Lenders, not borrowers, were the driving force behind the financial crisis

Editor’s note: RepoWatch would like to recognize Financial Times editor Gillian Tett, whose August 11 column about the Pozsar report proves once again that she is far ahead of other journalists in her understanding of the core issues facing financial markets today.

The two driving forces behind the financial crisis of 2007-2008 were large investors worldwide who demanded a safe place to invest their trillions of dollars and financial institutions who met that demand by creating highly rated mortgage-backed securities that turned out not to be as safe as advertised.

That’s the nut of an August 2011 study by International Monetary Fund economist Zoltan Pozsar.

If his theory is correct, the same dangers exist today. The same large pools of cash are looking for a safe place to invest, and the same financial institutions are trying to devise a way to get their business.

Ultimately, some of the cash ends up in FDIC-insured deposits and some of it buys Treasury bills, Pozsar writes. But because those options are limited, managers put some of the cash to work in the less regulated arena of shadow banking, for example by making repo loans or by buying asset-backed commercial paper, which banks and their off-the-books businesses sell to raise cash for their securitization operations. Repos and ABCPaper are considered safe because they’re short term, often overnight, and collateralized. Managers also put some of the cash in money market funds, which themselves make repo loans and buy asset-backed commercial paper.

Many economists have viewed shadow banking as having been created by financial institutions that wanted to operate outside the prying eyes of regulators. Pozsar, who authored an in-depth study of shadow banking last year, argues it should also be understood as a market-based solution to the needs of large investors, and he recommends that it be called market-based banking instead of shadow banking.

In the lead-up to the financial crisis, when managers of the cash pools couldn’t fit all their money into FDIC-insured deposits or buy enough Treasuries, they turned mainly to money market funds, ABCPaper and repos, writes Pozsar – exactly the elements of shadow banking that caused the panic in 2007 and 2008.

Supplying the shadow investment options were broker-dealers, Fannie Mae and Freddie Mac, off-the-books trusts or conduits, limited purpose finance companies, bank holding companies through their money market funds, and commercial banks through their off-the-books structured investment vehicles (SIVs).

Often managers of the cash pools actually preferred shadow banking investments to FDIC-insured deposits, Pozsar writes. That was because the managers could get collateral to reuse, they had Fannie and Freddie guarantees on many mortgage securities, they had bank guarantees behind money market funds, SIVs and conduits, and they got preferential treatment in bankruptcy court, meaning the cash pools got their money back faster from a bankruptcy than from the failure of an FDIC-insured bank.

“In other words, institutional cash pools are not particularly keen on being intermediated through the traditional banking system,” Pozsar writes.

The reforms now underway, driven by The Dodd-Frank Act and Basel III, fail to address the challenges posed by the demands of large investors, and that’s likely to lead to further financial crises in the future, Pozsar writes.

Institutional cash pools’ strong safety preferences were the principal drivers of the emergence of the market-based financial system. These preferences are either satisfied through policy or through solutions devised by the financial system. Frustrating the system’s ability to provide these solutions, while at the same time not addressing the vacuum this creates through policy, remain fundamental sources of systemic risk and point to more frequent banking crises ahead.

Pozsar throws his weight behind reforms that would make the shadow investment options as safe as FDIC-insured deposits – like the Federal Reserve and the U.S. Treasury did on an emergency basis in 2007 and 2008 – perhaps by issuing Treasury bills that these investors could buy, as earlier studies have suggested, or by creating special banks to create FDIC-insured securities that these investors could buy, as Yale University professors Gary Gorton and Andrew Metrick have suggested.

Such reforms will be especially needed as the supply of Fannie Mae- and Freddie Mac-insured securities shrinks, Pozsar writes.

Pozsar’s study looks at cash pools of $1 billion to more than $100 billion, which he estimates total $3.4 trillion today. They belong to global corporations like S&P 500 companies, securities lenders, pension funds, mutual funds, wealthy individuals, endowments, hedge funds, insurance companies and central counterparty clearing houses.

In 2006, at the peak before the crisis, these pools had 34.6 percent of their money in money market funds (which put one-fourth of their money in repos, on average), 28.8 percent in shadow banking investments (led by 14.9 percent in commercial paper and 3.4 percent in repos), 19.6 percent in bank deposits, and 9.1 percent in government securities like T-bills, Pozsar reports. From his paper:

Through the profiling of institutional cash pools, this paper explains the rise of the “shadow” banking system from a demand-side perspective. Explaining the rise of shadow banking from this angle paints a very different picture than the supply-side angle that views it as a story of banks’ funding preferences and arbitrage. Institutional cash pools prefer to avoid too much unsecured exposure to banks even through insured deposits. Short-term government
guaranteed securities are the next best choice, but their supply is insufficient. The shadow banking system arose to fill this vacuum.

According to Pozsar:

This paper is the first to study the phenomenon of institutional cash pools and to ask why wholesale funding markets have grown, what the growing presence of institutional cash pools means for financial stability, and whether, in the context of the rise of institutional cash pools, the effectiveness of an official safety net for banks and deposits only has been eroding over time.

Pozsar says his paper has five conclusions:

First, insured deposit alternatives dominate institutional cash pools’ investment portfolios relative to deposits. The principal reason for this is not search for yield, but search for principal safety and liquidity.

Second, between 2003 and 2008, institutional cash pools’ demand for insured deposit alternatives exceeded the outstanding amount of short-term government guaranteed instruments not held by foreign official investors by a cumulative of at least $1.5 trillion; the “shadow” banking system rose to fill this gap. From this perspective, the rise of “shadow” banking has an under-appreciated demand-side dimension to it.

Third, institutional cash pools’ preferred habitat is not deposits, but insured deposit alternatives. This is to say that institutional cash pools’ money demand is satisfied by non-M2 types of money. This is because institutional cash pools’ money demand is not for transaction purposes, but for liquidity and collateral management as well as investing purposes, which aren’t best met by deposits, but by Treasury bills and repos.

Fourth, the larger institutional cash pools and their demand for insured deposit alternatives grow, relative to the supply of short-term government-guaranteed instruments in the financial system, the less effective deposit insurance and bank-only  lender-of-last-resort access will be, as stabilizing forces in times of crises.

Fifth, an elegant way to solve the financial system’s fragility due to the rise of institutional cash pools and “shadow” banking would be to issue more Treasury bills and to explicitly incorporate the supply management of bills into the macroprudential tool kit (used to prevent financial instability). While not without costs or alternatives, this approach is less troublesome and complicated than the alternative of intense real-time monitoring and regulation of the shadow banking system.