Asset Backed Securities. Drunken Risibility.

Asset Backed Securities (ABS) are freely traded financial instruments that represent packages of loans issued by the commercial banks. The majority are created from mortgages, but credit card debt, commercial real estate loans, student loans, and hedge fund loans are also known to have been securitized. The earliest form of ABS within the American banking system appears to stem from the creation of the Federal National Mortgage Association (Fannie Mae) in 1938 as part of amendments to the US National Housing Act, a Great Depression measure aimed at creating loan liquidity. Fannie Mae, and the other Government Sponsored Enterprises buy loans from approved mortgage sellers, typically banks, and create guaranteed financial debt instruments from them, to be sold on the credit markets. The resulting bonds, backed as they are by loan insurance, are widely used in pension funds and insurance companies, as a secure, financial instrument providing a predictable, low risk return.

The creation of a more general form of Mortgage Backed Security is credited to Bob Dall and the trading desk of Salmon brothers in 1977 by Michael Lewis (Liar’s Poker Rising Through the Wreckage on Wall Street). Lewis also describes a rapid expansion in their sale beginning in 1981 as a side effect of the United States savings and loans crisis. The concept was extended in 1987 by bankers at Drexel Burnham Lambert Inc. to corporate bonds and loans in the form of Collateralized Debt Obligations (CDOs), which eventually came to include mortgage backed securities, and in the form of CDO-Squared instruments, pools of CDO.

Analysis of the systemic effects of Asset Backed Security has concentrated chiefly on their ability to improve the quantity of loans, or loan liquidity, which has been treated as a positive feature by Greenspan. It has also been noted that securitization allowed banks to increase their return on capital by transforming their operations into a credit generating pipeline process. Hyun Song Shin has also analysed their effect on bank leverage and the stability of the larger financial system within an accounting framework. He highlights the significance of loan supply factors in causing the sub-prime crisis. Although his model appears not to completely incorporate the full implications of the process operating within the capital reserve regulated banking system, it presents an alternate, matrix based analysis of the uncontrolled debt expansion that these instruments permit.

The systemic problem introduced by asset backed securities, or any form of sale that transfers loans made by commercial banking institutions outside the regulatory framework is that they allow banks to escape the explicit reserve and regulatory capital based regulation on the total amount of loans being issued against customer deposits. This has the effect of steadily increasing the ratio of bank originated loans to money on deposit within the banking system.

The following example demonstrates the problem using two banks, A and B. For simplicity fees related to loans and ABS sales are excluded. It is assumed that the deposit accounts are Net Transaction accounts carry a 10% reserve requirement, and that both banks are ”well capitalised” and that the risk weighted multiplier for the capital reserve for these loans is also 10.

The example proceeds as a series of interactions as money flows between the two banks. The liabilities (deposits) and assets (loans) are shown, with loans being separated into bank loans, and Mortgage Backed Securities (MBS), depending on their state.

Initial Conditions: To simplify Bank B is shown as having made no loans, and has excess reserves at the central bank to maintain the balance sheet. The normal inter-bank and central bank lending mechanisms would enable the bank to compensate for temporary imbalances during the process under normal conditions. All deposit money used within the example remains on deposit at either Bank A or Bank B. On the right hand side of the table the total amount of deposits and loans for both banks is shown.

Untitled

Step 1: Bank A creates a $1000 Mortgage Backed Security from the loan on its balance sheet.

Untitled

Step 2: The securitized loan is sold to the depositor at Bank B. $1000 is paid to Bank A from that depositor in payment for the loan. Bank A now has no loans outstanding against its deposits, and the securitized loan has been moved outside of banking system regulation. Note that total deposits at the two banks have temporarily shrunk due to the repayment of the loan capital at A. The actual transfer of the deposits between the banks is facilitated through the reserve holdings which also function as clearing funds.

Untitled

Step 3: As Bank A now has no loans against its deposits, and is within its regulatory capital ratios, it can make a new $1000 loan. The funds from this loan are deposited at Bank B. The sum of the deposits rises as a result as does the quantity of loans. Note that the transfer of the loan money from Bank A to Bank B again goes through the reserve holdings in the clearing system and restores the original balance at Bank B.

Untitled

Step 4: Bank A securitizes the loan made in Step 3 repeating Step 1.

Untitled

Step 5: Bank A sells the MBS to the depositor at Bank B, repeating Step 2.

Untitled

Step 6: Bank A makes a new loan which is deposited at Bank B, repeating Step 3.

Untitled

Step 7: Bank A securitizes the loan made in Step 6, repeating Step 4.

Untitled

Since the Deposit and Loan positions of the two banks are identical in all respects in Steps (1,4), (2,5), (3,6) and (4,7) the process can continue indefinitely, resulting in expansion of the total commercial bank originated loan supply independent of central bank control.

This is a simplified version of the flows between loans, deposits, and asset backed securities that occur daily in the banking system. At no point has either bank needed recourse to central bank funds, or broken any of their statutory requirements with respect to capitalisation or reserve requirements where they apply.

The problem is the implicit assumption with reserve based banking systems that bank originated loans remain within the banking system. Allowing the sale of loans to holders outside of the regulated banking system (i.e. to entities other than regulated banks) removes these loans from that control and thus creates a systemic loophole in the regulation of the commercial bank loan supply.

The introduction of loans sales has consequently created a novel situation in those modern economies that allow them, not only in causing a significant expansion in total lending from the banking sector, but also in changing the systemic relationship between the quantity of money in the system to the quantity of bank originated debt, and thereby considerably diluting the influence the central bank can exert over the loan supply. The requirement that no individual bank should lend more than their deposits has been enforced by required reserves at the central bank since the 19th century in Europe, and the early 20th century in the USA. Serendipitously, this also created a systemic limit on the ratio of money to bank originated lending within the monetary system. While the sale of Asset Backed Securities does not allow any individual bank to exceed this ratio at any given point in time, as the process evolves the banking system itself exceeds it as loans are moved outside the constraints provided by regulatory capital or reserve regulation, thereby creating a mechanism for unconstrained growth in commercial bank originated lending.

While the asset backed security problem explains the dramatic growth in banking sector debt that has occurred over the last three decades, it does not explain the accompanying growth in the money supply. Somewhat uniquely of the many regulatory challenges that the banking system has created down the centuries, the asset backed security problem, in and of itself does not cause the banks, or the banking system to ”print money”.

The question of what exactly constitutes money in modern banking systems is a non-trivial one. As the examples above show, bank loans create money in the form of bank deposits, and bank deposits can be used directly for monetary purposes either through cheques or more usually now direct electronic transfer. For economic purposes then, bank deposits can be regarded as directly equivalent to physical money. The reality within the banking system however is somewhat more complex, in that transfers between bank deposits must be performed using deposits in the clearing mechanisms, either through the reserves at the central bank, or the bank’s own asset deposits at other banks. Nominally limits on the total quantity of central bank reserves should in turn limit the growth in bank deposits from bank lending, but it is clear from the monetary statistics that this is not the case.

Individually commercial banks are limited in the amount of money they can lend. They are limited by any reserve requirements for their deposits, by the accounting framework that surrounds the precise classification of assets and liabilities within their locale, and by the ratio of their equity or regulatory capital to their outstanding, risk weighted loans as recommended by the Basel Accords. However none of these limits is sufficient to prevent uncontrolled expansion.

Reserve requirements at the central bank can only effectively limit bank deposits if they apply to all accounts in the system, and the central bank maintains control over any mechanisms that allow individual banks to increase their reserve holdings. This appears not to be the case. Basel capital restrictions can also limit bank lending. Assets (loans) held by banks are classified by type, and have accordingly different percentage capital requirements. Regulatory capital requirements are divided into two tiers of capital with different provisions and risk categorisation applying to instruments held in them. To be adequately capitalised under the Basel accords, a bank must maintain a ratio of at least 8% between its Tier 1 and Tier 2 capital reserves, and its loans. Equity capital reserves are provided by a bank’s owners and shareholders when the bank is created, and exist to provide a buffer protecting the bank’s depositors against loan defaults.

Under Basel regulation, regulatory capital can be held in a variety of instruments, depending on Tier 1 or Tier 2 status. It appears that some of those instruments, in particular subordinated debt and hybrid debt capital instruments, can represent debt issued from within the commercial banking system.

Annex A – Basel Capital Accords, Capital Elements Tier 1

(a) Paid-up share capital/common stock

(b) Disclosed reserves

Tier 2

(a) Undisclosed reserves

(b) Asset revaluation reserves

(c) General provisions/general loan-loss reserves

(d) Hybrid (debt/equity) capital instruments

(e) Subordinated debt

Subordinated debt is defined in Annex A of the Basel treaty as:

(e) Subordinated term debt: includes conventional unsecured subordinated debt capital instruments with a minimum original fixed term to maturity of over five years and limited life redeemable preference shares. During the last five years to maturity, a cumulative discount (or amortisation) factor of 20% per year will be applied to reflect the diminishing value of these instruments as a continuing source of strength. Unlike instruments included in item (d), these instruments are not normally available to participate in the losses of a bank which continues trading. For this reason these instruments will be limited to a maximum of 50% of tier 1.

This is debt issued by the bank, in various forms, but of guaranteed long duration, and controlled repayment. In effect, it allows Banks to hold borrowed money in regulatory capital. It is subordinate to the claims of depositors in the event of Bank failure. The inclusion of subordinated debt in Tier 2 allows financial instruments created from lending to become part of the regulatory control on further lending, creating a classic feedback loop. This can also occur as a second order effect if any form of regulatory capital can be purchased with money borrowed from within the banking system

Cryptocurrency and Efficient Market Hypothesis. Drunken Risibility.

According to the traditional definition, a currency has three main properties: (i) it serves as a medium of exchange, (ii) it is used as a unit of account and (iii) it allows to store value. Along economic history, monies were related to political power. In the beginning, coins were minted in precious metals. Therefore, the value of a coin was intrinsically determined by the value of the metal itself. Later, money was printed in paper bank notes, but its value was linked somewhat to a quantity in gold, guarded in the vault of a central bank. Nation states have been using their political power to regulate the use of currencies and impose one currency (usually the one issued by the same nation state) as legal tender for obligations within their territory. In the twentieth century, a major change took place: abandoning gold standard. The detachment of the currencies (specially the US dollar) from the gold standard meant a recognition that the value of a currency (specially in a world of fractional banking) was not related to its content or representation in gold, but to a broader concept as the confidence in the economy in which such currency is based. In this moment, the value of a currency reflects the best judgment about the monetary policy and the “health” of its economy.

In recent years, a new type of currency, a synthetic one, emerged. We name this new type as “synthetic” because it is not the decision of a nation state, nor represents any underlying asset or tangible wealth source. It appears as a new tradable asset resulting from a private agreement and facilitated by the anonymity of internet. Among this synthetic currencies, Bitcoin (BTC) emerges as the most important one, with a market capitalization of a few hundred million short of $80 billions.

bitcoin-price-bitstamp-sept1

Bitcoin Price Chart from Bitstamp

There are other cryptocurrencies, based on blockchain technology, such as Litecoin (LTC), Ethereum (ETH), Ripple (XRP). The website https://coinmarketcap.com/currencies/ counts up to 641 of such monies. However, as we can observe in the figure below, Bitcoin represents 89% of the capitalization of the market of all cryptocurrencies.

Untitled

Cryptocurrencies. Share of market capitalization of each currency.

One open question today is if Bitcoin is in fact a, or may be considered as a, currency. Until now, we cannot observe that Bitcoin fulfills the main properties of a standard currency. It is barely (though increasingly so!) accepted as a medium of exchange (e.g. to buy some products online), it is not used as unit of account (there are no financial statements valued in Bitcoins), and we can hardly believe that, given the great swings in price, anyone can consider Bitcoin as a suitable option to store value. Given these characteristics, Bitcoin could fit as an ideal asset for speculative purposes. There is no underlying asset to relate its value to and there is an open platform to operate round the clock.

Untitled

Bitcoin returns, sampled every 5 hours.

Speculation has a long history and it seems inherent to capitalism. One common feature of speculative assets in history has been the difficulty in valuation. Tulipmania, the South Sea bubble, and more others, reflect on one side human greedy behavior, and on the other side, the difficulty to set an objective value to an asset. All speculative behaviors were reflected in a super-exponential growth of the time series.

Cryptocurrencies can be seen as the libertarian response to central bank failure to manage financial crises, as the one occurred in 2008. Also cryptocurrencies can bypass national restrictions to international transfers, probably at a cheaper cost. Bitcoin was created by a person or group of persons under the pseudonym Satoshi Nakamoto. The discussion of Bitcoin has several perspectives. The computer science perspective deals with the strengths and weaknesses of blockchain technology. In fact, according to R. Ali et. al., the introduction of a “distributed ledger” is the key innovation. Traditional means of payments (e.g. a credit card), rely on a central clearing house that validate operations, acting as “middleman” between buyer and seller. On contrary, the payment validation system of Bitcoin is decentralized. There is a growing army of miners, who put their computer power at disposal of the network, validating transactions by gathering together blocks, adding them to the ledger and forming a ’block chain’. This work is remunerated by giving the miners Bitcoins, what makes (until now) the validating costs cheaper than in a centralized system. The validation is made by solving some kind of algorithm. With the time solving the algorithm becomes harder, since the whole ledger must be validated. Consequently it takes more time to solve it. Contrary to traditional currencies, the total number of Bitcoins to be issued is beforehand fixed: 21 million. In fact, the issuance rate of Bitcoins is expected to diminish over time. According to Laursen and Kyed, validating the public ledger was initially rewarded with 50 Bitcoins, but the protocol foresaw halving this quantity every four years. At the current pace, the maximum number of Bitcoins will be reached in 2140. Taking into account the decentralized character, Bitcoin transactions seem secure. All transactions are recorded in several computer servers around the world. In order to commit fraud, a person should change and validate (simultaneously) several ledgers, which is almost impossible. Additional, ledgers are public, with encrypted identities of parties, making transactions “pseudonymous, not anonymous”. The legal perspective of Bitcoin is fuzzy. Bitcoin is not issued, nor endorsed by a nation state. It is not an illegal substance. As such, its transaction is not regulated.

In particular, given the nonexistence of saving accounts in Bitcoin, and consequently the absense of a Bitcoin interest rate, precludes the idea of studying the price behavior in relation with cash flows generated by Bitcoins. As a consequence, the underlying dynamics of the price signal, finds the Efficient Market Hypothesis as a theoretical framework. The Efficient Market Hypothesis (EMH) is the cornerstone of financial economics. One of the seminal works on the stochastic dynamics of speculative prices is due to L Bachelier, who in his doctoral thesis developed the first mathematical model concerning the behavior of stock prices. The systematic study of informational efficiency begun in the 1960s, when financial economics was born as a new area within economics. The classical definition due to Eugene Fama (Foundations of Finance_ Portfolio Decisions and Securities Prices 1976-06) says that a market is informationally efficient if it “fully reflects all available information”. Therefore, the key element in assessing efficiency is to determine the appropriate set of information that impels prices. Following Efficient Capital Markets, informational efficiency can be divided into three categories: (i) weak efficiency, if prices reflect the information contained in the past series of prices, (ii) semi-strong efficiency, if prices reflect all public information and (iii) strong efficiency, if prices reflect all public and private information. As a corollary of the EMH, one cannot accept the presence of long memory in financial time series, since its existence would allow a riskless profitable trading strategy. If markets are informationally efficient, arbitrage prevent the possibility of such strategies. If we consider the financial market as a dynamical structure, short term memory can exist (to some extent) without contradicting the EMH. In fact, the presence of some mispriced assets is the necessary stimulus for individuals to trade and reach an (almost) arbitrage free situation. However, the presence of long range memory is at odds with the EMH, because it would allow stable trading rules to beat the market.

The presence of long range dependence in financial time series generates a vivid debate. Whereas the presence of short term memory can stimulate investors to exploit small extra returns, making them disappear, long range correlations poses a challenge to the established financial model. As recognized by Ciaian et. al., Bitcoin price is not driven by macro-financial indicators. Consequently a detailed analysis of the underlying dynamics (Hurst exponent) becomes important to understand its emerging behavior. There are several methods (both parametric and non parametric) to calculate the Hurst exponent, which become a mandatory framework to tackle BTC trading.