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Sunday, July 12, 2020

Government Is Causing Another Bank Crisis

The presumptive Democrat nominee for president, Joe Biden, has ramped up his radical rhetoric, now calling for an end to "shareholder capitalism". I am not going to spend time examining what his own administration under President Obama did in terms of crony capitalism; let's just note that they expertly maintained a cronyist tax system where influential lobbyists could carve out special favors, and that they forced banks into even more risk taking under Dodd-Frank.

Since I have just obtained a contract with a publisher for my book on socialism, I will also refrain from arguing Biden's ideological point. Rest assure there will be plenty of that in my book... What is important, though, is to remember that whenever government increases its presence in the private sector, be it by means of taxes, regulations or spending, it exacerbates the distortions that eventually lead to economic crises. When some rightfully raise the alarm bell that we are heading for another bank crisis, it is important to remember what role government plays in bringing about this crisis.

Before we move on, let me make clear that free-market capitalism with only a libertarian minimal government is not free of economic crises. The business cycle is inherent to a free-market economy; anyone who claims otherwise needs to study John Maynard Keynes, Arthur Okun, George Shackle, Hyman Minsky and Paul Davidson. The fact that none of these economists were libertarian, or even openly political, only adds to their credibility.

That said, thanks to its firm reliance on market prices and free enterprise, capitalism is the superior system for managing, mitigating and in some sense avoiding recessions. More importantly, it is the only economic system that can keep us out of depressions; the implosion of economic activity is always the cause of misguided government intervention into the economy. The problem with our long-term drift into stagnation and industrial poverty has the same cause: a government that slowly but relentlessly chokes the economy into a standstill.

Harmful intervention by government is both systemic or macroeconomic - the welfare state - and discrete or microeconomic. The rising risk for a bank crisis is a clear example of the latter, and the role that government plays is being badly under-appreciated. In an article in the latest issue of The Atlantic, Frank Partnoy provides a telling example:
You may think that [a bank crisis] is unlikely, with memories of the 2008 crash still so fresh. But banks learned few lessons from that calamity, and new laws intended to keep them from taking on too much risk have failed to do so. As a result, we could be on the precipice of another crash, one different from 2008 less in kind than in degree. this one could be worse.
Partnoy then goes on to point out that the 2008 crash was caused by over-exposure to subprime mortgages, and that Congress passed Dodd-Frank in an effort to encourage banks to "borrow less, make fewer long-shot bets, and be more transparent about their holdings." This, he says, is a lesson not learned: banks are still invested in collateralized instruments for fragmentation of risk. In short: a $100 loan is split up and sold off in, say, $10 pieces to mitigate the impact on the lender if the borrower defaults.

This is the same asset-management philosophy that led to the invention of the shareholder company a long time ago. In practice, of course, there are differences, but fragmentation of risk is in itself not a problem. The problem is instead in how these collateralized instruments - known as CLOs and CDOs - pay out their coupons, and how this payout model conspires with the overall structure of bank portfolios.

The coupon payout problem is caused by the sequence by which the interest is paid out. Those who bought into a CLO first also get their money first. For example, suppose a $100 CLO is split into four shares. Al buys his share first, Bill buys next, then Chris and Dan last. When the coupon interest payment of $2 comes due, Al gets 50 cents first, then Bill gets his check, after that Chris and finally Dan.

Suppose now that the borrower runs into problems and can't fully pay his loan. Suppose he can only make half of the payment. Al still gets his 50 cents, as does Bill. Chris and Dan, on the other hand, get no money.

It is here that the CLO asset becomes a problem. The interest it pays - in this case two percent - is based on the risk calculation for the asset itself, in other words the borrower of the entire loan of $100. This is the classical default risk, under which all the four investors are exposed to the same risk. However, because of the sequencing of the coupon payment, not all investors are exposed to the same risk - even though the interest they get is one and the same. In other words, every investor who has lower seniority than the first one (in our example Bill, Chris and Dan) is burdened with a risk for which there technically is no market price.

Since the less-senior investors are at higher risk for defaults, without being compensated with a higher interest rate, their asset portfolios are now slanted unfavorably in terms of risk and reward. To compensate for this, an asset manager has two choices:

1. He can expose his portfolio to higher risk with considerably higher returns; or
2. He can expand his holdings of virtually risk-free assets.

In reality, asset managers will strike a balance between these two, but they will almost always lean one way or the other. Those who lean in favor of higher risk, in pursuit of higher returns, will of course be the first in line to suffer defaults. By contrast, those who lean in favor of low-risk investments will be safer, accepting lower yield in return.

Here is where government steps in to mess things up (or at least one of its steps...). Over the past ten years commercial banks have increased their exposure to Treasurys, both mortgage-backed and traditional, by about 50 percent. Ten years ago approximately $15 of every $100 in commercial-bank assets was Treasury debt; today that share is almost $22. During the same period of time, yields on Treasurys have declined, especially on the traditional kind, where interest is now cemented in virtually-zero territory. All Treasurys with a maturity date of three years or shorter now yield below 0.2 percent. Even the ten-year benchmark Treasury now yields below one percent. If you lend the government your money for 30 years - until 2050 - you get 1.33 percent per year.

In June 2019, Treasurys of both kinds - mortgage-backed and traditional - accounted for 21 percent of bank portfolios. In June this year the share had increased to 22.2 percent. On July 1, the share was reported at 22.7 percent.

Most of this expansion has taken place in traditional Treasurys: on July 1 this year commercial banks held 35 percent more traditional government debt than a year earlier. By contrast, their ownership of mortgage-backed Treasurys increased by only 12 percent. Given the yield on traditional government debt, this is an unsustainable trajectory. As interest rates keep dropping; as banks buy more Treasurys; their need to expose themselves to higher-risk assets will only increase. 

If Congress could keep its debt within such a framework that those who invested in it actually made a little bit of money, it would be much easier for portfolio managers to keep their risk exposure both profitable and sustainable. As things look now, though, that appears to be only something to wish for.

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