Pervasive misunderstandings about the causes of the financial crisis have significantly slowed the economic recovery. The public mistakenly believes banks recklessly made no-money-down loans to homeowners, consequently suffered loan losses, and, as a result, needed the government to bail them out. A recent study finds that’s not the case. Nevertheless, the public continues to demand, and has extracted, financial and regulatory retribution from the banks, despite the fact that this slows the recovery.
In fact, banks found investors to make down payments on behalf of homeowners and, as a result, largely avoided losses despite a near 30% drop in real estate prices—proof that credit ratings were more accurate than popularly recognized. The new study analyzes 90% of the subprime mortgages (worth $2 trillion) issued between 2004 and 2006—the peak of the subprime frenzy—and finds that the AAA-rated tranches of these mortgage securitizations—the tranches predominantly held by banks—suffered only $1.8 billion of losses as of February 2011. In total, the loss on all A-rate tranches in the study have been less than $50 billion. For comparison, the market value of JP Morgan—one bank—is $220 billion (on 3/10/2014).
The Financial Crisis Inquiry Commission similarly predicted that losses on the AAA-rates tranches of subprime mortgage would be near-zero and that total losses would be less than $350 billion.
In truth, depositors—namely, intuitional investors—overreacted, panicked, ran to the banks, and withdrew their deposits in the face of a 30% drop in real estate prices. Banks were forced to sell assets—loans (IOUs from homeowners)—to fund withdrawals. With everyone selling loans and no one buying, financial assets temporarily fell to fire-sale prices. At those prices, banks could not sell enough assets to fund withdrawals and were rendered insolvent.
There is little reason to believe a 30% drop in real estate price wouldn’t have sparked a run on the banks even with conventional 20% homeowner down payments.
It’s well known to policymakers, that banking, unlike other parts of the economy, is highly unstable. If depositors panic and demand withdrawals en masse, they discover banks lent out deposits and consequently don’t have enough money to fund all the withdrawals in the short run. Under those circumstances, demand for withdrawals logically cascades to near-100%. No depositor wants to be left holding the bag, so each races the other to the bank.
After nearly 80 years without a major run on U.S. banks, everyone was lulled into believing that implicit government guarantees, which stand behind the banking system, had mitigated this risk. In the fall of 2008, they discovered this was not the case.
With a finite capacity for bearing risk, the economy has dialed-back risk-taking elsewhere to compensate for this now-recognized risk. Consumers spend a smaller share of their income and investors have slowed the pace of innovation and competitions. As a result, the economy now grows more slowly off a permanently lower base of demand.
If policy puts banks at greater risk from insolvency from withdrawals and not just from loan losses, it drives banks to hold more deposits in reserve to cover the risk of withdrawals. When we leave corn in the silo rather than eating it or planting it, growth slows, unemployment rises, and/or wages fall; as they have. It’s unfortunate that few people recognize this tradeoff.
Demanding that banks hold more equity is zero-sum. It just diverts equity from underwriting risk elsewhere for no net increase in risk-taking and growth overall. Again, it’s unfortunate that few people recognize this tradeoff.
One of the only ways to reduce the risk of withdrawals is to strengthen government guarantees of banks. But if guarantees are priced improperly, it can lead to “moral hazard”—banks taking more risk than they should.
Another way to reduce the risk of withdrawals is to reduce the supply of risk-averse capital—i.e., to reduce the need for lending to fully utilize the economy’s idle resources. One way the U.S. can do this is by demanding balanced foreign trade where it can—with China, for example, versus Saudi Arabia. This prevents surplus exporters, like China, who have an excess of risk-averse savings, from using the proceeds from our purchases of their goods to buy our assets—namely, government-guaranteed debt—instead of our goods, which employ our people. They add corn to our silo, when our silos are overflowing.
While it’s true the Chinese don’t deposit their risk-averse savings directly into U.S. banks, they do it indirectly by crowding out buyers for a fixed amount of government-guaranteed debt. The U.S. suffers slower growth, higher unemployment, and lower wages, if banks leave the resulting increase in corn sit idle or greater financial instability if they lend it out.
With a limited capacity to bear risk, the economy has dial back risk-taking to compensate for the now-recognized risk of bank runs and the impotency of implicit government guarantees to mitigate them. As a result, the economy grows more slowly from a permanently lower base of demand. Risk-averse savings sit unused. Unemployment has risen and incomes have fallen. If we recognized the banks were not rendered insolvent from loan losses, which turned out to be small, but from a run on the banks sparked by a 30% drop in real estate prices that likely would have occurred with conventional 20% down payments, we would be taking steps to mitigate the true problems underlying the anemic recovery rather than blaming banks and demanding retribution. We would be strengthening government guarantees of liquidity and reducing the supply of risk-averse capital. So far we’ve done neither.