The US Financial System and its Crises: From the 1907 Panic to the 2007 Crash [1st ed.] 978-3-030-14488-3;978-3-030-14489-0

Table of contents :
Front Matter ....Pages i-x
Introduction (Giorgio Pizzutto)....Pages 1-6
The US Financial System from the National Banking Act to the Panic of 1907 (Giorgio Pizzutto)....Pages 7-31
The Birth of the Federal Reserve and Its Monetary Policy (Giorgio Pizzutto)....Pages 33-56
Non-bank Financial Intermediaries and the Crisis of 1929 (Giorgio Pizzutto)....Pages 57-73
The Great Depression (Giorgio Pizzutto)....Pages 75-102
The Money Market After World War II: Securitization and the Role of Dealers (Giorgio Pizzutto)....Pages 103-134
Monetary Policy, Spread Compression, and the Housing Market (Giorgio Pizzutto)....Pages 135-172
The Money Market, the Collateral Market, and the Crisis of 2007–2008 (Giorgio Pizzutto)....Pages 173-197
Conclusions (Giorgio Pizzutto)....Pages 199-216
Back Matter ....Pages 217-219

Citation preview

PALGRAVE STUDIES IN ECONOMIC HISTORY

The US Financial System and its Crises From the 1907 Panic to the 2007 Crash Giorgio Pizzutto

Palgrave Studies in Economic History

Series Editor Kent Deng London School of Economics London, UK

Palgrave Studies in Economic History is designed to illuminate and enrich our understanding of economies and economic phenomena of the past. The series covers a vast range of topics including financial history, labour history, development economics, commercialisation, urbanisation, industrialisation, modernisation, globalisation, and changes in world economic orders. More information about this series at http://www.palgrave.com/gp/series/14632

Giorgio Pizzutto

The US Financial System and its Crises From the 1907 Panic to the 2007 Crash

Giorgio Pizzutto University of Milan Milan, Italy

Palgrave Studies in Economic History ISBN 978-3-030-14488-3 ISBN 978-3-030-14489-0  (eBook) https://doi.org/10.1007/978-3-030-14489-0 Library of Congress Control Number: 2019933325 © The Editor(s) (if applicable) and The Author(s), under exclusive licence to Springer International Publishing AG, part of Springer Nature 2019 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover illustration: Roman Sigaev/Alamy Stock Photo This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Contents

1 Introduction 1 2 The US Financial System from the National Banking Act to the Panic of 1907 7 3 The Birth of the Federal Reserve and Its Monetary Policy 33 4 Non-bank Financial Intermediaries and the Crisis of 1929 57 5 The Great Depression 75 6 The Money Market After World War II: Securitization and the Role of Dealers 103 7 Monetary Policy, Spread Compression, and the Housing Market 135

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8 The Money Market, the Collateral Market, and the Crisis of 2007–2008 173 9 Conclusions 199 Index 217

List of Figures

Fig. 4.1 Fig. 6.1 Fig. 6.2 Fig. 6.3 Fig. 6.4 Fig. 6.5 Fig. 6.6 Fig. 7.1 Fig. 8.1 Fig. 8.2 Fig. 8.3 Fig. 8.4

US short term interest rates 1925–1930 Representation of the repo market Securitization CDO securitization Dealers repo Dealers reverse repo Repo relation between hedge fund and dealer Subprime profitability Mortgage securitization and market flows Spread ABCP/treasury 3 months Dealer intermediation Securities in–securities out

69 109 122 123 129 130 132 142 176 179 187 188

vii

List of Tables

Table 5.1 US bank assets (1926–1934) (millions of dollars) Table 5.2 All member banks loan on securities, except to banks 1928–1933 (millions of dollars) Table 5.3 Brokers’ loans by and through reporting member banks in New York City (Table 18, p. 1020, Appendix VII - millions of dollars) Table 5.4 Total brokers’ loans (Table 20, p. 1021, Appendix VII - millions of dollars) Table 5.5 Brokers borrowing 1926–1929 (millions of dollars) Table 5.6 All member banks: investments 1928–1934  (millions of dollars) Table 5.7 Average prices of bonds listed on the New York Stock Exchange, 1930–1932 (indexed to the year 1929 = 100) Table 5.8 US capital issues 1927–1932 (millions of dollars) Table 7.1 CDO global issuance (billions of dollars) Table 7.2 Global CDO issuance by underlying collateral  (billions of dollars) Table 7.3 Mortgage originations by product: 2001–2007 and share of originations (billions of dollars, percent) Table 7.4 Residential mortgage deals in 420 ABS CDOs. Number of deals by vintage and mortgage loan type

82 83 83 84 85 88 89 96 143 143 146 146 ix

x     List of Tables

Table 7.5 CDO Issues (billions of dollars) Table 7.6 Total housing inventory for the USA (2000–2010 - millions) Table 7.7 Mortgage related losses to US Investment Banks (June 2008 - billions of dollars) Table 7.8 Dealers borrowing (Term securities lending facility and primary dealers lending facility - millions of dollars) Table 7.9 Conditional forecast of losses on subprime investments from Lehman Brothers Table 7.10 US homeownership rate (percent) Table 7.11 Vacation and investment property sales (percentage) Table 8.1 FHLB advances 2007 ($ billions) Table 8.2 Dealers collateral source 2007 and 2010 (hedge fund and securities lending) Table 8.3 Securities received from dealers as collateral with the permission to repledge and the collateral pledged to counterparties Table 8.4 Custodian by asset under custody (December 2010 - trillions of dollars)

148 152 157 157 158 160 164 183 189 190 191

1 Introduction

Literature on the financial system discusses two ways that crises come about: price inflation of assets followed by deflation; or a bank run causing a cascade of bank failures, destabilizing the entire banking system. Speculative bubbles in the financial market nucleate and grow when a difference is created between the intrinsic value of an asset and the price at which it is traded. In efficient, complete markets, the value of assets is strictly linked to the discounted cash flow of future payoffs. Prices respond immediately to new information from the market and are unaffected by the quantities bought and sold. The liquidity of the market ensures coherence among valuations that depend on intrinsic value and market price via the principle of arbitrage (Conant 1905; Fama 1970). In a speculative bubble, the asset is purchased regardless of the value determined by the discounted cash flow of future payoffs because the buyer hopes to sell it at a higher price in the future. Variations in the degree of rationality of the players and uneven distribution of information produce different patterns and equilibria (Brunnermeier and Oehmke 2013). In any case, the probability distribution that influences the valuation appears to be extrinsic both to the market and to the © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_1

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larger economy. The divergence from an appropriate assessment appears to be triggered by a variable of dubious economic significance. Critics of the concept of rationality and efficiency of financial markets underscore the importance of psychological elements that they explain as the irrational exuberance of investors (Shiller 2005; Akerlof and Shiller 2009). An element extrinsic to the dynamics of the economy is also found in models that seek to explain bank runs (Diamond and Dybvig 1983). The banks respond to the public’s need for liquidity by issuing deposits that can be converted into cash while investing in illiquid assets that cannot easily be rendered liquid on the market. The transformation of mature assets and the deadlines implicit in the bank’s assets and liabilities balance expose the bank to the risk of a run. The public is composed of agents with different preferences. Some are patient, others are impatient. No one knows ahead of time what his or her preferences will be in the future. It is thus in the interest of all agents to have an insurance mechanism that guarantees the necessary liquidity to the impatient consumer manifesting a preference. The banking system achieves a positive equilibrium when the demand for liquidity derives only from impatient consumers. If, on the other hand, the patient consumers find themselves forced to hasten their conversion decisions, fearing a similar behavior on the part of other patient consumers, the banking system would be forced to liquidate its long-term assets and eventually fail, because it would not be able to satisfy a widespread demand for liquidity. The patient consumer feels obliged to demand liquidity sooner because the banks act on a first-come, first-served basis. The sequential nature of conversion drives impatient consumers to demand liquidity once their preferences have been revealed; the patient consumers imitate them, fearing that other consumers sharing their preferences will beat them to it. In these models, no information is available regarding the position of the consumer in the line to obtain liquidity and no rationing mechanisms are provided to regulate the request for conversion in proportion to the amount of funds on deposit. A similar model can be constructed, mutatis mutandis, regardless of preferences, if we introduce the distinction between informed and

1 Introduction     3

non-informed consumers (He and Xiong 2012; He and Asaf 2014). If the stock of information does not increase, the convictions vis-à-vis the solvency of a bank remain stable within normal time limits and there is no possibility of a bank run. When new information is acquired by investors, the reaction will differ depending on how this information is classified and transformed into a new valuation. The information may increase fears of some investors regarding the solvency of a bank while others may assess the situation differently. However, fearing a bank run by the former, the latter choose to withdraw their investment to make sure others don’t beat them to the punch. The fear of a negative assessment by a group of investors may expose a solvent but illiquid bank to the risk of a bank run. The extrinsic element in this case is the information on the status of the bank and the banking system, the way it is assessed, and the time it takes different groups of investors to assimilate it. Interpretive models of financial crises are thus based on extrinsic elements, sunspot equilibria, self-fulfilling prophecies, and secondguessing the expectations of others. There is a grain of truth in all this, but it precludes the possibility of analyzing how instability is generated within financial markets and the incentives motivating the various players. An analysis of the crises in the US financial market appears to offer a more complex interpretive key regarding the instability of the financial system, which allows us to circumscribe the random variables that do not have a meaningful relation to macroeconomic and financial variables and thus give more space to explanations of the intrinsic dynamics of the financial system. This may also bring improvement in how regulation can be brought to bear, in an appropriate, targeted way, on the fragility of the financial system, on its functions rather than its institutions. This objective can be achieved by accounting for three elements that are usually ignored in current analyses: a. monetary policy plays a relevant role in both expanding and contracting financial cycles;

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b. non-bank financial brokers (broker-dealers, investment banks) play a key role in transmitting the positive and negative effects of monetary policy. These brokers use means of financing that are different from those used by commercial banks, they deal with the wholesale liquidity of the financial system and display high sensitivity to variations in the interest rate; c. banks, financial markets, and non-bank financial brokers are not mutually independent. The dynamics of their relations are important in understanding the development of financial crises. These three factors are a permanent characteristic of the US financial system, as well will see in our analysis of the crises of 1907, 1929, and 2007–2008. The idea that monetary policy shaped by the Taylor rule can create financial instability by keeping interest rates too low for too long has been developed recently by Borio and Zhu (2013), Adrian and Shin (2010), and Stein (2014) and has proven useful in explaining previous crises. The effects of monetary policy on non-bank financial brokers are either ignored or marginalized in the analyses of economists, even though an awareness of the connection was elucidated well over a century ago (Bagehot 1873). Non-bank financial brokers stand at the center of the money market and handle surplus liquidity that is systematically created by the financial system, absorbing this liquidity by issuing short-term liabilities that are used to finance the acquisition of long-term assets. The banking system “produces” new credit and corresponding deposits. The expansion of a commercial bank’s assets generates deposits. The non-bank financial brokers offer credit at a certain interest rate, seeking to finance this credit on the money market at a lower interest rate. Expansionary monetary policy at low interest rates stimulates the expansion of credit, expands non-bank brokerage, and tends to increase the cost of financial assets. Restrictive monetary policy, on the other hand, compresses the balance sheets of broker-dealers (Adrian and Shin 2008). Restrictive monetary policy and credit shrinkage reduce the value of financial assets; the bursting of a speculative bubble is not the unexpected outcome of a process driven by irrational exuberance, it is

1 Introduction     5

the outcome of a systematic, progressive increase in interest rates, which the central banks have often used to interrupt a boom cycle on the financial markets (denying the need and the possibility of intervention). Such restriction causes prices of financial assets to fall and interest rates to rise, reducing the profitability of the brokerage process and the amount of liquidity on the market, forcing players to sell financial assets, triggering a downward spiral. The effects of the dynamic relationship between interest rate and monetary policy are reflected in the risk premium. The risk premium is not a stable variable (Adrian and Shin 2010); its oscillation and the effects of this oscillation on the value of financial assets are closely related to monetary policy. The risk premium tends to shrink under expansionary monetary policy and expand when it becomes restrictive. The volatility of the interest rate amplifies the instability of the financial system. Exploring the dynamics of financial markets by analyzing the role that they play within the overall economic system and getting beyond the idea that these markets can be explained exclusively in terms of speculative intent is important to understanding the behavior of real markets and explaining how levels of production and employment are determined. Macroeconomic theory struggles to grasp this connection because current models view financial markets as mechanisms capable of redistributing consumption over time. They are seen as not affecting production levels or equilibrium conditions in the labor market. They are viewed as being neutral, in a certain sense, with respect to the real economy by virtue of their structure and regardless of the ModiglianiMiller theorem. Efforts are needed to get beyond this separation. The work below is intended as a contribution in this direction.

Bibliography Adrian, T., & Shin, S. (2008). Financial intermediaries, financial stability, and monetary policy (Staff Reports 346). Federal Reserve Bank of New York.

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Adrian, T., & Shin, S. (2010). Financial intermediaries and monetary policy. In B. M. Friedman & M. Woodford (Eds.), Handbook of monetary economics (Vol. 3, pp. 601–650). Amsterdam: Elsevier. Akerlof, G., & Shiller, R. (2009). Animal spirits: How human psychology drives the economy and why this matters for global capitalism. Princeton: Princeton University Press. Bagehot, W. (1873). Lombard street. London: Henry S. King. Borio, C., & Zhu, H. (2013). Capital regulation, risk taking and monetary policy: A missing link in the transmission mechanism. Journal of Financial Stability, 8(4), 236–251. Brunnermeier, M. K., & Oehmke, M. (2013). Bubbles, financial crises, and systemic risk. In Handbook of the economics of finance (Vol. 2, pp. 1221– 1288). Amsterdam: Elsevier. Conant, C. (1905). How the stock market reflects values. The North American Review, 180(580), 347–359. Diamond, D. W., & Dybvig, P. H. (1983). Bank runs, deposit insurance, and liquidity. Journal of Political Economy, 91(3), 401–419. Fama, E. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25, 383–417. He, Z., & Asaf, M. (2014). Information acquisition in rumor based bank runs. Journal of Finance, LXXI(3), 1113–1158. He, Z., & Xiong, W. (2012). Dynamic debt runs. Review of Financial Studies, 25, 1799–1843. Shiller, R. (2005). Irrational exuberance. Princeton: Princeton University Press. Stein, J. C. (2014). Incorporating financial stability considerations into a monetary policy framework. International Research Forum on Monetary Policy, Washington, DC, March 21.

2 The US Financial System from the National Banking Act to the Panic of 1907

The US financial system has always accommodated two contrasting philosophies that coexist without ever having struck a compromise capable of ensuring stability and efficiency. The Hamiltonian drive for centralization is at odds with a countertrend toward decentralization. This, in turn, has led to significant differences in regulations within the sector: National banks are subject to federal legislation, while state banks and investment trusts are molded on the heterogenous policies of the different states. The National Banking Act of 1863 was an attempt to strengthen central oversight and introduce shared rules after a period where banks were regulated according to criteria that varied from state to state. During the Free Banking Era (1837–1864), the US banking system had a number of particular characteristics: Banknotes were the primary means of payment while the amount of deposits was negligible. The banknotes, however, were not issued by a central bank but by a host of state-chartered banks, regulated by the individual states and not by a federal authority. The regulations regarded the convertibility of banknotes into specie (gold and silver); furthermore, the banks had to deposit, with the authority in their state, government bonds of an equivalent value to the banknotes they had issued. On the one © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_2

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hand, these bonds served as guarantees for those receiving the banknotes, on the other, by limiting the number of banknotes in circulation, they reduced the elasticity of credit. The banks earned interest on these bonds; however, should the banks refuse to convert the banknotes into specie on demand, the bonds were sold to cover the losses. Most states did not require their banks to hold specie reserves to cover their liabilities. This decentralized banking mechanism was not particularly effective, given that 30% of the banks failed prior to the enactment of the National Banking Act. Banks were exposed both to an aggregate, systematic risk and to an idiosyncratic risk. All banks were exposed to a systematic risk caused by fluctuations in the prices of bonds, which served as a guarantee for the issued banknotes. If the value of those bonds decreased, the number of banks declaring bankruptcy increased. Systematic risk is the inability of a bank to redeem the value of the issued banknotes at par. The systematic risk was compounded by an idiosyncratic risk for banks that did not diversify their asset portfolio by adding private sector loans to the government bonds, and for banks that had limited reserves of gold and silver (Jaremski 2010). On the system level, the proliferation of banknotes backed by different types of guarantees and fluctuations in their relative value had weakened the processes and efficiency of the domestic market (Gorton 1999). This complicated the bookkeeping of transactions and created obstacles to the unification of the commodities market. The institution of a system of national banks and the introduction of a national currency (the dollar) were meant to resolve this situation, providing stability to the real system and simplifying transactions. At the same time, the constraint imposed on the quantity of banknotes that could be issued—which had to be backed, as in the previous system, by government securities—limited the flexibility of credit and limited demand for credit from the private sector, during both economic expansion and contraction. The National Banking Act obliged all banks intending to enroll in the nationally regulated system to keep reserves proportional to their liabilities. It was commonly known at the time that banknotes and deposits created by the banking system were the counterparts,

2  The US Financial System from the National …     9

as liabilities, of bank credit; these assets implied liabilities and the system was stable only if the issuing banks had enough metal coin in their portfolio to allow immediate convertibility of banknotes and deposits at any time and under any circumstances. Hooper’s advice (1860) was thus taken. He had sought to demonstrate that the stability of the banking system was weakened precisely by the lack of a rule that uniformly determined the reserves that the banks had to keep. In his analysis of the various state banks, he noted that the banks of New Orleans, which had to maintain one-third of their liabilities in coin, were the most stable and earned more than other banks because of the constant expansion of the credit they offered. The reserves had to be specie and this micro-prudential action to bind the assets on the balance sheet of a financial intermediary would stand as a guideline for all subsequent regulatory actions. The micro-prudential principle is based on the idea that the bank must always be able to convert its liabilities into currency whenever requested. The principle initially applied when liabilities were represented by banknotes and later when deposits were added. It was presumed that their convertibility to cash was guaranteed. The presence of reserves on the level of individual banks was to allow the progressive introduction of a single national currency issued by the banks, its diffusion throughout the USA, and its acceptability as a means of payment. However, the new system could not be imposed on all banks. In response to resistance by many state banks to adoption of the new model and consequent loss of autonomy, Congress voted to introduce a high tax of 10% on the value of state-issued banknotes to discourage the continuation of the previous phase, characterized by the prevalence of multiple issues. The objective was to weaken the resistance of state-chartered banks that wanted to continue business as usual. However, the hope that these provisions would achieve the objective was short-lived because of an innovation in the payment system and federal regulations that penalized the profitability of the national banks with respect to their state-chartered counterparts. The tax on banknote issue lost its effectiveness with the introduction of transactional accounts and checks as an alternative to banknotes for making payments (Dunbar 1917; Goldenwieser 1932).

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The advantage of adopting national regulations lay in the possibility of issuing banknotes, although the introduction of deposits weakened this to some extent. Secondly, the opening of new banks often required capital provided by investors who resided in another state and thus preferred to obtain a federal license because they were already familiar with the rules regulating it. The rules imposed on state-chartered banks were generally more favorable. The capital necessary for opening a state bank was less than that needed to open a national bank; the proportion of obligatory reserves was lower; the state banks could hold long-term assets in their portfolio, something that was prohibited for national banks (think especially of the real estate market and the intensifying issue of bonds by companies at the end of the nineteenth century). The percentage of loans with respect to capital that could be given to a single individual was much higher for a state bank (Barnett 1910). All these elements favored the greater profitability of state banks and trust companies with respect to their federal counterparts. This higher profitability, in turn, made it possible to attract more deposits thanks to the payment of higher interest rates, which favored the opening of a significant number of state banks. In the aggregate, the state banks administrated a portfolio of assets comparable to that of the national banks in the early years of the twentieth century (Sprague 1903). The objective of the National Banking Act to unify the US banking system was largely a failure, and this remained true even after the founding of the Federal Reserve System. The US banking system has thus been characterized since the beginning by a significant and unresolved dualism: a system in which banks with different regulatory profiles, profitability, and functions all coexist. Specifically, for the national banks, in exchange for the privilege of issuing currency, a portfolio limit was imposed that required the financing of circulating capital, thus short-term loans. Vice versa, the other financial intermediaries had the possibility of directly or indirectly issuing long-term credit, integrating with the financial markets and financing the process of capital accumulation, in those years made particularly intense by technological innovations in railroads and other utilities.

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The institutional dualism translated into a dualism of function within the financial system. The conflict between national banks and other financial intermediaries over portfolio constraints is a constant feature of the US financial market from the National Banking Act until 1927, when the banks were substantially unified and commercial banks took their place de jure alongside the investment banks and trust companies in administering long-term credit. The distinction between commercial banks that administered shortterm credit and created deposits and the other financial intermediaries that financed investments with long-term credit significantly characterizes the functioning of the US financial system. Long-term financing took concrete form in the acquisition of bonds issued by corporations or in the financing of the purchase of stocks by investment banks via call loans. The National Banking Act imposed a reserve requirement of 25% of liabilities (issued currency plus deposits) on all banks receiving national bank charters. These reserve requirements obviously came at a price. To compensate for the resulting loss in profitability, banks were allowed to keep a portion of their reserves on deposit in other banks whose geographical location (in big cities) and financial resources made them major players in the network of banks in the USA. There were initially sixteen of these banks, later growing to forty-nine. We must not forget that the US banking system was founded on the principle of unit banking, which prohibited opening branches in other areas either within or outside of the home state. The result was a high number of modest-sized banks, contrasting with the development of banks in Europe. The possibility of transferring their reserves to the city banks allowed the banks to earn interest, partially compensating for the profitability lost by not being able to invest the reserves. It was believed that this would be sufficient to ensure the stability of the banking system. However, one crisis followed upon another with significant effects not only on the banks but also on the real economy. In addition to the reserves, a second mechanism created to protect the fragility of the banking system was loan certificates issued by clearinghouses. The clearinghouses were initially instituted to facilitate interbank transactions, balancing receivables against debts at the end of

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each day. Later, given the lack of a central bank, they played the role of lender of last resort. In a panic situation, the banks associated with a clearinghouse could obtain loan certificates issued with a value capped at 75% of the collateral securities. In addition to being pegged to the collateral on deposit, these certificates were used only in interbank transactions, but they made it possible to free up sufficient liquidity to cope with a possible bank run (Gorton 1985; Gorton and Mullineaux 1987). To access this emergency loan, the banks had to join the clearinghouse and accept its regulations, one of them being the requirement to hold 25% of the value of liabilities as reserves. A third element to be considered in the US banking system is government securities and the role they play when the Treasury decides to intervene in the money market to lessen tensions caused by a high demand for liquidity. The method of intervention was similar to what would later be called open market operations. There were two ways that the Treasury could exert an influence on the monetary base. First of all, during periods of budget surplus, the Treasury could buy back public debt using the surplus specie it kept in its Treasury (Kinley 1910). This type of intervention was prevalent up to 1890, after that the Treasury chose other instruments to ease financial markets in situations of scarce liquidity. The policy of Treasury Secretary Shaw (1902–1907) is emblematic in this regard. The Treasury could decide to advance payment of interest on government bonds; to transfer budget surpluses from the Treasury to the deposits in national banks; to require assets other than government securities as collateral for these deposits; and to relieve banks of the requirement of keeping reserves equal to 25% for new deposits (Andrew 1907). All these modes of intervention had the objective of minimizing the violent fluctuations characterizing the US financial markets. However, such interventions had significant contraindications. First of all, they were procyclical, because the Treasury had abundant liquidity when the economy was expanding and they thus tended to force expansion of credit rather than seeking to stabilize it when necessary. In the second place, as noted by Cleveland (1908), the systematic intervention of the Treasury on behalf of the banks favored a significant

2  The US Financial System from the National …     13

increase in indebtedness rather than increasing the capital in their asset structure and thus weakened the banking system, which found itself in a situation of undercapitalization during the subsequent phase of liquidity shrinkage. Similar observations regarding the disequilibrium between debt and capital have been put forward recently (Admati et al. 2010). In a decentralized system such as that in the USA, there were thus three instruments introduced with the goal of reducing the instability of the financial markets: reserves, credit certificates issued by clearinghouses, and transfers of Treasury funds to sustain bank liquidity. Before we examine how they work, we must go into some depth regarding the relations that were being created and strengthened among the various segments of the banking system, in particular, the relationship between the banks at the center of the system defined in the National Banking Act, and the banks located at the fringes of the system, either because they did not subscribe to it, or, while subscribing to it, they still found themselves in a situation of dependency on the big New York banks. In order to protect deposits after the financial crisis of 1837, some states required banks to maintain reserves equal to a certain percentage of their liabilities (Carlson 2013). This requirement was preserved and extended to all banks chartered under the National Banking Act as a form of micro-prudential regulation. The idea of keying reserves to deposits was explained by the fact that in a system still ruled by the principle of convertibility of banknotes and demand deposits into metal coin, the stability of a bank depended on its ability to satisfy conversion demands as quickly as possible to prevent panic from spreading to all account holders. For reasons of security, the account holders preferred keeping their money in the bank rather than as coins at home. This also allowed them to make payments by check, saving them a great deal of time. But the bank assets could not be converted into liquidity quickly at times of widespread demand. Thus the need to require every bank to keep reserves as a means for insuring deposits as a first line of defense to prevent the bank from failing when faced with a significant demand for conversion. The National Banking Act set forth three categories of bank: central reserve city banks (located in the biggest cities—New York, Chicago,

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St. Louis); reserve city banks (located in sixteen smaller cities); and country banks (all the rest). Since these banks were prohibited from opening branches, either in the state where they were headquartered or in other states, the result was a very large number of banks. The country banks had to maintain reserves equal to 15% of their deposits. Sixty percent of these reserves (9% of deposits) could be deposited in reserve city banks, while the remaining 40% (6% of deposits) had to remain at the individual bank. The reserve city banks had to maintain a higher percentage of reserves, equal to 25% of deposits, and could deposit 50% of these reserves in the central reserve city banks in New York, Chicago, and St. Louis. These latter banks also had a 25% reserve requirement, which they maintained internally. State-chartered banks were required to maintain reserves, a portion of which could be deposited in the central reserve city banks. One of the reasons for such a high percentage of reserves in the large national banks is the fact that these banks had to be able to meet a high demand for liquidity from the peripheral banks and from the banks that did not subscribe to the system introduced in 1863. Every peripheral bank, given the unit-banking prohibition against opening branches, had to establish stable relationships with other banks to ensure a series of essential services and survive in a market that extended well beyond the local boundaries of the bank’s operations. Interbank deposits laid the groundwork for a particular market known as correspondent banking. A correspondent banking relationship begins when a bank chooses to use services offered by a larger bank without directly investing resources to provide those services. Indeed, the choice of meeting needs on the market rather than exclusively within a vertically integrated structure is a choice that all enterprises have to contemplate. This is akin to today’s process of outsourcing. In the particular case of banks, the respondent bank deposited its reserves in a correspondent bank. These reserves might also earn interest in the neighborhood of 2%. The fact that the interest rate on those deposits remained constant for many years (Gendreau 1983) and was often significantly lower than market interest rates suggests an alternative explanation for the transfer of funds from suburban banks to the central correspondent banks.

2  The US Financial System from the National …     15

The reserves remained at the disposal of the correspondent bank, which often loaned them to broker-dealers who invested them in the stock market. The correspondent bank provided a credit and debt compensation service to the smaller bank, which was not able to administer it directly, given its small size and inability to muster the resources necessary to create this service internally. The correspondent bank thus acted as a clearinghouse. The decentralized structure of the system of reserves was accompanied by a decentralized interbank transaction mechanism. Unlike the German model, where both reserves and payments were centralized and controlled directly by the Reichsbank since its founding in 1876, in the USA, prior to the creation of the Fed, there was a decentralized system where the outlying banks deposited a portion of their reserves in the central banks (city banks) to meet their reserve requirements and to ensure regular payments to depositors whose counterparts were geographically distant, making payment settlement at a local clearinghouse infeasible. The US banking system was thus based on a system of correspondence relations among banks, as opposed to the centralized mechanism that prevailed in European countries in that period. In addition to this, the dualistic structure of the system drove the banks that did not subscribe to the National Banking Act to keep deposits at the national banks and to maintain correspondence relationships with them, partially so they could be guaranteed a loan if necessary. We must not forget that on many occasions, in order to circumvent portfolio constraints, the national banks opened statechartered banks so they could provide long-term credit on the financial markets. These latter banks had very close relations with national banks, keeping reserves in the parent bank. A similar process was recently instituted by the creation of Special Purpose Vehicles that administrate securitized financial activities with the support of the sponsor bank. In addition to primary reserves, the bank asset structure also included secondary reserves representing a second line of defense against a surge in demand for liquidity. As noted by Hollander (1913), the percentage of secondary reserves at US national banks was negligible in 1860 but grew progressively to reach 10% of their assets.

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One characteristic of the banking system in the period we are analyzing, and one that will continue to determine its flexibility and fragility, is the relationship between money markets and capital markets. The monetary and banking theory at the time (Conant 1909; Hollander 1913; Laughlin 1912) acknowledged the fact that demand deposits were a product of credit and not vice versa. The conversion of these deposits into metal coin had to be guaranteed at all times. Since only a small percentage of the deposits were held on reserve in liquid form, every bank had to have a way to ensure access to additional liquidity in the form of short-term loans to finance only real transactions, from intermediate commodities to the production of final goods. The sale of the goods allowed contract obligations to be met. The short duration of the loan allowed the banks to maintain a condition of permanent liquidity because there was continuous debt turnover (loans kept being repaid and reissued). This put the banks in an ideal position to be able to cope with a possible bank run. The functional objective of the commercial banks was to finance circulating capital in the broad sense, while they were supposed to avoid financing fixed capital. The theory was that financing circulating capital was the exclusive purview of the banking system. However, in practice, banking moved in a completely different direction, as noted by many authors (Moulton 1918 above all) because it had to ensure the financing of the economic system in the delicate shift from an agricultural economy to an industrial economy. As calculated by Davis and Gallmann (1994), the capital stock in the agricultural sector (land and livestock), which constituted nearly half of aggregate capital in 1800, fell drastically to less than a seventh by the beginning of the 1900s. At the same time, the non-agricultural capital stock rose to constitute two-thirds of the total (while the proportion of commodity reserves remained steady at 20%). Changes in the composition of production capacity were accompanied by powerful pressure on the financial market, which had the objective of obtaining the resources necessary to finance the accumulation of capital. On a practical level, and contrary to what was being suggested by banking theorists, the banks held stocks and bonds or stock-andbond-backed loans in their portfolios. While this was a characteristic

2  The US Financial System from the National …     17

initially only of state banks and trust companies, pressure subsequently grew to extend the long-term portfolio option to national banks. In order to prevent reduced profitability from weakening the national banking system and providing incentives to return to state-chartered banks, the idea slowly gained ground that all banks could hold longterm assets in their portfolios. This was officially instituted in 1927 with the enactment of the McFadden Act. Alongside the progressive increase in long-term assets in the portfolios, the US banking system was characterized by indirect exposure to the bond market and especially to the stock market via bank loans to brokers, who had to purchase stocks using debt to execute their customers’ orders. If, for example, a customer instructed a broker to purchase a certain number of stocks having a value of 1000 dollars, the broker had to obtain credit from the bank to fund the purchase. Assuming the customer was charged 10%, the broker had to come up with the remaining 900 dollars. The broker turned to the bank for a loan, offering as collateral the stocks that it has to buy for its customer. The bank applied a margin of 20% of the value of the stocks and gave the broker 800 dollars, which was added to the 100 dollars advanced by the customer to bring the total to 900 dollars. If the broker believed in the type of investment that it was being asked to make, it put in 100 dollars of its own, thus reaching the 1000 dollars necessary to purchase the stocks. The stocks would then be written over to the bank financing the operation as collateral for the loan. The individual who commissioned the purchase became the owner of the stocks, which are transferred temporarily to the bank (Pratt 1912). The bank may provide two types of credit: call loans or time loans. A time loan is given for a period ranging from thirty to ninety days at an interest rate that remains constant to maturity; a call loan must be repaid 24 hours after the contract is signed and is thus subject to the variations in market interest rate at the time of renewal. There were no particular differences in the security collateral involved in these two kinds of loans, whereas the margin for the 24-hour loans was higher than that for a time loan (Griffiss 1923).

18     G. Pizzutto

A justification for the presence in the portfolio both of stocks and bonds and of loans backed by stocks and bonds was advanced by the theory of secondary reserves, which posited that banks had to keep specie as their primary reserves and liquid financial assets as secondary reserves. The result was growing exposure of commercial banks and other financial intermediaries to the stock market, driven partially by the greater earnings on this type of investment. The composition of bank portfolios thus changed significantly. At the time of the enactment of the National Banking Act in 1863, the portion of total portfolio assets represented by financial assets rose from 1% to approximately 10%. At the same time, a strong decrease was observed in the proportion of loans and government bonds held in the portfolio, which dropped from 33% to 7% (Hollander 1913). The conviction that loans were highly liquid was so widespread that Conant (1899) went so far as to say that “securities form one of the greatest and most important parts of the modern mechanism of the exchange. They are, in many cases, as good as money and, in some cases, are better than money.” (See also Conant 1904). The financing of leveraged acquisition of shares in the absence of a mechanism for consolidation and multilateral compensation of transactions meant financial intermediaries had to pay for all acquisitions of stock separately, and the availability of credit demanded during expansion of the stock market was difficult to ensure. Furthermore, payment for stock purchases depended on the broker’s ability to find a financial backer; it could only find the necessary credit by offering the stock it intended to buy as collateral. At the same time, it could not purchase the stocks if it did not have the necessary financing. A vicious circle was thus created: no financing without stocks, and no stocks without financing. Creditors (the banks) resolved this via the mechanism of over-certification, i.e., with a document declaring that the check used to pay for the stocks was backed, when in reality the sum deposited by the broker was significantly less than that declared. New York banks allowed brokers to draft checks far in excess of their outstanding balance. Once the stocks had been purchased, they were written over to the bank as collateral, a collateralized credit contract was drawn up, the buyer undertook to pay interest on call or time loans,

2  The US Financial System from the National …     19

and the transaction was completed; except for the fact that it was repeated twenty-four hours later. The banks thus guaranteed a temporary loan to the brokers based exclusively on trust and could refuse to renew it. As Michie (1987) noted, one of the weaknesses of the US system of regulating financial transactions lays precisely in their timeframe. Having to settle the entire transaction within twenty-four hours— almost immediately—introduced an element of fragility into the system that was unknown in other stock markets, such as the London Stock Exchange, where purchases were settled fifteen days later and the brokers had enough time to seek liquidity and/or more favorable conditions for the payment of interest. This small amount of time also entailed significant exposure to risk of variation in interest rates (call loan rates). The volatility of these rates was a prevailing feature of the New York money market, where the outflow of reserves to country banks drained the deposits in the central banks and produced an increase in interest rates and subsequent crises in the stock market due to the sell-off of securities to obtain the liquidity necessary to offset the outflow of deposits. In the chain of financial brokerage, the brokers played a weak role because they were subject to the willingness of banks to regularly renew, at the daily deadline, a statement declaring the availability of financial assets greater than the amount of funds in their transactional accounts. At the same time, the banks risked bankruptcy if the brokers should fail. This was no limited phenomenon. For example, in 1882, the Comptroller of Currency reported that over-certification averaged 105% of the capital held by the national banks of New York on a daily basis and reached 312% of bank capital for the nine NYC “broker banks” (McSherry and Wilson 2013). The New York City Bank Clearinghouse Association, which included the major New York banks, was forced to suspend over-certification in 1873 out of fears that some brokers would not be able to deliver the collateralized stocks they had purchased via bank-certified loans for buyers who forewent purchase orders. This obviously caused the collapse of the stock market and the temporary shutdown of Wall Street. The non-renewal of over-certification forced brokers to sell a portion of

20     G. Pizzutto

the securities in their portfolio, causing stock prices to fall and a financial crisis to ensue. After 1873, the fragility of the financial brokerage mechanism continued to characterize the dynamics of financial markets and other crises would follow. In this period, the New York City Bank Clearinghouse Association continued to urge the New York Stock Exchange to create a clearinghouse that would consolidate stock market transactions so as to reduce the need to finance broker transactions and drastically reduce over-certification. This was achieved in 1892, when the New York Stock Exchange Clearing House was instituted. It succeeded in significantly reducing (by 90%) the need for financing brokers (Noyes 1893; McSherry and Wilson 2013). At the same time, the number of brokerage firms declaring bankruptcy also declined, and there was a significant reduction in the risk premium (Bernstein et al. 2014). The obligation imposed by the Comptroller of Currency to cease over-certification only regarding national banks. Financial brokers who needed short-term financing via over-certification then turned to trust companies (Brewer 1986, p. 328). Reduction in over-certification appeared to improve the stability of the stock market. As noted by Sprague (1910), the institution of the NYSE Clearing House prevented reoccurrence of the closure of the stock market witnessed in 1873. The market stayed open during the subsequent crises. However, the crises of 1903, 1907, and 1914 proved that the institutional and regulatory improvements were insufficient to definitively reduce the instability of financial markets. One explanation for this instability is that both past and new issues are traded on the stock market. If there were no new issues to finance, the link between the stock market and the banks would be very weak. Every purchase implies a sale. When the NYSE Clearing House compensation process covers all transactions and the seller decides to stay in the clearinghouse, the dealers use the seller’s liquidity to finance purchases on margin. If, on the other hand, the compensation process is only partial and, especially, when it is necessary to fund new issue, the intervention of the banking system is indispensable to finance the initial

2  The US Financial System from the National …     21

purchase of assets that will then be sold on the market and to finance those who intend to withdraw from the market. In the latter case, bank credit does not favor speculation; on the contrary, it finances those who withdraw credit from speculation on the stock market (Eiteman 1932). Stocks are variable-yield bonds of infinite duration. The increase in the value induced by expectations for their future revaluation induces the issuance of new stocks and requires bank credit. The failure to sell the newly issued stocks due to lack of demand drives the brokers who have them in their portfolio to sell them on the market so they can repay their debts to the banks. This initiates a process of loss in value, increase in margins, and further reduction in the value of the assets, something which is commonly referred to as fire sales, where prices fall below fundamental values (Shleifer and Vishny 2011). The 1907 financial crisis evidenced the connection between the national bank system, the non-bank financial intermediaries (trust companies), and the embryonic monetary policy growing out of the decisions of the Treasury prior to the creation of the Fed. The period 1902–1907 is characterized by the significant role played by the Treasury Department and its secretary, Leslie Shaw, whereby measures were implemented to increase the flexibility of money supply and compensate the imbalances that continued to arise due to the scarce flexibility of money supply keyed to gold and government securities deposited to guarantee the issue of bank notes. Kinley (1910) noted that there were essentially three instruments used for that purpose: a.  Transfer of government surplus from Treasury agencies to the banks; b.   The purchase or sale of government securities, prefiguring what would later become open market operations; c.  In extreme cases, when the above instruments could not be used (e.g., because all the surplus had already been transferred), modifications were made to the guarantee required for deposits deriving from a public budget surplus. This guarantee usually consisted of public securities, whereas in 1907, given the gravity of the situation and high demand for liquidity, the banks were allowed to use other types

22     G. Pizzutto

of financial assets in place of government securities. The banks were thus able to increase the issue of banknotes backed by public securities. This option could be further strengthened allowing the bank not to key reserves to Treasury deposits. The systematic use of this method led to negative outcomes. It was procyclical because the surplus tended to increase when the real economy was in a growth phase and tended to decrease during a recessive phase when the need for liquidity increased because of the resulting financial crises. It was precisely this characteristic that conditioned the evolution of the money market and the trend in interest rates in the period leading up to the crisis of 1907. The expansionary effect of Treasury policy and the simultaneous increase in worldwide gold production had the effect of reducing interest rates after 1900. The decrease was particularly accentuated in 1903, and especially in 1904, a period when the call money rate in New York for the purchase of financial assets fell to 1%, later rising to reach the high levels witnessed during the 1907 crisis (Andrew 1907, pp. 131–136). The expansion of credit, the decrease in the call money rate, and growth in the real economy motivated corporations to increase the issue of stocks and bonds significantly in the period 1903–1907. The issue (net of conversions) of new securities (stocks and bonds) amounted to 1.846 billion dollars in 1903, rose to 2.4 billion in 1904, and exploded in 1905 and 1906 to 3.3 and 3.1 billion, respectively (Conant 1909). Alongside this significant increase in stock issue, trust companies grew and strengthened their role in the American financial system in the period in question. The trust companies filled the void created by the fact that the commercial banks were subject to rather rigid regulations and strict constraints on their portfolios in exchange for the privilege of issuing banknotes. Trust companies and banks are different sorts of entities that meet different types of demand for financing (Breckinridge 1908). The dualism that developed in the US financial market between national banks subject to central regulation and state banks enjoying more favorable conditions can also be viewed from the viewpoint of the composition of broker portfolios.

2  The US Financial System from the National …     23

Sprague (1910) provides the following data regarding the assets of national banks, state banks, and trust companies (the latter subject to state banking regulations). Resources of Commercial Banks in the USA (in millions of dollars) National banks State banks Investment trusts

1888

1898

1908

2731 672 314

3978 1356 942

8714 4033 2866

Source Sprague (1910)

State banks and the trust companies were not subject to the National Banking Act and their consequent inability to issue banknotes was more than compensated by the greater profitability of their portfolios as compared to those of national banks. The difference in profitability depended essentially on the fact that trust companies made long-term investments and commercial banks made short-term investments. Furthermore, their liability structure was different. An examination of their balance sheets, and specifically liabilities, reveals that the principal difference between banks and trust companies was that commercial bank deposits were prevalently demand deposits subject to significant turnover for transactions and payments, while trust companies had more stable deposits and greater flexibility in how they were financed deriving from the fact that they paid interest on deposits and could thus attract more liquidity to meet their needs. On the other hand, the commercial banks were continually sanctioned by the Comptroller of Currency when they paid interest on deposits. The different modes of financing and remuneration explain why trust companies grew much faster than national banks in the early years of the twentieth century. The possibility of paying interest on deposits gave trust companies a greater ability to attract liquidity than commercial banks. This competitive advantage was used mainly to meet the demands of large corporations. At that time, and also in subsequent periods, large corporations always had the problem of where to park their liquidity while receiving some remuneration in exchange and having the certainty of being able to access their deposits in case of need.

24     G. Pizzutto

If instead we look at the asset side of the balance sheet, the most significant difference is that the trust companies did not have particular constraints and could make long-term investments, purchasing stock and bonds and issuing real estate mortgages, thus having flexibility in adapting to the trend in the market. The national banks, on the other hand, were required to hold government securities to cover the issue of banknotes and thus the composition of their portfolio was not very flexible and federal regulations prevented them from investing in the more profitable market segments. Stocks and bonds made up 24% of the portfolios of trust companies in 1900, while at national banks they did not exceed 13%. This does not mean that the trust company’s investment portfolio was particularly risky. They included a significant proportion of government securities, which could easily be converted into liquid assets. The ability to invest in bonds issued by corporations ensured above-average yield. Loans by trust companies that same year were substantially similar to those provided by commercial banks in terms of percentage of total portfolio but differed in composition. In particular, whereas commercial banks mainly discounted commercial paper and had only marginal investments in loans to stock market brokers, trust companies invested very little in commercial paper and were instead indirectly exposed to the risks of the stock market via call loans, i.e., loans backed by financial assets that allow buying on margin (Brewer 1986). A final relevant characteristic of trust company portfolios is that they held only half the cash of commercial banks. This obviously made it possible to have a portfolio with a higher percentage of assets that ensure positive yield than commercial banks. For example, in 1900, the ratio of cash to deposits for commercial banks was 20.4%, as opposed to 2.4% for trust companies (Andrew 1907, p. 34, Table 12). Given the structure and composition of the portfolios of commercial banks and trust companies, the financial crisis of 1907 may be seen as the effect of a sequence of endogenous shocks, similar to what would happen in the crises of 1929 and 2007–2008. Expansionary monetary policy translates into a reduction in shortterm interest rates, which induces an increase in the current value of financial assets on the stock and bond market, which in turn induces

2  The US Financial System from the National …     25

increased issue of new securities that are financed on margin by nonbank financial intermediaries using short-term credit provided on the money market by national banks and especially trust companies. The trust companies fulfill two functions in this context. Like the modern-day monetary funds, they provide non-bank financial intermediaries such as broker-dealers with the short-term liquidity they need to buy on margin, and especially to finance new issue in the period that the new issue is held either by them or by investment banks. Or they play the role of dealers financing themselves on the money market through deposits for which they pay interest and directly buying stocks and bonds. In 1905, the balance sheet of the trust companies exhibited a ratio of investments to deposits of approximately 40%, as opposed to 17% for national banks and state banks. And leverage, meant as the ratio of assets (financial investments) to capital, showed the same difference: 46% for national banks and 130% for trust companies. Again in 1905, the percentage of call loans backed by financial assets was 21% for national banks (14% in 1889) whereas for the New York banks that handled the reserves of the country banks, the percentage was 48% (35% in 1889) (Youngman 1906). With respect to the traditional conception of commercial bank, the financial system showed a greater diversity in this period and, most importantly, commercial paper did not play the central role that had been attributed to it when the National Bank Act was introduced. The shift in portfolio composition toward medium- to long-term financial assets was justified, on the one hand, by the process of capital accumulation (by the railroads first and foremost) and, on the other, by the ­theory of secondary reserves. Investments in securities were considered as safe as or even safer than commercial paper because securities could easily be sold on the secondary market. However, the most informed observers were skeptical on this point. Cleveland (1908) criticized this position, claiming that the financial investment was difficult to convert in the event of need because the simultaneous sale by all banks of the assets in their portfolios would have caused a collapse in prices, an increase in interest rate, and the liquidation of the assets purchased on margin, a process we now refer to as fire sales.

26     G. Pizzutto

As we have seen, trust companies were non-bank financial intermediaries that could not issue banknotes, they were strongly leveraged and had a very low level of reserves as compared to national banks. In order to remain profitable, the trust companies had always refused to join the clearinghouse to avoid the requirement of maintaining reserves equal to 25% of their deposits imposed by national banking regulations. At the same time, the connection between these financial intermediaries and the national banks was ensured by the presence of the same people on their boards of directors. Furthermore, the trust companies, like country banks, for that matter, deposited their (meager) reserves at national banks, and the national banks acted as clearinghouses for their payments. And as we saw before, the secondary reserves of these intermediaries were composed of short-term loans to brokers. Regarding bills brokers and discount houses in the London market, Bagehot (1858) noted that these intermediaries were in a certain sense forced not to maintain reserves because they had to pay interest to all those who deposited their liquid assets with them (commercial banks in particular). A high level of short-term leverage was thus an obligatory condition to ensure profitability of the intermediation process and constituted the main element of weakness in the financial market, as observed earlier by an anonymous commentator (X 1860). This observation may be applied mutatis mutandis to the US money market, where the financial intermediaries play an important role and the surplus liquidity that accumulated with these intermediaries was used to make call loans to finance the stock market or else was deposited in national banks. The structural problem associated with this surplus has to do with the speed at which the short-term assets could be liquidated. This forced the brokers to sell stocks purchased on margin on the market so they could repay short-term credit, leading to the collapse of the stock market. The Panic of 1907 originated in a failed attempt to corner the market on stock of the United Copper Company by a number of important players in the US financial system, initially taking the form of a bank run on the banks principally involved in the speculation, who saw the value of their assets collapse. The crisis caused the failure of the very important Knickerbocker Trust Company before spreading to other trust companies.

2  The US Financial System from the National …     27

When some operators feel that a given stock is significantly underpriced, they can invest their resources in the acquisition of the stock, causing its price to rise. The objective is to force those who had been short-selling to buy back the borrowed shares at a high price when they come due. Short-selling consists of borrowing an asset at a certain time, selling it on the market, and buying it back later at a lower price when it is time to repay the lender. The short-seller makes a profit if the market price decreases before the loan has to be returned. If instead the market price increases, the shortseller loses money. Cornering is a counter-strategy to make a profit by creating disadvantageous conditions for the short-seller by manipulating the price of the asset. In 1907, the counter-strategy turned out to be ineffective because the short-seller found a way to circumvent the market to buy back the stocks. The initial phase of the Panic of 1907 involved a trust company whose assets made it the third largest institutional player in the US market. The reconstruction by Bruner and Carr (2009) helps explain the relations among the various institutions in the US financial market. When the crisis hit, J. P. Morgan convoked the other trust companies and persuaded them to intervene in support of the flailing Knickerbocker Trust Company. The other trust companies agreed, but the panic spread too quickly and they too fell prey to a massive bank run that excluded the national banks, focusing instead on financial intermediaries who were weaker in terms of leverage and liquidity (Moen and Tallmann 1992). In this situation, the trust companies were forced to liquidate their secondary reserves and the stock market began to show signs of faltering. J. P. Morgan realized that the national banks might also fail in that situation because the massive sell-off by trust companies and brokers threatened to reduce the value of their assets and put the stability of the entire financial system at risk. It was then that Morgan convinced the major national banks to pump massive sums into the stock market, buying the stocks that the trust companies and brokers were selling as best they could. The panic was thus contained and Breckinridge (1908), a prominent player in the

28     G. Pizzutto

association of trust companies, could proudly proclaim the capacity of the institutions he represented to withstand the pressure that had come to bear in 1907, that he had repaid all debts contracted in that period, and had minimized the duration of the suspension of payments as an extreme measure to survive the bank run. Our analysis of the organization and instability of the US financial system from 1863 to 1907 allows us to identify certain characteristic traits that will continue to endure even after this crisis. In particular, the financial structure is built on four pillars whose interrelations make it possible to delineate the reasons for stable growth and crises in the financial markets: monetary policy, financial markets, commercial banks, and non-bank financial intermediation. The monetary policy in the period under consideration did not depend on the decisions of a central bank, but grew out of the choices of the Treasury, which modified the quantity of debt in the system via what would later be known as open market operations with the objective of improving the scarce elasticity of money supply. It also depended on the increase or decrease in gold reserves. Expansionary or contractionary monetary policy in this context had effects on interest rates and consequences for the profitability of non-bank financial intermediation. We may think of the financial system as a complex network containing two types of institution: commercial banks and non-bank financial intermediaries. The commercial banks offer credit and the corresponding deposits without being limited by savings. In the period we have examined, the commercial banks were regulated by the National Banking Act of 1864. The only constraint on the commercial banks was that of having to maintain reserves keyed to the amount of deposits they hold, varying by regulatory framework (state or national). Secondly, they had to assess the reliability of the debtor to which credit is provided. The interaction of monetary policy, financial markets, and financial intermediaries regulates the supply of credit to the real economy and thus directly influences aggregate demand. The expansionary phase favors economic growth, while the contraction of supply has a negative impact on demand.

2  The US Financial System from the National …     29

The interest rate does not regulate the commodities market and is not an intertemporal price, but it directly influences the profitability of non-bank financial intermediation. The non-bank financial intermediaries borrow in the short term to finance long-term credit. The trust companies, state banks, and broker-dealers are all institutions that may be classified as non-bank intermediaries in the period we have analyzed. A prolonged reduction in interest rates favored their indebtedness, the acquisition of risky assets, and the simultaneous reduction in the risk premium. As Bagehot (1858) noted, “If you leave much money in people’s hand to employ in their own advantage, and they cannot so employ it on obvious, good business, they are apt to search out bad business.” On the other hand, contractionary monetary policy shrinks the supply of credit because it increases the failure rate among debtors, reduces the profits of financial intermediaries, and drives the credit providers to demand an increase in the risk premium. From this perspective, the financial market directly influences aggregate demand through variations in the supply of credit that are associated with the profitability of the intermediation process. The analysis of the balance sheet of financial intermediaries from the perspective of assets and how they are financed turns out to be more effective than the concept of money supply and quantitative assessment. Focusing on balance sheet liabilities and thus on money hinders the analysis of the mechanism of credit and its non-neutrality with respect to the real economy.

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Barnett, G. (1910). State banks and trust companies since the passage of the National Bank Act (Vol. VII). National Monetary Commission. Bernstein, A., Hughson, E., & Weidenmier, M. (2014). Counterparty risk and the establishment of NYSE clearinghouse (NBER Working Paper 20459). Breckinridge, J. (1908). The trust company: A necessity. Banking Law Journal, 25(4), 851–860. Brewer, H. P. (1986). The emergence of trust company in New York City: 1870– 1900. New York: Garland. Bruner, R. F., & Carr, S. D. (2009). The panic of 1907: Lessons learned from the market’s perfect storm. New York: Wiley. Carlson, M. (2013). Lessons from the historical use of reserve requirements in the United States to promote bank liquidity (Finance and Economics Discussion Series 11-2013). Cleveland, F. (1908). The bank and the treasury. London: Longman, Green. Conant, C. A. (1899). Securities as means of payment. American Academy of Political and Social Sciences, 14, 25–47. Conant, C. A. (1904). Wall Street and the country: A study of recent financial tendencies. New York: Putnam’s. Conant, C. A. (1909). A history of modern bank of issue with an account of the economic crisis of the nineteenth century and the crisis of 1907. New York and London: Putnam’s. Davis, L. E., & Gallman, R. E. (1994). Savings, investment, and economic growth: The United States in the nineteenth century. In J. A. James & M. Thomas (Eds.), Capitalism in context: Essays on economic development and cultural change in honor of R. M. Hartwell (pp. 202–229). Chicago and London: University of Chicago Press. Dunbar, C. (1917). The theory and history of banking. New York: Putnam’s. Eiteman, W. J. (1932, October). The economic significance of brokers’ loans. Journal of Political Economy, 40(5), 677–690. Gendreau, B. C. (1983, November). The implicit return on bankers’ balances. Journal of Money, Credit and Banking, 15(4), 411–424. Goldenwieser, A. (1932). The dual banking in the United States. Material prepared for the information of the Federal Reserve System by the Federal Reserve Committee on Branch, Group, and Chain Banking. Gorton, G. (1985). Clearinghouse and the origin of central banking in the United States. Journal of Economic History, 45(2), 277–283. Gorton, G. (1999). Pricing free bank notes. Journal of Monetary Economics, 44, 33–64.

2  The US Financial System from the National …     31

Gorton, G., & Mullineaux, D. J. (1987). The joint production of confidence: Endogenous regulation and nineteenth century commercial-bank clearinghouses. Journal of Money, Credit and Banking, 19(4), 457–468. Griffis, B. (1923). The New York call money market (A dissertation). Hollander, J. H. (1913, December). The security holdings of national banks. The American Economic Review, 3(4), 793–814. Hooper, S. (1860). An examination of the theory end the effects of law regulating the amount of species in banks. Boston: Little, Brown. Jaremski, M. (2010). Free bank failures: Risky bonds versus undiversified portfolio. Journal of Money, Credit and Banking, 42(8), 1555–1587. Kinley, D. (1910). The independent treasury system of the United States and its relation with the banks of the country (Vol. VII). National Monetary Commission. Laughlin, L. (1912). The banking reform. Chicago: The National’ Citizens League for the Promotion of a Sound Banking System. McSherry, B., & Wilson, B. K. (2013). Overcertification and the NYCHA’s clamor for a NYSE clearinghouse. Quarterly Journal of Austrian Economics, 16(1), 13–26. Michie, R. (1987). The London and New York stock exchanges 1850–1914. London: Allen & Unwin. Moen, J., & Tallmann, E. (1992). The bank panic of 1907: The role of trust companies. The Journal of Economic History, 52(3), 611–630. Moulton, H. G. (1918). Commercial banking and capital formation: IV. Journal of Political Economy, 26(9), 849–888. Noyes, A. (1893). Stock exchange clearinghouse. Political Science Quarterly, 8(2), 252–267. Pratt, S. S. (1912). The work of Wall Street. New York and London: Appleton. Shleifer, A., & Vishny, R. (2011). Fire sales in finance and macroeconomics. Journal of Economic Perspectives, 25(1), 29–48. Sprague, O. W. (1903, March). The New York money market. The Economic Journal, 13(49), 30–57. Sprague, O. W. (1910). History of crisis under the national banking system. Washington, DC: National Monetary Commission. [X]. (1860). The grievance of the discount houses. Youngman, A. (1906). The growth of financial banking. Journal of Political Economy, 14(7), 435–443.

3 The Birth of the Federal Reserve and Its Monetary Policy

The US financial system is based on two elements: the national banks regulated by the National Banking Act and a series of non-bank intermediaries such as broker-dealers and trust companies. The connections between these various institutions are complex, but it is important to identify and contrast their functions if we are to understand the debate leading up to the institution of the Fed and its success or failure as regards the functioning of the US financial system. We need to have a clear understanding of two terms and how they relate: currency and credit. In a primitive banking system without deposits or checks, currency is created by loans. A loan represents an increase in a bank’s liabilities, which in this case consists of banknotes. Normally issued as a receipt for a deposit, the banknote in this case becomes credit issued by a bank that must be repaid at some time. The production of banknotes must be accompanied by a mechanism that ensures its conversion into commodity money. That is the function of the reserves. The balance between the amount of banknotes issued and the availability of commodity money in sufficient quantity to meet demands for banknote conversion is a fundamental element for the proper function of the system and for the creation of a reciprocal © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_3

33

34     G. Pizzutto

fiduciary relationship between the party extending credit and the party receiving credit. The credit recipient and the bank are linked by a reciprocal debt: The recipient has to repay the loan, but the banknotes used to purchase goods and services have to be convertible on demand and thus, by issuing banknotes, the bank has contracted a potential debt to the holder of the banknotes (Dunbar 1917; Keynes 1930, vol. 2). Non-bank intermediaries, on the other hand, do not create deposits in exchange for credit as commercial banks do, but use existing liquidity and go into debt to offer credit. In this case, the banks play the role of collector of surplus liquidity available on the market, transforming it into medium-to-long-term loans that will be used to purchase goods and services. The available liquidity transforms into a flow of credit to finance demand in real markets. For example, on the US financial market, the liquidity of businesses and the reserves of country banks could be transferred to the New York commercial banks, where they would be deposited. The commercial banks, in turn, transferred this liquidity to broker-dealers and investment banks that financed businesses through stock and bond placement. The commercial banks, according to the regulatory framework introduced by the National Banking Act, could not directly purchase stocks, but could indirectly finance their acquisition through short-term call loans. This function of transforming maturity is very sensitive to monetary policy, which influences the profitability of the financial intermediation process. The issues addressed at the time contemplated the weaknesses of the US financial system as regards the balance between issued banknotes and commodity money and focused on the function of banks and the sufficiency of their issue of banknotes. Specifically, attention was drawn to how decentralization favored the creation and continuing existence of a high number of small banks (approximately 30,000), each of which controlled a very narrow segment of the local market and maintained a high level of primary and secondary reserves, due to the lack of a centralized system featuring a lender of last resort. The US banks were aware of the fact that secondary reserves invested directly or indirectly in financial assets such as stocks and bonds could not be liquidated, if not at a discount, in a situation of aggregate, non-idiosyncratic risk. In this case, the tendency to sell seen in all banks had the consequence of

3  The Birth of the Federal Reserve and Its Monetary Policy     35

a fall in the price of securities and significant capital losses. It followed that there was a need to maintain a high level of primary reserves to be able to withstand a possible bank run. The European banking system had less need to maintain reserves since it could count on a central bank that could step in as lender of last resort in case of need. Initial discussion and criticism of the organization of the US financial system looked at the lack of elasticity in the “production” of banknotes. The quantity of banknotes created by banks was equal to the value of the Treasury bonds deposited as collateral. The banks thus earned interest on the banknotes they issued and interest on the government bonds on deposit. As Warburg (1914b) noted, the creation of banknotes was nevertheless not associated with the needs of the real economy since it depended on the volume and value of the government securities in circulation. When the price of the securities increased and yield diminished, the banks had no incentive to increase the supply of credit. Generally speaking, during a cyclical expansion phase the price of securities rose and yield diminished, so that the supply of credit tended to shrink when demand for credit in the economy was rising. Conversely, when yield increased, the supply of credit rose when demand was weak. It was thus necessary to create a central bank and implement monetary policy embodying discretionary rules that would allow adjustment of liquidity to the needs of real markets, moving away from the fixed rules keying it to government securities and overcoming the volatility of the credit supply deriving from it. For many years, the US banking system did not consider it opportune to exploit the potentials offered by this type of regulation to increase the supply of banknotes: Indeed, the quantity of banknotes “produced” by the banks was far less than the potential value of government securities, which constituted an upper limit on that supply. The reason for this gap very likely lay in the low profitability of this operation. The regulations specified that the volume of issued banknotes could not exceed 90% of the nominal value or market price (whichever was lower) of the government securities that had to be purchased by the banks to back the banknotes. When the price of the securities rose beyond their nominal value, the added costs did not translate into any

36     G. Pizzutto

earnings by the banks. The result was a loss in profitability that induced the banks to restrict the creation of banknotes (Cagan 1965, Ch. 3). This limit was compounded by demand for credit in a period when agriculture was a major economic sector. The rigidity of supply in certain periods of the year caused an increase in interest rates with negative impacts on the real economy. The country banks withdrew their reserves from the city banks to cope with the increase in demand for credit during the harvest period. The agricultural sector could also influence the dynamics of the financial market via the balance of trade. Abundant harvests meant commercial surpluses and the creation of a monetary base (at that time, gold) with a consequent reduction in interest rates, while poor harvests had the opposite effect (Kemmerer 1911). An alternative explanation attributed the scarce elasticity of credit to the fact that the banks could deposit a portion of their reserves in the New York banks in exchange for interest on those deposits (2%, as mentioned above). The payment of interest on deposits encouraged banks regularly to lend the liquidity available to them, thus preventing the creation of a reserve to use when demand for credit increased (Sprague 1910b). The lack of elasticity—or better, the volatility—in the supply of credit was attributed in this case to the way relations between US banks were regulated and to the characteristics of the money market. One proposal to change this, one that did not require the creation of a central bank, was to channel the liquidity of the country banks into illiquid investments in real estate. In this case, Sprague thought he could overcome the dualism of the financial system and increase its stability, transforming the liquidity customarily transferred to the New York banks into savings deposits in country banks. This way, the profitability of national banks would increase. The savings or time deposits into which the available liquidity was transferred would have reduced the instability deriving from the possibility for country banks to withdraw their reserves from the New York banks. There was a growing awareness among US financial circles after the Panic of 1907 of the need to accelerate progress toward the creation of a central bank.

3  The Birth of the Federal Reserve and Its Monetary Policy     37

The lack of elasticity in money supply was clearly and closely linked to the issue of decentralization. The issue of short-term liquidity control as an element of fragility in the US financial system was probably underestimated. It was believed that the institution of a central bank and the associated beginning of a commercial papers or bank acceptance market would have helped stabilize the financial system, transferring investor liquidity from the stock market to the short-term debt market linked to the real economy. Regardless of the different interpretations of the reasons for the volatility of credit supply and interest rates, the idea eventually prevailed that the introduction of a central bank was a necessary step in shaping a monetary policy that could satisfy credit demand, act counter-cyclically, and shield the trend in interest rates from the influence of exogenous shocks from the real economy. These positions led to the creation of the Fed in November 1913, even though it was greeted with significant skepticism and resistance as to its necessity (Sprague 1910a; Laughlin 1912 felt that instability and crises could be dealt with without altering the decentralized system). The preceding analysis of the fluctuations in credit supply and the need to find mechanisms of stabilization refers to scarce elasticity and stability in currency supply associated with a lack of synchronization between demand for credit from the real economy and the offer of credit from the financial market. We might define it as a physiological limit, built into the system, that depended on how the production of banknotes was regulated. The discussion overlooked the fact that the liabilities of the banking system were not composed of banknotes, but mainly deposits. From the viewpoint of the creation of credit, banknotes and deposits were created in conjunction with the extension of credit. The convenience of being able to make payments by check and the tax on the issue of banknotes had encouraged banks to increase this type of liability. The limited elasticity that legislators had imposed on the supply of banknotes was more than compensated by the ease of the banks in adapting their deposits to the evolution of demand in the real economy. It was no coincidence that around 1890, total deposits were some ten times the value of the circulating banknotes, as noted by Dunbar

38     G. Pizzutto

(1897). A solution would thus have been found to the problem of the elasticity of credit supply by letting the market work things out instead of giving individual states the power to issue banknotes as was requested from many sides (Dunbar 1897). The reform of the US financial system could not be reduced to an analysis of the mechanisms that regulated the supply of banknotes and their transformation, it was a broader problem regarding the functioning of the financial system and management of liquidity. Warburg (1914a) described the problem as follows: “In beginning to study the subject of monetary reform one is apt to think that the question of note issue is the primary one. After some years of struggling with this problem, one learns to understand that the question of effective reserves and liquid credits is the main question, and that note issue is only a secondary phase and of lesser importance.” According to Warburg, the recurring financial crises derived from the lack of a bank acceptance market and a lender of last resort. A reform based on these principles would have allowed the money market to function without causing continual crises. Demand for liquidity could not be satisfied by the liquidation of direct and indirect investments on the stock market because this would have caused a collapse of real estate values and an economic recession deriving from credit shrinkage. While the idea of implementing a central bank with a monopoly over the creation of a monetary base responded to the need to increase the elasticity of money supply, the more ambitious objective of the proponents of such an institution was to harness market liquidity, directing it toward transactions that directly financed real trade, pulling it out of investment in the New York stock and bond market. The problem was not just that of making the credit supply compatible with real economic demand, but to eliminate financial instability by managing surplus liquidity used by non-bank intermediaries in a serial process that often saw commercial banks as passive protagonists, more like brokers than dealers. From the reformers’ viewpoint, the introduction of a bank acceptance market and the institution of a central bank were parallel processes. Bank acceptance involves the issue of a payment order that an individual (drawer, generally a debtor) asks his bank to issue payable to

3  The Birth of the Federal Reserve and Its Monetary Policy     39

a payee. The payment order is generally not as immediate as a check but payable some months later. We might think of it as a post-dated check. In international transactions, the buyer and the seller of goods do not have direct knowledge of the counterpart and thus those who sold goods were not able to assess the reliability of the buyer. The bank got around this lack of information by endorsing and accepting the payment order and thus assuming responsibility for the final payment to the creditor/payee. The transfer by the buyer of goods to the bank responsible for final payment created the premises for the existence of a standardized market of commercial papers that could be negotiated on the secondary market. Bank acceptances could be discounted repeatedly on that market. Before reaching maturity, the discounted commercial papers were sold at a discount like Treasury bills (short-term government securities) and the difference between the value at maturity and current value represented the interest paid to obtain immediate liquidity. The regulations introduced by the National Banking Act did not allow intervention by the banking system as guarantor of final payment, and thus every time the banks discounted a commercial paper they kept the security they purchased in their portfolio, advancing funds to the drawer, without having the chance to resell it and discount it again. The commercial paper could thus not become a secondary reserve, it was an illiquid asset. The commercial banks and especially the city banks (in New York) thus filled the role not played by money funds. They could not invest directly in stock but financed new issue and transactions on the secondary market using the liquidity provided to them by corporations and country bank reserves. This liquidity represented the basis for shortterm loans to broker-dealers and could easily be liquidated, thus ending up constituting the most important component of the secondary reserves. The existence of a market for commercial paper had the further consequence that the repeated discounting of the papers reduced transaction risk because at every step the buyer placed his signature on the note, thus newly affirming the reliability of the creditor. The absence of a multiple guarantee market made it impossible to develop a money market where liquidity was invested in short-term

40     G. Pizzutto

commercial securities; instead, it was invested in the call loan market. The combination of this type of investment with the obligation to close financial transactions within the day made the probability of a crisis in the US financial market extremely high. The existence of a bank acceptance market in Europe and the creation of the central banks that rediscounted the acceptances were considered to be necessary steps toward reducing the volatility of interest rates, which in the USA were determined substantially on the market for loans made to purchase stocks (Jacobs 1910). According to the proponents of the central bank, the stabilization of interest rates would have been an automatic consequence of the creation of another shortterm asset market strictly linked to the dynamics of the real economy and controlled by the central bank. This way the real economy would be immune to financial shocks, and the liquidity would in some way be harnessed and anchored to short-term financial assets associated with real transactions. The idea behind it all was that the main assets of a bank should be commercial papers backed by a bank instead of stocks and bonds, or else loans with stocks and bonds as collateral. And the commercial papers had to be standardized and easily salable on the market—both quickly and without appreciable losses, preferably to other banks but also to the central bank in case of need. The capacity of the London financial market to put these principles into practice made it possible to control the credit market associated with international trade, including US trade, and to stabilize the financial market. This way it would be possible to prevent the financial crises caused by failure to renew shortterm loans on the stock market (Warburg 1914b). The objective of the new central bank was not just that of providing generic liquidity to the system and centralizing reserves, but to sta­ bilize the system, creating a bank acceptance market financed by the liquidity that usually flowed to New York banks and broker-­dealers. Hence, the banks would be able to sell their assets in case of need without destabilizing the market. In a certain sense, the objective was to build financial architecture that would allow the creation of significant market liquidity for short-term assets and for the financing of circulating capital just as the stocks and bonds market ensured liquidity for

3  The Birth of the Federal Reserve and Its Monetary Policy     41

medium-to-long-term assets. This way short-term financial assets could be an investment for surplus liquidity in the economy, a more stable alternative to call loans. In case of need, the banks could sell the acceptances to the central bank instead of withdrawing the liquidity extended to brokers. The process of discounting bank acceptances practiced by banks and by the central bank followed trends in the performance of the real economy. It thus tended to increase during expansionary phases and decrease during contractionary phases. Following the institution of a central bank, monetary policy could play an anticyclical function, increasing the discount rate to prevent excessive expansion or else reducing it in the event of a contraction in economic activity. The central bank would also have favored the reduction in the quantity of reserves held by banks, which in the event of a crisis could turn to a lender of last resort. The profitability of the entire banking system would increase, creating an incentive that would have encouraged banks not subscribing to the National Banking Act to rally around the project proposed by the Federal Reserve. The thinking on these principles rested on a premise that was never brought out into the open. The transactions taking place within an economic system are never synchronized. The big corporations, the banks, and individuals all have spending plans following their own timelines, and thus a great deal of liquidity is systematically generated and a use has to be found for it. Hence, just as the financial system has always sought to economize on the use of currency via clearinghouses, those who hold liquidity will always seek to invest it to avoid losing the interest it promises. The Federal Reserve was instituted to increase the elasticity of money supply, freeing currency issue from the constraint of government securities and creating a commercial paper market. The consequence was an essentially passive monetary policy strategy since the creation of currency followed production trends in line with the real bills doctrine. This would have automatically resolved the problem of the appropriate quantity of currency, convertibility would be maintained, and, in the event of a panic, the money supply could be increased to ensure

42     G. Pizzutto

that banks in difficulty would be assured the loans they might not find within the commercial banking system. The Federal Reserve took a very prudential stance in this regard, underscoring the need for banks not to systematically resort to loans from the central bank, but to do so only in emergency situations. The ideas were to prevent money supply from being systematically dictated by the private sector on the basis of profits to be made using this finance channel. These objectives gradually changed because the monetary policy initially implemented to adjust the supply of credit to demand later became an instrument for controlling the economic cycle. The idea was to reduce the volatility of the economy by adopting a contractionary monetary policy when growth became inflationary and expansionary monetary policy when the economy slowed down. Burgess (1927) and Riefler (1930) describe the shift from passive monetary policy, tending to follow the economic cycle, to an active, controlling monetary policy having the objective of stabilizing economic cycles. This transition was the result of failure to achieve one of the objectives set by the founders of the Fed and of the intuition that open market operations were an appropriate instrument of monetary policy. As we saw above, the replacement of government securities by commercial papers was the mechanism that should have been used by the nascent Fed to make possible a short-term financial assets market that would channel the liquidity present in the economy and in which the new central bank could intervene to regulate the money supply using the discount mechanism. However, the bank acceptance market did not take off as hoped. It is interesting to understand the reasons for the failure to create a bank acceptance market because this is an important difference with respect to the European monetary market, where these securities constituted the channel through which monetary policy was exercised. A commercial transaction could be regulated in numerous ways. In the USA, the transaction between the buyer and seller of goods took on different characteristics depending on the choices made by the buyer. If the buyer decided to pay up front to take advantage of the discount for cash payments offered by the seller, he would have to get the money

3  The Birth of the Federal Reserve and Its Monetary Policy     43

from a bank, underwriting a loan contract and giving the bank a promissory note pledging the unconditional repayment of the loan at a certain time in the future. The discount offered by the seller was often quite large, corresponding to an implicit interest rate that often fell into the range of 10–12%. There was thus a rather strong incentive for immediate payment, and this practice was quite common. Alternatively, if the buyer chose to wait and pay the entire price of the acquired goods at a certain future time, the seller would have to finance the sale, turning to his bank to obtain financing, justified by the payment he would earn in the future as recorded in his accounting books. The characteristics of this type of short-term loan require an analysis by the bank of the solvency of the borrower, a lien on his assets, and a possible request for collateral. The systemic consequences of this method of regulating commercial transactions were identified by Warburg as the illiquidity of the assets held in portfolio by the banks, which could thus not function as secondary reserves. As a result, the banks were driven to use call loans on the stock market for this purpose with the destabilizing consequences that were felt on more than one occasion. The promissory note was undersigned only by the party requesting the financing (the borrower), and it was thus very unlikely that a liquid commercial paper market could spring into being when the borrower’s solvency had to be ascertained on a case-by-case basis; the product was not standardized. The borrower’s uniqueness and his status as the only one responsible for meeting the conditions of the contract represented an obstacle to the creation of a market in which the banks could utilize available liquidity and the central bank could intervene as lender of last resort. The idea was thus to create a market for commercial or bank acceptances that could remedy the fragmentation of single over-the-counter transactions by instituting a standardized mechanism where the responsibility for the final payment was attributed to the issuer and to a party that ratified the exposure, assuming co-responsibility for repayment of the debt. In the case of commercial acceptance, the seller issued a payment order to the buyer, and the buyer signed the document and thus accepted the obligation to pay in the future.

44     G. Pizzutto

Due to the relatively small dimensions of each bank, the US financial market subsequently developed a model where the relations between businesses and banks were mediated by dealers, who centralized payment notes and financed the issuers, in turn taking out debts with the banking system (Steiner 1923). Those who sold goods after having obtained acceptance of the payment order by the buyer of the goods signed the note over to the dealers. The dealer, in turn, transferred the note to the bank and pocketed its fee, or else went into debt directly on the money market to finance the promissory notes, earning a profit based on the difference between active and passive interest rates. The institution of dealers who handled bills was also typical of the London market, where the liquidity needed by the intermediation process came out of the reserves of commercial banks (King 1936). A consolidated practice of the central bank was intervention to ensure credit to dealers in case of need, especially in the event of a rise in interest rates. The Fed justified this intervention by emphasizing the importance of a properly functioning acceptances market and the stability of the value of financial assets traded on that market. To prevent massive sell-offs of those assets and a consequent fall in their value, the Fed was willing to add those assets to its portfolio at a fixed interest rate even though the dealers were not members of the Federal Reserve System (see Burgess in Hearings 1927). Without this intervention, the market would probably have collapsed as happened in 1866 in England when the Bank of England refused to intervene to finance a major discount house that subsequently failed, dragging the country into a serious financial crisis (Flandreau and Ugolini 2014). The intervention of the Fed consisted in the temporary purchase (15day repurchase agreement) of commercial paper in the dealers’ portfolios. We must underscore how this market intervention cannot be considered an open market operation because it did not depend on a choice of monetary policy but was carried out in response to a request from a financial intermediary in difficulty, whose failure needed to be prevented to ensure the continuing viability and liquidity of a market that was considered vital. It was a support intervention in line with the objective of creating an acceptances market that could absorb the liquidity that generally went into the stock market.

3  The Birth of the Federal Reserve and Its Monetary Policy     45

Acceptance became bank acceptance when the bank of the party who signed the promissory note endorsed, in turn, the commitment to pay, thus assuming final responsibility for payment. The visibility and reputation of the bank were an additional guarantee that reduced the need to assess the reliability of the debtor and thus made it possible to create a bank acceptances market requiring extremely little information to be gathered since the assets were standardized and therefore insensitive to the information. In short, a market was created where transactional risk was extremely low, and it was not necessary to question the reliability of a circulating financial asset. Opacity, when things are going well, is a virtue of the money market (Dang et al. 2015). The creation of the acceptances market was part of an overall strategy whereby the credit extended by the Fed, discounting that type of financial instrument, would guarantee liquidity to member banks during situations of financial panic. Bank acceptances were considered the most liquid of short-term financial assets; they were expected to become the most desirable asset among those in the secondary reserves of banks, replacing call loans on the stock market. The creation of the acceptances market paralleled the use of the discount rate by the Fed as an instrument to carry out its function as lender of last resort. The initial goal of the reformers was to stabilize the financial markets, granting powers to the new institution to extend credit by rediscounting short-term commercial papers. The potentially unlimited nature of this credit would ensure achievement of this goal. The instrument of rediscounting was implemented by urging from the banks; it was thus a passive instrument activated in response to a request from the bank sector triggered by fluctuations in their balance sheets caused by real market trends. Limits on the type of loans that could be extended to banks were also introduced. In particular, the maximum term of the bond rediscounted by the Fed was 90 days. The prohibition on extending credit on medium- and long-term securities issued by the private sector was categorical. On the other hand, public securities were among those approved and accepted by the central bank. Furthermore, a limit on the quantity of credit that could be obtained by an individual or a business was also imposed: It could not exceed 10% of the borrower’s

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capital, similar to the constraint in force during the National Banking Act period. Lastly, the assets rediscounted by the central bank had to be countersigned by a bank within the Federal Reserve System (Hackley 1973). Objections were eventually raised to the accommodating nature of monetary policy, slowly transforming it into an active economic cycle control policy. Allowing developments in the real economy to determine monetary policy meant straying from the objective of economic stability, something that was all the more true when the abundance of gold reserves left the central bank without a reference criterion. The monetary policy followed by the European central banks can be summed up in three principles: guaranteed convertibility; guarantee of adequate level of reserves; and provision of credit in cases of financial instability or crisis. The discount rate was the tool for achieving these three objectives. The rate increased in the event of diminishing gold reserves and decreased when reserves were abundant and foreign trade generated a monetary base driving the market interest rate below that offered by the central bank. These conditions failed in the USA in the 1920s, when an abundance of gold relieved the monetary policymaker of its obligation to account for the external constraint; the lack of a criterion to guide the intervention of monetary policy unleashed fluctuations in economic activity and especially in prices. This needed to be brought back under control. Open market operations were the instrument used for this purpose. The buying and selling of government securities were part of a monetary policy mechanism that depended on the reasons why Federal Reserve member banks borrowed from the Fed. There were two contrasting theories in this regard. Some believed that the debt to the central bank depended on the profitability of the operation. Unlike in England, in the USA the relationship between the Fed and its member banks was continuous over time and the central bank sought to ensure the credit necessary for economic growth and not simply limit itself to rescue missions in the event of a crisis. According to some theorists, the banks borrowed when the interest rate charged by the central bank allowed them to extend their operations, when increased credit meant increased profit.

3  The Birth of the Federal Reserve and Its Monetary Policy     47

Others believed that the banks were reluctant to request credit from the central bank and thus went into debt only if necessary, seeking to pay off their debts as quickly as possible. This view ended up prevailing in shaping Fed policy. Open market operations were thus seen as a direct method of regulating debts to the central bank. A purchase of government securities increased the reserves of banks, which immediately reduced their indebtedness to the central bank. There were no variations to the central bank’s balance sheet because an increase in government securities in its portfolio was counterbalanced by a decrease in loans and discounts. A reduction in debt allowed the banks to implement an expansionary credit policy. This produced an increase in the quantity of credit just as certainly as a sale of securities increased the indebtedness of banks to the central bank and reduced credit. And this all happened without modifying the short-term ­interest rate. The two instruments (the discount rate and open market operations) were not seen as alternatives but instead as being complementary. Governor Benjamin Strong Jr. saw open market operations as a way to lay the groundwork for a variation in the discount rate. Thus expansionary policy increased the liquidity of the banking system and paved the way to a subsequent reduction in the discount rate. Open market operations prevented monetary policy based exclusively to the discount rate from generating excessive volatility on financial markets (Hearings 1927). At the same time, the problem persisted of control over the quality of credit, i.e., the way in which the liquidity freed up by this policy was used without violating the constraints imposed by the Federal Reserve Act. Qualitative credit control regarded the composition of commercial bank portfolios, whereas quantitative control referred to the appropriate amount of credit to keep price and production dynamics under control. Qualitative control did not have a theory behind it on which to ground its choices if not the often repeated stricture that commercial banks could not have stocks and bonds in their balance sheet. Long-term financing of capital accumulation was indirectly discouraged, through moral suasion and other means, because only short-term financial assets were accepted by the Fed in rediscount operations.

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The orientation of monetary policy ran countercurrent to the dynamics of financial markets, where, as we shall see, short-term financing lost ground to long-term investments. The attention paid to the assets on the banks’ balance sheets overshadowed another issue that was one of the initial motivations for creating the Fed: the elasticity of currency supply. Fluctuations in the supply of ready money relating to the seasonal and cyclical nature of the real economy drove country banks to withdraw their deposits from city banks, causing a financial crisis. Monetary policy can be based on the assets or liabilities of the banking system balance sheet. We are talking about credit in the former case and deposited or circulating currency in the latter. The link between the two elements is determined by the fact that the lending of assets creates corresponding liabilities. The composition of liabilities and their convertibility is a problem to be controlled because it falls to discretional choices made by the public. And these choices, especially in a situation of panic, can interfere with credit supply since banks, in conditions of stress, are forced to sell off their assets if the central bank does not intervene to finance them. Its focus on the question of control of cyclicity led the US central bank to overlook the question of the composition of liabilities and their control through an increase in the monetary base. The monetarist interpretation of the Great Depression by Warburton (1946) and Friedman and Schwartz (1963) contemplates this particular aspect of the issue of stabilization without accounting for the fact that it is the final outcome of monetary policy choices that influenced the interest rate structure and the composition of bank, non-bank financial intermediary, and corporate portfolios and only at the end of the process did these choices affect the liabilities on the balance sheet of the banking system. This aspect of the problem demands further discussion. At this point, it behooves us to analyze the relations between monetary policy and the money market immediately following the creation of the central bank. The instruments available to the Fed to control the economic cycle are open market operations and the discount rate. These instruments marked a significant change in the function of the Fed. The Fed tacitly abandoned the classic objective of a central bank to act as lender of last

3  The Birth of the Federal Reserve and Its Monetary Policy     49

resort and transformed monetary policy into an instrument of systematic control of credit with the goal of stabilizing the economic cycle. Expansionary open market operations were used to prevent a deflationary phase, while contractionary operations were used to reduce inflationary growth. The money market in which the Fed intervened was composed of four sub-markets that absorbed the available liquidity of the banking and non-bank sectors. The four markets were the market of trade and bank acceptances, the government securities market, the commercial paper market, and the stock market. The bank acceptances market encompassed some 600–800 million dollars of liquidity. The market included dealers who took out shortterm loans and provided credit by discounting trade and bank acceptances. In the event of need, the dealers could rely on the support of the central bank instead of selling assets on the market. The intervention of the Fed was different from open market operations on government securities because it came about on initiative of the dealers. The government securities market amounted to some two billion dollars, the commercial paper market 700 million, and the money market that financed purchases on margin on the stock market absorbed 2.8 billion dollars of liquidity (Burgess in Hearings 1927). The market operations regarded the acceptances market and the government securities market. The bank acceptances market was not particularly well developed in the USA, where businesses took short-term financing from the banks in exchange for promissory notes. The banks generally extended credit without asking how the credit would be used, but they did take the debtor’s balance sheet into account. Credit was generally extended to 50% of the borrower’s readily liquidable assets. The shift to another type of financing such as acceptances did not get off the ground in the USA for a variety of reasons, among which is the meager profitability of this type of transaction. In line with the goals of the Federal Reserve Act suggested by Warburg, in its early years the Fed insistently sought to promote the development of the acceptances market, intervening in a targeted manner to stabilize and extend the commercial short-term securities market. Specifically, it set a very low discount rate for bank acceptances, very often uncoupled from variations in discount rate for other types

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of financial assets such as government securities and commercial papers. Furthermore, it put pressure on member banks to stop them from entering the market to sell previously purchased acceptances. This way, the refinancing operation was more similar to a traditional rediscount than to an intervention in the open market, given its asymmetrical nature aiming to support acceptance prices. Lastly, the Fed has always been committed to ensuring dealers financing at a favorable interest rate, considering it necessary to maintain the stability of this type of financial intermediation. The dealers ensured the liquidity of this market, buying assets and financing themselves on the market or turning to the Fed when they could not find sufficient funds on the market or when interest rates rose. The profit from these operations derived from the difference between the interest paid on the loaned funds, discounting the acceptances, and the interest rate on borrowed funds. The preferential treatment of dealers was the object of much criticism and in any case still failed to get this market off the ground. On the one hand, the banks did not feel it made economic sense to buy acceptances because they could realize higher profits buying government securities or commercial papers. Pressure by the Fed also made it problematic to sell the purchased securities, and thus the demand for acceptances ended up being very limited and a significant share ended up in the Fed’s own portfolio. On the other hand, the businesses seeking financing found it more profitable to use traditional instruments because the acceptances market implied a high interest rate compounded by dealer fees and commissions applied by the commercial bank that backed the debt (Hardy 1932). To analyze the transition in monetary policy toward an anticyclical function, we have to turn to the government securities market. Here, we may effectively speak of open market operations, understood as the purchase and sale of government securities to regulate the money base and stabilize the economic system. These operations tended to assume a definitive character, unlike the current use of monetary policy based on short-term repurchase agreements (repos). The philosophy guiding these operations was based on the premise that the banks did not take out debts with the central bank for the

3  The Birth of the Federal Reserve and Its Monetary Policy     51

purpose of profit, but because they needed to reduce or at least keep that debt as low as possible. In the former case (reducing debt), open market operations would have been useless. Let us assume that the Fed wanted to adopt a monetary policy with the objective of slowing economic growth out of fear of inflation. A contractionary monetary policy would have translated into a sell-off of government securities and a reduction in the reserves of commercial banks, which would have been able to compensate for this by going into debt with the central bank to keep their supply of credit unaltered. The interest rate they paid to the central bank was such that it allowed them some profit margin. Conversely, in the second case (maintaining debt at minimum levels) the open market operations were a channel to accelerate the reduction of bank debt, favoring repayment in the case of an acquisition and obliging banks to go into debt against their wishes in the case of a sale of Treasuries. In this latter case, credit would decrease and the interest rates would increase. On the other hand, in the case of acquisition, the credit would increase and the interest rates would fall. Monetary policy was thus implemented via its capacity to regulate bank debt to the Fed and thus expand or contract credit and interest rates (Brunner and Meltzer 1964). The explanation for the choices of banks to permanently reduce their debts is a generally applicable mechanism that interprets any exogenous variation, such as the transfer of gold or a modification in the preferences of the public, who show lower demand for currency in favor of settling payments via deposits. An increase in available liquidity drives the banks to systematically reduce their debt to the central bank. Demand for reserves by banks is conditioned by the need to maintain a stable relationship between current reserves and obligatory reserves dictated by regulations. Obligatory reserves are pegged as a percentage of time and demand deposits via different coefficients. The banks have to align their effective reserves with the obligatory reserves by borrowing, if necessary, or the central bank can independently provide reserves through open market operations. The last element in our analysis of the monetary policy implementation mechanism is the relation between effective reserves and interest

52     G. Pizzutto

rate structure. Burgess (1927) claimed that this relationship was direct and predated the institution of the Fed. Analyzing the situation of the New York money market that handled the reserves of all banks subscribing to the National Banking Act, he noted that a situation of abundant reserves caused a reduction in short-term interest rates, whereas when the reserves diminished interest rates climbed steeply. All it took was a marginal variation in reserves to cause these effects. The institution of the Fed helped reduce the volatility of interest rates, but the relation between reserves and interest rates continued to hold, even if it had to be understood in light of the possibility of the banks to go into debt with the central bank. Open market operations tended to modify the sources of bank reserves, obliging them to modify their debt to the central bank, resulting in a variation in interest rates. Thus interest rates were the main indicator of either passive or active monetary policy. A low interest rate meant that monetary policy was expansionary, while a high interest rate was the signal that the policy was contractionary. The adoption of open market operations as a prevalently definitive instrument was an important element in the transformation of monetary policy from passive to active. The creation of monetary base in the period in question depended on international trade, in particular on gold flows that were determined not just by the trend in the balance of payments but also by the direct purchases that the USA made in that period. The USA sought to increase its gold reserves within the framework of an international monetary system wherein the dollar increasingly assumed the role of a reserve currency alongside the pound in the gold exchange standard. The increase in gold held by the United States Treasury, excluding the gold held on behalf of the central banks of other countries, grew from 2.7 billion dollars in 1918 to 4.3 billion in 1926. In this situation, the ratio between reserves and deposits could no longer be considered an indicator of monetary policy; the Fed was, in a certain sense, relieved of its obligation to use interest rates to stabilize the gold reserves and could thus focus on controlling the economic cycle and prices using open market operations. But the issue still stands

3  The Birth of the Federal Reserve and Its Monetary Policy     53

of the relation between the creation of monetary base through international trade and the domestic monetary base. The problem of the relation between the two sources of monetary base and the importance of the international trade channel is still a matter of debate. In particular, Wicker (1965) believes that open market operations represented an attempt to force a reduction in interest rates in order to stop what was deemed to be an excessive transfer of gold and to help Great Britain maintain its share of gold, which in that period was dwindling. Others believe that open market operations are aimed at sterilizing the influx of gold, while still others see the question of gold in this period as substantially irrelevant (this is the position held by Brunner and Metzler 1964). The large gold purchases by the USA had outcomes similar to open market operations. The commercial banks responded to the influx of monetary base by reducing their debt toward the central bank and increasing their offer of credit, bringing about a reduction in interest rates. This monetary transmission mechanism became yet stronger following a modification of the ratio of obligatory reserves, which was reduced after the institution of the Fed. The centralization of reserves and the creation of a lender of last resort reduced the need for single banks to maintain high levels of their own reserves. The reduction of the reserve coefficient in 1915 and again in 1924 contributed to the expansion of the credit supply. The percentage of reserves ranged from 10 to 13% in 1924 for demand deposits, while during the period under the National Banking Act it was closer to 25%. On time deposits, the percentage fell to 3% (Board of Governors of the Federal Reserve System, Annual Report—1915 and 1924). Reduction of the ratio of obligatory reserves, influx of gold that was only partially sterilized, and open market operations in 1924 and 1927 were the instruments that allowed an expansion of credit provided by the banking system and a reduction in interest rates. In this period, the US public debt to finance World War I was reduced considerably, aided by the high economic growth rate. Debt fell from 27 billion dollars in 1919 to 16 billion in 1929, freeing up financial resources that were then invested in substitutive financial assets issued by the private sector.

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We must also not forget that US monetary policy consistently kept the discount rate lower than the market interest rate so that rediscounting could be used systematically, unlike in the English money market, where the interest rate asked by the Bank of England was kept higher than the market rate to discourage the practice of borrowing from the central bank to buy assets on the market and pocket the difference (Keynes 1930, Ch. 32; Anderson 1949). All these factors brought about a progressive reduction in short-term interest rates, a reduction that was particularly accentuated in 1924 and 1927 in conjunction with the open market operations performed by the Fed. The reduction in nominal interest rates occurred across the board. For example, the interest rate on prime commercial paper, which was 8% in 1920, decreased to 3% in 1924; the rate on bank acceptances fell from 6 to 2%; the rate for call loans in the stock market dropped from 7 to 2% (Banking and Monetary Statistics 1941). In parallel, we also observe a reduction in long-term interest rates, which, as noted by Riefler (1930) and Keynes (1930), is systemic in both the USA and British markets. Expansionary monetary policy that acts via an increase in the monetary base influences short-term rates, then long-term rates, and—as Keynes thought—the process of accumulation of fixed capital by businesses. The control of the short-term interest rate influences the long-term rate and thus brings the long-term interest rate of the market into closer line with the natural interest rate. In this context, monetary policy is capable of maintaining an equilibrium among savings and investment and full employment. Critics of this approach (Simmons 1933) recognize the relevance of Keynes’s conclusions for the period 1920–1928 but underscore that the parallelism between short-term and long-term rates does not apply to the period 1928–1932, when a reduction in short-term interest rates was followed by an increase in long-term interest rates rather than by a decrease. The evolution of the relation between short-term and long-term rates may find an explanation in the fluctuation of the risk premium: In conditions of growth and expansionary monetary policy, the risk premium decreases, whereas it increases during a depression, weakening the effectiveness of monetary policy.

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Bibliography Anderson, B. (1949). Economics and the public welfare. Princeton, NJ: Van Norstrand, Inc. Board of Governors of the Federal Reserve System. (1915). Annual Report. Board of Governors of the Federal Reserve System. (1924). Annual Report. Board of Governors of the Federal Reserve System. (1941). Banking and Monetary Statistics. Brunner, K., & Meltzer, A. H. (1964). The attachment to the theory of free reserves. Subcommittee on Domestic Finance, Committee on Banking and Currency, House of Representatives. Burgess, W. R. (1927). The reserve banks and the money markets. New York: Harper and Brothers. Burgess, W. R., & Sprague, O. W. (1929). Money and credit and their effect on business. In Recent economic changes in the United States (pp. 661–712). NBER. Cagan, P. (1965). Determinants and effects of changes in the stock of money 1875–1960. NBER. Dang, T. V., Gorton, G., & Holmstrom, B. (2015). Ignorance, debt and financial crisis (Columbia Working Paper). Dunbar, C. F. (1897). The national banking system. Quarterly Journal of Economics, 12(1), 1–26. Dunbar, C. F. (1917). The theory and history of banking. New York: Putnam’s. Flandreau, M., & Ugolini, S. (2014). The crisis of 1866. In N. Dimsdale & A. Hotson (Eds.), British financial crises since 1825. Oxford: Oxford University Press. Friedman, A., & Schwarz, A. (1963). A monetary history of the United States, 1867–1960. Princeton: Princeton University Press. Hackley, H. (1973). Lending functions of the federal reserve banks: A history. Publications Services, Division of Administrative Services, Board of Governors of the Federal Reserve System. Hardy, C. ( 1932). Credit policies of the Federal Reserve System. Washington, DC: Brookings Institution. Hearings Before the Committee on Banking and Currency. (1927). Stabilization. Jacobs, M. L. (1910). Bank acceptances. National Monetary Committee. Kemmerer, E. W. (1911). Seasonal variations in the New York money market. American Economic Review, 1(1), 33–49.

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Keynes, J. M. (1930). Treatise on money. London: Macmillan. King, W. (1936). The history of the London discount market. London: Routledge. Laughlin, L. (1912). The banking reform. Chicago: The National’ Citizens League for the Promotion of a Sound Banking System. Riefler, W. (1930). Money rates and money markets in the United States. New York: Harper. Simmons, E. C. (1933). Mr. Keynes’ control schemes. American Economic Review, 23(2), 264–273. Sprague, O. W. (1910a). Proposal for strengthening the national banking system. Quarterly Journal of Economics, 24(4), 634–659. Sprague, O. W. (1910b). History of crisis under the national banking system. National Monetary Commission. Steiner, W. H. (1923). Development of American credit methods. The University Journal of Business, 1(4), 441–450. Warburg, P. M. (1914a). Circulating credits and bank acceptances. Proceedings of the Academy of Political Science in the City of New York, 4(4), 159–172. Warburg, P. M. (1914b). American and European banking methods and bank legislation compared. Proceedings of the Academy of Political Science in the City of New York, 4(4), 30–56. Warburton, C. (1946). Monetary control under the Federal Reserve Act. Political Science Quarterly, 61(4), 505–534. Wicker, E. (1965). Federal Reserve monetary policy 1922–33: A reinterpretation. Journal of Political Economy, 73(4), 325–343.

4 Non-bank Financial Intermediaries and the Crisis of 1929

According to Keynes, short-term and long-term interest rates regard the cost of financing circulating capital and fixed capital, respectively. The distinction between circulating capital and fixed capital and the way they are financed is an important question that has only been partially addressed in the literature. The authors of the principal papers on the banking system took a unified position based on the real bills doctrine. The assets of commercial banks were supposed to be composed exclusively of short-term credit serving to finance circulating capital. This mind-set was the premise for the Fed doctrine whereby the function of lender of last resort could only be exercised on behalf of those banks holding short-term commercial debts in their portfolio that could be rediscounted to the central bank. It is clear that this widely shared constraint placed a limit on the effectiveness of monetary policy, which depended on the presence of short-term assets that could be transferred to the Fed either definitively or as collateral for a loan. We must not forget that the explanation of the economic cycle advanced by Hawtrey (1913) presumed that fluctuations were strictly linked to circulating capital and the influence that monetary policy could have on stocks of goods held by firms in the real market. © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_4

57

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An increase in interest rates would push firms to reduce the ­volume of goods in their warehouses and cause a reduction in prices and production. A reduction in interest rates, on the other hand, would favor the opposite trend, which would slow down recovery. The structure of the US economy in the 1920s and the progressive ­evolution of the American financial market do not support the idea of the central importance of circulating capital as a foundational element of monetary policy or provide an explanation for the economic cycle. A progressive decrease in commercial loans in bank portfolios was observed in the 1920s. Currie (1931) noted that the commercial loans of banks in his sample had dropped by nearly half from 1920 to 1929, and Foulke (1931) underscored the fact that commercial loans were only important to medium-sized companies. Big corporations financed themselves on the financial market by issuing stocks and bonds. Bank balance sheets showed a reduction in commercial loans among their assets. At the same time, the balance sheets of companies saw a significant increase in long-term financing, which appeared among the assets of banks either because the banks directly acquired stocks and bonds or because they financed the broker-dealers who handled acquisitions on margin and new issue. The nascent literature on corporate finance was very sensitive to the distinction between fixed and circulating capital and underscored that the ratio of fixed to circulating capital was increasing significantly in those years in step with the emergence of big corporations. The crisis of 1920–1921 could be interpreted as deriving from an excess of circulating capital accumulated by companies during World War I in a period of rising prices. After prices stabilized, the companies were forced to liquidate this capital, causing a fall in prices and production. In that period, businesses were mainly interested in having circulating capital on hand to meet demand, and recovery from the crisis progressed in step with the liquidation of accumulated stocks of goods. Improved company organization ensured that production was better aligned with demand in the following period and the much more limited quantity of supplies on-hand reduced the demand for short-term

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credit. But the most significant element in the 1920s was a modification of the relationship between fixed and circulating capital. Dewing’s (1934) analysis of 169 US corporations showed a significant shift in the ratio of fixed to circulating capital, rising from two in 1919 to four toward the end of the 1920s. The change in this ratio, combined with the rationalization of goods management on the company level, also explains the reduction in commercial loans and the expansion of long-term financing of companies (stocks and bonds) by banks and financial markets. The distinction between short-term and long-term loans was introduced in the National Banking Act to place a portfolio constraint on banks subscribing to the new system. The resulting reduction of profitability gave banks an incentive to create parallel institutions that managed long-term credit via direct acquisition, while indirect financing continued through the credit provided by broker-dealers. Toward the end of the 1930s, the national banks had joined state banks and investment trusts in managing long-term credit and competed with investment banks in managing new issue, effectively transforming themselves into universal banks. The change in composition of the real business balance sheets also altered the nature of demand for financing. However, monetary policymakers did not seem to perceive the importance of this change and the long-term financial market was often labeled as being speculative, seen as an intermediation channel that siphoned off funds from the real economy. A side effect of this underestimation is the reduction, in both percentage and absolute terms, of assets accepted as collateral by the central bank and the weakening of this channel of stabilization immediately following the financial crisis of 1929. The idea of including longterm securities among the assets acceptable to the Fed was never taken into consideration. The years following World War I may be seen as an accelerated process of accumulation of fixed capital by businesses and families, coupled with a significant change in the composition of consumer spending, and in particular, an increase in consumption of durable goods. This process was financed prevalently through expansionary monetary policy

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and growing non-bank intermediation, in which commercial banks and other institutional investors participated indirectly. The result was a period of strong growth in production and employment. In 1921, there were 10.44 million agricultural workers in the US economy. This number remained substantially unaltered in 1930. Nonfarm employment grew in the same period from 26.6 to 33.8 million, while the overall unemployment rate dropped to 3%. GDP was seven billion dollars in 1921 and grew to 103 billion in 1929 (Census.gov statistical abstracts 2006). A review of the development financial market in that period allows us to make a quantitative assessment of the corresponding trend in debt. An analysis of firms’ balance sheets highlights how debt increased significantly in both absolute and relative terms in the private sector of the economy in the decade following World War I. There were also significant changes in terms of maturity, with short-term credit being replaced by long-term credit deriving from the issue of stocks and bonds. The earnings from these issues reduced debts to banks and refinanced existing debt at more favorable terms, while also financing the accumulation of capital, adding to non-distributed profits. Statistical sources differ somewhat in terms of absolute data to explain that process but are relatively homogeneous and convergent as to the interpretation of that process and with respect to the prevailing trends in financial markets (Fisher 1932; Edwards 1938; Kuvin 1936; Board of Governors of the Federal Reserve System, Banking and Monetary Statistics 1941). In absolute terms, the values of all stocks and bonds in the corporate sector increased from 1925 to 1929, falling again after the crisis. In particular, the value of preferred stocks rose from 15.9 to 19.7 billion dollars, falling again to 18.4 billion dollars in 1933. The index of common stocks rose from 59.0 to 85.5 billion dollars and then fell again to 74.1 billion dollars in 1933. Bonds rose from 28.5 to 44.0 and then fell to 42.9 billion dollars after the 1929 crisis (Edwards 1938, Table 42). If we examine the flows of new issues, we note two important elements in the composition of liabilities in the corporate sector: Stock issues increase in percentage over bond issues, and investment trusts significantly increase their issues in 1929. We will look at these data further on when we analyze the crisis in the stock market.

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Following an opposite trend, the amount of public (federal) debt decreased constantly from 19.9 billion dollars in 1925 to 16 billion in 1929, climbing back to 23.4 billion dollars in 1933. The overall amount of public debt (federal, state, and municipal) remained relatively stable around 32 billion dollars since the reduction in federal debt was compensated by an increase in state and municipal debt. The amount of overall private real estate debt (urban and non-urban) in 1932 was estimated at some 58 billion dollars by Doane (1933). Pearsons (1930) estimates the distribution of debt issued to finance the purchase of urban real estate at some 9 billion dollars in 1921, rising to 27 billion dollars in 1929. Commercial banks, insurance companies, and savings and loans associations each held an average of some 5 billion dollars of debt, approximately 8 billion was held by the Building and Loan associations, while the bonds issued to finance the real estate loans amounted to 4 billion dollars. These bonds were backed by loans and the real estate they financed and were managed by investment banks specialized in this market segment. The value of this segment of the bond market is probably underestimated. Later assessments (Horton 1937; Grebler et al. 1956) placed bonds issued by non-institutional investors in the range of 6–7 billion dollars, a more reasonable estimate when we consider that institutional investors also purchased bonds linked to the real estate market and thus indirectly financed that market. The index of long-term debt that financed the real estate market, set to 100 in 1913 when said debt amounted to 5 billion dollars, rose to 174 in 1921 and to 576 in 1929. The index of the value of real estate rose in the same period from 100 to 188, then decreased to 156 in 1931. The ratio of debt to aggregate value of property was estimated at 13% in 1913, rising to 37.5% in 1929. In 1931, following the crisis in the real estate market, it increased further to 44% (Edwards 1938). Other indicators show high increases in debt over a very limited time span. For example, the ratio of real estate debt to available income rose from 12.6 to 41.0% in 1930 (Grebler et al. 1956, Table 42). The importance of the real estate sector may be deduced from the construction industry’s percentage share of total gross capital formation.

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The value of the sum of durable goods destined for consumption and production and of all immovable assets reached 32 billion dollars in 1928. Of this, nearly 50% derived from production in the construction industry (Kuznets 1934, Table 5). In the period 1919–1932, the annual average gross production of capital goods was 27.3 billion dollars. Of this, 43% was attributable to the construction industry. A final observation regards consumer credit, which developed significantly in those years to finance the acquisition of automobiles and household appliances. In 1929, more than 4.3 billion dollars in credit was extended, mainly for the purchase of automobiles. These volumes collapsed in subsequent years, reaching a minimum of 1.363 billion dollars in 1932 (Holthausen et al. 1940). Kuznets reports that the value of trade in durable consumer goods rose from 7 billion dollars in 1920 to 9 billion dollars in 1928 (28% of total trade in capital goods) and then to 10 billion in 1929, plummeting to 3.7 billion in 1933 (Kuznets 1934, Table 5). This trend seems to confirm the concerns expressed by Rodd (1927), who had anticipated such a contraction in demand for durable consumer goods in the event of a crisis in other sectors of the US economy. Having examined the structure of debt and its increase, we now analyze monetary policy and its effect on interest rates. The relation between expansionary monetary policy and risk premium can be examined from two perspectives. First of all, it is a question of seeing how bond yield has been influenced by a monetary policy that tended to be expansionary up to 1928–1929. The variation of the monetary base caused by increases or decreases in the gold supply had always been counterbalanced by open market operations in order to stabilize the creation of a monetary base and prevent excessive volatility in the money supply. The process of sterilization weakened the automatic adjustment mechanism that is usually associated with the gold standard. In the period 1923–1926, the reduction in gold held by the Fed from 3.0 to 2.5 billion dollars was counterbalanced by the purchase of government securities and commercial paper through open market operations. The reserves held by commercial banks thus rose gradually from 1.9 billion dollars in 1923 to 2.47 billion in 1929 while the amount

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of money in circulation remained stable (Board of Governors of the Federal Reserve System [1943] Banking and Monetary Statistics, p. 331, Table 85). The most relevant consequence of the creation of the Fed and the monetary policy it implemented was a constant decrease in interest rates and interest-rate volatility in the period from the end of World War I to 1928 (Burgess and Sprague 1929). Particularly notable in the period in consideration is the progressive reduction in yield from risk-free financial assets. In a financial market with a diminishing amount of government securities, the highest rated private sector bonds were used to determine the risk premium. The ideal interest rate referred to a bond issued by the private sector that could ensure payment of interest and the repayment of capital, excluding administrative costs and inflation. An index of such risk-free bonds was constructed by Durand (1942) using bonds with high ratings and different maturities. The interest rate on these bonds decreased continuously after World War I from 5.5 to 4.0% in 1927. A similar trend was observed for government securities. For example, the interest rate on government securities was 5.32% in 1920 and fell to 3.34% in 1927. The reduction in yield on risk-free securities produces the consequence of a reduction in the risk premium. The yield for a triple-A corporate bond fell in that period from 6.12 to 4.55%, while a more risky BAA bond fell from 8.20 to 5.48%. The reduction in level and volatility of the interest rate for risk-free s­ ecurities induced a reduction in the differential and stimulated an increase in the issue of higher-risk assets, thus diminishing the quality of the issued bonds. This process was recently observed in accentuated form in association with monetary policy that reduced interest rates to a historical low during the expansionary phase in the early 2000s and again after the crisis of 2008 (Borio and Zhu 2013). The phenomenon was particularly relevant if we examine the performance of bonds issued by foreign residents and placed on the US financial markets by investment banks. We may observe (Mintz 1951) a decrease in the risk premium for high-yield bonds. While the default rate for these bonds rose from 30% in 1925 to 58% in 1926, the risk premium (difference between the yield of these bonds and the interest rate for an ideal bond as calculated

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by Durand) remained substantially stable, rising from 2.18 to 2.32%. In 1927–1928, with an increase in the default rate to 66%, the risk premium dropped to 2%, a premium sufficient to remunerate higher quality bonds in 1921–1924. In that period, investment banks were the ones looking for potential creditors, while very often in the early 1920s requests for credit were met with a polite refusal. This illustrates the shift from a market dominated by a demand for credit to a market where supply was the critical factor, probably to compensate for a reduction in yield. This phenomenon was observed not only for the foreign bond market but also in the market where bonds were issued by US residents. Hickman (1958) observed that toward the end of the 1920s, the rating agencies gave a generally higher-risk assessment generally to issued bonds than did the financial market, which clearly underestimated the decrease in quality of the credit it was financing. It was no coincidence that most bond failures in the following years were attributable to bonds issued in the final months prior to the Great Depression. More recent research has supported that observation (Daglish and Moore 2013), providing further support to the thesis that the worsening quality of debt should have made it possible to foresee that the yield on those bonds was destined to fall below the yield on government securities when the default rate and credit spread increased during the subsequent crisis (Greenwood and Hanson 2013). Thus empirical research seems to confirm that toward the end of the 1920s, the financial market was characterized by increased leverage, a worsening of the quality of bonds, and a compression of the risk premium induced by expansionary monetary policy. This created a tradeoff for monetary policy between macroeconomic stabilization and stability of financial markets (Stein 2014; Borio 2006; Turner 2013). The growth in overall debt issued by the private sector in the US economy was financed by traditional financial intermediaries such as banks and by financial markets through investment banks and broker-dealers. Federal Reserve member banks and all banks in general made big efforts in that period to become competitive in the longterm credit market, both credit to businesses and real estate credit. This translated into a slow increase in the share of long-term assets in the

4  Non-bank Financial Intermediaries and the Crisis of 1929     65

portfolio, either directly through purchases or indirectly via the financing of broker-dealers or operations on the New York market. Monetary policy and numerous scholars of banking economics have always looked with suspicion on this type of transaction. Very often, the financial market on which long-term securities were traded was labeled as speculative; monetary policy was criticized for having favored growth in debt through open market operations in 1924 and 1927 (Parker Willis 1929; Anderson 1924). Even within the Fed, certain economists (Miller, for example) were aligned with this thesis, implicating Governor Strong in expansionary monetary policy that would have generated an excessive increase in speculative credit. This negative assessment of monetary policy was justified by arguing that loans from banks to brokers had gone up too much, and this had boosted speculation at the cost of funding the real economy. Investment in stocks drained credit into a circuit that was self-perpetuating and devoid of any link to production—worse yet, it robbed the real economy of resources needed for growth. In substance, it was argued that purchases on margin were the element that favored this type of dynamic on financial markets. The central bank was thus urged to intervene to reestablish balance by implementing a contractionary monetary policy that would stop speculation and redirect credit flows into the real economy. This interpretation would appear to be confirmed if we look at the data regarding the evolution of loans from banks to brokers. In the period 1926–1929, the overall value of loans issued by banks in the Federal Reserve system grew significantly from 3.8 billion to nearly 7 billion dollars on the eve of the crisis of 1929. Combining this fact with the idea that the ability to purchase on margin was an incentive to purchase stocks in view of a future increase in value, the conviction spread that this type of development of the stock market had to be stopped to prevent negative impacts on production. Purchasing on margin and the growing credit provided by banks to these intermediaries was fueled by an increase in the prices of stocks and amplified these price increases in a later phase. In 1928, assimilating this thesis, monetary policy also decided that the alleged speculation had to be stopped and began raising interest rates until the stock market collapsed in October 1929.

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However, some questions may be raised regarding the premise upon which the contractionary monetary policy was based and the link between purchasing on margin, loans to brokers, and speculative dynamics. Margin requirements demanded of clients for broker loans had gone up long before the financial crisis (Smiley and Keehn 1988; Simmons 1930). Evidently, the conviction was spreading through the market that the stock quotes were too high. Secondly, the reasoning behind the speculation hypothesis did not account for how the bookkeeping of those purchases and sales of stocks worked or for the principle that every purchase corresponds to a sale. Anyone who wanted to purchase securities on the market had to open an account at the Stock Exchange. Assuming that the amount of assets on the market is constant, purchasing on margin does not require any own credit because the outlay of the buyer corresponds to the income of the seller and thus, in the aggregate, if all the participants remain within this ­clearinghouse, brokers have no need to go into debt; trade among b­rokers is a ­zero-sum equation (Eiteman 1932; Machlup 1940). Every broker buys and sells securities on the market. In cases where income is greater than outlay, the broker has excess liquidity that can be used to reduce any debt it might have or else it lends funds to other brokers who have a deficit, as happens on the interbank market. The brokers have ­discretionary management over the liquidity in their portfolio. On the other hand, they have to be ready to ensure liquidity to all those who want to liquidate their assets and leave the clearinghouse. The problem thus arises as how to explain the reason for the increase in credit obtained by brokers, the composition of the credit (banks vs. corporations), the reason for the increase in issue on the eve of the Great Depression, the use of the credit obtained following this issue (refunding vs. capital expenditures), the effects of contractionary monetary policy, and the collapse of the stock market. The increase in credit to brokers was not used to finance the acquisition on margin of stocks, but financed all the parties that decided to withdraw funds from their deposits in the NYSE clearinghouse, minus those who wanted to open a position therein. One explanation of the volume of short-term broker debt regards new stock issues.

4  Non-bank Financial Intermediaries and the Crisis of 1929     67

The financial market of the 1920s had passed from short-term financing to long-term financing, increasingly favoring the issue of new stocks rather than bonds. This choice was clearly favored by the increase in stock prices and by the fact that newly issued stocks were offered at a lower price than their current value. If we compare yield on stocks vs. yield on bonds, we note that both decrease over the years, but stock yield in 1928 was lower than bond yield (Burgess and Sprague 1929). While buying back company stocks produces an increase in the dividend, selling them reduces the share of bonds, shifts risk to the stockholders, and pushes toward a reduction of prices and yield. The operations that developed in 1928 and 1929 required financing through credit at a time when the corporations were withdrawing their funds from the clearinghouse where the capital increase operations had taken place. Those who purchased the newly issued stock could do so in two ways: selling the old stock in their portfolio and buying the new stock offered at a discount; or, alternatively, purchasing on margin. In the latter case, brokers had to increase their debt to finance the withdrawal of corporate funds acquired via capital increase in the NYSE clearinghouse. The broker did not have to go into debt to the banks if the funds remained within the clearinghouse, but only when they are withdrawn. Also in the case where there are no new issues of capital, the increase in debt of the intermediaries would signal that expectations for revaluation are weakening, prompting those who profited to leave the market and transfer their funds to the bank to finance the purchase of consumer goods or else because they feel that the market has exhausted its propulsive thrust. The increase in debt is a signal of the end of a speculative bubble and not a way of fueling it. However, the importance of this remains negligible if we keep in mind that over three billion dollars in new stocks were issued in 1929 and thus this new short-term debt financed this type of operation. A complementary explanation for the increase in loans to broker-dealers regards the placement of the new issues that were insured by dealers to corporations, advancing funds before distributing the new stocks to investors. In this phase, the dealers request funds that they can advance to the issuers while at the same time intervening (this was an American practice) in the market to stabilize the prices of the new

68     G. Pizzutto

issues. In the event of decreasing price, they buy previously issued stock. In the one case (selling old stock), the funds are used to finance corporations prior to final placement, in the other (purchasing on margin), they are used to buy stocks and prevent a decrease in price from negatively impacting on current placements or future issues. A significant change in the composition of stock issues was witnessed in 1929. Over 56% came from the financial sector (Machlup 1940, Appendix, Table 8). In particular, this datum is influenced by stocks issued by investment trusts, investment funds that issued increasing quantities of stocks to finance the purchase of other stock. Overall, this type of issue exceeded two billion dollars (Steiner 1935) and on the eve of the stock market crash of 1929, much of these stocks had yet to be placed and were still in the dealer portfolios (Beckart 1932, p. 118). It is quite probable that the increase in interest rates and the prospective reduction in the value of the stock market froze these issues in dealer portfolios; they were later liquidated contributing to the collapse of the stock market. How did the big financial and non-financial companies use the funds? The new issues had various objectives. First of all, the funds could be used to finance the accumulation of capital, added to non-distributed profits. In the second place, the restructuring of the financing allowed companies to depend less on long-term credit from banks and bolstered the process of reducing short-term debt. In the third place, companies could issue stock to exploit the favorable conditions of the market and accumulate liquidity, which would come in handy in later periods. In this third case, the available liquidity could be and was used to refinance brokers on the money market, especially thanks to the high interest rates in the Fed’s contractionary monetary policy. The high yield constituted a short-term alternative to an investment plan that required time to be implemented. In the case of investment trusts, the preference for this option was associated with the conviction that it would not have been advantageous to buy stock because the price was too high. Indeed, in 1928 the Fed intervened decisively in member banks, forcing them to reduce their exposure to brokers on the conviction

4  Non-bank Financial Intermediaries and the Crisis of 1929     69 ϭϮ

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that this type of loan drained resources from the real economy. Later, in order to rein in the “speculation,” it decided to intervene in the market, increasing the federal funds rate to 6.5%. The entire money market interest rate apparatus was driven toward increase (Fig. 4.1). In particular, the call loan interest rate that brokers paid to obtain credit rose beyond 10%. The overall volume of loans to brokers rose from 3.1 billion dollars in 1926 to 6.8 billion in October 1929 on the eve of the Great Crash. The Fed’s dissuasive action discouraged bank loans, which remained substantially stable at around a billion dollars, whereas loans from country banks, and especially loans on behalf of their customer, increased significantly. The same corporations that had been attracted by the increase in interest rates were the ones that provided liquidity to brokers and thus financed the stock issues of other corporations. The loans on behalf of other non-bank institutions rose from some 500 million dollars in 1926 to close to 4 billion dollars in October 1929. From this perspective, the banks were not guilty of financing speculation, it was the contractionary monetary policy that indirectly favored exactly what it was hoping to fight (Eiteman 1933).

70     G. Pizzutto

The Fed’s increase of interest rates was particularly aggressive if we keep in mind that inflation was already negative in the period of contractionary monetary policy. Measured in terms of real interest rate, the increase in the interest rate was particularly high, so high that it interrupted the process of non-bank financial intermediation. At a certain point, faced with an increase in interest rates, the corporations that provided financing to brokers via the banks felt that short-term loans would bring high returns but at the same time the underlying values were at risk because of the contractionary policy. On the other hand, the interest on on-margin financing was so high that the purchase of stocks, given their price and the cost of financing them, was hardly profitable. The effect of contractionary monetary policy on the dynamics of the stock market has only been marginally addressed by academic research. While the recent question of the search for yield and the risk-taking monetary channel has witnessed a spate of papers analyzing the effect of expansionary monetary policy, relatively little attention has been dedicated to the fact that contractionary monetary policy has always preceded collapses of the stock market. This is true for the crisis of 1929, for the Japanese crisis in the 1990s, and for the Great Recession in 2007–2008. The literature has focused on the effects of expansionary monetary policy, identifying the risk-taking channel as an added transmission channel that produces its effects on financial markets, inducing a reduction in risk premiums, but the question has never been asked about the consequences of contractionary monetary policy on the dynamics of financial markets. Even prior to the crisis of 1929, concerned voices had been raised regarding the momentous contractionary effects of monetary policy, but they were not heeded (see, e.g., Cassel and Fisher in Hearings 1928). Non-bank financial intermediation is based on the difference between the interest rate on collateralized borrowed liquidity and earnings on assets purchased with that liquidity. An increase in interest rates creates a pincer effect, because on the one hand it reduces the yield on the assets it finances and their market valuation, while on the other, it increases the risk premium and thus the cost of financing. Those who extend credit want an increase in interest rates, those who borrow are

4  Non-bank Financial Intermediaries and the Crisis of 1929     71

not able to pay those rates because yields have decreased. The process of intermediation thus fails. The non-bank liquidity that finances the stock market in the short term is withdrawn and the banks have to step in to fill the gap. Do not forget that the loans were short term. Between October 22 and October 29, 1929, third-party loans dropped from 3.8 to 2.4 billion dollars while the national banks had to step in to provide additional liquidity and their exposure to the brokers rose from one to two billion dollars in just a few days to prevent the vertical collapse of the market. Nevertheless, the overall short-term credit extended to brokers fell by a billion dollars because of the reduction in credit from country banks, having clear repercussions on the trend in stock prices (Federal Reserve Bulletin 1929, Table 141). An assessment of the effects of the financial market in this period leads us to conclude that the combination of contractionary monetary policy and an anomalous volume of new issues was substantially to blame for the collapse of the stock market. The anomaly of issue refers to the fact that in 1929, the overall value of this issue rose to ten, or perhaps eleven, billion dollars of stock. Of this, 27% was issued by investment trusts and only a relatively small share of the remaining 73% went to finance the purchase of capital goods (Eddy 1937); the rest went to service the debt.

Bibliography Anderson, B. M. (1924). Cheap money, gold and monetary policy. Chase Economic Bulletin, IV(3), 9. Beckart, B. H. (1932). The New York money market, vol. III: The uses of funds. New York: Columbia University Press. Board of Governors of the Federal Reserve System. (1943). Banking and monetary statistics 1914–41. Borio, C. (2006). Monetary and prudential policy at a crossroads? New challenges in the new century (BIS Working Paper 216). Borio, C., & Zhu, H. (2013). Capital regulation, risk taking and monetary policy: A missing link in the transmission mechanism. Journal of Financial Stability, 8(4), 236–251.

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Burgess, R., & Sprague, O. W. (1929). Money and credit and their effect on business. In Recent economic changes in the United States (pp. 661–712). NBER. Census.gov. (2006). Statistical abstracts of the United States. Currie, L. (1931). The decline of commercial loans. The Quarterly Journal of Economics, 45(4), 698–709. Daglish, T., & Moore, L. (2013). U.S. bonds markets and credit spreads during great depression (Working Paper). Dewing, S. (1934). The financial policy of corporations. New York: Ronald Press. Doane, R. (1933). Measurement of American wealth. New York: Harper and Brothers. Durand, D. (1942). Basics risk of corporate bonds, 1900–42. NBER. Eddy, G. (1937). Security issues and real investment in 1929. Review of Economics and Statistics, 19(2), 79–91. Edwards, G. E. (1938). The evolution of finance capitalism. New York: Longmans, Green. Eiteman, W. J. (1932, March). The economics of brokers’ loans. The American Economic Review, XXII, 66–77. Eiteman, W. J. (1933). The relation of call money rates to stock market speculation. Quarterly Journal of Economics, 47(3), 449–463. Federal Reserve Bulletin. (1929). Fisher, I. (1932). Booms and depression. New York: Adelphi Company. Foulke, R. A. (1931). The commercial papers market. New York: The Bankers Publishing. Grebler, L., Blank, D., & Winnick, L. (1956). Capital formation in residential real estate: Trends and prospects. Princeton: Princeton University Press. Greenwood, R., & Hanson, S. H. (2013). Issuer quality and the credit cycles. The Review of Financial Studies, 6(26), 1483–1525. Hawtrey, R. (1913). Good and bad trade. London: Constable. Hearings Before the Committee on Banking and Currency. (1928). Stabilization. Hickman, B. (1958). Corporate bond quality and investor experience. NBER. Holthausen, D., Merriam, M., & Rugent, R. (1940). The volume of consumer instalment credit 1929–38. NBER. Horton, D. (1937). Long-term debt in the United States. US Department Commerce. Kuvin, L. (1936). Private long term debt and interests in the United States. New York: National Industrial Conference Board.

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Kuznets, S. (1934, November). Gross capital formation (Bulletin). NBER. Machlup, F. (1940). Stock market, credit and capital formation. London: William Hodge. McGrattan, E., & Prescott, E. (2004). The 1929 stock market: Irving Fisher was right? International Economic Review, 45(4), 991–1009. Mintz, I. (1951). Deterioration in the quality of foreign bonds issued in the United States: 1920–1930. NBER. Parker Willis, H. (1929). The failure of the federal reserve. The North American Review, 227(5), 547–556. Persons, C. (1930). Credit expansions, 1920 to 1929, and its lessons. Quarterly Journal of Economics, 45(1), 94–130. Rodd, F. (1927). The deferred payments system in the United States. The Economic Journal, 36(142), 204–214. Simmons, E. H. H. (1930). Financing American industry: And other addresses. Ann Arbor: University of Michigan Library. Smiley, G., & Keehn, R. H. (1988). Margin purchases, brokers’ loans and the bull market of the twenties. Business and Economic History: Journal of the Business History Conference, 17, 129–142. Stein, J. C. (2014). Incorporating financial stability considerations into a monetary policy framework. International Research Forum on Monetary Policy, Washington, DC, March 21. Steiner, W. H. (1935). Security markets and banking and credit. In A. Bernheim & M. G. Schneider (Eds.), The securities markets. New York: Twentieth Century Fund. Turner, P. (2013). Benign neglect of long term interest rates (BIS Working Papers 403).

5 The Great Depression

While most literature on the Great Depression has focused on the stock market crash, we must not underestimate the importance of the real estate market in deepening the recession. The shift from an agricultural economy to an industrial economy was accompanied by a process of urbanization with increasing demand for new housing financed by banks and other investors. Financing mechanisms in the real estate market were offered by various entities such as insurance companies, savings and loans associations (S&Ls), and commercial banks entering the market in the second half of the 1920s following a relaxation of the constraints on long-term loans. Alongside these traditional financing vehicles, the residential real estate market was also financed by bonds (mortgages) guaranteed by the property itself, which covered some six or seven billion dollars of financing. The real estate market was nevertheless very fragile because of the characteristics of home mortgages. Mortgages were initially short-term non-amortized loans that had to paid off in a single installment at maturity (three to five years on average). This meant in effect that the short-term loan had to be refinanced at maturity. © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_5

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Furthermore, the assessment of the property used as collateral was very often higher than its market value. Thus the effective loan-tovalue ratio was higher than required by regulations, which generally imposed a limit of 50%. This is evident from an analysis of the process of financing residential capital accumulation. The reduction of equity in this market is a clear trend emerging from an analysis of data from the 1920s. It contributes to compensating the increasing tendency of businesses to self-finance. In the long term, the equilibrium between internal and external financing of capital accumulation in the private sector remained stable thanks to these two opposing trends (Kuznets 1934). Alongside institutional investors, the activities of non-bank financial intermediaries and the characteristics of the intermediation process introduced additional fragility into the financial system. The medium-term mortgages that were instituted later were financed through bonds backed by single properties and not by the aggregate of mortgages in the issuing bank’s portfolio. This solution obviously sacrificed all the risk-reduction benefits deriving from diversification. The creditors earned more from the fixed interest rate on the bonds than they did from the interest rate on government securities. On the average, the intermediary paid an interest rate of 5% on the bond, while the homeowner paid 6–8% on the mortgage. Of course, if any of the mortgagors defaulted, the ability of the intermediary to pay the creditor who bought the bonds was compromised. We must not forget that non-bank intermediation is a process that depends on the difference between lending and borrowing rates. In this case, the fixed interest rate on these bonds initially generated problems of liquidity and then of solvency for these non-bank investors. The solution adopted by other brokers to increase their stability was variable-rate financing that could adjust the borrowing rate to revenue inflows. This would guarantee the profitability of the intermediation process even in the event of a crisis in the real estate market, an option that was missing during the Great Depression. Finkelstein and Clarke (1937) argued that a reduction in the borrowing rate was the best way to restore stability to the real estate market. If payment of interest on aggregate debt were reduced, bondholders would have had to accept a reduction in yield in exchange for the certainty of recovering their capital.

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But financing costs can only be reduced during a crisis if the market is regulated by policy and limits are placed on the possibility of calling in loans. Otherwise, a market-based interest rate would tend to increase during a crisis in the real estate market because the risk premium would rise, as we saw in 2007, causing the failure of the asset-backed commercial paper (ABCP) market that financed the securitized mortgages (Covitz et al. 2009). Lastly, this segment of the real estate market was apparently very stable because a significant share of the bonds was backed by the issuer or insurance companies who undertook to cover any financing and/or capital losses. Insurance payments lowered yield because approximately 1% of the cost was borne by the bond buyer. In any case, net yield was significantly higher than that which could be obtained from government securities even though the risk was the same. Insuring bonds in the real estate market entailed systemic risks which would crop up again in 2007–2008 with the failure of AIG. For example, the American Bankers Association reported that the four major insurance companies in New York had issued guarantees on 850 million dollars in bonds when their aggregate capital amounted to only 52 million and that this represented a significant risk if issuers defaulted on some portion of the bonds (Chamberlain and Edwards 1927). This analysis identifies an element that is often given little regard in analyses of the Great Depression: The crisis in the real estate market caused by the vulnerabilities listed above compounded the crisis in the stock market, which financed businesses. This does not mean that the real estate market was at the epicenter of the Great Depression, but it certainly contributed to making it worse, reducing the value of assets held by families and businesses. This reduction regarded both the value of homes and the near total disappearance of savings invested in bonds that financed the real estate market. If we look at the timing of the crisis and a more complete set of indicators, we note that construction in the real estate sector had begun to slow down in most parts of the USA already in 1926, starting later in the more dynamic zones of the country, in concomitance with the 1929 stock market crisis. It is likely that the funds from the stock market kept things afloat in the more dynamic parts of the economy and the real

78     G. Pizzutto

estate crisis in those areas thus hit at the same time as the October 1929 crash (Nicholas and Scherbina 2013). While the above observations are applicable to the residential real estate market, recent research has located the start of the crisis of market-financed non-residential urban mortgages (mainly offices and hotels) in 1928 (Ashcraft and Wiggers 2012). The time gap between the reduction in bond issues in 1928 and their later drop in value may be explained by price-support actions undertaken by the investment houses that still needed to place securities on the market and thus intervened in the secondary market to maintain stability in their quoted value against supply pressure (Koester 1939a). Accompanying the collapse of the stock market, the failure of the industrial and real estate bond markets was a significant contributing factor in the period we are considering. The value of stocks, estimated at 85 billion dollars in 1929, had fallen to 12 billion dollars by 1932, while 25.8% of bonds issued by corporations were in default as of December 31, 1931 (Edwards 1938). This percentage had risen to 31% in 1936 (Edwards 1942). An aggregate value for the real estate market is not available. In terms of orders of magnitude, the failures may be estimated from Koester’s (1939b) study of the Chicago market, the second largest in the USA after New York. Out of a sample of real estate bonds valued at half a billion dollars, some 70% were in default in 1931, rising to 90% in 1936. Johnson (1936) analyzed a sample of real estate bonds with a value of one million dollars or more and found higher rates of default as the issue dates approached 1929. The final issues prior to the crisis of 1929 showed the maximum default rate of approximately 75%. We may estimate the effects of the collapse of the stock market on the supply of bank credit by examining the balance sheets of Federal Reserve member banks and other banks (state banks, loan and trust companies, mutual savings banks). Goldsmith (1958, Ch. 3, p. 53) pointed out that in analyzing the financial system, it was necessary to distinguish between: 1. Financial intermediaries (depositories) who are able to create money and are thus relatively unconstrained by pre-existing deposits in their

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lending and investment activities (not individually but as a group). Federal Reserve Banks and checking departments of commercial banks fall into this category; and 2. Financial intermediaries who are not able to create currency and are thus constrained by the composition and quantity of liabilities and their net worth. The first group is important because they “produce” new credit, while the second group manages financial intermediation, in particular, modifying the terms of maturity between those holding liquidity and seeking a way to invest it, and those who use the liquidity to finance capital accumulation (businesses and families) or public expenditures (governments, public administrations). Banks and market-based financial intermediaries are not entirely disjoint entities. The assets of commercial banks include directly purchased bonds and loans to brokers to finance the purchase of stocks and bonds. In the period 1921–1930, the aggregate percentage of loans backed by financial assets and bonds rose from 38 to 41%, the percentage of loans to the real estate sector rose from 5 to 7%, while “other loans,” which included short-term commercial loans, fell significantly from 37 to 28%. The composition of US aggregate debt thus changed significantly, with extended maturities and greater market mediation. Collateralized loans amounted to 19% of total of bank assets. The collateral backing them was primarily used to finance the private sector. Loans backed by public securities fell from 1.3 billion dollars in 1919 to 100 million dollars in 1928. In the same period, loans backed by stocks and bonds rose from 2.9 billion to 7 billion. Based on a sample of banks, stocks accounted for approximately 80% (Hearings 1931). Loans to broker-dealers from Federal Reserve Banks were in the neighborhood of 23% of total collateralized loans. The New York banks were much more exposed because their investment in this sector reached 41% of their assets. Including banks and non-bank intermediaries, the share of securitized loans to broker-dealers reached 53% on the eve of the Great Depression. The rest of the loans were addressed the private sector (businesses and families). There was also a significant share of non-securitized

80     G. Pizzutto

loans to broker-dealers from non-bank intermediaries. In this case, the banks acted as agents who earned a commission on the intermediation process without investing any of their own funds. Information on this alternative financing channel (from corporations and non-bank institutions) can be found in the Federal Reserve Bulletin (1930). Of this liquidity, 58% came from corporations. If we include loans from investment trusts, this percentage grows to 66%. In this case, there was no increase in deposits or liabilities in the banking system but simply the transfer of funds from one deposit to another. The quantitative importance of loans to broker-dealers by nonbank intermediaries is absolutely relevant. In the period 1927–1929, in response to repeated entreaties by the Fed, loans to brokers by member banks shrunk significantly, while loans from non-bank sources increased considerably. These loans were not direct but were handled via banks. The reason for this is probably that the banks offered a sort of implicit guarantee to borrowers. As was seen after the crisis of October 1929, in the event that loans were not rolled over, the banks would step in and provided the liquidity that should have come from the non-bank sources to prevent, at least in part, a contraction in short-term credit and the collapse of the financial system. In short, the New York banks acted as lenders of last resort for nonbank liquidity. Between October 1928 and October 1929, loans to brokers from the non-bank sector rose from 3.7 to 6.4 billion dollars, while bank loans remained stable at around 2.9 billion dollars. To stem loans to the financial markets and cut off the alleged speculation, the Fed acted on two levels: It pressured banks to prevent an increase in credit to brokers, and it raised interest rates. The New York Federal Reserve Bank, the most important of the member banks because of its influence on the stock market, had set the discount rate at 3.5%. In October 1929 that rate rose to 6%. The progressive increase in the interest rate also affected the call money markets, where rates reached as high as 15% and even 20%. Businesses that had a great deal of liquidity, partly thanks to issues in the previous months, transferred the liquidity to the brokers until they realized that it was not sustainable because the yield from the stock market had fallen to minimum levels as

5  The Great Depression     81

a result of overvaluation. The fear of a reduction in value of the quotation drove non-financial concerns to withdraw their short-term investments and not renew them at maturity. We must not forget that the most common term for call loans was twenty-four hours. As on other occasions, the New York banks and other Federal Reserve Banks stepped in to replace the liquidity that was being withdrawn from the market, thus undertaking a part of the financing to the brokers. Within a week, a billion dollars were invested in this rescue effort with the support of the central bank, which in turn provided liquidity to banks. The intervention was not sufficient because in the following period credit to brokers from country banks and the non-banking sector continued to decrease. In December 1929, loans fell from eight to four billion dollars while stock prices fell by 30%. The bond market also witnessed losses. The risk premium increased mainly for the high-yield segment in the period following the crash (Federal Reserve of New York Annual Report 1930). For example, the yield on a BAA bond, around 5% in 1929, rose to nearly 7% the following year and to 10% in 1931 as the risk premium increased. The partial support offered by the national banks to brokers who financed the financial market was not without consequences for their balance sheets, which furthered deteriorated because of the repricing of risk on the bond market and the reduction in the value of the bonds. The situation also worsened for the state banks and other financial intermediaries following the stock market and real estate market crisis. Table 5.1 presents the principal assets and liabilities of US banks in the period 1926–1934. The data are expressed in millions of dollars and illustrate the assets held by the US banking system in the years immediately prior and subsequent to the stock market crash of October 1929. The US banking system had and still has a very complex structure. The system included the national and state banks in the Federal Reserve System, the commercial banks outside of the Federal Reserve System that thus did not have access to Fed credit, and mutual savings banks. The value of the financial assets held by commercial banks outside of the Federal Reserve System has been calculated by subtracting the value of the assets in the portfolios of state banks that were members of the Federal Reserve System from the total assets of state banks.

82     G. Pizzutto Table 5.1  US bank assets (1926–1934) (millions of dollars) Date

All banks

National banks

State member banks

State non-member banks

Mutual savings banks

1926 1927 1928 1929 1930 1931 1932 1933 1934

51.4 53.6 57.6 58.9 58.5 55.1 46.3 40.3 42.5

19.1 20.2 22 21.4 21.7 20.8 17.4 15.4 17

12 12.5 13 14.2 13.9 13 10.5 9.3 10.1

12.3 12.3 13.4 13.7 14.9 10.9 8 5.5 5.5

7.9 8.5 9.1 9.4 9.6 10.4 10.2 9.9 9.8

Source Board of Governors of the Federal Reserve System, Banking and Monetary Statistics

Membership in the Federal Reserve System was voluntary, and many state banks preferred to remain outside so as not to be subject to reserve requirements, believing they could obtain the liquidity they needed indirectly by turning to member banks (Anderson et al. 2018). On the aggregate level, this choice quickly demonstrated its limitations given the fact that the most significant contraction of assets and credit after the crisis of 1929 was among banks that were not members of the Federal Reserve. Table 5.1 shows substantial stability in aggregate value of the assets in the portfolios of national and state banks up to 1931. A disaggregate analysis of loans and investments provides a more detailed view of the interrelations between the banking system and the financial markets. Table 5.2 describes the trend in security loans and investments by Federal Reserve member banks in the period 1928–1932. The data refer to a subset from Table 5.1 and are particularly significant because they describe the trend in loans by Federal Reserve Banks secured by stocks and bonds. A significant increase is observed in the period in question, reaching its peak prior to the crisis of October 1929 and then rapidly falling off. Loans on securities to broker-dealers make up a significant share of all collateralized loans provided by the banks. At the same time, to understand the operation and crisis of the financial system it is useful to remember that the banks financed only a part of these intermediaries.

5  The Great Depression     83 Table 5.2  All member banks loan on securities, except to banks 1928–1933 (millions of dollars) Date

Total

To broker-dealers in New York City

To broker-dealers To others outside New York City

October 1928 October 1929 October 1930 October 1931 October 1932 October 1933

8545 9994 10,336 7770 5500 4557

1899 1885 2472 928 414 748

850 939 774 521 258 178

5796 7170 7090 6321 4828 3031

Source Board of Governors of the Federal Reserve System, Banking and Monetary Statistics Table 5.3  Brokers’ loans by and through reporting member banks in New York City (Table 18, p. 1020, Appendix VII - millions of dollars) Date

For own account

For account of out-of-town banks

For account of others

Total

January 27, 1926 January 26, 1927 January 25, 1928 January 30, 1929 October 2, 1929

1,201 865 1,275 1,091 1,071

1,287 1,126 1,472 1,853 1,826

610 741 1,041 2,615 3,907

3,098 2,732 3,789 5,559 6,804

Source Federal Reserve Bank of New York

Table 5.3 presents total financing to broker-dealers from 1926 to 1929. Table 5.3 is divided into three types of loans: direct loans from the Federal Reserve Banks of New York (own account); loans from out-oftown banks passing through the Federal Reserve Banks of New York; loans from non-bank intermediaries that used the New York banks as agents (others). A more precise comparison of bank loans with respect to loans by non-bank intermediaries must consider the fact that the liquidity supplied by banks outside of New York City was only in part a direct investment by banks. Oftentimes in this case, the banks acted as intermediaries between non-bank investors who had liquidity and brokers. Financing to brokers also relied on other financial intermediaries such as private banks. Table 5.4 shows overall financing received by brokers from October 1928 to October 2, 1929, the eve of the stock market crash.

1,807 2,008 1,860

October 1928 January 1929 October 1929 2,835 3,346 4,944

866 1,071 1,472

Others by New York From private banks banks to New York exchange members 805 925 893

6,313 7,350 9,169

To brokers outside Total of New York

Source Federal Reserve Bank of New York, Federal Reserve Board, New York Stock Exchange

Bank account by New York banks

Date

Table 5.4  Total brokers’ loans (Table 20, p. 1021, Appendix VII - millions of dollars)

84     G. Pizzutto

5  The Great Depression     85

Loans to brokers are different from bank loans. They do not create new deposits but merely transfer funds from one deposit to another. They constitute liabilities in the banking system because the banks have to cover for the non-bank liquidity in the event that this liquidity is withdrawn from the money market. The central reserve banks (New York and Chicago) increased their credit in the two years following the collapse of the stock market. This does not mean an increase in credit to the private sector to finance investments, but simply the substitution of bank credit with short-term non-bank credit that had been offered to brokers the previous year. The funds offered by the big corporations and investment trusts covered 66% of financing to brokers in 1929. This share dropped to 22% in the months following the decision to close those positions and was partially substituted by credit from the central reserve banks. The US financial system thus consisted of the banks flanked by the money market that financed the capital market. Broker-dealers relied on short-term wholesale funding to finance their securities business (see Table 5.5), and this fact is a source of fragility in the financial system. The crisis in this intermediation mechanism then had repercussions for the banks and the credit supply. After the crisis of 1929, the banks found themselves forced to reduce loans and investments and redesign the compositions of their portfolios. From the end of 1929 to the last quarter of 1931, the US banking system reduced the quantity of commercial loans and thus the quantity of available assets that the Fed would accept as collateral. On the other hand, on the aggregate level, the banks reduced their financing to brokers, with the exception of the intervention of the Federal Reserve central banks. The levels of secure loans and real estate loans remained Table 5.5  Brokers borrowing 1926–1929 (millions of dollars) Date

Total

On demand

On time

September 1926 September 1927 September 1928 January 1929 September 1929

3,219 3,915 5,514 6,735 8,549

2,419 3,018 4,690 5,983 7,832

800 897 824 752 717

86     G. Pizzutto

stable. The stability of secure loans from banks means that in the two years following the crash of 1929, the banks partially took the place of brokers in directly financing businesses and families, accepting financial assets as collateral. The reduction in the offer of credit was nevertheless significant because of the simultaneous reduction of financing on the money market by corporations and investment trusts. Another way we can assess the net assets of the national banks is by distinguishing between assets that may be considered liquid and easily salable on the market, and illiquid assets. The former category includes commercial papers, cash, bank acceptances, net lending to banks, discountable loans to the central bank, government securities, and loans backed by government securities. The latter includes all non-government bonds, loans backed by non-government bonds, real estate loans, and loans that cannot be discounted to the Fed. Edwards (1938) examined the trends of these two categories in the period 1923–1933. The percentage of liquidity on the balance sheet decreased prior to the crisis of 1929. In particular, the percentage of illiquid assets in the portfolio of the central reserve city banks was 24% in 1923 and dropped to 15.6% in 1929, while the illiquid assets, including loans to broker-dealers rose from 75 to 80%. The reserve city banks remained relatively stable in the period 1923–1929, while the percentage of reserve assets (liquidable assets on reserve) in country bank portfolios decreased from 38% of total assets in 1923 to 29% in 1929, while illiquid assets rose from 62 to 71%. After 1929, the banks were mainly concerned with their survival and thus the share of liquid assets increased. The liquid assets in the Federal Reserve Banks rose from 19% in 1929 to 24% in 1930 and 37% in 1933. The percentages did not appear to change, at least in 1930 and 1931, for nationally and state-chartered banks. This is probably explainable by the fact that the values of the illiquid assets were not ­registered at their market value but at their historical cost, and thus the share attributed to them was greatly overestimated with respect to their ­effective value. The progressive reduction of liquidity in bank portfolios went in step with the reduction in the value of bank capital with respect to their

5  The Great Depression     87

illiquid assets, non-government bonds in particular. The ratio of net capital to illiquid assets, an important indicator of the solvency of the banking system, decreased for all three categories of national banks (Federal Reserve Banks, nationally chartered commercial banks, and country or state-chartered banks). In particular, in 1929, the ratio for Federal Reserve Banks was 194%, decreasing to 176 and 137, respectively, in 1930 and 1931. In 1929, the ratio for the nationally chartered commercial banks was 91%, decreasing to 88 and 65 in the following two years. The condition of the country banks was still worse, with a ratio of net capital to illiquid assets of 49%. The value of the securities in national bank portfolios decreased significantly in 1929–1931. This is partly because, in the event of need, the banks first liquidated their low-risk assets to avoid having to write them off as capital losses, and thus the average quality of their portfolios deteriorated after the crisis of 1929. An approximate assessment, deduced from the bond prices on the NYSE, places the cumulative value of the depreciation in 1932–1933 at 40%, very close to the value of net capital (Edwards 1934). It is quite probable that this assessment of the public and private bond market, in reference to the official Wall Street exchange, underestimates the size of the capital losses because trade on this market takes place mainly outside of organized markets. This is also true for the new issues market. The fragmentation and dispersion of information on this market made transaction costs significantly higher, liquidity lower, and the difference between bidding and asking prices higher than on organized markets. The cost of bonds was thus lower than those on which transactions in organized markets were based (Biais and Green 2007). The progressive weakening of bank balance sheets following the 1929 crisis and the contraction in loans drove banks to increase their investments to replace direct loans to the public sector. In 1930, this allowed the bond market to maintain stable prices. The most significant ­adjustment was the fact that the banks also began to purchase public bonds, which had represented a negligible share of bank portfolios in the 1920s but rose to 16% in 1931. Thus the composition of bank assets changed from a portfolio dominated by credit to the private sector to one where public bonds gained

88     G. Pizzutto Table 5.6  All member banks: investments 1928–1934 (millions of dollars) Date

Total

US government

Other securities

October 1928 October 1929 October 1930 October 1931 October 1932 October 1933 October 1934

10,904 9749 10,734 12,199 12,121 11,894 15,267

4386 4022 4095 5564 6366 6801 9895

6218 5727 6639 6635 5755 5093 5372

Source Board of Governors of the Federal Reserve System, Banking and Monetary Statistics

an increasingly significant share as source of revenues, taking the place of shrinking credit to the private sector, and added liquidity, since public securities could be used as collateral with the Fed in refinancing operations (Table 5.6). Table 5.6 illustrates the distribution of assets in the portfolios of Federal Reserve member banks in the period 1928–1934. The last quarter of 1931 represented a turning point for the US banking system due to the compound effect of a number of negative factors. First among them was a fall in bond prices as seen in Table 5.7, aggravated by the fact that some 60% of the bonds issued to finance the real estate market were considered deteriorated (Commercial and Financial Chronicle 1932, p. 3384). At the same time, skepticism about the solvency of the banking system drove the public to increase their demand for currency, forcing the banks to increase their liquidity and further decrease their commercial and secure loans, asking borrowers for early payment of debts, refusing to roll over corporate loans, and selling bonds. This was an additional factor hobbling the bond market. The liquidation of loan and investment stocks amounted to 2.5 billion dollars in that period, but it was not enough to restore the levels of liquidity that the banking system needed to cope with the bank run. To complete our analysis of the contraction of credit, we must also analyze the balance sheets of state banks that were not members of the Federal Reserve. The importance of these banks has not been fully recognized. In 1929, the overall value of financial assets in the portfolios

103.69 104.09 104.21 103.98 104.64 101.88 99.49 97.13

July 1930 October 1930 January 1931 April 1931 July 1931 October 1931 December 1931 January 1932

Source New York Stock Exchange Bulletin

101.73 103.33 102.69 103.37 104.45 98.12 96.42 88.44

US government State, county, and municipal

Date 93.82 95.98 91.04 91.29 89.40 76.20 67.49 63.13

94.68 96.94 94.08 95.84 95.91 88.59 86.76 81.82

Rail-road Public utility 93.37 95.08 89.97 90.76 89.01 77.32 71.52 66.53

All US companies 97.43 97.20 95.26 95.89 95.49 72.73 60.88 59.90

Foreign government

82.81 80.56 75.01 80.12 76.02 53.12 51.19 48.07

Foreign companies

97.64 98.83 95.90 96.40 95.86 88.34 84.13 80.19

All American Bonds

Table 5.7  Average prices of bonds listed on the New York Stock Exchange, 1930–1932 (indexed to the year 1929 = 100)

5  The Great Depression     89

90     G. Pizzutto

of these banks amounted to 16.8 billion dollars. The value decreased to 15.2 billion in 1930, 13.1 billion in 1931, and then collapsed to 6.5 billion in 1933. In the pyramid structure of the US banking system, the banks that were not members of the Fed kept their reserves on deposit in central reserve banks, which were forced to increase their liquidity to meet demand from non-member banks by decreasing their offer of credit. The interbank network, which maintained a fragile equilibrium between the regulated and non-regulated parts of the system, ended up amplifying the crisis of the financial markets and the banking system (Mitchener and Richardson 2016). Our aggregate analysis of the US banking system has described the effects of deflation in the financial markets on bank balance sheets and supports the hypothesis that the contraction of credit and bank failures that came with it was initially attributable to a reduction in the value of financial assets held in the portfolios of commercial banks. This interpretation differs from that of Friedman and Schwartz (1963), who concluded that the failure of the banking system was the result of a problem of illiquidity that the monetary authorities were not able to resolve with expansionary monetary policy. More than the liabilities of the banking system, what we must examine is the composition of the assets portfolio, seeking to understand how the weakening of the balance sheet was a harbinger of the increase of demand for liquidity by the public. The literature that initially attempted to explain the Great Depression was characterized by the debate between monetarists and Keynesians. Friedman and Schwartz (1963) vigorously defended the idea that the problem of the Great Depression was substantially a problem of illiquidity due to an exogenous shock to the money supply and to the money multiplier that the Fed was not able to handle, adopting stable or contractionary monetary policy when it would have been necessary to increase the money base via open market operations and loans to the banks. In terms of the model of the 1960s, this means a shift of the LM curve due to an increase in demand for money, a shock that impacted bank liabilities. Temin (1976), on the other hand, argued that this shift did not have to do with money but with aggregate demand, a shift in

5  The Great Depression     91

the IS curve induced first of all by uncertainty created after the crisis of 1929 (Romer 1990). A third explanation, proposed by Bernanke, complementary to Friedman and Schwartz, is based on the premise that the monetary hypothesis cannot explain a multi-year recessive phase, and so he shifts his attention from money to the financial market. The failure of this market to function properly explains, without needing to resort to hypotheses of irrational behaviors by the agents of the economic process, why the recession continued for many years. In the complete markets (a.k.a. Arrow and Debreu markets) hypothesis without bankruptcy, the explanation would not be problematic. In conditions of incomplete markets, the contracts between lenders and borrowers are drawn up without a detailed definition of how resources will be redistributed in the event of a bankruptcy. The condition of incompleteness is reduced if the incomplete contract is supplemented by shifting the burden of guarantee to the lender. In this case, the reduction in the value of the collateral increases the cost of the bank intermediation process in several ways. First of all, it increases the difference between the interest rate for risk-free assets and higher risk assets. Secondly, the banks providing the credit can decide not to extend more credit to a part of the private sector, instead shifting it to more secure sectors such as public debt. The decrease in the value of the collateral thus reduces the possibility of obtaining credit by potential creditors, aggregate demand shrinks, and the economy enters a recession. The introduction of financial markets into the explanation of the Great Depression represents a step forward with respect to the pre-­existing literature, even if it is based on the assumption that the financial market is characterized by costs associated with incomplete information that banks act to reduce. The interest rate as an intermediation cost tends to increase when the value of collateral decreases, or worse yet, the intermediaries abandon the field for other sectors with lower risk. Bernanke’s contribution is important because it marks the first step in considering the importance of financial markets, a view that would be reprised after the financial crisis of 2007–2008. But some pieces of the puzzle are still missing. Bernanke admits that his description does not take into consideration the period before the

92     G. Pizzutto

crisis of 1929 and the factors causing the explosion, but limits himself to explaining why it lasted so long. In the second place, he does not analyze the action of the financial market, where incomplete information and the cost of intermediation are not such big problems, and hence, the link between financial markets and the banking system is somewhat nebulous in his analysis. Let us start from the assumption that the operation of the financial system depends on the banking system and the financial markets. The interaction of these two systems with monetary policy generally produces satisfying results, decisively favoring growth and increase in living standards. When the credit mechanism is interrupted, the repercussions are significant, causing a slowdown in growth and employment that may continue for years. With respect to Bernanke’s analysis, the description of the operation of the financial system that we are proposing takes two additional elements into consideration: the operation of the financial market; and monetary policy in both an expansionary and a contractionary phase (so that we can understand its effects on the trend in credit). A third element regards the distinction between banks and markets. The banks do not intermediate savings and investments but create credit independently of deposits. The production of credit is uncoupled from deposits and savings. The deposits can increase only if there is an increase in the assets of the banking system. The banks offer a service to its depositors: management of a payment system. The depositors obtain this service at a very low cost because they allow the bank to use their deposits. On the aggregate level, the banking system cannot increase or decrease its deposits based on savings decisions. If an individual decides to manage his savings in a different way, the consequences are merely a transfer of funds from one deposit to another. The reconstruction of the relations between monetary policy and the financial system is based on the assumption that expansionary monetary policy entails a lowering of interest rates and an increase in the amount of private indebtedness. The 1920s were characterized by these two elements, which reduced the risk premium and contributed to high aggregate demand. The instrument of open market operations allowed the Fed to minimize fluctuations in the money base caused by inflows and outflows of gold, keeping bank credit stable in anticyclical mode as in 1927.

5  The Great Depression     93

In the USA, the relations between banks and markets are complicated by a restrictive regulatory framework that has always sought to prevent the expansion of individual banks, intervening both as regards their dimensions and the composition of their portfolios, thus causing a much greater expansion of the financial markets than has been seen in Europe. The 1920s in particular were characterized by an increase in bank credit, but especially by an increase in stock and bond issues. This favored the accumulation of capital on the one hand and the restructuring of the debt on the other. The structure of business debt changed over time. Businesses initially reduced their short-term exposure in favor of long-term debt. Later, especially in 1928–1929, they looked for financing on the stock market given its favorable conditions. The Fed did not change its policy grounded in the real bills doctrine and continued to consider only short-term bonds as acceptable financing instruments. It never considered the need to expand the portfolio of financial assets by including long-term financial instruments, thus weakening its function as lender of last resort during the bank crisis of 1933. As Eccles noted in the Committee on Banking and Currency (1935), only 12% of the assets in Federal Reserve member banks could be used as collateral for a loan from the Fed. In 1935, that percentage had decreased to 8%. In spite of requests to change this policy, the Fed continued to select assets that could be used for the discount on the basis of their characteristics: Timeframe, short-term maturity, and self-liquidation continued to be fundamental discriminating factors. Conversely, financial assets traded on markets were classified as speculative. The problem of the increase in credit must thus be seen as a relationship between banks and financial markets that provide credit to the private sector within a context whereby the Fed’s role as lender of last resort was limited because only short-term commercial assets were accepted as collateral. Meanwhile, the lion’s share of financing took place on the market, where the banks extended credit to brokers and indirectly financed capital accumulation and the restructuring of business debt. The mechanism worked as long as the Fed kept interest rates low. After the expansionary intervention in 1927, the Fed began to keep an eye on the stock market, even though monitoring this market was not

94     G. Pizzutto

one of its traditional objectives. But given the belief that the stock market was siphoning off credit from the real economy and thus preventing the central bank from fulfilling the purposes laid down in its charter, the stabilization of the stock market became a necessary goal. Control over stock prices and the alleged stock market speculation was not exclusively the Fed’s idea. The German central bank took a similar stance and implemented restrictive monetary policy starting in 1927, before a similar policy was implemented by the Fed. Restrictive monetary policy consisted in asking member banks to shut off the flow of credit to brokers and was coupled with a progressive rise in interest rates at a time when stock issues were skyrocketing. The Federal Reserve interest rate rose from 3.5% in 1927 to 6.5% in 1929. Yielding to pressure from central policymakers, the member banks called in credit from brokers. Meanwhile, attracted by the high rates on the call money market, big corporations and institutional investors transferred their available liquidity to the brokers, effectively taking the place of the banks and fueling a system that the Fed had sought to stifle. Given that the initial increase in interest rates did not produce the hoped-for results, the rates were pushed up still further with the explicit objective of stopping the rise of prices on the stock market. The increase in the discount rate to 6.5% in 1929 translated into a much higher increase of interest rates on the call loan money market, the arena for the loans requested by broker-dealers. On some days, interest rates on this market approached 12% (Federal Reserve Bank of New York 1929). The interpretation of the increase in loans to brokers—initially by the banking system and then by the non-bank sector, a channel where speculation was financed via acquisitions on margin—must be rethought by analyzing the relation between the clearinghouse that consolidated transactions among broker-dealers on the NYSE and the skyrocketing loans prior to the crisis. In order to buy or sell stocks on the NYSE, it was necessary to open an account at the Stock Exchange Clearing Corporation. The purchase or sale of stocks by Party A was made with respect to the sale or purchase by Party B. Any broker acting on behalf of numerous clients thus had to simultaneously buy or sell financial assets. The operations handled by the clearinghouse allowed brokers only to settle the deposits and withdrawals from their account. The

5  The Great Depression     95

request for a purchase on margin did not mean that the broker had to ask for a loan from a bank. At the end of the day, some brokers were in debt to the clearinghouse, while others had a surplus. The former requested credit from the bank at the end of the day, while those who had a surplus used it to pay down their bank debt. The brokers loaned money on a collective basis, and the clients borrowed individually. This mechanism changed if someone decided to close his account and leave the market. In this case, the broker had to borrow money to finance the requests of its client. Most importantly, broker debt increased when the stock of financial assets increased as a result of new issue. When new instruments are issued and underwritten by investment banks, they go through the clearinghouse and then are acquired by the corporations that issued them. When the corporations call in these funds, the brokers have to borrow money. It is the difference between income and outlay that generates the demand for credit, not the demand for purchases on margin by the client of a brokerage house (Eiteman 1932; Machlup 1940). Favorable stock market conditions in 1929 motivated businesses to increase their issue and restructure their debt (Table 5.8). The largest share of these stock issues was from financial companies and investment trusts whose stocks represented something completely new in the US market. The investment trusts were the equivalent of today’s investment funds. They thus issued stock to purchase existing stock, finding a fertile market fed by the idea that portfolio diversification meant reduced risk. In 1927, the stock issued by investment trusts amounted to approximately 300 million dollars. In January–August 1929, this figure rose to 2.2 billion dollars (Federal Reserve of New York 1929). Such large quantities of newly issued stock obliged brokers to turn to the market, which was initially fed by the banks. The intervention of the Fed to block this type of financing had its effect because bank credit to brokers decreased. But the simultaneous increase in interest rates attracted non-bank liquidity to the market from institutional investors, country bank reserves, and especially from corporations, whose liquidity had increased partly thanks to the financing obtained on the stock market, which was funneled back into that market because of the high yields that

96     G. Pizzutto Table 5.8  US capital issues 1927–1932 (millions of dollars) Date

Total domestic and foreign

State and Total domestic municipal issues

Corporate bonds and notes

Stocks

Foreign issues

1927 1928 1929 1930 1931 1932

7,556 8,040 10,091 6,909 3,089 1,165

6,219 6,789 9,420 6,004 2,860 1,157

3,183 2,385 2,078 2,980 1,240 305

1,474 2,961 5,924 1,503 311 20

1,337 1,351 671 905 229 8

1,475 1,379 1,418 1,434 1,235 755

Source Hearings (1935)

could be achieved there (Eiteman 1933). The monthly Federal Reserve Bulletin estimated corporate loans to brokers at 57% of the total. The liquidity arriving on the call money market was mainly short-term (overnight) liquidity similar to that handled today by money market funds. The stocks offered as collateral were prevalently new issue that the brokers had to finance so they could distribute them. While a portion of these stocks remained in the broker-dealers’ portfolio, their debt to the money market grew. Non-bank financial intermediaries thus assumed an important role in the final phase prior to the October stock market crash. Further analysis of the relation between monetary policy and non-bank intermediation may offer new possibilities of interpretation that shed additional light on the crisis of 2007–2008. In 1929, new stock issues reached 11 billion dollars, far more than the value of issued bonds. As Hollander (1911) noted, the money market played an important role in financing the transition from issue to final placement of the stocks and bonds. The broker-dealers borrowed money on the money market using the stocks in their portfolio as collateral. They used the borrowed money to purchase stocks issued by corporations, which are given the guarantee that the entire amount will be repaid to them within a very short time span. The reason that newly issued stocks are not sold directly to the final investors by the corporations lies in the uncertainty regarding the time span of the process of placement and the degree of coverage of the issued stock.

5  The Great Depression     97

One of the services provided by investment banks and broker-dealers is an immediate response to the needs of corporations, eliminating the placement process that might take a long time and not meet the corporation’s financing objectives. The US mechanism thus implied immediate availability of funds to the corporation that were guaranteed by the investment bank and its associated underwriter syndicate and by the broker-dealers who distributed the newly issued financial assets, unlike in England, where payment began on the fifteenth day after the issue (Steiner 1935). Furthermore, the investment banks supported the prices of the new stocks in the sixty days following their initial placement. This type of action was forcefully defended as a positive trait of the US financial market by the principal investment bankers of the day, who argued for the need to stabilize stock prices to ensure balanced distribution of newly issued stock and prevent volatility of quotations, which might lead to losses for the underwriters (Kuhn in Hearings 1936; Stock Exchange Practices 1932–1934, also known as the Pecora Report). The support activity not only regarded securities in the placement process but also other securities with similar characteristics present on the market, all with the objective of favoring the phase following the initial financing, when the investment banks distributed the assets in their portfolios to institutional investors or individuals. This activity generally lasted sixty days, but could stretch to as long as six months (Hearings 1936; Stock Exchange Practices 1932–1934; Edwards 1942). This function too had to be financed via loans on the money market, which in some cases were quite large, especially when stocks were shortsold with the aim of weakening quotations. Anderson (1949) noted that, just prior to the crisis of October 1929, the inability or unwillingness of an investment bank to defend the value of a security subject to underselling set off a rush to sell at market prices and the collapse of Wall Street. The inability to oppose short-selling is a clear signal of an incipient liquidity crisis and accentuates pressure to undersell. The intermediation mechanism financed itself on the money market and the interest rate on the call money market represented the cost of financing trading positions and underwriting new dealer stock issues,

98     G. Pizzutto

accompanied by interventions to stabilize the quotations of issued securities. The contractionary monetary policy implemented by the Fed in 1928 with the goal of stopping credit from draining into financial speculation had the specific objective of deflating stock prices by gradually increasing the discount rate. The rationale for this position was the idea that loans to brokers were necessary to finance purchases on margin, and thus the increase in the cost of debt would have eaten away at the profitability of this type of operation because the expected capital accumulation would not have been enough to compensate the payment of the interest on the loan that financed the purchases (Hamlin in Hearings Before Banking and Monetary Committee 1936). This position was widely shared among members of the Fed community (for a partially opposing position, see Hardy and Owens 1924). Our goal here is to understand how a progressive increase in the interest rate produced the consequence of a fall in stock market quotations. The market-mediated intermediation mechanism functions and guarantees efficiency and liquidity at normal times when the difference between the yield on receivables and financing costs is amply positive. A prolonged increase in interest rates has the consequence of a reduction in the value of financial assets in the portfolios of intermediaries at a particularly difficult time, when they are trying to sell stocks issued by corporations as quickly as possible on the market. The interest earned by the dealers in this process is known as underwriting spread and is equal to the difference between the price at which they sell the newly issued stocks on the market and the price they pay to the corporations. This spread must be compared to the cost of financing to assess the profitability of the intermediation process and ensure a positive carryover. Competition to control the market for new stock issues was accentuated due to the entry of national banks. The investment bankers no longer had exclusive control over the new issues, and the competitiveness of the national banks grew to the point where, in 1929, they controlled more than half the market. This increase in competition led to a reduction in yield on this type of asset, which was compensated by an increase in volumes traded. The market was characterized by an increase

5  The Great Depression     99

in credit supply at favorable conditions. The corporations took advantage of this to restructure their debt, altering the composition of their capital and increasing the share of stocks in their balance sheets, replacing debt with stocks. The structural factor and the reduction of yield accompanied contractionary monetary policy, which increased the cost of financing while at the same time reducing the value of the portfolio of financial intermediaries, who were forced to liquidate some of their assets to avoid bankruptcy when the financers did not renew short-term credit at maturity or asked for a higher interest rate due to the higher risk associated with collateral that was losing value. The reduction in the value of assets is accentuated by the recessive effects of the monetary policy on profits and thus on the ability of businesses to pay interest on their debts and pay out dividends. Contractionary monetary policy had already had a dampening effect on production prior to the collapse in October 1929 (Fabricant 1934). These factors reduced the profitability of financial intermediation and the subsequent liquidation of newly issued stocks that still had to be placed on the market. In October 1929, the liquidity of the stock market was no longer provided by the banks, which, in response to repeated urging by the Fed, reduced their financing of the stock market. The increase in interest rates that followed attracted liquidity from the non-bank sector because of high yields. A large part of this liquidity came from corporations, deriving from funds obtained via earlier stock issues that were once again placed on the money market because of the high interest rates. In October 1929, this liquidity was withdrawn from the market, and in a short amount of time, the short-term debts were partially replaced by financing from national banks supported by the Fed and in part settled by the liquidation of dealers’ assets. The margins requested by brokers were rather high, and thus the liquidation probably took place with purchase orders without price limits, which were satisfied in return for a significant drop in quotations. Fire sales damaged the balance sheets of the entire bank and non-bank financial system following an initial shock caused by the simultaneous withdrawal of non-bank investors from the market, who up until then had ensured liquidity even though it was at increasingly high interest rates.

100     G. Pizzutto

The fact that the differential between the call money market interest rate and other short-term interest rates rose slowly in the months leading up to the crisis (McGrattan and Prescott 2004) means that the investors’ aversion to risk was increasing and reflected in a higher risk premium. The epicenter of the crisis was the poor operation of the financial system. We may note that the increase in the ratio of circulating capital to deposits, a signal of a bank run, was accentuated only in 1931. In the previous period, the demand for circulating currency had decreased. The interpretation by Friedman and Schwartz describes the second phase of the crisis in the financial system and the banking system. The initial shock struck the non-bank intermediation system, and its failure then spread to the banking system. The reduction in the value of bank portfolios translated into a contraction of credit. The financial intermediation process was confronted with two types of interrelated risks: the reduction of the value of the financial assets held in the portfolio and the refusal by financers to roll over expiring short-term debt. The crisis of 1929 can be interpreted as a run on the brokers, who found themselves forced to sell off the assets in their portfolios on margin to avoid going bankrupt. The number of bankruptcies among the brokers was rather limited, but this can be explained by the fact that the margins were rather high, and thus the earnings deriving from the sales without limit on price were sufficient to cover the debts.

Bibliography Anderson, B. (1949). Economics and the public welfare. Princeton, NJ: Van Norstrand, Inc. Anderson, H., Calomiris, C., Jaremski, M., & Richardson, G. (2018). Liquidity risk, bank networks, and the value of joining the Federal Reserve System. Journal of Money, Credit and Banking, 50(1), 173–201. Ashcraft, A., & Wiggers, T. (2012). Defaults and losses on the commercial real estate bonds during the Great Depression era (Federal Reserve Bank of New York Staff Reports 544). Biais, B., & Green, R. (2007). The microstructure of the bond market in the 20th century (IDEI Working Paper 482).

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Chamberlain, L., & Edwards, G. (1927). The principles of bond investment. New York: Henry Holt. Commercial and Financial Cronicle. (1932). A weekly newspaper representing the industrial and commercial interests of the United States. Covitz, D., Liang, N., & Suarez, G. (2009). The evolution of the financial crisis: Panic in the asset-backed commercial paper market (FEDS 36). Edwards, G. W. (1934). Liquidity and solvency of national banks, 1923–33. The Journal of Business of the University of Chicago, 7(2), 161–172. Edwards, G. W. (1938). The evolution of finance capitalism. New York: Longmans, Green. Edwards, G. W. (1942). The myths of the security affiliates. The Journal of American Statistical Association, 37(318), 225–232. Eiteman, W. (1932, March). The economics of brokers’ loans. American Economic Review, XXII, 66–77. Eiteman, W. (1933). The relation of call money rates to stock market speculation. Quarterly Journal of Economics, 47(3), 449–463. Fabricant, S. (1934). Recent corporate profits in the United States. NBER. Federal Reserve Bank of New York. (1929). Economic Policy Review. Federal Reserve Bulletin. (1930). Federal Reserve of New York Annual Report. (1930). Filkenstein, M., & Clarke, J. (1937). Mortgage banks: A study in real estate finance. St. John’s Law Review, 12(1), article 3. Friedman, A., & Schwarz, A. (1963). A monetary history of the United States, 1867–1960. Princeton: Princeton University Press. Goldsmith, R. (1958). Financial intermediaries in the American economy since 1900. Princeton: Princeton University Press. Hardy, C. O., & Owens, R. (1924). Interest rates and stock speculation. London: Macmillan. Hearings Before a Subcommittee of the Committee on Banking and Currency. (1931). Hearings Before a Committee on Banking and Currency. (1935). The Banking Report Act of 1935. Hearings Before the Committee on Banking and Currency. (1936). Stock exchange practices. Hollander, J. H. (1911). Bank loans and stock exchange speculation. National Monetary Commission. Johnson, E. (1936). The record of long term real estate securities. Journal of Land and Public Utilities Economics, 12, 44–48.

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Koester, G. (1939a). Chicago real estate bonds, 1919–38: I. Corporate history. The Journal of Land & Public Utility Economics, 15(1), 49–58. Koester, G. (1939b). Chicago real estate bonds, 1919–38: II. Market behavior. The Journal of Land & Public Utility Economics, 15(2), 201–211. Kuznets, S. (1934, November). Gross capital formation (Bulletin). NBER. Machlup, F. (1940). Stock market, credit and capital formation. London: William Hodge. McGrattan, E., & Prescott, E. (2004). The 1929 stock market: Irving Fisher was right? International Economic Review, 45(4), 991–1009. Mitchener, K. J., & Richardson, G. (2016). Network contagion and interbank amplification during the Great Depression (NBER Working Paper 22074). Nicholas, T., & Scherbina, A. (2013). Real estate prices during the roaring twenties and the Great Depression. Real Estate Economics, 2, 278–309. Romer, C. D. (1990). The great crash and the great depression. Quarterly Journal of Economics, 105(3), 597–694. Steiner, W. H. (1935). Security markets and banking and credit. In A. Bernheim & M. G. Schneider (Eds.), The securities markets. New York: Twentieth Century Fund. Temin, P. (1976). Did monetary forces cause the great depression? New York: W. W. Norton.

6 The Money Market After World War II: Securitization and the Role of Dealers

The financial crisis of 1929 and following years had significant repercussions for the new issues market and the composition of bank portfolios. Firms were more than satisfied with the financing they had obtained in previous years. Furthermore, the contraction in aggregate demand prompted companies to postpone capital expenditures. The market for new stock issues all but dried up, while bonds continued to be issued to finance major ongoing projects initiated by corporations in the utilities sector. The funds were thus invested in multi-year projects planned in the years prior to the 1929 crisis. The collapse of new projects was accompanied by the near complete disappearance of demand for financing in the private sector (Edwards 1938). On the other hand, public spending began to increase in the 1930s and the bulk of financing shifted from the private to the public sector. This trend was accentuated when World War II broke out and the government securities market, which had all but disappeared at the end of the 1930s, regained a central role in the US financial market. The banking system responded to the economic crisis by reducing credit to the private sector because of the associated risk and compensated for this reduction by increasing investments in government securities. © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_6

103

104     G. Pizzutto

Government securities as a share of total debt rose from 9% in 1929 to 74% in 1951 (Woodlief 1952). The financial intermediation process of the 1930s witnessed the decline of the money market as a short-term financer of corporate stock and bond issues via broker-dealers. For many years, the liquidity created within the private sector (corporations, commercial banks, and institutional investors) found no profitable use. Things changed after World War II when the Fed abandoned the interest rate policy it had pursued to help finance the Treasury and concentrated on macroeconomic objectives (agreement of March 4, 1951), with a consequent increase in interest rates and their volatility (see Chandler and Harris in Hearings 1954). The new conditions on the money market prompted broker-dealers to seek less costly sources of financing than bank loans. Having financed the issue of new stock on the primary market and the positions of dealers on the secondary market up to 1929, the money market changed function, transforming into a source of liquidity to finance government securities trading and underwriting. Repurchase agreement (repo) financing once again rose to dominate this market, where government securities had replaced stocks. The difference in the collateral accepted on the financial market implied an almost inexistent margin compared to what had been demanded on the stock market in the 1920s, but also a reduction in its volatility. Investments in the money market in the early 1920s were the result of a transfer of reserves from country banks to the New York banks, where they were used to finance purchases on the stock market. The banks considered these assets to be secondary reserves that were extremely liquid and secure because they were backed by collateral. Nevertheless, this was a highly volatile market because the central bank always refused to intervene to stabilize the call money rate and never considered the possibility of accepting this type of financial asset as collateral for its loans (see Woodlief 1952 regarding differences in attitude and monetary policy in collateral accepted by the Fed). The extreme volatility and ease with which collateral was liquidated was a guarantee of the reliability of the investment for the lender, but it increased the systemic risk, as seen in the crises of 1907 and 1929.

6  The Money Market After World War II …     105

The attitude of the Fed toward government securities, on the contrary, aimed to avoid excessive fluctuation, initially by stabilizing prices and then, in the 1950s, having abandoned the stabilization policy, by showing a great openness to providing the necessary liquidity to dealers in case of need in order to prevent excessive volatility, which would have exacerbated the costs of public financing (Simmons 1954). The first government securities traded on the money market were short term—extremely short term according to the Fed’s bills-only policy at the time. Later, long-term securities began to be financed through this channel. The volume of government securities in dealer portfolios depended on the dealers’ function as underwriters of new issues and market makers. A market maker communicates the prices it is willing to pay for a security (bidding price) and the price it will sell that security for (asking price). The difference between the two generates part of the dealer’s profits. Dealers have relatively low equity with respect to the volumes traded and it is thus normal that these operators borrow to finance their inventories. They are significantly more leveraged than a commercial bank. The volume of government securities in dealer portfolios, coupled with their activity as market makers, was influenced by expectations regarding the trend in interest rates: Anticipating monetary policy decisions was and is an important element in dealer decision-making. Dealers expanded their portfolio when they sensed that a reduction in interest rates was imminent so they could make capital gains, and reduced it when they expected the Fed to implement contractionary monetary policy. Data from the years 1950–1957 show that dealers were adept at correctly anticipating monetary policy. Their profits followed the trend in monetary policy, increasing when interest rates decreased. In this situation, the dealers added assets because the cost of financing was relatively low and the value of the securities was going to increase (Metzler and van der Linde 1960). In a market where only government securities were traded, this mechanism produced limited and circumscribed crises because the type of security being traded was not subject to a credit risk but only to the risk of variations in the interest rate. Crises occurred nevertheless.

106     G. Pizzutto

Money market financing of the stock and government securities markets is part of an intermediation mechanism whereby the operators are obliged to borrow in order to offer credit because, unlike banks, they cannot generate credit on their own. One of their objectives is to obtain financing at the lowest cost possible. The repo market is one way to do this while reducing financing risk: a short-term collateralized loan as an alternative investment to bank deposits for those who have temporarily available liquidity and want to obtain a yield without running a risk of capital losses. The US money market was initially composed of reserves that country banks transferred to the New York banks, where they were invested in the stock market. The secondary reserves of commercial banks were thus composed of short-term collateralized loans. The extension of the repo mechanism to monetary policy was initially introduced by the Fed in the 1920s with the objective of developing the bank acceptances market. It is currently the monetary instrument normally used to regulate the liquidity and reserves of commercial banks, and especially to control the short-term interest rate as suggested by the Taylor rule. The repo market actually makes it possible to reduce the risk of long positions. To avoid capital losses, dealers began to utilize reverse repos in the 1960s instead of directly borrowing bonds and short-selling them. A reverse repo is simply a repo seen from the buyer’s point of view. The dealer issues credit and obtains financial assets as collateral, using these assets to open short positions to partially cover the corresponding long operations. The type of operation we have described here allowed dealers to borrow on the money market through repurchase agreements while simultaneously carrying out the opposite operation to maintain a balanced net portfolio and avoid capital losses deriving from monetary policy and variations in the interest rate. In a market where only government securities are traded, this mechanism produces limited, circumscribed crises, partly because the type of security being traded is not subject to a credit risk, but only the risk of a variation in interest rate. The repo market is something distinct from the interbank market. The interbank market is a segment of the short-term credit market

6  The Money Market After World War II …     107

in which only banks can participate. It was instituted in the 1920s to redistribute excess liquidity in the banking sector and settle interbank transactions. When the inflows to a deposit bank exceed the outflows, the bank can lend the excess liquidity to another bank that finds itself in the opposite situation so as to balance out their respective situations via a central bank clearinghouse and maintain the desired level of reserves. These transactions do not modify the overall level of reserves, but merely redistribute them among banks. The aggregate level of reserves is decided by the central bank when it creates a money base. The interbank market is the payment mechanism for the banking system. It is an uninsured market where risk is addressed through knowledge and the good reputation of the counterparty. Over time, another wholesale money market formed that was accessible to non-bank intermediaries who need to borrow funds or have an excess of liquidity that they want to lend (corporations, institutional investors, money funds, mutual funds, public corporations). These institutional investors often need to find a placement for their available liquidity. Deposits at commercial banks are guaranteed only up to a certain threshold and thus cannot be considered a safe haven for those who have a high amount of liquidity and want to earn interest. The transaction mechanism in this wholesale market is the repurchase agreement. A repo is a loan with a guarantee: The borrower transfers financial assets to the lender as collateral. At maturity, the borrower returns the money and regains control of those assets at a price determined at the time that the agreement was signed. In the event of breach of contract (bankruptcy, failure to repay some or all of the agreed sum, etc.), the lender can recoup its money by selling the assets given as collateral. The repo market plays an important role among financial markets. From the lender’s viewpoint, it allows non-bank operators to invest their liquidity with little risk. This is very important because these operators cannot find the same level of certainty in a deposit at a commercial bank, since deposit insurance only covers retail deposits below a rather low threshold. For example, a company may have accumulated funds to finance an investment and does not want to hold these funds

108     G. Pizzutto

on deposit without earning something on them. At the same time, it does not want to invest them in a risky venture. It can instead turn to the repo market, where it lends the funds and earns interest on them with its loan protected by collateral. The collateral is held by the lender for the entire duration of the contract. The company may draw up this contract directly with the borrower or else transfer the liquidity to money funds, which have the capacity and competency to trade wholesale liquidity. From the borrower’s viewpoint, it allows broker-dealers to maintain ownership of the securities they need for their intermediation operations, transferring them to the lenders for a limited time period and thus having additional liquidity (needing to use less of their own) to acquire some other asset. The repo markets thus make liquidity available without the borrower having to definitively surrender its assets. The presence of a large number of operators and the guarantee offered with the transaction allow this market to have relatively low interest rates compared to the interbank market. The repo rate is always less than Libor or the Federal funds rate and thus this market offers economic advantages to those who need a short-term loan. At the same time, the repo rate has a positive spread with respect to government securities and this differential represents an incentive for those who want to get a better yield on their investments than what they could get with Treasury bonds. We should keep in mind however that demand for short-term assets as an investment for liquid positions encountered a scarcity of credit in a period when all countries, starting with the USA, made significant gains in reducing their deficits and the offer of risk-free securities began to dwindle. An equally important boost for growth in this market was a policy of extremely low interest rates practiced by all central banks from 2001 on. As a consequence, many financial intermediaries were looking for financial assets that would provide yields higher than those achievable with government securities, which at the time were very close to zero, even on the money market. In general, the growth of the repo market was impetuous, with the prevalent interest rate in this market bracketed above by the interbank rate and below by the interest rate on government securities. The repo rate is implicitly determined by the financial transaction. Every time a

6  The Money Market After World War II …     109

security is given as collateral, the price agreed for its repurchase is always higher than its current price, and the difference represents the interest paid by the borrower in exchange for liquidity during the period of the agreement. Contracts on the repo market are generally very short term (quite often overnight). These contracts must thus be continually renewed to ensure continuity of liquidity to borrowers seeking to finance a position. The renewal generally occurs with the same dealer. The fact that the repo market has such short terms is an added guarantee to the lender. A money market based on repo contracts is a market that finances trade in the sense that it is used to finance the acquisition of the underlying collateral. In a normal transaction, the sequence would be that a party wishing to acquire a financial asset would have to procure the funds, pay for the asset, receive the asset, and lastly add it to its portfolio. In the repo market, the sequence of the transaction involves an initial agreement for the acquisition of a financial asset, which the borrower immediately transfers to the lender as collateral in exchange for funds used by the borrower to purchase the asset. This is typical of the financing operations of broker-dealers, who borrow to finance their operations (Fig. 6.1). However, this market is not completely without risk because the value of the collateral may fluctuate. The risk to the lender is borrower bankruptcy coupled with a drop in the value of the security given as collateral. The borrower also runs certain risks. The lender might fail KƉĞŶŝŶŐůĞŐ

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ĂƐŚƉƌŽǀŝĚĞƌ ƐĞĐƵƌŝƟĞƐ ůŽƐŝŶŐ ůĞŐ

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Fig. 6.1  Representation of the repo market

110     G. Pizzutto

and thus not return the asset. If the value of the asset given as collateral also increases, the loss to the borrower is only partially compensated by not having to repay the loan. To mitigate the risk, the transaction is accompanied by a discount known as a “haircut,” which reflects the perceived risk associated with the asset used as collateral. The higher the haircut, the lower the reliability of the asset. For example, a haircut of 10% means that a borrower would have to turn over collateral worth one million dollars to obtain a loan of $900,000. Likewise, a 20% haircut means an 800,000-dollar loan would require collateral worth one million and the borrower has to chip in 200,000 dollars of its own funds if it wants to purchase assets worth one million. Transactions of this type are also seen on other markets. One example is the real estate market, where the purchase of a house is financed in part with the buyer’s own funds and in part through a loan from a bank. If the margin is 10%, the ratio between the loan and the value of the purchased assets (loan to value) is 90%, whereas the collateral rate is 100/90 = 111%. Perhaps the best-known indicator for illustrating the amount covered by the loan and the borrower’s consequent level of indebtedness is leverage. Leverage is the reciprocal of margin. It is the ratio between the value of the asset and the borrower’s own capital necessary to purchase it. Own capital is thus the difference between the value of the financial asset or any other good that is purchased, and the amount borrowed. The value of the loan thus tends to be less than the value of the collateral and the initial margin serves to protect the lender from a sudden reduction in the value of the collateral, an increase in its volatility and illiquidity, and the counterparty credit risk (the risk that the borrower in a collateralized loan is partially or wholly unable to repay). The value of the margin and the collateral defined in the transaction is not fixed but may be changed to maintain the market value of the asset provided as collateral. If this value should decrease, the lender of money could make a margin call, asking the borrower to add collateral and thus implicitly increase the margin. An increase in margin means that the lender perceives a greater risk associated with its loan deriving from a possible reduction in value of the collateral and thus protects itself by

6  The Money Market After World War II …     111

increasing the margin. If the borrower is not able to meet the request, it risks losing the collateral. Indeed, the lender has the right to sell the temporarily held assets if the debtor is unable to meet a margin call. Conversely, if the market value should rise, the borrower could ask a partial return of the collateral. In the event that the collateral is not fully returned at maturity, the borrower does not repay the loan. A reverse repo is a repurchase agreement seen from the lender’s (the one buying the security) viewpoint. The lender acquires an asset in return for liquidity, pledging to return the asset at a certain price when the loan is repaid. In some cases, a reverse repo is the preparation for a short-sale: Instead of borrowing the asset that it intends to shortsell from another investor, the borrower prefers to acquire the asset by financing some counterparty who will offer that asset as collateral. In other cases, the reverse repo effectively entails lending money to a ­financial intermediary who needs credit and deposits assets it holds as collateral. In the former case, the transaction regards a specific asset, while in the latter the type of asset given as collateral is only of relative importance, the important thing is that it is acceptable and liquid. Reverse repos began to be used in the 1960s by those who were planning to short-sell. Instead of borrowing assets and paying a fee, they achieved the same result by going on the repo market as a lender of liquidity. The dealer who intended to short-sell thus acquired assets and then sold them, investing the proceeds in the repo market. To close the transaction, it then had to buy back the assets, with its profit represented by the interest it earned on the repo market. Short-selling is not without risks. The investor has to buy back the assets that it borrowed and return them to the lender. If the value of the assets rises before the investor buys them bank, it may incur significant losses. The repo market thus performed two functions: It reduced the cost of financing purchases of government securities and maintaining their value; and it used available surplus liquidity while guaranteeing the capital by transfer of collateral, repaying the loan at an interest rate above what could be earned on other short-term securities. Nevertheless, there were a number of vulnerabilities in the mechanism that came to light in the 1980s.

112     G. Pizzutto

Paul Volcker’s contractionary and anti-inflationary monetary policy generated an increase in interest rates that succeeded in reining in inflation, but at the same time it caused the failure of S&Ls, banks specialized in real estate credit, and numerous failures on the repo market. The case of Drysdale Government Securities is emblematic. One of the problems faced by dealers relates to monetary policy. The dealer has to anticipate the decisions of the Fed and compose its portfolio on the basis of current and expected levels of the interest rate decided by the Fed. The Fed began implementing a contractionary monetary policy in October 1979. Its mid-term objective was to control borrowed reserves. Up to then, the Fed’s objective had been to keep monetary stocks under control (M1 in particular), using the federal funds interest rate, the interbank rate, as an intermediate goal. The idea was that the interbank rate represented the opportunity cost of holding money: An increase in the interest rate reduced demand for money and thus the growth rate of M1; if the interest rate went down, demand for liquidity went up and thus the supply of money. This monetary strategy proved relatively ineffective in containing the increasing inflation in that period. The monetary authorities thus decided to adopt a much more direct approach to price controls, believing, in keeping with the rational expectations hypothesis, that the cost of the anti-inflationary policy in terms of unemployment would have been negligible. In that period, the Keynesian influence was waning while the idea that monetary policy was neutral was gaining ground (Sargent and Wallace 1975). The priority objective of stabilizing prices translated into a policy that sought to control the creation of a money base, letting the interbank market determine the interest rate. In particular, the Fed proposed monetary growth objectives compatible with price stability and set the growth rate of the non-borrowed monetary base created independently by open market operations. In the event that the money stocks grew beyond the proposed amount, the interbank rate would have gone up and the commercial banks would have had to increase their indebtedness to the central bank, paying the corresponding discount rate. If the commercial banks borrowed on the interbank market, they would have paid a high interest rate and the money supply would follow the expected pathway. The outcome of the change in monetary policy was

6  The Money Market After World War II …     113

an increase in the interest rates that commercial banks were forced to pay. This for two reasons: Commercial banks have always been reluctant to borrow from the central bank for questions of reputation; secondly, the discount rate could be increased, and in certain circumstances was increased, beyond the interbank rate, leaving the commercial banks with no alternative (for a more in-depth discussion, see Stevens 1981; Cook 1989). Lastly, repeated requests for financing were penalized by increasing interest rates. In the end, the control of the money base through the discount rate and a predetermined pathway of non-borrowed reserves reduced monetary growth, stabilized prices, and increased real interest rates. The effects of the increase in nominal and effective interest rates were not long in being felt on financial markets. The crisis of banks involved in financing the real estate market began in that period and dragged on unresolved until the end of the 1980s. S&L balance sheets were seriously weakened by the fact that the interest rate on their deposits was regulated and could not be increased, whereas the money funds instituted in that period offered higher returns that attracted depositors. A cap on interest rates was eliminated, but nevertheless the competitiveness of banks continued to be undermined by the fact that the interest paid on their loans was based on fixed rates and could thus not be adjusted to allow higher interest rates to be paid on transactional accounts. Changes in monetary policy were also felt in the repo market. The high interest rates drove finance and non-finance firms to rationalize liquidity management toward a progressive centralization within their respective organizational structures. The repo market represented an occasion to obtain a high yield at relatively low risk from that liquidity. In effect, in that period, credit risk was not a feature of the repo market, where only government securities were traded. Nevertheless, the risk deriving from the extreme volatility of interest rates produced many bankruptcies among dealers trading in government securities. For the Fed, keeping the money base under control meant letting interest rates be determined by the market. The resulting uncertainty prompted dealers to adopt coverage strategies to prevent capital losses caused by sudden changes in interest rates.

114     G. Pizzutto

In this framework, the failure of Drysdale Government Securities and other similar bankruptcies brought out the vulnerabilities of the repo market. In particular, the valuation of the government securities varied according to type of transaction. When the securities were bought and sold outright, their price included the interest that they had accumulated up to then (dirty price, all-in price). On the repo market, on the other hand, the assessment was made excluding interest because the contracts were prevalently overnight (clean price). This does not mean that the interest rates on securities did not have to be paid, it simply meant that the payment came at the conclusion of the transaction, when the lender of the securities decided to close the contract and request payment. In the meantime, the organizer of this type of trade accumulated liquidity at zero cost and reinvested it in the market. The difference between the dirty price and the clean price was significant in a period when interest rates approached 20%. The short-selling mechanism implies that those who intend to shortsell have to borrow securities and pay a fee to the lender. At the same time, given that the collateral is represented by cash, the lender of the securities pays the market interest rate on that liquidity, which in turn will be used to finance other assets. The dealer then earns added profits from securities lending or reverse repo operation. The volatility of interest rates prompted Drysdale to open short positions, short-selling government securities that it had borrowed on the repo market. It earned more from the first transaction than it did from the second, where the interest rates were not factored in. But the ­portfolio was not balanced because this dealer had short-sold securities for 4.5 billion dollars while investing 2.5 billion dollars in securities (Garbade 2006). In a period in which the interest rates had risen as a result of the Fed’s contractionary policy, this strategy had worked very well and brought in high profits. In the periods when the rates remained stable Drysdale earned the difference between interest rates: When the rates went up, they were compounded by earnings on short positions. But the dealer was caught unawares when the Fed decided to put an end to its contractionary monetary policy.

6  The Money Market After World War II …     115

The interest rates came down and the increase in the value of the securities made it impossible to meet the interest payment on the borrowed securities. Drysdale was not a primary dealer. It had a very low level of capitalization with a very high level of short positions and thus its failure caused a great deal of worry on the financial markets. The Fed’s support measures were not enough to prevent the failure of Drysdale Securities. The market realized that uncertainty in the valuation of government securities undermined faith. It understood that it was opportune to get beyond the bilateral transactions on the repo market, entrusting management of the transactions to a third party that would mediate relations between those who had available liquidity and those who demanded it, offering financial assets as collateral. This third party was tasked with organizing the transactions between dealers and the money market, establishing the value of traded assets, managing the collateral that often remained available to the initial owner, determining the margins, and registering the transactions. This gave rise to triparty repo, which would assume an important role in the years to come in stabilizing and growing the market, which remained grounded in a repo mechanism and the lending of securities. It is worth pointing out that the third party that manages these operations guarantees that that operations are carried out correctly between the two parties but does not provide credit. The sequential, non-simultaneous nature of the transactions exposed this institution to credit risk, similar to that which we saw when analyzing over-certification. The problem in systemic terms is important because the assets managed by the triparty repo custodial banks are on the order of tens of trillions of dollars and they are concentrated in two banks: The Bank of New York Mellon and JPMorgan Chase. The pressure brought to bear by the Fed has only recently led to a resolution of this problem. Repo and triparty repo were used principally to finance government securities trading. The first signs of non-governmental, real estate-backed financial assets appeared in the 1960s (Bernard 1967) and are contemporaneous with the beginning of the securitization process. From the post-World War II period to the end of the 1980s, the US financial market was prevalently characterized by government securities

116     G. Pizzutto

and corporate-issued stocks and bonds. After the crisis of 1929, the money market mainly financed the purchase of government securities through the repo market. Things changed around the 1980s, when the securitization process began to transform assets that up to then had been illiquid, such as real estate mortgages, into liquid assets through the creation of mortgage-backed securities (MBSs). The mechanism was destined to increase the volume of liquid assets traded on the market. This was not entirely a new thing; the first attempts along these lines date to the 1920s, when bonds were issued with coupons financed by interest paid on real estate mortgages. However, these mortgages remained in the portfolio of the lender, i.e., the bank. In the 1980s, the securitization process introduced an additional mechanism that increased the volume and type of securities traded on the financial market. It was based on the transfer of a pool of real estate mortgages to a third party outside of the bank so that the underwriters of the bonds guaranteed by these mortgages were not responsible for the entire portfolio of the bank that issued them, but only for the segment of assets that was transferred. The first type of securitization reduced risks through diversification, while the second reduced the risk of default because the banks making the original loan were separated from its subsequent management, which was completely independent and limited to the assets transferred to a structured investment vehicle (SIV). Securitized assets are generally classified into two categories: MBSs relating to the real estate market, and asset-backed securities (ABSs) for all other types of credit. MBSs differ from ABSs in terms of prepayment risk. Real estate mortgages can be paid off before maturity should the financial market become more favorable to the debtor, who is motivated by a reduction in interest rates to open a new mortgage at more advantageous conditions, using the new liquidity to pay off the previous loan. The objectives of securitization strictly regarded the profitability of the operation, which came at a lower financing cost for banks and reduced the amount of capital demanded by the Basel Standards.

6  The Money Market After World War II …     117

When a certain number of financial assets or loans on a bank’s balance sheet were transferred to a completely external vehicle, a separation was created between the portfolio of these shifted assets and the residual portfolio at the bank. The assessment of the ratings agency applied exclusively to the portfolio transferred to the SIV, not to the bank’s entire portfolio. This way a bank with a relatively modest rating on its aggregate asset portfolio could get a top rating on the SIV portfolio by carefully selecting assets and implementing measures to reduce the risk and uncertainty of this portfolio. Generally speaking, the objective was to obtain at least a single-A rating for the SIV portfolio and collateral added by investors, allowing the bank to structure the liabilities and financing at lower costs than obtainable from an assessment of the bank’s entire portfolio. This process, which reduced the risk of the SIV going bankrupt, demanded the total separation of the residual portfolio held by the bank and the portfolio transferred from the bank’s books to the SIV’s books. The achievement of a high rating also involved other added guarantee measures. They include the over-collateralization of the loan (the value of the SIV portfolio was greater than the value of the issued bonds), the organization of liabilities in tranches, and assurance from the sponsor bank (commercial and/or investment bank) that a line of liquidity was available in the event that the loans were not renewed by the investors, especially when the SIV liabilities were short term. Commercial and investment banks were crucial in creating and sponsoring securitized assets. Their role as originators and transformers of the portfolio assets was complemented by lines of credit introduced to boost the reliability of the vehicle (Cetorelli and Peristiani 2012). The underwriting and structuring of the new financial assets continued to be handled by dealers and investment banks. In addition to reducing financing costs, a complementary objective of securitization regarded the amount of capital imposed by the Basel Standards. By reducing the asset portfolio and transferring it to an external structure, it was possible to cull risky assets and thus free up capital for use in other investments to replace the transferred assets.

118     G. Pizzutto

From the viewpoint of the individual bank, there were a number of reasons to opt for a securitization strategy, which improved the efficiency and profitability of extending and financing loans. From the viewpoint of the financial system, a complementary objective was to reduce the systemic risk within the banking system. Securities issued by the SIV were underwritten by parties independent of the bank. The balance sheet of these parties, as in the insurance system, allowed for improved management of risk. The reduction in the concentration of risk was partially the result of spreading the risk among a plurality of intermediaries that could not invest in this type of asset in an illiquid state. The increased diversification of the portfolio further reinforced the stability of the financial system. The idea of transferring the credit risk was fundamental to the positive image in the eyes of central bankers and regulators of this structural transformation of the financial market (Basel Committee 2005). The residual risk remaining within the bank that initiated the securitization process was justified by the need to improve the reliability of the credit demanded by the financial markets, demonstrating that the sponsor had full faith in the value of the securitized assets, proving it by holding the riskiest tranche (first-loss tranche) in its own portfolio instead of selling it to another bank or to a hedge fund, as often happened. In a waterfall payment scheme, this meant holding onto the equity tranche, which was generally the first one to be affected by a failure to pay in the event of a reduction in interest rates available to the SIV. At the same time, the senior tranches had to be transferred to the investors (Franke and Krahnen 2008). We now examine the steps in the securitization process. Although complex, they are part of a market mechanism that strengthens the bond between the money market and the capital market, between shortto-medium-term liabilities and long-term assets. It is different from what happens in the banking system, where that process is determined by and concludes with credit being added to the asset side of a bank’s balance sheet. In the case of securitization, maturity is transformed through several steps via the agency of several institutions. We will provide a very simplified representation to better highlight the weak points. The first step in the securitization process involves

6  The Money Market After World War II …     119

gathering the assets that we want to securitize. In this case residential whole loans (RWL) (Valukas 2010, vol. 2). Generally, the structured investment vehicles are sponsored by commercial banks and acquire real estate mortgages from banks and other financial intermediaries specialized in providing mortgages. The purchases are financed by the issue of short-/medium-term securities with the SIV playing the role of temporary deposit for the assets until they are later transformed in the securitization process. The vehicle that functions as a repository is generally termed a “conduit.” It profits from the difference between the interest it earns on the assets it holds and the interest it has to pay on the bonds it issues to finance acquisitions. The equity of these intermediaries is generally zero because their portfolio is deemed to be risk free and the coverage costs are negligible. The assets in the portfolio are considered to be in transit for a limited period of time prior to their subsequent transformation. They are thus 100% leveraged. The profit derives from the difference between the interest collected on bonds in the portfolio and the interest paid to the lender who provided the capital necessary for the financing, which generally takes the form of asset-backed commercial paper (ABCP) maturing at 90 days. An estimation of the volume of mortgages representing the raw materials for the securitized assets is important because it helps clarify why the banks that sponsored these vehicles ended up in trouble during the financial crisis. According to 2007 IMF data (IMF 2008), the value of the mortgages awaiting securitization was 1.4 trillion dollars, approximately 10% of US GDP. We may note what appears to be a permanent feature of major financial crises: financial assets that still have to be distributed to the final investors and instead remain in the portfolios of intermediaries. In 1929, it was bank and investment-fund stocks; in 2007, it was a significant amount of real estate mortgages that had to be financed through the issue of short-term credit. After the assets pass through the conduit, the ABS is assembled and the securitized assets are underwritten before being distributed to the final investors. Technical and administrative management for this phase is in the hands of the investment banks. Very often the same dealers who bought and redistributed government securities in the 1950s and stocks in the 1930s preserved and extended their sphere of action into the securitization process.

120     G. Pizzutto

The dealers structure the ABSs in terms of their composition and method of financing, divide liabilities into tranches, and purchase those liabilities, thus allowing the SIV-ABS to become owner of the mortgages. They then distribute the bonds to the final investors after having had them rated by a ratings agency. The dealer thus acts as an intermediary between the SIV-ABS, which issues bonds backed by a portfolio of mortgages, and investors. The dealer finances its advance to the SIV-ABS on the money market, while the dealer’s profit depends on the difference between earnings on the sale of bonds and the costs of the SIV-ABS financing, and first and foremost, on the value of the assets purchased to compose the SIV-ABS, plus the costs of structuring and the risk it runs between the time it finances the bond issuer and the time it sells the various tranches to the final investors (according to FCIC 2011, the fee ranges between 50 and 150% the value of the issue). The dealers profit from the fees they receive for the structuring service, which is the difference between the price they get selling the tranches and the price they pay to the investment vehicle. Fees as a share of total profits increased significantly in this period, reaching 30% of overall earnings. This explains why the production of securitized assets was particularly significant in this period. In the final phase of the process, the dealer sells the bonds issued by the SIV-ABS. The tranches were previously created to modulate the supply of debts, making it compatible with the risk preferences of the various categories of investors, or with the constraints that the various institutions have to respect in determining the composition of their portfolios. This prepared the way for smooth placement. The assessment of the tranches by the ratings agencies is a prerequisite that ensures the reliability and liquidity of the operation. The securitized tranches deriving from a portfolio of securities are brought into alignment with the bond market. The time frame for this process is rather long, from six to nine months, and the interval between the various steps requires the support of the money market to fill any temporary gaps between payments that must be made and the earnings from the sale of the structured assets.

6  The Money Market After World War II …     121

In 2007, the estimated value of assets in SIV portfolios was around 400 billion dollars (IMF 2008). The securitization process is based on a financing mechanism that has evolved over the years. Initially, the bonds issued to finance the pool of mortgages assembled by the originators and transferred to the dealers had the same characteristics and bore the same credit risk. The interest rate paid on the bonds was guaranteed by the collective interest paid on the mortgages and was the same for all issued bonds; the risk for these bonds was linked to the characteristics of this particular market. In particular, in the event of a decrease in interest rates, the borrower could renegotiate the loan at more advantageous conditions, obliging the bond buyer to seek a new type of investment or else accept a lower yield. When the interest rates rose there was obviously no risk of prepayment, but the bond buyer had to record a capital loss. In a subsequent phase, the issued bonds were structured in different classes that were assigned increasing credit risks compensated by increasing interest rates. The process by which bonds were associated with a differentiated risk redistributed the average risk of the pool of assets, creating tranches with a below-average risk and tranches with an above-average risk with respect to the original mortgages. The redistribution of risk was closely connected to sequential or waterfall payments of interest on the tranches. Interest paid by debtors was used initially to pay the lowest-risk tranches (generally speaking, 80% of issues) and then the other tranches if the interest payment made that possible. The senior tranche, the first to be paid, had a lower yield because of the near certainty of payment. A default of any of the mortgages in the pool would translate into a failure to pay interest and capital to the mezzanine and equity(junior) tranches, which were paid later, and to which a high interest was attributed upon issue (see Fig. 6.2). The differentiation of risk on the supply side could be matched to the different aversions to risk by the institutions that bought the tranches, deriving both from personal (subjective) preferences and from regulatory conditions. Equity tranches were generally absorbed into hedge fund portfolios, while the senior tranches were acquired by pension funds and insurance companies.

122     G. Pizzutto

dƌĂŶƐĨĞƌŽĨĂƐƐĞƚƐ

ĐĂƐŚ ŽƌƌŽǁĞƌ

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ĐŽůůĂƚĞƌĂů hŶĚĞƌůLJŝŶŐ ĂƐƐĞƚ

ƐĞĐƵƌŝƚĞƐ ^Ws

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/ŶǀĞƐƚŽƌƐ ƐƐĞƚ ďĂĐŬĞĚ ƐĞĐƵƌŝƟĞƐ ^ĞŶŝŽƌƚƌĂŶĐŚĞ DĞnjnjĂŶŝŶĞ ĞƋƵŝƚLJ

Fig. 6.2  Securitization

The denomination of the tranches was a result of the rating assigned to them by the rating agency. The uppermost share of the principal was included in the triple-A tranche (between 75 and 85% of the total), while the other tranches with lower ratings were smaller. The number of tranches was not determined in a strict manner. In the case of securitization in tranches, they were divided into senior, mezzanine, and equity tranches. The senior tranche was assigned a triple-A rating, the mezzanine triple-B, and the equity tranche had no rating. The following step is a securitization process similar to the previous but with one significant difference: the portfolio that was to finance the tranches was formed of other tranches. The CDOs were formed of ABS tranches. The input to the second stage of securitization was previously securitized assets, particularly tranches of MBSs traded on the market and sometimes CDOs-squared were created with CDO liabilities (see Fig. 6.3). In 2004, collateralized debt obligations (CDOs) with these characteristics represented more than 40% of the market. The shift from primary securitization to secondary securitization was justified by the growing difficulty to offer products with acceptable yields to the market, even in presence of a decrease in yields that the CDOs could offer. In relative terms, their yield was greater than other, non-securitized assets or assets that had been securitized just once. For example, Moody (2005) calculated the expected yields from CDOs compared to other structured assets. Even with downward pressure on their yield, the CDOs were more profitable than other structured assets. Securitization was viewed positively on the microeconomic

6  The Money Market After World War II …     123

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DŽƌƚŐĂŐĞůŽĂŶƐ DŽƌƚŐĂŐĞďĂĐŬĞĚƐĞĐƵƌŝƟĞƐ



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Fig. 6.3  CDO securitization

level because it allowed individual banks to increase their liquidity and profitability; there was also an equally positive and widespread opinion of the structural evolution of the US financial market because it was believed that this process made it possible to reduce the risk of assets held by banks by transferring it outside of the banking system to institutional investors who were better equipped to handle it, such as insurance companies (Basel Committee 2005). In response to changes in the financial panorama, monetary policy continued to focus on macroeconomic objectives, believing that the financial market and the new instruments that had been created ensured an effective separation between monetary policy decisions and financial markets, whose stability had been endogenously strengthened through the process of securitization and the creation of credit derivatives. The conviction that the CDOs and credit default swaps (CDSs) strengthened the financial system was also expressed in the documents of the regulatory authorities (Basel Committee on Banking Supervision 2005). The idea of a complete dispersion of risk meant placing all the tranches with institutions other than the investment banks that had

124     G. Pizzutto

structured the process. The practice of dealers holding some tranches derived from the idea that the transfer to the final investors could be facilitated if the issuer held onto the riskiest tranches. This way a signal of trustworthiness was sent to the market. In a situation of asymmetrical information flow, keeping the tranches likely to be hit with the first losses was a very reassuring signal to all those who invested in the other tranches (De Marzo 2005; Franke and Krahnen 2005). The choice of the major investment banks was to maintain a growing share of the structured tranches. In particular, the senior tranches of the CDOs were among the assets of all investment banks, which recorded strong losses associated with this type of asset in 2007–2008. The reason for this portfolio choice diverged from the hypothetical transfer of risk that the securitization process should have provided. Instead of being spread out, risk ended up concentrated with the investment banks. Acharya et al. (2013) picks up Jones’s (2000) thesis to argue that the objective of securitization was not the redistribution of risk but rather the reduction in the amount of capital required by the Basel Standards. This may provide a partial explanation for the fact that the banks structured the securitization process and held the senior tranches, i.e., the least risky tranches. Given that the banks’ capital had to be proportional to the risk associated with their assets and given that the senior tranches were considered practically risk free, the banks could use securitization to reduce the required amount of capital while gaining in profitability. A complementary explanation by Shin (2010) suggests that the decision to hold onto the senior tranches was dictated by the banks’ need to increase the flow of new assets in response to an increase in the value of their existing asset stocks. In an expansionary phase of the credit cycle, the value of the assets increases in response to stable liabilities and the investment banks tend to expand their assets since they have unexploited “production capacity.” An alternative interpretation explains the investment banks’ portfolio choice in relation to the yield on other financial assets. The compressive effect of monetary policy on yields from risk-free assets prompted the investment banks to hold the senior tranches for the simple reason that they brought higher yields than other similarly rated assets.

6  The Money Market After World War II …     125

The growing use of a securitization process that used tranches created by an earlier securitization step made it possible to maintain the ­profitability of the process, using as prime input financial assets whose aggregate interest payments compensated the rising cost of financing. The average yield of the portfolio increased, as did risk. Apparently it was thought that the secondary securitization process redistributed risk to the junior tranches, underestimating the importance of the correlations among the different types of tranches. Broker-dealers played an important role in the US financial ­system during the 1920s, in the post-World War II period, and from the 1990s up to the crisis of 2007–2008. The role of a broker and the role of a dealer differ in that the former acts as an agent, executing orders on behalf of clients, while the latter as principal, trading on its own account. In the US framework, the two roles are generally combined in investment banks. Broker-dealers contract debt for different reasons. As brokers they borrow to finance purchases on margin on behalf of their clients. The role of brokers in driving speculation has probably been overestimated. The debts they contract to finance purchases on behalf of their clients depend only marginally on the level of the haircuts, which were usually rather high, especially for stock market securities, as was witnessed in the 1920s. The brokers have additional sources of financing in the deposits that the clients are required to keep at the stock exchange to finance their purchases. The broker’s accounting system aggregates the positions of all its clients. Some buy, some sell, some hold onto their funds for future purchases. Brokers’ demand for credit is thus limited and depends on the difference between their revenues and their expenses. The purchases on margin on behalf of their clients have only a marginal influence on their demand for credit. Pointing to the mechanism of purchasing on margin as the driver of speculation on the financial markets risks obscuring its more complex origins. The role of dealers is more relevant in explaining how the US financial system works. Dealers trade on both primary and secondary markets. They determine the characteristics of the new issues and give advice to those who need financing about how to compose and

126     G. Pizzutto

structure their debt. They underwrite the new issues of government securities and public offers of stocks and bonds by corporations. They then sell all or a part of the underwritten assets. To finance their purchases, dealers take out short-term debt and transfer stocks, bonds, and government securities as collateral for a loan on the repo market. They then transfer some or all of the newly issued securities to the final investors. Once the securities are placed on the market, their value and liquidity are guaranteed by bid and ask prices determined by dealers on the over-the-counter (OTC) market. Dealers pledge to buy and sell financial assets on the secondary market and guarantee the immediacy of the transaction, thus reducing the wait times necessary to find a counterparty. This type of financing takes place as part of the distribution of newly issued securities, which have to be transferred to the final investors to support their quotations, and on the secondary market to ensure an orderly transaction process and reduce volatility. The role of securities dealers has always included structuring and selling securities and stabilizing the market. The characteristics of the assets bought and sold have changed over time—corporate stocks and bonds in the 1920s, government securities in the post-World War II period, and then securitized assets—but the basic mechanism has not: The collateralized money market and associated leverage are the channels ­dealers use to finance the purchase of securities issued by corporations and the government to fund their expenditures. The repo market reduces the risk and cost of financing. A dealer that borrows funds obtains credit while paying a lower interest rate than it would on the interbank market, temporarily transferring assets to a counterparty without completely relinquishing ownership. The shortterm lender places its liquidity on this market, obtains a higher yield than it would from bank deposits, while also reducing risk via the temporary acquisition of assets as collateral. “Shadow banking,” referring to recently developed practices in non-bank intermediation, ends up being deceptive, because the money market and the capital market have always been linked, especially in the USA. Dealer profits depend on the difference between its expenses and its revenues. Revenues are ensured by the payment of fees

6  The Money Market After World War II …     127

associated with the process of creating new financial assets, generally determined by the difference between the price at which the dealer acquires newly issued assets and the price at which it sells them to the final investors. Other categories of revenues include interest on long-term portfolio assets, and capital gains and losses on portfolio assets bought or sold via market makers. The costs depend on the interest rate that the dealer has to pay to its financers on the money market and on the trend in margins. Given that the interest rate on the repo market is aligned with, but slightly lower than, the interbank rate, dealer costs are determined by the interest rate set by the Fed. Dealers can hold long positions, borrowing on the repo market, or hold short positions. For example, it is reasonable to hold a long position if there are expectations for expansionary monetary policy. A decrease in interest rates by the Fed leads to a decrease in interest rates on the repo market and thus lower financing costs. At the same time, asset prices tend to rise and the portfolio gains value. Conversely, if contractionary monetary policy is anticipated, short positions tend to be favored. For example, a dealer can short-sell a borrowed security today and buy it back later when the price has come down. The dealer then buys the asset back at a lower price, returns it to the lender, and pockets the difference. As an alternative, the dealer can obtain the security it plans to short in a reverse repo, i.e., giving a collateralized loan to the owner of the security. The reverse repo is not only used to acquire assets that one plans to short; it is also used in combination with a repo to allow the dealer to acquire funds on the repo market and extend credit in exchange for collateral via a reverse repo. The dealer borrows to become a lender, going into debt to become a creditor. This is different from the financing sought for a long position. The operations of investment banks within the US financial system are complex. When an investment bank (dealer) has to finance a position, it generally takes out short-term debt to purchase long-term assets. This type of operation, described above, has been and continues to be an important function of dealers in financial markets. It affects the flows of new issues and the stock of circulating assets.

128     G. Pizzutto

Before we continue in our description, it will be helpful to define the concept of leverage. An initial concept of leverage is the ratio of assets on the balance sheet to equity. In this case, we are talking about gross leverage and the assets are the total of all long and short positions. If long positions refer to something other than short assets, gross leverage measures the dealer’s risk exposure. In this case, the risk of long positions is in no way compensated by the short positions. The short positions, when they regard assets other than long assets, are separate sources of profits and losses. However, gross leverage overestimates the risk if a part of the short investments help hedge the risk of the long positions. If this is true for a large part of the short portfolio, a better indicator is net leverage. Net leverage is the difference between long and short positions in the same assets. Assessing the leverage of a dealer is complicated when the dealer’s activities do not merely regard financing positions but transform into a bona fide process of financial intermediation. In this case, the dealer borrows liquidity on the money market not just to finance its positions but also to finance other operators, hedge funds in particular. To increase their leverage, hedge funds engage dealers through a repo operation. They receive financing in exchange for the temporary transfer of purchased assets to the dealers. The dealers use these assets and other assets they have in their portfolio as collateral to borrow on the repo market. The permission to reuse the collateral allows the hedge funds to obtain more favorable financing conditions and the dealers to have a nearly permanent source of liquidity and potential financing. The term “net repo financing” refers to the difference between repo and reverse repo. The repo represents the overall debt of a dealer. Reverse repo is the collateralized loans extended by dealers to hedge funds or other investors. The difference is always positive and approximately represents the financing that dealers contract to finance their positions. An interesting indicator of the transfer of collateral is the difference between securities in and securities out. “Securities in” are financial assets that become available to a dealer as collateral for credit to another financial institution or as borrowed assets. “Securities out” are all assets transferred by the dealer on the money market as temporary collateral

6  The Money Market After World War II …     129

for financing or as a loan of assets to other institutions. Securities lending is only a small percentage of total repo activity. The following figures present aggregate data regarding repos and reverse repos in the period 2002–2013 (Figs. 6.4 and 6.5). The repo data refer to credit obtained by dealers on the money market, divided into overnight loans and fixed-term loans. On July 28, 2004, the ratio of the two was 1.04; on March 19, 2008, it had risen to 1.91. In less than five years, short-term lending had doubled from 1.49 trillion dollars to 3 trillion dollars while the fixed-term repo market remained relatively stable, going from 1.42 to 1.56 trillion. Overall, the value of total assets traded on the repo market rose from 1.91 to 4.56 trillion dollars. The assets traded on the reverse repo market were 2.11 trillion dollars on July 28, 2004, of which 607 were overnight and 1507 fixed term, ϯ͕ϱϬϬ͕ϬϬϬ ϯ͕ϬϬϬ͕ϬϬϬ Ϯ͕ϱϬϬ͕ϬϬϬ Ϯ͕ϬϬϬ͕ϬϬϬ ϭ͕ϱϬϬ͕ϬϬϬ ϭ͕ϬϬϬ͕ϬϬϬ ϱϬϬ͕ϬϬϬ Ϭ Ϯ Ϭ Ϭ ϯ

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Fig. 6.4  Dealers repo

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Ϯ Ϭ Ϭ ϵ ƚĞƌŵ

Ϯ Ϭ ϭ Ϭ

Ϯ Ϭ ϭ ϭ

Ϯ Ϭ ϭ Ϯ

Ϯ Ϭ ϭ ϯ

130     G. Pizzutto

ϮϱϬϬϬϬϬ ϮϬϬϬϬϬϬ ϭϱϬϬϬϬϬ ϭϬϬϬϬϬϬ ϱϬϬϬϬϬ Ϭ

Ϯ Ϭ Ϭ Ϯ

Ϯ Ϭ Ϭ ϯ

Ϯ Ϭ Ϭ ϰ

Ϯ Ϭ Ϭ ϱ ƚĞƌŵ

Ϯ Ϭ Ϭ ϲ

Ϯ Ϭ Ϭ ϳ

Ϯ Ϭ Ϭ ϴ

Ϯ Ϭ Ϭ ϵ

Ϯ Ϭ ϭ Ϭ

Ϯ Ϭ ϭ ϭ

Ϯ Ϭ ϭ Ϯ

Ϯ Ϭ ϭ ϯ

ŽǀĞƌŶŝŐŚƚ

Fig. 6.5  Dealers reverse repo

rising to 2.96 trillion, of which 1.24 were overnight and 1.73 were fixed term. The difference between volumes traded on the repo market and the reverse repo market rose from 790 billion dollars to 1.60 billion dollars. This is important because the financing of the dealers’ positions more or less equals this number. This difference fell by almost half after the crisis of 2008 to about 700 billion dollars. The role of the repo and reverse repo markets is particularly important when we analyze the relations between hedge funds and broker-dealers. In general terms, we may define a hedge fund as an investment and financial intermediation company that uses different instruments with respect to a traditional investment company. In particular, in addition to long-term investments, a hedge fund uses leverage, short-selling, and credit derivatives to reap high yields. Unlike investment funds, the yield on hedge funds is not keyed to a benchmark. In periods when monetary policy reduces yield on traditional bonds, institutional investors and traditional investment funds buy

6  The Money Market After World War II …     131

shares of hedge funds to increase the yield of their portfolios. Recent estimates show that some 4% of the assets managed by pension funds, insurance companies, and investment funds are invested in hedge funds. Investment in hedge funds is allowed only for a limited number of people or institutions. Qualified investors must have wealth of more than five million dollars and accredited investors must have more than one million dollars (for a total of one hundred). The hedge fund thus plays the role of supplementing the yield of traditional investors and this function was particularly big in the first decade of the third millennium, when the yields offered by the bond market were extremely low because of the monetary policy pursued by the central banks. To reap the benefits of its investment strategies, the hedge fund needs the support of a dealer at an investment bank. The dealer is the counterparty to a hedge fund, which seeks to increase yield through leverage. The financing that the hedge fund obtains from the dealer through prime brokerage services involves a repo operation with an agreed amount and margin. The dealer sets the margins and receives financial assets as collateral, which it reuses to obtain financing. The repo market is where transactions between hedge funds and dealers take place. In this context, the dealer plays a role similar to a bank because its liabilities are short term, while its assets are both short term and long term (Stigum and Crescenti 2007). The collateral given as a guarantee or transferred to the dealers is an important element in dealer financing. The fact that hedge fund assets are not segregated is compensated by an implicit reduction in the cost of financing. Relations between hedge funds and broker-dealers are further complicated by accounting rules. The transfer of assets from hedge funds to dealers as counterparties in a loan does not appear on the dealer’s balance sheet and often the process of accounting consolidation erases the transactions between the two institutions. For example, a dealer might use the assets it received as collateral and lend them to another bank or hedge fund that wants to borrow them to open a short position. In this case, the dealer uses its collateral very efficiently. For example, after opening a short position with the assets borrowed from the dealer, this

132     G. Pizzutto

hedge fund opens a long position and offers the dealer as collateral an asset that the dealer flips over into a loan to the first hedge fund. Credit and debt are perfectly compensated in these transactions and no variations in assets and liabilities are recorded on the balance sheets. A dealer’s balance sheet underestimates the credit that the dealer provides to another financial operator, using available collateral in an efficient manner. The dealer’s function in this case is to minimize the cost of obtaining credit on a systemic level. The hedge fund can borrow directly on the repo market or turn to the dealer to increase its leverage (Singh 2014). The repo market is thus the collateral market, whereas the triparty repo market is the monetary financing market (Fig. 6.6). The triparty repo market is where the dealers borrow money, generally using liquidity managed by money funds, providing assets obtained from hedge funds or held in their portfolios as collateral. Something is missing from the above discussion. Data regarding the transactions of primary dealers show that short-term financing obtained from these dealers does not transform completely into a long-term transfer. Starting in 2006, the share of short-term (overnight) dealer financing exceeded the value of long-term financing. This means that the dealers are financing hedge funds and mutual funds with shortterm loans, and that the hedge funds and mutual funds are then making ZĞƉŽͬƉƌŝŵĞďƌŽŬĞƌĂŐĞ ĐŽůůĂƚĞƌĂů ĐĂƐŚ ,ĞĚŐĞĨƵŶĚƐ

Fig. 6.6  Repo relation between hedge fund and dealer

ĞĂůĞƌďĂŶŬƐ

6  The Money Market After World War II …     133

long-term investments (Pozsar 2015). The earnings to dealers without transformation of maturity depends on the difference between the active interest that the dealer asks from other operators and the passive interest that it has to pay on the repo market. It uses government securities it obtained as collateral for an overnight loan to take out another overnight loan. In this case, we may speak of a matched-book, a situation where the maturities of the assets and liabilities on the dealer’s balance sheet are balanced; there is no imbalance between short-term liabilities and long-term assets. The dealer’s ability lies in getting an interest rate on repo market loans that is lower than the interest rates on reverse repo loans and getting a margin on the credit it issues that is higher than that it has to pay on the money market. The difference between margins allows the dealer to acquire credit to finance its own positions or make long-term investments at the same risk as assets traded in the intermediation process (Eren 2014).

Bibliography Acharya, V., Schnabl, P., & Suarez, G. (2013). Securitization without risk transfer. Journal of Financial Economics, 107, 515–536. Basel Committee on Banking Supervision. (2005). Credit risk transfer. Bernard, N. (1967). Views of the US Government securities dealers. TreasuryFederal Reserve Study of the U.S. Government Securities Market. Cetorelli, N., & Peristiani, S. (2012, July). The role of banks in asset securitization. Federal Reserve Bank of New York Economic Policy Review, 18(2), 47–64. Cook, T. (1989). The determinants of federal funds rates: 1979–1982 (Federal Reserve Bank of Richmond, Working Paper 88-07). De Marzo, P. (2005). Pooling and tranching of securities: A model of informed financial intermediation. Review of Financial Studies, 18(1), 1–35. Edwards, G. W. (1938). The evolution of finance capitalism. New York: Longmans, Green. Eren, E. (2014, July). Intermediary funding liquidity and rehypothecation as determinants of repo haircuts and interest rates. In 27th Australasian Finance and Banking Conference. FCIC. (2011). Financial Crisis Inquiry Commission: The report.

134     G. Pizzutto

Franke, G., & Krahnen, J. P. (2005). Default risk sharing between banks and markets: The contributions of Collateral Debt Obligations (NBER Working Paper 11741). Franke, G., & Krahnen, J. P. (2008). The future of securitization (Center for Financial Studies, 2008/31). Garbade, K. (2006). The evolution of repo contracting conventions in the 1980s. Federal Reserve Bank of New York, Economic Policy Review, 12(1), 27–42. Hearings Before the Committee on Banking and Currency. (1954). United States Monetary Policy. IMF. (2008, April). Global Financial Stability Report. Jobst, A. A. (2007). A primer on structured finance. Journal of Derivatives & Hedge Funds, 13(3), 199–213. Jones, D. (2000). Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues. Journal of Banking & Finance, 24(1–2), 35–58. Meltzer, A., & Von der Linde, G. (1960). A study of the Dealer market for Federal Government Securities, Joint Economic Committee Congress of the United States. US Government Printing Office. Moody. (2005). Structured finance: US CDO Review. Pozsar, Z. (2015). A macro view of shadow banking. Credit Suisse. Sargent, T., & Wallace, N. (1975). ‘Rational’ expectations, the optimal monetary instrument, and the optimal money supply rule. Journal of Political Economy, 83(2), 241–254. Shin, H. S. (2010). Clarendon lecture in finance. Oxford: Oxford University Press. Simmons, E. C. (1954). Sales of Government securities to Federal reserve banks under repurchase agreements. Journal of Finance, 9(1), 23–40. Singh, M. (2014). Financial plumbing and monetary policy (IMF Working Paper, 14/111). Stevens, E. J. (1981). The new procedure. Federal Reserve Bank of Cleveland (Summer), 1–17. Stigum, M., & Crescenti, A. (2007). Money market (4th ed.). New York: McGraw Hill. Valukas, R. (2010). Lehman Brothers holdings Inc. Chapter 11 Proceedings Examiner’s Report. New York: United States Bankruptcy Court. Woodlief, T. (1952, May). Money trends. Financial Analyst Journal, 15–22.

7 Monetary Policy, Spread Compression, and the Housing Market

At the beginning of the twenty-first century, the monetary policy adopted by the major industrialized nations followed an expansionary path entailing a particularly significant reduction in interest rates. The Fed, the ECB, and the Bank of Japan reduced their main refinancing operations rate (MRO) in a systematic and massive way at roughly the same time. Monetary policy had followed a Taylor rule since the beginning of the 1990s. The recession caused at the end of the twentieth century by contractionary monetary policy prompted the Fed to reduce the interest rate from 6% in 2000 to 1% in June 2003. This level was maintained for an entire year until the following June. This strongly expansionary monetary policy was probably motivated by fears that the USA would fall into a spiral similar to that seen in Japan, which was still struggling to resume growth ten years after its financial market crisis. Seeking to prevent deflation and stagnation, and confronted by a recovery that was weaker than expected and an unsatisfactory price dynamic, the Fed decided to implement a very aggressive expansionary monetary policy, as underscored by Bernanke (2010). Out of fear of not having any more cards to play, of having exploited all monetary policy instruments at its disposal in the event that the © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_7

135

136     G. Pizzutto

interest rate gradually descended to zero, the Fed drastically reduced the rate at the start and then stabilized it at around 1% so that it would still have some room to maneuver if necessary. The ECB reduced its interest rate in the same period from 4.75 to 2% in June 2003, choosing a less accentuated reduction than its transatlantic counterpart. It held the interest rate at that level for two and a half years, concerned that growth was too slow in the eurozone and fearing deflation. Following a similar line, the Bank of Japan reduced its interest rate to 0% for six years, 2000–2006, further strengthening its expansionary drive, which had not produced the hoped-for fruits in the previous years. Many criticized the monetary policy in this period, focusing their discussion on the link between interest rates and the real estate bubble. Taylor (2007) in particular argues that the interest rates in that period were lower than his rule would warrant and would have led to an increase in real estate prices. When the real estate bubble burst some time later, the effects spread to the financial markets and on to real markets. Taylor’s premise was that there is a direct link between monetary policy and the real estate market and that interest rates have an immediate influence on the trend in this market and any speculative bubbles that take form. If monetary policy has a direct effect on housing prices, it must wield the instrument of the interest rate to contain prices and prevent the bubble from getting out of hand. The underlying, still unresolved question is the tradeoff between macroeconomic objectives and the price of financial and real estate assets, and between prices and employment on the one hand and the stability of financial markets on the other. If we look at the effects of monetary policy on financial markets, we find confirmation that the expansionary monetary policy adopted by the major industrialized countries produced a reduction in the yield of all financial assets. The yield on Treasury bonds, as we know, represents an important reference point in calculating the spreads, i.e., the risk premiums of other financial assets, and so can be used as benchmarks. In the period when the Fed’s repo rate was brought down to 1%, the yield on 10-year

7  Monetary Policy, Spread Compression, and the Housing Market     137

bonds fell from 6.5 to 3.3% by mid-2003 and then rose slightly in the following years, but it never returned to previous levels. This trend seems to confirm the theses of several papers arguing that monetary policy has an influence on long-term interest rates. A change in monetary policy may be considered an endogenous factor when the monetary authorities receive new information on the state of the economy, or exogenous when it derives from a change in preferences (new Taylor rule parameters). In the former case, the central bank controls the short-term interbank rate and a change in policy affects all bonds, whatever their maturity: A drop in repo rates has an effect on the structure of the yield curve and causes a reduction in interest rates across the board. Financial markets may or may not anticipate the effects of monetary policy. In the case of symmetrical information, if the preferences of the central bank incorporated into the Taylor rule are known to the markets and they are stable, an inflation shock is instantly transmitted to shortand long-term interest rates, which move in the same direction. In this case, when the target repo market is modified, there are no significant variations in yield structure, as it has already adjusted to the new information. In the case of asymmetrical information, the central bank knows things that the markets do not know and thus a change in its policy and its target comes as a surprise to the financial markets, and bond prices adjust to account for the new information. If the monetary policy is not anticipated, the prices of bonds change when the new target rate is communicated, moving in the same direction as the short-term rate (Ellingsten and Soderstrom 2001, 2004; Romer 2000). In the period 2001–2004, this may have meant that the parallel reduction in the short- and long-term interest rates on government securities signaled that the information available to the Fed had caused a fear of deflation, with no changes in the preferences defined by the loss function or in the weights assigned to unemployment and inflation by the Taylor rule. If preferences change, a realignment of target would mean that shortterm and long-term rates do not move in the same direction, but in

138     G. Pizzutto

opposite directions, and the yield curve flattens out. For example, a more aggressive contractionary monetary policy would mean increased sensitivity of the Taylor rule to inflation with a more accentuated rise in short-term interest rates and a consequent reduction in long-term expectations for inflation. This type of interpretation describes rather well the effects of monetary policy in 2004–2006, which translated into a flattening of the forward interest rate curve. The reduction of the interest rate on US and other countries’ bonds was not limited to this market. Yield for AAA-rated corporate bonds fell by 3% from 8 to 5%. Not only yields but also the spreads of corporate bonds exhibited a downward trend. For example, the spread on HG corporate bonds fell on the US market from 270 basis points in 2002 to 80 basis points at the end of 2004, while the HY spread is even more significant in relative terms: It falls from 1300 to 250 basis points (IMF Global Financial Stability Report, April 2005, Ch. 2). If we analyze the yields of the bonds that financed the securitization of real estate mortgages, we again see the trend toward a reduction in rates. The mortgage-backed securities (MBS) market was particularly important in the US financial system in the early twenty-first century because it is a component of the stock of safe assets that compensated for the reduction in the issue of government securities that occurred in that period. Fannie Mae and Freddie Mac followed two different intermediation processes. In the first place, they securitized family mortgages issued by banks, mortgage companies, or thrifts (S&L associations), whose underlying value was represented by a pool of mortgages. In this case, the agencies issued bonds with some degree of credit risk and had to provide guarantees to investors regarding losses on interest and principal payments and possible mortgagor insolvency. The investors took it for granted that the government would intervene in the event that the agencies found themselves in a situation of pre-failure, which is exactly what happened in 2008. As an alternative asset, the agencies directly issued bonds and bought MBSs on the secondary market and were thus exposed to the risk of a change in interest rate. These two business lines were not equally

7  Monetary Policy, Spread Compression, and the Housing Market     139

profitable. For example, the securitization process ensured yields between 15 and 25 basis points, while the yield on purchased MBSs held in the portfolio exceeded 100 basis points (Jaffe 2003). Not surprisingly, the two government-sponsored enterprises (GSE) increased demand for MBSs, triggering a decrease in their yield and spread. The yield on MBSs has to be corrected to account for the prepayment risk. A mortgagor has the right to repay the loan prior to maturity if conditions on the financial market are such that it is possible to renegotiate the loan at a more advantageous rate. Generally speaking, expansionary monetary policy favors this solution, as was seen in the period after the Fed reduced its interest rate. The indicator used to correct interest rate on MBSs is the Libor Option-Adjusted Spread (LOAS) and represents the spread referenced to Libor of the yield of a bond issued by the GSEs and corrected for coverage of interest rate-change risk. In 2004, LOAS fell to near zero. At that time, the purchase of a bond issued by the governmental agencies guaranteed an interest rate practically equal to the interbank rate. The monetary policy practiced by central banks thus produced a systematic and general reduction in short- and long-term interest rates for risk-free assets (prime or high-grade assets) and subsequently reduced and compressed risk premiums. It was widely believed (Greenspan 2005) that there were no contraindications to a protracted policy of low interest rates because financial innovation would enhance the stability of the financial system, making it independent of monetary policy choices. The literature began to be populated with papers analyzing the relationship between monetary policy, financial markets, and appetite for risk, but focusing exclusively on the composition of commercial bank portfolios, developing the suggestion of Borio and Zhu (2013), who argued that changes in interest rates and monetary policy can alter investors’ perception and tolerance of risk, creating what they termed a “risk-taking channel.” For example, Maddaloni and Peydro (2011) reviewed information in the Euro Area Bank Lending Survey and found evidence that commercial banks loosened their credit standards during the period of low interest rates; Ioannidou et al. (2014) and Jimenez et al. (2014) reached the same conclusions analyzing the credit

140     G. Pizzutto

registries of Bolivian and Spanish banks. These analyses refer to partial ­equilibrium models. In a context of general market equilibrium, Gertler and Karadi (2011) and Gertler and Kiyotaki (2015) sought to extend the neo-Keynesian model by introducing a financial sector characterized by a double moral hazard. Interpretations of this type neglect the basic fact that the financial market is not composed exclusively of commercial banks. Non-bank intermediation plays a significant role, and the process of financial innovation has introduced a new type of structured credit whose interaction with monetary policy has not yet been adequately studied via comparative analysis. The consequences of a monetary policy of low interest rates are reflected in the choices of a certain number of players who are usually excluded from consideration. They include, first of all, insurance companies and pension funds. These players have specific nominal targets stipulated in contracts drawn up in the past that must be respected. If a pension fund has promised a yield of 8% and finds itself instead with a government security that yields 4%, it risks not being able to honor its commitments and must perforce move to riskier investments. As noted by Rajan (2006), this is a typical case of risk shifting: The intermediary is forced to opt for riskier choices because there is no alternative. This is different from the problem of moral hazard and risk shifting analyzed by Jensen and Meckling (1976). In this latter case, the risky choice is driven by the composition of liabilities in the intermediary’s portfolio. If a bank has a high level of debt, it can opt for high-risk loans that offer higher yield. If things go well, the shareholders will reap high yields, whereas in the event of default it further increases debt. Here, we find an increased appetite for risk—perhaps a sort of force-feeding—in an attempt to remedy a situation of reduced profitability. The issue of the stability of insurance companies and pension funds is extremely relevant: The total assets held by insurance companies and private and public pension funds were close to 14 trillion dollars on the US market, slightly in excess of US GDP (Federal Reserve Board, Flow of Funds, Tables L117, L118, L117, and L120). To give an idea of the weight of these intermediaries, the assets of commercial banks amounted to some 10 trillion dollars.

7  Monetary Policy, Spread Compression, and the Housing Market     141

The stability of a financial system of such dimensions is put to a severe test when inflation stabilizes in the economy because all contracts drawn up in the period of high inflation are characterized by payment structures geared to those conditions and poorly adapted to a situation where inflation is lower. Other players that should be considered are all those investors who have surplus liquidity to invest in short- or long-term assets, confronted by a situation of extremely low yields, and are thus anxious to find financial assets that promise higher yields. Think of the problems faced by the finance department of a large corporation, or the fact that tax revenues of local agencies are concentrated in time while expenditures are spread out over the entire year. And the central banks also seek higher yields than those offered by sovereign bonds: Excess liquidity seeks a use. Financial intermediaries who earn profits by taking out short-term debt to purchase long-term assets have similar problems, partly because they enter into competition with parties having surplus liquidity that can afford to purchase long-term securities at a discount with respect to those who have to borrow. To summarize, the drop in yield of assets induced by monetary policy (low interest rates) drove operators to seek alternative assets promising higher yields. In financial market jargon, the period is characterized by a continuing “search for yield” to support profits from intermediation. This is compounded by an incentive to engage in currency carry trade. If the central banks’ interest rates are very low (remember that the Bank of Japan kept its interest rate at 0% for six years), it is worthwhile to take out short-term debt and acquire long-term assets that promise higher yields to compensate for the loss of portfolio yield caused by the low interest rates instituted by monetary policy. This works if the monetary authorities provide assurances to the financial markets as to how long the low-rate policy will remain in effect, and, in the case of currency carry trade, if the exchange rates remain stable. The reduction in the volatility of interest rates in that period was due to the growing ability of monetary policy to influence expectations regarding future trends in interest rates. All volatility indicators were extremely low. Figure 7.1 provides an approximate idea of the fear index on financial markets (the Chicago Board Options

142     G. Pizzutto

Fig. 7.1  Subprime profitability (Source Deutsche Bank Research [2007])

Exchange Volatility Index—VIX). Values below 20 generally indicate stability, while higher values refer to increased volatility and thus instability. Starting in 2003, the value of this index decreases steadily to very low values: Risk is negligible, and investors are ready to bring riskier assets into their portfolios. The monetary policy implemented by the central banks and the resulting general reduction in asset yields drove investors to go on a search for yield, turning to innovative financial instruments such as securitization and the transformation of mortgages into liquid assets. Tranches were later used to finance this process and provide a secondary level of securitization. Collateralized debt obligations (CDOs) represent a specific second-level method of securitization that uses the tranches originally used in the process of mortgage securitization by the GSEs. CDO issues grew to meet the demand for assets providing a higher yield than that achievable with traditional securities issued by governments and businesses. The compression of yields continued in the US financial market even after 2004, when monetary policy became systematically contractionary and the interest rate on refinancing operations rose beyond 5%, without, however, easing the impact of the reduction in interest rates on mediumto long-term assets or the compression of the risk premium (IMF 2005).

7  Monetary Policy, Spread Compression, and the Housing Market     143 Table 7.1  CDO global issuance (billions of dollars) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

68 78 83 86 157 251 520 481 61 4

Source SIFMA Table 7.2  Global CDO issuance by underlying collateral (billions of dollars) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

HYL

IGB

SF

22 27 30 22 32 69 171 138 16 2

29 31 21 11 11 3 24 78 15 0

1 0 17 35 83 157 306 259 18 0

HYL = high yield loan IGB = investment grade bonds SF = structured finance Source SIFMA

There are many possible explanations for the prolongation of ­compressed yields after 2004 even with the implementation of contractionary monetary policy. But the consequences only further boosted the search for yields compatible with a condition of equilibrium and profitability of financial intermediation using securitization. The CDO market was particularly active precisely in the period when monetary policy became contractionary, from 2004 onward. Table 7.1 illustrates the flow of newly issued CDOs. Table 7.2 analyzes the composition of the values underlying the CDOs, highlighting the fact that risky financial assets became increasingly popular.

144     G. Pizzutto

A cash-flow CDO is a CDO that is created by buying the associated bonds on the market, as opposed to synthetic CDOs, which are formed by using the corresponding credit default swaps (CDSs). CDOs may be classified as arbitrage or balance sheet CDOs. Arbitrage transactions are intermediation mechanisms whose profits (excess spread) derive from a portfolio of securitized assets generally having an HY rating, financed with the issue of interest group notes (IG notes). In these transactions, the CDO issues two or more debt tranches and an equity (junior) tranche and uses the liquidity thus obtained to buy a diversified portfolio of securities providing payoffs sufficient to ensure payment of interest and the principal to the investors. The tranches are remunerated in a series or waterfall scheme starting from the senior tranche, which has to be paid off first and receives a lower interest rate than the subsequent tranches since it is the least risky. The arbitrage spread derives from the difference between interest on the assets in the CDO portfolio and the passive interest paid to investors. The equity (or junior) tranche receives the excess spread after payment of the debt tranches. The yield on the equity tranche in the absence of default is always higher than the average yield on the CDO portfolio. The excess spread is what the CDO asset manager seeks to maximize, because that is where he makes his money. The investor’s incentive to finance the CDOs depends on the fact that the yield on the various debt tranches is higher than the yield of a single bond with the same rating. Interest on the CDO tranches was variable and keyed to Libor. For example, a senior CDO tranche had a yield at par with Libor plus a few dozen basis points. It also enjoyed the advantage of an AAA rating, while Libor was rated AA. In a period when the central banking authorities had the objective of keeping interest rates very low to prevent deflation, a structure such as a CDO ensured the additional yield that the financial market was seeking, and the fact that the contractionary monetary policy after 2004 was not reflected in medium- to long-term interest rates only strengthened the trend. Such a significant increase in the issue of CDOs had the consequence of a significant reduction in the spreads of the underlying bonds. Structuring a cash CDO means taking action on the primary

7  Monetary Policy, Spread Compression, and the Housing Market     145

and secondary markets to purchase MBS bonds: The immediate consequence of a demand shock was an increase in price and a strong compression of cash bond spread. Researchers tend to be in agreement regarding the compression of the risk premium. Each time operators seek to exploit an increase in the spread to create a CDO with a certain profitability, the window of opportunity closed quickly because of the above-described mechanism. In an open market with very low transaction costs, the extra yield attracted new operators and the increase in demand for bonds compressed the yields, and thus the risk premium, into relatively short timeframes. For example, the market for CLOs (collateralized loan obligations, a type of CDO where the underlying value is loans to companies) was characterized by the securitization of 42% of the new bonds issued by companies in 2006. Demand reduced the role of traditional banks, which held 90% of business loans in 1994 but only 20% in 2006. On the other hand, the share held by non-bank intermediaries rose from 24 to 92% in the same period. The loans from non-bank intermediaries were characterized by a longer term than bank loans, giving them a greater yield (Nini 2008). There was thus a positive spread between the interest paid on institutional loans and loans offered by banks. Demand by CLOs for institutional loans exerted significant pressure on this differential. In early 2000, the spread was 89 basis points for a BB loan, while in the third quarter of 2006 the differential had been reduced to zero, and sometimes entered the negative zone (Standard & Poor’s cited by Lucas et al. 2007). A reduction in the spread was seen also in the subprime mortgage market. This is rather curious given the prevailing beliefs at the time, and the mechanism is similar to what was seen earlier for the corporate bond market. Non-prime mortgages grew significantly in 2004–2006 (see Table 7.3) in response to a slowdown in prime mortgages due to the increase in interest rates in 2004, which made refinancing mortgages less attractive. A survey of 420 CDOs conducted by UBS Group AG (see Table 7.4) shows that the composition of their portfolio depended heavily on

146     G. Pizzutto Table 7.3  Mortgage originations by product: 2001–2007 and share of originations (billions of dollars, percent)  Year

Prime

Percent

Non-prime

Percent

Total

2001 2002 2003 2004 2005 2006 2007

2002 2624 3504 1893 1762 1511 1509

77.2 78.9 78.8 59.1 53.2 49.3 62

591 701 941 1311 1550 1552 922

22.8 21.1 21.2 40.9 46.8 50.7 38

2593 3324 4445 3204 3312 3063 2431

Fonte Joint Center for Housing Studies of Harvard University (2008)

Table 7.4  Residential mortgage deals in 420 ABS CDOs. Number of deals by vintage and mortgage loan type Vintage

Subprime

Alt-A

Seconds

Prime

Total

2003 2004 2005 2006 2007 Total

215 371 488 522 150 1746

63 252 452 487 113 1367

7 25 62 69 21 184

144 188 209 142 28 711

429 836 1211 1220 312 4008

Fonte UBS Mortgage and ABS CDO Losses, December 13, 2007

subprime mortgages (Gorton 2010). This should come as no surprise since the CDOs were continuously seeking a primary input that would guarantee high yield, as compared to what was currently available on the market, and thus constituted the principal element of demand on the subprime mortgages market. It was then the task of the CDO to use the waterfall payment scheme to channel risk into the lower tranches. The demand for subprime mortgages by CDOs translated into a large reduction in spreads on the tranches that financed subprime mortgages. For example, the yield of a mezzanine tranche reached a spread of 500 basis points with respect to Libor in 2002–2003, shrinking to less than 100 basis points in 2006 with a reduction in the risk premium significantly less than the historical average for that kind of rating. Using another type of indicator for the spread between subprime MBSs and the interest rate of government securities, Deng et al. (2011)

7  Monetary Policy, Spread Compression, and the Housing Market     147

reached the same conclusion. The reduction of the spread on subprime mortgages was then reflected in the profitability of the CDOs that used them: Their profitability decreased from a yield above 6% in 2001 to 2% in 2006 (Deutsche Bank Research 2007). The risk premium should depend on the probability of default and the recovery rate, but these variables only partially explain the level and especially the oscillation of the spread (Collin-Dufresne et al. 2001; Huang and Huang 2012). Supply and demand conditions are another relevant element that must be taken into consideration. In this case, the reduction in yield on the bond market can be explained by taking into consideration the demand shock experienced by this market following the requests by CDOs. The attempt to assemble mortgages and corporate bonds to increase yield turned out to be illusory, because the increase in demand reduced their profitability and most importantly compressed the risk premium. As a positive side effect, it created extremely favorable conditions for financing businesses. This mechanism tended to be self-fueling because the volatility of the bond market does not seem to depend on the rating of the assets but rather on the level of the corresponding spread. Assets with a very limited spread are less volatile than assets with a wider spread. The markets associate greater risk with greater spreads. The decrease in volatility and perception of lower risk in this case are a consequence of the overall reduction in the risk premium. The reduction of spreads for corporate bonds and residential mortgage-backed securities (RMBSs) made it less financially advantageous to structure cash CDOs and pushed the market to create a new type of financial instrument, the synthetic CDO, which enjoyed the further advantage of being able to be structured in less time than a traditional CDO. A synthetic CDO differs from a cash CDO in two fundamental ways. One is the fact that the composition of the assets in a synthetic CDO does not require the purchase of bonds: Synthetic CDO assets are CDSs on pertinent bonds. In the second place, the liabilities of synthetic CDOs do not necessitate that all tranches be sold. It was often very difficult to sell all the tranches, and thus the shift was made to a new form of intermediation where the investors purchased just

148     G. Pizzutto

one tranche (usually the mezzanine tranche) and received in exchange an interest rate on that tranche appropriate to its risk profile. In other cases, the tranche was created ad hoc for the investor (bespoke tranche). In a traditional CDO, the overall risk absorbed by the investors was equal to the risk of the bonds composing the portfolio. Should an intermediary sell just one tranche, that intermediary is exposed with regard to the tranches it does not sell and to the premiums it has to pay when it buys insurance, and it has to offer collateral on the CDS market. By selling insurance, it obtains the revenues it needs to pay interest on the sold tranche (Tavakoli 2008). The amount of insurance that the intermediary sells to create coverage is known as the delta of the tranche or the elasticity of the tranche with respect to a variation of one basis point of the spread in reference to the underlying bond. Delta is a multiple of the value of the tranche and depends principally on tranche risk. For example, a tranche with an AAA rating will have a delta between 1.0 and 1.5 while a tranche with a BBB rating will have a delta between 5 and 6. The value of delta changes dynamically as a function of the variation of certain elements that define the risk of the various tranches. For example, an increase in the spread of a bond causes a reduction in the value of an equity tranche, which becomes riskier. The relation between spread and tranche value is analogous to that between interest rate and value of a bond. The following table presents CDO issues, distinguishing between cash CDOs and synthetic CDOs (Table 7.5). The apparently small volume of synthetic CDO issues does not mean that those issues had no effect on the bond market. Precisely for the particular nature of the issued tranche, the sale of protection entailed Table 7.5  CDO Issues (billions of dollars) 2005 2006 2007 2008 Source SIFMA

Cash flow

Synthetic

206 410 340 43

44 66 48 16

7  Monetary Policy, Spread Compression, and the Housing Market     149

a much higher multiple of the notional value of the sold tranche; an excess supply of insurance was created on the market by all dealers who had sold a single tranche and needed coverage. The reduction of the spreads created an opportunity for arbitrage between the CDS market and the bond market: The presence of a negative base made it possible to make a risk-free gain by buying bonds and getting coverage against default risk on the CDS market. To take a simplified example, let us suppose that a CDS and an obligation have the same maturity date. A CDS is a contract by which a party purchases insurance on the value of a certain asset, paying a premium to another party that sells insurance. In exchange for this payment, the insurer commits to pay in the event that the borrower defaults. If this credit event does not occur, the insurer merely collects the premiums from the party buying the insurance. The CDS represents the bond issuer’s market-assessed credit risk. But there is another way to assess credit risk. Let us recall, first of all, that Libor is the average of interbank interest rates on the British financial market. It is a non-collateralized interest rate that incorporates counterparty risk. It is a benchmark for evaluating financial markets, equivalent to a risk-free interest rate. The Z-spread (zero-volatility spread) is defined as the difference between the yield of a bond and Libor and represents the risk premium that bond issuers have to pay. As noted by Duffie (1999), in a frictionless market, there should be equivalence between the CDS spread relating to a certain bond and the spread with respect to Libor of a bond with similar maturity issued by a corporation. In this case, we have the following: CDS spread = Z-spread The base is defined as the difference between the values of the two spreads. Given a difference between two prices of credit risk, the financial market has an opportunity for arbitrage. Specifically, we have a negative base when the CDS spread is less than the Z-spread. In this case, the arbitrageur purchases a bond by borrowing on the interbank market, thus paying Libor and, at the same time, purchases insurance on that same amount. In this operation, the investor’s revenues come from the Z-spread, while the expenditures are the premium it pays for the corresponding insurance coverage, i.e., the CDS spread.

150     G. Pizzutto

The relation between arbitrage opportunity and single-tranche synthetic CDOs is created because the dealers who issue CDOs protect themselves by selling insurance for an amount that is a multiple of the notional value of the sold tranche and thus exert powerful downward pressure on the corresponding spreads. The reduction in the spreads then favors the purchaser of insurance, who is able to obtain the same level of protection at a lower price, whereas the insurance seller receives a lower premium. This mechanism nevertheless creates an arbitrage opportunity because it prompts the arbitrageurs to buy bonds. In this way, there is both a decrease in spreads and a decrease in bond yield. The final outcome is a compression of yields and the profitability of intermediation, which is reinforced by the low volatility following from it. But even the introduction of synthetic CDOs did not resolve the problem of profitability. So far, we have analyzed the dynamics of yield from demand-side financial intermediation. Structured financial instruments, and in particular the introduction of a second level of securitization in the form of CDOs, represent the initially successful attempt to obtain, through the pooling and tranche mechanism, higher yields than could be obtained from traditional financial assets following extremely expansionary monetary policy. When the policy changed direction, the process of intermediation progressively slowed down. The financial assets we have discussed to this point derive their value from real underlying values. The securitized real estate mortgages depend on the evolution of the housing market. Analyses of the real estate market and its phases of expansion and contraction are prevalently aimed at assessing housing demand, how this demand is financed, and who is financed. The literature has neglected to analyze the supply side. When we talk about a speculative bubble, we must suppose that on a market where prices tend to rise, supply must in some way be limited. But talking about a speculative bubble on the housing market is still problematic because houses are reproducible and the construction industry responds to increasing prices by increasing supply. An increase in supply should attenuate speculation. The real estate market is different from the stock market.

7  Monetary Policy, Spread Compression, and the Housing Market     151

So how can we explain the phases of expansion and contraction in housing prices? Why do prices go up in certain periods? If we look at things from the viewpoint of builders, we have to keep three things in mind: regulations in the various states; the availability of land where houses can be built; and the time it takes to build them. While the last two factors have to do with technology and are common to all the states, the question of regulations may explain the different dynamics observed in the different states and the inflation differential for this market. The analysis of supply and its elasticity with respect to prices is the central element in the analysis conducted by Glaeser et al. (2008). Supposing that demand is exogenous, its analysis stresses that the housing cycle in the USA—at least up to the first decade of the new millennium—depends on the relationship between price dynamics and regulations. The states that imposed significant constraints on permits for building new houses generally recorded higher prices than states that allow a certain expansion of supply and are more liberal as regards regulations on the characteristics of the houses that people intend to build. The distinction between inelastic supply and elastic supply also allows us to explain the pricing dynamic. In an expansionary phase, the states with inelastic supply will see housing prices rise, with a small variation in the quantity of new houses built, and thus an accelerated turnover of existing housing stocks. When demand later falls, prices return to pre-boom levels. Conversely, in states with highly elastic supply, the expansion phase coincides with an increase in prices, which is followed by an increase in new houses added to existing stocks. The increase is irreversible and thus the return to a normal market situation should coincide with prices overshooting downward (Houghwout et al. 2012). Overshooting downward lengthens market recovery time because the lack of profitability induces builders to decrease production to allow the market to absorb the excess stock. In this case, the time needed to allow the market to go back into an expansionary phase will be long because the new equilibrium price is lower than the cost of production and thus the construction companies will not have an incentive to expand supply. If the starting condition presupposed a price close to the cost of

152     G. Pizzutto

production and the new equilibrium is established below that value, the time needed for the market to move back into an expansionary phase may be quite long, because the construction of new houses will resume only when demand drives prices up and the construction companies will only resume building if they can make a profit. Table 7.6 represents the trend in housing stocks in the US housing market in the period 1999–2014. The stock of unsold houses began to grow around 2005. With a relatively stable trend in family growth in that period, the increase is significant and led to some three million unsold houses. The supply of houses also includes houses foreclosed by the banks. Supply on the housing market consists of existing houses, newly built homes, and, during crisis periods, houses put on the market due to foreclosures. This last group is a cogent variable in explaining the extremely long time that passed between the beginning of the real estate market crisis in 2005–2006, when the number of unsold houses began to increase, and its stabilization in 2012–2013, when unsold housing stocks returned to pre-crisis levels (Hedberg and Krainer 2012). The US real estate market is financed by issuing mortgages that remain partially illiquid and become part of the assets of the issuing bank, and partially securitized, that is, bundled into a pool by an institution outside of the bank that issued the loan. To finance this transfer, Table 7.6  Total housing inventory for the USA (2000–2010 - millions) Year

All housing units

Total occupied

Vacant

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

116.124 117.994 119.697 121.466 123.355 125.363 127.296 129.064 130.415 131.269 131.807

102.584 103.948 105.319 106.111 107.606 109.484 110.693 111.258 111.672 112.295 112.899

13.680 14.046 14.378 15.355 15.749 15.580 16.603 17.806 18.743 18.974 18.907

Source Bureau of Census

7  Monetary Policy, Spread Compression, and the Housing Market     153

the intermediary who buys the mortgages from the bank issues bonds that are purchased on the financial market. The share of securitized mortgages was around 60% in the first years of the third millennium. The securitization process was divided into two segments. One, implicitly insured by the government, is made up of governmental agencies that trade on the secondary market to purchase mortgages issued by banks and finance themselves by issuing mortgage-backed securities (MBSs). In theory, the agencies only buy mortgages with particular characteristics. For example, the ratio of loan to value of the property must be less than or equal to 80%, or else the mortgagor has to have a high FICO score, marking it as a prime borrower, and the overall value of the loan has to be below a given threshold. These constraints imposed upon governmental agencies tended to select loans with the objective of acquiring only mortgages with acceptable risks. The mortgages purchased by the agencies were known as prime or conforming mortgages. The other segment regarded mortgages that lacked some of the requisites for securitization by the agencies. The securitization process was performed through investment banks that handled the completely private securitization component (private label). The investment banks also financed the purchase by issuing MBSs. Non-prime or non-conforming mortgages were traded on this market. Non-prime mortgages may be broken down into subprime, Alt-A, and jumbo mortgages. Subprime mortgages refer to a borrower with a FICO score of less than 620–640, while the other two categories refer to prime borrowers who provide incomplete documentation or else request a very large loan, exceeding the limit imposed by the governmental agencies. The increase in jumbo mortgages was justified by the increase in home prices, which required a corresponding increase in the value of mortgages. This latter segment made up a minority, even though its growth was relevant in the years leading up to the financial crisis, reaching a share of 20% of new mortgages issued in 2004–2005. The prime/subprime distinction and the increase in the proportion of subprime mortgages in real estate debt meant that credit was being extended to low-income families with relatively low credit ratings. The creation of this type of credit increased the risk present in the real estate

154     G. Pizzutto

market and the associated financial market. Loans with characteristics not meeting the acceptability criteria of the governmental agencies tended to increase as objects of securitization. Those who issued new mortgages were tempted to go in this direction because they would not have to manage the credit risk in the following years, the risk being shifted to other parties (investment banks), which in turn financed themselves by issuing bonds bought by parties outside of the banking system. Granting credit to low-income families was also part of a political plan that sought to increase home ownership to promote integration among the different groups within the US population and achieve a widely held dream. The intermediation process in the private sector saw the process centering around the mortgage lenders and the investment banks that structured the mortgages and used them as collateral to finance their purchases. The intermediaries were better informed than the final investors as regards the characteristics of the families receiving credit. Precisely due to this lack of information, the final investor was not acquainted with the characteristics of the borrower and thus unable to evaluate the risk implicit in the mortgage, which served as collateral for the bonds it was buying. On the other hand, the mortgage lender had no incentive to select mortgagors with high credit ratings because it shed all credit risk through the securitization process. The mortgage lender’s priority interest was to increase the volume of credit and thus the fees it earned every time a new debt was created. Subprime mortgages, asymmetrical information, and securitization all combined to construct a representation of the crisis whereby the expansion of increasingly risky credit fueled the increase in demand and prices on the real estate market. The increase in the value of the property-related assets engendered conduct by investment banks that was different from the conduct of families. According to the received view, the banks have the objective of maintaining constant equity. If the equity increases because of an increase in the value of the assets held in the portfolio, the bank finds itself in a situation of excess “production capacity.” To bring the equity back to equilibrium, it expands its debt and its loans. This choice differs from that of families, who simply keep the new equity level (Adrian and Shin 2008, 2010).

7  Monetary Policy, Spread Compression, and the Housing Market     155

The second phase of the reconstruction affirms the importance of the type of credit extended, in particular the spreading use of mixed fixed-rate/variable-rate loans. Subprime mortgages, generally 30 years, are prevalently hybrid. Borrowers pay a fixed interest rate for the first two or three years, then shift to a variable interest rate for the remaining 27 or 28 years keyed to the interbank rate and thus very sensitive to monetary policy. When the Fed began raising interest rates, all those who had signed this type of hybrid contract found themselves having to pay higher interest rates that were not compatible with their income and many were thus forced to default. In Gorton’s interpretation (2010), the hybrid mortgages were designed with the assumption that this would not happen because the mortgage could be refinanced before the end of the fixed-rate period. The refinancing was only possible if the price of the real estate held as collateral remained constant or increased. In this case, the mortgagor could open a new mortgage and has another two or three years at a relatively low fixed rate. Housing prices began to fall in the period 2005–2006, and it was thus not possible to refinance these mortgages, especially mortgages issued when housing prices had reached a peak. The homeowners were thus unable to meet the higher interest payments and were forced to sell the property. Hence, negative equity meant default, sale of the property, and a collapse of prices. The decrease in housing prices was thus caused by the decision to sell by those people who had bought a house by taking out a loan. It was the excess of supply on the real estate market that caused prices to fall. The collapse in housing prices would transfer to the valuation of mortgages and their securitization. Given that assets in the first and second securitization process were financed on the repo market, the increase in margins would have forced those who had financed the purchase of these assets to increase their equity. The deleveraging process would transform into the sale of these financial assets with the consequent collapse of prices and a further increase in the margin demanded by financers. The interaction between market liquidity and funding liquidity (Brunnermeier and Pedersen 2009) would trigger a downward sales spiral transforming the real estate crisis into a deep market crisis, a contraction in credit supply, and a subsequent recession.

156     G. Pizzutto

However, this analysis is incomplete if it does not also take credit demand into account: Who is asking for credit and why? The prevailing interpretation of the financial crisis as it relates to the real estate market combines securitization and asymmetrical information and seeks to explain the financial crisis by suggesting that the offer of credit to highrisk low-income borrowers was proposed by banks that did not have to assume the credit risk, because the securitization process allowed them to transfer the risky loans to other players external to the banking system. The current interpretation nevertheless cannot explain why the investment banks that had structured the mortgages and held them in their portfolio were at the epicenter of the crisis. They evidently believed that the senior tranches were risk free and guaranteed high yields with negligible probability of default. The current position of regulators who require banks that intend to securitize assets to hold a percentage of those assets in their portfolio does little more than to ratify a process that is already broadly applied by investment banks in their portfolio choices. The fact that this policy failed to prevent a financial crisis raises some doubts as to the validity of the interpretation and the policies that grew out of it. It also tends to attribute a large and nearly exclusive importance to subprime mortgages. As noted above, the securitization process did not translate into a transfer of risk outside of the banking system because the dealers who structured the portfolio of real estate mortgages kept a significant share of the tranches. Table 7.7 shows the losses associated with the CDOs of the principal investment banks registered up to May 8, 2008, while Table 7.8 illustrates the loans that the investment banks obtained from the Fed through the Primary Dealer Credit Facility and the swap between government securities and other securities via the Term Securities Lending Facility, Schedule 1 and 2 auctions. The insiders, in this case the investment banks, had more information than the outsiders, but they evidently did not use this information to sell all the structured products they had in their portfolio to other parties that had only approximate information as to their quality. They must have thought that type of investment guaranteed a high yield at a relatively low risk. This explanation is confirmed by the personal financial choices of operators active in the securitization market. Many

7  Monetary Policy, Spread Compression, and the Housing Market     157 Table 7.7  Mortgage related losses to US Investment Banks (June 2008 - billions of dollars) Investment bank

Loss

Citigroup Merrill Lynch Bank of America Morgan Stanley JP Morgan Chase Washington Mutual Lehman Brothers

42.9 37.1 15.1 14.1 9.8 9.1 8.2

Source Bloomberg

Table 7.8  Dealers borrowing (Term securities lending facility and primary dealers lending facility - millions of dollars) Citigroup

9580

Merrill Lynch Morgan Stanley Goldman Sachs Bank of America Bear Stearns Lehman Brothers J.P. Morgan

6051 4625 4581 3006 2063 1845 1166

Source Federal Reserve Board

operators made personal portfolio choices based on the same convictions that shaped their professional choices. The great majority of operators active in the real estate market and dealing in associated financial products in 2005–2006 thought that the market was destined to maintain a positive status, that the prices of houses would have continued to grow moderately, and that the market for securitized products would have continued to provide a good yield (Cheng et al. 2014). This does not mean that a crisis in the real estate market and associated financial products was not one of the possible scenarios. This would have meant a 5% reduction in housing prices and losses for the sector estimated at 17% of the portfolio, something which was considered very improbable at the time, as we see in Table 7.9.

158     G. Pizzutto Table 7.9  Conditional forecast of losses on subprime investments from Lehman Brothers Name

Scenario

Aggressive

11% HPA over the life of the pool 15 8% for the life 15 HPA slows to 5% by end-2005 50 0% for the next three years 5% thereafter −5% for the next three years, 5% thereafter

Base Pessimistic Meltdown

Probability Cum loss

Legenda HPA: House Price Appreciation Source “HEL Bond Profile Across HPA Scenarios” from Lehman Brothers: “U.S. ABS Weekly Outlook,” August 15, 2005

This indicates how those who work in a sector as delicate as the financial sector process information, create a model, and form convictions that are generally shared within their professional peer group. It is certain that, in hindsight, expectations regarding trends in prices on the real estate market were largely unfounded. But why were expectations of future price trends so important and why was there such a great gap between expectations and what actually happened? Before we examine these questions, we have to add another element that challenges the current interpretation. A metric that is considered relevant in evaluating credit risk is the history of credit and the reliability of the people who request a real estate mortgage. People whose FICO score was less than 620 could not obtain regular credit conforming to the criteria established by Fannie Mae and Freddy Mac. These credit agencies handled the securitization process of mortgages meeting these criteria on the secondary market. Such mortgages were defined as prime mortgages. Subprime mortgages, on the other hand, were mortgages that did not meet these criteria. They were issued primarily by financial institutions that had no public insurance coverage. The term subprime is often associated with this metric, which is implicitly identified with people of low income. The other two types of non-prime mortgages are those issued to persons not providing full documentation or mortgages with a loan-to-value ratio greater than 80% (Alt-A), or jumbo mortgages exceeding the limit amount for loans

7  Monetary Policy, Spread Compression, and the Housing Market     159

accepted by the governmental agencies. These latter two types cannot be lumped into the class of loans extended to people with low income, but are loans that have risk factors that are greater than loans purchased by the governmental agencies for subsequent securitization. Often, this type of credit is extended to persons who have a medium or medium-high income and a very good credit rating. The fact that a loan was classified as risky did not necessarily mean that the person who received it was unreliable. There were only a modest number of loans extended to people with a FICO score of less than 620. For example, in the period 2003–2005, out of all people taking out their first mortgage to buy a house, less than 22% in terms of value went to people with a FICO score of less than 620 (200 billion out of a total of 920 billion dollars). The other 720 billion dollars went to people with a good credit rating (Bhutta 2015). In the real estate boom, we may note that the ownership rate, i.e., the ratio of owner-occupied dwellings to occupied dwellings, did not increase significantly during the years of the housing boom (2002– 2005). The number of owner-occupied houses rose from 1995 to 2001 by 7.854 million units. In the period of greater price appreciation (2001–2006), the increase was only 2.787 million units. In the period 2006–2015, the total number of owner-occupied dwellings fell from 76.544 million to 74.018 million, more than two and a half million fewer houses. The connection between the spread of subprime mortgages and the purchase of one’s first house appears rather weak (Table 7.10). We must underscore that the share of foreclosed dwellings financed with prime mortgages was virtually the same as that for subprime mortgages in the period 2007–2008, whereas in the following period, foreclosures on houses financed with prime mortgages greatly exceeded those on houses financed with subprime mortgages, which decreased significantly (see Ferreira and Gyourko 2015). A more comprehensive interpretation has to take into consideration the entire composition of demand for mortgages, using classifications that complement the traditional prime/subprime distinction. We may begin by looking at the inflows and outflows that affect the existing stock of mortgages. The increase in mortgages represents demand for

160     G. Pizzutto Table 7.10  US homeownership rate (percent) Year

Homeownership rate

1994 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

63.8 67.1 67.5 67.8 68 68.6 69.1 68.5 68.4 67.8 67.3 67.1

Source Bureau of Census

mortgages by people who are purchasing a house. These people may be subdivided into people who are buying a house they intend to live in, people who are buying a house as an investment or as a second house, and those who refinance an existing mortgage to take advantage of more advantageous market conditions. As regards this latter case, when the central bank reduces interest rates it is advantageous to prepay the mortgage and take out a new mortgage at these more favorable rates. Those who refinance a mortgage may also take advantage of an increase in real estate market prices not only by renegotiating a lower interest rate, but also taking out a bigger loan because the value of the collateral has increased. If we take these elements into consideration, a more complex picture of the evolution of the real estate market and the associated mortgages emerges. The first bit of information regards the evolution of aggregate real estate debt deriving from the difference between increase in demand for credit (a flow variable) and a reduction in debt stocks. Once a debt is contracted, it can only be reduced by paying it off or defaulting. In the period in question, this reduction is relatively stable, while the element that influences the debt stock is the increase in debt. The ebb and flow of new mortgages explain both the increase in aggregate stock and its subsequent contraction.

7  Monetary Policy, Spread Compression, and the Housing Market     161

The second interesting element is the composition of new debt inflows. In the two-year period 1999–2001, new debt amounted to 1.953 trillion dollars. In 2005–2007, it rose to 3.445 trillion. The value of mortgages for those who are buying their first house amounted to 626 billion dollars in 1999–2001, rose to 932 billion dollars in 2003– 2005, remained relatively stable at 925 billion in 2005–2007 and then decreased in later periods. The remaining debt (2.5 trillion dollars) is the sum of the debt contracted by: those who do not have debt (never had a debt in the past) and decide to enter the pool of persons who contract a debt using their house as collateral (a constant share at about 800 billion dollars); the investors who have one or more properties at the beginning of each two-year period, and acquire additional properties by borrowing after two years (a significantly growing share from 250 billion dollars in 1999–2001 to 886 billion dollars in 2005–2007); and those who refinance an existing mortgage to gain more advantageous conditions and increase the value of their debt. This latter financing channel is used by those who have a single property (from 339 to 763 billion dollars) and by those who have two or more properties (the most significant percentage gain from 65 to 294 billion dollars). Thus, less than 30% of the new mortgages were taken out by new homeowners. The rest regarded investors who purchased houses to rent or resell and make capital gains, or else purchased a second house. This category includes families who borrow money to obtain liquidity from their property and/or refinance their mortgage at more favorable rates. It is probable that the ascription of the term “subprime” to loans extended to people with weak credit ratings is partially to blame for the erroneous explanation of the crisis in the US real estate market. Actually, the term “subprime” also applies to mortgages extended to people with high credit ratings (FICO score above 680) and with a loan-to-value-of-property ratio above 90%. A loan is risky not only when it is given to a person with a high credit risk, but also when the property is purchased (almost) completely with borrowed funds (Hancock et al. 2005). When the equity is negligible and the purchase is for dwellings that are rented out or quickly resold, the risk associated

162     G. Pizzutto

with mortgage is much higher. It is no fluke that the interest rate on mortgages to finance the purchase of houses that will not be occupied by the buyer is relatively high; the lender believes that this operation is more likely to end in bankruptcy. The idea that income and mortgage had come uncoupled was a significant element in the received view. However, if we examine the incomes of families who acquired a mortgage, we discover something surprising. Adelino et al. (2016) show that the great majority of loans obtained in the period 2002–2006 were used to purchase bonds by families in the medium-high-income bracket, not low-income families. The number of low-income people holding a mortgage to buy their first home certainly increased, as we have already seen, but they remained a relatively low proportion of total mortgages because the increase in the number of low-income mortgagors was counterbalanced by the fact that the houses they bought were small houses with a low cost per square foot. The same observation holds if we consider mortgages to refinance a home and/or purchase a second home. Subprime mortgages must not be considered to be a central element in the real estate crisis. Ferreira and Gyourko (2011) analyzes the heterogeneous price dynamics in the major US cities and the various components that financed the demand for housing, noting that these mortgages were not the cause of the rise in prices observed in the initial phase of the boom, but simply a later increase as part of a process that affected all US families for different reasons. People who have taken out a mortgage have a number of options. They can continue to make regular payments, or they can opt for an implicit option call and refinance their debt if market conditions are favorable (e.g., if interest rates come down). In the latter case, we are talking about mortgage prepayment, meaning that the mortgage is paid off before maturity. As a third option, prepayment may also be used if the homeowner moves and needs to sell the house, or because it is economically advantageous to do so in terms of capital gains. The fourth and last option is to stop mortgage payments and enter default proceedings. Here, we must distinguish between a default that can be explained as a lack of liquidity, and a default attributable to a rational choice made by the homeowner who examines the state of his/her current and

7  Monetary Policy, Spread Compression, and the Housing Market     163

future finances and bases the decision as to whether or not to sell the ­mortgaged house on that. For example, if the value of the house is less than the value of the debt that will have to be paid in the future, and there are no prospects for an upward appraisal, the homeowner might decide to liquidate the property. Two basic elements in these analyses are the price of the houses and their appreciation or depreciation, and the ratio of value of the debt to the value of the house. The prevailing type of real estate loan in the period 2003–2005 was adjustable-rate mortgages (ARMs), which entailed payment of a fixed interest rate for a brief period, followed by adjustment of the interest rate, generally determined as the sum of six-month Libor plus a spread of 3%. The entry fee was not low, somewhere around 7%. The subsequent adjustment pushed the interest up to the full rate and keyed it to monetary policy, which was particularly contractionary in that period. The ARM contract was considered to be a bridge contract that was advantageous both to the lender and to the borrower. Before the interest-rate adjustment, the homeowner with this type of mortgage had the option of repaying the credit and taking out a similar mortgage for another two years. If the value of the house had continued on an upward trend, this operation was advantageous for the borrower, who could then negotiate a mortgage with higher equity and a narrower spread. The mortgagor preferred to keep some degree of control over the dynamics of the mortgage while keeping an eye on market conditions, trying to minimize the length of time of any financial commitments. Hence, the mortgages were renegotiated every two or three years at more favorable conditions for the mortgagor, perhaps passing from a subprime to a prime mortgage thanks to increased equity. In this way, the interest-rate adjustment was perpetually postponed. This type of contract aimed to strengthen borrower equity and avoid the shock of a variation in interest rate in the transition from the fixed-rate period to the variable-rate period (Demyanyk and Van Hemert 2009; Bhardwaj and Sengupta 2014). This mechanism rested on the assumption of financial stability and a constant upward trend in housing prices. When they began to decrease, it was no longer possible to refinance the mortgage. Confronted by

164     G. Pizzutto

an increase in mortgage payments and a reduction in the value of the house, the mortgagor might decide to default and relinquish the house. This outcome was amplified in cases where the purchaser does not actually occupy the house, but buys it as an alternative investment or else as a second house. In this case, the choice is dictated exclusively by financial considerations and not by non-monetary benefits, i.e., the emotional bond to one’s home and neighborhood (Robinson 2012). The interest rate on this type of mortgage demands a wider spread than for mortgages on owner-occupied homes because the probability that the purchaser will prepay or opt for strategic default is much higher. This latter stratagem does not depend on the ability to pay the interest and amortization, but on a rational assessment of the discounted cash flow of revenues and expenditures relating to the real estate investment, and thus on expectations regarding the future trend in housing prices. Table 7.11 presents data regarding housing sales in the USA by use, distinguishing between owner-occupied homes, second homes, and investment homes. The latter two categories make up a significant proportion of total newly purchased homes (35–40%). In the period 2003–2006, the values of owner-occupied home purchases remained relatively stable. On the other hand, the values of investment homes increased by some 500 billion dollars in 2003–2004 and by 300 billion in 2004–2005. Demand for investment homes then dropped by 900 billion dollars in 2005–2006, responding to a downturn in prices.

Table 7.11  Vacation and investment property sales (percentage) Year

Primary residences

Vacation properties

Investment properties

2003 2004 2005 2006 2007 2008 2009 2010

67 64 60 64 67 70 73 73

12 11 12 14 12 9 10 10

21 25 28 22 21 21 17 17

Source National Association of Realtors

7  Monetary Policy, Spread Compression, and the Housing Market     165

If we examine the supply side, we note that requests for new-home building permits rose until March 2006 and then dropped off. The housing glut is evidenced in the average selling time for a new house, which is generally about four months under normal conditions. It began to exceed this figure in 2005, prompting builders to slow the pace of new-home construction. The reason for this oscillation may be related to portfolio choices. At the end of the twentieth century, the contractionary monetary policy implemented by the Fed had created a recessionary phase while also bringing an end to the rise in prices on the stock market. The decrease in interest rates drove many families to seek higher yields on the real estate market as an alternative investment vehicle to stocks and bonds, where interest rates were vey low. The subsequent monetary squeeze increased financing costs for those seeking an investment of this type while also increasing interest rates on risk-free government securities and the risk premium on corporate bonds. This thus created an alternative investment arena with respect to the real estate market, where higher financing costs and higher yield on financial assets (government securities and corporate bonds) slowed growth. Housing demand declined significantly because high-income US families and financial intermediaries formerly operating in the real estate market chose to leave this market. Another factor reducing demand in the real estate market is the credit made available to finance the purchase of a home. Net mortgage stocks fell because fewer people opened new mortgages, not because fewer people were paying off their debts (see Federal Reserve Bulletin 2013, Table 4). The net deleveraging can be explained as the reduction in credit supply by banks and mortgage lenders in the early years of the crisis. The liquidity shock hitting the money market in 2007–2008 was propagated into the banking system causing a strong contraction in the credit supply to the private sector. As in the 1930s, the banks reacted by reducing financing to the private sector and increasing their acquisition of government securities. Credit was reduced to two segments of the private sector: corporations and families. Credit to families principally consists of real estate mortgages. The contraction of credit to the corporate sector has been documented by Ivashina and Scharfstein (2010), Cornett et al. (2011),

166     G. Pizzutto

and Allen and Paligarova (2015), while the reduction in real estate credit to families is analyzed by Antoniades (2014). A snapshot of the trend in mortgage demand and supply in the period 2000–2010 is given by the data provided after the passage of the Home Mortgage Disclosure Act (HMDA) in 1975. Every time someone applies for a loan at an HMDA-compliant institution, certain information must be entered into the Loan Application Register (LAR), including mortgage requests and approvals, the purpose of the loan (purchase or refinancing), and whether it will be an owner-occupied or investment home. There are a number of reasons why these data are interesting. First of all, we find that the principal reason for requesting a mortgage is to refinance an existing mortgage, permitting the mortgagor to reduce interest payments and also extract greater equity thanks to the increase in housing values. Secondly, the difference between mortgage requests and approvals tended to increase in 2003–2006. Denied requests fell from 2.583 million in 2003 to 429,000 in 2006, while the denial rate increased from 31 to 36%. This runs counter to the view that credit policy was loose in this period. The banks had begun adopted stricter standards in granting credit a few years before the beginning of the crisis and drastically reduced the credit supply in 2007–2008 following repeated crises in the money market and in the wholesale financing available to them. The liquidity shock had repercussions on the credit supply. The contemporary banking system may fall prey to a liquidity crisis when funding from the money market dries up and the corporations begin to rely heavily on lines of credit from their banks. Both of these factors were at work in 2007–2008. In that situation, the banks had to transfer assets off their balance sheets following the August 2007 crisis, which halted the securitization process and drove the corporations that could no longer find market financing to use lines of credit from the banks. On the one hand, the banks had to give up the idea of financing themselves on the money market, while on the other they had to increase credit to the business community. They reacted by reducing credit, a contraction mainly affecting the real estate market, and introduced very strict criteria for granting residual credit.

7  Monetary Policy, Spread Compression, and the Housing Market     167

The initial phase of the collapse of prices on the real estate market cannot be explained as an increase in supply deriving from homeowner default, but as a contraction in demand caused by a reduction in the bank credit supply. The relation between liquidity shock and contraction in credit to the real estate market is a topic that has only recently begun to be explored and thus there are not, as yet, many academic contributions (see Antoniades 2014; Calem et al. 2013). In order to complete our analysis of the real estate market and attempt an explanation for the unexpected fall in prices, it is useful to turn back to the examination of the effects of monetary policy on financial intermediation and the choice of type of financial product that the intermediaries offered in a period of contractionary monetary policy. To prevent an increase in interest rates from having a negative impact on credit demand, following the contractionary monetary policy of 2004 there was a change in the type of available real estate loans. While almost all mortgages were fixed rate in ordinary times, the progressive increase in interest rates drove lenders to craft a mixed-rate mortgage: fixed rate during the initial period and then variable to maturity. The fixed-rate period usually lasted two or three years (or perhaps longer) on a 30-year mortgage. After that, the interest rate was keyed to Libor or the interest rate on Treasury bonds, with the application of a spread in the neighborhood of 3%. There were also similar products aiming to support credit demand with a payment structure offering an interest rate that was lower than the fixed rate in the initial period because it postponed capital amortization to later periods. This strategy worked when housing prices were rising because it made it possible to refinance the debt, which tended to increase over time, and aligned with the reassessed value of the collateral. Rising home prices ensured such equilibrium. Prepayment and refinancing of a mortgage of increasing value also ensured the ability to meet increasing interest payments. This rather widespread interpretation associates the stability of the real estate market with a progressive increase in prices. There is another possible explanation, not alternative but complementary to this. Those who provided mortgages had to monitor when

168     G. Pizzutto

the trend in monetary policy changed direction, the amount of increase in interest rates, and how long this increase would last. It appears that although an increase in interest rates was largely taken for granted, no one expected such a large variation, more than four percentage points. Most importantly, no one expected that such a high interest rate would persist for so long. The systematic underestimation of the reduction and subsequent rise in interest rates is documented (e.g., by Rudebusch 2008), whereas no documentation is available as to expectations regarding the duration of contractionary monetary policy or the timeline for its subsequent reversal and a reduction in interest rates. An indirect sign may be seen by the fact that the forward interest rate curve flattens out in the period 2004–2006. This is generally interpreted as a sign that the financial markets are anticipating an imminent recessive phase and thus expect a prompt reduction in interest rates. The flattening trend would thus indicate that the financial markets had systematically underestimated the period of contractionary monetary policy. This underestimation has been confirmed by an analysis of the OIS yield curve by Sundaresan et al. (2016). This interpretation aligns with the fixed-rate/variable interest-rate mortgage. If interest rates had remained at 5.25% for only a short time (recall that the contractionary policy lasted until the first crisis in August 2007), it is very likely that the price reduction would have been less accentuated and those having to make mortgage payments would not have been faced with a rather steep increase in their payments while the house itself was depreciating in value. The Taylor rule guiding the Fed’s decisions suggested adjusting interest rates with the objective of stabilizing prices and employment. Variations in interest rate have a very significant impact on financial markets, but the central banks are not currently able to assess the consequences of their choices on financial stability. We will now analyze the crisis of 2007–2008. Our analysis starts with the money market and its link to long-term financing, continues to the crisis in this market and the repercussions for the banking system, and ends with the subsequent reduction in credit, which caused demand to collapse in the real estate market and in the general consumer market.

7  Monetary Policy, Spread Compression, and the Housing Market     169

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8 The Money Market, the Collateral Market, and the Crisis of 2007–2008

The financial crisis that began in August 2007 marked the beginning of a dramatic period for the US financial system, one that would continue for more than a year up to the failure of Lehman Brothers and beyond. The crisis took place in a segment of the financial system that links the money market and brief-term credit to long-term credit in the form of securitized mortgages. It is thus partially extraneous to the commercial banking system. Money markets and capital markets are linked via money market funds and the vehicles created by the banking system to externalize the securitization process. Money market funds handle wholesale liquidity that cannot be placed in bank deposits. They hold liquidity generated by large non-financial corporations, central banks, investment funds, and generally all financial intermediaries. These parties cannot put their liquidity in the bank for the simple reason that bank deposits are insured only up to a certain threshold. They thus seek a counterparty that can ensure this liquidity will retain its value by means of alternative mechanisms to retail deposits. Money market funds have never enjoyed government insurance—except during the 2008 crisis—and must thus choose an investment strategy that will reassure their depositors/financers, © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_8

173

174     G. Pizzutto

whose primary objective is not so much high yield but rather the stability of their capital. The sums they have on deposit must be immediately available without the risk of losing value. Institutional money market funds handle the liquidity of financial intermediaries and financial and non-financial corporations and constitute the most important component of money market funds. Retail funds handle the invested capital of families; the values here are much lower than in money market funds. The funds provide a higher yield than could be obtained with a bank account; they pledge to keep a stable quotation, investing primarily not only in short-term government securities (e.g., US Treasury bills and commercial paper) but also in corporate bonds (prime funds). Prime money market funds invest in short-term assets issued by commercial banks and investment banks. The recently introduced money market fund reform exempted money funds from the requirement of preserving the value of its investments at one dollar a share. The shift to a fluctuating value for the net asset value (NAV—the value of a fund’s assets minus the value of its liabilities) introduced a risk into investments in money market funds. Prior to the 2007–2008 crisis, money market funds preserved a constant value of their shares and were considered virtually as safe as bank deposits while offering a slightly higher yield. A significant portion of the assets in a money market fund portfolio is commercial papers, and thus, these funds increase demand for them. For large corporations, commercial papers are substitutes for bank loans and are issued directly on the market so that liquidity can be available quickly without the inconvenience of long, complex, time-consuming procedures. The stock of commercial papers on the money market amounted to approximately two trillion dollars prior to the financial crisis of 2007. At the same time, US government securities with maturity of less than one year amounted to just over one trillion dollars. Commercial papers and Treasury bonds were sold at a discount with respect to their face value. They were very often rolled over and generally came with a very low credit risk. In any case, they guaranteed yield slightly above Treasuries, providing money market funds with an incentive to have them in their portfolios. Their reliability was proven by the fact that the yield on commercial papers was less than the interbank rate.

8  The Money Market, the Collateral Market …     175

Commercial papers are classified as financial, non-financial, or assetbacked (ABCP = asset-backed commercial papers). The first two are not insured, whereas ABCPs are backed by securities. Commercial papers are thus the updated version of bank acceptances issued by corporations to finance their credit and their inventories. They were thus originally short-term debts financing short-term assets. The advent of ABCPs changed the balance sheet maturity structure for this type of intermediary and introduced liquidity risk into the market associated with asset/liability mismatch. The US regulatory framework eliminated issuer registration requirements if the placement was achieved through a transaction that was not a tender offer but substantially a bilateral contract between private parties who were capable of evaluating its content. In this case, the liquidity obtained could be used to finance longterm assets. While securitization was initially based on the issue of medium- to long-term bonds, in a later phase, the SIVs began issuing short-term securities (see FCIC) that financed an underlying portfolio composed of long-term assets such as MBSs or MBS tranches and their derivatives traded on the OTC market. The stock of ABCPs was in the neighborhood of 1.2 trillion dollars prior to the 2007 crisis. These quantities were the outcome of a significant increase in issues in the three previous years. Financial markets saw ABCPs as riskier than the traditional commercial papers; indeed, the ABCPs paid a spread above the interbank rate, while the yield on traditional commercial papers was lower than the interbank rate. Paradoxically, rather than reducing the risk premium, the collateral actually increased it because it made the yield on debt depend on the specific long-term assets financed by the debt. The investment banks played a significant role in the modification of the structure of the intermediation process and the transformation of maturity. This is because the investment banks initially limited themselves to structuring the securitization process without getting directly involved in the market. But later they found themselves coping with a decrease in demand for senior and super-senior tranches simply because they could no longer guarantee satisfactory yields. The following figure illustrates the relations between the banking system, CDOs, ABSs, and the ABCP conduit/SIVs (Fig. 8.1).

176     G. Pizzutto

CDO debt tranches

High risk investors

debt tranches loans

banks

ABS cash Senior tranches

SIV

Low risk investors Short term debt

Fig. 8.1  Mortgage securitization and market flows

The investment banks structured the securitization process by channeling real estate mortgages into the MBS portfolio; the CDOs that financed the MBSs then used the tranches as input. The tranches were selected so as to guarantee a positive spread between the average yield of assets acquired by the CDOs and the cost of financing the second phase of securitization, again structured as tranches. The reduction in interest rates between 2001 and 2004 motivated many homeowners to refinance their mortgages to take advantage of favorable conditions on the credit market. In 2004, when monetary policy entered a contractionary phase, real estate transactions became interwoven with the securitization process and the share of subprime mortgages began to grow, driven by strong demand from the second stage of securitization, particularly from CDOs. The explanation for this is rather simple and has to do with the fact that the tranches whose underlying assets were subprime mortgages provided a higher spread than prime mortgages and thus ensured the continuity of the intermediation process. Issues of subprime mortgages and issues of CDOs went hand in hand, but the excess of demand for subprime mortgages ended up driving up their prices and lowering

8  The Money Market, the Collateral Market …     177

the yield that could be obtained from them using these assets as CDO inputs. In particular, demand for senior tranches declined significantly because the spread offered to buyers with respect to Libor was extremely narrow and the investment banks found themselves forced to hold those tranches among their portfolio assets. Thus, in 2005 and 2006, securitization entailed the inclusion of senior and equity tranches in investment bank portfolios, while mezzanine tranches were transferred to the CDOs to fuel the process. This also allows us to understand the growth in the ABCP conduits and the SIVs created to finance the tranches that the investment banks were not able to place on the market. The difference between ABCP conduits and SIVs regards the way a possible liquidity crisis would be handled. The ABCP program provided that the sponsor would step in and cover the full needs of the vehicle in the event that financing was not provided by the market. To prevent the insolvency of the ABCP program, the intermediation process was overcollateralized. The value of the assets when the portfolio was put together had to be higher than the value of the debt so as to create a buffer in the event that the value of the portfolio assets should fall. The sponsor banks pledged to reacquire any deteriorated assets. The securitization process was designed to obtain high agency ratings so that prime money market funds could incorporate the issued bonds into their portfolios. This type of coverage was very burdensome for the sponsor banks and was complemented by introducing programs such as SIVs and extendible commercial papers, which did not come with such costs. In particular, the SIVs assembled financial assets, including tranches, on the secondary market and had to address the possibility of a need for refinancing, selling off the portfolio assets. In a crisis situation, this meant selling them for less than what could be hoped in normal times and thus not being able to repay debts at maturity. In the case of extendible commercial papers, in the same situation the operator could opt to extend the debt, transforming it from short term to medium term (greater than one year). Securitization is thus a process of transforming maturity and reallocating risk that links the money market to the capital market. In order to be able to function, the portfolio must be composed so as to ensure excess spread after having paid interest on issued tranches.

178     G. Pizzutto

The choice between a fixed-rate mortgage and a variable-rate mortgage influences the yield on the ABCP conduit/SIV portfolio and depends on monetary policy decisions. In a scenario where monetary policy becomes contractionary and interest rates begin to rise, as in 2004, the variable-rate option tends to prevail in new mortgages. The variability of the interest rate could take different forms, all of them having the objective of shifting some of the risks of such variations onto the borrower. On their part, borrowers tended to prefer paying an initial rate below the fixed interest rate, but underestimated the increase they would face in the future if contractionary monetary policy dragged on. The variable interest rate is the sum of two components: a reference index and an added spread or margin. The reference rate may be the interbank rate (generally Libor) or the interest rate on Treasury bonds and was substantially aligned to the Fed’s interest rate on refinancing operations. A yield spread is then added, which remains fixed for the entire duration of the loan. The variable rate generally kicked in after a period ranging from 1 to 10 years during which the borrower paid a fixed rate agreed at the time the mortgage was taken out. Generally speaking, 75% of the portfolio of a securitization program was composed of variable-rate mortgages, the rest fixed rate (Kendra 2007). An increase in Libor would thus reduce the excess spread originally deriving from the fact that the fixed mortgage interest rate did not adjust to the new interest rate. If the Fed continued to increase interest rates, the excess spread would shrink in step and the risk of failure due to diminishing profits would rise, especially if interest rates continued to rise and remained at high levels for a long period. The Fed’s contractionary policy lasted three years from June 2004 to August 2007, when interest rates plummeted following the crisis in the ABCP conduit and the SIVs. In 2006, the holders of adjustable-rate 2–28 (2 years fixed rate, 28 years adjustable rate) mortgages signed two years earlier had to begin paying interest indexed to Libor, without altering the spread with respect to Libor. An increase in outlays as a proportion of income for interest on variable-rate contracts affected earnings for intermediaries and compounded the reduction deriving from the share of fixed-rate mortgages. Payment of interest on debt could not be limitless; at a certain point, a portion of the loans defaulted.

8  The Money Market, the Collateral Market …     179

In the case of overcollateralized loans, the reduction in the value of the assets could only be absorbed if the risk premium requested by investors remained unchanged. This depended on whether risk aversion remained constant and on the relation between credit risk and the risk of interest rate adjustment. A prolonged rise in interest rates reduced the value of assets, increased the variable component of the interest rate that had to be paid but left the spread unchanged. At the same time, faced with a reduction in the value of the assets in the vehicle they are financing, investors request an increase in the risk premium to renew financing. The spread is constant on the assets side of the balance sheet but varies on the liabilities side. If the spread on liabilities rises beyond the value of the spread on assets, the intermediation process cannot ensure the excess spread, which is the reason for its existence. The belief that credit risk and interest rate risk are separable leads to an underestimation of the effects of contractionary monetary policy. Such a policy reduces the value of financial assets and increases the risk premium requested by investors. If the underlying assets cannot guarantee the cost of financing, failure is inevitable. The portfolio of securitized assets cannot achieve yields compatible with the interest rate demanded by investors—in this case money market funds—while ensuring an acceptable level of risk (Fig. 8.2). The financial system is supported by the financial market and the banking system. The banks are institutions capable of increasing the supply of credit to compensate crises in the financial markets, or forced

Fig. 8.2  Spread ABCP/treasury 3 months

180     G. Pizzutto

to decrease the supply of credit following a market crisis. The decision depends on how the financial market crisis affects the balance sheets of commercial banks. For example, during the crisis of 1998, liquidity was transferred from the troubled financial markets into bank deposits, and the increase in deposits allowed the banks to step in for the markets, ensuring needed credit to the business community. The literature has highlighted how the banks play a dual role as suppliers of liquidity. Through their lines of credit, they ensure that firms have the liquidity they need but cannot get from the market. If the businesses used all or some of the credit provided by the banks, the bank’s balance sheet would register an increase in assets. This would be possible only if the banks had a corresponding increase in deposits. And this transfer of liquidity from troubled markets to bank deposits can only happen if the deposits are perceived as being risk free. Hence, on the one hand, the banks commit to providing liquidity to businesses, and on the other, they guarantee the liquidity of their deposits. The interaction of the two functions stabilizes the financial system (Kashyap et al. 2002). If the expansion of credit to businesses were not accompanied by an influx of deposits, the outcome would be a worsening of the crisis. During the crisis in the 1930s, the liquidity shock from an increase in the spread on commercial papers translated into a reduction in the credit supply (Pennacchi 2006). The commercial banks did not function as stabilizers of the financial system during the Great Depression. They did so only after the introduction of deposit insurance in 1933, which drastically reduced liquidity risk. The assets and liabilities of commercial banks move along parallel and synergetic paths only if deposits are perceived as being risk free by the market. The crises in financial markets transform into crises of the financial system and then impact the real economy when commercial banks are forced to reduce the credit supply following a market crisis. Between August 2007 and the failure of Lehman Brothers in September 2008, the banks were in a bind for three reasons. First of all, they shifted off-balance-sheet assets into their portfolio. These assets included the SIV portfolio. The failed attempt to put together a fund to hold this portfolio with the contribution of the principal banks and the Treasury Department forced individual banks to reabsorb all the

8  The Money Market, the Collateral Market …     181

assets that they had transferred. As sponsors of the liquidity of the SIVs, they could not allow them to fail because this would have had negative repercussions on the trust between banks and financial markets. In this phase, the SIV debts were repaid regardless of the underlying value financing them, which was transferred back to the bank’s balance sheet as assets. Money market funds that had bought ABCPs issued by the SIVs suffered only negligible losses in 2007 because the sponsor banks repaid the debts at maturity, taking on real estate assets that had lost value in the meantime (Acharya et al. 2013). Secondly, the banks increased credit to non-financial firms that had lines of credit. A line of credit is an agreement between a bank and a company, setting out the maximum amount a business may borrow in a given time period. The line of credit provided the company a great deal of flexibility in meeting its financial needs because, unlike a debenture loan, interest is only paid on the amount of credit that is actually used. The use of lines of credit by businesses allowed them to maintain their investment plans in 2007 when liquidity dried up on the money market (Berrospiede et al. 2012). The third reason is the precautionary increase in demand for credit. For example, Ivashina and Scharfstein (2010) argue that businesses, worrying about the poor performance of the financial market, took precautions by acquiring liquidity that was not immediately necessary to finance investment projects but good to have in the event of further worsening of the situation on financial markets. The increase in value of the assets in the banking system in this period was not the outcome of rational choices but simply the fulfillment of a commitment made in the past, which required an expansion of credit in certain countries. However, the increase of assets in the portfolio that derived from this demanded an increase in financing that banks were not able to obtain by leveraging their deposits. In that period, the reliability of the banks was compromised by the awareness of the transfer of off-balance-sheet assets back onto the balance sheet, and the liquidity withdrawn from the money market flowed into government securities or bonds issued by the Federal Loan Home Bank (FLHB) system. Together with Fannie Mae and Freddie Mac, FLHB is one of the government agencies instituted to stabilize the housing

182     G. Pizzutto

market and favor growth in home ownership. While the first two securitized mortgages on the secondary market, the latter was a cooperative network of commercial banks and Savings & Loans dealing in mortgages instituted in 1932 during the Great Depression. FLHB members provided financing to other members. The liabilities were medium- and long-term bonds, which the financial markets viewed as being as reliable as government securities. During the crisis of 2007, liquidity flowed into securities issued by FLHB, which were considered even safer than bank deposits. At the same time, this bank increased its financing of commercial banks, acting as a lender of last resort in place of the Fed, which stepped in to lower the interest rate on refinancing operations. In the event of a liquidity crisis, banks are rather reluctant to borrow from the central banks for reasons of reputation. The opportunity offered by advances from the FHLB provided them with a flow of liquidity via non-traditional channels (Ashcroft et al. 2008). The following year, faith was restored in bank deposits when the Fed intervened in financial markets in a more systematic and comprehensive way, raising the value of insured deposits from 100,000 to 250,000 dollars (Table 8.1). Financing from banks through this channel was not enough to guarantee expansion of credit to the private sector. As noted by McCornett et al. (2011), with a partially illiquid portfolio as regards exposure to the real estate market and augmented leverage caused by the increased use of lines of credit and absorption of SIV assets, the banks responded by reducing the flow of new credit. As evidenced by a number of indicators, the banks adopted increasingly stringent criteria for granting credit and in particular became very selective in extending credit to the real estate sector (Antoniades 2014), bolstering a trend that had emerged in earlier years. The contraction in credit produced a fall in demand for housing and a collapse in prices. Negative equity accompanied by an increase in unemployment generated an increase in defaults by families, which reached their peak in 2009. There were 2.8 million foreclosures that year, an increase of 24% with respect to the 2.2 million in 2008, 81% over 2007 (1.5 million), and 179% over 2006 (1 million) (Sherlund 2010). The years following the financial crisis recorded the highest level of defaults and a decrease in home ownership.

8  The Money Market, the Collateral Market …     183 Table 8.1  FHLB advances 2007 ($ billions) Washington Mutual Bank of America Countrywide Wachovia Wells Fargo Citigroup

Advances Q.4 2007

Assets Q.4 2007

63.9 57.2 47.7 41.9 11.3 102

325 1667 121 741 529 1351

Source Ashcroft et al. (2008)

The reduction in availability of credit and the creation of new mortgages further pushed prices down and boosted defaults. Acquisitions of houses began to rise again in this period, fueled especially by the ­availability of l­iquidity, not by debt. For a long time, the banks imposed very strict standards on the extension of mortgages, which prevented the ­expansionary monetary policy from translating into an increase in the availability of credit. The absorption of ABCP conduit and SIV assets into bank portfolios and the failure of the money market segment that financed them drove dealers to seek alternative financing on the repo market. A repurchase agreement (repo) is a collateralized contract where a party having liquidity to invest lends it to a counterparty in exchange for the temporary transfer of financial assets that remain available to the lender until the loan is repaid. The difference between how much the borrower pays at term and how much credit it received is the interest paid on the operation. The amount of credit extended is always less than the value of the collateral so that the lender has a guarantee in the event of a variation in the market value of the asset. The ABCP market, on the other hand, is a market where issued bonds finance a specific portfolio of assets without them being transferred temporarily to the bond buyers to reduce the transaction risk. The repo market is a mechanism that organizes financial transactions and brings those with liquidity and wants to invest it into contact with those who are in search of financing. The transfer of collateral reduces the risk for the lender. When we speak of liquidity, we are referring to the liquidity held by institutional investors such as investment funds, large corporations, securities lenders, insurance funds, and also central

184     G. Pizzutto

banks. While retail liquidity finds its natural outlet in bank deposits, wholesale liquidity has to find alternative routes of investment. One possibility might be government securities, but this solution was not necessarily workable due to the scarcity of securities in circulation with respect to demand. And thus, the repo market was the chosen avenue for resolving the issue of investing liquidity and reducing risk. The US financial arena has always been plagued by the problem of liquidity and how it is invested. The volumes have tended to grow in recent years. For example, the liquidity available to financial and non-financial corporations increased from 1.22 trillion dollars in 1995 to 4.97 trillion in 2010 for an average yearly increase of 10%. If we take into account the trend in liquidity just in the non-financial corporations, the percentage increase is similar. In 2007, for example, liquidity was 1.18 trillion, rising to 1.6 trillion in 2011 (Sanchez and Yurdagul 2013) and to 1.73 trillion dollars in 2014. That year, 25% of the liquidity was held by five corporations: Apple, Microsoft, Google, Pfizer, and Cisco (Moody 2015). Poszar (2015) estimates that the liquidity available to investment funds was in the neighborhood of 400 billion dollars in 2007, rising to 500 billion in 2010. The propensity for liquidity of mutual funds continued to rise in subsequent years. For example, in 2014, the liquidity of long-term investment funds—the most significant component of US investment funds—amounted to 700 billion dollars, more than doubling since 2007 (300 billion) according to the Investment Company Institute (Annual Report 2015). Liquidity obtained as collateral by security lenders amounted to 1.2 trillion dollars in 2008, falling to 800 billion in 2010. Asset lending became a common practice in financial markets. Institutional investors lent assets they had in their portfolios to dealers, who used them on the repo market, in their activities as market makers, or in response to a request from another intermediary. Hedge funds borrowed assets and offered liquidity as collateral so they could open short positions. Institutional investors invested the liquidity they received and earned interest, which increased the yield of their portfolios. In a period when interest rates were near zero, even a small variation in yield helped maintain equilibrium in their balance sheets. During the financial crisis, this type of transaction was strongly curtailed, partly because the

8  The Money Market, the Collateral Market …     185

security borrowers liquidated their positions in an attempt to recover the liquidity they had provided as collateral. Short positions decreased in the following years, and broker-dealer balance sheets were reshaped, partially because of new regulations. It is probable that this component of aggregate liquidity stabilized and will not return, in the medium term, to pre-crisis levels. We also must not forget the liquid component of the central bank reserves, estimated at around one trillion dollars. Wholesale liquidity created within the real economy or the financial sector is either directly invested by holders or transferred to money market funds whose portfolio consists of short-term assets exchanged for collateral on the repo market. This liquidity is invested in money market funds and on the repo market, where it finances financial intermediaries who need short-term credit, especially broker-dealers. It was to this market that the banks turned after the ABCP market proved unable to ensure the financing they needed. One particular feature of the US repo market is the difference between repo in the strict sense and triparty repo. Transactions on the repo market are bilateral, involving the transfer of assets in exchange for credit. Transactions on the triparty repo market include a bank as a third party acting as a clearinghouse. The necessity of financing portfolios on the repo market after the crisis of 2007 might erroneously suggest limiting analysis of the financial system and the crisis of 2008 to a run on the repo market. According to the analysis by Gorton (2010) and Gorton and Metrick (2012), in response to an increase in margins or denial of refinancing, liquidity was withdrawn from the market, pushing investment banks toward bankruptcy. This part of our analysis considers the role of dealers as institutions that finance their positions on the money market and on the repo market in particular, thus using the repo contract. The dealers obtain liquidity on the repo market offering financial assets in return. The role of dealers up to the 1990s consisted in using this liquidity to make purchases on margin. Later, dealers changed into financial intermediaries who acquire liquidity, pay interest on it, and make a profit by lending this liquidity at a higher interest rate (Stigum and Crescenti 2007).

186     G. Pizzutto

Intermediation involves the transfer of liquidity from well-stocked, risk-averse parties to parties who use the liquidity to construct debt positions that provide yields equal to or greater than a given benchmark. In this context, the main users of dealer liquidity are hedge funds, real estate funds, and mutual funds (Fig. 8.3). Insurance companies and pension funds purchase increasing shares of hedge funds to achieve portfolio yields that can maintain equilibrium on their balance sheets. The analysis of the balance sheets, and dealer bookkeeping generally, provides us with the background to understand the reasons for the 2008 crisis. The difficulty in interpreting transactions in this segment of the financial market derives from the fact that dealer balance sheets do not immediately reveal their situation because many operations are consolidated, as permitted by bookkeeping regulations. Dealer balance sheets have to account for two elements: the transfer of liquidity and the transfer of collateral, used in turn to obtain loans. The term “securities in” includes all financial assets that become available to dealers. They become available in two ways: The main source is assets used as collateral for a loan to intermediaries, or they are assets that the dealers borrow for their own purposes. In the latter case, the dealers function as securities borrowers on their own behalf or because they have to write these assets over to hedge funds that want to open a short position. The hedge funds have neither the capacity nor the organization to trade directly on the OTC market if they want to open a short position and thus must turn to dealers to borrow the assets. As an alternative, the loan of financial assets can be managed by dealers acting as market makers or as a portfolio choice. Bonds are generally traded on the repo market, whereas stocks are traded on the securities lending market. The two ways outlined above regard incoming financial assets. Symmetrically, outgoing assets serve to finance their debt. They are recorded as “securities out.” Generally, dealers get their financing on the triparty repo market making broad use of assets they receive as collateral from hedge funds, as well as assets that are in their portfolio (Kirk et al. 2014). The first thing that can be deduced from the balance sheet is the difference between securities-out and securities-in. This difference provides an approximate measure of the financing of dealer positions

8  The Money Market, the Collateral Market …     187

Pension funds,banks

cash

Triparty repo

collateral

cash

Money market funds

cash collateral collateral Hedge funds

dealers cash

collateral Custodian banks cash/collateral

Fig. 8.3  Dealer intermediation

distinct from their intermediation activities. The difference between these two columns on dealer balance sheets tended to increase in the period leading up to the crisis of 2008, a sign that speculative financing, i.e., financing via the money market, of positions in the dealers’ portfolios was growing. This can be explained by the acquisition of previously externalized assets into their portfolios and as dealers’ portfolio choices, aiming to keep tranches of mortgages that have not found a market, i.e., that are securitized but not distributed, in their portfolios. The data regarding the repo market are less than the securities-out, which includes repo operations and the loan of financial assets. The reverse repo is less than the securities-in because it does not include borrowed financial assets. The Federal Reserve Bank of New York provides disaggregate data regarding government securities, MBSs, corporate bonds, and agency bonds that were part of the stock of collateral in dealer portfolios following lending operations. By subtracting the value of the reverse repo from the total of these four categories under the heading securities-in, we obtain the value of the financial assets borrowed by the dealers. If we subtract the value of the repo operations from the total of the securities-out headings, we obtain the value of the financial assets given as loans. Even though it is formally similar, the repo and reverse repo contract must be distinguished from the mechanism that regulates securities lending or borrowing. Even in this last case, we are talking about

188     G. Pizzutto

operations that regard the exchange of liquidity for collateral. Repo and securities lending represent the indebtedness of the dealers and the transfer of collateral, while reverse repo and securities borrowing represent the use of this liquidity, the investment of the dealers, and the acquisition of collateral. Repo and securities lending are classified as securities-out, while reverse repo and securities borrowing are classified as securities-in and show the movements of collateral. The difference between securities-out and securities-in is the net debt of dealers, used to finance their positions (see Fig. 8.4). The inventory of financial assets handled as collateral by dealers and appearing on the balance sheet only imperfectly represents the assets available for financial transactions. The possibility offered by bookkeeping rules for financial transactions makes it possible to consolidate many types of exchange and largely underestimates the effective inventory of available collateral. While from a quantitative point of view we need to go beyond the balance sheet to understand the value of the inventory of collateral available to dealers, this inventory always originates in hedge funds and

Fig. 8.4  Securities in–securities out

8  The Money Market, the Collateral Market …     189 Table 8.2  Dealers collateral source 2007 and 2010 (hedge fund and securities lending) Date

Hedge funds

Securities lending

2007 2010

1.7 1.3

1.7 1.1

Source Singh (2011)

securities lenders. Hedge funds finance themselves through dealers and provide financial assets as collateral that the dealers can then use to finance themselves, while securities lenders represented by the custodial banks lend financial assets in exchange for liquidity that they can invest. Table 8.2 represents the incoming collateral available to dealers deriving, respectively, from hedge funds and custodial banks as instructed by pension funds, insurance companies, and institutional investors who boost their yield by lending financial assets. In the case of a loan with cash as collateral, the plans for reinvesting the liquidity will further strengthen this objective. In the periods of extremely expansionary monetary policy, securities lending represents a channel through which portfolio yields can be boosted through a process of inverse transformation. Those who hold long-term assets lend them in exchange for liquidity that they invest in the short-term market. The dealer’s role involves channeling the collateral acquired through reverse repo operations and using it to finance the intermediation process. Table 8.3 describes the collateral available to the principal investment banks in 2007–2008. The first column under each month refers to the overall inventory of collateral that became available to dealers for reuse in repo operations. The second column represents the amount of collateral that was actually reused. The amount of available collateral decreased in 2008 because hedge funds and securities lenders chose to terminate their contracts out of fear of dealer bankruptcy. In a collateralized financial system, leverage has a different meaning than it does in a bank-based system. A reduction in leverage in the latter case enhances system stability; in a collateral-based system, when securities lenders decide to call in the loaned assets or hedge funds reduce

190     G. Pizzutto

their leverage to recover their collateral, dealers have less collateral available to them and are less able to finance themselves. In 2008, the perception of a possible failure of investment banks triggered a collateral run that reduced the investment banks’ ability to obtain credit on the repo market, where margins and demand for good-quality collateral were rising. Transactions among the various financial intermediaries we have described are based on a contract that sets the margin and the spread. Margin is the difference between the market value of an asset (security) deposited as collateral and the amount of liquidity received in exchange. In a repo, where a collateral provider (liquidity borrower) needs liquidity and deposits a security with the cash investor (liquidity lender) as collateral, the value of the security is higher than the value of the cash received in exchange. This difference is the margin. It protects the cash investor against the risk that the security decreases in value before the transaction is completed, which would mean that the collateral provider is able to pay less to buy it back, cutting into the cash investor’s profit. The idea is to post a margin high enough to absorb this difference and ensure some profit. In a reverse repo, where a cash investor needs a security and lends money to the collateral provider, the investor gives cash worth more than the security. This margin protects the collateral provider from the risk that the security increases in value prior to the conclusion of the transaction, which would mean that the collateral provider has to pay more to buy it back. In either case, the riskier the security, the higher the margin. If the value of the security rises or falls, the margin is adjusted accordingly. Table 8.3  Securities received from dealers as collateral with the permission to repledge and the collateral pledged to counterparties Dealers

November 2007

Morgan Stanley Goldman Sachs Merrill Lynch Lehman Brothers

948 891 853 798

Source Form 10 Q

August 2008 708 785 675 725

877 831 676 518

November 2008 680 691 535 427

294 578 327

227 445 251

8  The Money Market, the Collateral Market …     191

Recent studies have shown that margins are relatively stable on the t­riparty repo market (Copeland et al. 2014) but are quite variable on the repo market (Gorton 2010). The fact that there were initially divergent assessments of the trend in margins may be explained by the fact that different studies examined different markets. The study and model proposed by Infante (2015) reconcile the difference in importance attributed to margins, explaining it as a difference in the operating mechanisms of the repo market with respect to the triparty repo market. In particular, the stability of margins on the triparty repo market does not mean that the transactions are stable and refinancing is assured. The decision to cut off credit in a triparty repo contract can be made by cash lenders regardless of margins, looking instead at the reliability of the borrower. The conclusions presented in the literature can be further explored by analyzing the role of clearing banks (custodian banks) in triparty repo arrangements. In the USA, there are few clearing banks operating in this market. Figure 8.4 illustrates the value of the financial assets handled by the four principal US custodian banks. In the USA, the first two clearing banks handle triparty repos: Bank of New York Mellon (BNYM) and JP Morgan Chase (JPMC) (Table 8.4). Clearing banks act as intermediaries between liquidity providers (e.g., money market funds) and liquidity seekers (dealers). Dealers seek liquidity for two reasons: to finance their positions or to finance other operators, hedge funds first and foremost. In the latter case, we are talking about a “matched book” or “cash matching” approach. The money market we are examining is a short-term money market. In an overnight repo transaction, dealers (collateral providers) transfer financial assets to a money market fund (cash investor) toward the end of the day and obtain liquidity in exchange for a value lower than the value Table 8.4  Custodian by asset under custody (December 2010 - trillions of dollars) The Bank of New York Mellon J. P. Morgan State Street Corporation Citi Source Financial markets the Asian Banker

24.266 16.032 15.794 12.600

192     G. Pizzutto

of the assets given as collateral, which they pledge to buy back the next morning at a higher price than what they sold them for the previous day. The difference between the two prices represents the interest that the dealers pay to the money market funds. The clearing bank mediates this operation ensuring that everything proceeds according to the agreement. This means identifying and assessing the assets offered as collateral for the repurchase agreements, transferring the assets from the dealer’s account to the investor’s account, transferring the liquidity obtained in exchange for the assets from the investor’s account to the dealer’s account, adjusting the transaction margins to the market value of the assets and to investor demands, and verifying that the deposited assets are effectively available. All these functions require competencies and technological investments that dealers and money market funds do not have. The transfer of these functions to a clearing bank meets the need of keeping solid control over the financial assets given as collateral. The clearing banks are prohibited from reusing the collateral that they obtain from dealers. The timing of the transaction is important. The morning after the first transaction, the clearing bank repays the money market fund that lent liquidity to the dealer the previous evening, drawing the funds from a line of credit it has opened with the dealer, and transfers the asset given as collateral back to the dealer. The bank expects that a similar operation will take place that evening. In the ensuing time interval, the dealer is indebted to the bank for the money advanced to the fund. The bank plans to recover this money in the evening, when new liquidity is transferred from the money market fund. During the interval, the dealer provides instructions to the bank regarding the amount of credit it intends to obtain and the collateral it intends to offer in exchange. This leaves the clearing bank exposed to dealer credit risk. What was the normal policy of clearing banks toward dealers in 2007 and 2008? The clearing banks did not usually ask dealers for margins. For example, if a dealer obtained a loan of 9.8 million dollars in the evening from a money market fund in exchange for government bonds worth 10 million dollars (margin = 200,000 dollars), the following morning the clearing bank gave the dealer a line of credit equal to the value of the collateral. In this case, the dealer had use of an additional

8  The Money Market, the Collateral Market …     193

200,000 dollars in cash, a surplus it could use to open new positions or pay off or consolidate ongoing transactions. Following the commercial paper market crisis in 2007, the Federal Reserve Bank of New York, operating arm of the Federal Reserve Board, was rather concerned about the systemic crisis that could grow out of this type of procedure and asked the clearing banks to reconsider their relations with dealers, urging them to introduce a margin analogous to that asked by investors in the triparty repo market. In the previous example, the clearing bank would not have credited 10 million dollars to the dealer’s account, but only 9.8 million. The Federal Reserve Bank of New York, which has always performed a financial market control function on behalf of the Fed, feared that the clearing banks’ exposure to credit risk might lead to their failure if one of their client dealers should fail at a time when financial assets associated with the real estate market, either directly or indirectly via securitization, were losing value or were not traded. There is no precise information available as to the type of collateral used in triparty repo arrangements prior to the crisis of 2008, but a post-crisis assessment by the Fed identifies some 30% as non-governmental bonds (Federal Reserve Bank of New York 2010). This was obviously a source of concern because of the strategic importance of the clearing banks within the financial system. Toward the end of 2007, the Fed regulators began to pressure the clearing banks to improve their risk management procedures and introduce a margin on the credit they extended to dealers during the day. The Fed suggested that the margin was the analogue of that requested by money market funds. The clearing banks accepted the suggestion and gradually began introducing a margin on intraday transactions with dealers. The shift from zero margin to a positive margin was analogous to a margin call. This type of institutional explanation may also clarify the differences of opinion between those who argue that the repo market and margin calls triggered the crisis (Gorton and Metrick 2012) and those who claim that the margins did not change because triparty repo is supported by stable contracts that change very slowly over time or else cease suddenly when the lender loses faith (Copeland et al. 2014; Krishnamurthy et al. 2014). The margins in triparty repo arrangements were modified by

194     G. Pizzutto

the clearing banks, while the money market funds kept them stable or declined to provide the liquidity necessary to roll over the loans. The clearing banks thus asked the dealers to provide them with collateral for intraday loans. The dealers played for time and then, under pressure from the Fed, began to provide real estate assets to the clearing banks as collateral. The valuation of these assets by the two most important clearing banks was less than that estimated by the dealers. Faced with a request for other collateral with lower risk and greater market value, many investment banks balked because they did not have lowrisk collateral to transfer to the clearing banks so they could continue to obtain intraday financing. The Lehman Brothers liquidator meticulously reconstructs the relation between the doomed investment bank and JP Morgan Chase (Valukas Report 2010, vol. 4). The reason for the scarcity of collateral used by dealers (as securities borrowers) lies in the decision of the collateral providers, who deposited the securities either to obtain liquidity for their own purposes (hedge funds) or to earn a profit as securities lenders. Between 2007 and 2008, all investment banks registered a decrease in the collateral they received in exchange for loans and in the financial assets they borrowed from securities lenders. The contraction is most notable for dealers with significant exposure on the real estate market, while it was more contained for dealers trading on the stock market. It is important to explain why less collateral was available to dealers if we want to understand why the intermediation process broke down. The dealers use the collateral as a guarantee to borrow liquidity on the repo market. If the value of the collateral deteriorates, the process fails. The financial intermediation process is extremely efficient under normal conditions on financial markets, but it creates instability if things start to go sour. In the specific case of 2008, we saw that clearing banks urged the investment banks to increase the collateral they had to put up in a triparty repo arrangement to be able to borrow. It is reasonable to think that the progressively stricter conditions imposed by clearing banks on triparty repo arrangements, coupled with worsening conditions in the real estate market, drove dealers in turn to raise the margins on transactions with hedge funds. Alternatively, we may think that the hedge funds, working countercurrent to the dealers, decided on their own initiative to reduce their

8  The Money Market, the Collateral Market …     195

positions and leverage before the crisis hit (Ang et al. 2011). In any case, the reduction in leverage has different effects in a repo market than it does in a market without guarantees. In a non-collateralized market, lessening debt lowers systemic risk. In a repo or reverse repo market, deleveraging means reducing debt and the simultaneous calling in of collateral, which is no longer available to the dealers, reducing their ability to obtain credit. The securities lenders helped form collateral inventories available to dealers until 2008 and then decided to stop lending financial assets. The contract between dealers and securities lenders can be terminated by either party with no advance notice. Institutional investors lend financial assets in order to achieve additional yield over their portfolio yield. Dealers borrow assets on request from hedge funds that want to open short positions and are not able to purchase stocks directly on the market and so turn to the intermediation services of a dealer. On the other hand, dealers may borrow assets with the aim of acting as market makers or opening their own short positions as a way of covering and managing risk. In the USA, the lending of financial assets to dealers is accompanied by receipt of collateral in the form of cash that is usually reinvested temporarily in other financial assets. There are two alternative strategies for achieving the increase in yield sought by custodian banks that act as agents for securities lenders. One involves lending some general form of collateral, perhaps government securities or securities issued by some government agency, and receiving cash as collateral to re-invest in long-term assets with a higher risk profile. Interest paid to the dealer that provided the cash collateral must be subtracted from the interest earned on this investment. The other involves lending high-demand assets and paying a low or even negative interest rate on the cash obtained as collateral, investing the cash in very safe, short-term securities on the money market. In the former case, the liquidity risk is high. The AIG case is emblematic in this regard. The insurance company lent financial assets it had in its portfolio and invested the cash it obtained as collateral in real estate assets. If the borrowers return borrowed assets and demand cash in exchange and the securities lender has invested in long-term assets, the securities lender has to sell its portfolio assets at a discount, assets that might have a market at that time, thus weakening its balance sheet.

196     G. Pizzutto

Securities lenders drastically reduced the availability of collateral in 2007–2008. The deterioration of the situation on the real estate market gave securities lenders a strong incentive to call in the assets they had loaned out. At that time, the assets were particularly valuable as instruments that could be used to obtain liquidity, while the counterparty risk was increasing. The dealers were caught in a bind: On the one hand, the hedge funds and securities lenders tended to call in their collateral and the liquidity in dealers’ hands because they were afraid the dealers might fail; on the other, the clearing banks were pushing for an increase in collateral. In the extreme cases, such as Lehman Brothers, the clearing banks and investors in the triparty repo market refused to extend financing, leading to the collapse of the investment bank.

Bibliography Acharya, V., Schnabl, P., & Suarez, G. (2013). Securitization without risk transfer. Journal of Financial Econimics, 107, 515–536. Ang, A., Gorovyy, S., & Van Inwegen, G. B. (2011). Hedge fund leverage. Journal of Financial Economics, 102(1), 102–126. Antoniades, A. (2014). Liquidity risk and the credit crunch of 2007–08: Evidence from microlevel data on mortgage loans applications (BIS Working Paper 473). Ashcraft, A., Bech, M., & Frame Scott, W. (2008). The federal home loan bank system: The lender of next to last resort (Federal Reserve Bank of New York Staff Reports 357). Berrospiede, J., Meisenzahl, R., & Sullivan, B. (2012). Credit lines use and availability during the credit crisis:the importance of hedging (FED Finance and Economic Discussion Papers 2012–27). Copeland, A., Martin, A., & Walker, M. (2014). Repo runs: Evidence from the tri‐party repo market. The Journal of Finance, LXIX(6), 2343–2380. Covitz, D., Liang, N., & Suarez, G. (2013). The evolution of the financial crisis: Panic in the asset-backed commercial paper market. The Journal of Finance, LXVIII(3), 815–848. Federal Reserve Bank of New York. (2010). White paper triparty repo reform.

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Gorton, G. (2010). Slapped by the invisible hand: The panic of 2007. Oxford: Oxford University Press. Gorton, G., & Metrick, A. (2012). Securitized banking and the run on repo. Journal of Financial Economics, 104(3), 425–451. Infante, S. (2015). Liquidity windfalls: The consequences of repo reypothecation (Finance and Economics Discussion Series). Federal Reserve Board. Investment Company Institute. (2015). Annual Report. Ivashina, V., & Scharfstein, D. (2010). Bank lending during the financial crisis of 2008. Journal of Financial Economics, 97(3), 319–338. Kashyap, A., Rajan, R., & Stein, J. (2002). Banks as liquidity providers: An explanation for the coexistence of lending and deposit-taking. Journal of Finance, 57, 33–73. Kendra, K. (2007). Tranche ABX and basis risk in subprime RMBS structured portfolio. Fitch Ratings. Kirk, A. M., McAndrews, J., Sastry, P., & Weed, P. (2014). Matching collateral supply and financing demands in dealer banks. Economic Policy Review. Federal Reserve Bank of New York. Krishnamurthy, A., Nagel, S., & Orlov, D. (2014). Sizing up repo. Journal of Finance, 69(6), 2381–2417. McCornett, M., McNutt, J., Strahan, P., & Tehranian, H. (2011). Liquidity risk management and credit supply in the financial crisis. Journal of Financial Economics, 101(2), 297–312. Moody. (2015). Us non financial corporate cash pile grows to $ 1,73 trillion, led by technology. Pennacchi, G. (2006). Deposit insurance, bank regulation and financial system risk. Journal of Monetary Economics, 53, 1–30. Pozsar, Z. (2015). A macro view of shadow banking. Credit Suisse. Sanchez, J., & Yurdagul, E. (2013, January). Why are corporations holding so much cash? Federal Reserve of St. Louis. Regional economist, 1–8. Sherlund, S. (2010). Mortgage Defaults. Federal Reserve Bank of Chicago. Singh, M. (2011). Velocity of pledged collateral: Analysis and implications (IMF Working Paper 11/256). Singh, M. (2014). Collateral and financial plumbing. London: Risk Books. Stigum, M., & Crescenti, A. (2007). Money market (4th ed.). New York: McGraw Hill. Valukas, R. (2010). Lehman Brothers holdings Inc. Chapter 11 Proceedings Examiner’s Report. New York: United States Bankruptcy Court.

9 Conclusions

In the previous chapters, we have laid out an interpretation of the US financial crisis revolving around monetary policy and its effects on intermediation processes. We shall develop this interpretation further in this chapter. Prior to the financial crisis, monetary policy was focused on controlling the short-term interest rate via the main refinancing operations with the objective of influencing the interbank rate to achieve macroeconomic stabilization. The relation between monetary policy and financial intermediation was relegated to the background even though the creation of the central banks had, paradoxically, precisely the goal of stabilizing financial markets. The understanding of the relationship between monetary policy and financial markets focused on the role of the central bank in stopping speculation and endogenous financial bubbles. The central bank wields monetary policy as a means for keeping the market interest rate aligned with the natural interest rate. Although the theory of the natural interest rate is often overlooked, it underlies monetary policy choices. The Taylor rule suggests that the Fed’s interest rate should be set equal to the natural interest rate, deviating only when it © The Author(s) 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0_9

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becomes necessary to adjust the system to a target inflation rate under conditions of full employment. The real interest rate, in the tradition of Fisher and Wicksell, regulates the intertemporal distribution of consumption and does not depend on monetary policy, but rather on consumer preferences and technology. The macroeconomic models growing out of this tradition (RBC and DSGE) posit that the central bank has to follow the natural interest rate to ensure full employment without inflation in an economic arena where no one defaults. The risk premium is explained as the covariance between yield on financial assets and consumption and tends to compensate procyclical financial assets. The financial market plays a role of consumption smoothing, and countercyclical assets— precisely thanks to their insurance function—are very much in demand and easily absorbed into the portfolios of consumers, who are content with a rather modest gain. The risk premium, on the other hand, is high for financial assets (such as stocks) that tend to follow the economic cycle, providing positive yield when the consumer is relatively less in need of it. The representative agent maximizes a concave (risk-averse) utility function and distributes consumption over time and in different countries so as to maintain relatively constant marginal utility. The interest rate functions as an intertemporal price, ensuring the equilibrium of the consumer market and aligning production composition to achieve maximum utility. For example, if the real economy is expected to show sustained growth in the future, the interest rate must increase because future marginal utility will decrease and current marginal utility will grow; an excess of current marginal utility increases aggregate demand for goods in the short term. The interest rate must increase to maintain equilibrium in the consumer market, increasing savings and reducing current demand. Current demand is defined under conditions of full employment. The production function and the condition of job market equilibrium determine how much a system produces. The interest rate determines the composition of production in terms of consumption and investments (which increase future consumption) so as to maximize intertemporal utility.

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A particular version of this model explains instability in the financial sector when short-term debt is issued by the private sector. According to recent literature, when short-term debt is issued by the private sector, the instability of the financial sector may be evaluated according to the hypothesis, originally advanced by Krishnamurthy and VissingJorgensen (2012) that short-term government debt is a financial asset with attributes similar to currency and its yield depends on imbalances between supply and demand. In particular, the financial market appreciates the high liquidity of this debt because it can be bought and sold immediately (market liquidity), and secondly because its value is guaranteed in all countries of the world, even during a systemic crisis. Furthermore, it can be used as collateral when seeking credit and its margin is always extremely low (at least in the US financial market). With a generally stable growth trend, supply depends on the government deficit and how it is financed. A reduction in the supply of short-term government debt drives its price up and reduces its yield; in particular, it produces a reduction in the risk premium with respect to what corporations have to pay on their bonds. The permanent nature of this disequilibrium pushes the natural risk-free rate down and the market re-equilibrates if the central bank reduces the interest rate to align with the natural interest rate. When the interest rate reaches zero, monetary policy loses its effectiveness and the economic system establishes a new equilibrium at lower levels of production and employment. The economy is then in an extreme form of liquidity trap known as a safety trap induced by the disequilibrium between supply and demand of riskfree assets (Caballero et al. 2017). In the period leading up to the financial crisis, the demand for riskfree liquid assets was met by the private sector via securitization processes that created assets considered to be risk free. These were used to satisfy demand that the public sector was not able to meet. When private sector demand for currency-like financial assets is satisfied endogenously, the risk of roll-over is very high, as was seen in 2007. This premise underlies an interpretation of the 2007–2008 crisis which sees it as having been caused by a limited supply of risk-free assets, partially compensated by private debt through the securitization process,

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transforming risky assets into assets that financial markets and rating agencies consider risk free. In real business-cycle (RBC) theory, there are no other types of friction that can cause instability in the system; businesses produce homogeneous output. The representative agent then uses this output, transforming it into consumer goods and capital goods in a proportion aligning with the objective of maximizing expected utility according to a stochastic Euler equation. This process does not give rise to conflicts between those offering consumer goods and those transforming them into capital goods because the representative agent incorporates both functions. The dynamic stochastic general equilibrium (DSGE) model, as well as assuming price rigidity, represents a recent update of the RBC model, introducing the concept of financial market frictions. It differentiates among representative agents (firms, families, government), introducing the figure of the firm. The firm has the necessary knowledge and capacity to transform consumer goods into capital goods and must also use external financing to achieve its plans. The families do not possess the competency of the firm but have access to readily available resources (deferment of current consumption) that can be transferred to the firms via a financial intermediary, i.e., the bank. Financial frictions can arise between the bank and the firm and between the bank and the family due to asymmetrical information and moral hazard (see, e.g., Gertler and Kiyotaki 2015). In any case, these models too view the interest rate as the intertemporal price that should ensure equilibrium of the consumer market and coordinate the intertemporal distribution of consumption—excepting the financial frictions that generate a difference between interest rate received by savings account holders and interest rate paid by firms. The differential between remuneration of real capital and remuneration of real savings is a measure of financial friction (difference between the return firms earn from capital—plants and equipment—and the market cost of capital) (Woodford 2010). The interest rate regulates the intertemporal distribution of consumption and ensures the equilibrium of the consumer market in the present and in the future. The fact that the central bank, following the Wicksell–Woodford theory, understands monetary policy as the attempt

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to follow the natural interest rate, means taking for granted that the economic system is always on the path toward full employment and that any error in determining the interest rate in refinancing operations will have inflationary or deflationary consequences if the market interest rate is lower or higher than the natural interest rate. This will not be true, of course, if the natural interest rate falls into negative territory, because in this case monetary policy is ineffective and the adjustment of the consumer market translates into a reduction in production and savings. The role of the interest rate thus regards the consumer market and not the financial market. In our earlier analysis, we highlighted the fact that it is not the purpose of the financial market to equilibrate the consumer market. The financial market serves to transform debt and credit into terms of maturity and risk. It depends on the central bank and commercial banks, which have an unlimited potential to generate credit and to do so in a market insured by the value of the stock of assets that can be transferred as collateral. Intermediaries borrow on the financial market so that they can extend credit, they borrow to lend. They translate debt into terms of maturity and risk. If the Fed intends simply to adjust its monetary policy and its instrument (the interest rate on refinancing operations) to the natural interest rate, it ignores two important factors: the effects of monetary policy through variation of the interest rate on dynamics in the money market and the consequent impact on the profitability of financial intermediation. The fact that the central bank and the commercial banks can increase the credit supply, respectively, to commercial banks, and to firms, families, and the government, without the need for preexisting deposits, means that the problem of instability does not depend on the frictions in the real savings market, but rather on the process of intermediation, and in particular on the hope that the earnings of the borrower, net of spending decisions, will be sufficient in the future to repay the interest and the capital received as credit. This holds for both the financial and the non-financial sectors. The credit supply is thus limited not by the constraint represented by the deferment of current consumption, but by the risk aversion of the

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lender. The probability of default attributed to borrowers by the financial market determines the risk premium that the borrower has to pay, unless it opts not to accept the conditions and thus forego the loan. But it is not surprising that the explanation of risk premiums in macroeconomic models has no empirical support or that the equity premium continues to cause puzzlement. The transversality condition applied to the maximization of intertemporal utility excludes default and thus the idea that the risk premium depends on the probability that the borrower will default. The risk premium is not a stable quantity but changes over time and based on monetary policy. Changes in the interest rate on refinancing operations set by the Fed directly affect money market interest rates, the prices of financial assets, and the balance sheets of financial intermediaries. In normal times, interest rates on the interbank market, repo market, Treasuries market, and commercial paper market tend to move in the same direction, differing only by a differential to cover the risk premium, and of course affected by the conditions of supply and demand in the each of the various markets. The money market is not segmented; interest rate decisions by the Fed influence the prevailing interest rates on the short-term market. When the banking system is coupled with a market-oriented system, the sensitivity of financial intermediation processes to changes in the interest rate becomes much more significant. Since 1907, liquidity management has always represented a problem that not even the institution of the Fed was able to resolve. In the years prior to the crisis, the liquidity in the financial system was only partially available to families. Institutional investors, corporations, and investment funds transferred liquidity to money market funds or else invested it directly in the money market within a circuit that was nevertheless influenced by monetary policy decisions without having access to refinancing from the central bank, which was limited to the banking system. Significant stabilization was achieved in the period when the money market financed the acquisition of government securities by dealers. When, on the other hand, monetary financing regarded the stock market, as in the past century, or the private fixed-income market

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and securitization as in the period leading up to the financial crisis of 2007–2008, the fragility of intermediation processes was revealed in all its gravity. Monetary policy determines the cost of financing the process of financial intermediation. When the cost of debt falls, there are more possibilities for arbitrage, meant as the difference between how much one pays to borrow funds and how much one earns buying financial assets with those funds, and vice versa when interest rates rise. Assuming that monetary policy has to follow the natural interest rate means identifying intertemporal preferences and technology as the prevalent factors in determining the interest rate. Given this premise, monetary policy should be considered neutral with respect to the functioning of financial intermediation processes. Analyzing the effects of monetary policy on the real economy is important, but it is equally important to understand the mechanism of transmission of monetary policy to financial markets and to the profitability of the intermediation process. A reduction in the main refinancing rate (MRO), as was seen at the beginning of this century, also produced a reduction in the interest rate on risk-free, long-term bonds and an equally significant reduction in the risk premium. This compression of yields has continued to characterize the financial system even during phases of contractionary monetary policy. The non-alignment of long-term interest rates with the increase in the shortterm rates is explained by various factors, particularly demand by institutional investors (see Greenwood and Vissing-Jorgensen 2018), the calming effect of the Fed’s monetary policy on expectations for inflation, and the role of the dollar in the international monetary system. At this point, the search for yield became the central theme in explaining the evolution of financial markets in the years following the financial crisis. While macroeconomic models explain the risk premium based on the covariance between consumption and asset yield (too low) and risk aversion (too high) to match the risk premium to the data, the language of financial markets, on the other hand, explains the risk and risk premium of a financial asset as its probability of default. Monetary policy decisions and variations in the interest rate influence the profitability and failure rate of financial intermediaries because they affect the cost

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of financing directly and the value of the assets in their portfolio indirectly. The thinking whereby significant, prolonged variations in interest rates have no effect on financial markets, is a limitation in the rationale behind current monetary policy and the macroeconomic theory that justifies it. We must not forget that the interest rate fell by a full five percentage points in the early 2000s, remained at 1% for a year, and that the Fed then raised it by four percentage points and kept it there for another year until it was forced to lower it again when the crisis broke out in the ABCP/SIV market in August 2007. Financial intermediaries use capital and debt to buy other debt so they can finance businesses that produce goods and services, the government and families, or other financial enterprises. During an expansionary phase in the debt cycle, favored by a reduction in interest rates, financial intermediaries tend to increase the supply of credit for two reasons. One is that an increase in the price of financial assets boosts the value of capital and reduces leverage. As a result, the intermediation system tends to increase the supply of credit and reestablish the original ­conditions prior to the effects of asset price inflation. As underscored by Adrian and Shin (2009), the analysis of the balance sheets of non-financial enterprises regards the debt/equity ratio to finance a ­ flow of projects whose current value is known. Vice versa, with financial intermediation, the value of equity is fixed, while the value of assets changes to keep leverage stable. This causes the system to reinforce procyclical trends, increase demand for financial assets, and compress their yield. The reduction in the risk premium and volatility—and this is the second reason—reinforces the expansion of the balance sheet because it reduces the perceived risk. However, a problem arises regarding the effect produced by the expansion on asset yield. If the expansionary phase reduces yields, demand increases for financial assets promising higher yields; this is inevitable especially in those sectors where portfolio choices are oriented toward ensuring coverage of commitments to meet future payments. A change in interest rate has an effect on asset stocks and balance sheets, and an effect on flows and balance sheets of all financial

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intermediaries, especially banks, insurance companies, and pension funds. If the interest rate falls too close to zero, the banks suffer shrinking profits because the cost of financing (interest on deposits) cannot go into the negative zone. But the banking system can compensate the reduction in profitability in part by providing more loans because the banks are implicitly recapitalized by the reduction in interest rates and the increase in earnings from income not related to the interest rate. They can also adjust the maturities of their portfolio, shifting their assets toward the longer term and offering credit to the real estate market, which offers higher yields. In both cases, the composition of assets becomes more risky. Institutional investors such as pension funds and insurance companies with liability-driven policies, or investment funds whose primary objective is to achieve a certain yield to attract savings and liquidity, have to run for cover and buy financial assets in the market segments where yield is higher and thus inevitably risk as well. The securitization process sought to combine the search for yield with a low probability of default of the senior tranches to make them buyable to parties seeking high yield and limited risk. Given the globalized nature of the financial system, foreign operators also began to demand assets within the US financial system, which contributed to compressing the yield on risky assets. The securitization process is sensitive to reductions in the interest rate both because demand for high-yield assets rises (exogenous shock) and because the change in the interest rate affects the profitability of the financial institutions that manage the securitization process. With respect to the banking system, the cost of financing is variable and the problem of profitability and stability takes a different form. Securitizers do not have the same compensation instruments as banks. Once it has begun—fueled by external demand for securitized products by banks and institutional investors deriving from the reduction in interest rates—the securitization process, in order to continue to work using all the accumulated assets, has to rely on a portfolio that ensures a balance between interest received on assets in the portfolio and the cost of financing, which is influenced by monetary policy in

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a situation where assets and liabilities are continually assessed markto-market. The theory of search for yield as key to understanding the period prior to the 2007–2008 crisis must be completed by analyzing the relation between the monetary policy cycle and the development of the securitization process. Monetary policy was extremely expansionary up to June 2004, but the highest growth in CDO issues was seen in 2005 and 2006, when the Fed implemented an extremely contractionary monetary policy over a two-year period that ended in June 2006. When monetary policy is contractionary, demand increases for financial assets on the fixed-income market that are able to provide high yields even in a situation where the value of traditional financial assets (Treasuries and corporate bonds) will decrease as a result of an increase in the interest rate on central bank refinancing operations. The reduction in their price can be explained by the fact that these assets pay at a fixed rate. Financial markets generally anticipate the shift from expansionary to contractionary monetary policy. For example, in June 2003, after the recent reduction of the interest rate to 1%, there was a sell-off of long-term securities because investors felt that the expansionary cycle had ended and they were expecting the beginning of a contractionary phase (Bis 2003). This explains the growth in demand for variable-rate assets during the period of contractionary monetary policy. The price of these assets remains stable and there are no capital losses because interest payments are keyed to the interbank rate, Libor, which is indirectly controlled by monetary policy. This is why CDO issues increased most significantly precisely when monetary policy became contractionary. The CDO assets were prevalently variable-rate as were liabilities. Mortgages paid Libor plus a spread that was determined when the contract was drawn up and remained constant for the entire duration of the mortgage. Libor and the fixed spread thus represented the earnings for the CDO portfolio, while financing costs were represented by Libor plus a variable spread on the issued tranches. The less risky tranches, which were the first to be paid, earned a low spread (lower, at least, than the average interest rate paid on mortgages), while the spread was greater for the tranches that were paid later. The equilibrium of the intermediation process depended on demand and supply. Investor demand for yield provided by the

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various CDO tranches increased in the period 2004–2006 and demand increased for keying the interest rate to Libor during the period of contractionary monetary policy. This translated into an increase in demand for real estate mortgages, which provided fuel for the process, and into a reduction of the spread on the assets side, which reduced profit margins (Nadauld and Weisbach 2012; Deng et al. 2011; Justiniano et al. 2017). In its different phases, this process may be interpreted as a continual search to rebuild profit margins and a positive excess spread (arbitrage spread) by using increasingly risky assets as inputs to the securitization process in the face of a reduction in yield. The positive valuation of this transformation depended on the conviction that this shifted risk out of the banking system and lodged it with institutional investors better equipped to handle it. The banking system would have achieved greater stability by transferring credit risk. This is particularly true when monetary policy becomes contractionary and an increase in financing costs has to be compensated by an increase in interest received on portfolio assets. The financial engineering in this period continued to propose derivatives that were fed into the securitization process, in which risky assets promising a higher spread were transformed in part into risk-free assets. Each CDO was characterized by metrics that described the credit-worthiness of the portfolio assets, which portfolio managers were bound by contract to maintain. The weighted average rating factor (WARF) aggregated the ratings given by the agencies to the individual components of the portfolio into a single score. This indicator was specified in the contract drawn up with the investors and had to be maintained during the period in which the CDO was active. At the same time, the CDO had to obtain a yield deriving from its portfolio that was constantly higher than Libor by a percentage defined in the contract, so as to ensure positive arbitrage to the intermediation process. The tradeoff between these two objectives is clear. The choice of a potentially riskier indicator in terms of ratings ensured profitability but also exposure to the risk that the aggregate rating would be downgraded by the agencies and that the portfolio thus could not meet the contract terms. During the period of higher CDO issue, the yield fell for all tranches and especially for the senior tranches. Pressure from investors increased

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demand for financial assets that could serve as inputs for the securitization process. Their price thus rose and their yield fell, while at the same time the spread on assets in the portfolio decreased. The first phase of securitization depends on all the tranches being able to be placed externally according to the practice of “originate and distribute.” Subsequently, the demand for riskier tranches increases because of the reduction in yield on safer tranches due to high demand. At that point, the banks continue the securitization process but are forced to keep the senior tranches, which cannot be used in the CDOs, in their portfolio in order to be able to offer acceptable yields to the final investors. Thus the credit risk remained largely within the banking system. Senior tranches were incorporated into bank portfolios in different ways. One involved transferring a share to the SIVs or ABCP conduits financed through the money market, keeping the remaining share on the bank balance sheet, and insuring it through a CDS issued by an insurance company, AIG first and foremost. The objectives of reducing systemic risk and offering investors high yields on assets with a triple-A rating, which are thus buyable by many investors, can only be achieved if yields are acceptable to the tranche buyers. However, the process fails if the interest earned on a securitized portfolio is not high enough to ensure the payment of an appropriate yield as compared to other similarly rated assets. For example, in 2006 the yield on a short-term US government security exceeded 4% and the yield on the senior CDO tranches was equal to Libor plus about twenty basis points, with a significant difference in terms of liquidity. The government securities market was much more liquid than the market for senior tranches and the market began to question the triple-A rating of senior tranches, seeking insurance in exchange for payment of a CDS premium. The decrease in demand for senior tranches on the financial market drove investment banks to incorporate them into their portfolios directly or indirectly. They probably thought they could maintain the profitability of the process by managing a portfolio where both assets and liabilities were indexed to Libor. The acquisition of the supply chain of assets financing the real estate market, from mortgages to securitized

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assets, indicates that this rationale was widespread among investment banks. This contradicts the widely held idea that the valuation criteria had become laxer because of securitization. However, this observation overlooks an important detail: the capacity of the securitization process to maintain a positive arbitrage spread. The spread on the senior tranches was very low because it was clearly not possible to assemble a portfolio with a higher yield. An increase in the cost of financing due to contractionary monetary policy was compensated, albeit with some delay, by an increase in payment of interest on mortgages. The spread on assets was greater than the spread on liabilities. If the number of defaults was limited and the differential between the two spreads remained constant, equilibrium was assured. The effects of long-lasting contractionary monetary policy, both on the real estate market and on the spread differential between assets and liabilities, were underestimated. The spread paid on variable-rate mortgages was fixed for the entire duration of the loan, while the spread on ABCPs was renegotiated at each expiry. The risk premium on intermediation liabilities changes with market conditions and contractionary monetary policy transforms idiosyncratic risk into systemic risk; or at least that is what happened in 2006–2007, when the crisis in the real estate market spread to all the States of the Union and pushed prices further down than envisioned in the worst-case scenario. The Fed’s reduction in interest rate in 2007 did not succeed in stabilizing the financial market because the ABCP market continued to have a spread on liabilities far above the spread on assets for many months and thus the accumulated mortgages had a value of zero and could not be securitized. The decision by investment banks to incorporate senior tranches into their portfolios contradicts their traditional function as portfolio creators in the securitization process rather than direct investors and derives from an error in forecasting the impact of monetary policy on prices in the real estate market after the beginning of the contractionary phase in June 2004. Up to 2005, the investment banks managed to place the entire portfolio they were assembling. After that, they had difficulty continuing along this path because the high demand for real estate mortgages by the investment banks themselves and by other banks and

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financial firms kept spreads on mortgages very low and thus reduced the banks’ capacity to maintain a high spread on the senior tranches. The alternative was between liquidating everything and continuing to manage the process directly, committing the error of underestimating the effects of monetary policy on the real estate market. Indeed, assessments by the principal investment banks anticipated a reduction in prices on the real estate market after monetary contraction that was significantly less than what would actually happen. This may also be attributed to an underestimation of the duration of contractionary monetary policy, to the characteristics of the parties requesting mortgages, and to the effect of these factors on the evolution of current and expected prices on the real estate market. Recent studies (Adelino et al. 2016; Albanesi et al. 2017) have challenged the traditional interpretation whereby the financial crisis was due to the excessive provision of credit to families with low credit ratings and underscored the underestimation of the role of those who considered investments in homes as an alternative to financial assets. The reduction in interest rates after 2001 favored debt refinancing at a lower rate and the increase in leverage of families, and initiated inflation in the real estate market. When interest rates fell (and this lasted until June 2004), US families had the option of renegotiating their mortgage at more favorable interest rates, but also that of obtaining a larger mortgage if housing prices had risen in the meantime. In percentage terms, the loan-to-value ratio remained constant with respect to the previous periods. However, because of the concomitant increase in housing prices, leverage rose in absolute terms. As noted by Kandhari et al. (2013), the increase in leverage was irreversible. Unlike the financial market, the real estate market does not offer the possibility of reducing leverage. This is because the asset given as collateral is indivisible and thus acceptable leverage and positive equity depend exclusively on a constant appreciation in prices. As soon as prices begin to fall, the value of the debt exceeds the value of the collateral and defaults and/or sales begin, which accelerate the downward trend in prices. At this point, equity becomes negative and the excess of supply on the market further weakens prices. This dynamic is particularly accentuated

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if demand is from investors who intend to flip the houses in the short term to make capital gains. Monetary policy became contractionary in June 2004 and the prices of houses began to fall one year later in parallel with the accumulation of unsold houses and a drastic reduction in the construction of new houses. Contractionary policy lasted for two years, during which the securitization process continued to expand, but under the duress of diminished profitability, which was due, on the one hand, to a reduction in the spread on assets and, on the other, to the beginning of defaults. The transfer of a significant share of the senior tranches into the portfolios of investment banks was a consequence of this. The presence of senior tranches in the portfolio initiated a process that characterized the second phase of the crisis and has to do with the intermediation activities of dealers. The difficulty in financing their own positions overwhelmed the role of dealers as parties that borrow to lend. Financial intermediaries’ need to borrow in order to provide credit, turning to dealers to obtain the liquidity they need, depends on the portfolio choices that initially took form within the hedge fund sector and then slowly transferred to other sectors. The search for high yield in keeping with a publicly stated objective means active portfolio management with well identified benchmarks and recourse to leverage, short-selling, and credit derivatives. The brokerage service offered by dealers provides these intermediaries with a portfolio choice that aligns with their objectives. We must add that other financial intermediaries, institutional investors such as pension funds, had long been in a situation of chronic underfinancing and thus had to seek portfolio assets whose yield made it possible to achieve budget equilibrium both in terms of discounted cash flows of their assets and liabilities and in terms of cash flows. The fact that institutional investors were among the buyers of shares of hedge funds provides confirmation of this trend. On the one hand, the dealers managed their own positions, while on the other, they financed investments in alternative assets, borrowing in turn on the repo market. Unlike traditional intermediation, which takes out short-term debt to make long-term loans, a significant share of dealer loans are short term

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(Pozsar 2015) and finance the leverage that is structurally necessary to increase yield. The difficulty encountered in financing their own positions had the consequence of upsetting the role of dealers as mediators between liquidity and risk. The financial crisis of 2007–2008 brought to light a structural weakness in the function of financial markets and monetary policy. The expansionary monetary policy in the early years of the third millennium produced a general reduction in the yield of financial assets on the fixed-income market and a strong compression of the risk premium. The securitization process initially ensured an increase in yield, but this slowly evaporated over time and drove the dealers to bring tranches considered to be risk free into their portfolios, initially financing themselves on the ABCP market and then on the repo market. The monetary squeeze implemented by the Fed modified the terms of intermediation and the attendant arbitrage spread. In 2007, the risk premium demanded by those financing the process on the money market exceeded the risk premium paid on real estate mortgages, and the ABCP market came to a halt, while financing of securitized assets was transferred to the repo market and the crisis dragged on for a year until this second source of financing dried up due to a lack of collateral acceptable to the counterparties or simply because the market refused to finance the illiquid tranches in investment bank portfolios. All intermediation processes are based on the expectation of profitability. A financial institution is a business with rights to flows of future payments on the credit extended to other private, public, financial, or non-financial parties. The securitization process depended on the payment of real estate mortgages and was financed in turn by issuing debts whose rating and corresponding risk premium were defined based on current and expected payments of interest on mortgages. Contractionary monetary policy impacts both asset and liability spreads. A prolonged increase in the interest rate reduces income to firms, families, and the government and thus increases the probability of default for all those whose debts are counted as assets in the securitization process. Precisely for this reason, investor demand diminishes and the liability spread widens. The reduction in demand is further

9 Conclusions     215

accentuated by expectations regarding the duration of the contractionary monetary policy. When the financial markets feel that the contractionary phase in the monetary cycle has ended, they return to preferring a fixed rate. If the upward trend has ended, sooner or later monetary policy will go back to being expansionary and thus the value of fixedrate assets will increase. The widening of the spread on liabilities cannot be compensated by an increase in the spread on assets. The contracts relating to the existing asset stocks are based on a constant spread, while it is impossible to increase the spread on new mortgages in a situation where the economy is slowing and thus rising unemployment is expected. Well, it can be done, but in a situation where prices are destined to come down it is difficult to imagine that demand for credit will be sustained. If we analyze the trend in spread on ABCPs demanded by investors in 2007, we note a significant increase that the SIVs were not capable of meeting. Financial intermediation cannot work if the cost of debt is higher than earnings on the portfolio it finances. Monetary policy influences the securitization process in a procyclical manner when the transition from contractionary to expansionary monetary policy, and vice versa, comes in variations on the order of 4–5%. The securitization process tends to expand during the contractionary phase following the reduction in interest rate that redefines the characteristics of loans, shifting from fixed rate to variable rate. The increase in demand for primary assets reduces the spread on these assets, while at the same time the level of interest rate dampens price dynamics on the real estate market and the number of defaults begins to increase. Acting on the belief that monetary policy has no impact on financial intermediation and is neutral with respect to the spread on which such intermediation is based risks accentuating the instability of the financial system, especially when reductions in interest rate alternate with equally pronounced increases. Financial stability is a requisite for economic growth. Monetary policymakers must recognize this with the objective of assessing the effects of such policy on the securitization process, on the profitability of financial intermediation, and on the stability of the economic system.

216     G. Pizzutto

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Index

A

113, 119, 139, 140, 174, 180, 182, 203 investment bank 4, 11, 25, 34, 59, 61, 63, 64, 95, 97, 117, 119, 123–125, 127, 131, 153, 154, 156, 174–177, 185, 189, 190, 194, 196, 210–214 J.P. Morgan 27, 115, 191, 194 Lehman Brothers 173, 180, 194, 196 national bank 7–12, 14, 15, 17, 19–27, 33, 36, 59, 71, 81, 82, 86, 87, 98, 99

ABCP market 183, 185, 211, 214 Asset-backed securities (ABS) 116, 119, 120, 122 B

Banks central bank 5, 7, 12, 15, 19, 28, 35–38, 40–54, 57, 59, 65, 81, 85, 86, 94, 104, 107, 108, 112, 113, 131, 137, 139, 141, 142, 160, 168, 173, 182, 184, 185, 199–204, 208 commercial bank 4, 11, 16, 18, 22–26, 28, 34, 38, 39, 44, 47, 50, 51, 53, 57, 60–62, 75, 79, 81, 87, 90, 104–107, 112,

C

2007 Crash 96

© The Editor(s) (if applicable) and The Author(s), under exclusive licence to Springer International Publishing AG, part of Springer Nature 2019 G. Pizzutto, The US Financial System and its Crises, Palgrave Studies in Economic History, https://doi.org/10.1007/978-3-030-14489-0

217

218     Index

133, 135–142, 144, 145, 149, 155, 160, 162, 165, 167, 168, 176, 178, 179, 184, 204–207, 212

D

Dealer 20, 25, 38, 44, 49, 50, 67, 68, 83, 97–99, 103–106, 109, 111–115, 117, 119–121, 124– 133, 149, 150, 156, 183–196, 204, 213, 214 L F

Federal Reserve 10, 33, 41, 42, 44, 46, 47, 49, 53, 60, 63–65, 71, 78–83, 85–88, 93–96, 140, 165, 187, 193 Financial markets 2–5, 10, 12, 13, 15, 20, 28, 45, 47, 48, 59, 60, 63–65, 70, 80, 82, 90–93, 107, 113, 115, 118, 123, 125, 127, 135–137, 139, 141, 149, 168, 175, 179–182, 184, 194, 199, 202, 205, 206, 208, 214, 215

Liquid assets 24, 26, 86, 116, 142, 201 M

Monetary policy 3–5, 21, 24, 28, 29, 34, 35, 37, 41, 42, 44, 46–52, 54, 57–59, 62–66, 68–71, 90, 92, 94, 96, 98, 99, 104–106, 112–114, 123, 124, 127, 130, 131, 135–144, 150, 155, 163, 165, 167, 168, 176, 178, 179, 183, 189, 199–209, 211–215 Money supply 21, 28, 29, 37, 38, 41, 42, 62, 90, 112

G

Great Depression 48, 64, 66, 75–77, 79, 90, 91, 180, 182

N

Housing market 150, 152, 181

National Banking Act 7, 8, 10, 11, 13, 15, 18, 23, 28, 33, 34, 39, 41, 46, 52, 53, 59 Non-bank intermediaries 29, 33, 34, 38, 79, 80, 83, 107, 145

I

P

H

Illiquid assets 2, 86, 87 Interest rates 4, 5, 10, 14, 19, 22, 24, 28, 29, 36, 37, 40, 44, 50–54, 57, 58, 62, 63, 65, 68–70, 80, 92–95, 98–100, 104, 105, 108, 112–116, 118, 121, 127,

Panic of 1907 7, 26, 27, 36 Private sector 8, 42, 45, 53, 60, 63, 64, 76, 79, 85, 87, 88, 91, 93, 103, 104, 154, 165, 182, 201 Public debt 12, 53, 61, 91 Public sector 87, 103, 201

Index     219 R

Repo market 106–109, 111–116, 126–133, 137, 155, 183–187, 190, 191, 193–196, 204, 213, 214

Stock market crash 68, 75, 81, 83 Structured investment vehicle (SIV) 116–121, 178, 180–183, 206 T

S

Securitization 115–119, 121–125, 138, 139, 142, 143, 145, 150, 153–156, 158, 159, 166, 173, 175–178, 193, 201, 205, 207–211, 213–215 Short-term credit 11, 25, 26, 57, 58, 60, 71, 80, 99, 106, 119, 185 Spread compression 64, 145, 150

The Treasury 12, 21, 28, 35, 104, 180 Trust companies 10, 11, 17, 20–29, 33, 78 W

World War II/WWII 103, 104, 115, 125, 126