Regulatory failure

I'm reading John Allison's "The Financial Crisis," a free-market take on the collapse that precipitated the Great Recession.  He's been discussing the moral hazard of deposit insurance, a difficult topic for me.  I've known since the S&L crisis in the mid-1980's, which created the wave of bankruptcies on which I cut my teeth as a young lawyer, that deposit insurance threatens a dangerous spiral in interest paid on consumer deposits, followed by riskier bank investments needed to generate the higher interest.  Without deposit insurance, a bank that pays too high an interest rate on consumer deposits will face a corrective mechanism: the difficulty of finding safe borrowers who can pay high interest on loans.  If the bank takes too many wild flyers on its borrowers, it goes broke, and its depositors lose their money.  Depositors who don't want to lose their money won't deposit it in a bank with a reputation for wild-eyed lending.

No one likes this disciplinary mechanism, because it tends to lead to panics and bank runs, especially on the part of small mom-and-pop depositors with all their liquid eggs in one basket.  Politically and practically, we're going to have deposit insurance one way or another.  Allison points out, however, that even with deposit insurance, people with deposits over the insured limit can exert useful pressure on banks to moderate their appetite for making risky loans.  But in the run-up to the 2008/2009 financial crisis, the uninsured-depositor disciplinary mechanism broke down.

In July 2008, regulators shut down IndyMac, with loans (assets) of $32 billion and deposits (liabilities) of $19 billion, without opting to cover any of the $1 billion (5%) of its deposits that were uninsured, (that is, deposits exceeding $100,000 per customer).   It was the largest collapse of an FDIC-insured institution since Continental Illinois in 1984, and it hit the public hard.  Five percent of deposits being uninsured may not seem like a lot, but the public was nervous, and it didn't help that newscasts showed unhappy depositors lined up at windows.

So the stage was set for real jumpiness over the summer.  Regulators had known for most of the year that failure was inevitable at Washington Mutual, the country's largest savings & loan, with assets in mid-2008 of $308 billion and deposits of $188 billion.  Whether because of the IndyMac experience, general jumpiness in the real estate market, or machinations by regulators and their cronies (the last possibility is the subject of litigation that hasn't yet quit, six years later), WaMu suffered a $16 billion bank run in September 2008 just before regulators shut it down and sold its assets to J.P. Morgan for a pittance.   Regulators, in no mood to spark an even more widespread bank run, made a fateful decision to cover all uninsured deposits.

Here is where Allison argues the biggest mistake was made.   It would have been possible to cover the uninsured deposits with taxpayer money.  That would have been politically poisonous, of course, but infuriated taxpayers could have done little about it in the short run.  Instead, however, regulators dumped the entire hit on WaMu's bondholders:  that is, the capital markets that had provided liquidity to the bank via traditional loans rather than through insured deposits.  Unlike taxpayers, the capital markets could and did retaliate instantly.  Allison, who ran BB&T (a real-estate-oriented Atlanta bank), reports that the capital markets had been tight during that troubled summer, but BB&T had just succeeded in floating a bond issue before WaMu failed.  The day after the feds stiffed the WaMu bondholders, the capital market for banks dried up without a trace.  Allison argues that this event was far more damaging to the liquidity of the financial markets than the failure of Lehman Brothers that same month.  He also argues that it was D.C.'s panic over the dried-up capital markets resulting from the WaMu decision that drove the TARP bank-bailout bill later in the year.


David Foster said...

For those interested in financial regulation, I recommend Sheila Bair's book Bull by the Horns (Ms Bair being the former head of FDIC.) Well-written and few punches pulled: I doubt if Bair will be invited to any parties by either Timothy Geithner or that guy at Citigroup, whose name I have mercifully forgotten.

David Foster said...

Also: while Allison is correct that uninsured depositors could perform a useful function in disincentivizing wild-eyed lending...if they were not thinking that they would be getting bailed out in any case...the same is true of bondholders. People and institutions buying bonds are or at least should be concerned with the creditworthiness of the entity they are counting on to pay them back--bailing out bank bondholders creates the same kind of moral hazard as bailing out ininsured depositors.

Texan99 said...

Interesting. I've had a low opinion of Ms. Bair dating back to her role in the Maxxam/Hurwitz dispute. I'm not sure her actions re WaMu and J.P. Morgan hold up to scrutiny, either. The WaMu closing and sale were very, very stinky, and not only on account of the impact on the bondholders.

Actually, I detest the FDIC and all its minions. However appropriate their theoretical role may be, I've never seen it in specific action without revulsion, all the back to MCorp in the late 1980s, where they sued my client for $800 million in damages, not one penny of which held water. We didn't even have to go to trial: their pleadings were defective on their face. That was the beginning of the cracks in my confidence in federal regulators, and my journey away from the Democratic Party. I never believed another word I heard come out of that agency.

Texan99 said...

True enough about the role of bondholders, but the system breaks down if they think they're hedging against foolhardiness by the bank's officers and find out instead they're really hedging against regulatory risk. As it turned out, as soon as they learned they were supposed to be footing the bill for uninsured deposits, they closed up shop and invited the banks to find another source of capital. Hence the financial liquidity meltdown.

We then got to find out very slowly what kind of capital would be available to banks if the bondholders were supposed to insure the deposits. That can work, too, but it's a bad idea to spring surprises--especially because all future loans have to take into account the possibility that not all the regulatory surprises have been sprung yet.

David Foster said...

I haven't read Allison's book, but quite a few knowledgeable industry-watchers believe that the government has been TOO concerned with protecting bank bondholders. In any event, the decisions as to creditor priority should be a matter of settled definition and not established on-the-fly in a crisis situation, which does lead to regulatory risk.

Thoughts from John Hussman of Hussman Funds here:

Grim said...

Wait, am I understanding the argument correctly: that the mistake was asking the bondholders to honor their bonds, rather than bailing it out with taxpayer dollars? And the reason is that citizens are basically helpless to retaliate when their money is stolen, but banks are in a more powerful position to punish the government if it wrongs them?

Tell me I'm misreading that. If that's the problem, there's a much bigger problem.

David Foster said...

I believe that the Depositor Preference Act of 1993 REQUIRED the uninsured depositors to be given preference over bondholders (and, of course, shareholders.) The linked article suggests that the decision made by FDIC in real time was to give preference to, holders of swaps & futures contracts...over the bondholders, and that this was NOT legally required in the way that the preference to ordinary insured depositors was:

E Hines said...

Regulation/regulator failure really was well-known--or should have been--from the S&L debacle.

A bigger cause than the deposit insurance factor was the regulations that, in the interest of fairness to the little guy/homeowner wannabe, the S&Ls were capped on the interest rates they could charge on their loans, but they compete with the banks on the interest paid on savings (and checking, relatively new at the time) deposits.

Thus, the S&Ls were forced to lend long at low rates and borrow short for loanable funds at high rates. They were set up to fail as soon as borrowing rate blipped a little. The insured deposit factor, IMNSHO, only potentiated the outcome, it had only a small role in leading into that outcome.

The aftermath of the Panic of 2008, though, has been the direct result of the explicit bailout, and those results are continuing to be felt: in the suit against Citi because of the alleged misbehavior of a subsidiary Citi was "encouraged" to buy to help out the Feds, in the continued too big to fail bit that makes investing so dicey, etc.

A free market is very nearly always self-correcting, but it's messy in doing that. Modern Liberals/Progressives always have been terrified of that messiness.

Eric Hines

Texan99 said...

Grim, what do you mean by bondholders honoring their bonds? A bondholder is a creditor who has made a loan whose terms (interest, term, etc.) are spelled out in the loan instrument, called a bond. It's the borrower who has the obligation, not the bondholder.

David, that depositors are senior to equity is clear enough--all creditors are senior to equity by definition--but I'm not familiar with a law that subordinates the bondholders to uninsured depositors. If that was the law from 1993 on, it looks like the bondholders would have been factoring in the risk from the start. I'll have to go look that up! If that's the case, then Allison wasn't explaining the transaction very well. JP Morgan bought WaMu for a couple of billion dollars plus the assumption of some of its debts, not, apparently, including the bond debt.

raven said...

Speaking of regulatory failure, anyone catch this?

Grim said...

I just mean that a bond is an investment, and an assumption of risk. At least, so I think I understand. The only kind I know much about are US savings bonds. But if the government were to go bankrupt... er, were to admit that it was bankrupt, I'd assume that the bond would not be paid. I wouldn't think it was someone else's responsibility to make my loss good -- I took the risk, and I should honor my promise to accept the risk.

That's what I mean.

What David Foster is saying would make some sense: the bondholders might feel they were cheated if the risk wasn't ordinarily structured this way (as you say, if it wasn't priced into the bond market). If a special favor was done to put someone ahead of them in line, rather than being treated on equal grounds with others who were owed, I could see how they'd be miffed.

But the idea that the right response was to tap the taxpayer to make the bondholders whole -- because the situation is structured so that citizens have less power to punish the United States than the bondholders of banks -- is what bothers me. The idea of doing it I merely oppose, as I normally do bailouts; but the reasoning strikes me as actually alarming.

Texan99 said...

Allison's position depends on the notion that the normal commercial consequence of business failure would not elevate the uninsured depositors over ordinary creditors, including bondholders, and that the FDIC somehow jiggered that result. But it may be sort of like the GM bankruptcy, where the government bailed out politically favored creditors while choosing not to bail out others. If the government is donating bailout money, it's free to pick and choose who will receive it, and the creditors who don't happen to be on the politically favored list have no legitimate legal or commercial beef--at most they have a political one.

The WaMu bondholders and parent company (i.e., equity) sued J.P. Morgan and the FDIC, if I'm recalling correctly, arguing that something about the structure of the sale to JP Morgan improperly saddled the bondholders with the cost of bailing out the uninsured depositors. I'm not sure whether that's right; there was some kind of settlement, but I couldn't quite figure out what it meant the last time I tried to dig into it. If all that happened is that the bondholders are aggrieved they weren't included in the bailout, I don't see the problem. If somehow the price paid by JP Morgan was artificially reduced, so that the brunt landed on the bondholders, that would be a problem.

One way or another, though, people who might have become new bondholders recoiled from the WaMu deal (or from something else they saw and didn't like about the situation at that exact time) and quit lending new money, which is always their absolute right. That puts us in the position of figuring out how to replace the capital they used to provide, and figuring out what we're doing to chase them off. If we don't, we can't expect banks to keep lending.

Well, anyway, I'm thoroughly confused now.

E Hines said...

From the end of raven's link: "The best solution would be to pass the CFPB reform bill that Rep. Duffy introduced adding bipartisan oversight to the Bureau through an appointed commission," USCC Senior Advisor Brian Wise says.

No. That's second best at best. The best solution is to remove the CFPB from existence. It's a regulator we don't need at all.

Eric Hines

Dad29 said...

Back in the dim dark days of the early 1970's, banks were required to maintain a loan-to-deposit ratio in the high 70%-low 80% range.

Now we learn that L to D can be in the low 100's.

Maybe that's the place to start, eh? One suspects that the banks asked for a LOT more than they could digest--all in the name of "protecting the depositor" of course, or--perhaps more accurately--enhancing bonus income to bankers.


Grim said...

Well, at least the agency that Raven is talking about has perfected its internal accountability systems.