Source: https://syntheticassets.wordpress.com/
Timestamp: 2019-04-26 04:03:10+00:00

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Consider the practical questions of how the risks of financing 30 year fixed rate mortgages can be managed. There are two principal sources of risk: credit risk and interest rate risk; and two possible sources of funding: savings deposits and capital markets financing.
Credit risk is the risk that borrowers fail to make their payments. Even the best managed portfolio will have some regular level of default as borrowers are affected by illness and idiosyncratic hazards. Loan origination practices play a crucial role in credit risk, because if the borrowers are not carefully vetted, their likelihood of default will be higher. In addition, because of the regularity of economic cycles and the resulting fluctuations in employment, credit risk also has both a strong cyclical factor and includes the risk of extreme recessions/depressions. Finally, credit risk is also significantly affected by the loan products being offered: loan products that attract a more risky type of borrower can have dramatic effects on credit risk.
Interest rate risk exists because the funding of mortgage lending is typically shorter term than the mortgage loans themselves. That is, interest rate risk exists because of maturity mismatch between assets and liabilities. At any given moment in time the interest rate being paid on a 30 year fixed rate loan is greater than the interest rate being paid on savings accounts or on the capital market instruments used for funding. Interest rate risk exists because the interest rate on the 30 year fixed rate loan stays fixed for 30 years, whereas the interest rates paid on savings accounts and the instruments used for funding are shifting over time. If the revenue being paid into the bank or funding vehicle from the portfolio of 30 year loans falls below the interest rate expense the bank or funding vehicle must pay to fund that portfolio, then losses will force the bank or funding vehicle into bankruptcy. In short, interest rate risk is the risk that the mortgage lender ends up in a nonviable situation where the lender can no longer afford to pay the interest rate necessary to continue to fund the mortgage portfolio. As a result, when maturity mismatch increases, so does interest rate risk: a portfolio of 12 year loans is safer than a portfolio of 30 year loans with the same funding.
It is important to understand that the greater the maturity mismatch between assets and liabilities, the harder it is to manage not only interest rate risk, but also credit risk. Over a 30 year period the likelihood that an extreme, unexpected recession will occur is much higher than over a 12 year period, and the very slow rate of repayment of 30 year loans means that repositioning the portfolio is much more difficult than it is for 12 year loans. In short, short term financing of a 5 year loan portfolio is easier to manage than short term financing of a 12 year loan portfolio, which in turn is easier to manage than short term financing of a 30 year loan portfolio. This fact explains the structure of mortgage lending prior to the Depression, where the safety of commercial banks was considered a paramount goal, and savings and loan associations were less regulated, but attentive to the risks of mortgage lending.
Once one understands the risks of 30 year fixed rate mortgages, the question becomes how it is possible for the private sector to finance them. Let’s go over the options.
First, consider the case of the very short term funding provided by savings and commercial banks. One solution is for the banks to only lend a fraction of their balance sheets to mortgages, say 10 or 20 percent. In this situation, the banking system as a whole can almost certainly manage its way around the risks. On the other hand, there will be very little availability of these mortgages compared to what we are accustomed to today. In order to reduce demand to this level, one would have to assume that 30 year fixed rate mortgages are actually very expensive – at which point other mortgage options are likely to become popular. Arguably this was more or less the situation before the 1930s: there was a purely private bank-funded solution to the mortgage problem, but mortgages were much less favorable to consumers than the 30 year fixed rate mortgage to which we are all accustomed.
So what are the alternatives for savings and commercial banks to fund 30 year fixed rate mortgages at low rates and with general availability. Without some form of government support, there is little reason to believe that it is possible for the private sector to manage the risks of this extreme maturity mismatch when mortgages account for a significant fraction of bank balance sheets. To address credit risk, there needs to be a government backstop for the lenders in the event of a severe recession. In the 1930s when the 30 year mortgage was first introduced, Federal Housing Administration insurance was created to provide this backstop. In 2009-2011 there was a “backdoor bailout” by a vast broadening of Federal Housing Administration insurance and a program of Federal Reserve-financed refinancing of mortgages. Interest rate risk can be addressed by either financial repression that stymies the market forces raising short term interest rates and forces consumers to incur negative real returns on their savings and thus to bear the costs of funding mortgages, or a government backstop that supports the bank mortgage lenders through the period where they are upsidedown on their net interest rate revenue.
Elements of a policy of financial repression were attempted in the 1960s and 1970s, but there was no genuine commitment to stymying market forces (as there was in Nazi Germany, the classic case of financial repression) and as a result by the early 1980s the realization of interest rate risk had left vast swathes of the savings and loan industry bankrupt. Famously, the government instead of providing the necessary backstop promptly attempted through deregulation to allow the bankrupt savings and loans to earn their way to solvency – and succeeded only in making the problem worse. By the time the savings and loan industry was finally bailed out by the government in 1989, the cost of the bailout had increased dramatically.
A standard mechanism for reducing the cost of funding on capital markets is to have a capitalized corporation provide a guarantee to the debt security instead of having it issued by a bankruptcy-remote funding vehicle. A corporate guarantee on the debt ensures that the shareholders of the corporation will bear any losses before the investors do. Under these circumstances the mortgage backed security will bear an interest rate comparable to that of the debt issues of the corporate guarantor. This is a standard means of funding mortgages and is comparable to the system of “covered bond” finance in Europe.
Whether an entirely private corporation will be willing to take on the risks of providing such a guarantee to a securitization of 30 year fixed rate mortgages is I believe unknown. (If you know of an example, please let me know.) The PLMBS that were issued in the US in the early naughties did not have such a guarantee. By contrast, government guarantee of the securitization of 30 year fixed rate mortgages is definitely a viable model, as illustrated by Ginnie Mae, which still issues MBS today.
There is another hybrid model of capital market funding of 30 year mortgages: that of Fannie Mae and Freddie Mac, which were private, but “government-sponsored” corporations (“GSEs”) from 1970 to 2008. These GSEs provided a corporate guarantee of all of their securitizations which put their shareholders at risk, and their longevity is indicative of the fact this model is at least potentially viable. Even though the GSEs had shareholder funds at risk, they were highly regulated and received government support of their debt in the form, for example, of legal preferences for GSE debt over general corporate debt as an asset that may be held by banks and the Federal Reserve (and other regulated entities). Timothy Howard makes the case in The Mortgage Wars for the success of this model.
Under the GSE structure, government support allows the corporations to raise both short and long-term funds cheaply, regulatory requirements set the level of capitalization and monitors that the vehicle is meeting goals for the provision of low-cost mortgage finance, and the private capital at risk creates incentives for careful management of interest rate and credit risk. The corporate guarantee is the key element that makes the GSE structure work: it is in the interests of GSE to carefully supervise the quality of the mortgages it securitizes; in economics jargon incentives are aligned. Thus, the GSEs set the mortgage standards in the US mortgage market for decades – the word “subprime” originally meant that a mortgage was below GSE standards. They reviewed loans carefully and were able to weed out from a plethora of newly introduced loan characteristics those that were consistent with quality mortgages and those that were not. As a result, the securitization market that collapsed in 2007 was the private-label securitization market, not the GSE market.
Overall, the conclusion one draws from this discussion is important: there is virtually no reason to believe in the feasibility of the 30 year fixed rate mortgage as a financial product in the absence of some form of government support.
My next post will study what happened when the government, instead of recognizing that if it wanted to support the 30 year loan as a financial product, it would have to underwrite many of its risks, chose to distort financial regulation in order to promote cheap finance for housing.
 Because the norm with 30 year fixed rate mortgages is to permit payoff without a prepayment penalty, when 30 year interest rates fall, the interest rate being earned on the portfolio tends to fall quickly as borrowers choose to refinance their loans. There is no counterbalancing effect when 30 year interest rates rise. This makes the interest rate risk problem even more severe, and is known as prepayment risk.
 Note that in the 1930s the focus of concern was credit risk, not interest rate risk, because the gold standard had precluded interest rate risk for the preceding generation or two and the immediate problem was deflation and low interest rates.
 Owners of shares in Fannie Mae and Freddie Mac make the case that one should add the conversion and use of the GSEs as instrumentalities of the government to this list (Howard 2014: 250-53; http://www.housingwire.com/articles/print/29008-paying-fannie-and-freddie-investors-was-never-part-of-the-plan).
 The permissive attitude to the growth of Eurodollar accounts and money market mutual funds precluded a successful policy of financial repression.
 Howard (2014: 131) explains the flaws of PLMBS. Because there is no corporate guarantee, there is no incentive for credit standards to be enforced. Thus, when mortgage lenders generate new risky characteristics for loans and rating agencies make risk judgments without adequate or applicable historical data, there is nothing to stop these loans from being securitized and sold on to investors. In this environment relaxed underwriting can bring in new buyers who would not have qualified in the past.
Over the last quarter of the 20th century mortgages grew to make up the principal asset in commercial bank portfolios and concomitantly housing now plays an increasingly important role in the economic cycle (Jorda Schularick & Taylor 2014). The shift in commercial bank balance sheets is depicted in Charts 1, 2, 3, and 4 all of which are drawn from the historical data available on the FDIC’s website: https://banks.data.fdic.gov/explore/historical. The vertical lines on the charts divide them into three eras: the war and post-war era up until 1965, the era of inflation from 1965 to 1981, the era of regulatory reform from 1981 to 2008, and the post-crisis era.
Chart 1 provides context, giving an overview of how the asset side of the commercial banks’ balance sheet has evolved over time. During World War II Treasuries (held as investment securities) and cash accounted for more than 80% of bank balance sheets. This declined fairly steadily, so that in 2007 cash and investment securities (which now were dominated by Agency obligations) fell below 20% of assets. This decline was mostly accounted for by an increase in bank lending.
Chart 2 shows that the dramatic increase in commercial bank lending after World War II only represented an increasing flow of bank funding into business activity up until the early 80s (with a decline after the oil price shock of the mid-1970s). (Note that “C&I loans” is short for “commercial and industrial loans.”) From the early 1980s on, commercial bank business lending is mostly on the decline as a percentage of activity, and instead real estate loans begin to dominate commercial bank balance sheets. Furthermore, because most of the Agency securities in which commercial banks invest are also mortgage-backed, by 2004 an unprecedented 40% of commercial banks balance sheets are supporting real estate and that fraction has barely declined up to the present.
Chart 3 focuses on commercial bank loan portfolios and shows how the fractions of the commercial bank loan portfolio that went to businesses, to real estate and to individuals were remarkably stable up through the early 1980s except for a deviation presumably caused by the oil price shock of 1973. It also shows that during the era of regulatory reform business lending dropped from 40% of bank loans in the post-War era to 20% of bank loans today. At the same time real estate lending rose from 25% of bank lending to almost 60%. We also see that residential real estate lending makes up about 60% of commercial bank real estate lending, and except for a few years in the late 1980s has consistently comprised more than half of commercial bank real estate lending.
In short, the data makes us ask: What happened to commercial banks during the era of regulatory reform? Furthermore, the pattern of the data in Chart 3 indicates that residential mortgage policy might have something to do with it.
1930s monetary theory held that the use of demand deposits to finance long-term assets like real estate would foster asset price bubbles in the long-term assets thus financed due to the feedback loop between bank expansion of demand deposits, loans, and asset prices. As a result, in the 1930s commercial bank real estate loans were funded by savings and time deposits and accounted for only a fraction of them, typically about 40%. And savings deposits made up only a fraction of the deposit base compared to demand deposits. Thus, it is worth looking at what has happened to commercial bank liabilities, too.
Chart 4 shows that commercial bank liabilities were composed mostly of demand deposits in the immediate post-war period, but their share declined steadily from about 1955 to 2008. Unsurprisingly the most dramatic decline took place during the inflationary era when most depositors were looking for a way to avoid holding a non-interest bearing asset. Savings and time deposits make up by far the majority of bank liabilities today. Even so, the growth in real estate loans up until the 2007 crisis was much faster. As a result, the ratio of real estate loans to savings plus time deposits grew steadily from 1983 to 2007 (see Chart 5). Another point to take into consideration is that savings deposits are much easier to use for transactions today than they were 70 years ago, as there are now a variety of means by which savings are transferred automatically in order to cover checks.
Since real estate loans appear to have played a very important role in regulatory reform’s transformation of commercial banking, it’s worth taking a look at what was going on with the institutions that were set up in the 1930s to fund real estate loans, the thrifts. The FDIC has data on the thrifts under the title “Savings Institutions” dating from 1984.
Keep in mind, however, that these balance sheet data mask the fact that the thrift industry stopped growing at the end of the 1980s. Thus, even though thrifts accounted for approximately one-third of depository institution assets from the post-war period through 1988, today they account for only about 5% of depository institution assets. In short, what is going on in the diagrams below matters less and less over time to the economy as a whole.
Charts 6 and 7 demonstrate that for thrifts the era regulatory reform did not affect their activities. They would continue to specialize heavily in real estate loans right up until the 2008 crisis. And only in recent years have the thrifts begun to diversify their activities to a significant degree. Chart 8 presents thrift liabilities and demonstrates that aside from an increase in FHLB loans and in brokered deposits in the years preceding the recent crisis, the liability side of thrift balance sheets didn’t change much either.
To make very clear how the financial system as a whole evolved over the era of regulatory reform it is useful to combine the balance sheets of the commercial banks and the thrifts. (Together they cover close to 95% of depository assets. Credit Unions are omitted because I do not have that data.) Chart 9 presents holdings of loans and securities as a percent of assets. We see that changes in the aggregate balance sheet from 1984 to 2007 are in general not large with a few exceptions: the percent of combined commercial bank and thrift balance sheet devoted to business lending declined by 31%, while real estate loans increased by 21% and agencies increased by 48%.
On the other hand, Chart 10 presents the same data as Chart 9 with two differences: Both real estate loans and agencies on commercial bank balance sheets are separated from those on savings institution balance sheets. Chart 10 shows the primary transition that took place amongst depository institutions during the era of regulatory reform. Commercial banks started funding the mortgages that the shrinking thrift industry was no longer financing.
So what conclusion should we draw from these charts? The era of regulatory reform was one in which commercial banks grew to look more and more like the thrifts on both the deposit and liability sides of the balance sheet. As a result, the effect of the regulatory response to the instability of the thrift institutions in the 1970s and 1980s was to reform the banking system so that it would be more like the unstable institutions. One result of this reform was that when the 2007-09 crisis blew up the U.S. banking system was structurally unsound and had to be saved by a simply grotesque bailout of the commercial banks.
Arguably another result, as I will argue in an upcoming post, was that the new structure of the banking system fostered the growth of a housing price bubble. That post will also attempt to fathom why this rather obviously destabilizing reform of the banking system took place. Before doing so, however, in my next post I discuss the character of 30 year fixed rate mortgages and the challenges of financing them.
Thus, in the financial reform of the 1930s investment banking was separated from commercial banking and the existing distinction between mortgage lending institutions and commercial banks was preserved. This compartmentalized structure lasted for less than 40 years, as the inflation of the 1970s led to innovations and policy decisions that created deep fissures in the structure of the segmented system. By the 1980s reform was necessary. Both the policy decisions of the 1970s and the reforms of the 1980s were based on a completely different model of the financial system than that on which the 1930s structure had been built.
The discussion of this history will be separated into two parts: (i) the financial reform of the 1930s and the evolution of the segmented financial system through the 1960s, and (ii) the dissolution of that system. This blogpost addresses the early history.
In the years preceding the Depression mortgage lending was provided by a wide range of institutions including savings and loan associations, savings banks, mortgage companies, commercial banks and insurance companies. Only the savings and loan associations offered longer-term amortizing loans of up to 12 years. More typical loans were for five years or less and required only interest payments until maturity when a balloon payment of the whole principal was due.
This market structure reflected basic principles of asset-liability matching as they were applied to financial institutions at the time. In order to limit the likelihood of a liquidity crisis, commercial bank loans that were funded by demand deposits were generally short-term and/or callable. Longer term loans, such as mortgages, were funded by savings deposits which often required that notice be given before withdrawal. Thus, commercial banks were actively engaged in mortgage lending, but only with a small portion of their funding, since most of their funding was demand deposits. Even so, commercial banks were prohibited by statute from lending on mortgages of more than 5 years (Eccles 1937: 164). Thus, it was the savings banks and savings and loan associations that put most of their funds into mortgage lending.
The term savings and loan association reflects the concept underlying this cooperative means of mortgage finance. A member in the association was expected to keep his or her savings with it, earning a good rate of return, and in exchange the member was eligible for a loan. Thus, these cooperatives did not intermediate between a group that saved money and a distinct group that borrowed money. Instead, these mutual associations were created because those who were saving money would also need to borrow money to purchase property. Members had an interest in establishing a savings account in order to meet the eligibility requirements of the savings and loan association for a loan, and would often continue placing their savings with the association even after they had paid their loan since a competitive rate of interest was earned while at the same time they were supporting other members of the community.
The 12-year amortized loan was the means by which the savings and loans made it possible for the middle class to afford a home, while at the same time managing the risks of funding these purchases with savings accounts (Weiss 1989: 109). A $5000 home loan at 6% per annum amortized over 12 years results in a monthly payment just under $50 or about the weekly wage of a skilled urban worker. (At 9% interest the payment would be $57 per month.) At the same time even in the first year of a 12 year loan 6% of the principal is repaid, and on average across an evenly spaced portfolio of loans over 8% of principal is paid every year. In short, this was the type of loan that was both a little hard for a savings bank to manage and little bit of a stretch for a lower-middle class consumer at the time. By contrast, 30 year fixed rate loans strongly favor the consumer, and are very difficult for a depository institution to manage: A $5000 home loan at 6% amortized over 30 years results in a monthly payment of $30, just over 1% of principal is repaid in the first year and on average these loans repay 3% of principal every year.
In short, the reason that 30 year mortgages were not offered in the years preceding the Depression is because the savings banks funding mortgages could not possibly hope to manage the risks of lending over that time horizon. With 12 year loans 58% of their funds were committed for more than 5 years. With a portfolio of 30 year loans 83% of their funds would be committed for more than 5 years. Given that their liabilities were all short-term and a lot can change over the course of just 5 years, the 12 year amortized mortgage was considered to be the limit of risk that it was appropriate for a savings institution to take – for good reason.
On the other hand, this loan structure – and particularly the fact that many mortgages were insurance company, commercial bank, or personal loans that were only for about 5 years and were not amortizing – meant that a severe recession could cause defaults, foreclosures and declining housing prices. As a result, real estate crises in which many lenders failed were regular events: the late 1890s and mid-1920s are examples. Thus, the housing troubles of the 1930s differed mostly in terms of their severity and the nationwide reach of the crisis. During the Depression housing became a national problem, and it was addressed at the Federal level. Indeed, alongside employment and social security, preserving homes was one of the three goals President Roosevelt announced in his 1935 State of the Union speech.
The Federal Home Loan Bank System was established in 1932 under President Hoover (Pub. L. 72-304). It was modelled on the Federal Reserve System with 12 regional banks and a governing board, the Federal Home Loan Bank Board, in Washington, D.C. It was designed as a mutual association of savings institutions (also known as thrifts), all of which jointly guarantee Federal Home Loan Bank debt issues. These debt issues are used to fund purchases of mortgages originated by member institutions. Thus, the system was designed to serve as a source of liquidity for thrifts, which in 1932 financed over 46% of all residential mortgages.
Unfortunately, the Federal Home Loan Bank Act was a matter of too little, too late and did little to mitigate the housing crisis. Furthermore, like banks, many thrifts failed in 1932 and 1933. Unlike banks, thrifts were not covered by FDIC insurance when it was created in the Glass-Steagall Act of 1933, and as a result over the course of subsequent months savings migrated from thrifts to banks. By 1934 the thrifts’ share in the mortgage market had dropped to 37% (Lea 1996), a dramatic 20% decline over the course of two years.
In 1934 the National Housing Act (Pub. L. 73-479) was designed to stimulate the building trades and promote employment in them by creating both the Federal Savings and Loan Insurance Corporation (FSLIC) to support the thrifts, and the Federal Housing Administration (FHA) to support other mortgage lenders (Cong. Rec. 1934: 11189). The FSLIC was designed to stabilize the thrift institutions, just as the creation of the FDIC had stabilized the banking system a year earlier. The thrifts’ share of the mortgage market would slowly recover reaching 40% in 1952 and would peak at about 55% in the mid-1960s (PC on Housing, 1982; Lea 1996).
The FHA facilitated non-thrift mortgage lending by creating a consumer-friendly long-term amortized mortgage product that commercial banks and insurance companies could invest in. The FHA addressed the fact that these mortgages were not viewed as appropriate investments for banks and insurance companies by providing government insurance to long-term fixed-rate amortizing mortgages that met specified underwriting criteria. The insurance premium of one-half a percent on the principal value of the loan was paid by the borrower on top of an interest rate with a statutory maximum of 6%. At the same time the new law permitted national banks to hold FHA-insured loans despite the general statutory prohibition on loans in excess of 5 years or in excess of 50% of the property value. (State legislatures promptly passed similar enabling legislation for state-chartered banks, Eccles 1937.) Thus, the FHA program served the needs of insurance companies and commercial banks, and their share of mortgages outstanding grew from 10% each in 1932 to about 20% each in 1952 (Lea 1996).
By slowly increasing the participation of commercial banks and insurance companies in the mortgage market and by promoting consumer-friendly mortgages, the FHA almost certainly played a positive role in the recovery from the Depression and from World War II. This, however, came at a cost as the FHA played a dramatic role in shaping not just the structure of US mortgage markets, but also patterns of housing construction and of home-ownership in the US with vast and long-lasting unintended consequences.
America’s urban fabric places great emphasis on suburban living and on cars as means of transportation. Troubled inner-cities surrounded by well-to-do suburbs did not develop by accident, but in no small part because the FHA in its effort to promote the construction industry favored large, new buildings over the existing housing stock and more modest sized homes. Urban construction frequently did not qualify for insurance. The very structure of the typical American subdivision is a product of FHA handbooks, including the preference for strip malls over ubiquitous corner shops (Hanchett 2000; Zuegel 2018).
The FHA also played a huge role in institutionalizing redlining – or racially discriminatory practices – throughout the country and demanded racial and class-based segregation of subdivisions (Hanchett 2000; Brooks & Rose, 2013). And one should remember as one discusses the extraordinary advantages of federal support for housing finance that the groups that were deliberately excluded from these advantages are much less wealthy today than they would have been if the same advantages had been extended fairly to all citizens (Baradaran 2017).
But our focus here is on how the FHA transformed mortgage markets. The FHA played a huge role both in the standardization of mortgages and in the reduction of the costs paid by the homeowner: the 30-year fixed rate mortgage with a maximum 90% loan to value became the norm, as did relatively low interest rates. Prior to the FHA the typical first mortgage was for up to 60% of the home’s value at a rate between 6 and 10% (depending on location) and most borrowers also carried additional mortgages at higher rates (Eccles 1937; FHLB Review 1934: 18). Although the thrifts did much less FHA insured lending, they too extended the terms of their loans and increased the amount they were willing to lend against the value of the home.
The National Housing Act (specifically Title III of the Act) had envisioned that liquidity would be provided to the non-thrift mortgage market through the creation of federally chartered, but privately owned, national mortgage associations that would stand ready to buy FHA insured loans. In fact, not one such association was formed – possibly because the thrifts had successfully lobbied against giving the national mortgage association’s debt the same tax exemption as the Federal Home Loan Banks’ debt (Cong. Rec. 1934: 11181, 11208, 12566). To address this situation in 1938 the government-owned Federal National Mortgage Association (Fannie Mae) was created. In 1948 (Pub. L. 80-864) Fannie Mae was made a federally chartered institution and authorized to purchase in addition to FHA loans the Veteran Administration-insured loans that had been created by the post-War GI Bill (Pub. L. 78-346).
As the economy recovered and Fannie Mae’s role in the mortgage market increased, concerns were raised over an excessive government role in the mortgage market. Transition to private ownership on the model of the Federal Home Loan Banks – that is lenders who sold loans to Fannie Mae had to also hold Fannie Mae stock – was initiated in 1954 (Pub. L. 83-560). In 1964 Fannie Mae was authorized to bundle FHA and VA mortgages together and to sell interests in the bundles. That is, Fannie Mae was authorized to securitize FHA and VA mortgages. At the same time national banks, thrifts, and FHLBs were authorized to invest in these securitizations (Pub. L. 88-560). In 1968, however, Fannie Mae was separated into two entities (Pub. L. 90-448): Ginnie Mae (the Government National Mortgage Association) remained a government-owned entity that packaged together FHA and VA loans and sold the securitizations to private investors; Fannie Mae was transformed into a government-sponsored private corporation that was required to allocate a reasonable portion of its business to mortgages on low- and moderate-income housing and was authorized to securitize mortgages, subject to government supervision.
Observe that, because the thrifts had never relied heavily on Fannie Mae’s facilities, it was a commercial bank and insurance company-owned entity. The thrift industry immediately recognized that if Fannie Mae was authorized to securitize privately-originated mortgages, this could leave the thrifts at a disadvantage, so they lobbied for a similar facility. Thus, in 1970 the Federal Home Loan Mortgage Corporation (Freddie Mac) was created, as an entity owned by the FHL banks and run by the FHLB Board with authority to purchase conventional mortgages (with a limit on the amount and on the loan-to-value of each loan) and securitize them (Pub. L. 91-351). This same law explicitly authorized Fannie Mae to purchase conventional mortgages on the same terms. This had the effect of establishing both a statutory standard targeting low- and moderate-income housing and a statutory prudential limit on the riskiness of the mortgages.
Let’s pause for a moment and consider the structure of US mortgage markets in the post-War years. It was divided into two segments: the non-thrift financial institutions supported by Fannie Mae and the thrifts supported by the FHLB system, FSLIC deposit insurance, and later Freddie Mac. Up to 1968, the non-thrift financial institutions mostly originated FHA and VA insured loans that could be sold to Fannie Mae, and conventional loans (that is, those that were not government insured) were mostly originated by the thrifts. This structure had worked for most of the 1950s and 1960s, because the growth of lending by the thrifts had met the needs of the public and made government-insured loans a decreasing percentage of the mortgage market.
The problematic nature of private institutions funding 30 year loans with short-term deposits was in evidence by 1965 when the Federal Funds rate rose over 4%. Competition between thrifts led them to increase their savings account rates, which raised safety and soundness concerns at the Federal Home Loan Bank Board (Hester 1969). In 1966 Regulation Q, which had long governed the maximum interest rate paid on commercial bank savings deposits, was extended to the savings accounts held at thrifts and authority was given to the FHLB Board to set the maximum rate. The long-term effect of Regulation Q was, however, that as interest rates rose, the thrifts had fewer deposits with which to finance their activities, and through the early 1970s the diminished lending capacity of the Savings and Loans was a growing problem for the mortgage market.
As was noted above, 1930s financial sector regulation was constructed on the premise that commercial banks are special because their primary liabilities and thus their primary sources of funding circulate as money. Commercial banks, like the savings and loan associations, had developed because the same businessmen who often had positive cashflow – and thus money to put in the bank – also were very aware that sometimes they had negative cashflow and that short-term loans could be very valuable under these circumstances. These businessmen kept their money with their local bank, not because the were “savers,” but because by doing so they could also rely on the bank to advance them money when they needed a short-term loan. The commercial bank was thus a coordination device that converted the local money supply into a source of short-term funding for local businesses. That a bank-based money supply expands the working capital available to the business community was a fundamental precept of monetary theory at the time.
In short, in the 1930s money was understood to be a network phenomenon that – to a limited extent – the banks could expand at will without affecting prices. Of course, if the money supply expanded beyond a certain threshold, it could cause either localized inflation, for example when a particular type of long-term asset was being financed by the issue of bank money, or general inflation when an excessive monetary expansion was not so targeted. In short, in the 1930s monetary expansion was understood to be the cheapest way to fund productive activity both for the banks and for the economy as a whole as long as the coordination problem of not issuing too much money and thereby setting off inflation and instability could be addressed (Schumpeter 1939). For 1930s regulators the challenge of financial regulation was to harness the extraordinary power of monetary finance and at the same time control it.
The 1929 stock market crash had been fed by commercial banks offering accounts that invested in stock market margin loans paying as much as 10% per annum – for an overnight, overcollateralized loan – despite the jawboning of the Federal Reserve and influential Congressmen (Senate 1933). In short, the stock market crash had made it clear that the Federal Reserve did not have adequate control over the commercial banking system and the use of funds created by expansion of the money supply (Sissoko 2018). 1930s policymakers decided to turn the monetary system into one that was susceptible of control.
While it is generally understood that the Glass Steagall Act separated commercial banks from investment banks (or broker-dealers), the full impact of the Act on the banking system is underestimated. The Glass Steagall Act was designed to protect deposit-taking institutions by (i) preventing them not just from acting as broker-dealers, but also from intermediating security-backed loans to broker-dealers; (ii) empowering the Federal Reserve (a) to regulate the quantity of security-backed loans held by banks as well as interest rates paid by them on deposits, and (b) to replace bank officers and directors who fail to comply with banking laws or to respond to safety and soundness warnings; (iii) prohibiting a bank from lending to its own executive officers, and limiting loans to affiliates and investments in bank premises; (iv) setting capital requirements for all Federal Reserve member banks; (v) creating the FDIC to provide federal deposit insurance to commercial banks; and finally (vi) prohibiting broker-dealers from receiving deposits and requiring state or federal examination and supervision over any deposit-taking institution. For national banks the Act also imposed limits on the interest rate that could be charged on loans; as the limit was the higher of the state usury limit or 1% over the 90-day commercial bill rate, presumably the goal was to limit the risk involved in any national bank loan.
In short, the Senate’s concern with the use of bank loans and their destabilizing flow into securities markets was addressed from every angle. Federal Reserve member banks were forced to spin off any affiliates whose principal activity was broker-dealing (“the issue, underwriting, or distribution of securities”). And broker-dealers were prohibited from taking deposits. And member banks were prohibited from having an officer or director who was also an officer, director, or manager of a broker-dealer. And directors, officers, and employees of any bank organized or operating under the laws of the US were prohibited from being at the same time the director, officer, or employee of a business that makes loans secured by the collateral of stocks or bonds. And every deposit-taking institution was required to be subject to either state or federal examination and regulation. And Federal Reserve member banks were prohibited from intermediating non-bank loans to the broker-dealers if they are backed by securities. And the Federal Reserve was required to set limits on direct bank lending to broker-dealers that is secured by stock or bond collateral.
As a result of this structure the flow of funds from banks that had access to the Federal Reserve discount window into securities-based lending was strictly regulated by the Federal Reserve, and this was an essential part of the structure designed in the 1930s to stabilize the financial system. While federal deposit insurance, statutory capital requirements, constraints on self-dealing, and the additional authority over banks granted to the Federal Reserve surely also played a role in the decades of financial stability, it is a mistake to forget that the first goal of the Act was the firewall it constructed between deposit-taking institutions and securities markets.
Overall, the goal of the segmented structure created by the Glass-Steagall Act was to support a liberal flow of bank money – which monetary theory at the time viewed as playing a crucial supporting role in the circular movement of economic activity – while preventing that liberal flow of money from playing a significant role in the finance of capital market assets or real estate. This structure remained intact through the 1960s, until the inflation of the 1970s coincided with a shift in monetary theory that no longer viewed the flow of commercial bank money as both essential and in need of control. Thus, the 1970s were years of dramatic financial innovation that set the financial system on a very different path from that laid out in the 1930s. The history of this evolution is the topic of the next post.
 Mortgage companies were intermediaries that sold whole loans or covered bonds – that is, bonds guaranteed by the mortgage company – to investors including commercial banks and pension funds.
 See Michael J. Lea, Innovation and the Cost of Mortgage Credit: A Historical Perspective, 7 Housing Pol’y Debate 147, 154-59 (1996); Marc A. Weiss, Market and Financing Home Ownership: Mortgage Lending and Public Policy in the United States, 1918-1989, 18 Bus. & Econ. Hist. 110, 111-12 (1989); Daniel Immergluck, Private Risk, Public Risk: Public Policy, Market Development, and the Mortgage Crisis, 36 Fordham Urb. L.J., 447, (2009); David Min, Sturdy Foundations: Why Government Guarantees Reduce Taxpayer Risk in Mortgage Finance (Working paper: 2012).
 I am simplifying here by describing the situation with respect to the maximum term of a savings and loan mortgage of the 1920s.
 Note that another similar predecessor of the FHLB system was the Federal Farm Loan Act of 1916 (Pub. L. 64-158) which established 12 Federal Land Banks which were mutual associations owned by national farm loan associations and supervised by the Federal Farm Loan Board, and was designed to provide fairly priced credit to farmers. It was restructured in 1933 under the Farm Credit Administration which also refinanced mortgages for farmers. The Farm Credit System still operates today. See Quinn 2016.
 The crisis was also addressed in 1933 by two additional programs, the Home Owners Loan Corporation and the Reconstruction Finance Corporation, which purchased respectively defaulted mortgages and the stock of bankrupt banks and thrifts. Because these programs did not continue, they are not relevant to our discussion. Note also that the federal charter for savings and loans was created by the 1933 Home Owners Loan Act.
 This statutory maximum stayed in place until 1968 (Pub. L. 90-301).
 As the spouse of an architect, let me add that the real estate industry’s focus on square footage over quality living spaces has meant that the whole housing stock is of remarkably low quality in terms of the use of space and quality of life. Visitors from Europe sometimes remark on this. The FHA favored the “efficiency” of large operations over small craft builders (Hanchett 2000).
 Note that in 1959 Fannie Mae’s statutorily permitted investments had been expanded to include “obligations which were lawful investments for fiduciary, trust, or public funds” (Milgrom 1993: 83).
 For example Wicksell (1898: 135) wrote: “But money, which is the one thing for which there is really a demand for lending purposes, is elastic in amount. Its quantity can to some extent be accommodated—and in a completely developed credit system the accommodation is complete—to any position that the demand may assume.” See also Willis, American Banking 3-4 (1916); Dunbar 1909 13-14, 18.
Derivatives are financial contracts that do not involve direct investment in productive activity, as stocks and bonds do, but instead reference such contracts (or other phenomena including stock market indexes and even the weather). In short, they are called derivatives, because their value is derivative from that of other assets. While derivatives contracts take many forms, for the purposes of this post it is enough to understand a specific derivative, a futures contact. A futures contract is a standardized contract to purchase/sell a specific amount of a specific asset at a specific price on a specific future date.
Consider an example, in which I agree in December 2018 to sell 100 shares of Apple stock at a price of $150 a share (the current market price) on May 15, 2019. I will call the person who takes the other side of this agreement, my counterparty. Whether the market price of Apple is $140 or $158 on May 15 does not affect the price at which our contract will settle, because the whole point of a futures contract is to fix the price of the contract on the future date. For the purposes of discussion let’s assume that the price on May 15 turns out to be $158. Since I sell my shares at $150, I have $800 less, that is $8 less per share, than I would have if I had simply waited to sell my shares. Similarly, my counterparty has $800 more than she would have if she had simply waited to buy the shares.
Why would I have chosen to enter into this contract? If I owned Apple shares maybe I knew in December that I would need the money on May 15, but didn’t want to sell in December for tax purposes and was worried that the price would fall in the meanwhile. Alternatively, maybe I don’t own Apple shares, but have reason to believe that the price is going to fall over the next six months and want to have the opportunity to sell shares that I will be able to purchase at low price (as I expect to be the case in May) while selling at high price. In the first case, I am protecting myself against risk of loss – or hedging, and in the second case I am speculating on the price of the shares.
Thus, a crucial aspect of a derivatives contract is that the same contract can be used either to hedge an exposure – i.e. to insure against an existing risk – or it can be used to speculate on a change in prices. The derivatives contract itself will not give any indication how it is being used. If the owner of shares enters into a contract to sell them in the future, that is a means of protecting the owner against the risk of loss, and it would not be considered a wagering contract under the traditional law governing derivatives. Traditional gambling law applied only to derivatives where no contract participant was hedging, but instead both were speculating (in opposite directions) on a price movement.
With this introduction let’s get into some details.
Britain’s Gaming Act of 1845 laid a cornerstone of Anglo-American securities regulation: wagers, including derivatives that could be characterized as wagers, were void and could not be enforced as contracts. The reasoning behind this approach was cost-benefit analysis. Because a wager, by definition, involved two parties who did not have a real economic interest or productive purpose at stake, the benefit of enforcement was necessarily small and deemed not to be worthy of the costly expense of judicial resources (H.C. 1844: v-vi; see also testimony of Daniel Whittle Harvey, Esq., Commissioner of the City Police Force, Honorable Mr. Justice Patteson, and John Bush, Esq., Attorney and Solicitor).
In Britain, as in the US, the real world implications of a law are often determined only after the courts have interpreted the text of the law and developed a legal test that will be used to apply the law. In 1851, Grizewood v. Blane, 138 Eng Rep 578, 584 (C.B.), interpreted the 1845 Act, establishing a seminal precedent that would undergird Anglo-American securities law for the better part of a century: if one of the parties genuinely intended to deliver/receive the underlying asset (typically a question of fact for the jury), the transaction was not a wager, but instead a valid contract. Over the next 50 years many US state legislatures adopted similar gaming laws and many US courts cited Grizewood v. Blane on the interpretation of such statutes with respect to financial transactions. The Supreme Court affirmed this interpretation in Irwin v. Williar, 110 US 499 (1884).
Let us apply this legal test to the example given in the introductory paragraphs. If I am hedging my need to sell 100 shares of Apple in May, then the whole point of the transaction is that I expect to sell (and deliver) my shares. On the other hand, if I am speculating, then I don’t have any shares to sell, and it’s easiest to just pay the difference between the contract price and the actual price in May. In this example, I pay my counterparty $800 without a transfer of shares. The fact that I own shares and need to sell them in May would be strong evidence of my intent to deliver, and therefore that the contract is not a wager. By contrast, the absence of any such evidence together with the presence of a pattern of entering into futures contracts and settling differences without ever taking ownership of shares is likely to be viewed as evidence that I am speculating. If the same is also true of my counterparty, then the derivative is a wager. As noted, in practice the evidence on each party’s intent was typically submitted to the jury so the jury could make the factual determination with respect to each party.
During this period derivatives contracts, particularly those that were typically settled by paying price differences, were at risk of being deemed unenforceable in court. Because settling by paying price difference was common on the Exchanges, they had to develop their own mechanism by which they could enforce the claims of parties to these contracts. That mechanism was margin, which is a synonym for collateral. Upon entering into a derivatives contract a trader was asked to post to the exchange margin that would cover a portion of the value that the trader might end up owing on it. And on a regular basis the exchange would reevaluate the contract and change the amount of margin that must be posted to reflect how the contract had changed value over time. In this way, if the trader went bankrupt the exchange had the means to make sure payment was still made on the contract.
In short, the system of margining derivatives contracts was designed for an environment where legal enforcement of contracts was not likely to be available to traders. This alternate system for ensuring payment on derivatives conflicted with the bankruptcy code which sought to catalog all of a bankrupt’s assets and distribute them fairly across creditors. The Supreme Court in 1876 created a carve-out for exchanges, allowing them to process transactions according to their rules and indeed even allowing them to use the proceeds from the sale of the bankrupt’s seat on the exchange to settle any remaining debts on the exchange – all outside the reach of the bankruptcy court (Hyde v. Woods, 94 US 523, 1876). This special status was preserved for commodities exchanges when the Bankruptcy Code was revised in 1978 by allowing commodities brokers to foreclose on margin despite a bankruptcy. In 1982 the contractual rights set forth by the rules of securities exchanges were also exempted from bankruptcy (Pub. L. No. 97-222).
In the early 20th c. the invention of the telegraph posed an existential crisis for the Exchanges as their prices were instantly transmitted for off-exchange trading, threatening not just members’ income, but the price discovery process itself (Levy 2006). This led in 1905 to a Supreme Court determination that exchange-traded contracts were a special category due to the important role they play in setting prices for the business world, CBOT v. Christie Grain, 198 US 236 (1905). This decision distinguished exchange-traded contracts from off-exchange contracts and deemed only the former legally enforceable. The wagering laws that had been enacted at the state level continued to apply to derivatives contracts that were not traded on an exchange.
The Commodities Exchange Act of 1936 was therefore building on existing law when it prohibited trade in derivatives referencing commodities with two exceptions: exchange-traded contracts and contracts where the intent was to deliver the underlying. In 1974 when the CFTC was created and tasked with enforcing the Act, the definition of a commodity was deliberately amended to cover not just virtually all goods, but also “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in … .” In short, the CFTC was granted jurisdiction over derivatives referencing virtually anything, except for categories that would be explicitly excluded, including currencies, government bonds and mortgages that were considered the domain of banks, and options on securities that were removed to the sole jurisdiction of the SEC.
As a result, during the 1980s there were two tiers of regulation governing derivatives. At the Federal level the CFTC Act made derivatives presumptively illegal, unless they were traded on an exchange, the intent was to deliver the underlying, or they were explicitly excluded from the CFTC’s jurisdiction. And at the state level derivatives contracts were void unless they either served to insure one party from an existing risk or the intent was to deliver the underlying.
At the same time, subsequent to the Savings and Loan crisis there were growing markets in new categories of derivatives, interest rates swaps which reference Treasuries, and foreign exchange swaps. The 1974 Treasury Amendment’s exemption of commercial banking activities excluded some such derivatives from the CFTC’s jurisdiction. By 1985, however, products outside the exemption were being developed, and US investment banks were prominent dealers in this market alongside three major commercial banks. These dealers formed the International Swaps Dealers Association (ISDA) with the explicit goals of standardizing the unregulated contracts to facilitate trade, and addressing accounting and regulatory issues. Effectively the ISDA was acting as a Self-Regulatory Organization (SRO) like the National Association of Securities Dealers, but without any supervising regulator. The market grew rapidly and increased tenfold from 1986 to 1990. (Sissoko 2017).
In 1990 at the request of the ISDA the Bankruptcy Code was amended to exempt interest rate and currency swaps as well as “any other similar agreement” from provisions of the Code (Pub. L. No. 101-311). Observe that, whereas the original Bankruptcy Code exemptions had only been granted to the contractual rights created by the rules of the regulated Exchanges (and related SROs), in 1990 these exemptions were granted to unregulated financial contracts and to contractual rights founded in common law; in short, this new exemption was much broader than the 1982 exemption. Having opened this breach in the financial regulatory structure, industry lobbyists spent the next decade and half forcing the gap open as wide as possible.
A 1992 law granted the CFTC the power to exempt any contract from its oversight and by doing so to preempt the application to the exempt contract “of any State or local law that prohibits or regulates gaming or the operation of ‘bucket shops’” (Futures Trading Practices Act, Pub. L. No. 102-546). The structure of this exemption power was unwise, and set a dangerous precedent. In order for the CFTC to exempt a contract from its own oversight, it also had to exempt the contract from one aspect of the traditional State law regulating securities contracts. In short, instead of treating the law that had supported economic activity for more than a century as valuable infrastructure, the 1992 law treated it as disposable. As a result, even the subject experts who staffed the CFTC were not given the choice of exempting a contract from CFTC oversight while at the same time leaving in place traditional state-based restrictions on wagering-type contracts.
In 1993 the CFTC exempted interest rate and currency swaps as well as “any other similar agreement” with the qualifications that they could not be standardized, fungible contracts and that they not be traded through a multilateral execution facility (58 FR 5587 at 5589 (Jan. 22, 1993)). By 1998 the swaps market had evolved such that it was no longer evident that the contracts complied with the qualifications on the exemption, and scandals that had led to litigation indicated that unwitting participants had in some cases been defrauded. When the CFTC proposed to revisit the question of regulating of the swaps market, stating explicitly that any such regulation would only be prospective (63 FR 26, May 12, 1998), industry lobbyists has sufficient influence at the Federal Reserve and Treasury to successfully pressure Congress to enact a six-month moratorium on the CFTC release (Greenberger 2018: 21-23).
The final outcome of the full-bore industry response to the CFTC’s proposal to evaluate the need for regulation of swaps was the enactment of the Commodities Futures Modernization Act of 2000 (CFMA; Pub. L. No. 106-554), which excluded not just interest rate and currency swaps, but financial derivatives more generally from the Commodity Exchange Act – as long as they were traded by “eligible contract participants,” roughly speaking entities with more than $10 million in assets. By excluding these derivatives from the Act itself, they were not just removed from the jurisdiction of the CFTC, but also from the CEA’s anti-fraud and anti-manipulation provisions. Furthermore, when it came to the application of State law excluded contracts were treated like contracts that had been exempted as per the 1992 FTPA; in other words, the CFMA explicitly preempted any application of state gambling law to excluded contracts (Greenberger 2018: 27-28).
Although the CFMA established over-the-counter derivatives as an entirely unregulated market and allowed to the ISDA to organize that market unsupervised and without the constraints on anti-competitive practices that had been adopted throughout the financial system in the 1930s, this was not, however, enough.
The margining system that had been developed to enable the earliest exchanges to enforce their contracts without relying on the legal system could be used to create leverage that was invisible to the Federal Reserve, which was still using theoretic frameworks appropriate to unsecured interbank lending, and had not yet mastered the implications of the growing use of margin by the biggest financial participants. With the Fed blind not just to the risks of the derivatives margining system but also to the extent of its growth, commercial and investment banks could take on an unregulated form of leverage.
It seems unlikely that many of the financial industry lobbyists saw the big picture of what they were doing when they lobbied for the 2005 bankruptcy act. Most likely they simply saw an opportunity to shift the rules in a way that would be profitable for them and went for it, without a thought for the broader economy at all.
The outcome was legal reform of the Bankruptcy Code as it affected financial institutions that was just as stunning in its implications as the CFMA had been with respect to derivatives regulation: In an early paper I dubbed this legislation “The No Derivative Left Behind Act of 2005” (Sissoko 2010). The goal of the reform was to make it possible for the broker-dealer banks to manage collateral, not contract by contract, but in a way that would make the collateral as mobile as possible. The banks wanted to be able to aggregate all the margin posted by a certain counterparty on all of its contracts and deal with it as a whole. Since the broker-dealers (but for the most part not their clients) could reuse – or rehypothecate – the margin that was posted to them, the ability to aggregate collateral positions would free up more collateral for the broker-dealers to reuse. Reusing margin is a way for a bank to leverage its balance sheet.
The ability to aggregate collateral positions was created by, first, granting exemption from the Bankruptcy Code to master agreements that were designed to bring a wide variety of different contracts under a single netting agreement, and, second, by revising the specific terms of the bankruptcy exemptions granted to the different types of contract so that they would be uniform – and thus amenable to aggregation. Unsurprisingly the way the various terms were made uniform was by taking the broadest grant of exemption from the Bankruptcy Code and applying it to the various contracts (Sissoko 2010).
For example, exemption from the Bankruptcy Code for options on securities had been limited as was noted above to contractual rights established by the rules of a securities exchange. This was expanded to include the terms that applied to swaps and thus to the more general contractual rights that exist under common law. This was a vast change in the applicability of the Bankruptcy Code exemptions.
Other revisions in the 2005 Act also broadened its reach: to allow for new products to be developed, each type of exempt contract was defined to include similar contracts. One practitioner’s comment on the new definition of a swap was: “Read literally this language cedes the content of the definition to the players in the market.” Kettering (2008: 1712). In addition, before the 2005 Act exempt repurchase agreements had been limited for the most part to those referencing Treasuries and Agencies. After the Act, repurchase agreements on securities and mortgages had been included in the definition of securities, and were therefore exempt.
Like the CFMA, the hubris implied by this law boggles the mind. The bankruptcy exemptions had been created to facilitate the operation of Exchanges because they could not rely on the courts to enforce their speculative contracts. The whole logic of this financial structure was turned on its head by applying the exemptions to off-exchange contracts, that had already been exempted from the state and common law governing speculative contracts. Not only this, but this brand-new, ill-considered financial structure was not applied to some very narrow set of contracts, but it was applied to a vast range of contracts and was designed to make it easy for the interested parties who had lobbied for the law to expand the range of contracts at will.
Just three years after the law was passed, the implications of establishing a vast unregulated financial market with extraordinary privileges under the Bankruptcy Code were realized. The repurchase agreement market which was a core part of the margining system for this unregulated market experienced a massive run and came close to bringing down the financial system entirely. The margining system was saved only by the Federal Reserve’s unprecedented measures.
With the Dodd-Frank Act supervision has been extended over these instruments, and many have been forced to trade on exchanges. The basic incoherence of this new financial structure remains, however. Off-exchange contracts are still exempt from provisions of the Bankruptcy Code and from state wagering laws. The central banks are struggling to develop a theoretic framework that can allow them to manage the new system of margin-based interbank lending successfully. It remains to be seen if the growth rates achieved under the old system can be attained under the new one.
 Note that Kreitner (2000)’s discussion of the intersection between securities regulation and wagering law starts with Williar, and this case apparently does not offer the best explanation of the logic underlying this form of securities regulation. Kreitner (2000) argues that moral rather than economic considerations drove this form of securities regulation.
 As Levy (2006) observes, while there are many cases arguing that exchange-traded contracts were void as wagers in the late 19th century, not one of them is brought by a member of the exchange. That is, they are all brought by the clients of exchange members.
 In 1865 the Chicago Board of Trade introduced the first standardized futures contract together with the requirement that a “performance bond,” which serves the same function as margin, be posted by futures traders.
 The bank contracts were exempted in the 1974 Treasury Amendment to the CEA and securities with the 1982 enactment of the Shad Johnson Accord (GAO 2000).
 Because the era of federal common law had ended in 1938, the exchange trading exemption to state wagering laws was unsettled.
 In current law this exclusion is found in 7 USC s. 16(e)(2).
Note: Updated January 14 2019 to add more explanatory text regarding derivatives.
From the beginning there was a “private offering exemption” to both the disclosure requirements of the Securities Act of 1933 (“’33 Act”) and the investment company registration requirement of the Investment Company Act of 1940 (“’40 Act”). The basic idea behind ’33 Act and the ’40 Act exemptions were somewhat different, however. For the ’40 Act if an issuer’s activities were sufficiently small and didn’t involve marketing to the public they didn’t need to be covered. For the ’33 Act the focus was on the fact that certain financial professionals, such as banks, as well as the principals of a corporation did not need the protection of the disclosure requirements.
Thus, the original ‘40 Act had the “section 3(c)(1)” exemption for funds “that are beneficially owned by not more than 100 persons” and that issue securities that are not offered publicly. Companies that were required to register under the ’40 Act faced leverage restrictions and controls on self-dealing amongst other requirements. Until 1996, a private fund that sought to opt out of the ’40 Act had to fall under the 100 investor exemption. Obviously, this constrained the size of any given hedge fund or private equity fund.
Similarly, the original ’33 Act had the Section 4(a)(2) exemption from the disclosure requirements for “transactions not involving any public offering.” From the earliest days, this was understood to exempt corporate activities such as obtaining bank loans, placing securities privately with institutions, and promoting a business endeavor amongst a small group of closely related individuals (SEC 2015: 11). This approach was affirmed by the Supreme Court in 1953 which interpreted a non-public offering to include “an offering to those who are shown to be able to fend for themselves” and found that an offering to corporate executives “who, because of their position, have access to the same kind of information that the Securities Act would make available in the form of a registration statement” could also fall within the exemption.
In short, for the first decades of this comprehensive regulatory regime, the private offering exemption was narrow, and offered little or no scope for hedge funds to operate. Needless to say, the financial industry pushed continuously to widen the scope of the exemption.
In short, the ’33 Act’s goal of investor protection meant that regulation had to ensure that even sophisticated investors received the relevant information to evaluate. On the other hand, the rule imposed no constraint on the amount of money that could be raised from those 35 investors.
A year later Rule 240 was adopted to benefit small businesses by exempting issuers raising less than $100,000 in a 12 month period with no general advertising, and with no more than 100 investors. Notably, the requirement that investors have access to information comparable to a registration statement was omitted from this Rule, presumably in order to reduce the costs and legal risks faced by small businesses.
The pressure for broader exemptions continued and was met in 1980 with Rule 242, which was the first time the concept of an “accredited investor” was used. An “accredited investor” included categories that had long been covered by the 4(a)(2) exemption including banks, institutional investors, and directors and executives of the issuer. Added to these groups were pension funds (explicitly), and anyone who purchased $150,000 of the issuer’s securities. And this rule no longer required that the investor be furnished with information “based on the assumption that accredited persons were in a position to ask for and obtain the information they believed was relevant” (SEC 2015: 14). In short, Rule 242 blew a hole in the comprehensive regulatory regime, but was designed to harm only those wealthy and institutional investors that happened to lack the financial acumen the SEC attributed to them.
A few months later in the Small Business Investment Incentive Act of 1980 (Pub.L. 96-477) the concept of “accredited investor” was made law. The legislation (i) defined the term to include the broad categories of financial intermediaries covered by Rule 242 while authorizing the SEC to adopt additional categories and (ii) created a new exemption for issues of up to $5 million to accredited investors only (SEC 2015: 15).
Just two years later, the SEC replaced all of these refinements of the private offering exemptions with a single regulation, Regulation D. Regulation D was organized around the concept of the “accredited investor” and at the same time widened its scope. In addition to those covered by Rule 242 were added anyone with substantial net worth ($1 million) or income ($200,000 per annum), and any entity all of whose owners were accredited investors. At the same time the SEC explained that purpose of this redefinition was to define a class of investors who did not need the ’33 Act’s protections, because of their sophistication, ability to sustain loss, or ability to fend for themselves (SEC 2015: 17).
Reg D significantly revised the three categories of exempt issues: Rule 504 exempted the sale of up to $500,000 without general solicitation (imposing no limitations on number or type of investors). Rule 505 exempted the sale of up to $5 milllion in a 12 month period to an unlimited number of accredited investors and 35 additional persons without general solicitation. Rule 506 dramatically broadened the Rule 146 safe harbor by treating as private offerings sales of unlimited amounts of securities to an unlimited number of accredited investors and up to 35 non-accredited, but sophisticated, investors without general solicitation. Although Rule 506 was viewed as a replacement for Rule 146, by allowing unlimited amounts to be raised from an unlimited number of investors, it was different in character from the original Rule 146. In addition, Rule 506 eliminated entirely the requirement for accredited investors that they be furnished with or have access to information comparable to a registration statement.
Observe the structure of this change. It would have been very hard for the SEC to argue that the Regulation D exemptions were consistent with the legislature’s intent in enacting the ’33 Act, because in 1933 the primary purpose was to protect investors by addressing the problem of information asymmetry in the market and there was no intent to exempt wealthy individuals or pension beneficiaries (through their fiduciaries) from that protection. This was clear in in 1974 when Rule 146 was adopted. But, with the passage of the Small Business Investment Incentive Act of 1980 the relevant intent when discussing an “accredited investor” was that of the 1980 legislature – and the stated intent of that legislature was to increase the ability of “small business” to raise capital. Thus, the adopting release for Regulation D states that its purpose is to “facilitate capital formation consistent with the protection of investors” and the emphasis throughout the release is on small business. Hedge funds and leveraged buyout companies were small businesses – not just from an employment perspective, but at the time in terms of their capacity to raise funds too. The latter was, however, due to the constraints imposed by the regulatory regime, as would become clear after those constraints were relaxed.
To summarize, the 1980 law opened the door to a 180 degree shift in the focus of the ’33 Act from the goal of protecting the beneficial owners of securities to the goal of making it easier for “small businesses” to raise vast amounts of money. And Regulation D threw that door wide open by eliminating the constraints that were designed to ensure that the exemptions were targeted to small businesses. Not only was an exemption created that allowed unlimited sums to be raised without any disclosure whatsoever, but the same exemption allowed that money to be raise from an unlimited number of wealthy investors.
With Regulation D a new era in U.S. finance was born. The 1980s saw private equity funds take off along with leveraged buyouts, see Chart 1. The economic inefficiencies created by leveraged buyouts were immediately recognized (e.g. Shleifer and Summers 1988), but apparently no connection was drawn linking the growth of these funds and their economically inefficient activities to the lifting of the ’33 Act’s limitations on private fundraising by securities issuers.
Even though Regulation D made it much easier for investment funds to raise money without disclosure, most funds did not want to register under the ’40 Act and as a result in order to qualify for the 3(c)(1) exemption the number of investors was capped at 100. It was not until 1996 that the National Securities Markets Improvement Act created a new exemption from registration under the ‘40 Act. Section 3(c)(7) funds are permitted an unlimited number of investors as long as they are “qualified purchasers,” a category which includes individuals with $5 million in investments and institutional investors with at least $25 million in assets under management. Legislative history indicates that Congress deemed these investors to be capable of evaluating “on their own behalf matters such as the level of a fund’s management fees, governance provisions, transactions with affiliates, investment risk, leverage, and redemption rights” (S. Rep. No. 104-293). In other words, as the SEC explained “Congress determined that the amount of a person’s investments should be used to measure a person’s financial sophistication” (2015: 25).
Thus, after 1996 we see once again a significant acceleration in growth of private funds, see Chart 2.
Data from: Joenvaara, Kosowski, & Tolonen (2012). For hedge fund AUM over time, see here.
This unregulated environment fostered certain decades-long frauds like that perpetrated by Bernie Madoff and insider trading as took place at SAC Capital. The remarkable window that has been opened into one wealthy family’s activities by the Mueller investigation naturally raises the question of the degree to which these underreporting investment funds are systematically breaking the law on the principle that they are very unlikely to ever be caught doing so.
“laissez fair policy nurtured a mushroom propagation of investment trusts of incalculable economic significance. The investment company became the instrumentality of financiers and industrialists to facilitate acquisition of concentrated control of the wealth and industries of the country. The investment trust was the vehicle employed by individuals to enhance their personal fortunes in violation of their trusteeship, to the financial detriment of the public. Conflicts of duty and interest existing between managers of the investment trusts and the investing public were resolved against the investor. The consequences of these management trusts have been calamitous to the Nation. … the exposure of the abuses and evils of investment trusts must be expeditiously translated into legislative action to prevent recurrence of these practices” (S. Rep. 73-1455: 333).
“Finally, particularly with respect to those companies which have not registered their securities under the Securities Act of 1933 or the Securities Exchange Act of 1934, and only a small number has so registered its securities, the investor has been unable to obtain adequate information as to their operations. The accounting practices and financial reports to stockholders of management investment companies frequently are deficient and inadequate in many respects and ofttimes are misleading. In many cases, dividends have been declared and paid without informing the stockholders that such dividends represented not earning but a return of capital to stockholders.” (S. Rpt. No 76-1775: 8).
Currently in the US hedge funds have $4 trillion in assets under management and private equity funds have $2.5 trillion (SEC Private Fund Statistics Q1 2018). As the total assets of the U.S. commercial banking system are a little less than $17 trillion, we find that the funds in the US that are not subject to standard controls on the use and abuse of asymmetric information are equivalent in size to one-third of the banking system. In short, one driver of financialization and the inequality associated with it is the vast quantity of underregulated investment funds that hide in the shadows of the US financial system.
It’s worth mentioning that the 1980s and 1990s also witnessed the proliferation of business forms that offer limited liability without either corporate status or corporate taxation. The limited liability company or LLC is the foremost of these structures, and plays a part in the development of a vast financial system that hides in the shadows of the regulated financial system. Many hedge funds are structured as LLCs.
Prior to 1988 the only business structure that combined pass-through taxation with limited liability was the S-corporation. The Chapter S election is available only to small corporations with no more than 100 shareholders, all of whom are individuals. In 1988 the IRS granted the LLC structure the “pass through” tax status that makes it such a useful tool for structuring and hiding assets. By 1996 LLC statutes had been enacted in every state. A variety of other limited liability business structures that have pass through taxation are also available now.
Overall, a vast swathe of the US financial system operates in the dark with minimal supervision even today. That this situation was allowed to develop in the name of financing “small business” is astounding.
An adjustment should be made in our understanding of the purpose of our financial regulatory laws: The deployment of hundreds of millions of dollars in funds has public implications. For this reason alone, all investment companies with assets under management in excess of $500 million and either at least one pension fund investor (and thus hundreds of beneficial investors) or more than 35 investors should be subject to the Securities Act’s reporting requirements.
 SEC v. Ralston Purina, 346 U.S. 119 (1953).
(v) There was no general advertising or solicitation.
 The Dodd Frank Act, Section 413(a) caused the value of a primary residence to be excluded from the measure of net worth.
 In 1988 the Commission’s position that a $150,000 investment guaranteed that the investor had sufficient “bargaining power” that no protection was needed was reconsidered “particularly at the $150,000 level” and this criterion for accredited investor status was withdrawn entirely (SEC 2015: 17-18).
 The crude model of capital formation underlying this approach is remarkable coming from an agency that was created in order to address problems of information asymmetry. Afterall, it is investor protections that safeguard the economy’s long-term capacity to raise capital.
 This growth has been attributed to other causes such as anti-takeover statutes or high yield bonds, but the timing doesn’t line up for these. High yield bonds began to take off as an asset class in the 1970s. And when the Supreme Court struck down an anti-takeover statute in 1982, it was far from clear that this would invalidate the statutes that had been enacted in other states, and indeed in 1987 the Supreme Court upheld an anti-takeover statute – and leveraged buyouts continued to boom.
 Note that in order to avoid registration under Section 12(g) of the ’34 Act, most funds today limit their investors to 499.
 In the original law only 35 shareholders were permitted.
This post opens the discussion with a background exposition of the US Depression era financial legislation and what it was designed to do.
In the 1930s and 40s a comprehensive regulatory regime was designed for the financial system. The designers of this system had learned from the real estate and the stock market booms and busts of the 1920s and were not just conscious of the credit-creation function of banking, but also of the disastrous consequences that result when bank credit is used to finance leveraged positions in financial or real assets. Thus, the system was designed with firewalls that would keep credit from flowing inefficiently from the banking system into sectors, like housing and stock market investments, where there was abundant empirical evidence that the primary result would be asset price inflation.
The new system also took into account the fact that state and common law had long granted a limited form of self-governance to the commodities and securities exchanges, which set rules for their members, and gained certain privileges in deference to the role they played in establishing the prices for financial contracts. In the new regime the Exchanges would be recognized as “Self Regulatory Organizations.” Every one of them was, however, made subject to the supervision of either the SEC or the Secretary of Agriculture (prior to the creation of the CFTC).
The financial regulatory laws enacted in the 1930s and early 1940s were designed to augment the existing legal regime governing financial contracts, which was constructed on the principle that financial contracts are legally enforceable only when they are tied to the real economy. Thus, if any one of three conditions are met (i) the contract insures one party against an existing risk, (ii) the intent is to deliver the underlying asset, or (iii) the contract is traded on a designated exchange, the contract is deemed to play a role in distributing real economic risk and is legally enforceable. On the other hand, a financial contract where both parties were speculating on some future event – such as the price of an asset – had to be traded on an exchange or it would be considered a wager and void.
The financial regulatory laws enacted in the 1930s and early 1940s were designed as a comprehensive regulatory regime where every financial product had a designated regulator. The first step in this process had been the Federal Home Loan Bank Act of 1932 which established a Federal Home Loan Bank System to support liquidity in the mortgage markets on the model of the Federal Reserve System. Mortgage lending had never been a significant activity for commercial banks, but was instead the purview of a variety of savings associations. Very innovative policies would be put in place to support the mortgage markets over the course of the decade, but this history is not pertinent here.
The second step in the process of creating a comprehensive regime with firewalls designed to construct a silo’d financial system was to separate out banks from brokers and dealers on financial markets. Formal separation of the commercial banks from their investment banking affiliates was adopted in the Banking Act of 1933 (“the Glass-Steagall Act”).
The next step was to extend federal law to cover the broker-dealers, the exchanges, and over-the-counter markets. The latter were covered, not because major improprieties on OTC markets had been discovered in the years leading up to the Great Depression, but because legislators recognized that “since business tends to flow from regulated to unregulated markets … the regulation of exchange markets made necessary the regulation of [over the] counter markets” (SEC Tenth Annual Report, 1945: 44). That is, 1930s legislators were well aware of the need for a comprehensive regulatory regime. Thus, the Securities Act of 1933 (“’33 Act”), the Securities Exchange Act of 1934 (“’34 Act”), the Commodity Exchange Act of 1936 (“CEA”), and the Investment Company Act of 1940 (“’40 Act”) were designed to ensure that there was no unregulated financial market into which business could flow.
The Commodity Exchange Act of 1936 (CEA) prohibited trading of commodities contracts for future delivery – a category which encompasses options and swaps contracts that reference commodities — with two exceptions, contracts traded on designated markets and the forward contract exclusion (which requires that delivery is expected take place). Observe that this prohibition was simply a means of bringing well-established state and common law rules under the purview of federal law.
The SEC regulated broker-dealers and their over-the-counter transactions through the creation of a new self-regulatory organization (explicitly authorized by the Maloney Act of 1938), the National Association of Securities Dealers (which was replaced in 2007 by FINRA, the Financial Industry Regulatory Authority). This decision to create an SRO for the purpose of regulating the formerly unregulated segments of the securities markets should have been viewed as precedent. Any unregulated financial market, needed to form a self-regulatory organization, and apply to the SEC (or the CFTC as might be appropriate) for its right to exist.
So how did we go from a system of comprehensive regulation in 1940 to the 2008 environment where vast swathes of the financial system were unregulated? The short answer is that the deregulatory ideology of the 1980s and 1990s turned a comprehensive regulatory regime into a tattered web of regulations and in doing so facilitated the growth of the same kind of conduct that the regulatory regime had been designed to repress in the first place.
 Notice that in a contract where both parties are speculating, neither party has a real economic risk that is being transferred; instead, the two parties are just making different predictions about the future. As a result, the frequent claim that speculation serves to transfer risk away from those who will have difficulty bearing is not applicable to those contracts that were treated as wagering contracts under 19th and early 20th century financial regulatory principles.
 Stein, “The Exchange-Trading Requirement of the Commodity Exchange Act,” 41 Vand. L. Rev 473, 480-81, 491 (1988). See also Lynn Stout, “Why the law hates speculators,” Duke Law Journal, 48(701), pp. 722 – 3.
What makes banks unstable is that their liabilities are on demand (i.e. they borrow short) while their assets pay out only over the course of years (i.e. they lend long). A principle reason that we are worried about “shadow” banks is that they have the same instability as banks, but lack the protections in the form of a strict regulatory regime and a lender of last resort. When shadow banks have this instability it is because they borrow short to lend long.
This approach makes it easy to understand the world of shadow banking, because there are only a limited number of financial instruments that are used to borrow on a short-term basis. Thus, for the most part shadow banks have to finance themselves on the commercial paper market (unsecured financing) or on the repo market (secured financing) or, especially for investment banks, via derivatives collateral (e.g. that is posted by prime brokerage clients). These are the major sources of wholesale short-term funding.
So typically when a financial product is subject to losses due to a run-prone (and therefore classified as a shadow bank), it’s because of the product’s relationship to the commercial paper market, to the repo market, and/or to the derivatives market.* The latter two, which comprise the collateralized segment of shadow banking, are the most complicated, because the run can come from many different directions: that is, lenders may stop lending (e.g. Lehman Bros), borrowers who post collateral may stop posting collateral (e.g. novation at Bear Stearns), and for derivatives contracts conditions may shift so that suddenly collateral posting requirements increase (e.g. AIG).
While repos have been around for centuries, a “repo market” in which anyone can participate and where collateral other than government debt is posted is a relatively new phenomenon. Similarly derivatives contracts have been subject to margin requirements for more than a century, but in the past these contracts were exchange-traded and exchanges set the rules both for margin and for eligibility to trade on the exchange.
Thus, what made repo and derivatives financially innovative in the 1980s and 1990s was that suddenly there were unregulated over the counter (OTC) markets in them. What “unregulated” really meant, however, was that the big banks wrote the rules for this market themselves in the form of International Swaps and Derivatives Association (ISDA) protocols and contracts.
Thus, one of the ISDA’s first projects was lobbying in the US for exceptions to the existing regulatory regime. Progress was incremental, but a long series of legislative amendments to the financial regulatory regime starting in 1982 and culminating in the bankruptcy reform act of 2005 effectively placed the whole system of repo and margin collateral outside the financial regulatory regime that had been set up in the 1930s and 1940s (for details see here, or ungated). These reforms also exempted these contracts from the bankruptcy code’s protections for debtors (see here or ungated).
Where the US led others followed. Gabor (2016) documents how Germany and Britain came to adopt the US model of collateralized lending, despite the central banks’ serious reservations about the system’s implications for financial stability. The world economy entered into 2008 with repo and derivatives markets effectively subject only to the private “regulation” of ISDA protocols and contracts.
Indeed the International Capital Markets Association has put it quite bluntly that it considers the systemic risk associated with fire sales in repo and derivatives markets to be a problem that “the authorities” are expected to step in and address.
In short, the collateralized shadow banking system is constructed on the expectation of a “Fed put”. Instead of attempting to build a robust infrastructure of debt, shadow banking embraces the risk of fire sales and expects the governments that don’t make the shadow banking rules to bail it out.
The only sure-fire way to eliminate the risk of fire sales is to reduce the financial system’s reliance on repo- and margin-type contracts that allow a decline in the value of collateral to be a trigger for demanding additional funds. Based on financial market history this would almost certainly require an increase in the use of unsecured interbank debt markets. However, not much progress has been made on this front, especially since the EU’s proposed Financial Transactions Tax stalled in 2015.
Collateral has shifted mostly to sovereign debt. This helps stabilize the market, but perhaps only temporarily as a broad range of collateral is still officially acceptable (so deterioration of the quality of collateral can creep in).
Approximately 50% of derivatives now are held with central counterparties. (The estimate is based on a 2015 BIS report.) This reduces the risk that the failure of a small market participant sets off a chain of failures that results in a fire sale. There is some concern however that fire sale risk has been transformed into the risk of a failure of a central counterparty.
Derivatives are now officially regulated by either the CFTC or the SEC and and there has been an effort to harmonize OTC margining requirements internationally.
Under pressure from regulators a voluntary stay protocol has been developed by the ISDA that is designed to work with the regulators’ special resolution regimes and to limit the right to terminate a contract due the default of a related entity. In the US systemically important banks are required to include this protocol in their OTC derivatives contracts.
Bank liquidity regulations have been adopted that limit the degree to which regulated banks are exposed to significant risk in these markets.
Notice that these new regulations embrace the basic framework of collateralized shadow banking: much of the focus is on making sure that enough collateral is being used. Special rules are designed to protect the largest banks and the banking system more generally. But aside from protecting the banks, it’s not clear that significant measures have been taken to eliminate the risk of fire sales that originate outside the banking system. Assuming that these regulations are effective at protecting the banks, this raises the question: Who bears the fire sale risk in this new environment?
Thanks to @kiffmeister for requesting that I write up this blogpost.
* While one can usually figure this out after the run has occurred, current regulation does not necessarily make the relevant information available before a run has occurred. Mutual funds are a case in point: the vast majority of them have so little exposure to repo and derivatives markets that it can be ignored, but the few that take on significant risk may have disclosures that are hard to distinguish ex ante from the ones that don’t (e.g. Oppenheimer Core Bond Fund in 2008).
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