A Crisis of Reserves

The Antiplanner continues to read recent books about the 2008 financial crisis, but there are definite diminishing returns. I just finished Roger Lowenstein‘s The End of Wall Street and found it disappointing. It covered almost exactly the same ground as Too Big to Fail, but unlike the latter book, which was based mainly on interviews, Lowenstein’s book seems to be based heavily on articles and op eds in various newspapers and magazines.

The book is poorly referenced–sometimes a citation to a critical point lists nothing more than a person’s name–and somewhat superficial in its description of complex events. Lowenstein focuses heavily on subprime mortgages, but (as I’ll explain in detail in a later post) I don’t think they were the real problem. “Rampant speculation (and abuse) in mortgages was surely the primary cause of the bubble,” he concludes, but he doesn’t even sound like he believes it. There was just as much mortgage “abuse” in Texas as in California, yet Texas had no bubble. Rampant speculation only takes place after prices are already rapidly rising, so such speculation by itself can’t have caused the bubble.

I did learn one important point. Earlier I noted that Jeffrey Friedman argues that SEC rules that gave three companies–Moody’s, Standard & Poors, and Fitch–a legal oligopoly in rating securities was a major problem. I questioned whether more competition would have made any difference since ratings were purchased by bond sellers, and the sellers would just go to companies that gave them the ratings they liked. It would be better, I suggested, if buyers paid for the ratings rather than sellers.

It turns out Friedman and I are both right. Before the oligopoly, Lowenstein notes, bond buyers did pay for ratings (through subscription services). It was only after the oligopoly was created that the ratings companies found it more lucrative to be paid by security sellers (pp. 39-40). If Friedman had made that point, I missed it, and it would have helped his argument make a lot more sense.

Lowenstein makes another important point that supports what I’ve concluded from reading many other books: “The root of the crisis,” he says, “was that every bank in the Western world had orders to reduce leverage” (p. 257). What does this mean?

The recent financial crisis has been called a crisis of confidence. One day, banks and other financial institutions had faith in each other; the next day, they did not and so they stopped lending. If only everyone’s confidence could have been restored, the reasoning goes, there would have been no crisis. Unfortunately (or fortunately, if you want to believe the system is less fragile than that), that’s wrong.

The crisis has also been called a crisis of liquidity. The banks had the money they needed, but it just wasn’t liquid. They made the mistake of “borrowing short and lending long,” i.e., borrowing on short-term (such as 45-day) notes and lending for 15 to 30 years or more. At some point, the owners of the short-term notes asked for their money back, but the banks couldn’t pay for 15 to 30 years. The remedy would seem to be simple: pass rules preventing banks from borrowing short and lending long. However, that wasn’t the real problem either.

The crisis has also been called a result of the system being too big or too interconnected to fail. AIG owed close to $100 billion to each of twelve major banks. If AIG failed, those banks could fail too, followed by all the other financial institutions that they owed money to. But healthy systems are always interconnected; being too big or too interconnected was not the real core of the problem.

Another explanation is that this was a crisis of solvency. Banks such as CitiGroup and Lehman Brothers were overleveraged, meaning a small decline in the value of their assets, such as mortgage bonds, would render their net values negative. AIG, which had insured those mortgage bonds, didn’t have the cash to pay out that insurance. While this was a real problem, it isn’t what caused the financial meltdown experienced in fall of 2008.
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The real problem was a crisis of reserves. Banks are intermediaries; they borrow money from some and lend it to others. Bankers have long known that they can’t lend all their money out because some of the people they borrow it from may want it back before the people they lend it to pay it back. So they keep some cash or some other liquid form of money such as Treasury bills in reserve.

Banks that accept deposits face legal reserve requirements that are risk adjusted. If a bank lends money to a corporation, it needs to keep 8 percent of the loan in reserve. Mortgages are supposed to be less risky than corporations, so if a bank lends to a homebuyer, it needs to keep only 4 percent in reserve. Government-sponsored enterprises such as Fannie Mae are supposed to be even less risky, so if a bank buys Fannie Mae bonds, it needs to keep only 1.6 percent in reserve.

Investment banks, which deal with stocks and bonds, faced less government regulation, but instead were regulated by the market. Contracts would specify, for example, lower reserve requirements for buyers of a triple-A rated bond or securities from a triple-A rated company and higher requirements for AA-, A-, or B-rated bonds or securities. If a company is downgraded, its collateral increases, meaning it must put up more cash than before.

A bank could therefore increase its leverage–the amount of money it lends out relative to the amount it keeps in reserve–by lending to homebuyers, selling the mortgages to Fannie or Freddie, then buying bonds from Fannie or Freddie. They could also securitize the mortgages–package a thousand or so into a bond–and sell the bonds. Once off their books, they didn’t have to count them, but even on their books, with most such bonds being rated triple-A, they only had to keep minimal reserves.

The crisis came about because companies misjudged the reserves or collateral required for the mortgages, bonds, and other securities they were trading. The ratings agencies overestimated the safety of mortgage bonds. AIG and other insurers overestimated the safety of the insurance policies they were providing on those bonds.

When the housing market peaked in 2006, the ratings agencies realized they had overrated mortgage bonds and started downgrading the bonds. This forced the deposit banks that owned the bonds to increase their reserve requirements to legal levels. Some, such as CitiBank, owned so many bonds that they could not possibly come up with enough cash to fulfill their reserve requirements.

Investment banks, such as Bear Stearns and Lehman Brothers, faced collateral calls from the banks, such as JPMorgan Chase, that they had borrowed money from. When they couldn’t meet those calls, they went broke.

AIG had insured around $50 billion of mortgage bonds. It thought those bonds were perfectly safe so it failed to provide any reserves for that insurance. AIG was a wealthy company, one of the few to enjoy a triple-A corporate rating, but most of its assets were tied up in reserves for its various state insurance subsidiaries. As the ratings agencies downgraded the mortgage bonds, they also threatened to downgrade AIG’s corporate rating. Under the contracts for its mortgage insurance (credit default swaps), a single downgrade would require AIG to put $10 billion in cash–cash it didn’t have–to provide assurance that it could meet its obligations.

All of these changes in reserve requirements and collateral calls put banks and other institutions behind the eight-ball: suddenly they needed more cash than they had. They couldn’t lend out money because they needed all the money they had to fill their reserves. They couldn’t borrow money because everyone else was also scrambling to meet their reserve requirements.

Understanding that the immediate cause of the meltdown was a crisis of reserves, and that this crisis stemmed from the downgrading of mortgage bonds by the ratings agencies, is critical to understanding the underlying cause of the crisis. I discuss that in detail in a future post.