The following is an excellent excerpt from the book “THE BANKERS’ NEW CLOTHES: What’s Wrong with Banking and What to Do about It” by Anat Admati and Martin Hellwig from Chapter Ten titled “Must Banks Borrow So Much?” on page 158 and I quote: “Cutting Corners through Innovations – Another one of the fancy terms in banking textbooks that we mentioned briefly in Chapter 4 is maturity transformation. The term sounds impressive, just as the word cauliflower sounded to Mark Twain until he realized that “cauliflower is nothing but cabbage with a college education.” Maturity transformation simply means that banks use short-term debts like deposits to finance long-term investments like loans. According to banking textbooks, this is one of banks’ core functions.
Maturity transformation is closely related to liquidity transformation, but it is not the same. For example, a bank might fund a set of mortgage loans that have ten years to go by issuing a ten-year bond, that is, debt that is paid over ten years. In this case, the length of time until the loans expire—their maturity—is the same as the length of time until the loans expire—their maturity—is the same as the length of time until the bond expires, so there is no maturity transformation. However, the bond may be traded in the bond market, in which case it can be easily converted into cash, unlike the individual mortgage loans, so there is some liquidity transformation.
Funding ten-year mortgage loans by means of short-term debt, however, would be a form of maturity transformation. In Chapter 4, we discussed this type of transformation as characteristic of traditional commercial banks or savings banks such as the fictional Bailey Building and Loan Association. Such banks were funded by deposits that could be withdrawn at short notice, and the banks used the deposits to make long-lasting home mortgages.
When banks engage in liquidity transformation, and especially when they also engage in maturity transformation, they face not only a risk of liquidity problems and runs but also a risk of insolvency, which is much more serious. For example, if interest rates on the home mortgages are fixed, and at some point in the lifetime of those mortgages the interest rate on deposits becomes much higher, the bank can become insolvent. As we discussed, this happened to many U.S. savings institutions in the early 1980s.
Securitization of mortgages was a response to this experience. Selling home mortgages off to others looked like a good way to eliminate the risks that maturity transformation created. However, the risks were not eliminated; they were merely moved elsewhere.
To see how risks persisted, consider a typical funding chain, as discussed in Chapter 5. The chain would begin with a private individual or a nonfinancial company investing in a money market fund. The money market mutual fund, in turn provided an overnight loan to a bank or to a so-called structured investment vehicle, a subsidiary created by a bank, usually to avoid regulation.
Next the bank or the bank’s subsidiary used the money it got from the money market fund to buy mortgage-related securities that had been created by subsidiaries of investment banks out of large packages of mortgages that they had acquired from the original mortgage banks. The mortgage banks, in turn, had these mortgages to sell because they lent money to homeowners.
In this chain of transactions, the investment that we started with, that of the private individual or the nonfinancial company in the money market fund, was “transformed: into an investment in the properties that homeowners bought. The investment went from a money-like short-term debt commitment that the money market mutual fund made to the investor to houses that would likely last a few decades. Moreover, the mortgage-related securities ended up being held by banks, and gain these investments were funded by short-term debt.
If one believes that the role of banking is to “produce liquid debt,” one will marvel at the wonders of financial engineering that have made it possible to transform trillions of dollars of the money-like debts of banks and financial institutions into housing and real estate investments. If instead one is concerned about having a safe and healthy financial system, one may wonder about the risks that might arise from so much maturity transformation. As in the case of the Bailey Building and Loan Association in the movie It’s a Wonderful Life, one type of risk is a run that disrupts the funding of the banks holding the mortgage-related securities. A more serious risk is the possibility that the bank will become insolvent, which is precisely what happened to a number of banks in 2007 and 2008.
Unlike the insolvencies in the early 1980s, those in 2007 and 2008 were not directly caused by interest rates’ changing. Many mortgages had adjustable interest rates, which went up along with market rates in 2005-2007. However, these rate adjustments led to many defaults on mortgages because borrowers could not pay the higher interest.
The interest rate increases in the United States in 2005-2007 were much smaller than those in the late 1970s and late 1980s, but, coupled with the questionable creditworthiness of borrowers, the increases were enough to usher in the turnaround in U.S. real estate prices and trigger many delinquencies on mortgages. When the risks in mortgage-related securities became apparent in the summer of 2007, the prices of these securities declined significantly. Given that the institutions holding them had very little equity, many became distressed, some insolvent.
In Chapter 5 we discussed the contagion risks associated with long and complicated chains of transactions. These claims allowed participants to fool themselves about the risks to which they were exposed. There was substantial amount of maturity transformation in the system, but none of the participants seemed to have seen the risks from where they stood. Quite possibly, given the incentives of many of the participants, they preferred to ignore the risks.
By splitting the overall operation into many different and connected steps, market participants were able to hide the risks and tell themselves, their supervisors, and their customers that everything was safe and liquid because each step by itself seemed safe. Creditors were enthusiastic about the ability to invest in money-like debt that paid slightly more interest than government debt, and lots of questionable mortgages were made to feed the rush of securitization and the “production” of liquid debt.
Why All This Complexity? – The complicated chain of transactions just discussed is an example of the increase in the interconnectedness of the financial system in recent decades. As we noted in Chapter 5, this interconnectedness was key to the contagion that caused the 2007-2009 financial crisis to be as damaging as it was.
The increase in interconnectedness was not due just to a desire for greater efficiency. At least some elements of the chain of transactions were due to participants’ trying to get around the prevailing regulations. For example, the continued prominence in the U.S. financial system of money market mutual funds, which played a major role in the post-Lehman panic, is due to their being able to offer the same services as banks without being subject to the same regulations. They can generate higher returns for investors because they are not part of the deposit insurance system and therefore do not have to pay insurance fees. In September 2008, however, the U.S. government chose to provide them with guarantees anyway rather than allowing the run of investors on money market mutual funds and the run of money market mutual funds on banks to continue to destabilize the financial system.
In chapter 5 we mentioned that the bailout of AIG was motivated by the fear of contagion from an AIG default on its commitments to credit insurance. Banks had bought this insurance in order to reduce estimates of their risks and, by implication, their required equity. Without the AIG bailout, the credit insurance might have been worthless, and the banks would have been hit by the credit risks that they thought they had insured.
Putting mortgage-related securities into structured investment vehicles (SIVs), entities that could be kept off the banks’ balance sheets, was also motivated by the desire to get around regulation. Regulators treated the SIVs as if they were separate from the sponsoring banks. Therefore, the banks were not required to have any equity funding of the investments. However, the SIVs could obtain outside funding only because the sponsoring banks provided guarantees for them. Banks bore the risks of the SIVs without backing this commitment by equity and thus without the ability to absorb losses.
There was (and still is) an element of make-believe in all of this. As bankers and investors pursued higher returns, actual or imagined, they downplayed the risks. Banks claimed to hedge risks in ways that fooled supervisors as well as the bankers themselves but ended up being ineffective. No one bothered to keep track of where in the system the risks were going. Some of the gains in returns seemed extremely small relative to the risks involved. For example, the extra interest earned on relatively “safe” mortgage-related securities might be as low as 0.1 percent, which was hardly enough compensation for the actual risks involved.
Why were people so willing to fool not only the regulators and their bosses but possibly also themselves? The answer is that they had incentives to do so. As discussed in Chapter 8, bankers are paid bonuses on the basis of their assessed contributions to profits, with little accounting for risks. Investing $1 billion in a security whose return promises to be 0.1 percent above the borrowing cost may seem very attractive and a reason for paying high bonus because, if nothing goes wrong, the investment will show a profit of $1 million per year. If, a year later, the security’s value declines by 10 percent, the bank loses $100 million, but that need not affect the bonus that the banker had received for making the investment.
Bankers generally act in response to the incentives they are given, even if their actions do not generate sustainable benefits for anyone but themselves. Borrowing a bit more in order to make a risky investment that pays barely more than the borrowing rate may be attractive to a banker if he does not have to take the additional risk into account. Because of the risk, however, this borrowing and the investment made with borrowed funds may well be undesirable for the bank’s shareholders, its other creditors, and society.
As discussed in Chapter 3, heavy borrowers are affected by debt overhang, which makes them exist reducing their indebtedness if doing so would make their remaining debt safer at their expense. In fact, heavy borrowers have incentives to increase their borrowing even if it is inefficient.
In our mortgage example, we saw that Kate might be reluctant to invest $50,000 in renovating her house even if the renovation increases the value of the house by more than it costs; the reason is that the investment will increase the value of her equity by less than $50,000 if there is a possibility that she might end up underwater. In this case the investment will benefit Kate’s creditors rather than Kate. Kate might also be tempted to take a second mortgage, increasing the likelihood that she will default. Similarly, managers and shareholders may have reasons to resist taking actions to make banks safer, and they may even try to take additional risk at the expense of their creditors—and of society.
Why do creditors agree to lend to banks under such circumstances? One answer is that at least some of them are insured and have nothing to worry about. This is the case of depositors whose claims are covered by deposit insurance. Insured creditors have no reason to monitor what a bank does and how much risk it takes. Since the introduction of deposit insurance, deposits have actually been a rather stable source of funding for banks.
Another reason creditors lend under such circumstances is that they believe they can protect themselves by providing only short-term loans. Providing short-term loans enables creditors to react quickly to bad news about a bank by withdrawing their funding. By providing only short-term loans, creditors also protect themselves against the bank’s issuing new debt that might have priority over their claims.
Bank borrowing involves a kind of rat race in which every creditor tries to make sure that he will be repaid before the others. One way to do this is to lend for very brief periods only—for example, overnight. The maturity transformation that banks engage in, which involves using deposits and short-term debt to fund longer-term investments, is at least partly a result of this rat race. People lend to banks through deposits and other types of money-like debt not only because this is convenient but also because they want to make sure they have priority over all other creditors. Repeated overnight lending that borrowers must renew every day gives creditors a sense of being in control.
(IN TALKING ABOUT STRUCTURED INVESTMENT VEHICLES, I QUOTE FROM NOTE 45 ON PAGE 299:
“45. Gorton (2010, 123 ff) argues that events in the summer of 2007 are more appropriately interpreted as a panic that resulted from the fact that nobody knew which mortgage-related securities were affected and which ones were not. He emphasizes liquidity problems from the breakdown of funding for structured investment vehicles in the summer of 2007, comparing it to a nineteenth-century run. However, the breakdown of funding for structured investment vehicles in the summer of 2007 meant only that the sponsoring banks had to take the mortgage-related securities held by these vehicles onto their own books. These banks typically did not have serious funding problems, but once they moved these assets onto their balance sheets, they did not have enough equity to back them. Because of the price declines, some, like the German Industriekreditbank and Sachsische Landesbank, became insolvent right away and had to be bailed out. Others just found that the price declines squeezed their equity more and more as the contagion effects discussed in Chapter 5 played out. The actual funding problems came later, in March 2008 for Bear Stearns and in September 2008 for Lehman Brothers, when their solvency began to be doubted. Krishnamurthy et al. (2012) show that, except for broker-dealer banks like Bear Stearns or Lehman Brothers, repo lending, which is emphasized by Gorton (2010), played a much smaller role than asset-backed commercial paper; in their account, the breakdown of funding for asset-backed commercial paper in the summer of 2007 had little semblance to a bank run; by contrast, the Bear Stearns and Lehman Brothers episodes did involve repos and did have some elements of a run.”
IF YOU WANT TO KNOW MORE ABOUT STRUCTURED INVESTMENT VEHICLES, LOOK UP THE FOLLOWING ARTICLE ON: http://www.investopedia.com/terms/s/structured-investment-vehicle.asp
I TOTALLY AGREE WITH THE AUTHORS THAT ALL THE BANKERS ARE WORRIED ABOUT IS HOW THE CEOs AND EXECUTIVES ARE GETTING PAID, USING STOCK OPTIONS, WHICH ARE DERIVATIVES, THIS EVEN TOOK PLACE IN THE BANK I WAS BANKING AT BEFORE IT GOT SOLD. WHAT I’M HEARING TODAY, AFTER THE 2008 CRISIS, THEY’RE STILL DOING BUSINESS THE SAME WAY, KEEP ON EXPANDING THE GROWING TOXIC DERIVATIVE MARKET AND PUSHING FOR EVEN BIGGER AND BIGGER BANKS TO SEE THEM IN AND TO KEEP DRIVING OUT OF BUSINESS AS MANY MEDIUM AND SMALL BANKS AS THEY CAN. EVEN OUR SMALL LOCAL BANKS AREN’T DOING IT RIGHT. YOU CAN BUY A HOUSE WITH NO MONEY DOWN AND AFTER THE BANK GETS THE LOAN, WITHIN A FEW DAYS, THEY SELL THE LOANS TO AN OUT OF STATE BANK AND MANY TIMES NOT TELLING THE CUSTOMER THAT THEY ARE SELLING THE LOAN, WHICH WILL IN THE END, LEAD TO BANKRUPTCY WHICH IS SOMETHING WE MUST ELIMINATE AS MUCH AS POSSIBLE AND BY GETTING BACK TO THE OLD WAYS WE HAD WITH 10 PERCENT DOWN AND KEEPING THE LOANS LOCAL WOULD DEFINITELY HELP. I BELIEVE THE SUBSIDIES THAT THE BANKS RECEIVE HAVE A LOT TO DO WITH IT JUST LIKE IN AGRICULTURE WITH THEIR BIGGER FARMS. I NEVER ACTUALLY THOUGHT THE GOVERNMENT WOULD GO OUT AND PROMOTE CLASS WARFARE WITH PEOPLE LIKE REPUBLICAN DICK CHENEY, PROMOTING MORE WAR AND LESS FOOD STAMPS WHICH SOUNDS LIKE MORE OF THE REPUBLICAN TRICKLE-DOWN THEORY THAT ISN’T WORKING. I PERSONALLY WOULD LIKE A PUBLIC STATE BANK TO PUT MY MONEY IN BECAUSE I HEAR THEY’RE MORE COMPETITIVE LIKE NORTH DAKOTA HAS.
LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AARP Members