If you want to read more about messed-up incentives, Patrick McKenzie wrote a long article about this [1]: > Suppose you’re a salesman and you’ve identified th

If you want to read more about messed-up incentives, Patrick McKenzie wrote a long article about this [1]: > Suppose you’re a salesman and you’ve identified that the deposit franchise is a natural hedge. Bracket the question of whether you can convince the decisionmakers for the deposit franchise to do business with you. Who in the economy most needs an interest rate hedge? Who could you sell that to? > I claim that it is the mortgage industrial complex, and if you want me to be more specific, it is the government-sponsored entities (Fannie Mae, Freddie Mac, etc). They [enable] the housing market operating in the U.S. by providing securitization infrastructure which, as a side effect, backstops credit risk in conforming mortgages with the full faith and credit of the U.S. government. Agency mortgage backed securities (MBS) are the second largest dollar-denominated fixed income category in the world. They are much larger than minor players like “all corporate bonds combined.” [...] > 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. > 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. [...] > 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. [...] > It was not an accident that banks loaded up on MBS. We wanted them to. We told them to. (By "we" I assume he means bank regulators.) > [...] We didn’t expect the rate hikes to blow up a large chunk of the U.S. banking sector. We knew they would cause losses, to banks and all other holders of financial assets, but modeled them as survivable and more palatable for society than continuing inflation was. We appear to continue to believe that, at least to the extent we believe we can have our cake and eat it too. So I'm wondering what the implications are of this. Banks taking interest rate risk is traditional. Mortgage-backed securities are a diversified version of that, which lowers most risks (or at least, we assume so after 2008) but not interest rate risk. If the implication is that banks shouldn't fund Fannie Mae / Mac as much as they did, who should? [1] https://www.bitsaboutmoney.com/archive/deposit-franchises-as-natural-hedges/ https://www.bitsaboutmoney.com/archive/deposit-franchises-as...