Dodd-Frank was one of the worst laws ever enacted. My guess is they will blow it on prediction markets too. Prediction markets are great, except not in athletics or movie/stage/tv awards. CFTC should regulate, but states ought to do sports etc
"The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run"
Was it? Lehman Bros. wasn't a bank supervised by the Federal Reserve. Neither was the American International Group (AIG). In what way was this a failure of the U.S. financial regulatory regime?
By which I mean becomes readily apparent with only a little bit of research.
Regulatory failures included not realizing the scale of the exposures, not grasping the interconnectivity between highly regulated and less regulated players, not understanding that ample liquidity masks actual default rates (eg credit card balances rolled from bank A to even hungrier bank B count as being paid off at bank A, lowering default experience and encouraging more risk, same with mortgage loans quickly paid off due to “flipping” a property - lowers experienced default risk meaning VAR and credit models encourage more risk). See also Minsky.
Critially, a regulator-imposed capital charge regime (Basel 2) that zero-weighted “AAA” assets, was a huge contributor, causing the manufacture of these assets when too easy Fed policy collapsed interest rates and credit spreads. European banks needed short term dollar financing to fund all of the “AAA” assets they bought and then suddenly nobody would lend to these banks (liquidity crisis).
You are right, though, about the SEC regulated broker dealers getting into more trouble than the banks.
I’d have to dig up the analysis I did way back when, but my recollection is that Lehman tripled the size of its balance sheet assets from 2004-end 2007, while increasing its leverage ratio to 30-1 or so. Merrill and Bear Stearns more than doubled the size of their balance sheets in those few years, without increasing capital (massive leverage). These firms were simply large carry trades that relied on short term funding continually being rolled over until the better assets were bundled and sold off (and replaced with ever more assets funded by short term credit, repo and commercial paper)
As in 2020-2022 the Fed in 2004-2005 depressed yields and incented players to take ever crazier risks if they wanted to earn positive spread. Their was suddenly a rush for yield (credit spread by non banks and capital efficient “AAA” yield by banks) as well as a rush for consumer assets that seemingly offered high realized carry (credit cards and mortgages) relative to corporate loans. Banks that had those higher yielding portfolios traded at much higher multiples than more conservative banks.
Goldman was a little more responsible in balance sheet leverage than the other brokers, but they relied very heavily on AiG for “AAA” credit insurance wrappers for the assets they sold off.
Ultimately a lot of the funding for the brokers like Lehman came from commercial banks as did some of the credit hedging. JPM, Citi and B of A were amongst Lehman’s largest creditors in bankruptcy.
I get what you're saying. I too looked closely at the causes of the crisis in 2008 and the knock-on effects. I don't know whether Dodd-Franks had a role in those failures, but it appeared to me at the time that it was Lehman Bros. management that messed up in the management of their 'book' such that they were woefully unprepared for a market call when it came. But, I'm not an industry insider and can only go by the views of those who were closer to the action, if not a part of it.
I think John and others get carried away when they lump the 'guardians' under the category "American financial regulators", as though the private sector players did not have a hand in the initiation of the debacle.
As to 2020-2022, in or about March of 2020 there was a severe liquidity crisis that required the Fed to become involved with the money markets on an emergency basis. It did so by providing liquidity to the market quickly. It may not have been to John's liking later, but I don't recall that he had an opinion then or later that year, pro or con. He might have done. I was reading his blog posts regularly as a subscriber, and most but not all were about the pandemic at the time.
The pandemic of 2020-22 was an unusual crisis spanning Trump's last year in his first term as president, and Biden's first two years of his first term in office. Both resorted to the 'helicopter drop'. It appeared clear at the time that the sudden injection of cash was ill-timed and ill-considered, but that is a personal opinion, and others may hasten to differ.
On the Federal Reserve decision to provide liquidity to cities and states, the rational put forward was convincing to me at the time. Cities obtain a significant proportion of their revenues from the sales and use taxes at the retail level, in some instances up to 40% of their operating revenues. The shut-down enforced by the states and counties impaired the ability of the cities to cover their operating costs. Likewise, for the states that rely on the income tax and the retail tax and the quarterly payment property tax remittances for their revenues. Extending emergency funding by buying municipal and state paper seemed sensible to me at the time.
As for MBS purchases and the purchases of Treasury notes in the secondary market, in order to lower the interest rate, those activities did not appear to me at the time to be objectionable or inflationary. The clearly inflationary action was the fiscal authorities' 'helicopter drops', esp. Joe Biden's one and only effort in that direction. But, what do I know? Probably not as much as others, perhaps a little more than most.
Yellen really blew it with SVB. One of the initiatives post GFC was to force banks to have more long term funding (corporate debt) and to e sure adequate, liquid, short term assets vs deposits.
Senior corporate term debt should be pari passu with large uninsured deposits.
Yellen chose to save depositors and stuff bond holders to pay for it. And now all short term deposits are effectively guaranteed
So much for banks sourcing more long-term funding to prevent runs. Between SVB and credit Suisse, that will never happen again. Instead we have the taxpayer on the hook for all short term funding. Insanity.
And if the Fed had done even a passable job of regulation and continued irresponsible QE and ZIRP well beyond when needed then US commercial/regional banks wouldn’t have been scrambling to buy 15 year paper at sub 2 percent to make a tiny RoA vs deposits and SVB never would have been able to make such a ridiculous bet by rolling short term deposits of PE and VC sponsors into long dated mortgage backs.
Their management should have been jailed (but they were big donors) and the SF Fed team should have been sacked.
Seems like we have been playing regulatory cat & mouse forever. Regulations get written, clever people find ways around them or the regulators get captured by the industry they are charged with regulating. Financial institutions take risks, that’s part of business. When the risks pay off the C-suite is richly rewarded, if they blow up the C-suite rides off with their millions intact. And that is the problem - in too many cases leadership has no skin in the game. So how about replacing thousands of pages of complex regulations with something simple. You take an imprudent risk that results in your institution suffering a loss that requires public intervention and you are rendered destitute. Bank account, portfolio, retirement, real estate, toys - gone. Applies to the C-suite. Maybe with skin in the game these people will start managing these institutions like it was their money - because in a way it will be.
John H. Cochrane paid for his doctorate in economics with this story. Such things often have a way of changing names, and causes, but eventually the truth does appear. Having also known who Kevin Warsh, I am overawed by this story and look forward to the full version.
Dodd-Frank was one of the worst laws ever enacted. My guess is they will blow it on prediction markets too. Prediction markets are great, except not in athletics or movie/stage/tv awards. CFTC should regulate, but states ought to do sports etc
"The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run"
Was it? Lehman Bros. wasn't a bank supervised by the Federal Reserve. Neither was the American International Group (AIG). In what way was this a failure of the U.S. financial regulatory regime?
The answers are out there and self-evident for the curious
"Self-evident"? How so?
By which I mean becomes readily apparent with only a little bit of research.
Regulatory failures included not realizing the scale of the exposures, not grasping the interconnectivity between highly regulated and less regulated players, not understanding that ample liquidity masks actual default rates (eg credit card balances rolled from bank A to even hungrier bank B count as being paid off at bank A, lowering default experience and encouraging more risk, same with mortgage loans quickly paid off due to “flipping” a property - lowers experienced default risk meaning VAR and credit models encourage more risk). See also Minsky.
Critially, a regulator-imposed capital charge regime (Basel 2) that zero-weighted “AAA” assets, was a huge contributor, causing the manufacture of these assets when too easy Fed policy collapsed interest rates and credit spreads. European banks needed short term dollar financing to fund all of the “AAA” assets they bought and then suddenly nobody would lend to these banks (liquidity crisis).
You are right, though, about the SEC regulated broker dealers getting into more trouble than the banks.
I’d have to dig up the analysis I did way back when, but my recollection is that Lehman tripled the size of its balance sheet assets from 2004-end 2007, while increasing its leverage ratio to 30-1 or so. Merrill and Bear Stearns more than doubled the size of their balance sheets in those few years, without increasing capital (massive leverage). These firms were simply large carry trades that relied on short term funding continually being rolled over until the better assets were bundled and sold off (and replaced with ever more assets funded by short term credit, repo and commercial paper)
As in 2020-2022 the Fed in 2004-2005 depressed yields and incented players to take ever crazier risks if they wanted to earn positive spread. Their was suddenly a rush for yield (credit spread by non banks and capital efficient “AAA” yield by banks) as well as a rush for consumer assets that seemingly offered high realized carry (credit cards and mortgages) relative to corporate loans. Banks that had those higher yielding portfolios traded at much higher multiples than more conservative banks.
Goldman was a little more responsible in balance sheet leverage than the other brokers, but they relied very heavily on AiG for “AAA” credit insurance wrappers for the assets they sold off.
Ultimately a lot of the funding for the brokers like Lehman came from commercial banks as did some of the credit hedging. JPM, Citi and B of A were amongst Lehman’s largest creditors in bankruptcy.
I get what you're saying. I too looked closely at the causes of the crisis in 2008 and the knock-on effects. I don't know whether Dodd-Franks had a role in those failures, but it appeared to me at the time that it was Lehman Bros. management that messed up in the management of their 'book' such that they were woefully unprepared for a market call when it came. But, I'm not an industry insider and can only go by the views of those who were closer to the action, if not a part of it.
I think John and others get carried away when they lump the 'guardians' under the category "American financial regulators", as though the private sector players did not have a hand in the initiation of the debacle.
As to 2020-2022, in or about March of 2020 there was a severe liquidity crisis that required the Fed to become involved with the money markets on an emergency basis. It did so by providing liquidity to the market quickly. It may not have been to John's liking later, but I don't recall that he had an opinion then or later that year, pro or con. He might have done. I was reading his blog posts regularly as a subscriber, and most but not all were about the pandemic at the time.
The pandemic of 2020-22 was an unusual crisis spanning Trump's last year in his first term as president, and Biden's first two years of his first term in office. Both resorted to the 'helicopter drop'. It appeared clear at the time that the sudden injection of cash was ill-timed and ill-considered, but that is a personal opinion, and others may hasten to differ.
On the Federal Reserve decision to provide liquidity to cities and states, the rational put forward was convincing to me at the time. Cities obtain a significant proportion of their revenues from the sales and use taxes at the retail level, in some instances up to 40% of their operating revenues. The shut-down enforced by the states and counties impaired the ability of the cities to cover their operating costs. Likewise, for the states that rely on the income tax and the retail tax and the quarterly payment property tax remittances for their revenues. Extending emergency funding by buying municipal and state paper seemed sensible to me at the time.
As for MBS purchases and the purchases of Treasury notes in the secondary market, in order to lower the interest rate, those activities did not appear to me at the time to be objectionable or inflationary. The clearly inflationary action was the fiscal authorities' 'helicopter drops', esp. Joe Biden's one and only effort in that direction. But, what do I know? Probably not as much as others, perhaps a little more than most.
Yellen really blew it with SVB. One of the initiatives post GFC was to force banks to have more long term funding (corporate debt) and to e sure adequate, liquid, short term assets vs deposits.
Senior corporate term debt should be pari passu with large uninsured deposits.
Yellen chose to save depositors and stuff bond holders to pay for it. And now all short term deposits are effectively guaranteed
So much for banks sourcing more long-term funding to prevent runs. Between SVB and credit Suisse, that will never happen again. Instead we have the taxpayer on the hook for all short term funding. Insanity.
And if the Fed had done even a passable job of regulation and continued irresponsible QE and ZIRP well beyond when needed then US commercial/regional banks wouldn’t have been scrambling to buy 15 year paper at sub 2 percent to make a tiny RoA vs deposits and SVB never would have been able to make such a ridiculous bet by rolling short term deposits of PE and VC sponsors into long dated mortgage backs.
Their management should have been jailed (but they were big donors) and the SF Fed team should have been sacked.
Really great article Professor Cochrane! Nailed the problems with our current(and past) financial regulation regime.
Seems like we have been playing regulatory cat & mouse forever. Regulations get written, clever people find ways around them or the regulators get captured by the industry they are charged with regulating. Financial institutions take risks, that’s part of business. When the risks pay off the C-suite is richly rewarded, if they blow up the C-suite rides off with their millions intact. And that is the problem - in too many cases leadership has no skin in the game. So how about replacing thousands of pages of complex regulations with something simple. You take an imprudent risk that results in your institution suffering a loss that requires public intervention and you are rendered destitute. Bank account, portfolio, retirement, real estate, toys - gone. Applies to the C-suite. Maybe with skin in the game these people will start managing these institutions like it was their money - because in a way it will be.
Mervyn King had a better idea in a post GFC book- less leverage and more capital in the system.
Unfortunately neither voters nor politicians want this- they love booms and easy credit and then search for scapegoats when it all blows up
John H. Cochrane paid for his doctorate in economics with this story. Such things often have a way of changing names, and causes, but eventually the truth does appear. Having also known who Kevin Warsh, I am overawed by this story and look forward to the full version.