Pieces Of The Puzzle (unfinished)

This is entry is unfinished. I still need to add explanation. I am traveling on Sunday and will update this entry in 24-36 hours.)

An Analysis of Bank Failures: 1984 to 1989

(emphasis mine) [my comment]

… regulators also must cater to a political clientele who are intermediate or competing principals. As illustrated by the cases of Lincoln Savings and Loan in California and Vernon Savings and Loan in Texas, the political costs to the regulator of closing insolvent institutions can be quite large. Principal-agent problems also arise from the post-government career opportunity set facing a regulator. As Kane (1989) points out, individual regulators have incentives to not take actions in the public's interest if they are seen to damage their post-government career prospects, especially if the developing crisis can be pushed off into future and into someone else* s tenure as regulator.

… tapping the Treasury line of credit or drawing on the implicit Treasury guarantees (for example, the issuance of notes by the FSLIC) has political costs associated with it. The forbearance policies adopted by the now-defunct FSLIC after it became insolvent in the early 1980s graphically illustrate the importance of this constraint on the ability of the FDIC to close institutions as they are found to be insolvent. …
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As we have seen with the forbearance policies adopted for thrift institutions, insolvent institutions that are profitable are less likely to be closed down than insolvent institutions that are losing money. …. Note that a liquidity crisis that may arise out of insolvency might force the FDIC to close an insolvent institution by increasing the political costs of not acting. Therefore, the less liquid the institution, the greater the probability it will be closed.
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As predicted by our model, the less liquid a bank, the greater the probability the FDIC will close it when the bank becomes insolvent.

In other words, banks that are more efficient are less likely to be closed by the FDIC when they become insolvent than are inefficient banks. ... As predicted by the model, insolvent banks that are profitable are less likely to be closed than unprofitable ones. This result is consistent with the forbearance policies of the federal bank and thrift regulators during the 1980s. Thrifts had to be both insolvent and losing money to be targeted for closure prior to the passing of FIRREA in 1989.
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The decision to close a bank is usually based on some measure of solvency. Prior to 1933, the solvency test applied in national bank closing cases was either incapacity to pay obligations as they matured or balance-sheet insolvency. Since then, the Office of the Comptroller of the Currency has tended to use only the former, "maturing obligations" test, although the statutory basis for the latter, "balance-sheet" test remains in the statue books.

1) Both politicians and regulators have incentives to not take actions in the public's interest.

2) politicians/regulators have always chosen the . Patching up developing crisis (and making them bigger) enough so they get pushed into someone else's tenure.

3) Basically politicians/regulators won't close banks because of balance-sheet insolvency. They only close banks when they are so insolvency that they are running out of cash and can't pay their "maturing obligations".

Key point: when insolvent institutions run out of liquidity (money), it triggers politically/financially costly government takeover.

International Banking Crises: Large-scale Failures, Massive Government Interventions

Problem Bank Resolution: Evaluating the Options
by Anthony M. Santomero and Paul Hoffman
October 1998

I. Introduction

The banking systems in too many countries are insolvent; whether one looks at Japan, Malaysia, Thailand, Korea, China or Russia, the same situation is uncovered. Bank balance sheets have weakened, and there are real questions about the solvency of the entire system. At first, regulators and policymakers do not want to look, hoping that time will redress the ills and raise the value of troubled assets. However, in most cases, they come to recognize the obvious - some sooner than others. When this time comes, the regulator looks first for causes then for scapegoats, but eventually they look for answers. They slowly recognize the need to resolve their financial structure problems.
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The Role of Institutions in the Financial Sector

The discussion of bank crises and options for resolution can not begin without a recognition of the perceived importance of the banking sector to policymakers and economists alike. One worries about bank problems because banks are viewed by both of these groups as warranting special attention.

The current view of the role of these intermediaries is that they serve two primary functions that are essential for the smooth operation of an aggregate economy. First and foremost, they are generators or creators of assets. These assets are obtained from either the government, to finance deficits, or from the private sector. In the latter case, they are expected to screen the set of borrowing opportunities presented to them, using an expertise and specific capital that is unique to this sector (Diamond 1984; Bhattacharya and Thakor 1993). Projects found worthy are financed and monitored until repayment. This second phase of the lending function, ongoing servicing and monitoring, is critical for a number of reasons. First, once the loan is made, it is frequently illiquid and difficult to value without substantial effort (Gorton and Pennacchi 1990). Second, such oversight by firms who are responsible for financing the investment project often leads to higher returns from the endeavor, as investors respond to ongoing monitoring by increasing effort and closer adherence to the proposed purpose of the loan (Allen and Gale 1988). In both cases, the existence of a monitoring institution improves the performance of the project returns accruing to the stakeholders of the intermediary itself.

The second function of the intermediary sector is the channeling of savings resources to a higher purpose. This is achieved in two distinct ways. For transaction balances, the financial sector has developed the capacity to use idle balances, even while the payment system functions efficiently. From the perspective of the institution, it provides depository services in order to finance the lending activity outlined. Yet the fact that financial institutions are central to the clearing process suggests a need for regulatory concern and oversight (viz., the integrity of the payment system) (Goodfriend 1989). For standard savings balances, return must warrant risk and delayed consumption. The institution offers standard financial assets to the public which must be priced to permit a positive return for deferred consumption.

As an intermediary, the financial institution provides both of these functions simultaneously (i.e., it makes loans and assumes liabilities). In fact, it often does so with assets that have maturity lengths that differ substantially from the average maturity of its liabilities. In so doing, the standard asset-transformation function inclucles maturity transformation as well as resource mobilization. While these can be viewed as mostly complimentary services, at times the use of relatively liquid liabilities to finance illiquid and longer-term risk assets generates an inherent instability in the system (Diamond and Dybvig 1983; Gorton 1988), yet it is central to providing the economy its value-added activity of mobilizing savings assets into productive real investment.

The Instability of the Sector

Given this description of functions performed by the sector, it should be transparent that some regulatory oversight of this sector is appropriate. Financial institutions are structurally vulnerable because they finance the holdings of direct claims that can be valued only imperfectly with short-term liabilities that are viewed as redeemable at par. In addition, they provide the valuable service of maturity transformation which is mutually beneficial to borrowers and savers, but which may, nonetheless, place the financial institution itself in jeopardy (see Kareken and Wallace 1978; Jacklin 1987; Santomero 1992). In addition, marketability and valuation are likely to be fundamental characteristics of most of the direct claims held by these institutions. Therefore, holders of their claims (liability holders) cannot readily evaluate the solvency of the institutions by affirming that the market value of its assets exceeds the promised value of its aggregate liabilities.

Nonetheless, depositors and many other liability holders place funds in these institutions fully expecting to be able to withdraw them whenever they choose. In most circumstances, their withdrawals are purely random and statistically predictable. However, if liability holders become concerned about the solvency of the institution, withdrawals may become systematic and jeopardize the liquidity and solvency of the entire industry (Gorton 1988; Jacklin and Bhattacharya 1988).

Runs, once begun, tend to be self-reinforcing. News that the depository institution is selling direct claims at distressed prices or is borrowing at very high rates will further undermine the confidence of current and potential depositors. Even those who believe that with sufficient time the financial institution would be able to redeem all of its liabilities have a motive to join the run. They have reason to fear that the costs from the hurried liquidation of direct claims in response to the run by other creditors might render such an institution insolvent. This is the story that Diamond and Dybvig (1983) relate so forcefully.

This vulnerability to runs is more than the strictly private concern of an individual depository institution and its customers. It becomes a public policy concern when a loss of confidence in the solvency of the sector or many of its members leads to a contagious loss of confidence in other institutions. This will destroy not only the specific capital of the institution under pressure but also diminish the capacity of the financial sector to fund economically viable projects and monitor them to a satisfactory conclusion (Bernanke and Gertler(1989;1990)and Gertler(1988)). This is a particularly serious problem when there are a few large institutions with national or international franchises. The larger the institutions, the greater the likelihood that the failure of any one will attract public attention and undermine confidence in the financial system in general, and in other similar large financial institutions in particular.

I.3 The Financial Safety Net

It is for this reason that regulators everywhere have chosen to establish a mechanism to address the problem of weakness in the financial institution sector. The financial safety net, an elaborate set of institutional mechanisms for protecting the financial system, has been constructed, which has largely succeeded in preventing contagious runs in the financial sector. Through this mechanism, most countries have developed a regulatory structure that prevents the amplification of shocks through the financial system. This safety net can be viewed as a set of preventive measures that can and should be triggered at various stages in the evolution of a financial crisis.

However, the safety net has worked only moderately well over the past half century. The chartering and prudential functions, so key to the integrity of the financial sector have been responsible for maintaining a reasonably good reputation for the sector as a whole, worldwide. While crises of confidence occasionally arise, they are the noted exception, not the rule. Likewise, since the 1930s remedies aimed at the last stages of contagion control, the lender of last resort function and the monetary neutralization of a crisis, have been largely successful.

Regulators and policymakers have had less success in dealing with a situation when a large institution or the industry as a whole is faced with a solvency crisis. Some regulators have been successful in navigating through these waters, closing troubled institutions early and containing a solvency crisis to a subset of the industry. All too often, however, when problems are the result of anything more than idiosyncratic behavior on the part of one entity, the record has been decidedly mixed. Sectors have fallen victim to contagion; governments have been left with large bills; and the institutional structure has been badly damaged.

This is in part due to the political nature of the process,
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II. Options Available For The Resolution of Problem Institutions

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The second point mentioned relates to the scale of the problem to be addressed. Often economists are quick to argue that failure should have a rapid and brutal response. Failed private institutions should pay the private penalty for default. However, while this result may be [is] viable in theory, it is never employed in practice. In reality, the options open to the regulator will depend not only on the state of the institutions involved, but also on the state of the industry and the broader financial market itself.

Resolution options open to an isolated failure of a single institution are different than those available to the regulator when facing system-wide failure or the collapse of a whole market. This is true for at least two reasons. First, if the institution is part of a collapsing financial system, the reasons for establishing a safety net in the first place become critical. The regulator has no interest in closing the entire banking system because of a financial collapse or a sectoral decline which renders capital ratios negligible or indeed negative. The resultant cost of such a move, in terms of investment disruption and consumer confidence, is in all likelihood far larger than the regulatory process would tolerate, to say nothing of the political costs attendant to such a crisis. Likewise, given the systemic nature of a problem which could wipe out an entire sector, it is not at all clear that the immediate liquidation of financial assets to satisfy creditors is an appropriate strategy. Firesale prices, large bid—ask spreads, and the virtual lack of bids are common elements of a mass liquidation. The regulator accomplishes little by adding to the frenzy.

This having been noted, systemic problems must be addressed. No central bank has the capacity, nor should it have the authority, to sustain a bankrupt structure indefinitely. The issues that arise must be addressed and a resolution achieved. We are all too familiar with banking systems that remain bankrupt for long periods of time. The inevitable result is neither efficient funding of capital projects central to growth nor a stable depository structure in which depositors have confidence. The result is inefficiency, distrust, and subsequent collapse.

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Complete List of Options Available

There are several ways to continue operations, to force a merger, or to liquidate.

Forbearance

An institution which is experiencing financial distress may be able to resolve its problems if given time. The granting of time for a management turnaround, the orderly disposal of problem assets, and/or the generation of positive profits against which to charge off losses is defined as forbearance.

As this suggests, forbearance can occur for two separate reasons. Either the firm is thought to be bankrupt but the timing of the liquidation is deferred for market reasons, or the firm is perceived as salvageable if given enough time to recover from an unexpected and large loss. In the first case, it is sometimes alleged that immediate liquidation of assets is not possible in the real world. It is argued that pressure to liquidate assets can lead to returns which do not reflect fair market value. Therefore, to achieve maximum return an institution is given leeway to liquidate its assets as favorable bids are received. However, the institution is viewed as managing to liquidation, rather than solvency.
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Various mechanisms can be used in support of forbearance. Small cash-flow problems can be ameliorated by allowing access to central bank funding, using either direct borrowing lines or refinancing vehicles. Lines of credit drawn on the central bank or arranged by it through private-sector institutions are another approach that has been employed. Such arrangements usually come with implicit government guarantees along with promises of further capital infusion or deposit backing if financial conditions deteriorate. …

A strong argument against forbearance is based upon the management-moral-hazard argument, a line of reasoning that raises relevant concerns both for the assisted institution and for the signal such actions send to other solvent institutions. If a troubled insolvent bank is aware that a further government bailout is an option, management may feel it has nothing to lose by further increasing risk in the hope of achieving solvency. It may then invest in high-risk strategies at the expense of its government guarantor. This attitude has often resulted in subsequent higher closure costs and has frequently been associated with the thrift crisis in the United States. For this reason, regulators are wary of forbearance and usually implement it only in combination with strict monitoring.

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Purchases and Assumption

This is basically a form of acquisition. An acquirer may either purchase the entire bank balance sheet or just the retail deposit base and a subset of the assets. If the whole bank is purchased, the acquirer may receive a government payment covering the difference between the market value of assets and liabilities. If only some deposits are purchased, the acquirer may be given the option of purchasing any of the others and get their pick of bank assets. What is purchased is decided upon through either negotiation or prior partitioning by regulators.

The purchase and assumption agreement (P&A) is often enhanced by government guarantees. These often take the form of putbacks, whereby the government promises to buy back the assets at a stated percentage of value within a specified time frame. The percentage is a declining function of time; therefore, there is an incentive for the acquirer to quickly identify problem assets. This guarantee is essentially a put option issued by the banking authorities.

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Liquidation with and without Government Assistance

Regulators have often shown great reluctance to liquidate banks. Perhaps this is because in many countries liquidation must proceed through the court system. However, it may also be because banks are seen as unique in their importance to a country’s financial base. A loss of confidence in banking could result in a severe economic contraction, as has been noted. However, as we also point out, this aversion to liquidation can lead to perverse incentives. If aid is offered, it is essentially rewarding an inefficient bank. It is for this reason that many economists and politicians have concluded that if a bank is poorly run, it should be allowed to fail.

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U.S. Experience

Perhaps the best place to begin in the United States is to review the decline in the U.S. thrift industry. Forbearance was initially the primary tool used in an attempt to resolve the Thrift Crisis of the 1980s. This was by directive of the Federal Home Loan Bank Board (FHLB) and drew justification from earlier banking acts, such as the Garn-St.Germain Depository Institutions Act of 1982.

Nakamura (1990) points out that forbearance was supported by those who felt the state of the economy required caution, considering the deep recession of the early 1980s. Dissolving or merging insolvent thrifts would have been difficult in this environment, it was argued at the time. Regulatory authorities firmly believed in an imminent economic recovery and the lowering of interest rates. In addition, a practical consideration was the possibility that the FSLIC's insurance fund was insufficient to undertake wide-scale closure. Replenishment would likely be politically unpopular. Unfortunately, the dissipation of the recession in 1982 made these constraints of less importance but the policy of forbearance was continued.

The effectiveness of forbearance was hindered by two key problems that were part of the thrift crisis. Capital requirements were not risk-based and there was inadequate FHLB staffing for oversight. On top of this, along with forbearance came new accounting practices. Thrifts were given the option of using less stringent regulatory accounting practices (RAP), rather than generally accepted accounting practices (GAAP). This created the illusion of healthier balance sheets than was, in fact, the case. The results were disastrous.

Dellas et al. (1996) find that the average time from insolvency to closure was 38 months. The Congressional Budget Office (CBO) estimated that over $60 billion of additional costs can be attributed to the delay in closure.
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Access to the Federal Reserve's discount window did not seem to mitigate the crisis or its cost either. As is well known, such borrowing is allowed only in order to meet short-term liquidity problems. Nonetheless, many thrifts availed themselves of this option during the Thrift Crisis. Critics have voiced the view that the Fed was too lenient in allowing troubled thrifts to habitually use this source of cash during this period. It became, in a sense, a form of forbearance.

In 1991, the House Banking Committee found that 90% of institutions receiving credit at the discount window from January 1985 to May 1991 subsequently failed (see Dellas et al (1996)). It was stated that troubled institutions which were assigned CAMEL-5 status stayed open an average of 10 to 12 months. The implication was that without this source of liquidity thrifts would have failed earlier, thereby saving taxpayer money.

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Regulators also have had the option of direct cash infusion as a tool toward regaining a thrift's financial health. Open thrift assistance (OTA) was used sparingly by the FDIC because it was felt that aid of this sort would take away management and shareholder's incentive to regain solvency. The FDIC's rule was that neither group should be allowed to profit from OTA. Nonetheless, it was widely viewed as a form of subsidy that allowed unhealthy institutions to take market share away from healthy thrifts, hardly a desirable side effect of the resolution option.

In addition to the complaints concerning noncompetitive bidding, FSLIC incentives, such as future payments for capital losses, yield maintenance guarantees, and tax benefits, were all criticized for creating moral hazard and adverse selection problems.
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Throughout the period, mergers in both the thrift and the banking industries continued, both assisted and unassisted. Assisted mergers were termed P&As. In a P&A, the buyer assumes either all or only insured deposit liabilities and purchases a portion of the assets. Assets that are not purchased are further marketed and, if unsold, placed in an agency pool earmarked for liquidation. Details of P&A agreements over the period were quite flexible, with the unique method now known as a good-bank, bad-bank structure first used in the 1984 bailout of Continental Illinois. For this transaction, a subsidiary was created which became the repository of the institution’s bad loans. The subsidiaries’ sole purpose was the liquidation of these loans.

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In retrospect, it is generally agreed that liquidation of failed banks has been expensive in the United States. Indeed, it has been much more costly than bankruptcies in other industries, as James (1991) pointed out. This is why the regulatory authorities seemingly put a premium on rehabilitating troubled banks. Ultimately, however, decisions must be based on cost/benefit analysis. If it is less expensive to close a bank, it must be closed. …

Ultimately, approximately 40 percent of savings and loans were liquidated. Closure was initially slow under the FSLIC, but accelerated under the RTC. At the end of 1995, when the RTC itself was closed, over 1,600 thrifts had been liquidated. The total cost of the Thrift Crisis has been estimated in the neighborhood of $150 billion. Regulatory authorities were clearly unprepared for the magnitude of the Thrift Crisis. Costs were multiplied by initial inaction and bureaucratic inefficiency. There was a steep learning curve, which by the 1989 creation of the RTC began to level off. Unlike countries that subsequently experienced similar problems, the United States was fortunate that the thrift problem was small in relation to the total size of the financial system.
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THE IMPLICATIONS OF INTERNATIONAL EXPERIENCE

As is apparent, there are any number of ways in which the regulatory authority can intervene in the financial sector. In the three regions examined, we have seen the full array of the seven models discussed. In each and every case, regulatory intervention is described as essential, and the circumstances unique. In each case, regulators attempt to limit the impact of the crisis by some form of forbearance. Capital inflow usually follows, and merger talks are not far behind. Often, merger is tantamount to liquidation, as a forced P&A has the effect of liquidation with government assistance. In the end, costs are higher than expected, and the industry structure changes more than anticipated. If there are lessons from the experience, several come to the surface:

1. Costs of intervention are generally larger than anticipated.
2. Interventions aimed at preserving the current institutional structure generally do not achieve the expected outcome.
3. The only sure resolution appears to come from confronting the insolvency directly and addressing its financial implications, no matter how large.

Regulators, however, often delay action in the hope of a turnaround. If the regulator is lucky, a change in the aggregate economy will remedy the financial imbalance. However, regulators are rarely lucky, at least in recent history. Resolution options available to regulators only permit them to delay the effects of a massive asset-valuation change on bank structure in the hope of a return to financial viability. If they do not set off a series of counterproductive incentive effects, they may offer both the regulator and the bank manager time to shore up balance sheets and improve profitability. But they offer only a little time and often require considerable luck. If the banking system cannot correct its problems in short order, as was the case in the U.S. Thrift Crisis, or if the economy continues to deteriorate, as in the Scandinavian case, or if the losses are too large, as in France, the policy will not achieve its end. On the edges, these policy options may offer some hope to sustain the institutions’ lending capacity and consumer confidence for a short period of time. However, in the end, all of these options are no replacement for sound bank management and a sound balance sheet.
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RESOLVING AND RECAPITALIZING INSOLVENT BANKS

Banks become economically insolvent when the market value of their assets declines below the market value of their deposits. At this point, the market value of their private capital is negative and, unless conditions change for the better, they are unable to repay their deposits in full and on time. In the absence of government-provided guarantees, knowledgeable depositors would have run on their banks in an attempt to withdraw their funds at par value. Unless the insolvent bank is recapitalized, sold to a solvent institution, or legally declared insolvent and resolved through receivership, satisfying depositor claims in full on a first-come, first-served basis is unfair, as it shifts the losses totally to the later claimants. In the process, the bank must sell off (is stripped of its remaining best assets, on which it experiences the smallest fire-sale losses). At some point, the bank will begin to experience sufficiently large losses on its asset sales to prevent it from satisfying further depositor claims in full, and will suspend operations. At this point, the solvency problem has resulted in a liquidity problem that forced an end to the unstructured liquidation and introduced a more formal structured resolution that treats the remaining claimants more fairly.

Because it negates the rationale for runs, government-provided guarantees effectively shift the timing of the resolution of insolvencies from the private market to the bank regulators. The guarantees relieve the liquidity problem, but not the solvency problem. The guaranteed deposits at economically insolvent banks are effectively implicit off-budget liabilities of the government that should more appropriately be recorded as explicit on-budget government debt obligations.’ To the extent insolvent banks are permitted by the regulators to continue to operate, they are likely to continue to generate losses, both by continuing to lend to the same insolvent borrowers and by increasing their risk exposure further by “gambling for resurrection.” if they win, they may be able to regain solvency and reclaim private ownership. If they lose, the losses are borne by the deposit insurance agency and/or the government.

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Unless there is only weak demand for banking services, insolvent banks need not be liquidated. They can be sold or otherwise recapitalized, either as a complete entity or as one or more smaller entities. However, potential buyers will bid for these institutions only if their estimated present value net worths are at least positive. Thus, in order to receive bids, the negative net worths of the institutions cannot exceed their estimated franchise values. If they do, the government must inject public funds or reduce uninsured depositor and other stake-holder claims to the point that this condition is satisfied. As noted earlier, this is not always easy. In particular, public support must be obtained for the use of taxpayer funds. Because many bank insolvencies are associated by the public with fraudulent, unethical, or self-serving behavior by either or both bank management and bank regulators, the public is reluctant to provide support until it is convinced that the funds will not be used to perpetuate such behavior or reward the alleged perpetrators. Moreover, if the funds are used incorrectly once, the government loses considerable credibility and the public becomes even more reluctant to support additional commitments.

The recent experiences of the United States and Japan are informative. The U.S. Thrift Crisis began in the late 1970s, primarily as an interest rate risk problem. To a considerable extent encouraged, if not forced, by government policy to extend long-term fixed-rate residential mortgage loans financed by short-term deposits, the savings and loan associations were exposed to large interest rate risk. Such exposure would probably not have occurred in the absence of government-provided deposit insurance, as the depositors would have fled to safer, less-exposed institutions. When interest rates jumped abruptly in response to a sharp acceleration in the rate of inflation, many thrifts were driven into economic insolvency. By 1982, some 90 percent of all savings and loans were unprofitable, and two-thirds were market-value insolvent (Kaufman 1995). The regulators were unprepared for this crisis and rather than resolve the insolvencies, provided forbearance in the hope that interest rates would decline. They won their bet and rates did decline.

But many insolvent or undercapitalized institutions either unintentionally, because of economic recessions in their market areas, or intentionally, by “gambling for resurrection,” replaced their interest rate risk with credit risk. The resulting losses were accompanied by widespread media publicity about fraudulent and self-serving behavior. Although an increasing number of insolvent institutions were resolved, in many cases the regulators again postponed taking stronger actions and the number and size of insolvencies increased. Afraid to give official recognition to the large and smoldering problem, the government denied its size and promised that only industry-provided funds were necessary to resolve the insolvencies. Only after these proved insufficient and the debacle expanded to the point that it could no longer be contained without the use of large amounts of public funds did the government give official recognition to the problem and persuade the public that withholding such funds would only increase the need for more funds later and that the funds would be used only to make good the government guarantee on deposits.

Not What They Had In Mind

From the 1930s onward, mortgage lending was undertaken by institutions whose liabilities were guaranteed by the Federal government. In addition to Fannie Mae, which was chartered in 1938, there were the savings and loans, which had Federal deposit insurance.

By the late 1960s, restrictions on interstate banking and Regulation Q (which set regulatory ceilings on the interest rates that thrifts could pay depositors) created a shortage of mortgage funds in fast-growing regions, particularly in California. Rather than fix this problem by addressing the regulatory causes, Congress chartered Freddie Mac to do what it had forbidden the S&Ls to do: raise funds in one part of the country to finance mortgage lending elsewhere. Freddie Mac created a secondary market in mortgages, in which mortgages could be pooled together and sold as securities.

In fact, the mortgage securities market was initially a government-created phenomenon. In 1968, Congress created the Government National Mortgage Association (CNMA) to sell securities backed by mortgages guaranteed through government programs of the Federal Housing Administration (FHA) and the Veterans Administration (VA). One purpose was to get these mortgages off the books of the Federal government so that the Administration would not have to keep coming back to Congress to request increases in the debt ceiling, for these requests created opportunities for Congress to express frustration with the Vietnam War as part of this process of trying to trim the government’s balance sheet, Fannie Mae was sold to private investors.

By the early 1980s, S&Ls needed a new source of funds [or they would run out of liquidity (cash) and failed with politically/financially costly fallout for politicians/regulators]. They could not sell their mortgages without incurring losses that would have exposed their insolvency. Instead, with the approval of regulators, investment bankers concocted a scheme under which a savings and loan would pool mortgages into securities which would be guaranteed by Freddie Mac. The S&L would retain the security and use it as collateral to borrow in the capital market [This wasn’t all. Politicians also passed the 1984 safe harbor exemptions (see below)]. However unlike an outright sale of the mortgages, the securitized mortgage transaction would not trigger a write-down of the mortgage assets to market values. The accounting treatment of mortgage securities, in which they were maintained at fictional book-market values, enabled the S&Ls to keep a pretense of viability as they borrowed against their mortgage assets, Fannie Mae soon joined Freddie Mac in undertaking these transactions,

Thus, from the largely by anomalies in accounting treatment and regulation. GNMA was developed in order to move mortgages off the government’s books, even though government was still providing guarantees against default. Congress created Freddie Mac to work around the problems caused by regulation Q and interstate banking restrictions. And the growth in securitization by Freddie Mac and Fannie Mae was fueled by the desire of regulators to allow S&Ls to raise funds using their mortgage assets without having to recognize the loss in market value on those assets. Mortgage securitization did not emerge organically from the market. Instead, it was used by policy makers to solve various short term problems.

Securitization failed to prop up the S&L industry.

In order for the S&Ls raise funds using their mortgage assets (without having to recognize the loss in market value), securitization by Freddie Mac and Fannie Mae wasn’t enough, because the S&Ls were still insolvent. Healthy financial institutions are not going to lend money to banks which they know not well-managed…UNLESS they are given some type of protection from standard bankruptcy procedures.

1984 safe harbor exemptions

*****Safe Harbor Provisions*****

Over time a collateralized interbank lending system developed [now you know why]. Forgetting their Keynes, banks put their trust in collateral to protect them against losses. Collateral allowed them to do business with other banks which they knew were not well-managed. It made them confident that they didn’t need to provision for losses. Weak firms maintained a deep web of connections with the rest of the financial system, which was itself overleveraged. And then in March 2008 the banks came face to face with the fallacy of liquidity. As they suddenly realized that collateral could not protect them if one of their own failed, they withdrew their credit lines causing the very failure that they feared.


…, the 1984 repo amendment exempted repurchase agreements on Treasuries, Agencies and certificates of deposit from standard bankruptcy procedures. By guaranteeing that these repos could not be tied up in bankruptcy the law reduced the risks faced by dealers who worked with small liquidity and capital margins and thus encouraged them to operate on a highly leveraged basis.
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it is important to recognize how profoundly bankruptcy law is weakened by the safe harbor exemptions. Standard bankruptcy procedure guarantees that a secured lender gets the lesser of the amount due on the loan or the value of the collateral plus an unsecured claim for the remainder of the loan. If a loan is overcollateralized the bankruptcy trustee has the right to reclaim the excess amount for the benefit of the other creditors. By contrast, safe harbor protections allow the lender to seize collateral – and it’s not obvious that the trustee is in a position to determine whether or not excess collateral was posted. While this already undercuts the very principles of bankruptcy, the safe harbor privileges go further: even if the transfer of collateral was fraudulent, as long as it was received in good faith, the other creditors in a bankruptcy action have no rights to it.

My reaction: Not only did politicians/regulators ignore the problem of S&L, they also:

1) Allowed the S&L to pool mortgages into securities which would be guaranteed by Freddie Mac.

2) Passed safe harbor provision so the S&L would be able to borrow using the government guaranteed security as collateral, despite being insolvent.

3) Overlook S&L accounting anomalies.

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http://en.wikipedia.org/wiki/Early_1980s_recession

In 1980, there were approximately 4,590 state- and federally-chartered savings and loan institutions (S&Ls) with total assets of $616 billion. Beginning in 1979, S&Ls began losing money due to spiraling interest rates. Net S&L income, which totaled $781 million in 1980, fell to a loss of $4.6 billion in 1981 and a loss of $4.1 billion in 1982. Tangible net worth for the entire S&L industry was virtually zero.

…the FHLBB and FSLIC rarely forced S&Ls to correct poor financial practices. The FHLBB relied heavily on its persuasive powers and the states to enforce banking regulations. With only five enforcement lawyers, the FHLBB was in a poor position to enforce the law even had it wanted to.

One consequence of the FHLBB's lack of enforcement abilities was the promotion of deregulation and aggressive, expanded lending to forestall insolvency. In November 1980, the FHLBB lowered net worth requirements for federally-insured S&Ls from 5% of deposits to 4%. The FHLBB further lowered net worth requirements to 3% in January 1982. Additionally, the agency only required S&Ls to meet these requirements over a 20-year period. This phase-in rule meant that S&Ls less than 20 years old had practically no capital reserve requirements. This encouraged extensive chartering of new S&Ls, because a $2 million investment could be leveraged into $1.3 billion in lending.

Congressional deregulation worsened the S&L crisis. The Economic Recovery Tax Act of 1981 encouraged a boom in commercial real estate building projects. The passage of DIDMCA and the Garn-St. Germain act expanded the authority of federally-chartered S&Ls to make acquisition, development, and construction real estate loans and eliminated the statutory limit on loan-to-value ratios. These changes allowed S&Ls to make high-risk loans to developers. Beginning in 1982, many S&Ls rapidly shifted away from traditional home mortgage financing and into new, high-risk investment activities such as casinos, fast-food franchises, ski resorts, junk bonds, arbitrage schemes, and derivative instruments.
…
As the risk exposure of S&Ls expanded, the economy slid into the recession. Soon, hundreds of S&Ls were insolvent. Between 1980 and 1983, 118 S&Ls with $43 billion in assets failed. …

Federal inaction worsened the industry's problems. Responsibility for handling the S&L crisis lay with the Cabinet Council on Economic Affairs (CCEA), an intergovernmental council located within the Executive Office of the President. At the time, the CCEA was chaired by Treasury Secretary Donald Regan. The CCEA pushed the FHLBB to refrain from re-regulating the S&L industry, and adamantly opposed any governmental expenditures to resolve the S&L problem. Furthermore, the Reagan administration did not want to alarm the public by closing a large number of S&Ls. These actions significantly worsened the S&L crisis.

This Savings and Loan Mess Won't Go Away

This Savings and Loan Mess Won't Go Away
By Bert Ely
7/17/1986
…
The administration has proposed legislation to bail out FSLIC. However, its plan will not work. The Congressional Budget Office very wisely called it "a budgetary gimmick." In effect, the plan, which will come up for committee action in both houses within a week, is nothing more than a 30-month punt of the FSLIC mess into the next administration. The bailout plan actually would work against the long-term interest of the healthier two-thirds of the nation's thrifts. It is an 11th-hour desperation measure designed to preserve the status quo in an obsolete industry. Further, delay in attacking the FSLIC crisis will cost taxpayers unnecessary billions of dollars. Faces Enormous Future Losses
…
This bailout plan would not work for several reasons. First, it would not raise enough money. The present value of the resources the plan would generate is just $12 billion, assuming no future growth in thrift deposits. This is at least $17 billion less than the losses now facing FSLIC.

Second, the 2,000 or so healthy thrifts would bear the full costs of this bailout. But their pockets are not deep enough to absorb FSLIC's prospective losses. Further, it is a dangerous precedent to ask an industry's winners to bail out its losers.

Finally, the plan suggests that FSLIC spend just $5 billion annually over the next five or six years to resolve its problems. However, FSLIC should spend up to $15 billion annually over the next two years in order to minimize its eventual losses from failing thrifts. The administration's more leisurely pace would greatly increase FSLIC's losses due to the costs of delay.

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http://en.wikipedia.org/wiki/Early_1980s_recession

In 1984, the Continental Illinois National Bank and Trust Company, the nation's seventh-largest bank (with $45 billion in assets), failed. The FDIC had long known of Continental Illinois' problems. The bank had first approached failure in July 1982 when the Penn Square Bank, which had partnered with Continental Illinois in a number of high-risk lending ventures, collapsed. But federal regulators were reassured by Continental Illinois executives that steps were being taken to ensure the bank's financial security. After Continental Illinois' collapse, federal regulators were willing to let the bank fail in order to reduce moral hazard and encourage other banks to rein in some of their more risky lending practices. But members of Congress and the press felt Continental Illinois was "too big to fail." In May 1984, federal banking regulators were forced to offer a $4.5 billion rescue package to Continental Illinois.

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The Six Trillion Dollar Debt Iceberg; A Review of the Government's Risk Exposure

June 28, 1990
The Six Trillion Dollar Debt Iceberg; A Review of the Government's Risk Exposure
by Utt, Ronald

In a congressional floor speech last spring decrying the cost of the savings and loan (S&L) bailout, now estimated at between $150 billion and $300 billion, Representative Major Owens, the New York Democrat, declared that he believed there had never been a single item in peacetime that cost the government so much money. Owens raised an intriguing question, and research into federal budget history reveals that he was right. Only World War II cost more than the S&L bailout, at least in nominal dollars. But an examination of the finances of other government-backed agencies indicates that the bailout may be just the tip of a fiscal iceberg about to strike the American taxpayer. The total financial obligation of agencies underwritten by the federal government is now some $5.8 trillion and much of that obligation is in bad shape.

The S&L disaster represents an staggering breakdown of government, and the hidden costs to Americans likely will turn out to be several times the amount that the hapless taxpayer is scheduled to pay directly in extra taxes. It will take years to unravel what really happened and why. But one thing is clear: the governments mega-billion dollar commitment to guarantee the deposits of the savings and loans insured by the Federal Savings and Loan In surance Corporation (FSLIC) was grossly mismanaged, and these perverse incentives offered by the insurance program led to the wholesale looting of hundreds of thrift institutions.

Worsening Daily. As the S&L bailout legislation went through Congress most lawmakers tried to convince Americans that the crisis was just an isolated incident, however costly, and that the vast bulk of the government credit programs are well-managed and pose little risk to the taxpayer. While taxpayers may wish for this to be so, a cursory examination of the federal governments vast credit empire actually reveals repeated instances of huge financial risks that are worsening by the day. In fact, the $958.9 billion in S&L deposits insured by the FSLIC at the end of 1989 represents just a small fraction of the financial liabilities the federal government has assumed through its many direct lending, loan guarantee, and insurance programs. The $4.2 billion loss at the Federal Housing Administration revealed in May 1989 in a General-Accounting Office.(GAO) audit and the Office of Management and Budgets Om) projection that the losses continue, are just among the latest hint of a vast liability that could land in the lap of taxpayers. The governments total risk exposure of nearly $6 trillion dollars is more than twice the national debt held by the public and more than five times the annual federal budget.

Comprehensive Effort Needed. A number of these programs already are encountering serious financial problems. Others could join them over the next year, depending upon how the economy performs. Like the FSLIC, some of these programs require immediate attention to stanch enormous losses and limit potential future claims on the taxpayer. Unfortunately, no such comprehensive effort is under way in Congress or the White House. Worse still, to the extent that credit-related legislation is being considered by Congress some of it would make the situation even worse.

…
CONCLUSION

The vast system of federal credit programs, with their $5.8 trillion in outstanding obligations is in serious trouble. It costs-the taxpayers billions of dollars a year in bailouts, defaults, and unneeded subsidies. Beyond these direct costs to American taxpayers is a host of indirect costs due to the disruption they cause to U.S. financial markets and the country’s ability to deploy its capital resources in an efficient and productive fashion.

Facing the Fact. This national embarrassment and potential catastrophe must be brought under control as swiftly as possible through an Omnibus Credit Reform Bill that makes fundamental changes in the way these programs are structured and operated. Many of the reforms that should be contained in such a measure already have the support of the Administration and in Congress. Unfortunately, the reform approach to this date has been piecemeal, and thus misses the opportunity to achieve comprehensive reform, dealing with problems before they worsen. Congress must at last face up to the fact that the savings and loan crisis, and the other emerging problems associated with federal credit and guarantee programs, are not isolated and unconnected. Rather, they indicate systemic flaws. The solution is system-wide reform.

…
THE HOUSING CREDIT PROGRAMS

Despite the prevailing popular view that the 1980s was a decade of government retrenchment, there was in fact a rapid growth of government credit programs, often at the expense of private financial institutions unable to compete with generous government subsidies. Indeed, one factor in the S&L collapse was aggressive government mortgage lending activity that depressed the earnings generated from traditional savings and loan lending activities. In the residential housing mortgage market, for example, expanding government programs led to the effective federalization of much of the nation’s housing finance market, and to the assumption of multi-billion dollar liabilities by the taxpayer. Federal and federally-sponsored mortgage credit support accounted for just 17 percent of outstanding mortgages in 1980, but by the end of 1989, 41 percent of outstanding home mortgages had been guaranteed by federal agencies or securitized by GSEs as the Federal National Mortgage Association, the Federal Housing Administration, the Government National Mortgage Association, and the Federal Home Loan Mortgage Association widened their activities and displaced private providers of mortgage credit and insurance. There has been similar growth in the agriculture sector, with a vast array of subsidized federal credit support programs for farmers adding momentum to the agriculture debt crisis that first emerged in the middle of the decade.

What is ironic about this rapid growth in credit programs during the economically buoyant 1980s is that the vast majority of the programs were created during the Great Depression to help revive a struggling economy.

…
3) The Federal National Mortgage Association

The Program. The Federal National Mortgage Association (FNMA) known as Fannie Mae, is a privately-owned, government-sponsored enterprise (GSE) chartered and organized by the FHA in 1938 to provide secondary market support for the newly-devised FHA mortgages. …

The Problem By practicing a savings and loan investment strategy of borrowing short term to fund long-term investments in residential mortgages FNMA is vulnerable to any rise in interest rates which would increase its borrowing-costs and thus squeeze profits and reserves: The degree of risk facing FNMA is underscored by a report from the Department of Housing and Urban Development, which notes that the rise in interest rates between 1978 and 1981 reduced the FNMAs mark-to-market net worth from negative $387 million to a staggering negative $11 billion! During this same period the FNMA also faced a growing default problem. The subsequent decline in interest rates and a massive expansion in its investment program helped reverse the deterioration through much of the 1980s. …

Even more disturbing is that while the FNMA continues to operate under conditions of a limited cushion of reserves, it does so as an increasingly important participant in the nation’s residential mortgage market. In part, the growing federalization of the mortgage market, noted earlier, is due to the rapid growth of FNMA activities in the 1980s. Approximately 90 percent of-all originated mortgages are eligible for support from the FNMA or its sister institution, the Federal Home Loan Mortgage Corporation (FHLMC). In 1986 these two institutions purchased loans equal to 82 percent of this eligible amount. At the same time, virtually all of the FHA and VA loans originated that year were repackaged into GNMAs pass-through securities, which are 100 percent guaranteed by the government.

Given this commanding presence in the U.S. residential mortgage market — a presence that will increase because of the declining role of the savings and loan industry — any financial problems at the FNMA or its companion institutions could have devastating implications for the American housing market and the financial system as well as for the hapless taxpayer who would no doubt be called upon to bail out the agencies.

…
1) The Federal Deposit Insurance Corporation

The Program. In an effort to stabilize America’s financial system during the Depression and restore confidence in depository institutions, Congress enacted the Banking Act of 1933. …

The Problem. Confidence in the federal deposit insurance system was shaken when the extensive failures in the savings and loan industry vastly exceeded the reserves of the FSLIC, causing it to seek huge infusions of cash from the U.S. Treasury, the remaining S&Ls, and the taxpayer. Between now and 1999, the total cost of the bailout is estimated to fall somewhere in the range of 150 billion to $300 billion. Although the commercial banking system had at first managed to escape the problems confronting its sister industry, solvency problems are beginning to emerge and there is growing concern regarding the ability of the FDIC to fulfill its obligations during a sustained period of financial stress.

Although the number of problem banks dropped to 1,394 in 1988 from a peak of 1,575 in 1987, the 200 banks failing that year and the 22 that required financial assistance cost the FDIC $7.3 billion, leading to the first-ever loss experienced by the agency. Another 206 banks failed in 1989, costing the FDIC 4.1 billion. The FDICs reserves fell from $18.3 billion in 1987 to $16.3 bil lion at the end of 1988 and to $14.3 billion by 1989. Reporting on its most recent audit of the FDIC, the GAO concludes that the ratio of the FDICs insurance fund balance to insured deposits declined to the lowest level ever estimated by the Corporation to be 0.83 percent.

… Using historic failure rates for both problem and nonproblem banks, and relating these rates to the volume of bank assets at risk and the likely resolution costs, the Shadow Committee estimates the total of FDIC booked and unbooked losses at $21.3 billion, an amount exceeding current FDIC reserves.

Even more pessimistic than the Shadow Committee is CleaningUp the Deposit Mess, a 1989 report by three private sector economists. The economists question the view that the worst is behind the FDIC, contending that given the large number and asset size of weak banks, the extent to which GAAP accounting techniques (Generally Accepted Accounting Principles) hide market value losses, and the potential for rapid asset deterioration, it is possible that losses in the commercial banking industry could eclipse those of the thrift industry, especially if the economy enters a recession before the weak capitalization of many banks is corrected.

The authors conclusion is based on an analysis of the banking industry’s balance sheet and their argument that many banks are very thinly capitalized having actual reserves below 3 percent of assets.

My reaction: This article shows that the US government had a strong incentive not to let the country fall into a deep recession, which would have triggered loses.

“A number of these programs already are encountering serious financial problems. Others could join them over the next year, depending upon how the economy performs”

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Deposit Insurance and Other Liability Guarantees

a. How does the “clean” P&A differ from the “total bank” P&A?

Under a clean P&A the good assets and all deposits of a failed institution are assumed by another bank. The difference between the total value of the deposits (larger) and the value of the good assets (smaller) is paid in a cash infusion by the FDIC. Under the total bank P&A [purchase and assumption], all assets are transferred to the assuming bank with the option that the bank could put back to the FDIC at a later date those assets that were identified to be questionable from a credit perspective. This method required a smaller cash infusion by the FDIC at the time of the assumption.

The FDIC purchase and assumption agreement (P&A) is often enhanced by government guarantees. These often take the form of putbacks, whereby the government promises to buy back the assets. This guarantee is essentially a put option issued by the banking authorities.


Now look at the graph below. The FDIC, when closing all those banks and thrifts, wrote puts on a mountain of bad debt. If the US had experienced a severe recession, defaults would have magnified the cost of the S&L crisis several times.

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The Misuse of the Fed's Discount Window

The Misuse of the Fed's Discount Window
Anna J. Schwartz
1992
…
In 1925 the Federal Reserve Board collected data on the number of member banks continuously indebted to their Reserve Banks for at least a year. As of August 31, 1925, 593 member banks had been borrowing for a year or more. Of this number, 239 had been borrowing since 1920 and 122 had begun borrowing before that. The Fed guessed that at least 80 percent of the 259 national member banks that had failed since 1920 had been "habitual borrowers" prior to their failure. Of 457 continuous borrowers in 1926, 41 banks suspended operations in 1927, while 24 liquidated voluntarily or merged (Shull 1971, 34-35).

The reason for citing these statistics for the 1920s is to call attention to an early episode in Federal Reserve history that contravened the ancient injunction to central banks to lend only to illiquid banks, not to insolvent ones, and that is eerily similar to a current episode. …

The current episode came to light after the House Banking Committee requested data on all insured depository institutions that borrowed funds from the discount window from January 11, 1985, through May 10, 1991. Regulators grade banks on their performance, according to a scale of 1 to 5. The grades are based on five measures known by the acronym of CAMEL, for Capital adequacy, Asset quality, Management, Earnings, Liquidity.' The Federal Reserve -reported that of 530 borrowers from 1985 on that failed within three years of the onset of their borrowings, 437 were classified as most -problem-ridden with a CAMEL rating of 5, the poorest rating; 51 borrowers had the next lowest rating, CAMEL 4. One borrower with a CAMEL rating of 5 remained open for as long as 56 months. The whole class of CAMEL 5-rated institutions were allowed to continue operations for a mean period of about one year.

At the time of failure, 60 percent of the borrowers had outstanding discount window loans. These loans were granted almost daily to institutions with a high probability of insolvency in the near term, new borrowings rolling over balances due. In aggregate, the loans of this group at the time of failure amounted to $8.3 billion, of which $7.9 billion was extended when the institutions were operating with a CAMEL 5 rating. Three months prior to failure, borrowings of all 530 institutions peaked at $8.1 billion. Rather than encouraging banks to pursue strategies to preserve their size, regulators often encourage institutions that are about to fail to shrink drastically first, so as to diminish the pool of assets that have to be liquidated after closing.

Some observers of bank performance have asserted that it is impossible to know whether an institution that applies for discount window assistance faces a liquidity or solvency problem. That assertion may be defensible for discount window lending in the 1920s even though an t -estimated 80 percent of long-time borrowers failed, since CAMEL ratings did not then exist. Currently, CAMEL ratings 4 and 5 are known promptly. Why should it be impossible or even difficult to distinguish between an illiquid and an insolvent bank?

Brief official descriptions of composite CAMEL 4 and 5 ratings follow:

CAMEL 4 "Institutions in this group have an immoderate volume of serious financial weaknesses or a combination of other conditions that are unsatisfactory. Major and serious problems or unsafe and unsound conditions I may exist which are not being satisfactorily addressed or resolved."

CAMEL 5 "This category is reserved for institutions with an extremely high immediate or near-term probability of failure."
…
The discount window provided accommodation for periods up to 90 days for a nonagricultural discount or advance collateralized by eligible paper or government obligations, but of up to nine months for agricultural paper. As noted earlier, continuous borrowing year in and year out in the 1920s was not uncommon. A later (1954) Federal Reserve document, deploring continuous borrowing, noted that "it was possible by the mid-Thirties to speak of an established tradition against member bank reliance on the discount facility as a supplement to its resources" (Shull 1971, 41). A similar statement appears in an internal Federal Reserve history of the discount mechanism: "extended borrowings by a member bank from its Reserve Bank would in effect constitute a use of Federal Reserve credit as a substitute for the member's capital" (Hackley 1973, 194). The 1973 version of Regulation A states, as a general principle, that "Federal Reserve credit is not a substitute for capital and ordinarily is not available for extended periods." Both the 1980 and 1990 versions of Regulation A state, as a general requirement, that "Federal Reserve credit is not a substitute for capital."
…
2. ASSISTANCE TO INSOLVENT NONBANKS AND BANKS SINCE THE 1970s
…
B. Assistance to CAMEL 4- and 5- rated banks

In 1974 the Federal Reserve behaved contrary to traditional principles when uninsured depositors started a run on the Franklin National Bank after news surfaced that it had large foreign exchange losses. The Comptroller of the Currency did not close it promptly. The decision of the regulators was that the Federal Reserve discount window, starting in May, would provide loans until the FDIC found a purchaser of the failed institution. Over the next five months, the Federal Reserve Bank of New York lent continuously to Franklin; the maximum amount lent, on October 7, 1974, was $1.75 billion, representing nearly one-half of Franklin's assets. On October 8, the bank was declared insolvent and taken over by a foreign consortium.

…
The rescue of Franklin National Bank shifted discount window use from short-term liquidity assistance to long-term support of an insolvent institution pending final resolution of its problems. The bank was insolvent when its borrowing began and insolvent when its borrowing ended. The loans merely replaced funds that depositors withdrew, the inflow from the Reserve Bank matching withdrawals.

The undeclared insolvency of Continental Illinois in 1984 was also papered over by extensive discount window lending from May 1984 to February 1985, albeit with smaller subsidies than in the case of Franklin National-an amendment to Regulation A as of September 25, 1974, permitted application of a special rate on emergency credit after eight weeks that was closer to a market rate. The borrowing covering Continental's holding company as well as the bank at some dates amounted to as much as $8 billion. [This $8 billion can be seen in the huge spike in borrowed reserves in 1984-85 on graph below]

The discount window has been valued by the Federal Reserve as a mechanism for directing funds to an individual bank with liquidity problems. It regarded its loans to Franklin National and Continental Illinois as exceptional occurrences. However, when hundreds of CAMEL 4 and 5-rated banks, as noted at the beginning of this paper, were receiving extended accommodation even though they faced a high probability of near-term failure, discounting can no longer be regarded simply as a means of providing temporary liquidity. What explains this transformation in practice?

C. Why the Departure From the Historic Norm of Discount Window Use?

In the United States, with federal spending budgeted at an all-time high, policy makers see the discount window as a mechanism for providing funds off budget. Legislation is necessary to authorize the Fed to provide assistance to favored nonbanks, so the use of the window isn't kept secret, but it may seem a cost-free way of funding them because repayment can be rolled forward indefinitely. This may explain the recent spate of efforts to use discount window assistance for nonbanks.
…
3. COSTS OF LENDING TO INSOLVENT INSTITUTIONS
…
Discount window accommodation to insolvent institutions, whether banks or nonbanks, misallocates resources. Political decisions substitute for market decisions. Institutions that have failed the market test of viability should not be supported by the Fed's money issues.

A depository institution traditionally was said to be eligible for discount window assistance when it was illiquid but solvent. In recent years, it has been given assistance when it was liquid but its insolvency was undeclared. On a market value basis, an institution is insolvent when assets are less than liabilities. Since book values are the usual measure of assets and liabilities, the divergence between assets and liabilities may only be revealed long after the market value of its assets has fallen below the market value of its liabilities. In addition, an institution may be liquid but insolvent, so long as its cash flow is positive.

A decision to declare an institution insolvent is the prerogative of the chartering agency: the Comptroller of the Currency for national banks, state authorities for state-chartered banks supervised by the Fed and the FDIC. The FDIC, since 1989, however, can both remove deposit insurance and substitute itself as receiver of state banks. It can force a state to close banks and, as the thrift insurer, close insolvent insured thrifts. (It does not have authority to close credit unions.) If the chartering agency has delayed closure, the Federal Reserve has acted as if a troubled institution is entitled to discount window assistance provided it can furnish acceptable collateral. The question I raise is window whether the Federal Reserve's position is defensible when inferior CAMEL ratings provide independent evidence on the likelihood of insolvency in the near Or immediate future.
…

Open market operations are anonymous. The market allocates reserve injections or withdrawals among participants according to their relative size and current opportunities. Much greater discretion is exercised by the Federal Reserve in the allocation of reserves through discounting, since the Fed knows the institutions that request discount accommodation. The public learns about the magnitude of both open market operations and discount window credit from the data the Federal Reserve publishes, but it does not learn the names of the banks that received loans. The data made available to the House Banking Committee in 1991 revealed the names of the institutions that had failed despite extended discount window loans, but not the names of the few banks that had received such loans but had not failed. The secrecy may be good public policy, but it leaves open the question whether provision of loans on a case-by-case basis assures equal treatment for all. This is an argument against discount window lending in general, not specifically to insolvent banks, an argument that has often been made in the past without reference to the specific problem of insolvent banks (for example, Friedman 1960, 38).

Since the 1970s, the Federal Reserve has extended long-term discount window assistance to depository institutions that by objective standards were likely to fail. It has done so in the belief that, in the absence of such assistance, contagious effects would spread from the troubled institutions to sound ones. The belief is particularly entrenched for large troubled intermediaries, reflecting an apprehension that halting the operation of such institutions would have dire unsettling effects on financial markets. Before 1985, the goal of such discount window assistance was a restructuring of the problem institution as a viable entity with both insured and uninsured deposits made whole.

…
Since 1985, prolonged discount window assistance has generally terminated not with restructuring but with closure of the insolvent banks. When banks are known to be insolvent, postponement of recognition of losses that have occurred might well have increased current losses. Uninsured depositors have more time to, withdraw their funds. The insurance agency, which is to say the taxpayer) ultimately bears any added costs of delayed closure. By lending to the banks in question, the Federal Reserve encourages this practice. Absent regulatory restraints or incentives to the contrary, the policy clearly encourages risk-taking and invites moral hazard problems. …

Discount window lending to insolvent banks might cease if, under the terms of the FDIC Improvement Act of 1991, the Fed no longer advanced funds to keep critically undercapitalized institutions in operation, and the insurance agency took prompt corrective action to appoint a receiver for those institutions.’ [The FDIC Improvement Act of 1991 made the Federal Reserve financially liable to pay any excess costs of bank failure attributable to lending by the discount window to failing banks]

4. COULD REFORM REMEDY WHAT'S WRONG WITH THE DISCOUNT WINDOW?
…
Since the 1970s, the Federal Reserve has acted on the belief that discount window assistance to banks with a high probability of insolvency in the near term, especially large ones, will, by delaying closure, eliminate contagious effects on financial markets.

In practice, the Federal Reserve’s discount window activities have created perverse incentives, shifting risk from depositors to taxpayers. If a threat of systemic bank failures did arise, the Fed should counter it by open market operations, rather than by assistance to individual institutions.
…
5. CONCLUDING COMMENTS

I’ve surveyed the changes in Federal Reserve discount window practices since the System’s founding. Early on the System emphasized that borrowing was supposed to be limited to short term reserve needs. By the 1980s, hundreds of banks rated by regulators as having a high probability of failure in the near term and which ultimately failed were receiving extended accommodation at the discount window.

My reading of this recent experience is that the change in discount window practices, by delaying closure of failed institutions, increased the losses the FDIC and ultimately taxpayers bore. Recent legislation limits use of the discount window for long-term loans to troubled banks. More important, it also provides that a supervisory agency is to appoint a receiver for an institution that falls below a critical capital ratio, curtailing the regulator's discretion regarding when to intervene in the case of an undercapitalized bank.

Deposit Insurance and Other Liability Guarantees

19. What are some of the essential features of the FDICIA of 1991 with regard to the resolution of failing DIs?

The FDICIA of 1991 has made it very difficult for regulators to delay the closing of failing DIs unless the danger of a systemic risk can be shown. They are expected to use the least cost resolution (LCR) strategy to close down DIs, and shareholders and uninsured depositors are expected to bear the brunt of the loss. Unlike in prior years, the FDIC will only subsidize if the liquidated assets are not sufficient to cover the insured deposits. The General Accounting Office has also been authorized to audit failure resolutions used by regulators to ensure that the least cost strategy has been adopted.
…

1) Since 1985, prolonged discount window assistance has generally terminated not with restructuring but with closure of the insolvent banks.

2) The FDICIA of 1991 made it very difficult for regulators to delay the closing of failing DIs unless the danger of a systemic risk can be shown

3) Insolvent financial institutions needed a need source of cash.


Discount Window Lending VS Gold Leasing

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OBSERVATIONS FROM THE TRADING FLOOR DURING THE 1987 CRASH

American Monetary Institute
Stephen Zarlenga, Director
Dedicated to the independent study of monetary history, theory, and reform
OBSERVATIONS FROM THE TRADING FLOOR DURING THE 1987 CRASH


2007 Introduction: The "Classic" pattern for major crashes is a market high in summer followed by a substantial drop and then a retracement upwards into early October leading to the crash type activity in late October.
These observations show

Why its foolish to believe the hype from "hedge" funds that they will provide liquidity!

Because the American Monetary Institute works in the monetary area, its not unusual for people to ask us where the markets are going? As a publicly supported charity we don't give investment advice. But we do have an awareness of these matters and we tell friends the following:

Where the market will go is more a political matter than an economic one. For example:

* If corporations had to properly fund their retirement promises to working people, that could easily knock 25% off the market's total valuation.
* If the corporations were paying their fair share of taxes in this country, that could easily knock another 25% off the market's total valuation.
* Proper cost accounting for pollution, and its health effects could knock another 25% off the markets total valuation.
*Removal of special privileges unfairly granted to business, serving to concentrate wealth into the wrong hands could easily remove 25% of the markets value.
* Providing universal health care to all Americans through non-profit governmental programs would probably increase the markets total valuation by 25%!
* Continuing to have the banking system provide almost unlimited funds to the corrupt American financial system is the only reason the stock and real estate markets are at these high levels. If that support increases, it can continue to maintain these high levels.

It is mainly politics and a corrupt media that determines which of the above take place. And that is what makes it extremely difficult to find any secure values to place ones savings into. If one stays out of the madness, prices can still keep going up out of sight, leaving one "behind." If one enters the madness, there is always the risk of major crashes, wiping out savings.

That's what happened in 1987 (written in 1997):

In 1987, I was a floor trader on the New York Futures Exchange (NYFE), a subsidiary of the New York Stock Exchange. I remember well how that crash looked from the floor of the Exchange the week of October 19-23, 1987. The previous week had seen a large drop, with the various indexes closing the prior Friday, right at their long, long term trend lines. Many traders considered this a support level, but at the Monday opening, the market gapped down strongly. …

The two big crash days were Monday and Tuesday, with the bottom arriving on Tuesday. The market had its worst drop ever in one day, falling 508 points on Monday alone.

At that time, the NYFE pit was located adjacent to the New York Stock Exchange. The main contracts traded were the NYSE Composite Index, and the CRB Index.

In my mind’s eye, I remember the trading room those two days, with its high ceiling, as containing a large diffused, electrically charged storm cloud. It was over twenty years ago yet the psychological cloud is still there! So much devastation was occurring all around.

At various stages of the panic, Partners from the major NYSE member firms came down into the futures trading room, looking like death, to check on their agents. I remarked to X, who represented the largest of them that they’d do better to stay in their offices, rather than display that much evident fear.

During the day on Monday the NYFE pit got thinner and thinner as floor traders either got smashed, scared, or had their trading badges revoked by representatives of the clearing houses, who came to the floor to pull out traders they had previously guaranteed. All traders without years of experience were summarily removed. Without a clearing house guarantee they had to stop trading.

Others were allowed to continue trading only “for liquidation”; to make trades which would liquidate their existing positions. One “out-trade” (mistaken trade not later confirmed by the opposing trader) could be devastating under such conditions, where the traders were expected to split the loss (or profit) involved in the disputed trade. They were usually losses because if it was profitable, the opposing brokers trade checker was usually sharp enough to accept it as valid, especially if he heard no other trade checker in the trade checking room calling for the trade as one of theirs.

By Tuesday the NYFE pit opened in the morning with only about 20 “locals” present, compared to a normal number of around 110 persons in the pit. I remember one character was humorously wearing a football helmet. By the end of the day, and on Wednesday there were only from 8 to 12 people in the pit, most of them acting as brokers rather than trading their own accounts. The football helmet had been exchanged for a Samurai headband. That day one of the old standing insults against the NYFE was actually true that “you could fire a shotgun into the NYFE pit and not hit anyone!”

The CRB (commodity futures index) pit was adjacent to the NYFE pit. Tuesday was the big day in the CRB pit…. The CRB contract closed as usual, at 2 PM on Monday, and almost half of the damage to the stock market had occurred afterward from 2 PM to 4 PM. I had gone short the CRB on Mondays close; but the added severity of the stock market drop left me concerned that gold would react upwards, counter to the stocks.

The CRB index is complex to trade, because prices change in the morning as one or another commodity market opens for trading. Gold is among the first commodities to open, and I thought I could be knocked out of the short position on the opening. But Gold opened limit down. [Gold suppression. It might not even have been intentional, Wall Street were desperate for liquidity and went heavily short physical gold to raise cash.]

At the end of the day Tuesday, virtually all the CRB traders deserted the pit, and ran for the hills. Convinced of an imminent banking collapse they withdrew their funds from their clearing houses, thereby losing their trading privileges. One of the clearing houses, unsure of its position, issued them checks which were not signed!

That clearing firm had guaranteed an options market maker who had sold lots of out of the money puts, and had been “blown out” on Monday with a $20 million loss, when those far away puts came into the money. This was a clear demonstration of the limitation of the “Black Shoales” option valuing system he had used. The error of that system was that those far out puts had been valued at zero, requiring no offset; but there is no such thing as a zero in nature.

It was an interesting case. That options trader had been one of the NYFE’s greatest success stories, having gone in the previous 5 years from $10,000 net worth to $10 million, and was then wiped out in a day, with the clearing house suing him to recover its losses. He had grown very sure of himself, and became convinced of his invincibility, like many involved in today’s markets.

One Problem With Correlation

Six months prior to the crash he had made some errors in the CRB pit over a period of 3 months, dropping several hundred thousand dollars, in a stubborn attempt to hedge a large short position in oil, with long positions in the CRB. He thought this would work because the two contracts had a high positive correlation in the past.

It is always tricky to make that sort of bet, based merely on correlation numbers without real cause and effect connections, or only partial ones. Almost every day for two months that trader bought 10 to 20 CRB futures contracts, paying a premium of 150 points on each contract. His long CRB position was transparent to the pit, and the CRB just kept falling slowly, until the day he sold it out in February 1987.

What probably happened to that trader was that as XX sold him CRB futures, instead of offsetting his position by buying the underlying CRB elements, which would have pushed the price up, XX may have just offset his CRB shorts by buying the oil futures that the trader was short. In other words taking the exact opposite side of the traders position, but having the advantage of the 150 point premium he was charging.

This also points out the problem of transparency. Some brokers made no effort to hide the source of their orders, which would sometimes be raped by the pit. Large orders going into a thin pit (30 or more contracts) should include advance notice of extra compensation for the broker as a reward for good execution. An extra $3 to $8 per contract goes a long way with most brokers, and could save thousands in execution prices.

There were also big success stories from the crash. XXX, who handled the orders for the far away months, was said to have been able to hit a large standing buy order for an out month future on Monday’s opening, and apparently was $5,000,000 richer by Tuesday’s close. Not bad for a twenty two year old kid with no college education, and little prior capital. XXX was truly a success story he quit the exchange and went back to school.

Wednesday, there were only two traders left in the CRB pit, XX, (who was a major arbitrageur and broker) and myself (I was not a broker). Since XX was the only broker in the pit, when orders to buy or sell came in, he had to pull in a broker from the Composite pit to handle the other side of it, or broker both sides of it, by repeating aloud three times the buy or sell order, and only then, filling it himself.

One thing that the 1987 crash made very clear was that there was no real liquidity in the markets, when it was needed. Virtually all the fund managers tried to do the same thing at the same time: to sell short the stock index futures, in a futile attempt to hedge their stock positions.

They created a huge discount in the futures market, varying from 10 to $12,000 per contract, on a contract which only had a total value of $98,000 at the end of August, and $51,500 at the low point on Tuesday. The S&P futures contract went to a discount of nearly $20,000. The arbitrageurs who bought futures from them at a big discount, turned around and sold the underlying stocks, pushing the cash markets down, feeding the process and eventually driving the market into the ground.

The liquidity situation today would most certainly be similarly inadequate if everyone tries to do the same thing.

Some of the biggest firms in Wall Street found they could not stop their pre-programmed computers from automatically engaging in this derivatives trading. According to private reports they had to unplug or cut the wiring to computers, or find other ways to cut off the electricity to them (there were rumors about fireman's axes from hallways being used), for they couldn’t be switched off and were issuing orders directly to the exchange floors.

The New York Stock Exchange at one point on Monday and Tuesday seriously considered closing down entirely for a period of days or weeks and made this public. For some reason, it was pretended that such a closure was unprecedented (they were probably ignorant of their own history). It was at this point, in consultations with the Federal Reserve System’s Alan Greenspan, that Greenspan made an uncharacteristic announcement. He said in no uncertain terms that the FED would make credit available to the brokerage community, as needed.

This was a turning point, as Greenspan’s recent appointment as Chairman of the Fed in mid 1987 had been one of the early reasons for the market’s sell off. Greenspan’s extreme concern in “fighting inflation” was known, and this translates in the mind of market participants into monetary contraction and higher interest rates. Apparently he redefined how the money supply would be calculated, for policy decision purposes.

Greenspan’s crucial announcement was, as I characterized in the first report, in “Benjamin Strong fashion”, since Strong had realized his power as a central banker to break any money panic. Market participants began to realize that their brokerages and clearing houses wouldn’t fail due to a liquidity crisis. [1987 was a liquidity crisis]

The visible cause of the recovery was when the MMI future (Major Market Index) of blue chips began to trade at a premium, midday Tuesday, at a time when one after another Dow stock had been closed down for trading. The meltdown began to reverse. Arbitrageurs bought the underlying stocks, re-opening them, and sold the MMI futures at a premium. It was later found that only about 800 contracts bought in the MMI futures was sufficient to create the premium and start the recovery.

Soon after the crash, maximum daily trading limits and circuit breakers were established by the Stock exchanges; a solution which the agricultural and other commodities markets had used successfully for decades. These limits were a good idea, and I have personally witnessed them in action on several occasions, bringing an end to wild over reactions in the stock index futures. Its remarkable how much panic can be dissipated in a 15 minute breather. However, if there were some factual causal reason for a major sell off, those limits would be only temporary band aids.

This whole experience was very instructive and helpful to me, in accelerating my dropping an ideological commitment to “laissez Faire” free markets [a lot of people had this reaction. It eventually lead to the creation of the Plunge Protection Team (PPT)]. Life became more complex I no longer had the simple “one theory fits all situations” formula suggested by Ayn Rand’s novels! Unfortunately most libertarians still view those novels as historical "evidence!"

After the trading limits were imposed, an article by a free market ideologue criticized market participants for compromising the free unrestricted market and knuckling under to government in establishing the trading limits! It’s not the first time that those with real experience with market behavior were criticized by ideologues, for accepting compromises and controls on markets. Those with the experience know firsthand some of the limitations of markets and know that at the crunch times, the markets must be able to come back for government help. [again, the roots of the PPT are seen here]

One other factor which the crash demonstrated is still not fully appreciated by economists, traders, and investors alike: That the futures “tail” was quite capable of wagging the stock market “dog”. I had learned this earlier in the CRB pit, watching how a purchase or sale of just 10 CRB futures contracts, led within three to five minutes to changes in the prices of the underlying commodity prices. It was a causal relationship, as arbitrageurs who took on the futures long or short position then had to offset these positions in the underlying commodities.

Another important lesson to learn from the 1987 crash was to suspend the normal concept of time, and to follow the rules for support and resistance levels without any consideration for how fast they were being reached.

HOW WE PREDICTED THAT NO DEPRESSION WOULD FOLLOW

The severity of the 1987 crash led immediately to comparisons with 1929, and to questions whether an economic depression would follow. Many traders, who thought of themselves as fearless, had even withdrawn from their clearing houses, fearing that the clearing houses, if not the banking system, would fall.

I told one of them XXXX a friend of mine, that if he really planned to be a broker, he had to come back in, with at least the minimum required reserve, and just view it as a necessary part of professionalism in doing his business. He came back on Thursday, and we had three or four people in the CRB pit. So the fear of collapse was real and palpable at the nation’s exchanges.

On Wednesday October 21^st, the day after the crash lows, the New York Composite futures had recovered exactly one half of the entire fall from the August highs. It was exactly one half, to the nearest tick! (a tick is the smallest unit of change allowed in the futures contract $25 in the NYFE Composite) In 1929 the DJIA topped out at 381 in August. After the October 1929 crash bottomed in November at 199 in the DJIA, it took until April 1930 to make a 52% recovery, before going down for 2 ½ more years to new lows, at 41 in the DJIA. Clearly the situations were different.

On the exchange floor a number of CRB traders especially wanted to have some guide from the past, as to what could be expected to happen to commodity prices. We did something unheard of for floor traders we commissioned research which I supervised, of the 1929 crash, which mainly uncovered the fact that commodity prices had been slowly but persistently falling, for several years prior to 1929. After the crash they continued to fall, for three more years, at a more rapid rate.

In 1987 the situation for commodity prices was very different (see chart # 4, CRB 1985-88). The CRB index had made its all time high of 338 in 1980, a year of surging metals prices, and a 20% prime rate. But the price action since then was not in a consistent decline, but erratic with large rallies and declines, and from August 1986 it had been rising strongly. Furthermore after two wild days in the CRB pit caused by the stock exchange crash, the CRB index resumed its erratic rise.

Commodity prices both before and after the 1987 crash were therefore a strong indication that the crash problem was specific to the mechanics of the stock market, and not a general monetary or economic phenomena. In particular it was related to derivatives trading. The money managers had not fully understood the lack of liquidity in the futures pits. Their rush to sell created 10, 15, and 20 and even 40 handle discounts in the futures pits, compared to cash prices (a “handle” represents 100 points in the index).

Those who bought futures from them at these discounts, then rushed to offset their positions by selling the underlying stocks, “at the market.” This process was repeated all day for two days, and that’s what caused the meltdown of the New York Stock Exchange in October 1987.

A Brief History of the 1987 Stock Market Crash
with a Discussion of the Federal Reserve Response
Mark Carlson_
Board of Governors of the Federal Reserve
November 2006


2.3 Tuesday, October 20, 1987

…
Before it opens, the CME clearinghouse collects margin payments from members to cover losses that occurred the previous day on their open positions. (Margins will be discussed in some detail below.) Margin payments are then made to members for open positions in which the value improved the previous day. Typically these payments are completed by noon. On October 20, two CME clearinghouse members had not received margin payments due to them by noon, which started rumors about the solvency of the CME and its ability to make these payments. These rumors proved unfounded but nevertheless reportedly deterred some investors from trading on the CME (Brady Report 1988, p. 40). Bid-ask spreads widened, and trading was characterized as disorderly (Brady Report Study VI, pp. 64-65).

…
3 Factors that contributed to the severity of the crash
…
3.1 Margin Calls

Margin calls, as they were implemented during this period, were one factor that reduced market liquidity, especially in the futures markets, and likely contributed to the severity of the decline. When investors entered into a contract in futures markets, they were required to post a portion of the value of that contract, called a margin, in an account with the broker. Brokers in turn posted margins with the exchange on behalf of their clients and for their proprietary trading desk. Margin requirements could be met by posting cash or selected instruments such as Treasury securities. If the value of the investor’s position declined due to changes in market prices, his margin account was debited and he was generally required to post additional margin to his account to ensure that he would be able to meet his obligations when the contracts expired; this action is referred to as a margin call (Brady Report 1988, Study VI, pp. 23-24, Saunders and Cornett 2007). The funds debited from the accounts of investors whose positions declined were used to credit accounts of investors whose positions improved. When adjusting the margin accounts, the exchanges first made margin calls against all the positions that lost value and then later credited accounts belonging to investors whose positions gained in value (so even if an investors had offsetting positions, they would be required to post margin on the position that lost money and would only receive credit for the position that gained in value later.) Calls for additional margin could be made throughout the day, and were always done at the end of the day. For intraday margin calls, investors needed to post additional margin within the hour; for end-of-day margin calls, additional margin were required to be posted before the exchange opened the next day. Only after receiving funds to cover end-of-day margins did the exchange clearinghouse credit the accounts of investors whose positions rose in value.

The sharp price movements on Oct. 19 on futures contracts resulted in record intra and end-of-day margin calls for firms that were members of the CME clearinghouse; these margin calls were about ten times the average size. Because payments to investors whose positions have gained in value are made well after payments have been collected, these margin calls likely reduced the ability of some market participants to enter new positions, and, as noted in the Brady Report (1988, Study VI p. 73) strained institutions needing to extend credit to those meeting margin calls.

Coordinating payment flows to make sure margin accounts were fully funded prior to the opening of markets also made for some tense moments. The end-of-day margin calls needed to be met on the morning of Oct. 20 before the start of business. To meet these margin calls, clearinghouse member firms drew on their credit lines with the four banks that provided settlement services for the CME. These banks were reportedly concerned as the margin calls exceeded lending limits and increased their exposure to the securities industry at a point when financial markets were tumbling. Further, the amount of intraday credit typically extended to securities firms was already a worry to some of the settlement banks. Many of the CME clearinghouse member firms were subsidiaries of Wall Street broker-dealers that had close relationships with large New York banks. Thus, the clearinghouse member firms would generally repay the credit extended by the Chicago based settlement banks with funds borrowed from banks in New York. To help make the extensions of credit and transfers of funds proceed smoothly, the Federal Reserve Banks of Chicago and New York reportedly let commercial banks in both districts know that the Federal Reserve would help provide liquidity for the loans. Due in part to the efforts of the Federal Reserve, on Oct. 20—the day following the crash—the settlement banks extended the necessary credit, and the accounts for CME clearinghouse members were fully funded by market opening. However, some transfers from banks in New York to banks in Chicago on Oct. 20 were delayed as Fedwire transactions between New York and Chicago were disrupted from around 10:00 am to 12:30 pm (Central Standard Time) due to computer problems (Brady Report 1988, Study VI, p. 71; Greenspan 1988, pp. 119-120). Members of the Options Clearing Corporation (OCC), which cleared transactions for the CBOE, also faced substantial intraday margin calls. New York banks delayed confirming payments on OCC drafts. Banks clearing transactions for the OCC permitted clearinghouse members to overdraft their accounts until payments could be confirmed (Bernanke 1990). Morning settlement on Oct. 20 was not completed for the OCC until two and a half hours after the usual time (Brady Report 1988, Study VI, p. 75).16

Banks responded to the need to meet margin calls by extending credit, despite any concerns that they may have had about the size of their exposure to the securities industry. Without these extensions of credit, some institutions would not have been able to satisfy their margin requirement and trading would likely have been severely disrupted. Federal Reserve data related to the credit extended to brokers and dealers by banks jumped notably between the weeks of Oct. 14 and 21.

(see Figure 3). Financing needs were greatest in New York and Chicago with, as noted above, many of the brokers and dealers in Chicago relying on banks in New York. When the expansion of loans is broken down by the location of the lender, there was a very sharp expansion of lending to brokers and dealers by banks located in New York City and a rise in lending by banks in Chicago (see Figure 4). The SEC reported that banks were more attentive to the collateral posted by the brokers and dealers, but in general extended credit following existing lending procedures (SEC Report 1988, pp. 5-24–5-29).

Failure of retail investors to meet margin calls spurred liquidations in options markets. Brokers placed emergency margin calls to their retail investors with exposed options positions. In the absence of additional margin, these positions were supposed to be liquidated. The Brady Report indicates that this happened frequently (Study III, p. 21) and these liquidations likely added to the selling pressure in financial markets.

…
4 Response of the Federal Reserve

In an effort to restrain the declines in financial markets and to prevent any spillovers to the real economy, the Federal Reserve acted to provide liquidity to the financial system and did so in a public manner that was aimed at supporting market confidence. One of the most prominent actions of the Federal Reserve was to issue a statement on Tuesday morning (as noted above) indicating that it would support market liquidity. This statement was referred to by one market participant as “the most calming thing that was said [Tuesday]” (Murray 1987b), and likely contributed to the rebound that morning.

The Federal Reserve followed-up the statement by carrying out open market operations that pushed the federal funds rate down to around 7 percent on Tuesday from over 7.5 percent on Monday (see Figure 5). This was done to “provide significant liquidity to relieve the turbulence and tension in the wake of the financial market upheaval” (FOMC transcripts, meeting of Nov. 3, 1987, comments by Peter Sternlight, p. 2). Other short-term interest rates followed the federal funds rate lower thus reducing costs for borrowers. For the next several weeks, the Federal Reserve continued to inject reserves to buoy liquidity in financial markets. Open market operations expanded the Federal Reserve system’s securities holdings notably (see Figure 6); however, it did not appear to expand exceptionally rapidly.

Following the crisis, open market operations were conducted in a high profile manner in order to underscore to market participants that the Federal Reserve was providing liquidity support (FOMC transcripts, meeting of Nov. 3, 1987, comments by Peter Sternlight, p. 3). Open market operations were frequently conducted an hour or more before the normally scheduled market intervention period (Winkler 1987). When entering the market early, the Trading Desk at the Federal Reserve Bank of New York would notify dealers on the preceding afternoon (FOMC transcripts, meeting of Nov. 3, 1987, comments by Peter Sternlight, p. 3).

The Federal Reserve also worked with banks and securities firms to encourage the availability of credit to support the liquidity and funding needs of brokers and dealers. As noted earlier, the extension of credit by banks to the securities firms was key to the ability of these firms to meet their clearing and settlement obligations and to continue to operate in these markets. In testimony given in 1994 to the Senate Banking Committee, Chairman Greenspan indicated that “[t]elephone calls placed by officials of the Federal Reserve Bank of New York to senior management of the major New York City banks helped to assure a continuing supply of credit to the clearinghouse members, which enabled those members to make the necessary margin payments” (Greenspan 1994, p. 137). Contemporary newspaper articles reported similar information:

John S. Reed, the chairman of Citicorp, has been quoted as saying that his bank’s lending to securities firms soared to $1.4 billion on Oct. 20, from a more normal level of $200 million to $400 million, after he received a telephone call from E. Gerald Corrigan, president of the New York Federal Reserve Bank. (Sterngold 1987)

Alerted by calls about the developing credit crisis from Mr. Phelan [Chairman of the NYSE] and others, the Fed leaned heavily on the big New York banks to meet Wall Street’s soaring demand for credit. Mr. Corrigan and key aides personally telephoned top bankers to get the message across...The banks were told to keep an eye on the big picture—the global financial system on which all their business ultimately depends. A senior New York banker says the Fed’s message was, ’We’re here. Whatever you need, we’ll give you.’ (Stewart and Hertzberg 1987)

Government, and in particular U.S. Treasury, securities are often used as collateral in repurchase agreements and other financial contracts (and can also be pledged to satisfy margin calls). Trading and lending these securities is an important source of market liquidity. After the stock market crash, there was reportedly some reluctance by holders of government securities to lend them as freely as they typically did, possibly owing to concerns about counterparty risk, which led to scarcity of some securities and a rise in fails to deliver (Greenspan 1988, p. 92). Problems trading government securities could potentially spill over into other markets. To respond to this trend and enhance liquidity in the government securities market, the Federal Reserve temporarily liberalized the rules governing lending of securities from its portfolio by suspending the per issue and per dealer limits on the amount of loans as well as the requirement that the loans not be made to facilitate a short sale (FOMC transcripts, meeting of Nov. 3, 1987, presentation by Peter Sternlight, p. 7).

There were also a variety of supervisory efforts to ensure the soundness of the financial system. The Federal Reserve placed examiners in major banking institutions and monitored developments (Greenspan 1988, pp. 90-92). This action was taken in part to identify potential runs as well as to assess the banking industry’s credit exposure to securities firms through loans, loan commitments, and letters of credit. Monitoring efforts by the Federal Reserve went beyond the banking industry and included stepped up daily monitoring of the government securities markets and of the health of primary dealer and inter-dealer brokers. These latter efforts also involved keeping in close touch with officials from a variety of agencies and institutions such as the Securities and Exchange Commission, National Association of Securities Dealers, New York Stock Exchange, and the Treasury Department.

Finally, in an effort to facilitate settlement and clearing of transactions and loans by settlement banks to brokers and dealers, the Federal Reserve extended Fedwire hours on several occasions (Greenspan 1988, p. 92). [Fedwire is what banks use to transfer their reserve balances (their cash) to other financial institutions.]

The response of the Federal Reserve, and other regulators, appears to have contributed to improved market conditions. Reflecting the additions of reserves through open market operations and the reduction in the federal funds rate, other short-term interest rates declined. The liquidity support likely contributed substantially toward a return to normal market functioning. Within a few days, some measures of market uncertainty, such as the implied volatility on the S&P 100, declined, although they remained elevated compared to pre-crash levels (see Figure 7).

5 Conclusion

The 1987 stock market crash was a shock to the stability of the financial system, not just because of the size of the drop in price, but importantly because market functioning was significantly impaired. The volume of sell orders at times overwhelmed NYSE specialists and they were forced to suspend trading in some stocks. Stock trading suspension played a role in temporarily halting trading in some option and futures contracts on other exchanges. Difficulties ensuring the necessary credit extensions and payment flows to settle margin accounts caused concern about the clearinghouse operations. The issues raised by the crash helped spur upgrades of facilities and systems by the exchanges and clearinghouses.

The Federal Reserve responses to the stock market crash illustrates three varieties of tools that can be used when responding to a crisis. The first variety of tools include the high-profile public actions taken to support market sentiment. The most obvious of these is the public statement the morning of Tuesday, Oct. 20 that indicated that the Federal Reserve was taking positive steps to meet market needs for liquidity. The second set of tools employed were those that boosted the liquidity of the financial system. These tools included the use of open market operations and lowering of the federal funds rate to support the liquidity of the banking system as well as liberalizing the rules regarding lending of securities from the system account. Finally, the Federal Reserve encouraged various market participants, in particular banks lending to brokers and dealers, to work cooperatively and flexibly with their customers. These efforts appear to have been vital in allowing markets to open Tuesday morning and made an important contribution to the improvement in market functioning in subsequent weeks.

Amendments of Section 13

II. Amendments of Section 13 (3) in FDICIA

Section 13 (3) has been discussed very little since the 1930s, so it might seem unusual to find Section 473, amending Section 13 (3), inserted in the final stages of the congressional deliberations on FDICIA in November 1991. Increasingly, however, since the stock market crash of October 1987, some policymakers had been discussing the potential use of the Reserve Banks' discount windows to relieve nonbank financial firms' liquidity crises directly. Procedurally, there were enough obstacles to such use of the discount window to discourage financial firms from relying on Section 13 (3) to rescue them in a liquidity crisis: The procedural starting point always was an emergency declaration approved by at least five members of the Board. …

(Not finished)

--------------------------------

President’s Working Group focusing on liquidity

It is astounding to note that in 1999 the President’s Working Group recognized the fact that expansions of safe harbor had a tendency to encourage the market to grow bigger, but chose to focus on the benefits of “liquidity” and to ignore the possibility that increasing the exposure of market participants to counterparties could adversely affect systemic risk. They write:

The ability to net may also contribute to market liquidity by permitting more activity between counterparties within prudent credit limits. This added liquidity can be important in minimizing market disruptions due to the failure of a market participant.

In short, the President’s Working Group assumed that market participants would keep exposures to a prudent level once safe harbor was in place, even though they had not done so in the absence of safe harbor protection.

Eric de Carbonnel

Market Skeptics

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