Moral Hazard and the Foreclosure Crisis

An important fact has been omitted from the ongoing discussion of the widespread failure to follow legal procedure not only in foreclosures, but also in forming and managing mortgage backed securities:  This is just another example of the consequences of moral hazard that is deeply engrained in the way our financial markets work.  The financial industry functions on the assumption that contracts and activities that are either illegal or unenforceable under current law will – as long as they involve significant bank losses or liabilities – always be made legal retroactively.

Over the past half century the financial industry has not treated the law as a bedrock institution that constrains the nature of its activities, but rather as a set of rules that can be forced to adapt to the industry’s needs and desires.  Thus, the industry knowingly and deliberately creates standardized contracts that are either designed to circumvent the law or in some cases flatly illegal under current interpretations of the law, and then when a case involving the contract arises (which in many instances happens only long after the standardized contract has become an institution), the financial industry tells the court that the dubious or illegal contract is so widespread that the court would create systemic risk by enforcing the law.  (This idea was established by Kenneth Kettering in “Securitization and its Discontents” and the next two paragraphs draw very heavily from Kettering’s article and perhaps form little more than an opinionated summary of several of his sections.)

Standby letters of credit are a clear example of this phenomenon.  In the 1950s banks started issuing “standby” letters of credit, which unlike traditional letters of credit (which were a form of secured loan) are nothing more than guarantees of the debt of bank clients.  As banking law in the United States has prohibited banks from issuing rendered bank guarantees of client debt unenforceable since at least the early years of the 20th century, the “standby” letter of credit was just an effort to repackage a product that was clearly unenforceable by making use of the name of a bank product of long-standing.  This effort was successful.  By the time that a bank failure led the FDIC to challenge the validity of the standby letter of credit in 1973, the market was so big that the FDIC was not willing to put forth its strongest argument – that as a guarantee, the product was unenforceable – because of the consequences of annulling such a large quantity of bank liabilities.  The consequence of this timidity was to grant the standby letter of credit the same standing in an FDIC resolution as a bank deposit.

Repurchase agreements are another example.  The UCC since 1972 has stated that its provisions on secured transactions apply “to any transaction (regardless of its form) which is intended to create a security interest …”  To argue that repurchase agreements did not fall under UCC §9-102 (now §9-109) because they took the form of a sale and repurchase is to engage in sophistry with the clear purpose of subverting the intent of the law.  And yet in the early 1980s – after the market for repurchase agreements had grown to exceed 5% of US GDP – this is precisely the argument that banks were making to judges in an effort to keep repurchase agreements out of bankruptcy court.  Because there were in fact judges who viewed it as their duty to protect the rule of law from the sophistry of the financiers despite – possibly genuine – claims of systemic risk, the industry did an end-run around the Bankruptcy Code by convincing Congress in 1984 to exempt from the Code those categories of repurchase agreements that were actually traded.

The whole over the counter derivatives market also falls into this category.  In 1936 the Commodities Exchange Act (CEA) codified the common law rules (pp. 722 – 23 in link) that had developed over the previous century by making contracts for future delivery (i.e. derivatives and forwards) legal if either (i) they were traded on an exchange or (ii) the intent of the parties was to settle the contract by transferring the underlying asset.  In 1974 the CEA was amended to explicitly include financial contracts under the provisions above and creating the CFTC as an agency enforcing the CEA.  In short, under the CEA the whole over the counter derivatives market as it developed through the 80s and early 90s was plainly illegal – until in 1993 Congress amended  the CEA to allow the CFTC to exempt certain contracts from the law.  (The CFTC under Wendy Gramm promptly exempted swaps and the controversy over Brooksley Born’s stymied attempts to oversee the over-the-counter derivatives market revolved around the wisdom of this exemption — see especially the comments in this link.  In the second comment, note the securities lawyer’s observation that there was not a single law firm in New York at the time willing to support Rubin/Treasury’s so-called claim that the CFTC did not have jurisdiction over swaps.  The Rubin/Treasury view is here and a more objective view here.)

We have a financial industry that views as normal the practice of deliberately creating systemic risk by developing financial instruments that will cause our largest banks to collapse, if the law in its current form is in fact enforced.  The end result of this process is that we have a legal system that – at least when it comes to financial transactions – is composed of laws written by and for the benefit of financial institutions themselves.

While I have a lot of sympathy for Paul Jackson’s point that these procedural matters don’t really matter to those who have defaulted on their mortgages, because in the vast majority of cases their default means they don’t have much of a legal claim to the house, the complete failure by a financial industry full to the gills with well-paid lawyers and real estate experts to comply with the laws governing mortgages and the transfer of real property is a big issue.  (And I see that Paul Jackson agrees with me on that last point.)  It is a big issue precisely because it demonstrates in very plain terms the financial industry’s utter contempt for the rule of law and for the tax-paying public that is counted on to open its wallet every time a bank sneezes.


Subprime vs subprime

The financial industry’s way with words — that is, the industry’s way of making sure that words never mean what you think they mean — has tripped up the academics once again.  The recent debate between Raghuram Rajan and Paul Krugman over the role played by Fannie Mae and Freddie Mac seems to hinge on the fact that they are talking at cross purposes.

The commonly understood meaning of “subprime” when referring to securitized mortgages is to be found in wikipedia:

Varieties of underlying mortgages in the pool:

  • Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
  • Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.) (Article on Alt-A)
  • Subprime: weaker credit scores, no verification of income or assets, etc.

There are also jumbo mortgages, when the size is bigger than the “conforming loan amount” as set by Fannie Mae.

Since a “conforming mortgage” is one that meets the criteria set by Fannie Mae and Freddie Mac, the traditional meaning of subprime is a loan that does not meet Fannie Mae and Freddie Mac’s criteria for a reason other than loan amount.  (Alt-A came much later than sub-prime.)  For this reason it is common to see the words “prime” and “conforming” used interchangeably in mortgage articles.

Thus using the traditional approach, any MBS issued by Fannie or Freddie is, by definition, not a sub-prime MBS.  When Fannie and Freddie invested in sub-prime they did so by buying up privately issued sub-prime MBS.  It seems obvious that in this market Fannie and Freddie were two of many, many guilty parties.

What makes the whole discussion complicated is that (I think) the GSE’s loan criteria became less discriminating over time.  Thus, if one wants to fix the definition of sub-prime based on the GSE’s standards in, for example, 1998, one can claim that the GSEs themselves were issuing “non-conforming” MBS.  On the other hand, it is unarguable that even when the GSEs were issuing “non-conforming” MBS, the loan criteria were always noticeably stricter than those in the privately issued subprime MBS market.  The bottom line is that the lending behavior of the GSEs is not well suited to a casual assertion that they started issuing subprime MBS, but instead deserves a carefully researched dissertation that breaks loans into far more granular categories than prime, subprime and Alt-A.

Tanta is of course the go-to source for anyone who wants to understand the nitty-gritty details of the mortgage market.  For an extremely thorough discussion of what precisely it means for a loan to be sub-prime or Alt-A see here, and here for a thorough discussion of what precisely the GSEs were doing when they securitized loans — see in particular the paragraph that starts:  “Propaganda from certain other market participants aside, you cannot just put any old loan in a GSE MBS.”

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.

On “too big to fail” financial markets

Yves Smith is confused by the fact that the securitization industry wasn’t carefully following legal procedure as it sold mortgages from one bank to another and then into the securitization trust.

But it isn’t surprising that judges are plenty unsympathetic, and in cases, outraged. The law is all about sanctity of process, both the underlying law and court proceedings. Cases typically revolve around disputes of fact or grey areas of the law. This isn’t grey (whether a party has standing to file a suit is fundamental) and the law in this area is well established. Basically, the securitization industry tried creating rules outside any established legal framework and judges are having none of it.

She and anybody else who’s confused about the financial industry’s modus operandi when it comes to the law over the past few decades needs to read Kenneth Kettering’s Securitization and its Discontents.

Kettering makes a simple point:  Whether you’re talking about repos or standby letters of credit or any of a number of financial practices of questionable legality, the financial industry has found that the best way to get the law rewritten in their favor to create a “too big to fail” market in the contract.  Once the market is so big that enforcing the law will create large scale disruption in financial markets, each judge is left with a choice — made explicit in “friend of the court” briefs written by financial players — enforce existing law and risk causing a financial collapse or create some pretext for claiming that what the financial industry says is the law is in fact the law.

According to Kettering the huge securitization industry, built on dubious legal foundations, is just the continuation of a long standing process used by the financial industry to overturn centuries of legal precedents and generate precedents and laws that favor the financial industry.

What is the parallel banking system?

Note:  This is part 3 of 3.  See also here and here.

The Traditional Banking System

A small business woman who has been operating her firm for several years on a shoestring budget but always managed to turn a tidy profit walks into an appointment with her local banker.  She has prepared for weeks for this half hour to present her business prospects and her preparation will pay off.  A $100,000 loan is approved and within a week that amount is added to her checking account at the bank.

It’s worth pausing to think for a moment about where that $100,000 of loan money comes from.  When a bank finds a creditworthy borrower who is able and willing to pay a market rate of interest on a loan, the bank does not need to have cash on hand.  Any bank has the capacity to create money by simply crediting the borrower’s checking account with the amount approved for the loan.  From the bank’s point of view both its loans and its deposits increase by $100,000.  However, since checking accounts are an important component of the money supply, from the economy’s point of view, the bank has just created money out of thin air.

The limitation on the bank’s ability to create money is its capital stock.  While the calculation of regulatory capital requirements is complex, in general a bank’s capital should be no less than 4% of its total loan portfolio. Thus in order to make the $100,000 loan, the bank will have to have $4,000 of capital over and above the capital required before the loan was made.  Now, you need to understand that capital is, by definition, not money that a bank can raise by borrowing.  The capital that stands behind a bank’s loans needs to be the bank’s own money – it cannot be owed to depositors or other banks or even to a Federal Reserve Bank.  Capital is the money the owners of the bank have invested in it plus any profits that have been reinvested.

Of course, for every $4,000 the owners invest, the bank can make $100,000 worth of loans, so a bank’s ability to create money is substantial, even if it is limited.  Furthermore, the bank can  earn interest on the whole $100,000, so capital requirements leave plenty of room for a bank to make good profits on its lending activities.  For this reason, in a country with a well functioning banking system borrowing is usually not particularly difficult for those who can convince a bank that they are creditworthy.

(For any reader who’s just decided that opening a bank is surefire way to solve all of your financial problems, I have to inform you that that scam has been tried so many times that the regulators are already on to you: Loans to the managers and owners of a bank are tracked very closely.)

It’s true also that the bank will be required to hold reserves against the $100,000 increase in deposits.  A $100,000 increase in deposits will lead approximately to a $10,000 increase the balance the bank is required to hold at its local Federal Reserve Bank.  This, however, is not a constraint on the bank’s lending to good clients, because the bank can always choose to borrow the $10,000 at an interest rate significantly lower than the one it is charging its customer.  Furthermore, our business woman undoubtedly borrowed the money because she had a use for it, so that $100,000 is not likely to sit in the bank increasing required reserves for long.

It is important to notice in this example that our bank has not used depositors’ money to make this loan.  Even if our business woman uses the full $100,000 to write a check purchasing a piece of equipment, the bank still does not need to turn to depositors to fund the loan.  When the check is cleared, as far as the Fed is concerned $100,000 of the bank’s reserves have been transferred to another bank.  Our bank, however, can simply replace the reserves by borrowing them on the interbank lending market at an interest rate well below that which it is earning on the loan.

Some might argue that in order for there to be funds available for borrowing on the interbank lending market it must be the case that some bank has deposits that have not yet been lent out.  This is indeed true, but, of course, we know that some bank has deposits that have not yet been lent out – because some bank just received the $100,000 in deposits that our bank created.

In fact, the only circumstance in which depositors’ money would be needed to fund the loan is when our business woman takes the $100,000 in cash from the bank and spends it somewhere, where it will not be deposited back in the banking system.  This is one of the reasons that economies which rely heavily on banks find that simply being a banked economy gives them a huge boost in terms of economic growth:  banked economies have an easy time creating money to meet the needs of entrepreneurs, whereas under-banked economies have a much less effective mechanism for making loans via money creation.  (See Diagram 1.)

Bank money

It is true that the Fed can choose to restrain the banking system from creating money so easily.  This is possible because the Fed can use open market operations to control the total quantity of reserves available to the banking system.  The $100,000 loan/deposit that was just created raises the total quantity of reserves that the banking system as a whole needs to maintain by $10,000.

If the Fed keeps the total quantity of reserves constant, we will see that the demand for reserves on the interbank lending market has increased without a change in supply.  This will mean that banks with reserves available for lending can charge a higher price, and we would observe an increase in the federal funds rate, which is the interest rate at which banks lend reserves from one to another.

Since the 1980’s, however, it has been Federal Reserve policy to manage reserves with the goal of ensuring that the federal funds rate is at a specific target level.  Thus, for the most part banks find that as they create money by making loans and generating deposits the Fed increases the supply of bank reserves to accommodate the increase in the money supply.  Of course, when the Fed has just put into place a policy of tightening the money supply and raising the federal funds rate, there is a sudden reduction in reserves.  Once the new, higher target interest rate has been reached, banks can again expect the supply of reserves to expand as they generate new – higher interest rate – loans.

As a tool of monetary policy, changing the target level of the federal funds rate is a very effective way of changing the lending behavior of all the banks in the economy.  When banks have to pay more to borrow reserves, they charge a higher interest rate to the customers who are borrowing from them, and this higher interest rate has the effect of reducing the amount that people want to borrow from banks.  This is the actual mechanism by which modern monetary policy can put a damper on bank lending and on money supply growth.  Of course, lowering the federal funds rate has the reverse effect.

Because the Fed can choose to set the interbank borrowing rate so high that there is very little demand on the part of businesses and individuals for loans, the Fed has the power to put a complete stop to money creation by banks.  In fact in the early 1980s, the Fed actually caused the federal funds rate to rise above 18%.  While this was a short-term policy with a very specific policy goal, it was remarkably effective at bringing the economy to a standstill.  Needless-to-say,  this was an exceptional circumstance, and typical Fed policy does not involve stopping the money creation function of banks or the economic activity it generates, even temporarily.

The key here is to understand what it means when we say that banks create money:  Banks generate deposits by making loans.  This process creates an interdependent relationship between the local business community and the local banking system, because both benefit from each other.

Regulators limit the banking system’s ability to create money by setting a target level for the interest rate at which reserves are borrowed on the interbank lending market.  This monetary policy is intended to keep banks from creating so much money that prices and inflation start to rise.

At the level of the individual bank, regulators limit the bank’s ability to create money by imposing capital requirements.  Capital requirements put banks in a position where the owners of the bank can afford to absorb the expense of loans that have gone bad.  If the quantity of bad loans exceeds the capital position of the bank, the bank will go bankrupt, and in the absence of deposit insurance, depositors will experience losses.  In the presence of deposit insurance, the purpose of capital requirements is to keep the claims on the deposit insurer to a minimum so that the deposit insurer does not risk bankruptcy – which in the US will trigger a taxpayer bailout of the deposit insurer.

Hopefully the attentive reader now has alarm bells ringing in his head:  “Wait a minute, didn’t you just say in the last chapter that one purpose of creating asset backed commercial paper conduits was so that banks could make loans that weren’t subject to the regulators’ requirements?  What’s supposed to keep bad loans from driving the conduits into bankruptcy if they aren’t subject to capital requirements?  What’s supposed to keep the money supply from growing so fast that inflation takes off, if conduits aren’t subject to reserve requirements?”

Good questions.

The parallel or shadow banking system

Recall how an asset backed commercial paper conduit functions:  money market fund managers buy asset backed commercial paper and, thereby fund a wide variety of loans that traditionally were made by banks.  Asset backed commercial paper conduits invest in residential and commercial mortgages, unsecured corporate loans, automobile loans, credit card receivables, other accounts receivable, corporate and government bonds and a whole variety of structured finance products like CDOs, CLOs and SIVs.

The reason that Paul McCulley of Pimco coined the term “the shadow banking system” to describe the early 21st century role of ABCP is that ABCP conduits perform the same function in the economy that banks do.  Investors in money market funds often treat them as interest-bearing bank accounts – with the understanding that they are uninsured accounts.  The fact that over a 40 year history there has been only one case in which a money market fund lost money contributes to investors’ impression that they are no different from deposits, as does the fact that many funds come with check books.[1] When money market funds invest in ABCP conduits, their loans are use to finance corporate working capital, corporate fixed capital and residential investment.  Traditionally, it was the banking sector that specialized in these areas of finance, particularly for small and medium sized firms.  See Diagram 2 for an illustration of how ABCP can be used to create money.

Conduit money
ABCP conduits are like banks because both depend on deposit-like financing that can be withdrawn at very short notice, and both use these funds to invest in longer-term assets such as mortgages and corporate loans.  The crucial difference between the banking system and the ABCP market is that the banking system has access to financial support services when it runs into problems.

After the Great Depression in which one third of all banks failed, the FDIC was created to provide federal insurance for bank deposits, and the Federal Reserve took on the responsibility of supporting sound banks through a crisis.  Precisely because the government has committed to support the banking system through a financial crisis, the banking industry is possibly the most regulated industry in the country.

Thus the difference between the ABCP market and the banking system is that the latter is protected from a bank run by (i) the fact that every bank can borrow directly from the Federal Reserve in case of a sudden withdrawal of deposits and (ii) deposit insurance.  Because the federal government guarantees that depositors’ funds will be repaid even when a bank goes bankrupt, there is no reason for depositors to flood an unstable bank with withdrawal requests.

The fact that the ABCP market is both unregulated and unprotected explains why it is called the “shadow” banking system.  ABCP conduits have no required reserve ratios and no capital requirements.  They are subject only to the discipline of the market.  Unfortunately, ABCP usually matures in three months or less and typically pays less than one half of one percent more than Treasury securities.  For this reason the cost to an investor of carefully reviewing a conduit’s assets and structure generally exceeds the benefits an investor can expect from investing in the ABCP of the conduit.  And so we find that the evaluation of a conduit’s creditworthiness was outsourced to the credit rating agencies.

The end result of an environment where “market discipline” is enforced only by the threat of a downgrade from the credit rating agencies is that the credit rating agencies become the de facto regulators of the ABCP market.  The credit rating agencies are, of course, not true regulators, because stability of the ABCP market as a whole is not within their purview.  They have a much narrower agenda:  they evaluate only the ability of individual conduits to repay the commercial paper that they issue.  To put it bluntly, as long as contracts are in place to ensure that the commercial paper issued by the conduit will be repaid even if the conduit collapses, the credit rating agencies don’t need to do a thorough evaluation of the risk of collapse of the ABCP conduit itself.

The credit rating agencies recognized that ABCP conduits, like banks, are subject to runs, because money market investors can suddenly decide to withdraw their funds, and they recognized that, as is the case with banks, bad assets can bankrupt a conduit and generate losses for ABCP investors.  To address the liquidity risk, instead of required reserves, conduits must have access to a liquidity facility that stands ready to cover their whole issue of commercial paper.  It is the banks that provide this liquidity facility in exchange for a fee.  To address the credit risk, instead of capital requirements, ABCP conduits are also required to pay the banks for credit enhancement, which offers some protection against bad assets.

In short, the credit rating agencies “regulated” the ABCP conduits by requiring that the banking system stand ready to support all of a conduit’s commercial paper in case of a run and be ready to support a conduit’s bad debt as long as it remained below a certain fraction of assets.  Because conduits were never required to be capitalized or to maintain reserves, in retrospect we can conclude that the ABCP market was indeed a shadow banking system – it was entirely dependent on the real banking system and could never hope to stand alone.

The problem with this system where highly regulated banks support an alterego that is monitored only by the credit rating agencies, is that nobody can be responsible for the stability of the integrated system.  Bank regulators tried to limit the banks’ exposure to conduits by adjusting the capital requirements relating to liquidity facilities and credit enhancement.  In the meanwhile, the credit rating agencies were approving the use of liquidity and credit facilities that allowed banks to evade the intent (if not the letter) of the regulatory requirements.  An example of this is the liquidity put described in the previous chapter.

I should note here that the term “shadow banking system” was coined after the financial community experienced a run on asset-backed commercial paper.[2] While it is easy to see in retrospect that it was a mistake for regulators to allow the development of a parallel banking system in which bank supported lending took place beyond their view, the simple fact is that only a very, very few people recognized how profoundly unstable financial markets can be.[3] Everyone else thought it was simply impossible for a market with as many participants as the ABCP market to find that suddenly there were no buyers – and not just for one week, but for week after week after week.  Because of this profound failure to understand the nature of financial markets, regulators viewed the growth of ABCP as a benign event, which served only to increase the availability of credit throughout the economy. [4]

The parallel banking system matures

By 1997 the ABCP market was well enough established to grow at a rate of more than $100 billion each year.  While 2002 saw the start of a three-year break in this pattern of strong growth, this is easily explained by the collapse of Enron and the consequent uncertainty surrounding the regulation of ABCP conduits. By the middle of 2004 the regulatory issues had been resolved and ABCP was once again growing at a rate of more than $100 billion a year.

The greatest growth in ABCP took place from June 2006 to June 2007.  In this period, ABCP increased by more than $238 billion.  As domestic deposits in the banking system over the same period grew by $255 billion, the ABCP market was providing almost as much additional liquidity to the U.S. economy as the banking system itself.

In this period from June 2006 to June 2007, banks were required to back any assets that were supported by a liquidity facility with one tenth of the capital that would be required if the asset was owned by the bank.  Against any assets that were supported by credit enhancement the bank was required to hold capital just as if the asset were on its balance sheet.  If 10% of the average conduit’s assets had a credit enhancement, then  each dollar of bank capital could support approximately $125 of loans when the loans were placed in a conduit (as compared to $25 when the loans were kept by the bank).

One thing is clear.  The outsourcing of bank lending to ABCP conduits made it possible for bank capital to support a far greater number of loans than could have been supported in the traditional banking sector.  Since housing prices were rising at the same time as a massive increase in securitization was taking place and the increase in ABCP represented in part an increase in the funds available to finance the purchase of homes, it is entirely possible that this increase in funds contributed to the increase in housing prices.    In other words, the price inflation we have seen over the past year in housing and other real estate, may be explained, in part, by the growth of conduits that were subject only indirectly to regulatory capital requirements.

[1] In 1994 Community Assets Management paid only 96 cents on the dollar to investors.  Money market funds were added to the definition of M2 in 1980.

[2] I believe the first use of the term is by Paul McCulley of Pimco in his September 2007 newsletter.

[3] Raghuram Rajan is one.

[4] On the other hand, there were quite a few in the investment world who viewed the growth of asset backed commercial paper and, in particular, its important role in funding complex structured finance products with caution and even concern.  Several money market fund managers took a conservative approach and avoided asset-backed commercial paper entirely.

The parallel banking system: The regulation of ABCP

Note:  This is post 2 of 3.  See also here and here.

The problem of implicit recourse

While asset backed commercial paper programs started as a way for firms to borrow against the collateral of their financial assets, such as accounts receivable, it didn’t take long for banks to realize that a very wide variety of assets could be financed using ABCP.  All of the loan types that banks held on their balance sheets in the past found their way into asset backed commercial paper conduits:  residential mortgages, commercial mortgages, unsecured business loans, corporate bonds, government bonds, etc.

Thus by the late 1980s ABCP conduits had evolved such that banks were deliberately taking loans off their balance sheets and placing them in conduits in order to reduce the amount of capital that regulators required of them.  For the most part regulators viewed this phenomenon as a positive development, since it meant that a third party, the conduit, would absorb a large portion of any losses on the loans.  To the degree that the conduit would be taking the losses, there was no need for the bank to hold capital against the loans.

While the relationship between conduits and sponsoring financial institutions was subject to steadily increasing regulation over time, the conduits themselves were not regulated.  They fall into the same regulatory category as hedge funds:  because investments in conduits cannot be marketed or sold to the general public, regulators rely on the self-interest of sophisticated investors to act as a market force that makes government supervision of conduits unnecessary.

Through the 1990s, it became clear that the conduits which were created by banks to hold bank loans were far less independent in practice than they were on paper.  While some banks ignored the structured finance revolution and continued to hold loans on their balance sheets as they had in the past, the banks that chose to create conduits developed a new business model.  They originated loans with no intention of holding them on balance sheet.  Banks that followed the new originate and distribute model of lending were dependent on their conduits in order to continue their loan activities.

Thus, when problematic assets were going to cause a conduit to default, the sponsoring bank suddenly found itself in a position where, if the conduit was allowed to default, the bank would lack the credibility to continue placing assets in any other conduit – and this would be extremely detrimental to its business model.  Repeatedly throughout the 1990s regulators agreed that it was in a bank’s interest to support a faltering conduit – despite the fact that on paper the bank had no obligation to do so.  In short, it became clear that when a bank sold a loan to a conduit, it was in practice a recourse sale – that is, a sale where the bank can be required to take back the asset when it goes into default.

Here, we run into a problem.  The accounting rules for recourse sales are crystal clear:  a recourse sale is not a “true sale,” so a loan sold with recourse cannot be removed from the seller’s balance sheet.  While implicit recourse was not yet explicitly covered by accounting rules, the violation of accounting principles was evident.  Throughout the later years of the 1990s, regulators struggled with the problem of implicit recourse for loans sold to conduits, and by 2002 had a new policy:  Banks that provided recourse for assets that had been sold to conduits were threatened with an increase in regulatory capital requirements.

The main effect of stricter regulation was, however, to drive implicit recourse deeper underground.  For example in the early years of the current decade there was a noteworthy growth in loans bought back from conduits on the basis of fraud.  Under accounting rules a clause requiring the repurchase of fraudulent loans does not make the sale a recourse sale.  In 2001, NextBank was forced by regulators to take a conduit on balance sheet, because it was clearly using “fraud losses” to hide the fact that it was buying back bad assets from the conduit.  This caused the bank to fail and be seized by the FDIC.  NextBank, however, is an exceptional case that did not set a precedent for the banking system as a whole.  Researchers have found evidence that other banks were also using “fraud losses” to hide recourse loans and did not suffer regulatory interference.[1]

In short, while it was well understood that banks were using conduits to reduce and even avoid regulatory capital requirements, it is not clear that anyone – the bankers, the regulators or the researchers – was genuinely concerned that the banks were undercapitalized.  Many seem to have held the view that capital requirements were too strict and thus that, at least to some degree, avoiding them was in the interests of economic efficiency.  (It is worth noting that in precisely these years the Basel II international regulatory standards for banks were being negotiated – and that one goal of Basel II was to reduce the conservative regulatory capital requirements that had been put in place by the Basel I accord.)  The regulators, like the banks themselves, could not imagine a real-world scenario in which many conduits would simultaneously draw on their credit and liquidity facilities.

Efforts to regulate liquidity facilities

By March 2004, the Enron scandal had led to the revision of accounting standards.  Enron used conduits to hide losses from the public.  And the new accounting rule, FIN 46R, stated that, if a single organization was exposed to the majority of a conduit’s expected losses then that organization would have to take the conduit on balance sheet.  The new rule also required firms to evaluate the degree to which they were either implicitly or explicitly exposed to losses from off balance sheet conduits on a regular basis.  This new rule forced several banks to consolidate asset backed commercial paper conduits onto their balance sheets.

However, since banks were using conduits to fund new loans, not to hide losses, regulators did not view the accounting changes as particularly relevant to banking.  The regulators argued that, because the banks’ exposure to losses from conduits was limited to the credit and liquidity enhancement that they were contractually obliged to provide, treating banks as if they were exposed to 100% of the conduits losses by forcing them to take the conduits on balance sheet results in excessive capital requirements.  Thus, to this day the calculation of a bank’s risk-based capital requirement does not include any ABCP conduit assets that have been consolidated on to the bank’s balance sheet.[2]

Despite such regulatory indulgence, banks have shown a strong preference for conduits that do not need to be consolidated on balance sheet.  Now ABCP conduits are designed so that multiple banks or firms sell assets into the conduit and each is obliged to buy back only a portion of the assets in case of default.  In this manner no single entity is exposed to the majority of the conduit’s expected losses.  At the end of 2006 about half or $600 billion of the ABCP conduits in the US took this form.[3]

Although the regulators decided to allow banks to ignore ABCP conduits when calculating their risk based capital requirements, they were well aware that implicit recourse could be a problem for conduits.  Thus, the regulators also put into place stricter capital requirements for commitments to provide credit and liquidity enhancement.

Since 1992, the capital requirements that banks faced were much higher for credit enhancement than for liquidity support.  In fact a bank that provided 100% credit enhancement to a conduit was required to hold capital, just as if the loans were on its balance sheet.  When credit enhancement was only for a fraction of the conduit’s assets, the bank was required to treat that fraction of the assets as though they were on its balance sheet.  On the other hand up through the middle of 2005 there was no capital requirement for any liquidity facility of less than one year’s duration. It didn’t take banks long to figure out that, by designing a 364 day liquidity facility that also provided credit enhancement, they could minimize regulatory capital requirements.

This practice of combining a liquidity facility with credit enhancement did not escape the notice of regulators.  Thus, in the same final ruling that mitigated the effects of post-Enron accounting changes on banks, the capital requirements for short-term liquidity facilities were increased:  “ineligible” liquidity facilities would be treated as equivalent to credit enhancement, while “eligible” liquidity facilities would require a tenth of the capital required for credit enhancement. The following scold was published with regulatory guidance on the ruling:

The agencies reiterate their position that the primary function of an eligible ABCP liquidity facility is to provide liquidity – not credit enhancement. Further, the agencies emphasize their view, as stated in the ABCP rule, that an eligible liquidity facility should not be used to purchase or otherwise fund assets with the high degree of credit risk typically associated with seriously delinquent and defaulted assets and assets that are below investment grade. [4]

An eligible ABCP liquidity facility includes a provision that reduces the funding obligation, before any funds are drawn, by the quantity of assets that are 90 days or more past due, in default, or below investment grade to the degree that these assets are in excess of the credit enhancement available to the conduit.  In other words, a liquidity facility is eligible as long as it explicitly precludes the funding of high-risk assets that are not already covered by credit enhancement.[5],[6]

It is worth observing that the qualification “to the degree that these assets are in excess of the credit enhancement available to the conduit” is not actually part of the final rule issued by regulators on July 28, 2004.  In fact, in the background information published with the final rule, the regulators state that commenters had requested that “guarantees providing credit protection” be taken into account and for this reason a clause was added to final rule excepting assets protected by a government or agency guarantee.  The relaxation of the final rule as it relates to private sector credit enhancement took the form of interagency guidance published on August 4, 2005.  It is not clear to me how this guidance can be considered consistent with the plain text of the final rule.

In order for a conduit to receive an A1/P1/F1 rating from the credit rating agencies, typically a conduit must have 100% liquidity support.  Thus, as soon as the assets in default exceed the credit enhancement available to the conduit, this rule creates a very awkward situation for the sponsoring bank.  Either the liquidity facility is reduced so that it does not cover the impaired assets and this puts the conduit’s credit rating at risk, or the liquidity facility becomes ineligible and the bank must treat all the assets in the conduit as if they were on balance sheet.

In the context of this regulatory environment, let’s try to make sense of an event that shocked the financial world in November of 2007:  $25 billion of new sub-prime CDO exposure suddenly appeared on Citigroup’s third quarter balance sheet.  The question everybody was asking was:  How could Citi have failed to report this exposure in previous financial statements?  The explanation:  When Citi sold these CDOs to conduits they were sold with a “liquidity put.”  The liquidity put “allowed any buyer of these CDOs who ran into financing problems to sell them back – at original value – to Citi.”[7]

How can a “liquidity put” be consistent with the regulatory standards we’ve just explained?  A liquidity put could be part of an eligible liquidity facility as long as financing problems could trigger a repurchase of the asset only if the asset retained its first tier rating.  Furthermore, since typically under the law, the reason a recourse sale is not considered a “true sale” is that the seller retains the credit risk of the loan, a liquidity put may not be used to purchase an impaired asset.  Thus a liquidity put must be triggered by a financing problem and explicitly rule out repurchase of an asset that has been downgraded or is seriously delinquent.

The example of Citibank indicates, however, that, because delinquencies and downgrades are anticipated before they occur and commercial paper is rolled over on a frequent basis, the expectation of asset impairment precipitates a liquidity crisis for the conduit before the assets are formally recognized as impaired.  Thus, in practice, the seller of a liquidity put is exposed to the credit risk of the underlying loans.

As a dramatic overhaul of the treatment of off-balance sheet entities in financial statements is underway, it is appears that regulators and accounting professionals have a clear understanding of the deficiencies of recent industry practices. [8]


[2] From a final rule published in the Federal Register on July 28, 2004 and available at:

“The agencies [The Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of Thrift Supervision] believe that the consolidation of ABCP program assets generally would result in risk-based capital requirements that do not appropriately reflect the risks faced by banking organizations involved with the programs. Sponsoring banking organizations generally face limited risk exposure to ABCP programs. This risk usually is confined to the credit enhancements and liquidity facility arrangements that sponsoring banking organizations provide to these programs. In addition, operational controls and structural provisions, along with overcollateralization or other credit enhancements provided by the companies that sell assets into ABCP programs, mitigate the risks to which sponsoring banking organizations are exposed. …

The final rule will make permanent the exclusion of ABCP program assets consolidated under FIN 46-R and any associated minority interests from risk-weighted assets and tier 1 capital, respectively, when sponsoring banking organizations calculate their tier 1 and total risk-based capital ratios.”

“Effective September 30,2004, the federal banking agencies amended the risk-based capital standards to permit bank holding companies and other sponsoring banking organizations, when calculating their risk-based capital ratios, to exclude from their risk-weighted asset base those assets in asset-backed commercial paper (ABCP) programs that are consolidated onto the sponsoring banking organizations’ balance sheets.”

Federal Bank Holding Company Law, 1997, by Pauline B. Heller, Melanie Fein p. 5-16.7

[3] MARKETS AND INVESTING: Guide to the vehicles: conduits, SIVs and SIV-lites

Financial Times

Published: Aug 15, 2007,id=070815000650,print=yes.html

[4] SR Letters 2005-13. .

[5], p. 18.  Note that the original rule proposed that eligible liquidity facilities require one fifth of the capital required for credit enhancement and that the liquidity facility be reduced by the quantity of loans that were 60 days or more past due.

[6] SR Letters 2005-13. .

[7]Loomis, Carol, November 28 2007 Robert Rubin on the job he never wanted, Fortune Magazine

Bank of America also announced $10 billion of CDO exposure due to liquidity puts.


The parallel banking system: What is Asset Backed Commercial Paper?

Note:  This is post 1 of 3.  See also here and here.

Before there was asset backed commercial paper …

Asset backed commercial paper is a relatively new invention, but commercial paper is not.  Traditional commercial paper is way for firms to borrow money without offering the lender any collateral for a period of time from overnight up to 270 days.  Because there is no collateral to secure the loan, typically only large well-known firms can issue commercial paper.

Commercial paper has been around for centuries and predates the development of a modern banking system.  World famous bankers like the Medici in Florence, the Fuggers of medieval Germany and the Rothschilds made fortunes by trading in commercial paper.  Thus, commercial paper is an asset class that has stood the test of time.

The basic idea behind commercial paper is this:  When a large company with stable revenues and sound finances like General Electric Corporation wants to borrow money for three months, there are plenty of people who will lend the company money on an unsecured basis (in other words, with no guarantees aside from GE’s promise to repay the funds). Why are people willing to trust GE with their money?  Because there is virtually no likelihood that GE will go bankrupt within the three month duration of the loan instead of paying off the debt.

Of course, once in a while a firm that issues commercial paper does go bankrupt.  One of the more recent examples, Mercury Financial Co., a major issuer of automobile loans, defaulted on $315 million of commercial paper in 1997.  But such cases are very rare, so large, creditworthy firms in the US continue to borrow huge sums using commercial paper on a daily basis, and this has been common practice in the US and Europe for centuries.

Since the 1970s, the number of buyers in the commercial paper market has increased dramatically in the United States.  The reason for this is the growth of money market mutual funds.  Money market mutual funds accept investments of as little as $1,000 and invest in short-term assets like commercial paper and U.S. Treasury bills.  Because they aim to invest in assets that are so safe that they will not experience losses (and historically there have been almost no losses),[1] each share in a money market fund is worth $1 and this allows the fund to function just like an interest paying bank account.  Many money market funds even allow investors to withdraw money using checks.

The reason money market funds grew so dramatically in the last quarter of the 20th century is that they offered investors interest payments close to the return on U.S. Treasury bills – and this return was much higher than that offered by banks on savings or checking accounts.  Chart 1 shows how the assets in money market mutual funds have increased from 1975 to today.  You can see that in 1980 less than $100 billion were invested in money market funds, and nowadays more than $2 trillion is held by investors in money market funds.  Thus over the past quarter of a century there has been approximately a 20 fold increase in the funds available to purchase commercial paper.

Chart from “US Money Market Funds: A Regulatory Success Story”, Peter G. Crane, Crane Data LLC – 28 Nov 2006

What has been happening over the past 25 years is that corporations have been able to borrow money directly on the commercial paper market instead of turning to banks for loans.  The flip side of this transition is that investors have been choosing not to deposit their money in banks, but to invest in money market mutual funds and thus indirectly in commercial paper.  This process where the traditional lending relationship between firms and banks is displaced by market based lending is called disintermediation.  Charts 2 and 3 show how the issue of commercial paper increased from 1965 to the present.

Chart 2:
Chart 2:

from Instruments of the Money Market, edited by Timothy Q. Cook and Robert K. Laroche, 1993

Chart 3:  Data from
Chart 3: Data from

Asset backed commercial paper:  The early years

Asset backed commercial paper (ABCP) was first issued in the mid-1980s.  An important impetus for the development of ABCP was the introduction by the Securities and Exchange Commission of regulation for money market mutual funds in 1983.  The big change was that money market funds were required to invest the vast majority of their portfolio in first tier commercial paper.  First tier commercial paper must receive the highest possible rating from one of the major credit rating agencies, such as Standard and Poors, Moody’s or Fitch.  The rating A1 (S&P), P1 (Moody’s) or F1 (Fitch) means that the commercial paper is as unlikely to default as the US government.

This regulation dramatically reduced the demand for second tier commercial paper, which is rated A2/P2/F2 and is somewhat more likely to default than first tier paper.  Many firms, which had been actively issuing second tier commercial paper, suddenly found themselves looking for a new source of funds.  Asset backed commercial paper programs were established so these firms could continue borrowing on commercial paper markets.

In an asset backed commercial paper program a special purpose entity, often called a conduit, is created.[2] The firm takes a group of assets that it could typically use as collateral for a bank loan, like a portfolio of credit card receivables or car loans, and sells the assets to the conduit.  The firm usually continues to service the assets by collecting payments and sending them on to the conduit.  In this early period, it was also common for the firm to retain the obligation to buy back assets that go into default.

The conduit, which is legally an independent third party,[3] sells commercial paper to finance its purchases of business loans.  This is asset backed commercial paper because it is literally the income from the loans owned by the conduit that enables the conduit to pay the interest on its commercial paper and, as the loans are paid off, to reduce the amount of commercial paper that it issues.[4]

Notice the structure of a commercial paper conduit:  the loans owned by the conduit are often scheduled to be paid off only after a few years, while the commercial paper comes due in a matter of months.  Thus, the conduit does not have enough money to pay off the commercial paper in full when it comes due.  This means that the conduit will run into trouble if it cannot issue new commercial paper when the old commercial paper matures.  In other words, the conduit is dependent on the liquidity of the commercial paper market.

From a financial point of view this means that in order for the conduit to find buyers for its commercial paper, it must have a plan for what it is going to do if it cannot issue new commercial paper.  To deal with this liquidity risk all conduits pay a bank to guarantee that the bank will buy the conduit’s commercial paper if the commercial paper market is not functioning.  This guarantee is called a liquidity facility.

Not only does a conduit need to have a liquidity facility, but it also needs to have a plan for what it will do if a bunch of the loans that it owns go into default.  In particular, since the SEC requires that a money market’s assets be composed mostly of first tier commercial paper, asset backed commercial paper programs need an A1/P1/F1 rating.  To earn their highest rating the credit rating agencies require (i) that a liquidity facility covers 100% of commercial paper issues and (ii) that an asset backed commercial paper program protect lenders from default by ensuring that even if 15% (and sometimes more) of the assets go into default, the commercial paper will be paid.  This protection against default is achieved by some combination of the following three possibilities:  (a) the firm that sells the loans is required to buy them back if they go into default,  (b) over-collateralization, where the amount of commercial paper issued (and the amount paid by the conduit for the assets) is less than the full value of the assets, and (c) credit enhancement, where a bank commits – for a fee – to purchase some of the conduit’s assets at full value if they go into default.

For a bank that sells a liquidity facility only, the distinction between credit enhancement and a backup line of liquidity is important.  In the event that the conduit cannot roll over its commercial paper because it has assets that are in default, the bank does not need to honor the liquidity commitment.  (Legally this is usually called a “material adverse circumstance,” which negates the initial commitment.)

As you may have noticed, from the beginning ABCP programs provided ample opportunities for banks to earn income from fees.  Not only could banks provide credit enhancement and liquidity facilities, but they often earned income from advising the firms that set up ABCP programs.  Banks usually determined the credit standards for assets that were placed in an ABCP program including the appropriate level of over-collateralization, and they monitored the program’s portfolio of assets on an on-going basis.  Thus, banks were very supportive of the growth of ABCP because it opened up an important role for them to play in the new world of market-based lending.

The regulatory changes faced by banks in the 1980s also encouraged the development of asset backed securitization programs.  Regulators were increasing the capital requirements for banks.  To increase capital, a bank needs to raise money.  This can be done by holding onto and reinvesting profits or by selling new shares of ownership in the bank.

Another way to meet the higher capital requirements demanded by regulators was to reduce the quantity of assets on which the capital requirements were based.  When a bank makes a loan and keeps it until it is completely paid off, the loan is an asset on the bank’s balance sheet.  When the bank sells the loan, the asset is removed from the bank’s balance sheet.  Bank capital requirements are based on the assets a bank holds on its balance sheet.  Thus banks could meet regulators’ demands by selling some of loans that they held on their balance sheets.

Asset backed commercial paper programs give firms access to the funds they seek, generate fee income for banks, and place the loans created with a third party, the conduit.  By keeping these loans off the bank’s balance sheet, these programs help reduce the capital requirements faced by banks.

Asset backed commercial paper conduits are one of the founding pillars of the securitization revolution.  Securitization is a term that refers to the practice of financing loans that were traditionally held on a bank’s balance sheet by selling the loans to an independent conduit.  Securitization takes hard-to-sell loans and turns them into a tradable asset.

The commercial paper issued by these conduits can only be sold if it carries a first tier credit rating, and a first tier credit rating will only be granted if the conduit has sufficient liquidity protection and credit enhancement.  Thus the legal contracts that are used to create the conduit must be carefully structured to meet the demands of the credit rating agencies.

Let’s pause for a second and think about what it is that securitization is doing in the commercial paper market.  It replaces traditional commercial paper, or a promise of repayment backed by the full faith and credit of a large firm, with ABCP, or a promise supported by collateral and bank guarantees.  Now, since the extra interest you can earn by investing in asset backed commercial paper is much less than 1% and ABCP is very short-term, it simply isn’t worth an investor’s time to go through and carefully check out the quality of the collateral backing the conduit.  This means that investors in ABCP are placing their trust in the bank guarantee and sponsorship of the conduit – even though the bank usually only guarantees a fraction of the assets.

The fundamental contradiction of these structured finance products is this:  the investor is counting on the bank sponsorship and guarantee of the conduit to protect the investor from losses, while the bank is counting on the investor to absorb the losses if the conduit turns out to have more bad assets than expected.  Because exposing the investor to losses on low-yield commercial paper is a sure-fire way of scaring the investor away from that bank’s conduits, if not from the ABCP asset class as a whole, banks face a very strong incentive to provide support to the conduit well beyond a bank’s contractual obligations.  Of course, when a bank takes action to protect the investors in a conduit, one cannot help but question whether the conduit is in fact a truly independent third party.  As ABCP programs evolved, signs of this fundamental contradiction between the contractual and the actual behavior of these conduits continued to grow.

Sources:  Asset-backed commercial paper programs.

From: Federal Reserve Bulletin  |  Date: 2/1/1992  |  Author: Boemio, Thomas R.; Edwards, Gerald A., Jr.; Kavanagh, Barbara

The evolution of the U.S. commercial paper market since 1980.

From: Federal Reserve Bulletin  |  Date: 12/1/1992  |  Author: Post, Mitchell A.

[1] “Only one small money market fund in the US has ‘broken the buck’, in the 1990s.”

[2] The terms conduit, special purpose entity (SPE) and special purpose vehicle (SPV) are used interchangeably.  (Observe, however, that a qualifying SPE (QSPE) is a distinct term defined by the accounting regulation SFAS 140.)

[3] To be more accurate the conduit needs to be “bankruptcy remote.”  This is a very technical term, which speaking roughly means that its activities are strictly limited in scope, that it has an independent director, that any claimants to the assets in the conduit other than the commercial paper owners cannot force it into bankruptcy and that it is run as a business entirely separate from all other persons and entities.  The last two conditions are meant to ensure that, in the event of the bankruptcy of the sponsoring bank or firm, the conduit’s assets are protected from the bankrupt entity’s creditors.  For the gory details see pp. 19 ff.

[4] In practice, the conduits that are created by asset backed commercial paper programs are typically designed as on-going concerns that continuously replace any loans that are paid off with new loans and replace any commercial paper that is paid off with new commercial paper.

The parallel banking system: An outdated introduction

I was surprised that the discussion at the Atlantic implied that there are a lot of people who don’t understand the basic structure of the parallel banking system that has developed since the 1980s.  I wrote a piece in early 2008 that was outdated as soon as it was completed and that I mothballed.  I think I explained the parallel banking system fairly clearly, however — and so I thought I’d put what I wrote up in a series of posts.

For amusement here is the (totally outdated) introduction.  (It’s pretty clear at this point that the current crisis extends far beyond asset backed commercial paper.)

The Anatomy of a Crisis:  Introduction

The financial crisis of 2007 that has roiled markets across the world and caused investors to question the solvency of some of the world’s largest financial institutions was set off by unusually high default rates on sub-prime mortgages issued in the US.  For this reason, politicians and regulators have spent a lot of time talking about how to fix the mortgage markets.  Unfortunately these well-meaning individuals have been confusing the catalyst of the crisis with the cause of the crisis.

This book will explain the cause of the crisis – and while we will certainly spend some time exploring why the subprime mortgage market is in such a bad state – our main focus will be the asset backed commercial paper market, which is the key to understanding why the crisis happened – and how to avoid crises in the future.

Initially the problem with subprime mortgages was viewed as nothing more than a bit of noise that would indeed result in losses for some financial institutions, but would have no more effect on financial markets than any other bad investment.  At least that’s what people thought, until the second week of August.  To get an idea of why asset backed commercial paper (ABCP) is so important take a look at this graph.

The financial crisis started in the second week of August 2007 when issuers of asset backed commercial paper failed to find buyers for their paper.  The financial crisis will end when the asset backed commercial paper market stabilizes.

CP to 2007

The reason that it is taking a long time for the asset backed commercial paper market to stabilize is that buyers of this paper don’t like taking on risk.  ABCP buyers are almost always people who are responsible for watching over money that their employers or clients want to have access to at any point in time.  The one thing they can’t do is go back to the boss and say:  “Sorry, I lost some of your money.”  Higher returns are definitely better than lower returns, but genuine risk of losses is an absolute no-no.  Money market fund managers, corporate treasurers and fiduciary institutions were all parking their excess funds in asset backed commercial paper because they had been told by their brokers and the rating agencies that it was perfectly safe — and that they could earn higher interest rates on their money without significant risk.

Now, there is a whole crowd of people who will read that last sentence and just crack up laughing.  Why?  Because there’s one unbreakable rule in the world of finance and that is that you don’t earn higher returns without taking on greater risk.  If that were actually possible, your broker wouldn’t be selling the product to you – he’d be too busy buying into this “free lunch” himself.

ABCP funds most of the new-fangled financial products that were used to finance everything from corporate loans to commercial real estate loans to residential mortgages to consumer car loans.  Did you catch that?  Residential mortgages.  Yep, that includes sub-prime.

When these risk averse investors realized that they could be exposed to the losses on sub-prime mortgages, they also realized that they could potentially be exposed to losses from all those other loans they were financing.  In other words, they finally realized that they were taking on the risk that they might have to admit to the boss that they had lost money.  The drop you see in the ABCP chart is these investors deciding that ABCP is too risky for them.

Bill Gross, manager of one of the world’s largest mutual funds, predicted that ABCP will disappear entirely.[1] Even if it doesn’t disappear, the flight of money away from ABCP is a problem for many of the investment products created by Wall Street over the last decade.

CDOs, CLOs, SIVs and a host of other Wall Street acronyms are structured finance deals that have a pretty similar structure.  About 10% of the deal is high risk.  Anyone who invests in this portion of the deal is agreeing to take all of the losses that the deal incurs up to that 10% investment amount.  Precisely because there are investors who take the first losses, the other 90% of the deal is considered relatively low risk.  A big chunk of the rest of the money is raised using asset backed commercial paper.  Once the money is raised, it is used to buy loans.  As I noted above, these loans can include a wide variety of commercial, consumer and real estate loans.

Why is most of the deal financed using asset backed commercial paper and other short-term notes?  Because short-term loans are generally cheap – investors don’t expect to earn too much in interest if they’re lending the money for a year or less.  This frees up more of the return from the underlying loans to be paid to other investors.  Without this ability to increase the returns for the investors who were bearing the first risk, these deals could not have been put together.  In other words, cheap money borrowed through asset backed commercial paper markets was crucial to most of the structured finance deals created by Wall Street over the past decade.

When investors got scared about the risks involved in asset backed commercial paper, it became a lot harder or even impossible for many structured finance deals to be completed.  Unfortunately, more than 50% of residential real estate loans[2], 28% of commercial real estate loans[3] and 67% of corporate leveraged loans[4] had been going into structured finance products over the last few years.  Thus when structured finance products couldn’t raise money, this meant that there was much less money available to finance mortgages and many other loans.

Sub-prime mortgage lending was the first section of the credit market to freeze up, but it was just the canary in the coal-mine.  At first, investment banks hoped that investors were only refusing to buy asset backed commercial paper with subprime exposure, and so they stopped buying subprime mortgages.  In the summer of 2007, x mortgage lenders who specialized in the origination of subprime loans went bankrupt.

Soon, however, it was clear that investors were worried not just about subprime but about asset backed commercial paper in general.  Through 2007 as investment banks adjusted to a $100 billion per month reduction in the funds they could raise to buy loans, they became much more selective.  They stopped buying most mortgages, leaving the market to two special government sponsored mortgage-buying firms, Fannie Mae and Freddie Mac.  Since both of these firms wouldn’t buy any loans in excess of $417,000, it became very hard to get a “jumbo” mortgage in excess of this amount.  The credit contraction extended, however, beyond real estate.  Banks also looked for ways to avoid making leveraged loans (which are used to finance businesses buying other businesses) that they had spent the last six months negotiating.

Some might think that this credit contraction isn’t really such a big deal – after all a bunch of loans that would have been made in the past were not made.  Sure, if you happened to be one of the few people who really wanted to buy a house in the last few months of 2007, you were pretty unlucky, but why should the rest of us care?

Well, when you’re talking about expensive assets like houses that can really only be purchased with the help of a loan, a major reduction in credit can have a lot of side effects.  In particular, the first effect of a reduction in credit is a reduction in the number of people buying houses – without a change in the number of houses for sale.  Now instead of having two buyers bidding up the sale price of the house, a lucky seller may only get one offer.  And unlucky sellers may watch their house sit on the market for months.

Thus, the second effect of a credit contraction is an increase in the number of unsold houses sitting on the market.  Since credit conditions mean that the market still has a shortage of buyers, the tendency is for selling a house to get harder and harder the longer the credit contraction continues.

Of course, when there are a lot of houses for sale and just a few buyers, we expect some of the sellers to start offering a really good deal to any buyers they may find.  The third effect of a credit contraction is a fall in housing prices.

If you are one of the people who bought recently and you’re looking to sell your house, you may find that you can’t get what you paid for it.  And, if you happened to make a very small down-payment, you may find that you owe more money on your house than you can get by selling it.  In this situation, if you’re unlucky and sickness or unemployment prevents you from making your mortgage payments, you won’t be able to pay off your mortgage by selling your house.  You may have no choice but to default on the loan and lose the house.

And those who bought the house as an investment may look at the size of their loan, compare it to what they could get by selling it and then conclude that the investment was a mistake.  They may just send their keys in to the bank and walk away with no house, but no mortgage either.

In other words, in markets where buyers are dependent on loans in order to make a purchase, a credit contraction can lead to a downward spiral with a self-reinforcing feedback loop:

Fewer buyers — fewer sales — increase in houses for sale — prices fall — increase in foreclosures — increase in houses for sale — prices fall further

This process is likely to continue until the credit situation stabilizes and the number of buyers increases.

Of course, this negative dynamic in which a credit contraction drives prices down doesn’t only happen in the housing market.  It can happen in any market where most purchases are depend on loans.  The process is starting in commercial real estate.  And has reduced the value of corporations that are targets for take-over.  But most of us first saw the consequences of the credit contraction when we realized that house prices were dropping faster than we ever thought possible.

This book is about a financial innovation called asset backed commercial paper and how it ended up wrecking havoc on the lives of tens of thousands of home-owners and profoundly affecting the opportunities available to just about everybody who lives in the United States of America.

[1] “The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,” Bill Gross, manager of the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co., said in an interview today.

[2] Chain of fools, Feb 7th 2008, The Economist 19% in private MBS

[3] Wall Street Gears for Its New Pain, By LINGLING WEI and RANDALL SMITH

March 3, 2008; Page C1,

[4] In death, afterlife, by Vipal Monga, Updated 03:19 PM EST, Mar-7-2008

Ann Rutledge channels Confucius

“If language is not correct, then what is said is not what is meant; if what is said is not what is meant, then what must be done remains undone; if this remains undone, morals and art will deteriorate; if justice goes astray, the people will stand about in helpless confusion. Hence there must be no arbitrariness in what is said. This matters above everything.”

From The Analects of Confucius, Book 13, Verse 3 (James R. Ware, translated in 1980.)

According to Ann Rutledge, who has been in the securitization business for decades and is a scathing critic of current practices, the solution to the current problems with securitization is:  creating formal definitions for the terms used in the industry.

The problem with the shadow banking system

The discussion over at the Atlantic has evolved so now the argument is that regulators knew about the “shadow banking system” and, thus, its failures are the regulators fault.  Of course, there’s some truth to this view — but it also implies that the shadow banking system should be regulated.

When I hear the term “shadow banking system” I don’t think of “shadow” as meaning “in the shadows” or “hiding”, I think of it as a term like “shadow government” in the UK.  In other words, the “shadow banking system” is just a parallel banking system.  It’s public; everybody who cares to know knows about it, but the average person pays it no attention because it doesn’t appear to have any effect on their lives.

The problem with the shadow banking system is that it’s every bit as unstable as a traditional banking system, without any of the safeguards in terms of capital requirements and a lender of last resort.

In other words, the problem with the shadow banking system is that it wasn’t regulated as a banking system.  It’s certainly fair to argue that the fact that it’s not regulated as a banking system is the fault of the regulators, but to argue that it doesn’t need to be regulated strikes me as daft.