It can happen again

James Wood as the CEO of failing Lehman Brothers

Since I put up that thread last night on the HBO docudrama Too Big to Fail, I thought I’d look for some research coming out of financial economists on those events. I’m still reading “House of Cards” off and on which is a  more wonky version of  Too Big to Fail.  I’ve also done my share of reading various research articles that pop up in academic journals.  Mark Thoma had a link to a Minneapolis Fed paper by Robert Lucas and Nancy Stokey.  Lucas is one of the premier freshwater economists and the paper fit the bill.  You become very familiar with the Lucas Critique in graduate school. It’s seminal.

If you watched the HBO presentation, you may recall that Ben Bernanke explained that there was a liquidity or credit crisis that resulted from the downward spiraling financial market conditions. The director punctuated this by showing the head of GE on the phone saying that GE wasn’t able to do its regular business because it’s commercial paper wasn’t going to be renewed or rolled-over.  Commercial paper is the vehicle for borrowing short term working capital. The market is only available to high quality companies.  This was one of the first signs that the contagion was outside of the mortgage markets. There was no money to lend to high quality huge corporations in retail and manufacturing. All outstanding dollars were being brought back to lenders to cover their losses and up their capital in response.  You may have seen my earlier comment that it was rumored at the time that McDonald’s couldn’t get theirs renewed either and was about one week away from not being able to make its payroll.  Many businesses rely on short term borrowing for working capital and most of these businesses are sitting in your local strip malls.

The prime commercial paper market  seems like a gigantic leap from the mortgage repurchase (repo) markets where the contagion started as real estate prices plummeted and troubles in sub prime mortgages became apparent.  The problem is that well diversified shadow banks–like insurance companies, investment banks, Money Market funds, and Hedge funds–are invested all over the place.  If they start losing big in one area, they have to pull their money back to cover it.  They pull the short term money first to avoid penalties and loss of higher yielding assets. Institutions’ exposure to the real estate markets and the repo market was so huge that it started sucking the money out of every other credit market.  They needed the money to cover the losses. Some of the banks were more than able to cover themselves and their capital requirements by doing this.  You also saw this at the end of the show.  The deal is that wasn’t the only problem at that point.  If banks continued to draw funds down from other markets, it was bound to start taking other US businesses and consumers down.  The banks needed to shove more money out the door and not pull it back in according to monetary policy theory as shown by empirical evidence during the Great Depression. The phenomenon is called a liquidity crisis, a credit crunch basically represents a nontraditional bank run.

There are many markets unfamiliar to most people that could set off contagions that impact the real economy.  They are still out there. Reliance on capital creates this situation.  Trying to wring every last penny out of every last dollar through sophisticated cash management programs exacerbates it. A lot of what happens with liquidity crises is that people and business start holding on to money because of panic and uncertainty.  They want to overprotect themselves. This makes the situation worse.  Keynes referred to this as animistic spirits.   Lucas defines it like this.

Liquidity crises that induce or exacerbate deep recessions, as in 1930 or 2008, are situations in which individuals and firms want to build holdings of liquid assets. Heightened risk, or a perception of it, substantially increases demand for these assets. This reduces the supply available for normal transactions, leading to production and employment declines.

What happened in September 2008 was a kind of bank run. Creditors lost confidence in the ability of investment banks to redeem short-term loans, leading to a precipitous decline in lending in the repurchase agreements (repo) market. Massive lending by the Fed resolved the financial crisis, but not before reductions in business and household spending had led to the worst U.S. recession since the 1930s.

Lucas looks at the moral hazard created by deposit insurance as well other risk tools like swap and reinsurance markets using models that were developed in the 1980s that still stand today.  You may remember the huge role of AIG in all of this.  All the banks thought they were safe because they had insured their positions with AIG (credit default swaps, reinsurance, etc.) so therefore they thought they could take on more risk as they increased their volume of stinker loans.  What no one knew at the time was that AIG had pretty much insured the majority of the market. It was betting that real estate prices would never go down.  If AIG would’ve tanked, those insurance policies were dead and so was the rest of its line which included folks’ pensions and life insurance policies.  The AIG exposure was the Rubicon.

If you think you’re insured against a risk, you will take on more risk.  The banks thought they were insured.  Thus, the moral hazard is created.  The best way to explain it is using safety belts in cars.  People actually tend to drive faster when wearing seat belts and engage in riskier behavior because they feel safer. Deposit insurance creates a feeling of safety in both depositors and lenders.  There were never runs on checking or savings accounts during the entire crisis. It happened in Money Market Accounts which are close substitutes but not insured as people wanted to move their funds to their safer accounts.  Money Markets lend big time to the repo markets.

You may recall that TARP switched midstream from a program of buying toxic assets to a recapitalization venture.  The liquidity/credit crisis was basically the reason.  Bernanke told Paulson that it would take several months to value and clear out toxic assets.  They did this later through the QE program where they allowed almost anything as collateral for cheap loans for almost any one at the Fed’s discount window. What they did with the TARP was force the big banks to sell them none-voting preferred stock in exchange for a given amount of capital.  It was a form of nationalization without completely taking over banks.  The banks were supposed to create loans with this and replenish the credit markets.  That happened to a limited extent.  It didn’t replenish all of the credit markets.  Most notably credit for small businesses and consumers remained tight for some time.  They still are quite tight.

The Lucas and Stokey paper concludes that there was likely to be a repeat of the 2008 scenario because all the underlying factors are still basically in place.  Repo markets of any kind generally attract hedge funds and money market funds so there’s a very good chance your pension, IRA, or money market fund probably had a piece of the action in some way and is still out there today in something similar today.  Money makers hate idle money.  The Repo markets tend to be a place to stash funds via loans while fund managers are awaiting longer term investments .  It’s a way to maintain liquidity but still get a return.  So, if any repo market tanks, it drains the liquidity out of any lender in there at the time.

Lucas and Stokey argue that the US experienced a nontraditional bank run which is not preventable under current circumstances.  You didn’t see small depositors worried like they were in 1929 because we’ve now got deposit insurance.  They believe that the FDIC is good for their deposits.  But, there was a incredible run on Money Market Accounts that are not insured. Many people many not have even been aware that most funds were seriously in trouble at the time.  The panic happened in the non-insured accounts.

Lucas and Stokey argue that Dodd-Frank does nothing to stop a repeat of the situation that occurred during the crisis because the bank still knows its deposits are insured so it feels safe enough to venture into other things.   This allows them to engage in risky behavior like a driver with a seatbelt.  Now, the shadow banks that do this on a grand scale are technically banks too.  If they take deposits, they too would become like commercial banks and gain access to deposit insurance.  Mutual of Omaha, once primarily a health and life insurer, now has a thriving bank business.  So does General Motors and General Electric.

John Kareken and Neil Wallace analyzed the incentive effects of deposit insurance in a 1978 paper that has not lost its relevance. Deposit insurance commits the government to pay depositors in the event of asset gambles that turn out badly. An insured bank that takes on risky investments can earn a higher return, and this additional return can be passed on to depositors and shareholders without passing on the added risk. The bank need not fear losing customers by holding a risky portfolio. Indeed, it can gain customers, by offering higher interest than its more cautious rivals. In effect, deposit insurance is a contingent cash transfer from the public to the creditors, depositors and owners of banks, encouraging banks to hold riskier asset portfolios.

Parts of the Dodd-Frank Act are motivated by the desire to protect depositors from unscrupulous or foolish bankers. This is surely a legitimate concern, but it is unrelated to the point of the Kareken and Wallace analysis. Their point, and it is fundamental, is that public funds are committed to banks and their depositors together, altering their joint willingness to take on risk. How they divide the surplus is a secondary matter for this point. Regulating the portfolios of insured banks is the only effective way to deal with this problem.

Why this doesn’t work is the very same reason why people left traditional savings accounts for Money Market Accounts in the 1980s.  Depositors can find close substitutes with higher returns if banks are held to investing in only low return, safe investments.  Depositors believed that Money Market Accounts were basically safe–even though not insured–and were invested in those. The Money Market Accounts were active in the Repo Market when it tanked so there went the ‘deposits’ in the  Money Market Accounts. I recall my sister trying to move money out of one of her Money Market funds at the time. She couldn’t do it.  Most folks were trying to pull their balances out–if the could–and put them in insured deposits.  My MMAs were locked in because they sit in a 403(b) with restrictions on how much you can move.  Banks can only offer accounts with high market rates if they can invest the proceeds in riskier assets.

There were no runs on commercial banks during the financial crisis of 2008. Deposit insurance through the Federal Deposit Insurance Corporation (FDIC) was effective in eliminating the incentive for depositors to withdraw funds. Indeed, as we will see below, demand deposits at commercial banks increased significantly during the crisis. There were two runs on investment banks, however. The run on Bear Stearns in March ended with its purchase by JPMorgan Chase, and the run on Lehman Brothers in September ended with its bankruptcy. In addition, there was an incipient run on money market mutual funds following the collapse of Lehman, halted only when the Treasury stepped in to provide deposit insurance for those institutions.

The problem here is that deposit insurance is limited and investors want higher returns and find alternative vehicles. This part of the market will always be vulnerable to panics.  Additionally, regulators will most likely always be caught off guard because it’s hard to predict and and prevent bubbles. This means that now and in the future, the Fed is likely to be the central player as the lender of last resort.  That leads me to something pointed out in the paper that is probably important to discuss here.  If the Fed does do something like TARP or QE then it has a responsibility to be clear about what it is doing and under what conditions it’s doing it.  It also has to be consistent.  Treating Bear Stearns different from Lehmann Brothers sent a mixed message that confused and panicked the market.

Here’s their main and interesting policy suggestion.

There are two goals here: to have a credible policy for how liquidity will be injected in a crisis and to provide proper incentives for banks during ordinary times. Both goals are met by the Bagehot rule: In a crisis, the central bank should lend on good collateral at a penalty rate. To implement this rule, we need to know how much the Fed should lend and what assets will be regarded as good collateral.

Time consistency requires that no upper bound be placed on crisis lending. The guidelines we have for monetary policy, whether stated in terms of monetary aggregates or interest rates, are directed at long-term objectives and are no help in a liquidity crisis. After the Lehman failure in the fall of 2008, the Fed expanded bank reserves from $40 billion to $800 billion in three months, surely exceeding by far any limit that would have been imposed in August. Even with this decisive response, spending declined sharply over next two quarters.

Because crises occur too rarely for the ex ante formulation of useful quantitative rules, the Fed should have considerable discretion in times of crisis. Nevertheless, because policies should be predictable, the Fed should describe the indicators it will use to decide when lending has reached a sufficient level.

Defining good collateral is more complicated. The quality of collateral is in the eye of the lender, and it can change dramatically from week to week. In this application, though, the lender is the Fed, and it is the responsibility of the Fed to define what it will treat as good collateral. To this end, the Fed should announce an ordering of assets by their quality. The list should be long enough to cover all contingencies, and it would need to be revised from time to time.

In such a regime, banks outside the FDIC would be free to choose their portfolios, with clients, bondholders and equity holders bearing the risk that those choices entail. The lower return on lower-risk assets would be offset, at least in part, by their superior status as collateral in the event of a crisis.

Avoiding liquidity crises altogether is probably more than we can hope for. What we can do is put in place mechanisms to make such crises infrequent and to make their effects manageable.

The events of 2008 illustrate the importance of an announced and well-understood policy. Over the years prior to 2008, investors came to understand that the Fed was operating under an implicit too-big-to-fail policy, in the sense that the depositors/creditors of large banks would be protected. No other policy was ever discussed, and the Fed’s assistance in engineering the orderly exit of Bear Stearns in March 2008 was surely interpreted as evidence that this policy was still in place. The abrupt end of Lehman in September was then all the more shocking.

There is no gain from allowing uncertainty about how the Fed will behave. The beliefs of depositors/lenders are critical in determining the contagion effects of runs that do occur. By announcing a credible policy, the Fed can affect those beliefs, and the Fed needs to use this tool.

Lucas and Stokey seemed to think that the Fed basically did things correctly and will need to do similar things in the future.  The distinction is that now they should be able to outline what will and will not be acceptable as collateral so that banks know before hand. That could set an threshold of some kind for bad investing by insured depositories.  There is still a lot of trash pledged as collateral on the central bank’s balance sheet. This probably means that Frank-Dodd must be enhanced at a time when most banks would like a lot of it gone.  However, there must be some cost to accepting deposit insurance or the risk of moral hazard will be high and the chance of a repeat will be even higher.

Here’s a few other things you may want to check out:

‘Tag, You’re It! Too Big to Fail Risk Transferred, Not Eliminated’:  This is an article from The Atlantic on credit default swaps and deals a lot with AIG.

‘Too Big to Fail’ – real story’s not over; Too Big to Fail’ movie ends early in the crisis. But policymakers, public still struggling with aftermath of ‘too big to fail’ decisions:  This is from the Christian Science Monitor. There’s additional information on the TARP program and the Fed’s moves.

What ‘Too Big to Fail’ remembers: This is from Ezra Klein at WAPO.  It points to a much wonkier and infinite fascinating paper by economists Mark Zandi and Allan Blinder here: How the Great Recession was Brought to an End.  This is an academic work with graphs and models and shows the role of both the FED and the Obama stimulus in the recession’s trough.