Moral Culpability And The Crisis: Our Least Sexy Title Ever

Ever since we experienced the highly enjoyable financial panic of 2008, people have been casting about for someone to blame. And why not? Every great crisis needs an equally great bad guy. It's fun, and it increases the chance that your abject misery will eventually get optioned into movie rights.

But there's one bad guy that's proving surprisingly popular: The homebuyers themselves. Why not? They were the irresponsible borrowers who took on too much debt, far too soon, and sent the economy into crisis. This is America, after all. If you have to hate someone, you might as well hate the common man.

We're probably behind the ball on this one, seeing as how the recession ended while we were suffering a particularly bad hangover during the entire month of June, 2009, so we should probably let this one go. But we're immodest fellows here at the Strawman Blogger, so late or not, we're going to put this myth to rest.

Don't worry. You can thank us later.

First, let's get a few things out of the way. Homeowners assumed too much debt in the crisis. That much is obvious:

And it also had very predictable consequences:

But participating in a crisis doesn't make you culpable for it. When you buy a home, you work with a team of people: Real estate agents who help you shop for a home, lenders who finance it, and industry experts who provide advice and perspective along the way. Each one earns money when you buy a home. And each one earns more money the more home you buy.

And, during the worst housing bubble in American history, each one argued that a bubble wasn't possible.

Realtors fed that delusion. In 2005, David Lereah, Chief Economist and Senior VP for the National Association of Realtors (NAR), argued that, "[t]here is virtually no risk of a national housing price bubble based on the fundamental demand for housing." In 2006, he predicted a "soft landing for the housing markets." Even as late as October, 2007, the NAR continued to peddle the line that, "[t]he speculative excesses have been removed from the market and home sales are returning to fundamentally health levels."

Nor were they alone. On August 18, 2007, celebrity columnist Ben Stein appeared on Cavuto on Business to state that, "[t]he credit crunch is way overblown ... The subprime problem is a problem, but it's a tiny problem in the context of this economy ... It's a buying opportunity, especially for the financials, maybe like I've never seen before in my entire life.

Financial firms were not immune to the excess. Abetted by the ratings agencies, which catastrophically failed to recognize the growing risks in the mortgage market, large investment banks were net long in housing until the bitter end. Even the previously responsible JPMorgan Chase, which had long avoided the collateralized debt obligation business, was eventually burned by the infamous Magnetar trade, losing $880 million on the Squared CDO alone.

But perhaps the most memorable remark came from then-Fed Chairman Alan Greenspan, who stated, "Although a 'bubble' in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets ... Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications."

Homeowners took on too much debt. More than they could afford. But they didn't do it alone. They did it on the advice of their realtors, who assured them that housing was a good investment. They did it with loans from their banks, who were eager to finance mortgages in any way possible. They did so with liquidity provided by Wall Street, who's addiction to mortgage securitization fueled the crisis. And they did it on the advice and encouragement of financial experts and the Federal Reserve itself.

Each of these actors were experts in their own field. Should home buyers have ignored their advice? Perhaps. But arguing that means admitting that the entire mortgage industry was engaged in an exercise of bad faith - providing bad advice to good people, in hopes of turning a profit.

So who was at fault, you ask? Everyone. And no one. That's the trouble with bubbles. They work because they're so damn convincing. If no one believed in them, they wouldn't happen in the first place.

Well. That, and the bankers, of course.

In Which We Follow Up From Yesterday

Each happy marriage is alike
Each unhappy marriage is unhappy in its own way.
- Tolstoy, Anna Karenina
Yesterday, dear readers, we failed you. We went and wrote a long, charming, cutting, and utterly enlightening post about the too-big-to-fail banks, but completely forgot to explain a key point: Why makes these banks too-big-to-fail in the first place?

See, not everyone has bought into this particular bit of dogma. Quite a few smart and well-intentioned people have argued that the best thing to do is leave the banking sector to its dirty fate. Damn the torpedoes! Full speed ahead, and all that.

Here at the Strawman Blogger, we aren’t too fond of that plan. But don’t take our word for it. Instead, let’s have a serious talk about financial crisis, what it means for you, and why we probably don’t want to go and irresponsibly let banks crash down willy-nilly.

Financial Crises – A Case Study

Recessions can be wildly different. They’re a bit like bacteria – there’s one in every shape and form. So Volcker’s recession, brought on as the Federal Reserve crushed inflation with staggering interest rates, was structurally from the dotcom crash, which was a much more conventional asset bubble.

But financial crises are all a little alike. It starts with a liquidity mismatch between someone’s assets and their liabilities, moves to a funding gap, and eventually ends up as systemic contagion. Follow us? Don’t worry. We’ll get you there.

To understand the financial crisis of September 2008, it actually helps to visualize a classic bank run. A typical bank earns money in a simple way. It takes in money through the form of deposits and sends it out in the form of loans. The difference between what it pays on deposits and earns on loans is its profit spread.

Of course, that model poses a few problems for the bank. Most notably, its liabilities are very liquid – people can withdraw their deposits at any time. But its loans are highly illiquid, locked up for anywhere between five and thirty years. Generally, this isn’t a problem. Banks are always careful to keep enough cash on hand to meet the needs of their depositors. But if something changes – if something spooks depositors into withdrawing a lot of money at once – a funding gap appears. Banks can’t redeem their assets quickly enough to meet their liabilities. A bank fails.

And what if the bank failed in such a way that people start to doubt the stability of other banks? They’d respond pretty rationally, by attempting to withdraw their money from similar institutions, which only creates the same problem writ large. A crisis at a single bank becomes a crisis for all banks. A bank run.

Of course, we don’t have bank runs anymore. Largely, that’s down to the FDIC. If a bank fails, the FDIC insures their deposits. More than that, it winds down the bank in an orderly fashion, sell its deposits to another institution, and pays out any bad liabilities from the insurance fund. People no longer have any reasons to withdraw their money because they know their money is protected.

Flash Forward

So we’ve solved the problem of bank runs. Why the Great Recession?

Ah, but it’s a brilliant interesting story. It all started with the rise of the shadow banking system.

A shadow bank is an intermediary. It doesn’t take deposits like a traditional bank. Instead, it channels money from institutional investors to regular businesses – among them, large financial institutions. Big banks.

Now, shadow banks have a peculiar asset and liability mismatch. Each day, they raise a substantial amount of money through the repo market and associated other forms of short-term financing.

This money goes to fund their day-to-day operations. But while their funding is liquid, the investments of a shadow bank tend be highly illiquid – long-term positions in the securities market that are difficult to unwind quickly. Not unlike the deposit versus loan mismatch we detailed above.

When significant questions are raised about a shadow bank’s viability, short-term lenders and the repo market react. Funding becomes more expensive or dries up completely. Investors demand a haircut. If doubts are severe enough, it can affect a shadow bank's ability to continue as a going concern.

And what if investors have similar concerns about other institutions? In unison, they start to get antsy about the repo market. That’s largely what happened after Lehmann collapsed in September of 2008. TED and LIBOR rates shot through the roof, investors panicked, and market liquidity vanished. We remember those days. They weren’t terribly fun.

Further, the liquidity mismatch has systemic implications. A shadow bank can’t passively sit by as its core capital is eroded. Instead, it will attempt to sell its long-term securities position to offset its losses. But when the market is crowded with sellers, it’s forced to discount these assets further, which makes its capital ratios look even worse, which scares even more investors away. And we haven’t even started on mark-to-market rules. It’s all quite a mess.

And size matters. If a shadow bank is large enough, its asset positions can be huge – to the tune of billions and billions of dollars. When this happens, it depresses prices across the system as whole. A large enough institution can set off a panic on its own.

From Wall Street To You

But what does that mean to you? Everything. The trouble doesn’t stay in the shadow banking sector. Since the repeal of Glass-Steagal, the biggest banks in the country also have investment operations. Shadow banking and commercial banking are two sides of the same coin. Pinched between their inability to finance their operations and the pressures placed on their own investment banks, these companies aren’t able to perform their traditional functions.

A bank without liquidity can’t extend new loans. That means that consumer credit collapses, which in turn affects the real market. Auto lenders can’t sell inventory, homes sit unsold. And many businesses, small and large, depend on short-term credit to meet their daily needs. Businesses, too, can have asset-liability mismatches. Invoices take months to redeem; payroll is due every two weeks.

From a shadow bank to a loan to your very own paycheck. Too-big-to-fail matters.

What Is To Be Done

As we said yesterday, it would be quite nice to cut the banking sector down to size. We don’t need reasons for this. We’re powered by our own sense of smugness.

But that’s not enough. As smarter men have mentioned, many small shadow banks can still pose systemic risks. So we’ll need to regulate them better. In the end, we’ll need a resolution authority that looks a lot like the FDIC, with the power to insure transactions on the repo market and wind down failed institutions.

It also might help to re-instate the traditional division between investment and commercial banking. Like Hamlet and his mother, they just don’t belong together.

Cutting the world’s problems down to size. That’s how we roll.

In Which We Ridicule Too-Big-To-Fail

Meet the new boss
Same as the old boss
- The Who
Over the next few weeks, the Strawman Blogger is going to try to bury the hatchet when it comes to healthcare reform. The headlines have moved on, and the Strawman Blogger doesn't want to get left behind. Frankly, we need the page hits.

Instead, we're going to transition back into the world of finance. No more individual mandate in this blog; the SMB is all about leverage limits and the crisis in Greece. Get with the times, people.

To kick it all off, we're going to talk about the thing that's on everyone's mind: Too-big-to-fail. These are the bailout banks, the institutions large enough that, when the financial crisis rolled around, the government stepped in to keep them afloat. No one likes them very much, but they're here to stay.

So today we'll talk about the common solutions for the too-big-to-fail problem. We'll discuss their merits and we'll tell you what needs to be done.

Solutions you can use. That's what were about at the SMB.

The Contenders

There are quite a few suggestions to the too-big-too-fail problem, but they mostly fall into three discrete themes. Let's jump right in:

The first theme, as the old quote goes, is that too-big-too-fail is too big to exist. Got a big bank? Break 'em up. Either redraw the old line between investment banks and commercial deposit-takers or find another way to take them to pieces. But they gotta go.

We have sympathy for this position.

The second theme - championed by the likes of Paul Krugman - is that too big to fail isn't the problem. Or at least, not the problem worth focusing on. Krugman in particular has commented that a widespread series of small bank failures would pose the same risk to the financial system as the collapse of one or two large institutions. In his mind, it's the resolution powers of the FDIC that protect us from this risk. When a small bank collapses, the FDIC steps in to mop up the mess. Deposits are protected, assets are stripped and sold.

There is no similar protection for large institutions that have significant operations in the shadow banking sector, relying heavily on short-term borrowing. As these uninsured operations fall outside the purview of the FDIC, there is no mechanism that allows for an orderly collapse.

In this school of thought, something similar to the FDIC is needed for the shadow too-big-to-fail banks. If a capable resolution authority is able to dismantle big firms, protect their deposits, and impoverish their shareholders, the problem goes away. The too-big-to-fail fails.

Thirdly and lastly, there's the package of financial reforms preferred by the administration and congress. They don't do much more than nod in the direction of the too big to fail phenomena. Instead, they believe that a better regulatory structure - in particular, investing the Federal Reserve with oversight of important financial firms, bringing over-the-counter financial products like derivatives onto traded exchanges, and (maybe) creating a consumer protection board will prevent those nefarious and negligent practices that so nearly destroyed the world economy.

That's it. Better regulators? Consider us under-fucking-whelmed. In case you haven't noticed, our current crop of barely competent, functionally handicapped, practically illiterate regulators managed to miss the biggest financial crisis in the last eighty years until it was steamrollering over their fucking legs. It is unclear how they can be trusted to catch the next one.

Not that they would bother to look in the first place. Most regulators are too busy maneuvering for cushy exit jobs in the same companies they're supposed to be policing. Enforcing cuts in your future employer's leverage ratio is unlikely to endear you to Human Resources. It's called regulatory capture: See examples here and here. And here.

But honestly? All of that doesn't even matter. Here's the dirty little secret of the Great Recession: They didn't see it coming. There was no small army of brave regulators railroaded by the power of the Street. There was no corrupt cabal of crooked public servants, turning a blind eye to excess in return for their thirty pieces of silver. No one was outgunned or corrupt. They were just stupid. They drank the Kool-Aid, same as everyone else, and they thought the good times would last and last.

So the next time a financial crisis rolls around, new rules won't help. Caution is temporary. Stupidity is forever.

Our Estimable Opinion

So where does that leave us? Should we break up the big banks, create a resolution authority, or just cross our fingers and hope for the best?

Far be it for us to disagree with a Nobel Laureate, but we think Krugman has it wrong. Or at least, he's right in the wrong way. See, we weren't entirely fair to Congress in the description above. Chris Dodd's bill does include a resolution authority, and it forces big firms to pay into an insurance fund for that purpose. Congress has even bandied about the idea of strict leverage limits. The truth is muddled between our extremes. We lied to you. We're very sorry.

But we did it for a reason. There's a problem with resolving a big, failed firm. No one's ever done it before. Big firms fails during big crisis, and a big crisis is an unlikely time to grow a pair of testicles. We're unconvinced that, faced with a climate like that of September '08, the Federal Reserve would take a cool look around, let out a whistle, and take the axe to a bank like Citigroup. That requires a supreme level of cold badass. Cold badass is not what public servants are known for.

So we take a resolution authority with a grain of salt, for the same reasons we don't believe in better regulation. They both take someone smart, capable, and ballsy in the drivers seat. That combination doesn't come around too often.

Our Estimable Solutions

Break them up. So Krugman disagrees with us. Who cares? Cordon off investment banks from commercial deposit takers, impose strict leverage limits, impose capital ceilings, and then hell, regulate whatever's left if it makes you feel better.

We think this for two reasons. First, the collapse of many small firms can endanger the financial sector, but that's ok. The collapse of a broad number of small firms tends to happen because of a market failure, and market failures may just be unpreventable.

The failure of single-institutions, on the other hand, can be an isolated phenomenon. Long-Term Capital Management didn't fail because the broader economy stopped functioning. It just made a spectacularly ill-timed arbitrage and watched the world play hell with its spreads while its capital drained away. But because it was large enough, and interconnected enough, LCTM was saved anyway.

We don't actually mind saving banks during a market failure. We do mind having to clean up the mess of the rich kids during the not-so-bad times. Too-big-to-exist clears this up nicely.

And lastly, we'll level with you. Why do we really want to break up Wall Street and the big banks? Because we can. Because it's not clear that Wall Street isn't just full of rent-seekers who add nothing to productive society. Because it's not clear that Wall Street today is any more efficient at allocating capital than they were forty years ago. Because there are no real efficiencies of scale for a bank that holds ten percent of America's deposited assets, and a hell of a lot of drawbacks. Because together they drain talent from areas of American industry that could actually use it. Because. We. Bloody. Well. Can.

Maybe, as Krugman says, there will be market failures and global panics and financial catastrophes long after the big banks are dead and buried. Why not? There were before. But given a choice between a world of panics with big banks and panics without, we'll opt for the latter. We'd rather spend our money on people we like.