Jim Hamilton must feel like a Cassandra. Last August, he warned that the GSEs were in danger of having the ambiguous status of their implied guarantee tested. That came in January, and was finessed with various new Fed facilities.
Hamilton has also warned repeatedly that the Fed needs to consider institutional reform, not merely bailing out the boat as it continues to founder. He continued on that theme today in Econbrowser in parsing Bernanke’s remarks on Tuesday. Most observers focused on his comments on the continued rockiness of the markets; Hamilton worried about other oversights:
Bernanke concludes that it’s the responsibility of the central bank to stop such self-fulfilling instability. But he neglects to discuss the key feature of a healthy financial system that is supposed to prevent such a problem from ever arising. Specifically, any institution that is in this position of borrowing short and lending long needs to ensure that a certain fraction of the funds it is lending came not from borrowers but instead from the owners of the institution itself, in the form of net equity. The goal is for the size of this net equity to be larger than the losses the institution would incur from selling its less-liquid assets at steep discounts. As long as it is, no creditors ever have reason to demand cash, and there would be no need for the central bank to step in to prevent a self-fulfilling breakdown.
And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion. Much of these were credit-default swaps, in which the seller receives a fee in exchange for promising to pay any losses incurred by the buyer on some specified asset and time interval. If every such asset lost 100% of its value over the period, then maybe Bear is supposed to pay or receive $13.4 trillion. In practice, the actual price moves and net sum owed would be a small fraction of that notional total.
Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You’re doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.
If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional. But these weren’t traded on a regular exchange, so there was no margin requirement, and apparently no real limit on the size of the exposures that Bear Stearns could take on, or the size of what they could bring down with them if they fell.
And that raises the question, Why were counterparties willing to accept these trades with no margin to guarantee payment? To this I’m afraid the answer is, they figured Bear was too big for the Fed to allow it to fail. And on this, I’m afraid they proved to be exactly correct.
I would feel better if Bernanke were less focused on how to “provide liquidity” and more focused on how to get the system deleveraged and more transparent.
A minor quibble: we looked at the footnotes on Bear’s derivatives positions when it was going down for good, and much of it looked to be more plain vanilla interest rate swaps. But the general point is well taken. Bear was a significant CDS writer, and its equity was insufficient given the size of its derivatives book.