Dismantling the economy’s legal infrastructure V-4: the transformation of mortgage finance in the 1980s

The 1980s saw dramatic reform of the structure of the banking system as the 1970 Hunt Commission’s recommendations for increasing the flow of funds into the mortgage market began to be adopted: first, bank and thrift funding was put on an equal footing; then, existing restrictions on mortgage lending by both commercial banks and thrifts were largely eliminated; at the same time, a policy of regulatory forbearance towards the troubled thrifts was enacted – in the vain hope that they would earn their way to solvency.

Legislation during these years also promoted the growth of mortgage securitization which played an increasingly important role in the mortgage market. The originate-to-distribute model of mortgage finance was born, where non-bank affiliates of commercial banks originated mortgages, and Fannie Mae and Freddie Mac set the standards that “conforming” mortgages had to meet in order to be salable. In short, over the course of the 1980s the mortgage finance system was completely transformed from one in which banks played a peripheral role to one where banks played the most important role. This took place because the predominant theory at the time, portfolio theory, saw no reason to maintain the distinction between banks and thrifts that had been drawn when banking theory was dominant.

It was in this period that the US banking system was effectively divided into two classes. An elite segment of very large banks thrived in the new environment and were able to leverage the new system of “market-based” finance into special treatment: these were the too-big-to-fail banks. The rest of the banking system, however, struggled in this environment where non-banks and the elite banks had special privileges that the typical bank did not. This section addresses the reforms that directly affected the majority of banks, while the next section will focus on the nascent too-big-to-fail banks.

Charts 1 through 4 below, drawn from FDIC data, demonstrate how very different the business model of the 7 largest US commercial banks was from that of the bulk of the banking system. Over the course of the 26 years covered by these charts the 7 largest US banks grew from accounting for only 20% of US bank assets to accounting for about 50% of US commercial bank assets just prior to the 2007-09 crisis. They continue to account for about 50% of assets today.

Chart 1: US commercial bank assets excluding the seven largest banks

Assets CB less 7

Chart 2: Seven largest US commercial bank assets

Assets Big 7

Chart 3: US commercial bank liabilities excluding seven largest banks

Liab CB less 7

Chart 4: Seven largest US commercial banks liabilitiesLiab big 7

The problem of monetary control

By the end of the 1970s many commercial banks were struggling. Their key source of funding was being eroded by competition with financial intermediaries that had been granted preferential regulatory status: the thrifts in the Northeast could pay interest on transaction accounts, MMFs could pay interest while offering limited checkwriting privileges, and for their biggest clients the banks had to compete with the totally unregulated Eurodollar market. In this difficult environment regulators had suddenly authorized the writing of “off balance sheet” guarantees. Unsurprisingly this set off destabilizing competitive dynamics, where the largest banks began to shift their business to fee-earning off-balance-sheet activities, promoting disintermediation at the expense of the banking system as a whole. Thus, in Chart 5 we see significant growth in MMFs and deposit substitutes at the end of the 1970s even as the growth in demand deposits stagnates.

Chart 5: Cash assets

Cash assets

Through the 1970s the Federal Reserve actively managed reserve requirements and their application to different instruments – including Eurodollar funding – in order to control the supply of credit. The Fed found, however, that banks were giving up their Federal Reserve membership in order to escape the regulatory burden of maintaining non-interest-bearing required reserves. Over the course of the 1970s the percent of transaction deposits held by member banks fell from 75% to 65% (and this measure did not include MMFs). The Fed’s ability to implement monetary policy was being eroded. A unilateral Fed proposal to start paying interest on reserves was blocked by Congressional opposition (Feinman 1993: 575-78). The Fed believed that monetary control required extending its authority to impose reserve requirements to cover all depository institutions (Volcker 1979). (Note that Volcker in his testimony on this issue is clearly aware that MMFs also have implications for monetary control, but does not appear to have solutions to offer.)

The Depository Institutions Deregulation and Monetary Control Act of 1980 (“DIDMCA,” Pub. L. 96-221) largely eliminated the distinction between thrifts and commercial banks on the liability side of the balance sheet (as the 1970 Commission had recommended):[1] it authorized thrifts to offer checkable deposits, phased out Regulation Q’s interest rate caps on all depository institution accounts, made thrifts subject to the Federal Reserve’s reserve requirements (with an eight year phase in), opened the Fed’s discount window to the thrifts, and raised the deposit insurance limit for both banks and thrifts to $100,000. On the asset side of the balance sheet, it repealed all usury restrictions on mortgages, including those at the state level (CEA 1981: 111).

Observe that the standard view at the time attributed the stabilization of the banking system in the 1930s to deposit insurance[2] (since the structural reforms of the 1930s were viewed as misguided) and thus there was an expectation that the expansion of deposit insurance mandated by the 1980 Act – together with the elimination of Regulation Q – would give the banks and thrifts a decisive competitive advantage over MMFs and Eurodollar accounts (FDIC 1997: 93). While DIDMCA was effective at stemming the outflow of deposits (see Chart 5), it slowed the growth of MMFs only temporarily.

In fact, there is strong evidence that any government sanction of a financial instrument that, like a bank deposit, is convertible at par into currency will be perceived as official support by the general public: the second wave growth of MMFs (see Chart 5) dates to the 1983 decision by the SEC (48 FR 32555) to formally authorize accounting for money market funds like bank deposits (that is, with a $1 net asset value) instead of using investment fund accounting. It is doubtful that MMFs are consistent with the intent of the Investment Company Act of 1940, which has two sections on “face amount certificate” companies that specify the capital and reserves that these companies are required to hold. As a result, in order for MMFs to operate as they had at the end of the 1970s, the SEC had to grant them exemptions from the Act and Rule 2a-4 (see 47 FR 5428). The 1983 Final Rule formalized this process of granting exemptions to the law in a regulation. In short, the post-Depression regulatory structure was explicitly designed to prevent investment funds from competing with deposits – unless they, like banks had capital and reserves. We have apparently learned the hard way that this structural separation was as important as deposit insurance in stabilizing the banking system post-Depression.

The Garn St Germain Act and its consequences

By 1980 the thrifts had been struggling for years with their legacy portfolios of long-term mortgages that had low fixed interest rates. The dramatic interest rate increases that accompanied Volcker’s policy of taming inflation had a devastating effect on these institutions, leaving many of them insolvent. Instead of recognizing the need to follow Roosevelt’s 1933 model of dealing assertively with a banking crisis by closing some thrifts and recapitalizing others, policymakers chose to eliminate restrictions on the thrifts’ asset portfolios in the hope that the thrifts would be able to earn their way to solvency.

The 1980 DIDMCA had already eliminated all interest rate ceilings on mortgages. In 1982 legislation dramatically broadened not just the types of residential mortgages the thrifts could make, permitting adjustable rate mortgages, balloon payments and negative amortization, but also dramatically increased what had been strict caps on commercial real estate lending (Pub. L. 97-320; McCoy et al. 2009: 499). It also eliminated entirely statutory limits on mortgage lending by commercial banks (§403(a)) such as the requirement that aggregate real estate loans not guaranteed or insured by a government agency could not exceed the greater of bank capital plus surplus or savings plus time deposits.[3]

For the first time in US history the regulation of bank mortgage lending was being left entirely in the hands of regulators. That is, the statutory restrictions on banking that legislators of the 1930s had put in place to protect financial stability and prevent real estate bubbles were first reframed by portfolio theory as “anti-competitive” and “inefficient,” and then eliminated by legislators unfamiliar with the actual history of the legislation. The OCC responded promptly with a regulation that placed no restrictions on national bank real estate lending (FDIC 1997: 95). In addition, within 5 years of this dramatic shift away from statutory restrictions, every single member of the Federal Reserve Board of Governors had been appointed by Reagan and the Fed was throwing its weight behind a deregulatory agenda.

Another part of the same legislation, known as the Garn St. Germain Act, made it easier for the depository institution insurers to provide assistance to troubled banks. Since 1935 the FDIC and FSLIC had been authorized to provide assistance to the merger of a failing bank with a sound one (Isaac 1984: 202). In some cases, the insurers provided “open bank assistance” to these mergers in the form of loans, deposits or purchases of assets, so that deposit-holders and other bank counterparties of the failed institution would experience no inconvenience. Prior to the Garn St. Germain Act the statutory requirements for such assistance were the determinations (i) that the institution was in danger of closing and (ii) that its services were “essential to the community.” Subsequent to the act these criteria were broadened significantly: the insurers could provide open bank assistance for the purpose of preventing the closing of an institution, restoring a closed institution to normal operation, or due to the danger of financial instability (§§ 111, 122; Gorinson & Manishin 1983: 1325).[4] They also could provide this assistance in additional ways including purchasing securities, assuming liabilities, and making contributions. The issue of “net worth certificates” to undercapitalized institutions whose loan portfolios were at least 20% mortgages were authorized (Title II).[5]

Observe that it was not just the thrifts that would be transformed by the Garn St. Germain Act. The law made it possible for the FDIC in 1984 to take Continental Illinois National Bank over on the basis of financial stability concerns. The development of the “too big to fail” doctrine protecting large banks will be explored in the next section. The same legislation also raised the statutory limit on national bank loans to a single borrower from 10% of bank capital to 15% of capital or, if the loan was secured by marketable assets, to 25% of bank capital (FDIC 1997: 94). While small rural banks were the public poster child for this reform, it had obvious benefits for the too-big-to-banks that often dealt with large corporate and government accounts.

As for the thrifts, as might have been expected, the reforms proved disastrous. Insolvent institutions are, after all, not well positioned to go through the learning process of mastering a new business. By 1989 the thrifts’ worsening condition could no longer be ignored and was addressed in the Financial Institutions Reform, Recovery and Enforcement Act (“FIRREA,” Pub. L. No. 101-73) by a complete overhaul of the regulatory structure governing them. The FHLB Board was abolished and replaced by two new agencies, the Office of Thrift Supervision governing the thrifts and the Federal Housing Finance Board governing the Federal Home Loan Banks. Freddie Mac was placed under the supervision of the Department of Housing and Urban Development, just like Fannie Mae (Colton 2002: 14). At long last, a new Resolution Trust Corporation was created to administer the assets of the failed thrifts, and the FSLIC was replaced by a fund administered by the FDIC. FIRREA required those thrifts that were solvent to lower their risks by selling loans and increasing their holdings of liquid assets. The resolution of the insolvent thrifts would end up costing more than $130 billion. As an additional step in the elimination of the structural distinction between the thrifts and the commercial banks, FIRREA opened membership in the FHLB system to commercial banks.

We should also note that in 1987 the Competitive Equality Banking Act was passed (“CEBA”, Pub. L. 100-86).[6] It had the important effect of closing the “non-bank bank” loophole, that had been created in 1970 when the Bank Holding Company Act had been amended to define a bank as an entity that accepted demand deposits and made commercial loans. By either restricting funding to exclude demand deposits or avoiding making commercial loans, a financial institution could preclude Federal Reserve regulation of its holding company. In the early 1980s the OCC did a brisk business in such “non-bank” charters. CEBA redefined a bank to include any entity insured by the FDIC in addition to any entity that accepted transaction accounts and made commercial loans (FDIC 1997: 98).[7]

Mortgage Securitization

One consequence of the efforts to deal with the troubled thrifts was the stimulation of securitization. When a thrift sold a below-market-rate mortgage, instead of taking the loss immediately – which would have reflected the reality of the transaction – thrifts were permitted by an FHLB Board policy adopted in 1981 to spread the loss over the remaining years of the mortgage (Lea 1996: 166). The result of this policy was a boom in mortgage securitization that facilitated a transition in the finance of conventional mortgages from the thrifts to the GSEs. As a result, the GSEs were financing more than half of all mortgages originated in the US from the late 1980s on and most of these mortgages were then securitized (Lea 1996: 166). In short, the collapse of the thrifts was eased dramatically by the rise of agency securitization.

While Freddie Mac’s business model from its founding in 1970 was based on the securitization of conventional mortgages (Howard 2014: 117), through the 1970s Fannie Mae focused on purchasing loans for its own portfolio and addressed the challenges of mortgage finance in the 1970s by shortening the length of its funding. Thus, the high interest rates of 1979 affected Fannie Mae in the same way that it had affected the thrifts: Fannie Mae was losing money on a daily basis and risked exhausting its capital. Fannie Mae, however, unlike the thrifts was not offered capital relief or allowed to change its mission. Indeed, the recommendation of the 1982 President’s Commission on Housing was that the GSEs should be fully privatized. Left to earn its way into solvency, Fannie Mae was successful in doing so by (i) dramatically widening the types of mortgages it purchased to include for example ARMs (On these mortgages Fannie required originator guarantees instead of underwriting the loans itself.) (ii) funding new purchases with debt issues that were maturity matched; (iii) generating fee income by securitizing mortgages (starting in 1981); and (iv) as interest rates fell extending debt maturities (Howard 2014: 27-28).

In 1983 Freddie Mac developed the first mortgage backed securitization that used tranching to address the uncertainty inherent in the timing of mortgage prepayments: some tranches were designed to pay off first. (This product was called a Collateralized Mortgage Obligation or CMO, but to limit the use of jargon I will call it a multi-tranche MBS.) While the multi-tranche MBS had more desirable properties for investors than the single tranche MBS, it was not clear under contemporary tax laws whether pass-through taxation would always apply or whether the structure itself could be subject to taxation (creating an undesirable situation of taxation both at the level of the structure and at the level of the investor) (Howard 2014: 118). This problem was addressed in the 1986 Tax Reform Act (Pub. L. 99-514) which created Real Estate Mortgage Investment Conduits (REMICs). By qualifying as a REMIC an MBS could have pass-through taxation (Howard 2014: 120).

This tax reform had been recommended by the 1982 President’s Commission on Housing, which also advocated that “all mortgage lenders and borrowers should have unrestricted access to the money and capital markets” (Colton 2002: 11). Thus, the Commission recommended the 1984 Secondary Mortgage Market Enhancement Act (SMMEA) which sought to put private label mortgage backed securities (PLMBS) on an even playing field with Agency MBS. Prior to this legislation PLMBS had been subject as securities to significant registration requirements and did not qualify as legal investments for many regulated entities. SMMEA exempted PLMBS from state antifraud and registration laws and made them legal investments for banks, thrifts, insurance companies, and pension funds (Howard 2014: 119-20).

Note that the latter created a significant distinction between Agency MBS and PLMBS. Agency MBS was deemed an appropriate investment for banks because the agencies were closely regulated government-sponsored entities with the goal of benefiting homeowners and the mortgage market. While PLMBS was also issued by regulated entities, that is banks, the goals of bank regulation place emphasis on the safety and soundness of the banking system and allow for bank failure. And there was no expectation that bank regulators should emphasize the interests of the mortgage market – or of MBS investors. Thus, SMMEA introduced the additional criterion that PLMBS had to receive an investment grade rating from a rating agency in order to be deemed an appropriate investment for a bank or other regulated institution. The end result was, however, that SMMEA was one of the early laws granting the credit rating agencies “de facto” supervisory authority over a segment of the financial industry.

As a result of this legislation, the market evolved so that the GSEs set standards for the mortgages they would purchase and securitize, and those loans that fell outside this category were held by banks or thrifts or placed in PLMBS. The loans eligible for purchase by the GSEs were known as “conforming” loans, while the ineligible loans were “non-conforming” and comprised of “jumbo” loans – or loans for an amount in excess of the GSEs’ statutory maximum – and “subprime” loans – which didn’t meet the GSEs’ lending criteria. (Later, and especially when the GSEs broadened their lending criteria, the number of categories increased and the terminology shifted.)

Because the GSEs made their money on volume, they competed to reduce costs to borrowers and to reduce origination costs by, for example, developing automated underwriting programs and encouraging competition between a large population of loan originators (Howard 2014: 90-91). To better match liabilities with assets, the GSEs started issuing callable debt, which by 1990 had become common (Howard 2014: 43). At the same time, because they bore the credit risk of every loan purchased for the life of the loan, they studied the market in order to set sustainable credit standards (Howard 2014: 91). By 1993 Fannie Mae, which had been at risk of failure in the early 1980s had brought its credit losses down to 4 basis points – despite lending on newer products like adjustable rate mortgages (Howard 2014: 46).

As securitization grew to be a more and more important source of mortgage finance, mortgage lending itself transitioned from the originate-to-hold to the originate-to-distribute model. This was accompanied by a shift to the origination of most mortgages by unregulated mortgage companies and brokers instead of by regulated thrifts as had been the case in the past (Immergluck 2009: 465). These unregulated mortgage companies were often subsidiaries of the bank holding companies. On the one hand, the new system was fiercely competitive which tended to keep costs down. On the other hand, many of the originators were thinly capitalized (Lea 1996: 168-69). On balance, however, mortgage securitization functioned well through the 1980s and 1990s.

Through most of the 1990s the GSEs made possible the standardization of mortgage underwriting and kept the cost of the 30 year mortgage consistently low at a spread of less than 1.5% to the 10 year US Treasury Bond (see Chart 6).[8] This was made possible by the entry of mutual funds, pension funds, and foreign entities into US housing investment (Lea 1996: 167).

Chart 6: Mortgage and Baa bond spreads

30Yr mtg 10 yr T spread

[1] On the asset side, it also allowed savings and loans to hold 20 % of their assets as consumer loans.

[2] See Isaac (1984: 198) citing Friedman and Galbraith.

[3] Additional restrictions that were lifted had required 30-year amortization for certain loans, had limited the maximum loan-to-value of mortgages, and had limited the aggregate unpaid balance on second lien real estate loans to 20% of bank capital plus surplus.

[4] It is highly likely that the Federal Reserve pushed for the addition of this latter clause, but I have not yet been able to document this claim.

[5] Mergers were also permitted across regulatory boundaries (e.g. of banks and thrifts or despite geographic restrictions), but only after determining that mergers within regulatory boundaries were not equally advantageous (Gorinson & Manishin 1983: 1326).

[6] The Fed had just lost a lawsuit challenging its effort to close the loophole by adopting regulations that relied on very broad rather than narrow interpretations of the relevant terms. Board of Governors of the Federal Reserve v. Dimension Financial Corporation, 474 U.S. 361 (1986).

[7] CEBA also imposed a six-month moratorium on regulatory agency decisions that expanded the role of banks in securities, insurance, or real estate (FDIC 1997: 97). In theory Congress was to reach a decision on these issues and enact a new statutory framework to replace Glass-Steagall. No such law was passed, however, and as soon as the moratorium was over the regulatory repeal of the statutory framework (that will be discussed in detail in a section on the Greenspan era) continued.

[8] As Lea notes standardization might have worked against the interests of non-traditional borrowers who could no longer successfully appeal their case to the local lender (1996: 167).

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The dismantling of the economy’s legal infrastructure V-3: Portfolio theory replaces banking theory

The inflation of the 1960s and ‘70s put a great deal of stress on the compartmentalized financial system that had been constructed in the 1930s. This stress caused fissures in the 1930s financial structure in no small part due to a shift in the intellectual framework through the which the financial system was viewed.

From the perspective of the banking theory which underlay the reforms of the 1930s, banks are special, because they issue monetary liabilities and serve as a coordinating device that promotes growth by making the monetary finance of working capital possible. For this reason, it is essential both to protect their special role in the financial system and to circumscribe and control bank activities in order to prevent expansion of the money supply from fostering asset price bubbles or inflation. Thus, the 1930s framework instructed regulators to manage the stressors on the financial system in such a way that the core functions of the banking system would be protected.

By the 1970s, however, policymakers were working with a different monetary model than the one that had been used to design the structure of the financial system in the 1930s. In the 1970s the dominant intellectual framework, portfolio theory, claimed that banks intermediated between borrowers and lenders and were “special” only due to the privileges granted to them by law; non-bank financial intermediaries could provide the same services as banks and the money-ness of their liabilities was just a matter of degree, not kind (Tobin 1963; see also Keeley & Furlong 1986). With this new intellectual framework, policymakers did not perceive a need to police the boundary between bank liabilities and non-bank liabilities in order to protect the special status and role of banks in the economy (which notably was precisely what the Glass-Steagall Act was designed to do). Instead, policymakers believed that non-banks could provide the same services as banks and thus that competition between banks and non-banks was healthy.

Thus, when the inflation of the 1960s and ‘70s led to the growth of non-bank financial intermediation, this was viewed as healthy competition for banks, not a as a stressor that threatened to destabilize the banking system. In this environment, financial innovation was allowed to create profound fissures in the banking structure that had been designed in the 1930s. By 1980 the system was clearly breaking down. Subsequent reform was based on the new theory that banks were just one kind of financial intermediary and should be forced to compete for funds with non-banks.[1] In the jargon of sociology, portfolio theory became performative; that is, the theory was no longer just a description of the world, but began to transform it.

Portfolio theory affected the mortgage market as the legal distinctions between thrifts and commercial banks were steadily eliminated. Bank funding was also transformed in a way that raised the costs to banks and ultimately led to the transformation of bank asset portfolios, facilitated by regulators who sought to increase banks’ income-earning capabilities. As banks were permitted by supportive regulators to encroach upon the broker-dealers’ business, by the 1990s the Glass-Steagall Act mostly constrained the activities of the broker-dealers and not those of the commercial banks.

After three decades of on-going transformation of the financial system, the US entered the 21st century with a financial structure that embraced an intellectual framework where banks were just one of many financial intermediaries competing on a playing field that was superficially even. In fact, over the course of the 2007-09 crisis we learned that banks are special – because they have access to the Federal Reserve’s discount window – and a major part of their business was providing guarantees to non-banks that effectively gave the non-banks indirect access to the discount window.

This post addresses the fissures created during the 1960s and ‘70s in the compartmentalized banking system and how they were aggravated by portfolio theory. Subsequent posts will address regulatory reforms under Volcker, under Greenspan, and in the run up to the crisis.

The era of inflation, 1965 to 1980

Recall that the 1930s reform of the banking system created a segmented structure with commercial banks separate from investment banks and with two types of mortgage finance: government insured mortgages that were typically funded by commercial banks and insurance companies and “conventional” mortgages that were funded by the thrifts, which specialized in mortgage lending. Commercial banks could sell their mortgages to Fannie Mae while the Federal Home Loan Banks provided liquidity to the thrifts.

The late 1960s saw inflation and two sharp increases in interest rates. The first increase raised concerns about the viability of the thrifts as they raised the rates paid on savings in order to compete for funding. For this reason, in 1966 Regulation Q, which had since the 1930s restricted the interest that banks could pay on savings, was extended to the thrifts. The end result was, however that the savings and loan industry – which since 1945 had been growing by 11 to 19% per annum – suddenly found itself struggling to maintain funding levels. Commercial banks, on the other hand, had historically relied on non-interest-bearing demand deposits for funding, and so were less dependent than thrifts on savings accounts and less affected by the macroeconomic situation. As the thrifts were by far the most important source of residential mortgage finance, the availability of mortgages dropped, precipitating a crisis that was only addressed in part by legislation in 1968 and 1970.[2]

Thus, in 1970 when the President’s Commission on Financial Structure and Regulation was appointed,[3] one of its’ principal tasks was to offer recommendations for transforming the financial system into one capable of achieving the administration’s housing goals (PCFSR 1972: 25, 48, 78). Two additional concerns were the finance of small businesses and of state and local government, which had also been adversely affected by the macroeconomic situation (PCFSR 1972: 49). The Commission stated pointedly in its report that it was not tasked with critical examination of the administration’s goals but only with how to achieve them and also offered the caveat that inflationary fiscal policy was the unaddressed underlying cause of the mortgage finance problem (PCFSR 1972: 8, 78-79).

As was noted above, by the 1970s the intellectual framework embraced by policymakers was based on portfolio theory and this was a very different monetary model from the banking theory that had been used to design the structure of the financial system in the 1930s. The new framework posited that non-banks could provide the same services as banks and promoted the idea that competition between non-banks and banks could ensure that financial services were more efficiently provided to consumers and firms.

In 1972 the Commission explained how to restructure the financial system to promote the finance of mortgages: convert the thrifts into commercial banks and authorize the use of demand deposit funding for mortgage finance (PCFSR 1972: 37, 40, 48).[4] This policy was described as an increase in competition between financial intermediaries that was desirable, because commercial banks with their lower cost funding could provide borrowers with cheaper loans (PCFSR 1974: 45). The only danger that the Commission saw arising from this policy was that of an increase in bank failures, a risk that could be managed with safety and soundness tests (PCFSR 1972: 45, 48). That is, even though the Commission framed banks as “creating money” (PCFSR 1972: 43, 45), its members did not perceive the danger of financial market instability that can arise when money creation is combined with the finance of long-term assets.

Of the recommendations made by the Commission, only a few were implemented promptly: in 1973 Regulation Q ceilings for large time deposits were suspended, and in 1974 constraints on commercial bank funding of mortgages were relaxed and securitization was promoted (Consumer Home Mortgage Assistance Act, Pub. L. 93-383).[5] Many more of the Commission’s proposals would be adopted over the course of subsequent decades including: the elimination of the regulation of interest rates on savings accounts (PCFSR 1972: 23); the elimination of restrictions on branch banking (PCFSR 1972: 59, 61-62); the use of insurance contracts to address interest rate risk, in other words, interest rate swaps (PCFSR 1972: 83);[6] the promotion of variable rate mortgages (PCFSR 1972: 81-82); the elimination of statutory restrictions on assets eligible for discount at the Fed (PCFSR 1972: 48); the treatment of subordinated thrift and bank debt as regulatory capital (PCFSR 1972: 41, 51);[7] and the elimination of statutory limitations on banks’ off-balance sheet guarantees (i.e. acceptances) (PCFSR 1972: 49-50).[8]

From the perspective of 1930s banking theory these policy recommendations did not make sense: careful regulation is needed both to protect banks’ special role in the financial system and to circumscribe bank activities in order to prevent expansion of the money supply from fostering asset price bubbles or inflation. As a result of the very different monetary framework being used in the 1970s, however, the blueprint for financial reform that was laid out in the early 1970s sought very deliberately to erase the clearly drawn distinction between commercial banks and thrifts.

Subsequent regulation typically emphasized the importance of facilitating competition between intermediaries and of removing the “inefficiencies” created by the “anti-competitive” restrictions placed on commercial bank activities (CEA 1981: 111; Isaac 1984: 197-98). Some of these reforms, such as the lifting of constraints on interest rates paid by depository institutions and the elimination of branch banking restrictions, have likely improved the operation of the financial system.[9] There was however a failure when reforming the structure put in place in the 1930s to distinguish the wheat from the chaff, because the aspects of the 1930s structure that served to stabilize the financial system were impossible to see when they were evaluated using a theoretic framework, portfolio theory, that took financial stability as given. In the language of economic sociology, portfolio theory played a performative role in reshaping the real world environment to conform with the theory: financial stability became an assumed property of the system, rather than one that was carefully crafted and protected.

The inflation of the late 1960s did not just result in the development of a blueprint for transformation of the financial system, but also had a more direct effect on the financial system. When the larger commercial banks due to Regulation Q were unable to offer their best corporate clients a competitive rate on savings accounts, in an effort to keep their business the banks facilitated the transfer of savings accounts into lending on repo, commercial paper, Treasury bills, bankers’ acceptances, and other money market instruments (PCFSR 1972: 28; CEA 1981: 108-09; Hahn 1993: 111). To address the funding gap thus created, the large banks were able to turn to Eurodollar markets or issue commercial paper at the holding company level which would then buy loans from the subsidiary bank (PCFSR 1972: 47). In short, already in the 1960s inflation had begun to result in disintermediation of the banking system. This left the smaller banks and the smaller businesses that did not have access to these options at a disadvantage.

Four key elements of the disintermediation of the banks that were important through the 1970s and 1980s are discussed in detail below: thrift transaction accounts, Eurodollar markets, money market mutual funds, and the standby letter of credit.

Thrift transaction accounts

Based on the traditional banking theory of the 1930s, when thrift funding first became a problem in the late 1960s the government should have made a determination of how important consumer-friendly mortgages were as a policy matter and then based on the answer either subsidized the thrifts’ activities directly or allowed the thrift industry – and the availability of mortgages – to shrink. Unsurprisingly, politicians preferred to have their cake and eat it too – and by embracing the new theory that the 1930s restrictions on banking were anti-competitive they were able, temporarily at least, to do so.

By the mid-1970s the FHLB Board was encouraging thrifts to compete with banks by making transactions using savings accounts easier. Thus, thrifts were early adopters of ATM machines and of contracting with local business to provide point-of-sale access to thrift savings accounts (Lovati 1975). Around the same time the laws governing thrifts were relaxed to permit those located in New England and New York to offer what were effectively interest-bearing checking accounts (CEA 1981: 110).[10] As interest rates continued to rise over the course of the 1970s, the effect of this new policy was to redirect the flow of transaction accounts from commercial banks which faced a statutory prohibition on paying interest on checking accounts to the thrifts.[11]

Eurodollar accounts

A Eurodollar account is an account denominated in US dollars that is held outside of the United States. As every Eurodollar account is associated with a US clearing account, Eurodollar accounts are either held at the foreign branches of US banks, or at foreign banks which access the US clearing system through US correspondent banks.[12]

The Eurodollar system began to develop in the 1950s as British exchange controls and the weakness of the pound led to the dollar being the preferred currency for the finance of international trade, while at the same time the banks with expertise in international trade finance were mostly British. The Eurodollar system made it possible for international trade to continue as it had in the past, just denominated in dollars held abroad rather than in British pounds. The British (and other foreign) banks were not subject to US regulation (including Regulation Q, reserve requirements, and FDIC fees) and British regulation of international finance was “light touch.” As a result, Eurodollar accounts were for the most part unregulated.[13] On the other hand, mostly located in Europe, Eurodollar accounts were completely inaccessible to most individuals and small firms in the US.

Banks issuing Eurodollar deposits could not just pay higher interest rates than US banks, they also had lower operating costs because they did not need to meet reserve requirements or pay FDIC fees. As a result, these banks could also afford to charge less on loans. In short, the Eurodollar market did not compete with the US banking system on an even playing field. Foreign bank lending in the US more than doubled over the course of the 1970s (CEA 1981: 109).

Money market funds

In 1971 the first money market fund was created. A money market fund (MMF) is an investment product offered by a brokerage firm or mutual fund company that invests only in short term assets and that treats its shares as having a fixed value that earns interest, just like a savings account. These “interest-bearing” accounts also offer some check-writing privileges. As the accounting treatment for MMFs was first addressed by the SEC in 1977 (42 FR 28999) and only formally approved by the SEC in 1983 (48 FR 32555), this was a case of industry pushing boundaries and being successful after the instrument had become “too big to fail.”[14] By the end of 1982 nearly as much money was held in MMFs as in demand deposits at commercial banks (see Chart 1).[15]

Chart 1: Cash Assets, https://fred.stlouisfed.org/graph/?g=mYXZ

Cash assets

If regulators had required MMFs to obtain a banking charter in order to offer fixed value accounts and/or checking privileges, and if MMFs had therefore chosen investment fund regulation, mark-to-market valuation and no checking privileges, they probably would still have seen some growth in the 1970s. But they also would probably have been a short-lived wonder that saw massive outflows to the banking system as soon as banks were permitted to pay competitive rates. In short, if regulators had embraced the 1930s view of banking and defended the special role of banks, the disintermediation of banks would have been smaller and most importantly much easier to reverse.

Unsurprisingly, with what used to be bank deposits flowing into MMFs, the banks also found they were facing stiff competition on the lending side of the market. From 1972 to 1979 the role played by the commercial paper market in short-term business lending nearly doubled. In addition, as was noted above, business lending by foreign banks more than doubled. At the demand of their biggest clients domestic banks were forced to lend below the “prime rate” – nominally the rate they offer their best customers – and saw their share of short-term business debt drop from 86% in 1972 to 60% in 1979 (CEA 1981: 109).

The standby letter of credit and loan commitments

The growth of the commercial paper market was only possible, because bank regulators allowed banks to provide guarantees that supported its issue. Lenders in the commercial paper market recognized that commercial firms could face unpredictable liquidity crises and were unwilling to lend to them at competitive rates unless a bank was willing to guarantee payment on the paper in the event of a liquidity crisis. Thus, issues of non-bank commercial paper were – and are – typically supported by a bank guarantee (Hurley 1977: 530; Stigum & Crescenzi 2007).

The law governing bank guarantees in the US was clear in the early 1970s: there were specific recognized types of guarantee that were permitted, including letters of credit. Guarantees that did not fall under a recognized category were ultra vires and most likely void. A letter of credit (LOC) is a contract for a bank to make payment if the conditions in the letter of credit are met, and is a traditional means by which international trade is financed since the seller of goods can reliably collect payment from the bank on the basis of shipping documentation.  A couple of creative bank lawyers created the “standby letter of credit” in the early 1950s, which was a promise to pay a customer’s obligation upon evidence of the customer’s default. The standby LOC is distinguished from the LOC by the fact that the bank does not anticipate having to make payment on it. A standby LOC is the equivalent of a guarantee of a customer’s liability,[16] which (with explicit exceptions) was ultra vires. The OCC, the national banks’ regulator, turned a blind eye to it, and through the 1960s this was a corner of the banking world that drew little attention (Kettering 2008: 1662-66).

In the early 1970s the Fed was trying to hold a strict line on traditional banking regulation. It deemed that if a bank issued commercial paper, borrowed using a repo, or guaranteed a customer’s IOU, all those liabilities were subject to the regulations governing deposits including required reserves and interest rate ceilings (Mayer 1974: 236). Similarly, the FDIC treated standby letters of credit as violations of their regulations. But neither the Fed nor the FDIC regulated national banks. The dramatic growth in the use of these instruments by national banks forced the Fed and FDIC to relax their stance, and in 1974 the regulators jointly agreed to very limited regulation – requiring reporting of outstanding standbys in the footnotes to the banks’ financial statements as well as treating them as loans for some purposes (Kettering 2008: 1667-69). The regulators all defended this policy before Congress in 1976, when Congress, worried that regulatory competition was weakening the banking system, threatened to impose strict controls on these instruments (US Senate 1976).

It was generally recognized at the time that by issuing a standby letter of credit, a bank was engaging in “off-balance sheet” banking: this was a way to fund off-balance sheet assets with off-balance sheet liabilities and earn a fee instead of an interest rate spread (Naegele 1976: 278; Keeley 1988: 12). The opportunities for regulatory arbitrage are obvious (and indeed what the Fed was trying to avoid with its initial strict policy). The door was, however, opened in the 1970s, and now bank guarantees of customer liabilities are treated as bank activities of long-standing (Kettering: 2008: 1671).

Capital requirements on standby LOCs were not imposed until the early 1990s when the Basel I Accord was implemented (Kettering 2008: 1671). Even then, however, guarantees that were short-term or “of less than one year” were granted a zero credit conversion factor under the risk-weighting rules – in other words, some guarantees were not subject to capital requirements at all. Needless to say, banks structured their guarantees in order to take advantage of lower capital ratios (Moody’s 1997: 4).

Summary: the disintermediation of the 1970s

In short, the massive disintermediation of the banks that took off in the 1970s was only possible, because regulators allowed it to happen. While some leakage into the Eurodollar markets – which provided support to the international role of the dollar – was inevitable, it was also naturally limited in scope. By contrast, the growth of money market funds and of bank-supported commercial paper markets was not inevitable. It was instead the product of a combination of forces including the fragmented structure of US regulation that hampered the enforcement of strict regulatory policies, and an environment where the predominant monetary theory held that the services provided by banks could also be provided by competitive financial intermediaries. Indeed, in some ways MMFs were a realization of the portfolio theory vision expressed by Tobin in his 1963 paper on banking.

But portfolio theory, like all theories, is an incomplete representation of a more complex reality. Thus, if the primary effect of portfolio theory in this period was to transform the financial system to be more like the theory, an important secondary effect was to obscure the actual relationship between the banks and the money market funds and commercial paper markets with which they were putatively in competition. While MMFs that invested only in government obligations could be viewed as “narrow banks” that competed with the conventional banks, for decades such MMFs comprised only about 25% of all MMFs or less. The vast majority of money market funds served as an indirect form of bank finance.

Chart 2: Taxable Money Market Fund Assets from 2015 ICI Fact Book

MMF assets

Chart 2 (which aggregates both Prime and Government MMFs) shows that bank CDs, commercial paper and repos made up 70 to 80% of MMF assets in the 1980s. Repos were typically repos of government debt obligations with a bank counterparty and thus served as a means by which banks could treat their government debt holdings as liquid assets. While commercial paper could be financial or non-financial, the Federal Reserves’ Flow of Funds report (Table B.103) makes it clear that there simply wasn’t enough non-financial commercial paper outstanding to make up more than a portion of MMFs commercial paper assets.[17] In short, in most years half or more of the MMFs’ commercial paper holdings were comprised of financial commercial paper, that is, commercial paper issued by banks. Furthermore, as was discussed in detail above even non-financial commercial paper relied on the support of off-balance-sheet bank guarantees.

In short, MMFs were only nominally in competition with banks. In practice, MMFs were just an indirect way of funding banks. They served to replace direct deposit-based bank funding with more indirect, wholesale bank funding intermediated through the MMFs.

Just as MMFs were only nominally in competition with banks, commercial paper could not be accurately characterized as “market-based” competition for bank loans. First, as was noted above most of the commercial paper outstanding was financial commercial paper and thus provided wholesale financing for banks, not competition for bank loans. Secondly, non-financial commercial paper relied heavily on off-balance-sheet bank guarantees. Indeed, the regulators of the 1970s viewed the guarantees that supported the commercial paper market as a means for banks to make off-balance-sheet loans (OCC 1974, 39 FR 28974; FDIC 1974, 39 FR 29178; Federal Reserve 1974, 39 FR 29916). As a result, while non-financial commercial paper did encroach on bank’s direct lending activity, it was only able to do so because of indirect “loans” in the form of off-balance-sheet guarantees provided by banks to support the issue of non-financial commercial paper. Another illustration of the complexity of the banks’ relationship to the commercial paper market is the fact that the Federal Reserve Board permitted banks to “engage to a limited extent in commercial paper placement activity” starting in December 1986 (73 Federal Reserve Bulletin 138, 1987). From the perspective of many borrowers, commercial paper may have just looked like a special kind of a bank loan.

Thus, portfolio theory didn’t just shape a new financial system, it also had the effect of obscuring the relationship between the new entities and instruments and the banking system. By framing MMFs as “competing” with banks for deposits, portfolio theory concealed the fact that MMFs mostly served as an indirect “wholesale” channel of bank funding. Similarly, by framing commercial paper as “competing” with bank lending activities, portfolio theory concealed the fact that the off-balance-sheet bank obligations that made the issue of non-financial commercial paper possible were themselves variants of loans – and consequently that commercial paper was arguably just a more complicated form of bank lending.

Portfolio theory, by concealing the true nature of the transformation of the financial system, also concealed the fact that in this new system of indirect rather than direct bank intermediation, the largest banks had a significant advantage. Wholesale funding carries risks for the lender that deposits don’t and therefore wholesale funding markets favor large, too-big-to-fail banks. For the same reason, too-big-to-fail banks had an advantage in providing the guarantees supporting commercial paper issues. In short, the principal effect of the shift from banking theory to portfolio was not the advertised effect, that of promoting competition and facilitating the growth of “market-based” lending, but instead to promote the interests of large, too-big-to-fail banks which played key roles in making the so-called “market-based” lending work.

 

[1] There was a general movement in favor of “pro-competitive” deregulation at this time (see Derthick and Quirk 2001). Note that I put “pro-competitive” in scare quotes, because it is regulation that makes it possible for markets to be competitive, and the question should be directed to whether the market is correctly regulated to promote competition and other important goals – such as fair access and management of externalities.

[2] By creating Freddie Mac and authorizing an expanded role for Fannie Mae in the mortgage market this legislation enabled the GSEs to play an important role in supporting mortgage markets.

[3] President Nixon was fulfilling a campaign promise made to business leaders to establish a panel studying financial structure for the stated purpose of addressing the problem of the Democrat’s overregulation of the financial sector and to prevent impairment of the nation’s ability to raise capital (NYT Oct 2, 1968, p. 28). He appointed a panel composed mostly of business executives and apparently the report was written for the most part by the staff of professional economists (Luttrell 1972).

[4] Given that this position is central to the Commission’s recommendations, it is remarkable that the Commission also observes that it is in general best to pursue “social priority investments” via tax credits and direct subsidies to consumers in order to “avoid the warping of financial institutions” (PCFSR 1972: 86).

[5] National banks were permitted to hold loans of up to 90% of the value of residential property as long as the loan was amortizing and the term was no more than 30 years. (In 1955 the maximum term of National bank real estate loans had been extended from 10 years to 20 years, Pub. L. 84-343). The loan to value permitted on mortgages purchased or securitized by Fannie Mae and Freddie Mac was raised to 80%, with an exception as long as the excess over this level was covered by private mortgage insurance. For national banks aggregate real estate loans not insured/guaranteed by an Agency could not exceed the greater of capital plus surplus or savings plus time deposits. Second lien loans could not account for more than 20% of capital plus surplus. (§ 24(a)(3) ).

[6] Note, however, that the Report finds that “Since the principal causes of wide interest rate movements are changes in the mix of monetary and fiscal policies, the only appropriate insurer against interest rate risks would appear to be a federal government agency.” (PCFSR 1972: 83).

[7] Note that bank debts of less than seven years – including repurchase agreements – were treated as deposits and subject to both reserve requirements and interest rate regulation (PCFSR 1972: 51). In the inflationary environment of the 1970s there probably was a need to distinguish bank deposits from repos and subordinated debt.

[8] Note that the Commission was aware of the benefits of securitization, but, concerned that it contributed to disintermediation, gave it only lukewarm support (PCFSR 1972: 84).

[9] One should note, however, that Regulation Q meant that monetary policy that pushed interest rates above the statutory limit could have a fairly immediate quantity effect on bank funding and this gave monetary policy an effectiveness that has arguably never been recovered.

[10] Technically they were NOW (negotiable order of withdrawal) accounts.

[11] Congress authorized NOW accounts in New York in October 1978. The next four months saw a rare decline in national demand deposits of 1%, while “Other checkable deposits” which include NOW accounts doubled. On the other hand, at the same time commercial banks were permitted to offer “automatic transfer of savings” or ATS accounts which also fall under “Other checkable deposits” (WaPo Oct 29 1978), so the causality here is unclear.

[12] While the account is held outside the US, every Eurodollar account clears within the US system and every Eurodollar transfer is associated with a transfer of reserves from one US bank to another within the US (just as would be the case with a domestic transfer of funds). Because of the way Eurodollar accounts are cleared, one can reasonably claim that even though the Eurodollar account is held abroad, the dollars never actually leave the US. Given this structure, the Eurodollar system was only possible because US regulators facilitated its operation.

[13] Note that while branches of US banks located in foreign countries were also not subject to Regulation Q, reserve requirements, or FDIC fees, there were constraints on the transfer of money within a bank from the US to its foreign branch.

[14] See Kettering (2007) on too big to fail financial instruments.

[15] Note that in the early 1970s Regulation Q was suspended for large time deposits. This policy was inadequate to reverse the flow of funds out of banks.

[16] The SEC recognized this fact by treating standby LOCs as guarantees within the meaning of the Securities Act (Kettering 2008: 1664).

[17] In addition, I have data on financial and non-financial commercial paper outstanding from 1991 to the present that was downloaded in the past from the Federal Reserve website. (Currently the data on the 1990s is apparently no longer available.) These data make it clear that since 1991 financial commercial paper outstanding has been at least double non-financial commercial paper and that the ratio has grown significantly over time.

The dismantling of the economy’s legal infrastructure V-2: An aside on the financial economics of the 30 year mortgage

Consider the practical questions of how the risks of financing 30 year fixed rate mortgages can be managed. There are two principal sources of risk: credit risk and interest rate risk; and two possible sources of funding: savings deposits and capital markets financing.

Credit risk is the risk that borrowers fail to make their payments. Even the best managed portfolio will have some regular level of default as borrowers are affected by illness and idiosyncratic hazards. Loan origination practices play a crucial role in credit risk, because if the borrowers are not carefully vetted, their likelihood of default will be higher. In addition, because of the regularity of economic cycles and the resulting fluctuations in employment, credit risk also has both a strong cyclical factor and includes the risk of extreme recessions/depressions. Finally, credit risk is also significantly affected by the loan products being offered: loan products that attract a more risky type of borrower can have dramatic effects on credit risk.

Interest rate risk exists because the funding of mortgage lending is typically shorter term than the mortgage loans themselves. That is, interest rate risk exists because of maturity mismatch between assets and liabilities. At any given moment in time the interest rate being paid on a 30 year fixed rate loan is greater than the interest rate being paid on savings accounts or on the capital market instruments used for funding. Interest rate risk exists because the interest rate on the 30 year fixed rate loan stays fixed for 30 years,[1] whereas the interest rates paid on savings accounts and the instruments used for funding are shifting over time. If the revenue being paid into the bank or funding vehicle from the portfolio of 30 year loans falls below the interest rate expense the bank or funding vehicle must pay to fund that portfolio, then losses will force the bank or funding vehicle into bankruptcy. In short, interest rate risk is the risk that the mortgage lender ends up in a nonviable situation where the lender can no longer afford to pay the interest rate necessary to continue to fund the mortgage portfolio. As a result, when maturity mismatch increases, so does interest rate risk: a portfolio of 12 year loans is safer than a portfolio of 30 year loans with the same funding.

It is important to understand that the greater the maturity mismatch between assets and liabilities, the harder it is to manage not only interest rate risk, but also credit risk. Over a 30 year period the likelihood that an extreme, unexpected recession will occur is much higher than over a 12 year period, and the very slow rate of repayment of 30 year loans means that repositioning the portfolio is much more difficult than it is for 12 year loans. In short, short term financing of a 5 year loan portfolio is easier to manage than short term financing of a 12 year loan portfolio, which in turn is easier to manage than short term financing of a 30 year loan portfolio. This fact explains the structure of mortgage lending prior to the Depression, where the safety of commercial banks was considered a paramount goal, and savings and loan associations were less regulated, but attentive to the risks of mortgage lending.

Once one understands the risks of 30 year fixed rate mortgages, the question becomes how it is possible for the private sector to finance them. Let’s go over the options.

First, consider the case of the very short term funding provided by savings and commercial banks. One solution is for the banks to only lend a fraction of their balance sheets to mortgages, say 10 or 20 percent. In this situation, the banking system as a whole can almost certainly manage its way around the risks. On the other hand, there will be very little availability of these mortgages compared to what we are accustomed to today. In order to reduce demand to this level, one would have to assume that 30 year fixed rate mortgages are actually very expensive – at which point other mortgage options are likely to become popular. Arguably this was more or less the situation before the 1930s: there was a purely private bank-funded solution to the mortgage problem, but mortgages were much less favorable to consumers than the 30 year fixed rate mortgage to which we are all accustomed.

So what are the alternatives for savings and commercial banks to fund 30 year fixed rate mortgages at low rates and with general availability. Without some form of government support, there is little reason to believe that it is possible for the private sector to manage the risks of this extreme maturity mismatch when mortgages account for a significant fraction of bank balance sheets. To address credit risk, there needs to be a government backstop for the lenders in the event of a severe recession. In the 1930s when the 30 year mortgage was first introduced, Federal Housing Administration insurance was created to provide this backstop.[2] In 2009-2011 there was a “backdoor bailout” by a vast broadening of Federal Housing Administration insurance and a program of Federal Reserve-financed refinancing of mortgages.[3] Interest rate risk can be addressed by either financial repression that stymies the market forces raising short term interest rates and forces consumers to incur negative real returns on their savings and thus to bear the costs of funding mortgages, or a government backstop that supports the bank mortgage lenders through the period where they are upsidedown on their net interest rate revenue.

Elements of a policy of financial repression were attempted in the 1960s and 1970s, but there was no genuine commitment to stymying market forces[4] (as there was in Nazi Germany, the classic case of financial repression) and as a result by the early 1980s the realization of interest rate risk had left vast swathes of the savings and loan industry bankrupt. Famously, the government instead of providing the necessary backstop promptly attempted through deregulation to allow the bankrupt savings and loans to earn their way to solvency – and succeeded only in making the problem worse. By the time the savings and loan industry was finally bailed out by the government in 1989, the cost of the bailout had increased dramatically.

An alternate solution to private sector funding of 30 year mortgages is to finance them using capital market instruments. In particular if funding is both longer-term than the mortgage portfolio and callable (that is, the borrower can choose to pay it before maturity), then interest rate risk cannot drive the funding vehicle into bankruptcy. The reason long-term funding must be callable in order to address interest rate risk is that the typical 30 year mortgage permits prepayment and is therefore refinanced when interest rates decline. In order for maturity matching to work, the funding instrument must also be pre-payable. Even if interest rate risk is addressed by maturity matching, credit risk remains and can cause the funding vehicle to go bankrupt, putting losses to the capital markets investors. Thus, because the 30 year lending horizon is inherently risky and because the embedded call option also has a price, capital markets investors are likely to demand relatively high rates for this product, which will in turn mean that for the vehicle to be financially viable 30 year mortgages will have to have relatively high rates. Certainly, in an environment where government subsidization of 30 year mortgages is the norm and is expected, it will be impossible for a purely private funding vehicle that eschews maturity mismatch to compete. (While this type of funding did exist for a short time in the US in the early ‘00s, the market for private label mortgage backed securities (PLMBS) collapsed entirely and had to be bailed out alongside the banks that participated in it.[5] It is no longer a meaningful player in the US mortgage market.)

A standard mechanism for reducing the cost of funding on capital markets is to have a capitalized corporation provide a guarantee to the debt security instead of having it issued by a bankruptcy-remote funding vehicle. A corporate guarantee on the debt ensures that the shareholders of the corporation will bear any losses before the investors do. Under these circumstances the mortgage backed security will bear an interest rate comparable to that of the debt issues of the corporate guarantor. This is a standard means of funding mortgages and is comparable to the system of “covered bond” finance in Europe.

Whether an entirely private corporation will be willing to take on the risks of providing such a guarantee to a securitization of 30 year fixed rate mortgages is I believe unknown. (If you know of an example, please let me know.) The PLMBS that were issued in the US in the early naughties did not have such a guarantee. By contrast, government guarantee of the securitization of 30 year fixed rate mortgages is definitely a viable model, as illustrated by Ginnie Mae, which still issues MBS today.

There is another hybrid model of capital market funding of 30 year mortgages: that of Fannie Mae and Freddie Mac, which were private, but “government-sponsored” corporations (“GSEs”) from 1970 to 2008. These GSEs provided a corporate guarantee of all of their securitizations which put their shareholders at risk, and their longevity is indicative of the fact this model is at least potentially viable. Even though the GSEs had shareholder funds at risk, they were highly regulated and received government support of their debt in the form, for example, of legal preferences for GSE debt over general corporate debt as an asset that may be held by banks and the Federal Reserve (and other regulated entities). Timothy Howard makes the case in The Mortgage Wars for the success of this model.

Under the GSE structure, government support allows the corporations to raise both short and long-term funds cheaply, regulatory requirements set the level of capitalization and monitors that the vehicle is meeting goals for the provision of low-cost mortgage finance, and the private capital at risk creates incentives for careful management of interest rate and credit risk. The corporate guarantee is the key element that makes the GSE structure work: it is in the interests of GSE to carefully supervise the quality of the mortgages it securitizes; in economics jargon incentives are aligned. Thus, the GSEs set the mortgage standards in the US mortgage market for decades – the word “subprime” originally meant that a mortgage was below GSE standards. They reviewed loans carefully and were able to weed out from a plethora of newly introduced loan characteristics those that were consistent with quality mortgages and those that were not. As a result, the securitization market that collapsed in 2007 was the private-label securitization market, not the GSE market.

Howard (2014) makes the case that through the 1990s and into the early naughties Fannie Mae had exceptionally high quality risk management. This is, however, also the pitfall of this GSE model. As Howard’s account itself indicates risk management was such a difficult task that a change in management at the end of 2004 was sufficient to destabilize a very effective mortgage funding mechanism. (On the other hand, one does need to be careful about allowing sceptics of government support to prove their point by sabotaging the GSEs, as Howard argues OFHEO, Fannie Mae’s regulator did. I, unfortunately, have no capacity to weigh these claims on their merits.)

Overall, the conclusion one draws from this discussion is important: there is virtually no reason to believe in the feasibility of the 30 year fixed rate mortgage as a financial product in the absence of some form of government support.

My next post will study what happened when the government, instead of recognizing that if it wanted to support the 30 year loan as a financial product, it would have to underwrite many of its risks, chose to distort financial regulation in order to promote cheap finance for housing.

[1] Because the norm with 30 year fixed rate mortgages is to permit payoff without a prepayment penalty, when 30 year interest rates fall, the interest rate being earned on the portfolio tends to fall quickly as borrowers choose to refinance their loans. There is no counterbalancing effect when 30 year interest rates rise. This makes the interest rate risk problem even more severe, and is known as prepayment risk.

[2] Note that in the 1930s the focus of concern was credit risk, not interest rate risk, because the gold standard had precluded interest rate risk for the preceding generation or two and the immediate problem was deflation and low interest rates.

[3] Owners of shares in Fannie Mae and Freddie Mac make the case that one should add the conversion and use of the GSEs as instrumentalities of the government to this list (Howard 2014: 250-53; http://www.housingwire.com/articles/print/29008-paying-fannie-and-freddie-investors-was-never-part-of-the-plan).

[4] The permissive attitude to the growth of Eurodollar accounts and money market mutual funds precluded a successful policy of financial repression.

[5] Howard (2014: 131) explains the flaws of PLMBS. Because there is no corporate guarantee, there is no incentive for credit standards to be enforced. Thus, when mortgage lenders generate new risky characteristics for loans and rating agencies make risk judgments without adequate or applicable historical data, there is nothing to stop these loans from being securitized and sold on to investors. In this environment relaxed underwriting can bring in new buyers who would not have qualified in the past.

The dismantling of the economy’s legal infrastructure V-1: The evolution of bank balance sheets

Over the last quarter of the 20th century mortgages grew to make up the principal asset in commercial bank portfolios and concomitantly housing now plays an increasingly important role in the economic cycle (Jorda Schularick & Taylor 2014). The shift in commercial bank balance sheets is depicted in Charts 1, 2, 3, and 4 all of which are drawn from the historical data available on the FDIC’s website: https://banks.data.fdic.gov/explore/historical. The vertical lines on the charts divide them into three eras: the war and post-war era up until 1965, the era of inflation from 1965 to 1981, the era of regulatory reform from 1981 to 2008, and the post-crisis era.

Chart 1 provides context, giving an overview of how the asset side of the commercial banks’ balance sheet has evolved over time. During World War II Treasuries (held as investment securities) and cash accounted for more than 80% of bank balance sheets. This declined fairly steadily, so that in 2007 cash and investment securities (which now were dominated by Agency obligations) fell below 20% of assets. This decline was mostly accounted for by an increase in bank lending.

Chart 1: US Commercial Bank Assets

CB Assets

Chart 2 shows that the dramatic increase in commercial bank lending after World War II only represented an increasing flow of bank funding into business activity up until the early 80s (with a decline after the oil price shock of the mid-1970s). (Note that “C&I loans” is short for “commercial and industrial loans.”) From the early 1980s on, commercial bank business lending is mostly on the decline as a percentage of activity, and instead real estate loans begin to dominate commercial bank balance sheets. Furthermore, because most of the Agency securities in which commercial banks invest are also mortgage-backed, by 2004 an unprecedented 40% of commercial banks balance sheets are supporting real estate and that fraction has barely declined up to the present.

Chart 2: Select US Commercial Bank Holdings as a percent of assets

CB Holdings ov Assets

Chart 3 focuses on commercial bank loan portfolios and shows how the fractions of the commercial bank loan portfolio that went to businesses, to real estate and to individuals were remarkably stable up through the early 1980s except for a deviation presumably caused by the oil price shock of 1973. It also shows that during the era of regulatory reform business lending dropped from 40% of bank loans in the post-War era to 20% of bank loans today. At the same time real estate lending rose from 25% of bank lending to almost 60%. We also see that residential real estate lending makes up about 60% of commercial bank real estate lending, and except for a few years in the late 1980s has consistently comprised more than half of commercial bank real estate lending.

Chart 3: Select US Commercial Bank loans as a percent of total loans

CB Loans o Total

In short, the data makes us ask: What happened to commercial banks during the era of regulatory reform? Furthermore, the pattern of the data in Chart 3 indicates that residential mortgage policy might have something to do with it.

1930s monetary theory held that the use of demand deposits to finance long-term assets like real estate would foster asset price bubbles in the long-term assets thus financed due to the feedback loop between bank expansion of demand deposits, loans, and asset prices. As a result, in the 1930s commercial bank real estate loans were funded by savings and time deposits and accounted for only a fraction of them, typically about 40%. And savings deposits made up only a fraction of the deposit base compared to demand deposits. Thus, it is worth looking at what has happened to commercial bank liabilities, too.

Chart 4 shows that commercial bank liabilities were composed mostly of demand deposits in the immediate post-war period, but their share declined steadily from about 1955 to 2008. Unsurprisingly the most dramatic decline took place during the inflationary era when most depositors were looking for a way to avoid holding a non-interest bearing asset. Savings and time deposits make up by far the majority of bank liabilities today. Even so, the growth in real estate loans up until the 2007 crisis was much faster. As a result, the ratio of real estate loans to savings plus time deposits grew steadily from 1983 to 2007 (see Chart 5). Another point to take into consideration is that savings deposits are much easier to use for transactions today than they were 70 years ago, as there are now a variety of means by which savings are transferred automatically in order to cover checks.

Chart 4: US Commercial Bank Liabilities

CB Liabilities

Chart 5: US commercial bank real estate as a fraction of savings + time deposits

RE ov Svgs

Since real estate loans appear to have played a very important role in regulatory reform’s transformation of commercial banking, it’s worth taking a look at what was going on with the institutions that were set up in the 1930s to fund real estate loans, the thrifts. The FDIC has data on the thrifts under the title “Savings Institutions” dating from 1984.

Keep in mind, however, that these balance sheet data mask the fact that the thrift industry stopped growing at the end of the 1980s. Thus, even though thrifts accounted for approximately one-third of depository institution assets from the post-war period through 1988, today they account for only about 5% of depository institution assets. In short, what is going on in the diagrams below matters less and less over time to the economy as a whole.

Charts 6 and 7 demonstrate that for thrifts the era regulatory reform did not affect their activities. They would continue to specialize heavily in real estate loans right up until the 2008 crisis. And only in recent years have the thrifts begun to diversify their activities to a significant degree. Chart 8 presents thrift liabilities and demonstrates that aside from an increase in FHLB loans and in brokered deposits in the years preceding the recent crisis, the liability side of thrift balance sheets didn’t change much either.

Chart 6: Savings institutions holdings as a percent of assets

SI Holdings ov Assets

Chart 7: Select saving institution loans as a percent of total loans

SI Loans o Total

Chart 8: Savings institution liabilities

SI Liabilities

To make very clear how the financial system as a whole evolved over the era of regulatory reform it is useful to combine the balance sheets of the commercial banks and the thrifts. (Together they cover close to 95% of depository assets. Credit Unions are omitted because I do not have that data.) Chart 9 presents holdings of loans and securities as a percent of assets. We see that changes in the aggregate balance sheet from 1984 to 2007 are in general not large with a few exceptions: the percent of combined commercial bank and thrift balance sheet devoted to business lending declined by 31%, while real estate loans increased by 21% and agencies increased by 48%.

On the other hand, Chart 10 presents the same data as Chart 9 with two differences: Both real estate loans and agencies on commercial bank balance sheets are separated from those on savings institution balance sheets. Chart 10 shows the primary transition that took place amongst depository institutions during the era of regulatory reform. Commercial banks started funding the mortgages that the shrinking thrift industry was no longer financing.

Chart 9: Select holdings as percent assets for commercial banks and thrifts combined

CBnSI

Chart 10: Select holdings as percent assets for commercial banks and thrifts combined with separate detail for real estate loans and agencies

CBnSI spec

So what conclusion should we draw from these charts? The era of regulatory reform was one in which commercial banks grew to look more and more like the thrifts on both the deposit and liability sides of the balance sheet. As a result, the effect of the regulatory response to the instability of the thrift institutions in the 1970s and 1980s was to reform the banking system so that it would be more like the unstable institutions. One result of this reform was that when the 2007-09 crisis blew up the U.S. banking system was structurally unsound and had to be saved by a simply grotesque bailout of the commercial banks.

Arguably another result, as I will argue in an upcoming post, was that the new structure of the banking system fostered the growth of a housing price bubble. That post will also attempt to fathom why this rather obviously destabilizing reform of the banking system took place. Before doing so, however, in my next post I discuss the character of 30 year fixed rate mortgages and the challenges of financing them.

 

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

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.