Collateralized shadow banking: still at risk of fire sales

A few basic points about shadow banking ten years after the crisis:

“What shadow banking is” isn’t very complicated if banking is defined as “borrowing short to lend long”

What makes banks unstable is that their liabilities are on demand (i.e. they borrow short) while their assets pay out only over the course of years (i.e. they lend long). A principle reason that we are worried about “shadow” banks is that they have the same instability as banks, but lack the protections in the form of a strict regulatory regime and a lender of last resort. When shadow banks have this instability it is because they borrow short to lend long.

This approach makes it easy to understand the world of shadow banking, because there are only a limited number of financial instruments that are used to borrow on a short-term basis. Thus, for the most part shadow banks have to finance themselves on the commercial paper market (unsecured financing) or on the repo market (secured financing) or, especially for investment banks, via derivatives collateral (e.g. that is posted by prime brokerage clients). These are the major sources of wholesale short-term funding.

So typically when a financial product is subject to losses due to a run-prone (and therefore classified as a shadow bank), it’s because of the product’s relationship to the commercial paper market, to the repo market, and/or to the derivatives market.* The latter two, which comprise the collateralized segment of shadow banking, are the most complicated, because the run can come from many different directions: that is, lenders may stop lending (e.g. Lehman Bros), borrowers who post collateral may stop posting collateral (e.g. novation at Bear Stearns), and for derivatives contracts conditions may shift so that suddenly collateral posting requirements increase (e.g. AIG).

Collateralized shadow banking is governed by ISDA protocols and contracts, not the traditional law governing debt

While repos have been around for centuries, a “repo market” in which anyone can participate and where collateral other than government debt is posted is a relatively new phenomenon. Similarly derivatives contracts have been subject to margin requirements for more than a century, but in the past these contracts were exchange-traded and exchanges set the rules both for margin and for eligibility to trade on the exchange.

Thus, what made repo and derivatives financially innovative in the 1980s and 1990s was that suddenly there were unregulated over the counter (OTC) markets in them. What “unregulated” really meant, however, was that the big banks wrote the rules for this market themselves in the form of International Swaps and Derivatives Association (ISDA) protocols and contracts.

In the early days of repo and derivatives it was far from clear that they wouldn’t fall under the existing regulatory regime as securities (regulated by the SEC), or as commodities and/or futures (regulated by the CFTC). (The legal definitions of the SEC’s and the CFTC’s jurisdiction was deliberately made very broad in the implementing legislation, so an intuitive understanding of these terms will not coincide with their legal definitions.) Similarly, it was far from clear that the collateral posted in these OTC contracts would not be subject to the standard terms in the bankruptcy code governing collateralized debt. (Kettering who describes repos in this era as too big to fail products is great on this.)

Thus, one of the ISDA’s first projects was lobbying in the US for exceptions to the existing regulatory regime. Progress was incremental, but a long series of legislative amendments to the financial regulatory regime starting in 1982 and culminating in the bankruptcy reform act of 2005 effectively placed the whole system of repo and margin collateral outside the financial regulatory regime that had been set up in the 1930s and 1940s (for details see here, or ungated). These reforms also exempted these contracts from the bankruptcy code’s protections for debtors (see here or ungated).

Where the US led others followed. Gabor (2016) documents how Germany and Britain came to adopt the US model of collateralized lending, despite the central banks’ serious reservations about the system’s implications for financial stability. The world economy entered into 2008 with repo and derivatives markets effectively subject only to the private “regulation” of ISDA protocols and contracts.

Despite reforms, the instability at the heart of the collateralized shadow banking system has yet to be addressed

We saw in 2008 how the collateralized shadow banking system relies extremely heavily on the central bank for stability. (Federal Reserve programs to support the repo market included the TSLF and the PDCF.  Data released by the Fed indicates that at the peak of the crisis it accepted substantial amounts of very risky collateral.)

Indeed the International Capital Markets Association has put it quite bluntly that it considers the systemic risk associated with fire sales in repo and derivatives markets to be a problem that “the authorities” are expected to step in and address.

“The question is how to mitigate such systemic liquidity risk. We believe that systemic risks require systemic responses. In this case, the authorities can be expected to intervene as lenders of last resort to ensure the liquidity of the system as a whole. For their part, market users should be expected to remain creditworthy and to have liquidity buffers sufficient to sustain themselves until official intervention restores sufficient liquidity to obviate the need for fire sales.”

In short, the collateralized shadow banking system is constructed on the expectation of a “Fed put”. Instead of attempting to build a robust infrastructure of debt, shadow banking embraces the risk of fire sales and expects the governments that don’t make the shadow banking rules to bail it out.

The only sure-fire way to eliminate the risk of fire sales is to reduce the financial system’s reliance on repo- and margin-type contracts that allow a decline in the value of collateral to be a trigger for demanding additional funds. Based on financial market history this would almost certainly require an increase in the use of unsecured interbank debt markets. However, not much progress has been made on this front, especially since the EU’s proposed Financial Transactions Tax stalled in 2015.

On the other hand, significant reforms have been made since 2008 (Please let me know if I’ve left out anything important.) :

  • Collateral has shifted mostly to sovereign debt. This helps stabilize the market, but perhaps only temporarily as a broad range of collateral is still officially acceptable (so deterioration of the quality of collateral can creep in).
  • Approximately 50% of derivatives now are held with central counterparties. (The estimate is based on a 2015 BIS report.) This reduces the risk that the failure of a small market participant sets off a chain of failures that results in a fire sale. There is some concern however that fire sale risk has been transformed into the risk of a failure of a central counterparty.
  • Derivatives are now officially regulated by either the CFTC or the SEC and and there has been an effort to harmonize OTC margining requirements internationally.
  • Under pressure from regulators a voluntary stay protocol has been developed by the ISDA that is designed to work with the regulators’ special resolution regimes and to limit the right to terminate a contract due the default of a related entity. In the US systemically important banks are required to include this protocol in their OTC derivatives contracts.
  • Bank liquidity regulations have been adopted that limit the degree to which regulated banks are exposed to significant risk in these markets.

Notice that these new regulations embrace the basic framework of collateralized shadow banking: much of the focus is on making sure that enough collateral is being used. Special rules are designed to protect the largest banks and the banking system more generally. But aside from protecting the banks, it’s not clear that significant measures have been taken to eliminate the risk of fire sales that originate outside the banking system. Assuming that these regulations are effective at protecting the banks, this raises the question: Who bears the fire sale risk in this new environment?

Thanks to @kiffmeister for requesting that I write up this blogpost.

* While one can usually figure this out after the run has occurred, current regulation does not necessarily make the relevant information available before a run has occurred. Mutual funds are a case in point: the vast majority of them have so little exposure to repo and derivatives markets that it can be ignored, but the few that take on significant risk may have disclosures that are hard to distinguish ex ante from the ones that don’t (e.g. Oppenheimer Core Bond Fund in 2008).

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Integrating finance and macro: the problem of modeling debt

So I have finally read Mian and Sufi’s House of Debt. They do an excellent job of setting forth an argument that has met with quite a bit of resistance within the economics profession: the growth of household debt before the crisis and the failure to reduce it after the crisis explains to a large degree the severity of the crisis. (House of Debt was written in 2014, so if you’re thinking: “But wait, that argument is mainstream now” you would be correct.) I actually read the whole book which can be taken as approval of both its structure and the quality of the writing. (On the “life is short” principle I typically don’t get through a book is poorly structured or poorly written.) The book is widely cited and almost universally acknowledged as one of the foremost expressions of the household balance sheet view of the 2007-09 financial crisis. Thus, I am going to take the book’s many excellent qualities as given and focus on the most important flaw that underlies the book, because that flaw also underlies most economic analysis of the way financial factors played a role in the crisis.

While it is wonderful that Mian and Sufi are talking about debt, the way they are talking about debt and in particular their underlying model of debt is very problematic. Furthermore, the errors in their underlying model of debt are so ubiquitous in economic theory that these errors function as a constraint preventing the development of models that can accurately represent the relationship between finance and the real economy. In short, while this post will focus on a critique of Mian and Sufi (2014), this book is really just standing in for all the economic works that make the same assumptions, some of which I will reference below.

Holmstrom (2014) presents the standard economists’ model of debt, which underlies Mian and Sufi’s discussion too, using this diagram:

Holmstrom debt

Debt is modeled as a promise to make a fixed payment that will only be met if the borrower has enough money at the time payment is due. This diagram treats the value of the borrower’s collateral as equal to her entire wealth, assumes that the value of the collateral may take on values ranging linearly from 0 to something well in excess of the amount to be repaid on the debt, and assumes that the lender can take the collateral if the debt is not paid. Thus, the lender’s payoff increases linearly until the value of the collateral exceeds the amount due on the debt at which point the payoff to the lender is fixed.

There is nothing wrong with this model as a first pass at modeling debt. It is widely used for good reason. But the basic model also dates back to the 1980s (I connect it with a paper by Hal Cole that I can’t locate, but am not entirely sure of its origins) and it is remarkable that the model has not in ensuing decades been amended to allow for the much greater complexity of real world debt. Treating this model as if it represents the general category of “debt” and not the specific simple case that is easiest to model is a huge mistake that permeates the economics profession.

So what’s wrong with this model?

1)   It is used to treat “debt” as homogeneous

The model assumes that all debt takes a single specific contractual form modeled on a mortgage. In fact, debt is broad term that encompasses a huge range of different contractual provisions. Debt can be structured to favor the borrower or it can be structured to favor the lender. A debt contract can be designed so that it is hardly distinguishable from equity or so that the lender bears virtually no risk of loss. Economists need to stop talking about “debt” as a homogeneous product and start talking about the specific kinds of debt they mean to address.

For much of the discussion in Mian and Sufi, the standard model is appropriate, because their main focus of inquiry is mortgages, and this is a reasonable model of mortgage debt. On the other hand, this model leads them to make generalizations about debt itself that are simply nonsense, e.g. “This is a fundamental feature of debt: it imposes enormous losses on exactly the households that have the least” (p. 23). If they simply replaced the term “debt” with the phrase “the current US mortgage system” there would be nothing wrong with this sentence. When, however, they generalize from the problems with US mortgages to “debt” itself, they misfire badly. As I note above, this problem is not in any way restricted to Mian and Sufi, this is a general problem that permeates and degrades much of the economic discussion of debt.

It is highly unlikely that the economics can make progress in its efforts to study the relationship between finance and the real economy so long as the profession’s vocabulary for discussing something as fundamental to finance as “debt” is so utterly impoverished.

2)   Failure to model uncollateralized debt

Uncollateralized debt has very different properties from collateralized debt. In economic theory models debt is almost always modeled to be collateralized and is therefore backward looking (see, e.g. Holmstrom 2014 or Gertler and Gilchrist 2018). An agent must already own something pledgeable in order to borrow. This ensures that wealthy agents can borrow more and grow more wealthy, whereas poor agents are likely to be constrained forever. This framing of debt is closely related to the inequality dynamics described by Mian and Sufi.

By contrast, when debt is uncollateralized, it can be forward looking. If I can convince a bank that after investing the proceeds of a loan of $50,000 today, my business will give me revenues of $100,000 in a year, the bank can fund the loan with nothing more than my personal promise to pay it back (and the knowledge that our legal and social system will impose significant costs on me for a failure to pay, e.g. a public judgment against me, and a defective credit report). As long as I am expected to have the funds to pay back the loan when the debt is due, there’s no reason at all for the loan to depend on my ownership of more than $50,000 in assets to be used as collateral. For relatively small amounts and short periods of time this type of unsecured lending is very common in practice and has been very common for centuries.

Effectively the habits of thought that economists adopt when they think about debt are unreasonably constraining their ability to model the relationship between finance and the real economy. And these same habits of thought tend to rule out by assumption the possibility of inequality-reducing debt.

3)   Inaccurate assumptions about the legal framework governing debt

“Debt leads to bubbles in part because it gives lenders a sense of security that they will be unaffected if the bubble bursts” (p. 114).

This is simply not a property of “debt.” In the event of a bubble that bursts there will be a rash of bankruptcies and the basic rule in bankruptcy in this situation is cramdown: the borrowers’ debt is written down to the post-crash value of the collateral. In short, the standard legal procedure governing debt addresses precisely the macroeconomic problem in question here. A lender who lends into a bubble is at risk of loss. As a general statement, Mian and Sufi’s claim is simply incorrect. It is, however, (1) an accurate description of the model of debt that they are working with and more importantly (2) an accurate description of the law governing US mortgages on first homes, because of the explicit exception for these loans in the bankruptcy code. (Interestingly enough, the rules for the treatment of second homes in bankruptcy do allow cramdown.)

Thus, when Mian and Sufi write “Our main argument is that a more even distribution of losses between debtors and creditors is not only fair, but makes more sense from a macroeconomic perspective” (p. 150), what they are missing is an acknowledgement that “debt” as a general category is usually subject to treatment in bankruptcy that addresses their macroeconomic concerns. “The inflexibility of debt contracts” (p. 168) about which Mian and Sufi complain exists in their model and in US mortgage markets, but is not in fact a property of “debt contracts” themselves under the current legal regime in the US.

What should economic models of private debt do?

Economic models that seek to integrate finance and macro need to be very conscious of the different kinds of private debt and make deliberate decisions about why a specific form of debt is being modeled. To assist in this project, I present here a simple hierarchy of different types of debt that are likely to have very different macroeconomic consequences and thus should be modeled differently. (It’s possible and even likely that I have omitted an important type of debt, so this hierarchy is open to revision.)

The types are ranked from those that are most favorable to the lender to those that are most favorable to the borrower. (Note (i) I use “mortgage” as a general term for a collateralized loan, and (ii) the listed term of the loan should be understood as typical and not as claim that these types of debt are restricted to this term.)

  • Repurchase agreement or margin loan: ultra-short-term, overcollateralization, marketable collateral, immediate right to seize the collateral if it falls in value (and isn’t increased).
    Comment 1: A vigilant lender cannot lose money on a repo.
    Comment 2: There has been significant work on repo since the crisis, e.g. Brunnermeier and Pedersen 2008, but as far as know there is no “workhorse” model comparable to the model of debt above. (Please correct me if I’m wrong.) My impression is that much of the work on repo has been empirical (e.g. Adrian and Shin 2010).
  • Mortgage with recourse: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, right to be paid in full if the collateral value at the time of default is deficient.
  • Mortgage without recourse: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, no right to further payment. (This is the type of debt that corresponds to the “standard” model of debt discussed above.)
  • Mortgage with cramdown: long-term, overcollateralization, a right to seize the collateral only after the borrower defaults, but subject to cramdown if the borrower declares bankruptcy.
  • Unsecured debt with bank guarantee (e.g. commercial paper): short-term, no collateral, lender relies on bank guarantee.
  • General unsecured debt: short-term or long-term, no collateral. Enforcement must be via long-term incentives (reputation) and/or penalties imposed by the legal system for failure to pay. Corporate bonds fall under this heading.

REITs are not the largest borrowers on the repo market

I have a nit to pick with Tracy Alloway’s recent reporting on the repo market. She writes:

What remains of the $4.2tn market is increasingly being taken up by non-bank entities such as real estate investment trusts (Reits), mutual funds and hedge funds . . . The growing use of repo has been particularly marked among Reits, which have overtaken banks and broker-dealers as the largest borrowers in the market, according to Federal Reserve data. To purchase long-term mortgage assets, Reits have increased their repo borrowings to $281bn, up from $90.4bn in 2009. Closed-end funds, which invest in assets ranging from corporate bonds to municipal debt, also have increased their borrowing in the repo market, from $2.74bn at the end of 2007 to almost $8bn now, according to Fitch Ratings data.

Her data is apparently derived from the flow of funds data, which states that in Dec 2013 REITS has $281 bn in repo borrowings and broker dealers had $135 bn in *net* repo borrowing.

If REITs had indeed “overtaken” banks and broker-dealers as the largest borrowers in the market with a share of $281 bn, it would be very hard to explain how the market could possibly be a $4.2 tn market. In fact, of course, the broker-dealers are using their own (government supported) creditworthiness to intermediate access to the repo market for their customers, who don’t have the credit to borrow directly on the tri-party repo market. For this reason, it is almost certain that broker-dealers remain the largest borrowers on the market. In fact on page 170 of JPM’s 2013 10-K we find that this one bank had $156 bn of borrowings in the repo market. GS 10-K has $165 bn in such borrowings (p 173).  In short, the fact that the broker-dealers are intermediating access to credit should not be used to obfuscate the fact that they are the largest borrowers on the repo market.

 

What are the elements of a healthy financial system?

Gary Gorton argues that the repo and securitization markets that developed over the last quarter of the 20th century are healthy phenomena and that we really don’t have much choice, but to preserve them.  While there are many aspects of his analysis with which I agree, I draw very different conclusions from the evidence he cites.  The bullet points below are the conclusions of this paper (h/t Felix Salmon actually that should be h/t Richard Smith — my apologies for sloppy link-tracking — was too overcome by the debating spirit once I took a look at the paper in question).

•As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.

I have no argument with this narrative of financial evolution, but I think that Gorton is missing an important point.  Money market mutual funds (MMMFs) are banks that are exempt from capital requirements, because they are (in theory, if not in practice) not protected by deposit insurance.  Any regulation that puts traditional banks in competition with money market mutual funds is sure to result in an undercapitalized banking system — either because uncapitalized MMMFs take over the role of intermediation or because the banks find ways around traditional capital requirements.

In fact, I agree with many aspects of Gorton’s analysis:

Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed. If an industry is not profitable, the owners exit the industry by not investing; they invest elsewhere. … One form of exit is for banks to not hold loans but to sell the loans; securitization is the selling of portfolios of loans. Selling loans – while news to some people—has been going on now for about 30 years without problems.

My difference with Gorton lies in the approach to MMMFs and securitization.  I think that MMMFs are uncapitalized banks and that securitization was the process by which traditional banks also became undercapitalized.  Thus both are a major source of financial instability.  Gorton, by contrast, believes that MMMFs and securitization have stood the test of time.

In my view, the fact that this predictable evolution occurred does not mean that it was a healthy development for the financial system.  The fact that it took 30 years for all the contradictions built into this brave new financial system to result in a crisis large enough to threaten the whole financial system does not mean that crisis was not inevitable from the beginning.

•The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short‐term, safe, interest‐earning, transaction account like demand deposits: repo. Repo also grew enormously, and came to use securitization as an important source of collateral.

Once again, I don’t see that the fact that securitized assets were used as an important source of collateral in repo as evidence that this phenomenon is either good or healthy.  In all likelihood, the bankruptcy reform act of 2005 (which expanded the priority status in bankruptcy proceedings of Treasury/Agency repo to virtually all repo contracts) precipitated the growth of low-quality repo and may (given the absence of repo data this is all but impossible to demonstrate) have been a proximate cause of the catastrophic failures of Bear Stearns and Lehman Bros.

It’s my impression — once again on the basis of very limited data — that the repo market currently has shrunk to depend mostly on the traditional high-quality collateral that underlay its growth over the last quarter of the 20th century.  And that the broker dealers have shrunk their balance sheets and changed their liability structure to adapt to this new environment.  This change is healthy, because high-quality assets are by their very nature protected from the 20% and higher haircuts that precipitated the repo crises of 2008.  In my view the growth of the repo market is not unhealthy, as long as the market is restricted to only the highest quality assets.

•Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.

Absolutely, “repo is money”.  And sound backing for the money supply is found (i) in a Central Bank that holds mostly government debt as backing for the money supply and (ii) in a banking system that is well capitalized.  If banks want to use repos for funding (which are collateralized, rather than protected by capital reserves like traditional loans) then they need to rely on collateral that is appropriate backing for the money supply — like Treasuries.  Allowing senior tranches of synthetic CDOs — in other words credit default swaps — to be used as backing for the money supply was madness.  And I sincerely hope that our regulators do not experiment again with the degradation of the money supply that took place in the late naughties.

•In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.

“Firm failures should not be caused by fire sales.”  This statement is just far to general.  If hedge funds fail because of fire sales, the appropriate regulatory response is:  “Sorry, folks.  Shit happens.”  Our regulators do not have a responsibility for ensuring that all markets are liquid all the time.  If they ever try to take on this responsibility, they will probably be as successful as the Soviet Union was in planning production.

Banks that play an important role in the monetary system are different matter, but even here the goal of regulators is not to prevent firm failures — the goal is only to protect the stability of the money supply.  Traditionally (see Bagehot’s reaction to the failure of Overend Gurney) the first bank is allowed to collapse and the central bank provides abundant liquidity to support the remaining banks through the fire sales.  Any bank whose capital is wiped out by the failure of the first bank to honor its liabilities is also allowed to fail (since it faces a solvency not a liquidity crisis).

When one remembers that the goal of regulators is not to protect firms from failure, but to protect the stability of the money supply, one realizes why it is so important for regulators to demand that repos be backed only by the highest quality assets.  Any other policy will force the central bank to take low quality assets onto its balance sheet in a crisis and undermine the stability of the money supply.

One also realizes that there is a strong theoretic foundation for the argument that banks should be small.  The failure of any large bank that holds more than 5% of the economy’s deposits can undermine the stability of the money supply — and may put regulators in a position where they are forced to conflate protection of the money supply with protection of an individual firm from failure.  I don’t think that the dangers created by government officials who believe that their job is to protect firms in a free market economy from failure need to be explained.

• The crisis was not a one‐time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.

Bank liabilities have a vulnerability — and banks protect themselves from that vulnerability by being well-capitalized.  The fact that securitization undermines a bank’s capital position is precisely the reason that it has come in for so much criticism.  When and if securitizations are structured as true sales with no implicit or explicit recourse to bank balance sheets, they will be a positive addition to our financial arsenal.  However, as long as securitizations just represent bank assets against which banks are not required to hold capital reserves, they weaken the financial system rather than strengthening it.

In my view the elements of a healthy financial system are:

(i) a central bank that stands ready to provide abundant liquidity in a crisis, but will not step in to protect individual firms from failure.
(ii) a well-capitalized banking system.
(iii) absence of pseudo-banks that face preferential regulation like money market funds.
(iv) regulators who understand the many ways in which banks underwrite “market-based” lending and who require banks to hold reserves to honor their commitments to such “market-based” lending programs.

What is to be done? #1-13

To address the systemic risks caused by collateralized interbank lending, it is important to discourage large financial institutions from borrowing on a collateralized basis.  For example, if large financial institutions are prohibited from entering into over the counter derivative contracts that require them to post collateral, then their counterparties will be forced to evaluate the credit risk of being exposed to them.  Since every counterparty will favor the more creditworthy financial institutions, market forces will once again function to encourage the growth of conservatively run firms.

Collateral is intrinsic to the market for repurchase agreements and this market is far too large to disrupt by prohibiting the participation of large financial institutions.  On the other hand after the recent turmoil, it should not be difficult to remove the safe harbor protection for repos of less liquid assets – effectively, it is advisable to repeal those sections of the 2005 Bankruptcy Act that apply to repurchase agreements.  The repo market functioned reasonably well for a quarter of a century and imploded shortly after it was enlarged to included riskier assets.  As the riskier assets were the first to be rejected by repo counterparties, the presumption must be that we are better off with the narrower privileges granted to repurchase agreements in 1984.

To those who would argue that collateralization is necessary in order for derivative markets to function, I observe that this claim is simply false.  Collateralization of over the counter derivative contracts was introduced in the early 1990s.[1] Thus, the market for interest rate and currency swaps grew to more than $10 trillion in notional value before collateralization of derivatives became common.[2] Clearly, collateralization is not necessary to the operation of derivative markets.

In fact, financial markets are likely to be healthier when uncollateralized contracts are the norm.  In an environment where the credit risk inherent in every contract is obvious, there will be very few participants who are willing to do business with an unsound counterparty.  When unsound counterparties are shunned, the business of well-managed firms grows and the business of poorly managed firms shrinks.  Thus in an environment with uncollateralized contracts the natural dynamics of the financial system will tend to reduce leverage and promote stability.  This stands in stark contrast to the dynamics generated by a financial system that relies on collateral.

While unsecured interbank lending plays an important role in financial stability, it is appropriate to require collateral when dealing with an unreliable or an unproven business partner.  As long as some derivative contracts continue to require that collateral be posted, financial statements need to give the user an idea of how the collateral situation may change over the quarter.  For example firms could be required to report the maximum amount of collateral that could be called in two scenarios (i) the most adverse pricing environment and (ii) the most adverse pricing environment that was actually experienced over the past twenty-five years.

Furthermore, if Congress were interested in more thorough reform of over the counter derivatives markets, it could repeal the derivative and repo related bankruptcy amendments of 1984, 1990 and 2005, redefine repurchase agreements and swaps as securities and rely on the 1982 bankruptcy amendment to protect the interests of repo and swaps traders.  For this reform to work repo traders would have to form a Repo Trader’s Association and register with the SEC as a self regulatory organization.  Similarly, the ISDA – or an American offshoot of it – would have to act as a self regulatory organization subject to the supervision of the SEC.  Under this scenario repos and swaps would become regulated contracts like futures and options and receive the same protections – including safe harbor under the bankruptcy code – that other regulated derivatives receive.


[1] 1999 ISDA Collateral Review, p. 1  http://www.isda.org/press/pdf/colrev99.pdf

[2] The ISDA reports that by the end of 1994 there $11.3 trillion of currency and interest rate swaps outstanding.
http://www.isda.org/statistics/pdf/ISDA-Market-Survey-results1987-present.xls

Evaluating Collateralized Interbank Lending #1-12

The 2008 crisis demonstrated unequivocally that when the borrower is a large financial institution, collateralized lending does not protect the lender from losses.  Without the intervention of the Federal Reserve as a lender who was willing to accept collateral that nobody else was taking, many of the largest repo market participants would have been forced to sell this collateral in order to meet their obligations.  These forced sales would have driven asset prices far below those observed in 2008 – and all the major players in the repo market would have posted much larger losses than they did.

The case of AIG provides further evidence that collateralizing derivatives fails to protect the “in the money” counterparty from losses.  Collateral calls following a rating agency downgrade of the firm drove it towards bankruptcy and precipitated a bailout in the form of a loan from the Federal Reserve.  Notably $22 billion was passed from the Fed through AIG to counterparties in 2008.  It is abundantly clear that this collateral would not have been posted in the absence of government intervention and thus, if standard bankruptcy procedure had been followed, AIG’s counterparties would have been short $22 billion on their derivative contracts.

The 2008 crisis demonstrates that the only protection a bank has against the failure of a large counterparty is the intervention of the central bank.  Because of the fear of fire sales, collateral fell in value just when its protection was most important to lenders.  Similarly, large collateral calls themselves precipitated bankruptcies – with the result that without the help of the Federal Reserve the collateral would never have been posted.  In short, collateral was worse than useless throughout the crisis, because it served to destabilize financial institutions rather than to stabilize them.

The 2008 crisis raises this question:  Is collateralized interbank lending an inherently destabilizing force in a financial system? Three quarters of a century ago J.M. Keynes expressed the problem perfectly:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities.  It forgets that there is no such thing as liquidity of investment for the community as a whole.[1]

The exemptions to the bankruptcy code for derivatives and the collateralized interbank lending regime that grew out of these exemptions are built on the fallacy that there is such a thing “as liquidity of investment for the community as a whole.”  Keynes also remarked on the most important cost created by ignoring the fallacy of liquidity:

The fact that each individual investor flatters himself that his commitment is “liquid” (though this cannot be true of all investors collectively) calms his nerves and makes him much more willing to run a risk.[2]

The collateralized interbank lending regime encourages banks to believe that their collateral is “liquid”, protecting them from losses in the event that a counterparty defaults.  Adherence to this fallacy has two consequences: (i) banks do not set aside reserves or hold capital to protect themselves against losses that they cannot imagine, and (ii) banks do not monitor counterparties carefully, because they believe that they are fully protected by collateral.  Both of these consequences are extremely detrimental to financial stability:  the financial system as a whole is undercapitalized and in the absence of screening for credit risk the weakest financial institutions end up interconnected with every other firm.  In such an environment, when one firm starts to wobble the whole financial structure can easily come tumbling down.

As last year’s Federal Reserve intervention demonstrated, collateralized interbank lending only protects lenders if the central bank is willing to intervene to prevent a fire sale of collateral.  But then, what is the role of collateral?  After all, the lender of last resort has a long tradition of protecting financial systems where interbank lending is unsecured.  Collateral serves only to create the illusion of a security that does not exist.  This illusion causes banks to reduce the capital they set aside to protect against unexpected losses and to cut back on monitoring the credit risk of their counterparties.  In short, the existing collateralized derivatives regime is inherently destabilizing:  It is not designed to function in an environment where a large financial institution can fail, it tends to reduce capital levels and increase lending to weak firms, and finally, because of the safe harbor exemptions, it all but guarantees that a run on a large financial institution will take place.


[1] Keynes, 1935, General Theory, p. 155.

[2] Keynes, 1935, General Theory, p. 160.

The Financial Collapse of 2008 #1-11

This repo market instability became evident in March 2008, when rumors were swirling about Bear Stearns’ financial condition.  Counterparties did not want to risk holding collateral that could only be sold at fire sale prices in the event of a Bear Stearns’ bankruptcy – so they refused to lend to Bear against anything but the highest quality collateral.  Since Bear Stearns financed half of its balance sheet on the repo market, this withdrawal of credit was disastrous.  In the absence of credit drawn on repos Bear did not have the liquidity necessary to meet its short-term obligations.

In the case of Bear Stearns, fear of a bankruptcy filing precipitated a withdrawal of credit that made bankruptcy almost inevitable – and destroyed the firm.  In September 2008 Lehman Brothers collapsed when it too faced a bank run as fellow bankers withdrew credit and issued collateral calls.[1] At the time of the Lehman failure, Merrill Lynch was at risk of the same treatment and was saved only by Bank of America’s eleventh hour purchase.  Within days Goldman Sachs and Morgan Stanley were also at risk – exactly one week after Lehman filed for bankruptcy the Federal Reserve announced expedited approval for the transformation of these firms into bank holding companies with full access to the Fed’s support for commercial banks.[2]

In short, every firm that relied on repurchase agreements as an important source of funding – and did not have full access to the liquidity facilities of the central bank – faced a bank run and either failed or was rescued.  Safe harbor for repurchase agreements that are backed by securities of limited liquidity sets up an institutional structure that is prone to bank runs.  Whenever there is some small likelihood that a firm a might declare bankruptcy, counterparties protect themselves from the possibility of losses in a fire sale by withdrawing credit from the firm – and driving it into bankruptcy.  The repo markets we have now can only be described as fundamentally unstable.

The financial instability created by the run on Bear Stearns forced the Federal Reserve to take extraordinary action.  The Fed appealed to its authority under section 13(3) of the Federal Reserve Act to lend in exigent circumstances to financial institutions that were not commercial banks.  This authority was last exercised more than 50 years ago.

Using its emergency powers the Fed initiated two programs in March 2008:  the Term Securities Lending Facility and the Primary Dealer Credit Facility.  The Term Securities Lending Facility allows investment banks to temporarily trade highly rated private sector debt for Treasury securities.  In the Primary Dealer Credit Facility the Fed lends to investment banks against investment grade collateral.  Both of these programs were clearly designed to deal with the collapse of repo markets trading less liquid securities.  In addition, the Fed lent $29 billion to JP Morgan Chase to facilitate the purchase of Bear Stearns.  This loan was extraordinary because it was a non-recourse loan – in other words, JP Morgan Chase has the legal right to walk away from the loan leaving the Fed with only the collateral as payment.

As a consequence of the March 2008 collapse of the repo market, the Federal Reserve was exposed to private sector credit risk.  By the start of September it held as much as $100 billion of private sector assets that had been traded temporarily for Treasuries.  September was a disastrous month for the investments banks.  On September 14, the day before Lehman Brothers filed for bankruptcy, the Fed agreed to accept all collateral that had commonly been used in repo markets – including collateral that was not investment grade – in the Primary Dealer Credit Facility and extended the Term Securities Lending Facility to include all investment grade securities, not just those that were AAA rated.  (Lehman did not have access to these programs, because it did not meet the Fed’s criteria for a sound financial institution.)  By October 1st, the investment banks had borrowed almost $150 billion directly from the Fed.  This, in addition to $230 billion of private sector assets temporarily exchanged for Treasuries.[3]

In short, the collapse of the repo market in 2008 forced the Federal Reserve to intervene to protect the financial system by exchanging the risky assets that had been used as repo collateral for cash and Treasuries – the Fed chose in 2008 to act as a lender of last resort to the market for repurchase agreements.  As of mid-2009 these programs had shrunk to almost nothing, indicating either that the investment banks have found other sources of financing – possibly due to their new status as bank holding companies – or that repo markets have to some degree recovered.  Now that the crisis in the market for repurchase agreements is over, we can take the time to evaluate whether this is an appropriate role for the Federal Reserve or whether the repo market itself needs to be reformed.


[1] CARRICK MOLLENKAMP, SUSANNE CRAIG, JEFFREY MCCRACKEN and JON HILSENRATH, Oct 6, 2008, “The Two Faces of Lehman’s Fall,”  Wall Street Journal.

[2] Neil Irwin, July 21 2009, “At NY Fed Blending in is part of the job,” Washington Post, http://www.washingtonpost.com/wp-dyn/content/article/2009/07/19/AR2009071902148.html?wprss=rss_business indicates that Sept 18 is the date the New York Fed realized GS and MS were facing runs.  Federal Reserve Board, September 22, 2008 “Order approving formation of bank holding companies”
http://federalreserve.gov/newsevents/press/orders/orders20080922a1.pdf
http://federalreserve.gov/newsevents/press/orders/orders20080922a2.pdf
Gary B. Gorton, 2009, “Slapped in the face by the invisible hand” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882) documents the withdrawal of credit from the repo market in the form of increasing haircuts – and discusses its similarity to a bank run.

[3] This may not represent the full extent of Federal Reserve lending to investment banks on October 1, 2008 as both Morgan Stanley and Goldman Sachs were now bank holding companies and could access liquidity facilities like the discount window and the Term Auction Facility.

10-6-09 update note: Corrected error regarding TSLF.