The Big Con — Reassessing the Great Recession and its “Fi…


Investment and financial theme with panoramic view of Mumbai financial capital of IndiaGetty

Everyone knows what caused the Great Recession (GR). Bad banks issued bad mortgages. Bad bankers over leveraged. Bad shadow banks evaded regulators. Bad rating companies over-rated securities. Bad regulators slept at the wheel. Bad households drove up house prices. Bad derivatives expanded. Bad traders overtraded. In sum, bad banks full of bad bankers did bad things.

Some bad banking is a constant. But this time was different. Virtually all outstanding mortgages were subprime and virtually all subprimes were fraudulent no-doc, liar, and NINJA loans. Bank leverage reached record levels. Massively bribed rating companies gave triple As to securities that were triple Fs. Regulators were totally outgunned, outnumbered, and out of touch. House prices soared forming an incredible bubble. Derivatives became “weapons of mass destruction.”[1] Trading grew exponentially. And well-greased politicians looked the other way. The Financial Crisis Inquiry Commission summed it all up in two words – “pervasive permissiveness.”

There’s just one problem with this narrative. As argued here, it doesn’t fit the facts. Worse, it diverts attention from the real problem. The real problem wasn’t rampant misuse of a good banking system. It was regular use of a bad banking system – a banking system built to fail.

Structural failures have structural causes. The Hindenberg had a short circuit. The Challenger had faulty O-rings. The Titanic had unsealed bulkheads. The I-35 Mississippi Bridge had inadequate gusset plates. Our banking system had leverage and opacity. It failed colossally. It was bailed out, rebuilt to original spec, and is set to die another day.

All structural banking models feature multiple equilibrium (ME), broadly defined. Whether it’s people running on banks or banks running on banks, bank runs trigger firing runs. Firing runs reference firing someone else’s customers for fear others are firing yours. Firing runs exacerbate bank runs, producing a vicious cycle and flipping the economy from a good to a bad state (equilibrium).

The FCIC didn’t reference a single economic analysis of banking, let alone ME. There was no mention of Keynes (1936), Bryant (1980), Diamond (1982), Diamond and Dybvig (1983), Shell (1989), Peck and Shell (2003), Bikhchandani, et. al. (1992), Cooper (1999), Chamley (2004), Goldstein and Pauzner (2005), Bebchuk and Goldstein (2011), or any other classic ME study that would have screamed SYSTEM, NOT OPERATORS! No surprise. The FCIC was built to miss and retain the forest. It had ten commissioners. Only one was an economist and he had no background in banking.

Pardoning the Usual Suspects

If the GR’s accused villains held smoking guns, everyone would know who shot the sheriff. They didn’t. Lo (2012), after reviewing 21 GR books, concluded that none agreed who done it. Makes sense. The facts clear them all.

Subprimes

Subprime losses were too small to produce a recession, let alone a “Great” one. Indeed, during the GR, the subprime foreclosure rate peaked at only 15 percent.[2] Since at most, only 14 percent of outstanding mortgages during the GR were subprime, at most, only 2.1 (.15 x .14) percent of all mortgages during the GR represented foreclosed subprimes.

Furthermore, if subprimes were terrible assets, the Fed’s $29 billion purchase of Bear Stearns’ worst subprimes – a clear overpayment to bribe JP Morgan to buy Bear — would have produced a major loss. Despite the subsequent GR, these worst-of-class subprimes didn’t lose a penny. Indeed, the investment repaid $31.5 billion.[3]

The Housing Price Bubble”

The FCIC included “an unsustainable rise in housing prices” in its top-7 GR causes. Prior to 2007, real house prices rose steadily for 32 years. The rise was slow – 64 percent compared to 170 percent for real GDP. Yes, roughly a third of this increase occurred in from 2003-2007. But, during this period, real house prices rose by only 2 percentage points more per year than did real GDP. One can construct models with real housing prices staying fixed and the quantity of houses rising or with the opposite. Given the increasing urbanization of the country, the fixed supply of central city land, and the remarkable foreign demand for U.S. housing,[4] an irrational bubble isn’t needed to explain the pre-GR real price rise. Indeed, the FCIC’s “housing-price bubble” could be called “normal increases following years of abnormally low increases.” Moreover, housing-price changes simply redistribute between sellers and buyers, but have no impact on the economy’s real wealth. Hence, the alleged bursting of “the housing price bubble” did not constitute a real shock to the economy.

Ratings Shopping

The FCIC’s report states that failures of the big-three rating companies were “key enablers of the financial meltdown.” But Benmelech and Dlugosz (2010), who studied the rating of 180,000 CDO tranches, concluded, “It is not clear that rating shopping led to the ratings collapse as the majority of the tranches in our sample are rated by two or three agencies.”[5] Since structured-finance securities represented only 35 percent of the U.S. bond market in 2008, since only 7 percent of these securities were re-rated, and since, at most, 20 percent were over-rated due to ratings shopping, overrating affected less than one half of one percent of the U.S. bond market. In addition, this figure overstates the importance of ratings shopping as the downgrades were caused by the GR. I.e., why re-rate and lose the next bribe unless you’re forced to by the market?

Bank Leverage

A stable fable re the run up to the GR is that banks dramatically increased their leverage. Not so. Fed data show bank leverage falling from 1988 through 2008.[6] Equity rose from 6 percent of bank assets in Q1 1988 to 10 percent in Q1 2008. Leverage was also not particularly high in either Bear Stearns or Lehman.[7]

According to Christopher Cox, former Chair of the Securities and Exchange Commission, Bear Stearns was well capitalized when it failed, with a capital ratio over 13 percent and a debt-equity ratio of 6 to 1.[8]  Cox stated,

The fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. … at all times until its agreement to be acquired by JP Morgan Chase …, the firm had a capital cushion well above what is required to meet supervisory standards… .[9]

In the event, Bear’s actual capital ratio didn’t matter. ME mattered. Creditors, past and prospective, came to believe, based on innocent and guilty rumors, that other creditors were pulling the plug. This did likewise.

Lehman was also well capitalized prior to its demise. It had tier-1 capital of 11 percent when its creditors pulled the plug.[10] An 11 percent capital ratio is close to the current banking system’s tier-1 capital ratio of 12.3 percent according to the Fed’s recent stress tests. Thus, today’s banking system is no safer than the day Lehman was driven out of business.[11]

Mortgage Debt

Another GR “smoking gun” is the pre-GR run up of mortgage debt, which roughly doubled between 2002 and 2007.[12] But the increase in borrowing to purchase homes wasn’t associated with a rise in household consumption relative to GDP. Instead, Americans borrowed to invest. And although the ratio of mortgage debt to household net wealth rose, the rise was minor. So too was the rise in debt payments relative to personal income.[13]

Derivatives

The reigning narrative – that derivatives were overrated, complex securities sold to naïve investors doesn’t jive with Ospinal and Uhlig (2018).[14] They examined 8,615, 2007-2013 residential mortgage-backed securities (RMBS), almost all of which were rated AAA. Three quarters of the AAA-rated RMBS had essentially zero losses through 2013. On a principal-weighted basis, the average loss rate was only 0.42 percent. Most striking, AAA-rated RMBS out preformed the universe of AAA-rated securities.

Repurchase Agreements

Repos are charged with helping dramatically raise bank leverage pre-GR. But, again, bank leverage didn’t rise. Yes, Repos rose — by roughly $27 billion — in the months prior to the GR.[15] But the rise was trivial – just 0.3 percent of outstanding total bank liabilities.[16]

No Skin in the Game

Fahlenbrach and Stulz (2011) examined pre-GR executive compensation contracts of 95 banks. The stock and option compensation in these contracts exceeded wages by a factor of eight.[17] The authors also state,

Banks with higher option (and bonus) compensation … for their CEOs did not perform worse during the crisis. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis. Consequently, they suffered extremely large wealth losses in the wake of the crisis.

Jimmy Cayne, Bear’s CEO, is an example. He lost $1 billion. In short, bankers had plenty of skin in the game.

Regulatory Capture

The main job of bank regulators is overseeing bank leverage. Since bank leverage was not historically high, indeed fell in the advent to the GR, regulators did their job. What they didn’t can couldn’t do is prevent our unstable economy from switching equilibriums.

Democratization of Finance

Politicians, some say, forced Fanny and Freddie to support too much risky to the poor. But for this to be a major cause of the GR, losses from subprime mortgage foreclosures would need to have been much larger.

Fed Interest Rate Policy

In the 1990s, the expected real 30-year mortgage rate averaged 7.91 percent. It averaged 6.27 between January 2000 and December 2007.[18] This decline is too small to matter. Furthermore, the Fed doesn’t directly control long-term nominal, let alone real mortgage rates. As for adjustable rate 5/1-year adjustable rate mortgages (ARMs), its real rate averaged between 5 and 6 percent in the two years preceding the GR. Real rates of this magnitude are not low.[19]

Unsafe at Any Speed

Bank failures have a special midwife – opacity. Opacity permits misinformation to spread and be spread. Bear was among the first to be picked off by short sellers because it was viewed as particularly opaque. According to Cohan (2010), no one on the street or inside the bank, really knew what its assets were worth. The fact that Bear’s stock was valued at $60 per share one week before it was sold for $2 per share says that its asset valuation was a matter of pure conjecture. Apparently, before it didn’t, the market thought Bear’s assets were worth something because everyone else thought its assets were worth something. Such self-fulfilling prophecies is the stuff of ME.

Lehman’s CEO, Richard Fuld, publicly testified, “… what happened to Lehman Brothers could have happened to any financial institution.[20] The facts support his view. Bankers didn’t destroy the banking system. The banking system destroyed the banking system. It operated in the dark and it operated with leverage. That, plus rumors of rampant malfeasance, brought the entire house of cards tumbling down.

The take away is that banking can’t be fixed with cosmetic reforms, such as the U.S. Dodd-Frank reform or the UK’s Vickers Commission Report.[21] What’s needed is a system with zero leverage and full, government-supervised disclosure. Why zero leverage and full disclosure? The answer is simple. You can’t be a little bit pregnant. Any degree of leverage and opacity invites ME.

Kotlikoff (2010) provides a very simple means, called Limited Purpose Banking (LPB), to fix banking for good. LPB would transform all financial corporations into 100 percent equity-financed mutual fund holding companies subject to full and real-time disclosure, effected by private firms working exclusively for the government.

Note: The column is appearing in several media and social media outlets.

References

Bebchuk, Lucian A., and Itay Goldstein. “Self-fulfilling credit market freezes.” The Review of Financial Studies 24, no. 11 (2011): 3519-3555.

Benmelech, Efraim, and Jennifer Dlugosz. “The credit rating crisis.” NBER macroeconomics annual 24, no. 1 (2010): 161-208.

Bikhchandani, Sushil, David Hirshleifer, and Ivo Welch. “A theory of fads, fashion, custom, and cultural change as informational cascades.” Journal of political Economy 100, no. 5 (1992): 992-1026.

Bryant, John. “A model of reserves, bank runs, and deposit insurance.” Journal of banking & finance 4, no. 4 (1980): 335-344.

Chamley, Christophe. Rational herds: Economic models of social learning. Cambridge University Press, 2004.

Cohan, William D. House of cards: A tale of hubris and wretched excess on Wall Street. Anchor, 2010.

Cooper, Russell. Coordination games. Cambridge University Press, 1999.

Diamond, Douglas W., and Philip H. Dybvig. “Bank runs, deposit insurance, and liquidity.” Journal of political economy91, no. 3 (1983): 401-419.

Diamond, Peter A. “Aggregate demand management in search equilibrium.” Journal of political Economy 90, no. 5 (1982): 881-894.

Goldstein, Itay, and Ady Pauzner. “Demand–deposit contracts and the probability of bank runs.” the Journal of Finance 60, no. 3 (2005): 1293-1327.

John, M. “Keynes, The General Theory of Employment, Interest and Money.” DE Moggridge (Ed.) 7 (1936).

Kotlikoff, Laurence J. Economic Consequences of the Vickers Commission. Civitas, 2012. (available at www.kotlikoff.net)

Kotlikoff, Laurence J. Jimmy Stewart is dead: Ending the world’s ongoing financial plague with limited purpose banking. John Wiley & Sons, 2010.

Lo, Andrew W. “Reading about the financial crisis: A twenty-one-book review.” Journal of economic literature 50, no. 1 (2012): 151-78.

Ospina, Juan, and Harald Uhlig. Mortgage-backed securities and the financial crisis of 2008: a post mortem. No. w24509. National Bureau of Economic Research, 2018.

Peck, James, and Karl Shell. “Equilibrium bank runs.” Journal of political Economy 111, no. 1 (2003): 103-123.

Shell, Karl. “Sunspot equilibrium.” In General Equilibrium, pp. 274-280. Palgrave Macmillan, London, 1989.

[1] This was Warren Buffett’s term. https://finance.yahoo.com/news/how-buffett-used–financial-weapons-of-mass-destruction–to-make-billions-of-dollars-175922498.html

[2] .15 x .14 divided by .05 x .86 equals .488.

https://www.google.com/search?tbm=isch&q=mba+chart+subprime+series+delinquency+chart&chips=q:mba+chart+subprime+series+delinquency+chart,online_chips:delinquency+rates,online_chips:subprime+mortgages&sa=X&ved=0ahUKEwi_yb-XzMTdAhXOmuAKHfb7BkwQ4lYIKigB&biw=1261&bih=710&dpr=2#imgrc=jmEmu25vcPO3RM:

[3] https://247wallst.com/banking-finance/2018/09/18/new-york-fed-sees-2-5-billion-profit-on-bear-stearns-in-final-maiden-lane-sales/ To be precise, the Fed establish an LLC to purchase $30 billion of Bear’s “junk” assets with a $29 billion loan from the Fed and a $1 billion loan from JP Morgan. (see https://www.federalreserve.gov/regreform/reform-bearstearns.htm)

[4] See https://seekingalpha.com/article/4060386-u-s-real-estate-market-trends-characteristics-outlook?page=2

[5] http://www.nber.org/chapters/c11794.pdf, p. 203.

[6] https://fred.stlouisfed.org/series/EQTA

[7] https://www.theatlantic.com/magazine/archive/2012/06/how-we-got-the-crash-wrong/308984/

[8] https://www.sec.gov/news/press/2008/2008-48.htm

[9] Ibid

[10] https://www.americanrhetoric.com/speeches/richardfuldlehmanbrosbankruptcytestimony.htm Here is Fuld’s relevant testimony re its 11 to 1 Tier 1 capital. “As far as the leverage, and I spoke about it earlier, there’s a very big difference between the 30 times and where we were when we finished in the third quarter at 101/2. A big piece of what that 30 was, again, was the match book, which was governments and agencies. So that should not be considered as an additional piece of risky leverage. Again, I will say that on September 10th we finished with the best or one of the best leverage ratios on the street and one of the best tier 1 capital ratios on the street. And, even to your question, that’s how I viewed the company, and that’s why I viewed it as strong, Mr. Congressman. Those were the metrics. Those were the metrics that the regulators used. Those were the metrics that all of us in the industry used, and ours were one of the best.”

[11] https://www.federalreserve.gov/newsevents/pressreleases/bcreg20180621a.htm

[12] https://fred.stlouisfed.org/series/MDOTHIOH

[13] https://fred.stlouisfed.org/series/TDSP

[14] Ospina, Juan, and Harald Uhlig. Mortgage-backed securities and the financial crisis of 2008: a post mortem. No. w24509. National Bureau of Economic Research, 2018.

[15] https://fred.stlouisfed.org/series/WREPO

[16] https://fred.stlouisfed.org/series/TLBACBW027NBOG

[17] Fahlenbrach, Rüdiger, and René M. Stulz. “Bank CEO incentives and the credit crisis.” Journal of financial economics99, no. 1 (2011): 11-26.

[18] See https://fred.stlouisfed.org/series/MORTGAGE30US#0 and https://fred.stlouisfed.org/series/PCEPI.

[19] https://fred.stlouisfed.org/series/MORTGAGE5US#0 and https://fred.stlouisfed.org/series/PCEPI.

[20] https://www.americanrhetoric.com/speeches/richardfuldlehmanbrosbankruptcytestimony.htm

[21] See Kotlikoff (2012) for a discussion of the British Vickers Commission reform.

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