Wednesday, December 2, 2009

The Engine: Fractional-Reserve Banking (Part 3)

So we now have three groups that should have a good understanding of the risks inherent with a fractional-reserve banking system, and incentives to serve as watchdogs against excessive risk-taking by the banks. We have:

1. Depositors.
2. Bank owners.
3. Government regulators.

As stated previously, measures have been put in place which have systematically compromised each of these groups. Let's start with depositors.

Depositors: Compromised by deposit insurance

Deposit insurance was introduced by an Alabama politician as an emergency measure. Small banks in his district feared consolidation and believed that large, networked banks such as the Canadian ones (which, as noted, were permitted to have branch banking) would outcompete the independent banks on the dimensions of stability and safety. Initially, deposit insurance would only really benefit small accounts such as these concerned Alabama banks tended to hold; the larger banks in New York and Chicago were not particularly affected by deposit insurance either way. It was seen by virtually everyone involved as true special interest legislation. The program was expanded during the New Deal, but was actually opposed by FDR as it was seen by many as a policy that could become very dangerous if applied in an unconstrained manner.

In 1980, FDIC insurance was raised by statute to cover $100,000. More recently, coverage has been expanded to $250,000 accounts. I have heard arguments that the FDIC does not protect the truly affluent because of coverage limits, but these arguments seem to me to be a bit naive. If you had a family of five, for example, each member of the family could open an individual account, protected by statute (in practice, government insurance has not been limited by account size, but let's assume that the letter of the law is followed) for $250,000. After five individual accounts are opened, any pair of family members could open a joint account, also covered for $250k. Then any three family members could do the same, followed by any four, followed by a family account. The family could then go to another bank and repeat the same process.

Because this could quickly become tedious, an academic at Princeton created "CDARS". CDARS allows a high net-worth individual to open, say, a $20 million account at one bank and have the full value of the account protected by the FDIC. Essentially, the initial bank will enter into a series of certificate of deposit agreements with many other banks and the net effect is similar to what would have happened if the $20 million had been split into eighty $250,000 cohorts and deployed in separate accounts. I believe that CDARS gives you access to FDIC coverage for amounts of up to $50 million in a single account package (i.e., single statement issued to you by the initiating bank).

I am not going to argue for or against deposit insurance---it certainly has a populist charm and it seems "fair" on a satisfying, intuitive level. I will say that economic life is full of unintended consequences, and a direct, inescapable consequence of the FDIC is that depositors have almost no reason to care about monitoring risk-seeking behavior at the banks that are taking their deposits. This is an extremely important development: as we have seen, depositors in a fractional-reserve system are in a practical sense making loans to their bankers, loans that can be used by the banks to seek profits from interest-rate differentials. Depositors would normally be an important source of market discipline in this system, but this discipline has been removed.

Because of this issue, a provision was placed in the important Gramm-Leach-Bliley Act of 1999 (which repealed part of Glass-Steagall and allowed for mergers between commercial banks, investment banks, and insurance companies) that would have created a subordinated debt requirement in large US banks. This debt component would have been sold to sophisticated institutional investors and would amount to 2-3% of capitalization. The important part here is that the debt would have been, by statute, prohibited from being saved with government bailout money. The idea was that an early-warning system for excessive risk taking would be created, a sort of "canary in the coal mine" to try to enforce market discipline in the absence of depositor interest in such monitoring efforts. In the event that a bank got itself into trouble, concerned holders of the subordinated debt would try to unload the securities, and any buyers would no doubt require a steep discount. The deterioration in value would serve as a distress signal. Despite being generally lauded by economists involved, the provision was withdrawn from Gramm-Leach-Bliley at the insistence of the banks.

Bank Owners: Compromised by Moral Hazard

Equity holders in banks are, as a general rule, relatively unconcerned about bank runs. Even in the Scottish free banking experience of Adam Smith's day, banks were running hot fractional-reserve systems with reserve ratios (c) of only .01 or .02 in terms of gold actually held by the bank against issued paper notes. Longstanding actuarial work has revealed that such low reserve ratios are sufficient during all but the most extreme conditions, and those who have taken equity stakes in a bank are not going to scale to the most extreme downside risks because a propensity for doing so would have selected them out of the pool of interested bank investors from the beginning. The bank run potential has decreased as federal deposit insurance, branch and interbank lending systems, and the Federal Reserve "lender of last resort" have made the concept of depositor risk-monitoring of banks largely obsolete.

What equity holders in banks are chiefly concerned with are their returns, both absolute and risk-adjusted. For proper risk-reward calculation to take place in a market environment, there must be transparency regarding upside and downside potential. Equity holders, at least equity holders of a rational bent, would normally want to make sure that a bank did not put money into risky loans and investments. The problem is that an interlocking series of moral hazards has distorted the way in which risks are calculated. There are many distortions, but I will focus here on three:

1. "The Greenspan Put"
2. Bailout Mentality ("Too Big To Fail")
3. Bias towards short-volatility strategies

Briefly going over each in turn... The Greenspan Put refers to the anticipated response by central banks, most specifically the Federal Reserve (which will be discussed in the next section), to market crisis events. As per the Keynesian playbook, central banks are expected to respond to economic downturns or emergencies by immediately lowering interest rates, thus flooding the market with liquidity, encouraging borrowing and consumption over saving, and in some ways protecting what would otherwise be bad investments.

The Bailout Mentality is a variation on this theme. It implies that national governments and formidable international NGOs (World Bank, IMF) will not allow large, important corporations or some sovereign governments to fail. Thus, the market was shocked when the IMF failed to intervene to prevent the Russian government's default in the late 1990s, despite the fact that Russian bonds were paying an unsustainably high coupon. In the case of a successful bet on a bailout being triggered, those who held credit default swaps written by AIG were able to breathe a collective sigh of relief when Uncle Sam poured billions into AIG to prevent its counterparties from taking large losses.

The moral hazard created by the Bailout Mentality is this: owners may feel that downside risk on given investments, should these investments go sour, is artificially limited by government rescue efforts that will be triggered in an emergency. The rule of thumb here is to make sure that the investment is large enough to pose a "systemic risk" or "contagion risk", or at least to make sure that stakeholders in the failed business/industry are critical to the careers of politicians equipped with an intervention mechanism.

George Cooper, the author of the highly readable and insightful book "The Origin of Financial Crises", describes a core philosophical inconsistency that arises from the Greenspan Put/Bailout Mentality. Cooper posits that bank owners and other involved private parties will tend to push for free market fundamentalism when times are good, but will incoherently argue for government monetary and fiscal stimulus---Keynesian interventionist techniques---during recessions and emergencies. He says, "In short, today's efficient market consensus has adopted Keynesian stimulus policy, dramatically extended its implementation and at the same time forgot that these policies were born out of a sophisticated repudiation of efficient market theory. Needless to say, the intellectual bankruptcy of this position does not make for good policy." I would add that this inconsistency is layered upon the pre-existing tension that we have seen within mismatched definitions of the roles that depositors and lenders play in a fractional-reserve banking system.

The bias towards short-volatility strategies is more subtle. A short-volatility investment or trading strategy bets that volatility in asset prices will remain within certain bands. The controlling assumption is that prices will tend to mean-revert---there will not be sudden, violent departures from the norm. When this does happen, these strategies can lose large amounts of of money very quickly. However, the Greenspan Put and Bailout Mentality worked together to create an additional sense of security that violent price excursions were attenuated.

For senior management, the beauty of a short-volatility strategy is that it gives the appearance of being low in risk, often for extended periods of time. Think of an insurance company collecting a steady supply of premium payments to insure homeowners against hurricane-related losses. Until a major hurricane arrives, the company looks like it provides its shareholders with steady, predictable growth. When the storm hits, the company may blow up---however, in this case the "insurers" had reason to believe that Federal Reserve interest-rate cuts and government bailouts would allow them to essentially "put" the price tag for the calamity to other parties.

So you could think of the short-volatility trader expecting the Federal Reserve and bailout programs to provide a floor for asset prices, or even a kind of rubber band that will cause prices to spring back to pre-crisis levels quickly through monetary asset value reflation and subsidies. This belief can create incentives for a dangerous practice called the "martingale betting progression" (to be covered in much more detail in a future post), in which a trader who has taken heavy losses on a position increases his exposure to the position rather than liquidating it.

One signature of short-volatility strategies is that they tend to have a suspiciously high frequency of small winners. If the only measurement period available consists of these "up days", the strategy will look extremely safe and attractive to many investors, at least superficially. I believe that the following anecdote may have some value: Goldman Sachs, generally regarded as the most prestigious and profitable of the large investment banks, has for some time been pulling most of its revenue from trading operations. Goldman had 166 negative trading days for the period 2002-2005 inclusive, more than twice as many negative days as the next "most frequent loser" in its peer cohort, Morgan Stanley (MS had 80 during the period). Merrill Lynch (with 42), Bear Sterns (41), and Lehman (41) had the lowest number of negative trading days (approx. 25% of Goldman's), but less profitable overall trading operations. It is *perhaps* also instructional that Merrill, Bear, and Lehman were destroyed by the 2008 crisis, although I hesitate to blame their problems directly on short vol strategies and I am aware that Goldman and MS both also have historically included these types of approaches in their trading portfolios. Still...

Suffice to say that the risk management practices used by major financial institutions have contained biases that lean them towards short-volatility strategies, often by making assumptions about market price behavior that were based on insufficiently homogeneous data sets---the risk models were "trained" using data from a recent historical period that happened to feature very low volatility in asset prices, under the expectation that A) this low volatility regime would persist into the future; and B) the low volatility regime was the result of the Federal Reserve having perfected the science of central banking and now being capable of helping to generate the old Keynesian dream of a perpetual boom. This was not necessarily a bad assumption at the time, given the very high expectations that things like the Greenspan Put would continue to be successfully employed. Authors such as Nassim Taleb will argue that the assumption of low volatility and the obsession with managing performance through short-volatility strategies (which trade smooth returns for hidden, extreme event "iceberg risks") were far more insidious and that decision-makers at these financial institutions were in some cases guilty of criminal behavior.

Problems with the way that risks and financial performance are measured and the perverse incentives that can be created are subjects that are near and dear to me, because they are found in the hedge fund industry in an even more virulent form. For now, I'll just suggest that the ways that risks were managed in banks contained assumptions about volatilities, correlations, and codependencies that led to portfolios that were not always robust to exogenous shocks. Off-balance-sheet vehicles owned by bank holding companies complicated matters even further, as did some of the enormously complicated structures (synthetic CDOs). Rooting through all this stuff to determine true risk exposures may have been possible if a sophisticated, activist institutional-type investor with concentrated shareholding power was involved in a risky bank, but US laws against concentrated shareholdings (Investment Company Act, Bank Holding Company Act) have made this problematic. Even then, the same moral hazard issues would have to be overcome.

When we discuss the "Gas Pedal" of our car schema (credit derivatives), we will touch on some of the quantitative risk modeling approaches that were employed by these institutions and where they made assumptions that ultimately were proven to have been inappropriate.

Government regulators: Compromised by a politically popular affordable housing mandate

Speaking of inappropriate, a very naughty relationship was formed between two large GSEs (Government Sponsored Enterprises) and key members of the US government, particularly a series of Democrats within the Congressional leadership. The GSEs in question are Fannie Mae and Freddie Mac and the result of this inappropriate relationship was a mandate for the two mortgage giants to "make markets" in aspects of affordable housing, particularly subprime. Making markets entailed having a voracious appetite for purchasing and distributing mortgage-backed securities.

I believe that government agencies also came to count on the Greenspan Put as a panacea if things went truly wrong.

This is such a fascinating part of the debacle that I consider the government's role in the crisis to be equivalent to the steering wheel of our fictitious car, and thus worth its own, separate blog entry. It is my position that government policy "steered" the credit expansion qualities of fractional-reserve banking and the Federal Reserve and the moral hazard issues within the bank shareholder environment towards the housing market. Furthermore, I would state that several of the disaster's chief architects have managed to reinvent themselves as populist regulatory champions and to cast the blame on deregulated financial markets.

With the three major stakeholding actors compromised and unable to provide adequate risk-monitoring operations, the task unfortunately fell to a group that has not been mentioned yet: the short-sellers (not to be confused with short-volatility strategies---short-vol traders are betting that asset prices will tend to revert to the mean; short-sellers are betting that prices will decline). Short-selling vigilantes have the right incentives to try to enforce market discipline, but as we know they became vilified during the crisis (as usual) and had the game changed on them by edict (shortselling prohibitions were put in place to prevent "bear raids" on the most troubled and toxic financial institutions). I am not going to engage in an ethical debate regarding the topic of short-selling, but I will say that it has historically been a tricky thing to pull off consistently in the equities markets, and that a failure to allow short-sellers to profit when they are correctly positioned (few dedicated short-selling hedge funds survive for very long against the general upward drift of the stock market) could have a number of adverse unintended consequences for the overall health of our capital markets, namely damage to the all-important function of price discovery.

In the next piece, I'll start talking about the Federal Reserve and how expansionary "easy money" policies contributed to the housing/debt crisis.

No comments:

Post a Comment