Dec 17, 2013

The "equally safe" phenomenon

In the 2007-2008 financial crisis, institutional investors found out that investing in money markets, particularly in repurchase agreements and commercial paper, was not nearly as safe as depositing money in a bank account or acquiring short-term US Treasury securities; although prior to the crash, these four types of instruments were generally deemed of equivalent safety. This is not the first time in financial history when seemingly safe and liquid instruments take a free ride on commercial banks' and government securities' reputation for solidity, ultimately causing major financial crises. Some of the most noteworthy examples are presented here. The structure of this analysis is as follows:

2008 financial crisis
1975 British secondary banking crisis
1907 panic on Wall Street
1929 Wall Street crash
1866 panic in the UK
1763 panic in Netherlands
Conclusion
Appendix: Summary of panic origins

The 2007-2008 financial crisis

Since the early 1990s, and especially in the 2000s, there has been an enormous growth of cash holdings on the balance sheets of major American corporations, cash assets at asset management firms, and collateral in the form of cash in securities lenders’ accounts. These firms wanted to find a secure and liquid market where they could invest their cash pools for a short time period, obtain a little return, and get the funds back as soon as needed. Their requirements were satisfied in money markets - markets for short-term securities lending and borrowing - in which the above-mentioned firms lent cash, while investment banks, hedge funds, insurance companies, as well as other financial entities, borrowed the cash to finance their day-to-day operations.

Because the firms with large cash pools sought the highest security for their investments, investment banks and other borrowers backed their borrowing with highly-rated securitized products, products that were based mostly on the good and timely payments of residential mortgages. Since the market viewed securitized products being very safe, cash-rich firms went ahead with lending cash in money markets. In reality, of course, securitized products were not nearly as safe as they were perceived, because many mortgages were made to subprime homeowners.

Meanwhile, home prices were rising, Wall Street firms were awash with liquidity coming from money markets, and investors were buying everything left and right. The good times soon ended, when from June 2004 to July 2006, aiming to prevent inflation, the Federal Reserve raised the federal funds rate from 1% to over 5%, resulting in slower economic growth, higher unemployment, declining house prices, and subsequently in defaults of subprime borrowers on their loans. Subprime borrowers could no longer continue making rapidly rising monthly mortgage payments because the mortgages were based on adjustable interest rates that spiked in tandem with the federal funds rate (Investment Company Institute, 2009).

Securitized products began massively underperforming since they were depended on unmissed mortgage payments. Cash-rich firms realized that the highly secure securitized products, that backed their lending transactions, were not that safe at all, and abruptly withdrew cash provision from money markets. On the other side of the transaction, investment banks and other financial institutions could no longer continue their daily operations due to the enormous dependence on uninterrupted funding from money markets. The so-called shadow ran - or the evaporation of short-term cash funding - ensured, the stock market tanked, and economic growth collapsed. Finita la comedia.

Remember how unrestricted and easy bank runs were prior to the establishment of the FDIC. When depositors feared for the safety of their deposits, they ran on banks en-masse. Equally, one is impressed with the easiness of a modern shadow run. Nothing forces lenders to continue supplying capital to commercial paper and repo markets.

Nothing forces lenders to continue supplying capital to commercial paper and repo markets.

Indeed, just like depositors before the crash of 1929 and the establishment of the FDIC, who earned a meager 3.8% on their savings deposits1, did not have much to lose by withdrawing their funds from commercial banks, money market lenders during the Great Recession of 2008 would not have lost much by keeping cash to themselves, given that one-month commercial paper issued by financial firms, such as Lehman Brothers, was yielding only 2.4% in annualized return in 2008 (Board of Governors of the Fed, 2012). Higher yields could not assure lenders to continue providing funding because high yields were self-destructive to the borrowers and could not be sustained for long. Nor the fact that commercial paper was backed by structured assets was enough to comfort lenders, because in a highly illiquid and volatile market, everything loses value except truly safe instruments, namely government securities. Therefore, nothing can save a modern firm from a shadow run.

The fact remains that in a modern financial system sensitive cash lenders hold in their hands the fate of shadow banks2, traditional banks, and the real economy. This is rather astonishing. The American economy is at the mercy of money market lenders, and cash is the king.

The secondary banking crisis of 1973-1975 in the UK
In the early 1970s, the British real estate market experienced a boom - a euphoric acquisition and development of properties, both residential and commercial - that was fed by abundant availability of loans provided by the so-called fringe or secondary banks. The fringe banks in turn got financing in money markets, in which British corporations lent unused cash in exchange for a small return.

The fringe banks, as the name suggests, were barely regulated and were required to provide only annual balance sheet data to British supervisory authorities. In spite of this, corporations were not troubled about transacting with such shadowy institutions. The certificates of deposit sold by fringe banks (Geisst, 1995) in money markets were viewed nearly as safe as bank deposits and government securities, and the counterparty risk - the risk that the party on the other side of the transaction might default - was perceived as nonexistent. In truth, fringe banks were much riskier because of their business model, in which they made long-term loans from short-term certificates of deposit. Yet, money market lenders never bothered to think about this simple fact. Such was the case until a crisis arrived, and reminded money market participants that their views had been illusory.

The fact remains that in a modern financial system sensitive cash lenders hold in their hands the fate of shadow banks, traditional banks, and the real economy. This is rather astonishing. The American economy is at the mercy of money market lenders, and cash is the king.

When in November 1973, with the goal of preventing inflation, the Bank of England raised interest rates to a high of 13%, numerous property investors and homebuyers were no longer able to pay for their mortgages and started defaulting. Unfulfilled monthly mortgage payments immediately translated into financial problems for fringe banks. Money market lenders realized that fringe banks were in trouble, and from the fear of not getting their money back, withdrew cash provision from money markets. A classical squeeze on both sides - demand (evaporation of cash provision from money markets) and supply (failed mortgage payments) - ensued, and the real estate market tanked (Capie, 2012).. Transacting in "equally safe" money market instruments with fringe banks turned out to be vastly different from dealing with truly safe, government-backed money market instruments.

A highly similar situation occurred in the American real estate market merely 33 years later, which should serve as a reminder to a very LT investor of the importance of studying economic history. Fringe banks of the 1970s played in essence the same role shadow banks did in the US in the 2000s, with the only difference being that the fringe banks supplied loans directly to homeowners and investors, while the shadow banks bought loans from commercial banks and mortgage originators, that in turn made mortgages to families and speculators. The same function, just a bit more complicated in structure.

Transacting in "equally safe" money market instruments with fringe banks turned out to be vastly different from dealing with truly safe, government-backed money market instruments.

The Panic of 1907
In the early 1900's stock investing was becoming steadily popular, fueled by the abundant supply of margin loans, provided by brokers. Brokers themselves financed margin loans in the call loan market, in which commercial banks and trust companies loaned depositors' money to brokers. A key feature of call loans was that their providers - commercial banks and trusts - could demand the loaned cash back at any time, in turn forcing brokers to cut on margin loans to stock market investors.

Since trust companies were at the epicenter of the panic, an understanding their operations is essential. Trusts of the time were deposit-taking institutions that provided essentially the same set of services as commercial banks, yet were very lightly regulated. Before 1906, for example, trusts were not even required to keep reserves on their books, in contrast to national banks that were obliged to preserve as much as 25% of their deposits (Moen & Tallman, 1992). Despite this, the public deemed trusts to be as trustworthy and equally safe as commercial banks, enabling trusts to take a free ride on banks' reputation for soundness. In reality trusts were not nearly as secure since their loan composition was riskier and depositors' money was not protected from trust defaults; in contrast, deposits at banks were implicitly insured by the New York Clearinghouse, which acted as a private version of the FDIC.

Despite this, the public deemed trusts to be as trustworthy and equally safe as commercial banks, enabling trusts to take a free ride on banks' reputation for soundness.

The importance of trusts to the New York market is further highlighted by the following facts. First, the value of assets held by New York City trusts was approximately as large as the value of assets at national banks in the city. Second, call loans occupied a large, though not precisely known, portion of trusts' overall lending capacity. National banks, for example, loaned out nearly 40% of their assets in the form of call loans (Moen & Tallman, 2003). These characteristics made trusts crucial players in supplying capital for stock purchases made on margin.

Although the economy and the stock market were in decline since the early part of 1907, nothing evidently foreshadowed an upcoming disaster. The trouble began when a financier named Augustus Heinze tried, unsuccessfully, to orchestrate a speculative attack on the stock of United Copper Company. After the failed attempt, Heinze was forced to resign from Mercantile National Bank, where he had served as the president. As a consequence, the bank sustained a serious reputational blow - depositors rushed en masse to withdraw their personal savings. Given that banks at the time had no explicit deposit insurance - only an implicit one, provided by the New York Clearinghouse - it is evident that the depositors did act rationally by rushing to withdraw their money. The situation was stabilized however when the New York Clearinghouse provided cash infusion to the bank. A few days later the public learned that the president of the third largest trust company in NYC, the Knickerbocker Trust Company, was involved in the speculative attack too, and a run on that trust ensued. The run ended with the trust suspending operations after being unable to satisfy all withdrawal requests. The next day, the frightened public rushed to withdraw funds from the second largest trust in New York, the Trust Company of America. This was instantly followed by a run on remaining trusts (Moen & Tallman, 1992).

As trusts scraped for funds to meet depositors' demands, they fist depleted their slim cash reserves, then turned to monetizing their second most liquid assets, namely call loans extended to brokers. Trusts grasped for this potential lifesaver because call loans had to be returned in cash practically immediately upon request. Overwhelmed by trusts' requests, brokers were forced to redeem margin loans made to stock market investors, in turn compelling investors to start liquidating their stock positions to pay the brokers back. As the supply of stocks outstripped the demand for them, investors had no other choice but to dispose their positions at fire sale - or very depressed - prices. The stock market plunged, in effect transferring the panic from the trust sector to capital markets.

Given that these events took place when a substantial number of all stocks were purchased on margin, it is clear that trusts held in their hands the fate of the US stock market. Without any exogenous pressure on them, if they only wished, trusts could have substantially depressed stock market prices by simultaneously withdrawing call loan provision from brokers. Alas, a real negative exogenously-caused shock did occur in the form of massive depositor withdrawals from trusts. This forced trusts to cut the credit flow to brokers, and subsequently to stock speculators.

Given that these events took place when a substantial number of all stocks were purchased on margin, it is clear that trusts held in their hands the fate of the US stock market. Without any exogenous pressure on them, if they only wished, trusts could have substantially depressed stock market prices by simultaneously withdrawing call loan provision from brokers.

The 1929 Wall Street Crash
In 1929, call loans again played a central role in contributing to the collapse of the stock market. If in 1907, the intermediation mechanism looked like this: depositors - trusts - brokers - stock speculators, then in 1929 the flow of funds originated with corporations and to a lesser extent with commercial banks, and their depositors.

In the late 1920s, taking advantage the cheap and abundant credit in the economy, corporations issued large amounts of stocks and bonds. The amount of funds raised turned out to be greater than corporations could efficiently employ. The extra cash corporations sought to invest in highly safe and liquid instruments (Haney, Logan, & Gavens, 1932). Since the call loan market satisfied these requirements and paid a bit more than a bank deposit or a Treasury security, corporate entities readily channeled their cash pools there. In this market, brokers borrowed funds to finance margin loans they extended to stock market investors. Corporations took the creditworthiness of the call loan market as a given, while the credit quality of borrowers - in this case, brokers and ultimately stock market investors - was not supposed to be doubted; it was assumed they would always be able to pay their margin loans and call loans back. On top of that, corporations firmly believed in the stability of the call loan market, because of the undeviating support provided by commercial banks. This is evidenced by the following commentary made by the Subcommittee on Senate Resolution in 1931: "large commercial banks ... have regularly shown a willingness to increase loans for their own account to replace the loans of (corporations) when the latter are withdrawn, thus giving a de facto guarantee of the safety and liquidity of such advances" (U.S. Senate, 1931a).

(U.S. Senate, 1931a)

At the peak of the call loan provision, on October 4, 1929, over $10.5 billion in loans came from commercial banks, while another $6.4 billion was supplied by nonbanks, namely corporations and other institutional entities. When it became evident that too many stocks were purchased on margin, and that this scheme could not last forever, corporations - from the fear of not getting their funds back - withdrew $4 billion of the cash they had provided to brokers by the end of 1929. This action triggered brokers to recall margin loans from stock investors, who in turn rushed to liquidate their positions at whatever prices they could obtain. By the end of June, 1931 call loans from nonbank entities virtually ceased to exist, dropping to a pitiful $366 million.

The sensitivity of corporate cash pools to conditions in the stock market was accurately recognized by the second president of the New York Fed, George L. Harrison, who, back in a 1931 Senate hearing, said that "when the ... pressure begins to work in New York, the first loans that begin to go are the call loans" (U.S. Senate, 1931b). This statement highlights the fact that the $4 billion of corporate cash pools could have been withdrawn from the market in a blink of an eye. Given that a typical margin for stock purchases was 25% at the time (Galbraith, 2009), the $4 billion in call loans supported $5 billion in stock market values, or 5.6%3 of the total market capitalization of the New York Stock Exchange. A withdrawal of $4 billion in call loans would have translated into 5.6% of the value of NYSE stocks being simultaneously dumped on the market, depressing prices all across the board. "The statement of many people is that you cannot call the loans without causing disaster." (U.S. Senate, 1931c) - was a common view at the time! In fact, this statement is true during any crisis.

Harrison added that call loans were "money loaned by lenders who had no responsibility to the money market or to the banking system" (U.S. Senate, 1931d), implying that corporations did not care about the overall stock market situation; they only cared about preserving their own financial stability. Yet, their cumulative cash withdrawal backfired on them when the disaster on the stock exchange spilled into the real economy in the form of the Great Depression.

"when the ... pressure begins to work in New York, the first loans that begin to go are the call loans"

In an act of a remarkable insight, Harrison named the whole arrangement where corporations lent money to the call loan market as the "bootleg banking system" (U.S. Senate, 1931d) - a rather synonymous term to the modern shadow banking system, although the latter encompasses a greater variety of functions than just cash lending.

In the stock market crash of 1929 investors learned none of the lessons the 1907 panic had tried to teach them, which similarly occurred because of the withdrawal of short-term cash provision from the call loan market. This vividly shows that a time period equivalent to one generation is enough to make investors forget even if they had gotten badly scalded before. Most likely, however, investors of the roaring twenties never learned nor even understood the lesson of 1907. History shows that investors of the 2007-2008 financial crisis are unlikely to be different.

1763 Netherlands
In 1763 Netherlands, it was common practice for merchant banks - financial entities that provided financing to merchants and traded goods on their own account, but took no deposits - to finance themselves by issuing short-term debt on a continuous basis. Short-term debt at that time came in the form of acceptance loans, a modern-day equivalent of commercial paper, secured by assets, which were commodity shipments in this case. When a merchant bank named Gebroeders de Neufville - one of the largest issuers of acceptance loans in Amsterdam - collapsed, because it was unable to make a weekly interest payment on its debt in time, cash lenders became unwilling to roll over the debt of remaining merchant banks that operated under analogous business plans (Quinn & Roberds, 2012). A collapse of multiple merchant banks ensued.

1866 England
Another example of the "equally safe" phenomenon took place in England in 1866, where because of the failure of Overend, Gurney and Company - one of the major discount houses in London at that time - lenders refused to fund “short-term commercial credit instruments” (Flandreau & Ugolini, 2011), called acceptances, which were deemed unjustifiably secure in the past. The loss of funding liquidity for remaining discount houses was comparable to the experiences modern financial institutions had to go through after the Lehman collapse.

Conclusion
The conclusion to be drawn from financial history, both early modern and contemporary, is that in a crisis, two different money market products cannot and will not perform identically no matter how much protection is bought on them, how beautifully they are wrapped with safety measures, how vocally they are advertised, or how long they have behaved like their truly safe counterparts. When a crisis arrives, seemingly "equally safe" instruments have always turned out to be not nearly as safe and liquid as bank accounts and Treasury securities; although up to the point of the crash, these two types of instruments have always been considered as equals, and not only in perception, but also in the nearly identical rate of return. In the 2008 financial crisis, repurchase agreements and commercial paper turned out to be not as safe. In the secondary banking crisis of 1975, the certificates of deposit issued by fringe banks ended up being not as safe. In 1907 and 1929, the call loan market happened to be not as safe. In 1763 Netherlands and 1866 England, acceptance loans eventuated as not a sure thing.

Financial history - which always repeats itself - tells us that in the future, repurchase agreements and commercial paper, and other short-term instruments, such as auction rate securities, tender offer bonds, and variable debt obligations, will again turn out to be not as safe. By having a solid understanding of this phenomenon, a very LT investor will be far ahead of other market participants in moving his assets out of seemingly safe and seemingly liquid instruments, and repositioning his portfolio into truly secure investments.

Financial history - which always repeats itself - tells us that in the future, repurchase agreements and commercial paper, and other short-term instruments ... will again turn out to be not as safe.

Appendix: Summary of panic origins
- Shadow banking of the 2000s: cash-rich corporations, asset management firms, & securities lenders withdraw cash from money markets, investment banks & other nonbank financial firms go bankrupt, stock market tanks
- Fringe banking of the 1970s: cash-rich corporations withdraw cash from money markets, fringe banks go bankrupt, real estate market tanks
- Bootleg banking of 1929: cash-rich corporations and commercial banks withdraw cash from the call loan market, brokers request margin loans back from stock investors, stock market tanks
- Pre-Federal Reserve banking of 1907: depositors withdraw cash from trusts, trusts withdraw cash from the call loan market, brokers request margin loans back from stock investors, stock market tanks

In short
- Shadow banking of the 2000s: corporations; asset management firms, securities lenders (shadow banks)
- Fringe banking of the 1970s: fringe banks (shadow banks)
- Bootleg banking of 1929: corporations & commercial banks
- Pre-Federal Reserve banking of 1907: trusts (shadow banks)

Footnotes

1. Passbook rates – a modern equivalent to saving deposit rates – were on average 3.8% between 1926 and 1930*. This occurred against the backdrop of the annual inflation rate of approximately negative 1%, and S&P500 averaging 11.6%, 37.5%, 43.6%, negative 8.4%, and negative 24.9% during the same five-year period.**
* (Rolnick,1987).
** (Federal Reserve Bank of Minneapolis, 2012).

2. The Financial Stability Board defines the shadow banking system as a group of entities that “perform bank-like functions”*, while being situated “outside the regular banking system”*. The definition purposely covers a wide range of non-bank market-based institutions to capture all intermediation outside commercial banking , including investment banks, broker dealers, hedge funds, asset management firms, insurance companies, government-sponsored enterprises, such as Fannie Mae, and the financial products these firms create and intermediate.
* (Financial Stability Board, 2011).

3. 5.6% is calculated by dividing $5 billion by $89.7 billion, the total market capitalization of 846 companies listed on NYSE*.
* (McGrattan & Prescott, 2004).

Sources

Board of Governors of the Federal Reserve Bank. (2012). 30-Day AA Financial Commercial Paper Interest Rate 1997 to 2012.

Capie, F. (2012). The Bank of England: 1950s and 1979. New York, NY: Cambridge University Press.

Federal Reserve Bank of Minneapolis. (2012). Consumer price index, 1913-.

Financial Stability Board. (2011). Shadow Banking: Scoping the Issues: A Background Note of the Financial Stability Board. Basel, Switzerland: Financial Stability Board.

Flandreau, M. & Ugolini, S. (2011). Where It All Began: Lending of Last Resort and the Bank of England during the Overend, Gurney Panic of 1866. (The Graduate Institute Working Paper No: 04/2011). Genève, Switzerland: The Graduate Institute.

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Geisst, C. (1995). Exchange Rate Chaos: 25 Years of Finance and Consumer Democracy. London, UK: Routledge.

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Investment Company Institute. (2009). Report of the money market working group. Washington, DC: Investment Company Institute.

McGrattan, E. & Prescott, E. (2004). The 1929 stock market: Irving Fisher was right. International Economic Review 45(4), 991-1009. DOI: 10.1111/j.0020-6598.2004.00295.x

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Quinn,S. & Roberds,W. (2012). Responding to a Shadow Banking Crisis: The Lessons of 1763. Atlanta, GA: Federal Reserve Bank of Atlanta.

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U.S. Senate, Committee on Banking and Currency (1931a). Operation of the National and Federal Reserve Systems: Hearings on S.R. 71, Appendix, Part VII (p.1025). Hearings before a Subcommittee of the Committee on Banking and Currency, 71 Congress, 3rd session. Washington, D.C.: United States Government Printing Office.

U.S. Senate, Committee on Banking and Currency (1931b). Operation of the National and Federal Reserve Systems: Hearings on S.R. 71, Part I (p.57). Hearings before a Subcommittee of the Committee on Banking and Currency, 71 Congress, 3rd session. Washington, D.C.: United States Government Printing Office.

U.S. Senate, Committee on Banking and Currency (1931c). Operation of the National and Federal Reserve Systems: Hearings on S.R. 71, Part I (p.151). Hearings before a Subcommittee of the Committee on Banking and Currency, 71 Congress, 3rd session. Washington, D.C.: United States Government Printing Office.

U.S. Senate, Committee on Banking and Currency (1931d). 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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