"Deposit Insurance" for the Shadow Banking System

Here are some more thoughts inspired by Gary Gorton's work and discussions at the Economics Blogger Forum. During the Great Depression of the 1930s there were runs on the banking system. These panics were based on depositors rushing to get their money back from the banks. The federal government response was to create deposit insurance. This response worked but it also created moral hazard problems that, in turn, required more government regulation.

During the Great Recession of the late 2000s something similar happened. There was a run on the shadow banking system in the repurchase agreement (repo) market by institutional investors and nonfinancial firms. Repos represent a liability for the shadow banking system just as deposits do for the traditional banking system. According to Gorton, the repo market is around $12 trillion in size (compared to about $10 trillion in assets for the traditional U.S. banking system) so this was a major bank run. Like deposit holders during the Great Depression, repo holders in this crisis wanted their money back and could get it by (1) forcing the shadow banks to take a haircut on the collateral used in repos or (2) not renewing the repos . As a result, repo markets began freezing up and threatened the shadow banking system. Since the shadow banking system is a conduit for funding the traditional banking system, financial intermediation in general became threatened (See Gorton for more details). The official response to this banking panic was for the Federal Reserve to create liquidity programs to effectively unthaw the repo market. Like deposit insurance in the 1930s, this government intervention stopped the run on the shadow banking system. Now that these liquidity facilities have been tested and shown to work, there is an expectation they will be used again if needed. And like the deposit insurance for the traditional banking system, this modern form of "deposit insurance" for the shadow banking system is bound to create moral hazard problems that will ultimately lead to more government regulation. These are interesting parallels.

The emergence of the shadow banking system, therefore, not only has implications for the correct measure of the money supply, but also for what will be the new moral hazard and government regulation of the financial system.

The Insolvency of the U.S. Banking System

Is the U.S. banking system insolvent? If so, the current U. S. Treasury bailout plan for banks is doomed since it is premised on the view that the banking system is facing a crisis of liquidity not solvency. Paul Krugman nicely summarizes the thinking behind the Treasury program:

The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

I find it hard to believe this is a liquidity crisis. Take one look at the balance sheet of the U.S. banking system and it is hard to escape the conclusion that the U.S. banking system is insolvent. Both Nouriel Roubini and Michael Pomerleano examined the banking system's balance sheet and concluded there is an insolvency problem. Here is Pomerleano:

The banking system is severely undercapitalized, with numerous insolvent banks. Clearly a more robust banking system requires far more capital and a robust loan loss reserve adding to the capital cushion. Until the trillion plus of impaired assets are removed and the banking system is recapitalized, credit flows will be restricted. In this context, it is puzzling why the administration is tinkering at the fringes with programs designed to enrich Wall Street. Geithner and Summers need to address the banking problems square-on.

So what exactly does the U.S. banking systems balance sheet look like? Thankfully, Tyler Durden at Zero Hedge went to the trouble of creating a consolidated balance sheet for the U.S. banking system for 2008:Q2. As Felix Salmon notes, the numbers from this balance sheet are "terrifying." I have posted a picture of the balance sheet below. (Click on the figure to enlarge.)

Tyler explains the gravity of the situation as seen in this balance sheet:

The biggest concern is the roughly $8.1 trillion in loans currently on the asset side of the equation, however the other assets, which include $2.8 trillion in securities and $2.5 trillion in other assets should not be ignored. I point out the loans as this is where the vast majority of the "toxic assets" reside. The real question mark is what is the true value of this $8.1 trillion number as the financial system contracts massively. As has been pointed out, banks have taken only about $1.2 trillion in write downs against these assets.

Is that amount of write downs enough?

Not by a long shot if one considers the various guarantee and support programs enacted by the Federal Reserve and the Treasury. In a normal world, the Assets, by definition, should equal the Liabilities plus Shareholder Equity. As nobody knows what the true value of the assets really is, the Bail Out support programs are designed to provide the backing to make it seem like the almost $8 trillion in deposits, the core of bank and thrift liabilities, are not "supported" by toxic assets, or "hot air" to use popular jargon. As presented, the various Bail Out programs now support over 72% of the total liabilities on the balance sheet. The implications of this are staggering: Roubini anticipates the total amount of write downs (in the US) will reach $3.6 trillion, or another $2.4 trillion to go. The revised IMF estimate (which is not the final one by a long shot) estimates $3.1 trillion in total US losses, or another roughly $2 trillion to go. These provisions are optimistic. Why - because through its various implicit and explicit guarantees the administration is saying the total pain could potentially reach $8.8 trillion.

According to Tyler, then, there is only about $1.4 trillion in bank capital with potential write downs ranging from $3 trillion t0 almost almost $9 trillion. That spells an insolvent U.S. banking system. It is also striking that 72% of the liabilities in the U.S. banking system are being supported by the government. With so much existing government support how much different would outright nationalization be? The only downside I can see is that a restructuring of the U.S. banking system could trigger another credit crisis. But either way there is some cost. I say we take the hit now and restructure the banks.

Considering the Consequences

Here are couple of articles that speak to the consequences of the Fed's actions since the outbreak of the financial crisis. From The Economist we learn that one reason for the run up in commodity prices is that the Fed is exporting its loose monetary policy to the world:

[...]

Another reason to suspect that the Fed is more than a bit player is that American interest-rate decisions have a disproportionate effect on global monetary conditions. Some emerging economies still peg their currencies to the dollar; many others have been reluctant to let their exchange rates rise enough to make up for the dollar's decline. As a result, monetary conditions in many emerging markets remain too loose. This fuels domestic demand, pushing up pressure on prices, particularly of commodities. All of which suggests that the Fed's decisions are propagated widely through the dollar.

[...]

So here we have another observer effectively claiming the Fed is a monetary hegemon and consequently, its choices affect many nations. I am glad I am not alone on this point. Closer to home we learn the Fed is now facing the consequences of its decision to rescue Bear Sterns from bankruptcy. Bloomberg's Craig Torres tells us that

...Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is ``a potential crisis in the student-loan market'' requiring ``similar bold action,'' Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

Student loans are just the start. Former Fed officials and other Fed-watchers say that Bernanke's actions in saving Bear Stearns will expose the central bank to continuing pressure to use its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians. The Fed satisfied Dodd's request today, expanding the swaps to include securities backed by student debt.

``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Critics argue that the result will be to foster greater risk-taking among investors emboldened by the belief that the government will bail them out of bad decisions.

To be fair, though, the Fed believed the alternative to rescuing Bear Sterns was a systemic failure of the financial system. Fed officials understood problems like the above might arise, but were willing to risk them in order to avoid the greater costs of a financial meltdown. However, as Ken Rogoff notes in the same article,

They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.

So the Fed-bail-out genie is out of the bottle and investors have taken notice. As long as that genie stays out of the bottle there is no way to escape further regulation in financial markets as noted by Alan Blinder.

Bernanke to Reinhart:"Et tu, Brute?"

Vincent Reinhart, former director of the Division of Monetary Affairs at the Federal Reserve and coauthor with Ben Bernanke on several papers, had an article in the Wall Street Journal titled "Our Overextended Fed." In this piece, Reinhart takes to task his former colleagues at the Fed for setting moral hazard-creating precedents as well sending panic signals to investors. His frank rebuke of the Fed's actions are surprising for a former high-ranking Fed official.

Our Overextended Fed

In the past few weeks, the Federal Reserve has fundamentally redefined the role of a central bank in a market economy.

Almost one-half of our nation's central bank balance sheet -- more than $400 billion -- is exposed to credit risk through new lending facilities. It has also entered an open-ended commitment to use its discount window to back stop major securities firms. Those efforts will influence the depth of the recession that the U.S. economy has likely already entered, and will leave a durable imprint on the financial landscape for many years to come.

[...]

The desire on the part of policy makers to draw a line defending the existing structure of the financial system is understandable. But one can wonder if the trenches the Federal Reserve has dug are this generation's Maginot Line -- ineffective in defense and costly in the long run.

The Federal Reserve put its balance sheet in harm's way to give assurance to Bear Stearns's creditors and extended that protection to the other primary dealers. In doing so, the Board of Governors of the Federal Reserve had to determine unanimously (since they only had five members at the time) that these were "unusual and exigent" circumstance and that failure to lend to Bear would have adverse consequences for the U.S. economy. The signaling aspect of that decision cannot help but have adverse consequences for investors' willingness to take on risk.

Moreover, the implicit declaration that a midsize investment bank was systematically important puts any firm at least as big as Bear in the cross-hairs of speculators. In coming days, how can the Federal Reserve turn away another like-sized entity, whether primary dealer or not, that is suddenly in the marketplace's disfavor for having used leverage to borrow at short-term maturities to fund longer-term obligations?

In such circumstances, the Federal Reserve's $900 billion balance sheet will not look that big. And the Federal Reserve will have ceded control of its balance sheet to the needs of private-sector entities.

More seriously, the Federal Reserve's action can only be viewed as rewarding bad behavior. Remember that Bear opened this financial crisis when it revealed problems at its sponsored hedge funds last June. That it did not spend the next nine months resolving its problematic positions and getting sufficient capital did not prevent it from getting a "get out of jail free" card from the Federal Reserve.

[...]

Read the Rest.

Is Nouriel Roubini Losing his Religion?

Nouriel Roubini is one of the few economists to early on make the call that our current financial quagmire was a solvency crisis rather than one of just illiquidity. As a result, Nouriel concluded back in August that "liquidity injections and lender of last resort bail out of insolvent borrowers--however necessary and unavoidable during a liquidity panic--will not work; they will only postpone and exacerbate the eventual and unavoidable insolvencies." I found his reasoning then and now to be compelling.

Recently, however, it appears that Nouriel has begun to lose his religion. He wrote a post to his blog a few days titled "Why monetary policy easing is warranted even in the current insolvency crisis." In this piece, Nouriel makes that argument that there should be global easing of monetary policy so as to

"... reduce the length of such a recession and dampen its depth. Monetary policy may be impotent in affecting the likelihood of a economic downturn... but it is not impotent in affecting how deep and long such a recession will be."

Nouriel goes on to say he believes monetary policy can dampen the severity of the recession without (1) postponing the needed real economic adjustments, (2) creating new asset bubbles elsewhere, or (3) generating excessive inflationary pressures. So Nouriel now is articulating the following: let the recession happen, but do not let it get out of hand. In other words, let's avoid the Great Depression scenario of the 1930s where bad policies let a normal recession--that may have been necessary to purge the excesses of the 1920s--turn ugly.

The Great Depression is one scenario. Let me propose another one that I believe fits our current situation better: Japan in the 1990s. Here, there was an asset bubble that popped and similarly led to rot in the banking system--large amount of non-performing loans--that was not quickly removed. The rot, in turn, contributed to a stagnant economy for almost a decade. The non-performing loans and government support programs in Japan sound eerily familiar to the situations in the U.S. today. If the Japan scenario is the right one, then Nouriel's proposal simply postpones and potentially creates more problems down the road.

Paul Krugman, who has not lost his religion on this topic, says the following

"
How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years. Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed."

I hope Nouriel's concerns over a Great Depression type scenario are wrong, but the alternative Japan scenario is not much better. Hang in there world.

Bill Gross on Adding More Liquidity

Bill Gross of PIMCO has just posted his latest investment outlook. These reports are always interesting and filled with colorful imagery (recall his comparing the new sexy credit derivatives to hookers with six-inch heels). In this latest report, Bill Gross examines the recent market turmoil and considers the implications of injecting more liquidity to the markets:

"Housing prices could probably be supported by substantial cuts in short-term interest rates, but even cuts of 200-300 basis points by the Fed would not avert a built-in upward adjustment of ARM interest rates, nor would it guarantee that the private mortgage market – flush with fears of depreciating collateral – would follow the Fed down in terms of 15-30 year mortgage yields and relaxed lending standards. Additionally, cuts of such magnitude would almost guarantee a resurgence of speculative investment via hedge funds and levered conduits which have proved to be the Achilles heel of the current crisis. Secretary Paulson might also have a bone to pick with this “Bernanke housing put” since it more than likely would weaken the dollar – even produce a run – which would threaten the long-term reserve status of greenbacks and the ongoing prosperity of the U.S. hegemon."

These points are essentially identical to the ones I made in my previous post: (1) this is an insolvency crisis not a liquidity crisis: there are real painful adjustments that have to be made in the housing sector, (2) injecting more liquidity will only led to more of the financial imbalances that got us here in the first place, and (3) there may long-term implications to monetary accommodation today, such as increased moral hazard and a weakening dollar.

Sound Policy or Liquidity Addicts?

What is the appropriate role of the Federal Reserve at this time? Most views on this question fall into one of three camps: (1) the 'inject much more liquidity now' view, (2) the 'inject some liquidy now to prevent contagion' view, (3) and the 'exercise monetary restraint now' view. What to make of these competing views? I want to focus in this posting on the 'inject more liquidity now' view. This group represents the Jim Cramers of the world who never tire of calling for more monetary easing whenver a finanical storm besets the markets. Below is an Op-Ed piece I wrote that addresses this very group.

Sound Policy or Liquidity Addicts?

"Ben Bernanke needs to open the discount window…He is being an academic! This is no time to be an academic. Open the darn discount window! ...My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he's nuts! They're nuts! They know nothing! . . . The Fed is asleep…"
Jim Cramer on CNBC, August 3, 2007

Jim Cramer could not be happier. The Federal Reserve surprise discount rate cut of 50 basis points this past Friday spurred a brief recovery in markets and has created expectations of a Federal Funds rate cut in the September FOMC meeting. Jim Cramer and others like him who had been calling for an easing of monetary policy by the Federal Reserve surely feel vindicated by the market’s response on Friday and now are even more emboldened in their call for further interest rate cuts. But does this policy response make sense? Are these champions of interest rate cutting promoting sound policies that address the underlying problems or are they liquidity addicts simply begging for another shot of liquidity to get them through the hangover of the last monetary easing binge?

There are several compelling reasons to believe that these calls for the easing of monetary conditions are in fact nothing more than the cries of liquidity addicts hoping to avoid the needed correction in financial markets. First, the Jim Cramers of the world fail to recognize the difference between a liquidity crisis and an insolvency crisis. A liquidity crisis is when an individual, firm, or some sector of the economy is solvent but temporarily short of liquidity. For example, if an individual is unexpectedly hit with major medical expenses that he cannot pay out of pocket, but could pay once he sells some of his assets, such as land, then this individual is facing a liquidity crisis. However, if this same individual cannot pay out of pocket and has no assets to draw on then he is insolvent and facing an insolvency crisis. In the former case, extending credit or liquidity to this individual makes sense since he has assets to cover the new line of credit, but in the latter case extending credit would only postpone and maybe worsen the insolvency. This distinction is important because as Nouriel Roubini has shown the current turmoil in global markets is the result of an insolvency crisis not a liquidity crisis. Roubini notes in particular that this crisis stems from insolvencies and bankruptcies in mortgage-ladened households, mortgage lenders, home builders, and some hedge funds all of whom were driven by real economic distortions in the housing sector. These excesses in the housing sector simply cannot be waved away by some magical liquidity wand. This current insolvency crisis stands in stark contrast to a true liquidity crisis that emerged with the Long-Term Capital Management hedge fund debacle in 1998. Then, the Federal Reserve was able to successfully intervene and thwart a credit crunch, but it occurred in the context of a robust economy with no signs of broad insolvency. Believing that more monetary accommodation now will save the day misses this important distinction.

The Jim Cramers of the world also seem to forget what got us here in the first place: past monetary excesses. Following the recession of 2001 and the deflation scare of 2003, the Federal Reserve lowered it policy interest rates from a high of 6.5% in early 2001 to a low of 1% that was maintained through the summer of 2004. Although monetary policy began tightening in the second half of 2004, the federal funds rate was still lower than the year-on-year growth rate of nominal GDP through 2006. By keeping the interest rate below the growth rate of the economy for so long, there was every incentive for excessive leverage. Moreover, the lowering of interest rates in response to the deflation scare of 2003 looks to be particularly distortionary in retrospect. Rapid productivity gains appear to have been the source of the low inflation in 2003, but rapid productivity gains imply a higher policy interest rate, not a lower one, is needed for monetary policy to stabilize economic activity. It is no coincidence that these policy moves coincided with the housing boom and the related distortions in mortgage markets that are only now beginning to be worked out. The irony in all of this is that the Jim Cramers of the world are now calling for more of the same liquidity medicine that generated the financial imbalances in the first place—a surge sign of liquidity addiction.

Finally, the Jim Cramers of the world fail to grasp the implications of their policy prescriptions going forward. As has been discussed already on these pages, every time the Federal Reserve steps in to calm financial markets it creates less incentive for investors to be more careful next time. To the extent the Federal Reserve is setting a precedent in the mind of investors and creating moral hazard, it is perpetuating a culture of liquidity addiction. If the Federal Reserve continues to follow down this path of accommodating the markets, then we have not seen the last Jim Cramer rant against the Federal Reserve nor the last of the liquidity addicts. Another implication going forward of this policy prescription for more monetary easing is that it may put downward pressure on the dollar. To the extent the dollar has been overvalued this may be a good outcome, but ongoing interest rates cuts in the midst of market turmoil and could lead to an outright run on the dollar. Either the Jim Cramers of the world simply cannot see far foward enough to appreciate these dangers or they personally high discount rates.

The Jim Cramers of the world then are liquidity addicts who are prescribing the U.S. economy go on another Fed Spirits binge and put off the financial hangover until another day. The U.S. economy has been down this road before after the last asset bubble burst in the early 2000s. Here is hoping the Federal Reserve does not follow their policy recommendations, but allows the U.S. economy to finally sober up.