiscal problem for Congress, not a monetary issue. A muni bailout would increase the immense debt hanging over the economy and the risk of future inflation.

The challenge ahead for the Fed is to clean up the debris -- including all the special structures created to contain the crisis. Obama will want a Fed chairman who can convince the markets that the central bank will crush inflation, regardless of the short-term pain or the howls from politicians. He will need someone who can reverse gears in a hurry and who can say no convincingly.

Is that person likely to be the quiet radical, Bernanke; or the outspoken, market-savvy former Treasury secretary, Summers; or some dark-horse candidate? Each would have strengths and liabilities at a post-crisis Fed, but there's a strong argument for not changing what, right now, looks like a winning team.

The writer is co-host of PostGlobal, an online discussion of international issues.

His e-mail address is davidignatius@washpost.com."

So Felix is right. The last thing we need is for the government to perpetuate the delusion that financial markets are risk free

From Mother Jones:

"Risk

— By Kevin Drum | Fri May 29, 2009 9:55 AM PST

Economist Gary Gorton has written a 20,000 word paper on the subject of "informationally-insensitive debt" — i.e., ultra-safe investments like federally insured bank deposits. Ezra Klein boils this down to a thousand words. I boldly push the boundaries even further:

The morons who inhabit Wall Street thought they had removed all risk from inherently risky investments. They were wrong.

There! Twenty words. That's a compression ratio even greater than Ezra's. Felix Salmon comments:

Gorton's solution to this problem is to involve the government in all manner of regulation — and insurance — of the securitization market, thereby making [asset back commerical paper] behave much like federally-insured bank deposits. I don't like this solution at all, since it would send the contingent liabilities of the government into the stratosphere, and more importantly would ratify the demand for informationally-insensitive assets by creating trillions of dollars of new ones.

In my view of the crisis, it's precisely the demand for informationally-insensitive assets which is the problem. And we need to get individuals, companies, and institutional investors out of the mindset that they can do an elegant little two-step around the inescapable fact that anybody with money to invest perforce must take a certain amount of risk. If you have a world where people are all looking for risk-free assets, you end up shunting all that risk into the tails. And the way to reduce tail risk is to get everybody to accept a small amount of risk on an everyday basis. We don't need more informationally-insensitive assets, we need less of them.

I agree. There's a common view that investors in the period up until 2006 were practically drunk on risk, pricing it nearly at zero — but now, after the crash, they've become more risk averse than your grandmother. They're almost completely unwilling to accept any risk at any price.

I think this view is fundamentally wrong. What really happened is that in the early part of the decade investors became convinced that they could avoid risk entirely via financial engineering. They were, in fact, immensely risk averse, but this wasn't obvious because they were buying up every security in sight. The post-crash flight to quality, it turns out, wasn't really a flight at all. Modern investors have been afraid of risk all along.

So Felix is right. The last thing we need is for the government to perpetuate the delusion that financial markets are risk free. For small retail bank depositors, that's fine. For the big boys it's not. They need to relearn the art of genuinely analyzing risk and taking it on knowingly, rather than pretending they can hedge it away under all circumstances. After all, accurate analysis of risk is essential to the efficient allocation of capital, and efficient allocation of capital is one of the keys to economic growth. It's time for Wall Street to get back to basics."

Me:

Government Guarantees

Submitted by Don the libertarian Democrat (not verified) on May 29, 2009 - 12:48pm.

I know that my position is disputable, but the point of government guarantees is to remove the need to spend large sums of money, as we're doing now. As with Deposit Insurance, the guarantee is to stop a panic and allow a reasonable unwinding of investments. The reason that the government has to do it is that only it has the resources needed to back up such a guarantee. Like the FDIC, however, funded by the banks, we don't want to have to ever go to the government.

Gorton's point is valid. As well, there's the question about whether, having set up a Lender Of Last Resort, namely, the Fed, you can ever actually wring out the view of an Implicit Government Guarantee. So, in my view, Gorton's view makes sense.

However, as we've seen, you also need to be able to seize insolvent businesses when necessary, regardless of their power and connections. That is a dicey proposition. I currently prefer a Narrow Banking base, but that's a tough sell. Still, I basically agree with Gorton.

I also don't buy the Stupidity Defense, Complexity Defense, Elmer Fudd Defense, Ostrich Defense, Herd Defense, Devil Made Me Do It Defense, etc. This is always the first stage in assessing a financial panic. Going forward, litigation and good investigative reporting will show that Fraud, Negligence, Collusion, and Fiduciary Mismanagement were the second leading cause of our crisis. The first cause was the Government Guarantees Combined With Deregulation, a toxic brew, as in the S and L Crisis. You can't have both. Akerlof's concept of Looting applies here.

I know that I could be wrong, so that all I'm asking for is a serious investigation into crimes and civil complaints.

Gorton’s solution to this problem is to involve the government in all manner of regulation — and insurance — of the securitization market

From Reuters:

"Felix Salmon

nonrival, nonexcludable

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May 29th, 2009

Why the government shouldn’t insure securitized assets

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Posted by: Felix Salmon

Tags: economics

Ezra Klein does us all a favor this morning by spending 1,000 words or so summarizing a 20,000-word, 53-page paper by Yale’s Gary Gorton. Now to make it even shorter!

The key concept is the distinction between informationally-sensitive financial assets — assets which change in price when new information emerges — and informationally-insensitive financial assets — assets which don’t change in price when new information emerges. In the latter bucket we can include insured bank deposits, but bank deposits are insured only up to $250,000, and there are a lot of companies and other institutional investors who just want a safe place to park their cash and are also on the hunt for informationally-insensitive assets.

They found them — or thought they found them — in things like asset-backed commercial paper: they would hand over cash, and receive the senior tranches of securitized loans as collateral. When that happens, writes Gorton,

A ‘banking panic’ occurs when ‘informationally-insensitive’ debt becomes ‘informationally-sensitive’ due to a shock, in this case the shock to subprime mortgage values due to house prices falling.

Gorton’s solution to this problem is to involve the government in all manner of regulation — and insurance — of the securitization market, thereby making ABCP behave much like federally-insured bank deposits. I don’t like this solution at all, since it would send the contingent liabilities of the government into the stratosphere, and more importantly would ratify the demand for informationally-insensitive assets by creating trillions of dollars of new ones.

In my view of the crisis, it’s precisely the demand for informationally-insensitive assets which is the problem. And we need to get individuals, companies, and institutional investors out of the mindset that they can do an elegant little two-step around the inescapable fact that anybody with money to invest perforce must take a certain amount of risk. If you have a world where people are all looking for risk-free assets, you end up shunting all that risk into the tails. And the way to reduce tail risk is to get everybody to accept a small amount of risk on an everyday basis. We don’t need more informationally-insensitive assets, we need less of them."

Me:

I disagree. I did agree with almost all of Gorton’s views. For one thing, he agrees that we had, what I, in my sophisticated way, have been calling since September, a Calling Run, meant to connote a bank run like occurrence of getting to cash or safe investments. It’s been followed by a Proactivity Run and Savings Spree, thereby showing that my sophistication hasn’t increased.

The problem was Debt-Deflation or a Debt-Deflationary Spiral. I derived this view from Irving Fisher, assuming that, if he were alive, he’d acknowledge the parentage of my views. In any case, there are two solutions:

1) Bagehot’s Principles, meaning issuing a full government guarantee that necessitates, in order to work, an FDIC like agency that shuts down insolvent businesses without caring about their power or connections. This was my original view, and it’s like Gorton’s, and Felix dislikes it because of the guarantees.

Two points:

A: If you have a Lender of Last Resort, these guarantees might well be ineradicably implicit.
B: The point isn’t to have to spend the money, but simply allow enough confidence for a reasonable unwinding. Only a government has the resources for this, sad to say.

2) The other alternative is a split between Narrow/Limited Banking and Investment Concerns, which would be self-insured, while the Banks are government guaranteed, to the extent that they need to be.

Both are meant to stop major events like Calling Runs, not investors losing money. It seems to me that worrying about the particular investments verges on worrying about people losing money or trying to avoid recessions, which I consider impossible. We should focus on major events, not creating a perpetually spooked market.

I switched to Narrow Banking merely because I’ve experienced a crisis of faith in regulators as a class, although I agree that there are better and worse. I’m willing to become a believer again given a compelling scripture.

- Posted by Don the libertarian Democrat

A classic bank run, you say? Hmm, where have I heard that before?

From Econbrowser:

"More papers on the credit crunch

Links to some interesting papers that I recently read.

The first comes from a conference on financial markets held at the start of this month at the University of Illinois in Chicago. Last fall, V.V. Chari, Larry Christiano, and Pat Kehoe received a lot of attention (e.g., Tabarrok, Avent, Economist, Kwak, Bonddad, and Thoma [1], [2], [3],) for noting that aggregate lending by banks was in fact increasing during the period in which many analysts were describing it as sharply curtailed. At the Chicago conference, Federal Reserve Bank of Boston economists Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, and Judit Montoriol-Garriga argued that those aggregate numbers conceal some very significant compositional trends, namely, previously existing lines of credit were being drawn on by borrowers and a sharply increased fraction of lending was consumed by securities originally intended for securitization but which banks were forced to hold on their own books.

Another interesting conference was held two weeks later at the Federal Reserve Bank of Atlanta, from which I found the paper by Gary Gorton quite interesting. (You can also find it discussed by Falkenblog, Cowen, Kling, and Klein). Gorton views the recent problems as an ongoing banking panic. Here are some excerpts:

A banking panic means that the banking system is insolvent. The banking system cannot honor contractual demands; there are no private agents who can buy the amount of assets necessary to recapitalize the banking system, even if they knew the value of the assets, because of the sheer size of the banking system. When the banking system is insolvent, many markets stop functioning and this leads to very significant effects on the real economy....

The current crisis has its roots in the transformation of the banking system, which involved two important changes. First, derivative securities have grown exponentially in the last twenty-five years, and this has created an enormous demand for collateral, i.e., informationally-insensitive debt. Second, there has been the movement of massive amounts of loans originated by banks into the capital markets in the form of securitization and loan sales. Securitization involves the issuance of bonds ("tranches") that came to be used extensively as collateral in sale and repurchase transactions ("repo"), freeing other categories of assets, mostly treasuries, for use as collateral for derivatives transactions and for use in settlement systems.... [R]epo is a form of banking in that it involves the "deposit" of money on call (as repo is short-term, e.g., mostly over night) backed by collateral. The current panic centered on the repo market, which suffered a run when "depositors" required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty "bank" fail....

Securitized asset classes, e.g., mortgages, credit card receivables, auto loans, may be examples of relatively informationally-insensitive debt, created by the private sector without government insurance....

A "systemic shock" to the financial system is an event that causes such debt to become informationally-sensitive, that is, subject to adverse selection because the shock creates sufficient uncertainty as to make speculation profitable. The details of how that happens are discussed below, but in summary, fear of the resulting lemons market can cause the (inefficient) collapse of trading in debt and a stoppage of new credit being issued.

A classic bank run, you say? Hmm, where have I heard that before? But I think there's more that needs to be said about the regulatory environment that is supposed to prevent this kind of thing.

Gorton's paper might offer some support for those who think that we just got stuck on the bad side of a structure with multiple possible equilibria. An alternative and more pessimistic perspective is developed in a recent note by Federal Reserve Bank of San Francisco economists Reuven Glick and Kevin Lansing. Glick and Lansing view the problem as more structural and fundamental, resulting from an unsustainable run-up of household debt. Their analysis was also highlighted by Thoma and Bloomberg.

---

Technorati Tags: macroeconomics, economics, Federal Reserve, bank panic, credit crunch

Posted by James Hamilton "

"September 01, 2007

Comments on Housing and the Monetary Transmission Mechanism

Here are the comments that I delivered this morning at the Fed Jackson Hole conference.

Governor Mishkin has done a nice job of categorizing the various channels by which the consequences of monetary policy might be transmitted to the economy. I'd like to take a step back and reflect on what are the instruments of monetary policy, the transmission of whose effects we're discussing.

The instrument of monetary policy that we tend to think of first is the time path of short-term interest rates. It's natural to start there, because it's easy to quantify exactly what the Fed is doing.

But another instrument of monetary policy that I think needs to be discussed involves regulation and supervision of the financial system. This is inherently a messier question. It's harder to quantify the effects, and many of the issues I'm going to be raising today may be outside the current regulatory authority of the Federal Reserve itself. Indeed, one way you can view the history of our financial system is that a certain type of problem becomes recognized, we develop regulations to deal with it, and then new parallel institutions evolve, outside that regulatory framework, where the same kind of problem arises in a new setting.

Although the regulatory question is messier to address, I think we'd all agree there have been periods historically where it played a key role in determining the course of events. The most recent experience might be the 1980s, for which you all know the story.¹ As a result of a series of bad luck and bad decisions, a significant number of U.S. banks and savings and loans at the time ended up with a position of negative net equity. But that did not prevent them from being able to borrow large sums at favorable rates, thanks to deposit insurance. The decision problem for an entity in that situation has a clear solution-- with the lower part of the distribution truncated, you want to maximize the variance of the investments you fund with that borrowing. That recklessness in lending was a factor aggravating both the boom and the subsequent bust of that episode. Fortunately, through a combination of good luck and good policies, we were able to correct the resulting mess in a way that avoided the more severe problems that some of us were anticipating at the time.

Why do I suggest that there might be something similar going on in the current environment? I'm basically very puzzled by the terms of some of the mortgage loans that we've seen offered over the last few years-- for example, mortgages with no downpayment, negative amortization, no investigation or documentation of the borrowers' ability to repay, and loans to households who had demonstrated problems managing simple credit card debt.

The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run, and potentially applies to any institution whose assets have a longer maturity than its liabilities. The problem arises when the losses on the institution's assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent.

In the traditional story, the institution we were talking about was a bank, its long term assets were loans, and its short term liabilities were deposits. In the current situation, the institution could be a bank or investment fund, the assets could be mortgage-backed securities or their derivatives, and the short-term credit could be commercial paper. The names and the players may have changed, but the economic principles are exactly the same. How much of a worry this might be depends on the size of specific potential losses for Institution X relative to its net equity, and the volume of short-term loans that could potentially be disrupted as a result.

This is not just a theoretical possibility. My understanding is that this is exactly what happened to Germany's IKB Deutsche Industriebank on August 9 to set off the tumult in global short-term capital markets.²

Governor Mishkin discusses the potential role of real estate prices in the monetary transmission mechanism. I am seeing that not as an issue in its own right, but instead as a symptom and a propagation mechanism of the broader problem. It is a symptom in the sense that, if loans were extended to people who shouldn't have received them, real estate prices would have been bid up higher than they should have been. And it is a propagation mechanism in the sense that, as long as house prices continued to rise, all sins were forgiven. Even a completely fraudulent loan would not go into default when there's sufficient price appreciation, since the perpetrator is better off repaying the loan in order to enjoy the capital gain.

The problem is that, as this process gets undone, both effects operate in reverse. A credit crunch means that some people who should get loans don't receive them, depressing real estate prices, and as prices fall, some loans will become delinquent that otherwise might not. If such fundamentals are indeed contributing factors on the way up and the way down, the magnitude of the resulting decline in real estate prices, and their implications for default rates, could be much bigger than the reassuring numbers Mishkin invites us to remember based on the historical variability of these series. What worries me in particular is, if we see this much in the way of delinquencies and short-term credit concerns in the current economic environment, in which GDP has still been growing and house price declines are quite modest, what can we expect with a full-blown recession and, say, a 20% decline in average real estate values?

Now, the question that all this leads me to ask is why-- why did all this happen? Why were loans offered at such terms? I'm not sure that I have all the answers, but I am sure that this is the right question. And if you reject my answers, I hope it's because you have even better answers, and not because you dismiss the question.

It seems the basic facts highlighted in Green and Wachter's paper yesterday might be a good place to begin. Since 1990, U.S. nominal GDP has increased about 80% (logarithmically). Outstanding mortgage debt grew 50% more than this, raising the debt/GDP ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed by Fannie and Freddie grew 75% faster than GDP, while mortgages held outright by the two GSEs increased 150% more than GDP. The share of all mortgages held outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% in 2006, which includes $170 billion in subprime AAA-rated private label securities. The fraction had been as high as 20.5% in 2002.³. It is hard to escape the inference that expansion of the role of the GSEs may have had something to do with the expansion of mortgage debt.

Source: Green and Wachter (2007).

This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises-- about $70 billion last year-- represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we'd have at least part of the answer to the puzzle.

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I'm thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, "the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default." And the Fed says, "oh yes we would." And the market says, "oh no you wouldn't."

It's a game of chicken. And one thing that's very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do. That would be an event with significant macroeconomic externalities that the Fed is very much committed to avoid.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs' assets and liabilities, and making sure the net equity is sufficient to ensure that it's the owners, and not the rest of us, who are absorbing any risks. So here's my key recommendation-- any insitution that is deemed to be "too big to fail" should be subject to capital controls that assure an adequate net equity cushion.

While I think the answer to our question may begin here, it certainly doesn't end, as indeed, thanks to Lockhart, the growth of mortgages held outright by the GSEs in 2006 was held in balance, and we simply saw privately-issued mortgage-backed securities jump in to take their place, with their share of U.S. mortgages spiking from 8.6% in 2003 to 17.4% in 2005. One might argue that the buyers of these private securities may have made a similar calculation, insofar as the same aggregate conditions that keep Fannie and Freddie afloat would perhaps also be enough to keep their noses above water. Or perhaps Professor Shiller is right, that psychologically each investor deluded himself into thinking it must be OK because he saw everybody else doing the same thing. Or maybe they were more rationally thinking, "the Fed wouldn't let us all go down, would it?" And the Fed says, "oh yes we would." And once again, regulation, not selecting an optimal value for the fed funds target, has to be the way you want to play that game.

If these bad loans were all a big miscalculation, perhaps that is something the Fed might consider addressing as a regulatory problem as well. The flow of accurate information is absolutely vital for properly functioning capital markets. I have found myself frustrated, in looking through the annual reports of some of the corporations and funds involved in this phenomena, at just how difficult it is to get a clear picture of exactly where the exposures are. I think the accounting profession has let us down here, which you might describe as a kind of networking equilibrium problem. But if the Federal Reserve were to develop and insist on certain standards of accounting transparency for its member institutions, that might help to be a stimulus to get much more useful public documentation for everybody.

It also might be useful to revisit whether Fed regulations themselves may be contributing to this misinformation. Frame and Scott (2007) report that U.S. depository institutions face a 4% capital-to-assets requirement for mortgages held outright but only a 1.6% requirement for AA-rated mortgage-backed securities, which seems to me to reflect the (in my opinion mistaken) assumption that cross-sectional heterogeneity is currently the principal source of risk for mortgage repayment. Perhaps it's also awkward for the Fed to declare that agency debt is riskier than Treasury debt and yet treat the two as equivalent for so many purposes.

Of course I grant the traditional argument that regulation necessarily involves some loss of efficiency. But to that my answer is, it's worth a bit of inefficiency if it enables us to avoid a full-fledged financial crisis. I'd also point out that, if our problems do indeed materially worsen, the political calls for regulation will become impossible to resist, and much of the cures recommended by the politicians would create dreadful new problems of their own-- that too is part of the historical pattern we've seen repeated many times. For this reason, I think it would be wise for the Federal Reserve to be clear on exactly what changes in regulatory authority could help prevent a replay of these developments, and preposition itself as an advocate to get these implemented now. Such steps will also be necessary, I think, to restore confidence in the system, if the situation indeed worsens from here.

Now, I should also emphasize that understanding how we got into this situation is a different question from how we get out. Tighter capital controls by themselves right now would surely make the matter worse, and allowing an expansion of the GSE liabilities may be as good a short-term fix as anybody has. But I do not think we should do so without seeing clearly the nature of the underlying problem, and certainly cannot think that by itself expansion of GSE liabilities represents any kind of long-run solution.

Finally, in closing, suppose that I'm wrong about all of this. Suppose that the developments I've been talking about-- the appearence of loan originators in every strip mall, anxious to lend to anyone, and other parties just as anxious to buy those loans up-- suppose that it is all a response to the traditional monetary instrument, the manipulation of the short-term interest rate. After all, a 1% short-term rate, 6% 30-year mortgage rate, and 13% house price appreciation, such as we saw in 2004, is plenty of incentive to borrow and repay. I used to believe that this was sufficient to account for all that we were seeing, and many of you perhaps still think that way. But if it were the case that all these institutional changes are just a response to interest rates, it means that the lags in the monetary transmission process are substantially longer than many of us had supposed. If people were still buying houses in 2006 as a result of institutions that sprung up from the conditions in 2004,it means that, if we thought in 2004 that overstimulation could easily be corrected by bringing rates back up, then we would have been wrong. And likewise, suppose you believe that the pain we're seeing now, and may continue to see for a matter of years, until the new loan originators all go out of business, and recent buyers are forced out of their homes, is simply a response to a monetary tightening that ended a year ago. If so, then if we think today that, if things get really bad, we can always fix things by rapidly bringing interest rates back down-- well, then, once again, we'd be wrong.

---

Footnotes

1. See for example Kane (1989) and Keeley (1990). Return to text

2. Wall Street Journal, August 10, 2007, p. A1. Return to text

3. Sources: Office of Federal Housing Enterprise Oversight, Enterprise Share of Residential Mortgage Debt Outstanding: 1990 - 2007Q1, and Lockhart (2007). Return to text

---

References

Frame, W. Scott, and Lawrence J. White. 2007. "Charter Value, Risk-Taking Incentives, and Emerging Competition for Fannie Mae and Freddie Mac," Journal of Money, Credit, and Banking, 39, pp. 83-103.

Green, Richard K., and Susan M. Wachter. 2007. "The Housing Finance Revolution."

Kane, Edward J. 1989. The S&L Insurance Mess: How Did It Happen? (Washington: Urban Institute Press).

Keeley, Michael C. 1990. "Deposit INsurance, Risk, and Market Power in Banking," American Economic Review, 80, pp. 1183-1200.

Lockhart, James A. III. 2007. Housing, Subprime, and GSE Reform: Where Are We Headed?

Shiller, Robert J. 2007. "Recent Trends in House Prices and Home Ownership."

Posted by James Hamilton"

"September 06, 2007

Borrowing short and lending long

Here I elaborate on the description of the nature of current problems in financial markets that I offered at the Fed's Jackson Hole conference last week.

A traditional bank is in the business of taking the funds it receives from its depositors and investing them in projects with higher rates of interest. If that was all that is involved, however, the system would be highly unstable, because it's always possible that the bank could lose money on its long-term investments if interest rates rise or worsening economic conditions lead some of its borrowers to default. In such a situation, if the customers all decide they want their money back, there wouldn't be enough to pay them all.

The way this problem is solved is to have the capital that the bank lends come not just from its depositors but also in part from the owners of the bank. These owners should have invested some of their own money to start the bank and reinvested some of the profits of the bank to allow it to grow. The capital that comes from the owners rather than depositors is known as the bank's net equity. The idea is that if the bank takes a loss on its investments, that loss comes out of net equity, and there's still money to pay off all the people who deposited money in the bank.

And what if the losses are bigger than the net equity? Then we're back to the unstable equilibrium, in which each depositor has an incentive to be the first one to get his or her money back, the situation for a classic bank run. Depositors may not be sure which banks have adequate net equity and which don't, so some will be trying to get their money out of banks that are really in good shape. As a result of the bank run, however, those previously solvent institutions will have to sell off their long-term assets, perhaps at a significant loss if they have to be unloaded at fire-sale prices in a panicked market. The result of this may be that the bank panics themselves create new insolvencies, and the problem cascades into a worsening situation.

Historical experience teaches us that this is a highly undesirable scenario, and can create significant economic hardship for people who are completely innocent bystanders. For this reason, we have developed institutions to regulate the banking system, one key goal of which is to ensure that banks always retain sufficient net equity to be able to weather such storms.

What has happened over the last decade is that a variety of new institutions have evolved that play a similar role to that of traditional banks, but that are outside the existing regulatory structure. Rather than acquire funds from depositors, these new financial intermediaries may get their funds by issuing commercial paper. And instead of lending directly, these institutions may be buying assets such as mortgage-backed securities, which pay the holder a certain subset of the receipts on a larger collection of mortgages that are held by the issuer. Although the names and the players have changed, it is still the same old business of financial intermediation, namely, borrowing short and lending long.

There are a variety of new players involved. The principals could be hedge funds or foreign or domestic investment banks. Others could be conduits or structured investment vehicles, artificial entities created by banks, perhaps on behalf of clients. The conduit issues commercial paper and uses the proceeds to purchase other securities. The conduit generates some profits for the bank but is technically not owned by the bank itself and therefore is off of the bank's regular balance sheet.

This system has seen an explosion in recent years, with the Wall Street Journal reporting that conduits have issued nearly $1.5 trillion in commercial paper. Their thirst for investment assets may have been a big factor driving the recklessness in mortgage lending standards, as a result of which much of the assets backing that commercial paper have experienced significant losses.

Without an adequate cushion of net equity for these new financial intermediaries, and with tremendous uncertainty about the quality of the assets they are holding, the result is that those who formerly bought the commercial paper are now very reluctant to renew those loans, a phenomenon that PIMCO's Paul McCulley described at the Fed Jackson Hole conference as a "run on the shadow banking system." I heard others at the conference claim that there might be as much as $1.3 trillion in commercial paper that will be up for renewal in the next few weeks, with great nervousness about what this will entail.

In some cases, these intermediaries have lines of credit with conventional investment banks on which they will be drawing heavily, which will cause these off-balance-sheet entities to quickly become on-balance-sheet problems. Their losses may severely erode the net equity of the institution extending the line of credit. How big a mess will this be? I don't think anybody really knows for sure.

In my remarks at Jackson Hole, I basically suggested that we should be thinking about both the causes and potential solutions to the current problem not just in terms of choosing an "optimal" level for the fed funds target interest rate, but also in terms of seeking regulatory and supervisory reforms, the ultimate goal of which would be to ensure that any financial institution whose failure would exert significant negative externalities on the rest of us should be subject to net equity requirements, so that most of the money the players in this game are risking is their own.

I also recommended that we need reforms to make the whole system more transparent. I think the accounting profession has let us down, in that it is very difficult to look at the annual reports of some of the institutions involved and determine what exactly the exposures are. In theory, competitive market pressures are supposed to result in incentives for private auditors to ensure accurate and informative reports. But I think there is a networking equilibrium issue here in which it is very hard for one auditor to try to change the rules if nobody else does, even if getting everybody to change at once would unambiguously improve social welfare. I recommended that the Federal Reserve could itself be a catalyst for such a change by revisiting the reporting requirements on its member institutions.

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Technorati Tags: macroeconomics, housing, Federal Reserve, bank run, economics, bank conduits, shadow banking system

Posted by James Hamilton"

Me:
Previewing your Comment
"The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run, and potentially applies to any institution whose assets have a longer maturity than its liabilities. The problem arises when the losses on the institution's assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent." I call this a Calling Run, and agree with you. But my notion of this came from Irving Fisher's classic paper "The Debt-Deflation Theory Of Great Depressions", and Debt-Deflation is what frightened me, not a contained run on some kinds of investments. Was this your worry as well? In other words, the fear was a run that spread outside of its purview. Posted by Don the libertarian Democrat

we set up groups to oversee those AAA securities used in repo transactions, and perhaps put a government guarantee on them

TO BE NOTED: From Falkenblog:

"Gary Gorton Explains the Crisis

This financial crisis has had two legs: the initial boom and bust in housing prices, primarily in the USA, and the accelerator mechanism that then turned this crisis into a panic, affecting financial institutions almost indiscriminately, and countries furthest away from the USA (eg, Russia, Brazil), actually were among the worst performers. I think the boom and bust in the housing market was a combination of a benign history combined with a variety of forces encouraging lower mortgage lending standards under the assumption that a disparate origination statistics by race were the result of arbitrary underwriting standards, and that housing prices would not fall in aggregate (nominally, they had not really done so in the historical record). The government keeps meticulous data on loan originations by race to satisfy the Home Mortgage Disclosure Act, but does not keep track of default rates by these same categories (see here). After all, you don't want to give lenders an ability to defend their unconscionable redlining.

But until today, I was totally befuddled by the transmission mechanism, the amplifier. I mentioned that last year at this time I was at an NBER conference, and Markus Brunnemeier pointed out that the decline in housing prices was insignificant relative to the change in stock market, and this was in May 2008! Almost everyone in the audience of esteemed financial researchers agreed, and thought the market was in a curious overreaction. That is, we did not know why a loss of $X in housing valuation, caused a $10X change in the stock market--and it was only to get much worse. You see, greed, hubris, fat tails, copulas, regulatory arbitrage, do not really work. Merton's explanation that as equity prices fall, both equity values and volatility increase, presumes the equity value fall that needs explaining (after all, it is much greater than the value of the housing price fall).

Gary Gorton makes the first really compelling explanation I have seen, and he's an economist. He is drawing on his experience as a consultant at AIG, and his experience modeling bank runs. I think this highlights that those best able to fix things should not have totally clean hands. Banks are complex institutions that have a lot of very particular attributes to their balance sheets and cash flows, and while a physicist or non-economist would be untainted by failure to foresee the crisis, this also neglects the steep learning curve they would also face. It is easier to correct experts than create them anew, groups are rarely incorrigible when it comes to big mistakes everyone sees as such (in contrast, to say a post-modern literary theorist, whose failures are less concrete). Gorton did not anticipate the 2008 events, but his analysis is much richer than those blaming complexity or hubris (Merton did a nice job of noting that ABS are actually much less complex than your average equity security given that it is a residual to a firm with lots of discretion).

The Gorton story is as follows. We have not had a true bank run since the Great Depression in the US, so we forgot what they look like. The essence of a bank run is described in those books on Bear Stearns: sparked by plausible speculation and a first mover, if you think a bank is losing other depositors, it pays to take out your deposits, and as no bank is sufficiently liquid to pay off all its depositors immediately, if this idea become popular the bank is doomed as each depositor seeks its own self-interest in getting to be first in line for their money.

In the old system, retail customers would put their money in a bank. These depositors have assets that can be used for transactional purposes, they can write a check, and have the money wired out in a matter of days. Yet, the money can be lent by bank, and using the law of large numbers, the bank can estimate their daily cash needs, keep a sufficient amount of reserves, and everything is kosher. Since the Great Depression, retail runs are no longer an issue. Yet now financial institutions are highly dependent on wholesale depositors. These are institutions, like hedge funds, and instead of depositing money in a bank, they deposit Treasuries, and more frequently, AAA rated securities (often derivatives). These depositor have overnight repo returns that can be used for transactional purposes because they can be turned to cash in a day's notice, but just like the retail story with the money, the AAA bonds the wholesale depositors leave can be lent (rehypothecated) by the bank. Retail cash was replaced by AAA debt.

Thus AAA rated bonds become cash used as deposits, and as AAA rated Asset Backed Securities had higher yields, but similar treatment to Treasuries, they gained more and more popularity. A key to these AAA rated bonds is that their default rates are, basically, zero. That is, at Moody's we estimated them at 0.01% annually. One should expect to see one or two of these securities default in one's working life. Thus, they are informationally insensitive, because they have so much safety in them, going over their risks is pointless, uninteresting. That is, as these things have reams of data that show zero default rates, and the market thinks they have almost zero default rate, it was counterproductive to get worked up about their future default rates. You would have wasted a career crying wolf about AAA-rated securities from 1940-2005.

A systemic shock to the financial system is an event thtat causes such debt to become informationally sensitive, in this case, the shock to housing prices. But when these assets become stressed, everyone is understandably perplexed. It's as if the electricity stops working, an event no one really contemplated, and it is too late for everyone to become an electrician. Thus, the concern about asset backed securities and AAA rated bonds of all kinds, become suspect. What were previously information insensitive becomes really complicated, as one works through the details of derivatives, or balance sheets of banks, that were previously assumed to have a 0.01% annualized default rate. This is because bayesian updating suggests that when you have several AAA rated defaults, the probability is that your model is incorrect, as opposed to just having bad luck, and you have to first figure out what that model is, and where it broke down (ie, is it just the housing price assumption?).

This is consistent with bank panics pre-1933 in the USA. Historically, the public becomes wary of all bank deposits, and the bank's balance sheets go from informationally insensitive to sensitive, unmasking their complexity. Nonetheless, the actual number of bank failures in these crises was comparatively low (excluding the Great Depression).

Say the banking system has assets of $100 financed by equity capital of $10, long-term debt of $40, and short term financing in the form of repo of $50. In the panic, repo haircuts rise to 20 percent as banks are wary of previously Gold AAA rated securities, amounting to a withdrawl of $10, so the system has to either shrink, borrow, or get an equity injection to make up for this. As we saw, after some early equity injections during the fall of 2007, this source dried up, as did the possibility of borrowing. That leaves asset sales. So the system as a whole needs to sell $10 of assets. They sell their tradeable securities as their liabilities decrease, and those securities are in a pricing matrix with the AAA rated collateral that is increasing its haircut. Gorton estimates the banking system needed to replace about $2 trillion of financing when the repo market haircuts rose. This is the amplifier.


The increase in haircuts basically removed liabilities from the banking system, and the prices fell on many comparable securities as banks shed assets. In the fire sale, assets are now worth $80; equity is wiped out. The system is insolvent at current market price levels.

How do we know depositors were confused about which banks were at risk? The evidence is that non-subprime related asset classes like auto loans, credit cards, and emerging market debt saw their spreads rise significantly only when the interbank market started to breakdown.

A banking panic is a systemic event because the banking system as a whole is always insolvent in such a scenario.

Thus, the problem is that repo replaced retail deposits as the center of the bank run, as AAA rated securities of all types used in these transactions were all downgraded implicitly to non-prime (below A2/P2), and in many cases based on Mortgages which historically were the safest asset class in the US. There was a bank run, but it was by the 'shadow bank sector', and so all we could see were the effects, but not the cause.

His suggestion is that we set up groups to oversee those AAA securities used in repo transactions, and perhaps put a government guarantee on them. Clearly, this will solve the 2008 crisis, but as always one needs to be looking forward. Bank crises are much less frequent in the 20th century than the 19th, but we need to be mindful of fixing the cause and not the symptom. Looked at in this narrative I marvel at how the future can be so like the past, but different enough to escape notice in real time. I suppose every war or financial crisis is like that.

Posted by Eric Falkenstein "