The banking crisis, and the wrong lesson

I've always liked the business pages of The Independent. I corresponded for years with the estimable Diane Coyle, then the newspaper's economics editor, about asset price bubbles and financial panics. This was during the Asian currency crisis of 1998, and the rise and fall of the Internet stocks thereafter. I was just some irksome banker, but she would always reply immediately and at length.

But here is an Independent columnist who has looked at today's financial panics and determinedly alighted on the wrong answer. He is Ben Chu, who writes:

"One of the piquant ironies of the effective nationalisation of a large chunk of the British high street banking sector this morning is that it leaves those politicians and commentators who have spent their careers ridiculing the clumsiness of the state and scorning any form of government intervention in society utterly bereft.... And the political, as well as the financial landscape, is transformed at a stroke."

No.

The policy questions that the financial crisis raises replicate the debates of the late nineteenth century and early twentieth, during the first great wave of globalisation.  From 1896 to 1914, the global economy became more integrated and freer - in the movement of capital, goods and labour - than it had ever been, or ever has been since. Underdeveloped economies, notably Canada and Argentina, became wealthy. And regulation became a contentious political issue. Agrarian populists in the US demanded national control of the economy, as did the labour movements of Europe. They were wrong.

The better political course would have been to create international institutions. They might have preserved the European peace that had prevailed since the Congress of Vienna, and mitigated the risk that politics would revert to atavistic nationalisms. In the event, the first concerted attempt to create such institutions was made in the far less favourable circumstances of the postwar settlement at Versailles. The attempt failed, and governments turned to utterly catastrophic policies of economic nationalism and protectionism.

The issue in today's financial crisis is not the state, but politics. Politics has not been adequate to the expansion of financial markets. When a few badly-sold mortgages in the US can set off an international banking crisis, then international supervision is clearly wanting. The challenge is to create effective institutions for finance, on the model of the institutions that exist - and perform an essential function - in international trade. That is far from the demand of anti-globalisers and statists: it's a recognition that markets require institutions if they are to work.

Comments

[Snorri Godhi]

"From 1896 to 1914, the global economy became more integrated and freer - in the movement of capital, goods and labour - than it had ever been"

Oliver: I must admit to complete ignorance here. Could you please enlighten us as to what happened in 1896 to mark the beginning of this golden age?

[Oliver Kamm]

Sorry, I ought to have explained the date. It marked the end of the Great Depression that had begun in 1873. It is a slightly misleading name, because the Depression took the form not of a big crash - as the 1929 stock market crash precipitated the Great Depression of the 1930s - but of a steady fall in prices of raw materials, goods and services. The Depression ended in 1896, when commodity prices - principally gold and wheat - suddenly turned round.

[Dom]

First, I love your blog, and I turn here first to get difficult points of economics explained.

Now please, write a post that explains the following, because I really don't get it, and when I bring it up with others they act like they understand it, but they really don't. Here it is:

"When a few badly-sold mortgages in the US can set off an international banking crisis ..."

How exactly did that happen? It seems like such a small amount of money in the grand (global) scheme of things.

One of my neighbors defaulted on her mortgage, and now Iceland is bankrupt. Explain, please.

[John Louis Swaine]

If I may hazard an explanation:

In 1977 President Carter signed into law a bill known as the Community Reinvestment Act. Its laudable aim being to encourage homeownership and bring mortgages within reach of lower-income Americans (particularly minorities in low-value areas), subject to considerable regulation.

It achieved this end by obliging financial institutions to offer mortgages to that segment of the market, with threat of financial penalties for those who failed to comply.

The Act underwent several changes over time and when its sister legislation, the Federal Housing Enterprises Financial Safety and Soundness Act was passed in 1992, Fannie Mae and Freddie Mac entered the scene.

Fannie Mae was at this time a quasi government body (jointly held by private equity and the state with a line of credit direct to the federal treasury) that basically purchased and securitized mortgages - that is to say it granted mortgages and tied them up into neat boxes which could be bought, sold or traded like treasury bonds.

Further changes and amendments were made to the Community Reinvestment Act, most notably in 1995 at the behest of President Clinton, streamlining the regulatory process with the aim of expanding the volume of mortgages offered under the system.

Fannie Mae accelerated its granting of mortgages to high-risk borrowers and towards the end of the century we started to see a decoupling of housing prices from inflation - in effect an asset bubble.

Efforts to impose stricter regulation upon Fannie Mae were blocked by congress (particularly by politicians who received considerable campaign donations from the company - the very ugly side of a having a Private/Public hybrid body of its sort in existence).

So now we have a large volume of securitized mortgages floating around - enter the investment banks.

Investment banks typically trade on a much higher leverage than a regular bank. For example, whereas a normal bank might keep about 10% liquidity relative to the amount of loans and investments it has active, an investment bank will often trade at a lower relative percentage - in effect taking more risk with less substance to back it up.

As Oliver Kamm notes, this happened alongside the meteoric economic growth of newly developing economies such as China and India which resulted in a massive influx of capital. Central banks kept interest rates artificially low to handle the tide of new wealth, decreasing the cost of borrowing and leaving banks scrambling to provide high-yield investments.

Some investment banks were trading derivatives of the securitized "sub-prime" mortgages (those mortgages which were granted to higher-risk borrowers) and leveraging them to dangerous levels to provide such a yield. Induced by a mixture of commercial pressure and abject irresponsibility.

Therefore, when significant numbers of sub-prime mortgagors starter to default on their payments, the assets upon which the Investment Banks were trading depreciated drastically.

Some banks were heavily hit by this, others not so greatly - it depended on their portfolio. If a bank was heavily leveraging sub-prime mortgage derivatives then they were likely to find themselves greatly under-capitalized, in effect writing cheques their pockets could no longer cash. HSBC for instance had a very low exposure to sub-prime assets and so remained at a healthy level of capitalization.

So what we have now is a situation in which some banks are under-capitalized and some aren't. Broadly speaking, investment banks who had over-leveraged on sub-prime derivatives took a giant shower, more risk-adverse institutions remained relatively stable.

The problem is that this led to a freeze in inter-bank lending - who wants to lend money if they're not sure they'll ever see it again?

The solution is to re-capitalize the banks, which need help. The market went some way towards this end (Warren Buffet bought a big fat slice of Goldman Sachs) but has since decided to wait for governments to step in.

Recapitalizing banks dilutes existing shareholding in those institutions but those banks, which want to survive have to accept such a deal.

Some of the banks, which failed to accept this inevitability are bankrupt outright - Lehman Brothers being a classic example. A lot of the anger directed towards the CEO Dick Fuld, is grounded in an understandable belief that he knew his bank's assets were vaporous and was either unwilling or too incompetent to put a deal in place to address the problem before the bank went under.

Of course, some people just hate bankers - but that's another story.

[Tony Francis]

I think you are a bit simplistic in your assertion that a global political solution could have avoided World War I. A global political solution could, in theory, avoid all problems, including wars. Competition over natural resources was a cause of the Great War. Curiously, socialism as a political force had virtually died in the middle of the 19th century. Laissez faire capitalism was in full effect. The belief in the US was that a man could make, by himself, and of himself, a fortune. The greatest exemplar was perhaps George Pullman. http://www.en.wikipedia.org/wiki/George_Pullman
He made his own factories, rules and even a town named after himself. Robert Todd Lincoln, ignored calls to run for the US presidency, and instead, became the lawyer for Pullman.
http://www.en.wikipedia.org/wiki/Robert_Todd_Lincoln
The fortunes of economic depression changed Pullman from a great man to one reviled. Even his grave was buried under tons of concrete to avoid desecration.

Pullman's town was taken away by the state, and all railroads in the US would be (temporarily) nationalized in WW I. Afterward, taxation of the railroads would build highways and subsidize airlines. Despite the cries of capitalists, the railroads had been built with massive government subsidies in the first place.
Karl Marx had written Das Kapital in the 1860s, just in time for the "Long Depression" which began in 1873. It is difficult to believe that all political leadership in Europe at the dawn of WW I were inter-related. They were all first cousins. This represented an old, tottering end to feudalism. Interestingly, Marx was backward looking as well. He believed in the eternal existence of both the feudal state and religion. The only objection he had was who would be in control of both. Communism took on a religious zeal.

In 1873, the Republicans were blamed for the crash, and thrown out of office.
http://www.en.wikipedia.org/wiki/Panic_of_1873
As we are witnessing, the rhetoric of Marxism still works, under the right social conditions, even in the US. It will get Obama into office.

[Dom]

Thanks for info, John. As good as anything OK would have written.

My last point of confusion is this. If I make a bad loan, even if the CRA demands I make a bad loan, I generally lose money. It seems that banks were making money. For example, the Sandlers made millions. Now foreign nations got in on the act. How did that happen?

[Snorri Godhi]

Oliver: thank you for the clarification.

Needless to say, not all was well with the World in the period 1896--1914. In particular, there was the tragedy of the Belgian Congo (Congo Free state up to 1908), which personally I find more morally repellent than the Holocaust or the Holodomor, possibly because I cannot easily blame it on socialism. People who whine about modern capitalism should remember that even the Great Depression was a holiday compared to the Congo Free State.

[Peter T]

I'd like to second the request made by Dom. I've heard from more than one source that this lies at the heart of the matter. Further explanation as to the cause and effect would be very welcome.

[Tony Francis]

The sub-prime loans were generally adjustable rate mortgages. Often these were given to persons who paid little or nothing down, interest only loans, and the like. The rates were scheduled to increase, which made it unrealistic that it could be paid off. By that time, the loans had been bundled and sold around the world for a fee. It can be argued that Greenspan left the interest rate too low for too long, feeding the housing price bubble. Once that collapsed, a large portion of the economy was paralyzed: no loans for new building, too many houses built on speculation, no more buying of supplies for new houses, no more employment in the building trades, etc. Personally, I think gasoline hitting $3, then $4 a gallon tipped it over the edge. I noticed renters stopped paying rent because no one was getting their hair done, no one was spending money at restaurants, etc. But that is anecdotal. These articles may be of help:
http://www.en.wikipedia.org/wiki/Subprime_crisis_impact_timeline
http://www.en.wikipedia.org/wiki/United_States_housing_bubble
http://www.en.wikipedia.org/wiki/Adjustable_rate_mortgage

[John Louis Swaine]

The Sandlers in particular made money because they got out at precisely the right time. Their company would be (and indeed has been, albeit now as part of Wachovia) severely hit by the bubble bursting.

The housing bubble has actually been bursting in earnest for a couple of years (12.7% from Feb 2007-2008) which has a knock on effect upon the value of securitized mortgages.

Because the only recourse for a mortgagee (ie: the bank) in the case of a default by the mortgagor is generally foreclosure, as we start to see houses becoming worth drastically less than the sum for which they are mortgaged it begins to make economic sense for some homeowners to default on their mortgages even if they can pay their dues. The properties join the herd of unsold property which further depresses housing prices creating a cycle of depreciation.

It takes time to play out but it the results can (and have) been devastating.

The banks which have had the most exposure to sub-prime assets have either seen a drastic drop in earnings or posted losses (Lehman Bros posted two consecutive quarters of losses, UBS have had a similarly disastrous time).

So some banks have made money - their losses from securitized mortgages and their derivatives have been offset by gains from aspects of their portfolio, (which is after all the way in which a financial institution should be organized, with limited exposure to each market).

As for banks in foreign nations, international finance is heavily interwoven and derivatives from securitized sup-prime mortgages have been bought and sold all over the world, even tied into new financial products. It's like having a batch of poisoned raisins, it's not just the raisins bought in the little red boxes on their own which are toxic, some of the raisins may wind up being baked into cookies that are sold and consumed in many different countries.

It's really a matter of exposure.