When can banks create their own capital?

A commenter directed me to an excellent article by Richard Werner comparing three different approaches to banking. The first two are commonly found in the economics literature, and the third is the credit creation theory of banking. Werner’s article provides a very good analysis of the three approaches, and weighs in heavily in favor of the credit creation theory.

Werner points out that when regulators use the wrong model, they inadvertently allow banks to do things that they should not be allowed to do. More precisely, Werner finds that when regulators try to impose capital constraints on banks without understanding how banks function, they leave open the possibility that the banks find a way to create capital “out of thin air,” which clearly is not the regulator’s intent.

In this post I want to point out that Werner does not give the best example of how banks can sometimes create their own capital. I offer two more examples of how banks created their own capital in the years leading up to the crisis.

1. The SIVs that blew up in 2007

You may remember Hank Paulson running around Europe in the early fall of 2007 trying to drum up support for something called the Master Liquidity Enhancement Conduit (MLEC) or more simply the Super-SIV. He was trying to address the problem that structured vehicles called SIVs were blowing up left, right, and center at the time.

These vehicles were essentially ways for banks to create capital.  Here’s how:

According to a Bear Stearns report at the time, 43% of the assets in the SIVs were bank debt, and commentators a the time make it clear that the kind of bank debt in the SIVs was a special kind of debt that was acceptable as capital for the purposes of bank capital requirements because of the strong rights given to the issuer to forgo making interest payments on the debt.

The liability side of a SIV was comprised of 4-6% equity and the rest senior liabilities, Medium Term Notes (MTNs) of a few years maturity and Commercial Paper (CP) that had to be refinanced every few months. Obviously SIVs had roll-over (or liquidity) risk, since their assets were much longer than their liabilities. The rating agencies addressed this roll-over risk by requiring the SIVs to have access to a liquidity facility provided by  a bank. More precisely the reason a SIV shadow bank was allowed to exist was because there was a highly rated traditional bank that had a contractual commitment to provide funds to the SIV on a same-day basis in the event that the liquidity risk was realized. Furthermore, triggers in the structured vehicle’s paperwork required it to go into wind down mode if, for example, the value of its assets fell below a certain threshold. All the SIVs breached their triggers in Fall 2007.

Those with an understanding of the credit creation theory of banking would recognize immediately that the “liquidity facility” provided by the traditional bank was a classic way for a bank to transform the SIV’s liabilities into monetary assets. That’s why money market funds and others seeking very liquid assets were willing to hold SIV CP and MTNs. In short, a basic understanding of an SIV asset and liability structure and of the banks’ relationship to it would have been a red flag to a regulator conversant with the credit creation theory that banks were literally creating their own capital.

2. The pre-2007 US Federal Home Loan Bank (FHLB) System

In the early naughties all of the FHLBs revised their capital plans. For someone with an understanding of the credit creation theory, these capital plans were clearly consistent with virtually unlimited finance of mortgages.

The FHLBs form a system with a single regulator and together offer a joint guarantee of all FHLB liabilities. The FHLB system is one of the “agencies” that can easily raise money at low cost on public debt markets. Each FHLB covers a specific region of the country and is cooperatively owned by its member banks. In 2007 every major bank in the US was a member of the FHLB system. As a result, FHLB debt was effectively guaranteed by the whole of the US banking system. Once again using the credit creation theory, we find that the bank guarantee converted FHLB liabilities into monetary assets.

The basic structure of the FHLBs support of the mortgage market was this (note that I will frequently use the past tense, because I haven’t looked up what the current capital structure is and believe that it has changed):

The FHLBs faced a 4% capital requirement on their loans. Using the Atlanta FHLB’s capital plan as an example, we find that whenever a member bank borrowed from the Atlanta FHL bank, it was required to increase its capital contribution by 4.5% of the loan. This guaranteed that the Atlanta FHL bank could never fall foul of its 4% capital requirement — and that there was a virtually unlimited supply of funds available to finance mortgages in the US.

The only constraint exercised by FHLBs on this system was that they would not lend for the full value of any mortgage. Agency MBS faced a 5% haircut, private label MBS faced a minimum 10% haircut, and individual mortgages faced higher haircuts.

In short, the FHLB system was designed to make it possible for the FHLBs to be lenders of last resort to mortgage lenders. As long as a member bank’s assets were mortgages that qualified for FHL bank loans, credit was available for a bank that was in trouble.

The system was designed in the 1930s — by people who understood the credit creation theory of banking — to deliberately exclude commercial banks which financed commercial activity and whose last-resort lender was the Federal Reserve. Only when the FIRRE Act in 1989 was passed subsequent to the Savings and Loan crisis were commercial banks permitted to become FHLB members.

From a credit creation theory perspective this major shift in US bank regulation ensured that the full credit creation capacity of the commercial banking system was united with the US mortgage lending system making it possible for the FHLBs to create their own capital and use it to provide virtually unlimited funds to finance mortgage lending in the US.

 

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Missing the point on the “wages of sin”

Ryan Avent seeks to rebut Matt Klein on the issue of whether a popped real estate bubble must have adverse consequences on the economy as a whole. Afterall, as Avent points out the houses are built and in the worst case we can just let them rot and turn our efforts to gainful production. He “dreams of a day when the only people who suffer from money-losing investments are the money-losing investors.”

The problem with our reaction to the real estate bubble is that the “money-losing investors” haven’t lost their money (yet). The houses were built on debt and there are vast losses on that debt that have not yet been realized.  There’s no issue of morality here.  Someone has to take the losses.  It should have been the banks (who had vast exposure on second liens) and the mortgage investors. Instead, we’ve been protecting the financial sector by convincing people to continue making payments at bubble prices on their houses.  That’s the point of HAMP, the government modification program.

The “wages of sin” language is unfortunate, but the point that nothing good can come of prolonging the financial sector’s realization of its losses over a decade or more remains. The nature of debt means that losses must be realized — and this truth remains with or without moralistic framing.

Vast numbers of mortgagees still owe twice as much as their homes are worth are are continuing to make payments (in December 2012 30% of mortgagees in the crisis states were underwater, 4.7% of all mortgagees owed twice as much as their homes were worth) — in part because the payments have been temporarily reduced through HAMP and HAMP-like mods. These payments are going to support the banks and mortgage investors, who are currently accounting for these loans as though there are no losses (i.e. because payments are current). Instead of these individuals’ income being freed to circulate in the economy productively, this income is spent on preventing the realization of losses in the financial sector.

People who know economics generally assume that what is happening can’t happen, because it doesn’t make sense.  Any rational homeowner would walk away from a mortgage that’s the double the value of the home — and indeed sometime over the course of the 40 to 50 years that this debt is to be paid most likely the homeowners will choose to walk away. However, currently large chunks of U.S. income are being spent on preventing the realization of financial sector losses. I would say that it’s no coincidence that the overall economy is simultaneously remarkably weak.

Given how poorly our financial system is functioning when it comes to simply recognizing losses and moving on, Matt Klein may be right to ask: “Wouldn’t it be ironic if our unwillingness to punish reckless lenders for their sins crippled our economy for a generation?”

The macroeconomic case for principal reduction

Three Federal Reserve economists describe the case for principal reduction as follows:

The idea that a program to reduce principal balances on mortgage loans will cure the nation’s housing ills at little or no cost has been kicking around since the very early stages of the foreclosure crisis and refuses to die. … Why do so many wonks love principal reduction? Because they think principal reduction prevents foreclosures at no cost to anyone—not taxpayers, not banks, not shareholders, not borrowers.  It is the quintessential win-win or even win-win-win solution.

The logic of principal reduction is that in a foreclosure, a lender recovers at most the value of the house in question and typically far less. … In contrast, reducing the principal balance to equal the value of the house guarantees the lender at least the value of the house because the borrower now has positive equity and research shows that borrowers with positive equity don’t default. … Lenders could reduce principal and increase profits!

These economists assume that the argument in favor of principal reduction is founded on microeconomic principals — a search for the trade that creates the greatest economic surplus.  And, thus, they “disprove” the argument by questioning whether principal reduction is profitable for the lenders.

The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages.  … in this simple example, the lender will obtain more money by choosing to forgo principal reduction.  The obvious response is that the optimal policy should be to offer principal reduction to [the borrower who will default on the mortgage] and not the other.

In fact, the strongest arguments in favor of principal reduction do not rely on the assumption that everybody wins.  Here are three such arguments.

(i)  The concept that mortgage debt should not be written down as a matter of course depends on specific view of debt.  The basic question that arises when one discusses “debt” is:  Is a promise to pay a fixed sum of money absolute or is it negotiable?

In general in the context of the modern American economy, the conclusion is that the debt becomes negotiable when the borrower declares bankruptcy.  Thus, United Airlines and a variety of other businesses have been able to discard their pension plans without liquidating the business and distributing a fair share of assets to the pensioners.  Similarly if a corporation has a mortgage, the “cram down” provision in Chapter 11 allows the bankruptcy court to write the amount of the debt owed down to the value of the property.  In fact, “cram down” exists in personal bankruptcy law as well — but there is one exception to it:  primary residences.

Thus, the basic principal on which the American economy functions is that debt has an element of negotiability.  One almost always has the right to threaten to declare bankruptcy and then force the creditor to write the debt down closer to its fair market value.  It doesn’t take very sophisticated economic analysis to understand that this property of the American economy helps reduce the likelihood of asset price bubbles, since it gives creditors a strong incentive to lend no more than the property is likely to be worth over the life of the loan.

While it is true that primary residences are excepted from cramdown, this doesn’t really explain why the American understanding of debt should differ just because that debt relates to a primary residence.  Obviously it’s in corporate interests to treat corporate debts as negotiable and consumer debts as absolute, but I suspect that it would be close to impossible to find a rational justification for such treatment of consumers as second class citizens.

(ii)  Moral hazard for financial institutions is created when loans against assets are protected from being marked down to their market value.   If banks are allowed to profit from their role in creating an asset price bubble in housing, then they are not discouraged from repeating the same behavior.  Thus, banks need to lose money on these underwater mortgages, or they will face incentives to be careless about lending against overinflated housing values and will promote housing bubbles again in the future.

(iii)  Most importantly, however, principal reductions are probably necessary for economic recovery.  A borrower whose house is worth 50% of the loan and gets a standard HAMP modification will, typically, (1) within eight years face a 33% increase in mortgage payments that were already set at the boundary of affordability and (2) not be in positive equity territory for 20-25 years (recall that a standard HAMP modification is not fully amortizing over 30 years).  In other words these are borrowers who are at high risk of default for the next quarter century.

The simplistic “will he or won’t he” analysis presented by the Federal Reserve economists failures to capture the nature of the housing market where “will he or won’t he” needs to be asked in every period until the loan is fully paid off.  Laurie Goodman (the report is not available on line as far as I now, but a report on a lecture using similar data is available here) has done this analysis and concluded that principal reduction is necessary to reduce the number of future defaults.

Our current housing policy is likely to prolong the experience of housing market default across a decade or even longer.  Those who support principal reduction are concerned that the economy will not recover until the constant influx of foreclosed homes onto the market slows.  There are two surefire ways of achieving this end:  the first is a general inflation that will pull house prices along with it and the other is a massive reduction in principal balances that will enable the vast majority of those who cannot afford to pay their mortgages to choose to sell their homes.

Of course, principal reductions are not costless — they are designed to place a fair share of the costs of a housing bubble on financial institutions.  Principal reductions are, however, almost certainly less costly than attempting to push most of the costs of a housing bubble that was inflated by under-regulated out-of-control financial institutions onto middle class consumers, whom economists are imagining will one day soon have the financial wherewithal to support a growing economy.