The dismantling of the economy’s legal infrastructure IV: the 1930s restructuring of the banking system [Updated]

1930s banking reform was predicated on the assumption that because commercial banks issue monetary liabilities, it is essential to control the flow of credit – financed by the expansion of the money supply – from banks. In the absence of such control the economy is prone to destabilizing asset price bubbles, because in Anglo-American financial systems there are robust capital markets, and feedback loops can develop between the expansion of the money supply by the banking system and securities prices or real property prices. Given the demonstrated inability in the 1930s of the recently-created Federal Reserve to impose such control through regulation, Congress took a statutory approach and created a compartmentalized financial system. Legislative history makes it clear that preventing the instability associated with asset price bubbles was a motivating force behind the legislation (Senate Report 1933; Sissoko 2018). [Update 2-6- 2019: The link to the Senate Report has been added at the bottom of the post.]

Thus, in the financial reform of the 1930s investment banking was separated from commercial banking and the existing distinction between mortgage lending institutions and commercial banks was preserved. This compartmentalized structure lasted for less than 40 years, as the inflation of the 1970s led to innovations and policy decisions that created deep fissures in the structure of the segmented system. By the 1980s reform was necessary. Both the policy decisions of the 1970s and the reforms of the 1980s were based on a completely different model of the financial system than that on which the 1930s structure had been built.

The discussion of this history will be separated into two parts: (i) the financial reform of the 1930s and the evolution of the segmented financial system through the 1960s, and (ii) the dissolution of that system. This blogpost addresses the early history.

Mortgage lending in the 1920s

In the years preceding the Depression mortgage lending was provided by a wide range of institutions including savings and loan associations, savings banks, mortgage companies,[1] commercial banks and insurance companies. Only the savings and loan associations offered longer-term amortizing loans of up to 12 years. More typical loans were for five years or less and required only interest payments until maturity when a balloon payment of the whole principal was due.[2]

This market structure reflected basic principles of asset-liability matching as they were applied to financial institutions at the time. In order to limit the likelihood of a liquidity crisis, commercial bank loans that were funded by demand deposits were generally short-term and/or callable. Longer term loans, such as mortgages, were funded by savings deposits which often required that notice be given before withdrawal. Thus, commercial banks were actively engaged in mortgage lending, but only with a small portion of their funding, since most of their funding was demand deposits. Even so, commercial banks were prohibited by statute from lending on mortgages of more than 5 years (Eccles 1937: 164). Thus, it was the savings banks and savings and loan associations that put most of their funds into mortgage lending.

The term savings and loan association reflects the concept underlying this cooperative means of mortgage finance. A member in the association was expected to keep his or her savings with it, earning a good rate of return, and in exchange the member was eligible for a loan. Thus, these cooperatives did not intermediate between a group that saved money and a distinct group that borrowed money. Instead, these mutual associations were created because those who were saving money would also need to borrow money to purchase property. Members had an interest in establishing a savings account in order to meet the eligibility requirements of the savings and loan association for a loan, and would often continue placing their savings with the association even after they had paid their loan since a competitive rate of interest was earned while at the same time they were supporting other members of the community.

The 12-year amortized loan[3] was the means by which the savings and loans made it possible for the middle class to afford a home, while at the same time managing the risks of funding these purchases with savings accounts (Weiss 1989: 109). A $5000 home loan at 6% per annum amortized over 12 years results in a monthly payment just under $50 or about the weekly wage of a skilled urban worker. (At 9% interest the payment would be $57 per month.) At the same time even in the first year of a 12 year loan 6% of the principal is repaid, and on average across an evenly spaced portfolio of loans over 8% of principal is paid every year. In short, this was the type of loan that was both a little hard for a savings bank to manage and little bit of a stretch for a lower-middle class consumer at the time. By contrast, 30 year fixed rate loans strongly favor the consumer, and are very difficult for a depository institution to manage: A $5000 home loan at 6% amortized over 30 years results in a monthly payment of $30, just over 1% of principal is repaid in the first year and on average these loans repay 3% of principal every year.

In short, the reason that 30 year mortgages were not offered in the years preceding the Depression is because the savings banks funding mortgages could not possibly hope to manage the risks of lending over that time horizon. With 12 year loans 58% of their funds were committed for more than 5 years. With a portfolio of 30 year loans 83% of their funds would be committed for more than 5 years. Given that their liabilities were all short-term and a lot can change over the course of just 5 years, the 12 year amortized mortgage was considered to be the limit of risk that it was appropriate for a savings institution to take – for good reason.

On the other hand, this loan structure – and particularly the fact that many mortgages were insurance company, commercial bank, or personal loans that were only for about 5 years and were not amortizing – meant that a severe recession could cause defaults, foreclosures and declining housing prices. As a result, real estate crises in which many lenders failed were regular events: the late 1890s and mid-1920s are examples. Thus, the housing troubles of the 1930s differed mostly in terms of their severity and the nationwide reach of the crisis. During the Depression housing became a national problem, and it was addressed at the Federal level. Indeed, alongside employment and social security, preserving homes was one of the three goals President Roosevelt announced in his 1935 State of the Union speech.

Mortgage lending: the reforms of the 1930s and their consequences

The Federal Home Loan Bank System was established in 1932 under President Hoover (Pub. L. 72-304). It was modelled on the Federal Reserve System with 12 regional banks and a governing board, the Federal Home Loan Bank Board, in Washington, D.C. It was designed as a mutual association of savings institutions (also known as thrifts), all of which jointly guarantee Federal Home Loan Bank debt issues. These debt issues are used to fund purchases of mortgages originated by member institutions. Thus, the system was designed to serve as a source of liquidity for thrifts, which in 1932 financed over 46% of all residential mortgages.[4]

Unfortunately, the Federal Home Loan Bank Act was a matter of too little, too late and did little to mitigate the housing crisis. Furthermore, like banks, many thrifts failed in 1932 and 1933. Unlike banks, thrifts were not covered by FDIC insurance when it was created in the Glass-Steagall Act of 1933, and as a result over the course of subsequent months savings migrated from thrifts to banks. By 1934 the thrifts’ share in the mortgage market had dropped to 37% (Lea 1996), a dramatic 20% decline over the course of two years.

In 1934 the National Housing Act (Pub. L. 73-479) was designed to stimulate the building trades and promote employment in them by creating both the Federal Savings and Loan Insurance Corporation (FSLIC) to support the thrifts, and the Federal Housing Administration (FHA) to support other mortgage lenders (Cong. Rec. 1934: 11189).[5] The FSLIC was designed to stabilize the thrift institutions, just as the creation of the FDIC had stabilized the banking system a year earlier. The thrifts’ share of the mortgage market would slowly recover reaching 40% in 1952 and would peak at about 55% in the mid-1960s (PC on Housing, 1982; Lea 1996).

The FHA facilitated non-thrift mortgage lending by creating a consumer-friendly long-term amortized mortgage product that commercial banks and insurance companies could invest in. The FHA addressed the fact that these mortgages were not viewed as appropriate investments for banks and insurance companies by providing government insurance to long-term fixed-rate amortizing mortgages that met specified underwriting criteria. The insurance premium of one-half a percent on the principal value of the loan was paid by the borrower on top of an interest rate with a statutory maximum of 6%.[6] At the same time the new law permitted national banks to hold FHA-insured loans despite the general statutory prohibition on loans in excess of 5 years or in excess of 50% of the property value. (State legislatures promptly passed similar enabling legislation for state-chartered banks, Eccles 1937.) Thus, the FHA program served the needs of insurance companies and commercial banks, and their share of mortgages outstanding grew from 10% each in 1932 to about 20% each in 1952 (Lea 1996).

Mortgages outstanding by holder

By slowly increasing the participation of commercial banks and insurance companies in the mortgage market and by promoting consumer-friendly mortgages, the FHA almost certainly played a positive role in the recovery from the Depression and from World War II. This, however, came at a cost as the FHA played a dramatic role in shaping not just the structure of US mortgage markets, but also patterns of housing construction and of home-ownership in the US with vast and long-lasting unintended consequences.

America’s urban fabric places great emphasis on suburban living and on cars as means of transportation. Troubled inner-cities surrounded by well-to-do suburbs did not develop by accident, but in no small part because the FHA in its effort to promote the construction industry favored large, new buildings over the existing housing stock and more modest sized homes. Urban construction frequently did not qualify for insurance. The very structure of the typical American subdivision is a product of FHA handbooks, including the preference for strip malls over ubiquitous corner shops (Hanchett 2000; Zuegel 2018).[7]

The FHA also played a huge role in institutionalizing redlining – or racially discriminatory practices – throughout the country and demanded racial and class-based segregation of subdivisions (Hanchett 2000; Brooks & Rose, 2013). And one should remember as one discusses the extraordinary advantages of federal support for housing finance that the groups that were deliberately excluded from these advantages are much less wealthy today than they would have been if the same advantages had been extended fairly to all citizens (Baradaran 2017).

But our focus here is on how the FHA transformed mortgage markets. The FHA played a huge role both in the standardization of mortgages and in the reduction of the costs paid by the homeowner: the 30-year fixed rate mortgage with a maximum 90% loan to value became the norm, as did relatively low interest rates. Prior to the FHA the typical first mortgage was for up to 60% of the home’s value at a rate between 6 and 10% (depending on location) and most borrowers also carried additional mortgages at higher rates (Eccles 1937; FHLB Review 1934: 18). Although the thrifts did much less FHA insured lending, they too extended the terms of their loans and increased the amount they were willing to lend against the value of the home.

The National Housing Act (specifically Title III of the Act) had envisioned that liquidity would be provided to the non-thrift mortgage market through the creation of federally chartered, but privately owned, national mortgage associations that would stand ready to buy FHA insured loans. In fact, not one such association was formed – possibly because the thrifts had successfully lobbied against giving the national mortgage association’s debt the same tax exemption as the Federal Home Loan Banks’ debt (Cong. Rec. 1934: 11181, 11208, 12566). To address this situation in 1938 the government-owned Federal National Mortgage Association (Fannie Mae) was created. In 1948 (Pub. L. 80-864) Fannie Mae was made a federally chartered institution and authorized to purchase in addition to FHA loans the Veteran Administration-insured loans that had been created by the post-War GI Bill (Pub. L. 78-346).

As the economy recovered and Fannie Mae’s role in the mortgage market increased, concerns were raised over an excessive government role in the mortgage market. Transition to private ownership on the model of the Federal Home Loan Banks – that is lenders who sold loans to Fannie Mae had to also hold Fannie Mae stock – was initiated in 1954 (Pub. L. 83-560). In 1964 Fannie Mae was authorized to bundle FHA and VA mortgages together and to sell interests in the bundles. That is, Fannie Mae was authorized to securitize FHA and VA mortgages. At the same time national banks, thrifts, and FHLBs were authorized to invest in these securitizations (Pub. L. 88-560). In 1968, however, Fannie Mae was separated into two entities (Pub. L. 90-448): Ginnie Mae (the Government National Mortgage Association) remained a government-owned entity that packaged together FHA and VA loans and sold the securitizations to private investors; Fannie Mae was transformed into a government-sponsored private corporation that was required to allocate a reasonable portion of its business to mortgages on low- and moderate-income housing and was authorized to securitize mortgages, subject to government supervision.[8]

Observe that, because the thrifts had never relied heavily on Fannie Mae’s facilities, it was a commercial bank and insurance company-owned entity. The thrift industry immediately recognized that if Fannie Mae was authorized to securitize privately-originated mortgages, this could leave the thrifts at a disadvantage, so they lobbied for a similar facility.[9] Thus, in 1970 the Federal Home Loan Mortgage Corporation (Freddie Mac) was created, as an entity owned by the FHL banks and run by the FHLB Board with authority to purchase conventional mortgages (with a limit on the amount and on the loan-to-value of each loan) and securitize them (Pub. L. 91-351). This same law explicitly authorized Fannie Mae to purchase conventional mortgages on the same terms. This had the effect of establishing both a statutory standard targeting low- and moderate-income housing and a statutory prudential limit on the riskiness of the mortgages.

Let’s pause for a moment and consider the structure of US mortgage markets in the post-War years. It was divided into two segments: the non-thrift financial institutions supported by Fannie Mae and the thrifts supported by the FHLB system, FSLIC deposit insurance, and later Freddie Mac. Up to 1968, the non-thrift financial institutions mostly originated FHA and VA insured loans that could be sold to Fannie Mae, and conventional loans (that is, those that were not government insured) were mostly originated by the thrifts. This structure had worked for most of the 1950s and 1960s, because the growth of lending by the thrifts had met the needs of the public and made government-insured loans a decreasing percentage of the mortgage market.

The problematic nature of private institutions funding 30 year loans with short-term deposits was in evidence by 1965 when the Federal Funds rate rose over 4%. Competition between thrifts led them to increase their savings account rates, which raised safety and soundness concerns at the Federal Home Loan Bank Board (Hester 1969). In 1966 Regulation Q, which had long governed the maximum interest rate paid on commercial bank savings deposits, was extended to the savings accounts held at thrifts and authority was given to the FHLB Board to set the maximum rate. The long-term effect of Regulation Q was, however, that as interest rates rose, the thrifts had fewer deposits with which to finance their activities, and through the early 1970s the diminished lending capacity of the Savings and Loans was a growing problem for the mortgage market.

Investment banking: the reforms of the 1930s

As was noted above, 1930s financial sector regulation was constructed on the premise that commercial banks are special because their primary liabilities and thus their primary sources of funding circulate as money. Commercial banks, like the savings and loan associations, had developed because the same businessmen who often had positive cashflow – and thus money to put in the bank – also were very aware that sometimes they had negative cashflow and that short-term loans could be very valuable under these circumstances. These businessmen kept their money with their local bank, not because the were “savers,” but because by doing so they could also rely on the bank to advance them money when they needed a short-term loan. The commercial bank was thus a coordination device that converted the local money supply into a source of short-term funding for local businesses. That a bank-based money supply expands the working capital available to the business community was a fundamental precept of  monetary theory at the time.[10]

In short, in the 1930s money was understood to be a network phenomenon that – to a limited extent – the banks could expand at will without affecting prices. Of course, if the money supply expanded beyond a certain threshold, it could cause either localized inflation, for example when a particular type of long-term asset was being financed by the issue of bank money, or general inflation when an excessive monetary expansion was not so targeted. In short, in the 1930s monetary expansion was understood to be the cheapest way to fund productive activity both for the banks and for the economy as a whole as long as the coordination problem of not issuing too much money and thereby setting off inflation and instability could be addressed (Schumpeter 1939). For 1930s regulators the challenge of financial regulation was to harness the extraordinary power of monetary finance and at the same time control it.

The 1929 stock market crash had been fed by commercial banks offering accounts that invested in stock market margin loans paying as much as 10% per annum – for an overnight, overcollateralized loan – despite the jawboning of the Federal Reserve and influential Congressmen (Senate 1933). In short, the stock market crash had made it clear that the Federal Reserve did not have adequate control over the commercial banking system and the use of funds created by expansion of the money supply (Sissoko 2018). 1930s policymakers decided to turn the monetary system into one that was susceptible of control.

Because of the ease with which the commercial banks can expand the money supply and because of the tendency for bank finance of long-term assets to result in asset price bubbles as had occurred in 1929, the most important aspect of this control was the structural separation of the commercial banks from the investment banks. The Senate Report on the Glass Steagall Act clearly identifies the asset price bubble in the stock market as a consequence of a feedback mechanism generated by bank finance of margin loans (Senate 1933; Sissoko 2018. See also Adrian & Shin 2010). Thus, when the Senate Report summarizes the ills that the Glass-Steagall is designed to address, the first point is “bank loans and their uses” and the Report goes into some detail into how the legislation is designed to control and restrain the use of bank loans. In short, the legislative history is crystal clear: the Glass Steagall Act was passed for the purpose of controlling the flow of bank money. (Note that real estate finance was already for the most part a structurally separate activity and thus was not directly addressed in the bills reforming the commercial banking system.)

While it is generally understood that the Glass Steagall Act separated commercial banks from investment banks (or broker-dealers), the full impact of the Act on the banking system is underestimated. The Glass Steagall Act was designed to protect deposit-taking institutions by (i) preventing them not just from acting as broker-dealers, but also from intermediating security-backed loans to broker-dealers; (ii) empowering the Federal Reserve (a) to regulate the quantity of security-backed loans held by banks as well as interest rates paid by them on deposits, and (b) to replace bank officers and directors who fail to comply with banking laws or to respond to safety and soundness warnings; (iii) prohibiting a bank from lending to its own executive officers, and limiting loans to affiliates and investments in bank premises; (iv) setting capital requirements for all Federal Reserve member banks; (v) creating the FDIC to provide federal deposit insurance to commercial banks; and finally (vi) prohibiting broker-dealers from receiving deposits and requiring state or federal examination and supervision over any deposit-taking institution. For national banks the Act also imposed limits on the interest rate that could be charged on loans; as the limit was the higher of the state usury limit or 1% over the 90-day commercial bill rate, presumably the goal was to limit the risk involved in any national bank loan.

In short, the Senate’s concern with the use of bank loans and their destabilizing flow into securities markets was addressed from every angle. Federal Reserve member banks were forced to spin off any affiliates whose principal activity was broker-dealing (“the issue, underwriting, or distribution of securities”). And broker-dealers were prohibited from taking deposits. And member banks were prohibited from having an officer or director who was also an officer, director, or manager of a broker-dealer. And directors, officers, and employees of any bank organized or operating under the laws of the US were prohibited from being at the same time the director, officer, or employee of a business that makes loans secured by the collateral of stocks or bonds. And every deposit-taking institution was required to be subject to either state or federal examination and regulation. And Federal Reserve member banks were prohibited from intermediating non-bank loans to the broker-dealers if they are backed by securities. And the Federal Reserve was required to set limits on direct bank lending to broker-dealers that is secured by stock or bond collateral.

As a result of this structure the flow of funds from banks that had access to the Federal Reserve discount window into securities-based lending was strictly regulated by the Federal Reserve, and this was an essential part of the structure designed in the 1930s to stabilize the financial system. While federal deposit insurance, statutory capital requirements, constraints on self-dealing, and the additional authority over banks granted to the Federal Reserve surely also played a role in the decades of financial stability, it is a mistake to forget that the first goal of the Act was the firewall it constructed between deposit-taking institutions and securities markets.

Overall, the goal of the segmented structure created by the Glass-Steagall Act was to support a liberal flow of bank money – which monetary theory at the time viewed as playing a crucial supporting role in the circular movement of economic activity – while preventing that liberal flow of money from playing a significant role in the finance of capital market assets or real estate. This structure remained intact through the 1960s, until the inflation of the 1970s coincided with a shift in monetary theory that no longer viewed the flow of commercial bank money as both essential and in need of control. Thus, the 1970s were years of dramatic financial innovation that set the financial system on a very different path from that laid out in the 1930s. The history of this evolution is the topic of the next post.

[1] Mortgage companies were intermediaries that sold whole loans or covered bonds – that is, bonds guaranteed by the mortgage company – to investors including commercial banks and pension funds.

[2] See Michael J. Lea, Innovation and the Cost of Mortgage Credit: A Historical Perspective, 7 Housing Pol’y Debate 147, 154-59 (1996); Marc A. Weiss, Market and Financing Home Ownership: Mortgage Lending and Public Policy in the United States, 1918-1989, 18 Bus. & Econ. Hist. 110, 111-12 (1989); Daniel Immergluck, Private Risk, Public Risk: Public Policy, Market Development, and the Mortgage Crisis, 36 Fordham Urb. L.J., 447, (2009); David Min, Sturdy Foundations: Why Government Guarantees Reduce Taxpayer Risk in Mortgage Finance (Working paper: 2012).

[3] I am simplifying here by describing the situation with respect to the maximum term of a savings and loan mortgage of the 1920s.

[4] Note that another similar predecessor of the FHLB system was the Federal Farm Loan Act of 1916 (Pub. L. 64-158) which established 12 Federal Land Banks which were mutual associations owned by national farm loan associations and supervised by the Federal Farm Loan Board, and was designed to provide fairly priced credit to farmers. It was restructured in 1933 under the Farm Credit Administration which also refinanced mortgages for farmers. The Farm Credit System still operates today. See Quinn 2016.

[5] The crisis was also addressed in 1933 by two additional programs, the Home Owners Loan Corporation and the Reconstruction Finance Corporation, which purchased respectively defaulted mortgages and the stock of bankrupt banks and thrifts. Because these programs did not continue, they are not relevant to our discussion. Note also that the federal charter for savings and loans was created by the 1933 Home Owners Loan Act.

[6] This statutory maximum stayed in place until 1968 (Pub. L. 90-301).

[7] As the spouse of an architect, let me add that the real estate industry’s focus on square footage over quality living spaces has meant that the whole housing stock is of remarkably low quality in terms of the use of space and quality of life. Visitors from Europe sometimes remark on this. The FHA favored the “efficiency” of large operations over small craft builders (Hanchett 2000).

[8] Note that in 1959 Fannie Mae’s statutorily permitted investments had been expanded to include “obligations which were lawful investments for fiduciary, trust, or public funds” (Milgrom 1993: 83).

[9] William Osborn of the National League of Insured Savings Associations testimony March 5, 1970 to the Senate Subcommittee on Housing and Urban Affairs of the Committee on Banking and Currency, Hearing on Secondary Mortgage Market and Mortgage Credit p. 284 (“The National League has no objection to the establishment of a secondary market for conventional mortgages in FNMA as long as a similar facility is made available through the Federal Home Loan Bank System.”)

[10] For example Wicksell (1898: 135) wrote: “But money, which is the one thing for which there is really a demand for lending purposes, is elastic in amount. Its quantity can to some extent be accommodated—and in a completely developed credit system the accommodation is complete—to any position that the demand may assume.” See also Willis, American Banking 3-4 (1916); Dunbar 1909 13-14, 18.

Update 2-6-2019: Link to Senate Report on Glass Steagall Act:  1933 S Rpt on Banking Act

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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.

 

 

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.

A Taxonomy of Liquidity I

My recent review of Andolfatto (2018) reminds me that underlying the debate between mainstream and heterodox approaches to money is a fundamental dispute over a factual question: Do financial markets and/or non-bank financial institutions provide the same services as banks?

Mainstream approaches typically claim that “clearly” financial markets and non-banks do provide the same services and that the differences are just a matter of degree. In my view, these claims are factually wrong. In this essay I am going to work through a taxonomy of liquidity that is designed to distinguish between the fundamentally different types of liquidity provided by the different types of financial contracts. In my view it is a category error to treat these different types of liquidity as if they were equivalent and interchangeable.

Preliminary question: What do banks do?

I’m going to take it as given that we can agree that banks create money by issuing monetary liabilities. Given this, what I think a lot of modern scholars miss is that those monetary liabilities can be either on balance sheet or off balance sheet. There is a tendency to focus, as Andolfatto (2018) does, on banks’ on balance sheet lending, where the banks issue money in order to fund loans. In fact, however, banks’ contingent, off balance sheet liabilities have for the past few centuries played a crucial role in the monetary system – and they still do today.

When a bank earns fee income by selling the issuer of an asset a credit line that will be used to repay the asset’s owner in the event of a default, the bank is monetizing that asset. Effectively by taking on the tail risk of the asset, the bank turns the asset into the equivalent of a bank liability, even though the bank’s liability is contingent. These contingent bank liabilities are extremely common and may go under the name of acceptance, letter of credit, standby facility, bank credit line, etc.

Because the focus of the mainstream literature on banking is on balance sheet banking, mainstream scholars typically distinguish banks, where debt is held on balance sheet, from markets, where debt is traded. But this framing elides the fact that very often debt is tradable only because of an off balance sheet bank guarantee. As a result, in using this framing mainstream scholars often draw a distinction between banks and markets that is fundamentally misguided.

More recently banks have taken on another role in markets. Morgan Guaranty Trust, which later became JPMorgan Chase, played a crucial role in the development of the modern repo market by market making in repo on the balance sheet of the depository institution so that repo regularly accounted for 10% or more of the depository institution’s assets and of the depository institution’s liabilities from the late 1990s on. Of course, JPMorgan also became a tri-party clearing bank for the repo market. Now that JPMorgan has pulled out of the repo market, the Federal Reserve itself stands ready to lend on the market through its Reverse Repo Program.

Similarly, banks like JPMorgan Chase have been dealers in the derivatives markets since their earliest development, and even today JPMorgan’s depository institution accounts for more than 20% of the US derivatives market (see Table 3 of the OCC’s latest derivatives report). So nowadays we have depository institutions that are not only supporting financial markets via the guarantees they provided to the assets traded on them – as depository institutions have always done – but that also are the key market makers in markets that are viewed as essential to so-called “market-based” lending.

In short, drawing a bright-line distinction between financial markets and banks is a mistake.

Even so, the traditional equity and bond markets continue to operate with relatively minor connections to depository institutions (at least as far as I am aware). These financial markets can properly be viewed as “market-based” lending that is distinct from banks. Thus, while it may be correct to draw a clear distinction between traditional capital markets and banks, it’s also essential to recognize that markets in most other assets, including commercial paper, securitizations, repo, derivatives, etc., rely heavily on the explicit and implicit support of depository institutions for their basic functioning.

This understanding of the nature of financial markets motivates the following taxonomy of liquidity. Taxonomy 1

In addition, to distinguishing between the market, hybrid and bank liquidity that can be provided to an asset, this taxonomy makes another point: different types of liquidity provide very different services to the asset owner.

Market liquidity is the first entry, as it is the archetype that provides the most common mental reference point when one discusses liquidity. Market liquidity refers to the ability to sell an asset without suffering much loss in terms of price. Implicit in the concept is that there is a “true” sale for accounting purposes and that the seller of the asset successfully transfers all of the risk of the asset to the new owner. Thus the balance sheet of the seller of the asset increases by the value of the asset which is received in cash and decreases by the removal from the balance sheet of the risk of the asset (both credit and liquidity).

Nowadays one sometimes hears repos referred to as a kind of market liquidity. This diagram is designed to point out the limitations of repo-based liquidity. As the chart indicates in the row titled “Overnight reverse repo”, repo allows the asset owner to have access to cash without transferring any of the risk of the asset away. This is a very important distinction between market liquidity and repo-based liquidity. Arguably the latter should be called funding and the term liquidity should not be associated with repos at all. Certainly the two concepts are very, very different.

There are two other entries under Hybrid liquidity. The discount market is a historical phenomenon that was very important in 19th century Britain. Bills could trade easily on the discount market as long as they had been “accepted” (i.e. guaranteed) by a bank. A discount market sale was not, however, like a capital market sale: in order to sell a bill the owner had to endorse it, and the endorsement obligated the owner to pay up in the event that the bill went into default. Thus a discount market sale is an effective transfer of the liquidity risk of the bill, without transferring the credit risk of the bill.

A credit default swap is designed to protect the buyer against the credit risk of the asset. Effectively an asset owner can pay the equivalent of an insurance premium in exchange for a promise of payment if the asset goes into default. Note that in this case, the asset owner continues to hold the asset unencumbered on her balance sheet and thus receives no cash upfront from the seller of credit default swap protection. This explains the zero in the “Principal value of asset” column. (Note also that I have depicted credit default swaps here as if they are an effective way to transfer the credit risk of an asset. In fact, these markets are very complicated and there is some concern recently regarding how successful credit default swaps are at transferring the credit risk of an asset.)

There are two entries under “Bank-based liquidity”. The first is a “bank credit/liquidity facility”: this represents the case where for a fee a bank guarantees payment on an asset. As in the case of a credit default swap, this functions effectively as insurance for the holder of the asset, there is no transfer of the asset to the bank, and of course the asset owner receives no payment for the value of the asset from the bank. (On the other hand, the fact that the asset is accompanied by a bank guarantee typically makes it easy for the asset owner to transfer the asset to a third-party in exchange for goods or cash, for example on money markets like commercial paper or discount markets.)

Another important form of bank-based liquidity is the central bank discount window. All loans at the discount window are recourse loans, and as a result in exchange for the central bank’s cash the owner of the asset is able to lay off the liquidity risk, but not the credit risk of the asset.

The point of going through this Taxonomy of Liquidity in somewhat excruciating detail is to make it clear that it is a mistake to talk about “credit” or “liquidity” as if they are simple one-dimensional concepts. Similarly, it is very difficult to draw a bright line distinction between financial markets and banks. Anyone who wants to model money needs to be aware of these issues.

 

A heterodox critique of Andolfatto (2018)

Note: The goal of this post is to stimulate a conversation on how to model banks using economic theory. It may be impenetrable to those who are not already aficionados of economic theory.

In this post I am going to reinterpret a model of banking written by David Andolfatto that is available here. Before I reinterpret the model that Andolfatto presents, let me make some basic observations about the type of environment that is being studied here. First, this is a model of normal times: at present no effort is being made to incorporate crises or even the possibility of crises in the model. Second, there is a sense in which this is a model of short-term lending: all loans are one-period loans and no multi-period loans are considered. Indeed the model is structured so that there is no value to longer term lending.

Andolfatto recognizes that one of the cornerstones of heterodox theory is that banks create the money that they lend. When he introduces banks into his model, however, he ignores this principle and instead models banks according to the standard loanable funds approach as more “trustworthy” than non-banks. That is, he models θb > θ, where θ is a trust parameter. Effectively, he assumes the mainstream view that liquidity is a spectrum phenomenon and that banks just sit incrementally higher on the spectrum than other debt issuers.

I would argue that this framing fails to capture the idea that banks create money. When we say that banks “create money” what we mean is that banks issue liabilities that are generally accepted by the public. If I bring a $20,000 cashiers’ check issued by a bank to purchase a car – aside from confirming that the check is not a fake – just about any car dealership in the country will accept as if it were cash. In short, when we say that banks “create money,” we are saying that the trust parameter is so high that the banks’ liabilities are for practical purposes (in normal times) indistinguishable from fiat money issued by the government. For this reason, the assumption that is consistent with the claim that banks create money is not θb > θ, it is θb = infinity.

On the other hand, at the same time that banks can create money with ease, they are constrained because everybody expects them to give it back on demand. The car dealership accepts the large cashiers’ check, because it represents a promise to deliver the funds to the car dealership within a matter of days, if not faster. Thus, banks can create money and can borrow with extraordinary ease, but the loans are always short-term loans that the bank needs to be prepared to repay promptly.

In fact, Andolfatto presents his results under the assumption that θb = infinity, and he structures the model so that all loans are one-period, or short-term, loans. Thus, we can easily interpret Andolfatto’s model as a model of banks that create money. If we interpret Andolfatto’s model in this way, however, it’s not clear how to relate the model to either financial markets or non-banks.

Market-based lending does not function to finance working capital without bank credit and liquidity support (see, e.g., Stigum and Crescenzi 2007 pp. 976-77 on commercial paper), so if we are going to distinguish financial markets from banks we need to model them as long-term lending markets. Just as the short term assets sold on markets depend on bank guarantees, so do non-banks when they invest in these bank supported assets. Thus, non-bank lending, when it is being distinguished from bank lending, also needs to be modeled as long-term lending. Since there is only one-period, short-term debt in this model, there is no way to discuss market-based or non-bank lending as distinct from bank lending in this model.

This interpretation of the model is completely different from Andolfatto who claims:

“In the model, banks and financial markets are competing mechanisms for allocating credit. Banks are “special” only to the extent they are better than markets at funding investment. This specialness is not (in the model) logically rooted in their ability to create money. In particular, bond-finance in the model is “special” if it is the lower cost way to fund investment. Variations in the parameter that governs the willingness/ability of non-bank creditors to extend credit generates business cycles in the exact same way it would in a banking economy.”

But what Andolfatto has done is to reduce the statement that banks create money to a claim that banks can fund their loans ex nihilo: trust makes it possible for banks to finance working capital in this way. This framework underestimates what it means to say that banks create money, which I argue includes not just (i) the ability to fund loans ex nihilo, but also (ii) the “on demand” nature of the bank’s liability when it funds such loans. In short, there is a fundamental category distinction between bank obligations that are inherently monetary because they are payable at par “on demand” and non-bank obligations which do not have this property.

By modelling in detail only the investment financing side of the bank’s activities and not the monetary or “on demand” aspect of the bank’s liabilities, Andolfatto’s interpretation of his model abstracts from the concept of “money” itself. I would argue that the right way to bring the concept of money back into this model is to recognize that each period over which the bank is lending is fundamentally short, such as a week or a month. There is no evidence that capital markets can finance this type of activity without bank support.

In short, Andolfatto’s whole discussion assumes that “banks and financial markets are competing mechanisms for allocating credit,” and it assumes that it is appropriate to model “credit” as entirely homogeneous. In fact, “credit” is an overarching category that embraces more than one distinct form of lending. Bank credit, because it associated with the expansion of the money supply is categorically different from a bond issue, which does not increase the supply of “on demand” liabilities in the economy. Treating a 10 year bond obligation as substantially the same as a one-month advance of workers’ wages, because they are both “credit” fails to draw enough real-world distinctions about the nature of the financial system to be useful.

Thus, in my view if we are to treat the banking section of the Andolfatto model as a model of banking, then we must also recognize that it cannot at the same time be a model of financial markets. In order to introduce financial markets into the model, it will be necessary to introduce longer term debt.

A brief history of the shadow banking collapse in 2007-08

A large number of “market-based” financing vehicles that developed in the years leading up the the 2007 crisis were designed to exploit the fact that some investors were only worried about AAA-ratings (or for commercial paper A1/P1-ratings) and didn’t bother to understand the products they were investing in. Several of these vehicles were literally designed to blow up — they had liquidation triggers that when breached in an adverse market could result in complete loss of the investment. Others were designed to draw down bank liquidity lines when the economic situation became more difficult. (The latter could only exist because of a reinterpretation of a 2004 final rule promulgated by the Joint Bank Regulators that had the effect of gutting the regulation. See here.) Others would expose investors in AAA rated assets to massive losses if mortgage default rates were significantly higher what was expected and/or exhibited more correlation than was expected.

None of these products was viable once investors and bank regulators had seen how they worked in practice. Thus, these products had a very short life and markets for them collapsed entirely in 2007-08. This post briefly reviews this history.

A. In 2007 the commercial paper segment of the shadow banking system collapsed.

The first commercial paper issuers to go were structured vehicles that didn’t have committed bank lines of liquidity support, but instead supported their commercial paper issues by contractual terms that could force liquidation in order to pay up on the commercial paper. Structured Investment Vehicles (SIVs) are examples. Shortly thereafter structured vehicles that did have bank lines of liquidity support, such as CDOs and MBS (only a small fraction of which were financed with commercial paper), drew down the bank liquidity lines with dramatic effects on the balance sheets of the banks involved. To protect the banks from catastrophe the Federal Reserve gave them special regulatory exemptions (see the Supervisory Letters to Citibank, Bank of America, and JP Morgan Chase dated August 20, 2007 and to other banks in subsequent months) and permitted banks to pledge at the discount window ABCP for which they provided back up lines of credit (WSJ Aug 27 2007). These exemptions together with the Term Auction Facility made it possible for the ABCP market to deflate slowly over the course of three years, rather than collapsing quickly and taking a few banks with it.

In short in 2007 the Federal Reserve let a variety of different shadow bank models collapse, while protecting the banks and stabilizing the money supply by keeping the ABCP market from collapsing too quickly. These decisions were classic lender of last resort decisions that had the effect of allowing some entities to fail and other to survive with central bank support. They are also fairly uncontroversial: just about everybody agrees that the Fed acted appropriately at this point in the crisis.

B. From 2007 to 2008 a huge number of structured finance vehicles went Boom

At the same time some of the more esoteric structured vehicles that issued longer term obligations but also relied on liquidation triggers to support their issues blew up. Examples of this category include Leveraged Super Senior CDOs and Constant Proportion Debt Obligations. In a leveraged super senior CDO investors pay, for example, $60 million to earn 1.5% per annum spread over safe assets by selling an insurance policy (that is, CDS protection) on the $750 million most senior tranche of a CDO. Because the investors are putting up so little money the LSS CDO has a liquidation trigger, so that if the insured tranche falls by, for example, 4% in value, the structured liquidates, and an alternate insurance policy is purchased on the market. The investors then get whatever is left after the insured party is protected. These structures all blew up in 2007.

The Constant Proportion Debt Obligation was an even crazier product. Instead of insuring only the senior most tranche of a CDO, it sold insurance on a high grade bond index, including 125 names. Because there were no subordinated tranches to protect it from losses, the insurance premium was higher. The CPDO was structured to take the excess insurance premium (i.e. that which was not paid out as a bond yield to the marks who “invested” in this AAA-rated product) and put it aside. If everything goes well in three years the CPDO can stop insuring debt and pay the promised yield by just investing in safe assets. Of course, if everything goes badly, liquidation triggers are hit and the investor loses. Guess what happened in 2007?

CDO squared and ABS CDO’s are similarly products that pay an investor a bond-like yield to take an equity-like risk. They, however, had tranches that were rated up to AAA by the rating agencies, and in some cases even the brokers selling the products appeared to believe that they were just another kind of bond. Cordell, Huang & Williams (2012) found that the AAA-rated ABS CDO bonds lost more than half their value. More specifically they found that median junior AAA-rated ABS CDO bond lost 100% of its value, and that senior AAA-rated ABS CDO bonds did better, but also lost more than half of their value. And virtually every bond rated below AAA lost all of its value (Table 12). Now that investors understand this product, they won’t touch it with a ten foot pole.

C. Private Label Mortgage Backed Securitization evaporates

Underlying the losses on ABS CDOs were losses on private label mortgage backed securities. 75% of ABS CDO issuance was in the years 2005-2007 and over these years 68-78% of the collateral in ABS CDOs was private label mortgage collateral
(again from the great paper by Cordell, Huang and Williams Figure 2).

Cordell, Huang and Williams also finds that the lower tranches of subprime MBS were apparently never sold in any significant numbers to investors. Instead they were placed into CDOs (p. 9). This inability to place the lower rated tranches as well as other structural problems with the treatment of investors may explain the complete collapse of the private label MBS market, which is documented in Goodman 2015.

 

In short, SIVs, CDOs, and private label MBS were all effectively shadow banks that provided financing to the real economy during their lifetimes, but were not structured in a way that made them viable long term products. Thus, they disappeared as soon as they were exposed to an adverse environment. When this happened, the funding they had provided to the real economy disappeared (see Mian and Sufi 2018). This showed up as funding stress on the market.

Despite the stress the failures of these vehicles put on markets, the consensus seems to be universal that the Federal Reserve’s job was to protect the regulated banks, not to worry about the disappearance of the “market-based” lending structures. On the other hand, the liquidation and deterioration of these products sent waves through financial markets from August 2007 on that the Federal Reserve and the other central banks had to navigate.