Why Bagehot wrote Lombard Street

A recent exchange made me think for the first time about the events preceding the publication of Lombard Street. The financial crisis of 1866 had rocked the financial system dramatically without really destabilizing it. But Bagehot saw in that crisis the possibility of total financial collapse. (A detailed description of financial collapse takes up much of Chapter 7, part II of Lombard Street.) For this reason he thought it was important to explain what made it possible for the British economy to survive such brutal storms -- and thus to make it clear to politicians and to the Governors of the Bank of England what their obligations were in a crisis.

After 1844 politicians played an important role in the Bank of England's lender of last resort activities. The Banking Act of 1844 (Peel's Act) restricted the issue of Bank Notes. It was, however, written with an escape clause, allowing the law to be suspended by executive order (i.e. bypassing Parliament). And in every subsequent crisis 1847, 1857, 1866, the law had to be suspended in order for the Bank of England to act as lender of last resort to the banking system. That is, without suspension of the law the Bank would have run out of Bank Notes.

Peel's Act was so controversial that Bagehot states: "Two hosts of eager disputants on this subject ask of every new writer the one question -- Are you with us or against us? and they care for little else." For this reason Bagehot chooses not to take sides in the debate, but instead to explain clearly (without condemning the law itself) why Peel's Act had to be suspended in 1847, 1857 and 1866.

Bagehot's main concern in Lombard Street is to put an end to any controversy over:
(i) the importance of suspending Peel's Act in a financial crisis
(ii) the importance of copious lending by the Bank of England in a crisis.
Chapter 7 is dedicated to explaining that public uncertainty about either of these two actions in a crisis is dangerous. He concludes:

The best palliative to a panic is a confidence in the adequate amount of the Bank reserve, and in the efficient use of that reserve. And until we have on this point a clear understanding with the Bank of England, both our liability to crises and our terror at crises will always be greater than they would otherwise be.

Note the subtle reference to Peel's Act in the first sentence. Bagehot avoids controversy, but makes his point clear. In the second sentence he calls on the Bank to publicly acknowledge its role as lender of last resort to the financial system.

One thing needs to be emphasized: Bagehot is concerned about uncertainty -- but that uncertainty references explicitly whether or not a lender of last resort exists and will step in to provide liquidity in a crisis. Thus Bagehot wants the Bank of England to reduce uncertainty in the financial system, but only by promising to lend copiously against high quality assets.

He is entirely at ease with the fact that the Bank of England allowed Overends Gurney, a systemically important bill broker, to fail despite the fact that the failure rocked the financial system with uncertainty, as illustrated by the following two quotes:

In 1866 undoubtedly a panic occurred, but I do not think that the Bank of England can be blamed for it. They had in their till an exceedingly good reserve according to the estimate of that time—a sufficient reserve, in all probability, to have coped with the crises of 1847 and 1857. The suspension of Overend and Gurney—the most trusted private firm in England—caused an alarm, in suddenness and magnitude, without example.

no cause is more capable of producing a panic, perhaps none is so capable, as the failure of a first-rate joint stock bank in London. Such an event would have something like the effect of the failure of Overend, Gurney and Co.; scarcely any other event would have an equal effect.

Thus, Bagehot does not argue that the lender of last resort should act to eliminate general uncertainty, he argues only that a lender of last resort should eliminate uncertainty about the actions it will take in the midst of a financial panic.

Learning from the Crises of 1857 and 1866 Continued

In my last post I never did get to the parallels between 1857/66 and today. First of all note that in 1857 Gurneys was a huge player in the money market and thus in 1857 when the Bank of England lent £9 million to the bill brokers, you can expect that at least £2 million and possibly as much as £4 million went to Gurneys.

In other words the Bank of England probably saw evidence that in a crisis the line of credit it was giving to an individual firm was becoming unreasonably large. Even if all the bills discounted at the Bank by Gurneys were good quality bills at this particular time, the Bank was opening itself to a future problem where reliance on the careful management of Gurneys allowed low quality bills to be discounted at the Bank and thus exposed the Bank to significant credit losses. As the Bank was a private institution, it had an obvious interest in limiting it's exposure to the credit risk of a single firm or to the credit judgment of a single underwriter of commercial bills.

In fact, it was precisely the ultra-conservative management of the Bank of England that created the trust necessary for the Bank to be relied on as a lender of last resort:

The great respectability of the directors, and the steady attention many of them have always given the business of the Bank, have kept it entirely free from anything dishonorable and discreditable. Steady merchants collected in council are an admirable judge of bills and securities. They always know the questionable standing of dangerous persons; they are quick to note the smallest signs of corrupt transactions; and no sophistry will persuade the best of them out of their good instincts. You could not have made the directors of the Bank of England do the sort of business which 'Overends' at last did, except by a moral miracle—except by changing their nature. And the fatal career of the Bank of the United States would, under their management, have been equally impossible. Of the ultimate solvency of the Bank of England, or of the eventual safety of its vast capital, even at the worst periods of its history, there has not been the least doubt.

Thus, in 1858 the Bank put in place a policy that only allowed bill brokers access to emergency credit by exception. The purpose of the policy was to force bill brokers to keep their own reserve, or in other words to be prepared to act as their own lenders of last resort.

Thus, faced with financial innovation and the growth of an extremely large, highly leveraged firm closely intertwined with the banking system, the Bank of England immediately made it clear that it did not support the growth of this firm. It set a policy: if financial innovation was going to allow huge firms to develop, then those firms should be prepared to support themselves through a crisis.

One obvious consequence of this policy is to push the bill brokers to reduce their leverage ratios and thus reduce the likelihood that they will (i) need the services of a lender of last resort and (ii) cause a financial crisis by failing. In short, even though the Bank of England had no regulatory authority whatsoever over the financial system, the fact that it was the lender of last resort meant that its policy decisions affected the stability of the financial system by affecting the leverage in the financial system.

Contrast the behavior of the Bank of England in 1857-8 with the behavior of authorities in the US after the 1987 investment banking crisis. In 1987 the stock market crash could have led to the complete collapse of the investment banking industry were it not for the actions of the New York Federal Reserve President (who basically told the commercial banks to give the investment banks unsecured loans). Notice that at the moment of the 1857 and the 1987 crises both central banks took aggressive action. The difference is in their behavior after the crisis was over. The Bank of England immediately acted in a manner that would push the firms that were endangering the financial system to reduce their leverage ratios and be less reliant on the Bank of England in the future. By contrast, the Federal Reserve stood by without objection when Congress extended it's authority to permit it to lend directly to the investment banks in the 1991 FDICIA law.

In other words the two Banks took diametrically opposed actions: that of the Bank of England would tend over the long run to decrease the leverage of financial institutions and thus decrease the risk of financial instability, whereas that of the Fed tended to increase leverage and increase instability over the long run. Observe, however, that the short run effects of these different policies were precisely the opposite of their long run effects.

The willingness of the Bank of England to let a bill broker fail was tested within a decade. Overend and Gurneys actually made the decision easier by being the subject of rumors (which turned out to be well founded) for over a year before they finally turned to the Bank of England for aid in 1866. (The Economist wrote at the time "the failure of Overend, Gurney and Co. Ltd. has given rise to a panic more suitable to their historical than to their recent reputation." Victor Morgan, 1943) Despite their size, the Bank of England did indeed refuse to discount their bills -- and the result was a financial crisis that matched the worst in living memory.

On the other hand, no further failures threatened to rock the market until 1890, when Barings' exposure to South American loans could have resulted in failure and a major crisis. The potential losses were so great that the Bank of England refused to intervene directly, but it did broker a joint support from the other large banking houses. Overall, however, England's financial system was remarkably stable from 1866 up through 1914 (the year which marked the beginning of the end of the gold standard).

By contrast the Federal Reserve's policy of bringing the investment banks under their wing forced the Fed in 1998 to extend the safety net even further. When the Fed brokered a bailout, it was not a bailout of a systemically important bank, it was the bailout of a hedge fund. In hindsight it's extremely easy to see that the fact that a hedge fund had grown large enough to be systemically important was a clear sign that the financial system was dangerously overleveraged.

If the Fed had been a private bank like the Bank of England in 1857, at this juncture it would have made it clear to all members of the financial system that its balance sheet could not support the liabilities that were growing. It would have told them that they needed to start paying attention to their own reserves by dramatically reducing their leverage ratios.

Instead, the calming effects of an endless sequence of government bailouts of the banking system (Continental Illinois in 1984, Brady Bonds in 1989, low interest rates to ease the burden of bad debts in the early 90s, the late 90s and early noughts) left the Fed with the illusion that financial instability was no longer a problem that needed to be addressed, while at the same time fostering an accumulation of dead wood in the financial system that ensured that the resulting conflagration would be beyond all imagination.

In short, while the Bank of England in 1858 was willing to precipitate a crisis in order to foster stability, the Fed in the 1980s and 90s fostered the illusion of stability, while at the same time creating an environment where crisis was inevitable. Thus, just as the forest manager is better off allowing small fires to flare up regularly, so a central banker is better off precipitating small crises to avoid a disastrous and uncontrolled burn.

Learning from the Crises of 1857 and 1866

I've been rereading Lombard Street, this time reading it as a history of the money market in mid-nineteenth century England. There are some very, very interesting parallels to the current crisis.

In particular, the period (after the passing of the Bank Charter of 1844) was one of remarkable financial innovation. On the one hand, banks that had initially issued circulating notes adapted to the new environment by converting to deposit banks and eventually offering checking accounts. On the other hand, new bank like financial intermediaries were developing. Bagehot calls these financial intermediaries bill brokers, and elsewhere they are called discount houses. In any case, as Bagehot makes clear bill brokers, that in the past were pure brokers matching savers with credit-worthy borrowers, had become intermediaries who guaranteed the bills that they placed in large quantities with banks. This was a tight margin business where the "brokers" borrowed most of their capital from these same banks and thus they were essentially earning money on spreads and the value of their highly specialized knowledge of the quality of commercial bills. Aggressive competition meant that it was not profitable for these brokers to maintain reserves (i.e. capital) to back up their guarantees. Instead the bill brokers relied on the Bank of England's discount policy: Even in the worst of crises the Bank was expected to discount good bills at Bank rate.

In the crisis of 1857, the Bank of England advanced more than £9 million to the bill brokers and only £8 million to bankers. After the crisis, the Bank stated a new policy which restricted the Bank tranactions of the bill brokers to advances which were only offered on a quarterly basis. Should the brokers need discounts at any other time, they would have to ask for an exception to the Bank's policy. The stated goal of the policy was to make the brokers "keep their own reserve."

Needless to say, the bill brokers were unhappy with the new policy. Gurneys, which controlled more than half of the commercial bill market and was in many ways a competitor of the Bank of England, apparently tried to start a run on the Bank in April of 1860 by withdrawing from its deposit account an outrageous sum of money all at once. (While Bagehot claims the sum was £3 million, other sources cite a figure of £1.65 million.) This action was roundly condemned in the press.

In the meanwhile Gurneys was being poorly run by a second generation of the family. As badly underwritten bills went into default, the company advanced money on mortgages and even ended up running a fleet of steamships -- also unsuccessfully. By matching short term obligations with long term assets, Gurneys violated one of the most fundamental principles of 19th century banking. This explains the strong words Bagehot uses to describe the company:

The case of Overend, Gurney and Co., the model instance of all evil in business, is a most alarming example of [the] evil [of a hereditary business of great magnitude]. No cleverer men of business probably ... could well be found than the founders and first managers of that house. But in a very few years the rule in it passed to a generation whose folly surpassed the usual limit of imaginable incapacity. In a short time they substituted ruin for prosperity and changed opulence into insolvency.

In 1865 before all of Gurney's problems were public knowledge, the partners took the firm public, creating Overend, Gurney and Co. While this action required the Gurney family to guarantee the new firm against losses on the business of the old, presumably it was hoped that new capital would save the firm. Unfortunately the losses were so great that the Gurneys had to liquidate their personal property and news of this event caused a run on the Company. Those who had bought shares in 1865 ended up losing £2.9 million. (Because they had only paid 30% of the face value of their shares, they had the misfortune to face a capital call in order to satisfy obligations to creditors -- who were paid in full.) The lawsuit that followed this failure found the Gurneys' actions to be incompetent rather than fraudulent and they were acquitted. (Ackrill and Hannah, 2001, Barclays: The Business of Banking, 1690-1996, p. 46-7)

Because many London banks were exposed to Gurneys, there was a run on the London banks and many solvent banks, such as the Bank of London, failed. Wikipedia claims that in the crisis that followed there were a total of 200 bank and commercial failures. By any standard the crisis was severe. In particular because London held large foreign deposits that were slow to return after the run, the Bank of England was forced to keep the Bank Rate elevated for a full three months -- which undoubtedly aggravated the domestic consequences of the crisis.

It was, however, a watershed because for the first time the Governor of the Bank of England publicly acknowledged "a duty ... of supporting the banking community", that is, he acknowledged that the bank was the lender of last resort to the banking system. (While the Bank had been playing this role for almost a century, it often did so with reluctance and heretofore had never publicly recognized the role as an obligation.)

For this reason, Bagehot repeatedly treats the Bank of England's actions in 1866 as the model for a lender of last resort. A few points are worth mentioning:

(i) In Bagehot's time, it was exceptional for lender of last resort activities to last more than a few weeks. Frequently the simple fact that they were available (e.g. a lifting of government restrictions) was enough to end the panic.

(ii) A lender of last resort is not expected to prevent the failure of a systemically important bank. On the contrary, Overend, Gurney and Co. was systemically important, but it was also so badly managed that the Bank of England could not be expected to discount its paper.

(iii) A successful lender of last resort action will leave the bulk of the financial system standing (i.e. at least say 75% to 90% of the banks). Bank failures -- even large numbers of bank failures -- are part of a typical lender of last resort activity.

(iv) The government should never support a bad bank; such action could only serve to prevent the development of good banks.

So long as the security of the Money Market is not entirely to be relied on, the Goverment of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

Update: This post is continued here.

Solutions to the CDS overhang

Solution 1: My first thought was this: Since too many of the dealer-counterparties can't honor their commitments and a chain of failures is the necessary consequence, there's nothing to do but nationalize all the dealer banks and, by aggregating them, wipe out their commitments to one another. However, since JP Morgan seems to have been relatively conservatively run, this is somewhat unfortunate. I imagined a conversation between Geithner and Dimon as follows: "Look, you prepared for a crisis, just not this crisis. I'm sorry we've got to nationalize JPM, but we do have a consolation prize: How would like to manage the great stinking bankpile as your government portfolio?"
(Look, Ma, bank's a four-letter word. Hoocoodanode?)

Solution 2: But then I went for my weekend jog and came up with what I think is a much better solution. Before buying or guaranteeing toxic assets, the government should require participation fees from the banks on the following basis: For each participating bank the Fed should sum the absolute value of the bank's net notional positions over each category of CDS. Let's call this number the bank's non-dealer position. The participation fee should be the non-dealer position (possibly after subtracting off the lowest non-dealer position, so that one dealer bank is guaranteed to pay nothing). The government may choose to finance this fee as a preferred stock-type loan.

What is the advantage of the non-dealer position fee? Two types of banks are creating chaos in the markets: those that guaranteed debt they could not afford to guarantee and those that ignored the dangerous exposure of their counterparties and bought insurance that they knew (or should have known) could only be honored if the government intervened in the market. Both sides of these trades were toxic. On the other hand, any bank that actually behaved as a dealer and thus carefully maintained offsetting positions in each market will find that its non-dealer position is small. This latter type of bank was relying only on the market continuing to function, not on being able to extract money from a government bailout. After paying the fee, every bank is entitled to government protection on it's CDS portfolio either via sales or insurance.

Thus the non-dealer position fee can force the banks that were engaging in the toxic aspects of the CDS trade to bear the costs of the bailout. Will these banks refuse to participate in the toxic asset purchase/guarantee plan? Possibly, but if so they can be required to mark their books to market and will most likely be nationalized due to insolvency. (If too many banks refuse to play ball, the government can "buy" the CDS from the true dealer banks and then play hardball with the CDS counterparties.)

How is that asset guarantee program s'posed to work?

What makes anyone believe that the troubled banks can afford to pay a reasonable insurance premium on their toxic assets?

For example, the NYT has an article describing one MBS. The MBS is composed of 9,000 second lien mortgages and let's assume that the face value of each averages a little over $50,000 so the total value of the MBS (all tranches) is $500 million. Given the valuation the bank puts on the bond, this may well be the senior tranche, so let's assume the bank has a $250 million senior exposure to losses on these mortgages (i.e. the portfolio needs to lose half its value for the bank to lose a penny). The article states that the bank carries this bond at 97 cents on the dollar or $242.5 million.

However, as anyone who follows the mortgage market knows, second lien loans suffer very badly when housing prices fall dramatically -- because in case of foreclosure there's unlikely to be anything left for the second lien holder. Therefore there is some significant probability that a very large number of these mortgages go into default -- with a recovery of zero.

That's why S&P stated that in their worse case scenario the value of the bank's tranche was worth just 53 cents on the dollar or roughly speaking that only $132.5 million of principal will be recovered (assuming $500 million of loans and a senior tranche of $250 million). Let's say there's a 20% probability that this worse case scenario materializes.

In this case the insurance premium collected by the government insurer of the senior 90% losses of this particular tranche needs to be well over 0.20 ($242.5 - $132.5 - $24.25) = $17.15 million (since a full analysis would not assume that with 80% probability losses are less than $24.25 million and therefore cost the government nothing). In other words for assets of this quality the bank would have to pay significantly more than 7% of the face value of the assets as a premium. Spreading this premium over five years would result in a charge that would have to be well over 1.4% of face value per year.

By contrast in the Bank of America deal that is being used as model for this type of insurance the Fed is charging only 0.2% per year in premiums. Of course, the correct premium depends on what's in the portfolio -- which is not public information -- but it is certainly possible that the Fed is charging only a fraction of a fair market premium for the insurance policy.

If the Fed follows the policy reported in the press of insuring the assets that haven't been written down yet (but like the bond in the NYT article should have been written down), then either the premiums need to be very high relative to the face value of the assets or the government will end up tranferring massive amounts of value to the banks and their shareholders.

In short, if paying banks a fair price for their bad assets is likely to render them insolvent, then charging a fair insurance premium for those assets is also likely to render them insolvent. The only "advantage" of insurance over the purchase of the bad assets is that the government gets to duplicate the outrageously stupid behavior of our bank managers -- they get to make optimistic estimates that indicate that the losses will never show up -- until they do.

Ongoing dialog on derivatives

Apparently the Atlantic Business Channel has a long delay in posting comments, since Derivative Dribble submitted his reply shortly after my post went up, but it didn't appear on the blog for at least 6 hours after that (I checked). Anyhow, since comments are so delayed at the The Atlantic, I thought I would go ahead and post my response to DD here. (These are approximate. I didn't actually copy the posts before hitting submit -- someday I'll learn!)

I'll keep updating this post if the dialog continues.

Derivative Dribble (DD) responded to my post with the following.

ACC,

As I've said a million times, CDSs, like all contracts, create counterparty risks and therefore can create substantial reliance costs. That is not at issue in this article.

Secondly, unfunded derivatives cannot be considered "allocations of capital" since they are, by definition unfunded. That cash is free to circulate through the capital markets.

Posted by: Derivative Dribble | January 29, 2009 4:57 PM



My comment 1: Two questions:

(i) How is counterparty risk different from credit risk? They both involve the risk that a counterparty fails to make payment on a liability.
(ii) Unfunded derivatives are nothing more than a promise to make payment in the future. What “cash” are you talking about?



My comment 2: Just a note for the blog administrator: The delay between the submission of comments and the posting of comments is irritating.

Understanding the Demon in CDS

This is a response to Charles Davi's post at The Atlantic Business Channel. You should read it before reading this post.

Davi writes: I often note that derivatives cannot create net losses in the system. That is, they simply transfer money between two parties. If one party loses X, the other gains X, so the net loss between the two parties is zero.

This argument implicitly assumes government subsidization of “too big to fail" banks. All derivative contracts create counterparty risk, which is just another name for the credit risk associated with the derivative. Because sudden price movements (such as we have seen regularly in financial markets lately) may force the debtor counterparty to default on the CDS (and declare bankruptcy) before enough collateral has been transferred to the creditor counterparty to cover the obligation, one needs to consider what happens in the circumstance that the debtor (or losing) counterparty defaults suddenly: then not only does X contribute to the debtor counterparty’s unpayable obligations, the creditor counterparty does not gain X. Conclusion: not only can “poorly underwritten mortgages can create net losses,” but a poor choice of CDS counterparty can also create net losses – and be evidence of inefficient allocation of capital

The only way to avoid net losses as a potential outcome of trading derivatives is to make it impossible for debtor counterparties to go bankrupt. Effectively that is what the government has done by guaranteeing the debt of the major money center banks. The fact that Davi’s argument can be sustained is not a function of the nature of derivative markets, but rather of State intervention in derivative markets.

I can agree with Davi that the ability “to express a negative view of mortgage default risk” contributed to the popping of the mortgage bubble that was created by the securitization process. However, the fact that popping the bubble took a long time (specifically from January 2006 to August 2007) meant that "too big to fail" financial institutions were able to rack up huge losses by selling CDS insurance (often indirectly through off-balance sheet entities) before the bubble was good and truly popped.

When Davi writes “depending on whether the synthetics are fully funded or not, the principal investment will go to the Treasuries market or back into the capital markets respectively,” he exhibits a fundamental misconception about the nature of CDS that David Harper has pointed out repeatedly on Davi’s Derivative Dribble website.

It is obvious to anyone who compares the size of the CDS market with the size of securities markets in the US (and indeed the world) that “the principal investment” (i.e. the notional value of the CDS) does not get invested in Treasuries or capital markets. When synthetics are not funded, they are backed only by the promise of the protection seller to make good on the contractual obligation – that is, they are pure counterparty (aka credit) risk.

The buyer of protection sold by a partially funded synthetic or hybrid CDO is short the credit risk of the entities referenced in the CDS sold by the CDO and long the credit risk of the super senior counterparty. (The super senior tranche of a synthetic or hybrid CDO is almost always an unfunded CDS.)

Davi makes this claim: “Only when interest rates on MBSs drop low enough, along with the price of protection on MBSs, will protection buyers enter CDS contracts.” This is true only if the efficient markets theorem holds and interest rates instantaneously reflect expectations of default. In general, when expectations of MBS default rise, protections buyers will enter CDS contracts over time driving up the price of protection on CDS and mortgage interest rates. As noted above it took a year and half for this process to play out in financial markets.

The problem with CDS is not intrinsic to the derivative contract itself, but the fact that "too big to fail" banks were allowed to sell protection (when the buyer did not have an insured interest) in the market.