The bailouts during the recent financial crisis enraged the public. They felt unfairand counterproductive: people who take risks must be allowed to fail. If we reward firms that make irresponsible investments, costing taxpayers billions of dollars, aren’t we encouraging them to continue to act irresponsibly, setting the stage for future crises? And beyond the ethics of it was the question of whether the government even had the authority to bail out failing firms like Bear Stearns and AIG. The answer, according to Eric A. Posner, is no. The federal government freely and frequently violated the law with the bailoutsbut it did so in the public interest. An understandable lack of sympathy toward Wall Street has obscured the fact that bailouts have happened throughout economic history and are unavoidable in any modern, market-based economy. And they’re actually good. Contrary to popular belief, the financial system cannot operate properly unless the government stands ready to bail out banks and other firms. During the recent crisis, Posner agues, the law didn’t give federal agencies sufficient power to rescue the financial system. The legal constraints were damaging, but harm was limited because the agencieswith a few exceptionsviolated or improvised elaborate evasions of the law. Yet the agencies also abused their power. If illegal actions were what it took to advance the public interest, Posner argues, we ought to change the law, but we need to do so in a way that also prevents agencies from misusing their authority. In the aftermath of the crisis, confusion about what agencies did do, should have done, and were allowed to do, has prevented a clear and realistic assessment and may hamper our response to future crises.
Taking up the common objections raised by both right and left, Posner argues that future bailouts will occur. Acknowledging that inevitability, we can and must look ahead and carefully assess our policy options before we need them.
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About the Author
Eric A. Posner is the Kirkland and Ellis Professor of Law at the University of Chicago Law School. He is the author or coauthor of several books, including Law and Happiness and The Perils of Global Legalism.
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The Transformation of the Financial System
At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.
Ben Bernanke (2007), March 28, 2007
In his short story, "The Library of Babel," Jorge Luis Borges describes a library with more books than there are atoms in the universe. Books about the financial crisis are not numerous enough to fill Borges's library, but one should be forgiven for thinking that they might be. While we don't need another description of the financial crisis, I provide a brief version in this chapter and the next, emphasizing those points that are relevant to my arguments about law and policy.
The Transformation of the Financial System
Many things caused the financial crisis, but the major cause turns out to be simple and, with the benefit of hindsight, even obvious. The financial crisis took place because the financial system had undergone a transformation that left behind the legal structure that was designed to prevent financial crises from occurring. The transformation took place in part because that legal structure created costs for financial institutions and their customers, and, as in the natural order of things, these institutions developed methods for evading the law without breaking it — "regulatory arbitrage," in the lingo of economists. The transformation also took place because the world changed: the needs of borrowers and savers changed, and the financial system changed so as to serve them; and technology changed, allowing for financial innovations that created new types of transactions and institutions. While many experts — including financial economists, industry practitioners, and regulatory officials — recognized the transformation as it was occurring, they did not realize that the transformation outstripped the law and created new risks of a financial crisis. In fact, they believed the opposite: that the transformation created a safer financial system rather than a riskier one. This is why the legal developments leading up to the financial crisis were, in the main, deregulatory, which (unknown to nearly everyone) enhanced the risk of a crisis rather than (as nearly everyone believed) reduced financial instability; why the crisis was a surprise; and why the Fed was forced to innovate, in some cases breaking the law, to respond to it.
The (Not So) Good Old Days
The backbone of the financial system was banking. A bank took deposits from ordinary people and businesses and lent them out long term to people so that they could buy homes and cars, and businesses so that they could buy equipment and pay their employees in advance of revenues. In this way the bank acted as an intermediary between short-term savers — people who needed access to their funds on demand — and long-term borrowers, who needed assurance that they would not be required to repay loans in full until they had lived in their houses for 30 years, driven their car for 5 years, or (if they were businesses) obtained revenues from the project that the loan financed. This process is called maturity transformation — the short-term maturity of the savers' loans to the banks is transformed into the long-term maturity of the loans that the banks make to their borrowers.
The key to maturity transformation is a statistical law — the law of large numbers. A bank takes money from thousands of customers, who are constantly depositing and withdrawing money from their checking accounts. Often, when a customer withdraws money from her checking account she is merely writing a check to another bank customer — so the bank does not actually pay out cash but instead notes that it now owes less to the first customer and more to the second. While different customers are withdrawing and depositing, closing out old accounts and starting new ones, the bank can assume that on average a balance of incoming funds will be maintained, and it is this balance that the bank, in effect, lends out to borrowers for the long term. No one will finance a home purchase by taking short-term loans; the bank does that for the home buyer, and this is how the bank generates economic value, creating a valuable long-term loan for the home buyer while compensating savers by giving them interest and payment services like checking.
Unfortunately, this system is also fragile. It assumes that the probability that the decision by one depositor to withdraw money from the bank is uncorrelated (or sufficiently uncorrelated) with withdrawals by other depositors. The assumption holds in normal times, but it can be violated. If the only big employer in a small town shuts down, nearly all depositors may withdraw money to carry them through hard times. Or if a rumor starts that the bank is being mismanaged, depositors may withdraw their money because they fear the bank will not have funds to repay them. In both cases, a run can start. A run occurs when people withdraw money from a healthy bank because they lose confidence that it will be able to repay them — even if the bank actually can repay them. A run can quickly empty the vaults of a bank — banks do not keep much cash on hand because they can earn more money by lending it out. Banks may be able to borrow from other banks to stem a run, but in the worst case, they must sell off their assets (mostly long-term loans like mortgages) at fire-sale prices to raise cash to pay the withdrawing depositors. When assets are sold at fire-sale prices, they rarely generate much cash. The healthy bank becomes illiquid (it lacks cash), and then in selling assets at low prices to raise cash, it becomes insolvent and shuts down. The bank fires its employees, who lose their relationship-specific knowledge about borrowers, and calls in loans where it can — and all of this causes economic damage unless other banks can quickly take up the slack.
Banks do not stand alone; they operate through networks consisting of numerous banks. There are two reasons for this. First, banks offer payment services, and these take place through bank-to-bank interactions. If a customer of bank A writes a check to a customer of bank B, banks A and B manage this transaction by adjusting the balances of their customers and adjusting the balance in the account that one of the banks keeps with the other. Second, banks lend money to each other short-term because at any given time one bank will have money it doesn't need and another bank will need additional money. The network system helps banks in one way but makes them vulnerable in another way. If a single bank is subject to a run, it can quickly borrow money from other banks and use it to pay off customers until they come to their senses. Those banks will lend to the first bank against the valuable home mortgages it owns and other assets. If the bank is located in a town suffering from factory closures and long-term decline, the bank can borrow enough from other banks to sell off its loans in an orderly fashion over a long period of time, in this way avoiding the destructive fire-sale consequences of a run.
However, the network also creates a kind of fragility because a run on one bank can be transmitted through the network to other banks. If a run starts on bank A, and bank A raises cash by withdrawing its deposits with banks B and C, then customers of bank B and C might worry that those banks will not be able to honor their debts as well. If the customers of B and C start running on those banks as well, then the entire system might collapse, converting a local crisis into a regional or national crisis in which money is sucked out of the economy and commerce grinds to a halt.
In the old days, banks guarded themselves against runs by maintaining cash on hand and capital cushions, but their incentives to do so fell below the social optimum because the costs of a crisis extend across the economy and are not fully internalized by banks themselves. In response, governments created a regulatory regime with two major elements. First, governments imposed a rigorous, extensive system of regulation on banks, whose goal was to ensure that banks engaged in safe practices — made low-risk rather than high-risk loans, maintained diversified portfolios, stayed out of risky lines of business, kept sufficient cash on hand, and maintained large capital cushions. Second, governments guaranteed deposits — through explicit insurance like the FDIC system, and a vaguer promise to make emergency loans to banks that are in trouble, the Lender of Last Resort (LLR) function. The two elements were closely tied. The insurance system reduced the incentive of depositors to choose safe banks over risky banks and monitor the behavior of banks. This created moral hazard, which the ex ante system of regulation tried to counter.
This system of financial regulation came to maturity in the United States during the Great Depression, and it seemed to work well enough over the next several decades. But by the 1970s, it was in disarray. One of the problems with the regulatory system was that it went too far. In the interest of safety and soundness, banks were kept out of lines of business — insurance, securities underwriting — that might have allowed them to reduce risk (through diversification) and provide financial services more efficiently to their customers. They were also — for the most part — not allowed to branch across state lines or even within states. This kept the banks small and fragmented, insufficiently diversified across geographic space. The banking system was also artificially divided into savings and loans or thrifts, which were oriented toward consumer depositors and home buyers, and "commercial banks," which were oriented toward business. Regulators and, eventually, Congress dismantled many of these barriers. The inflation shock of the 1970s caught the S&Ls in a squeeze between their legacy 30-year mortgages, which they had issued at low interest rates, and their financing needs, which required payment of high interest rates. Much of the now-maligned movement of financial deregulation, which began in the 1970s and accelerated in the 1980s and 1990s, was a sensible response to these problems.
Deregulation was not the only response to the perceived excesses of the regulation; transformation within the industry was another. The transformation reflected two sources of demand. First, because regulation imposes costs on financial intermediaries and their customers, customers sought ways to avoid the most heavily regulated portion of the industry — banking. This was a form of regulatory arbitrage — although it is not clear whether it should have been condemned for evading safety-promoting regulations needed to prevent a crisis or praised for evading excessive regulations that created costs. Probably a bit of both.
Second, the transformation responded to growing demand across the world for highly liquid and safe assets. Under the old system, pension funds, insurance companies, sovereign wealth funds, and other huge institutions that sought liquid and safe assets were limited to insured bank deposits. These were zero risk (at least in the United States) and more liquid than the only other zero-risk asset, US debt. But as Pozsar (2011) notes, there was an upper limit on the supply of insured deposits. Under US law at the time, a deposit account was insured up to $100,000, and while investors could spread their wealth across banks, they could choose among only so many banks — and mergers were rapidly shrinking the number of banks. The increasing demand for safe, liquid investments — Pozsar (2011, 5) estimates that the holdings of "institutional cash pools" increased from $100 billion in 1990 to $2.2 trillion in 2007, or possibly as much as $3.8 trillion — spurred the financial system to construct new securities thought to be as safe and liquid as insured deposits. Pozsar's analysis turns the traditional, moralistic account of the financial crisis on its head: its cause was not the drive for risk — for gambles based on the promise of socialized losses — but the drive for safety.
The new system, which would come to be called shadow banking, provided an answer. That sinister name was bestowed on the system by a financial executive — in 2007! — decades after it had come into effect. It was not entirely new and drew on many established financial practices, which may be why no one fully understood the nature of the transformation.
Consider a bank that issues a mortgage to a home buyer. Under the traditional system, the bank kept the mortgage on its books and the homeowner made payments to it every month for the next 30 years. The bank had a strong incentive to screen mortgage applicants for credit risk because if the borrower defaulted, the bank would be forced to go through the expensive process of foreclosure and may not be fully paid back from the proceeds of the sale. For this reason, the bank also had a strong incentive to keep tabs on the homeowner and renegotiate the loan if he had trouble making payments. But while the bank had very good incentives, the necessity of keeping this asset on its books exposed it to considerable risk. If interest rates rose or housing prices fell, the risk of default increased, and there was little the bank could do about it. Moreover, if depositors needed their cash back, the bank would have trouble selling off the mortgage in short order and would take a loss. In the traditional model, banks were vulnerable to runs; FDIC insurance along with government regulation ensured financial stability. But government regulation imposed costs on banks, costs that the banks sought to minimize or avoid.
Under the modern system, the bank or other financial entity, generically called a mortgage originator, initiates the mortgage to the home buyer and may temporarily hold it on its books, but sells it off as quickly as possible. The buyer of the mortgage is Fannie Mae or Freddie Mac, two quasiprivate entities that I will discuss later; or an investment bank; or a trust operated by a commercial bank or its holding company; or another similar private financial institution. The buyer collects a large portfolio of loans, diversified across various dimensions (for example, region), and converts them into securities. These securities are sold to investors. The securities give investors a right to a stream of payments, just like any bond, with the payments coming out of the principal and interest payments made by the homeowners to the intermediary. The payments are structured so that some securities are super-safe, while others are highly risky. The super-safe securities are super-safe because their owners have the right to be paid from the entire pool of cash generated from the homeowners' payments before the owners of the less safe securities are paid. If a few homeowners default, the safe tranches are unaffected, while the lower tranches take the hit. That is why the super-safe tranches came to be regarded as good as bank deposits, effectively money — liquid and safe, and hence ideal for pensions, insurance companies, banks, and other investors who needed to be certain that a portion of their holdings could be converted into cash and paid to customers, depositors, or short-term lenders on a moment's notice. Credit-rating agencies formalize this arrangement by stamping AAA on the safe bonds.
These securities are called mortgage-backed securities (MBSs), and they have existed since the Great Depression, thanks to the involvement of Fannie and other government entities. But their volume, and significance for the financial system, grew exponentially in the 1990s and 2000s when private financial institutions also got into the act. These institutions created a range of related securities, including asset-backed securities (ABSs), which used other assets, like car and credit card loans as well as mortgages, and collateralized debt obligations (CDOs). These asset classes had many differences, but they all followed the logic of the MBS.
Another innovation was the credit default swap (CDS). A CDS is just an insurance policy, typically on a bond or another financial instrument. Imagine that an investor owns a bond issued by IBM. She worries that IBM will default on the bond. She could unload this default risk by selling the bond, but she could also protect herself from default by buying a CDS from an investment bank or other financial institution. Under the terms of the CDS, the insurer pays the investor the par value of the IBM bond if IBM defaults on the bond. In return, the investor pays the insurer a small amount of money, akin to an insurance premium. If IBM defaults, the investor hands over the bond to the insurer and receives the payout. Note, however, that the investor takes on the "counterparty risk" that the insurer will be insolvent when payment is due.
Excerpted from "Last Resort"
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Table of Contents
Introduction One The Transformation of the Financial System Two Crisis Three The Lawfulness of the Rescue Four The Trial of AIG Five Fannie and Freddie Six The Bankruptcies of General Motors and Chrysler Seven Takings and Government Action in Emergencies Eight Politics and Reform Acknowledgments Notes References Index