The Fruits of Civilization (26-12) The 2008 Recession

The 2008 Recession

There appear signs of froth in some local markets where home prices seem to have risen to unsustainable levels. ~ US Federal Reserve Chairman Alan Greenspan in July 2005

The financial crisis of 2008 was fueled by low interest rates, easily available credit, scant regulation, and toxic mortgages.

Giving liquidity to bankers is like giving a barrel of beer to a drunk. You know exactly what is going to happen. You just don’t know which wall he is going to choose. ~ English investment banker Nick Sibley

The bubble began with George W. Bush, whose tax policies as President were a giveaway to the wealthy. 80% of the $3.4 trillion in cumulative tax cuts 2001–2005 freed funds that flowed to investors. $2.6 trillion went into the pockets of those who didn’t need the money. This savings glut spilled into the market.

This global money parade does not seek long-term investment in real assets that actually produce things of some use, but rather creates short-term paper products that produce no real income stream or jobs, save for financial traders. ~ Jack Rasmus

The run-up to 2008 was a replay of the savings and loan (S&L) bubble 2 decades earlier, with a twist of financial manipulation that made the consequences much worse, by fraudulently spreading the risk around. As in the S&L episode, the federal government let the bubble be blown, then bailed out the financial industry when it burst.

Financial firms have become very good at generating high profits for themselves at the cost of creating asset bubbles whose unsustainability they obscure through pooling, structuring, and other techniques. When the bubble bursts, these firms deftly use their economic weight and political influence to secure rescue money and subsidies from the public purse, which then has to be refilled by the general public through tax hikes and spending cuts. This scenario has been repeated dozens of times all over the world in the last 3 decades. ~ Ha-Joon Chang in 2014

○○○

Bank loans pour money into the economy. Economic theory predicts judicious distribution into productive assets, as economic agency is assumed a rational process.

In actuality, money flows to where returns are highest at presumed levels of risk amenable to a borrower. A confluence of greed and fear drive investment, whereas good sense only occasionally kibitzes from the backseat.

From 1978 to 2007, the amount of debt held by the financial sector soared from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product. ~ US Financial Crisis Inquiry Commission

○○○

The Roaring Twenties has been a reference period for frivolous speculation. The mood leading to 2008 was much the same. But, in terms of magnitude, the 1920s had nothing on the 2000s bubble. Whereas debt-financed spending never exceeded 10% of GDP in the 1920s, it rarely fell below 20% in the decade before the 2008 crash. 1929 US GDP was $101 billion. In 2007, GDP was $1,225 billion (in 1929 dollars).

The key factor in both the Great Depression and Great Recession was the same: the collapse of debt-financed demand.

Housing is far bigger economically than commercial property. Housing starts are a large chunk of the volatile bit of the economy. This means that changes in home investment have a disproportionate impact.

Real estate is also especial sector of the economy because of its connection with finance. Property is debt-ridden, and so banking lending practices and housing activity are inextricably linked. The reason for this liaison is 2-fold: the high price of real property, and the fact that land, and buildings, are the tangible assets which ostensibly hold value, providing lenders with the surest collateral. The psychological cushion that banks feel in lending for real estate inclines them to overindulge: a facile sense of security with systemic implications.

While property can cause crashes, the sector traditionally leads economies out of recession. These extremes illustrate the continuing connection between finance and real estate.

Into the 21st century, the bulk of lending increasingly went into mortgages, feeding inflation in that sector, as more and more money chased after modestly growing housing stocks. This happened in the US, UK, and much of continental Europe. $4 trillion was sunk into new American mortgages 2002–2006. Accelerating a trend that started in the late 1980s, British banks doubled the debt and money poured in the economy from 2000 to 2007.

Only 8% of the trillion pounds that UK banks created went to businesses outside the financial sector, which itself soaked up 32% of the funds. Generating money with money is the purest form of financial bubble blowing. 31% went to residential property, pushing up house prices faster than wages. 20% got lodged in commercial real estate.

The conventional analysis of the mortgage crisis is that poor people were reckless. But it was wealthy and middle-class house flippers and real estate moguls on the make that blew the bubble. When the bubble popped, affluent investors accounted for a disproportionate share of defaults, as they had scant incentive to hold onto their extra properties. By contrast, the share of single-mortgage borrowers who could not keep up with their payments barely budged.

○○○

Secured loans supposedly pose less risk to a borrower, but that ignores the systemic hazard of an entire sector crashing; which is what happened. The problem was exacerbated by the way that the loans were managed: bundled into packages as mortgage-backed securities that were sold to investors around the world as low-risk instruments. Trillions of dollars in real estate loans became embedded throughout the financial system.

The securities were supposedly low risk owing to their being bundled. Risk of failure on any one property would have modest impact on the security as a whole.

When bundling began, sellers themselves had no idea how risky the securities might be, as the bundling was haphazard. The contents of these securities were often inscrutable, as repackaging was common, ostensibly to blend the supposed risk of an instrument to a desired degree.

By 2006, banks selling these securities knew that trouble was looming. When an analyst wrote a positive report about mortgage securities in April 2006, the head of due diligence at investment bank Goldman Sachs wrote in an email: “if they only knew.” But they kept on peddling.

After the bubble burst, all of the major US banks settled up with the federal government for the massive fraud they had committed. JP Morgan Chase alone ponied up $13 billion: a fraction of the lucre the bank had made in the long-running scam.

There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner.

The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. ~ US Financial Crisis Inquiry Commission

I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk. But I believed then, as now, that the benefits of broadened home ownership are worth the risk. ~ Alan Greenspan in September 2007

Mortgages were simply the tip of the iceberg. Consumers had generally gotten in over their heads in debt.

Household debt soared in the years leading up to the downturn. In advanced economies, during the 5 years preceding 2007, the ratio of household debt to income rose by an average of 39 percentage points, to 138%. The concurrent boom in both house prices and the stock market meant that household debt relative to assets held broadly stable, which masked households’ growing exposure to a sharp fall in asset prices. ~ IMF

In the years leading up to the crisis, too many financial institutions, as well as too many households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value of their investments declined even modestly. ~ US Financial Crisis Inquiry Commission

Interest has to be paid on loans. With debt rising faster than incomes, repayment became too much of a burden for a tiny minority of homeowners: they stopped repaying their mortgage loans in 2005–2006, setting off the crisis.

Banks shortsightedly reacted by limiting new lending to households and businesses. The sudden credit crunch immediately caused an economic seizure. Marginal companies went wobbly, laying off workers.

As house prices declined, households saw their wealth shrink relative to their debt. With less income and more unemployment, consumer-fueled economies rapidly spiraled downward.

As housing prices fell, global investor demand for mortgage-backed securities evaporated. In July 2007, investment bank Bear Sterns announced that 2 of its hedge funds, which were heavily invested in these securities, had imploded. Within 2 months Bear was on its knees, having lost the trust necessary to do business with other banks.

On 14 March 2008, the Federal Reserve Bank of New York agreed to provide a $25 billion short-term liquidity loan to Bear Sterns that the market was refusing. The next day the Fed changed its mind.

On 16 March 2008, JP Morgan Chase bought Bear for $2 a share: less than 7% of its market value 2 days before. In January 2007, before the debacle, Bear’s stock price had been trading at $172 per share.

8 days later, JP Morgan Chase upped its offer to $10 per share, to fend off a class-action lawsuit filed on behalf of Bear Sterns shareholders, and to prevent former employees, many of whom had been compensated in Bear Sterns stock, from leaving for other firms.

Begun in 1850, Lehman Brothers had grown to be the 4th-largest American investment bank. It held a mortgage lender, BNC Mortgage, and was heavily vested in mortgage-backed securities. In August 2007, Lehman shuttered BNC’s doors. By September 2008, Lehman itself was on the ropes: its stock price a tiny fraction of what it had been 2 years earlier. Like Bear Sterns before it, no other financial firm wanted to do business with Lehman Brothers.

No buyer could be found for Lehman. British financial regulators vetoed Barclay Bank’s bid to buy the crippled firm. The US Federal Reserve resisted Bank of America’s request for government backing of its purchase. So, on September 15, Lehman filed for bankruptcy. This event burst the bubble.

Stock market reaction was immediate. The Dow Jones closed down 4.4% that day: the largest drop since the days following the 11 September 2001 terrorist attacks that took down the World Trade Center twin towers in New York City.

October 2008 was a bleak month for stock markets around the world. The Dow dropped 22% from 1 October through 10 October.

To lick their wounds, banks cut lending to the bone, tipping economies in most of the world into recession.

○○○

Markets have become more complex, and institutions – both bank and non-bank entities – are now larger and connected more closely through a complicated set of relationships. ~ American economist Thomas Hoenig

No bank was unscathed by the crisis. Those most exposed were local and regional institutions that catered to retail customers and offered mortgage loans.

Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity are in a state of shocked disbelief. ~ Alan Greenspan in January 2009

Malfeasance by the financial sector was nothing to the US government. While Congress was fretting over scraps to help victims of the fiasco, the Federal Reserve secretly provided $7.8 trillion in low-cost loans to the biggest banks between August 2007 and March 2009. Nearly 25% of the profits that the 6 biggest US banks turned during that period owed to Fed largesse. And that was just the start of the “quantitative easing” with which the Federal Reserve greased a trickle-down recovery.

In the wake of the crash, flush with proceeds from taxpayers, behemoth banks got even bigger by buying on the cheap those that stumbled and were not propped up by the government. At the end of 2007, the 3 largest US banks – Bank of America, JP Morgan Chase and Citigroup – collectively held 21% of all American deposits. By the end of 2008 they had gobbled their way to 33%.

Consolidation is a natural part of credit cycles. ~ American attorney Sheila Bair, head of the US Federal Deposit Insurance Corporation (FDIC) (2006–2011)

Thus, the largest banks in the US and other countries remained “too big to fail.” In the event of another panic, the government would have to bail them out at taxpayer expense, or the country would face financial meltdown.

The goal to end too-big-to-fail and protect the American taxpayer by ending bailouts remains just that: only a goal. ~ Thomas Hoenig, director of the FDIC, in 2016

○○○

It was the failure to properly price risky assets that characterized the crisis. ~ Alan Greenspan

Subprime loans, although only a tiny fraction of global finance, caused contagious hysteria on the world banking system. Banks rode risk to a tremendous fall, from which recovery got its legs only in 2017, 9 years later. Even then, American wages remained low. The recovery was largely to businesses’ benefit.

Dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis. ~ US Financial Crisis Inquiry Commission

The idea that markets are self-regulating received a mortal blow in the recent financial crisis and should be buried once and for all. Markets require other social institutions to support them. In other words, markets do not create, regulate, stabilize, or sustain themselves. ~ Turkish economist Dani Rodrik

Religious adherents of capitalism refuse to face reality. When markets lurch, as they regularly do, zealots point the finger of failure elsewhere.

Government policies rewarded shortsighted collective risk-taking and penalized long-term business leadership. The banking crisis should be understood more fundamentally as a government failure than as a market or business failure. ~ American economist Mark Perry

Blaming government for failing to adequately regulate the financial sector is rich in irony. However true it may be, complaining so is a damning indictment of capitalism: that businessmen must be constantly watched to avoid serious societal dislocation. It is the strongest-possible purely economic argument to abolish capitalism altogether.

Greed is a timeless and universal component of human nature, and it influences the public sphere at least as much as the private sector. ~ Mark Perry, who blamed “excessive government protection of creditors” as causing the crisis.

(Perry’s recommended policy solution is the free-market curative for egregious risk-taking: letting the entangled financial sector utterly implode so that it may learn its lesson. This would create the most severe crises imaginable, as shown by government inaction in the wake of bank failures at the onset of the Great Depression. Perry is typical of religious proponents of unfettered markets: studiously ignorant of history and how the financial industry functions.)

Parry has a point. Money buys power in modern democracies, as it has throughout history: governments are ever under the sway of the wealthy.

Government policies promoting and encouraging speculative forms of investment since the late 1970s have contributed significantly to the excessive concentration of income and wealth that has taken place over the last 3 decades – both in the US and globally. ~ Jack Rasmus in 2010

However corrupt, plutocratic government is not the source of the problem. The ascription for greed lies with those who commit it, not its permissive facilitator.

We cannot control ourselves. You have to step in and control Wall Street. ~ American investment banker John Mack in 2009, in an appeal to financial regulators

Major financial institutions had shoddy, risky, and deceptive practices. Those institutions deceived their clients and deceived the public, and they were aided and abetted by deferential regulators and credit rating agencies who had conflicts of interest. ~ American senator Carl Levin

○○○

History has repeatedly shown capitalism to be a deeply flawed economic system. Cyclical problems persist and have only grown in severity as the finance sector has matured, mutating from ersatz resource allocator to defective perpetual-motion machine aimed at artificial profits: making money with money.

Money was meant to be the neutral agent of commerce. Now it has become the neurotic master. ~ American economic journalist William Greider

○○○

What we are witnessing, in the broadest sense, is the bankruptcy of modern economics. ~ American economic journalist Robert Samuelson

In the aftermath of the housing bubble, over 4 million American families lost their homes to foreclosure. Nearly $11 trillion in US household notional wealth vanished. Life savings were swept away.

The deep recession that began in December 2007, when the economy began to contract, and ended in June 2009, when the economy began to expand again, has had a lasting effect on the labor market. ~ US Congressional Budget Office

The unemployment rate in the US shot up to 25% after the bubble burst and took the better part of a decade to recover. For young adults trying to enter the labor market, prospects had not been so bleak since the Great Depression.

Recession-plagued nation demands new bubble to invest in. ~ satirical newspaper The Onion in 2008

○○○

Financial institutions heighten risks by originating poorly underwritten loans. ~ 2013 guidance from the US Comptroller of the Currency, Federal Reserve, and Federal Deposit Insurance Corporation

Bank lending was restrained for years after the 2008 financial meltdown, as regulations were put in place to prevent high-risk lending. This changed in 2017 when the Trump administration took power and stripped away post-crisis financial rules.

Lending surged, invigorating the economy. But all was not sanguine under the surface. Unconstrained, the largest banks indulged in leveraged loans which reaped high fees and thereby up-front profits. These loans were to companies on the edge: unable to survive without a massive financial infusion and likely to go under with the next downturn even after receiving funding.

Over the past 35 years, these are some of the worst underwritten loans. ~ American bank examiner Timothy Long

The big banks cut their exposure by packaging and selling the leveraged loans to investors – the same practice of offloading risk that led to the 2008 financial meltdown.

We market them out, and it’s gone. ~ American banker Brian Moynihan, Bank of America CEO

Someone’s going to get hurt there. ~ American banker Jamie Dimon, JP Morgan Chase CEO, on marketing leveraged loans

We are in the 8th year of a 7-year credit cycle. When things turn, they are going to turn hard. ~ Timothy Long in early 2019

○○○

Throughout US history, the financial industry has played a major role in creating – and exploiting – economic distress. ~ American economist Sarah Anderson et al

Let’s leave this slice of history with a couple of snapshots of how banks treat their customers.