Felix Salmon appears to be deeply confused about what he calls the “moral hazard trade” (otherwise known as the TBTF subsidy). James Surowieki challenged Felix’s earlier posts about the moral hazard trade, asking, “If big banks have lower borrowing costs than small banks, he asks, why do we automatically attribute that to moral hazard (the idea that they’re much more likely to get bailed out in extremis) rather than the simple fact that they’re less likely to default?” In response, Felix cites a recent anomalous spike in the COFI (cost of funds index) which was attributable to a change in the index components, and which essentially showed that Wachovia has a much lower cost of funds than small banks:

This datapoint is telling, because Wachovia — largely because of the Golden West acquisition — was a very rocky bank indeed, and was sold as a highly-distressed asset to Wells Fargo. The fact that its cost of funds was so low clearly had nothing to do with its inherent safety, which means that we have to attribute it instead to the moral hazard trade.
Um, what? All this proves is that big banks tend to have a lower cost of funds than small banks. No one is disputing that. The dispute is over how much of that lower cost of funds is attributable to implicit government support, and how much is attributable to other factors, such as the relative credit risk in the portfolios of big banks vs. small banks. Felix simply asserts, without any evidence, that “clearly” the difference had nothing to do with any other factors, and therefore concludes that the entire difference must be attributable to the moral hazard trade.

Of course, it’s not at all “clear” that the entire difference is attributable to the moral hazard trade. For one thing, small banks’ balance sheets tend to be heavily concentrated in real estate loans — especially commercial real estate, which is in a free-fall right now. The big banks — which got badly burned by CRE in the early ‘90s — tend to be significantly less concentrated in CRE. So that’s one factor that undoubtedly accounts for some of the difference in small banks’ cost of funds.

How much of the difference is attributable to small banks’ exposure to CRE, and how much is attributable to the moral hazard trade? I don’t know. (And I’m not denying that the moral hazard trade accounts for some of the difference; it definitely does.) My point is simply that there are lots of factors at play here. You can’t just assert that there are obviously no other factors at play, and that the entire difference must be attributable to the moral hazard trade.

4 comments:

Anonymous said...

"Felix simply asserts, without any evidence..."

I find it hard to understand how you came to this conclusion. Salmon cited that the Golden West acquisition made Wachovia a highly distressed asset. I think the clear implication of his point was that Wachovia was no different than any community bank that was a problem bank subjected to the PCA process, except that the regulators would never put a large bank through the PCA process and would bail out any large bank, and thus Wachovia's costs were lower.

You might disagree with Salmon, but I think his argument was very clear, backed by evidence (i.e., Wachovia's condition due to the Golden West acquisition), and reasonable, even if you think it ultimately wrong.

I also find your CRE argument very unconvincing. CRE had not yet cratered like residential RE as of September 2008. Admittedly many at that time saw it coming, so one could argue that small banks' costs would already be high, but (a) costs for an expected, but not yet entirely existing, CRE crash would still seem to be at least somewhat lower than costs for a known and current problem like Wachovia's acquisition of Golden West and its option ARMs/residential RE portfolio, and (b) I see absolutely nothing -- nothing -- that leads me to believe that large financial institutions' ownership of toxic assets (MBSs, CDOs, etc) was any less a threat to their existence than small banks' ownership of CRE loans. In fact, it seems almost impossible to say otherwise in light of the events from August 07 to October 08. So if toxic assets were as big of a threat to large financial institutions as CRE is to community banks, there still needs to be some other explanation for the difference in funding costs...like a moral hazard premium.

Anonymous said...

It's the moral hazard trade.

The thing is there really is nothing else. There is no other reason why the big banks would be more creditworthy than the small ones -- when in fact they have extremely large evidence of being less creditworthy *absent the bailouts*.

But they are more likely to get bailed out. Therefore more creditworthy.

The impetus is on *you* to provide an alternative explanation. "Big banks are less likely to fail" doesn't pass the smell test, as it is simply outright false, and you can run historical statistics to prove it.

Anonymous said...

anon at 12:31 AM, exactly what evidence is there for this? Care to show us those historical statistics? Would love to see a full analysis done because most of the banks that have gone to the wall are small ones.

Danny

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