District of Columbia Federal Judge, Rosemary Collyer, recently denied the Financial Stability Oversight Council’s (FSOC’s) request to dismiss MetLife’s challenge to the FSOC’s systemically important financial institution (SIFI) designation. Instead, Judge Collyer dismissed the FSOC’s designation, determining MetLife was not “Too Big to Fail.” Whether the decision holds up remains to be seen, but economically speaking that decision sounds right.
Section 113 of Dodd Frank stipulates that nonbank financial institutions can be hand-selected for SIFI designation based on criteria such as size, complexity or interconnectedness. However, the crisis was about regulations that encouraged holdings of the assets that went bust, rather than financial firm characteristics like size, complexity or interconnectedness, as Dodd Frank suggests.
To see why, first consider that MetLife is an insurance conglomerate and should be regulated as such, especially since it sold its banking subsidiary, MetLife Bank, in 2013. Between Q1 2006 and Q1 2009, total deposits at MetLife ranged from $4.5 billion to $7.5 billion, and MetLife had $6.4 billion in total deposits when MetLife Bank was soldto GE Capital. Still, MetLife’s total deposits were greatly exceeded by the firm’s other liabilities such that deposits were usually under 1 percent and never exceeded 1.6 percent of liabilities between Q1 2006 and Q1 2009. For comparison, during that same time the average bank had about 80 percent of its liabilities in the form of deposits. Rather than firm liabilities, firm assets should be cause for concern.
Leading up to the crisis, when it still owned a banking subsidiary, MetLife invested in a fairly high fraction of the highly rated, private-label mortgage backed securities (MBSs) tranches that performed poorly during the crisis. Using a measure that Professors Isil Erel, Taylor Nadauld and Rene Stulz applied to examine why banks held such assets, MetLife increased the fraction of its total assets allocated to those assets from 6.9 percent in Q1 2006 to 9.7 percent in Q1 2009.
For comparison, at one end of the spectrum, the average bank had only 1.6 percent in Q1 2006 and only 0.6 percent in Q1 2009-and at the other end of the spectrum Citigroup had 3.6 percent in Q1 2006 and 4.4 percent in Q1 2009. Of course, Citigroup also had an additional 5 percent of its investments allocated to highly rated tranches of Collateralized Debt Obligations (CDOs) that performed even worse than the highly rated, private-label MBS tranches.
As a recent Philadelphia Fed study showed, CDOs were the instrument at the heart of the crisis because write-downs on the total volume issued averaged 60 percent. To understand why CDOs were so destructive, a study by Professors Coval, Jurek and Stafford showedthat CDOs were overpriced relative to similar securities, because the prices ignored risks in the broader economy, such as the housing market. The underlying CDO collateral not only had higher default risk, but also default correlations because the collateral was typically originated at roughly the same time and from the same region. Had they adequately reflected what was happening in the broader economy, the prices (and ratings) would have been lower and yields much higher.
In relative terms then, MetLife took a cautious approach to investing in the highly rated tranches, while Citigroup took an aggressive approach. The difference in approaches helps explains why when MetLife and Citigroup closing share prices hit their crisis-related low points on March 9, 2009, when MetLife was trading at close to $12 a share and Citigroup was trading at about $1. But why might an insurance company, which took a relatively cautious approach to highly rated tranche holdings, have invested in these securities?
A study by Professors Craig Merrill, Taylor Nadauld and Philip Strahan found that insurance company capital requirements distorted balance sheets toward those holdings between 2003 and 2007. In particular, some insurance companies held those securities because they offered higher yields for a given dollar of capital. The effects were particularly evident in accounts that had disproportionately higher regulatory capital requirements for assets with low credit ratings, which encouraged them to find highly rated assets.
Thus, for insurance companies during the crisis, system-wide risks came from complex regulatory capital requirements that gave incentives to hold assets that went bust. This flaw could be addressed at the state, rather than federal level, with simpler, higher capital requirements.