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Updated Comments on 2008 Financial/Economic Crisis (December 2008)
Since the onset of the full-scale financial crisis in mid September and my comments
concerning it, new information and developments have sparked additional questions and
clarification of existing questions.
How precarious was/is the situation in financial markets?
Most people seem now to appreciate that the situation in September/October was serious,
yet, just how serious is still not widely understood. On the “wholesale” side of short term
credit markets, the equivalent of a “bank run” emerged. Institutions and wealthy
investors moved huge sums away from their typical accounts and into Treasury Bills.
This put substantial sections of the “retail” financial system (checking, debit, and credit
accounts for households and businesses) in extreme danger of being frozen. Rumors
from within the Fed indicate that these retail effects came within a few hours of
materializing. The behavior of interest rates backs up the rumors. The rate on 3-month
Treasury bills dipped near zero while rates on other sources of short term funds climbed
to 5% and above -- indicating that these sources had all but disappeared.
Why has so much money been put into or put up as guarantees for the
banking/financial system? Doesn’t this justify saving any and every large business?
Banking and financial firms stand in a unique position at the very center of the crossroads
of the “payments system.” Most payments from borrowers to depositors, from employers
to employees, from consumers to businesses flow through them. If these payments
systems falter on a large scale with only cash purchases and payments and limitations on
checking, debit, and credit accounts, the failures and freezes on “Wall Street” would
cripple “Main Street” very, very quickly. In this way, banking/finance services resemble
basic services such as electricity and water – if they don’t flow, nothing works.
If housing markets are at the root of the problem, why not put more money/effort
toward limiting foreclosures rates?
Because of its immediacy and widespread implications, the payments crisis has been the
central focus. However, efforts toward modifying loan agreements are going forward. .
Although not making headlines, all of the major banks have implemented policies to
renegotiate the terms of large percentages of their troubled mortgages. JP Morgan Chase,
for instance, is working on renegotiating over 70% of 65,000 mortgage in difficulty. The
FDIC has also been modifying terms on troubled mortgages for institutions that have
failed.
Some policy makers (such as the FDIC Chairperson) and economists (such as Harvard’s
Martin Feldstein and more recently Fed Chairman Ben Bernnake) have encouraged the
adoption of broader loan modification plans. For example, the FDIC has forwarded a
plan by which the agency would make $1000 per renegotiated loan available to
institutions and would agree to guarantee 50% of any losses incurred if modified loans
defaulted. Feldstein and others have suggested similar “opt-in” plans. The FDIC
estimates a $25 billion expense to their plan. To date, however, policy makers (both the
White House and Congress) have not endorsed these plans. The reason appears to be
political – each side wanting the other to take responsibility.
In addition, the modification of loan terms through renegotiation has been slow because
many of the troubled mortgages are bundled together into pooled instruments discussed
below. This bundling drastically complicates renegotiation. The rights of renegotiation
do not necessarily reside with a single entity. In addition, healthy and unhealthy
mortgages are combined together and must be disentangled, a slow process.
Is the situation in financial markets improving any?
The wholesale side of short term credit between banks and companies has improved but
remains very abnormal. Typically the differences between T-Bill rates and other short
term funds are tiny -- small fractions of 1%. Currently, the differences run on the order
of 2%. Even overnight loans in these markets stand nearly 1% above Treasury rates. The
3-month Treasury Bill rate hovers barely above 0.0%, indicating that many institutions
and wealthy investors still harbor deep suspicions about defaults on even these short term
loans and prefer to park their cash in the safest haven (Treasury Bills).
As widely reported, the stock market continues to swing wildly – down 30-40% since
early September. Besides the losses to investors, the downward swings have pushed the
stock values of many seemingly viable companies near bankruptcy levels as investors run
away from any perceptions of risky situations. Meat processing stocks are a particular
example. If companies with relatively sound long run outlooks get pushed into
bankruptcy by short term panic selling, that bodes ill for the economy.
How did we get here? Can high housing prices and their collapse do this much
damage?
The housing market comprised part of the iceberg but not the whole of it. The housing
market both contributed to and reflected an economy-wide trend from 2001 onward of
unusually high borrowing/lending. In 1990, the ratio of household sector debt to income
stood at 60%. By 2000, this figure had risen to 70%. In six more short years, this ratio
jumped all the way to 100%. Such growth in the “leveraging” of income increases
purchasing power. It also generates larger capital gains when the purchased item is a
long-lived asset like housing and resold. The trouble is, that such debt-leveraged
purchases also fuel greater losses and increases financial stress when prices decline.
A combination of influences spurred the rapid expansion of debt and leveraging: a)
households that made choices to take on much more debt relative to their incomes; b)
very lenient lending terms by banks and financial markets, and c) a variety of government
programs intent on expanding home ownership and provide more lenient credit terms.
Along side this growing reliance on debt-financed purchases, financial markets
developed instruments that they intended to provide “insurance” against defaults in
housing markets or other debts. These included the bundling of mortgages and other
debs together into “Collateralized Mortgage (or Debt) Obligations” that traded like bonds
as well as more exotic forms of debt “insurance” such as “Credit Default Swaps.” Most
of the insolvent financial firms and banks such as AIG held large amounts of these
“insurance” instruments. The problem with such “insurance” against default is, like all
insurance, they work only when small parts of the insured market experience problems.
If a sizable percentage of Allstate holders, for instance, file big claims on their insured
property in a year, the insurance becomes worthless. That describes what happened in
financial markets. With large decreases in housing prices and defaults growing at a pace
much higher than anticipated by the financiers, the insurance provided only the mirage of
a backstop. What was thought to insure against losses only added to the losses.
Will things get as bad as the Great Depression?
During the Depression of the 1930s, incomes fell, on average, by 30 percent and
unemployment reached 25 percent. Like the 1920s, debt-laden purchases abound. On the
down side, the reliance on non-cash payments systems is much higher now than then,
making the links between financial sector problems and the rest of the economy more
immediate. On the up side, we do have several things going for us now that make a repeat
of economic disaster less likely (though not impossible).
First, the Federal Reserve (supported by the U.S. Treasury) has been very proactive in
trying to keep short term credit markets working and keeping banks operating. So far,
when banks have become insolvent, the Fed/FDIC facilitated sales to keep deposits and
payments moving. In contrast, at the outset of the 1930s, the Fed essentially did nothing
to help the banking system. (See Milton Friedman’s TV series: Free To Choose:
Anatomy of a Crisis for details). As a result, thousands of banks failed, many depositors
lost their holdings, and credit markets dried up for nearly a decade. The Fed is not allpowerful or all-knowing. Mistakes have and will be made, but, overall, their
contributions have helped mitigate, or, at least, push back a catastrophe. Again, the
electrical service analogy applies. In the 1930s, when the wires started falling, nothing
was done. In the current situation, they continue to be put back up, even if on some
shaky soil. Second, many social safety nets such as unemployment payments, social
security, Medicaid, and others exist now that did not in the 1930s. This helps those
experiencing the most trouble able to continue making key purchasing for their
households. Third, Percentages do not tell the whole story. Current household wealth
and living standards exceed those of the 1930s by many times. Unlike 1930, very few
now live close to subsistence. A 30% reduction in income during the 1930s put many
families in a hand-to-mouth existence. Even if average consumption levels fall back to
1990s levels, those levels are still very high. Today, tough economic times for a
household of modest income levels will mean cutting back on Christmas purchases, on
eating out, on clothing purchases, on travel, or similar items. Yet, with wealth levels,
social safety nets, and private charities, food, clothing, housing, and medical care should
not only be available but, in most cases, exceed consumption levels from the 1970s much
less the 1930s.
Isn’t the Fed to Blame?
The charge of the Fed being the vehicle for the run-up in household debt gets a lot of
traction. While convenient and simple, it just does not hold up to scrutiny. As I noted in
the September post, inflation from 2001 to 2005 ranged between 1.6% and 3.4% annually
and 13% for the whole period. Blaming a 13% rise in the average price level over 4
years for a 100% increase in some housing markets or an increase in household debt to
income from 70% to 100% is a bit like blaming an electrical blackout on the guy who
turned on his garbage disposal – yes, there is some connection but it’s a drop in the
bucket.
One very large misunderstanding pertains to the Fed’s role as “lender of last resort” to the
banking sector. To some, even among economists, this means that the Fed should only
provide assistance directly to banks. For example, the assistance to “Commercial Paper”
markets where money market funds have lots of short term cash at risk has come under
criticism. The trouble is that this fails to grasp the “wholesale” side of credit markets and
their inter-connections with the retail side. The idea that retail banking services and
payments can withstand a freeze on the wholesale side is a stretch.
The Fed has made some errors. The decision to let Lehman Brothers fail while rescuing
AIG has been widely criticized for precipitating the September financial crisis. Yet, their
reluctance arose, in part, out of political criticism from both the left and right in the
rescue of Bear Stearns in March (rescue of creditors, not stockholders) and the ensuing
“bailing out Wall Street” mantra. The Fed, despite what some may think, is not entirely
independent of the political system or climate. Some economists, such as Princeton’s
Alan Blinder, have chided the Fed for not communicating the scale and scope of the crisis
better; but in this, the Fed stood between two very undesirable alternatives: use relatively
broad language trying to reassure depositors and credit holders but failing to really get the
attention of the public or express more clearly the true gravity of the situation and create
panic. They chose the former as the lesser of two evils.
Doesn’t this show that the financial market are regulated too little and that
deregulation over the past two decades is a failure?
The “deregulation” in banking in the 1980s and 1990s accomplished two primary
outcomes: 1) permitting the geographic expansion of banks; this change has helped
alleviate pressures on banks in the current crisis by reducing the number of banks with
loans outstanding in only the most troubled areas; 2) permitting banks to expand the array
of financial services offered; this has no direct link to the current crisis since things like
mortgage lending and consumer credit were already part of bank products.
Banking and finance in the U.S. are, in fact, highly regulated, witnessed by the thousands
of pages of federal regulations in the Code of Federal Regulations related to
banking/finance. If just passing laws and rules were the simple answer, we should be in
great shape.
Markets, in general, are very good at valuing everything from butter to stocks. The
current crisis makes more than obvious the fact that, sometimes, market valuations do not
make sense. Sometimes, markets fund too much debt. Sometimes, they develop new
products, like default insurance, without fully grasping the possible implications.
However, it should be noted that it has been nearly 80 years since this kind of broadbased market miscalculation and confusion has ensued.
Ideally, politics would provide protections for and from markets that enhance their
benefits and limit their shortcomings. Politics, like markets, do not offer utopian
solutions. In the current situation, political actions contributed to rather than protecting
from things such as high debt to income ratios and too lenient lending policies.
Furthermore, political actions often create rules with superficial appeal that do very little
good and may do harm. As case in point, one regulatory agenda over the past two
decades has been “disclosure” in financial transactions. Yet, anyone who has ever signed
papers at a mortgage closing knows that “disclosure” has been regulated to the point of
sapping meaning and relevance from it. Fostering a mountain of disclosure ultimately
discloses next to nothing. Politicians also often over-react to crisis, searching for voters
drawn to simple but misguided “solutions.” In response to the 1930s financial and
economic crisis, many stifling policies were adopted or policies that did little more than
favor one part of the financial industry over another part or keep wages unrealistically
high and worsen unemployment.
Rather than trying to come up with all sorts of regulatory solutions limiting financial
services or trying to get politicians and their helpers into the business of financial market
design such as micromanaging the role of standardized exchanges or clearinghouses, I
would propose that just a couple of more modest changes would have kept the current
situation from developing into what it has: 1) More stringent capital controls on financial
institutions. Broker-dealer firms like Bear Stearns and Lehman faced regulations limiting
the ratio of assets holdings versus owner investments (equity). These limits, though in
existence, were not nearly tight enough, permitting ratios in excess of 30. To some
extent, this advice is moot for the time being, as these broker-dealer firms have become
bank holding companies, subject to more stringent capital requirements. 2) More
stringent standards and auditing of bank/finance customer creditworthiness and use of
funds. Among some non-bank loan originators and among some banks, there was not
due diligence to ascertain the true status of customer income/net worth. Of course, this
requires politicians refraining from agendas pushing leniency in lending standards.
Finally, increased regulatory stringency in these areas needs to be pursued in modestly,
not wildly. The idea is not to turn banks into simply money warehouses where deposited
money just sits for a fee. In the 1930s, the regulatory response in financial markets
substantially lengthened the Depression by limiting access to funding to only a small
number of businesses or individuals. We want to provide safeguards without making
homeownership or business ventures a cash only business.