The dismantling of the economy’s legal infrastructure III: Derivatives [Updated]

Derivatives are financial contracts that do not involve direct investment in productive activity, as stocks and bonds do, but instead reference such contracts (or other phenomena including stock market indexes and even the weather). In short, they are called derivatives, because their value is derivative from that of other assets. While derivatives contracts take many forms, for the purposes of this post it is enough to understand a specific derivative, a futures contact. A futures contract is a standardized contract to purchase/sell a specific amount of a specific asset at a specific price on a specific future date.

Consider an example, in which I agree in December 2018 to sell 100 shares of Apple stock at a price of $150 a share (the current market price) on May 15, 2019. I will call the person who takes the other side of this agreement, my counterparty. Whether the market price of Apple is $140 or $158 on May 15 does not affect the price at which our contract will settle, because the whole point of a futures contract is to fix the price of the contract on the future date. For the purposes of discussion let’s assume that the price on May 15 turns out to be $158. Since I sell my shares at $150, I have $800 less, that is $8 less per share, than I would have if I had simply waited to sell my shares. Similarly, my counterparty has $800 more than she would have if she had simply waited to buy the shares.

Why would I have chosen to enter into this contract? If I owned Apple shares maybe I knew in December that I would need the money on May 15, but didn’t want to sell in December for tax purposes and was worried that the price would fall in the meanwhile. Alternatively, maybe I don’t own Apple shares, but have reason to believe that the price is going to fall over the next six months and want to have the opportunity to sell shares that I will be able to purchase at low price (as I expect to be the case in May) while selling at high price. In the first case, I am protecting myself against risk of loss – or hedging, and in the second case I am speculating on the price of the shares.

Why would my counterparty have chosen to enter into this contract? Perhaps, she expects the price of Apple shares to go up over the next six months, but doesn’t have the money to buy them now and wants to lock in today’s price on a contract that can be paid for when her funds are available. In other words, she is speculating on the price of the shares, since she could simply wait and buy the shares when her funds are available. (A retail investor would not be hedging, since that would imply some kind of an obligation to possess shares in May that aren’t owned in December. By contrast, a financial professional might have such an obligation and be using such a position to hedge an exposure.)

Thus, a crucial aspect of a derivatives contract is that the same contract can be used either to hedge an exposure – i.e. to insure against an existing risk – or it can be used to speculate on a change in prices. The derivatives contract itself will not give any indication how it is being used. If the owner of shares enters into a contract to sell them in the future, that is a means of protecting the owner against the risk of loss, and it would not be considered a wagering contract under the traditional law governing derivatives. Traditional gambling law applied only to derivatives where no contract participant was hedging, but instead both were speculating (in opposite directions) on a price movement.

With this introduction let’s get into some details.

Britain’s Gaming Act of 1845 laid a cornerstone of Anglo-American securities regulation: wagers, including derivatives that could be characterized as wagers, were void and could not be enforced as contracts. The reasoning behind this approach was cost-benefit analysis. Because a wager, by definition, involved two parties who did not have a real economic interest or productive purpose at stake, the benefit of enforcement was necessarily small and deemed not to be worthy of the costly expense of judicial resources (H.C. 1844: v-vi; see also testimony of Daniel Whittle Harvey, Esq., Commissioner of the City Police Force, Honorable Mr. Justice Patteson, and John Bush, Esq., Attorney and Solicitor).

In Britain, as in the US, the real world implications of a law are often determined only after the courts have interpreted the text of the law and developed a legal test that will be used to apply the law. In 1851, Grizewood v. Blane, 138 Eng Rep 578, 584 (C.B.), interpreted the 1845 Act, establishing a seminal precedent that would undergird Anglo-American securities law for the better part of a century: if one of the parties genuinely intended to deliver/receive the underlying asset (typically a question of fact for the jury), the transaction was not a wager, but instead a valid contract. Over the next 50 years many US state legislatures adopted similar gaming laws and many US courts cited Grizewood v. Blane on the interpretation of such statutes with respect to financial transactions. The Supreme Court affirmed this interpretation in Irwin v. Williar, 110 US 499 (1884).[1]

Let us apply this legal test to the example given in the introductory paragraphs. If I am hedging my need to sell 100 shares of Apple in May, then the whole point of the transaction is that I expect to sell (and deliver) my shares. On the other hand, if I am speculating, then I don’t have any shares to sell, and it’s easiest to just pay the difference between the contract price and the actual price in May. In this example, I pay my counterparty $800 without a transfer of shares. The fact that I own shares and need to sell them in May would be strong evidence of my intent to deliver, and therefore that the contract is not a wager. By contrast, the absence of any such evidence together with the presence of a pattern of entering into futures contracts and settling differences without ever taking ownership of shares is likely to be viewed as evidence that I am speculating. If the same is also true of my counterparty, then the derivative is a wager. As noted, in practice the evidence on each party’s intent was typically submitted to the jury so the jury could make the factual determination with respect to each party.

During this period derivatives contracts, particularly those that were typically settled by paying price differences, were at risk of being deemed unenforceable in court. Because settling by paying price difference was common on the Exchanges, they had to develop their own mechanism by which they could enforce the claims of parties to these contracts.[2] That mechanism was margin, which is a synonym for collateral.[3] Upon entering into a derivatives contract a trader was asked to post to the exchange margin that would cover a portion of the value that the trader might end up owing on it. And on a regular basis the exchange would reevaluate the contract and change the amount of margin that must be posted to reflect how the contract had changed value over time. In this way, if the trader went bankrupt the exchange had the means to make sure payment was still made on the contract.

In short, the system of margining derivatives contracts was designed for an environment where legal enforcement of contracts was not likely to be available to traders. This alternate system for ensuring payment on derivatives conflicted with the bankruptcy code which sought to catalog all of a bankrupt’s assets and distribute them fairly across creditors. The Supreme Court in 1876 created a carve-out for exchanges, allowing them to process transactions according to their rules and indeed even allowing them to use the proceeds from the sale of the bankrupt’s seat on the exchange to settle any remaining debts on the exchange – all outside the reach of the bankruptcy court (Hyde v. Woods, 94 US 523, 1876). This special status was preserved for commodities exchanges when the Bankruptcy Code was revised in 1978 by allowing commodities brokers to foreclose on margin despite a bankruptcy. In 1982 the contractual rights set forth by the rules of securities exchanges were also exempted from bankruptcy (Pub. L. No. 97-222).

In the early 20th c. the invention of the telegraph posed an existential crisis for the Exchanges as their prices were instantly transmitted for off-exchange trading, threatening not just members’ income, but the price discovery process itself (Levy 2006). This led in 1905 to a Supreme Court determination that exchange-traded contracts were a special category due to the important role they play in setting prices for the business world, CBOT v. Christie Grain, 198 US 236 (1905). This decision distinguished exchange-traded contracts from off-exchange contracts and deemed only the former legally enforceable. The wagering laws that had been enacted at the state level continued to apply to derivatives contracts that were not traded on an exchange.

The Commodities Exchange Act of 1936 was therefore building on existing law when it prohibited trade in derivatives referencing commodities with two exceptions: exchange-traded contracts and contracts where the intent was to deliver the underlying.[4] In 1974 when the CFTC was created and tasked with enforcing the Act, the definition of a commodity was deliberately amended to cover not just virtually all goods, but also “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in … .” In short, the CFTC was granted jurisdiction over derivatives referencing virtually anything, except for categories that would be explicitly excluded, including currencies, government bonds and mortgages that were considered the domain of banks, and options on securities that were removed to the sole jurisdiction of the SEC.[5]

As a result, during the 1980s there were two tiers of regulation governing derivatives. At the Federal level the CFTC Act made derivatives presumptively illegal, unless they were traded on an exchange, the intent was to deliver the underlying, or they were explicitly excluded from the CFTC’s jurisdiction. And at the state level derivatives contracts were void unless they either served to insure one party from an existing risk or the intent was to deliver the underlying.[6]

At the same time, subsequent to the Savings and Loan crisis there were growing markets in new categories of derivatives, interest rates swaps which reference Treasuries, and foreign exchange swaps. The 1974 Treasury Amendment’s exemption of commercial banking activities excluded some such derivatives from the CFTC’s jurisdiction. By 1985, however, products outside the exemption were being developed, and US investment banks were prominent dealers in this market alongside three major commercial banks. These dealers formed the International Swaps Dealers Association (ISDA) with the explicit goals of standardizing the unregulated contracts to facilitate trade, and addressing accounting and regulatory issues. Effectively the ISDA was acting as a Self-Regulatory Organization (SRO) like the National Association of Securities Dealers, but without any supervising regulator. The market grew rapidly and increased tenfold from 1986 to 1990. (Sissoko 2017).

In 1990 at the request of the ISDA the Bankruptcy Code was amended to exempt interest rate and currency swaps as well as “any other similar agreement” from provisions of the Code (Pub. L. No. 101-311). Observe that, whereas the original Bankruptcy Code exemptions had only been granted to the contractual rights created by the rules of the regulated Exchanges (and related SROs), in 1990 these exemptions were granted to unregulated financial contracts and to contractual rights founded in common law; in short, this new exemption was much broader than the 1982 exemption. Having opened this breach in the financial regulatory structure, industry lobbyists spent the next decade and half forcing the gap open as wide as possible.

A 1992 law granted the CFTC the power to exempt any contract from its oversight and by doing so to preempt the application to the exempt contract “of any State or local law that prohibits or regulates gaming or the operation of ‘bucket shops’” (Futures Trading Practices Act, Pub. L. No. 102-546). The structure of this exemption power was unwise, and set a dangerous precedent. In order for the CFTC to exempt a contract from its own oversight, it also had to exempt the contract from one aspect of the traditional State law regulating securities contracts. In short, instead of treating the law that had supported economic activity for more than a century as valuable infrastructure, the 1992 law treated it as disposable. As a result, even the subject experts who staffed the CFTC were not given the choice of exempting a contract from CFTC oversight while at the same time leaving in place traditional state-based restrictions on wagering-type contracts.

In 1993 the CFTC exempted interest rate and currency swaps as well as “any other similar agreement” with the qualifications that they could not be standardized, fungible contracts and that they not be traded through a multilateral execution facility (58 FR 5587 at 5589 (Jan. 22, 1993)). By 1998 the swaps market had evolved such that it was no longer evident that the contracts complied with the qualifications on the exemption, and scandals that had led to litigation indicated that unwitting participants had in some cases been defrauded. When the CFTC proposed to revisit the question of regulating of the swaps market, stating explicitly that any such regulation would only be prospective (63 FR 26, May 12, 1998), industry lobbyists has sufficient influence at the Federal Reserve and Treasury to successfully pressure Congress to enact a six-month moratorium on the CFTC release (Greenberger 2018: 21-23).

The final outcome of the full-bore industry response to the CFTC’s proposal to evaluate the need for regulation of swaps was the enactment of the Commodities Futures Modernization Act of 2000 (CFMA; Pub. L. No. 106-554), which excluded not just interest rate and currency swaps, but financial derivatives more generally from the Commodity Exchange Act – as long as they were traded by “eligible contract participants,” roughly speaking entities with more than $10 million in assets. By excluding these derivatives from the Act itself, they were not just removed from the jurisdiction of the CFTC, but also from the CEA’s anti-fraud and anti-manipulation provisions. Furthermore, when it came to the application of State law excluded contracts were treated like contracts that had been exempted as per the 1992 FTPA; in other words, the CFMA explicitly preempted any application of state gambling law to excluded contracts (Greenberger 2018: 27-28).[7]

Pause for a moment to consider the hubris embedded in the CFMA. At least the 1992 FTPA had left the discretion to the subject experts at the CFTC to determine whether or not to exempt contracts from both oversight and state law. In the CFMA Congress assumed that it had the ability to judge not just whether the excluded contracts should be subject to the CFTC’s oversight but also whether they should be exempt from the State law and common law that had served the economy well for more than a century. And this decision was taken without even commissioning a study of the reasoning behind the use of the traditional wagering law to restrain securities markets. (One is reminded of Chesterton’s fence: “If you don’t see the use of something. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.”)

Although the CFMA established over-the-counter derivatives as an entirely unregulated market and allowed to the ISDA to organize that market unsupervised and without the constraints on anti-competitive practices that had been adopted throughout the financial system in the 1930s, this was not, however, enough.

The margining system that had been developed to enable the earliest exchanges to enforce their contracts without relying on the legal system could be used to create leverage that was invisible to the Federal Reserve, which was still using theoretic frameworks appropriate to unsecured interbank lending, and had not yet mastered the implications of the growing use of margin by the biggest financial participants. With the Fed blind not just to the risks of the derivatives margining system but also to the extent of its growth, commercial and investment banks could take on an unregulated form of leverage.

It seems unlikely that many of the financial industry lobbyists saw the big picture of what they were doing when they lobbied for the 2005 bankruptcy act. Most likely they simply saw an opportunity to shift the rules in a way that would be profitable for them and went for it, without a thought for the broader economy at all.

The outcome was legal reform of the Bankruptcy Code as it affected financial institutions that was just as stunning in its implications as the CFMA had been with respect to derivatives regulation: In an early paper I dubbed this legislation “The No Derivative Left Behind Act of 2005” (Sissoko 2010). The goal of the reform was to make it possible for the broker-dealer banks to manage collateral, not contract by contract, but in a way that would make the collateral as mobile as possible. The banks wanted to be able to aggregate all the margin posted by a certain counterparty on all of its contracts and deal with it as a whole. Since the broker-dealers (but for the most part not their clients) could reuse – or rehypothecate – the margin that was posted to them, the ability to aggregate collateral positions would free up more collateral for the broker-dealers to reuse. Reusing margin is a way for a bank to leverage its balance sheet.

The ability to aggregate collateral positions was created by, first, granting exemption from the Bankruptcy Code to master agreements that were designed to bring a wide variety of different contracts under a single netting agreement, and, second, by revising the specific terms of the bankruptcy exemptions granted to the different types of contract so that they would be uniform – and thus amenable to aggregation. Unsurprisingly the way the various terms were made uniform was by taking the broadest grant of exemption from the Bankruptcy Code and applying it to the various contracts (Sissoko 2010).

For example, exemption from the Bankruptcy Code for options on securities had been limited as was noted above to contractual rights established by the rules of a securities exchange. This was expanded to include the terms that applied to swaps and thus to the more general contractual rights that exist under common law. This was a vast change in the applicability of the Bankruptcy Code exemptions.

Other revisions in the 2005 Act also broadened its reach: to allow for new products to be developed, each type of exempt contract was defined to include similar contracts. One practitioner’s comment on the new definition of a swap was: “Read literally this language cedes the content of the definition to the players in the market.” Kettering (2008: 1712). In addition, before the 2005 Act exempt repurchase agreements had been limited for the most part to those referencing Treasuries and Agencies. After the Act, repurchase agreements on securities and mortgages had been included in the definition of securities, and were therefore exempt.

Like the CFMA, the hubris implied by this law boggles the mind. The bankruptcy exemptions had been created to facilitate the operation of Exchanges because they could not rely on the courts to enforce their speculative contracts. The whole logic of this financial structure was turned on its head by applying the exemptions to off-exchange contracts, that had already been exempted from the state and common law governing speculative contracts. Not only this, but this brand-new, ill-considered financial structure was not applied to some very narrow set of contracts, but it was applied to a vast range of contracts and was designed to make it easy for the interested parties who had lobbied for the law to expand the range of contracts at will.

Just three years after the law was passed, the implications of establishing a vast unregulated financial market with extraordinary privileges under the Bankruptcy Code were realized. The repurchase agreement market which was a core part of the margining system for this unregulated market experienced a massive run and came close to bringing down the financial system entirely. The margining system was saved only by the Federal Reserve’s unprecedented measures.

With the Dodd-Frank Act supervision has been extended over these instruments, and many have been forced to trade on exchanges. The basic incoherence of this new financial structure remains, however. Off-exchange contracts are still exempt from provisions of the Bankruptcy Code and from state wagering laws. The central banks are struggling to develop a theoretic framework that can allow them to manage the new system of margin-based interbank lending successfully. It remains to be seen if the growth rates achieved under the old system can be attained under the new one.

[1] Note that Kreitner (2000)’s discussion of the intersection between securities regulation and wagering law starts with Williar, and this case apparently does not offer the best explanation of the logic underlying this form of securities regulation. Kreitner (2000) argues that moral rather than economic considerations drove this form of securities regulation.

[2] As Levy (2006) observes, while there are many cases arguing that exchange-traded contracts were void as wagers in the late 19th century, not one of them is brought by a member of the exchange. That is, they are all brought by the clients of exchange members.

[3] In 1865 the Chicago Board of Trade introduced the first standardized futures contract together with the requirement that a “performance bond,” which serves the same function as margin, be posted by futures traders.

[4] Derivatives were covered by the term “contracts for future delivery,” but the law was careful to state that “The term ‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery,” thus creating what was known as the “forward contract exclusion.” (as currently encoded, 7 U.S.C. 1(a)(27))

[5] The bank contracts were exempted in the 1974 Treasury Amendment to the CEA and securities with the 1982 enactment of the Shad Johnson Accord (GAO 2000).

[6] Because the era of federal common law had ended in 1938, the exchange trading exemption to state wagering laws was unsettled.

[7] In current law this exclusion is found in 7 USC s. 16(e)(2).

Note: Updated January 14 2019 to add more explanatory text regarding derivatives.

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The dismantling of the economy’s legal infrastructure II: Investment funds

From the beginning there was a “private offering exemption” to both the disclosure requirements of the Securities Act of 1933 (“’33 Act”) and the investment company registration requirement of the Investment Company Act of 1940 (“’40 Act”). The basic idea behind ’33 Act and the ’40 Act exemptions were somewhat different, however. For the ’40 Act if an issuer’s activities were sufficiently small and didn’t involve marketing to the public they didn’t need to be covered. For the ’33 Act the focus was on the fact that certain financial professionals, such as banks, as well as the principals of a corporation did not need the protection of the disclosure requirements.

Thus, the original ‘40 Act had the “section 3(c)(1)” exemption for funds “that are beneficially owned by not more than 100 persons” and that issue securities that are not offered publicly. Companies that were required to register under the ’40 Act faced leverage restrictions and controls on self-dealing amongst other requirements. Until 1996, a private fund that sought to opt out of the ’40 Act had to fall under the 100 investor exemption. Obviously, this constrained the size of any given hedge fund or private equity fund.

Similarly, the original ’33 Act had the Section 4(a)(2) exemption from the disclosure requirements for “transactions not involving any public offering.” From the earliest days, this was understood to exempt corporate activities such as obtaining bank loans, placing securities privately with institutions, and promoting a business endeavor amongst a small group of closely related individuals (SEC 2015: 11). This approach was affirmed by the Supreme Court in 1953 which interpreted a non-public offering to include “an offering to those who are shown to be able to fend for themselves” and found that an offering to corporate executives “who, because of their position, have access to the same kind of information that the Securities Act would make available in the form of a registration statement” could also fall within the exemption.[1]

In short, for the first decades of this comprehensive regulatory regime, the private offering exemption was narrow, and offered little or no scope for hedge funds to operate. Needless to say, the financial industry pushed continuously to widen the scope of the exemption.

The process by which hedge funds were allowed to grow started slowly when in 1974 the SEC adopted Rule 146 which stated that the Section 4(a)(2) exemption would apply to offerings with no more than 35 purchasers, with dissemination of information comparable to a registration statement, and “reasonable belief” that purchasers or their representatives had the capacity to evaluate the information.[2] The Rule allowed sales to purchasers who couldn’t evaluate the information themselves, but instead (i) were wealthy enough to bear the risks associated with the security, and (ii) had a representative with the capacity to evaluate the information, thus creating an investment category specifically for wealthy individuals. At the same time in the Adopting Release the Commission declared:

“[I]t is frequently asserted that wealthy persons and certain other persons such as lawyers, accountants and businessmen are “sophisticated” investors who do not need the protections afforded by the Act. It is the Commission’s view that “sophistication” is not a substitute for access to the same type of information that registration would provide.” (SEC Rule 146 Adopting Release No. 33-5487, 39 FR 15621)

In short, the ’33 Act’s goal of investor protection meant that regulation had to ensure that even sophisticated investors received the relevant information to evaluate. On the other hand, the rule imposed no constraint on the amount of money that could be raised from those 35 investors.

A year later Rule 240 was adopted to benefit small businesses by exempting issuers raising less than $100,000 in a 12 month period with no general advertising, and with no more than 100 investors. Notably, the requirement that investors have access to information comparable to a registration statement was omitted from this Rule, presumably in order to reduce the costs and legal risks faced by small businesses.

The pressure for broader exemptions continued and was met in 1980 with Rule 242, which was the first time the concept of an “accredited investor” was used. An “accredited investor” included categories that had long been covered by the 4(a)(2) exemption including banks, institutional investors, and directors and executives of the issuer. Added to these groups were pension funds (explicitly), and anyone who purchased $150,000 of the issuer’s securities. And this rule no longer required that the investor be furnished with information “based on the assumption that accredited persons were in a position to ask for and obtain the information they believed was relevant” (SEC 2015: 14). In short, Rule 242 blew a hole in the comprehensive regulatory regime, but was designed to harm only those wealthy and institutional investors that happened to lack the financial acumen the SEC attributed to them.

A few months later in the Small Business Investment Incentive Act of 1980 (Pub.L. 96-477) the concept of “accredited investor” was made law. The legislation (i) defined the term to include the broad categories of financial intermediaries covered by Rule 242 while authorizing the SEC to adopt additional categories and (ii) created a new exemption for issues of up to $5 million to accredited investors only (SEC 2015: 15).

Just two years later, the SEC replaced all of these refinements of the private offering exemptions with a single regulation, Regulation D. Regulation D was organized around the concept of the “accredited investor” and at the same time widened its scope. In addition to those covered by Rule 242 were added anyone with substantial net worth ($1 million)[3] or income ($200,000 per annum), and any entity all of whose owners were accredited investors. At the same time the SEC explained that purpose of this redefinition was to define a class of investors who did not need the ’33 Act’s protections, because of their sophistication, ability to sustain loss, or ability to fend for themselves (SEC 2015: 17).[4]

Reg D significantly revised the three categories of exempt issues: Rule 504 exempted the sale of up to $500,000 without general solicitation (imposing no limitations on number or type of investors). Rule 505 exempted the sale of up to $5 milllion in a 12 month period to an unlimited number of accredited investors and 35 additional persons without general solicitation. Rule 506 dramatically broadened the Rule 146 safe harbor by treating as private offerings sales of unlimited amounts of securities to an unlimited number of accredited investors and up to 35 non-accredited, but sophisticated, investors without general solicitation. Although Rule 506 was viewed as a replacement for Rule 146, by allowing unlimited amounts to be raised from an unlimited number of investors, it was different in character from the original Rule 146. In addition, Rule 506 eliminated entirely the requirement for accredited investors that they be furnished with or have access to information comparable to a registration statement.

Observe the structure of this change. It would have been very hard for the SEC to argue that the Regulation D exemptions were consistent with the legislature’s intent in enacting the ’33 Act, because in 1933 the primary purpose was to protect investors by addressing the problem of information asymmetry in the market and there was no intent to exempt wealthy individuals or pension beneficiaries (through their fiduciaries) from that protection. This was clear in in 1974 when Rule 146 was adopted. But, with the passage of the Small Business Investment Incentive Act of 1980 the relevant intent when discussing an “accredited investor” was that of the 1980 legislature – and the stated intent of that legislature was to increase the ability of “small business” to raise capital. Thus, the adopting release for Regulation D states that its purpose is to “facilitate capital formation consistent with the protection of investors” and the emphasis throughout the release is on small business.[5] Hedge funds and leveraged buyout companies were small businesses – not just from an employment perspective, but at the time in terms of their capacity to raise funds too. The latter was, however, due to the constraints imposed by the regulatory regime, as would become clear after those constraints were relaxed.

To summarize, the 1980 law opened the door to a 180 degree shift in the focus of the ’33 Act from the goal of protecting the beneficial owners of securities to the goal of making it easier for “small businesses” to raise vast amounts of money. And Regulation D threw that door wide open by eliminating the constraints that were designed to ensure that the exemptions were targeted to small businesses. Not only was an exemption created that allowed unlimited sums to be raised without any disclosure whatsoever, but the same exemption allowed that money to be raise from an unlimited number of wealthy investors.

With Regulation D a new era in U.S. finance was born.[6] The 1980s saw private equity funds take off along with leveraged buyouts, see Chart 1. The economic inefficiencies created by leveraged buyouts were immediately recognized (e.g. Shleifer and Summers 1988), but apparently no connection was drawn linking the growth of these funds and their economically inefficient activities to the lifting of the ’33 Act’s limitations on private fundraising by securities issuers.

pe funds.pdf

Even though Regulation D made it much easier for investment funds to raise money without disclosure, most funds did not want to register under the ’40 Act and as a result in order to qualify for the 3(c)(1) exemption the number of investors was capped at 100. It was not until 1996 that the National Securities Markets Improvement Act created a new exemption from registration under the ‘40 Act. Section 3(c)(7) funds are permitted an unlimited number of investors as long as they are “qualified purchasers,” a category which includes individuals with $5 million in investments and institutional investors with at least $25 million in assets under management.[7] Legislative history indicates that Congress deemed these investors to be capable of evaluating “on their own behalf matters such as the level of a fund’s management fees, governance provisions, transactions with affiliates, investment risk, leverage, and redemption rights” (S. Rep. No. 104-293). In other words, as the SEC explained “Congress determined that the amount of a person’s investments should be used to measure a person’s financial sophistication” (2015: 25).

Thus, after 1996 we see once again a significant acceleration in growth of private funds, see Chart 2.

hedge funds

Data from: Joenvaara, Kosowski, & Tolonen (2012). For hedge fund AUM over time, see here.

 

This unregulated environment fostered certain decades-long frauds like that perpetrated by Bernie Madoff and insider trading as took place at SAC Capital. The remarkable window that has been opened into one wealthy family’s activities by the Mueller investigation naturally raises the question of the degree to which these underreporting investment funds are systematically breaking the law on the principle that they are very unlikely to ever be caught doing so.

The wrongdoing that has been uncovered is entirely consistent with the wrongdoing that the Investment Company Act was designed to prevent. Six years before the Act was passed the Pecora Committee Report discussed the problem of investment trusts:

“laissez fair policy nurtured a mushroom propagation of investment trusts of incalculable economic significance. The investment company became the instrumentality of financiers and industrialists to facilitate acquisition of concentrated control of the wealth and industries of the country. The investment trust was the vehicle employed by individuals to enhance their personal fortunes in violation of their trusteeship, to the financial detriment of the public. Conflicts of duty and interest existing between managers of the investment trusts and the investing public were resolved against the investor. The consequences of these management trusts have been calamitous to the Nation. … the exposure of the abuses and evils of investment trusts must be expeditiously translated into legislative action to prevent recurrence of these practices” (S. Rep. 73-1455: 333).

In the event Congress moved with much more deliberation than Senator Pecora demanded. The newly created SEC was tasked with studying the problem, and the law was developed in close consultation with the investment industry. As a result, the final bill was sent to Congress with the full support of the both the SEC and the investment industry, leading a prominent legal scholar to remark that “the passage of such comprehensive legislation with virtually no debate is probably without precedent” (Jaretski 1941: 310-11). In short, the Investment Company Act was carefully designed to work to the benefit of the financial industry by improving its operation. While the term asymmetric information had not yet been coined, contemporary Congressional reports on the Act make it clear that that the law was carefully targeted to address information problems. To quote from the Senate Report on the Act:

“The representatives of the investment trust industry were of the unanimous opinion that ‘self-dealing’ – that is, transactions between officers, directors, and similar persons and the investment companies with which they are associated – presented opportunities for gross abuse by unscrupulous persons, through unloading of securities upon the companies, unfair purchases from the companies, the obtaining of unsecured or inadequately secured loans from the companies, etc. The industry recognized that, even for the most conscientious managements, transactions between these affiliated persons and the investment companies present many difficulties. Many investment companies have voluntarily barred this type of transaction. …

“Finally, particularly with respect to those companies which have not registered their securities under the Securities Act of 1933 or the Securities Exchange Act of 1934, and only a small number has so registered its securities, the investor has been unable to obtain adequate information as to their operations. The accounting practices and financial reports to stockholders of management investment companies frequently are deficient and inadequate in many respects and ofttimes are misleading. In many cases, dividends have been declared and paid without informing the stockholders that such dividends represented not earning but a return of capital to stockholders.” (S. Rpt. No 76-1775: 8).

Currently in the US hedge funds have $4 trillion in assets under management and private equity funds have $2.5 trillion (SEC Private Fund Statistics Q1 2018). As the total assets of the U.S. commercial banking system are a little less than $17 trillion, we find that the funds in the US that are not subject to standard controls on the use and abuse of asymmetric information are equivalent in size to one-third of the banking system. In short, one driver of financialization and the inequality associated with it is the vast quantity of underregulated investment funds that hide in the shadows of the US financial system.

It’s worth mentioning that the 1980s and 1990s also witnessed the proliferation of business forms that offer limited liability without either corporate status or corporate taxation. The limited liability company or LLC is the foremost of these structures, and plays a part in the development of a vast financial system that hides in the shadows of the regulated financial system. Many hedge funds are structured as LLCs.

Prior to 1988 the only business structure that combined pass-through taxation with limited liability was the S-corporation. The Chapter S election is available only to small corporations with no more than 100 shareholders,[8] all of whom are individuals. In 1988 the IRS granted the LLC structure the “pass through” tax status that makes it such a useful tool for structuring and hiding assets. By 1996 LLC statutes had been enacted in every state. A variety of other limited liability business structures that have pass through taxation are also available now.

Overall, a vast swathe of the US financial system operates in the dark with minimal supervision even today. That this situation was allowed to develop in the name of financing “small business” is astounding.

An adjustment should be made in our understanding of the purpose of our financial regulatory laws: The deployment of hundreds of millions of dollars in funds has public implications. For this reason alone, all investment companies with assets under management in excess of $500 million and either at least one pension fund investor (and thus hundreds of beneficial investors) or more than 35 investors should be subject to the Securities Act’s reporting requirements.

[1] SEC v. Ralston Purina, 346 U.S. 119 (1953).

[2] Rule 146 stated that the Section 4(a)(2) exemption would apply if:
(i)            Offerings were limited to 35 purchasers;
(ii)           Offerees had access to or were furnished with information comparable to what a registration statement would contain;
(iii)          Issuers reasonably believed that all offerees either (a) had the requisite knowledge and experience in financial matters to evaluate the risks of the investment or (b) could bear the economic risks of the investment;
(iv)          Sales were made only to those who had the requisite knowledge and experience or who had a representative who was capable of providing the requisite knowledge and experience;
(v)           There was no general advertising or solicitation.

[3] The Dodd Frank Act, Section 413(a) caused the value of a primary residence to be excluded from the measure of net worth.

[4] In 1988 the Commission’s position that a $150,000 investment guaranteed that the investor had sufficient “bargaining power” that no protection was needed was reconsidered “particularly at the $150,000 level” and this criterion for accredited investor status was withdrawn entirely (SEC 2015: 17-18).

[5] The crude model of capital formation underlying this approach is remarkable coming from an agency that was created in order to address problems of information asymmetry. Afterall, it is investor protections that safeguard the economy’s long-term capacity to raise capital.

[6] This growth has been attributed to other causes such as anti-takeover statutes or high yield bonds, but the timing doesn’t line up for these. High yield bonds began to take off as an asset class in the 1970s. And when the Supreme Court struck down an anti-takeover statute in 1982, it was far from clear that this would invalidate the statutes that had been enacted in other states, and indeed in 1987 the Supreme Court upheld an anti-takeover statute – and leveraged buyouts continued to boom.

[7] Note that in order to avoid registration under Section 12(g) of the ’34 Act, most funds today limit their investors to 499.

[8] In the original law only 35 shareholders were permitted.

The dismantling of the economy’s legal infrastructure I: Background

In December I attended a remarkable conference, Money as a Democratic Medium, where a whole spectrum of progressive critiques of the current economic situation were discussed. I noticed, however, that many attendees did not seem to entirely grasp that our currently state of financial instability and financially-driven inequality was very much constructed by legislation from the 1980s on that revised the laws governing our financial infrastructure — and that these laws were passed due to aggressive lobbying by the financial interests that benefited from them. So my next series of posts will go into some detail on how the comprehensive regulatory regime that was so carefully designed in the 1930s was dismantled. (Note that Katharina Pistor is one of the few who has a good grasp of this problem, and these posts complement her work.)

This post opens the discussion with a background exposition of the US Depression era financial legislation and what it was designed to do.

In the 1930s and 40s a comprehensive regulatory regime was designed for the financial system. The designers of this system had learned from the real estate and the stock market booms and busts of the 1920s and were not just conscious of the credit-creation function of banking, but also of the disastrous consequences that result when bank credit is used to finance leveraged positions in financial or real assets. Thus, the system was designed with firewalls that would keep credit from flowing inefficiently from the banking system into sectors, like housing and stock market investments, where there was abundant empirical evidence that the primary result would be asset price inflation.

The new system also took into account the fact that state and common law had long granted a limited form of self-governance to the commodities and securities exchanges, which set rules for their members, and gained certain privileges in deference to the role they played in establishing the prices for financial contracts. In the new regime the Exchanges would be recognized as “Self Regulatory Organizations.” Every one of them was, however, made subject to the supervision of either the SEC or the Secretary of Agriculture (prior to the creation of the CFTC).

The financial regulatory laws enacted in the 1930s and early 1940s were designed to augment the existing legal regime governing financial contracts, which was constructed on the principle that financial contracts are legally enforceable only when they are tied to the real economy. Thus, if any one of three conditions are met (i) the contract insures one party against an existing risk, (ii) the intent is to deliver the underlying asset, or (iii) the contract is traded on a designated exchange, the contract is deemed to play a role in distributing real economic risk and is legally enforceable. On the other hand, a financial contract where both parties were speculating on some future event – such as the price of an asset – had to be traded on an exchange or it would be considered a wager and void.[1]

The financial regulatory laws enacted in the 1930s and early 1940s were designed as a comprehensive regulatory regime where every financial product had a designated regulator. The first step in this process had been the Federal Home Loan Bank Act of 1932 which established a Federal Home Loan Bank System to support liquidity in the mortgage markets on the model of the Federal Reserve System. Mortgage lending had never been a significant activity for commercial banks, but was instead the purview of a variety of savings associations. Very innovative policies would be put in place to support the mortgage markets over the course of the decade, but this history is not pertinent here.

The second step in the process of creating a comprehensive regime with firewalls designed to construct a silo’d financial system was to separate out banks from brokers and dealers on financial markets. Formal separation of the commercial banks from their investment banking affiliates was adopted in the Banking Act of 1933 (“the Glass-Steagall Act”).

The next step was to extend federal law to cover the broker-dealers, the exchanges, and over-the-counter markets. The latter were covered, not because major improprieties on OTC markets had been discovered in the years leading up to the Great Depression, but because legislators recognized that “since business tends to flow from regulated to unregulated markets … the regulation of exchange markets made necessary the regulation of [over the] counter markets” (SEC Tenth Annual Report, 1945: 44). That is, 1930s legislators were well aware of the need for a comprehensive regulatory regime. Thus, the Securities Act of 1933 (“’33 Act”), the Securities Exchange Act of 1934 (“’34 Act”), the Commodity Exchange Act of 1936 (“CEA”), and the Investment Company Act of 1940 (“’40 Act”) were designed to ensure that there was no unregulated financial market into which business could flow.

The Commodity Exchange Act of 1936 (CEA) prohibited trading of commodities contracts for future delivery – a category which encompasses options and swaps contracts that reference commodities — with two exceptions, contracts traded on designated markets and the forward contract exclusion (which requires that delivery is expected take place).[2] Observe that this prohibition was simply a means of bringing well-established state and common law rules under the purview of federal law.

The SEC regulated broker-dealers and their over-the-counter transactions through the creation of a new self-regulatory organization (explicitly authorized by the Maloney Act of 1938), the National Association of Securities Dealers (which was replaced in 2007 by FINRA, the Financial Industry Regulatory Authority). This decision to create an SRO for the purpose of regulating the formerly unregulated segments of the securities markets should have been viewed as precedent. Any unregulated financial market, needed to form a self-regulatory organization, and apply to the SEC (or the CFTC as might be appropriate) for its right to exist.

So how did we go from a system of comprehensive regulation in 1940 to the 2008 environment where vast swathes of the financial system were unregulated? The short answer is that the deregulatory ideology of the 1980s and 1990s turned a comprehensive regulatory regime into a tattered web of regulations and in doing so facilitated the growth of the same kind of conduct that the regulatory regime had been designed to repress in the first place.

Links [to be updated]

The dismantling of the economy’s legal infrastrucure II: Hedge and private equity funds

The dismantling of the economy’s legal infrastructure III: Derivatives

The dismantling of the economy’s legal infrastructure IV: Mortgage lending

The dismantling of the economy’s legal infrastructure V: Commercial and investment banking

[1] Notice that in a contract where both parties are speculating, neither party has a real economic risk that is being transferred; instead, the two parties are just making different predictions about the future. As a result, the frequent claim that speculation serves to transfer risk away from those who will have difficulty bearing is not applicable to those contracts that were treated as wagering contracts under 19th and early 20th century financial regulatory principles.

[2] Stein, “The Exchange-Trading Requirement of the Commodity Exchange Act,” 41 Vand. L. Rev 473, 480-81, 491 (1988). See also Lynn Stout, “Why the law hates speculators,” Duke Law Journal, 48(701), pp. 722 – 3.

 

 

Collateralized shadow banking: still at risk of fire sales

A few basic points about shadow banking ten years after the crisis:

“What shadow banking is” isn’t very complicated if banking is defined as “borrowing short to lend long”

What makes banks unstable is that their liabilities are on demand (i.e. they borrow short) while their assets pay out only over the course of years (i.e. they lend long). A principle reason that we are worried about “shadow” banks is that they have the same instability as banks, but lack the protections in the form of a strict regulatory regime and a lender of last resort. When shadow banks have this instability it is because they borrow short to lend long.

This approach makes it easy to understand the world of shadow banking, because there are only a limited number of financial instruments that are used to borrow on a short-term basis. Thus, for the most part shadow banks have to finance themselves on the commercial paper market (unsecured financing) or on the repo market (secured financing) or, especially for investment banks, via derivatives collateral (e.g. that is posted by prime brokerage clients). These are the major sources of wholesale short-term funding.

So typically when a financial product is subject to losses due to a run-prone (and therefore classified as a shadow bank), it’s because of the product’s relationship to the commercial paper market, to the repo market, and/or to the derivatives market.* The latter two, which comprise the collateralized segment of shadow banking, are the most complicated, because the run can come from many different directions: that is, lenders may stop lending (e.g. Lehman Bros), borrowers who post collateral may stop posting collateral (e.g. novation at Bear Stearns), and for derivatives contracts conditions may shift so that suddenly collateral posting requirements increase (e.g. AIG).

Collateralized shadow banking is governed by ISDA protocols and contracts, not the traditional law governing debt

While repos have been around for centuries, a “repo market” in which anyone can participate and where collateral other than government debt is posted is a relatively new phenomenon. Similarly derivatives contracts have been subject to margin requirements for more than a century, but in the past these contracts were exchange-traded and exchanges set the rules both for margin and for eligibility to trade on the exchange.

Thus, what made repo and derivatives financially innovative in the 1980s and 1990s was that suddenly there were unregulated over the counter (OTC) markets in them. What “unregulated” really meant, however, was that the big banks wrote the rules for this market themselves in the form of International Swaps and Derivatives Association (ISDA) protocols and contracts.

In the early days of repo and derivatives it was far from clear that they wouldn’t fall under the existing regulatory regime as securities (regulated by the SEC), or as commodities and/or futures (regulated by the CFTC). (The legal definitions of the SEC’s and the CFTC’s jurisdiction was deliberately made very broad in the implementing legislation, so an intuitive understanding of these terms will not coincide with their legal definitions.) Similarly, it was far from clear that the collateral posted in these OTC contracts would not be subject to the standard terms in the bankruptcy code governing collateralized debt. (Kettering who describes repos in this era as too big to fail products is great on this.)

Thus, one of the ISDA’s first projects was lobbying in the US for exceptions to the existing regulatory regime. Progress was incremental, but a long series of legislative amendments to the financial regulatory regime starting in 1982 and culminating in the bankruptcy reform act of 2005 effectively placed the whole system of repo and margin collateral outside the financial regulatory regime that had been set up in the 1930s and 1940s (for details see here, or ungated). These reforms also exempted these contracts from the bankruptcy code’s protections for debtors (see here or ungated).

Where the US led others followed. Gabor (2016) documents how Germany and Britain came to adopt the US model of collateralized lending, despite the central banks’ serious reservations about the system’s implications for financial stability. The world economy entered into 2008 with repo and derivatives markets effectively subject only to the private “regulation” of ISDA protocols and contracts.

Despite reforms, the instability at the heart of the collateralized shadow banking system has yet to be addressed

We saw in 2008 how the collateralized shadow banking system relies extremely heavily on the central bank for stability. (Federal Reserve programs to support the repo market included the TSLF and the PDCF.  Data released by the Fed indicates that at the peak of the crisis it accepted substantial amounts of very risky collateral.)

Indeed the International Capital Markets Association has put it quite bluntly that it considers the systemic risk associated with fire sales in repo and derivatives markets to be a problem that “the authorities” are expected to step in and address.

“The question is how to mitigate such systemic liquidity risk. We believe that systemic risks require systemic responses. In this case, the authorities can be expected to intervene as lenders of last resort to ensure the liquidity of the system as a whole. For their part, market users should be expected to remain creditworthy and to have liquidity buffers sufficient to sustain themselves until official intervention restores sufficient liquidity to obviate the need for fire sales.”

In short, the collateralized shadow banking system is constructed on the expectation of a “Fed put”. Instead of attempting to build a robust infrastructure of debt, shadow banking embraces the risk of fire sales and expects the governments that don’t make the shadow banking rules to bail it out.

The only sure-fire way to eliminate the risk of fire sales is to reduce the financial system’s reliance on repo- and margin-type contracts that allow a decline in the value of collateral to be a trigger for demanding additional funds. Based on financial market history this would almost certainly require an increase in the use of unsecured interbank debt markets. However, not much progress has been made on this front, especially since the EU’s proposed Financial Transactions Tax stalled in 2015.

On the other hand, significant reforms have been made since 2008 (Please let me know if I’ve left out anything important.) :

  • Collateral has shifted mostly to sovereign debt. This helps stabilize the market, but perhaps only temporarily as a broad range of collateral is still officially acceptable (so deterioration of the quality of collateral can creep in).
  • Approximately 50% of derivatives now are held with central counterparties. (The estimate is based on a 2015 BIS report.) This reduces the risk that the failure of a small market participant sets off a chain of failures that results in a fire sale. There is some concern however that fire sale risk has been transformed into the risk of a failure of a central counterparty.
  • Derivatives are now officially regulated by either the CFTC or the SEC and and there has been an effort to harmonize OTC margining requirements internationally.
  • Under pressure from regulators a voluntary stay protocol has been developed by the ISDA that is designed to work with the regulators’ special resolution regimes and to limit the right to terminate a contract due the default of a related entity. In the US systemically important banks are required to include this protocol in their OTC derivatives contracts.
  • Bank liquidity regulations have been adopted that limit the degree to which regulated banks are exposed to significant risk in these markets.

Notice that these new regulations embrace the basic framework of collateralized shadow banking: much of the focus is on making sure that enough collateral is being used. Special rules are designed to protect the largest banks and the banking system more generally. But aside from protecting the banks, it’s not clear that significant measures have been taken to eliminate the risk of fire sales that originate outside the banking system. Assuming that these regulations are effective at protecting the banks, this raises the question: Who bears the fire sale risk in this new environment?

Thanks to @kiffmeister for requesting that I write up this blogpost.

* While one can usually figure this out after the run has occurred, current regulation does not necessarily make the relevant information available before a run has occurred. Mutual funds are a case in point: the vast majority of them have so little exposure to repo and derivatives markets that it can be ignored, but the few that take on significant risk may have disclosures that are hard to distinguish ex ante from the ones that don’t (e.g. Oppenheimer Core Bond Fund in 2008).

Integrating finance and macro: the problem of modeling debt

So I have finally read Mian and Sufi’s House of Debt. They do an excellent job of setting forth an argument that has met with quite a bit of resistance within the economics profession: the growth of household debt before the crisis and the failure to reduce it after the crisis explains to a large degree the severity of the crisis. (House of Debt was written in 2014, so if you’re thinking: “But wait, that argument is mainstream now” you would be correct.) I actually read the whole book which can be taken as approval of both its structure and the quality of the writing. (On the “life is short” principle I typically don’t get through a book is poorly structured or poorly written.) The book is widely cited and almost universally acknowledged as one of the foremost expressions of the household balance sheet view of the 2007-09 financial crisis. Thus, I am going to take the book’s many excellent qualities as given and focus on the most important flaw that underlies the book, because that flaw also underlies most economic analysis of the way financial factors played a role in the crisis.

While it is wonderful that Mian and Sufi are talking about debt, the way they are talking about debt and in particular their underlying model of debt is very problematic. Furthermore, the errors in their underlying model of debt are so ubiquitous in economic theory that these errors function as a constraint preventing the development of models that can accurately represent the relationship between finance and the real economy. In short, while this post will focus on a critique of Mian and Sufi (2014), this book is really just standing in for all the economic works that make the same assumptions, some of which I will reference below.

Holmstrom (2014) presents the standard economists’ model of debt, which underlies Mian and Sufi’s discussion too, using this diagram:

Holmstrom debt

Debt is modeled as a promise to make a fixed payment that will only be met if the borrower has enough money at the time payment is due. This diagram treats the value of the borrower’s collateral as equal to her entire wealth, assumes that the value of the collateral may take on values ranging linearly from 0 to something well in excess of the amount to be repaid on the debt, and assumes that the lender can take the collateral if the debt is not paid. Thus, the lender’s payoff increases linearly until the value of the collateral exceeds the amount due on the debt at which point the payoff to the lender is fixed.

There is nothing wrong with this model as a first pass at modeling debt. It is widely used for good reason. But the basic model also dates back to the 1980s (I connect it with a paper by Hal Cole that I can’t locate, but am not entirely sure of its origins) and it is remarkable that the model has not in ensuing decades been amended to allow for the much greater complexity of real world debt. Treating this model as if it represents the general category of “debt” and not the specific simple case that is easiest to model is a huge mistake that permeates the economics profession.

So what’s wrong with this model?

1)   It is used to treat “debt” as homogeneous

The model assumes that all debt takes a single specific contractual form modeled on a mortgage. In fact, debt is broad term that encompasses a huge range of different contractual provisions. Debt can be structured to favor the borrower or it can be structured to favor the lender. A debt contract can be designed so that it is hardly distinguishable from equity or so that the lender bears virtually no risk of loss. Economists need to stop talking about “debt” as a homogeneous product and start talking about the specific kinds of debt they mean to address.

For much of the discussion in Mian and Sufi, the standard model is appropriate, because their main focus of inquiry is mortgages, and this is a reasonable model of mortgage debt. On the other hand, this model leads them to make generalizations about debt itself that are simply nonsense, e.g. “This is a fundamental feature of debt: it imposes enormous losses on exactly the households that have the least” (p. 23). If they simply replaced the term “debt” with the phrase “the current US mortgage system” there would be nothing wrong with this sentence. When, however, they generalize from the problems with US mortgages to “debt” itself, they misfire badly. As I note above, this problem is not in any way restricted to Mian and Sufi, this is a general problem that permeates and degrades much of the economic discussion of debt.

It is highly unlikely that the economics can make progress in its efforts to study the relationship between finance and the real economy so long as the profession’s vocabulary for discussing something as fundamental to finance as “debt” is so utterly impoverished.

2)   Failure to model uncollateralized debt

Uncollateralized debt has very different properties from collateralized debt. In economic theory models debt is almost always modeled to be collateralized and is therefore backward looking (see, e.g. Holmstrom 2014 or Gertler and Gilchrist 2018). An agent must already own something pledgeable in order to borrow. This ensures that wealthy agents can borrow more and grow more wealthy, whereas poor agents are likely to be constrained forever. This framing of debt is closely related to the inequality dynamics described by Mian and Sufi.

By contrast, when debt is uncollateralized, it can be forward looking. If I can convince a bank that after investing the proceeds of a loan of $50,000 today, my business will give me revenues of $100,000 in a year, the bank can fund the loan with nothing more than my personal promise to pay it back (and the knowledge that our legal and social system will impose significant costs on me for a failure to pay, e.g. a public judgment against me, and a defective credit report). As long as I am expected to have the funds to pay back the loan when the debt is due, there’s no reason at all for the loan to depend on my ownership of more than $50,000 in assets to be used as collateral. For relatively small amounts and short periods of time this type of unsecured lending is very common in practice and has been very common for centuries.

Effectively the habits of thought that economists adopt when they think about debt are unreasonably constraining their ability to model the relationship between finance and the real economy. And these same habits of thought tend to rule out by assumption the possibility of inequality-reducing debt.

3)   Inaccurate assumptions about the legal framework governing debt

“Debt leads to bubbles in part because it gives lenders a sense of security that they will be unaffected if the bubble bursts” (p. 114).

This is simply not a property of “debt.” In the event of a bubble that bursts there will be a rash of bankruptcies and the basic rule in bankruptcy in this situation is cramdown: the borrowers’ debt is written down to the post-crash value of the collateral. In short, the standard legal procedure governing debt addresses precisely the macroeconomic problem in question here. A lender who lends into a bubble is at risk of loss. As a general statement, Mian and Sufi’s claim is simply incorrect. It is, however, (1) an accurate description of the model of debt that they are working with and more importantly (2) an accurate description of the law governing US mortgages on first homes, because of the explicit exception for these loans in the bankruptcy code. (Interestingly enough, the rules for the treatment of second homes in bankruptcy do allow cramdown.)

Thus, when Mian and Sufi write “Our main argument is that a more even distribution of losses between debtors and creditors is not only fair, but makes more sense from a macroeconomic perspective” (p. 150), what they are missing is an acknowledgement that “debt” as a general category is usually subject to treatment in bankruptcy that addresses their macroeconomic concerns. “The inflexibility of debt contracts” (p. 168) about which Mian and Sufi complain exists in their model and in US mortgage markets, but is not in fact a property of “debt contracts” themselves under the current legal regime in the US.

What should economic models of private debt do?

Economic models that seek to integrate finance and macro need to be very conscious of the different kinds of private debt and make deliberate decisions about why a specific form of debt is being modeled. To assist in this project, I present here a simple hierarchy of different types of debt that are likely to have very different macroeconomic consequences and thus should be modeled differently. (It’s possible and even likely that I have omitted an important type of debt, so this hierarchy is open to revision.)

The types are ranked from those that are most favorable to the lender to those that are most favorable to the borrower. (Note (i) I use “mortgage” as a general term for a collateralized loan, and (ii) the listed term of the loan should be understood as typical and not as claim that these types of debt are restricted to this term.)

  • Repurchase agreement or margin loan: ultra-short-term, overcollateralization, marketable collateral, immediate right to seize the collateral if it falls in value (and isn’t increased).
    Comment 1: A vigilant lender cannot lose money on a repo.
    Comment 2: There has been significant work on repo since the crisis, e.g. Brunnermeier and Pedersen 2008, but as far as know there is no “workhorse” model comparable to the model of debt above. (Please correct me if I’m wrong.) My impression is that much of the work on repo has been empirical (e.g. Adrian and Shin 2010).
  • Mortgage with recourse: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, right to be paid in full if the collateral value at the time of default is deficient.
  • Mortgage without recourse: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, no right to further payment. (This is the type of debt that corresponds to the “standard” model of debt discussed above.)
  • Mortgage with cramdown: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, but subject to cramdown if the borrower declares bankruptcy.
  • Unsecured debt with bank guarantee (e.g. commercial paper): short-term, no collateral, lender relies on bank guarantee.
  • General unsecured debt: short-term or long-term, no collateral. Enforcement must be via long-term incentives (reputation) and/or penalties imposed by the legal system for failure to pay. Corporate bonds fall under this heading.

On Modeling Money, Banks and Markets

Every good model is designed to emphasize certain empirical regularities that characterize the real world and by doing so to explain certain aspects of how the real world functions. Thus, the first question when discussing how to model money and banking is: What are the empirical regularities that a model of money and banking should capture?

Drawing on my knowledge not only of the history of money and banking, but also of the structure of modern money markets, I have strong views on the empirical regularities that a model of money and banking should capture. Depending on the purpose of the model, there can be good reasons for focusing on getting either the asset or the liability side of banking right, so I will set forth the relevant empirical regularities separately for the two sides of the bank balance sheet. (Obviously there are also benefits to putting both into the same model, but frequently with formal modelling it is useful to start with something simple.) In both cases, first I state the key features that model should have and then I follow up with a brief discussion of some of the objections that I expect to hear to the approach I am describing.

Banks as issuers of money

When modelling the liability side of banking, there are two key features:

(1) Bank liabilities circulate as money. This means that bank liabilities are generally accepted, or, in other words, that the bank is trusted by everybody in normal times; and

(2) Any constraints on bank borrowing should be clearly explained, and should not imply that the individual members of the public are imposing borrowing constraints on banks. Thus, Diamond and Dybvig appropriately explains a run as a coordination problem, which is not at heart an individual action. And there can clearly be a constraint imposed by an outside authority like a regulator or central bank. But the idea that the individual members of the public refuse to lend to the bank past a certain amount should be viewed as contradicting the basic fact that bank liabilities circulate as money because banks are trusted by the public.

Discussion

Sometimes the claim is made that non-bank liabilities can also circulate as money. While it is true that there are historical examples of private non-bank liabilities circulating as money, these are almost always very localized affairs and thus don’t actually represent examples of generally acceptable means of exchange. These examples are not only lacking in geographic breadth, they are also typically short-lived, of very limited scope, and rare. In short, historical examples of circulating private non-bank liabilities are essentially measure zero events in the history of money. While certain historical events may be worth modeling in order to understand the event in question, these episodes are of far too little importance to be incorporated into a model that is trying to understand the general principles of money and banking.

The basic implication of the approach that I am advocating is that banks are not just a little more trustworthy than other economic entities. When modelling banks (in normal times), banks sit at the extreme of a spectrum of trustworthiness. Thus, models that purport to treat the trustworthiness of banks as only incrementally distinguished from other agents should not be considered as logically consistent with the statement that banks are issuers of money.

Banks as lenders

When modelling the asset side of banking — and especially when modelling how bank lending compares to market-based lending — the essential empirical regularities are:

(1) Banks, with their easy access to liquidity via the issue of monetary liabilities, are the economy’s short-term lenders.

(2) If there is going to be market-based short-term lending that competes directly with banks, then the banks’ role in “wrapping” (or guaranteeing) the short-term debt to make it saleable should be modeled. The reason for this is that in practice bank lending is frequently indirect and takes the form of a backup promise to pay in case the original borrower defaults; the use of these bank guarantees is so common that money market assets are in practice not marketable without bank support. (For a lengthier discussion of this issue, see here.) Note that for simplicity, both market-based short term lending and the bank guarantees that support it can be omitted from most models. It is, however, a clear error to include market-based short term lending without modelling the bank guarantees that support it.

(3) The market-based lending that takes place without bank support is long-term lending, such as 5-30 year bonds. Banks don’t have a comparative advantage here, because their ability to issue monetary liabilities is as likely to get them into trouble as to help them when the loan is long term. (They can easily like the S&Ls or Diamond-Dybvig run into financing problems.)

Thus, a key issue that a model seeking to address both bank lending and market-based lending is: What is the term of the lending in the model? Many models have both bank lending and market-based lending for the same term of the loan. I would argue that all models with this characteristic are effectively assuming long-term lending. Thus, when they find that markets can in many circumstances lend just as well as banks, they reach this conclusion by looking at the type of lending in which banks do not have a comparative advantage. A better way to model bank lending together with market-based lending is to model banks as lending short-term, e.g. working capital, while market-based lending is long-term (with or without banks competing in long-term lending).

Discussion

Many economic theory papers that purport to study money and banking effectively assume that markets in debt can exist in the absence of banks. One might almost say that these papers take markets as the fundamental economic unit and are trying to place banks within that context.

At least from my perspective, this presumption is precisely what heterodox theory seeks to challenge. My read of the history is that, while markets certainly existed before banks became important, neoclassical markets where there is something akin to a single price for a good could only be imagined in a world where banks were providing liquidity so that the typical trader was not liquidity constrained.

That is, “markets” in the sense of common usage have of course always been around, but this is a completely different concept from what an economist means when speaking of markets where every homogeneous good has a single price. Historically it is true that every community has, for example, weekly markets where people get together to trade. Prices in those markets are, however, typically based on individual bargaining and are very variable depending on who you are. People who have traveled broadly may have visited this kind of market, where a local friend is likely to tell you “Just let me know what you want to buy and then go away. I’ll handle the negotiations.” The neoclassical economic model is not designed to capture this kind of market.

The kind of markets that are made possible by banks are neoclassical-like markets. Based on sources like Adam Smith it appears that this type of market only started to grow up in Britain in the late 18th century. Suddenly people had access to enough liquidity that differential liquidity constraints stopped being the determining factor in prices, as is the case in traditional markets. And as Larry Neal explains in The Rise of Financial Capitalism (1990: 35) it was around the same time that published price lists expanded dramatically and began to take on “an increasingly official character.”

Thus, I would argue that markets as they are typically modeled in economic theory papers exist only because banks provide the liquidity that makes the efficient prices they produce feasible. For this reason, a realistic model of banks and markets will reflect the role played by bank-based liquidity in the formation of market prices. This view, as was discussed in this post, is consistent with the realities of markets today, where short-term lending is heavily dependent on banks – and of course it’s hard to imagine how capital markets could function, in the absence of these bank-dependent money markets.

To summarize, in order to capture both bank lending and market-based lending an economic model needs to have at least a three period horizon with banks offering one period debt and markets offering two period debt. Ideally the model would be able to illustrate why markets are better for long term debt and banks are better for short-term debt.

Many thanks to David Andolfatto as this blog post was generated by email correspondence with him.

Taxonomy of liquidity II: Price stable liquidity

In Taxonomy of liquidity I I found that the distinction between market-based lending and bank lending could be clearly drawn only if the term “market-based lending” was used to refer strictly to traditional capital markets, that is, to the stock and bond markets, because money markets, repo markets, derivatives markets, etc. are all very dependent on explicit and implicit commercial bank guarantees. Here I want to address a different issue: the distinction between price stable liquidity and price disclosing liquidity.

Price disclosing liquidity is fairly intuitive. It is associated with the market liquidity that is available on stock markets or long term bond markets. Even though we consider Treasury bonds or Apple stock to be extremely liquid assets, we also understand that the prices of these assets are not stable, as any intraday chart of their prices will show. Stock and bond markets are designed to give asset holders a reliable venue in which to sell, while at the same time allowing prices to move to reflect what may be very short-term shifts in supply and demand.

Money market liquidity is different from this description of capital market liquidity. Money markets are markets where people who have cash that they will need in the near future try to earn a little interest. For this reason, money market investors are notoriously averse to sustaining capital losses (Stigum and Crescenzi 2007 p. 479). Furthermore, money market instruments are by definition short-term. Thus, unlike capital market issues, every issuer on the money market is more or less continuously raising funds. For this reason, when money market investors are worried that they may incur a loss, they don’t even need to sell their holdings to cause problems for the issuer; all they need to do is to refuse to invest in the new issues and the money market will be disrupted. In addition, because money market investors expect to need the money in the near future and are thus risk-averse, many of them avoid money market instruments that have any aura of credit risk.

An example of how money market investors react to losses is the behavior of prime money market fund investors in September 2008 after one prime money market fund, the Reserve Fund, announced that it would incur a small loss. The panic was so severe that the Federal Reserve, the FDIC, and Department of Treasury all established programs to support money market funds and the commercial paper in which they invested.

Thus, it is the nature of money markets that they are expected to provide price stable liquidity (cf. Holmstrom 2015). This form of liquidity is completely different from the liquidity provided by the stock market where losses are expected on a regular basis.

One of the reasons that banks play such an important role in money markets is that bank liabilities are promises to make payment at par. Banks offer price stable liquidity. Not only are banks generally managed so that they can offer price stable liquidity, but the banking system itself – and in particular the structural support provided by the central bank – is designed to protect the system of price stable liquidity. Indeed, it is because price stable liquidity is integral to the business of banking that credit rating agencies generally demand that money market instruments receive liquidity and credit support from a bank in order to qualify for the highest credit rating.

In my previous post I explained that a discount market is an unusual kind of market, because each seller is required to endorse the bill when it is sold and thereby to guarantee payment on the bill in case of default. The importance of price stable liquidity on the money market explains this requirement, and explains the essential difference between the London Discount Market and the London Stock Exchange in the 19th century. When every seller has to guarantee the value of the bill, the incentive structure of the discount market is such that only high quality debt trades, and with every trade the credit quality of the debt increases. This is clearly a means of supporting the price stability of the instruments that trade on the discount market. On the stock exchange, there was no such requirement, because it would have obviated the purpose of the sale.

Why is price stable liquidity so important on the money market? When short term instruments can’t be relied on to hold their value, the public starts to look for better places to put their money, and there are enough reasonable somewhat risky alternatives, including other currencies, that the monetary system will break down if it doesn’t offer enough stability. For a money market to survive over the long term it needs to be in the top of its class in terms of stability.

In short, there’s another aspect of liquidity to add to our taxonomy. Capital markets offer price disclosing liquidity, whereas banks and discount markets offer price stable liquidity. More generally, money markets need to offer price stable liquidity or they will be subject to panics and may be at risk of collapse.