Charles Calomiris on Capital Requirements, Leverage, and Financial Regulation
Mar 5 2012

Charles Calomiris of Columbia University talks with EconTalk host Russ Roberts about corporate debt, capital requirements, and financial regulation. This is an in-depth conversation about how debt works on a firm's balance sheet and the risks that debt vs. equity pose for the survival of the firm. Calomiris applies these insights to financial regulation--how it works in practice and the firm's choices in responding to various interventions including bailouts and capital requirements. The conversation closes with a discussion of some of the government interventions in the financial crisis.

John Cochrane on the Financial Crisis
John Cochrane, of the University of Chicago, talks with EconTalk host Russ Roberts about the financial crisis. He talks about the origins of the crisis, why the Troubled Assets Relief Program (TARP) was flawed from the beginning, why mark-to-market accounting...
Anat Admati on Financial Regulation
Anat Admati of Stanford University talks with EconTalk host Russ Roberts about ways to make the financial system more stable. In particular, Admati explores the implications of higher capital requirements. She argues that current policies subsidize leverage--high levels of debt...
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Mar 5 2012 at 9:15am

The institutional investors involved in the repo loans aren’t just banks. They include companies like APD and their competitors. For instance, ADP is a payroll company. They’re paid by their clients to distribute paychecks to millions of Americans. Let’s say on Tuesday night they get paid by a client to cut your payroll check on Wednesday morning. Once they get the money, they turn around and invest it in an overnight market (like these repo markets, among others). On Wednesday morning they collect the money, plus interest, to pay your paycheck. ADP makes some of their money by charging their clients for their payroll services, but they make much more from the interest on these overnight ventures.

Mar 5 2012 at 12:23pm

The money market funds were huge holders of repos and that was primarily money held by individuals who made little or no distinction between those funds and insured cds. I really belive that the closing of the Reserve money fund was the catalyst because they saw individuals panic about getting their money. The Reserve held too much Lehaman paper and they broke the buck…panic ensued.

Maribel Tipton
Mar 5 2012 at 1:06pm

It would probably be helpful to people in understanding the whole accounting example if we begin first with:


and that these accounts change over time but always have to BALANCE to maintain the equality, so that a change in one has to translate into a change in the other.


“Holding more cash” VS “Raising more capital” as two ways of fulfilling capital requirements, are basically two sides of the same coin. When you raise more Capital ie. Equity you add ex. $10m to your RIGHT side and then you balance it with $10m cash on the LEFT side. This is where the second option becomes available, you can either hold the cash or lend it. Bottomline you have to have a certain amount of cash to cover your deposits. You can do this by not lending as much of the cash, raising MORE cash through investors, or by selling existing loans ie. converting existing loans to cash.

Maribel Tipton
Mar 5 2012 at 1:11pm

It would probably be helpful to people in understanding the whole accounting example if we begin first with:


and that these accounts change over time but always have to BALANCE to maintain the equality, so that a change in one has to translate into a change in the other.


“Holding more cash” VS “Raising more capital” as two ways of fulfilling capital requirements, are basically two sides of the same coin. When you raise more Capital ie. Equity you add ex. $10m to your RIGHT side and then you balance it with $10m cash on the LEFT side. This is where the second option becomes available, you can either hold the cash or lend it. Bottomline you have to have a certain amount of cash to cover your deposits. You can do this by not lending as much of the cash, raising MORE cash through investors, or by selling existing loans ie. converting existing loans to cash.

Mar 5 2012 at 1:42pm

Love the podcast!

To answer the question you asked. I don’t mind at all that you go deep into the weeds. In fact that is why I tune in.

Mar 5 2012 at 2:15pm

This book is partly about how capital regulation, Basel rules in particular, encouraged commercial banks to invest in mortgages and mortgage-backed securities and discouraged investing in business and consumer loans, which led to a credit crisis.

Brad Hutchings
Mar 5 2012 at 4:04pm

I was paying attention too, and yes, the reason I listen to these is precisely because you’ve gone deep into the weeds. Collectively, one common notion that you’ve driven into my head with the financial crisis related podcasts is that good intentions for various government policies will usually provide cover for all sorts of mischief. An example from this podcast: I was not aware of the original politics of deposit insurance. I can see why it was such a popular idea and how easy it would have been for the public to ignore the particular moral hazard.

Per Kurowski
Mar 5 2012 at 5:26pm

Indeed Calomiris and his friends are getting closer to the truth of the crisis… but they have not yet arrived there.

Calomiris talks about banker´s faulty risk-models but it suffices to note that the Basel II regulators own risk-weights, applicable to banks which did not have their own models, was only 20 percent for triple-A rated securities and “infallible” sovereigns like Greece. Which means that the 8 percent basic capital requirement is reduced to 1.6 percent; which means an authorized bank leverage of 62.5 to 1 when engaged in business with these clients.

But the worst mistake, that not yet acknowledged in the debate by the experts, and which directly caused the crisis is the following:

Banks already clear for perceived risks, like those included in credit ratings, by means of the interest rates, the amounts exposed and the other general terms and so, when regulators set the capital requirements also based on the same perceptions they are double dipping into the perceptions; leading to what is officially deemed as not risky becoming even more attractive and what is officially deemed as risky becoming even less attractive.

Any information, like risk of default information becomes bad, even if it is perfect, if excessively considered.

The reason this has not been understood can perhaps be explained by the fact that everyone, Calomiris included, talk about this crisis as a result of excessive risk-taking… even though the fact that all the problems are derived from excessive exposure to what was perceived as absolutely not risky, and there is a lack of exposure to the officially “risky”, like to small businesses and entrepreneurs, and which would indicate us being more in in the presence of a regulatory induced and perverse excessive risk-adverseness,

Regulators, when they with unbelievable hubris decided to play the risk-managers for the world, just forgot or ignored the fact that all bank crises have always resulted from excessive exposures to what was considered as safe, and never ever form excessive exposures to what ex-ante was considered to be risky.

[bitly url changed to full url for reader convenience–Econliib Ed.]

Mar 5 2012 at 5:27pm

Thought: Can you think of owner equity in a house and bank cash reserves as a combined buffer?

In other words, if banks required 20% down, could they not be safe with lower reserves? Conversely if they allowed 5% or 10% down, wouldn’t they need to raise reserves?

I would have liked it if you explored exactly what form the “cash” that banks hold takes. I assume it is not greenbacks, so it must be an investment. But if it’s an investment, it may go bad, so cycle back to what is “cash”

Mar 5 2012 at 7:37pm

Great podcast, Russ. This is the most interesting podcast I’ve listened to in several months. I had grown tired of podcasts about the financial crisis but I greatly appreciate this one. Thanks very much.

Mar 5 2012 at 8:18pm

“And I’m enjoying every minute of it. Those of you out there who have listened this far–I don’t know how much you enjoy hearing these kind of what I call the basics, podcasts where we delve into these fundamentals to help people understand. If you like this, let me know: if you’ve listened this far. Maybe you turned it off–not another podcast about the financial crisis, bookkeeping issues. Let me hear from you if you like this, or if you are a dutiful listener and you don’t like, but you are still listening, you can let me know, too.”

I enjoyed every moment of it!

Mar 5 2012 at 8:50pm

Another cudo for an entertaining episode in the weeds. The audio quality and Calomiris’ articulation were very good, and the miles on the highway melted in the dusk.

My lingering unease is with the realization that not only is there no real-time adjustment to asset values, it doesn’t even happen when the periodic results are announced.

Mar 5 2012 at 9:02pm

I always appreciate your discussions that go back to the basics and keep us grounded in the fundamentals– thanks for providing this great forum for thought and conversation!

Alan Ridgeway
Mar 5 2012 at 9:52pm

1) I like that you go deep into the weeds. It’s one of the reasons I listen to podcasts. Podcasts, books and film documentaries see to be the deepest media. But podcasts I can listen to while I drive, while I clean the kitchen, and while I wait for the kids to finish drama or martial arts. Hence keep it deep.

2) I don’t mind you covering the basics. I try to recommend your podcast as much as possible to people who did not earn a degree in business. With most guests, the podcast is approachable.

3) I like it when you cover the 2008 financial crises related topics. This event and what led up to it will be graduate level discussion for a long time. I think the oversimplification of “the 1% is out to get us”, is a disservice fr anyone trying to identify and prevent a similar problem. I think your show is doing a better job at giving us a well rounded perspective to thinking rationally about the problem and possible insight about what needs to change in the future.

Tim Vlamis
Mar 6 2012 at 12:30am

Excellent podcast. Many thanks for the information included and for digging into “technicalities”. Since you brought up balance sheet analysis of banks, I’d really like to ask Professor Calomiris for his insight on the derivative position for the largest commercial banks. As of the end of 2011, the largest peer group (the 85 commercial banks with more than $10 Billion in assets) had a balance sheet position in derivatives equaling 2,237% of their total assets while the next largest peer group of banks (the 429 commercial banks with between $1B and $10B in assets) had a balance sheet position of only 5.5% in derivatives of their total assets. Anyone can check these figures for themselves by going to the SDI query interface on the FDIC website . It’s a great tool for exploring the position and structure of your favorite bank or savings and loan and running reports comparing them against their peer group and other peer groups. Simply choose the above peer groups and run balance sheet positions for them as a percentage of assets. For something truly frightening, drill into the derivatives column for more detail to see how their positions in interest rate swaps compare with foreign exchange derivatives and more.

I understand that banks take countervailing positions (mostly to try to reduce risk), but I find it difficult to believe that derivative accounts that large aren’t hiding something. Why is there such a discrepancy between the largest banks and medium sized banks? How can regulations be written to apply to banks with such vastly different structures? How is any balance sheet credible when there are (off balance sheet) obligations that dwarf all their other positions by an order of magnitude?

I’ve run the derivative positions by peer group (and for many large banks) for several years and they have been steadily rising. Why? Their loan balances aren’t. Why is it necessary or prudent to take these kinds of positions when clearly other (somewhat smaller) commercial banks aren’t doing it?

If you run the query by dollars instead of % of assets, the total derivative position for the largest 85 banks is more than $230 Trillion, a truly awe inspiring (and frightening) number. I just hope they have good accountants and auditors.

Thanks again for all the excellent information. I’m looking forward to continuing to learn for you.

[typo fixed by request–Econlib Ed.]

Mar 6 2012 at 4:45am

Please feel free to delve into the basics, especially as they relate to real world examples, at any time.

Mar 6 2012 at 8:34am

What about an EconTalk with Gary Gorton?

Richard W. Fulmer
Mar 6 2012 at 9:01am

Kevin D. Williamson wrote a good article on repos for National Review:

Mar 6 2012 at 9:41am

I just discovered this podcast and I’ve been listenting on the way to work. I’m having a great time, so keep it up!

I work for one of the “Big-4” banks, but my background is in technology, not economics and finance. It’s intesely interesting for me to lean about the principals and ideas that govern the industry and institution I work for.

As for covering the “basics”, please keep doing that. When trying to understand any subject, it is important to start from a place that is known and proceed to the place that is unknown. Start from first principals and work your way out from there. I imagine that a large part of your audience is hobbyists like me and need this kind of progression.

It also seems to me that the heart of many issues in banking and finance lies in the “mere bookkeeping” details.

Mar 6 2012 at 9:57am

I am barely beyond the 45 minute question, but so far it has been very useful (though I hear an undertone of frustration at the lack of a whiteboard).

Mar 6 2012 at 10:47am

Really great podcast, i love the crisis-casts and Calomiris’ previous appearance, like this one, was excellent.

Mar 6 2012 at 11:16am

Great podcast – need more like this one, big thanks to Charles for his willingness to engage and educate.

Mar 6 2012 at 11:18am

Great podcast, it helped to hear that simple example of how this all comes together…I’m a regular listener here and on and this is the first podcast that explained this fundamental basic principle of how banks and ‘leverage’ actually work (we hear about fractional reserve banking but this is the first time the idea was clearly explained). It really helped to hear and more basic stuff like this would probably help a lot of listeners.

It was extremely useful to see how a few investments gone bad can put a lender in big trouble and how it snowballs into their stocks not really being worth what they’re trying to get because potential creditors should be skeptical of a new stock offerings. This is the first time the vicious circle of how these banks get leveraged and stay leveraged and ‘chasing their own tail’ so to speak happens.

Real world examples of how things go awry would top it all off so we can learn from the theoretical example then see how it actually worked or failed in a real example that we can relate to.

Mar 6 2012 at 12:19pm

Great podcast!

I’m a longtime listener and I appreciate the detailed deep dive. Please continue exploring the financial crisis in this manner.

Mar 6 2012 at 12:30pm

I enjoy these kinds of podcasts. I don’t know how much I’m retaining, but it was good to take the journey.

Mar 6 2012 at 3:03pm

Hi Russ,

As many others have noted in the comments already, thanks for digging into the technicalities. I’ve really appreciated your podcast for the past 2 years. Thanks!

Keith Wiggans
Mar 6 2012 at 4:09pm

Excellent episode! I learned so much.

Mar 6 2012 at 5:22pm

I’ve read a number of Calomiris’s papers and I think he understands–and can explain–the causes of the crisis better than anyone else. I would have liked to hear a bit more on his take of what we can expect from the new regime under Dodd-Frank (Frank’n Dodd as Streetwise Professor calls them). He did say toward the end that perverse incentives haven’t been fixed.

Regarding the perversity of the Basel rules, my favorite is that banks had (and I presume still have) to hold only half as much capital for MBS as for outright mortgages. IN other words, the Basel rules created a powerful incentive to sell mortgages and buy them back packaged in opaque MBS that no one could value.

Sri Hari
Mar 6 2012 at 6:41pm

Very informative podcast!! You should delve more into basics and not less, please!! It should be made mandatory for the regulators to listen to your podcasts, so that they can refresh the basics from time-to- time and to get the details correct!! It will be a much safer world then.

Mar 6 2012 at 7:16pm


Great podcast. The discussion of the basics of a bank’s balance sheet pointed out to me why there is so little understanding of the financial crisis – a deposit is a bank’s liability and a loan is an asset. This is counter-intuitive and hard to grasp for the lay person so most people fall into the trap of relying on political sound bites and regulatory ‘quick fixes’.

I also liked the historical perspective – capital requirements are a response to a policy choice – deposit insurance reduces the incentive to hold capital and surprise – we ‘need’ capital requirements.

Thanks again for a thought provoking discussion.

Rob Lopez
Mar 6 2012 at 7:49pm

Hi Russ,

You asked for feedback about this type of podcast where you try to increase understanding of a complex issue by starting with the basics and working through simple examples in detail. I love this approach, and your podcasts like this are among my favorites. In this podcast I especially liked the enumeration of the different responses to a decrease in the toy bank’s asset values and what they represent: fire sale, de-leveraging, credit crunch, etc. Please consider more podcasts of this kind.



Mar 6 2012 at 7:59pm

I really enjoyed this podcast, especially the numerical examples. Please do more of this, and you guys did a wonderful job of creating examples on the fly.

Sri Hari
Mar 6 2012 at 8:01pm

Calomiris says the reasons why private market discipline was not imposed by creditors on these banks were due to ineptness of multitudes regulatory bodies!!

Can we then blame the corruption in the less developed world on ignorance and apathy ??? Well, this is the slippery slope William Black was mentioning in his podcast-unwillingness to confront these issues as fraud.

Until US recognises these corrupt practices are at the root of the financial crisis and prosecutes the financial intermediaries that have gotten ‘criminogenic’ (using term used by Black) due to lax regulatory regimes, the whole world is condemned to repeat it again and again.

John H
Mar 6 2012 at 8:28pm

I loved the podcast this week. I’ve been listening in for the past few months during my commute into DC. It’s very refreshing to begin with the basic financial accounting transactions that take place & aggregate it to the financial market impacts. I will actually listen to the 2nd half of the podcast again tomorrow to make sure I follow. These types of podcasts are great.


Mar 6 2012 at 10:42pm

I also love the “basics” style of podcast. This one defined a lot of terms I’ve heard thrown around the past 4 years, such as “commercial paper”.

I think it would be great if you could even preface the podcast tags with the word “Basic” somewhere, so I could see on iTunes very quickly any “basic” podcasts that I want to re-listen to.

Now for a question: When the banks were bailed out in 2008 and everybody was complaining that they kept the money, instead of lending it out, did they hold onto the cash because they needed to in order to meet their cash requirement minimums to offset the failing loans they held?

Mar 6 2012 at 11:33pm

Great podcast, very informative. Do not mind shows like this at all. Don’t get in-depth looks into the inner-workings of our system like this from anywhere else. And as a person looking to study economics in the future, podcasts such as this help form strong foundations.

David S
Mar 7 2012 at 1:16am

Terrific podcast. I appreciate the depth and detail. I discovered Econtalk about a year ago and I look forward to each discussion. I appreciate your fair-mindedness, humility, and probing and thoughtful questions. I don’t always agree with you, but I like the fact that these podcasts constantly challenge me to rethink my own views.

Mar 7 2012 at 9:42am

I really like podcasts like this. Knowing the details and the inner workings is how we make decisions on your own. Hearing a paraphrased version is when we have to take people’s word for how it works. Too dangerous in this society. I really like the “nuts and bolts” pod casts even if they take 2 hours.

Bob Mounger
Mar 7 2012 at 9:43am

Liked this show. One thing I don’t understand is: what is the difference between a “COCO” & preferred stock?

Mar 7 2012 at 10:34am

Russ – thanks again for a deep and very informative discussion.

I also was reminded by Per Kurowski’s comment of a discussion I heard a couple years back about the crisis, describing why banks created mortgage-backed securities (MBS). The summary of the argument was “they were desperate to create as much AAA as they possibly could.” The capital rules certainly help clear this up.

If a mortgage is one risk class, requiring some set amount of capital reserves, but an MBS is a “safer” class, with less capital required, of course the banks will securitize. The risk class of the individual mortgages is of course based on a statistical model because banks aren’t in the business of holding one mortgage, but many. Securitizing seems simply to be a way of lying about the risk, both to ourselves and to each other, because the statistical risk of the group is by definition the same as the statistical risk of each individual item.

Either we get smarter and avoid being fooled by our own inventiveness, or we change the rules as Per Kurowski seems to suggest. In my experience, we are quite good at fooling ourselves, so maybe we should set capital requirements as a fixed amount, with no risk-weighting. A mortgage is either a good bet or it isn’t then. No hiding the risk in securitization.

Ghengis Khak
Mar 7 2012 at 11:56am

You requested feedback on whether we enjoy these podcasts where you go deep into the weeds on a technical topic.

I rather enjoy them; keep up the good work.

Mar 7 2012 at 12:38pm

To answer Russ’s question, Yes! I love when this podcast goes in-depth on more fundamental concepts such as this. Keep it up please! very informative, very entertaining.

jakub rezek
Mar 7 2012 at 1:50pm

I really liked this podcast and the one with William Blake as guest. I listened to both multiple times. I liked the scenarios, how they played out from simple to more involved ones. Please do keep making it.

Hans J
Mar 7 2012 at 4:05pm

Keep going into the weeds.

Scott M
Mar 7 2012 at 6:15pm

+ 1 for podcast episodes that delve into the basics.

Dan G
Mar 7 2012 at 8:23pm

Great start to divulging into the full picture of things. Love the depth started in this podcast. I could of kept listening if you two had more time. I look forward to part 2 and part 3.

Scott Simmonds
Mar 7 2012 at 9:48pm

Another “yes” on this stuff. Its basic but exceedingly important. Guests like CC provide insight and value.

David C
Mar 7 2012 at 9:55pm

Thoroughly enjoyed the topic and going into the nitty-gritty of the basics. Thanks for the podcast.

James A
Mar 8 2012 at 3:53am

Absolutely brilliant podcast. Great to go back to the fundamentals. This is one of my favourite EconTalk podcasts of all time.

Becky Washington
Mar 8 2012 at 9:45am

I, too, appreciate all of these discussions.

Yes, at 45 minutes my eyes are glazing over and I realize I will have to go back and listen several more times but I have the motivation to do so.

My concern is that if people below average intelligence, which must, by definition, be half of people, do not have the motivation to continue struggling to understand, how will our society restore trust in the banking system?

When the commenter says “I think the oversimplification of ‘the 1% is out to get us’, is a disservice for anyone trying to identify and prevent a similar problem,” can you blame people for believing that? When the best and brightest turn good intentions into harmful policies, (and bad intentions into harmful policies) can the common person have any hope of really knowing what’s going on until it’s too late? Or even then?

Joe B
Mar 8 2012 at 11:06am

I have been listening for about a year and enjoy the way you get into the details, but this was one of the best. Even when I am sure that the topic will have no interest I end up being fascinated by the end. The podcast with the owner of the hair salon was a good example of that.

Like Becky W., I will need to go back and listen to this one several more times, but I look forward to doing that.

Mar 8 2012 at 1:49pm

Just a vote, as you asked for, that I think podcasts like this are very worthwhile! In fact, this could have been a very well managed 2-parter. Do not fall back to ‘101’ podcasts, but definitely hit up the experts for a good overview (part 1) and then a deep-dive (part 1 and 2)… but I’m just a Principal Engineer in the Energy Industry, what do I know 🙂

David Blair
Mar 8 2012 at 2:27pm

Hi Russ:

Per your question about these “101” type podcasts, yes, they’re great for me. I mean, who wouldn’t want to hear an Ivy League prof giving a one-hour lesson in his area of expertise? This one was so informative, I listened to it twice.


Mar 8 2012 at 8:12pm

Hi Russ and Charles,

Please feel free to delve into these issues at this and greater depth. I am an accounting student and I thoroughly enjoyed this podcast and others of similar depth.


Mar 8 2012 at 11:18pm

Dear Russ,

Thanks for an excellent podcast. By playing the student, you basically showed how excellent a teacher you are.

Taking up the analogy of the Vanilla bank and the idea of you coming back to it at every possible opportunity made the concepts very clear.

I plan to go through the transcripts and work out some math to make sure i followed everything.

Please continue to dig deep.

With Regards

Mar 9 2012 at 12:13am

I almost never comment on these podcasts, but I felt I had to on this one. I have listened to every Econtalk episode on iTunes, and this one is probably my favorite. I listened twice and went through the examples in my head to make sure I understood. This topic is so central to everything, and I realize now that it was a gaping hole in my understanding of the world.

Mar 9 2012 at 5:57am

This is one the best episodes of Econtalk. Keep up the good work.

Mort Dubois
Mar 9 2012 at 12:20pm

Since you asked, these heavily technical podcasts aren’t my favorite (I personally prefer the interviews with real businesses.) However, what make this podcast stand above all rivals is the variety. Every Monday I eagerly look forward to being educated and challenged. This particular subject was well presented and helped in understanding many of your other podcasts. So I give it a thumbs up, with the caveat that the overall mix you have going is excellent, and you probably shouldn’t shift it in any particular direction.

Lorraine Charlton
Mar 9 2012 at 3:00pm

To answer your question: I like the remedial podcasts. I learned quite a bit even though I worked as a lobbyist in Europe on the issues discussed (including a heavy emphasis on CoCos). More, please.

BTW, I would be interested in hearing a discussion on whether the shareholder model of governance is sufficiently broken that the removal of deposit insurance might not have acted as a brake on risk taking. Perhaps I’m the only person who feels this way, but I just don’t see it making a difference except at the margins.

Mar 10 2012 at 2:42pm

Calomiris on Capital Requirements was excellent. Brought a lot of light to a complicated area of the economy and one that was at the base of the financial crisis. Please do more of these.

Ed Thompson
Mar 10 2012 at 7:23pm

Great Episode!

As someone who is not part of the economist world, I really enjoy podcasts where you explain fundamentals.

Russ, you are very good at explaining things and asking the questions to get your guests to explain terms they are using. You are very good about letting your guests discuss their perspective even when it is different than your own.

Really enjoy the podcast.

Mar 10 2012 at 10:22pm

Dr. Roberts,

Great, as ussual. Frankly, there is not one of your podcasts that I regret taking the time to listen to the discourse. The details are always kept in frame where your audience always seems to be able to follow.

As for my constructive critism. When Dr. Calomiris provides a definition several times he did assume the audience already knew what the origins of the words being used and started where I thought it was in the middle of a defintion, but the quality of all the information was very informative.

I would add that a sense of the interest rate affect on assets was not emphasized. Take for example you had 80 loans, 10 cash, and 10 equity and you simple had marginal default rate of 1% loan values higher then expected. This small default could have a significant affect on equity because you investors may have been expecting a 10% return on investment and now only getting say 7% and then drawing new capital in to the fund you may need to pay 15% to cover the increased risk of the investment.

So I would have asked that you go further into the weeds and discuss the way interest rates vary with risk even in fixed institutions.

Mar 11 2012 at 1:39pm


Loved the format and content of today’s podcast. I have been listening weekly since 2006. This week’s was one of the best.

Tjalco P. van der Meij
Mar 11 2012 at 3:00pm

Dear Mr. Roberts,

In response to your appeal for comments on the suitability of the above podcast I like to confirm that for me at least it was very suitable.
I have an accounting background but I learned a few new facts about bank accounting methods which were unknown to me.
I found the commentary easy to follow and hope that you will from time to time have podcasts on this type of subject.

Joel Grover
Mar 11 2012 at 3:48pm

Russ: Thanks for another terrific podcast. I really would like to see more like this one: It explained enough about how these things are supposed to work to make clearer many of the reasons for the meltdown. (If guys like you and Calomiris aren’t going to undertake educating all of us who aren’t economists or professors of finance who will?) I liked especially that you identified the mistakes that were made, who made them and discussed your views on why (incompetence or malice?) they were made. You’re also doing a major public service: What taxpayer in this country hasn’t had his confidence and trust in the federal government and our financial ministers severely shaken by this. Most of the major media are useless or collusive in reporting what has happened so please keep up your explication of this collosal mess.

Arvind Padhye
Mar 11 2012 at 11:03pm

You wanted to to know if it makes sense to us – listeners – to discuss and understand these things from first principles — 80/20 loans/cash, 90/10 borrow/equity etc. Sure, it does. Very much so. It was great. But, it seems that such simplicity wouldn’t last long. Even in this program, see how quickly things got complex once the guest introduced a different form of equity — I think it was a tier above the core equity. So, that seems to be the risk of simplifying. But certainly it makes sense while it lasts. Thanks for a great program.

Pune India

Jeff Sadighi
Mar 12 2012 at 12:59am

ANOTHER great podcast! Thank-you so much!! This is the kind of detail folks need to understand to form the ideas that can save our republic.

This podcast makes a great case for returning to real money, and showing how government ‘protection’ just increases the ability of the banking system to damage America’s economy and her People’s future opportunities.

Mar 12 2012 at 8:46am

Russ, in answer to your question…YES please continue this stort of stuff. It’s VERY informative.

Mar 12 2012 at 8:47am

New listener here, about 2/3 through this podcast and have to say it’s great. Love the level of detail and would love to hear more podcasts where guests get deep into the details (at least relative to other podcasts). Keep up the good work.

Johnny Wilson
Mar 12 2012 at 9:40am

I procrastinated listening to this podcast because I thought it was going to be a boring redundancy. However, I probably learned more about this issue than I have in any of the podcasts I’ve listened to in the last five months.

Yes, I particularly like it when Russ says, “I’m confused” and then reduces complex ideas to a mental paradigm that I can follow (I think of them as mental diagrams like in old-fashioned English courses).

This was a great podcast!

Mar 12 2012 at 11:37am

Yes. This type of podcast is great. I starred it in my google rss feed for re-listening!

Mar 12 2012 at 2:51pm

I concur with the posters above. The Calomiris episode was interesting and informative even for those of us with a fair degree of regulatory and accounting knowledge. Revisiting basic principles and probing relatively familiar concepts is a healthy, useful effort. Please keep them coming.

Mar 12 2012 at 9:11pm

Excellent discussion. I’m a big fan of these “explaining the basics” podcasts

Ken Riddell
Mar 12 2012 at 10:16pm

Great podcast Russ – You asked whether your listeners appreciate these more detailed and instructive episodes – I, for one, definitely do! Keep it up!


Davis Griffin
Mar 13 2012 at 8:20pm

I think this was one of the better podcasts Russ. You have done an admirable job of dissecting the crisis, but it’s difficult to wrap your brain around policy choices. More robust disclosure of underlying assets and limits on size might help to create an environment where creditors can fulfill their watchdog role and mitigate the too big to fail risk. I agree with your Hayekian perspective that free markets without government “subsidies” would be a better policy approach. We would still have recessions and bubbles, but we would learn from them. Processes and ways of doing business would adapt and improve. The current situation is solidifying big governments reason for being.

Mar 14 2012 at 12:06am

Regarding your question about the podcast, I love it! I learned a lot from this podcast.

Mar 14 2012 at 4:49am

Excellent podcast! Thanks for the free education.

Mar 14 2012 at 10:03am

Russ – four thoughts

1. First time commenter.

2. To answer your question at minute 46. Yes. Your delving into the weeds is why I enjoy the podcast. I have a 70+ mile commute (each way, been doing it for over a decade, sigh) and your podcast helps me pass the time while learning. Keep up the great work.

3. I searched the comment section for “Geitner” and didn’t find any on the subject, by name at least. Was anyone else struck by the revelation about Geitner at the end of the podcast? Maybe history book or novels are the best place to explore the human frailty aspect of the crisis, which I think is a crucial element.

4. Rugby also has Yellow and Red Cards. A Yellow card gets you ten minutes in the Sin Bin (same as a penalty box in hockey). Red card gets you kicked out of the game and then brought before a sactioning board later in the week. Anyway, this year the International Rugby Board has also added a White Card. This is used when a referee, who also has two assistant referees helping on each sideline, thinks something bad/foul may have happened but isn’t sure. The game tape is then reviewed after the game to determine if something indeed happened.

Fines and jail time are the equivalents of Yellow and Red Cards that our elected officials/law enforcement can use to punish offenders. The authorities could also use the equivalent of a White Card – – they could review events and determine culpability after the fact. Of course we know a recurring theme of your podcasts is the reluctance of elected officials to open up a can of worms.

I see your show as serving the review function of a White Card. If only you also had the authority to punish!!!! Keep up the great work.

Mar 14 2012 at 5:56pm

You asked for listener feedback: Ditto what the other commenters have said about about this podcast being helpful. Great podcast!

Ed G.
Mar 14 2012 at 8:29pm

This was really educational. When I hear a podcast like this, or one like, “The best way to rob a bank is to own it,” I need to listen to it twice to understand it all, but it is well worth it for what I learn.

I’d like to hear more like this!

Sabine Schnittger
Mar 15 2012 at 6:54am

Hi, in answer to your question, I love the show and I thought this one was particularly interesting. I have been out of university a long time and really enjoy the shows that go into a topic in some depth. In the last few months you’ve had a few that discussed macroeconomic policies, the role of the Fed and so forth, which were also great (like all the others). I have certainly become a dedicated listener ..
All the best,

Jude B.
Mar 15 2012 at 1:01pm

First time commenter, long time listener. I really enjoyed this episode. It sounds like I share the opinion of many other listeners.

In full disclosure, I am a Ph.D. student in economics.

Keep up the good work. Isn’t it about time to have Mike Munger back?

Mar 15 2012 at 5:06pm

Hi. Just wanted to say that I really like the “basics” podcasts where you cover this sort of thing. Keep it coming! Great ‘cast!

Dave Potts
Mar 16 2012 at 3:13pm

Another +1 vote for the podcasts that go over the basics in detail.

Marty Heyman
Mar 17 2012 at 11:19am


As always, a great podcast. The problem is not getting 45 minutes into the weeds. The problem with this podcast, was that it was discussing the options open to someone running a 100% reserve bank (like a credit union with outside investors). Interesting and instructive but fundamentally irrelevant to the underlying issues of a Fractional Reserve banking system where banks are leveraged like eight or nine to one … many or even most of the points you and Charles touched on become VERY different (the math becomes a great deal more difficult too).

Mar 17 2012 at 1:07pm

I also enjoyed the podcast. Covering the basics is one reason I really like your podcasts. Really good work, very enjoyable.

Thanks again!

Mar 18 2012 at 5:06pm

I also really enjoyed the podcast. Discussing one subject in depth is definitely part of why I tune in. Please keep them coming!

Mar 19 2012 at 4:42am

“And I’m enjoying every minute of it. Those of you out there who have listened this far–I don’t know how much you enjoy hearing these kind of what I call the basics, podcasts where we delve into these fundamentals to help people understand. If you like this, let me know: if you’ve listened this far. Maybe you turned it off–not another podcast about the financial crisis, bookkeeping issues. Let me hear from you if you like this, or if you are a dutiful listener and you don’t like, but you are still listening, you can let me know, too.”

Great Podcast. Learned a lot in this one. Wouldn’t mind more of this sort.

Mar 19 2012 at 10:25pm

Here is another enthusiastic vote for this episode! As someone said above, I do particularly like it, Russ, when you come out of the gate with “I’m confused about…” because I know your questions and comments will delve into the fundamentals of the topic. Thank you!

Mar 20 2012 at 1:14pm

I really enjoyed this podcast, and all your podcasts on the crisis, many of which I’ve listened to more than once and passed on to friends. Please keep probing the crisis and its aftermath.

PS: Interview suggestion: Jeremy Grantham, founder of money management firm GMO. His firm has done a lot of research on asset class bubbles in different markets, countries and historical periods. Grantham predicted the recent troubles in his famously eloquent quarterly letters. Ed Chancellor, historian of panics, works for him now.

Mar 21 2012 at 9:28am

Wonderful podcast. Thanks Russ and Charles.

Roger McKinney
Mar 21 2012 at 10:43am

I had read Gorton’s “Slapped by the invisible Hand” and several of his articles. Then I listened to this pod cast. It was very interesting, btw.

But I still didn’t have a good grasp of what happened with the MBS’s and investment banks. So I looked up MBS’s in my daughter’s graduate finance book and I think it explained things better than anyone I have heard or read so far.

The text points out that Fannie has been selling MBS’s since the 1930’s. It sold bonds for which the interest was paid by mortgages.

Savings banks have always sold MBS’s in that they have sold bonds to finance lending to home buyers.

The only twist added by investment banks were the tranches.

Jeremy Mardambek
Mar 24 2012 at 8:14pm

Great podcast and I enjoyed the 101 aspect of it.

Mar 25 2012 at 11:59am

Next time, maybe Mr. Calomiris can explain how one stress tests a bank.


Mar 27 2012 at 2:43pm

No problem with this episode! Like many other commenters, I appreciated the dip into the basics because banking is not my industry. I will probably listen to it at least twice, as I have other episodes, just to let it sink in a bit more.

This is a great podcast series. I recommend it often without reservation.

Mar 27 2012 at 6:40pm

Since I’m not an economist or a banker, I really appreciated reviewing the basics of banking, and I would like to see more podcasts like this in the future.


Mar 28 2012 at 12:07am

A great episode. The best ones are always the ones i listen to multiple times to get deeper into the discussion.

I really appreciate your comfort with knowing where your limits of expertise are and having your guest fill in gaps in you knowledge, instead of just pretending.

Mar 28 2012 at 4:04pm

You asked for feedback if I liked this podcast. I did, very much. I enjoy when you get into details like this and am always a little disappointed when you run out of time with a guest and have to stop them.

Thank you, love the podcast.

l learn a lot
Apr 1 2012 at 9:32am

Thank you for your time on these podcasts. I always learn a lot, especially the ones about the basics. Keep it up.


Apr 3 2012 at 6:06pm

[Comment removed for supplying false email address. Email the to request restoring this comment. A valid email address is required to post comments on EconLog and EconTalk.–Econlib Ed.]

Comments are closed.


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Podcast Episode Highlights
0:36Intro. [Recording date: February 15, 2012.] Russ: Financial regulation and how greater regulation of the financial system might be achieved. You have been critical of the current system. The current system, of course, includes the recent past and the present, and how that might be improved. You've made some suggestions. I want to start with some basic ideas that we've touched on in many other podcasts, but we are going to try to go deeply into the foundations to try to bring people up to speed, including myself. First, when we talk about a bank having a particular amount of capital, or if we talk about capital requirements, which is going to be related to what we call leverage--the ratio of debt to equity or debt to capital. What are we talking about? What does that actually mean in practice? Guest: Well, the word "capital" as it pertains to banking is, from a regulatory standpoint, is referring to regulatory capital requirements. Regulatory capital is not just the equity value of the bank on a book-value basis. It also includes other capital items. Now, this is a little bit tricky to explain to people who aren't familiar with finance and accounting; so I think the easiest way to get at it is the following. Capital is a shock absorber. And if you are the U.S. government and you are looking at a bank, you first look at all the deposits of the bank. And what we learned in this crisis is that even the ones that don't have deposit insurance--if you are going to cover them--because they might be in excess of $250,000 you are still covering them, guaranteeing them--they still certainly aren't capital. They are not something that we are depending on to absorb shocks. Because they are going to be--the people holding those claims against the bank--are going to always be made whole, no matter what happens on the asset side of the bank's balance sheet. Russ: You are saying that because of the Federal Deposit Insurance Corporation [FDIC]. Because we have statutorily-- Guest: Not just because of the FDIC. You know, Russ, we threw out the FDCI Act of 1991 complete banana-republic style, in the United States. We violated it. We decided not to stay with the provisions that were supposed to limit the insurance of uninsured debt in the midst of the crisis. We just pretended that that act didn't exist. Russ: We ignored it. We've talked about that before. We are talking about Federal Deposit Insurance Corporation Improvement Act [FDICIA], the improvement act. Guest: Which was supposed to--it's not just the things that FDIC insures that are protected. If the government issues blanket guarantees, as we did during the crisis, and if furthermore makes Fed lending available on a very generous basis, there are lots of ways to protect different claims on the bank. Well, what I'm saying is that if you are looking at this from a regulator's standpoint, or from say the taxpayer's standpoint, you look at the items on the bank's balance sheet. The assets can go up and down in value, and you need something to absorb the shock. When the assets go down in value, somebody has to lose. It's just arithmetic, right? Some claims on the bank have to fall in value when the assets' value falls. And capital is best thought of as: If you take a realistic perspective on which claims can fall in value, those are the claims that really constitute capital of the bank. So from a regulatory perspective, we want to make sure that there's enough on the bank's balance sheet that we can realistically refer to as capital that when the assets of the bank's balance sheet fall in value, that there's something there to absorb the shock. Because if there isn't enough of that stuff there, who is going to absorb the shock? The U.S. taxpayers.
4:55Russ: So, let's talk about this at an individual level, to help me understand it. Because I think I understand it really well at the individual level. When I go to the bank, I get in trouble because my accounting knowledge is mediocre. And you can enhance that, I hope. So, at the individual level, if I want to buy a house that costs a price of $250,000, and I put 20% down--I put down $50,000 and I borrow the other $200,000 from a bank--then I have $50,000 of equity in the bank--excuse me, in the house. So, if the value of the house, unexpectedly perhaps, goes down from say $250,000 to $225,000, I only owe the bank $200,000. So, the bank is okay if the value goes down to $225,000. They are still happy that they lent me the money. Because if worst comes to worst, and I lose my job and I can't pay my mortgage payments, the bank can reclaim the house, sell it for $225,000, and get their money back. $200,000. Guest: Exactly. So your $50,000 down-payment is capital. Russ: Correct. That's my cushion; that's my buffer. The shock absorber that you are talking about. Now can you tell me a story for a financial institution--and let's start with a vanilla bank, which is going to be a bank that has depositors. And then we'll move on to an investment bank, which to me is a little more complicated. Let's start with the vanilla bank. How would this work? Guest: Let's make a real simple bank. It has loans, and cash for assets. Let's say it has $80 million of loans and $20 million of cash. And let's say that it has $90 million of deposits, FDIC insured deposits, on the liability side; and $10 million in capital. Meaning, just to keep it simple, just the equity that shareholders in the bank own. Russ: So, I got lost in that, because the numbers were different. So, I raise $90 million from my depositors. I'm bank. I take that $90 million and what do I do with it? And excuse me: and I raise $10 million from people who bought my stock. Guest: Exactly. So now you have $100 million. And what you do is you lend out $80 million of it in loans. Russ: Which are risky--you are uncertain whether they are going to work out. Guest: Which are risky. And you are also holding the rest of it just in cash, the $20 million. So your bank's assets are $80 million in loans--what people owe you--plus $20 million in cash. And on the other side, the liability side, you have $90 million of deposits and $10 million that is claims owed to your stockholders. That is, they have what are called the residual claim. Whatever you get after you pay off your depositors, your $90 million to in depositors, will stay with your stockholders. So, just now let's talk about shock absorber and why we think about capital as a shock absorber. Perfectly analogously to your mortgage example that you gave a minute ago, if the value of those risky loans--suppose that I've got $80 million of loans outstanding--but suppose that $10 million decide not to pay me back. And they go bust and I can't get anything back from any of those. A complete loss on $10 million of my loans. Well, what just happened? Well, I have enough left in assets--I still have $70 million of good loans; I have $20 million of cash--that's $90 million. It's just enough to pay off all my depositors. The reason is because capital was an adequate buffer. Capital was adequate to absorb the losses coming from those risky assets. And so, in that situation I had enough capital. But I just want to give one quick addendum to this. Suppose that the losses had been greater. Suppose instead of only losing $10 million, I had lost $20 million. Well, those FDIC insured deposits are still going to get their money. So, where does the other $10 million come from? Now this bank has what we call a negative net worth, negative $10 million? Well, that's going to come from the U.S. taxpayers. So, the reason from a regulatory standpoint that we care so much about capital adequacy is because we care about making sure that the people running the bank for their own profit and pleasure are--that is the stockholders who control the bank, who control managers, must be responsible for what is going on--they get the benefit of the profit, but we also make sure that they are responsible for dealing with the downside. When the downside occurs they are the ones who lose, not the U.S. taxpayers. Russ: So, we'll talk later about how that might work in the absence of an FDIC guarantee, because that would change the incentives of both the depositors, who under the current law only have to worry about the solvency of the U.S. government. Guest: Exactly. That's a very important point, that the bankers are going to behave differently if they are insured or they are not insured. And the reason that we really need to worry about this from a regulatory standpoint is because the government now is the one who is really standing to lose. Russ: You and I. Guest: All of us are. But the point is, the depositors, as depositors, are protected. Now the same people, as taxpayers, may be bearing some of the cost of the protection of the bank, but as depositors they are protected. And that means, as you were just saying, they don't really have much incentive to be worrying about their bank. Whereas in the olden days, before we have protection of the bank depositors, bank depositors were really being very attentive to what was going on in banks and were making sure that the banks were worried. And, as I like to say: If the depositors aren't worried, the bankers aren't scared. Russ: Yes, and of course the moral hazard problem is that if you know that your depositors aren't worried, you are not scared. You can risk a higher rate of interest to offer them, because if you can't pay it off, they'll get their money back anyway. Guest: Exactly. If you pay a little bit above the risk-free interest rate that people earn on other things, and they know that there's no risk, you are going to attract money like gangbusters. Right? You are paying someone even a quarter of a percentage point more than they can earn elsewhere, with no additional risk--you are going to get a lot of money. And that is exactly the thing we worry about. So, we have to make sure, in a regulatory system where we protect bank deposits and other bank debts, that banks are adequately capitalized. And when we do that, not only do we protect sort of after the fact by absorbing losses, but the most important thing, which you were hinting at already, is that we affect the bankers' incentives toward risk. So capital, as a shock absorber, isn't just there to protect us against bad luck. It's also there, through protecting against bad luck, it's there to change the incentives of bankers toward risk.
12:39Russ: Yes. It's to protect us from imprudence. Guest: Exactly. Russ: And fraud. We recently had William Black on talking about fraud. I understand the incentives for fraud. I think there's an interaction there between the incentives for fraud and moral hazard that maybe we'll get to. But I want to make sure I understand the example, because I'm a little bit confused. I open a bank. And for some reason I'm a credible person to invest with. You, depositors give me $90 million; I get another $10 million from people who think this is a good investment. They are going to share in any profits of the bank with me. I take the $100 million; I make $80 million in loans; and I keep $20 million off to the side, in cash. Which is a bummer, because it's not earning very much money. It's not earning as much as the loans are. So, there's a natural temptation to make that cushion of $20 million smaller, but the smaller I make it, the less likely people are, in the absence of deposit insurance, people are going to get nervous for the same reason the regulators get nervous when there is deposit insurance--that there's not a cushion. So, in that story, when I have $80 million in loans and $20 million in cash, and I have $90 million in deposits and $10 million in equity, what is my leverage? What is my capital ratio in that story? Guest: Well, if you define your capital ratio or leverage ratio as the book value of your equity, or the book value of your capital, relative to the book value of your total assets--let's call it equity/assets--it's 10%. Russ: So, I'm leveraged 9:1. That would be the lingo. Guest: Yes, you could say it that way: debt to equity is 9 to 1. Russ: What I'm confused about is that in that story, usually when we talk about leverage, the "1" that's capital, the $1 out of every $10 in that story, the one we just created--that's my cushion. But it looks like the $20 million in cash is the cushion. Why is the equity the cushion? Guest: Oh, I'm so glad you said that. I have a lot of articles I'm writing about exactly this point. Because notice that's what's really protecting the taxpayers is a combination of the cash on the left-hand side--the asset side--and the capital on the right-hand side. Bankers have always understood this. Prudential regulation didn't used to be about capital ratios. It used to be about cash ratios. What's really funny is that starting in the 1980s, the shift was to focus on the capital ratios as the thing that was making people behave honestly and protecting against loss, buffering against losses. But the main focus used to be on cash. And my view is: We have to think with both sides of our brain here, and it's really the combination of cash and capital that matters. Let me go through an example, just to clarify that. Let's stay with our example. We have a bank that has $80 million in loans, $20 million in cash on the asset side. It's financing that--it's getting its money from--$90 million of depositors and $10 million contributed by stockholders. So the $90 million contributed by deposited, $10 million contributed by stockholders, went toward lending $80 million and keeping $20 million in cash. Now, if we think about risk on risky assets as a possibility of a percentage loss-- Russ: Yeah, that's why I'm getting confused. Guest: I promise you, you won't get confused. I'm going to give you two alternative versions and you'll see how it differs. So, suppose you give a 10% loss. Russ: Let me try to do this. I'll be the student. So, I had $80 million in loans I was expecting, but it turns out 10% of them turn out to be bad, so I only collect $72 million. Is that what you want me to do? Guest: Exactly. So, you only collect $72 million. Take that $72 million; add it with the $20 million in cash--because cash can't fall in value-- Russ: Correct. Well, it can, but not in nominal value. Guest: Not in its cash value. So, you've got $72 million worth of loans, because you lost 10% of them, plus your cash. Now you've got $92 million. How much deposits do you have to pay? Russ: $90 million. So, I'm okay. Guest: So you're okay. Russ: And more importantly, if there were a run on the bank, if for some reason people were anxious about their deposits and they all showed up at the same time--which never happens unless there's this weird psychological anxiety that spreads throughout the group of depositors--they could all get their money back. There would be no "It's a Wonderful Life" scene where Jimmy Stewart is trying to talk him into taking less than they want. We all understand that. Guest: Well, let's slow down on that, because that's not exactly-- I mean, I do agree with you, but how I agree with you is pretty complicated. Because notice, we've got $90 million in deposits, and we have only $20 million in cash, so if all $90 million came back and asked for their money, we wouldn't have enough cash to pay them. And then we'd have to start selling our loans. Russ: Oh, right. Sorry. Because all the loans don't pay off at the same time. Guest: And the problem might be we might not be able to realize, in the secondary market, the full value on our loans. But I do still agree with you, though. And here's what we know from empirical evidence and hundreds of years of history. People don't come and randomly ask for their money back all at once. Which isn't surprising. What they do is they come back when they are worried about the default risk of the bank. So, if the bank isn't at risk of defaulting on depositors, they don't tend to run and ask for all their money back. And so I would actually say that it is true that if we had in the example we just went through, possibility of that 10% loss on the $80 million of loans, so we go down to $72 million of loans; add to that the $20 million in cash we are holding; we still have $92 million. And we have more than enough to pay off our depositors. The depositors know that we have more than enough. There's no reason for them to run. Russ: We're solvent. Guest: We're solvent.
19:25Guest: But now let's look at a different version. We raise the same $90 million from our depositors; we raise the same $10 million from our stockholders; but now we lend all of it out. Russ: No cash. Guest: We lend all of it out in loans. And now we get a 10% decline. Well, the 10% decline means that the loans fall to $90 million in value. Now we are still solvent. We have 0 net worth. But you could say we have just enough. Russ: We're on the cusp. Guest: On the cusp. Now if we had constructed this example with an 11% decline--let's go back to our two cases. We started in the one with $80 million in loans and $20 million in cash--with an 11% decline we have a loss of about $9 million, so we are still solvent. But if instead of $80 million in loans and $20 in cash, we had $100 million in loans, an 11% decline means we lose $11 million; now we are insolvent. So what did we just learn? Russ: Insolvent meaning that if our depositors realize this, they will realize there is not enough liquidity to satisfy our demands in total. And it wouldn't be a bad idea to run to the bank. Guest: Better run to the bank, because the last one in the line isn't going to get their money. What happens then, what this logic shows--which people in banking have known forever--is that really there are two ways to skin the cat. The cat we are trying to skin here is to prevent risks that are arising on the asset side to leading to insolvency of the bank. And there are two ways to mitigate against those risks. One of them is by holding a higher proportion of cash on your asset side. And the other is by financing yourself with a higher proportion of equity or capital on your liability side. And those are two different ways to skin the cat. Meaning: if you tell me a level of risk of insolvency for the bank that you want to achieve--meaning give me a certain probability of insolvency--I can get to that probability with a combination of a lot of cash and a little bit of capital, or a lot of capital and a little bit of cash. I can get to the same result in terms of insolvency with different combinations of cash and capital. Now, the reason I'm emphasizing this so much is--this is a lot of what I've been writing about lately--is that we need to think about cash requirements, not just capital requirements in our prudential regulation. Think about them from the perspective of reducing default risk in banks. And so, I just gave you an example of how cash and capital can both work. But one thing I would say--and I don't want to belabor the point too much, but I want to make one important point: there really is, in a model where we can see these losses, in a world where when a bank suffers a loss everything is observable. Russ: It's transparent. Guest: And there's not much of a difference between using cash and using capital to solve the problem. Russ: Correct. Because it really is the same thing. Guest: Well, they are similar. They are not the same. One is solving the problem with holding cash; the other is by raising a higher percentage of your funds from capital. Here's where they get completely different. Suppose that you can't observe the loan losses. Russ: Or, the bank can but the outsiders can't. The bank knows that this region where they've made a disproportionate share of their loans has got some unemployment; it looks like there's going to be a higher default rate than they've anticipated. Guest: Exactly. And now let's add another wrinkle to it. Even though the government supervisors and regulators might be able to observe them. Russ: Because they are monitoring the books every once in a while. Guest: But they have strong incentives to do something called forbearance. By the way, whenever you hear three-syllable words in finance, they typically are synonymous with "lie." So, you only hear about how banks are "evergreening." And regulators are "forbearing." Whenever you hear words like that--first of all, evergreening invokes this beautiful forest. And forbearance is a Biblical concept. It's God's patience with us, his condescension for us. It makes you think something noble is happening. All that's happening is a conspiracy of lying, not to recognize loan losses. Why? Because the bankers don't want to recognize them; that might require them to raise more capital or go out of business or something. And the regulators don't want to recognize them because it's politically extremely inconvenient for their bosses. And so what you end up with is, the taxpayers, if you just rely entirely on capital requirements, notice that capital in our example, when the loss occurs, it only shows up in the bookkeeping when you recognize the loss. So let's go back to our example. You've got $80 million in loans, $20 million in cash; the loans fall in value by 10%. But if you don't recognize the decline in value-- Russ: Recognize meaning on the books. Guest: Yes. You pretend it didn't happen. Then your books still show that you have $10 million in capital. Russ: 10%. Guest: Yes; they still show a capital ratio of 10%. That doesn't mean that's real. It just means that's what the accounts show. And one thing that's really interesting about cash is, what we just showed is, that capital is an accounting fiction. Capital can be manipulated by banks and their supervisors and regulators to political purposes to mask losses when it suits both of their interests. Which is almost always. During crises they want to mask their losses. Russ: I want to push off. You are talking about the political pressure. It's sort of like when you borrow from the guy on the corner and he comes to collect and you say: I need another week. He might hit your knees with a baseball bat. But he might let you go for a week. You're going to plead for it. It's a bad example, a guy with a baseball bat, because he breaks your knees. But the regulator might say: If I put it off a month, or 6 months or a quarter or whatever it is, it will maybe turn out fine. Maybe the assets will re-increase in value, and then this whole thing will blow over. Guest: There's an old principle in banking which is: The one thing you never do with a borrower--and in this case the borrowers in a sense from the taxpayers--the one thing you never do is just give someone more time. You might want to give him more time with some additional restrictions. With a plan of action, with some recognition that there is a problem. But you never want to give somebody who is in a losing situation more time because what they do with more time when they are already underwater is they take big risks. Russ: Because they have no downside. Guest: And so this whole forbearance-evergreening thing is really the reason why small losses turn into big losses in banking.
26:56Russ: So we need to go a little bit more into the forbearance. Let's go back to our example. Let's say there is a 10% capital requirement, and I'm doing fine. I'm meeting that requirement. Now all of a sudden a bunch of my loans turn bad, 10%. I think I want to conclude that my capital requirements aren't being satisfied; I need to do something. Is that correct? Guest: Yes. Russ: And the forbearance is going to be: Well, you don't have; we'll give you a little more chance. Guest: Exactly. We'll give you a little more time. Let's make it really interesting, because we've been too conservative in our thinking here. Let's let the value of the loans fall 20%. So now our loans went from $80 million; they fell by $16 million. So now our loans are $64; plus our $20 in cash--we've got $84 million--and we have $90 million in deposits. Our capital ratio is right now really negative--what would you describe it as? We have a total of $84 but we have $100 in debt, so we've got -$16 million. Did I get that wrong? Let's slow down a little. We had a 20% loss in our loans, so our loans fell by $16; so they are still worth $64; plus $20 of cash. So my total assets are worth $84 million. I have $90 in deposits--ah, that's what it is. I have $90 in deposits. So I have a negative $6. I have -$6 million in net worth. I am insolvent to the tune of -$6 million. So, if I have to recognize those losses, the regulator would tell me: You are insolvent; you have to go to your stockholders and raise more capital; go to the market, find a way to raise more capital; try to convince people that you are worth saving; and have them cough up capital. Russ: And in that case how much would I need? I'm having some trouble with my balance sheet. Guest: Well, with my requirement--suppose that my capital requirement is we have to--we're being arbitrary so let's continue with that. Suppose that we have a requirement that says we have to raise 8% of our non-cash assets as capital. That would mean that you would have to raise, on your book value of assets, which are $80 of noncash assets. Russ: No, my non-cash assets are $64. Guest: Well, not on a market-value basis, or on a book value basis. Remember you have to have capital adequacy to make sure your deposits are paid. I'm trying to keep this on a real regulatory basis. So, if you have risk assets of $80, and you have an 8% capital requirement against your non-cash assets, that means you have to have 8% of $80, which is--help me out here-- Russ: $6.4.Guest: And so what the regulatory capital would say: against your risky assets, you have to have $6.4 million, not -$6 million. So you better go to the capital markets and raise $12 of new equity. That might not be easy to do if you are insolvent. But the point is, that's what you'd have to do if the regulator were doing his job. He would require you not just to get back to a point of 0, but to get back to a point where you had-- Russ: I had the cushion back. Guest: Right, where you'd get that cushion back. And the cushion is defined in some minimal sense to make sure that going forward, now we've lost our money, you have to have enough capital to replace the losses and to have enough going forward that we are not so concerned about future losses wiping out your bank. Russ: Even bigger future losses than we've already incurred.
31:04Russ: Let's take a real-world example of this. Because with that example I got lost. So I want to take a less numerical example and try to figure out how it would apply. So, in March of 2008 when Bear Stearns was in trouble, one of the things that happened was that people became aware that some of the assets that every investment bank was holding were not as valuable as they had thought before. That the default risk in mortgage-backed securities that were on the books of those institutions were worth less than before. And that's analogous to the defaults in the loans that we just talked about, with a vanilla bank. Guest: Yes, it is. It's a decline in value that's understood in the market. Russ: So, Lehman, watching this happen, and watching all the creditors of Bear Stearns who got their money back, was not as interested in dealing with that recognition of the new marketplace as they would be in a world where the government had not helped Bear Stearns's creditors. Because when the government helped Bear Stearns's creditors, it said to Lehman, well, you know, keep lending to them; it's going to be okay. Guest: Think about this for a minute. Initially the deal was that not only were Bear Stearns's creditors bailed out. The initial deal was that Bear Stearns's stockholders got $2/share, initially; and then that deal got renegotiated up to $10 a share. So not only were the creditors bailed out of Bear Stearns, but the stockholders were, too. Russ: Should have been wiped out totally. Guest: So, the real issue there is, Merrill Lynch and Lehman and some other institutions, but those are the two most obvious examples, in the spring and summer of 2008, they had 6 months to go out and raise new capital. But let's look at it. I won't say the name of the person, but I had breakfast with a prominent person, one of those banks; and I asked him: You know the market now knows that you've got declined asset values; you need to go out and raise some more equity. I said: There's lots of people out there who want to buy your equity. He said: Yeah; the problem is they don't want to pay the price we want. We don't like the price. Russ: Funny how that works. Guest: So, here's the thing. If you are protected on the downside, you look at Bear Stearns and you say: The Bear Stearns stockholders got $10 a share from Uncle Sam. Russ: Sort of. Guest: Instead of selling my equity cheap, for let's say $12 a share into the market, why don't I wait, hope that the market conditions improve, in which case I don't have to sell equity cheap and dilute myself; and on the downside if something goes wrong I'll get my $10 a share just like Bear Stearns. And so the problem was, it wasn't even just that the creditors were protected. It was that the stockholders were actually receiving, at Bear Stearns, $10 a share. Russ: Okay, but I want to make sure I want to understand the range of actions that the bank can take. When we use the phrase "raise more equity," what we mean is issue additional shares of the stock. That's why you are talking about dilution. Offering a new stock option to raise capital, raise equity, to build a cushion against future realizations of losses in asset value. Now the alternative is to sell assets and convert them to cash. Guest: Well, there's more alternatives. Russ: Give me some. Guest: Let's go through them one at a time. Russ: And the reason I mention the equity not being the only one is that as you point out not only does it dilute the existing shareholders--which the executives are not too keen on because they own a lot--as you say, in that breakfast conversation, when people things aren't going so well, they are not so excited to invest in the company. They are willing to do it if you give them a low enough price because they are willing to buy a lottery ticket; but it's not so exciting. Guest: And part of the thing is that outside equity investors don't know as much about your assets as you do. And so when you go to the market and say: I want you to have the opportunity of owning an interest in my company. Is that because you are generous? There's this great upside that you are generous about? Or because you happen to know there's about to be an announcement of a problem right after I make my contribution of investing in the equity? And then you, Russ, as the new investor, take a ride with me on the downside. So, when you are in the middle of a financial crisis and you are dealing with banks whose assets are very hard for outsiders to know as much about as the bankers who made them, then you have a little bit of a challenge. It's not an insurmountable challenge, but it's still a challenge to convince people that you are worth investing in. What that means is that you will tend to spend a lot of money for your investment bank on the road show, taking everybody through the due diligence. And you are also going to have to offer things at a little bit of a discount. That's called dilution. In order to encourage people who are already suspicious. As Groucho Marx said: You wouldn't want to belong to any club that would have you as a member. And it's the same thing with stock. If a company is desperately eager to sell you stock, you are a little bit concerned about what you might be buying. Where is the hidden problem? Russ: Could be that they have this great opportunity; they've decided to use the cash for that. But that's only one possibility. So let's get to the other-- Guest: But notice that the one you mentioned has exactly the same problem. If you get back to a higher capital ratio by getting rid of your assets and your debt. So, let's go to our bank example. Let's be very specific here. We have $80 million in loans, $20 million in cash; and we have an 8% capital requirement against our non-cash. So that means we have to hold at least $6.4 million in capital. So we're fine, because we've got $10 million in capital; we've got $90 in deposits. But then we start being concerned because we see some losses in our loans. Now one way we could deal with this is to sell off some of our good loans and then use the proceeds from the sale of those good loans to pay off some of our depositors. And that would increase our equity ratio through what's called deleveraging. Which is, it's not that you raised new equity. You just sold off some of your assets and used the proceeds to retire some of your debt. That would be another way to get back to a higher equity ratio. Russ: That makes sense. Guest: Well, the problem is, you've got to sell those loans. And if there's that same information problem that I mentioned before where potential buyers of new equity aren't so sure about the value of your assets, well then if you actually try to sell those assets into the market, people aren't going to be so sure about their value either. Russ: Or more realistically, we know they are lower. Because market conditions have changed and that's why we have a problem. Guest: But what normally happens in this circumstance is, if there is this troubled group of assets, because it's so hard to value them accurately, people when they are buying those assets also want a discount. Russ: Understand. It's the same problem. Guest: Sometimes that's called a fire sale discount. Russ: But it's not 0. People sometimes say: Well, you can't sell them.
39:28Guest: But Russ, you have other choices. I want to go through your other choices. They are going to be the ones you are going to like better. Russ: Bring them on. Guest: Next choice is: instead of selling off these questionable assets that have fallen in value in order to realize, to get your deleveraging going, you have another way to deleverage. I'm your good customer. I've got a line of credit. I'm your good loan customer; you are the guy running the bank. And my line of credit comes up for renewal, and you just say: I want you to pay off your loan. Russ: Instead of rolling it over. Guest: Exactly. You just say: Pay it off. You say: There's nothing wrong with me. I'm an innocent victim here. You say: Yep, you're an innocent victim of my capital requirements. That's called a credit crunch. When the bank suffers a loss from one class of assets and it has to meet its capital requirements, if we don't have evergreening and forbearance, often the path of least resistance is instead of going to the market to raise new equity, instead of trying to sell off your dodgy assets in some kind of secondary market, which is going to be very hard, what you do is you just don't roll over your good loans. Or another way to say it, which we find over and over again is: When people have to sell off assets they often sell off the higher quality assets, because those are the ones that are easier to sell. And that's just like deciding not to renew your good loan risks. And so there really are innocent victims out there. When the Russian crisis hit in 1998, Brazilian sovereign debts fell a lot in value, because the firms, the hedge funds that were holding both, had to meet their debt calls for the banks, which said: Hey, you just had some losses; you have to cut your debt, you have to deleverage. The banks deleveraged--how did they do it? They couldn't sell the Russian debt. Russ: No one wanted it. They wanted it, but too cheap. Guest: So what did you do? You sold the Brazilian debts. And then the Brazilians are saying: Hey, what's going on here? What did we do? And the answer is: You didn't do anything except the people holding your debts happen to need to sell stuff. Massively. And so, similarly, in a credit crunch, it's often the innocent victims who wonder what happened. Why are their debts being sold, why are their loans not being rolled over? And yet that's exactly what economic theory would tell you to expect. Because that's the path of least resistance. Russ: So, do you have any other options for me? That's three. Give me some more. Guest: Now the next option is: Suppose that we define capital--remember capital is a shock absorber. But capital doesn't necessarily have to be equity. It doesn't have to be stock. So, we could imagine capital being a debt instrument that converts into stock. And the idea here is that it might be that this dilution problem we talked about, that is how if you tried to sell stock into the market it's going to be very difficult, that that problem isn't going to be as great if you are trying to sell something called convertible debt. And so part of capital, under the Basel capital requirements and a lot of capital requirement systems, part of capital is convertible debt. And we have one particular version which regulators are talking about; and I'm proposing a specific version of it as part of the capital requirement, called contingent capital certificates, contingent convertibles, or CoCos for short. And the idea of this is that it might be that since you are more protected on the downside--you are not protected but you are a little bit more protected. If you are the CoCo holder, you still have equity holders in the bank who are junior to you. So, think of it like a waterfall, where in the waterfall you've got the depositors of the bank--the most senior claimants. They get the money first, whatever money there is to be had. Next are the CoCo holders. And then finally, if there is any money left over, are the equity holders. Russ: So, CoCos are in between promises like depositors and equity holders. But I don't understand how they work yet. So try again. Guest: So, the idea here is that if you tell banks: You can satisfy some of your capital requirements not just with equity but also with these CoCos that that might be helpful for banks in mitigating the costs, reducing the costs of raising capital in the market when they need to. And that's one of the main advantages of convertible debts. Of course this is a very complicated topic; we are now in pretty complicated finance theory about how to structure balance sheets in the optimal way. The key thing that I want to get at this point is just one idea; and we've known this in corporate finance a lot, which is a lot of different studies talking about it: that if you are issuing into the market at a bad time for you, for your business, if you issue convertible debt--that is, debts that convert to equity--you will not have the same kinds of dilution problems for your shareholders than if you were issuing shares into the market. Russ: Because there's some uncertainty about whether it will convert or not? Is that why? Guest: Exactly. You are not asking someone--remember the Groucho Marx point--we are not asking you to become a stockholder like me. I'm asking you to be somebody who is senior to me. I'm the stockholder and I want you to give me money but you are still in line ahead of me. Russ: So, it's not dilution, but it's semi-dilution, because it's basically saying--you still have the same claims on the company, but there's a chance that you might not get exactly what you expect. Guest: Exactly. You are at risk but you are less at risk than if you bought stock. And I--suppose I'm the existing stockholder and I have a little bit of a loss and I come to you and say: Russ, remember we were talking on your program about this idea. What do you think? I'm the stockholder and I don't want to sell stock because I really have confidence in my firm. But I'm going to give you special protection. I'm standing between you and any losses. I'm the stockholder, all losses come out of my pocket before you lose a dime. I lose everything before you lose a dime. And I want you to cough up some contingent capital, some convertible debts; and yes, there's a chance you are going to lose money, but I promise you you won't lose a dime until I've lost everything.
46:35Russ: Okay, so that's interesting; but I think, and as you say, it's a little bit arcane. I'm just going to make an aside here--we're about 46 minutes into this podcast. And I'm enjoying every minute of it. Those of you out there who have listened this far--I don't know how much you enjoy hearing these kind of what I call the basics, podcasts where we delve into these fundamentals to help people understand. If you like this, let me know: if you've listened this far. Maybe you turned it off--not another podcast about the financial crisis, bookkeeping issues. Let me hear from you if you like this, or if you are a dutiful listener and you don't like, but you are still listening, you can let me know, too. I think there are two things I need to figure out. I'm learning something really important here; I hope others are, too. Here are the two things I'd like to get to: they are the following. What is the natural incentive of the bank to leverage that makes it necessary for the regulatory folks to make these requirements? That's the first question. The second question, much harder for me because I'm very confused about it, is when we are not in a world of depositors, which is the investment bank--when we are not in a vanilla bank, American FDIC-insured stuff but we are in this more complicated shadowy bank world, I want to figure out how the story changes, if at all. Let's start with the first one. Let's say there's no regulatory requirements. None. There's no FDIC. I'm a bank; I want to attract deposits, and I want to invest those deposits in loans and other things. Houses. All kinds of assets, potentially. And to do that, I've got to make sure that you as the depositor feel comfortable with what I'm doing. So, one way, and there are many ways, is to set aside a cushion. Like we've talked about. Could be two cushions--equity or cash. Now, what we do know, even if you don't understand what we've been talking about so far, is that banks like leverage. So, why is there a natural incentive to exploit the FDIC guarantee? What's going on that makes leverage so attractive for them. Well, it used to be, before FDIC, that the banker borrowed money from depositors; depositors knew that they were at risk of losing it; and that meant that depositors were worried. Which made bankers scared. How did the bankers convince depositors not to be worried? They held enough equity on their liability side and they held enough cash on their asset side. And in fact, especially because during crises it can be hard to really be confident about the bank's bookkeeping on capital, the way banks really restored confidence was they accumulated cash. Because if you are accumulating a lot of cash, depositors know there is going to be cash there. Russ: There's not uncertainty about the value of the asset. Guest: Exactly. Here's how dramatic it was. In 1929, New York City banks, on their asset side, were holding about 1/4 of their assets in cash assets--that's Treasury Bills and cash at the Fed. By the end of the 1930s, they were holding 3/4 of their assets in cash. Those banks didn't fail. They didn't experience runs even, the NYC banks in the 1930s. What they did experience was a lot of depositor concern. They as felt that concern in the form of some withdrawal pressures, they felt very strong pressures to reassure depositors. They cut their dividends, so that they could try to boost their capital ratios; and they raised their cash ratios dramatically, from 25% up to 75%. And that's how they stayed in business. Now, that's the old days. When depositors worried and bankers were scared. Once you had FDIC insurance, the depositors aren't worried. Well, if the depositors aren't worried, then the banker is thinking: Whatever I do, even if I hold very little capital and very little cash, I still only have to pay a very low interest rate on those deposits. Now, imagine if I told--most corporations in the world, if they increase their leverage, they have to pay more to their debts. Russ: You are talking about a regular "company," not a financial institution. Guest: Yes. Or a bank, prior to FDIC insurance. If you increased leverage, all of a sudden people start asking for a substantial amount more money for their debts. And that discourages you. Just as the banks I talked about, in the 1920s and 1930s, they were encouraged by markets to keep their leverage appropriate. And to keep their cash appropriate. Notice, we don't have capital requirements for non-financial companies. We don't need to. Russ: Microsoft. Guest: Yeah. Microsoft doesn't need a capital requirement or a cash requirement. They are rewarded in the market for having adequate capital and adequate cash because if they go off of capital adequacy, the markets will penalize them. They'll have to pay a lot more for their debt; their stock prices will fall; everybody will say: What's going on at Microsoft? But bankers, once they are insured--when they increase their leverage, they don't have to pay higher costs of debt. And so that's called the moral hazard problem. That's the temptation. Because you actually can show that bankers will increase their profits by leveraging more because their deposits are protected. So bankers face a strong incentive to increase leverage. It just comes from the fact that the normal effect of increasing leverage and raising your cost of funding doesn't apply when you are funding is insured. Russ: Okay. Guest: So that's why we need capital requirements. We need capital ratio requirements and cash ratio requirements, both. Russ: Well, you say we need them. We need them if we are going to have insurance. My alternative would be to get rid of the insurance. Guest: Well, I've written quite a bit about that topic. There's a very good economic argument for doing that. I would also just remind everyone that the person who passed deposit insurance, the person who was President when it was passed, Franklin Roosevelt, was against it. Russ: Yeah, he had been against it. The Republicans pushed it through. Guest: It was actually Henry Steagall of Alabama who really pushed it through. And the reason they pushed it through was they wanted to subsidize the small banks that were at risk. And so it was small banks in mainly rural areas that had a huge amount of political interest in pushing that through. And there was logrolling done in the Banking Act of 1933 that made this happen. There's a long political history of this going beyond that; I don't want to get into it except to say I've come to the conclusion that politically, getting ride of deposit insurance doesn't solve our problems in the United States. Russ: You have it anyway. I've heard people saying that. Guest: Because we have a political problem. A new book that Steve Haber and I are writing called Fragile Banks, Unlikely Partners: Why Banking Is All About Politics and Always Has Been--we're talking about this problem. And basically the problem is in the United States we have a political coalition which is a very unlikely one, between big bankers and what we call urban populists. And what this means is the kinds of subsidies for risk-taking that occur to the benefit of the big banks and to the benefit of affordable housing policy and other kinds of policies are very much there on purpose--to satisfy certain political constituencies. And ultimately deposit insurance and bank regulations, the phenomena that are--you might think you are going to control the world with them, but they are really just outcomes of deep political processes. I'm not even sure we are at a point where making changes in deposit insurance coverage are credibly. Russ: Yeah, I agree. Guest: And that's the problem.
55:08Russ: Let's move on. By the way, I look forward to talking to you about that book down the road. Let's talk about--we're very close for me on actually understanding this, so I don't want to miss the opportunity. Let's move from an FDIC insured bank that takes deposits from people who have savings accounts; they use that money to then fund loans. That's the model we've been talking about. Let's move to an investment bank, which I am confused about two things, that you are going to help me understand. One is: Did they have capital requirements like a regular bank? Guest: Yes, they did. Russ: And the second question: They are on paper leveraged much more highly than the so-called vanilla banks. And the second question, and this is the one I'm really interested in, is: Who is funding the leverage if it's not depositors? Let's start with the first question, which is just the regulatory environment that say, Lehman or Bear or Morgan Stanley is in. Guest: East to answer all these questions. The first was: Were the investment banks subject to capital requirements like the commercial banks? And the answer is: Yes. Starting in 2002, in response to European complaints that American investment banks were not regulated under the Basel system, the United States imposed the Basel system on the investment banks. Now, the Basel system thinks about capital requirements using something called a risk-based capital system. It measures risk-weighted assets. Under Basel I and Basel II, it imposed an 8% capital requirement, on a risk-weighted basis. So, for example, just in our little example we've been using: If you had $80 million in risky assets, with risk weights of 1, meaning they are considered-- Russ: Average. Guest: Yes, let's call it average risk weight. Then your capital requirement would be 8% of that $80 million. Because it would be 8% of risk-weight 1, multiplied by $80 million. Russ: But if it's triple-A, if it's a really "safe" asset, then you could go to what? Guest: Very low. So, notice that under the Basel II system, some of these investment banks had capital ratios of 3%. But their capital ratios on a risk-weighted basis were still about 8%, you see. Because the risk weights were very low--they were less than 1. Now, where do those risk weights come from? If I told a 10-year old, they wouldn't believe me. Russ: I know. They come from the banks, I know. Guest: The banks made them up. Russ: And the regulators said: Your models look pretty good to me. So the safe stuff is then mortgages, because we know housing prices are good. Guest: How could those go down in value? Russ: And debt from Greece. Because Greece is a country. Guest: We all know that sovereign debt is almost riskless. Russ: If it's European. And Greece is in Europe. Guest: So, actually, these are really important issues nowadays. So, remember: Risk weights are a regulatory, therefore a political, concept. They are determined in practice by the banks' own models, or by ratings' agencies' opinions. Russ: Which, by the way, is really just a fancy version of forbearance. Guest: Absolutely. Well, it can be. Unless there is something credible about the way that's done. Now, there are some ideas, I've been writing about ways to try to make those ideas more credible. But let's just not go off on tangents. Let's stay with your question: Yes. They are not very credible. And so the problem is that capital--real capital relative to total assets--can get very small. Notice that the banks in the United States, commercial banks, had an additional requirement, over and above the Basel system requirement. They had to also meet what was called the simple leverage requirement, which meant that no matter what risk weights they attached to their requirements, they had to, in order to be well-capitalized, have at least 5% of their total assets in capital. So, the reason that commercial banks were not able to get their capital ratios down as low as the investment banks is that on top of the Basel II system, they had this special leverage requirement. Russ: Now we are at the key question. So, what is the role of depositors? And I want to come back to saying something I've said a million times, but I'll keep saying it because I think it's so important; I think people have trouble understanding it. It came up in the podcast with William Black. People say--including him--the equity holders get wiped out, so obviously market discipline doesn't matter. But the equity holders, they get wiped out once in a while. They expect that. They diversify. That's why they have the upside. It's the fixed-income folks, it's the creditors, who have no upside, only care about the downside, who I call the watchdogs of recklessness. So if you take away their incentive, the watchdogs of recklessness, you get more recklessness. So, here's the question. In our story about a commercial bank, we know who the depositors are. They are people like you and me who have savings accounts in these banks. In the case of an investment bank, they are borrowing and financing their investments with a very different kind of thing. What is it? Guest: Now we are getting somewhere, aren't we? Russ: I hope so. Guest: Well, how different is it? That'll be the question. So, let's see. Suppose they invented something that was a very short-term instrument. I'm not going to even give it a name yet. Russ: I know the name of it. Because I find this mystifying. So, keep going. Guest: So, suppose it's overnight. It matures overnight. And suppose that its total quantity is even greater than the total amount of deposits in the banking system. So that there's this overnight money that they are funding themselves from, of huge quantity. Maybe, I'm going to say, $8 trillion. We don't know, to this day we don't know what the number was. But I'm going to tell you $8 trillion. Now, if it was $8 trillion of what are called repurchases, or repos, now look at what the politician and the regulator are facing. If this bank gets into trouble, and it loses a significant percentage of its value; and since it only has 3% of equity, then that means, that if it starts losing significant value on its asset side, that means that some of these repo guys aren't going to get their money back. Or they are at significant risk now that they might not get their money back. As they start seeing this happen, they might decide not to roll over their repos. And what actually happens--it's a little bit more complicated. There were these things called repo haircuts, which just meant that they started requiring more collateral against the overnight debts. To make a long story short, what happens is, the government doesn't like the way that story ends. It doesn't want to see deleveraging, which means all sorts of assets being sold. Trillions of dollars worth of assets being put up for sale all of a sudden in investment banks; the possibility of investment banks going bust, with counterparty risk--that means all of the contracts they've entered into not being honored--leading to financial chaos in the minds of the politicians and the regulators. And so, what do they decide to do? Well, you know what they are going to do. They are going to apply deposit insurance to these debts of the investment banks. That's what we're talking about, right? And in fact, the money market mutual funds shares are going to be insured, because they didn't like the fact that some of the Lehman paper might not be repaid. So, financial intermediaries all over the world, whether they--they didn't have to have things called deposits. If they had assets-backed commercial paper, commercial paper, medium term notes, repos, even the shares in the money market mutual funds--all got treated like they were just insured debts.
1:03:57Russ: I sort of get that. I'd love to avoid going into detail on how the repo market actually worked. I love your shorthand way of saying it: It's an overnight loan. Let's not talk about how it was actually executed for a moment. Maybe we can get away without doing that. We've talked about it a little before, a long time ago on this program. But what was going on is I'm borrowing overnight. And the next morning, I say: Can I do that again? Guest: Exactly. Russ: And the reason you are lending to me overnight is that I'm putting up as collateral--yes, they are usually fine, and so far they seem to be totally okay. They seem to be worth what you say they are worth. And that's how that market worked in a very abstract way. Guest: Right, and you could see, as the assets start to decline in value, and if they start getting a little riskier, either of the two--if they start being perceived as at risk to decline in value or they start declining--you start asking for more collateral against each dollar that you are lending me. Overnight. Where am I supposed to get this collateral? Russ: Because my assets are strapped. Guest: And so ultimately what it comes down to is, as the collateral demands get higher, we start seeing that people either start throwing assets off like crazy, which is causing asset prices to fall dramatically. Or, they can't repay their debts. In other words, they are not allowed to roll over their debts and they might not be able to repay their debts. So, you start looking at a situation where-- Russ: Panic-- Guest: The government says: Well, let's just guarantee everything. Which is what we did. Russ: Right. But I need to hear--we are real close to the punchline of the story. Try to tell me that repo story in the context--I understand that the government treated the people who lent money to these investment banks as if they were depositors who had insurance. Whether it was because of political forces or fear of systemic risk or contagion or whatever it was doesn't matter. That's the way they treated them. Here's what I don't understand. I want to make the analogy--perhaps I can't--but I want to make the analogy to our previous story of equity and leverage and capital ratios. So, I'm Bear Stearns. Every night I am borrowing massive sums of money. Can you tell me the story of the 80-20/90-10 in that? Tell me how it works. Guest: Sure. Substitute, instead of deposits, call it repos. Instead of bank deposits, the way you are raising your money is with this overnight debt. And notice that: Why did people like complying with that? Russ: Yeah, I want to know that. Why was it so attractive? Guest: Well, it comes down to the same thing. It turns out that there's a very large group of people in the world, institutional investors, who, as part of their portfolios, want to hold something that they regard as nearly riskless. And that turns into what is called money market instruments. Deposits, commercial paper, asset-backed commercial paper, and repo. And so the institutional investors can carry--these are all debt obligations by somebody. By banks, by commercial paper conduits, by commercial paper issuers, by investment banks. All of that list of things I described, which are called money market instruments, they are all considered very low risk. And there is a particular appetite on a particular institutional investor's balance sheet, where you have certain amount of cash assets. And so as long as--he's interested in some of his portfolio being in these very low-risk things. And so there's an appetite out there for institutional investors to invest in things that have the properties of being very low risk. And so the investment banks were able to say: Well, you've got an appetite for very low risk things; we can supply those. We'll call them repos. It's overnight money and it's collateralized. So, if you ever need it back, you can get it back. Sounds pretty good, so long as everybody doesn't want it back on the same day. Russ: But is it correct to say that, given that this is the shortest of short-term loans, almost the shortest--overnight; it's not an hour from now but it's overnight--the idea would be then that if I decide to change my mind and I want access to that, I want to do something more risky with my money instead of lending it at a relatively low rate overnight, I can. Because it's flexible. I can. It's only a day. Guest: Only a day. Exactly. So you have flexibility. But you also have protection. Russ: Because you have collateral. Guest: You have collateral and the short maturity also gives you protection, too. Because things don't go south in two hours in the world. Things go south over a matter of days or weeks. And so, by having overnight maturity, you have protection. You can get out. Commercial paper has a maturity--we are talking about commercial paper you buy, maybe nonfinancial terms. Russ: What is commercial paper? Guest: Commercial paper is a promissory note issued by anyone who is in the commercial paper market. It's rated and it typically has a maturity of under 270 days, I think it is. It's a negotiable instrument, governed under certain law. But the key thing about it is: It's of the highest quality. So, there are only two ratings that matter in commercial paper: Hello and Goodbye. There is no junk commercial paper. Commercial paper is being held by people, it's like a cash substitute. If you start looking as an issuer, if the growth rate of your earnings or your sales start to decline a little bit, you basically get your yellow card, or your red card--like in soccer. You are told you are out. When you issue commercial paper, the average maturity is usually about a month. Russ: So all it is, is a bond that has a very short time frame from a very safe issuer. Guest: And because of the short time frame, and the safe issuer, it's actually considered to be very liquid. It's not just that it's tradable. It's also that you know you can convert it to cash very quickly, because it matures. And you don't have to know about the issuer's prospects till eternity. You just have to know about them for a month. And so repos are even more extreme. They are collateralized, by specific assets. You get to decide on a day-by-day basis whether you want your money back. You could also decide: I'll let you keep the money but you have to cough up more collateral. And so it's a way--if the investors have a certain amount of assets that they want, that they consider to be very, very safe--and that's exactly what was going on. Investment banks found a way to cater to that taste by promising something that looked like it was really safe. And it was safe--except if all of a sudden the investment banks all had similar kinds of losses of large amounts. And now they've got to figure out: How do we convince these repo guys not to leave? How do we convince them not to demand more collateral than we have, and how do we convince them not to leave? And the answer is: You can't. And if you can't, ultimately you start getting a meltdown in the financial system. It's all coming from the fact that the mortgage-backed securities are declining in value on the balance sheets. And so, what's the answer? The answer we came up with was: Just bail everybody out. Not a very attractive answer.
1:11:56Russ: Here's the punchline, that I'm still confused about. A lot of people describe the Bear Stearns describe the Bear Stearns event of 2008 as a bailout of Bear Stearns. It's not really a bailout of Bear Stearns. Bear Stearns disappears. Their equity holders, as we've already mentioned, initially were going to get $2; eventually they got $10. It's down from $1.70; it was an unpleasant period of time there. It didn't turn out as they had hoped. But the real point is that people who had held those repos of Bear Stearns were made whole by J.P. Morgan Chase. JP Morgan Chase honored all of them. Now, they were only willing to do that because the government guaranteed $32 million of "toxic assets." Guest: But shareholders were bailed out, too. Russ: A little bit. But I want to put that to the side. Because in other cases of what I call these creditor bailouts, the shareholders were wiped out. Guest: True. Russ: Continental Illinois, they were wiped out; a lot of times we are only talking about bond holders, so the Mexico guarantee was creditors of Mexico. So here's my question. Who were the creditors of Bear Stearns? I know JP Morgan Chase was one of the biggest ones. And they bought them. So that's a weird situation. I was told maybe they were a clearing house; what it meant to be their creditor was a little more complicated than just what we are talking about here in terms of repos and financing. So, who got made whole in the Bear Stearns rescue who didn't get made whole in the Lehman Brothers--because they didn't do it? Who got made whole in Citigroup and these other examples? Who were these people who were jumping up and down with joy when they realized for a minute they were going to get wiped out and then realized: No we're not; we're going to get everything back. Guest: Well, it's a broad range of holders. Because we are talking about many trillions of dollars' worth of debts. And it's mainly short term debts. Citibank was running conduits from which it was issuing medium term notes, commercial paper, asset-backed commercial paper. All of those people were at risk; but they ended up not losing a dime. Right? All of the holders of commercial paper issued by Citibank's special investment vehicles were beneficiaries of the bailout. Similarly, all of the repo holders, who were beneficiaries of the interventions to protect Bear Stearns, to protect the various banks who were involved in the repo market. I mean, repo, as I said, was a multi-trillion dollar market. Russ: Do we know who they were? Guest: I don't know who they were. Russ: The reason I ask-- Guest: We're talking about across all these asset categories, when you add them all together. Russ: But-- Guest: It's institutional investors, broadly speaking. And to some extent--for example, the Lehman commercial paper that's experiencing losses, that's being spread through the money market mutual fund industry. Russ: Right. Guest: So, we can kind of see who the beneficiaries are; but to a large extent they are institutional investors who are holding repo and asset-backed commercial paper and commercial paper. And of course banks that are holding interbank deposits. So, you are right that short-term creditors, largely institutional investors, are the major beneficiaries. Exactly who is benefiting from which-- Russ: It's a little more complicated, because--let me structure this a little differently. Let's suppose it comes to be believed, in the United States and maybe elsewhere, as it turns out to be, that creditors, lenders, bondholders of large financial institutions were going to be made whole. Which was true for everybody except Lehman's creditors. Now Lehman filed bankruptcy in September or October of 2008. And I looked at their bankruptcy filing, and their largest creditors--the largest creditor was quite large, I think it was Citi. And then most of their other creditors were Japanese and Asian, Korean banks who don't have a lot of political pull in the United States. So I wondered, when I saw that, were the other banks different? And in particular, you would think there would be two groups that would benefit from these kind of creditor rescues. One would be the creditors, obviously; they would clamor for rescue. They would call Hank Paulson if they could reach him. But the other people of course are the banks themselves, who profit from the opportunity to leverage. Those are the two groups that have a political stake in this system. I wondered--at first I thought, they are kind of the same. Overnight in this repo market, they are lending to each other. It's not just like there are some banks that are repo banks. Guest: No, no. But it's not just the banks. It's all the institutional investors. Remember, we've got hedge funds. Russ: Pension funds. Guest: Mutual funds, insurance companies. So, we've got a large group of investors who are not part of the same institutions that are the issuers of repo, or the issuers of commercial paper. So, it's not just that they are all lending it to each other. Russ: Because it can't be. Guest: It's not. On net--we don't know the exact amount, but on net it's the non-bank institutional investors who are, internationally and domestically, who are the holders of these debts.
1:17:46Russ: So, what's the political economy of that? Why did the U.S. government save those folks? Guest: Well, and as you pointed out, it didn't in the case of Lehman. But it's a really interesting question. I've thought a lot about what's going on here. I think that it's hard to really--I don't buy in to some of the stories that say things like, oh, Hank Paulson really wanted to save AIG because he cared about Goldman and really hated Lehman. I don't believe those stories. I think that there was inconsistency. Russ: It would make for a good movie. Could be true. Guest: I'm not saying it's not true. I'm just saying it's not the way I think these people probably behaved. I think that the main thing to say here is number 1, there was huge incompetence due to inexperience. The people we had at the top of this effort really didn't know what they were doing. And I mean that as an historian who has focused a lot of my career and research on financial crises. We had incompetent management. The Federal Reserve did not understand securitization. It did not understand financial risks very well. My friend, Ben Bernanke, is a great economist; he knows a lot about the Great Depression; I think he was not really aware of what was going on as of 2006 and even early 2007. And I am absolutely sure that Hank Paulson was not aware of what was going on. And more importantly, they didn't even really know what they didn't know; and they didn't know because of the U.S.'s experience. They didn't really understand crisis management. What I mean by crisis management--I wrote a paper in 2005 with two World Bank economists who'd spent a lot of their lives working in different crisis countries on how you deal with financial crises. There's actually a group of 100 episodes in the last 20-30 years of countries that have financial crises and how you dealt with them. There's a wide range of things you can know about this topic. We just didn't have any real institutional memory or understanding of it. I just think that we mismanaged it. I look at the variety of experiences, and the fact that we did some balance and didn't do others as largely reflecting just incompetence, rather than some sort of conspiracy to sometimes help and sometimes not. But I'll tell you one other thing about Lehman. Russ: But I've got to interrupt you there. You can come back and tell me about Lehman. Hold that thought. Are you really suggesting that this relentless policy, going back to Continental Illinois, of rescuing creditors is just incompetence? Guest: No, I'm not saying that. I'm talking about--I thought you were asking me about why it was such a kind of random policy: AIG gets bailed out and Lehman doesn't. Russ: I agree with you; that's hard to know. It was a little bit chaotic. Their public statements I don't find credible. But it could be true. Guest: The public statements are not credible. But I'm going to tell you another one here. Here's the secret I'm going to reveal to you and your listeners, without telling you my source. Russ: That's in-credible, but go ahead. Guest: In the summer of 2008, it's probably pretty well known at this point that Met Life looked at buying Lehman. Russ: A lot of people did. Barclay's was in the market; there was a Japanese firm. Guest: Yes. Well, MetLife looked very carefully and they really wanted to get into this area. And as much as they wanted to get into it, they concluded that Lehman was so dead, so under the water, that they couldn't touch it. That was not September of 2008; that was some time around May, June of 2008. And someone called Tim Geithner, who at that point was at the Federal Reserve Bank of New York, and said: Tim, I'm a member of the Board of a certain company and I've heard something; and what it comes down to is what I've heard is that MetLife has done its due diligence, and as much as they'd like to do this, they can't do it; and so you have a deeply insolvent financial institution on your hands called Lehman Brothers. And you've got to figure something out about it. Russ: Free ride on their analysis and get to work. Guest: Yeah. And then Geithner apparently pooh-poohed it. And the person on that line said to him: Look, MetLife would like to do this deal, from what I understand; they would like the numbers to work. So what's their incentive for-- Russ: For being so pessimistic. Guest: For being pessimistic. They have no incentive for being pessimistic. They'd like to make it work. They are walking away. And Tim: Wake up call, man! Now, if you want to start talking about incompetence, let's start there. And then what happens with this incompetent individual? I have to be frank: He then gets promoted. Russ: Yeah, it's depressing. To me, the biggest thing that disturbs me about that is that when AIG was rescued and there was negotiating, and of course the rescue would give haircuts to their creditors because they weren't going to pay them all back; and once the government stepped in, the negotiations just weren't very effective. Because they just said: Well, let's wait. And Geithner supposedly insisted that there would be no discounts. And I think--I don't understand that. Guest: Well, that one I'm more forgiving about. Because the problem there is you are playing chicken. The creditors are thinking: I know that the Fed is not going to pull the trigger on this because if they don't--if I'm playing a game of chicken and you are driving the motorcycle at me and I'm driving the motorcycle at you, and I know that I am wearing some kind of bulletproof outfit and you are not, you don't have a helmet and I do, I know that you are going to swerve away first. And I think the problem was that people were correct in surmising that the government wasn't going to allow further meltdown on the AIG deal. And so the creditors hung tough. Russ: But couldn't the government have said $.90 on the dollar? Guest: Well, they could have said anything. But the point is it's a game of chicken. The creditors could say: That's not good enough; let's go to bankruptcy. And the view was: That would have caused so much damage that even though it would have hurt the creditors, it was something that the creditors correctly surmised the government wasn't willing to do. So, if you are negotiating with somebody and you know they are not willing to do what they are threatening, you are going to hold out, right? Russ: Yeah. Guest: So the creditors had us over a barrel. Which was the reason Ben Bernanke argued we needed to have this resolution authority in Dodd-Frank. And I thought it was a reasonable argument, except they crafted it in such a way that it's completely non-credible. So, it's just been one comedy of errors after another. It's hard to understand. We're in exactly the same position again. Russ: Well, it's like FDICIA. Guest: It's exactly like FDICIA. Russ: We fixed it except we are not going to use it. Guest: Your program's been great at bringing out a lot of these things. The problem is: How many people have the hour to sit and listen to us, and then they have to do with it something--vote or something. I hate to be so pessimistic, but the people who are making so much money by ignoring these problems and buying politicians, one way or the other, who will ignore these problems, is really our problem. And we have--it comes down to the politics of this. And we are really not going to solve this problem very easily, because Americans need to understand it and hold politicians accountable. Judging by where we are right now, with how much economic literacy there seems to be in our country in understanding what's happened and who is responsible and what's wrong, I have to say I'm not that optimistic. I wish I could say different, but I'm not. Russ: Well, on the positive side, I don't agree with the analysis of Occupy Wall Street, and I don't agree with their solution. I think they miss--like you say, I think they have sufficient economic literacy. People are saying what they are saying. But they are on to something. Guest: Oh, absolutely. Russ: They understand that there is something not quite kosher about the way that the banks and the government are interacting. So, I'm a little more optimistic. Guest: Well, I like your optimism. After all, Winston Churchill really got it right when he said: America will always do the right thing, after it's tried everything else.