Gary Gorton argues that the repo and securitization markets that developed over the last quarter of the 20th century are healthy phenomena and that we really don’t have much choice, but to preserve them. While there are many aspects of his analysis with which I agree, I draw very different conclusions from the evidence he cites. The bullet points below are the conclusions of this paper (h/t Felix Salmon actually that should be h/t Richard Smith — my apologies for sloppy link-tracking — was too overcome by the debating spirit once I took a look at the paper in question).
•As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.
I have no argument with this narrative of financial evolution, but I think that Gorton is missing an important point. Money market mutual funds (MMMFs) are banks that are exempt from capital requirements, because they are (in theory, if not in practice) not protected by deposit insurance. Any regulation that puts traditional banks in competition with money market mutual funds is sure to result in an undercapitalized banking system — either because uncapitalized MMMFs take over the role of intermediation or because the banks find ways around traditional capital requirements.
In fact, I agree with many aspects of Gorton’s analysis:
Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed. If an industry is not profitable, the owners exit the industry by not investing; they invest elsewhere. … One form of exit is for banks to not hold loans but to sell the loans; securitization is the selling of portfolios of loans. Selling loans – while news to some people—has been going on now for about 30 years without problems.
My difference with Gorton lies in the approach to MMMFs and securitization. I think that MMMFs are uncapitalized banks and that securitization was the process by which traditional banks also became undercapitalized. Thus both are a major source of financial instability. Gorton, by contrast, believes that MMMFs and securitization have stood the test of time.
In my view, the fact that this predictable evolution occurred does not mean that it was a healthy development for the financial system. The fact that it took 30 years for all the contradictions built into this brave new financial system to result in a crisis large enough to threaten the whole financial system does not mean that crisis was not inevitable from the beginning.
•The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short‐term, safe, interest‐earning, transaction account like demand deposits: repo. Repo also grew enormously, and came to use securitization as an important source of collateral.
Once again, I don’t see that the fact that securitized assets were used as an important source of collateral in repo as evidence that this phenomenon is either good or healthy. In all likelihood, the bankruptcy reform act of 2005 (which expanded the priority status in bankruptcy proceedings of Treasury/Agency repo to virtually all repo contracts) precipitated the growth of low-quality repo and may (given the absence of repo data this is all but impossible to demonstrate) have been a proximate cause of the catastrophic failures of Bear Stearns and Lehman Bros.
It’s my impression — once again on the basis of very limited data — that the repo market currently has shrunk to depend mostly on the traditional high-quality collateral that underlay its growth over the last quarter of the 20th century. And that the broker dealers have shrunk their balance sheets and changed their liability structure to adapt to this new environment. This change is healthy, because high-quality assets are by their very nature protected from the 20% and higher haircuts that precipitated the repo crises of 2008. In my view the growth of the repo market is not unhealthy, as long as the market is restricted to only the highest quality assets.
•Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.
Absolutely, “repo is money”. And sound backing for the money supply is found (i) in a Central Bank that holds mostly government debt as backing for the money supply and (ii) in a banking system that is well capitalized. If banks want to use repos for funding (which are collateralized, rather than protected by capital reserves like traditional loans) then they need to rely on collateral that is appropriate backing for the money supply — like Treasuries. Allowing senior tranches of synthetic CDOs — in other words credit default swaps — to be used as backing for the money supply was madness. And I sincerely hope that our regulators do not experiment again with the degradation of the money supply that took place in the late naughties.
•In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.
“Firm failures should not be caused by fire sales.” This statement is just far to general. If hedge funds fail because of fire sales, the appropriate regulatory response is: “Sorry, folks. Shit happens.” Our regulators do not have a responsibility for ensuring that all markets are liquid all the time. If they ever try to take on this responsibility, they will probably be as successful as the Soviet Union was in planning production.
Banks that play an important role in the monetary system are different matter, but even here the goal of regulators is not to prevent firm failures — the goal is only to protect the stability of the money supply. Traditionally (see Bagehot’s reaction to the failure of Overend Gurney) the first bank is allowed to collapse and the central bank provides abundant liquidity to support the remaining banks through the fire sales. Any bank whose capital is wiped out by the failure of the first bank to honor its liabilities is also allowed to fail (since it faces a solvency not a liquidity crisis).
When one remembers that the goal of regulators is not to protect firms from failure, but to protect the stability of the money supply, one realizes why it is so important for regulators to demand that repos be backed only by the highest quality assets. Any other policy will force the central bank to take low quality assets onto its balance sheet in a crisis and undermine the stability of the money supply.
One also realizes that there is a strong theoretic foundation for the argument that banks should be small. The failure of any large bank that holds more than 5% of the economy’s deposits can undermine the stability of the money supply — and may put regulators in a position where they are forced to conflate protection of the money supply with protection of an individual firm from failure. I don’t think that the dangers created by government officials who believe that their job is to protect firms in a free market economy from failure need to be explained.
• The crisis was not a one‐time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.
Bank liabilities have a vulnerability — and banks protect themselves from that vulnerability by being well-capitalized. The fact that securitization undermines a bank’s capital position is precisely the reason that it has come in for so much criticism. When and if securitizations are structured as true sales with no implicit or explicit recourse to bank balance sheets, they will be a positive addition to our financial arsenal. However, as long as securitizations just represent bank assets against which banks are not required to hold capital reserves, they weaken the financial system rather than strengthening it.
In my view the elements of a healthy financial system are:
(i) a central bank that stands ready to provide abundant liquidity in a crisis, but will not step in to protect individual firms from failure.
(ii) a well-capitalized banking system.
(iii) absence of pseudo-banks that face preferential regulation like money market funds.
(iv) regulators who understand the many ways in which banks underwrite “market-based” lending and who require banks to hold reserves to honor their commitments to such “market-based” lending programs.