Overuse of Short-term Debt Brought System Down

Published on April 10, 2009

Like all others, the current financial crisis is connected to short-term debt and potential runs on short-term debt, said Douglas Diamond , Merton S. Miller Distinguished Service Professor of Finance. “This run on short-term debt turned some small losses into big losses,” Diamond said during a panel at the University of Chicago Conference on the Financial Crisis.

The conference, organized by the Money and Markets Workshop of the Council on Advanced Studies in Humanities and the Social Sciences, featured four panels of social science experts from London and throughout the United States. The daylong event was held at the Franke Institute for the Humanities at the Joseph Regenstein Library at the Hyde Park campus on April 10.

Short-term debt is the best way to borrow as much as possible against a given set of assets, because such lenders will run to get paid first if borrowers might default, Diamond said. “This is great if you want to commit to pay your short-term lenders, but it’s not so great if everybody does this,” he said. “A severe overuse of short-term debt became pretty clear in this crisis.”

These relatively small losses brought down the financial world because they were concentrated in a few investment banks, and also in the commercial banks (in a hidden way), Diamond said. Structured investment vehicles once removed from the balance sheets of commercial banks returned because of written contracts or moral obligations, he said.

“Investment banks were actually the key transmission mechanism for this thing,” Diamond said. “They were borrowing a ton against mortgage-backed securities and convertible bonds, which are complicated instruments you wouldn’t want to get as collateral. Many who lent using repurchase agreements weren’t even legally able to hold these assets got them when Lehman defaulted and were immediately forced to sell them. It was the ultimate fire sale. There was this huge levering up of investment banks, particularly by issuing overnight debt.”

No lenders were available to meet the sudden need to repay all of these large amounts of short-term debt, he said. Initially the Federal Reserve was not allowed to lend against such assets, Diamond said.

With prices depressed, a subtle dynamic occurs in which bargain hunters wait to buy because they know prices will be even lower later, Diamond said. “You don’t want to trade or invest,” he said. “You basically require this very high rate of return on your investments, if you’re one of these smart lenders who could be potentially buying these, say, asset-backed securities. So lending sort of comes to a halt, because we see a fire sale may be coming soon.”

In response to the crisis, an apolitical group of economists to which Diamond belongs (the Squam Lake Working Group) issued three recommendations on regulatory reform, he said:

  • The current system provides too little disclosure of systemic risk. “We propose a good summary of counter-party exposures and systematic risk exposures that would be required worldwide,” Diamond said.
  • Bank capital requirements must be increased when on banks that create systemic risks such those with large mismatches between long-term illiquid assets, those financed primarily withshort-term debt, or banks that are either very large or are holding illiquid positions that are nearly identical to most other institution’s holdings.
  • An improved mechanism must be created for bank holding companies or other institutions to allow regulators, outside of bankruptcy, to convert certain debt to equity to keep banks from failing or dumping assets.

                                                                                                                    — Phil Rockrohr