"A New Kind of Bank Run"

Floyd Norris makes a good point about modern bank runs, or something just like them. The problem is that entities outside the traditional banking sector have been engaged in bank-like functions and are hence subject to bank-like problems such as bank-runs. Here's how it works.

Hedge funds can be hit with withdrawals even if they are not in trouble themselves, at least initially, due to uncertainties about the future state of the market.

But like a bank who lends out most of the deposit it receives, a hedge fund uses the deposits it receives to purchase securities and other assets for its portfolio. Thus, unless it has substantial cash reserves on-hand (part of the scramble now is to build cash reserves), when investors make withdrawals the fund must begin to liquidate its portfolio to pay them off.

But if nobody will purchase mortgage-backed securities, who do you sell to? With nobody buying the assets the fund is trying to sell, they are forced to try to raise cash in other ways, and problems mount.

And it can feed on itself, just like a bank run. If investors hear that people are having trouble getting their money out of a particular fund, or from funds generally, they will rush to get their money out before the fund fails, and the problems get worse as funds try to sell assets to raise the needed cash.

So it's sort of like a bank run, but without a standing lending facility (i.e. the equivalent of a discount window) available to meet the demand for liquidity, though such institutions could be created.

I see Brad DeLong has noted this as well in " Paul Krugman Recommends Floyd Norris Today," so I'll send you there to read the Norris article.

Comments

[billy]

Here the assets are worthless or worth much less. It's not that the CDO assets pay for themselves over 15-30 years, it's that the assets are never going to pay off, or pay off much, much less.

Similarly the recent LBO deals. They will never pay off at current prices.

says...

The typical bank run scenario is a multiple equilibrium case, in which because there is a coordination problem and the "bad" equilibrium (i.e. the run) is the outcome. This is not the problem with hedge funds. Hedge funds are in trouble because the made investments which performed badly, now they have to face the consequences. You cannot have a return of 15-20% forever. If the Fed bails them out they will be encouraged to take even more risks when the crisis is over making the next crisis even worse.

[billy]

The typical bank run scenario is a multiple equilibrium case, in which because there is a coordination problem and the "bad" equilibrium (i.e. the run) is the outcome.

The bank run scenario is supposed to be a mismatch of durations. When the loans the bank gave out repay themselves over 30 years and the deposits backing them can be withdrawn overnight.

Today there is a run on hedge funds, and they cannot sell the crap they own. They are worthless or worth much less.

Chickens.Home.Roost.

If there are traitors, they are the ones who allowed this to happen, not someone protesting the Iraq mess.

Who is going to pay the price for the cleanup? Is it the crooks who made the billion dollar bonus and fees? Or the general public?

says...

Today there is a run on hedge funds, and they cannot sell the crap they own. They are worthless or worth much less.

Investor X invested in Hedge Fund Y which invested in stock Z. Stock Z went down. Hedge Fund Y lost money and so did investor X. That is not a run.

In other words, a HF collected $10M from 10 investors and bought stocks for $100M. Now the stocks go down and the hedge fund is only worth $50M. If an investor decides to leave the fund then he/she gets $5M. If all the investors decide to leave the fund then they each get $5M. No run, just a bad investment. Simple as that.

[Laurent GUERBY]

"The central banks, while clearly crucial to dealing with the loss of faith in the new financial system, lost influence under that system. Loans could be arranged by nonbanks, not subject to bank regulators, and the regulators were hesitant to impose rules that would not apply to all lenders...."

Incredible lies.

Only banks lend money and no one force hedge fund and rich investors to buy debt packaged by banks.

Central choose not to regulate bank lending prefering the lazy approach of setting short term rates and taking a nap.

The current event are 100% due to central bank failure to do their job of not being always friends of private banks.

Why lying about that so blatantly?

...

[billy]

Think this crunch is the end of the unaccountable and rash behavior? No way. Here is more

http://dealbook.blogs.nytimes.com/2007/08/10/the-buyout-loan-merry-go-round/

It is well known on Wall Street that private equity firms are pressuring banks to make good on their commitments to fund their deals, even though the banks are having lots of trouble farming the debt out to investors. But here is the latest wrinkle: Many of those same private equity firms are offering to buy that debt from the beleaguered banks — at a steep discount, of course.
....
Ironies abound, but here is the most obvious one: In looking to buy the debt, private equity managers are seeking to profit off the banks’ pain — pain which they themselves took part in causing, by holding the banks’ feet to the fire.
....
But wait, the debt carousel keeps spinning: To buy these leveraged loans, many private equity firms will want to use leverage — in effect, borrowing part of the purchase price. Who might lend them the money to do it? You guessed it: the banks.

[wood turtle]

Is it really the job of the Feds, to bail out hedge funds?

[James Killus]

It's actually hard to tell how much of the current problem is simply due to bad loans that will never pay out, loans that might be salvaged if they could be renegotiated (but cannot, because the securitization of the loans has left no negotiator on the lenders' side), or simple illiquidity during a panic.

What is fairly easy to tell is who is panicking: hedge fund investors, who are generally quite wealthy. However, if there are any pension fund managers among them, I want to see some jail time for somebody. "Prudent man" my eye.

Unfortunately, it's pretty clear that the "trickle down theory" does work, at least for the bad stuff. Stock and bond markets generally are in turmoil, and some financial institutions may go belly-up, taking not just the rich guys' mad money, but some ordinary folk money as well. And this is before the inevitable "let's make it up by taking the money away from somebody else" gets under way.

[BJ Feng]

I think leverage is the key. Leveraged funds who own CMOs and CDOs might not be able to sell their holdings. Even worse, selling some of their holdings at this time might fetch a very low price and they might have to reprice all of their holdings at that low price if they did sell. That puts them in a very bad position. I believe a lot of the turmoil in the markets is due to these funds trying to sell anything they can other than their CMOs. That way they won't have to reprice their assets and can at least maintain the illusion of solvency.

[Institutional Investor]

"What is fairly easy to tell is who is panicking: hedge fund investors, who are generally quite wealthy. However, if there are any pension fund managers among them, I want to see some jail time for somebody. "Prudent man" my eye."

What about all the hedge funds that are profiting now. Should all the trustees on those pension funds go to jail. Why don't we go back and lock up anyone who was in small/mid cap growth at the end of the tech bubble. I spoke with half a dozen fund of funds managers this week, all then were up in july and through the first week of august. I spoke with three others that were only down 1-2%, which is much better than the S&P. Just because a few dozen single strategy hedge funds go belly up, doesn't mean the 8,000-10,000 that are up there are all bad. Sure there are a significant amount of them that extremely leveraged and have made a incorrect bet, but at the same time there are a many who aren't exposed (because they they aren't invested in this area) or have made the correct tactical decisions. It sounds like all the hedge fund lynching is from people who have no direct experience with them or the industry.

[James Killus]

Institutional Investor,

I try to give some leeway to people misinterpreting my comments, if only because I sometimes make remarks for entertainment value, and besides, I'm just a complex and complicated a guy, with really complex and complicated thoughts that are often opaque to mere mortals.

Still, the "why not then is pretty lame. Are the holders of the 8,000-10,000 hedge funds, that you say are fine, panicking? If not, then if you were to perhaps re-read what I wrote you might conclude that I was not referring to them.

I also think that the "prudent man" theory gets some different interpretations when comparing the management of, say a pension fund, to a fund that only accepts individuals with a multimillion dollar buy-in. It's one of those "widows and orphans" arguments.

But any fiduciary who chases 30%-40% is not being prudent by any stretch of my imagination. Perhaps your imagination streches further than mine. If so, God speed, but watch out for the potholes.

[Lafayette]

MT: But if nobody will purchase mortgage-backed securities, who do you sell to? With nobody buying the assets the fund is trying to sell, they are forced to try to raise cash in other ways, and problems mount.

The above condenses well enough the idiocy of what happened in the US. The damage done to the reputation of the American banking system is irreparable -- at least for some time to come.

To think that the banking system, under the watchful eye of the Fed, would be allow to repackage this fraudulent risk (yes, fraudulent is the proper word for it) and sell it on international capital markets is incredible.

And, this was done under who's watch at the Fed? Anybody still think that Greenberg is the "saint" of American finance? Look again.

Or that the trust in American banking regulation is irreproachable? Think twice. Anybody feel that key markets (meaning finance) should "regulate themselves"? Think that one through thrice. Preferably whilst you still have job.

All this is part of the pell-mell rush to "make a megabuck" in the American fashion and now, after this latest bit of "exaggerated exuberance", somebody is going to have to pay the piper.

People who play with words deserved to be burnt by them.

[Lafayette]

II: Just because a few dozen single strategy hedge funds go belly up, doesn't mean the 8,000-10,000 that are up there are all bad.

Point well taken. But, again, hedge funds, per se, are NOT the point of it all. Regulatory laxity is.

The major part of the onlookers to this latest financial catastrophe could not care a piddle for "hedge funds". But, when the banking system requires hundreds of billions of dollars overnight to shore up its liquidity, where do you think it comes from, II?

The pockets of those invested in hedge-funds? No, for the most part it comes from central bank reserves ... and we all know who owns those. People like you and me. I.e., national treasuries that contribute to them.

What happened was a disservice to all and it should not have happened. This security risk should never have been allowed to be repackaged and resold to disperse the risk -- because everyone knew it for what it was whilst it was going on.

A scam.

[cm]

Institutional Investor: The key phrase is "fiduciary", or rather violation of fiduciary responsibility. Of course it is always hard to establish absence of good faith.

[David Wozney]

“But like a bank who lends out most of the deposit it receives, ...”

“It can't be stressed too much that the private banks, unlike non-bank lenders, create the money they lend. They do not — as is so widely imagined, even by the bankers themselves — lend their depositors’ money”, according to Harold Chorney, Associate Professor of Political Economy and Public Policy, Concordia University, Montreal; John Hotson, Professor of Economics, University of Waterloo; and Mario Seccareccia, Associate Professor of Economics, University of Ottawa on page 19 of the “The Deficit Made Me Do It!”, published in May 1992.

“Each and every time a bank makes a loan (or purchases securities), new bank credit is created — new deposits — brand new money”, according to Graham Towers, Governor of the Bank of Canada from 1934 to 1954.

[Lafayette]

Chorney : "It can't be stressed too much that the private banks, unlike non-bank lenders, create the money they lend. They do not — as is so widely imagined, even by the bankers themselves — lend their depositors’ money”, according to Harold Chorney"

This is not entirely true. They lend both their depositor's money and whatever they can borrow on capital markets at better than overnight money-market rates - keeping within Reserve requirements.

"Create" does not mean "loan". The state creates money, not bankers. Bankers make loans. It is important not to abuse the word "create".

When sub-prime loans evaporate with the morning dew, there is no "un-creation". Central banks pump reserve money into liquidity to cover the losses. This is "creating money"? Hardly.

[David Wozney]

Re: “The state creates money, not bankers.”

“Appendix E - Money Is Created by Banks
Evidence Given by Graham Towers

Some of the most frank evidence on banking practices was given by Graham F. Towers, Governor of the Central Bank of Canada (from 1934 to 1955), before the Canadian Government's Committee on Banking and Commerce, in 1939. Its proceedings cover 850 pages. (Standing Committee on Banking and Commerce, Minutes of Proceedings and Evidence Respecting the Bank of Canada, Ottawa, J.O. Patenaude, I.S.O., Printer to the King's Most Excellent Majesty, 1939.) Most of the evidence quoted was the result of interrogation by Mr. “Gerry” McGeer, K.C., a former mayor of Vancouver, who clearly understood the essentials of central banking. Here are a few excerpts:

Q. But there is no question about it that banks create the medium of exchange?

Mr. Towers: That is right. That is what they are for... That is the Banking business, just in the same way that a steel plant makes steel. (p. 287)

The manufacturing process consists of making a pen-and-ink or typewriter entry on a card in a book. That is all. (pp. 76 and 238)

Each and every time a bank makes a loan (or purchases securities), new bank credit is created - new deposits - brand new money. (pp. 113 and 238)

Broadly speaking, all new money comes out of a Bank in the form of loans.

As loans are debts, then under the present system all money is debt. (p. 459)

Q. When $1,000,000 worth of bonds is presented (by the government) to the bank, a million dollars of new money or the equivalent is created?

Mr. Towers: Yes.

Q. Is it a fact that a million dollars of new money is created?

Mr. Towers: That is right.

Q. Now, the same thing holds true when the municipality or the province goes to the bank?

Mr. Towers: Or an individual borrower.

Q. Or when a private person goes to a bank?

Mr. Towers: Yes.

Q. When I borrow $100 from the bank as a private citizen, the bank makes a bookkeeping entry, and there is a $100 increase in the deposits of that bank, in the total deposits of that bank?

Mr. Towers: Yes. (p. 238)

Q. Mr. Towers, when you allow the merchant banking system to issue bank deposits which, with the practice of using the cheques as we have it in vogue today, constitutes the medium of exchange upon which I think 95 per cent of our public and private business is transacted, you virtually allow the banks to issue an effective substitute for money, do you not?

Mr. Towers: The bank deposits are actual money in that sense, yes.

Q. In that sense they are actual money, but, as a matter of fact, they are not actual money but credit, bookkeeping accounts, which are used as a substitute for money?

Mr. Towers: Yes.

Q. Then we authorize the banks to issue a substitute for money?

Mr. Towers: Yes, I think that is a very fair statement of banking. (p. 285)

Q. 12 per cent of the money in use in Canada is issued by the Government through the Mint and the Bank of Canada, and 88 per cent is issued by the merchant banks of Canada on the reserves issued by the Bank of Canada?

Mr. Towers: Yes.

Q. But if the issue of currency and money is a high prerogative of government, then that high prerogative has been transferred to the extent of 88 per cent from the Government to the merchant banking system?

Mr. Towers: Yes. (p. 286)

Q. Will you tell me why a government with power to create money, should give that power away to a private monopoly, and then borrow that which parliament can create itself, back at interest, to the point of national bankruptcy?

Mr. Towers: If parliament wants to change the form of operating the banking system, then certainly that is within the power of parliament. (p. 394) ...”

[Lafayette]

DW, you don't get the point ... despite the above post.

Look up the definition of the word "create". Banks do not bring into existence money. They simply exploit the multiplier effect of financial borrowing.

[burritoboy]

What you're describing is not precisely a bank run nor can hedge funds create credit. The money supply is expanded when the hedge fund receives the loan from a bank allowing it to use leverage: i.e., it's the banks (not the hedge fund) creating additional money supply, just as in any other more familiar situation.

Many hedge funds do not allow immediate withdrawal, and I've seen one fund that asked for a three-year lockup (no withdrawals whatsoever) and even then only allowed you to withdraw funds over a period of another three years. Most funds I'm familiar with at most allow monthly withdrawals after a full 31 day warning. (i.e. you ask for a withdrawal on Sept 2, you get your money Oct 31 or Nov 1).

Where the problem more immediately comes from is: all ABS hedge funds use leverage, leverage that's collateralized by the investment portfolio itself. Value of collateral becomes unclear and your leverage provider gets worried.

[David Wozney]

Re: “The state creates money, not bankers.” “Banks do not bring into existence money.”

The following quotes are from http://www.hansard.act.gov.au/hansard/1990/pdfs/19900920.pdf

“The Right Honourable Reginald McKenna, one-time Chancellor of the Exchequer and Chairman of the Midland Bank in the United Kingdom, addressing a meeting of the shareholders of the bank on 25 January 1924, stated:

I am afraid the ordinary citizen will not like to be told that the banks can, and do, create and destroy money. The amount of money in existence varies only with the action of the banks increasing or decreasing deposits and bank purchases. We know how this is effected. Every loan, overdraft or bank purchase creates a deposit, and every repayment of a loan, overdraft or bank sale destroys a deposit.

That came from Post-War Banking by Reginald McKenna.”

“Governor Eccles, one-time head of the Federal Reserve Bank Board of the United States, said in giving evidence before a congressional inquiry:

The banks can create and destroy money. Bank credit is money. It's the money we do most of our business with, not the currency which we usually think of as money.”