Christopher Papagianis

Sandy Weill’s comments this week are just the latest dustup in the debate about the existence of financial institutions that are labeled by regulators and market participants as being too big to fail. Despite the criticisms leveled at these firms, the largest banks have only gotten bigger over the last few years – and U.S. regulators still appear underprepared to resolve a future failure of a systemically important financial institution without setting off broader market panic.

Against this backdrop, new bank reform proposals are likely to get a lot more attention on Capitol Hill heading into the November election. Catalysts for this debate are sure to include the stories around JPMorgan’s London Whale trader and the brewing Libor scandal.

In a recent paper, academics Frederic Schweikhard and Zoe Tsesmelidakis examined the borrowing advantage that large financial institutions had from 2007 to 2010 as result of the market’s perception that their liabilities were backed by the federal government. Taxpayers subsidized TBTF banks to the tune of $130 billion, according to their findings. Citigroup was the single biggest beneficiary of government support, totaling $50 billion, but even well capitalized JPMorgan is estimated to have gained $10 billion in value from taxpayer guarantees.

Privately, the big banks think this is old news. They are quick to note that Congress addressed the issue of taxpayer bailouts back in 2010, when it passed the 2,000-page Dodd-Frank financial reform bill. Among its many directives, the law created a new systemic risk council of regulators and tasked it with designing and implementing a new “resolution regime” for big and complex financial institutions. The goal was to empower a new council to regulate and oversee the failure of future financial institutions and to guard against taxpayer guarantees or systemic consequences for the overall economy. While it’s certainly debatable whether Dodd-Frank achieved some progress in this area, credit rating agencies are still signaling to the market that the government would likely step in and protect bank creditors. As long as this is true, big banks continue to have a borrowing advantage. Even granting additional discretion to regulators solves nothing if economic vulnerabilities still make a bailout the less harmful choice when the next crisis arrives.

During the debates this fall, Mitt Romney will surely confront President Obama on the limitations of the financial reforms that his administration advanced, including the Dodd-Frank Act. The TBTF problem stands above all others in this area and presents an opportunity for a defining contrast before the election. A new choir of analysts – including those on the right that are steeped in both policy and political strategy – are also starting to argue that what looks like good policy on the big banks might also be good politics (see here and here and here).

In the near term, Weill’s comments have helped push the policy spotlight back on whether a version of Glass-Steagall should be imposed – effectively drawing new lines between essential banking functions (i.e., deposit taking, settling payments and offering loans) and more speculative financial functions (i.e., brokerage and derivatives trading). Proponents of this idea argue that the latter should still be allowed – and under less regulation or supervision – but only without the promise of taxpayer support should one of these institutions fail. Deciding where to draw these lines can be extremely challenging, as proved by the rulemaking for permissible activities under the Volcker Rule, which is barely comprehensible even to the most seasoned experts.

While the chorus in favor of breaking apart TBTF banks into separate commercial and investment entities will surely continue, there are two other categories of reforms that are likely to get even more traction as this debate unfolds. The first would seek to impose more meaningful caps on the size and leverage of TBTF banks, effectively shrinking them over time. The second would attack the prospect of future bailouts head-on by making it clear upfront that the equity holders and creditors of TBTF institutions would face haircuts in the event of a failure.

Thomas Hoenig, a former Federal Reserve governor and current director at the FDIC, is the author of one of the more far-reaching proposals to restructure bank activities. The general thrust of this plan (as he calls it, a Glass-Steagall “for today”) would be for regulators to designate what activities are allowable – for example, traditional banking services, such as taking deposits and underwriting securities – while prohibiting more complicated tasks, such as proprietary trading or derivative transactions that expose banks to financial risks and increase the complexity of bank regulation.

The UK’s Independent Commission on Banking, commonly known as the “Vickers Report”, has offered a similar plan to ring-fence retail deposits and allow for limited risk management or hedging strategies. Outside the fence would be securities and derivatives trading, underwriting, and securitization. The fence would effectively separate bank subsidiaries so they would be operationally independent.

Both Hoenig’s plan and the ring-fencing concept essentially seek to bring back a Glass-Steagall-like barrier between commercial banking – everyday banking involving deposits and lending – and investment banking, which handles more complicated banking functions like security underwriting and company mergers. However, as University of Chicago economists John Cochrane and Luigi Zingales have argued, the real distinction is between financial intermediary functions – collecting deposits, making loans, serving as a broker between buyers and sellers of securities – and proprietary trading. These intermediary functions are socially valuable in that a lot of economic activity depends on their very existence. The same is not true of proprietary trading. Yet, losses on proprietary trading can erode the capital necessary to support intermediation.

On Capitol Hill, Senator Sherrod Brown just reintroduced the SAFE Act, which takes a different route by effectively shrinking the largest banks through a series of caps on the total share of bank deposits that one institution can control, caps on non-deposit liabilities, and a tougher limit on allowable leverage. What most people have forgotten is that a version of this bill was offered as an amendment to the Dodd-Frank Act back in 2010. While it failed to pass then, garnering only 33 votes in favor, parsing the yeas and nays reveals some important clues as to where senators may be heading in 2012. It’s particularly interesting that some key Republicans voted for his amendment, including Senators Richard Shelby and Tom Coburn. A few others sought to keep their powder dry on this tough vote, choosing to abstain (Senators David Vitter and Jim DeMint).

Over the last few years, other Republicans in the both the House (see Representative Spencer Bachus’s proposal) and the Senate (see Senator Jeff Sessions’s proposal) have introduced bills to update the bankruptcy code so there is an orderly way to resolve large and complex firms that are failing. (Creating a bail-in regime is also under consideration.) The measures all seek to improve the code as a means to promote market discipline and thus protect taxpayers long term. The principal advantage, compared with Dodd-Frank (and specifically Title 2), would be to substitute regulator discretion during the next crisis with clear rules that could eliminate any borrowing advantage in the near term, or imputed subsidy for banks and their creditors.

Bank bailouts are not favors randomly dispensed to clients – they are generally motivated by a desire to prevent the chaos that would arise from cascading losses. By reducing expectations of bailouts and increasing the cushions to absorb losses, clear rules and increased capital change the facts on the ground and make bailouts less likely. As long as market participants (and creditors specifically) interpret regulator discretion as increasing the chances that some government power will be used to bail them out when the next panic ensues, big banks will still be advantaged at the expense of taxpayers. The logic behind an alternative resolution regime is to squarely address the economic costs that bailouts seek to suppress.

A group of academics from across the country has come together to propose just such a thing: an entirely new chapter in the bankruptcy code. The authors note that the existing bankruptcy process does not work particularly well for large and complex financial firms, as we saw with Lehman Brothers. At the same time, the new bank resolution authority in Dodd-Frank is an incomplete fix. The current system preserves regulatory discretion over how to handle the failures of financial institutions and leaves open the possibility that some creditors may be bailed out in the future. It is better, this group argues, to fix the current bankruptcy regime so that clear rules govern the resolution of major financial institutions.

The overarching goal should be to change the expectations of market participants and regulators on the risk of future bailouts. Market participants should have incentives to engage in more extensive credit analysis and upfront monitoring of bank liabilities and leverage. This will make future bailouts less likely, because through greater market discipline there will be fewer panics. And if regulators perceive that banks can be allowed to fail in an orderly manner, they will also be less inclined to prop up or confirm their TBTF status through interventions and bailouts.

Driven by the political debate, policymakers will increasingly have reason to revisit several aspects of Dodd-Frank this fall and into 2013. The leading candidates to take over the chairmanship of the powerful House Financial Services Committee are certainly convinced that the system is still plagued by the TBTF syndrome. This is true both for Republicans like Representatives Jeb Hensarling and Ed Royce, as well as the next-in-line  Democratic member, Representative Maxine Waters. Senators are likewise focused on the threat of future taxpayer bailouts, including the top Republican on the Banking Committee, Senator Shelby, and his Democratic colleague Senator Brown.

Thankfully, there is still time to fix financial regulation and end the bailouts that go along with too-big-to-fail banks.

Arpit Gupta, a Ph.D. student in finance at Columbia University’s Graduate School of Business, contributed to this column.

PHOTO: Sanford I. Weill, chief of the Travelers Group (L), and John S. Reed, chief of Citicorp, shake hands at a press conference in April 1998 in New York, where it was announced that the two companies would merge in a deal worth more than $70 billion.

Arpit Gupta, a Ph.D. student in finance at Columbia University’s Graduate School of Business, contributed to this column.

Just as the recession in the early 2000s became linked with the bursting of the tech bubble, for many the financial crisis in 2008 has been synonymous with the blow-up of subprime mortgages.

But there was more to 2008 than that.

Gary Gorton, an economist at Yale, recently published an analysis that shows how well some subprime mortgage-backed securities have performed over the past few years – a very counterintuitive conclusion. Citing one of his graduate students, Gorton explains that AAA/Aaa-rated subprime bonds issued in the peak bubble years (when mortgage underwriting was arguably the weakest in history) were only down 0.17 percent as of 2011. In other words, the highly rated subprime bonds – or toxic assets so associated with the financial crisis – have experienced only minimal losses since the bubble popped.

Of course, that bond statistic ignores the numerous costs borne by the federal government in response to the crisis. For example, the mortgage giants Fannie Mae and Freddie Mac required more than a $150 billion bailout, and the Federal Reserve dropped and held interest rates to historical lows, in part so that millions of homeowners could refinance their mortgages (often into new mortgage products that were also backed by taxpayers through another government program). That is, it’s important to acknowledge that subprime mortgage products have done relatively well partly because of post-crisis government interventions that were costly for taxpayers.

Nevertheless, the subprime bonds’ better-than-expected performance can help us think through the broader role of highly rated securities in the financial crisis. In particular, it helps focus our attention away from the assets themselves (as it now appears that some subprime securities held up surprisingly well) and toward how the assets were financed using leverage and risky holding structures.

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Consider the production process for mortgage securities during the crisis. To convert bundles of poorer-quality mortgages into valuable securities, banks made use of waterfall structures in securitization. Any future losses on subprime mortgages would first go to the lower-rated tranches of the securities. The highest-rated tranches – given AAA status – would only lose money in the event of extraordinary mortgage losses, which effectively wiped out the lower-rated tranches. Generally, lower-rated tranches accounted for 20 to 25 percent of the securitization. This meant that if mortgages defaulted and only 50 percent of the value was recovered through foreclosure, then between 40 percent and 50 percent of the mortgages in a pool would have to default for the AAA noteholder to suffer any losses. While defaults and loss severities on subprime loans have been bad, they have not been this extreme in most cases thus far, which is why the highly rated subprime bonds seem to have escaped serious losses so far – declining in value only a small amount, as Gorton suggests.

If the performance of these mortgage pools remains sustainable in the future, then one surprising conclusion post-crisis may be that the securitization waterfall structure will have actually held up surprisingly well. The construction of mortgage-backed securities in most instances will have sufficiently left enough of a buffer in place to protect the highest-rated tranches from serious losses.

Of course, the much bigger problems lay in the quality of that buffer – the lower-rated pieces of subprime mortgage-backed securities. These were generated in many cases almost as a waste by-product of the securitization process. As the housing bubble burst, it was the holders of these assets that suffered massive losses, since they were in the first loss position.

While it was originally difficult to find willing buyers of the lower-rated pieces of subprime mortgage-backed securities, issuers eventually combined and repackaged them into derivative products called collateralized debt obligations. It was these products – including the so-called synthetic variety, which relied on credit default swaps – that proved to be the real problem products. Many of them were held by structured investment vehicles (often sponsored by banks) and constitute one of the reasons financial institutions faced insolvency during the crisis.

Underlying the demand for CDO products was the phenomenon previously discussed: the universal hunger for highly rated financial products. Overwhelming demand for AAA-rated securities induced banks to create new financial instruments that effectively stretched the definitional bounds of what was truly a quality or safe asset. These structured products wound up constituting a large fraction of the losses borne by subprime mortgages.

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The problem with securities during the financial crisis wasn’t just how they impacted the asset side of the balance sheet. Rather, the greatest fallout appears to be the result of how these (and other similar) securities were funded through short-term loans on the wholesale market.

Prior to the financial crisis, in the so-called shadow banking system, banks came to use securities – highly rated MBS and asset-backed commercial paper – for the purposes of short-term borrowing and lending. The higher the security was rated, the greater its collateral value, which allowed the bank to secure more funding on better terms.

The onset of the financial crisis led to large-scale downgrades of many of the securities that were used as collateral. Even though a lot of these securities did not end up experiencing large credit losses over time (per Gorton), they did suffer huge declines in market value (at least initially).

Many mortgage securities were used in relationships of overnight lending referred to as repo – between banks and other financial institutions. The downgrading of mortgage-backed securities led to greater margin calls, leading to trading losses and finally some fire-asset sales. In short, these assets could no longer support the loans secured against them; their collateral value fell and, effectively, there was a “run” on major aspects of the financial system as lenders demanded their money back. The resulting losses – from the collapse of trading arrangements, not of the underlying securities – wound up bankrupting major financial participants like Bear Sterns and Lehman Brothers.

Recent research by Northwestern economist Arvind Krishnamurthy and colleagues has found that similar problems with asset-backed commercial paper were actually far greater in scope. The resulting collapse of credit in other areas of the financial sector, such as money market mutual funds, subsequently fueled the recession.

The lesson is that it wasn’t just the product that was the issue – fragile financing mechanisms were really the key driver in the financial crisis. If financial intermediaries had held their asset positions with less leverage or with longer-duration borrowings, they would have been able to ride out market gyrations. Instead, reliance on debt and short-term holdings forced banks into costly sales and drove widespread insolvency.

The mix of leverage and the shared interdependence on extremely short-term wholesale funding markets (comprising both repos and commercial paper) turned what were initially relatively small losses into tens of trillions in lost output globally.

In many respects, the pre-crisis shadow banking system resembled the pre-Depression-era banking system, which was also prone to fragility and frequent crises. The problem back in the 1930s was partially addressed through the use of deposit insurance, which limited the potential for bank runs (though with the cost of boosting moral hazard).

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Regulators today face two options in dealing with this complex financial system. One option would be to further encourage financial complexity but offer sufficient insurance (along the lines of the FDIC deposit guarantee) to financial institutions. However, this would expose taxpayers to future losses that could rise into the trillions, meaning the guarantee itself might not be sufficient to prevent a crisis to begin with. Additionally, it would further fuel moral hazard.

Another option would be to recognize the systemic fragility and work to combat the underlying sources. The first of these is the widespread reliance on “safe assets,” which itself is partially a regulator-driven phenomenon. As we’ve seen, regulators’ preferences for seemingly safe assets incentivizes market participants to create and transform risky assets into new products that can be passed off as safe. Additionally, no asset is truly safe from losses to begin with, and doubling down on that fiction simply raises the stakes when default finally happens.

The second core reform should be to restructure the liability system of systemically important financial institutions. Maturity mismatch, to the extent it happens, should take place in traditionally regulated commercial banking institutions. Firms should be free to pursue real financial innovation, so long as their actions do not result in demands for bailouts or contagious financial losses for others.

A review of this narrative suggests a rather stark picture of the reality of the modern financial system. Rather than the financial crisis being a one-off result of a historically anomalous housing boom, it increasingly appears that the central problem was a financial system so levered and dependent on near-term financing that relatively small losses could spark big problems. Absent reform, look for this pattern to return.

The policy response that perhaps best connects the U.S. financial crisis and the still brewing eurozone problem is that regulators have endeavored to make financial institutions more resilient. Policymakers on both sides of the Atlantic have focused on increasing financial institutions’ capital and liquidity positions to try to limit future bank failures and systemic risk. Both goals are served by increasing banks’ holdings of “safe assets” that are easily sold and retain value across different global economic environments.

But what if there simply aren’t enough safe assets to go around? After all, safe assets aren’t only being gobbled up in the name of financial stability. Today, the global investor universe is undoubtedly more risk-adverse and is naturally hungrier for these same stores of value. From insurers to pension funds, the demand for safe assets – and the corresponding dearth of supply – has led to strange, if not ominous, distortions in the market.

For example, over the last few years there have been numerous periods where the yields for short-term U.S. and German sovereign debt have turned negative. The real yields, or the amount earned after adjusting for inflation, on front-end Treasury notes are currently less than -1 percent. This means investors have been putting aside their search for yield, willing to lock in (small) losses with their new purchases because there were very few alternative and liquid markets where they could park their money on better terms.

In a recent report, the IMF explores this growing tension between the supply and demand of safe assets – and the takeaways are nothing short of frightening.

Let’s start with what are considered safe assets today – even though, of course, this categorization is crude and likely to be overly inclusive. There is sovereign debt (with debt ratings above A/BBB), investment grade corporate debt, gold, and also highly rated securitizations and covered bonds. The IMF estimates that there are approximately $75 trillion of these safe assets in the market today.

With banks, pension funds, insurance companies, sovereign wealth funds and central banks all gorging on these assets to differing degrees, real prices have been on a tear. But, surely the market will eventually adjust as the supply trajectory for these assets grows overtime to meet the new demand, naturally releasing some of the pressure around prices?

A close look at just the narrative around government bonds reveals the extent of the problem ahead and why the market shouldn’t be counted on to self-correct. Back in 2007, before the housing bubble popped in the U.S., roughly 70 percent of the sovereign debt for the world’s most advanced countries was rated -AAA. Today, this rating only applies to 50 percent of these countries, a drop affecting approximately $15 trillion in “safe” sovereign assets.

The fluid crisis in Europe is one reason that a snapshot of countries’ credit profiles is of limited value, at least for the foreseeable future. The IMF projected that more than a dozen countries could fall from the class of safe asset issuers in the coming years. It concluded that by 2016 the total pool of safe assets might fall by 16 percent, or more than $9 trillion. In short, global fiscal retrenchment – here in the U.S. and across Europe – is expected to be slow and painful.

Some might argue that a drop in the supply of safe assets means that buyers will have to move down the safety scale and purchase assets that are only a little bit riskier. But this only makes the system more vulnerable. If the financial crises of the last few years have taught one consistent lesson, it’s that there really isn’t such a thing as a truly safe asset. Practically everyone now appreciates that there is no hidden part of the globe where an investor can buy an asset that doesn’t contain at least some amount of credit, inflation, currency or market risk.

There is a problem with the theory that the global economic crises have corrected all the past flaws with how risk is measured and priced, particularly with regard to once-heralded safe assets like sovereign bonds or mortgage-related securities.

First, it overlooks just how ingrained the concept of safe assets is in the global financial regulatory architecture. The problem in the euro zone banking system is partly due to banks holding their home government’s debt for regulatory and central bank funding purposes. Banks and other financial institutions are increasingly asked to use high-quality collateral as margin in derivatives trades. Reforms in this area make sense since derivative bets were insufficiently capitalized – but the impact of new rules, like margin requirements, on the demand for safe assets and on credit availability has to be acknowledged.

The problem is that all the regulatory efforts that seek to reduce leverage in the financial system not only presuppose the existence of safe assets but also assume that what is and is not a safe asset can be known with any degree of certainty.

Japan’s government debt, for example, is still considered to be among the safest in the world, despite a gross debt to GDP ratio of over 200 percent. How can one know if or when market participants will regard Japan’s debt with the same apprehension that they regard Spain’s today?

On the supply side, there are very few bright spots. Sure, a greater number of  emerging countries will join their more developed brethren over time, but few analysts expect a flurry of new emerging economies to start issuing AAA-rated sovereign debt in the near term.  Building the required legal institutions and financial architecture will take years, if not decades, for some countries to make this transition.

The private sector used to be a prime provider of safe assets through production channels like securitization. Private-sector issuance in the U.S. alone has declined by more than $3 trillion since 2007. There are obvious tensions between the desire for additional debt issuance and its impact on the safety of the issuer. The future of the housing government-sponsored enterprises (GSEs) also looms large given the importance of their debt and mortgage-backed securities as collateral.

While some are rightfully calling for a rebalancing of the U.S. mortgage market away from the government (since it is guaranteeing practically all new mortgages today), others are worried that this transition will lead to less government-backed MBS issuance – an important component of the current global supply of safe assets.

Eventually, the labored search for safe assets will drive prices to the point where investors have to settle for riskier assets. With interest rates that are expected to stay close to zero for some time (reflecting a world with slow growth and increased financial stress), the market is only becoming more susceptible to ripple effects from sudden drops in prices that turn safe assets almost overnight into unsafe ones, which then may no longer count or satisfy a key regulatory requirement. As the IMF puts it: “Demand-supply imbalances in safe asset markets could also lead to more short-term volatility jumps, herding, and cliff effects” – and even fuel new asset bubbles.

Ratings downgrades on U.S. and European sovereign securities teach us that what is a safe asset one day can be almost toxic the next. Building a regulatory architecture on these assets becomes dangerous because the transition from “safe” to “toxic” is likely to come at the same time that a bank’s dependence on the asset’s safety is greatest. As we have seen, the biggest panics are those that involve what were presumed to be safe assets, like the short-term commercial paper of Lehman. By hinging regulation on them again, the world seems to be tempting fate.