From the blog post: [...] [...] [....] [...] [...]
From the blog post:
I have not seen a sympathetic explanation of how well-intentioned, smart people could actually intentionally take the risks that resulted in the present crisis. Past advocates for that risk-taking might be understandably reticent about advancing their arguments for raising on the flop now that we’ve seen the river. So I thought I’d provide a sketch of the world as we understood it until very recently.
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Now, if you cast your memory back to the high-quality assets of certain recently failed banks which suffered large mark-to-market impairments, do you remember their constitution? They were largely a mix of Treasuries and, hmm, wait a minute, a much larger amount of agency MBS [mortgage-backed securities].
SVB, ~$80 billion in MBS. Signature Bank, ~$20 billion. First Republic, only about ~$10 billion.
These portfolios increased in size materially during a period of low interest rates, backing up the truck on interest rate risk effectively, and then had a foreseeable outcome (billions of dollars in losses) when interest rates rose.
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It was the repeated advice of people in corridors in power, including bank boards, bank risk departments, and crucially bank regulators, that regional banks should buy more agency MBS at prevailing margins.
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This advice did not minimize for interest rate risk, to put it mildly. Society has many demands of the banking system and “Don’t take interest rate risk” is not very high on that list. (A computer can be perfectly secure if it is turned off and a bank can be perfectly neutral on interest rate risks if it simply doesn’t participate in credit creation. Plausibly you need a paperweight in your life and if so you can use either of those things.)
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I express certainty that there were formal incentive systems which encoded this recommendation. For example, one of many ways by which we regulate banks is by capital requirements. Different assets require different amounts of capital to carry them on the books, in a process called “risk weighting.” Since banks will optimize for return on capital, adjusting risk weights is a way to substantially guide their behavior via shaping incentives without directly mandating one’s preferred outcome.
This topic gets very wonky, so, spoiler alert: a quick perusal of risk weights, which are objective facts about the world banks operate in that you can present in a table, will show an enormous thumb in favor of MBS. Where is the corresponding table of concern for interest rate risks? To make a very long story short, while bank regulators notionally care about interest rate risk they care about it a lot less. The shape of our last crisis was about credit quality and counterparty risk rather than interest rates.
Our generals wrote our specs for these weapon systems to thoroughly address the inadequacies in previous weapons systems in the environment of previous wars; a shame we’re fighting in a new environment but that is sort of the way of things.
It was not an accident that banks loaded up on MBS. We wanted them to. We told them to.
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Many commentators have expressed surprise that banks loaded up on interest rate risk without hedging it.
I… am confused as to what instrument, and what counterparty, exists to hedge a one trillion dollar loss on a rates bet. You should have hedged, fine, assert that we roll back history to about 2019 and that society successfully identifies someone to take a one trillion dollar loss.
From the blog post:
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