Some fresh thinking points to bank practices as root cause of the Global Financial Crisis – Wray, Levy Institute
Much has been written on the Global Financial Crisis (GFC) and the focus has leant heavily on re-regulation, and higher bank capital. However there remains a nagging sense that nothing really has changed and that it could happen again.
This piece from Wray at Levy is a refreshing look at some practical aspects of the GFC that resonate more clearly as potential foundational causes and that remain in place, and are not dealt with by regulation, at least not directly.
The first is financial leverage amongst banks.
We can think of this as financial layering: financial institutions borrowing from each other to lend. This led to complex linkages, such that failure of one financial institution (Bear or Lehman) would topple all the others that held its liabilities. This explanation clearly highlights one of the greatest indicators of financial fragility, and I think it is the closest to Minsky’s explanation, and much closer to getting it right.
Why did the markets inexplicably freeze on the week of September 14th, 2008? This tight reliance between each other because of interbank lending at record levels could be one legitimate reason for interbank trust literally falling off a cliff. The graph shows growth in financial sector lending from negligible in the 60’s to 25% higher than consumer debt in 2008.
Another parallel explanation lies in the Shadow Banking system which is generally comprised of large funds able to compete with banks because of their size. (emphasis mine)
pension funds, sovereign wealth funds, mutual funds, and insurance funds. Pension funds alone grew to about three-quarters the size of GDP. Managed money was largely unregulated and was able to compete with the regulated banks.
The broader point lies in the inherent volatility that comes from such large numbers relative to the regular commercial economy. The commercial economy is somewhat predictable unlike the shadow banking system.
By tapping managed money, they helped to bubble up stocks, then real estate, and finally commodities markets. To compete, banks created off-balance sheet entities (such as special purpose vehicles) that took huge risks without supervision. Those risks came back to banks when the crisis hit. It is difficult to imagine how we could have had the GFC without the rise of money managers and the shadow banks.
Wray goes on to make a few points on what he believes was the true cause of the GFC and with some colourful language leaves the cause firmly on the doorstep of the banks both then and still today as an mitigated risk.
1. The GFC was not a “Liquidity Crisis”
In my view, that is a gross misstatement. What actually happened is that default rates on risky mortgage loans rose sharply while home prices plateaued. Megabanks took a look at their balance sheets and realized they were not only holding trashy mortgage products, but also lots of liabilities of other mega financial institutions. It suddenly dawned on them that all the others probably had balance sheets as bad as theirs, so they refused to roll-over those short-term liabilities. And since the Leviathans were highly interconnected, when they stopped lending to one another the whole Ponzi pyramid scheme collapsed.
2. We Should Have Learned That Underwriting Matters.
All the big institutions involved in home finance reduced or eliminated underwriting over the past decade. The “efficient markets” hypothesis said you really do not need underwriting because markets will discover the proper prices for securitized loans; and lending was so much easier and cheaper to do if you did not bother to check the financial capacity of the borrower.
3. Unregulated and Unsupervised Financial Institutions Naturally Evolve into Control
But policy makers still do not want to recognize that there is fraud everywhere. We know that the banks committed lender fraud on an unprecedented scale (the best estimate is that 80% of all mortgage fraud was committed by lenders); we know they continue to commit foreclosure fraud (and that their creation, MERS—Mortgage Electronic Registry System—has irretrievably damaged the nation’s property records; this will take a decade to sort out); and we know they duped investors into buying toxic waste securities (using bait and switch—substituting the worst mortgages into the pools) and then bet against them using credit default swaps. Every time an investigator finally musters the courage to go after one of these banks, fraud is uncovered and a settlement is recovered.
Relevance to Bankwatch:
There is an uneasy feeling about banks and their stability, particularly US and Euro banks. The $5Bn investment by Buffet into BofA was an extraordinary example of this.