Sometime after 1987 I decided to keep a collection of books about financial crisis.
“Barbarians at the Gate,”1 was a good read, with smaller-than-life villains, but I gained more insight from the revisionists like Fenton Bailey2 defending Milken and his financial revolution.
It would hardly be possible to start a similar collection after the 2008 crisis, because so many books have been written and films made, but also because there are, as yet, few interesting revisionist works.
Financial markets today look very different to those in 2008. Banks are no longer important liquidity providers in many securities markets, yet they have more capital and generate lower returns on that equity capital. Regulatory and compliance costs are a much larger burden.
Financial institutions are much larger and barriers to entry for new players are a bigger burden than ever before. Regulations micro-manage bank asset holdings. Persistent extremely low interest rates have changed trading and investment strategies in a “stretch for yield.” Central bank balance sheets are enormous, and their floor-driven operating procedures are very different.
These are odd outcomes from a financial crisis that was arguably caused in part by a long-term decline in bond yields, loose monetary policy and a stretch for yield that provided the impetus for creating the risky assets that collapsed in value in 2008. During the crisis, practitioners were struck by the focus of policy makers on treating symptoms of the crisis, but often compounding the underlying problems by setting aside established practices and the rule of law, which generated uncertainty. We can now look back with more perspective and more data to assess what created the deepest financial collapse since the 1930’s.
Monetary policy is central to understanding the crisis and the Federal Reserve was the most active government agency in the response. The Fed fueled the sub-prime boom from 2001, by reducing interest rates to levels that were too low for too long in the face of rising productivity. This not only encouraged lending and credit excesses on the supply side of credit markets, it also increased risk appetite from investors with an insatiable demand for yield. Many of the egregious examples of fraudulent loan origination practices, rating agency inadequacies, poor due diligence, vulnerable structuring and excessive leverage are symptoms of these earlier monetary mistakes. However, with short-term interest rates at 5.25 percent by 2006-7, these problems started to show up in the market with the most excess, for property-secured mortgage loans.
Credit has been given to the Federal Reserve for its crisis response. However, now that minutes from the meetings of the time are becoming available, it is increasingly clear that they made grave mistakes in the early stages of managing the crisis. With oil prices driving up CPI inflation in early 2008, the FOMC offset emergency lending to collapsing domestic banks with large-scale sterilization3. With bad banks collapsing, the effect was to drain precious liquidity from good banks. On Oct. 6, 2008, the Fed started to pay interest on excess reserves (IOER), providing an immediate incentive for banks to hoard reserves, rather than lend. Over time, IOER became central to monetary policy and the new “floor” as the Fed moved away from its former open market-based interest rate setting operations.
These domestic mistakes understate the failure of the Fed to grasp the problems. Offshore “Eurodollar” debt markets had become very large sources of U.S. dollar liquidity for international markets. Outside the domestic purview of the Fed and easy access to emergency liquidity facilities, these money markets relied on access to “safe assets,” which could be offered in repo markets as collateral to secure liquidity. Agency securities (largely Freddie Mac and Fannie Mae) were very important, with their perceived semi-sovereign risk.
Safe assets were in short supply and were created through insurance and structures that created safe “tranches” from underlying risky credit. Inherent in these structures was a lot of counterparty risk – to banks, insurers and special purpose vehicles.
We now know how this structure collapsed. Falling property asset prices were already creating a scramble for safe assets and reducing liquidity in more structured sources of collateral. When Bear Sterns closed two large mortgage funds, counterparties fled the firm, creating a classic run. Support for Bear Sterns from the Fed in March 2008 left markets complacent about counterparty risk. The failure of Lehmann in September, without attention to counterparties, followed by the collapse of the largest credit insurer AIG, led to a collapse in Eurodollar markets that created a more global crisis. Collateral values tumbled or, more honestly, those values became unknowable. The collapse of Freddie Mac and Fannie Mae put at risk formerly unquestioned security values. A money market fund “broke the buck.” Mark-to-market accounting requirements reinforced uncertainty, where “marks” were unavailable in illiquid markets. Short-term financing, particularly in the commercial paper and asset-backed commercial paper market4, dried up for all but a few institutions.
It is hard to exaggerate the enormity of the monetary failure. The broad (Divisia M4) measure of money supply collapsed -8.3 percent between October 2008 and June 2010, despite the quantitative easing measures of the Fed. This decline was not made up until October 2012, four years after the decline began. Whilst broad money growth slowed in prior recessions, the money supply had not contracted since the 1930’s. Broad money growth in the U.S. remains below the pre-2008 period. We do not have global measures for broad money, but excluding China, the collapse was likely even more acute.
In retrospect, we can see that the problem of QE was (and remains) different to the inflationary fears that were initially generated. The real monetary problems were:
1. Privately generated “money”-like assets collapsed, feeding directly into the “real economy”;
2. Limited understanding of Eurodollar markets left many of the biggest problems unaddressed;
3. Interest on excess reserves reinforced “hoarding” of reserves by U.S. banks;
4. New capital and liquidity rules for banks and insurers further increased the demand for safe assets relative to the impaired supply;
5. Distortions in the prices of assets from QE undermined bank profitability and made it more difficult for markets to restructure and discover low risk alternatives to sovereign assets as collateral;
6. Regulatory uncertainty and higher costs of regulation reduced competition and innovation, impairing the intermediary functions of financial institutions; and
7. Fines and financial penalties on institutions increased capital demands on shareholders and undermined counterparty confidence.
QE only partially addressed the financial system issues. It was not an application of Bagehot’s dictum that a lender of last resort should lend freely, at a high rate of interest against good security5. Bagehot’s approach would have worked where it was needed, to provide liquidity and stabilize collateral values. Other measures taken by the Fed, such as putting in place swap lines with foreign central banks and emergency liquidity facilities, were consistent with Bagehot and vital to stabilizing markets.
Implemented with more of a view to theory than actual markets, QE added massively to the money base and the Fed believed that in doing so, it was avoiding the monetary mistakes of the Great Depression. However, broader money aggregates collapsed as there was a run on formerly safe assets and counterparties. The supply of broad money collapsed at a time when the demand for money and money substitutes was very high. Not only did QE distort prices, but the massive additions to bank reserves incentivized by the Fed program withdrew non-reserve money from the broader financial system. With negative real interest rates, the opportunity cost of holding money balances was low, increasing demand for those assets.
Fragile by design
It has been argued that the U.S. has a financial system that was “fragile by design”6, reflecting political compromises and populist preferences. The banking systems of Canada and Australia proved more robust. We can now see with more clarity the fragile elements of the system.
“Too big to fail” financial institutions, many protected by deposit insurance, created asymmetric risk and return payoffs for bank managers. Investors were also protected from having to price risks appropriately. Shocks to these assumptions about counterparty risk showed up this key fragility. After the crisis, removing these moral hazards was a focus of regulators and politicians. An elaborate structure of “living wills,” stress tests, “macro-prudential controls” and new capital instruments was designed to reduce the fiscal impacts and chances of bank failure. However, after all of those measures, it is now more apparent than ever that governments have assumed the responsibility for failure and it would remain untenable to let such a closely regulated institution fail.
Financial institution capital had become driven by regulation, rather than markets, with key institutions far too leveraged. BIS (Bank for International Settlement) capital rules favored some assets (mortgages, agency and sovereign debt) over others and distorted bank operations. New BIS rules require more ordinary equity for banks, but banks remain highly levered and risk weightings for assets arbitrary and distorting.
Money markets had provided liquidity based on collateral from assets that were not nearly as “safe” as presumed. The crisis increased reliance on interest-earning reserves and treasury collateral as safe assets for liquidity. Regulation since the crisis has increased the requirements to hold liquid assets and narrowed the assets considered liquid. This might have created a ready market for profligate governments to issue their securities to, but it is not clear that it has added to system stability.
Many of the problems with asset quality were in areas where banks were required to lend to meet “community reinvestment” obligations or were encouraged to lend to meet financial inclusion goals. Unfortunately, responses to the crisis reinforced some of these problems, with fines of banks dedicated to funding community organizations and the focus of the new CFPA running counter to sound origination standards.
Accountants escaped a lot of criticism after the financial crisis, but the creation of rules that “mark to market,” where real markets do not exist, and “mark to model,” where model parameters are indeterminate, created problems during the crisis that have not gone away.
The failure and “conservatorship” of the government-sponsored entities (GSEs) Freddie Mac and Fannie Mae was central to the crisis, revealing a fragility in the U.S. system that was absent in other countries. Yet there has been essentially no reform of these institutions. With the GSEs, FHA and the FHLB system7, the role of government in the U.S. mortgage market as an insurer or provider of mortgage securities is unique internationally and a key fragility in the system. It insulates from markets one of the largest sources of lower volatility assets and embeds in the system interest rate risk that is absent in other housing markets.
Key fragilities of the financial system that caused the crisis that began in 2008 have not been adequately addressed. Where government regulation failed, the role of governments and their agencies have increased. Where markets had worked well (equity markets and hedge funds), governments are more active. Where market mechanisms are needed, such as the creation of more liquid and safe assets, they have been largely prohibited. The reliance of the system on assets backed by the ever more fragile fiscal power of governments to tax has been vastly increased.
Banks have more capital, but they are less efficient and innovative. If there is hope, it is that outside the heavily regulated banking system, refugees from banks are teaming up with technology innovators to create alternatives. New blockchain-based transactional platforms promise settlement of transactions immediately, reducing counterparty risks. Opportunities for direct provision of credit through online marketplaces can introduce new equity to credit markets, without the need for highly leveraged intermediaries. New opportunities are emerging to pool and structure risks that match investors with those who need money or to hedge risks.
John Cochrane8, one of the best revisionist thinkers about the financial system, has argued convincingly that risks in the current system remain too large. That has prompted a stifling regulatory overlay that is reducing growth. He argues that with modern technology we can have a fully equity-financed banking system, that would require little or no regulation. It might well be that new innovations will enable a global financial system that is less fragile, more market driven and far more efficient. That will only emerge if governments stand down from fighting the last war.
1 Bryan Burrough and John Helyar Barbarians at the Gate: The Fall of RJR Nabisco, Harper and Row, 1989
2 Fenton Bailey The Junk Bond Revolution: Michael Milken, Wall Street and the ‘Roaring Eighties’, Mandarin, 1991
3 George Selgin Sterilization, Fed Style (www.alt-m.org/2015/12/04/sterilization-fed-style/)
4 Marcin Kacperczyk and Philipp Schnabl “When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009”, Journal of Economic Perspectives – Volume 24, Number 1 – Winter 2010 – Pages 29-50
5 Although as pointed out by George Selgin (Fatalistically Flawed: A Review Essay on Fragile by Design, International Finance 18:1, 2015, pages 109-128), Bagehot did not advocate the Bank of England’s lender of last resort role, but his proposals as a second best alternative if there were not competing sources of reserves.
6 Charles Calomiris and Stephen Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, Princeton 2014
7 FHA is the Federal Homeloan Administration, FHLB refers to the 11 Federal Homeloan Banks
8 John H Cochrane, Equity-financed banking and a run-free financial system, https://faculty.chicagobooth.edu/john.cochrane/research/papers/run-free_talk_mn_2016.pdf