Spring 2020 Special Edition: Money in the Time of Coronavirus
Special Edition: Money in the Time of Coronavirus
Prompt for Discussion
Contributors: Katharina Pistor, James McAndrews, Saule Omarova, Mark Blyth, Jamee Moudud, Elham Saeidinezhad, Dan Awrey, Fadhel Kaboub, Leah Downey, Virginia France, Lev Menand, Nadav Orian Peer, Robert Hockett, Carolyn Sissoko, Jens van ‘t Klooster, Oscar Perry Abello, and Gerald Epstein
The financial strains brought by the coronavirus outbreak feel strangely reminiscent of 2008, and yet, markedly different. In the United States, at the writing of this prompt, the S&P 500 has crashed 25%, and the federal funds target rate is once again moving towards the zero bound. The treasury securities market is in disarray, and the Federal Reserve is set to increase its repo lending by over one trillion. In Washington, the administration’s insistence that concerns were overblown is now replaced with negotiations over the size and shape of a stimulus package. “I don’t want to use the b-word”, said a senior administration official about plans to support distressed industries, like airlines. The b-word is, of course, bailout.
So far, so 2008. But the monetary dynamics we are witnessing in the time of corona also take us into new territory. The proximate cause of the crisis past came from within the financial system itself: the housing credit bubble and abuses in subprime lending. The corona crisis, on the other hand, emerges from a material threat to human health. Where the 2008 crisis revealed the vulnerabilities of financial globalization, the corona crisis is disrupting the global production system, upending supply chains, and threatening shortages in essential inventories.
We wonder about the extent to which the policy arsenal of 2008 can contain the dislocations currently occurring, and what, exactly, stimulating consumer demand means when the consumer herself is in quarantine. Moreover, the crisis response to the corona crisis is taking place within an institutional setting that was itself reshaped by the 2008 crisis reforms. As corona strains unfold, it remains to be seen whether the promise of financial resilience will be borne out, or whether fundamental design flaws left in place will frustrate reformers’ efforts.
In this Special Edition Roundtable, JM invites contributors to provide live analysis of money in the time of corona, here in the U.S., and around the world.
C. Sissoko, The Problem with Shareholder Bailouts isn’t Moral Hazard, but Undermining State Capacity
April 10, 2020
Carolyn Sissoko, University of the West of England
Coronavirus and the immense economic costs associated with repressing its growth has provoked a debate over how to distribute those costs. Many law professors have argued that large, heavily-indebted corporations, such as airlines and private equity owned companies, that cannot afford the losses imposed by the coronavirus crisis need to be put through a government supported, expedited, and managed bankruptcy process along the lines of how the GM failure was managed in 2009 (e.g. Morrison and Saavedra 2020; Morgan Ricks; Ayotte and Skeel 2020). Underlying this approach is an emphasis on the importance of shareholders being wiped out – or at a minimum ending up sharing ownership with those who assist in the restructuring of the company. Several macroeconomists by contrast take a very different approach. They argue that the extent of the economic disruption caused by the coronavirus crisis is so great that it’s costs should be treated as a problem for the government, not for business. (E.g. Smith 2020; Bullard interview 2020. See also Farmer 2020.) Objections to the shareholder bailout approach are often immediately classified as concerns about “moral hazard” and then dismissed on the basis that it is unreasonable to expect businesses to prepare for an event such as the current crisis.
What underlies the gulf between these legal scholars and macroeconomists? Lawyers have a nuanced understanding of corporate structure and its economic consequences (see e.g. Pistor 2019), whereas macroeconomic models typically simplify this structure to the point of ignoring it entirely. As a result, the lawyers consider shareholder losses even, or perhaps especially, in the event of unexpectedandunforeseeable risk to be fundamental to how capitalism is supposed to operate. Implicitly, the lawyers understand that private sector risk-bearing plays an essential role in supporting state capacity and that turning this structure on its head is extraordinarily dangerous to our economic order. The macroeconomists by contrast are not in the habit of modeling the macroeconomic role played by corporate shareholders as risk-bearers in the economy and often have difficulty understanding this relationship. References to “moral hazard” are evidence of a purely microeconomic approach that fails to comprehend a macroeconomic risk-bearing role for the corporation.
What is a corporation? A corporation is a legal form that separates ownership of assets from control over the assets and from liability for the obligations associated with the assets. The corporate form both protects corporate assets from the shareholders (and the creditors of the shareholders) and shifts the risks of the corporation from the shareholders to the corporation’s employees, creditors, and the state. Corporations developed with these significant protections for shareholders in order to increase the willingness of the wealthy to invest not in land but in risky enterprise controlled by others – and the growth of corporations is associated with economic growth. The trade-off for the shareholder is that even though the investment is risky, the potential loss to the shareholder is limited to the amount of the shareholder’s investment. To the degree that the corporation incurs debts or causes tortious harm on behalf of the shareholder, the shareholder is shielded from liability for the actions the corporation took on the shareholder’s behalf. This liability shield means that much of the risk of corporate activity is borne by the corporation’s employees, suppliers, the public at large (in the event of torts), and the state.
Thus, the corporate form itself is means of providing public insurance to corporate shareholders against the loss of their wealth. The justification for providing this insurance is to induce wealthy shareholders to bear risk for the economy as a whole: the shareholders bear the first loss in exchange for being assured that that loss is limited, and reaping significant rewards if the corporation has profits instead of losses. Indeed, the only economic function of the shareholders in a publicly-listed company is to bear risk: the shareholders do not control the company and have minimal say in its management.
Private-equity-owned companies are, as the name implies, privately held. As a result, the private equity fund does control the company. In practice, however, the owners of the private equity fund do not control the companies they own, instead they are limited liability partners who, just as in the case of standard corporate structure, cede control to a group of managers. Just as in the case of corporate shareholders, the only economic function that the limited partners in a private equity fund perform is to bear risk for the economy. Indeed, it’s not entirely clear what the macroeconomic function of this two-tiered limited liability structure would be – though it has obvious private advantages to the managing partners of the private equity fund who get to combine control with the public insurance of limited liability for the actions of the firms they control.
Because the function of the shareholders in a public company and of the limited partners in a private equity fund is to bear risk, the idea that government support would protect the shareholders and limited partners from losses doesn’t make a lot of sense. The shareholders in a public company and in a private-equity-owned company can be replaced by a Chapter 11 bankruptcy process that converts debt into equity while allowing the corporation to continue operating. Indeed, this is the basic nature of our economic structure. The reason to avoid shareholder bailouts has nothing to do with “moral hazard.” Afterall, the shareholders and limited partners don’t even control the corporation. The reason to avoid shareholder bailouts is because the shareholders are there to bear risk for the economy.
A full understanding of this point requires an understanding of how private sector risk-bearing plays an important role in supporting state capacity. That is, the reason certain governments have a remarkable capacity both to borrow and to serve their citizens is because these governments are not alone in bearing risk, but have mechanisms that take advantage of private risk-bearing capacity. The financial revolution and the subsequent development of the public stock market provides the best illustration of this point.
The financial revolution represented a turning point in European history, because it took place in Britain and was the foundation of Britain’s capacity to win wars and build an empire (Dickson 1967; Roseveare 1991; Baugh 2011; Scott 2011). At the heart of financial revolution sat reliance on private sector risk-bearing both in the form of the Bank of England, which was chartered as a corporation, and in the form of private sector finance of British long-term debt. The market in public sector debt was the foundation upon which the market in corporate securities developed in the early 18th century.
From 1660 to 1763 Britain experienced a financial revolution that had several components: (i) the transformation of the state including (a) an annual budget approved by Parliament, (b) capacity to impose taxes and have them accepted by the populace, and (c) the growth of a professional and highly specialized administrative state; (ii) the transformation of government debt into annual issues of marketable, redeemable, long-term debt bearing an interest rate of 3 to 5%; and (iii) the transformation of private lending through both the Bank of England, which stabilized the value of sterling, and an active market for government debt, which supported borrowing from both domestic and foreign lenders.
The financial revolution has been widely recognized since the Seven Years War as the foundation of Britain’s pre-eminence during the years in which the Empire was consolidated. A comparison with 18th century France can illustrate how the financial revolution affected borrowing capacity: in the Seven Years War much of the French war effort was financed by short-term debts to suppliers at relatively high interest rates (Scott 2011: 433). Not only was this a less effective means of raising funds for the war, it left France with a crushing burden that destabilized the French financial system (ibid.). For this reason, the French sought (unsuccessfully) to emulate the British financial system which was described as “one of the wonders of the world”. (Ibid. See also Baugh 2011: 15).
It is worth emphasizing some of the aspects of the British system of public debt that made it so effective. The interest payments on the debt were fully funded by taxes. The debt was technically perpetual, which protected the state from the risk of being forced into default, but the debt was in practice supported by a variety of mechanisms for redemption. The relatively high interest (4 or 5%) debt that was issued at the height of a war was typically redeemed in a peacetime conversion to lower-rate debt. The long-term debt was also supported by a “Sinking Fund” that dedicated specific tax revenues to the purpose of paying off the debt. While there was an active market in government debt, the state did not raise funds on the market (despite efforts to do so in the mid-18th century). Instead, the state placed its debt privately with wealthy financiers who had the capacity to hold the debt over time and could use the public market to slowly rebalance their holdings of public debt (Dickson 1967: 226-28). Finally, in exigent circumstances the British government also had access to short-term debt, the issue of which was supported by the Bank of England. On the other hand, this short-term “unfunded” debt typically comprised 5% or less of the total debt burden, and even at the height of the Napoleonic Wars rose only to about 8% of the debt burden (see Thomas and Dimsdale 2017: Table A29).
A cornerstone of the Financial Revolution was the Stock Exchange where the long-term government debt traded – allowing the private investors a way of exiting their investment and providing market liquidity to the government debt. After the Napoleonic Wars the issues that traded on the Stock Exchange expanded to include a large number of private issues, and by the middle of the century there was a robust market in corporate securities.
This review of 300-year-old history is just a reminder that private sector risk bearing sits at the very heart of state capacity. Government capacity is not some kind of stand-alone phenomenon that can work independent of private sector risk bearing. It is instead a consequence of a robust institutional structure that makes it possible for burdens to be widely shared, not just by taxes but also through private sector losses on risky investments.
In short, the reason not to bailout corporate share-holders is not “moral hazard,” but because such a bailout represents a shift in the nature of burden sharing in a capitalist economy. It is the norm in macroeconomic models to treat corporations as pass-through vehicles (precisely what a corporation is not from a legal perspective), to abstract from bankruptcy (Goodhart and Tsomocos 2011), and to assume that the corporation’s income flows directly back to the shareholders – or even as in the case of Guerreri et al. (2020) back to the workers. The deficit of careful analysis by macroeconomists of the corporate form and of the role that it can play in macroeconomic risk-bearing naturally raises doubts about the degree to which macroeconomists can provide useful advice about the structure of corporate bailouts. The legal profession has the advantage of having thought long and hard about these issues. This debate matters today, because the Federal Reserve has – appropriately under the circumstances – stepped in to provide extraordinary support to US corporations. These actions have taken place so quickly, however, that the end game of these new policies has not yet been specified. Almost all of the support to the larger corporations is in the form of debt, and the Federal Reserve will, when the public health crisis is over, almost certainly have on its hands some corporations that are viable only as long as they have continued access to Federal Reserve lending and will be bankrupt without it. The lawyers will argue that government supported and managed bankruptcies should take place with significant losses to shareholders – even though such a policy will undoubtedly cause significant distress in the stock market. What will the macroeconomists say? Hopefully they will update their models and join the lawyers in demanding that the private sector, not just the government, bear the losses of coronavirus.
C. Sissoko, A Fire Sale in the US Treasury Market: What the Coronavirus Crisis Teaches us About the Fundamental Instability of our Current Financial Structure
March 27, 2020
Carolyn Sissoko, University of the West of England
A recurringthemein the papers that I have written is that asset price instability is endemic in a system of collateralized lending based on repurchase agreements. Even I, however, was caught completely off-guard when it was the US Treasury market that began to experience fire sales.
Almost everybody[i] thought that by moving the repo and derivatives collateral market into “safe assets” or bonds issued by the most credit-worthy sovereigns, the repo market could be de-risked. What we learned over the past few weeks is that the ineluctable logic of margin calls and forced sales can play havoc even in markets for the safest collateral. This throws into doubt the very concept of a “safe asset” and makes clear how dependent the concept is on the underlying market micro-structure.
Here is a chart that gives year-to-date values for the Fed’s policy rate (green), the market repo rate (SOFR: red), the yield on the 2-year Treasury (light blue), the yield on the 10-year Treasury (purple) and the yield on the 30-year Treasury (orange).
Keep in mind that when the Treasury yield declines, that means that people are buying Treasuries and that the price of Treasuries is increasing. And when the Treasury yield rises that means that people are selling Treasuries and that the price of Treasuries is falling.
Starting in mid-February, this chart depicts a ‘flight to safety’ into Treasuries as the corona virus crisis generated uncertainty for investors and they chose to shift into Treasuries. This is what we expect to happen with a ‘safe asset.’ What is remarkable about this chart is what happens after March 9. Treasuries are clearly being sold in significant amounts after March 9.
I have seen two explanations for the onset of this phenomenon. The first explains that the flight to safety took place faster in futures on Treasuries than in the actual Treasuries themselves and that this caused a significant price gap between the two contracts. As there are hedge funds that arbitrage these two prices – and, because the return on this trade is so small, engage in this arbitrage on a highly leveraged basis – the price gap resulted in significant mark-to-market losses for these funds. Apparently, these arbitrage funds chose to sell out of their positions – realizing their losses now before they got worse. Liquidation of arbitrage positions is notorious for causing price gaps to worsen and for causing others engaged in a similar trade to also choose to liquidate their positions. The liquidation of these positions involved selling Treasuries.
The second explanation starts with investors in bond funds, including both mutual funds and exchange-traded funds, deciding that they no longer wished to hold those positions since the coronavirus was likely to have a significant impact on many firms that issued bonds. When investors exit bond mutual funds, the managers of those funds have to reduce their holdings of bonds. The process for exchange-traded funds is more complicated, but has the same overall effect: if investors sell their bond ETFs, then the ETFs themselves will end up selling bonds. You can see the effect of these sales on the chart of the spread between corporate bond yields and Treasuries.
Since these sales were of corporate bond funds, one can easily ask how this behavior could end up causing a sale of Treasuries. The answer is that many bond funds have some Treasuries in their portfolios. As sales of corporate bonds ramped up and the bond fund managers didn’t like the prices they could get on the corporate bonds – or the price effects they would generate by adding to the sales – they turned to selling off Treasuries to meet their redemptions needs.
Whatever the underlying cause of the sales of Treasuries was, we can see in the first chart that, on March 10, sales of Treasuries were so significant that they drove the price of Treasuries down and their yields up. This continued through March 12, when the Federal Reserve tried to address the problem by flooding the repo market with $1.5 trillion. While the Fed was successful in bringing the repo rate, the Secured Overnight Financing rate (SOFR), down, repo liquidity couldn’t address the selling pressure in the Treasury market, and Treasury yields continued to rise.
The negative feedback loop in repo works like this: a decline in the value of collateral results in a margin call. As an example, assume a borrower has borrowed $98 by posting $100 in Treasury collateral and is required to maintain a haircut (or excess collateral) of 2%. Then a decline in the value of the Treasuries to $99 will lead to a $1 margin call that can be met with either cash or collateral. That is, to support a $98 loan, $100 of Treasury collateral must be maintained. Alternatively, a payment of $1 in cash will reduce the loan to $97 against $99 in collateral. If the borrower happens to own additional, unpledged Treasuries, the call is easily met. However, when the repo borrower is at the limits of her borrowing capacity, the margin call forces the borrower to scramble to meet the call with additional cash or collateral. This will in general force the borrower to sell something. In other words, margin calls generate a demand for cash.
Furthermore, if the borrower fails to meet the margin call, then the lender sells the collateral to pay back the $98 loan. Note that the lender has no incentive to seek the best price for the collateral – the lender just wants to make sure that the $98 loan is covered – any excess returns from the sale of the collateral have to be remitted to the borrower. In short, margin calls generate sales either from borrowers desperate for cash or from lenders who are liquidating the collateral to close out the repo loan. These sales push prices down further and generate more margin calls. The bottom line is that repo has always been associated with fire sales of assets in crises. These fire sales are a function of the contractual structure of the repo loan.
The issue at the present moment is that the coronavirus crisis has caused a significant increase in the volatility of many financial markets. When volatility increases, the collateral that needs to be posted in derivatives contracts typically increases too. So, the crisis has been accompanied by an increase in the collateral that needs to be posted. As a result, demand for collateral has increased. Collateral that could meet demand in late February would not be enough to meet demand in mid-March. (Indeed, it’s possible that this dynamic had already started playing a role well before March 13.)
At the same time, as we have seen, the fall in Treasury prices from March 9 to March 13 meant that the supply of collateral had declined. In fact, for 30-year Treasuries, a rise in yield of 0.5% as we see over this period can be associated with a decline in value of 8% or more. While the effects are smaller for Treasuries with shorter maturities, the aggregate effect on the supply of collateral that is generated by the interest rate movements in the first chart is both substantial and dramatic. Furthermore, this decline in value affects each and every owner of long Treasuries. In short, from March 9 to March 13 traders who held long Treasuries as “safe assets” learned (as they had always been told by people who pay attention to these things) that even Treasuries can be risky assets. This undoubtedly increased the demand for cash, and the incentive to sell long Treasuries.
This decline in the value of long Treasuries caused collateral positions everywhere to fall. The decline in collateral was inevitably accompanied by margin calls. In these circumstances there were inevitably some traders who were unable to meet the calls or who were desperately looking for cash to meet them. They looked at long Treasuries as risky assets, because they didn’t know how long this cycle of margin calls was going to continue – and how far the price of 30-year Treasuries could fall, which generated a strong demand for cash and very short Treasuries. Traders who didn’t meet their margin calls faced forced sales of their collateral, resulting in more sales of Treasuries. With these sales came lower prices and more margin calls and more sales, with no clear end in sight.
This is the fundamental nature of repo and similarly structured markets. When traders’ balance sheets are stressed, all it takes is a fall in the price of collateral to turn the repo market into a coordinating device that generates a vast liquidity drought, hitting everybody in the market. We saw this in March and September of 2008, but then the cycle was stopped by dramatic Federal Reserve action before Treasuries became illiquid. And almost everybody, certainly including myself, thought that the shift of the repo market out of private sector collateral would help stabilize it. What we learned over the past two weeks is that, in a crisis, repo markets don’t just act as a vortex sucking liquidity out of the financial system, but that this vortex is so strong that not even Treasuries can be treated as “safe assets.”
From March 15 through March 17, the Fed took dramatic actions, providing liquidity to the banking system, opening swap lines with five central banks, restarting quantitative easing, re-opening crisis programs to lend to investment banks against collateral and to help non-financial corporations to borrow on commercial paper markets. Even so, the yields on Treasuries continued to rise through March 18. Only after the Federal Reserve re-opened crisis support for money market funds (March 18) and extended swap lines to nine more central banks (March 19) did the yields on Treasuries finally begin to fall. Even so, by end of day on March 20, yields had still only fallen to their level on March 13 and remained far above their March 9 level.
Thus, on the morning of March 23, the Federal Reserve took unprecedented action, expanding its support of credit markets far beyond the policies it adopted in the 2008 crisis. Most important to the repo market, the Fed declared that it stood ready to buy Treasuries in unlimited amounts. In short, the Federal Reserve is now a backstop for the price of Treasuries at all maturities. In my opinion, the Fed’s actions on March 23 were designed to put a stop to the repo markets’ forced run on Treasuries. And I believe the Fed has succeeded: yields on Treasuries dropped on Monday and the Fed has the means to keep them from rising significantly.
While the Fed may have stabilized the Treasury market, when the health care crisis has passed, it will be time to reconsider whether we want to continue to rely on repo markets now that we have seen twice in a dozen years how they suck liquidity out financial markets just when it is most needed. Structural reform of our money markets needs to be on the agenda.