Lombard Street: Part Four

For all of Bagehot’s genius, many changes in financial institutions and market structure have occurred since he wrote Lombard Street, making some of his arguments irrelevant. For example, since we now operate on fiat currency, fears of running out of physical money are no longer material. Another important change is that many of our financial institutions are so highly leveraged with debt and interconnected to one another that lending at the high rates suggested by Bagehot would render them insolvent. In the event of a liquidity crisis, demand for the assets held on a bank’s balance sheet might temporarily drop (as we saw in 2008) thus dramatically dropping the value of the collateral the bank had been using to borrow in the repo market.  This could also make the bank insolvent. The line between illiquid and insolvent can become blurry in a crisis.

Now that I have explained a key piece of literature that can be applied to the 2008 crisis, I will explain what policies were actually used during the crisis.  An economist from the Federal Reserve, Edward Nelson, recently wrote a paper explaining in detail the framework used by the organization to combat the crisis. The title of the paper is Friedman’s Monetary Economics in Practice (found here: http://www.federalreserve.gov/pubs/feds/2011/201126/201126pap.pdf). First, however, I should explain how a liquidity crisis works in terms of the complicated tools available in 2008 rather than in Bagehot’s time. While hopefully I have conveyed the theory behind a liquidity crisis, it is important to understand the details of such a crisis to understand the nuances of the Federal Reserve’s policy responses. I believe that although it sounds complicated, anyone who is interested in economics and finance can understand the following description, even if they have never taken a course in the subject. If I leave any parts unclear please leave a comment so that I can answer your questions.

Unlike normal financial banks, such as Wells Fargo, there are financial firms called dealers, such as Goldman Sachs and Lehman Brothers. Dealers do not have access to central bank liquidity or deposit guarantees.  After the repeal of the Glass–Steagall Act in 1999, normal financial banks were able to create conduits that acted as dealers by exploiting an accounting loophole. The loophole allowed banks to keep dealers off of their balance sheets even though the financial bank still guaranteed the dealer’s losses (this should be a red flag in and of itself). Dealers associated with banks were able to convert “opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities” (Pozsar 2010, 1). They were able to do this without access to public liquidity such as deposit insurance or the Fed’s discount window. This conversion strategy created the asset backed commercial paper (ABCP) market as long-term assets were converted into shorter-term debt. Commercial paper is a note, similar to a bond, issued by a firm and is used to finance short-term operations. Dealers are able to finance their purchases of subprime mortgages (long-term assets) through issuance of this short-term commercial paper, thereby turning the process around and using short-term funding to buy long-term assets. This process works as long as the short-term debt market continues to function properly; the failure of this process would turn out to be an important factor in the 2008 crisis.

As I’ve said, dealers have no public insurance or FDIC-like guarantee. As a result they were subject to a sharper loss of confidence in the crisis, leading to a bank run. In addition, using long-term assets (e.g. MBS) as collateral to finance short-term operations is dangerous. Long-term assets are considered illiquid, and as a result are difficult to sell in the event of a crisis. Dealers would not be able to meet funding requirements if they could not sell their assets. In the case a firm defaulted and the other party who was holding their collateral needed to sell, they would have to sell at a massive discount to account for the fact that the MBS are illiquid. This makes it very difficult to raise the amount of money needed, the amount assumed to be on the balance sheet when assets like MBS are valued according to their long-term value. When you think about it outside of the acronyms it isn’t complicated: An MBS is a guarantee of the payment streams from people who own houses, the pool of mortgages that make up the mortgage-backed security, as they pay them over perhaps the next thirty years. The scenario I’ve just explained is often referred to as rollover risk.

In addition, private sector liquidity risk was poorly understood during the crisis. The AAA ratings assigned to ABS (including MBS) were only tested in a closed system. This means that rating agencies didn’t consider how the price of an asset might decline if another firm sold them off, thus increasing the supply and lowering the price (Pozsar 2010, 3). This led to the issue of the overall cost, such as externalities not exclusive to the involved firms, not being properly priced into securities. In addition, the rating agencies assumed correlations would hold steady in an extreme market. Yet in the liquidity crisis experienced in 2007-09, there was high serial correlation across assets, which forced massive sell offs of different assets in order to generate much-needed liquidity. For example, imagine an MBS secured by both an office building in Florida and a home in Seattle. These do not tend to have high correlation. However, if they are all being used to create short-term credit (the MBS backed by both properties is used as collateral), and the entire system falls, then they will be sold off together to generate fast cash. This means their correlation shoots up in times of crisis.

The ability to fund the dealer system described above was made possible through collateralized, AAA-rated assets and liabilities. These tools, combined with the traditional credit process, had the “potential to increase the efficiency of credit intermediation” (Pozsar 2010, 3). This was also due in part to the dealers’ ability to ignore traditional rules. By operating off-balance sheet and outside of regulatory oversight, they could ignore the usual regulations on assets such as ABS.

Let me explain more about asset-backed securities. Traditionally, when a mortgage is purchased, a bank is not able to use the full value of this mortgage (the expected future payments from the homeowner) finance short-term obligations since it is illiquid – the bank is receiving payments on the mortgage for many years, and therefore can’t realize its fully value right away. However, by dividing mortgages up into tranches and grouping them all together into an ABS, banks and their associated dealers were able to get lots of AAA-backed mortgages on their balance sheets that were then used to finance short-term obligations. A tranche is a simple concept that involves breaking up a group of MBS into a number of other groups, with the top group having first priority in payments, the second group second priority, and so forth. The process of taking mortgages and grouping them together into tranches is called securitization or creating a collateralized debt obligation (CDO). By creating pools of mortgages that were rated as AAA, essentially the safest rating possible, banks could use these assets as collateral for short-term financing.

The groups of mortgages included those issued ot people who were likely to default on their mortagage payments, hence the term “sub-prime mortgage.” These mortgages were grouped and placed in the bottom tranche of the MBS, the “D-level,” the riskiest and most rewarding tranche for an investor buying the MBS. Many people thought this system was genius because even though people who had a high chance of defaulting were given mortgages, and these mortgages were then grouped together and sold to investors, the theory was that the buyers of the “D-level” MBS knew the risk they were taking on and were able to suffer any losses from defaults. Even at the time everyone knew subprime mortgages were trash. But the point was that banks creating these tranches were able to strip off the rotten and worst parts of a group (the homes with the lowest chance of paying back) and sell it to someone willing to take on a higher risk and therefore receive a higher return (through higher interest payments on the mortgages). By dividing up risk they were able to give people homes who wouldn’t have met the traditional requirements before by matching them up with people willing to accept a high risk (for a high reward). However, there are many legitimate complaints about the people who purchased sub-prime mortgages. They often weren’t aware that they were part of a group that were considered at a high chance of defaulting, and genuinely thought they met reasonable underwriting requirements for receiving a mortgage (In a previous post I described how Washington Mutual was accused and settled for a related accusation).

Now back to the commercial paper. The surge of commercial paper issued by banks originated with the ability to avoid registration under the Securities Act of 1933. Typically any firm issuing a security has to provide a description of their property and business, of the security itself, and of corporate management, along with financial statements. Commercial paper can be exempt of this if it satisfies three criterions: first, it must mature in less than 270 days. Second, it must not be offered to the general public. Third, proceeds from issuance must only be used to finance current assets such as receivables or inventory. The creation of ABCP in the 1980s had massive effects on the commercial paper market. In 1990, ABCP comprised just 5.7% of $558 billion of commercial paper. Eventually this number ballooned to 56.8% of the $1.97 trillion commercial paper market in 2007 (Kacperczyk & Schnabl 2010, 9, 30).

These registration policies gave firms an incentive to issue ABCP as well as keep the issuers (dealers) as conduits instead of on their balance sheet. This all began with the noticeable increase of ABCP in the 1980’s, but there was another trend that helped create the storm. Conduits in the 1980s and early 1990s mainly invested in short-term and medium-term assets. However, they eventually switched to long-term ABS such as MBS as a new investment strategy leading up to the crisis. This created rollover risk due to the large asset-security liquidity mismatch (using short-term debt to purchase long-term assets). As a result, the large financial institutions had to guarantee to pay off these conduits were they to default, despite not having them on their official balance sheets (Kacperczyk & Schnabl 2010, 31-33). Essentially these financing methods comprised an entirely new and private market. The government did not insure the funds in this market, so the assets were expected but not guaranteed to remain at par value. In essence this exposes the market to the possibility of a de facto bank run, expect due to the institutional (private) nature of these funds, it would be large firms and institutions withdrawing the money rather than retail investors (individuals like you and me).

Dealers financed the purchase of securitized assets through rolling commercial paper, ensuring that funding would never run out. Paper was continually issued and overlapped with previous issuances to keep the money flowing. In 2007 commercial paper was the largest short-term debt instrument with more than $1.97 trillion outstanding. 80% of the commercial paper in the market came from the financial sector. The dealers offered long-term assets, MBS and other ABS, as collateral for commercial paper.

The crisis in ABCP was triggered by the evolving crisis in the subprime mortgage market (Kacperczyk & Schnabl 2010, 37). The bankruptcy of Bear Stearns hedge funds and BNP’s withdrawal suggested subprime mortgages might not be worth their AAA rating after all which, in turn, cast doubt on the true value of ABCP and the repo markets backed by those assets. Within two days, the spread on the overnight ABCP rate over the federal funds rate “increased from 10 basis points to 150 basis points” (Kacpercyzk & Schnabl 2010, 38). In non-industry terms, this means the cost to borrow ABCP above the official federal fund interest rate increased by nearly 1.5 percentage points, making it a lot more expensive. The rate charged in a repo market is called the haircut rate. Remember, repo means repurchase agreement. Imagine a dealer who is financing new subprime purchases with ABS they already own. The way they do this is they go on the repo market and say “We will sell this package of ABS for $100 and buy it back from you tomorrow for $101.” In this case the person who lends it to them will make $1. This is the haircut rate. While 1.5% might not seem like a large increase, many of these firms were leveraged 25-30 times, meaning they needed to continue borrowing a lot of money on the repo market.

The cost of holding ABS and using it as collateral drastically increased, more than doubling between 2007 and 2008. The rising haircut rates point to two important factors in the lead-up to the crisis. First, dealers like Lehman had to compensate for the additional risk and volatility of the assets. Second, the assets no longer had the same market value as the book value Lehman was currently paying on them. Those in the repo market still willing to finance these firms demanded much higher haircut rates. Lehman was forced to declare bankruptcy when the liquidity rates on short-term debt grew so high they could no longer continue to finance their long-term maturities on the MBS. They could no longer borrow at viable rates and the value of their assets had dropped so far that they went out of business. The value of the ABCP market fell from $1.18 trillion to $745 billion from August 2007 to August 2008. Commercial paper made up $1.97 trillion of the $5 trillion short-term debts financing market, with a second largest allocation of U.S. Treasury bills at $940 billion. Repo markets began demanding higher haircut rates due to fears on the volatility of the MBS. From spring of 2007 to spring of 2009 MBS haircut rates went from 200 to 500, 850 and 650 basis points (Krishnamurthy 2010).

Lehman was the first bank to go under because of their asset-liability mismatch, and their collapse triggered a downward spiral into complete crisis. Lehman had extreme counterparty and systemic risk to the system due to the mass amounts of ABS it held. As a result as Lehman fell into bankruptcy it began a fire-sale of securities. This basically means they were selling everything they owned. I like to imagine a steam-boat being chased down by a sea-monster with the crew throwing everything they can in the burner to generate more fuel. This had the effect of decreasing the price and as a result pushing down the price of similar securities held by financially safe banks and dealers. This led into a self-fulfilling prophecy as even secure banks could no longer gain access to liquidity due to the systemic risk caused by Lehman. The concept behind this spiral is simple. As Lehman sold ABS in their fire-sale the increased supply caused the price of ABS to decline. Other firms who were financially sound up until this point now had the value of the ABS they owned on their balance sheet decline in price due to Lehman selling. Since their assets were worth less they were no longer able to roll them over on the repo market to generate enough liquidity to meet their liabilities (the assets were worth less as collateral). At this point those banks had to sell their assets to generate liquidity just like Lehman had to do, and the entire system began to unravel. This theory assumes that the crisis caused asset prices to deviate significantly from fundamental values—and this deviation was part of the problem itself (Krishnamurthy 2010).

This leads back to Bagehot’s distinction between illiquidity and insolvency. Illiquidity is when the market is not reflecting the fundamental value of assets, in this case due to a panic, and firms are unable to meet their liabilities not because of a mistake they made, but because of a crisis that has cut off cash flows. Insolvency is when there is not a liquidity crisis, and assets still reflect their fundamental values, but the firm has simply collapsed due to its own failures. Determining whether various banks and dealers were actually insolvent or merely suffering from illiquidity during the crisis was incredibly difficult and didn’t end up mattering much at all. Even fundamentally sound banks were drawn down with others like Lehman that maybe did deserve to fail. This downward spiral can only be slowed by a quick injection of liquidity into the system, something that the Fed did provide (see this chart, for example: http://www.clevelandfed.org/research/data/credit_easing/index.cfm). Hopefully this post has made it more clear how the liquidity crisis of 2008 occurred and why it was so important for the Fed to provide liquidity to the system.


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