00:00:14
Um what about investment banks? Um it
00:00:17
was shocking quite frankly to see that
00:00:19
uh the Fed bailed out bear because it
00:00:23
was something they had a pretty firm
00:00:24
policy against doing for um the entire
00:00:28
uh t modern era in the US. We had taken
00:00:32
the traditional view that investment
00:00:35
banks could not be a source of systemic
00:00:37
risk. Why was that? Well, one for one
00:00:41
thing, unlike a bank where a bank
00:00:44
deposit depends on the health of the
00:00:45
bank if you want to get your money back.
00:00:48
If you're a customer of an investment
00:00:50
bank, I didn't say an investor, mind
00:00:52
you, I said a customer of an investment
00:00:54
bank, those securities are segregated,
00:00:58
you don't really have to depend on the
00:01:00
investment bank to get your uh
00:01:02
securities out. And you're seeing right
00:01:05
now a very easy, very straightforward
00:01:08
lift out of Layman Brothers of all of
00:01:10
the accounts that that um they have with
00:01:14
nobody really afraid that they're not
00:01:15
going to in fact layman is continuing to
00:01:17
trade for you today. Uh but they'll be
00:01:20
lifted out and put in another investment
00:01:21
bank with absolutely no harm. Uh there's
00:01:24
also cypic insurance to back it up. So
00:01:27
there's really not a risk that would
00:01:28
cause customers to run as there is in a
00:01:31
bank where bank depositors do need to
00:01:33
worry about the quality of their bank.
00:01:36
The other argument was that investment
00:01:38
banks hold mainly marketable securities
00:01:42
and that means that should they face a
00:01:45
liquidity crisis, they can delever very
00:01:48
easily because all they need to do is
00:01:51
sell securities so that their balance
00:01:53
sheet matches their funding base. A and
00:01:56
finally um the argument was that you
00:01:58
didn't need to worry about them from a
00:02:00
systemic perspective because their
00:02:02
access to the important clearing and
00:02:04
settlement system was through banks. So
00:02:07
you could really regulate investment
00:02:09
banks indirectly through banks.
00:02:12
We in fact had a test of that
00:02:14
hypothesis, not one that anybody
00:02:16
especially wanted to run, but the most
00:02:19
profitable firm on Wall Street uh during
00:02:21
the 1980s was Drexelburn and Lombair.
00:02:25
And in 1990, it was forced to um uh go
00:02:29
into chapter 11 bankruptcy. Um there was
00:02:32
absolutely no public intervention except
00:02:35
that the Bank of England and the New
00:02:37
York Fed acted as honor honest brokers
00:02:40
in order to unwind their positions. But
00:02:43
it had so little systemic consequence
00:02:45
that the stock market actually went up
00:02:48
the day that bear that uh Drexel Burnham
00:02:50
went down. The EU in contrast to the US
00:02:54
has long had the very opposite view of
00:02:56
investment banks. Part of that is
00:02:58
because almost all of the large European
00:03:01
investment banks have long had
00:03:03
investment banking powers. So they
00:03:05
really don't recognize the difference in
00:03:06
the category. The other reason is that
00:03:09
the big five US investment banks all
00:03:13
have important banking operations in
00:03:15
Europe um uh usually in London but also
00:03:19
in other places as well. So earlier this
00:03:23
decade, the EU insisted that we subject
00:03:28
investment banks to credential oversight
00:03:30
comparable to that applied to large US
00:03:33
banks. Now we had a law that permitted
00:03:35
us to do that. Um the uh Graham Leachch
00:03:39
Blly modernization act which was passed
00:03:42
in 1997
00:03:44
uh set up financial service holding
00:03:46
companies where the Fed would be the
00:03:47
supervisor or they permitted the
00:03:50
possibility of an investment bank
00:03:52
holding company which would permit the
00:03:54
SEC to be the oversight supervisor.
00:03:57
Investment banks however were free to
00:04:00
decide to do it or not. None of them
00:04:02
wanted to be regulated by the Fed and
00:04:04
one can well understand why not. Um nor
00:04:07
did they really want to be regulated by
00:04:09
the SEC. The compromise that was arrived
00:04:12
at was that they would become voluntary
00:04:15
consolidated supervised entities with
00:04:18
SEC oversight. And um as far as we can
00:04:21
tell it amounted to none at all. Uh the
00:04:23
SEC has still not been able to describe
00:04:25
what they did. Well, what's changed
00:04:28
since the days of Drexel Burnham? uh
00:04:30
because that was a tough time too. The
00:04:32
US economy was in recession. It was not
00:04:34
a time when anybody really wanted to run
00:04:36
an experiment of letting a a major firm
00:04:39
go. Well, it's not your father's
00:04:41
investment bank these days. What's
00:04:44
happened over time is that investment
00:04:46
banks have become more and more like
00:04:48
commercial banks. Their portfolios have
00:04:51
shifted sharply in favor of lower
00:04:53
quality, less liquid assets. They no
00:04:56
longer have balance sheets that are
00:04:58
mainly treasury bills and things they
00:05:00
can sell in a price. The proportion of
00:05:03
of uh leveraged loans, for example, has
00:05:06
grown eightfold from 2001 to 2007 on
00:05:10
their balance sheets. The other thing
00:05:12
that's happened is that their funding
00:05:14
base has has and they themselves have
00:05:17
become much more international. Now,
00:05:18
that could be a good thing because
00:05:20
diversification and funding is usually a
00:05:22
good thing. But it means that if you get
00:05:25
into trouble, you're going to have to
00:05:27
deal with the authorities in one country
00:05:29
to take funds from that country to help
00:05:33
you in the country where you may have a
00:05:35
deficit. And typically supervisors and
00:05:38
regulators look after their own first
00:05:41
and so it becomes an innovation. The
00:05:43
other enormous difference in the
00:05:45
investment banking business is that
00:05:47
they've become much much more leveraged.
00:05:50
This isn't even counting the embedded
00:05:52
leverage in the instruments that they
00:05:54
hold, the swaps, the futures, um, and
00:05:57
the uh, CDOS's and various sorts of
00:05:59
securitized debts. This is just looking
00:06:01
at net leverage. Bear Sterns had a 32:1
00:06:06
ratio, which is just incredible if you
00:06:09
think about it. It works really, really
00:06:12
well when profits are high, and that's
00:06:14
why these firms were so profitable in
00:06:16
good times. But it doesn't take much of
00:06:19
a hit to turn such an institution into
00:06:21
an insolvent institution.
00:06:24
The other major change in investment
00:06:26
banks has been the importance of repos.
00:06:28
Now repos in 1990 were about 13% of
00:06:33
federally insured bank deposits.
00:06:36
Repos uh last year were 60% of federally
00:06:42
insured bank deposits. So repos have
00:06:44
become a huge factor. Um, we thought
00:06:48
that it was a way for a firm to borrow
00:06:51
without reference to its own credit
00:06:53
risk, but somehow uh experts and the
00:06:56
profession mix missed the point that
00:06:59
counterparty risk can be very very
00:07:00
important. And as we've heard before,
00:07:03
they've become very involved uh in in
00:07:06
all sorts of over-the-counter markets,
00:07:07
particularly the credit default spot
00:07:09
market, which is more than 60 trillion
00:07:12
in in size. Uh now Bear Sterns was in a
00:07:16
very precarious position. It was obvious
00:07:19
as soon as their two hedge funds blew
00:07:20
up. Their equity price fell to almost
00:07:23
nothing. Um their liquidity position
00:07:26
which is something they really should
00:07:28
have been watching at year in 2007 was
00:07:30
the lowest of the five investment banks.
00:07:33
they were the most leveraged and you
00:07:35
could see in the credit default spreads
00:07:37
against Bear Sterns that in fact um they
00:07:41
were much higher than for any other
00:07:43
investment bank in uh January and
00:07:46
February and of course in March. Yet
00:07:48
nonetheless uh and I think Jeremy made
00:07:51
the argument and and uh it is I think
00:07:54
quite believable the Fed was caught by
00:07:56
surprise. Um the rapid demise of Bear
00:08:00
Sterns really did startle them. um the
00:08:03
prime brokerage specialty at the thing
00:08:05
at which Bear Sterns was really good
00:08:08
became a liability as the hedge funds
00:08:10
grew worried and withdrew all of their
00:08:12
funds. Um and you found that
00:08:14
over-the-counter derivatives parties um
00:08:16
really didn't want to have them as a
00:08:18
counterparty. They didn't want to take
00:08:19
the the uh counterparty risk. Lenders
00:08:22
wouldn't lend to them and some banks
00:08:24
even refused to clear for bear. So it
00:08:26
was essentially dead. The Fed then did
00:08:30
something really quite startling. Um,
00:08:32
they bailed them out. It was a shotgun
00:08:34
marriage with JP Morgan Chase, but they
00:08:37
uh put in $30 billion. It's true Chase
00:08:40
will have the first billion in loss, but
00:08:42
there's still 29 billion of taxpayers
00:08:45
money at risk. And it's at risk in a
00:08:48
very untransparent way. In a world where
00:08:51
SPEs and special purpose vehicles have
00:08:54
gotten us in trouble, what did the Fed
00:08:56
do? Well, they created an SPE and had it
00:08:59
managed off balance sheet. Nobody's sure
00:09:00
what's in it. They claim it's good
00:09:03
quality stuff, but but we don't really
00:09:04
know. Why did the Fed do that? Why did
00:09:08
the Fed um uh make this incredible break
00:09:11
with with its past? Well, they were
00:09:14
concerned that if we applied regular
00:09:17
bankruptcy laws, now we don't do that to
00:09:20
banks, but to investment banks, we do.
00:09:22
Uh and we're seeing how the experiment
00:09:24
works with Layman Brothers. We by no
00:09:26
means know exactly how it works. There
00:09:29
are stays that are automatically applied
00:09:32
and these stays which have a rationale
00:09:36
uh of letting the court figure out what
00:09:38
the assets are and what the liabilities
00:09:40
are and uh make sure that everybody gets
00:09:43
paid in an appropriate way um can have a
00:09:46
devastating effect on financial markets.
00:09:48
it can cause um counterparties to be
00:09:52
unable to hedge and uh the lack of
00:09:54
clarity regarding positions can cause
00:09:57
major failures. So we found a situation
00:10:01
where the Fed was not willing to take a
00:10:04
chance. Um what happened with layman
00:10:07
brothers? Well, one of the problems of
00:10:10
intervening as the Fed did is that it
00:10:12
creates moral hazard. Um, and the moral
00:10:15
hazard isn't just that investors won't
00:10:18
monitor as well. Not just that the
00:10:20
investment banks have a bigger incentive
00:10:22
to take risks. It's a moral hazard in
00:10:25
solving the problem, a private sector
00:10:28
deal. Why was it that it wasn't Sunday
00:10:31
morning that we uh had didn't know that
00:10:34
layman wasn't going to find a partner?
00:10:36
Well, they didn't fully believe that the
00:10:38
Treasury and Fred would let it go. And
00:10:41
there was good reason not to believe.
00:10:42
Layman Brothers was more than twice as
00:10:45
large as Bear Sterns. It had all of the
00:10:47
same interconnections. What was
00:10:50
different was that the Fed knew a lot
00:10:52
more about it because as Franklin
00:10:54
mentioned, they've had examiners in
00:10:56
there every day since since March. And
00:10:59
um uh the political factors uh may have
00:11:02
well entered in as well um because they
00:11:05
had just taken on six trillion with
00:11:07
Fanny, Freddy, and the Federal Home Loan
00:11:09
Bank system. Um so we're in a situation
00:11:13
where um we're playing an experiment
00:11:16
that they were afraid afraid to play in
00:11:18
March. It's hard to argue that markets
00:11:21
are in much more stable situation and
00:11:23
we'll just have to see how it goes.
00:11:25
Well, as I mentioned,
00:11:28
one of the uh things that's gone wrong
00:11:30
is risk management. A lot of the things
00:11:32
we thought we knew about risk management
00:11:33
turned out not to be true. And it's true
00:11:36
of each of the traditional silos of risk
00:11:38
management. market risk. Well, typically
00:11:42
when you look at market risk, you use
00:11:43
some sort of value at risk model that
00:11:45
looks at prices. But as trading rooms
00:11:49
increasingly trade in securities that
00:11:51
are credit risk intensive, you've got to
00:11:54
look at credit risk and liquidity risk
00:11:57
as well. And most firms were simply not
00:11:59
set up to do that. Um, credit risk um,
00:12:03
uh, also was a problem because, uh,
00:12:06
people didn't really understand its
00:12:07
relationship to liquidity risk.
00:12:09
Operational risk proved a problem
00:12:11
because most firms didn't have
00:12:13
management information systems that
00:12:15
could tell them what their full exposure
00:12:17
to these markets were. And so, you had
00:12:19
this embarrassing series of
00:12:20
announcements of even bigger and larger
00:12:23
um, uh, exposures and losses. and uh
00:12:27
operational risk failed to have a good
00:12:30
discipline for pricing these securities.
00:12:33
Um there's an interesting BIS paper that
00:12:35
shows the differences in pricing. Some
00:12:38
of them were very naive, looked uh
00:12:40
basically just at um the ratings and uh
00:12:44
had no real backup system. But there was
00:12:47
also a failure across silos. There was a
00:12:50
failure to anticipate that correlations
00:12:52
were not going to be stable. there was a
00:12:54
failure to realign risk management with
00:12:57
um uh the convergence of risk types. But
00:13:00
I'd like to finish um with um a plug for
00:13:03
a book that we're sponsoring at the uh
00:13:06
financial institution center. It's going
00:13:08
to be called the known, the unknown, and
00:13:10
the unknowable in financial
00:13:11
institutions.
00:13:13
And um I think it summarizes some of the
00:13:15
the lessons learned. Among the known, we
00:13:18
thought we knew a lot about models,
00:13:21
ratings, and insurance. And it turns out
00:13:24
we knew a lot less than we thought we
00:13:26
did. And um things you think you know
00:13:28
that just ain't so are really what can
00:13:30
bite you in a big way. The uh unknown
00:13:34
are things where there's sort of a big
00:13:35
variance. You just don't really know
00:13:37
with precision what the answer is. Um
00:13:40
and the problem is that regulation is
00:13:44
now insisting on a precision that's
00:13:47
simply impossible. that they're
00:13:49
insisting that institutions have capital
00:13:52
that will protect them against all but
00:13:55
003%
00:13:57
of the risk of default during a year.
00:13:59
And the fact is we just don't know what
00:14:01
those tales are like. And uh we're
00:14:04
deluding ourselves by playing that.
00:14:06
Finally, the unknowable. It may be that
00:14:09
modern financial systems are simply so
00:14:11
complex and the dynamics are so
00:14:14
complicated that um we really don't
00:14:19
understand them and probably can't
00:14:20
because they move very quickly. What's
00:14:23
the answer to that? Well, that means
00:14:25
that there's a lot of value in firms
00:14:28
stockpiling liquidity in extra capital
00:14:32
and in resiliency. The problem is um in
00:14:36
a world of takeovers and aggressive
00:14:38
hedge funds, it's not so clear that u
00:14:41
banks and insurance companies and other
00:14:43
financial institutions can get can get
00:14:45
by with having that kind of redundancy
00:14:47
in their balance sheets. Thanks.
