Everyone has their favorite cause of the financial crisis. For folks on the right, it’s government intervention through Fannie Mae and Freddie Mac or low interest rates. For folks on the left, it’s unscrupulous lending practices and excessive risk-taking by Wall Street.
The late Robin Williams once joked on the financial crisis, “we just had complex formulas, we just didn’t factor in greed and panic.” What if Williams had the best take on the crisis? What if the economic fundamentals that produced the Great Recession weren’t the greatest cause, but a general panic was? This is the thesis of a new NBER paper by Laurence J. Kotlikoff:
Most economists differ, not on the causes of the Great Recession, but on their relative importance. They concur, though, on the basic problem, namely human, not market failure. This study applies the evidence, some new, some old, to re-try the usual suspects. It finds none guilty. Instead, it identifies broadly defined multiple equilibrium, mediated by opacity, false rumors, and panic, as the real culprit. There are many models of bank runs. But each can trigger firing runs – firing someone else’s customers for fear that others are firing your customers. Firing runs, in turn, exacerbate bank runs, producing a vicious cycle. This cycle can be manipulated by those who benefit from economic distress (short sellers). If the banking system, not the banking players is the problem, the solution surely lies in fundamental banking reform. This paper concludes by pointing out that a reform that shifted to 100 percent, equity-financed mutual-fund banking with government-organized, real-time asset verification and disclosure could preclude financial runs and their ability to induce firing runs.
Kotlikoff begins by running through and addressing (“debunking” in his words) a number of economic fundamentals pointed to as causes of the crisis, finding they lack sufficient explanatory power in light of history.
Subprime loans and mortgage default?
In the run up to Lehman’s bankruptcy, subprimes never exceeded 14 percent of total outstanding mortgages and their share was below 12 percent on September 15, 2008 when Lehman shut its doors…Foreclosure rates on prime mortgages peaked at about 3.5 percent. Since at most, 14 percent of outstanding mortgages in 2009 were subprime, at most, 2.1… percent of all mortgages at the height of the Great Recession represented foreclosed subprime mortgages. At the recession’s peak, roughly 4.8 percent of all mortgages were in foreclosure. Subprimes constituted almost half of these foreclosures.
When the Great Recession began, the default (mortgage delinquencies plus foreclosures) rate on all mortgages was only 3.7 percent. It rose to 11.5 percent over the next two years as close to 9 million workers lost their jobs. I.e., the GR caused defaults, not the other way around. [Emphasis added]
Bank leverage actually fell over the period 1988 through 2008. Equity rose from 6 percent of bank assets in Q1 1988 to 10 percent in Q1 2008. Furthermore, leverage ratios, like mortgage default rates, are endogenous Given the severity of the stock market crash subsequent to Lehman’s failure, one might think that leverage ratios rose dramatically during the recession. Not the case. Federal Reserve data shows the equity ratio failing from 10 to just 9 percent – a higher value than was registered in the prior 16 years.
Lehman was also well capitalized prior to its demise. It had tier-1 capital of 11 percent when its creditors pulled the plug. An 11 percent capital ratio is close to the current banking system’s tier-1 capital ratio of 12.3 percent, calculated based on the Federal Reserve’s recent stress tests. This indicates that today’s banking system is no safer than was Lehman Brothers when it was driven out of business.
[S]uch loans [like teaser-rates, balloon payments, floating rates, and negative amortization] had been in existence since 1982, i.e., 26 years before the GR. Moreover, the share of subprime loans that were predatory could not have been that large since, at most, 15 percent went into foreclosure during the GR. But they did so in the context of an unemployment rate that reached 10 percent!…
If one assumes that all of the 2 percentage-point increase in subprimes involved predatory lending, we’re still talking about predatory lending causing, at most, 0.3 percent more mortgages to definitely default, namely, enter foreclosure.
The data Kotlikoff cites are accurate, though his approach is somewhat lacking in that it compares these fundamentals to historical norms. Sure, banks on the eve of the financial crisis were better capitalized than decades before, but 10% is far from the optimal capital requirement estimated by other studies.
Even so, he makes an important point. If all of the factors that contributed to the crisis have been seen before, why was this time different?
Instead of viewing the financial system as a Jenga tower with each of these problems as logs slowly pulled out until the whole thing collapses, his explanation for the cause, rather than symptoms, of the crisis is a bit more like a shaky-handed player getting nervous and knocking the tower over.
“Sheer panic” writes Kotlikoff, “facilitated by opacity, false rumors, misinformation, exaggeration and a strong assist from interested parties, flipped the economy to a very bad equilibrium. This diagnosis implies a deep structural problem in the financial system — one that seemingly can’t be addressed by Dodd-Frank or similar reforms proposed or enacted in Europe.”
This point has been made by others. Though the fundamentals of the financial sector made it a house of cards, a vicious cycle of bad news and pessimism (justified or not) can become a self-fulfilling prophecy.
Koltikoff’s solution? He recommends limited purpose banking (LPB), making all financial institutions 100% equity financed and subject to full, real-time disclosure. Under this system, banks and other financial institutions would function more like mutual funds.
Going 100% equity financed would be a major overhaul of the financial system–if the Minneapolis Plan would make the financial system ironclad, LPB would wrap it in mithril–but this is the type of thinking that is needed in debates on financial regulation. Different crises have different underlying fundamentals, but instead of fighting the last war, the overall structure of the financial system should be made more resilient.