Everyone knows that the United States faces a serious financial crisis and that the Administration is asking for an astoundingly large sum of money to fix the problem. Fewer may know what economists think about the crisis. Most academic economists - the economists who do not work for companies likely to benefit from the bailout, nor for the President - are opposed to this plan. This large group of experts has wide ranging political opinions, and includes democrats, republicans, and most likely some libertarians. So: why is there a crisis, what is this plan, and why are a large number of academic economists opposed to it?
We might start by asking how we got where we are today. The basic fact is that the housing market boomed and has now gone bust. As a consequence, a vast amount of financial securities, written on the expectations that the bust would never come, are now worth little. Was this a bubble, the natural working of the market, or was it a creation of government policy? Or, more probably, all three? Certainly there is a great deal of evidence that both the boom and the bust in the housing market were encouraged by government policy. The chart below shows an index of housing prices (the Case-Shiller Composite-10), and the short term nominal interest rate, the Fed Funds rate (multiplied by 10), which is set primarily by the Federal Reserve. Beginning right after 9-11-2001, the Fed Funds rate was very low in comparison to the earlier period. These low interest rates meant that money could be lent cheaply in the short-term, helping to fuel a lending boom in the mortgage market through the use of Adjustable Rate Mortgages (ARMs). The boom was also encouraged by lax supervision of the two government sponsored secondary mortgage lenders, Fannie Mae and Freddie Mac. These large Government Sponsored Enterprises (GSEs) bought nearly half the mortgages in the country from the banks that originated them, and resold them to investors as Mortgage Backed Securities (MBSs). Other, private, investment banks performed similar functions by creating, issuing and trading similar, unregulated, securities, such as Collateralized Debt Obbligations (CDOs), Collateralized Mortgage Obbligations (CMOs), Real Estate Mortgage Investment Conduits (REMICs) and so on. The total outstanding value, as of the end of 2007, of these kinds of securities is in the order of $6 trillion (http://www.sifma.org/research/statistics/statistics.html).
While not the only culprits, Fannie Mae and Freddie Mac were certainly, and by far, the two largest players in this market. With support from Congress they encouraged banks to make high risk loans with low teaser interest rates and little or no down payment. The Bush administration, repeatedly proposed greater oversight of the two GSEs, and was continually rebuffed by both Republican and Democratic Congresses. Private investment banks, and banks of any kind, also played an important role in the financing of the housing bubble and in the creation of MBSs of various kinds. The favorable lending rates on the short term market (at least until well into 2005) allowed banks to borrow cheap and lend, at a substantially higher rates, in the form of (long term) house mortgages that would, right after, be securitized and distributed through the financial system. Then, after several years of the housing boom, the Federal Reserve concluded that it had made a mistake setting interest rates so low and started to raise them. This suddenly took the fuel out of a car that was going full speed, sending an increasing number of borrowers into default and leading to the rapidly falling housing prices seen in the graph.
Next we should ask: what is the connection between the fall in housing prices and the difficulties in which banks find themselves? A homeowner typically borrows the money to purchase a home from a bank. For example, a purchaser might make a 20% down payment, and borrow the other 80% from a bank. If the price of the house were then to fall by 40% the homeowner would find themselves "upside down", owing more money on their house than the house is worth. If the homeowner wished to move, or fell on difficult financial times, they might choose to stop paying their mortgage, possibly by declaring bankruptcy, in which case the bank will foreclose the mortgage taking ownership of the house. That leaves the bank with a house less than the value of the loan, so the bank loses money. What are the losses suffered by banks as a result? At the beginning of the year, Standard & Poor's estimated that losses might exceed $265 billion.
To see how such a number might be computed, we start with market value of the US stock of civilian housing at the peak of the housing market. This occurred in the end of 2005 when the value of houses was roughly $21 trillion dollars. About half of that is mortgaged making the value of mortgage loans around $11 trillion dollars. As of now, the average foreclosure rate, the ratio between the value of unpaid mortgages on foreclosed houses, and the value of all mortgages is slightly below 3%. Against $11 trillion in loans, that means about $300 billion in bad loans. Of course even in good times there are bad mortgages: for example between 2000 and 2006 while the housing market was booming, the rate was about 1.5%, meaning that even if times were good there would be about $150 billion in bad loans. In addition, while the banks lose money because of foreclosures, they end up with the houses, so to figure the actual losses, we should subtract the resale value of the houses they end up owning. This would mean that losses beyond the ordinary might be as low as, say $50 billion or even less. On the other hand banks also lose money not only because of foreclosures but because they choose to renegotiate loans rather than foreclose. For example, Washington Mutual before it failed, had set aside $2 billion for mortgage "workouts" meaning negotiating more favorable terms for the borrowers. In addition it is not only actual losses that matter, but, since a mortgage runs for 10-30 years, future losses matter a great deal. These future losses may occur either because some people who are upside down and have not currently walked away from their mortgage may choose to do so in the future, or because the housing market may fall even further.
Although the future is unknowable, we can get an idea of how important future losses might be by examining how much equity home owners have in their homes. Owners with negative equity are a threat to walk away from their mortgages. Owners with low equity may have negative equity in the future if prices fall further. The chart below shows how much equity homeowners had in their homes at the end of 2006. Roughly 10% are upside down, with another 5% having equity of less than 5%. Given the substantial fall in housing prices since the end of 2006, that means that about 15% of all loans could be in negative territory, a considerably higher figure than the 3% who have already defaulted. (An exact calculation is difficult, because changes in houses prices in different parts of the country are extremely varied.) If we figure that on average the negative loans are about 10% below the average value of the mortgage, and recognize that a bank seizing a house significantly lowers the value of the house, we might estimate that about 3% of total mortgage debt represents a loss to the financial sector, or multiplying by $11 trillion, there are about $330 billion in losses. Another way to get at this, is to observe that if the housing market declines and homeowners that are upside down default on their loans, the financial sector will then absorb up to about 15% of those losses. Since the housing market has fallen about 20% from the peak, this also gives losses to the financial sector of about $330 billion. These numbers are similar to those of Standard & Poor's. However, if housing prices were to fall another 20%, potential losses could then approach $660 billion. So we see that while actual losses are not so large - on the order of $50 billion or less - future losses could approach the $700 billion being proposed in the bailout plan.
Where did all the money go?
The next thing to understand is how an entire financial superstructure was built on the shaky foundation of bad mortgage loans. In order to spread the risk of a single lender defaulting, many mortgages are packaged together as a single mortgage backed security that is then sold to investors. However, even a mortgage backed security is risky - for example, if the entire market falls - so these are further subdivided into tranches, with the riskier tranches being required to suffer losses before the safer tranches do. The key step consists in acquiring insurance, in one form or another, on these tranches, which allows them to be traded in the market and used as collateral for further borrowing. Various instruments can, and are, used for this purpose but Credit Default Swaps (CDSs) are by far the most common. The market for CDSs is now estimated to be $63 trillion, although not all of that involves mortgage backed securities. The point to be noticed is that the total value of outstanding mortgages is $11 trillion (and that includes lots of old and safe mortgages not in need of insurance), while the value of insurance contracts written on them is about five times as large. In fact, if the available estimate of $6 trillion for the total outstanding face value of all kinds of MBSs is correct, the ratio between the two nominal outstanding values (the actual amount insured and the one we would expect to be in need of insurance) is ten, which is a pretty large number. Clearly, Mortgage Backed Securities (MBSs), CDOs and so on, were used as collateral for lots of additional borrowing; further, either those securities were over-insured a great deal or insurance contracts were actually used for the opposite purpose, that is to say to take bets that increased the risk of existing MBSs' portfolios. Be it as it may, and lacking further information one cannot really say, the insurance offered by CDSs and similar derivative contracts was certainly a key instrument in this process that turned the value of U.S. mortgaged houses into the foundation of a particularly large and complicated castle of cards. That explains why, as the value of those houses is dropping the whole castle of cards threatens to crumble. If you would like to read more details about the problem, Diamond and Kashyap have a good writeup.
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There is a puzzling, truly puzzling, aspect of this story and it is the following. Apparently everything is due to the fall in house prices cascading through a chain of financial contracts. Nevertheless, if this chain of contracts was of the "normal" type - i.e. B lends A $100 and receives a piece of paper (IOU1) the collateral of which is the house worth $120. C lends B $100 and receives a piece of paper (IOU2) transferring the collateral. D lends C $100 and receives a piece of paper (IOU3) transferring the collateral ... and so on - there could not be the risk of a systemic disaster. This is because, when the price of the house A bought drops to $80, so that A defaults on her mortgage, B recovers $80 from the sale of the house, which it uses to (partially) satisfy its IOU2 with C that does the same with his IOU3 with D ... etcetera, until we end up with Z who is the actual lender/investor in the house A bought. Because Z is the one that, ultimately, invested his savings in the house, Z loses $20, while all the other intermediate parts in the credit-chain cancel out assets and liabilities nominally worth $100 and "pass on" the $80 traveling from A to Z. No disaster here.
The story does not change if, somewhere in the chain, we insert a party that buys insurance against the risk that the house will drop in value. So, for example, let C enter into a CDS with C' such that C' will pay C $100 in case B cannot pay its dues to C, while C will transfer to C' whatever payment it receives from B in that case. Assume C' asks for an upfront premium of $10 for such an insurance contract, corresponding to her assessment of the chances that the house A bought drops below $100 in value. Then, C' collects the $10 a fraction of which, together with those from many similar $10, she stores as a capital reserve. Should C' further secure herself by entering into similar "normal" insurance contracts, it is easy to see that what we are going to describe next becomes longer but does not change in substance. Assume, as before that A defaults on IOU1 because the house price drops to $80. Then B seizes the house and recovers $80, which are passed over to C who hands them out to C'. The latter takes the (fraction of) the $10 premium from her reserves (say $5) and, if it had calculated its probabilities correctly, it takes other three $5 bills from similar contracts that did not default (i.e. each one had a probability of 1/4 of defaulting) and hands over $100 to C. From then on the $100 travels forward, all the way to Z who, in this case, does not lose anything because C had bought insurance (and D knew, as did E, F ...). In this story, at worst, it is C' that suffers a loss, and this takes place if either C' did not compute correctly the probability of default or, which is the same, it consumed the full premium instead of saving a portion. In any case, no matter how stupid or lazy C' was, the total systemic loss is of $20, like before!
We could continue with more complicated examples, but one thing should be clear: either everyone got completely confused AND the actual drop in value of the US housing stock is a lot larger than the one we computed above OR something else happened. Here is why: simple back of the envelope calculations (report details?) show that the accumulated capital losses suffered by Bear and Sterns, Lehman, Washington Mutual, Wachovia and UBS (all losses that can clearly and directly attributed to mortgage related securities) since October 2007 substantially exceed $330 billion. Hence, either those five banks were the owner of the practical totality of "bad MBSs" (in which case: hurray, the worst is over and the future is bright) or there is something else that keeps preventing the rest of the banking system from functioning properly. What could be the something else? Short of taking "dark matter" seriously, we can think of only one hypothesis, which is the following.
Financial institutions of all kinds used derivative contracts to enter into reciprocal bets that (1) went against the wind - i.e. those that owned MBS also bet that interest rates would not increase, so that when they did they lost twice: first on the mortgage and then on the interest rate derivative; (2) were "insured" (in the sense of assessing creditworthiness of the counterparts) by collateral assets that were, in a way or another, linked to MBSs - hence when those payments were due the collaterals had also dropped in value and the creditworthiness was gone out of the window; (3) were for amounts that substantially exceeded the net worth of the overall system, i.e. the total capitalization of a large chunk - if not the entire - US banking industry; and, finally, (4) no one knows who owns/owes what, so that anyone can be a possibly defaulting counterpart in any short term lending/borrowing arrangement. We are not sure (meaning; we do not have a theorem stating that) how many of these four conditions should simultaneously occur to imply systemic collapse but our hunch is that, in practical circumstances, any three of them would do.
Now, this is not good news on the one hand, and important news on the other. It is not good news because, if that were the case, we would be facing major regulatory and supervisory failure at a scale never seen before in the post-WWII US financial sector. It is important news because, were that the case, we would know what to do. Unfortunately, and hic sunt leones, the data publicly available does not allow us to make any inference either way. As of now, all we can frankly register is a huge puzzle: where have all the money gone?
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Problems and Solutions
What is the problem that we now face? Some banks have made bad choices, as have some homeowners. So also have some automobile firms, people that have borrowed on their credit cards, made unwise marriages, and so forth. The government has not promised to bail any of them out, and if it did, it would encourage even more irresponsible behavior in the future. What is special about banking? The problem in banking is the possibility of cascading failures, that the failure of bad banks may drag down the good banks, leaving nobody to lend money to businesses, home-buyers and all the other people that who would like to borrow. One might fear that it would also deprive people with money deposited in banks of their savings, but the Federal Government does guarantee those deposits, at least up to a limit, so if a bank fails as Washington Mutual just did, the government will step in to pay the depositors. The problem of cascading failures is, nevertheless, potentially serious.
A simple example will illustrate the problem: I borrow $1 million from Michele and lend it to you. You invest the million unwisely and lose it all, declaring bankruptcy. That means I don't get repaid. How am I to repay Michele the million I borrowed from him? One possibility is that I can't, that I also go bankrupt, and so your bankruptcy causes me to go bankrupt. That is what is meant by a cascading failure, when one bankruptcy forces another. However, perhaps I own mortgage backed securities. It may be that these are good securities representing money lent to people who can and will repay, or bad securities representing money lent to people who cannot repay, just as you cannot. In the latter case, if my securities are bad, then I am insolvent, and I should go bankrupt. But it may simply be that I am illiquid, meaning that while the securities are sufficient to pay off the money I owe to Michele, I cannot readily cash them in to raise the funds to repay him.
This is where the "lemons" problem comes in. Potential buyers of my securities know that my securities may be good or bad, but without a lot of time, effort, and money, they cannot easily tell which is the case. I, on the other hand, know whether my securities are good or bad. So a potential buyer will charge a price based on the average quality of securities for sale. If both good and bad securities are for sale, they will offer to pay an average of the price of good securities and bad securities. The lemons problem is that if my securities are bad, I am very happy to accept that price, while if my securities are good, I am not so delighted to sell. In other words more bad securities will be offered for sale than good; that in turn further lowers the prices buyers will be willing to pay, further driving down the quality of securities for sale. In the worst case I can only sell my securities, good or bad, for the value of the lowest quality securities possible. This means I might have to go bankrupt, even though I hold securities adequate to pay my debts, simply because buyers cannot tell that my securities are really good. We would prefer that the banking system not collapse because the bad securities have driven out the good.
What is the solution? One is for the government to step in and buy securities, as proposed in the bailout plan before Congress. It is hard to know the consequences of this without knowing how the government will determine the price is pays for securities. One possibility is that it simply offers to buy a certain number of securities of a given risk class to whoever will sell it to them at the lowest price. What happens depend on whether all securities that are bid are identical in risk or not. If they are Larry Ausubel and Peter Cramton explained how they can be efficiently valued in an auction. If they are not, then if the government pays, say, $30 per security, it can be fairly confident that it will only get securities worth less than that with the taxholder responsible for the difference. Notice that the ones who reap the rewards are the holders of bad securities who sell to the government at what is for them a premium price. Those who made bad decision are rewarded, those who made good decisions are not. In effect in order to keep the bad banks from driving out the good we rescue the bad banks.
There are many alternative schemes to the one proposed by Treasury.
- Require banks to raise more capital. To do so the current shareholders and executives will have to relinquish some power and allow either foreign banks or foreign investors to enter as shareholders and have a say in the management of the bank. This requirement forces banks sell off their risky securities to be replaced with safer securities such as Treasury Bills. Forcing everyone to sell faces the same lemons problem that is faced by the Treasury scheme, except that now the losses are borne by the good banks rather than the taxpayer.
- Forgive debt in exchange for equity. That is those who are owed money by the bank are required to accept instead a share of the firms stock. This gets around the lemons problem because it does not force banks to liquidate good or bad securities. The cost of the scheme falls on the bond-holders: however, if the banks go bankrupt, they will be on the hook anyway. Zingales argues that debt forgiveness schemes have worked for resolving financial crises in the past.
- Buy foreclosed houses for the value of the mortgage. Although the actual cost of the Treasury plan is difficult to compute, since it is hard to know the value of securities we will wind up owning for $700 billion, this we know will cost $150 billion as of now. If we act quickly, therefore preventing the house prices from dropping much farther, that may be it. An important benefit of this approach is that it avoids the lemons problem entirely. A drawback is that it does not do anything about securities that are in trouble due to the possibility of future losses rather than present losses. It also leaves the government owning houses rather than securities, and houses are less easy to handle than securities.
- Force an orderly winding down of the housing based derivative market. It is likely at this point that a large fraction of the contracts currently alive have turned into empty gambles, in which one party is unable to pay. Markets are already operating in this direction as the number of outstanding CDSs suggest, but the process might be aided by an impartial arbiter.
The sky is not falling, and will not fall
Yes: there can be cascading bank failures and that is a bad thing. But it does not happen instantly, not tomorrow, not next week, not next month. Here is a graph of bank failures during the Great Depression which we supposedly face again if we don't approve the bailout plan immediately.
This is taken from a publication of the Federal Reserve Board. The point of the graph is simple: the banking system didn't fail all at once during at the beginning of the Great Depression: there was a continuing series of bank failures stretching over more than three years. And it bears emphasis: at the beginning of the Great Depression the Federal Reserve did exactly the wrong thing: it failed to provide liquidity to the system and allowed the money supply to contract. It is the documentation of this in the Monetary History of the United States for which Milton Friedman and Anna J. Schwartz are justly famed. At the moment the Federal Reserve has been carefully, and largely quietly, doing what it is supposed to do - namely exactly the opposite of what it did at the beginning of the Great Depression.
Looking at more recent times in the early years of this century Argentina suffered a dramatic banking crisis leading to a default on the public debt. For a few months this forced a nearly complete shutdown of the national banking system. Bailout or no, nobody is predicting such a dramatic collapse in the U.S. The effect of the banking collapse in Argentina can be seen in the per capita Gross Domestic Product (GDP, a measure of income, measured in Purchasing Power Parity units) show below
| 2005 | $14,024.26 |
| 2004 | $14,161.54 |
| 2003 | $14,298.07 |
| 2002 | $14,435.93 |
| 2001 | $14,578.37 |
| 2000 | $14,728.00 |
| 1999 | $14,885.85 |
The crisis occurred at the end of 2001, and during 2002. As can be seen it did not have much effect on GDP. While per capita income fell in Argentina pretty much continuously due to various poor economic policies, the fall was not especially aggravated by having banks closed for several months.
The bottom line, in the immediate future, is this. The Federal Reserve Bank and its sister agencies such as the Federal Deposit Insurance Corporation (FDIC) already have strong tools against a cascading failure of the banking system. They has been using those tools, including advancing credit to banks through the discount window, insuring deposits, and selectively allowing institutions to fail. We have seen isolated bank failures. There will be more in the future. We have not seen good banks fail, nor have we seen cascading failures. We have been given no reason to think anything of the sort is imminent. It is sad to say that despite this the U.S. Government is in a state of panic. Supposedly knowledgeable government officials talk as ATMs might stop working and firms will not be able to meet their payrolls. This is utter nonsense. To debunk the obvious: Washington Mutual failed Thursday night. Washington Mutual ATM cards continue to function as usual. Individual and corporate bank accounts are federally insured up to $100,000 per bank. The normal process of bank closure does not prevent bank customers from accessing their funds. As to payroll: We do not doubt that some firms of various sizes are going to fail to meet payroll and go bankrupt next week. It is likely that a few of them would have been able to survive if credit was more widely available at the moment. But most firms do not meet payroll by short-term borrowing. The fact that banks are reluctant to lend to each other does not have much impact on their ability to make short term loans to customers. And so on.
No objective reading of data we have access to indicates anything near as bad as the claims that are being made. It may be that eventually more intervention than the Federal Reserve and Treasury can do without Congressional action will be needed. However, this is not a natural calamity or a war where there will be large and irreparable harm if we do not act immediately. There is adequate time for the public, the Congress, the Treasury and Federal Reserve to think through the alternatives carefully, to monitor the situation with equal care, and if necessary intervene in markets in a way that makes sense.
Public officials, especially the Chairman of the Federal Reserve Board have an obligation to explain these facts and reassure people that they are not in danger of a catastrophic collapse. It is rather unfortunate, then, the opposite seems to be occurring. For example, on September 24 Ben Bernanke declared in front of Congress:
All told, real gross domestic product is likely to expand at a pace appreciably below its potential rate in the second half of this year and then to gradually pick up as financial markets return to more-normal functioning and the housing contraction runs its course. Given the extraordinary circumstances, greater-than-normal uncertainty surrounds any forecast of the pace of activity. In particular, the intensification of financial stress in recent weeks, which will make lenders still more cautious about extending credit to households and business, could prove a significant further drag on growth. The downside risks to the outlook thus remain a significant concern [...]Over time, a number of factors should promote the return of our economy to higher levels of employment and sustainable growth with price stability, including the stimulus being provided by monetary policy, lower oil and commodity prices, increasing stability in the mortgage and housing markets, and the natural recuperative powers of our economy. However, stabilization of our financial system is an essential precondition for economic recovery. I urge the Congress to act quickly to address the grave threats to financial stability that we currently face. For its part, the Federal Open Market Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.
Roughly speaking he said "things are not too bad, but gradually getting worse, and you better act quickly to give us $700 billion to fix it." The conclusion does not seem to follow. It is not surprising that people imagine that there is far more catastrophic information that he is not telling us. If the Federal Reserve Bank and Treasury in fact have information that things are worse than Bernanke reported they should tell us what it is. Otherwise they should stand up and make it clear that doomsday is not around the corner.
Days like the day of St. Michele of 2008 are not good for anyone and a certain degree of transparency from the Federal Reserve could spare us, at least, part of it.
From what I understand, the most immediate fear is the freezing of the money markets: as banks don't trust each other, they tend to decline requests of temporary credit positions (hence the escalating interbank rates, which, separately, also worsen the predicament of variable-rate mortgage owners, making the real estate prices drop faster etc.). That alone can bring the whole financial system to a standstill, even without anybody actually losing money. Consider that the interbank money flows (credit aside) are staggering: in 2005 only Fedwire processed payments for USD 2.1 trillion a day, and flows through CHIPS (used mostly for international payments) are probably of the same order of magnitude. Perhaps some sort of government guarantee against risks of counterparty default could help here, although it's hard to engineer it in a way that can't be misused by cunning financial institutions... For example, recently the ECB had to clampdown on abuses of its collateralized credit facility by banks who were allegedly taking advantage from it as a magic converter of newly-produced lemons into cash...