Download Another Great Recession Possible?

Will There Be Another Great Recession? (I of II)
The Great Recession in the U.S. started in December 2007, and
quickly spread to the rest of the world. The starting date was announced by
the National Bureau of Economic Research on December 1, 2008, fully 12
months after the Recession began. The patient had been sick, but it took
12 months for the doctor to pronounce that the patient was sick.
The Great Recession ended in June 2009. The ending date was
announced by the NBER on September 20, 2010, fully 15 months after the
Recession ended. Again, the patient had recovered, but it took 15 months
for the doctor to pronounce that the patient recovered.
Since we are already in the 9th year of the recovery, this may be a
good time to review what led to the Great Recession and crystal-ball what
the future might hold.
Mortgage-backed securities (MBS) are financial securities whose
payments of interest and principal are backed by the payments from a pool
of mortgages. Although the Federal Home Loan Mortgage Corporation
(Freddie Mac) began to sell mortgage-backed securities in 1970, they were
secured by the U.S. government. It was in 1981 when the Federal National
Mortgage Association (Fannie Mae) began to sell private-label MBS without
the backing of the government. This new practice injected elements of
speculation and danger into the MBS market that were not obvious to their
buyers until it was too late.
As stated by Paul Mizen in his September/October article in the
Federal Reserve Bank of St. Louis REVIEW (page 551), “The incentives for
the originators of the loans, faced with the knowledge that the products
would be combined in complex ways and sold, were different from those for
an originator who intended to hold the assets to maturity.” The former can
be greedy and remain anonymous, while the latter is likely cautious.
In 2008, the crisis unfolded rapidly. According to the 2009 Economic
Report of the President (page 74), “Within a 9-day period in September
2008, the crisis deepened abruptly with a series of stunning events.” On 7th,
Fannie Mae and Freddie Mac went into conservatorship because they
could not meet financial obligations. On 14th, Lehman Brothers filed
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bankruptcy. On 16th, the Federal Reserve Bank announced bail-out of AIG
(American International Group).
On Oct. 3, 2008, the then President Bush signed the $700B
Emergency Economic Stabilization Act into law, known as the bailout act.
On Feb. 17, 2009, President Obama signed the $787B American Recovery
and Reinvestment Act, known as the stimulus act. By now, the U.S.
economy and beyond were rapidly on downhill.
I found the following quotation. “Last year, the nation experienced a
financial panic, a so-called banker’s panic caused by unsound banking
practices. Although there is no clear, single cause of the financial panic,
this event shook our financial system to its foundation.” This insightful
quotation was made by Professor John Jenkins Wilmore who was Dean of
Engineering and Mines at Auburn University in Alabama in, amazingly,
1908.
Let me explain in plain English what led to the Great Recession.
Suppose that I pick a house to buy that is well beyond my income
level. I am known as a sub-prime borrower. I apply for a mortgage loan
through a local lender, known as originator because this is where all loan
process starts. The originator overvalues the house and allows me to
borrow more money than what I can pay, because the larger the amount,
the more the originator earns. I also pay mortgage rate that is higher than
usual rates because of my low income posing a greater risk of default.
Loans to sub-prime borrowers like me are called NINJA loans in that
borrowers had No verified INcome, Job, or Assets.
The originator sells my mortgage to larger mortgage companies,
investment banks, and commercial banks. These larger financial
companies securitize and repackage, or bundle, as bonds or CDOs
(collateralized debt obligations). These bundled bonds or CDOs are called
Mortgage-Backed Securities, or MBS.
These larger financial companies, in turn, sell the bundled bonds or
MBS, to hedge funds, retirement funds, financial companies, other banks,
businesses, and investors in the U.S. and other countries. These MBS are
rated but the rating companies make up-front fees from rating MBS, and
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more fees from advising clients on how to improve those ratings. Rating
companies have an incentive to overrate the MBS.
By now, buyers or final holders of these MBS have no idea of how
safe their securities are. There is a classic information asymmetry and
adverse selection between sellers and final buyers of the securities. There
is a large number of steps between originators and buyers of MBS that
contributed to underestimating the risk that was not properly appraised to
begin with.
Obviously, I cannot make the payment for the house I bought. I
cannot even sell the house, because there are so many people like me who
cannot make payment and are forced to sell the house. This leads to
oversupply of houses, lowering the price so much that even if I sell, I
cannot even pay the loan that I owe. I cannot pay to financial companies
that sold the MBS, which in turn cannot pay to bondholders. The Great
Recession began.
Will There Be Another Great Recession? (II of II)
Review of the Great Recession in the previous article in this column
raises two questions that merit answers. One relates to how laws of the
impacted the Great Recession 40 years later, and the other relates to
whether we have any crystal ball on possible repeat of the Great Recession
in the future.
Obviously, laws of the 1960s, 1970s and 1980s that allowed MBS in
general and MBS not secured by the government played a role in leading
to the Great Recession. Question then arises in why the Great Recession
developed so many years later in 2007. Answer is the following.
In the 1990s, there was a long prosperity in the world economy,
which is known as the Great Moderation in the U.S. and the Great Stability
in the United Kingdom. During these years, the economy grew steadily and
the rate of inflation was low, which led to a large amount of savings in
China, Japan, Germany, OPEC countries, the U.S., and other countries.
Because the interest rates were low, people with newly-found wealth began
to look for high yielding assets.
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Their demand for high yielding assets was met nicely by the supply of MBS
with the U.S. label and inflated ratings. These MBS carried high yields
because they are based on loans to sub-prime borrowers who had to pay
higher interest rates on their loans.
Financial economist Hyman P. Minsky, whose knowledge is well
under-appreciated, aptly predicted in the 1960s, long before the Great
Recession, by saying that “neither the boom, nor the debt deflation… and
certainly not a recovery can go on forever. Each state nurtures forces that
lead to its own destruction.”
Will there be a repeat of the Great Recession? I see a big potential
for the repeat. Rapidly-rising income of the wealthy, low interest rates, and
stock market bubble are all just as prevalent now as they were before the
Great Recession. Then, there is human ingenuity that does not always
contribute to humanity.
Minsky continues in the 1960s: “In a world of businessmen and
financial intermediaries who aggressively seek profit, innovators will always
outpace regulators; the authorities cannot prevent changes in the structure
of portfolios from occurring.” Let me introduce some of these financial
innovations or gimmicks whose sole contribution to the financial market
may well be greed and instability.
One example is short selling. Short seller borrows 100 shares from a
broker with a fee for, say, one week, expecting a fall in price. Seller sells
100 shares @$10 market price; total $1,000. Price falls to $7 one week
later as the short seller expected, and the seller buys 100 shares at $700.
The short seller returns 100 shares to the broker and earns $300 minus fee.
Short selling makes falling stock prices worse – more fluctuations. Some
suggested higher fees on trading to lower transactions of this nature.
Another example is Credit Default Swaps (CDSs). CDSs are
insurance-like contracts sold by banks, hedge funds, and insurance
companies to cover potential losses on corporate debts, municipal bonds,
and mortgage backed securities. AIG, for instance, suffered losses from
default of MBS with AIG’s CDSs during the early months of the Great
Recession. Worse yet, investors may buy CDSs on bonds likely to default
without owning the bonds, known as naked swaps. If bonds default, these
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investors make money. This practice is like buying a life insurance on
someone who is dying, hoping that he or she dies.
Mortgage-backed securities (MBS), portrayed as the culprit behind
the Great Recession, are complicated enough as is. In practice, the
concept is even more complicated by encompassing several types. Passthrough mortgage-backed security is a securitization of the mortgage
payments to the mortgage originators, and has two types such as
residential mortgage-backed security and commercial mortgage-backed
security. Collateralized mortgage obligation is a more complex MBS in
which the mortgages are ordered into tranches by some quality such as
repayment time, with each tranche sold as a separate security. Tranche
refers to a number of related securities offered as part of the same
transaction based on different levels of risk. It goes on and on.
Greedy human ingenuity appears to have no bounds.
On June 12, 2016 during his opening remarks at the Center for
American Progress and Americans for Financial Reform Conference in
Washington, D.C., Governor Daniel K. Tarullo of the Federal Reserve
Board used a term, shadow banking, which “would embrace all forms of
lending outside of prudentially regulated institutions.”
A friend of mine once told me that “one week is an eternity for
politicians.” Short-sighted policy decisions by politicians to please voters
every two or four years make the repeat of the Great Recession even more
likely. About 80 years ago, John Maynard Keynes wisely stated that "The
market can stay irrational longer than you can stay solvent" Keynes also
said that “The boom, not the slump, is the right time for austerity at the
Treasury.” Politicians practicing austerity during the boom are rare, if
existed.
Will there be a repeat of the Great Recession or worse? I would not
bet against it, although I have no idea of how and when it would start.
The End.
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