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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

pe funds.pdf

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

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

hedge funds

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Links [to be updated]

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

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

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

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

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

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

 

 

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.

Brokers, dealers and the regulation of markets: Applying finreg to the giant tech platforms

Frank Pasquale (h/t Steve Waldman) offers an interesting approach to dealing with the giant tech firms’ privileged access to data: he contrasts a Jeffersonian — “just break ’em up” approach — with a Hamiltonian — regulate them as natural monopolies approach. Although Pasquale favors the Hamiltonian approach, he opens his essay by discussing Hayekian prices. Hayekian prices simultaneously aggregate distributed knowledge about the object sold and summarize it, reflecting the essential information that the individuals trading in the market need to know. While gigantic firms are alternate way of aggregating data, there is little reason to believe that they could possibly produce the benefits of Hayekian prices, the whole point of which is to publicize for each good a specific and extremely important summary statistic, the competitive price.

Pasquale’s framing brings to mind an interest parallel with the history of financial markets. Financial markets have for centuries been centralized in stock/bond and commodities exchanges, because it was widely understood that price discovery works best when everyone trades at a single location. The single location by drawing almost all market activity offers both “liquidity” and the best prices. The dealers on these markets have always been recognized as having a privileged position because of their superior access to information about what’s going on in the market.

One way to understand Google, Amazon, and Facebook is that they are acting as dealers in a broader economic marketplace. That with their superior knowledge about supply and demand they have an ability to extract gains that is perfectly analogous to dealers in financial markets.

Given this framing, it’s worth revisiting one of the most effective ways of regulating financial markets: a simple, but strict, application of a branch of common law, the law of agency was applied to the regulation of the London Stock Exchange from the mid-1800s through the 1986 “Big Bang.” It was remarkably effective at both controlling conflicts of interest and producing stable prices, but post World War II was overshadowed and eclipsed by the conflict-of-interest-dominated U.S. markets. In the “Big Bang” British markets embraced the conflicted financial markets model — posing a regulatory challenge which was recognized at the time (see Christopher McMahon 1985), but was never really addressed.

The basic principles of traditional common law market regulation are as follows. When a consumer seeks to trade in a market, the consumer is presumed to be uninformed and to need the help of an agent. Thus, access to the market is through agents, called brokers. Because a broker is a consumer’s agent, the broker cannot trade directly with the consumer. Trading directly with the consumer would mean that the broker’s interests are directly adverse to those of the consumer, and this conflict of interest is viewed by the law as interfering with the broker’s ability to act an agent. (Such conflicts can be waived by the consumer, but in early 20th century British financial markets were generally not waived.)

A broker’s job is to help the consumer find the best terms offered by a dealer. Because dealers buy and sell, they are prohibited from acting as the agents of the consumers — and in general prohibited from interacting with them directly at all. Brokers force dealers to offer their clients good deals by demanding two-sided quotes and only after learning both the bid and the ask, revealing whether their client’s order is a buy or a sell. Brokers also typically get bids from different dealers to make sure that the the prices on offer are competitive.

Brokers and dealers are strictly prohibited from belonging to the same firm or otherwise working in concert. The validity of the price setting mechanism is based on the bright line drawn between the different functions of brokers and of dealers.

Note that this system was never used in the U.S., where the law of agency with respect to financial markets was interpreted very differently, and where financial markets were beset by conflicts of interest from their earliest origins. Thus, it was in the U.S. that the fixed fees paid to brokers were first criticized as anti-competitive and eventually eliminated. In Britain the elimination of fixed fees reduced the costs faced by large traders, but not those faced by small traders (Sissoko 2017). By adversely affecting the quality of the price setting mechanism, the actual costs to traders of eliminating the structured broker-dealer interaction was hidden. We now have markets beset by “flash-crashes,” “whales,” cancelled orders, 2-tier data services, etc. In short, our market structure instead of being designed to control information asymmetry, is extremely permissive of the exploitation of information asymmetry.

So what lessons can we draw from the structured broker-dealer interaction model of regulating financial markets? Maybe we should think about regulating Google, Amazon, and Facebook so that they have to choose between either being the agents in legal terms of those whose data they collect, or of being sellers of products (or agents of these sellers) and having no access to buyer’s data.

In short, access to customer data should be tied to agency obligations with respect to that data. Firms with access to such data can provide services to consumers that help them negotiate a good deal with the sellers of products that they are interested in, but their revenue should come solely from the fees that they charge to consumers on their purchases. They should not be able to either act as sellers themselves or to make any side deals with sellers.

This is the best way of protecting a Hayekian price formation process by making sure that the information that causes prices to move is the flow of buy or sell orders that is generated by a dealer making two-sided markets and choosing a certain price point. And concurrently by allowing individuals to make their decisions in light of the prices they face. Such competitive pricing has the benefit of ensuring that prices are informative and useful for coordinating economic decision making.

When prices are not set by dealers who are forced to make two-sided markets and who are given no information about the nature of the trader, but instead prices are set by hyper-informed market participants, prices stop having the meaning attributed to them by standard economic models. In fact, given asymmetric information trade itself can easily degenerate away from the win-win ideal of economic models into a means of extracting value from the uninformed, as has been demonstrated time and again both in theory and in practice.

Pasquale’s claim that regulators need to permit “good” trade on asymmetric information (that which “actually helps solve real-world problems”) and prevent “bad” trade on asymmetric information (that which constitutes “the mere accumulation of bargaining power and leverage”) seems fantastic. How is any regulator to have the omniscience to draw these distinctions? Or does the “mere” in the latter case indicate the good case is to be presumed by default?

Overall, it’s hard to imagine a means of regulating informational behemoths like Google, Amazon and Facebook that favors Hayekian prices without also destroying entirely their current business models. Even if the Hamiltonian path of regulating the beasts is chosen, the economics of information would direct regulators to attach agency obligations to the collection of consumer data, and with those obligations to prevent the monetization of that data except by means of fees charged to the consumer for helping them find the best prices for their purchases.

The 19th c. bank “bailout” that never happened

I’ve just read Eugene White’s Bank Underground post on the Baring liquidation in 1890. He is notable in getting the facts of what he calls the “rescue” mostly right. He accurately portrays the “good bank-bad bank” structure and the fact that the partners who owned the original bank bore the losses of the failure. What he doesn’t explain clearly is the degree to which the central bank demanded insurance from the private sector banks before agreeing to extend a credit line that would allow the liquidation of the bad bank to take place slowly.

These facts matter, because a good central banker has to make sure that the incentives faced by those in the financial community are properly aligned. In the case of Barings macroeconomic incentives were aligned by making it clear to the private banks that when a SIFI fails, the private banking sector will be forced to bear the losses of that failure. This brings every bank on board to the agenda of making sure the financial system is safely structured.

In the 19th c. the Bank of England understood that few things could be more destabilizing to the financial system than the expectation that the government or the central bank was willing to bear the losses of a SIFI failure. Thus, the Bank of England protected the financial system from the liquidity consequences of a fire sale due to the SIFI, but was very careful not to take on more than a small fraction (less than 6%) of the credit losses that would be created by the SIFI failure.

This is the comment I posted:

While this is one of the better discussions of the 1890 Barings liquidation, for some reason modern economic historians have a lot of difficulty acknowledging the degree to which moral hazard concerns drove central bank conduct in the 19th c. White writes:

The Barings rescue or “lifeboat” was announced on Saturday November 15, 1890. The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities. A four-year syndicate of banks would ratably share any loss from Barings’ liquidation. The guarantee fund of £17.1 million included all institutions, and some of the largest shares were assigned to banks whose inattentive lending had permitted Barings to swell its portfolio.

Clapham (cited by White), however makes it clear that the way the Bank of England drummed up support for the guarantee fund was by making a very credible threat to let Barings fail. Far from what is implied by the statement “The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities”, the Bank of England point blank refused to provide such an advance until and unless the guarantee fund was funded by private sector banks to protect the central bank from losses, Clapham p. 332-33.

In short, treating the £7.5 million (which is actually the maximum liability supported by the guarantee fund over a period of four years, Clapham p. 336) as a Bank of England advance may be technically correct because of the legal structure of the guarantee fund (which was managed by the Bank), but gets the economics of the situation dead wrong.

19th century and early 20th century British growth could only take place in an environment where central bankers in London were obsessed with the twin problems of aligning incentives and controlling moral hazard. Historians who pretend that anything else was the case are fostering very dangerous behavior in our current economic climate.

Note: Updated to make the last paragraph specific to Britain.

Lenders of Last Resort have duties in normal times too

I have a paper forthcoming in the Financial History Review that studies the role played by the Bank of England in the London money market at the turn of the 20th century. The Bank of England in this period is, of course, the archetype of a lender of last resort, so its activities shed light on what precisely it is that a lender of last resort does.

The most important implication of my study is that the standard understanding of what a lender of last resort does gets the Bank’s role precisely backwards. It is often claimed that the way that a lender of last resort functions is to make assets safe by standing ready to lend against them.

My study of the Bank of England makes it clear, however, that the duties of a lender of last resort go far beyond simply lending against assets to make them safe. What the Bank of England was doing was monitoring the whole of the money market, including the balance sheets of the principal banks that guaranteed the value of money market assets, to ensure that the assets that the Bank was engaged to support were of such high quality that it would be a good business decision for the Bank to support them.

In short, a lender of last resort does not just function in a crisis. A lender of last resort plays a crucial role in normal times of ensuring that the quality of assets that are eligible for last resort lending have an extremely low risk of default. This function of the central bank was known as “qualitative control” (although of course quantitative measures were used to predict when quality was in decline).

Overall, if we take the Bank of England as our model of a lender of last resort, then we must recognize that that the duty of such a lender is not just to lend, but also to constantly monitor the money market and limit the assets that trade on the money market to those that are of such high quality that when they are brought to the central bank in a crisis, it will be a good business decision for the bank to support them.

A central bank that fails to exercise this kind of control over the money market, can expect in a crisis to be forced, as the Fed was in 2008, to support the value of all kinds of assets that it does not have the capacity to value itself.

Note: the forthcoming paper is a new and much improved version of this paper.

An egregious error on the history of central bank actions in crises

Brad DeLong, who is a brilliant economic historian and whose work I greatly respect, has really mistaken his facts with respect to the history of the Bank of England. And in no small part because DeLong is so respected and so deserving of respect, this post is pure siwoti.

DeLong writes: “central banks are government-chartered corporations rather than government agencies precisely to give them additional freedom of action. Corporations can and do do things that are ultra vires. Governments then either sanction them, or decide not to. During British financial crises of the nineteenth century, the Bank of England repeatedly violated the terms of its 1844 charter restricting its powers to print bank notes. The Chancellor the Exchequer would then not take any steps in response to sanction it.”

DeLong gets the facts precisely backwards. In 19th century crises prior to any breach of the 1844 Act, the Act was suspended by the British government, which promised to indemnify the Bank for legal liability for any breach of the restrictions in the 1844 Act. The text of the 1847 letter was published in the Annual Register and was the model for subsequent letters. It read:

”Her Majesty’s Government have come to the conclusion that the time has arrived when they ought to attempt, by some extraordinary and temporary measure, to restore confidence to the mercantile and manufacturing community; for this purpose they recommend to the Directors of the Bank of England, in the present emergency, to enlarge the amount of their discounts and advances upon approved security, but that in order to retain this operation within reasonable limits, a high rate of interest should be charged. In present circumstances they would suggest, that the rate of interest should not be less than 8 per cent. If this course should lead to any infringement of the existing law, her Majesty’s Government will be prepared to propose to Parliament, on its meeting, a bill of indemnity. ”

In the kabuki show that took place during each of these events, the Bank typically denied that action on the part of the government was necessary. In 1847 it was the mercantile community that depended for existence on the support of the Bank, which sent a delegation to Downing Street to ask that the 1844 Act be suspended (Clapham, II, 208-09). Thus, the Bank most certainly did not act ultra vires. Instead, the terms of its charter were explicitly relaxed by the government each and every time the Bank breached the terms of the 1844 Act.

The relevant part of the 1857 Bill of Indemnity reads:

“the said Governor and Company, and all Persons who have been concerned in such Issues or in doing or advising any such Acts as aforesaid, are hereby indemnified and discharged in respect thereof, and all Indictments and Informations, Actions, Suits, Prosecutions, and Proceedings whatsoever commenced or to be commenced against the said Governor and Company or any Person or Persons in relation to the Acts or Matter aforesaid, or any of them, are hereby discharged and made void.” (See R.H. Inglis Palgrave, Bank Rate and the Money Market, 1903 p. 92)

In short, far from delegating to the central bank the authority to make the decision to take ultra vires actions, the Chancellor of the Exchequer and the Prime Minister were important participants in every single crisis — and they signed off on extraordinary actions by the Bank, before the Bank’s actions were taken.

Indeed, to the degree that the Bank issued notes beyond the constraints of the 1844 Act, the government was paid the profits from the issue of those notes. Effectively this was the quid pro quo for the government’s indemnity of the Bank. (See e.g., George Udny, Letter to the Secretary of State for India dated January 1861 pp. 25-26).

Note: updated 8-3-15 3:25 pm PST.

“Real bills” banking prevented Minsky moments

The “real bills” approach to banking is profoundly misunderstood, as I explain in this paper. What I’ve just recently realized is that Minsky’s financial instability hypothesis is probably derived from real bills. In particular, Minsky cites Schumpeter, who was I believe familiar with contemporary banking theory.

A real bill is a short-term loan that arises out of a commercial transaction. These bills circulated as money in the commercial cities of Europe in the 17th and 18th centuries because banks stood ready to buy the bills. In accounting terms a real bill monetizes an asset that is earned, but not yet realized. What very few modern writers understand is that if a bank, instead of demanding payment on a real bill, rolls it over, the resulting line of credit is not a real bill. There are many names for this kind of loan including fictitious bill, accommodation bill, and finance bill. Finance bill is the term that stuck and lasted into the 20th century.

Limiting credit to real bills is very constricting, so in Britain finance bills were made negotiable (so they too could circulate easily as money) in the 1830s. Through a series of subsequent crises Britain learned about the dangers of zombie banks and loose credit more generally. By the third quarter of the 19th century, however, the Bank of England had learned how to manage the brave new world of finance bills, and Britain experienced a century of banking stability.

What was the key to banking stability in Britain? The principle that money market instruments should not be used to (i) finance the purchase and carry of capital market assets (or land) or (ii) be rolled over to such a degree that they were effectively playing the same role as an equity stake in a firm. This is the real “real bills” approach to banking.

What I’ve just realized is that the same principle underlies Minsky’s financial instability hypothesis (probably through Schumpeter). In fact, when the early Fed was worried about credit markets, it discusses the problem of an excessive growth of speculative bills. (See the Fed’s 10th annual report.) And the Fed uses the term “speculative” in exactly the same sense that Minsky does.

Recall that Minsky defines three types of finance:

Hedge finance takes place when the borrower is able to pay both interest and principal out of cash flows. This is not destabilizing.

Speculative finance takes place when the borrower only has expectations of paying interest on the loan and thus the loan has to be rolled over repeatedly. Just like the Fed in 1923, Minsky argued that the growth of speculative finance was a sign of destabilization building up in the economy.

Ponzi finance takes place when the borrower’s cash flow leaves the borrower unable even to pay interest, so the borrower must either sell assets or rely on increases in asset value together with new loans to stay current on the debt. Minsky argued that this is what is going on right before a crash.

Overall, the real bills approach to managing the banking system should be understood as a policy of controlling the growth of speculative and Ponzi finance in the economy. The evidence indicates that the Bank of England was actually very good at doing this for many, many years.

A Counterproposal to “Shifts and Shocks”

Martin Wolf in Shifts and Shocks does a remarkable job of taking a comprehensive view of all the moving parts that have played a role in creating our current financial malaise and ongoing risks to financial stability. He also does a wonderful job of laying them out clearly for readers. Furthermore, I am entirely convinced by his diagnosis and prognoses of the Eurozone’s problems. When it comes to the question of the financial system more generally, however, even though I’m convinced that Wolf understands the symptoms, I don’t think he’s on target with either his diagnosis or his solutions. In fact, I think he too shows signs of being hampered by the problem of intellectual orthodoxy.

This post is therefore going to combine commentary on Shifts and Shocks with an introduction to my own views of how to understand the boondoggle that is the modern financial system. (I have nothing to say about the Eurozone’s grief except that you should read what Martin Wolf has to say about it.) For the long form of my views on the structural reform of the financial system, see here.

First, let me lay out the many things that Wolf gets right about the financial system.

  • The intellectual failures are accurately described:
    • orthodox economics failed to take into account the banking system’s role in creating credit, and thus failed to understand the instability that was building up in the system.
    • this has led to a dysfunctional and destabilizing relationship between the state and the private sector as suppliers of money
  • His basic conclusion is correct:
    • the system is designed to fail because banks finance long-term, risky and often illiquid assets with short-term, safe and highly liquid liabilities.
  • The inadequacy of the solutions currently being pursued is also made clear. Combining macro-prudential policy and “unlimited crisis intervention” with resolution authorities
    • just worsens the dysfunctional relationship between the state and the private sector
    • forces rulemaking that is designed to preserve a system that the regulators don’t trust and that is so complex it is “virtually inconceivable that it will work” (234)
  • His focus on the need for more government expenditure to support demand instead of attempts to induce the private sector to lever up yet again is correct.
  • The key takeaways from his conclusion are also entirely correct (349)
    • The insouciant position – that we should let the pre-crisis way of running the world economy and the financial system continue – is grotesquely dangerous.”
    • “leveraging up existing assets is just not a particularly valuable thing to do; it creates fragility, but little, if any, real new wealth.”

I think Wolf makes a mistaking in diagnosing the problem, however. One can view our current financial system as simply exhibiting the instability inherent in all modern economies (a la Minsky), or as exhibiting an unprecedented measure of instability even taking Minsky into account, or something in between. Wolf takes the hybrid position that while the basic sources of instability have been present in financial systems since time immemorial, “given contemporary information and communication technologies, modern financial innovations and globalization, the capacity of the system to generate complexity and fragility, surpasses anything seen historically, in its scope, scale and speed.” (321) This, I believe, is where the argument goes wrong.

To those familiar with financial history the complete collapse of a banking system is not a particularly unusual phenomenon. The banking system collapsed in Antwerp in the mid-15th century, in Venice in the late 16th century, in France in the early 18th century, and in Holland in the late 18th century. What is remarkable about 19th and 20th century banking is not its instability, but its lack of total collapse.

Indeed, the remarkable stability of the British banking system was founded in part on the analysis of the reasons behind 18th century financial instability on the continent. (There is no important British banking theorist who does not mention John Law and his misadventures in France.)  In particular, a basic principle of banking used to be that money market assets — and bank liabilities — should not finance long-term assets; capital markets should have the limited liquidity that derives from buyers and sellers meeting in a market. Thus, when Wolf finds that our modern system is “designed to fail” because money market assets are financing risky long-term assets, and that market liquidity is a dangerous illusion that breeds overconfidence and is sure to disappear when it is most needed (344), he is simply rediscovering centuries-old principles of what banks should not do.

By arguing that the structural flaws of modern finance are as common to the past as to the present, Wolf embraces the modern intellectual orthodoxy and sets up his radical solution: that our only option for structural reform that stabilizes banking is to take away from banks the ability to lend to the private sector and require that all debt be equity-financed. Thus, Wolf obfuscates the fact that the 19th and 20th century solution to banking instability was to limit the types of lending to the private sector that banks were allowed to engage in. Britain had a long run of success with such policies, as did the U.S. from the mid-1930s to the 1980s. (Recall that the S&Ls were set up in no small part to insulate the commercial banks from the dangers of mortgage lending — as a result the S&L crisis was expensive, but did not destabilize the commercial banks, and was compared to 2007-08 a minor crisis.) Thus, there is another option for structural reform — to stop viewing debt as a single aggregate and start analyzing which types of bank lending are extremely destabilizing and which are not.

The real flaw, however, in Wolf’s analysis is that he doesn’t have a model for why banking lending is important to the economy. Thus, when he acknowledges that it is possible that the benefits of “economic dynamism” due to banking exceed the massive risks that it creates (212-13), he doesn’t have a good explanation for what those benefits are. As a result, Wolf too is intellectually constrained by the poverty of modern banking theory.

19th c. bankers were far less confused about the benefits of banking. When everybody is willing to hold bank liabilities, banks have the ability to eliminate the liquidity constraints that prevent economic activity from taking place. The merchant who doesn’t have enough capital to buy at point A everything he can sell at point B, just needs a line of credit from the bank to optimize his business activities. This problem is ubiquitous and short-term lending by banks can solve it. Furthermore, because they solve it by expanding the money supply, and not by sourcing funds from long-term lenders, the amount of money available to borrow can easily expand. Of course, there are problems with business cycles and the fact that the incentives faced by banks need to be constantly monitored and maintained, but these are minor issues compared with the asset price bubbles that are created when banks get into long-term lending and that destabilized the financial system in 2007-08.

Overall, banks can do a lot to improve economic efficiency without getting into the business of long-term lending. And a recipe for financial stability should focus on making sure that long-term lending, not all bank lending, is funded by equity.

Notes on the History of Monetary Thought

I’m working on a series of papers on traditional banking theory as an alternative framework for understanding the relationship between banking, finance and the macroeconomy, (part 1 is here) and in this post I’m just jotting down some thoughts on the history of economic thought.

As my papers argue by the early 20th century there was a fairly coherent theory of the relationship between banking, economic activity, the price level, and the guidance of these factors using the central bank policy rate — I call this “traditional banking theory.” With the growth of the “quantity (of money) theorists,” this school was sometimes described as “qualitative,” but it’s proponents pointed out (Beckhart, AER 1940) that the two schools didn’t differ in the importance they placed on the use of data, but rather in the value of using aggregate quantities to determine policy.

There are two points to make here:

After the Depression (and I believe massive policy influence in the 1930s), this traditional school of monetary thought was entirely displaced by two aggregate theory approaches: Monetarists and Keynesians. The histories I am familiar with focused on the debate between the two macro schools and the view that macro cannot be understood without a micro-understanding of debt disappeared from academic discourse. (I still don’t understand how this happened, but maybe the “invention” of macro played a role in it.)

Traditional banking theory didn’t really disappear. Instead it became part of the vast gulf that developed between market practitioners and academic theorists. For example, Marcia Stigum’s Money Market, a textbook written based on interviews with practitioners, reflects aspects of traditional banking theory.