The Big Con
Reassessing the “Great Recession” and Its “Fix”by laurence kotlikoff
larry kotlikoff is a professor of economics at Boston University. This essay was adapted from a more technical article in Acta Oeconomica, a journal published by the Hungarian Academy of Sciences.
Illustrations by Hal Mayforth
Published July 29, 2019
Ten years after the Great Recession, economists still debate its causes and policymakers still wonder how to prevent the next one. MIT finance professor Andrew Lo reviewed 21 books on the crisis, concluding that: (There is) significant disagreement as to what the underlying causes … were and even less agreement as to what to do about it. But what may be more disconcerting for most economists is the fact that we can’t even agree on all the facts. Here, I argue that the alleged origins of the Great Recession (GR) are either (a) unsupported by the facts, (b) inconsistent with widely accepted economic theory or (c) descriptions of outcomes, not causes. In any event, a close look suggests that the GR was not particularly “great,” implying that its very title is part of the recession’s self-generated hysteria. My debunking of the standard narrative is followed by an alternative view of what produced this latest in a long history of U.S. banking failures and economic downturns — namely, pure misinformed panic, facilitated and sustained by leverage and opacity, which flipped the economy’s equilibrium.
The Official Post-Mortem
The 2009 report of the Financial Crisis Inquiry Commission (FCIC) included this summary:
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.
“Pervasive permissiveness” has a nice ring to it, summing up the standard assessment in two words and creating the foundation for the chosen remedy. It implies that the problem lay with people, not with the intrinsic nature of the economy or the banking system. It also says that banking’s fix is to ensure that people, including bankers, raters, regulators, investors, politicians and borrowers, behave. Yet these causes of the Great Recession seem largely a description — and all too often an exaggeration — of what transpired, not an explanation for why events unfolded as they did, let alone an admission that there is something terribly dangerous and unstable at the core of our banking system.
Blaming the Victim
Take subprime mortgages. Reading the FCIC report, one might conclude that a majority of outstanding mortgages issued before the GR were subprimes lacking high-quality collateral. This drastically overstates the importance of subprimes. In the run-up to Lehman’s bankruptcy, they never exceeded 14 percent of outstanding mortgages, and their share was below 12 percent on Sept. 15, 2008, when Lehman Brothers shut its doors. Furthermore, not all subprimes proved to be vulnerable when measured by foreclosure rates. At its peak, the subprime foreclosure rate was only 15 percent.
Now, 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 half of these foreclosures. This oversized share of subprimes in total foreclosures suggests they ignited the recession or at least helped make it “great.” But subprimes constituted over 60 percent of all foreclosures in 2004, when the economy was doing just fine.
Furthermore, one can’t claim subprime defaults caused the GR by considering defaults during the GR. When the Great Recession began, the default rate (delinquencies plus foreclosures) on all mortgages was only 3.7 percent. It rose to 11.5 percent over the next two years as close to nine million workers lost their jobs. The inescapable reality: the GR caused defaults, not the other way around.
In 2007, before the GR, the subprime foreclosure rate was 5 percent. It rose by a factor of roughly 3 during the GR. But the 2007 foreclosure rate for prime mortgages was 1 percent and rose by a factor of 4. Hence, one can argue that if bad mortgages caused the GR, primes more than subprimes were at fault.
Another piece of evidence on the actual problems with subprime securities comes from the Fed’s purchase from JP Morgan Chase of $29 billion in Bear Stearns’s subprime securities, part of a deal designed to persuade JPMC to take over Bear Stearns for next to nothing. These securities, which the market presumably valued at far less than $29 billion at the time, were placed in a limited liability vehicle called Maiden Lane. The name Maiden Lane was a euphemism, lying as it does at the rear end of the NY Fed. But when the dust settled, this subprime excrement was sold for $31.5 billion — a profit of more than $2 billion.
When the Great Recession began, the default 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. The inescapable reality: the GR caused defaults, not the other way around.
If subprimes were irrationally undervalued during the GR and weren’t the proximate cause of the GR, what about other alleged boogeymen?
The “Unsustainable” Rise in Housing Prices
The FCIC’s conclusions suggest that house prices can’t keep rising over long periods and were going absolutely crazy before the GR. In fact, real house prices rose virtually every year from 1975 to 2007. The rise was both smooth and gradual, with real house prices only 64 percent higher in 2007, even as real GDP rose by 170 percent.
The only period of exceptionally rapid rise in this 32-year period occurred between the first quarter of 2003 and the first quarter of 2007, when real house prices rose by 22 percent. But note that over this period real GDP rose by 14 percent. Hence, real house prices rose only 2 percent faster annually than did the economy during the period of “unsustainable” house price increases.
Certainly, a temporary drop in house prices could have produced a contraction in construction. But contractions in construction have also emerged — indeed they’ve generally occurred — in the context of rising house prices. Furthermore, a drop in house prices does not adversely impact most homeowners, who continue to enjoy the benefits of living in them.
The disagreement around the actual amount of Bear Stearns’ capital ratio tells us that the public, and bankers themselves, can easily reach and maintain incorrect conclusions about a bank’s ability to withstand a run.
As the GR took hold, many homeowners went underwater on their mortgages. This surely led to the observed rise in foreclosures as mortgagees jumped ship. But foreclosures don’t necessarily represent a significant net loss to the economy. The foreclosed house is, after all, still standing; ownership just switches hands.
In short, rising house prices are not required to keep the economy out of recession. Nor are declining house prices, even accompanied by mortgage defaults, an automatic harbinger — let alone a direct cause — of recessions.
The FCIC’s report states that failures of the Big Three securities rating companies were “essential cogs in the wheel of financial destruction” and “key enablers of the financial meltdown.” But a careful study by economists Efraim Benmelech and Jennifer Dlugosz identified notable holes in the argument.
Structured-finance securities represented only 35 percent of the U.S. bond market in 2008. Only 7 percent of those securities were re-rated, and at most 20 percent were overrated because of ratings shopping. Thus, over-rating affected less than one half of 1 percent of the U.S. bond market. Furthermore, this figure surely overstates the importance of ratings shopping, as many of the later downgrades were caused by the GR itself.
Increased Bank Leverage
Sky-high leverage is another part of the standard GR story. Banks, we were told, were leveraged 33 to 1 in 2008, compared with 12 to 1 in 2004. The only problem: it’s not true. 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.
Given the severity of the stock market plunge subsequent to Lehman’s failure, one might think that leverage ratios rose sharply during the recession. Not the case. Fed data show the equity ratio falling from 10 to just 9 percent — a higher value than was registered in the prior 16 years.
Fed data also suggest that banks as a group were leveraged only 10 to 1 at the beginning of 2008, when the GR officially began. But what about the large investment banks? Was their leverage exceptionally high before the GR? Actually, no.
Lehman was no more leveraged in 2007 than in 2003. And Bear Stearns was only slightly more leveraged in 2007 than in 2003. Interestingly, the three large investment banks that didn’t face runs — Goldman Sachs, Morgan Stanley and Merrill Lynch — did materially increase their leverage in the run-up to the GR, but not beyond leverage rates seen years in the past. Still, the fact that the investment banks that maintained their leverage came under attack, while the investment banks that raised their leverage did not, provides more evidence against leverage being the GR culprit.
Too Little Capital
Another view of GR’s cause is that banks failed because of insufficient capital. The goal, after all, of the post-GR Dodd-Frank Act’s stress tests is to ensure that banks have sufficient capital to prevent a replay. But again, what everybody “knows” doesn’t bear close examination.
The Wikipedia entry for Bear Stearns indicates the company was leveraged more than 35 to 1 leading up to its collapse. That’s a capital ratio of less than 3 percent — far below the regulatory standards of then or now. But Christopher Cox, chairman of the SEC during the Great Recession, claimed that when Bear Stearns failed, its capital ratio was actually over 13 percent. “The fate of Bear Stearns was the result of a lack of confidence,” he concluded, “not a lack of capital.” And Mary Schapiro, chairwoman of the SEC in 2009 to 2012, said much the same thing about Lehman Brothers.
There are, of course, different leverage/capital ratio measures. The complete disconnect between the Wikipedia entry and the statement by Cox may reflect any number of factors. The important point, though, is the yawning disagreement. This enormous discrepancy tells us that the public, and bankers themselves, can easily reach and maintain incorrect conclusions about a bank’s ability to withstand a run.
There is an even more important message in Cox’s additional statement that “the market rumors about Bear Stearns liquidity problems became self-fulfilling.” Cox is saying that Bear Stearns’s actual capital ratio didn’t matter. Creditors, past and prospective, came to believe that other creditors were pulling the plug. This dynamic can sink any bank, no matter its capital ratio, at any time.
Lehman was also well-capitalized before its demise. It had Tier 1 capital of 11 percent when its creditors pulled the plug — which is close to the current banking system’s Tier 1 capital ratio of 12.3 percent. Putting it another way, today’s banking system is apparently only marginally safer than Lehman Brothers was when it was driven out of business.
Egregious and Predatory Lending
The FCIC cites “egregious and predatory lending” as another cause of the GR. Such lending references adjustable-rate mortgages, mortgages with balloon payments, interest-only mortgages and the like. There is no doubt that many of them were made to borrowers who took on too much risk or agreed to pay interest rates that were predatorily high. But such loans had (legally) been in existence since 1982. 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. And they did so in the context of an unemployment rate that reached 10 percent.
In 2007, before the GR, the foreclosure rate was 5 percent. Its lowest value, between 2002 and 2007, was 3 percent. If one assumes that all of the two-percentage-point increase in subprimes involved predatory lending, we’re still talking about predatory lending causing, at most, 0.3 percent more mortgages to enter foreclosure. This is simply too small a figure to trigger a financial crisis.
Dramatic Increases in Household Mortgage Debt
Another GR “smoking gun” is the pre-GR run-up of mortgage debt, which roughly doubled from 2002 to 2007. But there is nothing in economic theory that suggests increased borrowing causes recessions. The increase in borrowing to purchase homes was not associated with a spending spree. Indeed, Americans, as a whole, borrowed more, not to spend, but to invest. And their borrowing was accompanied by an 83 percent increase in net wealth. The ratio of mortgage debt to household net wealth rose — but not by much, going from 17 percent in 2001 to 20 percent in 2007.
Exponential Growth in Trading by Financial Firms
The volume of trade in securities or anything else is not, in itself, evidence of an economic problem. One might claim that the volume of trade was coincident with an irrational bubble in financial markets. But the trades being counted here are those involving stock, and the run-up to the recession did not reflect unprecedentedly high stock market valuations. The equity market capitalization was 1.5 times GDP in 2000, 1.4 times GDP in 2007, and 1.5 times GDP in 2017.
Unregulated Derivatives and Repos
The GR was marked by the dissemination of news about derivatives with exotic-sounding names, such as RMBS, CDOs, synthetic CDOs, CDO2 and CDS. Because many were complex and not all were regulated, they were singled out repeatedly during the GR and included in the FCIC’s favorite list of bête noires.
But if these securities actually helped cause the GR, one would expect their value to have peaked before, not during, the GR. In fact, the net value of financial derivatives was 126 percent higher at the end of the GR than at the beginning.
The reigning narrative — that derivatives were misunderstood and overrated by compliant rating agencies — has been questioned in a recent study by economists Juan Ospina and Harald Uhlig. They examined 8,615 residential-mortgage-backed securities (RMBS) over the period 2007-2013. Through 2013, the cumulative loss on these “toxic” securities was only 2.3 percent. AAA-rated RMBS actually outperformed the universe of AAA-rated securities. Yes, losses were far higher for non-AAA-rated segments of the RMBS market. However, these securities represented a small fraction of the total.
What about repos, a form of short-term borrowing? They certainly increased in the run-up to the GR. But short-term financial-company borrowing has been growing far faster than the economy for decades. Of course, repos would be implicated in causing the GR had they been part of excessive leveraging by financial intermediaries. But, as discussed above, overall financial-company leverage actually fell before the GR.
Investors Mispriced/Ignored Risk
The Ospina and Uhlig paper also speaks to the assertion that Wall Street professionals acted like amateurs in the alleged lending euphoria leading up to the GR. Had that been the case, the RMBS assets would not have done so well in the teeth of the recession and major reduction in housing prices starting in 2006. Nor, as Andrew Lo pointed out, would CDOs have paid significantly higher returns than equally rated corporate bonds.
Unaligned CEO Incentives
Yet another alleged contributor to the meltdown was the failure of CEOs of financial institutions to have sufficient “skin in the game.” Jimmy Cayne, former head of Bear Stearns, would surely disagree: he lost close to $1 billion as his bank collapsed. Ken Lewis of the Bank of America lost $142 million. Economists Rüdiger Fahlenbrach and René M. Stulz examined executive compensation contracts of 95 banks in 2011, finding that performance-linked stock and option compensation in these contracts exceeded wages by a factor of eight. In short, there is no persuasive evidence that bankers were financially protected from the ensuing banking crisis.
There is no persuasive evidence that bankers were financially protected from the ensuing banking crisis.
This phrase alludes to the conflict of interest of regulators hoping/expecting to get jobs later on in the industries they regulate. But, as discussed earlier, financial leverage, which was the biggest issue in oversight, was not historically high before the GR. One could well argue that it was always too high, but that doesn’t help to explain the GR.
Democratization of Finance
Under this theory, regulators along with Fannie Mae and Freddie Mac, the government-sponsored enterprises that insured commercial mortgages and carried them in their portfolios, were too permissive with banks in their quest to help marginally qualified buyers get mortgages. But if this were the chief cause or even a major cause of the GR, subprime mortgages would need to have played a much larger role than they did.
Low Interest Rates
Many commentators blame the Fed, along with and Fannie and Freddie, for interest rates that encouraged imprudent borrowing. Thirty-year mortgage interest rates were certainly lower between 2000 and 2007 than in the prior quarter century. But they weren’t that low, adjusted for inflation. In the 1990s, the real 30-year mortgage rate averaged 7.91 percent. It averaged 6.27 between January 2000 and December 2007. This decline is hardly anyone’s idea of a smoking gun.
If the evidence rules out the usual suspects, what did cause the GR? I believe that sheer panic facilitated by opacity, false rumors, misinformation and exaggeration, along with 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 not addressed in Dodd-Frank or parallel reforms proposed or enacted in Europe.
Economics is chock-full of plausible mathematical models in which economies are vulnerable to rapid changes from one equilibrium to another. Indeed, a striking number generate multiple equilibriums in which financial-market collapse arises absent any fundamental problem. These suggest that the banking system is inherently built to fail and that focusing exclusively on the models’ “good” equilibrium is dangerous wishful thinking. The question is not whether the banking system will fail, but when.
Hence, it’s passing strange that the FCIC report makes no mention of this, which is akin to the FAA investigating a plane crash due to structural failure without referencing the plane’s blueprints. This, presumably, reflects the makeup of the FCIC, whose 10 members included just one economist (Douglas Holtz-Eakin, who is a fine economist but had no background in finance).
In completely ignoring the theory of bank runs, the FCIC pretended that what happened wasn’t intrinsic to how the financial market is structured. Instead, the commission appears to have rounded up the usual suspects and held a sham trial. Yet in the process of fingering multiple apparently innocent culprits, the report used the word panic 100 times. Here is the first.
Panic fanned by a lack of transparency of the balance sheets of major financial institutions, coupled with a tangle of interconnections among institutions perceived to be “too big to fail,” caused the credit markets to seize up.
This statement certainly links panic to opacity. But it falls far short of saying that the banking system and economy, as currently constituted, are inherently unstable.
If, as is surely the case, what happened to Lehman Brothers could have happened to any financial institution, it means that bad fundamentals weren’t a prerequisite for the GR bank runs. It also means that established lines of credit are worthless in a pinch because banks will run on banks at the first sign of a death throe. And certainly, there was no fundamental news in Bear’s last week that drove its stock value from $70 a share on March 10 to $2 a share on March 16. The only real news was that the bank was experiencing a defunding run and was desperately trying to stay afloat.
Betting on the Bad Equilibrium
Economists’ models of bank runs incorporate a variety of mechanisms and behaviors. What they don’t include is the possibility that some agents stand ready to manufacture financial collapse because doing so will line their pockets. In the days running up to Bear’s demise, hedge funds withdrew their deposits en masse from Bear’s prime brokerage. Did these hedge funds also take short positions and, effectively, corner the short market? The answer is unknown. What is known is that false rumors were planted that improved the position of the shorts.
Naked short selling also played a role in murdering the banks . . . short sellers effectively manufactured tens of millions of shares of the two companies and dumped them on the market.
Naked short selling — sales of a company’s stock by entities that don’t own the shares they are selling — also played a role in murdering the banks. As Bear and Lehman reached the ends of their tethers, short sellers effectively manufactured tens of millions of shares of the two companies and dumped them on the market. To date, the SEC has engaged in very few enforcement actions against naked short sellers.
Fear and the Real Economy
Models of multiple equilibrium implicitly feature the spread of fear. Consider, for example, the media’s references to recession. The Economist magazine views the use of the “R word” as so frightening and viral that it’s turned the word’s usage into a leading economic indicator.
Another indicator of fear is the VIX, the Chicago Board Options Exchange index that measures market expectations of stock volatility. The VIX more than doubled in the year before the onset of the GR and then rose by a factor of three when Lehman failed. There was no parallel change in the volatility of the real economy — no negative technology shock, no outbreak of war or the like. Just collective, coordinated, mass panic that sent the financial markets reeling.
Once Lehman failed, all bets were off, including those placed against financial collapse by the world’s largest insurer, AIG, which was next to go. Suddenly, it became clear that the global financial system could spontaneously implode and that there was no guarantee that governments could stop it.
They did stop it, but not before 29 of the world’s largest financial companies were either nationalized, sold off in shotgun weddings or went bankrupt. The fact that the panic moved back and forth across the ocean tells us that financial contagion spreads globally as well as domestically and doesn’t require interconnected balance sheets. This, too, represents evidence of multiple equilibrium.
Consider in this regard the Cypriot banking crisis of 2012-13. The possible failure of two small banks in tiny Cyprus became front page global news for weeks, but not because the two banks were important in themselves. Instead, their failure could have led to a run on banks in Greece, followed by a run on banks in Italy and Spain, followed by a run on… . Rather than let the two banks fail, multinational lending agencies bailed them out. This was a case of “too small to fail” — another clear sign of a global financial system that was too unstable (too prone to multiple equilibrium) to absorb even a minor jolt.
As the international financial system was effectively taken into receivership, the real economy ground down to a prolonged period of stagnation — and, in Spain and Greece, flat-out depression. In the United States, the index of consumer sentiment didn’t return to its 2007 peak for a decade. And this slow recovery is hard to explain except as the result of everyone expecting a slow recovery.
Banking Crises and Public Goods
Banking panics are economically deadly because the banks manage a critical public good — namely, the financial marketplace. Banks connect lenders with borrowers and savers with investors. If the banks go down, the financial market fails. Take, for example, the Fed’s description of Bear’s market making before its fall.
The imminent insolvency of Bear Stearns, the large presence of Bear Stearns in several important financial markets (including, in particular, the markets for repo-style transactions, over-the-counter derivative and foreign exchange transactions, mortgage-backed securities and securities clearing services) and the potential for contagion to similarly situated firms raised significant concern that the stability of financial markets would be seriously disrupted if Bear Stearns were suddenly unable to meet its obligations to counterparties, and the extension of credit allowed for an orderly resolution of the firm.
In the GR, the financial system froze. After Lehman, every remaining major bank and thousands of minor banks would probably have failed had the government not intervened in truly unprecedented fashion. The government, in this case, was primarily the Fed. It became, for all intents and purposes, the only fully functional bank in the country, making loans to all manner of financial and nonfinancial enterprises from the largest surviving banks to companies selling mobile homes. The Fed also bailed out, directly or indirectly (through other central banks), foreign financial entities.
Unsafe at any Speed
The banks could fail because they were leveraged. They promised to make repayments regardless of the circumstances. In the aftermath of Lehman’s collapse, the Fed effectively insured not just checking and savings accounts, but also money market funds. These obligations were, respectively, FDIC and Treasury obligations running to some $6 trillion. But neither institution had $6 trillion in ready cash to make good on its insurance. Hence, the Fed would have been on the hook. Indeed, had things gotten worse, there would surely have been a run on the life insurance industry’s cash-surrender value policies, which, at the time, also totaled roughly $6 trillion.
Now imagine that the government’s explicit and implicit pledges of insurance had been called by the public (that is, suppose the public had, despite the pledges, headed straight to the banks, money market funds and insurance companies to empty out their accounts and cash out their cash-surrender value policies). In this case, the Fed would have had to create $12 trillion virtually overnight. The M1 money supply at the time was just $1.5 trillion.
The United States has yet to experience a run on its central bank. But this is common in countries like Argentina, where the public and the financial community are well aware that the government’s pledge of deposit and related financial insurance can be honored only in the context of the wholesale printing of money. Such money printing means hyperinflation, leading people to run for their money before it becomes worthless in real terms. Thus, with central banks as with private banks, there are two equilibriums — everyone runs and no one runs.
The Role of Opacity
Bear Stearns was among the first to be picked off by those who stood to gain by a financial collapse because it was viewed as particularly opaque. No one on the Street or, it seems, inside the bank, knew what its assets were really worth. What they did know is that its relatively high leverage and opacity made it vulnerable.
If enough people think a bank is going down, that bank will go down regardless of its true condition. If enough people think the economy is going down, the economy will go down. And until we acknowledge these hard truths, financial crises will remain only a fear-mongered rumor away.
The fact that Bear’s stock was valued at $70 per share one week before JP Morgan Chase bought it for $2 per share (less a $29 billion sale of Bear’s troubled assets to the Fed valued at far less than $29 billion) tells us that no one knew anything about Bear’s assets, before or when it died. Its valuation was purely a matter of conjecture. (Note: the $2 was later adjusted to $10.)
Of course, it’s hard to prove that no one really understood Bear’s assets except, perhaps, CEO Jimmy Cayne. For what it’s worth, though, let me relate my own interview with an insider, my then-brother-in-law Jim, which I conducted in 2008.
Jim was a top banker with JP Morgan Chase and was one of some 200 of its bankers tasked to spend what turned out to be Bear’s final weekend valuing Bear’s assets. After Bear sold for less than the value of its headquarters building, I asked Jim how much he and his colleagues knew about Bear’s assets before they began looking at its books. His answer was “nothing.” I then asked Jim how much he and his colleagues knew about Bear’s assets after they spent almost three days looking at its books. His answer: “nothing.”
Bear’s collapse showed the market that there was potentially “no there there” in any of the banks. If Bear’s mysterious “rock solid” assets were worth a fortune yesterday but nothing today, maybe the same was true of other bank’s assets. And when the “trustworthy” bank fell because it became clear that no one could really understand its assets, either, the belief that yet more “trustworthy” banks’ assets were rock solid declined. The serial failure of the banks thus appears to accord with what opacity and faith-based asset valuations would deliver.
In the event, once mortgage-giant Countrywide and the 85-year-old Bear Stearns fell, other banks began to collapse. First, IndyMac, then Fannie Mae and Freddie Mac, followed by Merrill Lynch on the same weekend as Lehman. Next came AIG, Washington Mutual, Citigroup and Wachovia.
Eliminating the Twin Pillars of Financial Collapse
Banks that have zero leverage — that don’t owe anything to anyone — can’t go bankrupt. Hence, the obvious way to prevent future banking crises is to preclude all financial corporations from borrowing. Moreover, if opacity is a major problem, the answer is to have the government oversee disclosure.
Why the government? First, private parties can’t be trusted to provide truthful disclosure. Second, they can be mistrusted even if they are acting in a trustworthy manner. Third, information is a public good, making its disclosure a public good.
Dodd-Frank does precious little to alter financial company leverage or to limit the financial system’s opacity. And as noted, today’s banking system has essentially the same capital ratio as Lehman the day it died. As for making financial companies transparent, it’s business as usual on Wall Street and in the House Financial Services Committee and Senate Banking Committee, whose members’ biggest donors are the banks. The decision to ignore opacity is, arguably, the FCIC’s crowning failure. In the 633-page report, the word opacity appears just once.
What is to be done?
Standard explanations of the 2008 financial crisis and its associated Great Recession amount to a big con. Like the movie The Big Short, they make bad actors, not intrinsic problems with the financial system and the economy, the culprits.
Greedy/lazy/irresponsible people, we’re told, engaged in all manner of financial malfeasance. And what we’re told is true. But the story of these bad actors is not the real story of the Great Recession, which is that both the economy and the banking system are inherently unstable due to expectations-driven multiple equilibriums.
If enough people think a bank is going down, that bank will go down, regardless of its true condition. If enough people think the economy is going down, the economy will go down, full stop. And until we acknowledge these hard truths, financial crises will remain only a fear-mongered rumor away.
In my book Jimmy Stewart Is Dead, I propose to bulletproof the financial system with what I call Limited Purpose Banking (LPB). The idea is to transform all financial corporations into 100 percent equity-financed mutual funds and to streamline the hodge-podge of financial regulators to a single agency: the Federal Financial Authority. With no need to police leverage, this authority’s sole task would be to hire private firms that worked only for the authority and whose job would be to assure financial system transparency by verifying and disclosing all aspects of all assets held by the mutual funds.
The goal is to end systemic financial crises rooted in a combination of opacity and leverage.
In this regard, it’s worth pointing out that not a single equity-financed mutual fund failed during the GR. The only mutual funds that ran into trouble were money market funds, which were implicitly leveraged via their pledge to guarantee the return of every dollar invested.
Mutual funds holding only cash (all of it deposited with the Fed) would serve as the economywide payment system, facilitating trillions of dollars’ worth of transactions daily. They would cover their costs with transactions fees. Other mutual funds, which are 100 percent equity-financed, would trade securities, including the sort of derivatives that businesses need to hedge risk and that counterparties use to increase risk through leverage.
LPB mutual funds would buy and sell FFA-processed and disclosed securities at auction. This ensures that issuers of securities, be they households or firms, pay the lowest competitive rates.
The transition to LPB would be gradual. And it would be straightforward in light of the enormous excess reserves now in the banking system. From the day the reform began, financial corporations would face gradually increasing equity ratio requirements and be required to establish holding companies that issue only 100 percent equity-financed mutual funds. Alternatively, the transition could be driven by a gradually increasing tax on leverage by financial corporations that make it unprofitable to leverage assets.
Nonfinancial corporations would face rising restrictions such that, by the end of the transition, their borrowing could fund only real (as opposed to financial) investments or holdings of cash in cash mutual funds. Hence, there would be no “shadow banks” under LPB that cast a shadow over the stability of the payments system.
Got all that? Probably not — I’ve offered only the barest bones of explanation. Suffice it to say that there are no apparent conceptual (as opposed to political) barriers to creating an efficient, competitive financial system armored against the two sources of instability in our current system: leverage and opacity.