Joseph R. Mason

Fundamentals, Panics, and Bank Distress During the Depression

We assemble bank-level and other data for Fed member banks to model determinants of bank failure. Fundamentals explain bank failure risk well. The first two Friedman-Schwartz crises are not associated with positive unexplained residual failure risk, or increased importance of bank illiquidity for forecasting failure. The third Friedman-Schwartz crisis is more ambiguous, but increased residual failure risk is small in the aggregate. The final crisis (early 1933) saw a large unexplained increase in bank failure risk. Local contagion and illiquidity may have played a role in pre-1933 bank failures, even though those effects were not large in their aggregate impact.

Consequences of Bank Distress During the Great Depression

The consequences of bank distress for the economy during the Depression remain an area of unresolved controversy. Since John M. Keynes (1931) and Irving Fisher (1933), macroeconomists have argued that bank distress magnified the extent of the economic decline during the Depression. As the intermediaries controlling money and credit, banks were in a special position to transmit their distress to other sectors. But the mechanism through which banking distress mattered for the economy has been hotly contested. Milton Friedman and Anna J. Schwartz (1963) saw the contraction in the money multiplier—driven, in their view, by panicked depositors’ withdrawals of deposits—as the primary mechanism through which banking distress affected the real economy. They described the mechanism transmitting banking distress to the real sector as operating at the national level through changes in the aggregate supply of money and interest rates. Bank distress reduced the money supply available to the public either through the closure of banks and the consequent freezing of bank deposits, or the withdrawals of deposits by depositors that feared bank failure. Ben S. Bernanke (1983), building on Fisher (1933), emphasized the transmission of monetary shocks via their effects on the balance sheets of borrowers and on the supply of credit by banks. Borrowers’ balance sheets were worsened by debt deflation as the result of fixed dollar debt obligations—borrowers’ net worth and cash flow declined with the rising value of debt service costs relative to income. Borrowers with positive net present value projects, but weak balance sheets, had less internally generated retained earnings to invest and could not qualify for credit. Furthermore, Bernanke argued that the contraction of the money supply produced contraction of nominal income and prices relative to fixed debt service, which weakened borrowers’ balance sheets, and in turn, weakened banks. Not only did firms’ financial distress reduce the number of qualified borrowers, the contraction in banks’ net worth forced a reduction in the supply of bank loans to qualified borrowers. Many firms and individuals relied on banks for credit, and as those banks suffered losses of capital (due to asset value declines) and contractions in deposits (as depositors reacted to bank weakness by withdrawing their funds), even borrowers with viable projects and strong balance sheets experienced a decrease in the effective supply of loanable funds. Bernanke termed the combined weakening of borrowers’ balance sheets and the contraction in bank credit supply a rise in the “cost of credit intermediation.” The scarcity of perfect substitutes for the positive net present value investments of firms with weak balance sheets, and for the credit supplied by existing banks, implies that the weakening of firms’ and banks’ balance sheets, the disappearance of banks, and the contraction in surviving banks’ lending made it more difficult for the economy to channel funds to their best use. Thus, what began as a contraction in aggregate demand became a contraction in aggregate supply, which magnified adverse economic shocks and prolonged and deepened the Depression. The financial distress of firms and banks, and the decline in bank lending, were not only symptoms of the Depression, but means for magnifying the shocks that caused the Depression. Bernanke’s statistical evidence in support of this story is derived from time-series analysis at the national level, in * Calomiris: Graduate School of Business, 601 Uris Hall, Columbia University, 3022 Broadway, New York, NY 10027, and National Bureau of Economic Research (e-mail: cc374@columbia.edu); Mason: Department of Finance, Drexel University, 3141 Chestnut Street, Philadelphia, PA 19104 (e-mail: joe.mason@drexel.edu). We thank Valerie Ramey, David Wheelock, Charles Himmelberg, Steve Zeldes, Gary Gorton, two referees, and seminar participants at Columbia University, Wharton, Northwestern University and the 2001 Economic History Association Meetings for helpful comments on an earlier draft. We gratefully acknowledge support from the National Science Foundation, the University of Illinois, and the Federal Reserve Bank of St. Louis.

What is the value of recourse to asset-backed securities? A clinical study of credit card banks

The present paper uses data from revolving credit card securitizations to show that, conditional on being in a position where implicit recourse has become necessary and actually providing that recourse, recourse to securitized debt may benefit short- and long-term stock returns, and long-term operating performance of sponsors. The paper suggests that this result may come about because those sponsors providing the recourse do not seem to be extreme default or insolvency risks. However, sponsors providing recourse do experience an abnormal delay in their normal issuance cycle around the event. Hence, it appears that the asset-backed securities market is like the commercial paper market, where a firms ability to issue is directly correlated with credit quality. Therefore, although in violation of regulatory guidelines and FASB140, recourse may have beneficial effects for sponsors by revealing that the shocks that made recourse necessary are transitory. ; Also issued as Payment Cards Center Discussion Paper No. 03-04

The political economy of Reconstruction Finance Corporation assistance during the Great Depression

Abstract This paper analyzes the role of political rent-seeking in New Deal expenditures focusing on the Reconstruction Finance Corporation (RFC). Unlike other New Deal agencies, the RFC was not financed by government appropriations, it devolved assistance decisions, and primarily offered loans rather than grants. Although the RFC was subject to pressures for political favor during the Great Depression, the geographic distribution of RFC funds across states is not associated with standard political measures used to examine rent-seeking behavior in other studies of the New Deal.

Subprime Servicer Reporting Can Do More for Modification than Government Subsidies

Recent history is rife with examples of servicer problems and failures, resplendent with detail on best - and worst - practices. The industry has been through profitable highs and predatory lows, over time reacting to increased competition with greater efficiency and, where sensible, increased concentration reflective of scale economies in processing and knowledge. While the value of good mortgage (and all consumer loan) servicing is reflected in asset- and mortgage-backed security spreads, structurally-required credit enhancements, defaults and roll rates, and modification outcomes, that value lies primarily in processes and knowledge. Servicing is nothing if not a service industry, motivating borrowers to pay the loans under the servicers own management even when the borrower cannot afford to pay others. Such processes are the basis of managing initial defaults and getting borrowers back on track, whether that is through managing to roll the borrower back to current organically, or helping the borrower realign their finances in a modification. Even in foreclosure, there is value to be retained within the legal environment, among real estate professionals and vendors, and even with the foreclosed borrower. But intensively customer service-based enterprises such as servicing are hard to evaluate quantitatively, so that proving a servicers value is difficult even in the best business environment. Unfortunately, todays is not the best business environment, so proving servicer value has now become crucial to not only servicer survival, but the survival of the market as a whole. Regulators can therefore do a great service to both the industry and borrowers in todays financial climate by insisting that servicers report adequate information to assess not only the success of major modification initiatives, but also performance overall. The increased investor dependence on third-party servicing that has accompanied securitization necessitates substantial improvements to investor reporting in order to support appropriate administration and, where helpful, modification of consumer loans in both the private and public interest. Without information, even the most highly subsidized modification policies are bound to fail.

Business Aggression, Institutional Loans, and Credit Crisis: Evidence from Lending Practices in Leveraged Buyouts

This paper investigates the lending practices related to leverage buyouts (LBOs) market between high and low write-down institutions. The write-downs, which are a proxy for business aggression of institutions, are mainly related to credit crisis from the beginning of 2007 to August 10, 2008. We find that high (low) write-down institutions increase (decrease) loan market share dramatically during the period of 2001-2006. The increase is mainly driven by the segment of loans sold to institutional investors, such as collateralized loan obligations vehicle, hedge fund, and insurance companies. Institutional loans originated by high write-down institutions carry significantly fewer covenants and higher interest spread than those by low write-down institutions during 2001-2006. However, there are no such differences during 1995-2000. The aggressive lending practice by high write-down institutions to lower quality borrowers during 2001-2006 appeared to be mitigated by reputable private equity (PE) investors. High write-down institutions arranged loans with more covenants and lower interest spread for borrowers with investments from more reputable private equity investors. We contribute to extant literature in the area of financial crisis by providing empirical evidence that both business aggression of some institutions and the increase demand for institutional loans drive the peculiar lending practice during the easy credit period, which subsequently leads to declines in values of assets associated with these loans. Our focus on the role of PE reputation in mitigating aggressive lending practice complements recent studies in the area of LBO loans market and PE reputation, such as Demiroglu and James (2008) and Ivashina and Kovner (2008). The findings of demand pressure (credit supply) from institutional loans add to the analyses of Ivashina and Sun (2008) and Wang (2008). We provide additional evidence that such increase in institutional loans demand is filled by some aggressive financial institutions, which ex post incur high write-downs during the credit crisis. Many such institutions pay horrendous prices for their business aggression and have ceased to exist in the market.

The (Continuing) Information Problems in Structured Finance

The key problem facing markets today is information. Structured finance products are inherently complex and difficult to value. Hence, the marketplace is inherently opaque. Without adequate information, investors will not invest in either primary or secondary markets. In primary markets, such reluctance results in decreased lending. In secondary markets, such reluctance results in a steep lemons discount, arising because investors do not know the value of assets but are otherwise able to transact (which is not the same as a liquidity crunch, where investors know the value of investments but are nonetheless unable to transact). Regulators have done little to address the fundamental information problems that perpetuate the current crisis. The veracity of bond ratings has been called into question. The major Nationally Recognized Statistical Rating Organizations (NRSROs) have allowed their ratings to reflect different economic magnitudes of risk for different financial products. At the heart of these difficulties (particularly with respect to wide differences in the degree of economic risk attached to various ratings) are the conflicts of interest inherent in an issuer-pays ratings industry whose products are protected as opinions under the First Amendment.

Deriving Credit Portfolio Diversification Properties from Large Asset-Backed Security Pools

The present analysis estimates Markowitz portfolio correlations for retail loan portfolios. The correlations are derived from almost

Cliff Risk and the Credit Crisis

1 trillion of asset backed security pools originated by more than five hundred issuers between January 2000 and September 2003. Such a broad sample, comprised of several hundred thousand pool-month observations, provides a unique opportunity to infer asset correlation structures of commercial bank assets. Since the types of loans analyzed are rarely traded, Markowitz correlations are estimated from five different loan performance measures. The analysis demonstrates that the performance of many different loan credit types is weakly correlated, and is sometimes even negatively correlated. Hence, there is the potential to eliminate a significant amount of risk in diversified credit portfolios.

Self-reporting under SEC Reg AB and transparency in securitization Evidence from loan-level disclosure of risk factors in RMBS deals

AbstractThe following sections are included:IntroductionHow to Post Record Profits with Negative Cash FlowsHow to “Sell” Without Transferring ResponsibilityWithout Risk Transfer There Can be No True SaleSummary and Conclusion: Everything Old is New AgainReferences