A Money View of the FCIC Report: Part One

When the survival constraint bites

Financial Times article being discussed: US Panel’s Report Reflects Partisan Rift (Jan 30, 2011)

If you can’t roll your funding as it comes due, you are dead. That is what Hyman Minsky called “the survival constraint.”

From this point of view, the crisis looks like a series of ratchet steps down into the abyss, as the survival constraint shifted from one player to another—fail or bail? —until essentially the entire financial system was on life support provided by the only entity that does not face a survival constraint, the Fed.

Looking a little closer, we see that each of these critical ratchet points came after an earlier fateful decision—again fail or bail?—at a less critical spot in the system. Just so, way back at the beginning of the crisis, Bear Stearns faced the choice whether to provide support for two troubled hedge funds, or just close them down. The decision to support came at the cost of weakening its own balance sheet, ultimately fatally.

Similar earlier fateful decisions can be identified for Citi, for Fannie and Freddie, for Lehman, and for AIG. Read the report and you will see what I mean. For each firm there was a business case, a profit-maximization case, for bailing, and the firm took it. Profit-driven lender of last resort came before stability-driven public lender of last resort; no one could know in advance that it would not be enough.

Pulling the camera back to see the big picture, the crisis looks less like a set of dominos falling and more like a stress test of the entire shadow banking system. The dissenters to the FCIC report warn about “the dangerous imprecision of the term shadow banking” (p. 427) and their warning is well-taken as a criticism of the main body of the report. So let’s be more precise.

By “shadow banking system” I propose to mean the entire collection of interlocking balance sheets that came to link a household mortgage borrower on one end with an ultimate funder who holds shares in a money market mutual fund on the other end. In a Jimmy Stewart age, there was only a single bank in the middle, funding mortgage loans with deposits. In the last thirty years, however, we have shifted from a bank loan-based credit system to a capital market-based credit system (Figure 2.1, p. 32).

Inevitably crisis was going to test this new system, but no one knew where it would break when that test came. Now we have had the test. What broke?

So far as I can see, the critical pieces of the system that broke, and so turned a mere subprime crisis into a global financial crisis, were the tri-party repo system and the credit-derivative dealer system. Notwithstanding the suggestion that Goldman’s (rumored) refusal to accept novation triggered the run on Bear, it seems clear that it was JP Morgan’s insistence on collateral support for intraday credit involved in its tri-party repo operations that brought the end.

Even more, it seems clear that it was the Fed’s fear about systemic effects from disruption of the tri-party repo system that impelled it to act, and subsequent events make clear that those fears were very well founded. Six months later

“These developments triggered the event that Fed policymakers had worried about over the summer: an increase in collateral calls by the two tri-party repo clearing banks, JP Morgan and BNY Mellon. As had happened during the Bear episode, the two clearing banks became concerned about their intraday exposures to Morgan Stanley, Merrill, and Goldman.” (p. 361)

Lehman’s failure by contrast seems to have been largely a story of OTC derivatives exposure, “900,000 derivatives contracts with a myriad of counterparties” (p. 326), as also the AIG failure. But Lehman was allowed to fail, while AIG was bailed, why? The answer seems to have been that AIG had collateral that was acceptable to the Fed while Lehman did not. Merrill Lynch survived because Bank of America bought the firm; Lehman failed because Barclay’s didn’t buy the firm.

Significantly, in the aftermath of Lehman and AIG, OTC derivatives markets froze:

“Derivatives had been used to manage all manner of risk—the risk that currency exchange rates would fluctuate, the risk that interest rates would change, the risk that asset prices would move. Efficiently managing these risks in derivatives markets required liquidity so that positions could be adjusted daily and at little cost. But in the fall of 2008, everyone wanted to reduce exposure to everyone else. There was a rush for the exits as participants worked to get out of existing trades. And because everyone was worried about the risk inherent in the next trade, there often was no next trade—and volume fell further. The result was a vicious circle of justifiable caution and inaction.

Meanwhile, in the absence of a liquid derivatives market and efficient price discovery, every firm’s risk management became more expensive and difficult. The usual hedging mechanisms were impaired.” (p. 364)

Repo markets were a key funding source for the shadow banking system. Credit derivatives markets were a key risk management tool. Both failed, and in their failure provided a key mechanism spreading the crisis systemically.

But why did the systemic crisis become a global crisis? To be continued…

Share your perspective