Where Did All The Money Go?

Chapter 3: Mass Production, Income, Exports, and Debt

George H. Blackford © 2009, last updated 5/16/2014

 

The history of economic development over the past four hundred years has been one of ever increasing output throughout the world as productivity increases in agriculture, textiles, steel, transportation, manufacturing, and, in today's world, automation, communication, and information technologies have been made possible through specialization, the division of labor, and the development of other mass-production technologies.  

The concept of interchangeable parts along with technological advances in the machine-tool, steel, and transportation industries, combined with the use of assembly-line techniques and the development of electrical power and other utilities have led to a literal explosion in manufacturing since the beginning of the twentieth century.  Automobiles, airplanes, farm and industrial equipment, construction materials, electronic equipment, home appliances, power tools, medical equipment and supplies, drugs, furniture, clothing, meat packing, fast foods, canned goods and other processed foods—virtually all of the goods the vast majority of the people spend the bulk of their incomes on today and many of the services, such as big-box retail, financial, and distribution services, as well—have proved to be amenable to the mass-production techniques that were developed or refined in the last century. 

The process of technological advance and the development of mass-production techniques holds the potential for dramatic improvements in the economic wellbeing of the world’s population as ever greater quantities of goods can be produced with ever smaller amounts of human effort, but there is a catch: In order to be economically viable, mass production techniques require mass markets—that is, markets with large numbers of people who have purchasing power.  Otherwise, the mass quantities of goods and services that can be produced via mass-production techniques cannot be sold.  The existence of mass markets within a society, in turn, depends crucially of the distribution of income within that society:  The less concentrated the distribution of income, the larger the domestic mass market will be; the more concentrated the distribution of income, the smaller the domestic mass market will be.

This brings us to the crux of the problem endemic in the changes in the distribution of income that have taken place during the past thirty years, namely, that the share of income that went to the top 1% of the income distribution in the 2000s was twice what it was in the 1960s and 1970s.

Doubling the income share of the top 1% from approximately 8% in 1980 to 18% in 2007 means the share of the bottom 99% went from 92% to 82%.  As a result, the bottom 99% of the income distribution—99 out of 100 families—had, on average, 11% less purchasing power from income relative to the output produced in 2007 than the bottom 99% had relative to the output produced in 1980, and as we go down the income scale the reduction in purchasing power from income becomes more dramatic. The World Top Incomes Database shows that the fall in income for the bottom 90% of the income distribution from 1980 to 2007 was 20%.  This means that in 2007 the bottom 90% of the population—9 out of 10 families—had, on average, 20% less purchasing power from income relative to the output produced in 2007 than the bottom 90% had in 1980 relative to the output produced in 1980.

Exports and Imports

In addition to the decrease in domestic purchasing power from income relative to the output produced experienced by the vast majority of the population since 1985, a substantial portion of the remaining purchasing power generated through the production of goods and services has been siphoned off by an increase in imports relative to exports.

As can be seen in Figure 3.1, until 1983 the United States Current Account Balance barely exceeded 1% of GDP other than in the aftermath of World War II.  As a result, changes in imports and exports played a relatively minor role in the development of mass-production markets in the United States throughout most of the twentieth century.  This changed after 1982 as our current account deficit (i.e., negative Current Account Balance) grew.  While exports remained essentially unchanged from 1980 through 2007, going from 9.8% to 11.5% of GDP, imports increased from 10.3% to 16.4% of GDP.  As a result, our Current Account Balance went from a  0.3% of GDP surplus to a 4.8% deficit. 

Source:  Bureau of Economic Analysis (4.1 1.1.5)

One would expect this kind of structural change, when combined with the increased concentration of income, to have a disruptive effect on employment and output as prices and profits fell in those areas that compete with imports and serve mass markets while prices and profits increased in those areas that serve the top 1% of the income distribution.  But it would seem that the increase in income concentration and imports has had little effect on the viability of our domestic mass markets.  There has, of course, been a rather devastating effect in the manufacturing sector of our economy as the decline in the rust-belt states can attest, but in spite of the losses in manufacturing and the three minor recessions we experienced from 1980 through 2006, unemployment and inflation trended downward over the period as employment and productivity rose.  At the same time, mass market retailers such as Wall-Mart and Home Depot seem to have thrived. 

The purchasing power necessary to maintain domestic output and employment in our mass-production society had to come from somewhere as the incomes of the vast majority of the population fell relative to the ability to produce and imports rose relative to exports from 1985 through 2006.  Given the circumstances, the only place from which it could have come was through the transfer of purchasing power from those who had it and did not wish to purchase newly produced goods and services in the quantities needed to maintain our mass-production economy to the vast majority of the population that was losing purchasing power and was willing to purchase newly produced goods in the quantities needed to maintain our mass-production economy. This is especially so in view of the almost continuous increase in productivity that occurred since 1980.

100 Years of Income, Debt, and Economic Instability

The primary mechanism by which purchasing power is transferred from those who do not wish to spend to those who do wish to spend is through the creation of debt, that is, by those who have purchasing power and are unwilling to use it lending to those who are willing borrow in order to use it.[3.1]  To the extent borrowed money is used to purchase newly produced goods and services that would otherwise not have been purchased, an increase in debt leads to an increase in the demand for goods and services.  In so doing, increasing debt provides a mechanism by which it is possible to maintain mass markets and full employment as productivity increases, income becomes more concentrated, and imports increase relative to exports without the need for prices to adjust to redistribute income[3.2] or for exchange rates to adjust to reduce imports relative to exports. 

The point is, given the state of mass production technology within our society, the domestic markets necessary to support full employment could not have been maintained without an increase in debt as the income transfer to the top 1% and 10% of the income distribution examined in Chapter 1 took place and, thus, diluted the purchasing power of the rest of the population relative to the output produced.  This is especially so as the situation was made even worse as imports of mass produced goods increased relative to exports and productivity increased.  Since employment, output, and productivity all increased during this period, it should not be surprising to find that debt increased dramatically as well.[3.3]

The dramatic changes that have occurred in the concentration of income and the growth in debt since 1913 are shown in Figure 3.2 which plots the income share received by the Top 1% of the income distribution through 2012 as well as Total Debt, Non-Federal Debt, and Federal Debt outstanding in the United States from 1916 through 2013.  These changes have had profound effects on the development of mass markets and the utilization of mass-production technologies within the economic system throughout the twentieth century.  They have also had profound effects on economic instability.

Source: The World Top Incomes Database, Federal Reserve (L1), Historical Statistics of the U.S.
 (Cj870 Ca9-19),  Bureau of Economic Analysis (1.1.5).[3.4]

 

Turn of the Century Through the Great Depression

The expansion of mass production undoubtedly received a huge boost from the increase in Exports and the expansion of Federal Debt that accompanied the 1914 outbreak of World War I  That boost proved unsustainable, however, as the economy entered the 1920-1921 recession at war's end.  This recession was followed by a speculative bubble in the real-estate market that was superseded by a speculative bubble in the stock market. 

As can be seen in Figure 3.2, these two bubbles were accompanied by an increase in both debt and the concentration of income as Total Debt went from 156% of GDP in 1920 to 192% in 1928 and the income share received by the Top 1% went from 14.5% of total income (excluding capital gains) to 19.6% in those eight years. 

The expansion of debt that offset the concentration of income in the 1920s not only allowed the markets for mass-produced goods to grow with the economy during that decade,[3.5] as we will see in Chapter 4, it also made these markets increasingly vulnerable to an economic downturn and, in the process, undermined the stability of the financial system.  As a result, when the economic downturn began in the summer of 1929, and the stock market crashed in the fall of that year, the financial system began to founder.  The absence of deposit insurance combined with an unwillingness (or inability) of the Federal Reserve to prop up the banking system led to a run on the system in the fall of 1930 that caused the financial system to implode.  This worsened the economic downturn as the economy spiraled downward from 1929 through 1933. (Meltzer, Friedman and Schwartz, Fisher, Skidelsky Eichengreen Kindleberger)

The phenomenal fall in wages, prices, output, and income that resulted caused Total Debt as percent of GDP to increase from 184% of GDP in 1929 to 295% by 1933.  As we will see in Chapter 15, this dramatic increase in the debt ratio was caused by the 45% decrease in GDP that occurred during this period, rather than by an increase in debt.  Total debt actually fell by 12% from 1929 through 1933.  In the meantime, over 10,000 banks failed along with 129,000 other businesses; the unemployment rate soared to 25% of the labor force, and 12 million people found themselves unemployed by the time the downward spiral of the economy came to an end in 1933. 

This 283% debt ratio was, of course, unsustainable, and a massive deleveraging of the system took place as Total Debt as a percent of GDP fell from 295% in 1933 to 184% by 1940.  As we shall see, again in Chapter 15, this deleveraging took place through the growth in GDP as unemployment fell and output and prices increased rather than through a fall in the debt itself which actually increased during this period.

Even though GDP managed to increase by 80% from 1933 through 1940, the actions of the federal government were too little and too late to maintain the mass markets necessary to keep output from falling dramatically through 1933 or to bring the system back to full employment before 1942.  Federal Debt more than doubled, and even though the income share ae the Top 1% fell substantially from its 1928 high of 19.6%, it remained above 15% in all but one year during the 1930s.  The rate of unemployment remained above 14% for the entire decade following 1930 and, as is shown in Figure 3.3, did not fall below 14% until 1941. 

Source: Bureau of Labor Statistics (1), Economic Report of the President, 1960 (D17).

World War II and its Immediate Aftermath

The decade of the 1940s was dominated by World War II as the federal government took over the economy.  Not a single automobile was produced in the United States from early in 1942 through 1945, and production of other consumer durable goods was suspended as well.  Government mandated wage and price controls were instituted, and consumer goods were rationed as every effort was made to direct our economic resources into the production of war materials. The massive increases in government expenditures this entailed, combined with the extraordinary increase in the size of the military, brought the economy to near full employment in 1942 and to extraordinarily low levels of unemployment from 1943 through 1945. In addition, taxes were increased substantially as the top marginal tax rate was eventually set at 94%. (Kennedy)

In spite of the dramatic increase in Federal Debt during the war—from 44% of GDP in 1941 to 111% by 1945—Total Debt as a percent of GDP hardly increased as it went from 163% to 178%.  This feat was accomplished through a massive deleveraging of the non-federal sector of the economy as wage and price controls and rationing combined with the tremendous increase in production, hence, income, made it possible for the ratio of Non-Federal Debt to GDP to fall from 120% of GDP in 1941 to just 67% by 1945.  This fall in Non-Federal Debt set the stage for what was to follow.

The Prosperous Years: 1950 through 1973

The economy did not suffer the fate at the end of World War II it had suffered at the end of World War I.  A massive demobilization took place as our factories retooled from the mass production of war materials to the mass production of civilian goods, and millions of service men and women were discharged from the military, but there was no major recession, and, as can be seen in Figure 3.3, unemployment remained below 6% for twelve years following World War II and below 7% until 1975. 

The fact that Europe and Asia were devastated by the war aided the transition to a peacetime economy in that the need to rebuild the war-torn countries caused Exports (Figure 3.1) to remain high during the four years following the war.  At the same time, government policies, such as the GI Bill, helped to ease the transition from military to civilian life for millions of veterans as they mustered out of the service. 

Federal Debt decreased almost continuously relative to GDP following World War II, form a 1945 high of 111% of GDP to its post-war low of 23.1% of GDP in 1974—a fall of 88 percentage points.  Total debt, on the other hand, increased gradually relative to GDP from 1951 through 1981, going from 129% of GDP to 165%.  This increase of 36 percentage points in total debt took place in spite of a 44 percentage point decrease in Federal Debt over that 21 year period.  The reason is that while Federal Debt relative to GDP was decreasing over this period, it was decreasing at half the rate at which Non-Federal debt was increasing.  Non-Federal debt went from 67% of GDP in 1951 to 139% in 1981—a 72 percentage point increase that more than offset the 44 percentage point fall in Federal Debt. 

While there was a relatively large increase in Non-Federal Debt through 1975, that debt was sustainable in that it was not backed by investments based on speculative bubbles or on consumers’ incomes created by speculative bubbles. It was backed by profitable investments both in the private and public sectors of the economy—investments in private capital and public infrastructure that increased productivity sufficiently to be self financing—and by consumers’ incomes that were derived from the employment created by those profitable investments.

Given the financial regulatory system put in place in the 1930s, the fall in income share of the Top 1% throughout the 1950s and 1960s (from 11.4% of total income in 1950 to 7.7% in 1973) made it possible for domestic mass markets to grow with the economy in such a way as to support the increases in mass production and productivity that took place during this period with relatively full employment and without an expansion of exports relative to imports.  As a result, the domestic economy was able to grow and the vast majority of the population was able to prosper without creating the kinds of speculative bubbles that led to the economic catastrophe of the 1930s even though the expansion of domestic markets were aided by an expansion of debt. 

The Great Inflation

The latter half of the 1960s through the first half of the 1980s—an era dubbed The Great Inflation by Allen Meltzer—presented a unique challenge to economic policy makers. From 1952 through 1965 the effective annual rate of inflation was 1.72%. From 1965 through 1984 it was 5.96%, and from 1975 through 1981 it was 7.66%.  Efforts to end the inflation along with the 1973 Arab oil embargo and the concomitant quadrupling of the price of oil led to a number of shocks to the economic system. The turmoil of the times was reflected in a sharp fall in the growth of output in 1967, and a series of recessions that occurred in 1970, 1973-1975, 1980, and 1981.

The rise in interest rates combined with the 1980 and 1981 recessions that resulted from the efforts by the Federal Reserve to bring the inflation to an end left thrift institutions in desperate straits, but this did not pose a serious threat to the economic system itself.  The existence of deposit insurance made it possible to avoid a run on these institutions and this allowed time to resolve the problem in an orderly way.  The real threat to the system came from the changes in economic policies that took place in the 1980s in response to the problems caused by inflation and the energy crisis of the 1970s. 

Reagan's Revolution

The results of the policy shift that took place in the 1980s are reflected in Figure 3.2 by the increase in Total Debt as a percent of GDP from 164% in 1981 to 231% by 1990 as the ratio of Federal Debt to GDP increased by 16 percentage points and that of Non-Federal Debt by 51 percentage points. The 67 percentage point increase in Total Debt that took place during the 1980s was six times the average for the previous three decades, and it not only fueled speculative bubbles in the commercial real-estate markets that brought on the savings and loan crisis in the 1980s, it also funded the hostile takeover/junk bond bubble that helped to create the current account deficits shown in Figure 3.1 that contributed to the decline of our manufacturing industries.

What is of particular interest here, however, is how the increase in debt made it possible for unemployment to trend downward over the decade in spite of the fact that imports rose and then fell relative to exports and the concentration of income that went to the Top 1% of the income distribution increased from 8.2% of total income in 1980 to 13.0% by 1990. 

The Go-Go 1990s

The 1990s began with a minor recession as the unemployment rate reached 9.7% of the labor force in 1992, up from 5.3% in 1989.  Income concentration was fairly stable from 1988 through the first half of the 1990s as the share of the Top 1% went from 13.2% in 1988 to 12.9% in 1994.  Following 1994, however, there was a significant increase in concentration as the share that went to the Top 1% reached 16.5% by 2000.  This was above where it had been in the early 1920s when the speculative bubbles began and above where it had been in all but two of the years our economy had stagnated through the 1930s when there were no speculative bubbles or wars to stimulate the economy. 

There was some deleveraging that took place in the non-federal sector of the economy in the first two years of the 1990s, and then Non-Federal Debt continued upward at a steady pace until it began to increase more rapidly following 1997.  In the meantime, Federal Debt peaked at 48.5% of GDP in 1993 and declined to 31.8% of GDP by 2001 as Total Debt went from 231% of GDP in 1990 to 265% by 2000. 

At the same time, there was a dramatic increase in imports relative to exports as the deficit in our Current Account went from 1.3% to 4.0% of GDP. (Figure 3.1)  In addition, productivity increased dramatically as the average increase in output per hour during the last half of the 1990s was almost twice that of the average increase for the previous ten years.  All of these factors would have made it difficult, if not impossible, to maintain the domestic mass markets needed for full employment in the absence of the 33 percentage-point increase in Total Debt that took place during that period as unemployment fell from 7.5% of the labor force in 1992 to 4.0% in 2000. 

It is also worth noting that, by all accounts, financial wealth more than tripled in the five years from 1995 through 2000.  The NASDAQ Composite Index went from a low of 791 in 1995 to a high of 5048 in 2000 as the Standard & Poor's 500 Index went from 501 to 1527.  In the process, this unprecedented—except for the 1920s—increase in the value of stocks decreased the cost of equity capital for corporations, and thereby lowered the cost of financing investment through equity relative to the cost of financing investment through debt.  At the same time, the fact that realized capital gains steadily rose from 3.0% of total income in 1995 to 9.7% in 2000 made it possible for many to increase their consumption or investment expenditures without having to rely on debt.  Both of these factors would tend to bolster domestic markets by offsetting the effects of increasing imports and income concentration.

In addition, unlike the situation in 1980s, as we will see below, there was, in fact, a significant increase in the average real income that went to the bottom 90% of the income distribution from 1993 through 2000 in spite of the increase in the concentration of income at the top that took place during that period.  In any event, times seemed prosperous after 1995 until the stock market crashed in March of 2000, and the trillions of dollars of illusory paper wealth that had been created by the stock market bubble began to evaporate. 

Even though tens, if not hundreds of billions of dollars had been wasted in the development of worthless dotcom companies such as Webvan.com, Pets.com, and Flooz.com, and billions more had been wasted in companies such as Enron, Global Crossing, and WorldCom there was not a collapse in the financial system when the Dotcom Bubble burst comparable to what had taken place following the Crash of 1929.  What was different about the increase in paper wealth generated by the stock-market bubble in the latter half of the 1990s is that, unlike the 1920s, and in spite of the fact that Total Debt had increased substantially leading up to the crash, the Dotcom Bubble was not financed directly through an excessive buildup of debt collateralized by stocks. 

The reason is that since the Securities Exchange Act of 1934, the Federal Reserve has had the power to set the margin requirement on loans collateralized by stocks, that is, has the power to set the minimum down payment a buyer must put up when borrowing money to buy stocks.  The margin requirement was 50% during the 1990s which limited the amount of money speculators could borrow using stocks as collateral to 50% of the value of the stock.  In the 1920s the margin was as low as 10% in the unregulated markets of the times which allowed speculators to borrow as much as 90% of the purchase price when purchasing stock.  Even though the Federal Reserve refused to increase the margin requirement on stocks to keep the speculative bubble in the stock market from growing during the 1990s, the existence of a 50% margin requirement on loans collateralized by stocks minimized the damage caused by the Dotcom Bubble bursting. 

As a result, few defaulted on their loans when this bubble burst, and there was not a wave of distress selling of assets which, as we will see in Chapter 4, had occurred following the Crash of 1929.  While tens of millions of people were adversely affected as trillions of dollars of wealth disappeared into thin air, the financial system remained intact, and the economic system survived fairly well with a relatively minor economic downturn as unemployment increased from 4% of the labor force in 2000 to 6% by 2003.  And since there were no insured deposits involved, there was no government bailout of depositors with taxpayers' money as there had been in the savings and loan debacle of the 1980s, though the federal Pension Benefit Guarantee Corporation insurance program did take a hit. 

Then came the speculative bubble in the housing market brought on by the unregulated securitization of subprime mortgages.  Unlike the stock-market bubble of the 1990s, the housing-market bubble of the 2000s was financed directly through an excessive buildup of debt collateralized by mortgages.

Unregulated  Finance in the 2000s

Following passage of the Financial Services Modernization Act in 1999 and the Commodity Futures Modernization Act in 2000, the era of unregulated finance reached its pinnacle in the first half of the first decade of the twentieth-first century.  It was an era of abiding faith in the ability of freewheeling capitalism to solve our economic problems by allowing unfettered markets to allocate resources in their most efficient manner.  This freedom from regulation was supposed to bring economic prosperity to all.  As it turned out, it didn’t.  Instead, as is shown in Figure 3.1 and Figure 3.2, the cowboy finance that resulted led to dramatic increases in Imports, a further concentration of income, and a dramatic increase in debt. 

The income share of the Top 1% fell from 16.5% in 2000 to 15.0% in 2002 as the fallout from the recession took its toll, and then, following the Bush tax cuts, increased to 18.3% of total income by 2007—just 1.3 percentage points below the peak it had reached in 1928.  At the same time, imports increased relative to exports as the deficit in our Current Account went from 4.0% to 4.9% of GDP, and Total Debt increased continuously from 2000 through 2008—from 265% to 353% of GDP, an 88 percentage point increase in just seven years.  At this point Total Debt as a percent of GDP was excessive even by the standard set in 1933 after GDP had fallen by 40% from its 1929 high.[3.6]   By 2007 the GDP stood at $14.5 trillion and the Total debt at $51.1 trillion!

Why the System Collapsed 

Servicing a debt of $51 trillion out of an income of $14 trillion places a huge burden on the system through the transfer of income from debtors to creditors.  Even an average interest rate as low as 3% would require a transfer equal to 11% of GDP when total debt is as high as 370% of GDP.  An average interest rate of 5% would require a transfer equal to 18% of GDP.  In terms of real money, a 3% average rate of interest on the total debt of $54 trillion that existed in 2008 would have required that $1.6 trillion/year be transferred from debtors to creditors.  A 5% average rate of interest would have required a $2.7 trillion transfer. 

Figure 3.4 shows the interest rates paid on triple-A rated corporate bonds (Aaa Bonds), Municipal Bonds, conventional Mortgages, and Prime Rate loans from 1940 through 2012.  The graphs in this figure indicate that interest rates in the early 2000s were comparable to those in the 1960s when Total Debt was less than 150% of GDP.  It should be obvious that a return to the interest rates of the 1970s or 1990s with Total Debt equal to 353% of GDP, as it was in 2008, would present a daunting challenge. 

Source: Economic Report of the President, 2013 (B73PDF|XLS)

Even more important is the fact that Non-Federal Debt had risen to 321% of GDP by 2008.  Unlike the federal government which has the constitutional right to print money, those entities that make up the non-federal sector of the economy—whether they are individuals, businesses, financial institutions, or municipal governments—must service their debt out of income.  When they cannot service their debt out of income they must refinance.  Barring the ability to refinance, the only options to which they can turn is to the dreaded distress selling of assets or to default on their financial obligations—the kind of selling of assets and defaults that, as we shall see in Chapter 4 through Chapter 6, lead to financial crises. 

Non-federal debt of this magnitude makes the economic system extremely fragile, and when much of that debt is the product of financing a speculative bubble and backed by assets and incomes generated by that bubble, the situation is even worse.  It should be no surprise that in the face of the debt that existed in the mid 2000s, it was the upturn in interest rates in 2005 and 2006 caused by the Federal Reserve's attempt to moderate the housing boom that brought the housing bubble to an end in 2006 and sent shockwaves through the financial system in 2007.  

It should also be no surprise that the bursting of the housing bubble in the United States reverberated throughout the rest of the world.  The rise of the failed nineteenth-century ideology of Laissez-faire/free-market Capitalism that led to the deregulation of our financial system at home was not an exclusively American phenomenon.  It had been promulgated all over the world by institutions such as the International Monetary Fund in the name of the now infamous Washington Consensus. (Klein) The result was not only financial deregulation and a housing bubble in the United States financed by expanding debt, but in many countries in Europe and elsewhere around the world.  As a result, the crisis that was to explode in the American financial system in 2008 was destine to create a worldwide economic catastrophe. 

100 Years of Income and Unemployment

It is, perhaps, worth emphasizing the obvious at this point, namely, that the degree of concentration at the top of the income distribution is related to the income at the bottom, and both are affected by economic policies. 

Figure 3.5 plots the concentration of income of the Top 1% of the income distribution and the average real income (measured in 2012 prices) received by the Bottom 90% from 1913/17 through 2012.  The way in which economic policies have affected these variables over the past one hundred years can best be understood by examining the historical context in which these variables have changed. 

Source: The World Top Incomes Database.

Turn of the Century Through the Great Depression

The income share of the Top 1% (excluding capital gains) in this figure averaged 16.9% of total income from 1917 through 1933 with a low of 14.5% in 1920 and a high of 19.6% in 1928.  The average real income of the Bottom 90% averaged $9,447 during this period and fell from a high of $11,291 in 1917 to a low of $6,676 in 1920 but had increased back to $10,536 by 1929.  It then plummeted to $6,940 from 1929 through 1933. 

When we look at the historical context within which these changes took place we find that they began with World War I, followed by a rather steep recession in 1920 and 1921, a real-estate bubble from 1922 through 1926, a Stock-market bubble from 1926 through the fall of 1929, and three years of recession in which the rate of unemployment increased from 3.5% in 1929 to 24.9% in 1933. 

We also find that, except during World War I, this was an era of less government, lower taxes, and virtually no regulation, and it ended in the depths of the Great Depression at the beginning of the New Deal—that is, at the beginning of an era of more government, higher taxes, and more regulation.

The average real income of the Bottom 90% began to increase after 1933 but was essentially the same in 1940 ($9,862) as it had been in 1920 ($9,676) and was still significantly below where it stood in 1917 ($11,291).  At the same time, the concentration of income of the Top 1% averaged 15.9% from 1933 through 1940 and fell below 15% in only one year during that period.  Unemployment remained above 14% throughout that period. 

World War II and its Immediate Aftermath

Figure 1 and Figure 2 also shows the effects of World War II and its immediate aftermath as the government took over the economic system, instituted wage and price controls, rationed consumer goods, and increased personal and corporate tax rates dramatically.  The result was a dramatic fall in unemployment, and the concentration of income of the Top 1% fell from 15.7% of total income in 1940 to 11.4% by 1950.  At the same time there was a dramatic increase in the average real income of the Bottom 90% from $9,862 in 1940 to $18,797 in 1950. 

The Prosperous Years: 1950 through 1973

Over the 23 years following 1950 we see another dramatic increase in the average real income of the Bottom 90% as it went from $18,797 in 1950 to $34,956 in 1973.  At the same time, the concentration of total income at the top decreased fairly consistently throughout this period, falling from 11.4% of total income in 1950 to 7.7% in 1973.  

Unlike the period leading up to 1933, this was decidedly an era of higher taxes, more government, and more regulation of the economy. 

As can be seen in Figure 3.6, government made a relatively minor direct contribution to output in 1929, as reflected in the National Income and Product Accounts.  The direct contribution of All Governments (federal, state, plus local) to GDP was less than 10% in 1929.  It didn't exceed 15% until the beginning of the New Deal in 1933, and it remained at about that level through the remainder of the 1930s as the average real income of the Bottom 90% increased from $6,940 in 1933 to $9,862 in 1940. 

Source: Bureau of Economic Analysis (1.1.5)

In addition, taxes were exceedingly low prior to the 1930s.  The maximum marginal personal income tax rate was 7% before World War I, and even though it was raised to 77% during the war it had been cut back to 25% by 1925 where it remained until 1931.  The maximum corporate tax rate was 2% prior to World War I and was raised to 12% during the war where it essentially remained until 1932.

This changed dramatically in the 40 year period following the New Deal during which taxes and the direct contribution of All Governments to GDP increased dramatically as the average real income of the Bottom 90% increased fourfold, from $6,940 in 1933 to $34,956 in 1973. 

For the 23 year period from 1950 through 1973 the direct contribution of All Governments to GDP averaged 22.8% as the real income of the Bottom 90% increased from $18,797 to $34,956.  At the same time, the tax structure put in place during World War II was, for the most part, left in place.  The top marginal personal income tax rate was 91% and the corporate rate was 52% until the 1965, Kennedy-Johnson tax cuts reduced these rates to 70% and 48%. 

The increase in the direct contribution of All Governments to GDP not only represented a direct increase in output during this period, it also led to a direct increase in employment as employment by governments (excluding the military) increased from 9.8% of the labor force in 1950 to 15.5% in 1973.  (Figure 4)  The great bulk of this increase took the form of an increase in teachers, police officers, firefighters, public health and safety inspectors, and regulatory personnel. 

Bureau of Labor Statistics, (A-1 B-1)

The increase in the direct contribution of All Governments also led to substantial increases in productivity as a result of government investments in public education and scientific research, public transportation (city streets, county roads, state and interstate highways, bridges, ports, and subway, bus, and rapid transit systems), public health, water and waste treatment facilities, and other forms of public infrastructure.  In addition, government investments in our regulatory systems not only led to significant improvements in public health and safety during this period, they also kept the financial system from blowing up the economy—there were no speculative bubbles from 1933 through 1973 of the kind that lead to financial and economic crises.

It is clear from Figure 3.3 and Figure 3.5 through Figure 3.7 that this era of higher taxes, more government, and more regulation from 1950 through 1973 led to low unemployment (averaging 4.8% for the entire period and exceeding 6% in only two years) and a dramatic increase the average real income of the Bottom 90% of the income distribution.

It is also clear, or at least it should be clear, that the increase in real income at the bottom was one of the most important factors that fueled the economy during this period.  It was the increase in income at the bottom that caused the increase in output from 1950 through 1973, not the other way around. There is just no way all of the automobiles and refrigerators and washing machines and air conditioners and TVs and the countless other mass-produced goods and services that were produced during this period could have been sold if the income of the Bottom 90% had not increased in the way it did.

Who would have purchased all that mass-produced stuff if the concentration of income at the top and the average real income at the bottom had, instead, regressed back to their trends from 1917 through 1940 shown in Figure 3.5?  

What would it have taken to maintain a fully employed economy if, following World War II, the concentration of income at the top and the average real income at the bottom had reverted back to their trends leading up to the war?

The answer to the later question can be found by looking back to the era that preceded World War II—the speculative bubbles of the 1920s and the secular stagnation of the 1930s—during which the concentration of income at the top remained high and the average real income at the bottom failed to rise.  This was a period that ended in a decade in which the rate of unemployment never fell below 14% and in which the unemployment problem was not solved until the government took over the economy during World War II. 

The answer to the latter question can also be found by looking forward to the era that followed 1973 when the average real income at the bottom again failed to rise and the concentration of income at the top began to regain the ground it had lost since 1928.

The Great Inflation

Therate of unemployment was 5.6% in 1973.  From 1974 through 1980 it averaged 6.8%, and in 1980 the actual rate of unemployment stood at 7.1%.  Undoubtedly, these dismal unemployment statistics were partly caused by the episodes of tighter monetary policy that resulted from the tremulous efforts of the Federal Reserve to fight the inflation that was raging at the time, and partly by the reduction in the direct contribution of All Governments to GDP from 24.2% in 1967 to 20.6% in 1980.  It is also fairly safe to say that the relentless war waged against cost push inflation during this period played a major role in determining these statistics as the average real income of the Bottom 90% fell from $34,956 in 1973 to $32,413 by 1980. 

Then came the Reagan Revolution with its mantra of lower taxes, less government, and deregulation. 

Reagan's Revolution

While many government programs were cut during the Reagan years, as a result of the anti-Soviet defense buildup, the direct contribution of All Governments to GDP barely budged, going from 20.6% of GDP in 1980 to 20.5% in 1988.  Reagan's successes in lowering taxes (cutting the top marginal personal income and corporate tax rates from 70% and 48% in 1980 to 28% and 34%, respectively, by 1988) and deregulating the economy, however, did help to lower the unemployment rate to 5.3% by the time he left office as the commercial real estate and junk bond bubbles that led to the Savings and Loan Crisis grew.  But this triumph was short lived as these bubbles burst and unemployment rose to 7.5% in 1992 in the wake of the ensuing 1990 recession. 

The net effect of this episode was to increase the concentration of income of the Top 1% from 8.2% in 1980 to 13.5% by 1992 as the average real income of the Bottom 90% fell from $32,413 to $31,174 during this period. 

The Go-Go 1990s

Then came the 1990s in which we saw 1) a rather small increase in the top marginal personal and corporate tax rates from 28.0% and 34.0% to 39.6% and 35.0%, respectively, 2) a significant cut in the direct contribution of All Governments to GDP from 20.6% of GDP to 17.8%, 3) a dramatic increase in our current account deficit from 0.7% of GDP in 1992 to 4.0% by 2000, and 4) an almost total emasculation of the regulatory systems within the federal government. 

Aided by the largest stock-market bubble since the 1920s, the unemployment rate fell from 7.5% of the labor force in 1992 to just 4.0% in 2000 as the average real income of the Bottom 90% increased from $31,174 to $35,799, surpassing, for the first time, the $34,956 level it had achieved in 1973.  This feat was accomplished in spite of a significant increase in the concentration of income of the Top 1% from 13.5% to 16.5% of total income. 

Unfortunately, when the dotcom and telecom bubbles burst and the dust had settled from the resulting 2001 recession, by 2003 the rate of unemployment had increased to 6.0% of the labor force, and the average real income of the Bottom 90% had fallen back to $33,368 and was, again, below the level it had achieved in 1973. 

Unregulated  Finance in the 2000s

Finally, we have the aftermath of the financial deregulation of the late 1990s where the unemployment rate fell from to 6.0% in 2003 to 4.5% in 2007, and the average real income of the Bottom 90% increased somewhat during this period, from $33,368 to $34,816, slightly below the $34,956 level it had achieved in 1973. 

Then, in the wake of the housing bubble bursting in 2007 and the financial and economic systems melting down in 2008 the unemployment rate spiked to 9.6% of the labor force in 2010 and was still at 7.4% in 2013, six years after the recession began and in spite of a 4.2% fall in the labor force participation rate during this period.

But the real story of this era is the increase the income share of the Top 1% from 15.2% of total income in 2003 to 18.3% in 2007, falling to 16.7% in 2009 in the wake of the Housing Bubble bursting and then rebounding to 19.3% of total income by 2012—just 0.3 percentage points below the high of 19.6% it had achieved in 1928—while the average real income of the Bottom 90% fell from $34,816 in 2007 to $30,439 in 2012, a level not seen since 1967!

Summary

Just as it is clear from our historical examination of  Figure 3.1 that the end result of the era of higher taxes, more government, and more regulation was low unemployment and a dramatic increase the average real income of the Bottom 90% of the income distribution, it is just as clear from our historical examination of this figure that the end result of the two eras of lower taxes, less government, and deregulation that we have experienced during the past one hundred years was speculative bubbles, sporadic and rising unemployment, and falling average income for the Bottom 90% of the income distribution.  

These same results are embodied in Figure 3.8 which plots the average real income of the Top 1%, Top 5-1%, Top 10-5%, and the Bottom 90% of the income distribution from 1917 through 2012 on the same graph.

Source: The World Top Incomes Database.

There's something wrong with this picture, and it is fairly easy to see exactly what's wrong with it.  As John F. Kennedy pointed out, the rising tide that lifts all boats comes from a flood of rising income at the bottom of the income distribution not from spouting geysers at the top.      

Conclusion

Today we are faced with the same kind of situation we faced in the 1930s: Given the state of mass-production technology, the distribution of income is incapable of providing the domestic mass markets—that is, markets with large numbers of people who have purchasing power—needed to achieve full employment in the absence of a speculative bubble.  If we do not come to grips with this problem our domestic markets for mass-produced goods will continue to erode, and we will be plagued with boom and bust cycles of economic instability that eventually lead to economic stagnation as we run out of speculative bubbles to stimulate the economy.  It will be impossible to maintain the standard of living of the vast majority of our population in this situation as our economic resources are transferred out of those industries that produce for domestic mass markets and into those industries that produce for the privileged few. (King)

Not only will it be impossible to maintain the standard of living of the vast majority of our population if the concentration of income is not reduced, those at the top will eventually find they are getting a larger piece of an ever decreasing pie.  It is domestic mass markets that make mass production possible, and it is mass production—made possible by our domestic mass markets—that made the United States the economic powerhouse of the world. The erosion of our domestic mass markets erodes the very foundation on which our economic system rests, and to the extent this foundation is undermined, our ability to produce is undermined as well. (Ostry)

The only way a country can take advantage of mass-production technologies in the absence of an income distribution that provides domestic mass markets capable of purchasing the output it can produced without increasing debt relative to income is by producing for export and running a current account surplus.  Unfortunately, continually running a current account surplus leads to increasing the debts of foreigners relative to their incomes.

Increasing domestic debt relative to domestic income, or the debts of foreigners relative to their incomes is not sustainable in the long run.  The transfer burden from debtor to creditor must eventually overwhelm the system and lead to a financial crisis that will cause the system to collapse.  It is no accident that the current economic crisis began, and, at least so far, has hit the hardest those countries that were running substantial current account deficits in the face of speculative bubbles in their domestic economies. 

Appendix on Estimating Debt

The Historical Statistics of the U.S. (Cj870 Ca9-19 provides estimates of total debt from 1916 through 1976, and the Federal Reserve's Federal Reserve's Flow of Funds Accounts (L1) provide estimates of total debt from 1945 through 2013, but the two series are only roughly comparable. For the thirty-one years in which they overlap, the Federal Reserve's estimates as a percent of GDP are systematically below the Historical Statistic's estimates by an average of 12%. Both sets of data are plotted individually in Figure 3.9.

Source:  Federal Reserve (L1), Historical Statistics of the U.S. (Cj870 Ca9-19), 
Bureau of Economic Analysis (1.1.5).

In constructing Figure 3.2, the Historical Statistics' estimates were used to estimate Total Debt from 1900 through 1945 and the Flow of Funds' estimates were used from 1945 through 2012.  The estimates from both sources are plotted for the year 1945, hence, the two points in the Total Debt and Non-Federal Debt curves in Figure 3.2 where Non-Federal Debt is obtained by subtracting Federal Debt from Total Debt in this figure.  There was no need to make an adjustment if the Federal Debt and GDP series used in constructing this figure as the differences in the estimates provided by the Historical Statistics of the U.S. (Ca9-19) and the Bureau of Economic Analysis (1.1.5) in the years they overlap are insignificant.

When comparisons are made in the text between 1945 and years prior to 1945 the Historical Statistics value for 1945 will be used, and the Flow of Funds value will be used for comparing 1945 with subsequent years.

Endnotes

[3.1]  The idea that income must be redistributed to take advantage of an increase in productivity may seem to be unorthodox to some economists, but the need for redistribution is, in fact, implicit within the standard competitive model that lies at the core of neoclassical economics. The distribution of income is simply assumed to adjust automatically to accommodate increases in productivity in this model as the system is assumed to remain at full employment and long run economic profits are competed away. In the real world, of course, the economic system does not stay at full employment and economic profits do not necessarily get competed away. As a result, there is no reason to believe that a society that exists in the real world will be able to take full advantage of an increases in productivity irrespective of the distribution of income since the distribution of income does not necessarily adjust in the real world the way it is assumed to adjust in the competitive model.

It should, perhaps, also be noted that since this model is typically presented in terms of a system of equations derived from the optimizing behavior of a typical household and a typical firm, the distribution of income is not even considered in this model, except by way of the assumption that the amount of income the typical household receives is determined by the quantities of productive resources it owns and the prices these resources are able to command in the marketplace. As a result, the standard model gives only a partial explanation of the distribution of income.

Since income is determined by the ownership of productive resources in this model, it is implicitly assumed that the distribution of income is ultimately determined by the distribution of wealth among households. This means that to examine how the distribution of income affects the economic system we must go beyond the system of equations that are derived from the optimizing behavior of the typical household and firm and consider how the distribution of wealth can be expected to affect the preferences of the typical household and how these preferences can be expected to affect the typical firm.

If the typical household is to describe a society that has a high concentration of wealth and, hence, income, it is reasonable to assume that the preferences of the household that typifies that society will favor those kinds of outputs that serve the wealthy few rather than those that serve a mass market and that the typical firm will employ technologies that produce these kinds of outputs most efficiently. By the same token, if the household is to describe a society that has a low concentration of wealth/income it is reasonable to assume that the preferences of the typical household will favor those kinds of outputs that serve mass markets and the typical firm will employ technologies that produce these kind of outputs most efficiently. There is nothing in the standard model that is inconsistent with these assumptions.

[3.2] It is, perhaps, worth noting that a simple regression of the income share of the top 1% on the ratio of Total Debt to GDP explains 88% of the variation in this income share from 1970 through 2008:

SIMPLE REGRESSION P99-100 = 0.1041TotalD%GDP - 11.15CNST                  COEF.   SD. ER. t(37)   P-VALUE    PT.R SQ.       Debt%GDP   0.1041 6.295E-3 16.54   1.118E-18    0.8809           CNST -11.15   1.406    -7.93   1.696E-9     0.6296 R SQ. = 0.8809,  ADJ.R SQ. = 0.8776,  D.W. = 0.4462 SD.ER.EST. = 1.266,  F(1/37) = 273.5 (P-VALUE = 1.118E-18)

If we add exports, imports, productivity, prices, and unemployment to the mix, the explanatory power of the regression reaches 97% with all of the coefficients significant at the 5% level and a Durbin-Watson statistic in the upper half of the indeterminate range: 

MULTIPLE REGRESSION P99-100 = 0.02401Debt%GDP + 0.4219Exports%GDP - 0.3851Imports%GDP + 0.07293Productivity + 0.03409CPI - 0.5343UnemployRate + 0.8225CNST                   COEF.   SD. ER.  t(32)  P-VALUE PT.R SQ.      Debt%GDP  0.02401 0.01055   2.275  2.975E-2  0.1392   Exports%GDP  0.4219  0.1336    3.159  3.446E-3  0.2377   Imports%GDP -0.3851  0.1535   -2.509  1.737E-2  0.1644  Productivity  0.07293 0.03353   2.175  3.712E-2  0.1288           CPI  0.03409 0.009314  3.66   9.004E-4  0.2951  UnemployRate -0.5343  0.08673  -6.161  6.824E-7  0.5426          CNST  0.8225  2.196     0.3745 7.105E-1  4.363E-3 R SQ. = 0.9746,  ADJ.R SQ. = 0.9698,  D.W. = 1.414 SD.ER.EST. = 0.6282,  F(6/32) = 204.7 (P-VALUE = 4.354E-24)

Source: Piketty and Saez(XLS), ERP, 2011(B1PDF|XLS B42PDF|XLS B49PDF|XLS B60PDF|XLS B69PDF|XLS B72PDF|XLS  B104PDF|XLS), HSUS(Cj870-889).  See footnote 3.3.

[3.3] The role of borrowing in this situation is explained quit succinctly by Cynamon and Fazzari:

The willingness and ability of the bottom 95% to borrow excessively that kept their demand growing robustly despite their stagnant income growth and sowed the seeds of the Great Recession. Without this borrowing, demand from the bottom 95% cannot come close to attaining the level necessary to reach full employment. Demand from the top 5% has continued to follow the pre-recession trend, but this is not enough. The problem is not so much that output produced by the rising productivity of the middle class is distributed to the upper class, who do not spend it. Rather, the problem is that absent either wage and salary growth or excessive borrowing by the middle class, the spending of the bottom 95% is inadequate to generate the demand growth necessary to push the economy toward full employment at an acceptable pace. A large share of the aggregate income that we could enjoy if our resources were fully utilized is never created at all due to inadequate demand.

It is worth noting, however, that the government's increase in borrowing leading up to the Great Recession had the same effect in increasing demand as borrowing by the bottom 95%. 

[3.4] See the Appendix on Measuring Debt at the end of this chapter for an explanation of the way in which the data from the  Historical Statistics of the U.S., Federal Reserve Flow of Funds Accounts, and Bureau of Economic Analysis are used in this figure.

[3.5] Robert Reich in his Aftershock: The Next Economy and America's Future provides the following quote form Marriner Eccles's Beckoning Frontiers, published in 1950, in which Eccles describes the forces that led to the Great Depression:

As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth—not of existing wealth, but of wealth as it is currently produced—to provide men with buying power equal to the amount of goods and services offered by the nation's economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

Robert Reich and Marriner Eccles are the only two individuals I have run across so far that seem to understand problem of a concentration of the distribution of income in a mass-production economy.

[3.6] It should be noted that these are only rough comparisons due to the differences in the way current and historical total debt is estimated.  See the Appendix on Measuring Debt at the end of this chapter.

 

 

Where Did All The Money Go?

Chapter 5: Nineteenth Century Financial Crises

George H. Blackford © 2009, last updated 5/1/2014

Prior to the Civil War, all you needed to start a bank was a charter from a state and access to a printing press.  Banks would accept deposits, make loans, and print banknotes that were, in essence, a promise by the bank to pay the bearer on demand an amount of gold or silver at a fixed price.   Banks accepted deposits in the form of gold, silver, and banknotes issued by private banks and made loans, generally in the form of banknotes that they printed themselves.  The banknotes printed and issued by private banks circulated in the community alongside coins minted by the United States Mint and the mints of other countries.  Given the lack of specie (i.e., gold or silver coins) banknotes printed and issued by private banks served as the primary medium of exchange in the economy and were the dominant form of money.

There was a great deal of financial instability caused by this kind of monetary system, and there were at least three major financial crises prior to the Civil War, one in 1819, 1837, and 1857.  At the same time, there were two attempts by the federal government to regulate the financial system during this period.  The first was by way of the First Bank of the United States which existed from 1791 to 1811, and the second was by way of the Second Bank of the United States which existed from 1816 to 1836. 

First and Second Banks of the U. S.

The First and Second Banks of the United States were the only banks chartered by the federal government prior to the Civil War, and by virtue of the fact that federal deposits were kept in these banks they dominated the financial system.  They preformed many of the functions of a central bank in that they policed the other banks in the system by collecting their banknotes and presenting them for redemption in gold or silver thereby limiting the ability of the other banks to print money.  In so doing they controlled the money supply and credit conditions in the country and added an element of stability to the financial system. 

These banks, however, were private banks chartered to serve the interests of their stockholders, not to serve the public good, and it was felt by many that the political and economic power they wielded by virtue of their relationship to the government was abused.  The fate of the Second Bank of the United States was sealed when its president, Nicholas Biddle, opposed Andrew Jackson in the 1832 election.  A bill to renew its charter was vetoed by Jackson in that year, and the last nail was driven into its coffin in 1833 when Jackson decreed that no more government money would be deposited in the Second Bank of the United States.   (Trumbore eNCyclopedia Phillips)

The demise of the Second Bank of the United States left the country with no financial institution that could perform the functions of a central bank, but even with the First and Second Banks of the United States the situation was far from satisfactory.  Since each bank was responsible for the bank notes it issued, one had to evaluate the worth of a given banknote on the basis of the soundness of the issuing bank—that is, its ability to honor its promise to redeem its banknotes in gold or silver—and with hundreds of banks issuing these notes this was no easy task.  There were literally thousands of different kinds of banknotes in circulation by 1860, and, as a result, banknotes did not necessarily trade at par.  (Dwyer)  Banknotes issued by failed banks circulated alongside the notes of sound banks and, of course, counterfeiting has always been a problem—even before the Civil War.  (OCC)  The result was a very unstable and inefficient monetary system that hindered the growth of trade and economic development.  (Grossman)

National Banking Acts of 1863 and 1864

This situation changed dramatically with the passage of the National Banking Acts of 1863 and 1864.  These acts created the National Banking System with the intent of providing a stable and uniform national currency and, not coincidently, to help finance the Civil War.  These two goals were accomplished by requiring that the banknotes printed by national banks be backed by Treasury securities equal to ninety percent of the value of the banknotes printed by national banks.  These securities could then be sold to redeem the notes if the issuing bank failed.  In addition, in 1865 a 10% tax was levied on non-national-bank banknotes and on all transactions using non-national-bank banknotes.  The existence of this tax essentially forced all banks that wished to print their own banknotes to join the National Banking System.

The fact that banks were forced to purchase Treasury securities in order to print banknotes not only helped to finance the Civil war, it also limited the amount of banknotes that could be circulated in the economic system by the amount of Treasury securities that were available to banks to back the notes they issued.  The result was a stable, uniform national currency made up of 1) national banknotes tied to the total value of Treasury debt outstanding, 2) United Sates Notes which were the greenbacks printed by the federal government to pay the troops during the Civil War, and 3) Gold Certificates issued by the Treasury which were, in effect, warehouse receipts for gold held at the Treasury. (OCC)

While the National Banking Acts of 1863 and 1864, bolstered by the 1865 tax on non-national-bank banknotes, did provide a stable and uniform national currency, these dramatic changes in our financial system did not solve the problem of financial crises.  The reason is that these reforms failed to deal directly with the fundamental liquidity and solvency problems faced by banks that causes the financial system to be inherently unstable.   

Liquidity Problem of Banks

Most businesses can meet their liquidity needs (i.e., their needs for cash) by structuring the term to maturity of their liabilities (i.e., debts that they owe) to match the term to maturity of their assets (i.e., things that they own).  They can, for example, finance real estate which yields a return over a relatively long period of time with 15 to 20 year loans, equipment with a shorter lifespan with 5 to 10 year loans, and inventories with loans that corresponds to the period of time it takes for their inventories to turn over.  A business that has its liabilities structured in this way can generally muddle through with the hope of rebuilding its equity, even if it is insolvent (i.e., even if it owes more than the value of the assets it can sell to pay its debts) so long as it can service its debt and so long as it can retain the confidence of its short-term creditors. 

The situation is fundamentally different for a bank.  The primary source of funds for a bank is the deposits it issues, most of which are very short-term liabilities.  At the same time most of the assets of the bank are made up of relatively long-term commercial, business, and real estate loans that it makes to its customers.  These assets have term to maturities far beyond the term to maturities of the bank's deposits, many of which, namely, checking accounts, are payable on demand.  Thus, by their very nature banks are not able to structure the term to maturity of their liabilities to match the term to maturity of their assets.    

As was indicated above, an ordinary business can generally muddle through when it is in financial difficulty so long as it can service its debt and retain the confidence of its short-term creditors.  This is so because, in general, a relatively small portion of an ordinary business's total liabilities are short term and the number of short-term creditors with which it must contend is relatively small.  As a result, an ordinary business generally has the option of sitting down with its local banker and suppliers, opening its books, and undertaking a rational discussion of its financial viability to arrive at a rational decision as to whether or not its short-term credit should be continued.  The situation is much different for a bank. 

Even a small bank has literally thousands of short-term creditors that hold its deposits, and unlike the debts of most businesses, a large portion of a bank's deposits (its checking accounts) are payable on demand.  What’s more, in an unregulated financial system that lacks deposit insurance there is no incentive at all for the depositors of a bank to even listen if a bank tries to explain its financial situation.  The depositors know that if the bank were to fail those who close their accounts first while the bank still has cash on hand to cover its withdrawals will not lose their money, while those who wait will not be able to get their money out of the bank until its assets are liquidated.  As a result, those who wait potentially risk losing everything. 

This means that each individual bank, as well as the entire banking system itself, depends crucially on the confidence the public has in the bank and the banking system.  As a result, banks are particularly susceptible to a panic that results in what is known as a run on the bank where all of its depositors lose confidence in the bank and try to close their accounts at the same time.  And when a run occurs even the strongest bank can be driven out of business if it is unable to borrow enough funds to meet the demands of its depositors for cash or sell off its assets at prices sufficient to maintain its solvency.  

Solvency Problem of Banks

The solvency problem faced by any businesses, including a bank, is best understood in terms of the fundamental equation of double entry bookkeeping:

assets = liabilities + owners' equity

where assets refers to the value of everything the business owns; liabilities refers to the value of everything the business owes, and owners' equity (also referred to as equity, equity capital, or just capital) is defined as the difference between the value of the assets owned by the business and the value of the liabilities owed by the business:

owners' equity ≡ assets - liabilities.

The significance of this equation for our purposes is that it illustrates the solvency problem of banks, namely, the need to maintain a positive owners' equity.  If the value of the liabilities of a bank are greater than the value of its assets, its owners' equity (net worth, equity, . . . , etc.) will be negative and the bank will be insolvent.  The fact that it is insolvent means that if the bank (or any business that is insolvent) is forced into bankruptcy the value of its assets are insufficient to cover the value of its liabilities and some of its debtors will not get paid back what they have lent to the bank (or business).  This is a very precarious situation for a bank because in an unregulated banking system without deposit insurance, no one wants to hold deposits in a bank that is insolvent.

Not only is the liquidity problem of banks fundamentally different from the liquidity problem of ordinary businesses, the solvency problem of banks is fundamentally different as well.  Compared to banks, most businesses borrow very little relative to their equity capital, that is, relative to the amount of money the owners of the business have invested in the business.  In fact, many businesses operate without borrowing any money at all, and even more borrow less than the amount the owners have personally invested. 

The reason for this is that running a business is a risky endeavor.  Creditors refuse to lend to a business if the owners do not have a substantial amount of their own money invested in it, and the rates of interest businesses have to pay, especially small businesses, are generally fairly high.  As a result, business owners often find it more profitable to reinvest their profits in their business by paying off their debts as soon as possible than to continue to borrow, and the leverage ratio of most businesses—that is, their total debt divided by their equity capital—is relatively small. [5.1]

The situation is much different for a bank.  As was noted in Chapter 4, banks are in the business of borrowing from one group of people and lending to another group of people.   That's what banks do.  They make a profit from the difference between the costs of the funds they borrow in the form of deposits (and during the Nineteenth Century in the form of the banknotes they printed as well) and the revenues they receive from the loans they make to businesses and private individuals.  So long as the costs of the funds they borrow are less than the revenues they receive from their loans they can increase their profits by both borrowing and lending more money.  What's more, something magical happens when banks lend money.

If you have $1,000 in cash and decide to become a bank, when you lend your $1,000 to someone the chances are that whoever borrowed the money is going to spend it.  When the $1,000 you lent is spent the person who receives the money in exchange for whatever is purchased now has your $1,000.  He or she has but three choices as to what to do with it:  spend it, just hold on to it, or redeposit it in a bank.  If the choice is to redeposit it in your bank that means you are able to borrow your $1,000 back from the person who deposits it.  As a result your deposits will increase by $1,000 and you get the cash back. 

Even if your $1,000 is redeposited in another bank, whatever bank it is redeposited in will be able to borrow your $1,000 back from the person who deposits it and will be able to increase its cash by the $1,000 that you lent.  Thus, even though you lose the cash, some other bank will eventually gains the cash unless the non-bank public decides to hold more cash outside the banking system and the cash is not redeposited in a bank.

This is where the magic comes in because what this means is that whenever a bank makes a loan to one of its customers, unless the non-bank public decides to hold all of the newly lent cash outside the banking system, the banking system as a whole does not lose all of the cash that was lent:  To the extent it is redeposited in the bank that made the loan that bank gets some of the cash back, and to the extent it is redeposited in some other bank that bank gets some of the cash.  In either case the amount of cash in the banking system as a whole does not fall by the amount of the loan. 

What does change is the amount of money that the banking system is able to borrow from its depositors.  This amount increases by the portion of the loan that is redeposited in the banking system as deposits in the system increase by this amount.  In other words, unless the non-bank public decides to hold all of the newly lent cash outside the banking system, whenever a bank makes a loan it increases the amount of money the banking system as a whole is able to borrow from the non-bank public by the amount of the loan that is redeposited in the banking system.  No other industry can increase the amount of money it can borrow by increasing the amount of money it lends.  It's magic! 

The fact that the banking system increases the amount it can borrow when it increases the amount it lends has very important implications with regard to the stability of the financial system.  If you were the only bank in a small town during the nineteenth century when you started your bank with $1,000 to lend, and if every time you made a loan all of the proceeds of that loan were subsequently redeposited in your bank, your deposits would grow to $10,000 after you had made ten $1,000 loans while your cash and equity capital would remain at $1,000. 

If we ignore the other assets and liabilities of your bank, your financial position would look like Figure 5.1 where your bank’s assets are listed on the left side of the table in this figure, and your liabilities and net worth are listed on the right side of this table. 

Figure 5.1: Your Financial Situation after Lending $10,000.
Assets		Liabilities & Net Worth
Cash Reserves	$1,000	Deposits	$10,000
Loans	$10,000	Net Worth	$1,000
Total	$11,000	Total	$11,000

The fact that your deposits have grown to $10,000 after you have made ten $1,000 loans while your cash and equity remains at $1,000 in this situation means the leverage of your bank (your total debt divided by your net worth) increases from zero when you had no debt in the form of deposits to 10 when your deposits grew to $10,000.[5.2] 

This is a very profitable position for you to be in so long as it cost you less to manage your deposits than you make from your loans.  If, for example, you can lend at 5% and it cost you 3% to manage your deposits, before your deposits grew you could make only $50 a year by lending out your $1,000 worth of capital.  After you lend your $1,000 ten times and your deposits grew to $10,000 you would then be making $200 a year on your $1,000 investment in your bank—you would be taking in $500 on the $10,000 you had lent at 5% and it would cost you $300 (3% of $10,000 worth of deposits) to manage your $10,000 worth of deposits.  Thus, instead of only making a 5% return on your $1,000 worth of equity capital you would be making a 20% return on that capital. 

Leverage is a beautiful thing for a bank when it comes to making money.  If you were able to grow your deposits in this way to $30,000 by making $30,000 worth of loans that were redeposited in your bank, your financial situation would look like Figure 5.2. Your leverage ratio would be 30 to 1, and you would be able to make $600 ($30,000x.05 - $30,000x.03 = $600).  This would yield you 60% annual return on your $1,000 investment!  Even if it cost you as much as 4% to manage your deposits you would still be able to make $300 in this situation and earn a 30% return on your investment.

Figure 5.2: Your Financial Situation After Lending $30,000.
Assets		Liabilities & Net Worth
Cash Reserves	$1,000	Deposits	$30,000
Loans	$30,000	Net Worth	$1,000
Total	$31,000	Total	$31,000

While leverage can be a money making machine for banks, it also poses two serious risks.  The first comes from the fact that the use of leverage increases the liquidity problem of banks.  In the above example, you are only able to achieve 30 to 1 leverage because people are willing to lend you money by depositing it in your bank.  You have borrowed $30,000 from your depositors but only have $1,000 worth of cash on hand as a reserve to meet the needs of your depositors for currency.  If your depositors take currency out of their deposits faster than you take in currency from the repayment of your $30,000 worth of loans, your reserves of cash will fall.  Unless you can find an alternative way to raise cash in this situation—say, by borrowing from other banks or selling some of the asset you own for cash—you are going to be in trouble when you run out of cash since your depositors tend to get upset if you don't have the cash when they try to withdraw money from their accounts.

The second risk comes from the fact that the use of leverage increases your risk of becoming insolvent.  If your bank is leveraged at 30 to 1, a 3.3% fall in the value of your assets—say, because some of your debtors go bankrupt or abscond with the money—would wipe out your entire equity because when your equity is leveraged 30 to 1 the value of your equity is less than 3.3% of the value of your assets.  The value of your assets would fall below the value of your liabilities, in this situation, and you would then be insolvent.  As was noted above, in an unregulated banking system with no deposit insurance no one wants to keep money in an insolvent bank.  Even a rumor of your bank's insolvency could start a run and drive you out of business irrespective of your cash reserves or solvency before the run began, and, in the face of a run, as soon as you run out of cash you will be forced to close your doors.

It should be noted that the liquidity and solvency problems of banks are distinct problems.  The liquidity problem has to do with having enough cash on hand to meet your day to day obligations.  The solvency problem has to do with having assets of sufficient value to cover your debts.  If in the above example your debtors absconded with 3.4% your loans, your financial situation would look like Figure 5.3.  Your loans would now be worth only $28,980 (.966x$30,000) which means that when we add this to your $1,000 worth of cash the value of your assets would be $29,980 while your liabilities in the form of deposits would be $30,000.  You would be insolvent because your liabilities exceed your assets by $20, and you would not be able to pay off all of your depositors if you were forced into bankruptcy even though you still have $1,000 in cash to service your deposits.

Figure 5.3: Your Financial Situation after a 3.4% Loss.
Assets		Liabilities & Net Worth
Cash Reserves	$1,000	Deposits	$30,000
Loans	$28,980	Net Worth	$1,000
Total	$29,980	Total	$29,980

By the same token, if your debtors had not absconded but instead your depositors decided to withdraw $1,000 from their accounts you would be in trouble even though your solvency hadn't changed.  In this situation, your financial situation would look like Figure 5.4.  You would still have $30,000 worth of loans even though you lost all of your cash, but since you now have only $29,000 worth of debts in the form of deposits this leaves you with the same net worth of $1,000 that you had before your deposits and cash fell by $1,000.  But you would have no cash on hand to meet the demands of your depositors.  If someone tries to take money out of their deposit you don't have the cash to give to them even though you still have $1,000 in net worth.

Figure 5.4: Your Financial Situation after a $1,000 Withdrawal.
Assets		Liabilities & Net Worth
Cash Reserves	$0	Deposits	$29,000
Loans	$30,000	Net Worth	$1,000
Total	$30,000	Total	$30,000

Finally, it should be noted that the ability of banks to increase the amount they can borrow by increasing the amount they lend is not unlimited.  It depends crucially on the willingness of the non-bank public to keep their cash in banks.  An expansion of bank loans is generally accompanied by an increase in economic activity that increases the need for the non-bank public to hold currency outside of banks to finance their day to day transactions.  As a result, it is unlikely that all of the money lent will be redeposited in a bank.

If, for example, you started your small town bank with $1,000 cash and only 96% of your loans were redeposited in your bank you would not be able to leverage you capital 30 to 1 since 4% of the cash you lent would remain outside your bank as the currency held by the non-bank public increased.  Thus, by the time you made $25,000 worth of loans your deposits would have increased by $24,000, and you would be out of cash.  Your financial situation would look like Figure 5.5.

Figure 5.5: Your Financial Situation with a 96% Redeposit Rate.
Assets		Liabilities & Net Worth
Cash Reserves	$0	Deposits	$24,000
Loans	$25,000	Net Worth	$1,000
Total	$25,000	Total	$25,000

At this point you would have no more cash to lend.  Thus, the maximum leverage you could obtain would be 24 to 1 in this situation, but even this is not obtainable.  If you did leverage yourself this far you would have no cash reserves to meet the demands of your depositors in the event one of them wished to make a withdrawal.  To play it safe you would have to keep some cash on hand to meet this contingency. 

If you chose to keep cash reserves equal to, say, 5% of your deposits to protect yourself from unexpected withdrawals you could then only lend $11,364 before your deposits rose to $10,909 and your cash fell by $455 (4% of your $11,364 worth of loans) to $545 (5% of your $10,909 worth of deposits).  At that point your financial situation would look like Figure 5.6.

Figure 5.6: Your Financial Situation with a 96% Redeposit Rate and 5% Reserves.
Assets		Liabilities & Net Worth
Cash Reserves	$545	Deposits	$10,909
Loans	$11,364	Net Worth	$1,000
Total	$11,909	Total	$11,909

You would have to stop lending in order to maintain your cash reserves at 5% of your deposits and would, by choice, be limiting your leverage to a ratio of 10.909 to 1. 

Thus, during the nineteenth century the banking business was a continual balancing act between expanding leverage in order to increase profits while maintaining cash and equity reserves to deal with the liquidity and solvency problems that this expansion inevitably entails.  This balancing act was made even more difficult by virtue of the fact that when times were prosperous and money was being made hand over fist, the temptation to allow cash reserves to fall and to increase leverage was for many banks irresistible.  This was particularly so when people had confidence in the banking system and kept their money in the banks. 

Since, in this situation, deposits expand automatically as banks expand their loans, banks automatically receive the cash they need to further expand their loans and, hence, their leverage.  If banks did not make a determined effort to expand their cash and equity as their deposits were expanding during prosperous times their cash reserves as a percentage of their deposits would automatically fall and their leverage would automatically increase as well.  It is not until the crisis came and the non-bank public lost confidence in the system and began to withdraw their cash that banks would be forced to face the inevitable liquidity and solvency problems they had created for themselves.

Failings of the National Banking System

By virtue of the term structure of their assets and liabilities—that is, the fact that banks borrow short term and lend long term—and the ease with which banks can expand their leverage during prosperous times, the financial stability of banks is much more tenuous than that of an ordinary business.  Unfortunately, there was no mechanism within the National Banking System to deal with the tenuous nature of the financial stability of banks.  As a result, even though the National Banking System was able to provide a sound and stable currency, it was unable to provide a sound and stable financial system.

One of the reasons for this failing was that there were only two options available to a bank within this system when it needed cash to meet the demands of its depositors:  It could either borrow cash from other institutions or to sell whatever asset it owned that it could find a market for.  While an individual bank could obtain cash in this way, when the non-bank public wished to increase the currency held outside the banking system, an individual bank could only obtaining the cash in this way either by borrowing from some other bank or by selling something to someone who paid with cash drawn from a deposit in some other bank.  There was no mechanism within the National Banking System by which the banking system as a whole could increase the amount of cash available to the system in a situation where the non-bank public wished to increase the amount of cash it held outside the banking system.  This led to a serious problem.

During the normal course of economic activity there were seasonal changes in the demand for currency on the part of the non-bank public.  When the demand for currency increased, say during the spring when crops were planted and especially during the fall when additional currency was needed to pay seasonal workers during the harvest and to purchase the crops from farmers, currency would flow out of the banks.  This would place a strain on the cash available to banks to meet the needs of their depositors and would cause a tightening of the market for bank loans as banks were forced to pay out cash to their depositors as their customers paid off their loans rather than being able to relend the cash they received in this way. 

As currency flowed out of the banks to meet seasonal demands, banks were forced to cut back on their loans and interest rates would rise.  The pressure on the banks for cash would thus be transmitted to those who relied on the banks for credit.  Potential borrowers who were unable to get new loans and debtors who were unable to renew their existing loans at acceptable rates of interest would be forced to cut back their economic activity.  At the same time, debtors who could not renew their existing loans would be forced to sell the collateral underlying these loans or to sell other assets they owned in order to meet their obligations to the banks.  These forced sales of assets, in turn, caused a general fall in asset prices throughout the system which strained the system even further as debtors found it more difficult to meet their obligations to the banks in the face of falling asset prices.  If this strain became particularly severe it would cause some debtors to default which would threaten the solvency of their banks and in some instances lead to bank failures. 

Bank failures inevitably shook the confidence of the public and created the possibility of a financial crisis through a run on the system.  Once a run began, there was no mechanism within the National Banking System by which it could be contained since there was no way to replenish the cash that a panicked public took out of the banks.  When a bank ran out of cash it would be forced to shut down whether it was solvent or not, and if the panic was sufficiently widespread the system would simply implode as the entire system was forced to suspend payments of cash to depositors.  The end result was a massive disruption in economic output and employment with extreme hardship throughout the country. 

The instability caused by the rigidity of the supply of currency within the National Banking System became clear as the nineteenth century wore on and the country went through the financial crises of 1873, 1893, and 1907.  The experiences of these crises eventually led to the creation of the Federal Reserve System in 1913.

Endnote

[5.1] Leverage is sometimes defined as the ratio of total assets (rather than total debt) divided by equity.  Since the fundament equation of double entry bookkeeping (E = A - L) implies that the assets over equity ratio (A/E = L/E + 1) is always one greater than the liabilities over equity ratio, the two ratios measure the same thing, and the choice between them is, for the most part, arbitrary.    

[5.2] I have simplified this example of a nineteenth century bank by ignoring the way in which banknotes printed by the bank fit into the operation of the bank and the role played by gold in a banking system encumbered by the rules of the gold standard that existed at the time.  These are important to a faithful understanding of how the nineteenth century banking system functioned, but they are ignored here to simplify the exposition in order to highlight those aspects of the nineteenth century system that pertain directly to our modern system. 

 

Where Did All The Money Go?

Chapter 6: The Federal Reserve and Financial Regulation

George H. Blackford © 2009, last updated 5/1/2014

The Federal Reserve System (commonly referred to as "the Fed") was created in response to the crisis of 1907 in an attempt to deal with what was perceived at the time to be the central problem of the National Banking System, namely, the inability of this system to deal with seasonal changes in the demand for currency without placing a strain on banks and their ability to make loans.  This problem was dealt with by creating the Federal Reserve System as a central bank—that is, a bank in which other banks can open deposits and from which other banks can borrow money—and by giving the Federal Reserve the power to print its own currency.  At the same time, all other banks were prohibited from printing currency. (Bernanke)

The Federal Reserve thus became the lender of last resort within the banking system, willing and—given its ability to print money—able to lend cash to other banks to meet their needs.  It was believed that in addition to the ability to meet the seasonal needs of banks for cash, the Fed would also be able to eliminate financial crises by lending cash to sound banks during times of financial stress while allowing unsound banks to go out of business in an orderly fashion.

The mechanism by which the Federal Reserve functions within the financial system, and by which the Federal Reserve derives its power, is quite simple in principle and can be summarized as follows:

1. The Federal Reserve determines the amount of currency that is available to the economy.

2. The Federal Reserve also sets the reserve requirement ratio, that is, the fraction of deposits that banks must hold in the form of reserves, where reserves consist of either the currency banks have in their vaults (vault cash) or in their deposit at the Federal Reserve.

3. The non-bank public is free to determine how much of the currency that the Federal Reserve makes available to the economy is held outside of banks and how much is deposited in banks to serve as reserves against deposits. 

4. Banks are then allowed to expand their loans and deposits (in the manner explained in Chapter 5) until they cannot make additional loans without violating their reserve requirements.[6.1]   

Within this system, banks are limited in their ability to expand the amount they can borrow from their depositors as they expand the amount they lend by 1) the amount of currency the Fed makes available to the economic system, 2) the amount of this currency the non-bank public is willing to leave in banks, and 3) the reserve requirement ratio set by the Fed.  As is demonstrated below, the cornerstone of this system is the Federal Reserve’s ability to determine the amount of currency that is available to the economic system. 

Controlling the Amount of Currency

The amount of currency that is available to the economic system is referred to as high-powered money, where High-Powered Money is the sum of currency in circulation (that is, currency in the hands of the non-bank public) plus the reserves held by banks, either in the form of vault cash or as deposits at the Federal Reserve.  High-Powered Money is also referred to as the monetary base as it is the foundation on which the monetary system, indeed, the entire financial system rests. 

There are two ways in which the Federal Reserve can control the amount of High-Powered Money, hence, the amount of currency available to society. 

The Discount Window

The first is by making or retiring loans to banks.  The Federal Reserve makes and retires loans to banks through what is referred to as the discount window where the rate of interest charged for these loans is referred to as the discount rate.  All loans made by the Federal Reserve through the discount window must be fully backed by collateral supplied by the borrowing banks, and these loans are made at a discount to the face value of the collateral offered by the borrowing bank.  Hence, the terms discount window and discount rate.  (FRB) 

When the Federal Reserve makes a loan to a bank it does so by simply crediting the reserve deposit of that bank at the Federal Reserve by the amount of the loan.  As a result, the reserve component of High-Powered Money is increased directly by the amount of the loan.  By the same token, when the Federal Reserve retires a loan previously made to a bank, the bank pays off that loan by deducting the amount of the loan from its reserve deposit at the Federal Reserve.  As a result, the reserve component of High-Powered Money is decreased directly by the amount of the loan that is repaid. 

The way in which a $1,000 loan by the Fed to a commercial bank affects the financial situation of both the Fed and the Banking system and, thus, changes the amount of currency available to the economic system is illustrated in Figure 6.1.  When the Fed credits the amount of this loan to the reserve deposit of the borrowing bank, this transaction increases the Fed’s asset Loans to Banks and its liability Reserve Deposits held by banks by the amount of the loan, $1,000.  At the same time, it increases the banking system’s asset Reserve Deposits and its liability Loans from Fed by the same amount. 

Figure 6.1: A $1,000 Loan by the Fed to a Bank.
Federal Reserve
Assets		Liabilities
Loans to Banks	+$1,000	Reserve Deposits	+$1,000
Commercial Banks
Assets		Liabilities
Reserve Deposits	+$1,000	Bank Deposits	+$10,000

The fact that the reserve deposits in the banking system have increased by $1,000 as a result of this loan means that High-Powered Money—the sum of currency in circulation and reserve deposits—has increased by this amount, and since banks can withdraw an additional $1,000 worth of currency from their reserve account at the Federal Reserve after this transaction it means that the amount of currency available to the system has increased by $1,000. 

This process, of course, works in reverse when the loan is paid back by the bank.  The Fed’s asset Loans to Banks and its liability Reserve Deposits will fall by the amount of the repayment as the bank repays the loan by allowing the Fed to deduct the amount of the repayment from the bank's reserve deposit.  At the same time, the banking system’s asset Reserve Deposits and its liability Loans from Fed will fall by the same amount.  Thus, all of the pluses in Figure 6.1 become minuses. 

The fact that the reserves in the banking system must decrease by the amount of the repayment means that High-Powered Money will fall by this amount as well, and there will be $1,000 less currency available to the economic system than there was before the repayment took place since banks will now be able to withdraw $1,000 less currency from their reserve accounts than they could before the loan was made. 

Open Market Operations

The second way in which the Federal Reserve can control the amount of High-Powered Money is by buying or selling something.  While it doesn’t matter what the Federal Reserve buys or sells, when it comes to controlling the amount of High-Powered Money the Federal Reserve generally restricts itself to buying or selling government securities.  The decisions of the Fed to buy or sell government securities are made by the Federal Reserve’s Open Market Committee and are referred to as the Federal Reserve’s open market operations.  (FRB)

When the Federal Reserve buys a government security, the institution that sells the security receives a check written on the Federal Reserve for the amount paid for the security.  In the normal course of events, the check will be deposited in a bank, and, in turn, the bank will redeposit the check in its reserve account at the Federal Reserve.  As a result, the reserve component of High-Powered Money will increase by the amount of the check written on the Federal Reserve to purchase the government security.   

Figure 6.2 illustrates the situation where the Fed purchases a $1,000 government security from a member of the non-bank public.  This transaction increases the Fed’s asset Government Securities by the amount of the purchase, $1,000.  When the member of the non-bank public deposits the check it received for the security in its bank account, the banking system’s liability Bank Deposits increase by the amount of the check.  When the bank deposits the $1,000 check in its reserve account the banking system’s asset Reserves increases by the same amount as will the Fed's liability Reserve Deposits. 

Figure 6.2: A $1,000 Purchase of Government Security by the Fed.
Federal Reserve
Assets			Liabilities
Gov. Securities		+$1,000	Reserve Deposits		+$1,000
Commercial Banks
Assets			Liabilities
Reserve Deposits		+$1,000	Bank Deposits		+$1,000
Non-Bank Public
Assets			Liabilities
Bank Deposits		+$1,000	Bank Loans		+$1,000
Gov. Securities		-$1,000

The only change that has occurred in the financial situation of the non-bank public at this point is there has been an exchange of one kind of asset for another—Government Securities held by the non-bank public have gone down while Bank Deposits held by the non-bank public have gone up by the same amount, $1,000.  But the fact that the reserves in the banking system have increased by $1,000 as a result of this purchase by the Fed means that High-Powered Money has increased by this amount, and there is now $1,000 more currency available to the economic system than there was before this purchase took place. 

By the same token, when the Federal Reserve sells a government security it will receive a check written on a commercial bank for the amount of the sale.  The Federal Reserve will then deduct the amount of that check from the reserve deposit of the bank on which the check is written, and the reserve component of High-Powered Money will decrease by the amount of the check.  The bank, in turn, will deduct the amount of the check from the account on which the check was written.  As a result, all of the signs in Figure 6.2 will be reversed, and the amount of High-Powered Money, that is, the amount of currency available to the economic system, will be decreased accordingly.

Thus, when the Fed wants to increase the amount of currency available to the economy it can either increase the amount it lends to banks or it can purchase government securities.  When the Fed wants to decrease the amount of currency available to the economy it can either reduce the amount it lends to banks or it can sell government securities. 

Seasonal Demand for Currency

The ability of the Federal Reserve to control the amount of currency that is available to the economic system provided a mechanism by which the seasonal demand for currency problem that plagued the National Banking System could be eliminated.  After the Federal Reserve came into being, banks were no longer forced to contract their lending as currency flowed out of the banks in response to seasonal changes in the demand for currency.  Instead they could borrow from the Fed or the Fed could purchase government securities from the public in order to replenish the reserves that were lost as the currency flowed out of the banks, for example, during spring planting or the fall harvest.  By the same token, when the planting or harvest was over and the currency flowed back into the banks the Fed could absorb the excess currency as the loans it had made were repaid and as it sold the government securities it had purchased to meet the currency drain from banks during the planting or harvest seasons. 

It is important to note, however, that when the Federal Reserve changes the amount of High-Powered Money in this way it can lead to changes in the financial system that go beyond the changes indicated in Figure 6.1 and Figure 6.2 above.  The Federal Reserve is not simply a passive agent that responds to the seasonal changes in the demand for currency by the non-bank public.  The Fed can change the amount of High-Powered Money through its lending and open market operations in any way it chooses whether currency is flowing into or out of banks or not.  As a result, the Federal Reserve has the power to affect the ability of the banking system to make loans.  This gives the Federal Reserve the power to affect the credit conditions in the economic system irrespective of the seasonal demands for currency by the non-bank public.

Controlling Loans and Deposits

Consider the situation depicted in Figure 6.2 where the Fed has purchased a $1,000 government security from a member of the non-bank public and thereby increased the amount of deposits and reserves in the banking system by $1,000.  Now assume that the reserve requirement ratio is 10% and the banking system is fully loaned up before this transaction takes place—that is, that the actual reserves held by banks are equal to the reserves they are required to hold as determined by the size of their deposits and the reserve requirement ratio. 

Since the reserve requirement ratio is 10% and this transaction increased deposits by $1,000 the reserves banks are required to hold have increase by $100.  At the same time, this transaction also increases the reserves that banks actually have by $1,000.  As a result, there is $900 in excess reserves in the banking system ($1,000 increase in actual reserves minus the $100 increase in required reserves) after this transaction takes place that did not exist before this transaction took place.  These excess reserves represent cash banks hold in excess of what they are required to hold—cash that can be lent to and borrowed back from the non-bank public as loans and deposits grow in the banking system in manner discussed in Chapter 5. 

As banks make loans to and borrow the money back from the non-bank public the loans and deposits in the banking system can grow until there are no longer excess reserves in the banking system.  If there are no leakages of currency out of the banking system as this process of expansion takes place, the system will eventually reach the point depicted in Figure 6.3 where Bank Deposits increase by $10,000 and bank loans by an additional $9,000.

Figure 6.3: Secondary Effects of a $1,000 Purchase by the Fed.
Federal Reserve
Assets			Liabilities
Gov. Securities		+$1,000	Reserve Deposits		+$1,000
Commercial Banks
Assets			Liabilities
Reserve Deposits		+$1,000	Bank Deposits		+$10,000
Bank Loans		+$9,000
Non-Bank Public
Assets			Liabilities
Bank Deposits		+$10,000	Bank Loans		+$10,000
Gov. Securities		-$1,000

At this point the process of expansion must come to an end as required reserves will have increased by $1,000 (10% of the $10,000 increase in deposits), and there will no longer be excess reserves in the system.  At the same time, the non-bank public will have increased the deposits it owns by an additional $9,000 and will have gone $9,000 deeper in debt to the banks.  And all of this has taken place as a result of 1) the Federal Reserve purchasing a $1,000 government Security, 2) the banking systems willingness to lend its excess reserves, and 3) the non-bank public's willingness to deposit its excess cash in banking system. 

This process works in reverse, of course, if the Federal Reserve sells a $1,000 government security.  Reserves and deposits would fall by $1,000, and banks would find themselves with a $900 deficiency in reserves.  Banks would then be forced to reduce their outstanding loans by $9,000 as the non-bank public paid off their debts to the banks and bank deposits would fall by an additional $9,000.  All of the signs in Figure 6.3 would be reversed and there would no longer be a deficiency of reserves in the system.

The same kinds of results would be obtained if the Federal Reserve had increased its loans to banks by $1,000 in this situation instead of purchasing a government security.  The only difference would be that the loan would not have directly increased deposits by $1,000, and the non-bank public would not have sold a government security.  The entire $1,000 increase in reserves would be excess reserve, and banks would be able to increase their loans to the non-bank public by $10,000 instead of only $9,000.  The end result would be as depicted in Figure 6.4.

Figure 6.4: Secondary Effects of a $1,000 Loan by the Fed.
Federal Reserve
Assets			Liabilities
Loans to Banks		+$1,000	Reserve Deposits		+$1,000
Commercial Banks
Assets			Liabilities
Reserve Deposits		+$1,000	Bank Deposits		+$10,000
Bank Loans		+$10,000	Loans from Fed		+$1,000
Non-Bank Public
Assets			Liabilities
Bank Deposits		+$10,000	Bank Loans		+$10,000

Again, if the Fed had reduced its loans to banks by $1,000 instead of increased its loans by this amount all of the signs in Figure 6.4 would be reversed.

Roaring Twenties and Great Depression

While the Federal Reserve was able to solve the seasonal demand for currency problem that had plagued the National Banking System, it was not able to solve the financial crisis problem that it was hoped it would solve.  The inadequacy of the Federal Reserve in this regard became painfully obvious as the economy worked its way through the Roaring Twenties and into the Great Depression of the 1930s. 

As was noted in Chapter 4, the 1920s began with a minor recession in 1920-21, and then a speculative bubble in the real estate market began in 1921 and burst in 1926.  (White)  This real estate bubble was superseded by a speculative bubble in the stock market which began in 1926 and burst in October of 1929.  As real estate and stock prices fell the economy went into a recession, asset prices fell, debtors defaulted on their loans, and a banking crisis began in the fall of 1930 that didn't reach its climax until 1933 when some 5,190 banks went under in that year alone. 

As this drama unfolded it became impossible for the Federal Reserve to resolve the situation by simply providing cash to sound banks in order to save them while allowing unsound banks to go under.  Even though the Fed was able to deal with the liquidity problems of banks in meeting the demands of their depositors during the crisis, it was powerless when it came to dealing with the solvency problems of banks that developed during the crisis.  The problem was not that sound banks needed cash to meet their depositor’s demands for currency.  The problem was that the forced sale of assets throughout the system caused asset prices to fall, which, in turn, caused the value of the collateral underlying bank loans to fall below the value of the loans that had been made.  This drove otherwise sound banks into insolvency, and banks became unsound faster than they could be saved.   The result was the downward spiral described in Chapter 4 that led to the Great Depression of the 1930s. (Fisher Keynes Kindleberger)

The experience of the 1920s also revealed a number of serious deficiencies in the way the Federal Reserve was organized.  Because of the inherent mistrust of government in the United States at the time the Federal Reserve was founded, there was a determined effort to decentralize power within the Federal Reserve System.  Toward this end, the Federal Reserve was created as a voluntary, quasi private institution owned by the member banks, that is, by the banks that choose to join the Federal Reserve System.  Instead of creating a single bank, the country was broken up into twelve banking districts, each of which was given its own Federal Reserve Bank.  Each Federal Reserve Bank was governed by a nine member board of directors, six of which were elected by the member banks in its district and the remaining three were appointed by a seven member Federal Reserve Board that was established to oversee the system as a whole.  The Secretary of the Treasury and Comptroller of the Currency served on the Federal Reserve Board ex officio and the remaining five members were appointed by the President and confirmed by the Senate.  This arrangement insured that the individual Federal Reserve banks would be dominated by the member banks rather than by the federal government. 

In addition, even though the government appointed Federal Reserve Board was established to oversee the system as a whole, the lines of authority and responsibility between the board and the district banks were not clearly drawn.  As a result, there was no central authority within the system, and it was impossible for the Federal Reserve to pursue a unified or coherent national policy in the absence of a consensus since each of the twelve Federal Reserve district banks were free to follow their own lending and open market policies irrespective of the policies of the other district banks or those of the Federal Reserve Board.  (Meltzer)

To make things worse, there were few provisions in the original Federal Reserve Act that allowed the Federal Reserve to regulate or control the kinds of behavior on the part of financial institutions that inevitably lead to financial crises.  The focus of the act was on providing an elastic currency within the context of a decentralized system rather than on regulating or controlling the behavior of financial institutions as such. 

All of these factors combined to make it impossible for the Federal Reserve to curb the speculative behavior in the real estate and stock markets that led to the Crash of 1929 and, in fact, made it virtually inevitable that the Fed would finance the increase in debt that occurred during the 1920s that ultimately lead the country through a downward spiral of defaults and into the Great Depression of the 1930s. (Fisher Keynes Friedman Kindleberger Meltzer Eichengreen Bernanke)

The Curse of Prosperity

The problem of financial crises arises from the very nature of the financial system itself, starting with the fact that the financial system is, by its very nature, inherently unstable. As was explained in Chapter 5, during periods of economic growth and prosperity the temptation to allow cash reserves to fall and to increase leverage is irresistible for many financial institutions. In this situation we find that poorly managed financial institutions, by the very fact that they are poorly managed, tend to underestimate the risks of economic instability as they see the road to riches in increasing their leverage and in financing projects that pay the highest expected rates of return. Those projects inevitably turn out to be the most speculative projects that are the most at risk from economic instability. To make matters worse, as was explained in Chapter 4, there are powerful incentives for financial institutions to finance these projects since huge fortunes can be made by those who facilitate and are able to take advantage of the speculative bubbles that are created by this kind of speculative activity.

In addition, while most people are honest, many are not.  In an unregulated or poorly regulated financial system opportunities for fraud abound, and no other sector of the economy has the potential for illicit gains as does the financial sector.  (Black Fisher Phillips) It is no accident that the most notorious fraud of all time was perpetrated by Charles Ponzi—the man for whom the Ponzi scheme was named—during the unregulated era of the Roaring Twenties or that the greatest Ponzi scheme of all time was perpetrated by Bernie Madoff during the recent period of deregulation.  Nor is it a coincidence that the frauds of Charles Keating, Michael Milken, Ivan Boesky, Jeff Skilling, Ken Lay, Andy Fastow, and Bernie Ebbers occurred during this latter period.  As these individuals and countless others have shown, fortunes can be made in the financial sector by people who fraudulently game the system, and this fraud is most dangerous when it involves banks.  Given the banking system’s ability to increase the amount it can borrow as it increase the amount it lends and the fact that a substantial portion of the banking system’s liabilities, namely its checking accounts, are payable on demand, the banking system is particularly vulnerable to a run that can bring down the entire system like a house of cards.

This danger is particularly acute during prosperous times when highly leveraged, poorly and fraudulently managed banks can earn more money than moderately leveraged well managed banks. In this situation poorly/fraudulently managed banks can offer higher rates of interest to their depositors. This gives them a short-term competitive advantage in the market for bank deposits. At the same time, this situation presents a dilemma to the well managed banks. If they do not follow the lead of the poorly/fraudulently managed banks by matching the increases in interest on their deposits the well managed banks will lose deposits to poorly/fraudulently managed banks. What's more, if they do match these increases they will lose money unless they also abandon their reluctance to increase their leverage and finance the kinds of riskier speculative projects being financed by the poorly managed banks. (Black Fisher Phillips) As a result, the very existence of the well managed banks is threatened in this situation if they fail to follow the lead of the poorly/fraudulently managed banks.[6.2]

In addition, there are powerful psychological and social pressers that come to bear on those who try to run a well managed bank in this situation.  When others are making fortunes through what seem to be unsound competitive practices that threaten your bottom line, it is exceedingly difficult to risk being wrong on your own in standing up and going against the tide.  It is much easier to follow the crowd and risk going down together.  As was noted by John Maynard Keynes some seventy-five years ago

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him. (Keynes)

All of this feeds the speculation that leads to bubbles where prices are bid up to unsustainable levels and then fall precipitously as the markets crash.  This situation is similar to the effect on competitors when an ordinary business recklessly cuts prices and bids up the costs of resources, but the analogy ends here because there are two fundamental differences between ordinary businesses and banks.

First, unlike an ordinary business, when a poorly or fraudulently managed bank underestimates the risks of economic instability, leverages itself to dangerous levels, and increases interest rates on its deposits thereby inducing its competitors to follow suit it threatens the stability of the entire financial system.  If the bank is a particularly large or important bank, or if a relatively large number of its competitors are driven out of business, it can cause depositors to lose confidence in the system itself, and the ensuing panic can bring down the entire financial system as depositors try to get their money out of the banking system. 

Second, no other sector of the economy is as intricately intertwined with the entire economic system as is the financial sector in which banks play a central role.  When this sector falters in the wake of a bursting speculative bubble it puts the entire economic system at risk.  We don’t have to imagine a situation in which the financial difficulties of banks in an unregulated or poorly regulated financial system can bring down the entire economy.  This has proved to be the inevitable result throughout the history of banking and around the entire world whenever a banking system has been caught up in this kind of situation.  (Reinhart Rogoff Kindleberger MacKay Skidelsky 1819 1837 1857 1873 1893 1907 Friedman Galbraith)

Reforming the System

In 1932 the Senate Committee on Banking and Currency set out to investigate the cause of the developing depression. This investigation became known as the Pecora Commission after its chief counsel, Ferdinand Pecora. Pecora exposed massive levels of fraud, corruption, conflicts of interest, and incompetence on Wall Street which led to a public outcry for government regulation of the financial sector.  (Moyers Galbraith) The result was passage of the Glass-Steagall Act of 1933 which created the Federal Deposit Insurance Corporation (FDIC) and required the separation of commercial from investment banking and insurance to eliminate conflicts of interests that had fostered corruption in the markets for securities.  In addition, the Banking Act of 1935 centralized control of the Federal Reserve System in the Federal Reserve Board.  (Bernanke)  The Federal Reserve Board was also symbolically renamed the Board of Governors of the Federal Reserve System in the Banking Act of 1935, and the Board of Governors was reconstituted as its ex officio members were replace by members appointed by the president and confirmed by the Senate. 

At the same time, the legal authority to implement Federal Reserve policy was taken out of the hands of the individual Federal Reserve district banks and vested in a newly created Federal Reserve Open Market Committee (FOMC) made up of the seven members of the Board of Governors and five of the presidents of the individual Federal Reserve district banks.  The five presidents serve on a rotating basis except for the president of the New York Federal Reserve Bank who, because of the importance of New York City to the financial system, was given a permanent seat on the FOMC.  In addition, the Fed was given enhanced power to regulate and control speculative activities within the financial system.  It was given the power to set margin requirements on loans collateralized by shares of stock, for example, and to intervene in other financial markets as the need arose.

The point of this legislation was to provide a comprehensive system of government regulation designed to prevent financial crises before they began.  At the heart of this system was the FDIC insurance of bank deposits designed to prevent runs on banks.  While deposit insurance may prevent runs it cannot eliminate financial crises because it does nothing to keep poorly or fraudulently managed banks from overextending themselves.  Toward this end, the kinds of loans banks were allowed to make were were severely restricted as was the amount of money a bank was allowed to loan to a single customer.

To prevent poorly/fraudulently managed banks from having a competitive advantage over well managed banks in competing for deposits, banks were prohibited from paying interest on demand deposits (i.e., checking accounts), and the maximum interest rates banks were allowed to pay on time deposits (i.e., savings accounts) was set by the Fed. These rules were designed to protect the public and taxpayers (by way of the FDIC) from reckless and fraudulent behavior on the part of banks.  And to make all of this work, a comprehensive regulatory and supervisory system was put in place to ensure that banks were following the rules set down by the Fed and not gaming the system to get around the rules.

A similar regulatory system was put in place for thrift institutions such as savings and loan associations via the Federal Home Loan Bank Act of 1932 which created the Federal Home Loan Banking System (FHLB) that regulated savings and loan associations and the National Housing Act of 1934 which created the Federal Savings and Loan Insurance Corporation. (FSLIC)

From the 1930s through the 1960s policy makers took a decidedly pragmatic view of financial regulation in reining in the speculative and fraudulent urges of the financial sector.  Haunted by the specter of the Great Depression, they strengthened the regulatory system as the need arose.  The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC) to regulate investment banks and the stock exchanges in order to crack down on fraud and corruption in the securities markets.  Publicly traded corporations were required file disclosure statements with the SEC to make public important information about their firms subject to both civil and criminal penalties for false or misleading statements or for important omissions.  Insider trading was also outlawed as were the stock manipulation practices such as front running, disseminating false information, and artificially trading a security to mislead investors. 

The Maloney Act of 1938 amended the Securities Exchange Act to create Self Regulating Organizations (SROs) to provide direct oversight of securities firms under the supervision of the SEC and provided for the regulation of the Over-The-Counter (OTC) market for securities. The SEC was also authorized to impose its own capital requirements on securities firms, and in 1944 the SEC exempted from its capital rule any firm whose SRO imposed more comprehensive capital requirements.

In 1940 Congress passed the Investment Company and Investment Advisers Acts which brought mutual funds under the purview of federal regulation, and in 1956 the Bank Holding Company Act was passed restricting the actions of bank holding companies.  The International Banking and Financial Institutions Regulatory and Interest Rate Control Acts were passed in 1978 to bring foreign banks within the federal regulatory framework and to establish the limits and reporting requirements for bank insider transactions.   (RiskGlossary)

This regulation was designed to break the boom and bust cycle in the financial sector of the economy—which inevitably led to a boom and bust cycle in the economy as a whole—by prohibiting the kinds of reckless and irresponsible speculative and fraudulent practices that inevitably lead to insolvency on the part of poorly and fraudulently managed banks and drove many responsibly managed banks out of business and the system into crises.  What's more, these measures actually worked for over fifty years to accomplish this end. Unfortunately, things began to change in the 1970s and 1980s as attitudes toward government regulation of the economic system began to change. 

Endnotes

[6.1] While this mechanism is quite simple in principle, it is somewhat more complicated in practice.  The Federal Reserve System is a voluntary organization, and not all banks are members of the system.  Prior to 1980, the Fed only set the reserve requirement for member banks, that is, for banks that chose to become members of the Federal Reserve System.  Reserve requirements for nonmember banks were set by the states in which the nonmember banks were chartered.  In addition, there are different reserve requirements for different kinds of deposits, e.g., time deposits (savings accounts) have lower reserve requirement ratios than demand deposits (checking accounts).  What's more, the amount of currency banks held in their vaults (i.e., vault cash) was not considered to be part of reserves from 1917 to 1959.  To simplify the exposition in what follows these considerations are ignored and it is assumed there is only one reserve requirement ratio that applies to all deposits and that vault cash is part of reserves.  See Feinman for a history of the way reserves and reserve requirements were determined from the nineteenth century through the early 1990s.

[6.2] The nature of the problem here was succinctly put by Charles Prince, former CEO of Citigroup, in his infamous and much maligned comment in the Financial Times: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”  (See Reuters)

As memories of the Great Depression faded, an antigovernment movement began to take hold in the United States led by a group of people who possessed an abiding faith in the efficacy of free markets to solve all economic problems.  This movement became the foundation of the Conservative Movement in the 1960s and, in turn, provided the ideological foundation of the Republican Party in the 1970s.  Their mantra of lower taxes, less government, and deregulation combined with disdain for government has dominated the political debate ever since.  These ideas were in the forefront of the Reagan Revolution that began with the election of Ronald Reagan in 1980, and, as was noted in Chapter 4, they were embraced by the Democratic Party in the 1990s.  They reached a crescendo in the 2000s after the Republican Party took control of both the Whitehouse and Congress in 2000.  (Harvey Frank Amy Westen Altemeyer)  

The success of the Conservative Movement over the past thirty years in undermining the regulatory framework setup in response to the disaster that followed in the wake of the Crash of 1929 has been phenomenal—not only in passing legislation that deregulated our financial institutions but in reducing the funding for regulatory agencies and in fostering a non-enforcement attitude toward existing regulations as well.  At the same time, changes took place in our financial system that made what was left of our regulatory system in the early 2000s essentially unworkable.

Deregulation in the 1980s

It was clear in 1980 that thrift institutions (i.e., savings banks and savings and loan associations) were in serious trouble as a result of the rise of Money Market Mutual Funds (short-term mutual funds with all of the characteristics of a savings account) and Cash Management Accounts (money market funds that allowed customers to withdraw their funds by writing a check) in the 1970s.  Even though these funds were uninsured, the high interest rates in the late 1970s caused by the high rate of inflation during that era allowed money market funds to invest directly in Treasury securities backed by the full faith and credit of the federal government as well as in highly rated corporate debt and still pay a higher rate of interest to investors than was available on the regulated accounts at banks.  Thus, given the high quality of their investments, money market funds did not have to be insured to compete directly with the insured deposits of banks, and the resulting loss of deposits to money market funds put depository institutions in a serious bind. 

At the same time there was a second change in the financial system that was having a negative effect on banks, namely, the development of the market for Repurchase Agreements—a collateralized loan agreement wherein the borrower sells a security to a lender with the understanding that the borrower will buy it back (i.e., repurchase it) on a specific date at a higher price, the difference in price being the interest earned by the seller/lender.  (FRBNY FDIC) 

The market for repurchase agreements (and money market funds to the extent they invested in short-term corporate debt) competed directly with banks for their short-term loans.  This was so because the existence of an efficient market for repurchase agreements gave large depositors at banks the choice of leaving their unused balances in non-interest earning checking accounts or earning a return on these balances by lending them out for short periods of time, even as short as overnight, in the repurchase market.  Borrowers in these markets, thus, had a choice of borrowing for short periods of time either from a bank or from its depositors. 

By 1980 it was felt that something had to be done about money market funds and repurchase agreements—that either these markets had to be regulated in such a way as to keep them from competing with banks, or banks had to be deregulated.  In the deregulatory spirit of the times, this led to passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) which authorized Negotiable Order of Withdrawal (NOW) and Automatic Transfer System (ATS) accounts that effectively allowed banks to pay interest on their checking accounts and write checks on their savings accounts.  At the same time DIDMCA provided a mechanism by which interest rate ceilings on time deposits (savings accounts and certificates of deposit) would be phased out by 1986, and there was an expansion in the kinds of loans and investments that thrifts were allowed to make.  This act also increased the insurance on deposits from $40,000 to $100,000.  (FDIC)

While this act allowed banks, in effect, to pay interest on their checking accounts and write checks on their savings accounts, and, thus, to compete with money market accounts for deposits, it left the repurchase agreement market completely unregulated and the money market funds almost so, and it did little to solve the immediate problem of these institutions drawing off funds from banks, especially thrifts.  Thrifts held long-term assets, mostly mortgages, that paid fixed rates of interest.  They could not increase the interest rates on their deposits to match the rates offered by money market funds without losing money.  At the same time, when market rates go up, the value of assets that pay fixed rates of interest go down.  Thus, as thrifts lost deposits to money market funds they were forced to sell off their long-term assets at a loss to fund the withdrawals of their depositors.   

By 1982 thrifts were in serious trouble as a result of the economic recession and the high interest rates caused by the anti-inflationary policies of the Fed.  In response the Garn–St. Germain Depository Institutions Act of 1982 was passed to further deregulate banks.  This act lessened the capital and reserve requirements of banks; provided mechanisms to assist failing banks rather than closing them; accelerated the phase out of interest rate ceilings, and further expanded the kinds of loans and investments thrifts could make so as to allow them to become more like commercial banks that were fairing much better in the financial turmoil of the times than were thrifts.  (FDIC)  It also allowed banks to offer interest-only, balloon-payment, and adjustable-rate (ARM) mortgages.  In addition, in the years that followed, the Federal Reserve and the Comptroller of the Currency (the chief regulator of national banks) further relaxed the restrictions on the kinds of loans banks could make and allowed the non-bank subsidiaries of bank holding companies to buy and sell securities, such as derivatives, that they had previously been barred from holding.  (FCIC)

It was thought that increasing competition in the financial sector by allowing thrifts to become more like commercial banks and allowing thrifts and commercial banks greater flexibility in competing with mutual funds and in the market for repurchase agreements the system could be made stronger and more efficient.  All that was needed to bring this about was stable or declining interest rates to relieve the pressure on the solvency of thrifts.  Interest rates did continue to decline as hoped, but, unfortunately, the deregulatory provisions of these two acts in the hands of the free marketeers of the Reagan Administration led to an unmitigated disaster. 

The free-market philosophy of Reaganomics called for less government intervention in the market place.  The idea was to get the government out of the way and just let the market sort things out as these institutions competed their way out of the problems they were in.  The result was a reduction in the budgets and staffs of the regulatory agencies.  This led to less examinations and regulatory supervision at these institutions at a time when the thrift institutions were in financial difficulty and attempting to expand their operations into new areas.  (FDIC Black)

As was noted in Chapter 1, the result was the savings and loan crisis that began in the late 1980s—the first financial crisis to hit the United States since the Crash of 1929.  In the end, some 1,300 savings institutions failed, along with 1,600 banks, a total that, ironically, was greater than the 2,800 institutions newly chartered under the policy that led to this crisis.  In addition, some 300 fraudulently run savings and loans that were nothing more than Ponzi schemes failed at the peak of this disaster, over a thousand individuals associated with the savings and loan debacle were convicted of felonies, and it costs the American taxpayer $130 billion to clean up the mess.  In addition, this financial crisis was a precursor to the 1990-1991 recession.  (Black FDIC Krugman Akerlof Stewart)

The decision to deregulate the banking system in the face of the competition from money market funds and the markets for repurchase agreements in the early 1980s, rather than to expand the regulatory system to bring these funds and markets under the umbrella of the existing regulatory system, had profound effects on the financial system that went far beyond the savings and loan crisis.  In understanding these effects it is instructive to review how financial markets are organized and to examine the kinds of instruments that are traded in these markets.  It is also necessary to look at the role collateralization plays in today’s financial system.

Financial Markets and Instruments

The financial system is generally broken down into two markets:  The capital market which is concerned with long-term financing for periods of more than a year and the money market which is concerned with short-term financing for periods less than a year. 

The Capital Market

Stocks, bonds, and mortgages are sold in the capital market where Stocks are certificates of ownership of a corporation that give the holder a say in the management of the corporation and a right to its equity and profits.  More simply put, the stock holders are the owners of the corporation. 

A bond is a financial instrument that defines the terms on which the issuer—a government or a corporation—agrees to borrow money.  A bond generally has 1) a face value that defines how much the issuer (borrower) will pay the holder (lender) when the bond matures, 2) a maturity date that defines when the issuer will pay the holder the face value of the bond, and 3) an amount of interest and the terms, usually quarterly or biannually, on which interest will be paid to the holder of the bond. 

Bonds may or may not be backed by collateral.  If a bond is backed by collateral it is a collateralized bond and the bondholder has a right to the collateral in the event the issuer defaults, that is, fails to live up to the terms of the bond.  If a bond is not backed by collateral it is an uncollateralized bond.  In the event of a bankruptcy the holder of an uncollateralized bond has a claim against whatever is left over after the collateralized creditors have claimed their collateral.  Stock holders, being the owners of the corporation, are entitled to whatever is left, if anything, after all of the creditors are paid. 

A mortgage loan is essentially a collateralized bond where the collateral is real estate owned by the issuer of the mortgage. 

The Money Market

There are a number of financial instruments—generally referred as "paper"—that are bought and sold in the money market, the most important being:

1. Brokered Certificates of Deposit which are fixed term time deposits issued by banks and sold by brokers such as Merrill Lynch.

2. Repurchase Agreements which are collateralized loan agreements wherein, as was noted above, the borrower sells a security to a lender with the understanding that the borrower will buy it back (i.e., repurchase it) on a specific date at a higher price, the difference in price being the interest earned by the lender.  If the borrower defaults the lender can keep or sell the security.

3. Commercial Paper which are promissory notes (i.e., IOUs) that may or may not be collateralized, issued by corporations with strong credit ratings.  If the borrower defaults the lender has a right to the collateral if the paper is collateralized.  Otherwise the lender is a lesser creditor in the event of bankruptcy. 

4. Bankers' Acceptances which are a promise of a bank to pay a specified amount of money to the holder at a specified time and are generally used in international trade as a way to guarantee payment by a third party upon delivery;

5. Treasury Bills which are short-term government bonds with a maturity date less than a year.

6. Federal Funds which are the borrowing and lending of reserves between banks. 

Importance of Collateralization

Before the development of markets for collateralized financial instruments, most long-term financing was obtained in the bond market by issuing uncollateralized bonds or through the mortgage market by obtaining a mortgage loan directly from a bank or an insurance company.  By the same token, most short-term financing was obtained by borrowing directly from a bank. 

As a result, virtually all financing was obtained in highly regulated markets from lenders who had a powerful incentive to examine carefully the credit worthiness of the borrower.  In the case of uncollateralized bonds and unsecured loans, if the borrower defaulted and filed for bankruptcy the lender would get only what was left after the secured creditors claimed their collateral.  In the case of mortgage loans, the lender would get the property secured by the mortgage, but there were costs involved, and if the value of the property fell the mortgagee stood to lose.  In addition, the SEC, Fed, FDIC, and state banking and insurance agencies provided stability to these markets by overseeing them to prevent, as much as possible, recklessness and fraud on the part of borrowers and lenders. 

With the rise of collateralized financial instruments the structure of the financial markets changed—at first gradually in the 1970s and 1980s and then explosively in the 1990s and 2000s. 

Before the development of these instruments relatively few borrowers had access to the money market other than through a bank because lenders were unwilling to lend in this market to any but the most credit worthy borrowers.  The reason was the lenders in this market were forced to take a close look at the creditworthiness of the borrower before they made a loan since they were unsecured creditors and at risk of a serious loss if the borrower defaulted.  Only banks had the kind of personal contact with their borrowers to effectively evaluate the creditworthiness of most borrowers. 

When the loan was collateralized the focus shifted from the creditworthiness of the borrower to the quality of the collateral since the fact that the loan was collateralized meant the potential loss to the lender in the event of a default was reduced by the value of the collateral underlying the loan.  The development of collateralized financial instruments gave lenders a greater feeling of confidence in making short-term loans to borrowers they had shunned in the past because it was much easier, or so it seemed, to evaluate the value of the collateral underlying these loans than to evaluate the creditworthiness of a borrower that the lender did not know personally.  This allowed borrowers to have access to the short-term money market that had never had access to this market before, and it allowed them to finance their operations in ways not available to them before. 

For example, before the development of the market for collateralized commercial paper finance companies had to go to the capital market or a bank to borrow in order to relend to its customers.  With the development of the market for collateralized commercial paper these companies had the option of setting up a company referred to as Special Purpose Vehicle (SPV) for the specific purpose of providing a conduit to secure financing in the Asset-backed Commercial Paper (ABCP) market.  They did this by selling their loan contracts to the SPV (Special Purpose Vehicle) which, in turn, put these assets in a trust pledged as collateral against the commercial paper issued by SPV.  The SPV's commercial paper could then be sold in the ABCP market and the proceeds used to pay the finance company for the loan contracts.  What's more, the finance companies discovered that the shorter the term of the collateralized commercial paper the SPV issued, the lower the interest they had to pay.  This meant they had to roll over their debt more often—that is, issue new paper to pay off their old paper as it came due—but they could make more money by financing their operations by going to the money market in this way than by going to banks or the capital market.

Not only did finance companies find they could increase their profits by financing their operations in the money market, private investment companies—better known as hedge funds—also found that they could increase their profits by going to the money market as well.  Before the advent of the market for repurchase agreements, hedge funds were limited in their investments by their owners' funds and whatever funds they could obtain in the capital market through the sale of uncollateralized bonds and what they could borrow from banks.  With the market for repurchase agreements they found they could fund their operations by entering into repurchase agreements for the assets they purchased, and, in so doing, they could borrow more than they were previously able to borrow and at lower rates of interest—again, the shorter the term of borrowed funds, the lower the interest they had to pay.  This meant they also would have to roll over their debt more often, but, again, they could make more money by financing their operations this way than by going to banks or the capital market.

In addition to finance companies and hedge funds, investment banks such as Bear Stearns, bank holding companies such as Citigroup, and non financial companies such as Enron and Global Crossing found it profitable to create their own conduits to the short-term money market to fund their operations.  These conduits took the form of SPVs that had two things in common with the examples given above:  The first is that they made it possible to take advantage of the money market to secure short-term financing for long-term assets.  The second is that since SPVs are not publicly traded companies and are not banks, they are outside the purview of the SEC and bank regulators.  This second point is particularly relevant to bank holding companies and investment banks because they were allowed to structure their conduits in such a way as to take their long-term assets and the mechanism by which these assets were financed off their books and thereby avoid the scrutiny of their regulators.  It was also particularly relevant to companies like Enron and Global Crossing, and for the same reason except it was the scrutiny of their creditors and stockholders these companies were able to avoid.  

The Shadow Banking System

Money market funds, hedge funds, finance companies, investment banks, and bank holding companies are part of what is referred to as the Shadow Banking System because they operate in the same way banks operate in that they use short-term liabilities to fund long-term assets and they operate in the shadow of the regulatory system, so to speak, since they are less regulated that depository institutions and the SPVs they sponsored were beyond the reach of the financial regulators.  Since these institutions were less regulated than depository institutions, and there was no regulatory agency that oversees the SPVs that these institutions sponsor, the only limitation on the amount of leverage they and their SPVs can attain is the margin requirement placed on them by their creditors.  This requirement is referred to as the haircut in financial circles, and it is the difference between the value of a loan and the value of the collateral put up to secure the loan.  The margin (haircut) is generally expressed as a percentage of the collateral: A 5% margin means that the lender is willing to loan 95% of the value of the collateral. (Perotti)

The margin requirement limits the amount of leverage the borrower can obtain from a loan in that unless the borrower is able to fund the margin through some source of unsecured borrowing, the only way the margin can be financed is through the borrower's equity.  If, for example, the margin is 20% the lender will only lend 80% of the value of the collateral underlying the loan.  Since the other 20% of the collateral's value must be financed through the borrower's equity (assuming the borrower cannot obtain unsecured credit elsewhere) this limits the leverage created by the loan to 4 to 1.  (80%/20%)  By the same token, if the margin is 3% the leverage of the loan will be 32 to 1.  (97%/3%) 

The margin requirement also determines the extent to which the shadow banking system is, in effect, able to finance the amount of money it can borrow as a result of the amount of money it lends.  This is so because when a shadow bank purchases a security for $1,000 it is, in effect, lending that $1,000.  The margin determines the amount of that $1,000 the non-shadow banks are willing to lent back to the shadow banking system—the smaller the margin, the larger the amount the non-shadow bank institutions will be willing to lend back and the larger the amount of borrowing the shadow banking system will be able to finance as a result of its own lending. 

The process by which shadow banks increase the amount they can borrow by increasing the amount they lend is somewhat different than the way this is accomplished by ordinary banks, but the end result is the same.  When a non-shadow bank makes a loan it does not know how much of the loan the non-bank public will return to the banking system through an increase in deposits and how much will leave the banking system (the margin) through an increase in currency in circulation.  In addition, there is no reason to expect that the proceeds of the loan will be spent and redeposited in the bank that made the loan.  It is most likely to be redeposited in some other bank.  The basic difference with a shadow bank is that a shadow bank negotiates the amount that will be lent back before it makes the loan, and this amount is, in effect, lent directly back to the shadow bank that makes the loan. 

In order to appreciate the way shadow banks fit into the financial system, consider a situation in which there is $100 billion in high-powered money in the economy, $80 billion of which is held as currency in circulation and $20 billion is held as reserves in the banking system.  If the reserve and capital requirements are 10% and there is $20 billion worth of equity in the banking system, the $20 billion worth of reserves can be lent and redeposited in banks10 times until there are $200 billion worth of loans and deposits in the banking system in the manner indicated in Figure 7.1.[7.1] 

Figure 7.1: Loans and Deposits in Commercial Banks.
Assets		Liabilities
Reserves	$20	Deposits	$200
Loans	$200	Net Worth	$20
10% reserve and capital requirements Loans financed through short-term borrowing = $200

be able to expand their deposits by expanding their loans.  The leverage in the banking system that comes from bank deposits will be10 to 1 ($200/$20) in this situation, and there will be $200 billion of relatively long-term loans financed by $200 billion worth of short-term deposits.

Now assume a shadow banking system exists that has $10 billion worth of equity and that shadow banks are able to borrow at a 5% margin through the use of repurchase agreements.  This means the shadow banks can expand the amount of money they are able to lend through the purchase of securities to $200 billion by borrowing $190 billion.  This situation is depicted in Figure 7.2.

 

Figure 7.2: Loans, Deposits, and Repurchase Agreements.
Commercial Banks
Assets			Liabilities
Reserves		$20	Deposits		$200
Loans		$200	Net Worth		$20
Shadow Banks
Assets			Liabilities
Securities		$200	Repurchase Agreements		$190
			Net Worth		$20
10% reserve and capital requirements, 5% margin Long-term assets financed through short-term borrowing = $390 Short-term Leverage: Banks =10, Shadow Banks = 19, System = 13

The amount of high-powered money in the system is unchanged by the introduction of a shadow banking system, and the amount of currency in circulation, deposits, and bank loans are unchanged as well, but the total amount of loans financed through short-term borrowing has increased from $200 billion to $390 billion as a result of the additional $190 billion of borrowing.  In addition the leverage in the system that is created by short-term financing has increased from 10 to 1 to 13 to 1 ($390/$30) as a result of the 19 to 1 ($190/$10) leverage in the shadow banking system. 

Similarly, if the shadow banks can borrow at a 3 1/3% margin the situation will be as in Figure 7.3 where the shadow banks will be able to increase their holdings of securities to $300 billion.  The total amount of lending in the system that is financed by short-term financing will be $490 billion, and the leverage created by this kind of financing will be 16 to 1 ($490/$30) as a result of the 29 to 1 ($290/$10) leverage in the shadow banking system.

Figure 7.3: Loans, Deposits, and Repurchase Agreements.
Commercial Banks
Assets			Liabilities
Reserves		$20	Deposits		$200
Loans		$200	Net Worth		$20
Shadow Banks
Assets			Liabilities
Securities		$300	Repurchase Agreements		$290
			Net Worth		$10
10% reserve and capital requirement, 3 1/3% margin Long-term assets financed through short-term borrowing = $490 Short-term Leverage: Banks =10, Shadow Banks = 29, System = 16

Finally, it should be noted that if shadow banks are able to obtain an additional $10 billion of capital by way of unsecured loans the shadow banks will be able to expand their loans by an additional $300 billion as a result of this additional capital as in Figure 7.4. The total amount of loans financed through short-term borrowing and unsecured loans will increase to $780 billion; the leverage of the shadow banks will increase to 49 to 1 ($490/$10), and total leverage in the system created by short-term and unsecured financing will increase to 23 to 1 ($690/$30). 

Figure 7.4: Loans, Deposits, and Repurchase Agreements with Unsecured Credit.
Commercial Banks
Assets			Liabilities
Reserves		$20	Deposits		$200
Loans		$200	Net Worth		$20
Shadow Banks
Assets			Liabilities
Securities		$500	Repurchase Agreements		$480
			Unsecured Loans		$10
			Net Worth		$10
10% reserve and capital requirement, 3 1/3% margin Long-term assets financed through short-term borrowing = $490 Short-term Leverage: Banks =10, Shadow Banks = 29, System = 16

It is worth noting that a 2% decrease in asset prices would wipe out the net worth of the shadow banking system in this situation, and a 4% decrease would wipe out the net worth of the entire financial system.

At this point, the threat the shadow banks pose to the financial system and, indeed, to the economic system as a whole should be obvious.  Shadow banks finance their operations in the same way banks finance their operations, and shadow banks are subject to the same kinds liquidity and solvency problems that banks are subject to.  They are also subject to the same kinds of temptations to expand their leverage and to fund the same kinds of speculative activities that have wrought such havoc with the economic system throughout the history of banking. 

At the same time, shadow banks function outside the financial regulatory system.  Their short-term creditors are not insured by the FDIC.  They cannot borrow from the Federal Reserve, and, as a result, they are extremely vulnerable to the kind of irrational panic that leads to a run.  There is no lender of last resort that can meet their needs in the midst of a crisis.  The only way they can meet the demands of their creditors in the face of a run is by selling their assets, and if they are forced to sell their assets in the midst of a crisis the prices of their assets are susceptible to the same kind of downward spiral the assets of Nineteenth Century banks were susceptible to—the kind of downward spiral that followed the Crash of 1929 and led to the Great Depression of the 1930s. 

In addition, shadow banks are not constrained by the amount of high-powered money in the economy.  They have no use for currency, either in the form of vault cash or as a deposit at the Federal Reserve, and the amount of high-powered money in the economy does not constrain the amount of long-term lending they can finance through short-term borrowing.  As is indicated in the examples illustrated in Figure 7.1 through Figure 7.4 above, shadow banks can expand their lending even when reserves, deposits, and currency in circulation are fixed.  The only constraint on their lending is their equity, the amount of unsecured credit they are able to obtain, and the margin imposed by their creditors on repurchase agreements.

This would not be much of a problem if these institutions were relatively small and played a minor role in the financial system, but, as was noted above, and as is indicated in Figure 7.5, the growth of shadow banks was explosive in the 1990s and 2000s.  The shadow banking system was, in fact, significantly larger than the traditional banking system by 2007 when the financial system began to breakdown.  The asset-backed commercial paper issued by these institutions amounted to some $2.2 trillion in 2007, and the amount of money shadow banks financed overnight with repurchase agreements stood at $2.5 trillion.  The assets held by hedge funds had grown to $1.8 trillion, and the assets held by investment banks had grown to $4 trillion—a major portion of which was financed through repurchase agreements.  These numbers are to be compared to the total value of all of the assets held by the entire traditional banking system in 2007 which stood at $10 trillion.  (Geithner)  As is indicated in Figure 7.5, Shadow banks held well over $12 trillion dollars worth of assets in 2007.

Source: Financial Crisis Inquiry Report.

Far from being relatively small and playing a minor role in the financial system in 2007, shadow banks were huge and played a major role in this system.  Shadow banks were the major borrower in the market for repurchase agreements, and the lenders in this market were pension funds, money market funds, mutual funds, large corporations, banks, insurance companies, local governments, and any other large institution that had excess cash in the bank on which it wanted to earn a return for a few days or weeks or even just overnight.  Shadow banks owed money to literally everyone when the housing market reached its peak in 2006 and the system began to unravel in 2007.  Anyone vested in a pension plan or who owned a mutual fund, a money market account, an insurance policy, or stock in a large corporation or bank was owed money by shadow banks when the run on the system began in the summer of 2007. 

Endnote

[7.1] It should be noted reserve and capital requirements are not the same thing, and there is no reason the two requirements should be equal in the real world.  A 10% capital requirement means that banks must have equity equal to at least 10% of their assets.  A 10% reserve requirement means that banks must have reserves equal to at least 10% of their deposits.  Capital requirements limit assets and are designed to enhance the solvency of banks.  Reserve requirements limit deposits (a liability) and are designed to minimize the liquidity problem of banks.  In addition, just as there are different reserve requirements for different kinds of deposits, there are different capital requirement for different kinds of assets. 

The only reason it is assumed in this hypothetical example (and in the examples that follow) that the reserve and capital requirements are equal is to simplify the exposition in order to bring out the basic principles involved.  See Feinman for a discussion of how reserve requirements are determined.  The determination of capital requirements is explained in the 2002 Rule promulgated on November 29, 2001 by the OCC, FRS, FDIC, and OTS.

 

Where Did All The Money Go?

Chapter 8: Securitization, Derivatives, and Leverage

George H. Blackford © 2009, last updated 5/1/2014

 

Securitization is a process by which illiquid assets—that is, assets that cannot be easily sold and, hence, converted into cash in a timely manner without a significant reduction in price—are converted into liquid assets that can be quickly sold and converted into cash without a significant reduction in price.  We touched on the basics of securitization in Chapter 7 in our discussion of the way finance companies were able to gain access to the money market by setting up a Special Purpose Vehicle (SPV) to secure financing in the Asset-backed Commercial Paper (ABCP) market.  In so doing they were able to convert their illiquid assets (the loans made to their customers) into liquid assets (the ABCP issued by the SPV) that were easily sold in the money market. 

As was indicated in Chapter 7, the basic mechanism by which securitization is accomplished is fairly simple:

1. The originator of the securitization process creates a Special Purpose Vehicle (SPV) by forming a corporation (generally "off shore" in some country such as in the Cayman Islands to avoid regulation and taxes) for the purpose of purchasing the assets to be securitized.  The originator of this process is referred to as the sponsor of the SPV. 

2. The sponsor sells the assets to be securitized to the SPV. 

3. The SPV places these assets in a trust pledging the revenue from the assets as collateral for the securities issued by the SPV.  These securities are referred to as Asset-backed Securities (ABSs) and are either collateralized bonds or collateralized money market paper depending on whether their term to maturity is more than or less than a year. 

4. The proceeds from the sale of the securities issued by the SPV are used to pay the sponsor for the assets it sold to the SPV. 

Virtually all illiquid assets that generate an income stream have been securitized in this way since the 1980s including such things as automobile loans, credit card debt, accounts receivables, student loans, and residential and commercial mortgages, but of particular interest to us here is the securitization of mortgages.

Mortgage Backed Securities

Before 1938, home mortgages were highly illiquid assets, the reason being it is very difficult for a third party to judge the quality of a mortgage.  When a bank originates a mortgage it has a very good idea of the creditworthiness of the borrower, the quality of the real estate that is the collateral for the mortgage, and the characteristics of the neighborhood in which the real estate is located.  The further one gets from the bank that originated the mortgage the less one knows about these things.  As a result, the secondary market for mortgages—that is, the market in which existing mortgages are bought and sold—tended to be very local which made it difficult for people in smaller communities to obtain mortgages for the purpose of purchasing homes.

In 1938 the Federal National Mortgage Association (Fannie Mae) was created as a government agency to facilitate home ownership by providing a secondary market for government insured mortgages.  In 1968 Fannie Mae was privatized as a Government Sponsored Enterprise (GSE), and in 1970 the Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered as a GSE to provide a secondary market for non-government insured mortgages, and Fannie Mae was given this mission as well.  In the meantime the Government National Mortgage Association (Ginnie Mae) was created as a government agency to replace Fannie Mae in the market for federally insured mortgages.  Ginnie Mae is a government owned corporation within the Department of Housing and Urban Development (HUD), whereas, Fannie Mae and Freddie Mac are private corporations that were created by the government and then sold to the private sector. 

The GSEs and Ginnie Mae worked closely with mortgage originators, mostly banks and thrifts (i.e., savings banks and savings and loan associations), to maintain and improve underwriting standards (i.e., the standards by which loans are made) and were very successful in providing a nationwide mortgage market by purchasing mortgages from originators that met their underwriting requirements.  This, in turn, greatly facilitated home ownership throughout the country. 

Originally the GSEs financed their operations by selling uncollateralized bonds in the capital market to obtain the funds necessary to purchase mortgages from their originators, but in the 1970s they began securitizing the mortgages they purchased by sponsoring Special Purpose Vehicle and having their SPVs issue bonds collateralized by the revenues generated from the mortgages they had purchased.  The GSEs guaranteed the mortgages they sold to the SPVs they sponsored, and the bonds issued by their SPVs are referred to as agency Mortgage-Backed Securities or agency MBSs.

The GSEs dominated the secondary mortgage market through the 1990s, but in the 1980s private companies began securitizing mortgages as well.  The bonds issued by the SPVs sponsored by private companies are referred to as private-label Mortgage-Backed Securities or private-label MBSs.  Private securitizers—mostly investment banks, depository institutions, and mortgage banks—did not guarantee the mortgages they sold to their SPVs, and, as a result, private securitizers had to offer credit enhancements to minimize the interest rates they would have to pay on the MBSs they issued. 

One method of credit enhancement was to over collateralize the MBSs they issued so that the face value of the MBSs the SPV issued was below the face value of the mortgages held as collateral for their MBSs.  A second method was to provide an excess spread on the rate of interest received from the mortgages over the rate of interest paid on the MBSs so the amount of money taken in from the mortgages that collateralized their MBSs exceeded the amount the SPV was obligated to pay to bondholders.  However, the most important of these enhancements was subordination whereby the MBSs issued by the privately sponsored SPVs were structured in a hierarchy of tranches (a French word meaning slices) such that those MBSs in a lower tranche were subordinate to those in a higher tranche. 

The way subordination works is that the MBSs issued by the SPV are broken down into senior tranches which have first claim to the income received from the mortgages held by the SPV, junior tranches (also called mezzanine tranches) which have a claim to this income only after the MBSs in the senior tranches have been paid, and equity tranches (also called residual tranches) which are paid only after the MBSs in the senior and junior tranches have been paid.  This structure gives the MBSs in the senior and junior tranches protection against default on the mortgages held by the SPV in that the equity tranche has to be completely wiped out by mortgage defaults on the underlying mortgages before the income and principal payments available to service senior and junior tranches will be affected, and it gives even more protection to the MBSs in the senior trance as both the equity and junior tranches have to be wiped out before the income available to service the senior tranche will be affected. 

The way in which MBSs are structured is illustrated in Figure 8.1 which shows the structure of the CMLTI 206-NC2 offering sponsored by Citigroup in 2006.

Figure 8.1: Structure of the CMLTI 2006-NC2 MBS Offering.
Tranches	Amount*	Rating	% of Total	Cumulative %
Senior Investment Grade	$737.0	AAA	78.0%	78.0%
Junior Investment Grade	$97.5	AA	10.3%	88.3%
	$43.6	A	4.6%	92.9%
	$30.2	BBB	3.1%	96.0%
Junior Non- Investment Grade	$24.6	BB	2.6%	98.6%
Equity	$13.3	Not Rated	1.4%	100%
Total	$946.2		100%

Source: Financial Crisis Inquire Report, Security Exchange Commission.

*millions of dollars

This offering was backed by 4,499 mortgages with a principal value or $947 million, and was described as a “typical deal” in the final report of the Financial Crisis Inquire Commission.  As is shown in this figure, 78% of the MBSs in this offering were investment grade securities in the Senior Investment Grade tranche that were rated AAA by the rating agency Standard & Poor’s.  Another 18% were in the Junior Investment Grade tranches that were rated BBB or above, but less than AAA, which brought the total of the investment grade securities in this offering to 96%.  The 2.4% of the offering in the Junior Non-Investment Grade tranches that received a BB rating or below held a junk bond status, and the Equity tranches made up 1.4% of the offering.[8.1]

By structuring their offerings in this way, the sponsors of private-label Mortgage-Backed Securities were able to compete with the GSEs even though the sponsors of the private-label MBSs did not guarantee the mortgages that backed their MBSs.  As a result, private-label MBSs began to increase their share of the Mortgage-Backed Securities market dramatically in the 2000s, but there was a catch:  Virtually all of the demand was for the highest rated securities in the offerings, and there was relatively little demand for those that were lower rated.  (FCIC Smith)  This led to a problem. 

For securitization to work, all of the tranches in an offering must be sold.  Otherwise, there’s not enough money to purchase the collateral needed to make the offering viable.  When the lower rated securities can’t be sold elsewhere, the sponsor of the offering is forced to purchase them.  This limits the ability of the sponsoring institution to sponsor new offerings since its purchases from its previous offerings must be financed.  The ability to finance these purchases is limited by capital requirements in the case of a regulated institution such as an investment bank, or by margin requirements in the case of an unregulated institution such as a hedge fund.  When the sponsoring institutions reach their funding limits, they can no longer sponsor new MBS offerings.  To solve this problem the sponsors of Mortgage-Backed Securities turned to alchemy.

Collateralized Debt Obligations

Collateralized Debt Obligations (CDOs) are created in the same way Mortgage-Backed Securities are created and are divided into subordinate tranches with the equity and junior tranches being paid only after the senior tranches are paid, and the equity tranches being paid only after the senior and junior tranches are paid just as MBSs are structured.  In addition, CDO offerings were rated similarly by the rating agencies with 95% or so of the offering rated investment grade (BBB or higher) and as much as 80% of the offering in the senior, investment-grade tranches receiving a triple-A rating. 

The fundamental difference between Collateralized Debt Obligations and Mortgage-Backed Securities is in the nature of the collateral.  While MBSs are backed only by mortgages, CDOs use a variety of debt obligations for collateral—bonds, loans, and other Asset-backed Securities (ABSs)—rather than a single kind of financial instrument.  (FCIC)

Until the 2000s, CDOs were a relatively obscure financial product confined to a relatively small market, but in the early 2000s the CDO market simply exploded.  From 2003 to 2006 it increased more than seven fold as it went from $30 billion to $225 billion in just three years.  In the process, CDOs transformed the mortgage market by increasing the demand for MBSs in the lower rated tranches.  In 2004, CDOs were the dominate buyer of BBB-rated MBSs, and in 2005 they purchased virtually all of the BBB tranches of these securities.  Between 2003 and 2007 over $4 trillion Mortgage-Backed Securities were created and some $700 billion of CDOs that contained lower rated tranches of MBSs as collateral were created as well.  (FCIC) 

The alchemy involved in this process should be apparent.  By taking the lower rated MBSs and using them as collateral for CDOs, the sponsors of the SPVs that offered these CDOs for sale were able to convert as much as 80% of the BBB or BB rated MBSs held as collateral in their SPVs into triple-A rated securities in the form of AAA rated CDOs.  They were, indeed, able to make a silk purse out of a sow’s ear—or so it seemed—and the alchemy didn’t end there.  CDOs were often structured with the lower rated tranches of other CDOs as part of their collateral.  CDOs with 80% or more of their collateral in the form of lower rated tranches of other CDOs were referred to as CDOs squared, and by this sleight of hand the sponsors of the SPVs were able to convert more than 60% of the lower rated CDO tranches held in their portfolio of collateral into triple-A rated CDOs.  (FCIC) 

Collateralized Debt Obligations fueled the mortgage market as it expanded in the mid 2000s in that CDOs allowed the sponsors of MBSs to keep the lower rated tranches of the MBSs that they couldn’t sell otherwise off their books.  This freed up capital and, thus, allowed them to expand the creation of MBSs beyond what they would have been able to if the CDO market had not existed.  

Derivatives and Leverage

Leverage is a term used to describe methods by which investors can enhance their return on equity capital.  The most common kind of leverage is the kind discussed above and in Chapter 5 and Chapter 6 and again in Chapter 9, namely, borrowing money to increase the amount to invest.  This kind of leverage is referred to as balance sheet or debt leverage where the amount of leverage is measured by the debt to equity ratio—that is, by the value of the amount borrowed by the investor divided by the value of the equity owned by the investor.  There is another kind of leverage that can be used to increase the return on equity capital, namely, that which is obtained through the use of derivatives.  Derivatives are contracts that derive their value from some underlying asset or collection of assets.  They are used either to provide a hedge against a potential loss or to speculate on future events. 

Option Contracts

Perhaps, the simplest derivative to understand is an option contract.  An option contract is a financial instrument that gives the holder of the contract the right, but not an obligation, to either buy or sell, depending on the kind of option, an asset at a specified price during a specified period of time.  An option to purchase an asset is a call option.  An option to sell an asset is a put option.  While an option does not obligate the holder of the option in any way, if the holder of the option chooses to exercise the option during the specified time period the writer of the option is obligated to sell, in the case of a call option, or to purchase, in the case of a put option, the asset being optioned at the specified price. 

For example, if you purchase a 30-day option to purchase 100 shares of IBM stock at $100/share—a 30-day call option for 100 shares of IBM stock at $100/share—this gives you the right to purchase 100 shares of IBM stock for $100/share at any time during the next 30 days.  At the same time, it obligates the writer of the option to sell 100 shares of IBM stock to you at $100/share at any time you choose during the next 30 days. 

If you purchase a 30-day option to sell 100 shares of IBM stock for $100/share at any time during the next 30 days—a 30-day put option for 100 shares of IBM stock at $100/share—this gives you the right to sell 100 shares of IBM stock at $100/share at any time during the next 30 days.  At the same time it obligates the writer of the option to purchase 100 shares of IBM stock from you at $100/share at any time you choose during the next 30 days. 

If you own 100 shares of IBM stock that is worth $100/share you can use an option to hedge the risk of the value of your stock falling over the next six months by purchasing a 6-month put option that gives you the right to sell 100 shares of IBM stock at $100/share at any time during the next six months.  Having purchased such an option, if the price of IBM stock should fall to, say, $50/share you would be protected from that loss.  Your $5,000 loss in the value of your stock would be exactly offset by the $5,000 gain in the value of your option that gives you the right to sell your 100 shares of IBM stock at $100/share.  Your only loss would be the price you had to pay for the option.  

You can also use options to speculate on the price of IBM stock even if you don’t own the stock.  Suppose you believe that IBM stock is going to double in value over the next six months.  You can take advantage of this expectation either by purchasing IBM stock directly or by purchasing a 6-month call option for IBM stock.  If the price of IBM stock is $100/share it will cost you $10,000 to purchase 100 shares of stock.  If you purchase the stock and are right about the price of IBM doubling over the next six months, the price of your stock will increase to $200/share, your 100 shares of IBM stock will be worth $20,000, and you will make a $10,000 profit. 

Alternatively, if the price of a 6-month call option to purchase IBM stock for $100/share is $10/share, that same $10,000 you have to invest could be used to purchase an option that would give you the right to purchase 1,000 shares of IBM stock for $100/share.  If the price of IBM stock were to double the value of your option would increase from the $10,000 that you paid for it to $100,000 since your option gives you the right to purchase $200,000 worth of IBM stock for just $100,000.  As a result, you would be able to make a $90,000 profit ($200,000 - $100,000 -$10,000) by investing your $10,000 in the option as opposed to a $10,000 profit by investing in the stock.  Thus, purchasing the option allows you to leverage your $10,000 investment by increasing your profits 9 times what you would be able to make by buying the stock directly. 

Just as debt leverage increases your risk of loss as it increases your potential profit, the same is true for derivative leverage.  Even though your potential loss is limited to $10,000 whichever investment your chose to make in the above example, if you chose to invest in an option you will lose the entire $10,000 if the price of IBM fails to increase above $100.  You will not lose your entire $10,000 investment if you chose to purchase IBM stock directly unless the price of IBM stock goes to zero. 

Futures Contracts

Historically, derivatives in the form of futures contracts—an agreement to buy or sell something at a specific date and price in the future—have been around for over a hundred and fifty years, and just as with options contracts, futures contracts can be used to hedge against a potential loss or to speculate on changes in prices.

To see how a futures contract can be used to hedge against a potential loss, consider the plight of a farmer who knows approximately what it will cost to plant a particular crop in the spring and how much product he will have available to sell when it is harvested, but has no way of knowing what the price of that crop will be when he brings it to market.  If he plants the wrong crop he will lose money if the price at harvest time is below his costs of production.  One way he can hedge against this possibility is by entering into a contract in the spring with a miller to sell his crop in the fall at an agreed upon price.  By entering into this kind of contract both the farmer and the miller are able to protect themselves against adverse changes in prices when crops are brought to market in the fall.

As was noted, futures contracts can also be used to speculate on changes in prices.  If the price of wheat is $2/bushel in May and you think it will be $4/bushel in the September you can take advantage of this situation by buying wheat today, storing it until September and selling it in September at whatever the price turns out to be.  If your expectation is correct and the price in September is $4/bushel you will be able to make a profit of $2/bushel on each bushel of wheat you purchase and store, less the cost of storing the wheat from June to September.  If it costs you $1/bushel to store the wheat your net profit will be $1/bushel. 

Now suppose that you can enter into a futures contract to purchase wheat at $3/bushel in September, a price that is equal to the price of wheat today plus the cost of storing wheat that exists today until September.  If you enter into this contract and your expectation is correct and the price in September is $4/bushel you will make the same profit of $1/bushel when you purchase the wheat in September at $3/bushel and resell it at $4/bushel, less, of course, the cost of the commission to the broker who arranged the contract.  There are, however, a number of important differences. 

To begin with, when you purchase a futures contract you don't have to actually buy any wheat in order to make a profit.  As the price of wheat approaches $4/bushel in September, the value of your contract will approach $1/bushel since that’s the profit you can make on it when it comes due.  As a result, when your contract comes due in September you will be able to sell your contract to someone who actually wants to buy wheat or to someone who has contracted to sell wheat and wants to close out his or her contract to sell by buying an offsetting contract to buy without having to actually come up with the wheat needed to fulfill his or her contract to sell.  This makes speculating through futures contracts much less time consuming and less of a bother than actually purchasing and storing the commodity involved.

Second, it you wish to purchase, say, 10,000 bushels of wheat to speculate on the price of wheat in this situation you will have to come up with $20,000 to purchase the wheat and an additional $10,000 to store the wheat until September for a total of $30,000.   If the price of wheat is $2/bushel in May and you can purchase a futures contract to purchase 10,000 bushels of wheat at $3/bushel or less in September (the price in May plus the cost of storing the wheat until September) there is no reason for you to actually purchase the wheat since you will make at at least as much profit or more if you purchase the futures contract that commits you to purchase the wheat in September for $3/bushel as you will if you purchase the wheat at $2/bushel in May and store it until September. 

In addition, you will have to come up with much less cash to purchase the futures contract than you will have to come up with to purchase the wheat.  When you purchase a futures contract you only have to come up with the commission paid to the broker and enough collateral to convince the counterparty to your contract that you will, in fact, live up to your end of the contract.  The collateral posted on a futures contract is referred to as the margin, and it can be as little as 10% or even as low as 5% of the value of the wheat covered by the contract.  That means that instead of having to come up with $30,000 to purchase and store 10,000 bushels of wheat you can place the same bet on the price of wheat in September by coming up with only $3,000 (ignoring the broker's commission which I will do from now on to simplify the exposition) if the margin is 10% or only $1,500 if the margin is 5%. 

The potential leverage here should be obvious.  If you have $30,000 to invest in this speculative endeavor you have the option of using that $30,000 to purchase 10,000 bushels of wheat and storing it, or at a 10% margin you can use your $30,000 as collateral for 10 futures contracts that commit you to purchase 10,000 bushels of wheat each.  If you are right and the price of wheat is $4/bushel in September you will make a $10,000 profit on the 10,000 bushels of wheat you purchased with your $30,000 if you chose the first option, and you will make a $100,000 profit on the 100,000 bushels of wheat you have committed yourself to purchase with your $30,000 if you chose the second option.  In other words, you can leverage your investment tenfold by purchasing the futures contracts at a 10% margin.  If the margin is 5% you can leverage your investment twentyfold by purchasing 20 contracts that commit you to purchase 200,000 bushels of wheat. 

Finally, it should be obvious that the ability to purchase futures contracts not only leverages you profits, it leverages your risk as well.  If you purchase the wheat in the above example, and the price falls to $1/bushel instead or increasing to $4/bushel as you had expected, you will lose the $10,000 you spent on storage and an additional $10,000 when you are stuck with 10,000 bushels of wheat you bought at $2/bushel that can now only be sold at $1/bushel.  This 67% loss on your investment may sound grim, but if you had instead purchased 10 futures contracts on a 10% margin that committed you to purchase 100,000 bushels of wheat at $3/bushel and you can only sell that wheat for $1/bushel on its due date you are out $200,000.  That's a 667% loss on your investment.  If you had purchased 20 contracts on a 5% margin your loss would be $400,000 on your $30,000 investment.  That's more than 13 times the amount you had planned to invest in the first place!   

This brings us to a very important point:  When derivatives are used to hedge against a risk of potential loss the risk that is hedged is transferred from one party of the derivative contract to the other.  There is no increase in risk in the system as a whole, and there even may be a reduction in risk in the system as a whole if the risk is transferred from an individual or institution that is less able to cope with the potential loss to an individual or institution that is better able to cope with the potential loss.  As a result, using derivatives to hedge against a potential loss can have the effect of increasing the stability of the economic system as a whole.  This is not the case when derivatives are used for pure speculation.

When derivatives are used for pure speculation where neither party is hedging against a risk of potential loss, both parties to the contract assume risk that they otherwise would not have assumed.  There is no transfer of risk, and the total risk of potential loss in the system increases.  This should be clear from the example above.  When you purchase an option on 100 shares of IBM stock you do not own from a writer who is not hedging against a potential loss there is no transfer of risk.  Both you and the option writer are taking on risks of loss that you would not otherwise have.  The same is true in the futures market when neither party is hedging against a potential loss. 

The fact that speculators add to the liquidity of the market and thereby enhance the ability of other participants to hedge does not negate the fact that pure speculation increases the risk in the system as a whole and, as a result, reduces the stability of the system as a whole.  

While in theory, pure speculation is a zero-sum game where the losses of one party are equal to the gains by another and all that occurs as a result of speculation is a transfer of wealth from one group of individuals to another, in practice this is not necessarily the case and often is, in fact, not the case. This theory ignores the possibility of default on the part of those who speculate and the damage that can be done to those who are directly and indirectly affected by the speculative bubbles that are created as a result of speculation. 

When speculative bubbles burst, the inability of those affected to meet their contractual obligations can have a cascading effect that brings the entire economic system to its knees.  The history of this being so goes back at least 800 years. (Kindleberger MacKay Graeber)  The recognition of this problem led to the establishment of exchanges and clearinghouses.  These are institutions that were designed to minimize the risk of default and also to minimize the risk of manipulation and fraud within the market. 

Exchanges and Clearinghouses

The markets for options, futures, and many other derivatives have become highly efficient as these contracts have been standardized and are widely traded on exchanges where an exchange is simply a central meeting place where trading takes place.  The importance of an exchange is that it provides a place where trading is in the open, and all of the participants in the market can see the quantities bought and sold and the prices at which trades are made.  This kind of openness, or what is referred to as transparency in the market, is designed to minimize fraud and the ability of traders to manipulate prices. 

In addition, the risk of default on derivative contracts has been minimized through the establishment of clearinghouses whereby the contracts agreed upon between individuals at the exchange are cleared through a separate corporation, and that corporation—the clearing house—becomes the counterparty to the buyers and sellers in the contracts that are agreed upon in the exchange.  The way an exchange and clearinghouse work to minimize the creation of speculative bubbles and risk of default for those derivatives that are traded through an exchange with a clearinghouse can be seen by examining the way a futures contract comes into being. 

If you wish to enter into a contract to buy (or sell) wheat or some other commodity at some point in the future you go to your broker and place an order.  Your broker submits your order to the exchange where all of the offers to buy and sell are submitted by the brokers that are members of that exchange.  The brokers’ traders on the floor of the exchange match the offers to buy with the offers to sell where the prices at which the commodities are to be bought and sold in the future are determined through an auction process among the traders. 

At the end of each trading day the contracts that have been agreed upon are submitted to the clearinghouse to be cleared, and the cash transactions between the brokers and the clearinghouse are settled.  The outstanding contracts held by each broker's clients are then revalued in accordance with the prices set during the day, and each broker is required pay any balance its clients may have accumulated in order to maintain the margin required on their contracts to the clearinghouse as a result of the day’s trading.  Once the trades of the day have been reconciled, and the margin requirements have been met by the members of the exchange, the contracts between the clients of the brokers are dissolved, and the clearing house becomes the counterparty to each of the contracts the clients have entered into.  Your broker then delivers to you your contract with the clearinghouse that you sought to enter into.

The efficiency of this system arises from the fact that all of the participants in the market are policed by the brokers, by the exchange, by the clearing house, and the entire process is regulated by the government.  All transactions are executed publicly on the floor of the exchange, available for all to see, and changes in the values of the outstanding contracts are reconciled each day in order to maintain the collateral each broker must deposit with the clearinghouse as determined by the margin requirement on the contracts its clients have with the clearinghouse. 

You are legally responsible to your broker to perform on your contract and your broker is legally responsible for your performance to the clearinghouse as well.  That means that if you default on your contract your broker is responsible to make that contract good to the clearinghouse, and if your broker defaults to the clearinghouse, the clearinghouse is on the hook to make that contract good to whomever made it with you.  That protects the original counterparty to your contract from default on your part, and it also protects you from default on the part of the original counterparty to your contract since the counterparty’s broker is responsible for the contract his client made with you as is the clearinghouse. 

The only situation in which your contract will not be honored is if the clearinghouse were to default.  This is clearly a possibility, but the fact that a) the changes in the values of all outstanding contracts between brokers and the clearinghouse must be reconciled each day, b) each broker is required to maintain the margin on its clients contracts with the clearinghouse as the values of its clients contracts fluctuate each day, c) clients are required to maintain the margin on their contracts with their brokers as the value of the contracts fluctuate each day, and c) the fact that the behavior of all of the participants in the market is strictly regulated by the government minimizes this possibility.   

Trading in derivative contracts has been regulated by the government, in one way or another, since the 1880s, and trading in commodities options was banned altogether in 1936. The government sets the margin requirement that must be maintained against your account with your broker as well as against your broker’s account with the clearinghouse, as it does for all the clients and brokers in the system, in order to assure that each client will be able to make good to his or her broker and each broker will be able to make good to the clearinghouse on a daily basis any losses that may be realized. In addition, fraudulent, misleading, manipulative, and reckless or unsafe practices that threaten the solvency of the clearinghouse are prohibited and enforced through government regulations and regulators.

Credit Default Swaps and Synthetic CDOs

Even though derivatives have been around for a very long time, the way in which they have been used has changed dramatically over the past forty years.  Prior to the 1970s, futures contracts were used for commodities and, as has been noted, options trading in commodities was outlawed.  In the 1970s futures contracts for financial assets were introduced, and the ban on option trading in commodities was lifted in 1981.  Option trading was subsequently extended to include financial assets and foreign exchange as well as commodities, and new kinds of options and futures contracts were created—contracts based on indices of commodity and financial asset prices as opposed to those based on individual commodities and financial assets.  

At the same time, much of the trading in derivatives has moved from the exchange/clearinghouse environment to the over-the-counter market where contracts are not standardized and are made directly between individuals and institutions without the protection of a clearinghouse, with very little government regulation, and with very little if any transparency.  In addition, an entirely new category of derivative came into being, the swap, whereby contracts were devised that allowed income streams generated by assets to be exchanged in domestic as well as in foreign currencies, and in 1997 the Credit Default Swap was born.

Credit Default Swaps

A Credit Default Swap (CDS) is a kind of insurance contract wherein the seller of a CDS agrees to compensate the buyer against the consequence of an adverse credit event such as the issuer of a bond defaulting on its interest or principal payment.  The buyer pays the seller a quarterly or biannual premium for the protection provided by the seller where the protection generally consists of an agreed upon, lump-sum payment from the seller to the buyer should the credit event (e.g., default) occur.

The market for Credit Default Swaps came into being in the late 1990s, and this market played a crucial role in the mortgage market in the 2000s.  In particular, it played a crucial role in the markets for Mortgage Backed Securities and Collateralized Debt Obligations since CDSs made MBSs and CDOs more attractive to those who sought protection against the risk of these kinds of bonds defaulting.  Regulated institutions such as banks, for example, could reduce their capital requirements by purchasing credit default protection against the MBSs and CDOs they held, and hedge funds and other financial institutions could use CDSs to hedge positions that involved MBSs, CDOs, or other forms of Asset Backed Securities. 

Insurance is generally subject to government regulations that force insurance companies to maintain reserves commensurate with their obligations to policy holders.  Government regulations also outlaw insurance policies being issued to people who do not have an insurable interest in what is being insured and, in particular, they bar people from obtaining insurance on property they do not own.  In addition, people are generally not allowed to insure property for more than the damages they will incurred if the property is lost or damaged.  But even though CDSs are a kind of insurance, the Commodity Futures Modernization Act (CFMA) passed in 2000 explicitly blocked regulation of the market for Credit Default Swaps.  This made it possible for financial institutions to purchase and sell Credit Default Swaps to insure debt instruments that were not owned by the purchaser, to purchase and sell multiple CDS contracts against these same instruments, and for financial institutions to sell CDS insurance contracts without setting aside reserves.  It also made synthetic CDOs possible.

Synthetic CDOs

A Synthetic CDO is created and structured in the same way a MBS or an ordinary CDO is created and structured, but there are a number of important differences.  The first is that the Special Purpose Vehicles that create synthetic CDOs sell Credit Default Swaps and hold safe securities (such as government bonds) as collateral instead of actual mortgages or MBSs.  The way this works is the sponsor of a synthetic CDO incorporates a SPV and puts together a list of MBSs for which the sponsor wishes to sell default protection.  The SPV then sells Credit Default Swaps to those who are willing to pay a premium for default protection on the listed securities. 

The SPV then structures an offering of synthetic CDO tranches similar to the structure of the MBS offering shown in Figure 8.1 with the same kind of subordinated payout to the investors in the synthetic CDO securities that is used in the payout structure of ordinary CDOs and MBSs.  The proceeds from the sale of the synthetic CDOs are, in turn, invested in safe securities.  These safe securities become the collateral held by the SPV.  The interest payments received from these securities combined with the premium payments received from the CDS contracts sold by the SPV provide the funds needed to make the interest and principal payments on the synthetic CDOs purchased by investors.

This brings us to the second way in which synthetic CDOs differ from ordinary CDOs.  There are two kinds of investors in a synthetic CDO.  The first is the fully-funded investor described above.  Fully-funded investors are required to put up 100% of the money they are putting at risk.  They actually lend money to the SPV in order to receive interest payments on the CDOs they purchase.  This money is used to purchase the safe assets that the SPV uses as collateral.  The second kind of investor is the unfunded investor. 

Unfunded investors are not required to put money up front and do not lend money to the SPV.  Instead, unfunded investors, in effect, sell credit-default protection to the SPV—protection that insures payment to those who purchased Credit Default Swaps from the SPV.  All other investors are subordinate to the unfunded investors in a synthetic CDO offering, which means, of course, that all other investors in a synthetic CDO get paid after the unfunded investors get paid.  This adds another level of subordination to the tranche structure of the synthetic CDOs, namely, what is referred to as the Super-Senior tranche that is sold to unfunded investors.[8.2]

The way in which synthetic CDOs are structured is illustrated in Figure 8.2 which shows the structure of the ABACUS 2004-2 offering sponsored by Goldman Sachs in 2004.  In spite of the obvious differences between Figure 8.2 and Figure 8.1, they are very much the same in that 87% of the synthetic CDOs in Figure 8.2 are rated AAA or are subordinated above the triple-A tranches compared to 78% of the MBSs in Figure 8.1, and only 5% are rated less than investment grade in Figure 8.2 compared to 4% in Figure 8.1. 

Figure 8.2: Structure of the ABACUS 2004-2 Synthetic CDO Offering.
Tranches	Amount*	Rating	% of Total	Cumulative %
Super Senior Unfunded	$850.0	Not Rated	85.0%	85.0%
Senior Fully Funded Investment Grade	$20.0	AAA	2.0%	87.0%
Junior Fully Funded Investment Grade	$40.0	AA	4.0%	91.0%
	$30.0	A	3.0%	94.0%
	$10.0	BBB	1.0%	95.0%
Equity	$50.0	Not Rated	5.0%	100%
Total	$1,000.0		100%

Source: Financial Crisis Inquire Commission.

*millions of dollars

In terms of the payout from the investment, there is no difference between a synthetic CDO that sells CDSs and holds safe securities for collateral and an ordinary CDO that holds the actual MBSs that underlie the CDSs sold by the synthetic CDOs.  If there are no defaults in the underlying MBSs the CDO investors will all get paid whether the CDO is synthetic or not.  If some of the underlying MBSs default, some of the safe securities will have to be sold to pay off the CDSs that insured those MBSs.  In this situation, some of the investors who purchased the lower tranches of the synthetic CDOs will not get paid, but the same would be true if those investors had invested in the lower tranches of an ordinary CDO that actually held the MBSs that defaulted.  It makes no difference from the perspective of the payout to the investor what form the CDO takes.  In either case, the amount the investor gets paid or loses is the same.

There is, however, a fundamental difference between investing in a synthetic CDO and investing in an ordinary CDO in terms of the kind of investment being made. Investors who purchase ordinary CDOs are investing in the mortgage business. The money they are investing is used to purchase mortgages—albeit, indirectly by way of financing the tranches of the CDOs that are used to purchase MBSs that are used to purchase mortgages.

Investors who purchase synthetic CDOs are investing in the insurance business, not the mortgage business. The money they are investing is used to insure the debt instruments that underlie the CDSs sold by the SPV not to purchase mortgages. In addition, the collateral held by the SPV is not put up by the borrower, it is put up by the lender, and it is not held to protect those who lend by purchasing the synthetic CDOs. It is held to protect those who purchase the Credit Default Swaps that are sold by the SPV.

Not only were the fully funded investors in synthetic CDOs investing in the insurance business, they were investing in the insurance business in an unregulated market.  There were no government regulations that prevent those who were buying the MBS insurance offered by the SPV from being the very same people that selected the MBSs being insured. The conflict of interest here should be obvious, especially since the people who purchased the insurance and selected the MBSs to be insured did not have to own the MBSs they had selected.  They had nothing to lose if the MBSs they selected to insure went bad, and they receive a huge payout if these MBSs did in fact go bad.  

Initially, the institutions that sold Credit Default Swaps were pretty much limited to AIG and a few monocline insurance companies such as MBIA and Ambac, but with the invention of the synthetic CDO the major players in the MBS and CDO markets such as J. P. Morgan and Goldman Sacks were able to secure credit protection from an ever increasing number of investors through the sale of the fully-funded, synthetic CDOs.  All that was required to sell a fully-funded synthetic CDO was to find a buyer who 1) had enough money to make the purchase, 2) who sought the safety the investment-grade rating of these bonds seemed to provide, and 3) who was unable to understand exactly what it was that was being purchased.  Investment-grade, fully-funded, synthetic CDOs were sold to banks, pension funds, endowment funds, hedge funds, mutual funds, insurance companies, and municipal governments throughout the country and all over the world.  Virtually any entity that met the above criteria was fair game to those who sold these securities.  (FCIC WSFC)  

Finally, as is clear from the way in which the synthetic CDOs were structured, those who bought the unfunded, super-senior tranches were given added protection from loss by the fully-funded tranches since the fully-funded tranches were subordinated to the super-senior tranches and took the first losses.  This was particularly appealing to many of the institutions that sponsored synthetic CDOs since these institutions did not have to put up cash to purchase the Super Senior tranches they had created and could receive income from these tranches without having to set aside capital to support them.  As a result, many of the super-senior tranches of the synthetic CDOs ended up on the books of the financial institutions that sponsored these CDOs, much to their regret when the crisis came.  In other words, these institutions assumed the risk of selling credit-default protection to the SPV, a practice that proved disastrous in the fall of 2008.  (FCIC WSFC)

Shadow Banks, Derivatives, and Systemic Risk

The systemic risk the shadow banking system posed—that is, the threat to the financial and economic systems as a whole—especially when combined with an unregulated insurance market and derivatives markets that were not only unregulated but operated without exchanges or clearinghouses, should have been obvious to anyone with a reasonable understanding of the history of the financial system, but ideological blindness inspired by an almost religious faith in free markets made it impossible for policy makers and elected officials to take this risk seriously.  When this blindness was combined with the fact that the vast majority of elected officials knew virtually nothing about the history of the financial system, the stage was set for a catastrophe of epic proportions. 

The irony is that the first run on a shadow bank occurred ten years before the entire shadow banking system collapsed in the fall of 2008 when a run on the hedge fund Long-term Capital Management in 1998 nearly caused a worldwide financial meltdown. This run literally terrified policy makers and the entire financial community at the time, and, yet, as we will see, nothing was done to curb the excesses of the shadow banking system or to regulate the over-the-counter derivatives markets in the wake of this near catastrophe. 

Endnotes

[8.1]The ratings, AAA, BBB, etc., represent the rating agencies estimate of the probability of default for the security being rated based on the historical performance of securities that have held that particular rating in the past.  The ten year time horizon for the historical performance of Moody’s ratings from 1970-2010 is given in following table from Moody’s Confidence Intervals for Corporate Default Rates:

 

[8.2] The Super Senior tranches were only sold to the most creditworthy institutions with triple-A credit ratings such as to AIG and a few monocline insurance companies such as MBIA and Ambac—institutions that turned out, in the end, to be not so creditworthy, largely by virtue of the fact that they invested in the super senior tranches of the synthetic CDOs.