Streetwise Professor

July 29, 2021

Timmy!’s Back!

Former Treasury Secretary Timothy Geithner–better known as Timmy! to loooooongtime readers of this blog–is back, this time as Chair of the Group of 30 Working Group on Treasury Market Liquidity. The Working Group was tasked with addressing periodic seizures in the Treasury securities market, most notoriously during the onset of the Covid crisis in March 2020–something I wrote about here.

This is a tale of two reports: the diagnosis is spot on, the prescription pathetic.

The report recognizes that

the root cause of the increasing frequency of episodes of Treasury market dysfunction under stress is that the
aggregate amount of capital allocated to market-making by bank-affiliated dealers has not kept pace with the very rapid growth of marketable Treasury debt outstanding

In other words, supply of bank market making services has declined, and demand for market making services has gone up. What could go wrong, right?

Moreover, the report recognizes the supply side root cause of the root cause: post-Financial Crisis regulations, and in particular the Supplemental Leverage Ratio, or SLR:

Post-global financial crisis reforms have ensured that banks have adequate capital, even under stress, but certain provisions may be discouraging market-making in U.S. Treasury securities and Treasury repos, both in normal times and especially under stress. The most significant of those provisions is the Basel III leverage ratio, which in theUnited States is called the Supplementary Leverage Ratio (SLR) because all banks in the United States (not just internationally active banks) are subject to an additional “Tier 1”leverage ratio.

Obviously fiscal diarrhea has caused a flood of Treasury issuance that from time to time clogs the Treasury market plumbing, but that’s not something the plumber can fix. The plumber can put in bigger pipes, so of course the report recommends wholesale changes in the constraints on market making, the SLR in particular, right? Right?

Not really. Recommendation 6–SIX, mind you–is “think about doing something about SLR sometime”:

Banking regulators should review how market intermediation is treated in existing regulation, with a view to identifying provisions that could be modified to avoid disincentivizing market intermediation, without weakening overall resilience of the banking system. In particular, U.S. banking regulators should take steps to ensure that risk-insensitive leverage ratios function as backstops to risk-based capital requirements rather than constraints that bind frequently.

Wow. That’s sure a stirring call to action! Review with a view to. Like Scarlett O’Hara.

Rather than addressing either of what itself acknowledges are the two primary problems, the report recommends . . . wait for it . . . more central clearing of the Treasury market. Timothy Geithner, man with a hammer, looking for nails.

Clearing cash Treasuries will almost certainly have a trivial effect on market making capacity. The settlement cycle in Treasuries is already one day–something that is aspirational (don’t ask me why) in the stock market. That already limits significantly the counterparty credit risk in the market (and it’s not clear that counterparty credit risk is a serious impediment on market making, especially since it existed before the recent dislocations in the Treasury market, and therefore is unlikely to have been a major contributor to them).

The report recognizes this: “Counterparty credit risks on trades in U.S. Treasury securities are not as large as those in other U.S. financial markets, because the contractual settlement cycle for U.S. Treasury securities is shorter (usually one day) and Treasury security prices generally are less volatile than other securities prices.” Geithner (and most of the rest of the policymaking establishment) were wrong about clearing being a panacea in the swap markets: it’s far less likely to make a material difference in the market for cash Treasuries.

The failure to learn over the past decade plus is clear (no pun intended!) from the report’s list of supposed benefits of clearing, which include

reduction of counterparty credit and liquidity risks through netting of counterparty exposures and application of margin requirements and other risk mitigants, the creation of additional market-making capacity at all dealers as a result of recognition of the reduction of exposures achieved though multilateral netting

As I wrote extensively in 2008 and the years following, netting does not reduce counterparty credit risk or exposures: it reallocates them. Moreover, as I’ve also been on about for more than a fifth of my adult life (and I’m not young!), “margin requirements” create their own problems. In particular, as the report notes, as is the case in most crises the March 2020 Treasury crisis sparked a liquidity crisis–liquidity not in terms of the depth of Treasury markets (though that was an issue) but liquidity in terms of a large increase in the demand for cash. Margin requirements would likely exacerbate that, although the incremental effect is hard to determine given that existing bilateral exposures may be margined (something the report does not discuss). As seen in the GameStop fiasco, a big increase in margins in part driven by the central counterparty (ironically the DTCC, the parent of the FICC which the report wants to be the clearinghouse for its expanded clearing of Treasuries) was a major cause of disruptions. For the report to ignore altogether this issue is inexcusable.

Relatedly, the report touches only briefly on the role of basis trades in the events of March 2020. As I showed in the article linked above, these were a major contributor to the dislocations. And why? Precisely because of margin calls on futures.

Thus, the report fails to analyze completely its main recommendation, and in fact its recommendation is based on not just an incomplete but a faulty understanding of the implications of clearing (notably its mistaken beliefs about the benefits of netting). That is, just like in the aftermath of 2008, supposed solutions to systemic risk are based on decidedly non-systemic analyses.

Instead, shrinking from the core issue, the report focuses on a peripheral issue, and does not analyze that properly. Clearing! Yeah, that’s the ticket! Good for whatever ails ya!

In sum, meet the new Timmy! Same as the old Timmy!

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June 23, 2021

I Never Did Acid in the 70s, But I’m Experiencing Flashbacks Anyways

Filed under: Commodities,Economics,Financial crisis,Politics,Regulation — cpirrong @ 7:18 pm

I grew up in the 70s. I never did acid then (or ever!), but man am I experiencing flashbacks. Feckless progressive Democrat presidents. (Though Carter, while an idiot, was at least compos mentis, which is more than can be said of Señor Senile Joe Biden.) Crime. (I’m betting on a comeback of the Charles Bronson revenge and Clint Eastwood Dirty Harry genres.) All in all, the 70s sucked, and I am not nostalgically hoping for a reprise–I’m dreading it actually.

One of the things that sucked worst was inflation. The 1970s were the inflation decade (although it peaked in 1980-1981). In recent months, the price level measured by the CPI, PPI, and GDP deflator has been up substantially. CPI, for example, is up about 4.5 percent on a year-on-year basis. This has raised concerns about a return of 70s-style inflation. Are these concerns justified?

The jury is out, but there is reason for concern.

First, it is important to distinguish between one time changes in the price level and inflation. Inflation is a long term upward trend in the price level, rather than a single stair-step jump in the price level.

The impact of the pandemic (or, more accurately, the draconian policy response to the pandemic) has created the conditions for a one-time step up in the price level. The economic recovery from the pandemic is a positive aggregate demand shock. Moreover, it has occurred against the backdrop of constrained supply conditions that resulted from the pandemic. Upward shifts in supply and demand lead to a higher price level, ceteris paribus.

One would think that these are effectively one-time shocks–hopefully the pandemic is a one-time thing, and therefore the recovery from it is too. Furthermore, supply conditions should ease. (We are already seeing that in some sectors, such as lumber, though not in others, such as semiconductors. Policy, namely paying people not to work in some states, may impede the easing of supply conditions). Thus, one would expect that this is one time, and at least partially transitory, jump in the price level rather than inflation qua inflation.

That said, there are reasons for concern. Most notably, the fiscal diarrhea in the US, and the willingness of the Fed to finance (i.e., monetize) that spending is freighted with inflationary potential.

In the post-Financial Crisis era, the Fed mitigated the inflationary impact of QE and other expansive monetary policies by paying interest on reserves. So the inflationary threat that I worried about in 2009 (and asked Ben Bernanke about) never materialized. But that’s no reason for complacency. We dodged a bullet once, but that doesn’t mean we will always do so. Massive deficit spending accommodated by the monetary authority is highly likely to result in inflation, sooner or later. (I am inclined to favor Thomas Sargent’s fiscal theory of the price level.).

Part of the reason that inflation didn’t occur post-2008 was that money velocity plunged. Part of this was due to the Fed paying interest on reserves, which led banks to hold them (lend them to the Fed in effect) rather than lend them to private individuals and firms. But expectations, and the self-fulfilling nature thereof with respect to inflation, likely played a role too. In the gloomy aftermath of 2008 people expected low inflation (or even deflation), which made them more willing to hold rather than spend money balances–which results in low inflation, thereby validating the expectations and perpetuating the equilibrium.

But expectations are fickle things, and as a result there can be multiple equilibria. Fed board members have strenuously argued that the recent spurt in prices is a one-time stair step phenomenon, not the harbinger of inflation. But if the spurt results in an upward shift in inflationary expectations by the hoi polloi, people will be less willing to hold money balances at the existing price level, so they will try to reduce (i.e., spend) them, which leads to inflation–thereby validating the expectations.

Thus, it’s not so much what the Fed believe that matters. It’s about what you and me and other individuals and firms believe. Combine a negative fiscal picture with a surge in prices and it’s quite possible that inflation expectations soon will no longer be “anchored” at low levels, but will surge to higher levels, which would result in inflation no longer being anchored at low levels.

So although I think that the recent surge in the price level is of the one-time variety, that doesn’t mean everyone will think the same way. And if everyone doesn’t think the same way we may see a 70s rerun. The dire fiscal picture contributes to such worries.

When the subject of inflation comes up, as Dr. Commodities I’m often asked whether commodities are a good hedge. Intuitively it makes sense that they should be, but historically, they have not been. Commodity prices are much more volatile than the price level, and not that highly correlated. That is, relative prices move around a lot even when the price level trends upwards.

I think that availability bias is a big reason why people focus on commodity prices–they are readily observable, on a second-by-second basis, because they are actively traded on liquid markets. Other goods and services, not so much. But just because we can see them easily doesn’t mean that they are reliable beacons for the price level overall, or changes therein.

This brings to mind why we should really fear a return of 70s-style inflation (or worse, heaven forfend).

When sitting in (the great) Sherwin Rosen’s Econ 302 course at Chicago on a cold morning in February, 1982, I was startled when Sherwin’s normal rather droning delivery was interrupted by him shouting and pounding his right fist into his left palm: “And that’s the problem with inflation. IT FUCKS UP RELATIVE PRICES!!!!”

Some prices are stickier than others, meaning that inflation pressures can impact some goods and services more and sooner than others–thereby causing changes in relative prices.

This is a bad thing–and why Sherwin dropped the F-bomb about it–because relative prices guide resource allocation. If you fuck up relative prices, as inflation does, you interfere with resource allocation, leading to lower incomes and growth. Inflation has adverse real consequences.

So we should definitely fear an acid flashback to 70s inflation. And although I do not believe the recent surge in prices is a harbinger thereof, I think that there is a material risk that we may all experience such a flashback–even if you didn’t grow up in the 70s.

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June 10, 2021

Bad Day At BlackRock?

Filed under: Economics,Financial crisis,Politics,Regulation — cpirrong @ 6:16 pm

There has been something of a kerfuffle recently over the large scale purchases of single family homes by the likes of BlackRock and other institutional investors like pension funds. The criticism is somewhat redolent of the Occupy days, because it unites many on the left with some on the populist right, like J.D. Vance:

Understanding should come before judgment. So let’s try to figure out what is going on here. I don’t have a definitive answer, but my strong sense is that this phenomenon is ultimately a consequence of the 2008-2009 Financial Crisis, and the various policy responses to it.

One thing is clear is that the initial foray of institutional investors was a response to the Crisis. And no wonder. Massive amounts of single family homes were in foreclosure, and the biggest fire sale in American real estate history was underway. And in fire sales, those with “dry powder”–cash rich investors relatively undamaged by the crisis that sparks the sales–go bargain hunting. In 2009-2010, the bargains were in residential real estate, especially single family houses. And the “real money” investors like BlackRock and pension funds were best positioned to grab those bargains.

Here it is almost certain that the activities of BlackRock et al did elevate real estate prices. And a good thing, too, for the problem at the time was not that housing prices were too high, but too low. Without bargain hunters (or vultures, if you wish) housing prices would have been even lower, more homeowners would have been underwater, more of them would have been foreclosed, etc. Of course BlackRock et al were not doing this out of charity, but to make a buck. But they were responding to price signals and their actions almost certainly mitigated a horrible situation.

But as the WSJ article linked above notes, institutional investment in the housing sector has persisted after the fire sales ended–especially in places like Houston, Atlanta, and Nashville. This is characterized as a reach for yield strategy on the part of the institutional investors. The yield on rental property is apparently attractive relative to alternative investments. And no surprise: have you looked at bond yields recently? Like in the last 12 years? Is it any wonder that investors like pension funds (especially government funds that are hugely under water) are desperate for assets that generate a stream of cash flows at attractive rates?

But high yield suggests that prices are low in some sense, rather than high. (Price is in the denominator of the return calculation.) “Bubble” real estate markets are characterized by extremely low rental yields, not high ones.

Look at this another way. People are choosing to pay rent, rather than buy and make mortgage payments and forego income on the investment of a down payment amount. Why? Why are they paying rents that generate a high return for the housing owner, rather than buying homes and capturing that return themselves?

My answers will be somewhat speculative, but now the question is the important thing. Many individuals are choosing not to buy, and to pay rent instead. The rents that they are willing to pay are driven by the stream of benefits that they get from living in a single family home. Why don’t they outbid BlackRock or some state pension fund and pay a price that capitalizes that stream of benefits?

Note that there are clear advantages to occupiers owning. The Atlantic article linked earlier discusses the frictions associated with renting. Well, renter-landlord relations have been fraught always and everywhere. Rental contracts are not “complete”–they leave a lot of grey areas that give rise to conflict between owner and renter, and to opportunism by both. Those wasteful activities can be eliminated by having those who live in a home own it. That in and of itself should give individuals a bidding advantage over institutions when buying homes. Cut out the middleman and you cut out the transaction costs inherent in the landlord-tenant relationship.

So then what gives? Now for the speculation, which again revolves around the fallout from the Financial Crisis.

First, the leading diagnosis of the cause of the Financial Crisis was that it was too easy to get a mortgage. In response to this, post-Crisis legislation and regulation tightened up the home financing market. A lot. You can argue that the tightening was justified. You can argue that it went too far. But regardless, restrictions on the ability of individuals to finance a home purchase, or regulations that made it more expensive to do this, shifted the balance away from purchasing towards renting.

Indeed, if the likes of Elizabeth Warren were intellectually consistent (yeah I’m a comedian, I know), they should see the increased presence of Wall Street on Elm Street as a good thing, because it means that their endeavors to prevent another housing “bubble” have worked.

Second, the Financial Crisis took a severe toll on the balance sheets and creditworthiness of many individuals. Although these problems have dissipated, they haven’t disappeared. Combined with the more restrictive access to credit, these creditworthiness/balance sheet effects impede the ability of individuals to capture the high returns of home ownership, and they cannot compete on price with institutional investors who do not face such impediments.

Third–and this is perhaps the most speculative point of all–the Financial Crisis and the follow on Foreclosure Crisis arguably had an impact on the preferences of individuals, especially Millennials and Gen-Zs. Post-Crisis home ownership seemed less like a dream–it had a potential dark side. So many in those cohorts prefer to pay rent and give a high return to institutional investors and deal with the hassles of a landlord rather than buy and face the risk of financial ruin.

Fed policy may also play a role. It clearly has depressed returns on conventional fixed income investments–and has done so by design. That has made institutional investors look at non-traditional investments. But Fed policy alone can’t explain why yields on housing investments apparently haven’t fallen to the level of the low yields on bonds. There must be some other factor impeding the rise of housing prices to reduce the yields that the institutional investors are apparently capturing by buying and renting out single family homes. That brings us back to a search for factors (like those just discussed) that prevent individuals from outbidding institutional investors to capture the stream of returns from housing ownership (and to eliminate the costs that arise when the home occupier is not the owner).

In turn, this means that inquiry into this issue should focus on whether post-Crisis, there are excessive restrictions and costs imposed on individuals looking to finance home purchases. That is, are the post-2008 laws and regulations designed to prevent a recurrence of the housing boom too restrictive?

I don’t have an answer to that question, but again, posing the right question is where you have to start.

My provisional conclusion now is that institutional investors are doing what they do: responding to price signals in order to maximize risk adjusted returns. They are responding to incentives. To evaluate what is going on, it is necessary to evaluate whether those incentives have been distorted by ill-conceived policies.

Of course, these policies were not created in a vacuum. They are the result of a political process that includes lobbying and rent seeking by institutional investors, among others. They have an incentive to harm potential competitors in the housing market. So any inquiry should also focus on whether these institutional investors have helped rig the game against individuals by pressing for the imposition of unwarranted restrictions on home financing. If so, censorious judgment would be warranted.

So is burgeoning institutional ownership of single family housing a 2020s version of Bad Day at Black Rock? A 2020s film noir? I don’t know. But I have the questions and some provisional answers.

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March 31, 2021

Margin Call: From Movie to Reality Show

Filed under: Economics,Financial crisis — cpirrong @ 2:10 pm

The film Margin Call is an entertaining portrayal of big bank culture and behavior during the Financial Crisis. The basic plot involves a Wall Street bank that realizes that it holds a lot of toxic real estate/mortgage securities, and wants to unload them before everyone else figures out that their price is going to collapse. It succeeds, and saves itself from the fate of Lehman or Bear. I had to look past the basic plot vehicle: the ability of the bank to execute such massive sales without causing the price decline that it predicted is rather doubtful, at best. That said, the plot does provide an excellent backdrop for the personal dramas and interpersonal dynamics and characters that are Wall Street (and the City).

The Archegos implosion is a reality show version of Margin Call–right down to the title. The massive “private office” run by former Tiger Management wunderkind Bill Hwang put on massive positions (some long, some short) in a relatively small set of stocks. At least some of those positions were in the form of total return swaps, rather than purchases of the underlying stocks. Swaps embed leverage. A TRS is equivalent to a position in the stock financed with borrowing. It’s not clear from the reporting, but some may also have been old fashioned leveraged bets, with purchases of stocks on margin.

When prices went against the positions, Hwang faced huged margin calls that he did not meet. The prime brokers with whom he dealt then needed to liquidate large positions in the losing securities. Some of these stock holdings might have been the collateral that Hwang had posted, which the prime brokers seized when he defaulted. Some of them were almost certainly shares that the banks had bought as hedges of the total return swaps. Once Hwang defaulted, the banks’ short positions in the TRS went away, and they no longer needed the hedges.

Here’s where the Margin Call analogy really kicks in. Apparently Hwang’s major prime brokers, including Credit Suisse, Nomura, Morgan Stanley, and Goldman, discussed a coordinated liquidation of the stock positions in order to mitigate a panicked . Goldman (and maybe MS) listened politely, then pipped the others to the post and sold the stocks in big blocks before the others did. As a result, Credit Suisse and Nomura lost billions, and apparently Goldman and Morgan Stanley didn’t.

Goldman’s behavior is redolent of what they did in the Long Term Capital Management (LTCM) situation. One would have thought that CS and Nomura would have taken that into consideration, and hadn’t made themselves into the hindmost for the Devil’s taking.

Interestingly, although the block “fire sales” impacted the prices of the stocks Hwang traded, there doesn’t appear to have been a wider market fallout. Billions ain’t what they used to be. Even tens of billions ain’t what they used to be.

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January 29, 2021

GameStop-ped Up Robinhood’s Plumbing

The vertigo inducing story of GameStop ramped it up to 11 yesterday, with a furore over Robinhood’s restriction of trading in GME to liquidation only, and the news that it had sold out of its customers’ positions without the customers’ permission. These actions are widely perceived as an anti-populist capitulation to Big Finance.

Well, they are in a way–but NOT the way that is being widely portrayed. What is going on is an illustration of the old adage that clearing and settlement in securities markets (like the derivatives markets) is like the plumbing–you take it for granted until the toilet backs up.

You can piece together that Robinhood was dealing with a plumbing problem from a couple of stories. Most notably, it drew down on credit lines and tapped some of its big executing firms (e.g., Citadel) for cash. Why would it need cash? Because it needs to post margin to the Depositary Trust Clearing Corporation (DTCC) on its open positions. Other firms are in similar situations, and directly or indirectly GME positions give rise to margin obligations to the DTCC.

The rise in price alone increased margin requirements because given volatility, the higher the price of a stock, the larger the dollar amount of potential loss (e.g., the VaR) that can occur prior to settlement. This alone jacks up margins. Moreover, the increase in GME volatility, and various adders to margin requirements–most notably for gap risk and portfolio concentration–ramp up margins even more. So the action in GME has led to a big increase in margin requirements, and a commensurate need for cash. Robinhood, as the primary venue for GME buyers, had/has a particularly severe position concentration/gap problem. Hence Robinhood’s scramble for liquidity.

Given these circumstances, liquidity was obviously a constraint for Robinhood. Given this constraint, it could not handle additional positions, especially in GME or other names that create particularly acute margin/liquidity demands. It was already hitting a hard constraint. The only practical way that Robinhood (and perhaps other retail brokers, like TDAmeritrade) could respond in the short run was trading for liquidation only, i.e., allow customers to sell their existing GME positions, and not add to them.

By the way, trading for liquidation is a tool in the emergency action toolbook that futures exchanges have used from time-to-time to deal with similar situation.

To extend the plumbing analogy, Robinhood couldn’t add any new houses to its development because the sewer system couldn’t handle the load.

I remember some guy saying that clearing turns credit risk into liquidity risk. (Who was that guy? Pretty observant!) For that’s exactly what we are seeing here. In times of market dislocation in particular, clearing, which is intended to mitigate credit risk, creates big increases in demand for liquidity. Those increases can cause numerous knock on effects, including dislocations in markets totally unrelated to the original source of the dislocation, and financial distress at intermediaries. We are seeing both today.

It is particularly rich to see the outrage at Robinhood and other intermediaries expressed today by those who were ardent advocates of clearing as the key to restoring and preserving financial stability in the aftermath of the Financial Crisis. Er, I hate to say I told you so, but I told you so. It’s baked into the way clearing works, and in particular the way that clearing works in stressed market conditions. It doesn’t eliminate those stresses, but transfers them elsewhere in the financial system. Surprise!

The sick irony is that clearing was advocated as a means to tame big financial institutions, the banks in particular, and reduce the risks that they can impose on the financial system. So yes, in a very real sense in the GME drama we are seeing the system operate to protect Big Finance–but it’s doing so in exactly the way many of those screaming loudest today demanded 10 years ago. Exactly.

Another illustration of one of my adages to live by: be very careful what you ask for.

Margins are almost certainly behind Robinhood’s liquidating some customer accounts. If those accounts become undermargined, Robinhood (and indeed any broker) has the right to liquidate positions. It’s not even in the fine print. It’s on the website:

If you get a margin call, you need to bring your portfolio value (minus any cryptocurrency positions) back up to your minimum margin maintenance requirement, or you risk Robinhood having to liquidate your position(s) to bring your portfolio value (minus any cryptocurrency positions) back above your margin maintenance requirement.

Another Upside Down World aspect of the outrage we are seeing is the stirring defenses of speculation (some kinds of speculation by some people, anyways) by those in politics and on opinion pages who usually decry speculation as a great evil. Those who once bewailed bubbles now cheer for them. It’s also interesting to see the demonization of short sellers–whom those with average memories will remember were lionized (e.g., “The Big Short”) for blowing the whistle on the housing boom and the bank-created and -marketed derivative products that it spawned.

There are a lot of economic issues to sort through in the midst of the GME frenzy. There will be in the aftermath. Unfortunately, and perhaps not surprisingly given the times, virtually everything in the debate has been framed in political terms. Politics is all about distributive effects–helping my friends and hurting my enemies. It’s hard, but as an economist I try to focus on the efficiency effects first, and lay out the distributive consequences of various actions that improve efficiency.

What are the costs and benefits of short selling? Should the legal and regulatory system take a totally hands off approach even when prices are manifestly distorted? What are the costs and benefits of various responses to such manifest price distortions? What are the potential unintended consequences of various policy responses (clearing being a great example)? These are hard questions to answer, and answering them is even harder in the midst of a white-hot us vs. them political debate. And I can say with metaphysical certainty that 99 percent of the opinions I have seen expressed about these issues in recent days are steeped in ignorance and fueled by emotion.

There are definitely major problems–efficiency problems–with Big Finance and the regulation thereof. Ironically, many of these efficiency problems are the result of previous attempts to “solve” perceived problems. But that does not imply that every action taken to epater les banquiers (or frapper les financiers) will result in efficiency gains, or even benefit those (often with justification) aggrieved at the bankers. I thus fear that the policy response to GameStop will make things worse, not better.

It’s not as if this is new territory. I am reminded of 19th century farmers’ discontent with banks, railroads, and futures trading. There was a lot of merit in some of these criticisms, but all too often the proposed policies were directed at chimerical wrongs, and missed altogether the real problems. The post-1929 Crash/Great Depression regulatory surge was similarly flawed.

And alas, I think that we are doomed to repeat this learning the wrong lessons in the aftermath of GameStop and the attendant plumbing problems. Virtually everything I see in the public debate today reinforces that conviction.

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March 24, 2020

It Really Does Pain Me to Say I Told You So About Clearing, But . . .

In the aftermath of the last crisis, I played the role of Clearing Cassandra, warning that in the next crisis, supersizing of derivatives clearing would create systemic risks not because clearinghouses would fail, but because of the consequences of what they would do to survive: hike initial margins and collect huge variation margin payments that would suck liquidity out of the system at the same time liquidity supply contracted. This, in turn, would lead to asset fire sales, that would distort asset prices which would lead to further knock-on effects.

I wrote a lot about this 2008-2012, but here is a convenient link. Key quote from the abstract:

The author also believes that the larger collateral mandates and frequent marking‐to‐market will make the financial system more vulnerable since margin requirements tend to be “pro‐cyclical.” And more rigid collateralization mechanisms can restrict the supply of funding liquidity, and lead to spikes in funding liquidity demand that can reduce the liquidity of traded instruments and generate destabilizing feedback loops. 

Well, the next crisis is here, and these (conditional) predictions are being borne out. In spades.

Here’s what I wrote a few days ago as a contribution to the Regulatory Fundamentals Group newsletter:

In the aftermath of the last crisis of 2008-2009, G20 nations decided to mandate clearing of standardized OTC derivatives transactions.  The current coronavirus crisis is the first since those reforms were implemented (via Dodd-Frank in the US, for example), and this therefore gives the first opportunity to evaluate the performance of the supersized clearing ecosystem in “wartime” conditions.  


So far, despite the extreme price movements across the entire derivatives universe–equities, fixed income, currencies, and commodities (especially oil)–there have been no indications that clearinghouses have faced either financial or operational disruption.  No clearing members have defaulted, and as of now, there have been no serious concerns than any are on the verge of default. 

That said, there are two major reasons for concern.


First, the unprecedented volatility and uncertainty show no signs of dissipating, and as long as it continues, major financial institutions–including clearing firms–are at risk.  The present crisis did not originate in the banking/shadow banking sector (as the previous one did), but it is now demonstrably affecting it.  There are strong indicators of stress in the financial system, such as the blowouts in FRA-OIS spreads and dollar swap rates (both harbingers of the last crisis).  Central banks have intervened aggressively, but these worrying signs have eased only slightly.  

Second, as I wrote repeatedly during the debate over clearing mandates in the post-2008 crisis period, the most insidious systemic risk that supersized clearing creates is not the potential for the failure of a clearinghouse (triggered by the failure of one or more clearing members).  Instead, the biggest clearing-related systemic risk is that the very measures that clearinghouses take to ensure their integrity–specifically, frequent variation margining/marking-to-market–lead to large increases in the demand for liquidity precisely during circumstances when liquidity is evaporating.  Margin payments during the past several weeks have hit unprecedented–and indeed, previously unimaginable–levels.  The need to fund these payments has inevitably increased the demand for liquidity, and contributed to the extraordinary demand for liquidity and the concomitant indicators stressed liquidity conditions (e.g., the spreads and extraordinary central bank actions mentioned earlier).  It is impossible to quantify this impact at present, but it is plausibly large.  

In sum, the post-2008 Crisis clearing system is operating as designed during the 2020 Crisis, but it is unclear whether that is a feature, or a bug.  

It is becoming more clear: Bug, and the bugs are breeding. There have been multiple stories over the last couple of days of margin calls on hedging positions causing fire sales, with attendant price dislocations in markets like for mortgages. Like here, here, and here. I guarantee there are more than have been reported, and there will be still more. Indeed, I bet if you look at any pricing anomaly, it has been created by, or exacerbated by, margin calls. (Look at the muni market, for instance.)

But those in charge still don’t get it. CFTC chairman Heath Tarbert delivers happy talk in the WSJ, claiming that everything is hunky dory because all them margins bein’ paid! and as a result, derivatives markets are functioning, CCPs aren’t failing, etc.

This is exactly the kind of non-systemic thinking about systemic risk that I railed about a decade ago. Mr. Tarbert has a siloed view: he is assigned some authority over a subset of the financial system, sees that it is working fine, and concludes that rules regarding that subset are beneficial for the system as a whole.

Wrong. Wrong. Wrong. Wrong. WRONG.

You have to look at the system as a whole, and how the pieces of the system interact.

In the post-last-crisis period I wrote about the “Levee Effect”, namely, that measures designed to protect one part of the financial system would flood others, with ambiguous (at best) systemic consequences. The cascading margins and the effects of those margin calls are exactly what I warned about (to the accompaniment a collective shrug by those who mattered, which is why we are where we are).

What we are seeing is unintended consequences–unintended, but not unforeseeable.

Speaking of unintended consequences, perhaps one good effect of September’s repo market seizure was that it awoke the Fed to its actual job–providing liquidity in times of stress. The facilities put in place in the aftermath of the September SNAFU are being expanded–by orders of magnitude–to deal with the current spike in liquidity demand (including the part of the spike due to margin issues). Thank God the Fed didn’t have to think this up on the fly.

It also appears that either (a) the restrictions on the Fed imposed by Frankendodd are not operative now, or (b) the Fed is saying IDGAF so sue me and blowing through them. Either way, such liquidity seizure are what the Fed was created to address.

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March 13, 2020

Wuhan Virus and the Markets–WTF?

What a helluva few weeks it’s been, eh boys and girls? By way of post mortem (hopefully?) rather than prediction, here’s my take.

Under “normal” circumstances, two factors drive asset valuations: expectations of cash flows, and the rate at which investors discount those cash flows. COVID-19–Wuhan Virus, to call it by its proper name–has has profound influence on both.

WV has caused a major aggregate supply shock, and an aggregate demand shock, and these amplify one another. The aggregate supply shock stems from shutdown of productive capacity due to social distancing. And people who aren’t working aren’t earning and aren’t spending, hence the aggregate demand shock.

These developments obviously reduce the income streams from assets (e.g., corporate profits). That’s a negative for stocks.

As an aside, these factors defy traditional policy prescriptions. Monetary and fiscal policy are focused on addressing aggregate demand deficiencies, i.e., trying to move demand-deficient economies (where demand deficiencies arise from price rigidity and nominal shocks) back to the production possibilities frontier. Supply shocks shrink the PPF. Pushing the PPF back to its normal state in current circumstances is a function of public health policy, and even that is likely to be problematic given the huge uncertainties (that I discuss below) and the dubious competence of government authorities (which I discussed last week).

The pandemic nature of WV also makes it the systematic shock par excellence. It hits everyone and every asset class, and cannot be diversified away. A big increase in systematic risk results in a big increase in risk premia, meaning that the already depressed expected cash flows on risky assets get discounted at a higher rate, leading to lower valuations.

A lot higher rate, evidently. Why? Most likely because of the extreme uncertainty about the virus. Data on how infectious it is, how many people have been infected, the fatality rate, how it will be affected by warmer weather, etc., are extremely unreliable. In other words, we know almost nothing about the salient considerations.

This is in part due to lack of testing, and to inherent defects in the testing: those who get tested are disproportionately likely to be symptomatic, exposed, or hypochondriacal, leading to extreme sample selection biases. The tests are apparently unreliable, with high rates of false positives and false negatives. The RNA tests cannot detect past infections. It is in part due to the novelty of the virus. Is it like influenza, and will hence burn out when temperatures warm? Or not?

Another major source of uncertainty is due to the fact that the initial outbreak in China was covered up by the evil CCP regime. (Which now, in an Orwellian twistedness that only totalitarian regimes can muster, is boasting that it will save the world. And which is blaming the United States for its own abject failures. Which is why I insist on calling it the Wuhan Virus–so go ahead, call me a racist. IDGAF.) Thus, data from Ground Zero is lacking, or wildly unreliable. (Ground One–Iran–is equally duplicitous, and equally malign.)

This huge uncertainty regarding a major systematic factor leads to even greater discount rates–and hence to lower stock prices.

And then there is the truly disturbing factor. These textbook causal channels (lower expected cash flows, higher discount rates) have in turn caused changes in asset prices that force portfolio adjustments that move us into the realm of positive feedback mechanisms (which usually have negative effects!) and non-linearities. This represents a shift from “normal” times to decidedly abnormal ones.

When some investors engage in leveraged trading strategies, big price moves can force them to unwind/liquidate these strategies because they can no longer fund their large losses. These unwinds move asset prices yet more (as those who placed a lower valuation on these assets must absorb them from the levered, high-value owners who are forced to sell them). Which can force further unwinds, in perhaps completely unrelated assets.

Not knowing the extent or nature of these trading strategies, or the degree of leverage, it is virtually impossible to understand how these effects may cascade through the markets.

The most evident indicators of these stresses are in the funding markets. And we are seeing such stresses. The FRA-OIS spread (known in a previous incarnation–e.g., 2008–as the LIBOR-OIS spread) has blown out. Dollar swap rates are blowing out. The most vanilla of spreads–the basis net of carry between Treasury futures and the cheapest-to-deliver Treasury–have blown out. Further, the Fed has pumped in huge amounts liquidity into the system, and these alarming spread movements have not reversed. (One shudders to think they would have been worse absent such intervention.)

One thing to keep an eye on is derivatives clearing. As I warned repeatedly during the drive to mandate clearing, the true test of this mechanism is during periods of market disruption when large price moves trigger large margin calls.

Heretofore the clearing system seems to have operated without disruption. I note, however, that the strains in the funding markets likely reflect in part the need for liquidity to make margin calls. Big margin calls that must be met in near real-time contribute to stresses in the funding markets. Clearinghouses themselves may survive, but at the cost of imposing huge costs elsewhere in the financial system. (In my earlier writing on the systemic impacts of clearing mandates, I referred to this as the Levee Effect.)

The totally unnecessary side-show in the oil markets, where Putin and Mohammed bin Salman are waging an insane grudge match, is only contributing to these margin call-related strains. (Noticing a theme here? Authoritarian governments obsessed with control and “stability” have a preternatural disposition to creating chaos.)

Perhaps the only saving grace now, as opposed to 2008, is that the shock did not arise originally from the credit and liquidity supply sector, i.e., banks and shadow banks. But the credit/liquidity supply sector is clearly under strain, and if parts of it break under that strain yet another round of extremely disruptive knock-on effects will occur. Fortunately, this is one area where central banks can palliate, if not eliminate, the strains. (I say can, because being run by humans, there is no guarantee they will.)

Viruses operate according to their own imperatives, and the imperatives of one virus can differ dramatically from those of others. Pandemic shocks are inherently systematic risks, and the nature of the current risk is only dimly understood because we do not understand the imperatives of this particular virus. Indeed, it might be fair to put it in the category of Knightian Uncertainty, rather than risk. The shock is big enough to trigger non-linear feedbacks, which are themselves virtually impossible to predict.

In other words. We’ve been on a helluva ride. We’re in for a helluva right. Strap it tight, folks.

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February 28, 2020

If Only Economists Were So Powerful

Filed under: Economics,Financial crisis,Politics,Regulation — cpirrong @ 7:38 pm

Eminent economist Paul Romer has assumed the role of professional scold. A few years ago he excoriated other eminent economists (notably Robert Lucas) for “mathiness.” Now he is chastising the profession for enabling deregulation that has wreaked havoc across the land.

I have to say his essay is unpersuasive, not to say incoherent. One way of framing the issue is to contrast the view of Keynes:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

with that of Stigler (speaking of the passage of the Corn Laws):

economists exert a minor and scarcely detectable influence on the societies in which they live . . . if Cobden had spoken only Yiddish, and with a stammer, and Peel had been a narrow, stupid man, England would have moved toward free trade in grain as its agricultural classes declined and its manufacturing and commercial classes grew.

Romer is clearly in league with Keynes, rather than Stigler.

But he fails to make the case. This is true for many reasons. For one, he argues by anecdote, and hence his style is journalistic rather than rigorously scholarly. A few cherry-picked anecdotes–and Romer uses only three–are clearly insufficient to support Romer’s broader claim that the deregulation favored by many economists (not all) was on the whole baleful. There are entire areas of deregulation (e.g., transportation, telecommunications, restrictions on advertising) that he says nothing about, but which were the subject of massive scholarship in the 1970s and 1980s which demonstrated the inefficiency of the existing regulatory structure: the experience in these industries post-deregulation strongly supported the scholarship that criticized existing regulations.

One interesting example is pharmaceutical regulation, something that exercises Romer quite greatly. Sam Peltzman showed in the 1970s that efficacy regulation under the 1962 Drug Act amendments did not result in a reduction in the amount of inefficacious drugs introduced, but did reduce the rate of introduction of new, valuable therapies. All pain, no gain.

Romer has nothing to say about this.

With respect to pharma regulation, Romer blames the opioid crisis on “pliant pretend economist[s]” who “assume[d] the role of the philosopher-king—someone willing to protect the firm’s reckless behavior from government interference and to do so with a veneer of objectivity and scientific expertise.”

He doesn’t quote any economist, pretend, real or otherwise, playing the role of philosopher-king/academic scribbler whose frenzy regulators or legislators distilled into opioids. Instead, he says:

By the 1990s, such arguments were out of bounds, because the language and elaborate concepts of economists left no opening for more practically minded people to express their values plainly. And when the Drug Enforcement Administration finally tried to limit the distribution of these painkillers, pharmaceutical companies launched a massive lobbying effort in favor of a bill in Congress that would strip the DEA of the power to freeze suspicious narcotics shipments by drug companies. It is a safe bet that these lobbyists made their arguments to Congress in the language of growth, incentives, and the danger of innovation-killing regulations. The push succeeded, and the DEA lost one of its most powerful tools for saving lives.

Of course, during earlier eras, regulators allowed many industries to profit massively from products known to be harmful; Big Tobacco is the most obvious example. But until the 1980s, the overarching trend was toward restrictions that reined in these abuses. Progress was painfully slow, but it was progress nonetheless, and life expectancy increased. The difference today is that the United States is going backward, and in many cases, economists—even those acting in good faith—have provided the intellectual cover for this retreat.

So apparently, by highjacking the language economists prevented rational debate, thereby rendering legislators and regulators defenseless against predatory corporations.

Or something.

That is, not only does Romer fail to show that deregulation was on the whole detrimental, he also fails to show that economists had anything much to do with making it happen. He asserts the Keynesian line, but does not come close to proving it.

Indeed, the reverse is true. Romer’s argument actually supports Stigler’s claim, which can be “distilled” thus: money talks. Or to use Keynes’ term: vested interests talk. What economists said or didn’t say or how they said it or what language they said it in (English, Yiddish, Aramaic) was nothing, compared to the lobbying might of the pharma industry. So not only does Romer fail to identify any actual economist who advocated the policy that infuriates him, he fails to show that what any economist said meant squat for the outcome.

Indeed, this is precisely why a certain species of economists (Stigler, and well, yours truly) was/is so skeptical about regulation: it tends to favor the interests of the regulated. It always has, and it always will. Economic efficiency is a secondary consideration, and what economists have to say on the matter has little (if any) bearing on the outcome. If anything, Romer’s piece is a case for Public Choice economics. But that has implications that Romer would no doubt find inimical.

Romer’s other big anecdote is from the financial industry, namely the infamous Goldman Abacus transaction in which Goldman served as the middleman between John Paulson (who wanted to short US real estate) and a hapless German bank.

The stand in for all economists in this anecdote is one sorta economist: Alan Greenspan. Apparently, Greenspan was the Representative Agent for the economics profession. This is beyond simplistic. Insultingly so.

Another bogeyman in Romer’s telling is Michael Jensen:

Michael Jensen, an economist who helped reshape the U.S. financial sector in the late twentieth century. Jensen rightly worried about several problems that bedeviled the market, including how to keep corporate executives from promoting their own interests at the expense of shareholders. His proposed solutions—hostile takeovers, debt, and executive bonuses that tracked the share price of a firm, among other changes—were widely adopted.

Corporate shareholders saw their earnings skyrocket, but the main effect of the changes was to empower the financial sector, which Greenspan, for his part, worked doggedly to unfetter. As Lemann writes, Jensen’s ideas also helped chip away at the power of the traditional Corporate Man—the sort of executive whose pursuit of profit was tempered somewhat by a commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines. Taking his place was Transaction Man, who focused on little more than driving up share prices by any means necessary.

There is so much wild generalization here that I am at a loss of where to begin. For one thing, Jensen’s heyday was the 1980s LBO and hostile takeover boom, which had been largely stymied by regulation by the early-1990s, long before the Financial Crisis. (So much for the power of Jensen’s advocacy! Jensen’s hero, Michael Milken, was in jail, FFS.)

I am at a real loss to trace the connection between Jensen’s advocacy of measures to control managerial agency costs and, say, the real estate securitization boom of the mid-2000s. Romer certainly doesn’t lay out the road map. Here merely cites Jensen’s views and asserts some connection with those of Greenspan, and proclaims QED! The South Park Underwear Gnomes’ argumentation was tighter.

And again, what economists said was almost certainly irrelevant here. There were powerful forces–political as well as economic forces–behind the real estate boom and crash. Homeownership became a totem for politicians of both parties in the 1990s and 2000s. Wall Street was on board, because it realized this could be an engine for profit. Main Street financial institutions were on board for the same reason.

So what if Alan Greenspan was cool with this? If he hadn’t been, he wouldn’t have been around long. Economic and political interests found a convenient mouthpiece: the mouthpiece didn’t create the economic and political forces. At the end of the day, economists would not have mattered, and the financial sector would have gotten the mouthpiece it wanted.

This part made me roll my eyes:

the traditional Corporate Man—the sort of executive whose pursuit of profit was tempered somewhat by a commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines. Taking his place was Transaction Man, who focused on little more than driving up share prices by any means necessary.

Evidence for this “commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines” among 1960s-1970s corporate executives? None whatsoever. This is an ex cathedra pronouncement that bears no relationship to the reality of self-serving corporate management during this era–management that a 1970s Romer probably would have inveighed against as venal and self-serving (as many criticisms of managerial capitalism did).

No, the issue here is not Corporate Man vs. Transaction Man. It is Straw Man (Romer’s, specifically) vs. Reality.

Romer gives economists both too much credit, and too little. By painting all economists who criticized regulation (based on empirical evidence and theory) as stooges, he gives them too little credit. By blaming them for massive public policy failures, he gives them too much. If only we had such influence.

Does economics matter? Yes. Do economists matter? Not really. And the reason for these answers is the same. Economic considerations–distributive considerations in particular, as they operate through the political and regulatory system–drive political and regulatory outcomes. Economists can comment on this, analyze it, and even advocate particular outcomes. But their participation has as much effect on the outcome as a sportscaster’s does on who wins the Super Bowl.

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December 9, 2019

The Four Horsemen of the Repo Apocalypse

Filed under: Derivatives,Economics,Financial crisis,Regulation — cpirrong @ 9:42 pm

The BIS included a box on the September USD repo spike in a chapter to its Quarterly Review titled “Easing Trade Tensions Support Risky Assets.” The piece lays out many damning dots, but does not connect them. Let me give it a try.

In a nutshell, the BIS report says that as a result of the wind down of the extraordinary post-crisis monetary policy measures there has been a dramatic change in the funding structure in US markets. In particular, the “big four [US] banks” (which the BIS delicately–or is it cravenly?–doesn’t name) have flipped from being suppliers of repo collateral (and hence cash borrowers) to being suppliers of cash (and hence collateral borrowers). Further, other US banks are not viable competitors to the big four, nor are other potential cash suppliers such as money market funds because they have hit counterparty credit limits which have constrained their lending capacity. According to the BIS, these events has made The Big Four Banks Who Shall Not Be Named the “marginal lenders” in the repo market. And mark well: prices are set at the margin.

Further, “leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives.”

So here are the dots. Recent structural changes have given the Big Four Banks Who Shall Not Be Named a dominant position in the repo market. Their main potential competitors as suppliers of funds are constrained by size or regulation. There has been a large increase in demand for repo funding.

Not even being willing to name the banks (as if their identities are unknown), the BIS does not even draw the blindingly obvious implication of its analysis–that the Four Repo Horsemen have market power. A lot of market power. Are we supposed to believe that (out of the goodness of their hearts, perhaps) they did not exercise it? I didn’t just fall off the turnip truck.

Even the euphemism Big Four is deceptive, for in reality this group is dominated by one bank–Morgan. And of course Morgan has been loudest in its protestations that it really wanted to lend more, but just couldn’t, dammit, because of those cursed liquidity regulations.

The BIS attempts to run cover, and provide some rather lame excuses for the failure to lend more despite the high rates:

Besides these shifts in market structure and balance sheet composition, other factors may help to explain why banks did not lend into the repo market, despite attractive profit opportunities. A reduction in money market activity is a natural by-product of central bank balance sheet expansion. If it persists for a prolonged period, it may result in hysteresis effects that hamper market functioning. For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes. Moreover, for regulatory requirements – the liquidity coverage ratio – reserves and Treasuries are high-quality liquid assets (HQLA) of equivalent standing. But in practice, especially when managing internal intraday liquidity needs, banks prefer to keep reserves for their superior availability.

Hysterisis? Decaying internal processes and knowledge? Staff inexperience? Complete and utter argle bargle. We’re talking overnight secured lending here, not rocket science structured finance. It’s about as vanilla a banking transaction one could imagine. And LCR provides convenient cover.

The BIS lays out a compelling case that four major institutions have market power in repo. September events in particular are consistent with the exercise of market power, and the alternative explanations are beyond lame. Yet none dare speak its name, or even raise it as a possibility. Not the BIS. Not the Fed. Not the Treasury. Despite the systemic risks this poses.

The Financial Crisis supposedly changed everything. It apparently changed nothing.

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October 5, 2019

The Repo Spike: The Money Trust Revisited?

Filed under: Economics,Financial crisis,Regulation — cpirrong @ 6:42 pm

In the ongoing evaluation of what has been happening in the repo market, market participants have identified post-crisis regulations as a potential source of the problem. In particular, these regulations (including the Liquidity Coverage Ratio) require behemoth banks like JP Morgan and Citi to hold large amounts of reserves, and makes them reluctant to lend them out even when repo rates spike.

Having long said that the various liquidity regulations intended to prevent a recurrence of the last crisis could be the cause of a new one, I am certainly quite sympathetic to this view. However, information that is coming out now suggests another potentially complementary and aggravating factor.

In particular, reserve holdings are very concentrated:


Fed data show large banks are keeping a disproportionate amount in reserves, relative to their assets. The 25 largest US banks held an average of 8 per cent of their total assets in reserves at the end of the second quarter, versus 6 per cent for all other banks. 

Meanwhile, the four largest US banks — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — together held $377bn in cash reserves at the end of the second quarter this year, far more than the remaining 21 banks in the top 25

Moreover, the big banks have been reducing their reserves:

Analysts and bank rivals said big changes JPMorgan made in its balance sheet played a role in the spike in the repo market, which is an important adjunct to the Fed Funds market and used by the Fed to influence interest rates.
Without reliable sources of loans through the repo market, the financial system risks losing a valuable source of liquidity. Hedge funds, for example, use it to finance investments in U.S. Treasury securities and banks turn to it as option for raising suddenly-needed cash for clients.
Publicly-filed data shows JPMorgan reduced the cash it has on deposit at the Federal Reserve, from which it might have lent, by $158 billion in the year through June, a 57% decline.

Although JPMorgan’s moves appear to have been logical responses to interest rate trends and post-crisis banking regulations, which have limited it more than other banks, the data shows its switch accounted for about a third of the drop in all banking reserves at the Fed during the period.
“It was a very big move,” said one person who watches bank positions at the Fed but did not want to be named. An executive at a competing bank called the shift “massive”.
Other banks brought down their cash, too, but by only half the percentage, on average.
For example, Bank of America Corp (BAC.N), the second-biggest U.S. bank by assets, with a $2.4 trillion balance sheet, took down 30% of its deposits, a $29 billion reduction.

So . . . substantial concentrations of reserves, and declining levels of reserves. Yes, these are all potential consequences of Frankendodd. But they also are potentially symptomatic of market power and the exercise thereof.

This triggered a synapse, which led me to recall a 1993 article from the Journal of Monetary Economics by R. Glen Donaldson. Donaldson’s article was motivated by a study of the Panic of 1907, when a “cash syndicate” (led by . . . J.P. Morgan, in person and through his eponymous bank) lent to cash strapped trust companies facing depositor runs at very high rates.

Donaldson presents a model in which a spike in the need for cash by a set of market participants (trust companies facing depositor outflow, in his model) makes the funds held by a group of other institutions pivotal: these institutions face a downward sloping demand curve for their funds because of constraints on competitive suppliers of funds. The pivotal institutions supply funds (through a repo-like transaction in which they buy securities from the trusts) at a supercompetitive price (by buying the trusts’ securities at subcompetitive prices). In his model, collusion between the pivotal institutions exacerbates the rate spike.

The main implication of the model is that spikes in the demand for funds lead to spikes in interest rates that are bigger than would prevail in competitive conditions.

There is an element of non-linearity in the model, because the big suppliers’ funds are not pivotal in normal conditions, but become so when the demand becomes sufficiently large. This leads to a switch from competitive to monopoly pricing, which in turn causes a spike in rates.

I should note that the regulatory and market power stories are not mutually exclusive, and are indeed complementary. Regulatory constraints can increase the demand for funds (making it more likely that the big suppliers will be pivotal) and can reduce the supply of funds from the smaller suppliers (which lowers the threshold for the switch from competitive to monopoly pricing, and makes the demand curves for the big suppliers funds steeper, leading to a higher monopoly rate).

I therefore consider it a plausible hypothesis that market power contributed to the repo market spike, and that one channel by which regulations contributed to the spike was through its effect on market power.

How can this hypothesis be tested? Conceptually, if regulatory constraints alone caused the spike, then those in possession of large quantities of reserves (e.g., Morgan) were absolutely constrained in their ability to lend additional reserves: the difference between the repo rate and the Fed Funds rate would represent the shadow price on this regulatory constraint.

If a big bank or banks exercised market power, this constraint would not be binding.

Operationalizing this test is likely to be complex, however. Big holders of reserves will inevitably make all sorts of arguments to say that they couldn’t have lent more.

This brings to mind the California electricity crisis in 1999-2000, when generators operated below various capacity measures, but pleaded that constraints (by unplanned outages, or NOX regulations, etc.) reduced their effective capacity below these nominal capacity measures. Given the complexity of operating a power plant, it was very difficult to determine whether the generators were withholding capacity, or in fact offered as much as they were capable of doing.

Despite the difficulty of operationalizing the test, I think it is something for regulators to attempt. There is a colorable case that the repo rate rise was exacerbated by market power, and given the importance of this market, this possibility should be investigated rigorously.

As an aside, the Donaldson model appeared only a few months before my Journal of Business article on market power manipulation. The two articles have a lot in common, despite the fact that they were developed totally independently, and seemingly involve completely unrelated markets (money vs. physical commodities). However, the core arguments are similar: economic frictions can periodically create market power in markets that are usually competitive.

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