Strolling Down Maiden Lane

Greedy bankers. The Community Reinvestment Act (CRA). The bursting housing bubble. Consumers in hock using their homes as ATMs. NINJA (No Income, No Job or Assets) loans. Overextended banks. Deregulation. Overregulation. Too Big to Fail. Shadow banking.

I may have missed a few, but the above are the common, popular factors pundits and headlines claim caused 2008’s financial panic. Yet none of these factors are the proximate cause, and new evidence many haven’t noticed puts an exclamation point on that.

The factors above might contribute to the backdrop, but all are either insufficiently sizable or just plain untimely to have triggered panic. CRA passed decades before the panic. The Case/Shiller Index of Housing prices began falling in July 2006, not 2008.ⁱ Consumers were not broadly using their homes as ATMs—if they were, it's highly unlikely consumer spending wouldhave held up better than most other contributors to economic growth in the 2008 - 2009 recession. (It did.) As we’ve written here numerous times, the financial panic seemsto have been theunintended result of the implementation of FAS 157’s fair value accounting rule and the haphazard government actions that followed.

FAS 157 targeted accounting for mortgage-backed and other securitized loans—assets (later labeled “toxic”) previously accounted for as “held to maturity” were now to be valued based on the last observable trade. The rule was implemented in 2007—right about the top of the market. It was watered down for illiquid, “held to maturity” assets following Congressional hearings in March 2009—the bottom of the bear market. Perhaps a coincidence, but I doubt it. In my view, this accounting rule was toxic, not the assets. Once you see this, the whole financial crisis can be seen in an entirely different light.

The new evidence I’m referring to came in the form of a press release from the Federal Reserve, titled, innocuously, “Reserve Bank income and expense data and transfers to Treasury for 2013.” The Federal Reserve, though technically a “private” institution, transfers any profit from its actions to the Treasury on an annual basis. For 2013, that profit totaled $77.7 billion, down slightly from 2012’s record $88.4 billion.

The lion’s share of the Fed’s bigger profits are the proceeds of its quantitative easing bond buying. The size of the Fed’s balance sheet is up massively since 2008, so higher interest income (profitability) is unsurprising. However, there was an added contributor—one that went away in 2012, a reason 2013’s profits are slightly lower: Maiden Lane. Maiden Lane is actually three special purpose vehicles—funds, if you will—the Fed used to purchase various assets. Maiden Lane I was established in March 2008 as part of the Fed-brokered buyout of failing Bear Stearns by JPMorganChase. JPMorganChase would only agree to buy Bear if the government agreed to absolve it of Bear’s supposedly “toxic” assets (mortgage-backed securities, collateralized debt obligations, etc.). These assets, caught amid a negative feedback loop of writedown after writedown, destroyed Bear’s capital. (The same cascade of writedowns later took down Lehman, Wachovia, et al.) The Fed established this first Maiden Lane facility to buy these supposedly toxic assets. But in doing so, they established something exceedingly rare in economics and finance: a counterfactual.

Most times, finance and economics is ruled by theory you can’t definitively prove in the real world. There is no way, for example, we can definitively know how deep the recession would or would not have been absent the American Recovery and Reinvestment Act (2008’s stimulus). We didn’t try a recession sans stimulus, so we have nothing to compare to. However, this isn’t true as it applies to fair value accounting and securitized debt. While fair value accounting reigned for the banking sector generally, it never touched the Fed. Hence, when Maiden Lane I bought assets many thought were toxic, it moved the same bonds from an FAS 157 environment to a non-FAS 157 environment. So we can then see, plainly, which was toxic: The assets or the accounting rule?

And this is where Fed profitability comes in.

Maiden Lane I mostly ceased operations in 2012, as the bonds it owned either matured or were sold. In June 2012, the New York Fed (they managed the Maiden facilities) announced all of the $28 billion or so extended under Maiden Lane I had been repaid. The interest received along the way? Profit. The absence of gains and interest received from the closure of Maiden Lane in 2012 helped lower Fed profits from $88.9 billion to 2013’s $77.7 billion. Don’t get caught up in amounts and figures here. What the profits show is more important than size or level: It proves beyond doubt the assets bought weren’t toxic, unless somehow one can perform mental gymnastics sufficient to bend the definition of “toxic” to match “profitable.” Some assets did fail! But here the Fed was, supposedly buying the worst-of-the-worst. Once out of the FAS 157 vortex, the assets overwhelmingly did what they were designed to! The same cannot be said of FAS 157.

During the aforementioned Congressional hearings that led to FAS 157’s suspension (and later repeal), Congress heard from many interested parties. Some argued the rule simply shed light on the nasty reality of bank balance sheets. By valuing these securities at market, investors were supposedly given “transparency” into the dark reality of what banks held. Others, including former FDIC chairman William Isaac, argued banks were being unnecessarily imperiled by FAS 157. The requirement to mark assets to market subjected illiquid securities to the market prices bearing little resemblance to their actual long-term economic value. Isaac showed an example in which one bank which was forced to write down a security by more than $900 million—even though their loan losses incurred at the time of writedown were less than $2 million, and it projected worst-case scenario losses of $100 million. Market prices are not always rational in the short term. FAS 157 brought irrationality to regulatory capital, and with it, panic. A rule targeting transparency actually brought the opposite.

After the hearings, Congress more or less demanded FASB suspend the rule for “held to maturity” assets. And markets rebounded. But still, most folks have no idea what FAS 157 is. Or why it mattered so much! But consider: If banks weren’t forced to take big, sudden losses quashing more than $2 trillion in regulatory capital, chances are 2008’s financial panic wouldn’t have occurred.