Dec 22, 2013

How to identify the "equally safe" phenomenon

The "equally safe" phenomenon is not new to financial systems. Hence, the question is not whether "equally safe" instruments1 exist per se, but whether they are misused since misusage leads to crises. To identify whether equally safe instruments are misemployed, they should be examined from two sides - supply and demand.

From the supply side, we need to understand (1) how much cash is supplied today in comparison to recent history. Oversupply of cash makes investors go on an investment spree, creating a bubble. At a minimum, we should track the total amount of cash invested into equally safe instruments and compare it to historical levels, both in absolute and relative terms. A relative comparison can be gauged by a ratio of cash invested in equally safe instruments to the balance sheet size of the financial firms that end up using the cash.

We also need to understand (2) how the demand for cash affects the supply. Specifically, does the demand drive the supply, or the supply flows naturally without any stimulation on the part of the demand. In the case of the 2000s, did cash-rich lenders come to money markets voluntarily, or were they encouraged by cash borrowers to invest as much cash as the lenders could possibly find? In 1929, for instance, the rate on call loans was so high that it attracted "other lenders quite outside of the banking system to come in and lend their funds to speculators." (U.S. Senate, 1931), highlighting the fact that the supply of cash was very much affected by the demand.

On the demand side, we need to (1) track the amount of short-term funding on the balance sheets of cash borrowers. The over-reliance on short-term funding can lead to the demise of a borrower when liquidity becomes scarce. During the 2008 financial crisis, this happened to two leading investment banks - Lehman Brothers and Bear Stearns. Since Bear Stearns financed about 35% of its assets in the repurchase agreements market, obtaining $141 billion daily from repo lenders2, the withdrawal of lenders turned out to be lethal to the bank. Likewise, Lehman Brothers funded its day-to-day operations of long-term security purchases in the repo market, financing daily as much as 42% of its assets in this market alone3. With such a funding profile, the bank's downfall was imminent.

We also need to (2) evaluate how short-term funding is used by the borrowers. Are the borrowers funding low-risk day-to-day operations, or channeling the continually-received funds into risky investments? For instance, up to the point of the 2008 financial crisis, investment banks borrowed cash in money markets to finance long-term assets, such as structured products, which were risky instruments since they depended on subprime borrowers making unfaltering mortgage payments.

A very LT investor should look into concrete details of the equally safe investments depending on the year of his investments; nevertheless, the questions suggested above are sufficient to uncovering whether equally safe instruments are being misused.

Footnotes

1. The following instruments would have been classified as "equally safe" before the 2008 financial crisis: repurchase agreements, asset-backed commercial paper, auction rate securities, tender offer bonds, and variable debt obligations.

2. 35% is derived by dividing $141 billion (daily repo financing)* by $399 billion (total assets at the end of February 2008)**.
* (Gorton & Metrick, 2010)
** (Bear Stearns Companies Inc., 2008)

3. 42% is derived by dividing $269 billion (daily repo financing)* by $639 billion (total assets at the end of May 2008)**.
* (Gorton, G. & Metrick, A., 2010)
** (Lehman Brothers Holdings Inc., 2008)

Sources

Bear Stearns Companies Inc. (2008, Feb. 29). Quarterly Report.

Gorton, G. & Metrick, A. (2010). Securitized Banking and the Run on Repo (NBER Working Paper No. 15223). Cambridge, MA: National Bureau of Economic Research.

Lehman Brothers Holdings Inc. (2008, May 31). Quarterly Report.

U.S. Senate, Committee on Banking and Currency (1931). Operation of the National and Federal Reserve Systems: Hearings on S.R. 71, Part I (p.66). Hearings before a Subcommittee of the Committee on Banking and Currency, 71 Congress, 3rd session. Washington, D.C.: United States Government Printing Office.

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