A regression discontinuity test error

This is post 3 in my HAMP and principal reduction series. For the introductory post see here.

The series is motivated by Peter Ganong and Pascal Noel’s argument that mortgage modifications that include principal reduction have no significant effect on either default or consumption for underwater borrowers. In post 1 I explained how the framing of their paper focuses entirely on the short-run, as if the long run doesn’t matter – and characterize this as the ideology of financialization. In post 2 I explain why financialization is a problem.

In this post I am going to discuss a very technical problem with Ganong and Noel’s regression discontinuity test of the effect of principal reduction on default. The idea behind a regression discontinuity test is to use the fact that there is a variable that is used to classify people into two categories and then exploit the fact that near the boundary where the classification takes place there’s no significant difference between the characteristics of the people divided into the two groups. The test looks specifically at those who lie near the classification boundary and then compare how the groups in the two classifications differ. In this situation, the differences can be interpreted as having been caused by the classification.

Borrowers offered HAMP modifications were offered either standard HAMP or HAMP PRA which is HAMP with principal reduction. In principle those who received HAMP modifications had a net present value (NPV) of the HAMP modification in excess of the NPV of the HAMP PRA modification, and those who received a HAMP PRA modification had an NPV of HAMP PRA greater than NPV of HAMP. The relevant variable for classifying modifications is therefore ΔNPV (which is economists’ notation for the different between the two net present values). Note that in practice, the classification was not strict and there was a bias against principle reduction (see Figure 2a). This situation is addressed with a “fuzzy” regression discontinuity test.

The authors seek to measure how principal reduction affects default. They do this by first estimating the difference in the default rates for the two groups as they converge to the cutoff point ΔNPV = 0, and then estimating the difference in the rate of assignment to HAMP PRA for the two groups as they converge to the cutoff point ΔNPV = 0, and finally taking the ratio of the two (p. 12). The authors find that the difference in default rates is insignificant — and this is a key result that is actually used later in the paper (footnote 30) to assume that the effect of principle reduction can be discounted (apparently driving the results on p. 24).

My objection to this measure is that due to the structure of HAMP PRA, most of the time when ΔNPV is equal to or close to zero, that is because the principal reduction in HAMP PRA is so small that there is virtually no difference between HAMP and HAMP PRA. That is, as the ΔNPV converges to zero it is also converging to the case where there is no difference between the two programs and to the case where principal reduction is zero.

To see this consider the structure of HAMP PRA. If the loan to value (LTV) of the mortgage being modified is less than or equal to 115, then HAMP PRA does not apply and only HAMP is offered. If LTV > 115, then the principal reduction alternative must be considered. Under no circumstances will HAMP PRA reduce the LTV below 115. After the principal reduction amount has been determined for a HAMP PRA mod, the modification terms are set by putting the reduced principal loan through the standard HAMP waterfall. As a result of this process, when the LTV is near 115, a HAMP PRA is evaluated, but principal reduction will be very small and the loan will be virtually indistinguishable from a HAMP loan. In this case, HAMP and HAMP PRA have the same NPV (especially as the data was apparently reported only to one decimal point, see App. A Figure 5), and ΔNPV = 0.

While it may be the case that for a HAMP PRA modification with significant principal reduction the NPV happens to be the same as the NPV for HAMP, this will almost certainly be a rare occurrence. On the other hand, it will be very common that when the LTV is near 115, the ΔNPV = 0, which is just a reflection of the fact that the two modifications are virtually the same when LTV is near 115. Thus, the structure of the program means that there will be many results with ΔNPV = 0, and these loans will generally have LTV near 115 and very little principal modification. In short, as you converge to ΔNPV = 0 from the HAMP PRA side of the classification, you converge to a HAMP modification. Under these circumstances it would be extremely surprising to see a jump in default rates at ΔNPV = 0.

In short, there is no way to interpret the results of the test conducted by the authors as a test of the effect of principal reduction. Perhaps it should be characterized as a test of whether classification into HAMP PRA without principal reduction affects the default rate.

Note that the authors’ charts support this. In Appendix A, Figure 5(a) we see that almost 40% of the authors’ data for this test has ΔNPV = 0. On page 12 the authors indicate that they were told this was probably bad data, because it indicates that the servicer was lazy and only one NPV test was run. Thus this 40% of their data was thrown out as “bad.” Evidence that this 40% was heavily concentrated around LTV = 115 is given by Appendix A, Figure 4(d):

Here we see that as the LTV drops toward 120, ΔNPV converges to zero from both sides. Presumably the explanation for why it converges to 120 and not to 115 is because almost 40% of the data was thrown out. See also Appendix A Figure 6(d), which despite the exclusion of 40% of the data shows a steep decline in principal reduction as ΔNPV converges to 0 from the HAMP PRA side.

I think this is mostly a lesson that details matter and economics is hard. It is also important, however, to set the record straight: running a regression discontinuity test on HAMP data cannot tell us about the relationship between mortgage principal reductions and default.

What’s the problem with financialization?

This is post 2 in my HAMP and principal reduction series. For the introductory post see here.

The series is motivated by Peter Ganong and Pascal Noel’s argument that mortgage modifications that include principal reduction have no significant effect on either default or consumption for underwater borrowers. In post 1 I explained how the framing of their paper focuses entirely on the short-run, as if the long run doesn’t matter – and even uses language that indicates that people who take their long-run financial condition into account are behaving improperly. I call this exclusive focus on the short-run the ideology of financialization. I note at the end of post 1 that this ideology appears to have influenced both Geithner’s views and the structure of HAMP.

So this raises the question: What’s the problem with the ideology of financialization?

The short answer is that it appears to be designed to trap as many people into a state of debt peonage as possible. Debt peonage, by preventing people who are trapped in debt from realizing their full potential, is harmful to economic performance more generally.

Here’s the long answer.

By focusing attention on short-term payments and how sustainable they are today, while at the same time heaping heavy debt obligations into the future, modern finance has had devastating effects at both the individual and the aggregate levels. Heavy long-term debt burdens are guaranteed to be a problem for a subset of individual borrowers, such as those who are unexpectedly disabled or who see their income decline over time for other reasons. Mortgages with payments that balloon at some date in the future (such as those studied in Ganong and Noel’s paper) are by definition a gamble on future financial circumstances. This makes them entirely appropriate products for the small subset of borrowers who have the financial resources to deal with the worst case scenario, but the financial equivalent of Russian roulette for the majority of borrowers who don’t have financial backup in the worst case scenario. (Remember the probabilities are in your favor in Russian roulette, too.)

Gary Gorton once described the subprime mortgage model as one where the borrower is forced to refinance after a few years and this gives the bank the option every few years of whether or not to foreclose on the home. Because the mortgage borrower is in the position of having sold an option, the borrower’s position is closer to that of a renter than of homeowner. Mortgages that are structured to have payment increases a few years into the loan – which is the case for virtually all of the modifications offered to borrowers during the crisis – similarly tend to put the borrower into a situation more like that of a renter than a homeowner.

The ideology of financialization thus perverts the whole concept of debt. A debt contract is not a zero-sum transaction. Debt contracts exist because they are mutually beneficial and they should be designed to give benefits to both lenders and borrowers. Loans like subprime mortgages are literally designed to set the borrower up so the borrower will be forced into a renegotiation where the borrower can be held to his or her reservation value. That is, they are designed to shift the bargaining power in contracting in favor of the lender. HAMP modifications for underwater borrowers set up a similar situation.

Ganong and Noel treat this distorted bargaining situation as if it is normal in section 6 of their paper, where they purport to characterize “efficient modification design.” The first step in their analysis is to hold the borrowers who need modifications to their reservation values (p. 27).[1] Having done this, they then describe an “efficient frontier” that minimizes costs to lenders and taxpayers. A few decades ago when I studied Pareto efficiency, the characterization of the efficient frontier required shifting the planner’s weights on all members of the economy. What the authors have in fact presented is the constrained efficient frontier where the borrowers are held to their reservation values. Standard economic analysis indicates that starting from any point on this constrained efficient frontier, direct transfers from the lenders to the borrowers up until the point that the lenders are held to their reservation value should also be considered part of the efficient frontier.

In short, Ganong and Noel’s analysis is best viewed as a description of how the financial industry views and treats underwater borrowers, not as a description of policies that are objectively “efficient.” Indeed, when they “rank modification steps by their cost-effectiveness” they come very close to reproducing the HAMP waterfall (p. 31): the only difference is that maturity extension takes place before a temporary interest rate reduction. Perhaps the authors are providing valuable insight into how the HAMP waterfall was developed.

The unbalanced bargaining situation over contract terms that is presented in this paper should be viewed as a problem for the economy as a whole. As everybody realized post-crisis the macroeconomics of debt has not been fully explored by the economics profession and the profession is still in the early stages of addressing this lacuna. Thus, it is not surprising that this paper touches only very briefly on the macroeconomics of mortgage modification.

In my view the ideology of financialization with its short term focus has contributed significantly to growth of a heavily indebted economy. This burden of debt tends to reduce the bargaining power of the debtors and to interfere with their ability to realize their full potential in the economy. Arguably this heavily indebted economy is losing the capacity to grow because it is in a permanent balance sheet recession. At the same time, the ideology underlying financialization appears to be effectively a gamble that it’s okay to shift the debt off into the future, because we will grow out of it so it will not weigh heavily on the future. The risk is that, by taking it as given that g > r over the long run, this ideology may well be creating a situation of permanent balance sheet recession where g is necessarily less than r, even given optimal monetary policy.

[1] The authors justify this because they have “shown” that principal reductions for underwater borrowers do not reduce defaults or increase consumption. Of course, they have shown no such thing because they have only evaluated 5-10% of the life of the mortgage – and even that analysis is flawed.

The Ideology of Financialization

This is post 1 in my HAMP and principal reduction series. For the introductory post see here.

The analysis in Peter Ganong and Pascal Noel’s Liquidity vs. wealth in household debt obligations: Evidence from housing policy in the Great Recession is an object lesson in the ideological underpinnings of “financialization”. So this first post in my HAMP and principal reduction series dissects the general approach taken by this paper. Note that I have no reason to believe that these authors are intentionally promoting financialization. The fact that the framing may be unintentionally ideological makes it all the more important to expose the ideology latent in the paper.

The paper studies government and private mortgage modification programs and in particular seeks to differentiate the effects of principal reductions from those of payment reductions. The paper concludes “we find that principal reduction that increases housing wealth without affecting liquidity has no significant impact on default or consumption for underwater borrowers [and that] maturity extension, which immediately reduces payments but leaves long-term obligations approximately unchanged, does significantly reduce default rates” (p. 1). The path that the authors follow to arrive at these broad conclusions is truly remarkable.

The second paragraph of this paper frames the analysis of the relative effects of modifying mortgage debt by either reducing payments or forgiving mortgage principal. This first post will discuss only the first three sentences of this paragraph and what they imply. They read:

“The normative policy debate hinges on fundamental economic questions about the relative effect of short- vs long-term debt obligations. For default, the underlying question is whether it is primarily driven by a lack of cash to make payments in the short-term or whether it is a response to the total burden of long-term debt obligations, sometimes known as ‘strategic default.’ For consumption, the underlying question is whether underwater borrowers have a high marginal propensity to consume (MPC) out of either changes in total housing wealth or changes in immediate cash-flow.”

Each of the sentences in the paragraph above is remarkable in its own way. Let’s take them one at time.

First sentence

“The normative policy debate hinges on fundamental economic questions about the relative effect of short- vs long-term debt obligations.”

This is a paper about mortgage debt – that is, long term debt – and how it is restructured. This paper is, thus, not about “the relative effect of short- vs long-term debt obligations,” it is about how choices can be made regarding how long-term debt obligations are structured. This paper has nothing whatsoever to do with short-term debt obligations, which are, by definition, paid off within a year and  do not figure in paper’s analysis at any point.

On the other hand, the authors’ analysis is short-term. It evaluates data only on the first two to three years (on average)  after a mortgage is modified. The whole discussion takes it as given that it is appropriate to evaluate a long-term loan over a horizon that covers only 5 to 10% of its life, and that we can draw firm conclusions about the efficiency of a mortgage modification by only evaluating the first few years of the mortgage’s existence. Remember the authors were willing to state that “principal reduction … has no significant impact on default or consumption for underwater borrowers” even though they have no data on 90 – 95% of the performance of the mortgages they study (that is, on the latter 30-odd years of the mortgages’ existence).

Note that the problem here is not the nature of the data in the paper. It is natural that topical studies of mortgage performance will typically only cover a portion of those mortgages’ lives. But it should be equally natural that every statement in the study acknowledges the inadequacy of the data. For example, the authors could have written: “principal reduction … has no significant impact on immediate horizon default or immediate horizon consumption for underwater borrowers.” Instead, the authors choose to discuss short-term performance as if it is all that matters.

This focus on the short-term, as if it is all that matters, is I would argue the fundamental characteristic of “financialization.” It is also the classic financial conman’s bait and switch. The key when selling a shoddy financial product is to focus on how good it is in the short-term and to fail to discuss the long-term risks. When questions arise regarding the long-term risks, these risks are minimized and are not presented accurately. This bait and switch was practiced on municipal borrowers who issued adjustable rate securities and purchased interest rate swaps, on adjustable rate mortgage borrowers who were advised that they would be able to refinance before the mortgage rate adjusted up, and even on the Trustees of Harvard University, who apparently entered into interest rate swaps without bothering to understand to long-term obligations associated with them.

The authors embrace this deceptive framework of financialization whole-heartedly throughout the paper by discussing the short-term performance of long-term loans as if it is all that matters. While it is true that there are a few nods in footnotes and deep within the paper to what is being left out, they are wholly inadequate to address the fact that the basic framing of the paper is extremely misleading.

Second sentence

“For default, the underlying question is whether it is primarily driven by a lack of cash to make payments in the short-term or whether it is a response to the total burden of long-term debt obligations, sometimes known as ‘strategic default.’”

The second sentence is based on the classic distinction between a temporary liquidity-driven stoppage of payments and a stoppage due to negative net worth – i.e. insolvency. (Note that these are the two long-standing reasons for filing bankruptcy.) But the framing in this sentence is remarkably ideological.

The claim that those defaults that are “a response to the total burden of long-term debt obligations” are “sometimes known as ‘strategic default’” is ideologically loaded language. Because the term “strategic default” has a pejorative connotation, this sentence has the effect of putting a moralistic framing on the problem of default: liquidity-constrained defaults are implicitly unavoidable and therefore non-strategic and proper, whereas all non-liquidity-constrained defaults are strategic and implicitly improper. This framing ignores the fact that a default may be due to balance sheet insolvency, which will necessarily be “a response to the total burden of long-term debt obligations” and yet cannot be classified a “strategic” default. What is commonly referred to as strategic default is the case where the debtor is neither liquidity constrained, nor insolvent, but considers only the fact that for this particular asset the payments are effectively paying rent and do not build any principal in the property.

By linguistically excising the possibility that the weight of long-term debt obligations leads to an insolvency-driven default, the authors are already demonstrating their bias against principal reduction and once again exhibiting the ideology of financialization: all that matters is the short-term, therefore balance sheet insolvency driven by the weight of long-term debt does not need to be taken into account.

In short, the implicit claim is that even if the borrower is insolvent and not only has a right to the “fresh start” offered by bankruptcy, but likely needs it to get onto his or her feet again, this would be “strategic” and improper. Overall, the moralistic framing of the paper’s approach to debt is not consistent with either the long-standing U.S. legal framework governing debt which acknowledges the propriety of defaults due to insolvency, or with social norms regarding debt where business-logic default (which is a more neutral term than strategic default) is common.

Third sentence

“For consumption, the underlying question is whether underwater borrowers have a high marginal propensity to consume (MPC) out of either changes in total housing wealth or changes in immediate cash-flow.”

The underlying assumption in this sentence is that mortgage policy had as one of its goals immediate economic stimulus, and that one of the choices for generating this economic stimulus was to use mortgage modifications to encourage troubled borrowers to increase current consumption at the expense of a future debt burden. In short, this is the classic financialization approach: get the borrower to focus only on current needs and discourage focus on the costs of long-debt. Most remarkably it appears that Tim Geithner actually did view mortgage policy as having as one of its goals immediate economic stimulus and that this basic logic was his justification for preferring payment reduction to principal reduction.[1]

Just think about this for a moment: Policy makers in the midst of a crisis were so blinded by the ideology of financializaton that they used the government mortgage modification program as a form of short-term demand stimulus at the cost of inducing troubled borrowers (i.e. the struggling middle class) to further mortgage their futures. And this paper is a full-throated defense of these decisions.

The ideology of financialization has become powerful indeed.

Financialization Post 2 will answer the question: What’s the problem with the ideology of financialization?

[1] See, e.g., the quote from Geithner’s book in Mian & Sufi, Washington Post, 2014

HAMP and principal reduction: an overview

I spent the summer of 2011 helping mortgage borrowers (i) correct bank documentation regarding their loans and (ii) extract permanent mortgage modifications from banks. One of things I did was check the bank modifications for compliance with the government’s mortgage modification program, HAMP, and with the HAMP waterfall including the HAMP Principal Reduction Alternative. At that time I put together HAMP spreadsheets, and typically when I read articles about HAMP I go back to my spreadsheets to refresh my memory of the details of HAMP.

So when I learned about a paper that finds that HAMP “placed an inefficient emphasis on reducing borrowers’ total mortgage debt” and should have focused more on reducing borrowers payments in the short-run — which goes contrary to everything I know about HAMP, I decided to read the paper.

Now I am an economist, so even though my focus is not quantitative data analysis, when I bother to put the time into reading an econometric study it’s not difficult to see problems with the research design. On the other hand, I usually avoid being too critical, on the principle that econometrics is a little outside the area of my expertise. In this case, however, I know that very few people have enough knowledge of HAMP to actually evaluate the paper — and that many of those who do are interested parties.

The paper Peter Ganong and Pascal Noel’s Liquidity vs. wealth in household debt obligations: Evidence from housing policy in the Great Recession. This paper has been published as a working paper by the Washington Center for Equitable Growth and NBER, both of which provided funding for the research. Both the Wall Street Journal and Forbes have published articles on this paper. So as one of the few people who is capable offering a robust critique of the paper, I am going to do a series of posts explaining why the main conclusion of this paper is fatally flawed and why the paper reads to me as financial industry propaganda.

Note that I am not making any claims about the authors’ motivation in writing this paper. I see some evidence in the paper to support the view that the authors were manipulated by some of the people providing them with the data and explaining it to them. Overall, I think this paper should however serve as a cautionary tale for all those who are dependent on interested parties for their data.

Here is the overview of the blogposts I will post discussing this paper:

HAMP and principal reduction post 1: The ideology of financialization

HAMP and principal reduction post 2: What’s the problem with financialization?

HAMP and principal reduction post 3: A regression discontinuity error
The principal result in the paper is invalid, because the authors did not have a good understanding of HAMP and of HAMP PRA, and therefore did not understand how the variable they use to distinguish treatment from control groups converges to their threshold precisely when principal reduction converges to zero. The structure of this variable invalidates the regression discontinuity test that the authors perform.

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

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

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

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

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

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

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

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

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

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

C. Private Label Mortgage Backed Securitization evaporates

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

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

 

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

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

The 2007-09 crisis: not a panic, but the collapse of shadow banking models

This post is a response to Ben Bernanke’s retrospective on the crisis and also addresses some of the comments others have made on his retrospective.

But first let me start the post with a little etymology. The term “lender of last resort” is generally acknowledged to have originated with Francis Baring’s 1797 tract, Observations on the Establishment of the Bank of England. Baring, however, did not use the English phrase; instead he called the Bank of England, the dernier resort. The use of the French is telling, because it is a well-established French phrase referring to the “court of last appeal.” Thus, the etymology of the phrase “lender of last resort” indicates that this is the entity that makes the ultimate decision about rescuing a firm or affirming the market’s death sentence. In short, when we talk about the central bank as lender of last resort, we are talking about the final arbiter of which troubled firms have a right to continue to exist in the economy.

Why would a lender of last resort allow some firms to fail? Because in an economy where bank lending decisions can expand or contract the money supply, banks that engage in fraud or make dangerously stupid lending decisions affect financial stability. So a lender of last resort has to police the line between good bank lending and bad bank lending. This almost always means that some lenders need to be closed down — preferably before they destabilize the financial system.

Framing the lender of last resort as having a duty to determine which of the entities that are at risk of failing for lack of funding will survive and which will not, sheds light on the debate between Ben Bernanke, Paul Krugman, Dean Baker, and Brad Delong. The key to this is to reframe Ben Bernanke’s “panic” which he describes as lasting from August 2007 to Spring 2009 as the process by which the Federal Reserve allowed certain shadow banks — which had no reasonable expectation of Federal Reserve support — to collapse completely.

I. “Financial fragility” was initially driven by the collapse of non-viable funding models

1. Collapse of shadow banking vehicles (for details see this post)

In 2007 most of the commercial paper segment of the shadow banking system collapsed. These shadow banks included SIVs, and a few CDOs. (The commercial paper collapse was extended over three years, apparently due to Fed approved bank support of the market.) Several categories of commercial paper issuer entirely disappeared.

From 2007 to 2008 several other categories of shadow bank collapsed and disappeared. Some can be classified as existing only due to the excesses of the boom: e.g. Leveraged Super Senior CDO, Constant Proportion Debt Obligations, CDO squared, and ABS CDO. (The  latter two products are best described as combining the return of a bond with the risk of an equity share. Once investors figured this out, they ran for the hills.) Others, such as Private label mortgage backed securities, are less obviously flawed products, and yet 10 years after the crisis are hardly to be found.

All of these shadow banks were “market-based” products with no claim whatsoever to Federal Reserve support, so it was unremarkable that the Fed allowed them to collapse. On the other hand, they had been used to provide funding to the real economy. So their collapse was necessarily accompanied by a decline in real economy lending.

To describe this phenomenon of the collapse of non-viable shadow bank lending models as a “panic” is inaccurate. Lax financial regulation allowed non-viable entities to play a significant role in funding real activity pre-crisis. These entities failed when reality caught up to them. They did not fail because of a panic, they failed because they were non-viable. Because of the significant degree to which banks were exposed to these non-viable shadow banks, short-term funding costs rose more generally, but to a large degree rationally.

2.  End of the 2000’s investment banking model

Over the final decades of the 20th century U.S. investment banks transformed themselves from partnerships into corporations. As corporations they grew to rely much more significantly on borrowed funds than they had when partners’ capital was at risk. By 2007 the investment bank funding model in the U.S. relied extremely heavily on repurchase agreements, derivatives collateral, and commercial paper. Arguably, this was another non-viable shadow bank model.

Bear Stearns failed in March 2008 because of runs on these instruments. Lehman Brothers failed in September for similar reasons. Merrill Lynch was purchased by Bank of America in an 11th hour transaction. Morgan Stanley and Goldman Sachs were at the edge of failure, but saved by the Federal Reserve’s extremely fast decision to permit them to become bank holding companies with full access to the Federal Reserve’s lender of last resort facilities.

While some may believe that financial stability would have been better served by the Federal Reserve’s support of the 2000’s investment banking model, at this point the question is an unanswerable hypothetical. Because the Federal Reserve exercised its lender of last resort authority to refuse to support the 2000’s investment banking model, this shadow banking model no longer exists.

Thus, in September 2008, just as was the case in earlier months of short-term funding pressures,  a major cause of these pressures was real (though in this case elements of “panic” were also important): i.e. the collapse of a shadow banking model that was non-viable without central bank support. Once again, the fact that such a collapse had real effects is not at all surprising.

II. “Financial fragility” did culminate in a well-managed, short-lived panic

Unsurprisingly the collapse of the 2000’s investment banking model was such a significant event that it was in fact accompanied by panic. It is in the nature of a financial panic that it is best understood as the market’s expression of uncertainty as to where the central bank will draw the line between entities that are to be saved and those that are allowed to fail. Effectively, funding dries up for all entities that might hypothetically be allowed to fail. As the central bank makes clear where the lines will be drawn, the panic recedes. This view is supported by the programs that Bernanke lists as having had a distinctly beneficial effect on crisis indicators (p. 65): the Capital Purchase Program, the FDIC’s loan guarantee program, and the announcement of stress test results were all designed to make it clear that depository institutions would be supported through the crisis. Similarly, the support of money market funds gave confidence that no more money market funds would be allowed to “break the buck.”

As Bernanke observes “the [post-Lehman] panic was brought under control relatively quickly” (p. 65). Within six weeks funding pressures had already begun to ease up and by the end of 2008 they had almost entirely receded. In short, once it was clear which entities would be saved by the lender of last resort, there was no longer any cause for panic.

Brad DeLong in a review of Gennaioli and Schleifer’s new book argues that there might not have been a panic associated with Lehman’s failure if some form of resolution authority had been in place. With this I agree. As I argued here: it is almost certainly the case that if Treasury had reacted to the March 2008 Bear Stearns failure by carefully drawing up a Resolution Authority instead of the 3-page original TARP document, 2008 would have looked very different indeed. I also agree with DeLong’s positive evaluation of Gennaioli and Schliefer’s theory of investor psychology. In my view, however, their theory is more properly framed as putting modern bells and whistles on financial market dynamics that have been well-understood for centuries. The whole point of having a central bank and a lender of last resort is, after all, to control the dynamics generated by investor psychology (see e.g. Thornton 1802).

III. Additional bubbles explain Bernanke’s “non-mortgage” credit series

Ben Bernanke focuses on the housing bubble, but there were actually three bubbles created by the shadow banking boom of the early naughties: the housing bubble, the commercial real estate (CRE) bubble, and the syndicated loan “bubble”. SIFMA’s Global CDO data shows how MBS was only one form of shadow banking collateral. Lending to corporations was almost equally important.

As Dean Baker points out the CRE bubble peaked in September 2007. Commercial real estate prices dropped by over 30% over the course of the next 18 months.

The syndicated loan “bubble” has behaved differently. While the market was subject pre-crisis to a deterioration in loan terms that was comparable to the mortgage or CRE market, this “bubble” never popped. The length of the loans was such that not many matured in 2008, and many corporations had committed credit lines from banks that they were able to draw down. Thus, it was in 2009 that concerns about likely corporate defaults weighed heavily on the market (see here and here). These concerns were, however, never realized. The combination of ultra low interest rates, retail investors shifting their focus to bond funds and ETFs, and pension funds reaching for yield meant that corporations were typically able to refinance their way out of the loans, and no aggregate collapse was ever realized. (To see how short lived corporate deleveraging was, see here.)

Thus, the fact that 2009 was a year in which massive corporate bankruptcies were expected just over the horizon probably explains a lot of the stress exhibited by Bernanke’s non-mortgage credit series (which is composed of non-financial corporate credit indicators and consumer-oriented securitization indicators). Treating this series as representing “a run on securitized credit, especially non-mortgage credit” (p. 46) as if it can only be explained by “panic,” does not seem to address the deterioration of corporate fundamentals and the implications of those fundamentals for corporate employees.

Bernanke considers the possibility that borrower financial health drives this indicator, but rejects this explanation, because:  “First, aggregate balance sheets evolve relatively
slowly, which seems inconsistent with the sharp deterioration in the non-mortgage credit factor after Lehman, and (given the slow pace of deleveraging and financial recovery) looks especially inconsistent with the sharp improvement in this factor that began just a few months later” (p. 41). Bernanke appears to assume that the deterioration would have been driven by the housing bubble, but that is not my (or Dean Baker’s) claim. I am arguing that the collapse of the CRE bubble and the weight of needing to refinance maturing syndicated loans in an adverse environment caused corporate balance sheet deterioration. The improvement is then explained by the fact that CRE prices bottomed in mid-2009 and in early 2009 the Federal Reserve made clear its commitment to keep interest rates ultra-low for “an extended period” of time. Both of these helped corporates deal with their debt burden.

In short, I find that Ben Bernanke’s data is entirely consistent with the presence of only a short-lived panic in late 2008. The economic deterioration that Bernanke associates with the prolonged short-term funding crisis and the more short-lived non-mortgage credit crunch can be explained respectively by the collapse of a large number of shadow banking vehicles and by the deflation of the other two lending booms associated with the crisis.

IV. Why Ben Bernanke’s characterization of the crisis is problematic

Thus, my most serious objection to Ben Bernanke’s characterization of the crisis is that, having exercised the lender of last resort authority appropriately to its full potential by permitting shadow bank funding models that were deemed destabilizing to collapse, he seems to want to avoid acknowledging the actual nature of the central bank’s lender of last resort role. His description of the 2007-09 crisis as “a classic financial panic” implies that the crisis was fundamentally a coordination problem in which the public was choosing a bad equilibrium and just needed to be redirected by the central bank into a good equilibrium in order to improve economic performance. Brad DeLong also embraces the language of panic in his response to Bernanke on the AEA Discussion Forum: “all that needed to be done was to keep demand for safe assets from exploding.”

(For Paul Krugman the problem is to explain not just the depth of the recession that ended in mid-2009, but the extraordinarily slow recovery from that recession, which he dubs “the Great Shortfall”. I suspect much of the explanation for the Great Shortfall will be found in post-crisis policies that were designed to protect Wall Street balance sheets at the expense of pension funds and the public, but that is a very different post.)

If one reframes Bernanke’s data from August 2007 to Spring 2009 as representing the complete collapse of certain shadow bank funding models, we see the Federal Reserve as the ultimate decision maker over which funding models were allowed to survive. Because some shadow bank funding models were allowed — properly — to collapse short-term funding rates skyrocketed and areas of the real economy that had adapted to rely upon the doomed funding models struggled as they had to adjust to a world with a different set of choices. This adjustment was temporary because the Federal Reserve — properly — acted to promote restabilization of a financial system without the terminated shadow banks.

What drove the data was not the public choosing a bad equilibrium, (that is, a panic), but the Federal Reserve properly exerting its authority by allowing market forces to eliminate certain shadow banks. This authority is properly exercised because in a world with credit-based money such as ours, financial stability is only possible if the lines between bank-like lending that is acceptable and bank-like lending that is not acceptable are strictly drawn and carefully policed. Thus, the Federal Reserve’s most significant error was its failure to exercise this authority stringently enough long before the crisis broke in order to act preventively to forestall the financial instability that was experienced in 2007-09.

That said, Bernanke is rightly proud of the speed with which the post-Lehman panic was brought under control and is right to conclude that “the suite of policies that controlled the panic likely prevented a much deeper recession than (the already very severe) downturn that we suffered” (p. 66). He also draws a lesson from the crisis that is entirely consistent with the view of it presented here: “continued vigilance in ensuring financial stability” is absolutely necessary. Indeed, I suspect that he would agree with me that that the Federal Reserve should have exercised greater vigilance prior to 2007.

Why claims that the 2008 bailout was a “success” should make you angry

In 2008 we needed a bailout – or at least significant government/central bank intervention – but the bailout we got was unfair and almost certainly hampered the recovery. Furthermore, claims that “the bailout made money in the end” need to address the actual structure of the bailout.

So let’s talk about how the 2008-10 bailout of mortgage-related securities and instruments was structured. I focus on the mortgage-related bailout, because even when you’re talking about much more complicated instruments like CDOs, a lot of the trouble came from the outrageous practices that had been going on for the last few years in the US mortgage market. Here I’m not going to get into how the various instruments were related to mortgages, I’m just going to break down how the US used government funds to bail out the issuers and investors in private housing market-related instruments. There were three steps.

STEP 1: The Fed provided temporary assistance by supporting asset prices from March 2008 through February 2010 by accepting just about everything as collateral at the TSLF and PDCF and thus preventing fire sales of assets. The Fed also wrote supervisory letters granting bank holding companies (BHCs) the right to exceed normal limits on aid from the FDIC-insured bank to the investment bank, so that a lot of support of these asset markets took place on the balance sheets of the BHCs.

STEP 2: Many of the mortgages underlying the troubled assets were refinanced with the support of government guarantees against credit risk. The process of refinancing a mortgage requires the existing mortgage to be paid off in full. Thus, these refis had the effect of transferring poorly originated mortgages out of private portfolios and into government insured portfolios. This would not be a problem if the government insured mortgages were carefully originated, but that would not have solved the private sector’s problem, so that’s not what happened. Step 2 required both immense purchases by the government of mortgage backed securities and a simultaneously massive expansion in insurance offered for riskier loans.

1.  Massive purchases of GSE MBS.
The goals were to make sure the GSEs could continue to be active in the mortgage market, to drive down the 30 year mortgage rate to facilitate refinancing as well as purchases, and to raise the price of housing.

a. On Sept 7 2008 when Fannie Mae and Freddie Mac were put into conservatorship, Treasury also announced plan to purchase MBS securities. Apparently this program only ever reached about $200 billion in size (Sigtarp Report July 2010 136). Soon it was superseded by:

b. The Federal Reserve’s QE1: In November 2008 the Federal Reserve announced a massive program of supporting mortgage markets by buying mortgage backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. This purchase program ended up buying $1.25 trillion in MBS and continued until February 2010.

• By the end of 2008 the 30 year fixed mortgage rate had fallen by a full percentage point. and would only decline further in later years.

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• Private sector MBS issues had declined to almost nothing by mid 2008 and even GSE MBS issues had dropped over the course of 2008. In 2009 GSE MBS came roaring back so that by mid-2009 monthly MBS issues were almost as high as they had ever been. The fact that in several months Fed purchases in the form of QE1 exceeded GSE MBS issues undoubtedly played a role in this dramatic recovery of the MBS market.

from “Charting the Financial Crisis” by Brookings & Yale SOM

2.   FHA insurance grew to account for almost 1/3 of the mortgage market.
From mid-2009 to mid-2010 alone FHA and GNMA insured loans increased by $500 billion (Sigtarp Report July 2010 p. 119).

FHA insured loans became a growing and then significant portion of the mortgage market after the major subprime lenders collapsed in early 2007, and FHA became the only choice for borrowers who couldn’t put down much of a down payment. Prior to the crisis FHA loans accounted for as little as 3% of the market. By June 2009 FHA loans accounted for 30% of the market and would continue to do so for several years. (See Golobay 2009 and Berry 2011a.)

By mid-2011 all the major banks held billions in FHA insured loans that were 90 days or more past due: BoA $20 billion, WFC $14 billion, JPM $10 billion, Citi $5 billion. Eventually every major bank would end up settling lawsuits over misrepresentations in FHA insurance applications. In the meanwhile they were using FHA insurance as a cover to avoid taking writedowns on the loans. (See Berry 2011b.)

Here is the FHA’s 2015 report on how the loans it guarantees have been performing. Note that the FHA insured $73 billion single family mortgages in FY 2006, $84 billion in FY 2007, $205 billion in FY 2008 and $365 billion in FY 2009 (see Table 1 here.)

(Note that the decision to separate fiscal year 2009 into first half (October 2008 to March 2009) and second half (April 2009 to September 2009) appears to be a genuine effort to show how different the two cohorts are, and as far as I can tell should not be interpreted as questionable data manipulation.)<\small>

3. Expansion of loans eligible for securitization by Fannie Mae and Freddie Mac by increasing the conforming loan limit to $729,750 in high cost states (which lasted until 10-1-2011).

• The Special Inspector General for the Troubled Asset Relief Program concluded that the government had adopted an explicit policy of supporting housing market prices (SIGTARP report Jan 2010 p. 126). These programs stopped the decline in house prices nationally (the yellow line in the chart below) for the year 2009 and slowed the drop in house prices thereafter. As a result, nationally the bottom in housing prices wasn’t reached until January 2012. This meant that the massive 2009 government guaranteed refinancing of mortgages was deliberately executed at higher than market prices.

Before going on to Step 3, let’s pause for a moment to get a good picture of what is going on here. By late 2008, it had become abundantly clear that Private Label Securitization was a shitshow. Tanta, who had 20-odd years of mortgage industry experience and spent the months before her death blogging at Calculated Risk, put it well in a July 2007 blogpost :

“we as an industry have known how to prevent a lot of fraud for a long time; we just didn’t do it. It costs too much, and too many bonuses were at stake to carve out the percent of loan production it would take to get a handle on fraud. The only thing that got anybody’s attention, finally, was a flood of repurchase demands on radioactive EPD [early payment default, i.e. 3 missed payments in first 6 months of loan] loans and other violations of reps and warranties. If [you] want[] to accomplish something, I’d suggest [you] … start slapping some issuers around on their pre-purchase or pre-securitization quality control and due diligence.”

So what was going on in 2007 and 2008 is that the market was recognizing that the “Non-Agency MBS” in the chart below was going to perform very badly, because it was so full of loans that should never have been made.

In many cases the originators who were theoretically on the hook for the reps and warranties they had made when they sold the loans to Wall Street had been driven into bankruptcy by – you guessed it – claims based on their reps and warranties. The bag they had in theory been holding had most definitely been passed on to someone else, but it wasn’t clear yet to whom. The obvious candidate was the issuers who had packaged these loans – with utterly inadequate due diligence – into securities for investors to buy. The catch was that the issuers were all the big banks: Bank of America, JP Morgan Chase, Citibank, Goldman Sachs, etc.

And we had financial regulators who were like deer in the headlights, transfixed by terror, when they heard that one of the big retail banks might be in danger. These regulators threw themselves headlong into the project of rescuing the big banks from their failure to perform the due diligence necessary to issue mortgage-backed securities according to the terms in their securities documentation. While I suspect that Ben Bernanke never quite wrapped his head around these issues (he had plenty of other things to worry about), it seems fairly clear that Hank Paulson and Timothy Geithner worked consciously to “save the financial system” by hiving loans that should never have been made off onto the Government. Geithner, in particular, would almost certainly claim that this was the right thing to do in the interests of financial stability.[1]

Thus, the mortgage sector bailout was designed so that the mortgages underlying the private label mortgage backed securities (PLMBS), the bulk of which had been made at the peak of the bubble, would be refinanced out of the PLMBS securities as quickly as possible. The private sector had no interest in financing such an endeavor itself, so the only way to do it was through the government sponsored entities.

By engineering a drop in the 30 year mortgage rate (the announcement of QE1 was apparently enough to do this), an incentive was created for mortgagors to refinance their loans. The same Fed program ensured that Fannie Mae, Freddie Mac, and Ginnie Mae would have no problem getting the funds to buy the refinanced mortgages. There was only one catch, a nontrivial segment of the PLMBS mortgages were not of a quality that could be sold to Fannie and Freddie – and the same would be true of any refis of those mortgages. That’s where the FHA comes in: by guaranteeing 30% of all mortgages in the crucial years 2009-2010, the FHA provided a way for some of the more dubious mortgages in the PLMBS to be refinanced and be paid in full. FHA loans are typically securitized by Ginnie Mae and may also be held on a bank’s balance sheet. The PLMBS loans that were paid in full – due solely to the presence of government guarantees in the mortgage market – almost certainly played a huge role in protecting the returns on the PLMBS, in reducing the losses to investors, and in reducing the liability of the issuers for their due diligence failures.

The key point to remember here is that there was nothing “market” about this whole process. The Fed was both providing the funds and driving down the interest rates, while a government backstop for the credit risk on the loans was provided by the GSEs. Multiple experts described the housing finance market as having been “nationalized” or put “on government life support” in this period.

Because of the degree to which the government took over the mortgage market in these crucial years, it becomes a little silly to focus on the fact that no money was lost (in aggregate) due to the government’s support of PLMBS and related assets. (As far as I can tell the costs included in bailout figures never include the losses that the GSEs incurred on the loans guaranteed from 2008Q4 to 2010Q4.) Overall it can hardly be a surprise that the government made money on the officially recognized bailout loans given that the government also took steps in to make sure that many of the underlying assets were paid off in full.

At this point you may be saying: Well okay, but given that the Fed and Treasury were successful in returning the banks to health and the GSEs are all doing okay now too, was there really any harm done by a few years of de facto nationalization of the housing market?

This is where Step 3 comes in. The whole scheme only works because of Step 3, and Step 3 is what has most of those who understand what happened absolutely smoking mad about the bailouts. The key to the PLMBS performing well was that the mortgages in them had to be paid off in full. In order for the existing mortgage to be paid in full, the refi that pays it off will have to be for the same amount as the existing mortgage or a little more.

STEP 3: No principal reduction for mortgage holders. It was essential to make sure that people who hold mortgages don’t have access to a program that allows principal to be reduced. Effectively, since the banks can’t be the bagholders because of the terror of financial instability and the government can’t just be handed the bag because that has very bad visuals, the public had to be made the bagholders. The only way to do this was to make sure the public was not cut any breaks.

1. Prevent cramdown legislation from being passed
Cramdown is how bankruptcy law treats collateral that has fallen in value below the value of the loan. If the debtor declares bankruptcy, the lender only has a security interest up to the value of the collateral and remainder of the loan is not treated as collateralized debt. An exception was written into the 1977 Bankruptcy Code excluding mortgages on primary residences from cramdown. (The claim at the time was that this would be better for borrowers. LOLWT[2].) In short, the bankruptcy code takes the position that finding a good solution to someone’s inability to pay debt requires recognizing the economic reality of the situation in virtually every case except for mortgages on primary residences.

Forcing lenders to come to the table on the basis of economic reality is something that every collateralized borrower can do – except for the little guy whose only collateralized loan is on his/her primary residence. Fixing the cramdown inequity was one of President Obama’s promises before he was elected. But lo and behold Treasury staffers in his administration “stressed the effects of cramdown on the nation’s biggest banks, which were still fragile. The banks’ books could take a beating if too many consumers [were] lured into bankruptcy by cramdown ” (Kiel & Pierce 2011). Treasury’s position on this should be read: we need to bail out the banks, so we can’t allow the economic reality of the situation to affect the cut that the banks get.

2. Failure to establish an effective principal reduction program until 2012
In July 2010 SIGTARP called Treasury out for its failure to establish an effective principal reduction program as part of its mortgage modification program (Sigtarp Report July 2010 174ff.) However, not until May 2011 had the Treasury been sufficiently shamed over the lack of principal reductions to begin reporting on the Principal Reduction Alternative (PRA) data. By May 2011 less than 5000 permanent modifications had been started that included principal reduction. This was less than 1% of the permanent modifications started under the HAMP program (MHA Report May 2011).

This delay was important, because if borrowers had been offered modifications with principal reduction in the crucial years from 2009-10, it undoubtedly would have affected decisions to refinance loans that had been made at the peak of the bubble. By May 2012 permanent modifications with PRA that had been started had jumped to 83,362 which was over 8% of all permanent modifications started (MHA Report May 2012).  More recent reports indicate that ultimately 17% of all permanent modifications started included principal reduction. (MHA Report 2017Q4 p. 4)

3. Failure of FHA short refinance program. In August 2010 the FHA established a short refinance program which imposed strict rules on lenders including 10% 1^st lien principal writedowns.  A year later the program had helped only 246 borrowers, in part because Fannie and Freddie refused to participate, and the program was slated to be closed (Prior 2011).

So what’s my conclusion? Everybody who wants to tout the success of the bailout needs to tackle the reality of the bailout’s structure. There was a housing bubble. Somebody was going to have to absorb the losses that are created when lending takes place against overpriced assets.

Because in the name of financial stability the Fed and Treasury decided that banks weren’t going to bear any of the losses on the origination and securitization of bad mortgages, they had to find a way to put the tab to the government and to the public.

It was put to the government by putting the mortgage market on government life support from late 2008 to 2010, so that people would refinance out of the bad mortgages in PLMBS securitizations into FHA loans and into GSE MBS.

It was put to the public by making sure that their mortgages were not written down in value, even though the value of the house being used as collateral had collapsed. This means that the housing price bubble of 2006-07 is still with us today. It is being paid off by homeowners who are still paying these mortgages, who can’t spend that money on consumption, and who are scheduled to keep paying off bubble-level housing prices right up until 2050.

From Deutsche Bank via Tracy Alloway: https://twitter.com/tracyalloway/status/1040391962090590209

So when you see a chart like the one just above, which shows US consumers saving far more than predicted, you should recall that paying down mortgage principal counts as savings and a lightbulb should go off in your head. You should be thinking when you see this chart: “Aha. Look at all the US consumers who are still paying for the housing bubble. The 2008 crisis should have been handled differently.”

P.S. While we’re talking about anger and crisis housing policy let me offer two notes on HAMP modifications.

1. Look at this chart from “Charting the Financial Crisis” by Brookings & Yale SOM (part of a project advised by Tim Geithner)

They very carefully report the number of borrowers helped, but not the principal value of the mortgages before the modification and the principal value of the mortgage after the modification. Most HAMP modifications included significant increases in the principal borrowed, as not only interest accrued during trial modifications but also a variety of fees that borrows rarely understood or reviewed, were capitalized into the loans.

2. In general the HAMP program is performing execrably as might have been expected given its design. (See here for details.) After 60 months the program increases the payments that were carefully set to the maximum the borrower can afford when the loan was made. The program may continue to increase payments each year for 2 to 3 years, that is, at 72 and 84 months. In short, the program was designed to give borrowers as little as possible: borrowers get five years respite in payments without reducing the present value of the modified loan on bank balance sheets. To avoid hitting bank balance sheets payments have to go up for the remaining 35 years of the loan. On pages 7 and 9 of the 2017Q4 MHA Report, the data on performance is very carefully presented only up to 60 months. One has to read the appendices – specifically Appendix 6 – to learn that for each vintage with 84 months of data at least 50% (and up to 65%) of loans have become delinquent.

[1] I have a draft paper in which I draw the analogy between Geithner and a couple of early 19^th c. Bank of England directors who had been similarly traumatized by their early experiences dealing with financial crises and also advocated throwing money at them no matter what. The difference is that these two directors were lambasted by their contemporaries including Ricardo, and their claims have gone down in history as “answers that have become almost classical by their nonsense” (Bagehot 1873, p. 86).

[2] LOLWT = Laugh out loud with tears.

In search of financial stability: A comparison of proposals for reform

I. The liquidity view
a. Solution: Expansive LOLR
b. Solution: Narrow banking

II. The solvency view
a. Solution: PFAS – the dealer of last resort meets narrow banking
b. Solution: Controls on credit

The vast literature on the financial crisis includes a segment comprised of books that propose reforms to the financial system that are designed to promote financial stability. The initial goal of this post was to evaluate and compare some of the more recent contributions to this literature: Morgan Ricks’ The Money Problem (2015), Adair Turner’s Between Debt and the Devil (2015), and Mervyn King’s The End of Alchemy (2016). In order to help balance the discussion, I am also including Perry Mehrling’s The New Lombard Street (2011), Hal Scott’s Interconnectedness and Contagion (2012), and John Cochrane’s Toward a Run-Free Financial System (2014).

A first basic organizing principle for comparing these proposals is to separate the works by their view of the essential problem to be solved: some argue that we should focus on panics or on avoiding liquidity droughts, whereas others see the fundamental problem as one of solvency or too much private sector debt. Those who take the liquidity view make proposals that fall into two broad categories: the establishment of an expansive lender of last resort, and narrow banking proposals where the government backstops short-term debt. While some proponents of the solvency view also put forth narrow banking proposals, their proposals typically attempt to address the potential danger of too much government support for short-term debt and therefore are distinguished from the liquidity-based narrow banking proposals. Finally some advocates of the solvency view argue that financial stability necessitates controls that limit the private sector’s ability to originate debt.

This post addresses each of these arguments in turn.

The liquidity view

The list of authors who argue that the key to addressing financial stability is to focus on liquidity crises and their prevention is long. Here we will discuss the proposals put forth by John Cochrane, Perry Mehrling, Morgan Ricks, and Hal Scott.

Each of these authors is explicit that in his view the key to financial stability is the prevention of liquidity crises. For example, Morgan Ricks writes: “when it comes to financial stability policy, panics— widespread redemptions of the financial sector’s short- term debt— should be viewed as ‘the problem’ (the main one, anyway). More to the point: panic-proofing, as opposed to, say, asset bubble prevention or ‘systemic risk’ mitigation, should be the central objective of financial stability policy” (p. 3). This view is echoed by both John Cochrane: “At its core, our financial crisis was a systemic run. … The central task for a regulatory response, then, should be to eliminate runs” (p. 197); and Hal Scott: “Contagion occurs when short-term creditors run on solvent institutions, or institutions that would be solvent but for the fire sale of assets that are necessary to fund withdrawals” (CNBC comment) and “contagion, rather than asset or liability interconnectedness, was the primary driver of systemic risk in the recent financial crisis” (p. 293). Perry Mehrling also frames the crisis as fundamentally a matter of liquidity, acknowledging first that it was catalyzed by the decline in collateral valuations, but then explaining: “from a money view perspective, price is first of all a matter of market liquidity, and this perspective focuses attention on the dealer system that translated funding liquidity into market liquidity.” (p. 125).

All four of these authors focus on the fact that the financial system that faced crisis in 2007-09 was constructed upon a foundation of short-term liabilities of non-banks. They differ, however, on the question of whether central bank policy was a cause or a consequence of this financial structure. Both Mehrling and Scott focus on what the Federal Reserve did to address the 2007-09 crisis, whereas Cochrane and Ricks argue that lender of last resort support played an important role in moral hazard and the deterioration of financial institution balance sheets in the decades leading up to the crisis (Cochrane pp. 231-32; Ricks p. 195). Indeed Ricks argues against not just the implementation of last resort lending in the lead-up to the crisis, but even against the traditional lender of last resort, because, first, in his view it functions as a distortionary subsidy to financial institutions and, second, it will fail if these institutions do not have enough of the right sort of collateral (pp. 186-87).

Threading a path between these views I would argue that during the decades preceding and fostering the growth of this financial system built on the short-term liabilities of non-banks, a naïve view of the lender of last resort was promoted by Federal Reserve officials. Alan Greenspan declared that: “The management of systemic risk is properly the job of the central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events” (speech 1998). And through these formative decades Timothy Geithner, who would be President of the Federal Reserve Bank of New York and then Treasury Secretary during the crisis, was learning to ignore moral hazard concerns when dealing with crises (Geithner 2014).

Before exploring the details of the “panic-proofing” proposals, let’s briefly preview the contrary view that the crisis was a solvency crisis, and the critiques that the solvency proponents have to offer of the liquidity view. Mervyn King references Keynes’ exposition of uncertainty, animal spirits, and the fact that “a market economy is not self-stabilizing” to explain that sometimes an interim period of disequilibrium may be part of a necessary adjustment process as it becomes clear that the current pattern of behavior is no longer sustainable and that “the debts and credits that have built up … will eventually have to be cancelled” (pp. 294-323). In short, due to radical uncertainty, liquidity neither is nor should be “a permanent feature of financial markets” (p. 151). He remarks that: “Political pressures will always favor the provision of liquidity: lasting solutions require a willingness to tackle the solvency issues” (p. 368).

Adair Turner is more direct in his critique. His view that modern economies are reliant on too much private sector debt is supported by extensive empirical research (Jorda, Schularick & Taylor 2014, Mian & Sufi 2014), and he argues that those who deny that too much private sector debt has been originated are misled by a “presumption in favor of … as many financial contracts as possible as widely traded as possible [that] was an accepted article of faith” prior to the crisis (p. 29). Thus, from the perspective of Between Debt and the Devil, proponents of the liquidity view are likely to be captive minds who simply cannot conceive of the possibility that the debt that was originated prior to the crisis was in fact unsustainable and will at some time in the future end up in default.[1]

Only Ricks directly addresses and rejects the solvency view. His discussion does not, however, reach the question of whether a systemic panic is a necessary consequence of an environment with an unstable build-up of debt. Instead he focuses on how damaging the panic itself was. Thus, while one can read Ricks as arguing that the problem can be addressed either at the level of the debt bubble or at the level of the panic, the fact that he chooses to address the problem at the latter stage because it is only then that the problem becomes acute indicates that he considers “too much debt” to be a distinctly secondary concern.[2] This approach lends credence to Turner’s view that current modes of thought about finance preclude serious discussion of the problem of too much debt.

Unsurprisingly, neither King nor Turner supports the broad government guarantees that underlie all of the solutions proposed by the liquidity view proponents. Despite the common reliance of all four liquidity view authors on government guarantees to prevent crises, the form that these guarantees take is very different. Perry Mehrling and Hal Scott would implement these guarantees through expansive access to the lender of last resort without requiring major structural reform to the financial system. John Cochrane and Morgan Ricks, by contrast, propose complete transformation of the financial system before they would advocate government liquidity support.

Solution: Expand the role of the lender of last resort

Perry Mehrling’s argument in support of an expansive role for the lender of last resort is premised on the assumption that complete transformation of the financial system is not a practical solution. He writes: the “capital-market-based credit system … is now a more important source of credit than the traditional banking system. I take it as given that this brave new world is here to stay.” (p. 113). Similarly, even though Hal Scott does discuss proposals that place a cap on short-term funding for banks (p. 160 ff), he does not clearly address the possibility that such caps could be applied to non-banks as an alternative to lender of last resort support. In short, Scott implicitly, though not explicitly, adopts Mehrling’s approach: financial stability is a problem of stabilizing a financial system constructed upon a foundation of short-term liabilities of non-banks. (As we will see below, Cochrane and Ricks do not share this view.)

The most famous proponent of the lender of last resort as a form of “panic-proofing” is probably Timothy Geithner, who views 2007-09 as fundamentally a liquidity crisis and argues that the right way to deal with such a crisis is by providing government support to the financial institutions involved until such time as their balance sheets are repaired and they can function without government support.[3] This naïve view of the lender of last resort treats the moral hazard concerns of this central bank function as something that must be ignored during a crisis.[4]

Mehrling and Scott seek to lay analytic foundations for an expansive lender of last resort as a solution to panics. Scott in his book recounts the aggressive actions that did indeed have the effect of saving the financial system from contagion (though many have observe that economic performance subsequent to this bailout of dysfunctional finance has left much to be desired, e.g. Mian and Sufi 2014) and argues that: “History has taught us that contagion is an unavoidable risk of financial intermediation and that a strong lender of last resort is necessary to prevent it” (CNBC). In fact, Scott views the Lehman bankruptcy as a lesson that “to be effective, a central bank lender-of-last-resort must be unlimited and non-discretionary. The current [post Dodd-Frank] regime leaves open the risk that lender-of-last-resort assistance will be withheld from a distressed financial institution at a critical moment, and thus short-term creditors remain incentivized to withdraw in the face of such distress. An explicit guarantee, as opposed to the implied guarantee that existed before Lehman’s failure, assures short-term creditors that they will recover all of their funds, thus removing their incentive to run in anticipation of large losses” (p. 292). He makes clear in a later article that “the ability to lend to non-banks in a crisis is a crucial matter, and will become even more important, as over regulation of banks fuels the further growth of the shadow banking sector” (CNBC).

Perry Mehrling does not advocate for an “unlimited and non-discretionary” lender of last resort. Instead he argues that the Federal Reserve should convert into a regular facility the Primary Dealer Credit Facility, which was a program the Federal Reserve put into place during the crisis to support the value of private sector assets that were used as collateral in the tri-party repo market. (At its peak this facility held more than $60 billion of equities. See PDCF data .) Mehrling argues that the modern capital-market-based financial system needs such a “dealer of last resort” to set a price floor on private sector assets and that any moral hazard concerns created by this proposal can be addressed by careful pricing (pp. 134, 137-38).[5] Mervyn King doubts that central banks can implement such a policy successfully: “one of the most difficult issues in monetary policy today is the extent to which central banks should intervene in these asset markets – either to prevent an ‘excessive’ rise in asset prices in the first place or to support prices when they fall sharply. … I am not sure that their track record justifies an optimistic judgment of the ability of central banks [to do this]” (p. 265).

Overall, proponents of an expansive lender of last resort as a solution to the problem of liquidity crises generally start with the assumption that the existing financial structure cannot change and do not address the argument the existing financial structure is in fact a product of the expansion of central bank guarantees in the 1980s and 1990s. Adair Turner (likely with substantial agreement from Charles Goodhart, Mervyn King, and Martin Wolf) would probably argue that proponents of this view are captivated by pseudo-economic delusions and mistaken ideas that forestall an understanding of the fundamental problem of “too much debt.” In short, critics of the expansive lender of last resort proposal argue that far from stabilizing the financial system, the policy has a history of being destabilizing.

Solution: Narrow banking

John Cochrane and Morgan Ricks are united in their view that, even though excessive origination of debt is a predictable consequence of misguided government support for the financial system, the correct way to address this problem is to focus on run-prone (or short-term) financial claims and to design a monetary system backed by government obligations that will put an end to runs. While both authors favor structural financial reform that would effectively end – or at least severely restrict – private short-term debt, the monetary frameworks that the two authors adopt as they formulate their solutions are very different: Cochrane’s view of money is a fairly direct distillation of Milton Friedman’s approach, whereas Ricks develops more of a practitioner’s view that owes as much to Marcia Stigum and Diamond-Dybvig-type coordination problems as to any particular monetary theorist. The only common ground in the two views of money is that both treat money issued by the government as the anchor of their systems (Cochrane p. 224, Ricks p. 146).[6]

Both Cochrane and Ricks would transform the financial system by aggressively restricting the ability of both banks and non-banks to issue short-term, run-prone debt. In Cochrane’s proposal “demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries”(p. 198). Cochrane would restrict the degree to which any other short-term debt (except for trade credit) could be used to finance intermediaries by imposing a tax on such liabilities (p. 199). The result would be that “Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities [i.e. equity]” (p. 198). Ricks’ plan is more comprehensive because it would entirely prohibit nonbank issue of short-term debt, but somewhat less restrictive because it relies on government guarantees of bank liabilities rather than a mandate that banks hold government debt. Specifically, Ricks restricts the issue of short-term debt (except for trade credit) via “unauthorized banking provisions” that only permit banks to issue such debt, and requires that all short-term bank liabilities be explicitly guaranteed by the government (pp. 201, 235). Ricks’ proposal also imposes bank regulation similar to, but more strict than, what we have today including portfolio restrictions and capital requirements (p. 211). Ricks indicates that this proposal can be viewed as making explicit government guarantees that were formerly implicit (p. 25).

Both Cochrane and Ricks argue that government backing of short-term debt will eliminate the danger of runs (with of course the caveat that we are talking about the right sort of government). Whereas Ricks focuses in some detail on the structure of the monetary system, Cochrane’s emphasis is on the value of ensuring that most financial assets are backed by equity: “For the purpose of stopping runs, what really matters is that the value of investors’ claims floats freely and the investors have no claim on the company which could send it into bankruptcy” (p. 215). Ricks’ critique of Cochrane’s proposal is that he underestimates the demand for money-claims on banks and thus ties the supply of money to the quantity of short-term Treasuries available to back them. The advantage of Ricks’ sovereign guarantees of bank liabilities is that it allows the money supply to be backed in part by private sector assets and thus makes it possible for monetary policy to operate independent of fiscal policy (p. 182).

This significant difference in the two proposals is a consequence of the different monetary frameworks that the two authors employ. As noted above, Cochrane’s approach derives directly from Friedman’s and thus bank money, when it exists, is simply a function of government constraints. Ricks, by contrast, views banks as creating money and thus as playing an important part in determining the money supply. It is this latter approach that motivates Ricks to design a “narrow banking” system that nevertheless can allow for expansion of the money supply independent of government debt. Ricks observes that proposals like Cochrane’s (and Friedman 1960’s) envision a monetary system without a significant role for banks (p. 171).

In short, when Cochrane argues that the costs of his transformational plan are not too large, he does so without first modeling why money claims issued by banks are backed by private sector assets. Not only Ricks, but also Adair Turner, Martin Wolf and Charles Goodhart have argued that there are “positive benefits to private rather than public creation of purchasing power” and indeed, that this structure may play a role in “investment mobilization and thus economic growth” (Turner 188-89; see also Wolf 212-13).

Given that Cochrane – and all those who rely on Friedman’s monetary framework – have not thought through why we have the monetary and banking system that we have, his assertions appear “mystical and axiomatic” to use his own words (p. 223). For example, Cochrane writes that by limiting finance to equity finance “we can simply ensure that inevitable booms and busts, losses and failures, transfer seamlessly to final investors without producing runs” (p. 202). “Liquidity is now provided by the liquid markets for these securities, not by banks’ runprone redemption promises.” 226 This Friedman-esque vision of markets plus government as providing all the liquidity that an economy needs is combined with the remarkable claim that we no longer have a transactions need for bank liabilities.[7] Cochrane asseverates that “technology renders this ‘need’ [for short-term bank debt in transactions] obsolete. … We can now know exactly the prices of floating-value securities. Index funds, money market funds, mutual funds, exchange-traded funds, and long-term securitized debt have created floating-value securities that are nonetheless information-insensitive and thus extremely liquid. Consumers already routinely make most transactions via credit cards and debit cards linked to interest-paying accounts, which are in the end largely netted without anyone needing to hold inventories of runnable securities” (p. 222).

In short, Cochrane, because his theoretic framework is devoid of liquidity frictions, does not understand that the traditional settlement process whether for equity or for credit card purchases necessarily requires someone to hold unsecured short-term debt or in other words runnable securities. This is a simple consequence of the fact that the demand for balances cannot be netted instantaneously so that temporary imbalances must necessarily build up somewhere. The alternative is for each member to carry liquidity balances to meet gross, not net, demands. Thus, when you go to real-time gross settlement (RTGS) you increase the liquidity demands on each member of the system. RTGS in the US only functions because the Fed provides an expansive intraday liquidity line to banks (see Fed Funds p. 18). In short RTGS without abundant unsecured central bank support drains liquidity instead of providing it. (See Kaminska 2016 for liquidity problems related to collateralized central bank support.) In fact, arguably the banking system developed precisely in order to address the problem of providing unsecured credit to support netting as part of the settlement of payments.

Just as RTGS systems can inadvertently create liquidity droughts, so the system Cochrane envisions is more likely to be beset by liquidity problems, than “awash in liquidity” (p. 200) – unless of course the Fed is willing to take on significant intraday credit exposure to everybody participating in the RTGS system. (Here is an example of a liquidity frictions model that tackles these questions, Mills and Nesmith JME 2008). Overall the most important lesson to draw from Cochrane’s proposal is that we desperately need better models of banking and money, so we can do a better job of evaluating what it is that banks do.[8]

Another aspect of money that Ricks takes into account, but Cochrane with his simple Friedman-based monetary framework barely addresses is that banks are able to expose themselves to runnable, short-term debt even when they aren’t financing their balance sheets. Ricks argues: “Our monetary theory of banking … suggests that derivatives dealing is properly the domain of nonbank financial firms,” because “the amount of cash exchanged upfront [and therefore the money provided] is almost always very small in relation to the risk taken” (p. 208). Cochrane would not restrict such off-balance-sheet activities, and argues that “a few regulators” will be able to detect any dangerous behavior since leverage ratios will be very low (p. 216). Of course, one of the lessons of the crisis is that off-balance-sheet bank liabilities can be very large: Citibank (as well as UBS and Merrill Lynch) had to recognize upwards of $50 billion of derivatives exposures in the form of super-senior CDOs when its “liquidity puts” were drawn down (FCIC  Report, p. 260).

When we combine Cochrane’s casual approach to the danger of off-balance-sheet bank exposures with the view that “invoices [and] trade credit … are not runprone contracts” (p. 202), we find that his formulation of narrow banking leaves open the possibility that after his reforms the financial system could regenerate a very old – but not necessarily very stable – form of banking, acceptance banking. Whatever is classified as trade credit in Cochrane’s regime may be accepted or guaranteed by banks or unacknowledged shadow banks – and these acceptances may circulate as money just as they did in the 19^th century with destabilizing effect. In fact, Ricks’ proposal is also permissive of trade credit and therefore is subject to a similar critique: nothing prevents nonbanks from guaranteeing trade credit obligations and this is an avenue through which a new, unstable banking system can develop. This analysis points to another common criticism of narrow banking proposals: they may be impossible to design due to the “remarkable ability of innovative financial systems to replicate banklike maturity transformation” (Turner p. 189).

Overall, narrow banking proposals raise very important questions about whether our monetary system can be better designed to avoid liquidity crises, but (i) will be very hard to formulate in a way that precludes their circumvention, and (ii) are probably best read as evidence that we need much better models of money and banking, so that we can actually understand what the connections are between money, bank liabilities and private sector bank assets, before pursuing transformative change.

The solvency view

Transformational reform is also proposed by scholars who believe that the essential problem that must be addressed in modern financial systems is not liquidity, but solvency. “The fundamental problem is that modern financial systems left to themselves inevitably create debt in excessive quantities, and in particular debt that does not fund new capital investment, but rather the purchase of already existing assets” (Turner p. 3-4). Turner argues that when banks expand the money supply by creating debt that is used to purchase existing assets, the result is an increase in the prices of the assets thus purchased, which then justifies an increase in the debt collateralized by the asset – and thus an expansion of the money supply. The ultimate consequence of this “self-reinforcing credit and asset price cycle” is an asset price bubble (p. 6). When the bubble bursts, as eventually it must, the problem is not liquidity, but solvency. The economy is then burdened with an overhang of debt that is either bad in the sense that repayment is not feasible or uneconomic, because the debtor is servicing debt that is greater than the value of the asset. This basic critique of modern finance – and in particular of the finance of real estate – is advocated not just by Turner, but also by Martin Wolf 2014 and Charles Goodhart & Enrico Perotti 2015.

Mervyn King in The End of Alchemy takes a slightly different approach. He argues that “the most serious fault line in the management of money in our societies today” is “the alchemy of banking” or the system by which money “is created by private sector institutions” and then used to finance illiquid and risky investments (pp. 86, 104). In his view, however, it is important to emphasize that the causal force generating “too much debt” was not the banks themselves, but the demand for borrowing to finance real estate investment due to the savings generated by the structural current account surpluses of Asian countries and Germany together with the decline in real interest rates that resulted from deficit countries’ efforts to keep their economies growing when faced by these surpluses (p. 319, 325).[9] In short, while King agrees that we are currently faced with a state of disequilibrium characterized by too much debt, he explains this outcome via a change in our understanding of the state of the world, not via an inherently unsustainable asset price bubble (pp. 356-57).

Proponents of the solvency view believe that not only does financial stability require that our financial structure be transformed, but also that the only path forward will require debt forgiveness of some sort (King p. 346, Turner p. 225ff). Because the focus of this essay is on proposals for transformational reform of the financial system, devices to deal with the debt overhang will not be discussed. Instead we evaluate King’s proposal for a pawnbroker for all seasons and Turner’s argument that direct controls on the financial sector’s origination of debt instruments are necessary.

Solution: PFAS – the dealer of last resort meets narrow banking

Like John Cochrane and Morgan Ricks, Mervyn King focuses his attention on the design of a more stable monetary system. His proposal for a pawnbroker for all seasons (PFAS) combines aspects of the dealer of last resort and narrow banking proposals. In particular, he would allow the central bank to lend against risky collateral, but only upon terms that are specified well in advance, and he would combine this policy with a restriction that all short-term unsecured liabilities of a bank must be backed by a combination of cash, central bank reserves, and the committed central bank credit line.

King motivates his proposal as an improvement over the traditional lender of last resort, which he (like Ricks) views as suffering from a time inconsistency problem: “The essential problem with the traditional LOLR is that, in the presence of alchemy, the only way to provide sufficient liquidity in a crisis is to lend against bad collateral – at inadequate haircuts and low or zero penalty rates. Announcing in advance that it will follow Bagehot’s rule … will not prevent a central bank from wanting to deviate from it once a crisis hits. Anticipating that, banks have every incentive to run down their holdings of liquid assets” (p. 269). But in contrast to some proponents of an expansive lender of last resort, King argues that moral hazard concerns must be addressed ex ante: “It is not enough to respond to the crisis by throwing money at the system … ensuring that banks face incentives to prepare in normal times for access to liquidity in bad times matters just as much” (p. 270).

Specifically, under King’s proposal, as under the dealer of last resort, the central bank provides liquidity against risky assets and does so subject to a haircut, but importantly the PFAS would not just specify the haircut in advance, but would specify it with the expectation of not changing it for years (p. 277). Thus, the first step of the PFAS proposal is that assets must be pre-positioned as collateral for a specific loan amount. The second step of the proposal caps the short-term unsecured debt of the bank by the sum of the cash, the central bank reserves held by the bank, and the amount that the bank can draw from the central bank on the basis of pre-positioned collateral (p. 272). “The scheme would apply to all financial intermediaries, banks and shadow banks, which issued unsecured debt with a  maturity of less than one year above a de minimis proportion of the balance sheet” (p. 274).

King’s proposal addresses two important design concerns. First, even though banks can create money, “only the central bank can create liquidity” or “the ultimate form of money” (pp. 190, 259). For this reason, King finds that “liquidity regulation has to be seamlessly integrated with a central bank’s function as the lender of last resort” (p. 259).[10] This is achieved by using the credit line commitment of the central bank as a determinant of the cap on a bank’s runnable assets. Second, when a central bank increases its collateralized lending to a bank, the bank’s unsecured lenders are disadvantaged and this form of central bank liquidity support can have the effect of reducing the availability of – or even generating a run on – unsecured market-based lending to the bank. For this reason what is needed is a “single integrated framework within which to analyze the provision of money by central banks in both good time and bad times” (p. 208). Because unsecured lenders will know in advance that the pre-positioned collateral will be used to draw from the central bank, they will not expect it to be available to support their own claims and will demand to be paid a rate on the unsecured debt that compensates them for this fact.

This proposal achieves stability in much the same way that narrow banking does: “all deposits are backed by either actual cash or a guaranteed contingent claim on reserves at the central bank” (p. 271). Unlike Cochrane’s narrow banking, however, only indirect control is exercised over the bank’s asset portfolio. In comparison with Morgan Ricks’ proposal, the public guarantee is provided not with respect to the liabilities of a bank but instead with reference to its assets, and it is the central bank – or the ultimate provider of liquidity – not bank regulators who will make the decisions that affect the bank’s asset portfolio.

The issue of the degree of control exercised by the PFAS is, in fact, an interesting question. One of King’s goals is to “design a system which in effect imposes a tax on the degree of alchemy in our financial system” (p. 271). While each bank nominally is left to determine how to allocate its asset portfolio, the central bank has almost total control over how the tax is structured and, in particular, over which assets will be highly taxed and which will not. According to King the central bank “should be conservative when setting haircuts and, if in doubt, err on the high side. … on some assets they may well be 100%. … It is not the role of central banks to subsidize the existence of markets that would not otherwise exist” (p. 277-78). At least to the degree that a financial intermediary finances itself with deposits and other forms of unsecured short-term debt, it would appear that the PFAS will exercise a great deal of control over the assets that are thus financed.

Unsurprisingly End of Alchemy includes a robust defense of central bank discretion (p. 167). Thus, whether or not this proposal is subject to Ricks’ criticism of narrow banking as serving as an excessive constraint on the money supply will depend on the decisions of central bankers and how they exercise the control over the banking system granted to them by the PFAS proposal.

Solution: Controls on credit

Control over the types of assets that are financed by bank credit creation is also the solution that Adair Turner proposes. It is Turner who advocates most strongly for the view that “too much debt” explains the increasing instability of modern economies. Thus, for Turner “the amount of credit created and its allocation is too important to be left to the bankers; nor can it be left to free markets in securitized credit” (p. 104); instead it is necessary for bank regulators to control the growth of credit. Turner argues more specifically that the most important driving force behind instability was the “interaction between the potentially limitless supply of bank credit and the highly inelastic supply of real estate and locationally specific land. … Credit and real estate price cycles … are close to the whole story [of financial instability in advanced economies]” (p. 175).

Thus, Turner proposes that bank regulation should directly constrain certain types of finance including lending against real estate and shadow banking (p. 195). He would also constrain borrowers’ access to credit and slow international capital flows, which when they took the form of short-term debt simply increased the excess of funds flowing into “hot” real estate markets (p. 196).

Constraints on shadow banking are necessary because in the run-up to the recent crisis it had the effect of “turbocharg[ing] the [credit] cycle, [and] increasing the danger of the wrong sort of debt” (p. 90). Like Ricks and King (p. 94), Turner emphasizes that it was shadow banks that caused bank funding markets to seize up when “wholesale secured funding markets went into a meltdown driven by the very risk management tools that were supposed to make them safe” (p. 103).

While Adair Turner does not promote any version of narrow banking, he draws inspiration from narrow banking’s vision of a system where financial assets are financed by equity. Because “in principle the more that contracts take an equity and not a debt form, the more stable the economy will be,” “implicit taxes on credit creation can be a good thing” (p. 192) and “free market approaches to [credit markets] are simply not valid” (p. 190).

Turner’s focus is, however, very different. Whereas John Cochrane argues that there is no need to differentiate between the different types of credit markets (p. 213), Turner emphasizes the importance of the real estate market: Nowadays “most bank lending … finances the purchase of real estate. … [This] also reflects a bias for banks to prefer to lend against the security of real estate assets … [which] seems to simplify risk assessment” (p. 71). As “banks, unless constrained by policy, have an infinite capacity to create credit, money, and purchasing power … [this combination results in] credit and asset price cycles [that] are not just part of the story of financial instability in modern economies, they are its very essence” (p. 73).

Overall, Turner’s bottom line is that “we should not intervene in the allocation of credit to specific individuals or businesses, but we must constrain the overall quantity of credit and lean against the free market’s potentially harmful bias toward the ‘speculative’ finance of existing assets.” This policy “does not mean less growth, since a large proportion of credit is not essential to economic growth” (p. 208).

Conclusion

Discussions of financial stability and how to achieve it are characterized by a remarkable breadth of views. At one extreme are those who believe that modern finance is here to stay and that its stabilization requires a lender of last resort which plays a much expansive role than in the past. Critics of this approach argue that on the contrary, the expansion of the lender of last resort’s responsibilities over the course of the last three or four decades is what generated the modern financial system which is so very unstable.

Some of these critics of the modern financial system emphasize the liquidity problems it generates and others the solvency problems. All, however, are in agreement that, if financial stability is the goal, substantial reform of the modern financial system is necessary.

Proponents of the solvency view explain that the design of the modern financial system is so flawed that the origination of too much debt is a structural problem. As a result proponents of the solvency view find that either regulators or the central bank must constrain the capacity of all financial intermediaries to finance certain forms of debt – and real estate loans, in particular – using short-term instruments.

The proponents of the liquidity view who propose transformational reform of the financial system argue that only government backing of short-term liabilities can stabilize them. They differ on the degree to which banks have a role to play in a reformed financial system, however. And the comparison of these proposals leads me to conclude that we are in desperate need of better – formal, economic – models of money and banking in order to evaluate these questions.

So what’s my bottom line? I’ve been working on a model of money, bank liabilities, and private sector debt that speaks to all these issues. This model demonstrates that banks’ economic function is to underwrite the unsecured debt that makes the payments system work. By doing so banks bring agents who would otherwise be anonymous and autarkic into the economy. In effect, banks are paid enforcers of intertemporal budget constraints – and it is only because they provide this service that you and I can participate in the payments system and therefore in a modern economy. In short, I think we need a “banking school” model to help us tackle these problems. (Warning to Friedmanites: banking school is the devil that it was Friedman’s agenda to exterminate.) The details will, however, have to wait for another day.

[1] While Hal Scott’s opus has been described as showing “that none of the banks that fell or were rescued were important enough to another big institution to cause its failure” (Authers 2016), this fails to address the question of whether the whole system was beset by too much debt. The danger to the financial system of a “bad equilibrium” in which every participant underwrites too much debt has been recognized for decades (Goodhart 1988 p. 48).

[2] He writes: “this chapter offers reason to doubt that debt-fueled bubbles and the like pose a grave threat to the real economy in the absence of a panic” (p. 106) and “my claim is not that debt-fueled bubbles are insignificant … Rather, my claim is that panics appear to pose a far graver threat to the broader economy” (p. 141). This certainly seems to imply that is possible to have debt-fueled bubbles without also having a panic.

[3] In an interview Geithner states: “What’s unique about panics, and most dangerous, is the amount of collateral damage they do to the innocent, to people who had borrowed responsibly, who weren’t overexposed. The banking system is the lifeblood of the economy. It’s like the power grid. You have to make sure the lights stay on, because if the lights go out, then you face the damage like what you saw in the Great Depression … That requires doing things that are terribly unfair and look deeply offensive. It looks like you are rewarding the arsonist or protecting people from their mistakes, but there is no alternative. We didn’t do it for the banks. We did it to protect people from the failures of banks” (Wessel 2014).

[4] For a view of the lender of last resort which is more nuanced see Sissoko 2016. In fact, the origins of the term “lender of last resort” itself indicates that the central bank is rightly the “court of last appeal” which makes the ultimate determination of whether a financial firm is solvent or not. Implicit in the moniker is the idea that central banks should sometimes uphold the market’s death sentence for a financial firm – just as courts must sometimes uphold real-life death sentences (Sissoko 2014).

[5] Cochrane’s dry comment on the expansion of policy to the regulation of prices is: “What did the old lady eat after the horse?” (p. 238).

[6] This is unsurprising given that almost all modern academic analyses of money, including the heterodox literature, also emphasize the role of government in the money supply. Whether or not this consensus is well-founded is a topic for a different post.

[7] Perhaps Cochrane’s view of the capacity of markets to provide liquidity has changed in recent years. He writes in an October 2016 essay titled Volume and Information: “Information seems to need trades to percolate into prices. We just don’t understand why.” which would seem to imply that markets both demand liquidity and provide it.

[8] Indeed, this is clearly Morgan Ricks agenda (see p. 210). The weakness of Ricks’ approach is that he is a legal scholar and the agenda calls for formal economic analysis.

[9] Note that Turner and Wolf both agree that current account imbalances played an important role in generating the asset price bubbles.

[10] Here King is apparently questioning whether the liquidity coverage ratio specified by the Basel III accords makes sense.

Growth and financial instability: Schumpeter’s hypothesis

I have taken my own advice and read (most of) Schumpeter’s Business Cycles with some care. He has completely blown my mind — and I am left bewildered by how it is possible that this body of work has been all but forgotten.

All the elements of what is now known as the Kindleberger-Minsky model of financial crises were present in Chapter IV of Schumpeter’s Business Cycles, and indeed Minsky cites his advisor as an important source for the financial instability hypothesis.

There is a crucial aspect of Schumpeter’s analysis that is, however, typically omitted from discussions of “Minsky moments.” Schumpeter separated out the “displacement” and “boom” phases of crises as fundamentally productive phenomena: displacement is naturally caused when a transformative innovation is funded by credit creation through the financial system and a boom is the inevitable result. Thus, Schumpeter is careful to construct his argument so that there is no doubt that we need the financial system to create credit. Credit creation ensures that growth due to innovation is accompanied by growth in the money supply, and thus that innovation does not result in deflation.

In short, for Schumpeter displacements and booms are an essential part of the process by which innovation drives economic growth.

Unfortunately the same financial system that creates credit to fund innovation, also creates credit to fund many other activities, including the finance of inventories, expansion of existing businesses, and consumption, all of which appear initially to be justified by the dynamics of the boom, but which in the end cause the economy to overheat. Kindleberger calls this phenomenon “overtrading.” The counterpart to an overheated economy is bad debt. As this economy works through the bad debt, “abnormal” liquidation takes place and “destroys many things which could and would have survived without it. In particular, it often liquidates and weeds out firms which do not command adequate financial support, however sound their business may be.” 155. When the economic circumstances are particularly adverse, debt deflation can set in and cause a depression. This is the stage that Kindleberger named “revulsion.”

Overall, Schumpeter didn’t just describe the dynamics of bubble, he also argued that there was a close connection between these dynamics and the capacity of an economy to take advantage of innovation and to grow. In the process, he concluded that almost every economic “catastrophe” can be attributed to dysfunction in the banking sector – and in particular to a failure on the part of bank lenders and business borrowers to exert appropriate control on the use of credit.

Schumpeter’s error presumably was to acknowledge that it was beyond the scope of economic theory to determine how to discipline the banking and business communities in their use of credit. 156. Thus, the intellectual debates of the middle of the 20th were dominated by economic theorists who could offer simpler answers (spend money, increase the money supply) to extraordinarily complex problems.