Oscar Wilde was fond of saying that people rather than principles move the age.
In the case of banking reform, the problem is not one of principle (in the form
of regulation) nor of principal (proprietary trading), but of profitability.
Financial institutions flap around desperately in a low-return environment like
fish in oxygen-starved water. That is the source of the financial crisis, and
better principles can be ameliorative at best.
That is why I am mildly disappointed in former Federal Reserve chairman Paul
Volcker. He is one of the wisest men I have ever
met, and his contribution to saving the American economy in the early 1980s
ensures him an honored place in the history books. His valedictory contribution
to world financial health may be a plan to limit risk in the banking system,
which he previewed on February 1 on the op-ed page of the New York Times. What
he says is sensible, balanced and wise - but not directly relevant to the
problem at hand.
"The point of departure" for banking reform, Volcker writes, "is that adding
further layers of risk to the inherent risks of essential commercial bank
functions doesn't make sense, not when those risks arise from more speculative
activities far better suited for other areas of the financial markets."
Volcker added: "The specific points at issue are ownership or sponsorship of
hedge funds and private equity funds, and proprietary trading - that is,
placing bank capital at risk in the search of speculative profit rather than in
response to customer needs. Apart from the risks inherent in these activities,
they also present virtually insolvable conflicts of interest with customer
relationships, conflicts that simply cannot be escaped by an elaboration of
so-called Chinese walls between different divisions of an institution."
He's right, but it's beside the point. What brought the banks down was not
speculative bets in volatile markets but what appeared to be ultra-safe
investments in the most conservative assets available, namely medium-term bonds
rated Aaa/AAA by Moody's and Standard & Poor's, the major rating agencies.
The US Federal Reserve agreed to allow the banks to put on more leverage (that
is, allocate less of their own capital against prospective losses) than they
had in the past. But the Fed agreed to do this only for assets that were
supposed to be virtually default-proof. The ratings agencies "sold their soul
to the devil", as a Standard & Poor's analyst admitted in an e-mail later
brought to light by a congressional investigation, in order to rubber-stamp
riskier assets with the AAA label.
But that's because the banks couldn't find enough prime assets in which to
invest and had to find subprime assets to replace them.
I documented this deterioration during 2006, as I tried to build a start-up
research department at Cantor Fitzgerald, a second-tier brokerage firm. From a
business standpoint, the effort fizzled, and I moved in 2007 to a credit
derivatives hedge fund (we paid out our investors with profit in July 2008 and
closed the doors just before Lehman Brothers went bankrupt). Some of the
material below has appeared in my "Inner Workings"
blog on Atimes.net, but it seems worth reviewing in context of the banking
The intellectual effort of trying to establish the research department in 2006,
though in vain, was rewarding. In a series of reports to Cantor Fitzgerald
customers, I showed how global flows caused massive distortions in the pricing
of American securities, and created demand for highly-levered structured
instruments that (temporarily) provided higher returns.
There are two sides to every investment. One is the return you get; the other
is the return you require. For pension funds, the hurdle rate for investments
is the rate required to meet the contractual requirements of a defined-benefit
pension scheme. If corporations fall behind, eventually they will have to dip
into profits in order to make up the difference. Commercial banks pay a certain
amount for money, and lend it out for profit. The benchmark for banks' cost of
funds is the rate for interbank loans, or the London Interbank Offered Rate
(LIBOR). A few of the large banks have sufficient customer deposits to pay a
rate lower than LIBOR on certificates of deposits, but that is a secondary
The derivatives boom was in full flourish when I published my first research
report for Cantor, on January 5, 2006. I wrote:
In CS Lewis's Screwtape
Letters, an old devil gives practical advice to a novice demon.
Diabolical amounts of leverage compressed credit spreads during 2005. Wrong as
the market may be about inherent risk, it is likely to stay wrong, as the Fed
backs off from aggressive tightening, the threatened curve inversion fails to
materialize, absolute yield levels remain low, and investors enhance returns
Investors are not piling into levered ... structures because they are
complacent about credit risk. On the contrary, all the investors I know are
scared to death. But as long as the average US pension fund requires returns of
8.75% to meet its long-term obligations, and the aggregate corporate bond index
yields just over 5%, institutional investors will continue to pick up nickels
on the slope of the volcano. Sponsorship of ever-more-esoteric structures is a
failsafe symptom of yield dearth.
The insatiable hunger for
savings instruments on the part of the world's aging savers was responsible,
ultimately, for the great financial crisis. Huge foreign demand for US
securities pushed the returns of prime securities down to levels that made them
useless to most American investors, including pension funds which have fixed
return targets averaging 9%, and banks funding at LIBOR (the interbank cost of
funds). Once prime assets couldn't meet the requirements of investors, subprime
assets were invented to provide higher returns.
The charts below are derived from my 2006 spreadsheets; I published versions of
them in early 2006.
First, massive foreign inflows into the dollar drove US interest rates down.
The change in custody holdings in the chart below is the Fed's holdings of
Treasury securities on behalf of foreign central banks. The effect was most
obvious in 2003, when massive Asian central bank intervention to hold the
dollar up ballooned reserves. Asian central banks stopped their currencies from
rising by purchasing dollars on the open market. In turn, they invested the
dollars they bought into US Treasury securities. During the early part of the
2000s, the flood of Asian central bank purchases was big enough to depress the
overall level of rates.
We observe in the graph below a nearly perfect inverse relationship between the
change in foreign central banks' holdings of US Treasury securities (measured
by the custody holdings for foreign central banks at the Federal Reserve) and
the two-year Treasury yield:
Change in foreign central bank Treasury investments (custody holdings)
vs 2-year Treasury yield:
In 2003, the Federal Reserve misinterpreted this phenomenon. Future Fed
chairman Ben Bernanke and then Fed chairman Alan Greenspan fretted that the US
economy might be in the grip of deflation and kept interest rates too low for
too long. That contributed to the housing bubble. But something even pernicious
Banks borrow at LIBOR and lend at a margin above LIBOR. With the flood of
global savings pouring into American markets, prime investments began to yield
less than LIBOR for the first time. The most important instrument for
commercial banks next to loans is mortgage-backed securities. Mortgages are
complex instruments because homeowners can prepay their obligations if rates
fall; what matters to banks in the return on such securities is the return
after the cost of hedging for the effect of interest rate changes. By industry
convention, this expected return is measured as an option-adjusted spread above
Shown below is the LIBOR option-adjusted spread (that is, the expected excess
return over LIBOR after taking into account the value of embedded interest-rate
options) for a typical agency pass-through - that's prime mortgages (guaranteed
by a federal agency). This went from 80 basis points to zero between 2003 and
2005, as massive buying by Asian central banks and related agencies pushed down
the expected return to levels never before seen.
For that matter, the interest on high yield debt, adjusted for "expected loss"
(the average loss rate over the preceding 20 years) went to zero. And at the
same time, the yield on speculative grade (high yield) bonds adjusted for
long-term default rates also went to zero.
Expected return above LIBOR of mortgage-backed securities after hedging
costs (LIBOR option-adjusted spread) vs high yield return adjusted for expected
The sort of bonds that banks typically bought for their own portfolio were
paying the cost of funds or less, which meant, simply, that the banks couldn't
make a profit.
We can see how foreign inflows caused the collapse of agency spreads during
2003-2007. Below are reported net foreign purchases of securities issued by
Federal agencies (Fannie Mae and Freddie Mac mainly), against the LIBOR spread
of these securities. Foreign central banks were willing to buy these securities
at LIBOR minus 20 basis points because they had cash burning a hole in their
pockets and didn't need to worry about funding costs. But every other
institution that funded at LIBOR watched spreads fall with dismay. They simply
couldn't buy prime assets, given their own funding costs.
Yield of federal agency securities falls with higher foreign purchases.
As the funding costs of the federal agencies collapsed, they bought more
mortgages, and as they bought more mortgages, LIBOR option-adjusted spread
shrank, as per the second chart in the series. The close relationship between
the LIBOR funding costs of the federal agencies and mortgage-backed securities
is shown below.
Spread to cost of interbank funds of federal agency
(government-sponsored enterprise) securities drives down expected return of
That's why investors went to subprime. Structured securities backed by subprime
debt could be had with an undeserved AAA rating paying LIBOR +20 basis points
or LIBOR +25. The likes of Citigroup vacuumed them up in huge quantities and
stuck them in special investment vehicles with a paper-thin margin of capital
to cover losses. AAAs weren't supposed to have any losses, so the Fed went
along with it.
This created egregious mis-pricing of the whole credit market. I wrote on
January 27, 2006, "We do not value pigs by the attractiveness of their
physique, nor for the nobility of their character, but for their suitability
for sausage. In a credit market dominated by the CDO (collateralized debt
obligation) bid, the most valuable securities are the ones that offer the most
yield relative to default rates projected by the models that rating agencies
use to rate CDOs."
The financial crisis may have calmed down, but the sources of the crisis remain
unchanged: the industrial world is unable to fund the greatest retirement wave
in history at current returns. Everything that seems to offer yield turns
almost instantly into a mini-bubble.
Banking reform doesn't address the problems of the banks today. The commercial
and industrial loan book of American banks has fallen by 20% in the past year.
They are earning less interest overall, and the delinquency rate on their
remaining loans has tripled since 2007. They can't find mortgages to buy, given
the continuing depression in the housing market. What they can buy is US
Treasuries, and they are buying them in huge numbers.
Banks buy Treasuries to replace loans and other securities.
There is nothing wrong in principle with Paul Volcker's call for banking
caution. But the problems of the banking system can't be separated from the
larger economic picture. Without a way to match the aging savers of the
industrial world with the young workers and entrepreneurs of the global south,
banking problems will persist no matter what regulatory regime prevails.
Spengler is channeled by David P Goldman, senior editor at
First Things. From 1998 to 2002 he was head of credit strategy at
Credit Suisse, and from 2002 to 2005 he directed global fixed income research
at Bank of America.