A new study published by the NBER examines the losses suffered by AAA-rated mortgage securities issued in the lead up to the financial crisis. The study finds:
“Total cumulated losses [on AAA-rated securities] up to 2013 are under six percent. … The subprime AAA-rated RMBS did particularly well. … [The] returns on AAA RMBS strike us as rather reasonable, and unlikely to have thrown the financial system into the abyss. … Together, these facts call into question the conventional narrative, that improper ratings of RMBS were a major factor in the financial crisis of 2008.”
In my 2012 book, Unintended Consequences, I predicted pervasive misunderstandings about the financial crisis would lead to an unnecessarily slow recovery. In the subsection, “Fraudulent Syndication and Credit Ratings,” I argued that ratings were reasonable and that “no serious economist on either the left or the right, except perhaps those eschewing economics to demagogue the public, would argue that anyone could outguess the markets and surely not by enough of a margin to matter.” As evidence, I quoted from the Financial Crisis Inquiry Commission that found “‘by the end of 2009 [only] $320 billion worth of subprime and Alt-A tranches had been materially impaired,’meaning losses were imminent if incurred. The commission adds that ‘most of the triple-A tranches of mortgage-backed securities have avoided actual losses in cash flows through 2010 and may avoid significant realized losses going forward.’”
In March of 2014, when a follow-up study on mortgage losses was published, I reported:
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 has been less than $50 billion. For comparison, the market value of JP Morgan—one bank—is $220 billion (on 3/10/2014).
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.
As in the book, I concluded:
With a limited capacity to bear risk, the economy has dialed 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.
In the book, I also cautioned that financial innovation, such as credit default insurance, could magnify shocks because markets were less able to predict how the financial system would react to stress, without historical evidence.