The Banking Business…Note Quote

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Why is lending indispensable to banking? This not-so new question has garnered a lot of steam, especially in the wake of 2007-08 crisis. In India, however, this question has become quite a staple of CSOs purportedly carrying out research and analysis in what has, albeit wrongly, begun to be considered offshoots of neoliberal policies of capitalism favoring cronyism on one hand, and marginalizing priority sector focus by nationalized banks on the other. Though, it is a bit far-fetched to call this analysis mushrooming on artificially-tilled grounds, it nevertheless isn’t justified for the leaps such analyses assume don’t exist. The purpose of this piece is precisely to demystify and be a correctional to such erroneous thoughts feeding activism. 

The idea is to launch from the importance of lending practices to banking, and why if such practices weren’t the norm, banking as a business would falter. Monetary and financial systems are creations of double entry-accounting, in that, when banks lend, the process is a creation of a matrix/(ces) of new assets and new liabilities. Monetary system is a counterfactual, which is a bookkeeping mechanism for the intermediation of real economic activity giving a semblance of reality to finance capitalism in substance and form. Let us say, a bank A lends to a borrower. By this process, a new asset and a new liability is created for A, in that, there is a debit under bank assets, and a simultaneous credit on the borrower’s account. These accounting entries enhance bank’s and borrower’s  respective categories, making it operationally different from opening bank accounts marked by deposits. The bank now has an asset equal to the amount of the loan and a liability equal to the deposit. Put a bit more differently, bank A writes a cheque or draft for the borrower, thus debiting the borrower’s loan account and crediting a payment liability account. Now, this borrower decides to deposit this cheque/draft at a different bank B, which sees the balance sheet of B grow by the same amount, with a payment due asset and a deposit liability. This is what is a bit complicated and referred to as matrix/(ces) at the beginning of this paragraph. The obvious complication is due to a duplication of balance sheet across the banks A and B, which clearly stands in need of urgent resolution. This duplication is categorized under the accounting principle of ‘Float’, and is the primary requisite for resolving duplicity. Float is the amount of time it takes for money to move from one account to another. The time period is significant because it’s as if the funds are in two places at once. The money is still in the cheque writer’s account, and the cheque recipient may have deposited funds to their bank as well. The resolution is reached when the bank B clears the cheque/draft and receives a reserve balance credit in exchange, at which point the bank A sheds both reserve balances and its payment liability. Now, what has happened is that the systemic balance sheet has grown by the amount of the original loan and deposit, even if these are domiciles in two different banks A and B. In other words, B’s balance sheet has an increased deposits and reserves, while A’s balance sheet temporarily unchanged due to loan issued offset reserves decline. It needs to be noted that here a reserve requirement is created in addition to a capital requirement, the former with the creation of a deposit, while the latter with the creation of a loan, implying that loans create capital requirement, whereas deposits create reserve requirement.  Pari Passu, bank A will seek to borrow new funding from money markets and bank B could lend funds into these markets. This is a natural reaction to the fluctuating reserve distribution created at banks A and B. This course of normalization of reserve fluctuations is a basic function of commercial bank reserve management. Though, this is a typical case involving just two banks, a meshwork of different banks, their counterparties, are involved in such transactions that define present-day banking scenario, thus highlighting complexity referred to earlier. 

Now, there is something called the Cash Reserve Ratio (CRR), whereby banks in India (and elsewhere as well) are required to hold a certain proportion of their deposits in the form of cash. However, these banks don’t hold these as cash with themselves for they deposit such cash (also known as currency chests) with the Reserve Bank of India (RBI). For example, if the bank’s deposits increase by Rs. 100, and if the CRR is 4% (this is the present CRR stipulated by the RBI), then the banks will have to hold Rs. 4 with the RBI, and the bank will be able to use only Rs. 96 for investments and lending, or credit purpose. Therefore, higher the CRR, lower is the amount that banks will be able to use for lending and investment. CRR is a tool used by the RBI to control liquidity in the banking system. Now, if the bank A lends out Rs. 100, it incurs a reserve requirement of Rs. 4, or in other words, for every Rs. 100 loan, there is a simultaneous reserve requirement of Rs. 4 created in the form of reserve liability. But, there is a further ingredient to this banking complexity in the form of Tier-1 and Tier-2 capital as laid down by BASEL Accords, to which India is a signatory. Under the accord, bank’s capital consists of tier-1 and tier-2 capital, where tier-1 is bank’s core capital, while tier-2 is supplementary, and the sum of these two is bank’s total capital. This is a crucial component and is considered highly significant by regulators (like the RBI, for instance), for the capital ratio is used to determine and rank bank’s capital adequacy. tier-1 capital consists of shareholders’ equity and retained earnings, and gives a measure of when the bank must absorb losses without ceasing business operations. BASEL-3 has capped the minimum tier-1 capital ratio at 6%, which is calculated by dividing bank’s tier-1 capital by its total risk-based assets. Tier-2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss revenues, and undisclosed reserves. tier-2 capital is supplementary since it is less reliable than tier-1 capital. According to BASEL-3, the minimum total capital ratio is 8%, which indicates the minimum tier-2 capital ratio at 2%, as opposed to 6% for the tier-1 capital ratio. Going by these norms, a well capitalized bank in India must have a 8% combined tier-1 and tier-2 capital ratio, meaning that for every Rs. 100 bank loan, a simultaneous regulatory capital liability of Rs. 8 of tier-1/tier-2 is generated. Further, if a Rs. 100 loan has created a Rs. 100 deposit, it has actually created an asset of Rs. 100 for the bank, while at the same time a liability of Rs. 112, which is the sum of deposits and required reserves and capital. On the face of it, this looks like a losing deal for the bank. But, there is more than meets the eye here. 

Assume bank A lends Mr. Amit Modi Rs. 100, by crediting Mr. Modi’s deposit account held at A with Rs. 100. Two new liabilities are immediately created that need urgent addressing, viz. reserve and capital requirement. One way to raise Rs. 8 of required capital, bank A sells shares, or raise equity-like debt or retain earnings. The other way is to attach an origination fee of 10% (sorry for the excessively high figure here, but for sake of brevity, let’s keep it at 10%). This 10% origination fee helps maintain retained earnings and assist satisfying capital requirements. Now, what is happening here might look unique, but is the key to any banking business of lending, i.e. the bank A is meeting its capital requirement by discounting a deposit it created of its own loan, and thereby reducing its liability without actually reducing its asset. To put it differently, bank A extracts a 10% fee from Rs. 100 it loans, thus depositing an actual sum of only Rs. 90. With this, A’s reserve requirement decrease by Rs. 3.6 (remember 4% is the CRR). This in turn means that the loan of Rs. 100 made by A actually creates liabilities worth Rs. Rs. 108.4 (4-3.6 = 0.4 + 8). The RBI, which imposes the reserve requirement will follow up new deposit creation with a systemic injection sufficient to accommodate the requirement of bank B that has issued the deposit. And this new requirement is what is termed the targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the RBI. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types, including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the RBI is not a mere slush fund that provides unlimited funding to the banking system.  

The originating accounting entries in the above case are simple, a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital, especially equity capital, to take risk, and to take credit risk in particular. Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The asset-liability management function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities. The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity. The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets are in balance. The reserve system records the effect of this balance sheet activity. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis. 

Commercial banks’ ability to create money is constrained by capital. When a bank creates a new loan, with an associated new deposit, the bank’s balance sheet size increases, and the proportion of the balance sheet that is made up of equity (shareholders’ funds, as opposed to customer deposits, which are debt, not equity) decreases. If the bank lends so much that its equity slice approaches zero, as happened in some banks prior to the financial crisis, even a very small fall in asset prices is enough to render it insolvent. Regulatory capital requirements are intended to ensure that banks never reach such a fragile position. In contrast, central banks’ ability to create money is constrained by the willingness of their government to back them, and the ability of that government to tax the population. In practice, most central bank money these days is asset-backed, since central banks create new money when they buy assets in open market operations or Quantitative Easing, and when they lend to banks. However, in theory a central bank could literally spirit money from thin air without asset purchases or lending to banks. This is Milton Friedman’s famous helicopter drop. The central bank would become technically insolvent as a result, but provided the government is able to tax the population, that wouldn’t matter. The ability of the government to tax the population depends on the credibility of the government and the productive capacity of the economy. Hyperinflation can occur when the supply side of the economy collapses, rendering the population unable and/or unwilling to pay taxes. It can also occur when people distrust a government and its central bank so much that they refuse to use the currency that the central bank creates. Distrust can come about because people think the government is corrupt and/or irresponsible, or because they think that the government is going to fall and the money it creates will become worthless. But nowhere in the genesis of hyperinflation does central bank insolvency feature….

 

Banking Assets Depreciation, Insolvency and Liquidation: Why are Defaults so Contagious?

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Interlinkages across balance sheets of financial institutions may be modeled by a weighted directed graph G = (V, e) on the vertex set V = {1,…, n} = [n], whose elements represent financial institutions. The exposure matrix is given by e ∈ Rn×n, where the ijth entry e(i, j) represents the exposure (in monetary units) of institution i to institution j. The interbank assets of an institution i are given by

A(i) := ∑j e(i, j), which represents the interbank liabilities of i. In addition to these interbank assets and liabilities, a bank may hold other assets and liabilities (such as deposits).

The net worth of the bank, given by its capital c(i), represents its capacity for absorbing losses while remaining solvent. “Capital Ratio” of institution i, although technically, the ratio of capital to interbank assets and not total assets is given by

γ(i) := c(i)/A(i)

An institution is insolvent if its net worth is negative or zero, in which case, γ(i) is set to 0.

A financial network (e, γ) on the vertex set V = [n] is defined by

• a matrix of exposures {e(i, j)}1≤i,j≤n

• a set of capital ratios {γ(i)}1≤i≤n

In this network, the in-degree of a node i is given by

d(i) := #{j∈V | e(j, i)>0},

which represents the number of nodes exposed to i, while its out-degree

d+(i) := #{j∈V | e(i, j)>0}

represents the number of institutions i is exposed to. The set of initially insolvent institutions is represented by

D0(e, γ) = {i ∈ V | γ(i) = 0}

In a network (e, γ) of counterparties, the default of one or several nodes may lead to the insolvency of other nodes, generating a cascade of defaults. Starting from the set of initially insolvent institutions D0(e, γ) which represent fundamental defaults, contagious process is defined as:

Denoting by R(j) the recovery rate on the assets of j at default, the default of j induces a loss equal to (1 − R(j))e(i, j) for its counterparty i. If this loss exceeds the capital of i, then i becomes in turn insolvent. From the formula for Capital Ration, we have c(i) = γ(i)A(i). The set of nodes which become insolvent due to their exposures to initial defaults is

D1(e, γ) = {i ∈ V | γ(i)A(i) < ∑j∈D0 (1 − R(j)) e(i, j)}

This procedure may be iterated to define the default cascade initiated by a set of initial defaults.

So, when would a default cascade happen? Consider a financial network (e, γ) on the vertex set V = [n]. Set D0(e, γ) = {i ∈ V | γ(i) = 0} of initially insolvent institutions. The increasing sequence (Dk(e, γ), k ≥ 1) of subsets of V defined by

Dk(e, γ) = {i ∈ V | γ(i)A(i) < ∑j∈Dk-1(e,γ) (1−R(j)) e(i, j)}

is called the default cascade initiated by D0(e, γ).

Thus Dk(e, γ) represents the set of institutions whose capital is insufficient to absorb losses due to defaults of institutions in Dk-1(e, γ).

Thus, in a network of size n, the cascade ends after at most n − 1 iterations. Hence, Dn-1(e, γ) represents the set of all nodes which become insolvent starting from the initial set of defaults D0(e, γ).

Consider a financial network (e, γ) on the vertex set V = [n]. The fraction of defaults in the network (e, γ) (initiated by D0(e, γ) is given by

αn(e, γ) := |Dn-1(e, γ)|/n

The recovery rates R(i) may be exogenous or determined endogenously by redistributing assets of a defaulted entity among debtors, proportionally to their outstanding debt. The latter scenario is too optimistic since in practice liquidation takes time and assets may depreciate in value due to fire sales during liquidation. When examining the short term consequences of default, the most realistic assumption on recovery rates is zero: Assets held with a defaulted counterparty are frozen until liquidation takes place, a process which can in practice take a pretty long time to terminate.

Financial Fragility in the Margins. Thought of the Day 114.0

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If micro-economic crisis is caused by the draining of liquidity from an individual company (or household), macro-economic crisis or instability, in the sense of a reduction in the level of activity in the economy as a whole, is usually associated with an involuntary outflow of funds from companies (or households) as a whole. Macro-economic instability is a ‘real’ economic phenomenon, rather than a monetary contrivance, the sense in which it is used, for example, by the International Monetary Fund to mean price inflation in the non-financial economy. Neo-classical economics has a methodological predilection for attributing all changes in economic activity to relative price changes, specifically the price changes that undoubtedly accompany economic fluctuations. But there is sufficient evidence to indicate that falls in economic activity follow outflows of liquidity from the industrial and commercial company sector. Such outflows then lead to the deflation of economic activity that is the signal feature of economic recession and depression.

Let us start with a consideration of how vulnerable financial futures market themselves are to illiquidity, since this would indicate whether the firms operating in the market are ever likely to need to realize claims elsewhere in order to meet their liabilities to the market. Paradoxically, the very high level of intra-broker trading is a safety mechanism for the market, since it raises the velocity of circulation of whatever liquidity there is in the market: traders with liabilities outside the market are much more likely to have claims against other traders to set against those claims. This may be illustrated by considering the most extreme case of a futures market dominated by intra-broker trading, namely a market in which there are only two dealers who buy and sell financial futures contracts only between each other as rentiers, in other words for a profit which may include their premium or commission. On the expiry date of the contracts, conventionally set at three-monthly intervals in actual financial futures markets, some of these contracts will be profitable, some will be loss-making. Margin trading, however, requires all the profitable contracts to be fully paid up in order for their profit to be realized. The trader whose contracts are on balance profitable therefore cannot realize his profits until he has paid up his contracts with the other broker. The other broker will return the money in paying up his contracts, leaving only his losses to be raised by an inflow of money. Thus the only net inflow of money that is required is the amount of profit (or loss) made by the traders. However, an accommodating gross inflow is needed in the first instance in order to make the initial margin payments and settle contracts so that the net profit or loss may be realized.

The existence of more traders, and the system for avoiding counterparty risk commonly found in most futures market, whereby contracts are made with a central clearing house, introduce sequencing complications which may cause problems: having a central clearing house avoids the possibility that one trader’s default will cause other traders to default on their obligations. But it also denies traders the facility of giving each other credit, and thereby reduces the velocity of circulation of whatever liquidity is in the market. Having to pay all obligations in full to the central clearing house increases the money (or gross inflow) that broking firms and investors have to put into the market as margin payments or on settlement days. This increases the risk that a firm with large net liabilities in the financial futures market will be obliged to realize assets in other markets to meet those liabilities. In this way, the integrity of the market is protected by increasing the effective obligations of all traders, at the expense of potentially unsettling claims on other markets.

This risk is enhanced by the trading of rentiers, or banks and entrepreneurs operating as rentiers, hedging their futures contracts in other financial markets. However, while such incidents generate considerable excitement around the markets at the time of their occurrence, there is little evidence that they could cause involuntary outflows from the corporate sector on such a scale as to produce recession in the real economy. This is because financial futures are still used by few industrial and commercial companies, and their demand for financial derivatives instruments is limited by the relative expense of these instruments and their own exposure to changes in financial parameters (which may more easily be accommodated by holding appropriate stocks of liquid assets, i.e., liquidity preference). Therefore, the future of financial futures depends largely on the interest in them of the contemporary rentiers in pension, insurance and various other forms of investment funds. Their interest, in turn, depends on how those funds approach their ‘maturity’.

However, the decline of pension fund surpluses poses important problems for the main securities markets of the world where insurance and pension funds are now the dominant investors, as well as for more peripheral markets like emerging markets, venture capital and financial futures. A contraction in the net cash inflow of investment funds will be reflected in a reduction in the funds that they are investing, and a greater need to realize assets when a change in investment strategy is undertaken. In the main securities markets of the world, a reduction in the ‘new money’ that pension and insurance funds are putting into those securities markets will slow down the rate of growth of the prices in those markets. How such a fall in the institutions’ net cash inflow will affect the more marginal markets, such as emerging markets, venture capital and financial futures, depends on how institutional portfolios are managed in the period of declining net contributions inflows.

In general, investment managers in their own firms, or as employees of merchant or investment banks, compete to manage institutions’ funds. Such competition is likely to increase as investment funds approach ‘maturity’, i.e., as their cash outflows to investors, pensioners or insurance policyholders, rises faster than their cash inflow from contributions and premiums, so that there are less additional funds to be managed. In principle, this should not affect financial futures markets, in the first instance, since, as argued above, the short-term nature of their instruments and the large proportion in their business of intra-market trade makes them much less dependent on institutional cash inflows. However, this does not mean that they would be unaffected by changes in the portfolio preferences of investment funds in response to lower returns from the main securities markets. Such lower returns make financial investments like financial futures, venture capital and emerging markets, which are more marginal because they are so hazardous, more attractive to normally conservative fund managers. Investment funds typically put out sections of portfolios to specialist fund managers who are awarded contracts to manage a section according to the soundness of their reputation and the returns that they have made hitherto in portfolios under their management. A specialist fund manager reporting high, but not abnormal, profits in a fund devoted to financial futures, is likely to attract correspondingly more funds to manage when returns are lower in the main markets’ securities, even if other investors in financial futures experienced large losses. In this way, the maturing of investment funds could cause an increased inflow of rentier funds into financial futures markets.

An inflow of funds into a financial market entails an increase in liabilities to the rentiers outside the market supplying those funds. Even if profits made in the market as a whole also increase, so too will losses. While brokers commonly seek to hedge their positions within the futures market, rentiers have much greater possibilities of hedging their contracts in another market, where they have assets. An inflow into futures markets means that on any settlement day there will therefore be larger net outstanding claims against individual banks or investment funds in respect of their financial derivatives contracts. With margin trading, much larger gross financial inflows into financial futures markets will be required to settle maturing contracts. Some proportion of this will require the sale of securities in other markets. But if liquidity in integrated cash markets for securities is reduced by declining net inflows into pension funds, a failure to meet settlement obligations in futures markets is the alternative to forced liquidation of other assets. In this way futures markets will become more fragile.

Moreover, because of the hazardous nature of financial futures, high returns for an individual firm are difficult to sustain. Disappointment is more likely to be followed by the transfer of funds to management in some other peripheral market that shows a temporary high profit. While this should not affect capacity utilization in the futures market, because of intra-market trade, it is likely to cause much more volatile trading, and an increase in the pace at which new instruments are introduced (to attract investors) and fall into disuse. Pension funds whose returns fall below those required to meet future liabilities because of such instability would normally be required to obtain additional contributions from employers and employees. The resulting drain on the liquidity of the companies affected would cause a reduction in their fixed capital investment. This would be a plausible mechanism for transmitting fragility in the financial system into full-scale decline in the real economy.

The proliferation of financial futures markets has only had been marginally successful in substituting futures contracts for Keynesian liquidity preference as a means of accommodating uncertainty. A closer look at the agents in those markets and their market mechanisms indicates that the price system in them is flawed and trading hazardous risks in them adds to uncertainty rather than reducing it. The hedging of financial futures contracts in other financial markets means that the resulting forced liquidations elsewhere in the financial system are a real source of financial instability that is likely to worsen as slower growth in stock markets makes speculative financial investments appear more attractive. Capital-adequacy regulations are unlikely to reduce such instability, and may even increase it by increasing the capital committed to trading in financial futures. Such regulations can also create an atmosphere of financial security around these markets that may increase unstable speculative flows of liquidity into the markets. For the economy as a whole, the real problems are posed by the involvement of non-financial companies in financial futures markets. With the exception of a few spectacular scandals, non-financial companies have been wary of using financial futures, and it is important that they should continue to limit their interest in financial futures markets. Industrial and commercial companies, which generate their own liquidity through trade and production and hence have more limited financial assets to realize in order to meet financial futures liabilities in times of distress, are more vulnerable to unexpected outflows of liquidity in proportion to their increased exposure to financial markets. The liquidity which they need to set aside to meet such unexpected liabilities inevitably means a reduced commitment to investment in fixed capital and new technology.

Banking and Lending/Investment. How Monetary Policy Becomes Decisive? Some Branching Rumination.

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Among the most notoriously pernicious effects of asset price inflation is that it offers speculators the prospect of gain in excess of the costs of borrowing the money to buy the asset whose price is being inflated. This is how many unstable Ponzi financing structures begin. There are usually strict regulations to prevent or limit banks’ direct investment in financial instruments without any assured residual liquidity, such as equity or common stocks. However, it is less easy to prevent banks from lending to speculative investors, who then use the proceeds of their loans to buy securities or to limit lending secured on financial assets. As long as asset markets are being inflated, such credit expansions also conceal from banks, their shareholders and their regulators the disintermediation that occurs when the banks’ best borrowers, governments and large companies, use bills and company paper instead of bank loans for their short-term financing. As long as the boom proceeds, banks can enjoy the delusion that they can replace the business of governments and large companies with good lending secured on stocks.

In addition to undermining the solvency of the banking system, and distracting commerce and industry with the possibilities of lucrative corporate restructuring, capital market inflation also tends to make monetary policy ineffective. Monetary policy is principally the fixing of reserve requirements, buying and selling short-term paper or bills in the money or inter-bank markets, buying and selling government bonds and fixing short-term interest rates. As noted in the previous section, with capital market inflation there has been a proliferation of short-term financial assets traded in the money markets, as large companies and banks find it cheaper to issue their own paper than to borrow for banks. This disintermediation has extended the range of short-term liquid assets which banks may hold. As a result of this it is no longer possible for central banks, in countries experiencing capital market inflation, to control the overall amount of credit available in the economy: attempts to squeeze the liquidity of banks in order to limit their credit advances by, say, open market operations (selling government bonds) are frustrated by the ease with which banks may restore their liquidity by selling bonds or their holdings of short-term paper or bills. In this situation central banks have been forced to reduce the scope of their monetary policy to the setting of short-term interest rates.

Economists have long believed that monetary policy is effective in controlling price inflation in the economy at large, as opposed to inflation of securities prices. Various rationalizations have been advanced for this efficacy of monetary policy. For the most part they suppose some automatic causal connection between changes in the quantity of money in circulation and changes in prices, although the Austrian School of Economists (here, here, here, and here) tended on occasion to see the connection as being between changes in the rate of interest and changes in prices.

Whatever effect changes in the rate of interest may have on the aggregate of money circulating in the economy, the effect of such changes on prices has to be through the way in which an increase or decrease in the rate of interest causes alterations in expenditure in the economy. Businesses and households are usually hard-headed enough to decide their expenditure and financial commitments in the light of their nominal revenues and cash outflows, which may form their expectations, rather than in accordance with their expectations or optimizing calculations. If the same amount of money continues to be spent in the economy, then there is no effective reason for the business-people setting prices to vary prices. Only if expenditure in markets is rising or falling would retailers and industrialists consider increasing or decreasing prices. Because price expectations are observable directly with difficulty, they may explain everything in general and therefore lack precision in explaining anything in particular. Notwithstanding their effects on all sorts of expectations, interest rate changes affect inflation directly through their effects on expenditure.

The principal expenditure effects of changes in interest rates occur among net debtors in the economy, i.e., economic units whose financial liabilities exceed their financial assets. This is in contrast to net creditors, whose financial assets exceed their liabilities, and who are usually wealthy enough not to have their spending influenced by changes in interest rates. If they do not have sufficient liquid savings out of which to pay the increase in their debt service payments, then net debtors have their expenditure squeezed by having to devote more of their income to debt service payments. The principal net debtors are governments, households with mortgages and companies with large bank loans.

With or without capital market inflation, higher interest rates have never constrained government spending because of the ease with which governments may issue debt. In the case of indebted companies, the degree to which their expenditure is constrained by higher interest rates depends on their degree of indebtedness, the available facilities for additional financing and the liquidity of their assets. As a consequence of capital market inflation, larger companies reduce their borrowing from banks because it becomes cheaper and more convenient to raise even short- term finance in the booming securities markets. This then makes the expenditure of even indebted companies less immediately affected by changes in bank interest rates, because general changes in interest rates cannot affect the rate of discount or interest paid on securities already issued. Increases in short-term interest rates to reduce general price inflation can then be easily evaded by companies financing themselves by issuing longer-term securities, whose interest rates tend to be more stable. Furthermore, with capital market inflation, companies are more likely to be over-capitalized and have excessive financial liabilities, against which companies tend to hold a larger stock of more liquid assets. As inflated financial markets have become more unstable, this has further increased the liquidity preference of large companies. This excess liquidity enables the companies enjoying it to gain higher interest income to offset the higher cost of their borrowing and to maintain their planned spending. Larger companies, with access to capital markets, can afford to issue securities to replenish their liquid reserves.

If capital market inflation reduces the effectiveness of monetary policy against product price inflation, because of the reduced borrowing of companies and the ability of booming asset markets to absorb large quantities of bank credit, interest rate increases have appeared effective in puncturing asset market bubbles in general and capital market inflations in particular. Whether interest rate rises actually can effect an end to capital market inflation depends on how such rises actually affect the capital market. In asset markets, as with anti-inflationary policy in the rest of the economy, such increases are effective when they squeeze the liquidity of indebted economic units by increasing the outflow of cash needed to service debt payments and by discouraging further speculative borrowing. However, they can only be effective in this way if the credit being used to inflate the capital market is short term or is at variable rates of interest determined by the short-term rate.

Keynes’s speculative demand for money is the liquidity preference or demand for short-term securities of rentiers in relation to the yield on long-term securities. Keynes’s speculative motive is ‘a continuous response to gradual changes in the rate of interest’ in which, as interest rates along the whole maturity spectrum decline, there is a shift in rentiers’ portfolio preference toward more liquid assets. Keynes clearly equated a rise in equity (common stock) prices with just such a fall in interest rates. With falling interest rates, the increasing preference of rentiers for short-term financial assets could keep the capital market from excessive inflation.

But the relationship between rates of interest, capital market inflation and liquidity preference is somewhat more complicated. In reality, investors hold liquid assets not only for liquidity, which gives them the option to buy higher-yielding longer-term stocks when their prices fall, but also for yield. This marginalizes Keynes’s speculative motive for liquidity. The motive was based on Keynes’s distinction between what he called ‘speculation’ (investment for capital gain) and ‘enterprise’ (investment long term for income). In our times, the modern rentier is the fund manager investing long term on behalf of pension and insurance funds and competing for returns against other funds managers. An inflow into the capital markets in excess of the financing requirements of firms and governments results in rising prices and turnover of stock. This higher turnover means greater liquidity so that, as long as the capital market is being inflated, the speculative motive for liquidity is more easily satisfied in the market for long-term securities.

Furthermore, capital market inflation adds a premium of expected inflation, or prospective capital gain, to the yield on long-term financial instruments. Hence when the yield decreases, due to an increase in the securities’ market or actual price, the prospective capital gain will not fall in the face of this capital appreciation, but may even increase if it is large or abrupt. Rising short-term interest rates will therefore fail to induce a shift in the liquidity preference of rentiers towards short-term instruments until the central bank pushes these rates of interest above the sum of the prospective capital gain and the market yield on long-term stocks. Only at this point will there be a shift in investors’ preferences, causing capital market inflation to cease, or bursting an asset bubble.

This suggests a new financial instability hypothesis, albeit one that is more modest and more limited in scope and consequence than Minsky’s Financial Instability Hypothesis. During an economic boom, capital market inflation adds a premium of expected capital gain to the market yield on long-term stocks. As long as this yield plus the expected capital gain exceed the rate of interest on short-term securities set by the central bank’s monetary policy, rising short-term interest rates will have no effect on the inflow of funds into the capital market and, if this inflow is greater than the financing requirements of firms and governments, the resulting capital market inflation. Only when the short-term rate of interest exceeds the threshold set by the sum of the prospective capital gain and the yield on long-term stocks will there be a shift in rentiers’ preferences. The increase in liquidity preference will reduce the inflow of funds into the capital market. As the rise in stock prices moderates, the prospective capital gain gets smaller, and may even become negative. The rentiers’ liquidity preference increases further and eventually the stock market crashes, or ceases to be active in stocks of longer maturities.

At this point, the minimal or negative prospective capital gain makes equity or common stocks unattractive to rentiers at any positive yield, until the rate of interest on short-term securities falls below the sum of the prospective capital gain and the market yield on those stocks. When the short-term rate of interest does fall below this threshold, the resulting reduction in rentiers’ liquidity preference revives the capital market. Thus, in between the bursting of speculative bubbles and the resurrection of a dormant capital market, monetary policy has little effect on capital market inflation. Hence it is a poor regulator for ‘squeezing out inflationary expectations’ in the capital market.

Bear Stearns. Note Quote.

Like many of its competitors, Bear Stearns saw the rise of the hedge fund industry during the 1990s and began managing its own funds with outside investor capital under the name Bear Stearns Asset Management (BSAM). Unlike its competitors, Bear hired all of its fund managers internally, with each manager specializing in a particular security or asset class. Objections by some Bear executives, such as co-president Alan Schwartz, that such concentration of risk could raise volatility were ignored, and the impressive returns posted by internal funds such as Ralph Cioffi’s High-Grade Structured Credit Strategies Fund quieted any concerns.

Cioffi’s fund was invested in sophisticated credit derivatives backed by mortgage securities. When the housing bubble burst, he redoubled his bets, raising a new Enhanced Leverage High-Grade Structured Credit Strategies Fund that would use 100 leverage (as compared to the 35 leverage employed by the original fund). The market continued to turn disastrously against the fund, which was soon stuck with billions of dollars worth of illiquid, unprofitable mortgages. In an attempt to salvage the situation and cut his losses, Cioffi launched a vehicle named Everquest Financial and sold its shares to the public. But when journalists at the Wall Street Journal revealed that Everquest’s primary assets were the “toxic waste” of money-losing mortgage securities, Bear had no choice but to cancel the public offering. With spectacular losses mounting daily, investors attempted to withdraw their remaining holdings. In order to free up cash for such redemptions, the fund had to liquidate assets at a loss, selling that only put additional downward pressure on its already underwater positions. Lenders to the fund began making margin calls and threatening to seize its $1.2 billion in collateral.

In a less turbulent market it might have worked, but the subprime crisis had spent weeks on the front page of financial newspapers around the globe, and every bank on Wall Street was desperate to reduce its own exposure. Insulted and furious that Bear had refused to inject any of its own capital to save the funds, Steve Black, J.P. Morgan Chase head of investment banking, called Schwartz and said, “We’re defaulting you.”

The default and subsequent seizure of $400 million in collateral by Merrill Lynch proved highly damaging to Bear Stearns’s reputation across Wall Street. In a desperate attempt to save face under the scrutiny of the SEC, James Cayne made the unprecedented move of using $1.6 billion of Bear’s own capital to prop up the hedge funds. By late July 2007 even Bear’s continued support could no longer prop up Cioffi’s two beleaguered funds, which paid back just $300 million of the credit its parent had extended. With their holdings virtually worthless, the funds had no choice but to file for bankruptcy protection.

On November 14, just two weeks after the Journal story questioning Cayne’s commitment and leadership, Bear Stearns reported that it would write down $1.2 billion in mortgage- related losses. (The figure would later grow to $1.9 billion.) CFO Molinaro suggested that the worst had passed, and to outsiders, at least, the firm appeared to have narrowly escaped disaster.

Behind the scenes, however, Bear management had already begun searching for a white knight, hiring Gary Parr at Lazard to examine its options for a cash injection. Privately, Schwartz and Parr spoke with Kohlberg Kravis Roberts & Co. founder Henry Kravis, who had first learned the leveraged buyout market while a partner at Bear Stearns in the 1960s. Kravis sought entry into the profitable brokerage business at depressed prices, while Bear sought an injection of more than $2 billion in equity capital (for a reported 20% of the company) and the calming effect that a strong, respected personality like Kravis would have upon shareholders. Ultimately the deal fell apart, largely due to management’s fear that KKR’s significant equity stake and the presence of Kravis on the board would alienate the firm’s other private equity clientele, who often competed with KKR for deals. Throughout the fall Bear continued to search for potential acquirers. With the market watching intently to see if Bear shored up its financing, Cayne managed to close only a $1 billion cross-investment with CITIC, the state-owned investment company of the People’s Republic of China.

Bear’s $0.89 profit per share in the first quarter of 2008 did little to quiet the growing whispers of its financial instability. It seemed that every day another major investment bank reported mortgage-related losses, and for whatever reason Bear’s name kept cropping up in discussions of the by-then infamous subprime crisis. Exacerbating Bear’s public relations problem, the SEC had launched an investigation into the collapse of the two BSAM hedge funds, and rumors of massive losses at three major hedge funds further rattled an already uneasy market. Nonetheless, Bear executives felt that the storm had passed, reasoning that its almost $21 billion in cash reserves had convinced the market of its long-term viability.

Instead, on Monday, March 10, 2008, Moody’s downgraded 163 tranches of mortgage- backed bonds issued by Bear across fifteen transactions. The credit rating agency had drawn sharp criticism for its role in the subprime meltdown from analysts who felt the company had overestimated the creditworthiness of mortgage-backed securities and failed to alert the market of the danger as the housing market turned. As a result, Moody’s was in the process of downgrading nearly all of its ratings, but as the afternoon wore on, Bear’s stock price seemed to be reacting far more negatively than those of competitor firms.

Wall Street’s drive toward ever more sophisticated communications devices had created an interconnected network of traders and bankers across the world. On most days, Internet chat and mobile e-mail devices relayed gossip about compensation, major employee departures, and even sports betting lines. On the morning of March 10, however, they were carrying one message to the exclusion of all others: Bear was having liquidity problems. At noon, CNBC took the story public on Power Lunch. As Bear’s stock price fell more than 10 percent to $63, Ace Greenberg frantically placed calls to various executives, demanding that someone publicly deny any such problems. When contacted himself, Greenberg told a CNBC correspondent that the rumors were “totally ridiculous,” angering CFO Molinaro, who felt that denying the rumor would only legitimize it and trigger further panic selling, making prophecies of Bear’s illiquidity self-fulfilling. Just two hours later, however, Bear appeared to have dodged a bullet. News of New York governor Eliot Spitzer’s involvement in a high-class prostitution ring wiped any financial rumors off the front page, leading Bear executives to believe the worst was once again behind them.

Instead, the rumors exploded anew the next day, as many interpreted the Federal Reserve’s announcement of a new $200 billion lending program to help financial institutions through the credit crisis as aimed specifically toward Bear Stearns. The stock dipped as low as $55.42 before closing at $62.97. Meanwhile, Bear executives faced a new crisis in the form of an explosion of novation requests, in which a party to a risky contract tries to eliminate its risky position by selling it to a third party. Credit Suisse, Deutsche Bank, and Goldman Sachs all reported a deluge of novation requests from firms trying to reduce their exposure to Bear’s credit risk. The speed and force of this explosion of novation requests meant that before Bear could act, both Goldman Sachs and Credit Suisse issued e-mails to their traders holding up any requests relating to Bear Stearns pending approval by their credit departments. Once again, the electronically linked gossip network of trading desks around the world dealt a blow to investor confidence in Bear’s stability, as a false rumor circulated that Credit Suisse’s memo had forbidden its traders from engaging in any trades with Bear. The decrease in confidence in Bear’s liquidity could be quantified by the rise in the cost of credit default swaps on Bear’s debt. The price of such an instrument – which effectively acts as five years of insurance against a default on $10 million of Bear’s debt – spiked to more than $626,000 from less than $100,000 in October, indicating heavy betting by some firms that Bear would be unable to pay its liabilities.

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Internally, Bear debated whether to address the rumors publicly, ultimately deciding to arrange a Wednesday morning interview of Schwartz by CNBC correspondent David Faber. Not wanting to encourage rumors with a hasty departure, Schwartz did the interview live from Bear’s annual media conference in Palm Beach. Chosen because of his perceived friendliness to Bear, Faber nonetheless opened the interview with a devastating question that claimed direct knowledge of a trader whose credit department had temporarily held up a trade with Bear. Later during the interview Faber admitted that the trade had finally gone through, but he had called into question Bear’s fundamental capacity to operate as a trading firm. One veteran trader later commented,

You knew right at that moment that Bear Stearns was dead, right at the moment he asked that question. Once you raise that idea, that the firm can’t follow through on a trade, it’s over. Faber killed him. He just killed him.

Despite sentiment at Bear that Schwartz had finally put the company’s best foot forward and refuted rumors of its illiquidity, hedge funds began pulling their accounts in earnest, bringing Bear’s reserves down to $15 billion. Additionally, repo lenders – whose overnight loans to investment banks must be renewed daily – began informing Bear that they would not renew the next morning, forcing the firm to find new sources of credit. Schwartz phoned Parr at Lazard, Molinaro reviewed Bear’s plans for an emergency sale in the event of a crisis, and one of the firm’s attorneys called the president of the Federal Reserve to explain Bear’s situation and implore him to accelerate the newly announced program that would allow investment banks to use mortgage securities as collateral for emergency loans from the Fed’s discount window, normally reserved for commercial banks.

The trickle of withdrawals that had begun earlier in the week turned into an unstoppable torrent of cash flowing out the door on Thursday. Meanwhile, Bear’s stock continued its sustained nosedive, falling nearly 15% to an intraday low of $50.48 before rallying to close down 1.5%. At lunch, Schwartz assured a crowded meeting of Bear executives that the whirlwind rumors were simply market noise, only to find himself interrupted by Michael Minikes, senior managing director,

Do you have any idea what is going on? Our cash is flying out the door! Our clients are leaving us!

Hedge fund clients jumped ship in droves. Renaissance Technologies withdrew approximately $5 billion in trading accounts, and D. E. Shaw followed suit with an equal amount. That evening, Bear executives assembled in a sixth-floor conference room to survey the carnage. In less than a week, the firm had burned through all but $5.9 billion of its $18.3 billion in reserves, and was still on the hook for $2.4 billion in short-term debt to Citigroup. With a panicked market making more withdrawals the next day almost certain, Schwartz accepted the inevitable need for additional financing and had Parr revisit merger discussions with J.P. Morgan Chase CEO James Dimon that had stalled in the fall. Flabbergasted at the idea that an agreement could be reached that night, Dimon nonetheless agreed to send a team of bankers over to analyze Bear’s books.

Parr’s call interrupted Dimon’s 52nd birthday celebration at a Greek restaurant just a few blocks away from Bear headquarters, where a phalanx of attorneys had begun preparing emergency bankruptcy filings and documents necessary for a variety of cash-injecting transactions. Facing almost certain insolvency in the next 24 hours, Schwartz hastily called an emergency board meeting late that night, with most board members dialing in remotely. Bear’s nearly four hundred subsidiaries would make a bankruptcy filing impossibly complicated, so Schwartz continued to cling to the hope for an emergency cash infusion to get Bear through Friday. As J.P. Morgan’s bankers pored over Bear’s positions, they balked at the firm’s precarious position and the continued size of its mortgage holdings, insisting that the Fed get involved in a bailout they considered far too risky to take on alone.

Its role as a counterparty in trillions of dollars’ worth of derivatives contracts bore an eerie similarity to LTCM, and the Fed once again saw the potential for financial Armageddon if Bear were allowed to collapse of its own accord. An emergency liquidation of the firm’s assets would have put strong downward pressure on global securities prices, exacerbating an already chaotic market environment. Facing a hard deadline of credit markets’ open on Friday morning, the Fed and J.P. Morgan wrangled back and forth on how to save Bear. Working around the clock, they finally reached an agreement wherein J.P. Morgan would access the Fed’s discount window and in turn offer Bear a $30 billion credit line that, as dictated by a last-minute insertion by J.P. Morgan general counsel Steven Cutler, would be good for 28 days. As the press release went public, Bear executives cheered; Bear would have almost a month to seek alternative financing.

Where Bear had seen a lifeline, however, the market saw instead a last desperate gasp for help. Incredulous Bear executives could only watch in horror as the firm’s capital continued to fly out of its coffers. On Friday morning Bear burned through the last of its reserves in a matter of hours. A midday conference call in which Schwartz confidently assured investors that the credit line would allow Bear to continue “business as usual” did little to stop the bleeding, and its stock lost almost half of its already depressed value, closing at $30 per share.

All day Friday, Parr set about desperately trying to save his client, searching every corner of the financial world for potential investors or buyers of all or part of Bear. Given the severity of the situation, he could rule out nothing, from a sale of the lucrative prime brokerage operations to a merger or sale of the entire company. Ideally, he hoped to find what he termed a “validating investor,” a respected Wall Street name to join the board, adding immediate credibility and perhaps quieting the now deafening rumors of Bear’s imminent demise. Sadly, only a few such personalities with the reputation and war chest necessary to play the role of savior existed, and most of them had already passed on Bear.

Nonetheless, Schwartz left Bear headquarters on Friday evening relieved that the firm had lived to see the weekend and secured 28 days of breathing room. During the ride home to Greenwich, an unexpected phone call from New York Federal Reserve President Timothy Geithner and Treasury Secretary Henry Paulson shattered that illusion. Paulson told a stunned Schwartz that the Fed’s line of credit would expire Sunday night, giving Bear 48 hours to find a buyer or file for bankruptcy. The demise of the 28-day clause remains a mystery; the speed necessary early Friday morning and the inclusion of the clause by J.P. Morgan’s general counsel suggest that Bear executives had misinterpreted it, although others believe that Paulson and Geithner had soured both on Bear’s prospects and on market perception of an emergency loan from the Fed as Friday wore on. Either way, the Fed had made up its mind, and a Saturday morning appeal from Schwartz failed to sway Geithner.

All day Saturday prospective buyers streamed through Bear’s headquarters to pick through the rubble as Parr attempted to orchestrate Bear’s last-minute salvation. Chaos reigned, with representatives from every major bank on Wall Street, J. C. Flowers, KKR, and countless others poring over Bear’s positions in an effort to determine the value of Bear’s massive illiquid holdings and how the Fed would help in financing. Some prospective buyers wanted just a piece of the dying bank, others the whole firm, with still others proposing more complicated multiple-step transactions that would slice Bear to ribbons. One by one, they dropped out, until J. C. Flowers made an offer for 90% of Bear for a total of up to $2.6 billion, but the offer was contingent on the private equity firm raising $20 billion from a bank consortium, and $20 billion in risky credit was unlikely to appear overnight.

That left J.P. Morgan. Apparently the only bank willing to come to the rescue, J.P. Morgan had sent no fewer than 300 bankers representing 16 different product groups to Bear headquarters to value the firm. The sticking point, as with all the bidders, was Bear’s mortgage holdings. Even after a massive write-down, it was impossible to assign a value to such illiquid (and publicly maligned) securities with any degree of accuracy. Having forced the default of the BSAM hedge funds that started this mess less than a year earlier.

On its final 10Q in March, Bear listed $399 billion in assets and $387 billion in liabilities, leaving just $12 billion in equity for a 32 leverage multiple. Bear initially estimated that this included $120 billion of “risk-weighted” assets, those that might be subject to subsequent write-downs. As J.P. Morgan’s bankers worked around the clock trying to get to the bottom of Bear’s balance sheet, they came to estimate the figure at nearly $220 billion. That pessimistic outlook, combined with Sunday morning’s New York Times article reiterating Bear’s recent troubles, dulled J.P. Morgan’s appetite for jumping onto what appeared to be a sinking ship. Later, one J.P. Morgan banker shuddered, recalling the article. “That article certainly had an impact on my thinking. Just the reputational aspects of it, getting into bed with these people.”

On Saturday morning J.P. Morgan backed out and Dimon told a shell-shocked Schwartz to pursue any other option available to him. The problem was, no such alternative existed. Knowing this, and the possibility that the liquidation of Bear could throw the world’s financial markets into chaos, Fed representatives immediately phoned Dimon. As it had in the LTCM case a decade ago, the Fed relied heavily on suasion, or “jawboning,” the longtime practice of attempting to influence market participants by appeals to reason rather than a declaration by fiat. For hours, J.P. Morgan’s and the Fed’s highest-ranking officials played a game of high-stakes poker, with each side bluffing and Bear’s future hanging in the balance. The Fed wanted to avoid unprecedented government participation in the bailout of a private investment firm, while J.P. Morgan wanted to avoid taking on any of the “toxic waste” in Bear’s mortgage holdings. “They kept saying, ‘We’re not going to do it,’ and we kept saying, ‘We really think you should do it,’” recalled one Fed official. “This went on for hours . . . They kept saying, ‘We can’t do this on our own.’” With the hours ticking away until Monday’s Australian markets would open at 6:00 p.m. New York time, both sides had to compromise.

On Sunday afternoon, Schwartz stepped out of a 1:00 emergency meeting of Bear’s board of directors to take the call from Dimon. The offer would come somewhere in the range of $4 to 5 per share. Hearing the news from Schwartz, the Bear board erupted with rage. Dialing in from the bridge tournament in Detroit, Cayne exploded, ranting furiously that the firm should file for bankruptcy protection under Chapter 11 rather than accept such a humiliating offer, which would reduce his 5.66 million shares – once worth nearly $1 billion – to less than $30 million in value. In reality, however, bankruptcy was impossible. As Parr explained, changes to the federal bankruptcy code in 2005 meant that a Chapter 11 filing would be tantamount to Bear falling on its sword, because regulators would have to seize Bear’s accounts, immediately ceasing the firm’s operations and forcing its liquidation. There would be no reorganization.

Even as Cayne raged against the $4 offer, the Fed’s concern over the appearance of a $30 billion loan to a failing investment bank while American homeowners faced foreclosures compelled Treasury Secretary Paulson to pour salt in Bear’s wounds. Officially, the Fed had remained hands-off in the LTCM bailout, relying on its powers of suasion to convince other banks to step up in the name of market stability. Just 10 years later, they could find no takers. The speed of Bear’s collapse, the impossibility of conducting true due diligence in such a compressed time frame, and the incalculable risk of taking on Bear’s toxic mortgage holdings scared off every buyer and forced the Fed from an advisory role into a principal role in the bailout. Worried that a price deemed at all generous to Bear might subsequently encourage moral hazard – increased risky behavior by investment banks secure in the knowledge that in a worst-case scenario, disaster would be averted by a federal bailout – Paulson determined that the transaction, while rescuing the firm, also had to be punitive to Bear shareholders. He called Dimon, who reiterated the contemplated offer range.

“That sounds high tome,” Paulson told the J.P. Morgan chief. “I think this should be done at a very low price.” It was moments later that Braunstein called Parr. “The number’s $2.” Under Delaware law, executives must act on behalf of both shareholders and creditors when a company enters the “zone of insolvency,” and Schwartz knew that Bear had rocketed through that zone over the past few days. Faced with bankruptcy or J.P. Morgan, Bear had no choice but to accept the embarrassingly low offer that represented a 97% discount off its $32 close on Friday evening. Schwartz convinced the weary Bear board that $2 would be “better than nothing,” and by 6:30 p.m., the deal was unanimously approved.

After 85 years in the market, Bear Stearns ceased to exist.

Haircuts and Collaterals.

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In a repo-style securities financing transaction, the repo buyer or lender is exposed to the borrower’s default risk for the whole duration with a market contingent exposure, framed on a short window for default settlement. A margin period of risk (MPR) is a time period starting from the last date when margin is met to the date when the defaulting counterparty is closed out with completion of collateral asset disposal. MPR could cover a number of events or processes, including collateral valuation, margin calculation, margin call, valuation dispute and resolution, default notification and default grace period, and finally time to sell collateral to recover the lent principal and accrued interest. If the sales proceeds are not sufficient, the deficiency could be made a claim to the borrower’s estate, unless the repo is non-recourse. The lender’s exposure in a repo during the MPR is simply principal plus accrued and unpaid interest. Since the accrued and unpaid interest is usually margined at cash, repo exposure in the MPR is flat.

A flat exposure could apply to OTC derivatives as well. For an OTC netting, the mark-to-market of the derivatives could fluctuate as its underlying prices move. The derivatives exposure is formally set on the early termination date which could be days behind the point of default. The surviving counterparty, however, could have delta hedged against market factors following the default so that the derivative exposure remains a more manageable gamma exposure. For developing a collateral haircut model, what is generally assumed is a constant exposure during the MPR.

The primary driver of haircuts is asset volatility. Market liquidity risk is another significant one, as liquidation of the collateral assets might negatively impact the market, if the collateral portfolio is illiquid, large, or concentrated in certain asset sectors or classes. Market prices could be depressed, bid/ask spreads could widen, and some assets might have to be sold at a steep discount. This is particularly pronounced with private securitization and lower grade corporates, which trade infrequently and often rely on valuation services rather than actual market quotations. A haircut model therefore needs to capture liquidity risk, in addition to asset volatility.

In an idealized setting, we therefore consider a counterparty (or borrower) C’s default time at t, when the margin is last met, an MPR of u during which there is no margin posting, and the collateral assets are sold at time t+u instantaneously on the market, with a possible liquidation discount g.

Let us denote the collateral market value as B(t), exposure to the defaulting counterparty C as E(t). At time t, one share of the asset is margined properly, i.e., E(t) = (1-h)B(t), where h is a constant haircut, 1 >h ≥0. The margin agreement is assumed to have a zero minimum transfer amount. The lender would have a residual exposure (E(t) – B(t+u)(1-g))+, where g is a constant, 1 > g ≥ 0. Exposure to C is assumed flat after t. We can write the loss function from holding the collateral as follows,

L(t + u) = Et(1 – Bt+u/Bt (1 – g)/(1 – h))+ = (1 – g)Bt(1 – Bt+u/Bt (h – g)/(1 – g))+ —– (1)

Conditional on default happening at time t, the above determines a one-period loss distribution driven by asset price return B(t+u)/B(t). For repos, this loss function is slightly different from the lender’s ultimate loss which would be lessened due to a claim and recovery process. In the regulatory context, haircut is viewed as a mitigation to counterparty exposure and made independent of counterparty, so recovery from the defaulting party is not considered.

Let y = (1 – Bt+u/Bt) be the price decline. If g=0, Pr(y>h) equals to Pr(L(u)>0). There is no loss, if the price decline is less or equal to h. A first rupee loss will occur only if y > h. h thus provides a cushion before a loss is incurred. Given a target rating class’s default probability p, the first loss haircut can be written as

hp = inf{h > 0:Pr(L(u) > 0) ≤ p} —– (2)

Let VaRq denote the VaR of holding the asset, an amount which the price decline won’t exceed, given a confidence interval of q, say 99%. In light of the adoption of the expected shortfall (ES) in BASEL IV’s new market risk capital standard, we get a chance to define haircut as ES under the q-quantile,

hES = ESq = E[y|y > VaRq]

VaRq = inf{y0 > 0 : Pr(y > y0) ≤ 1 − q} —– (3)

Without the liquidity discount, hp is the same as VaRq. If haircuts are set to VaRq or hES, the market risk capital for holding the asset for the given MPR, defined as a multiple of VaR or ES, is zero. This implies that we can define a haircut to meet a minimum economic capital (EC) requirement C0,

hEC = inf{h ∈ R+: EC[L|h] ≤ C0} —– (4)

where EC is measured either as VaR or ES subtracted by expected loss (EL). For rating criteria employing EL based target per rating class, we could introduce one more definition of haircuts based on EL target L0,

hEL = inf{h ∈ R+: E[L|h] ≤ L0} —– (5)

The expected loss target L0 can be set based on EL criteria of certain designated high credit rating, whether bank internal or external. With an external rating such as Moody’s, for example, a firm can set the haircut to a level such that the expected (cumulative) loss satisfies the expected loss tolerance L0 of some predetermined Moody’s rating target, e.g., ‘Aaa’ or ‘Aa1’. In (4) and (5), loss L’s holding period does not have to be an MPR. In fact, these two definitions apply to the general trading book credit risk capital approach where the standard horizon is one year with a 99.9% confidence interval for default risk.

Different from VaRq, definitions hp, hEL, and hEC are based on a loss distribution solely generated by collateral market risk exposure. As such, we no longer apply the usual wholesale credit risk terminology of probability of default (PD) and loss given default (LGD) to determine EL as product of PD and LGD. Here EL is directly computed from a loss distribution originated from market risk and the haircut intends to be wholesale counterparty independent. For real repo transactions where repo haircuts are known to be counterparty dependent, these definitions remain fit, when the loss distribution incorporates the counterparty credit quality.

(Il)liquid Hedge Lock-Ups. Thought of the Day 107.0

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Hedge funds have historically limited their participation in illiquid investments, preferring to match their investment horizon to the typical one-year lock-up periods that their investors agree to. However, many hedge funds have increasingly invested in illiquid assets in an effort to augment returns. For example, they have invested in private investments in public equity (PIPEs), acquiring large minority holdings in public companies. Their purchases of CDOs and CLOs (collateralized loan obligations) are also somewhat illiquid, since these fixed income securities are difficult to price and there is a limited secondary market during times of crisis. In addition, hedge funds have participated in loans, and invested in physical assets. Sometimes, investments that were intended to be held for less than one year have become long-term, illiquid assets when the assets depreciated and hedge funds decided to continue holding the assets until values recovered, rather than selling at a loss. It is estimated that more than 20% of total assets under management by hedge funds are illiquid, hard-to-price assets. This makes hedge fund asset valuation difficult, and has created a mismatch between hedge fund assets and liabilities, giving rise to significant problems when investors attempt to withdraw their cash at the end of lock-up periods.

Hedge funds generally focus their investment strategies on financial assets that are liquid and able to be readily priced based on reported prices in the market for those assets or by reference to comparable assets that have a discernible price. Since most of these assets can be valued and sold over a short period of time to generate cash, hedge funds permit investors to invest in or withdraw money from the fund at regular intervals and managers receive performance fees based on quarterly mark-to-market valuations. However, in order to match up maturities of assets and liabilities for each investment strategy, most hedge funds have the ability to prevent invested capital from being withdrawn during certain periods of time. They achieve this though “lock-up” and “gate” provisions that are included in investment agreements with their investors.

A lock-up provision provides that during an initial investment period of, typically, one to two years, an investor is not allowed to withdraw any money from the fund. Generally, the lock-up period is a function of the investment strategy that is being pursued. Sometimes, lock-up periods are modified for specific investors through the use of a side letter agreement. However, this can become problematic because of the resulting different effective lock-up periods that apply to different investors who invest at the same time in the same fund. Also, this can trigger “most favored nations” provisions in other investor agreements.

A gate is a restriction that limits the amount of withdrawals during a quarterly or semi- annual redemption period after the lock-up period expires. Typically gates are percentages of a fund’s capital that can be withdrawn on a scheduled redemption date. A gate of 10 to 20% is common. A gate provision allows the hedge fund to increase exposure to illiquid assets without facing a liquidity crisis. In addition, it offers some protection to investors that do not attempt to withdraw funds because if withdrawals are too high, assets might have to be sold by the hedge fund at disadvantageous prices, causing a potential reduction in investment returns for remaining investors. During 2008 and 2009, as many hedge fund investors attempted to withdraw money based on poor returns and concerns about the financial crisis, there was considerable frustration and some litigation directed at hedge fund gate provisions.

Hedge funds sometimes use a “side pocket” account to house comparatively illiquid or hard-to-value assets. Once an asset is designated for inclusion in a side pocket, new investors don’t participate in the returns from this asset. When existing investors withdraw money from the hedge fund, they remain as investors in the side pocket asset until it either is sold or becomes liquid through a monetization event such as an IPO. Management fees are typically charged on side pocket assets based on their cost, rather than a mark-to-market value of the asset. Incentive fees are charged based on realized proceeds when the asset is sold. Usually, there is no requirement to force the sale of side pocket investments by a specific date. Sometimes, investors accuse hedge funds of putting distressed assets that were intended to be sold during a one-year horizon into a side pocket account to avoid dragging down the returns of the overall fund. Investors are concerned about unexpected illiquidity arising from a side pocket and the potential for even greater losses if a distressed asset that has been placed there continues to decline in value. Fund managers sometimes use even more drastic options to limit withdrawals, such as suspending all redemption rights (but only in the most dire circumstances).

Credit Bubbles. Thought of the Day 90.0

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At the macro-economic level of the gross statistics of money and loan supply to the economy, the reserve banking system creates a complex interplay between money, debt, supply and demand for goods, and the general price level. Rather than being constant, as implied by theoretical descriptions, money and loan supplies are constantly changing at a rate dependent on the average loan period, and a complex of details buried in the implementation and regulation of any given banking system.

Since the majority of loans are made for years at a time, the results of these interactions play out over a long enough time scale that gross monetary features of regulatory failure, such as continuous asset price inflation, have come to be regarded as normal, e.g. ”House prices always go up”. The price level however is not only dependent on purely monetary factors, but also on the supply and demand for goods and services, including financial assets such as shares, which requires that estimates of the real price level versus production be used. As a simplification, if constant demand for goods and services is assumed as shown in the table below, then there are two possible causes of price inflation, either the money supply available to purchase the good in question has increased, or the supply of the good has been reduced. Critically, the former is simply a mathematical effect, whilst the latter is a useful signal, providing economic information on relative supply and demand levels that can be used locally by consumers and producers to adapt their behaviour. Purely arbitrary changes in both the money and the loan supply that are induced by the mechanical operation of the banking system fail to provide any economic benefit, and by distorting the actual supply and demand signal can be actively harmful.

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Credit bubbles are often explained as a phenomena of irrational demand, and crowd behaviour. However, this explanation ignores the question of why they aren’t throttled by limits on the loan supply? An alternate explanation which can be offered is that their root cause is periodic failures in the regulation of the loan and money supply within the commercial banking system. The introduction of widespread securitized lending allows a rapid increase in the total amount of lending available from the banking system and an accompanying if somewhat smaller growth in the money supply. Channeled predominantly into property lending, the increased availability of money from lending sources, acted to increase house prices creating rational speculation on their increase, and over time a sizeable disruption in the market pricing mechanisms for all goods and services purchased through loans. Monetary statistics of this effect such as the Consumer Price Index (CPI) for example, are however at least partially masked by production deflation from the sizeable productivity increases over decades. Absent any limit on the total amount of credit being supplied, the only practical limit on borrowing is the availability of borrowers and their ability to sustain the capital and interest repayments demanded for their loans.

Owing to the asymmetric nature of long term debt flows there is a tendency for money to become concentrated in the lending centres, which then causes liquidity problems for the rest of the economy. Eventually repayment problems surface, especially if the practice of further borrowing to repay existing loans is allowed, since the underlying mathematical process is exponential. As general insolvency as well as a consequent debt deflation occurs, the money and loan supply contracts as the banking system removes loan capacity from the economy either from loan repayment, or as a result of bank failure. This leads to a domino effect as businesses that have become dependent on continuously rolling over debt fail and trigger further defaults. Monetary expansion and further lending is also constrained by the absence of qualified borrowers, and by the general unwillingness to either lend or borrow that results from the ensuing economic collapse. Further complications, as described by Ben Bernanke and Harold James, can occur when interactions between currencies are considered, in particular in conjunction with gold-based capital regulation, because of the difficulties in establishing the correct ratio of gold for each individual currency and maintaining it, in a system where lending and the associated money supply are continually fluctuating and gold is also being used at a national level for international debt repayments.

The debt to money imbalance created by the widespread, and global, sale of Asset Backed securities may be unique to this particular crisis. Although asset backed security issuance dropped considerably in 2008, as the resale markets were temporarily frozen, current stated policy in several countries, including the USA and the United Kingdom, is to encourage further securitization to assist the recovery of the banking sector. Unfortunately this appears to be succeeding.

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.

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

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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.

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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.

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

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

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

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

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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