Unintended Consequences: Why Everything You've Been Told About the Economy Is Wrong by Edward Conard

Author:Edward Conard
Language: eng
Format: mobi, pdf
ISBN: 1591845505
Publisher: Portfolio Hardcover
Published: 2012-06-07T00:00:00+00:00

FIGURE 6-1: Growth of U.S. Money Market Funds

Today, regional banks still look like the banks of old. Retail deposits, much of which the FDIC explicitly guarantees, supply 80 percent of their capital. The availability of these funds is limited, however, and as a result, regional banks remain small and local. Retail deposits fund only a small portion of the capital of large money-center banks. Almost all their capital comes from uninsured institutional funds. The growing size of institutional money-market funds allowed money-center financial institutions to grow large. Money-center banks are the vehicles that invest implicitly insured short-term funds. Ultimately, these debt holders panicked and ran.

Unguaranteed short-term debt flowed into commercial and investment banks in nontraditional ways, most significantly through the repo (repurchase) market. Through a repurchase agreement, banks and broker-dealers sell collateral—the financial assets of depositors, including the bank’s own assets—to lenders with an agreement to buy back the collateral at a predetermined price—to repurchase it.

Because the lender owns the security, this is a very safe way for lenders to loan funds. Without explicit government guarantees, repos become a primary source of short-term risk-averse funding. At an estimated $7 trillion to $11 trillion, the repo market has become “one of the largest financial markets” and a significant source of bank financing.6

Just like traditional depositors, the owners of the deposited securities demand the right to sell or withdraw their securities at any time (literally, “on demand”). Broker-dealers largely accommodate this by borrowing against securities overnight. Like any other on-demand bank deposit, these funds are used by broker-dealers to make loans. During the Crisis, customers withdrew their securities—just like depositors. Without deposited securities to borrow against, banks were forced to sell assets to continue funding loans. When securities prices fell to fire-sale levels, repo lenders refused to lend against the remaining securities.7 This effectively shut down the repo market.

Similar to repos, some securities holders, notably AIG, loaned their securities directly (rather than depositing them in banks) to borrow short-term funds. They used the proceeds from these loans to make illiquid investments. When prices fell, lenders returned the borrowers’ securities and demanded their funds. As with banks, the demands for withdrawals forced security lenders to sell assets to fund their investments.

Some pundits8 claim that mark-to-market accounting rules, which required banks to mark down the value of some assets to market prices, exacerbated the Crisis by spooking markets with low prices. The real problem with panicked withdrawals and the illiquidity of fire-sale-priced assets is hardly a simple matter of accounting. It doesn’t matter where the values of securities are marked. A repo lender can estimate the market value no matter the accounting marks. What matters is whether the repo market will continue to lend against the collateral of the security. They would not.

Banks also used structured investment vehicles (SIVs) and conduits to raise short-term debt from commercial money markets. Like banks, SIVs borrowed short and loaned long. With their heavy reliance on short-term debt, lenders were quick to withdraw funding from these entities as the Crisis unfolded.

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.