September 06, 2007
Borrowing short and lending long
Here I elaborate on the description of the nature of current problems in financial markets that I offered at the Fed's Jackson Hole conference last week.
A traditional bank is in the business of taking the funds it receives from its depositors and investing them in projects with higher rates of interest. If that was all that is involved, however, the system would be highly unstable, because it's always possible that the bank could lose money on its long-term investments if interest rates rise or worsening economic conditions lead some of its borrowers to default. In such a situation, if the customers all decide they want their money back, there wouldn't be enough to pay them all.
The way this problem is solved is to have the capital that the bank lends come not just from its depositors but also in part from the owners of the bank. These owners should have invested some of their own money to start the bank and reinvested some of the profits of the bank to allow it to grow. The capital that comes from the owners rather than depositors is known as the bank's net equity. The idea is that if the bank takes a loss on its investments, that loss comes out of net equity, and there's still money to pay off all the people who deposited money in the bank.
And what if the losses are bigger than the net equity? Then we're back to the unstable equilibrium, in which each depositor has an incentive to be the first one to get his or her money back, the situation for a classic bank run. Depositors may not be sure which banks have adequate net equity and which don't, so some will be trying to get their money out of banks that are really in good shape. As a result of the bank run, however, those previously solvent institutions will have to sell off their long-term assets, perhaps at a significant loss if they have to be unloaded at fire-sale prices in a panicked market. The result of this may be that the bank panics themselves create new insolvencies, and the problem cascades into a worsening situation.
Historical experience teaches us that this is a highly undesirable scenario, and can create significant economic hardship for people who are completely innocent bystanders. For this reason, we have developed institutions to regulate the banking system, one key goal of which is to ensure that banks always retain sufficient net equity to be able to weather such storms.
What has happened over the last decade is that a variety of new institutions have evolved that play a similar role to that of traditional banks, but that are outside the existing regulatory structure. Rather than acquire funds from depositors, these new financial intermediaries may get their funds by issuing commercial paper. And instead of lending directly, these institutions may be buying assets such as mortgage-backed securities, which pay the holder a certain subset of the receipts on a larger collection of mortgages that are held by the issuer. Although the names and the players have changed, it is still the same old business of financial intermediation, namely, borrowing short and lending long.
There are a variety of new players involved. The principals could be hedge funds or foreign or domestic investment banks. Others could be conduits or structured investment vehicles, artificial entities created by banks, perhaps on behalf of clients. The conduit issues commercial paper and uses the proceeds to purchase other securities. The conduit generates some profits for the bank but is technically not owned by the bank itself and therefore is off of the bank's regular balance sheet.
This system has seen an explosion in recent years, with the Wall Street Journal reporting that conduits have issued nearly $1.5 trillion in commercial paper. Their thirst for investment assets may have been a big factor driving the recklessness in mortgage lending standards, as a result of which much of the assets backing that commercial paper have experienced significant losses.
Without an adequate cushion of net equity for these new financial intermediaries, and with tremendous uncertainty about the quality of the assets they are holding, the result is that those who formerly bought the commercial paper are now very reluctant to renew those loans, a phenomenon that PIMCO's Paul McCulley described at the Fed Jackson Hole conference as a "run on the shadow banking system." I heard others at the conference claim that there might be as much as $1.3 trillion in commercial paper that will be up for renewal in the next few weeks, with great nervousness about what this will entail.
In some cases, these intermediaries have lines of credit with conventional investment banks on which they will be drawing heavily, which will cause these off-balance-sheet entities to quickly become on-balance-sheet problems. Their losses may severely erode the net equity of the institution extending the line of credit. How big a mess will this be? I don't think anybody really knows for sure.
In my remarks at Jackson Hole, I basically suggested that we should be thinking about both the causes and potential solutions to the current problem not just in terms of choosing an "optimal" level for the fed funds target interest rate, but also in terms of seeking regulatory and supervisory reforms, the ultimate goal of which would be to ensure that any financial institution whose failure would exert significant negative externalities on the rest of us should be subject to net equity requirements, so that most of the money the players in this game are risking is their own.
I also recommended that we need reforms to make the whole system more transparent. I think the accounting profession has let us down, in that it is very difficult to look at the annual reports of some of the institutions involved and determine what exactly the exposures are. In theory, competitive market pressures are supposed to result in incentives for private auditors to ensure accurate and informative reports. But I think there is a networking equilibrium issue here in which it is very hard for one auditor to try to change the rules if nobody else does, even if getting everybody to change at once would unambiguously improve social welfare. I recommended that the Federal Reserve could itself be a catalyst for such a change by revisiting the reporting requirements on its member institutions.
Posted by James Hamilton at September 6, 2007 03:06 PMdigg this | reddit
How hard do you imagine it would be to classify these myriad entities into those deserving regulation and those not?
Posted by: seth at September 6, 2007 06:06 PM
Paul over @ PIMCO sees the mess exactly as it is. But I would term it just a bit differently ... "a run on the con men."
To get this solved, this time we need to leave polite terminology behind and identify these people properly, as garden variety con men (and women), and then proceed to purge them from positions in which they endanger the stability of our civilization.
Depending on the actual (presently unknown) extent of the con (which will be determined by the levels of leverage used by these new entities) we my very well be moving into a situation that would cause many of the "greatest generation" to assert, "this is it!"
The behavior of gold during the past few days is certainly rather portentious.
Posted by: esb at September 6, 2007 06:45 PM
I think your remarks are very sound. I don't think "esb"'s or "paul"'s attempts to reduce the most sophisticated financial markets in global history to one-syllable catchphrases deserve much consideration.
I would note that net equity rules or no, margin rules or no, financial leverage is about the easiest thing in the world to create, especially given derivatives. You might find it more comprehensive to think in VaR terms.
I do think you are incorrect regarding transparency and auditors for a few reasons: first, what you are saying should be transparent are valuations but a) there have not been any serious charges that auditors were wrong when they issued their audits; b) valuation and audit are two different things entirely; c) valuations are going to change in between audits and there is nothing that audits can do to prevent that; d) valuations of iliquid securities depend on hosts of assumptions about markets and the securities, and unless you conceive of regulators establishing a predefined and comprehensive set of assumptions, there are no clear guidelines for valuation that are any different from what people use today; and e) valuations are frequently wrong even with good faith and honest reporting. Frankly, bank regulators have hardly been any more accurate in valuing distressed assets than accountants or investment bankers or the people who created the asset in the first place - hence the profits made by distressed debt investors.
Posted by: MT57 at September 7, 2007 10:44 AM
Financial disintermediation has been the defining concept of the mortgage industry for the last quarter of a century with lenders and borrowers not requiring the additional cost of equity that was previously associated with the bank's financing of mortgages.
Therefore, it seems to me that re-regulating the industry such that there would exist a requirement of a percentage of net equity for any mortgage lender would certainly raise the cost of financing for even the most 'vanilla' loans once the cost of equity (18% or so) was included. Would this not shift up the cost of mortgages and lower the prices of housing?
The question that I would ask: Is the current problem a results of the last quarter of a century financial disintermediation or the low interest rates and lax credit standards of the last five years?
Posted by: scott at September 7, 2007 10:51 AM
The bottom line here is that investors need ways to know which firms are writing sound mortgages and which are taking risks. That way they can restrict their runs just to the ones that deserve it, without dragging down everyone with them. It would seem that not only investors, but also financially sound institutions would have an incentive to open up the process so that audits and ratings can be made more reliable and trustworthy.
Posted by: Hal at September 7, 2007 05:08 PM
These markets are regulated and much more efficiently than if the government were to undertake it and impose a one-size fits all rule.
It's a market solution with self-regulation. The solution is called a rating. The rating agenices have said whether these conduits have the proper financing in place to avoid a run.
Now, you tell me, is it another victory for the the 'free-market' or not?
Of course the government has done it in the past, it was called Basle I. Did that work?
Posted by: jh at September 8, 2007 05:15 AM