Part 3 (1/2)

In principle, unsecured creditors of banks and other financial institutions could impose market discipline; their funds, after all, could be jeopardized if the institutions took too much risk But in the recent crisis, even these unsecured creditors did not impose market discipline The reasons were various: the unsecured claims were too small to make a difference; the unsecured creditors were treated mostly like secured creditors (insured depositors) and did not experience losses as they were bailed out; the lender-of-last-resort support of central banks prevented the working of market discipline

Not all financial institutions are covered by deposit insurance, but if there's one lesson of financial crises that does get reh, a lender of last resort will appear to save the day Ever since the Great Depression, central banks have consistently stepped into the breach and acted as the lender of last resort It happened in the LTCM crisis in 1998, when the New York Fed orchestrated a private bailout, and it happened again in the midst of the recent crisis, when the Federal Reserve made unprecedented levels of liquidity available to institutions like investis of deposit insurance

Knowing that a probable lender of last resort existed reduced financial institutions' incentive to hold a large aainst a bank run It also helped re incentive that the de facto depositors had to monitor these institutions' performance: should a crisis strike, they knew, central banks around the world could be counted on to save the day And in this respect, the calculations of all the financial system's players proved remarkably correct: in both the United States and abroad, central banks fell all over the firms There was one dramatic atte Lehe swaths of the financial system

If there was ever an argu banks and other financial firh liquidity, and shareholders ame and an incentive to monitor the firms they supposedly supervise And these requireovernment must play a major, if controversial, role Unfortunately, in the years leading up to the crisis, governovernh its absence, but through its not-so-subtle interventions as well

Government and Its Discontents

The Federal Reserve is arguably the overnood or for ill, as the career of Alan Greenspan aests That Greenspan presided over the Federal Reserve is ironic After all, as a young man he became smitten with the power of the free market In the 1950s he even became an acolyte of Ayn Rand, whose hard-core libertarian beliefs he adovernment should stay out of the econoovernment when the opportunity arose

Greenspan's first major appointment came in 1974 as chairman of President Gerald Ford's Council of Economic Advisers But this service paled in importance compared to his 1987 appointment as chairovern the freeFour months after his appointment, the stock market crashed, and Greenspan immediately rode to the rescue Out the ent any principled opposition to government intervention As he memorably put it, ”In a crisis environer-teret beyond this ie that the central bank had a role to play inthe effects of a financial crisis, he declined to do anything to prevent such crises fro-standing central banking philosophy that these powerful institutions should prevent bubbles fro that belief, former Federal Reserve chairman William McChesney Martin, Jr, once said that the job of the central banker was to ”take away the punch bowl just as the party gets going”

Greenspan revealed hi to take it away In 1996, as the stock iddy bubble focused on tech and Internet stocks, he warned of ”irrational exuberance,” then did next to nothing to stop the bubble fro a token increase of 25 basis points in the Federal funds rate When the dot-com bubble finally popped in 2000, Greenspan poured plenty more alcohol into the proverbial punch bowl In the wake of the attacks on Septens of a recovery started to appear When he finally resu rates in 2004, he did so in tiny and slow and predictable (a policy of ”) increments of 25 basis points every six weeks, when the Federal Open Market Co and normalized them too late and too slowly

The result was the housing andvast quantities of easy , Greenspanan entirely new one This policy was the inevitable consequence of the contradiction at the heart of his approach to central banking: helplessly watching bubbles on the way up, andfrantically to arrest the doard slide Unfortunately, it created a Greenspan put By the end of Greenspan's final term as chairman of the Federal Reserve, the Greenspan put was an article of faith a traders: the markets believed that the Fed would always ride to the rescue of reckless traders ruined after a bubble collapsed It created rand scale, and Greenspan deserves blame for it

Greenspan also deserves blaulate ress passed the Home Ownershi+p and Equity Protection Act in order to crack down on predatory lending practices Under its ter, but he refused to do so He continued to refuse even after Edward Gramlich, one of the members of the Federal Reserve Board, beseeched him to do so Greenspan later defended his refusal to o in and audit how they act on their e effort, and it's not clear tothat would have been hile without under the desired availability of subprime credits”

Revealing words, these Greenspan considered the advent of subpri, the inevitable consequence of letting markets run free Until very recently he continued to praise the role that financial ”innovation” played innumbers of Americans At one public event in 2005 he hailed the way financial innovation had ”led to rapid growth in subpri constructive innovation that is both responsive to market demand and beneficial to consumers”

In all fairness, Greenspan had plenty of coulation For the previous three decades, freeing financial ulations had been an article of faith a conservatives It also becaulations of the financial syste the Great Depression were phased out or eliminated

The all Act of 1933 Part of that landislation had created a firewall between commercial banks (which took deposits and ht, and sold securities) Those provisions suffered death by a thousand cuts Beginning in the late 1980s, the Federal Reserve Board pere of securities At first commercial banks could derive only 10 percent of their profits from securities operations, but in 1996 the Federal Reserve Board raised that threshold to 25 percent The following year Bankers Trust became the first commercial bank to purchase a securities firm; other banks soon followed suit

The catalyst for the final repeal of Glass-Steagall was the proposed er of Travelers with Citicorp This co, insurance underwriting, and securities underwriting under the same roof, forced the issue: the new financial behe laws Late in 1999, after intense lobbying, Congress repealed the reall via the Financial Services Modernization Act, paving the way for additional ers between investment banks, commercial banks, and insurers

One of the key players in the repeal of Glass-Steagall was Republican economist-turned-senator Phil Graulation, most famously in 2000, when he attached the Coet bill This act, which was never debated in the Senate or the House, effectively declared huge swaths of the derivativesthe instruulation were credit default swaps, which perainst defaults on bonds both very simple (such as those issued by an autoations backed by pools of e-backed securities) Credit default swaps, which mushroomed to reach a notional value of over 60 trillion by 2008, became one of the most important sources of ”systemic risk”-perils that threaten the entire financial system (For more on credit default swaps, see chapter 8) The push for deregulation also took place outside Congress In 2004 the five biggest investe Co to persuade it to loosen rules that restricted the a an exemption would allow the firms to tap billions of dollars hitherto held in capital reserve should they sustain major losses on their investments It would allow cuts in the cushi+on these firnified their potential for profits In a unanimous decision, the SEC coh not without soht be risky ”We've said these are the big guys,” observed one co, ”but thatto be an awfully big ulation by e (ratio of assets to capital) to ratios of 20, 25, or even ulated commercial banks

Not everyone thinks that deregulation alone is to blame for the crisis Some conservative coovernment, not too little The key claim here is that the Community Reinvestislation, which prevented banks frohborhoods when they made loans, es In the conservative interpretation, the original and the aislation-with the assistance of Fannie Mae and Freddie Mac-helped spur the subprime market and caused the eventual meltdown

It's an interesting argurowth in the sub-prime market was primarily underwritten not by Fannie Mae and Freddie Mac but by private e lenders like Countrywide Moreover, the Co bubble True, legislation passed in the 1990s coes that effectively included subprime loans In 1997, for example, some 42 percent of the loans they purchased had to coe for their neighborhood Soh the precise nuardless, overblown claile-handedly caused the subpri

What is true is that the federal govern sponsored and subsidized ho it a far less expensive and burdensome proposition than it would otherwise be Its subsidies include allowing hoe interest payments on their federal income tax returns Siains froovernment-sponsored enterprises-not only Fannie Mae, Freddie Mac, and FHA but the Federal Ho and ebubble, but they certainly created conditions that encouraged and sustained its growth

The Shadow Banks

If governulation helped reovernment to keep pace with financial innovation also played a role This failure goes far beyondthe bonus systeoes to the heart of the dramatic if unheralded rise, over the past thirty-plus years, of what Pacific Investe system”

The shadow banking system consists of financial institutions that look like banks, act like banks, and borrow and lend and invest like banks, but-and here's the iulated like banks Think for a moment about what constitutes a bank In simplest terms, a bank borrows money on a short-term basis, usually in the form of deposits ”lent” to it by depositors These deposits constitute most of the bank's liabilities: at any moment the depositors can deive it back

But banks don't just sit on deposits; they lend the-term investments, such as a ten-year loan to a corporation In other words, they borrow the deposits, make loans, and thereby e However, there's a catch: while the bank's liabilities are liquid (they're in the form of deposits), its assets are illiquid (they're tied up in land, new equips that can't immediately be turned into cash)

Norhly unlikely that all the depositors will rush to the bank at once, de their money back But occasionally they do precisely that, and the Great Depression is the example of what happens when panicked depositors flood a bank The perils of this dynamic were beautifully dramatized by Frank Capra's It's a Wonderful Life, which profiles the ups and downs in the life of se Bailey

One day, as Bailey is besieged by anxious depositors deives an i of this place all wrong,” he tells the depositors, who cling to the idea that theiridle in the vaults ”As if I had the money back in a safe,” he remonstrates ”The money's not here Your money's in Joe's houseAnd in the Kennedy house, and Mrs Backlin's house, and a hundred others” The liquid deposits, in other words, have been transformed into illiquid investments that are not readily converted back to cash As Bailey explains to the depositors, ”you're lending the to pay it back to you as best they can”

Bailey's predicament was typical of banks in the darkest hours of the Great Depression He was grappling with the ”maturity mismatch” between liabilities that are short-ter term that can rarely be turned into cash on the spur of the moment As a consequence, it's next to impossible to use the one to pay off the other without incurring treht sell off its assets, such as eneral panic has seized the banking syste, and these sales will fetch only a fraction of what they would command in normal times

So in practice, banks that fall victi illiquid to being insolvent Sometimes banks deserve that fate, as when their assets are insufficient to accoardless of the price at which they are sold But in plenty of other cases, a bank is solvent but has simply made illiquid investments As a consequence, its short-ter the Great Depression, banks failed for both reasons Soations to their depositors, whether there was a bank panic or not Others could have ations if they'd had help

That help could have come in two forms: lender-of-last-resort support and deposit insurance The first was available during the Great Depression, but the Federal Reserve failed to use it effectively; the second caislation created the Federal Deposit Insurance Corporation (FDIC) These two antidotes to bank runs are slightly different Lender-of-last-resort support stops a bank run by giving banks ready access to cash so they can pay off their depositors, thus sparing the to liquidate assets at fire-sale prices Deposit insurance, by contrast, prevents bank runs fro in the first place: it reassures depositors that they will get their money back if the bank becomes illiquid or even insolvent

In the postwar era, both lender-of-last-resort support and deposit insurance became the norm, not only in the United States but in most capitalist nations These protections caive up some of their autonomy in order to avoid the probleulation and supervision in the fore, and capital, which necessarily li beca joke had it that banking operated according to the 3-6-3 rule: bankers paid their depositors 3 percent interest, lent it out at 6 percent interest, and lined up to tee off at the golf course by three PM A slight exaggeration, perhaps, but the joke had rain of truth

As if that weren't enough to taulations iovernors from the countries thatSupervision, named after the Swiss city that is home to the Bank for International Settlelobal financial system In 1988 the committee introduced a capital adequacy syste the relative risks of different kinds of assets held by banks around the world This system, called the Basel Capital Accord, spelled out in no uncertain terms how much capital banks had to hold, relative to the risk of the assets in their custody The core of the agreement held that banks had to maintain a minimum capital standard of 8 percent, that is, hold reserves equivalent to or exceeding 8 percent of the total value of their ”risk-adjusted assets” (which es) Though the coal authority over member nations, its recohout the world

The co years it issued additional recommendations The stakes of those revisions were clear As one 1997 report of the co syste or developed, can threaten financial stability both within that country and internationally” That spirit informed a revision to the Basel Capital Accord in 2006, known as Basel II Unlike the first accord, not all the recommendations of Basel II have been implemented (For more on the Basel accords, see chapter 8) Why? Si for stability and security A growing number of people who joined the financial services industry from the 1980s onward realized that they couldto walk the banking tightrope without a safety net underneath There ays to conduct banking free of regulations, but also free of the protections afforded ordinary banks So began a gaulations in pursuit of higher profits This quest gave rise to the shadow banks

The shadow banks didn't have tellers; they didn't stand on street corners in neighborhoods across the country They had funny acronyms, or what Paul McCulley aptly called a ”whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures,” many of which lurked off the balance sheets of conventional banks The shadow banks cae lenders; structured investment vehicles (SIVs) and conduits, which financed themselves with complex short-term loans known as asset-backed commercial paper; investment banks and broker dealers, which financed thereements; money market funds, which relied on short-tere funds and private equity funds; and even state- and local-government-sponsored pools of auction-rate securities and tender option bonds, both of which had to be rolled over at a variable rate in weekly auctions Most of these shadow banks had one thing in common: a profound maturity mismatch They mostly borrowed in short-ter-term, illiquid assets They looked quite different fro & Loan, but they suffered from the same vulnerability to a bank run

This would not have been a probleular banks, sube for access to lender-of-last-resort support and the equivalent of deposit insurance But they did not Even worse, these institutions grew to rival the conventional banking syste comparable amounts ofsystem was at the heart of ould become the mother of all bank runs

A World Awash in Cash

All of these factors-financial innovation, failures of corporate governance, easy overn system-contributed to the onset of the crisis In lish-speaking world took the lead But the rest of the world helped set the stage for the crisis, even if it was hardly their intent to do so

Alan Greenspan was one of the first to recognize the problehtly noted that when he raised the federal funds rate fro-tere rates barelyhad had no effect This was not what the textbooks would have predicted In theory, long-tere rates should have crept upward in tune with the rate hikes

Greenspan called it the ”bond market conundrurated world economy, the rates at which the United States could borrow lobal s fro econos had to be invested soenerated by the United States But the low rates of return on the federal govern-ter a higher rate of return So they purchased the debt of Fannie Mae and Freddie Mac, along with the uaranteed by those institutions All were iuaranteed by the US Treasury

But overseas investors did not stop there Private creditors of the United States-particularly investors and financial institutions in Europe-became major purchasers of securitized products Estienerated by American financial institutions ended up in the portfolios of foreign investors In other words, the income stream from credit card debt, hoes ended up in the portfolios of foreign investors via the process of securitization By n creditors helped finance the borrowing binge that drove the bubble

Just how n investors underwrote the boom remains an open question Much rides on the answer: solut” hypothesis to blame the crisis on China and the other creditors of the United States That ly shi+fts the blame from problems in the United States But what is indisputable is that this pool of savings in search of investments ended up in the United States In the process, it inadvertently helped the United States live far beyond itsIndeed, had the United States been an e economy instead of the world's sole superpower, its creditors would have pulled the plug long ago

But they didn't Instead, easy lobal trend sustained the boom Combined with lax monetary policy, reckless financial innovation, the probleovernance, and the shadow banking systen money helped brew a disaster of epic proportions Still, none of these developments could alone cause a crisis An essential, additional factor made a catastrophe all but inevitable: the fact that ally reliant on debt or leverage

The Lure of Leverage