June 09, 2009
More on disaggregate bank landing
I'd like to mention two more useful analyses of the disaggregated behavior of bank lending over the last year. The first is from James Kwak at the Baseline Scenario, and the second is a new research paper by Silvio Contessi and Johanna Francis.
Posted by James Hamilton at June 9, 2009 08:00 PMdigg this | reddit
Nowhere does he mention that the “banks” he wants to defend were major players in enhanced income funds, securities lending, and SIVs, and the big ones, including JPMorgan, doubled as broker-dealers. More fundamentally, though, it never occurs to him that the banks who manufactured these securities – who paid mortgage lenders to drum up the borrowers, who created the models that rating agencies used to rate the securities, and who went out and sold the securities to those lazy investors – had anything to do with the credit crisis. This is free-market ideology taken to the point of nonsense: there was supply (household borrowing) and demand (hedge funds seeking yield), so we were forced to sell products that provided slightly higher yield at much higher risk. It’s the fault of the “lazy investors” for not realizing they were defective products – and it’s also their fault because they stopped buying them when they found out.
The major banks cranked out mortgage-backed and other asset-backed securities of increasing toxicity as long as they could until the bottom fell out of the market in 2008. When the crash came, they were unable to dump the securities they had in their pipelines and forced to hold onto them, causing a one-time increase in the “bank credit” on their balance sheets. As a result, they slammed the brakes on their lending, as documented in the Fed’s Survey on Bank Lending Practices. Trying to use the collapse of the securitization market as proof of the virtue of the banking sector is, as someone said of Kissinger’s Nobel Peace Prize, a bit much.
Kwak's criticism of Cembalest for using aggregate analysis without digging deeper is right on target, but Kwak actually does the same thing. He does not answer the question of why the banks engaged in their lending activities at this point in history. What was their motivation? Unless you dig down to the intervention by government especially congress through regulators and even direct threats you miss why events played out as they did at this time.
Government, through both positive and negative incentives, created the crisis. The negative incentives were regulations and laws that forced lending institutions to change their lending practices to lend to less qualified candidates. To hedge against loses banks engaged in bundling and other things to spread risk.
The positive incentives were primarily through Fannie and Freddie when these bundled loans and other instruments risks were shifted from the banks to these GSEs.
The crisis was not a market failure. It was a political leadership failure.
Posted by: DickF at June 10, 2009 07:06 AM
I only had time to scan the paper by Contessi and Francis but they seem to say basically the same thing as Kwak.
I am always amused by how scrupulously economists avoid criticism of government, but then it is logical. After all, who hires high paid economists? It is best not to bite the hand that feeds you. Criticism of the institution that you are doing everything you can to work for just isn’t a smart idea. So we get rationalizations and pabulum as economists are more concerned about building their résumés than reversing errors that make the economy tank.
Posted by: DickF at June 10, 2009 07:18 AM
DickF- Thanks for your comments. I would respond that there were very transparent reasons for both government and the banks to engage in the securitization bubble.
For Banks: 1) Securitization of consumer credit and mortgages allowed immediate profits to be taken on future debt payments via increases in credit rating and reduction in yield. 2) Erection of SIVs allowed the securitization instruments to be posted in off-shore entities escaping domestic reserve requirements. 3) There was an opinion by some banks that they would be isolated from SIV liability by government and the courts. That bet has proved to be incorrect. 4) The erection of an unregulated over-the-counter derivtives market made the international banking system so complicated and opaque that government would be forced to guarantee credit risk and provide liquidity in the inevitable event of a credit crisis. That bet has proved to be correct.
For Government: The securitization market provided more salable securities to mop up the persistant current account deficit. Playing ball with the banks by eliminating regulations provided a steady stream of campaign contributions as well as the illusion of economic growth via the leveraging of anything that wasn't nailed down.
Posted by: MarkS at June 10, 2009 08:21 AM
From MSNBC: China auto sales surge 47 percent in May.
Would you please confirm or refute May 15 cyclical trough hypothesis?
I ask this because of concerns about Laffer's WSJ op-ed piece today on the money supply. His chart could also use confirming or refuting.
Do we need an inflation watch? I ask this because if mortgages goes to 8%, and right now, that's looking more likely to me, then the budget constraint will cause house prices to drop by 25%+, ie, at a 5% mortgage payment on a $1 m house is the same as an 8% mortgage on a $735,000 house.
Finally, is your recession indicator still at 99.5%?
Posted by: Steve Kopits at June 10, 2009 08:23 AM
Shorter DickF -- If you research doesn't foster the DickF view of things, the researchers must be corrupt.
This is a very common stance, but somewhat silly. It carries with it at least two problems. One is that it puts the fella who hasn't done the research in the position of demanding a particular conclusion from those who have. The other is that anybody from any perspective can make the same demand. If we give weight to criticism like DickF has offered, researchers don't stand a chance. What ever direction they turn, no matter whose demands they satisfy, there can always be somebody demanding that they reach some other conclusion.
Posted by: kharris at June 10, 2009 09:16 AM
Thanks for the comments. You are essentially correct but you still need to go deeper. One example is 2) where the banks did exactly as you describe. This is one example of the unintended consequences of government regulation. One of the biggest problems with relying on government regulation is that if the regulation will reduce profitability the business will either find an alternative or will go bankrupt. The banks found alternatives while GM and Chysler went bankrupt.
Government intervention in the market is nearly always about short circuiting market discipline. Anyone who is honest with themselves knows that politicians will use regulations and intervention to gain reelection. A criminal is not changed into a saint simply because he gets elected.
Posted by: DickF at June 10, 2009 10:29 AM
Steve Kopits: I certainly have called no cyclical trough. Our recession indicator index is only updated with the first GDP release of a quarter, and looks back from there at the previous quarter before that. For updated assessments I might refer you to the ADS index.
Posted by: JDH at June 10, 2009 12:40 PM
Yes, I looked at the ADS index. Looks to me like it's past the trough. Auto sales: past the trough. Same for housing. Same for employment. Oil prices. Consumer confidence. Equities. Treasuries. All look past the trough to me.
If I'm right, Uncle Ben had better start thinking how he's going to get the genie back in the bottle. And I think we'd better get a serious energy policy, because at $80 oil we're back in the hopper.
So it makes, to my way of thinking, a material difference whether we're still pre-trough or post-trough. If we're pre-trough, then we can afford to be careless with monetary policy and commodity prices. If we're post-trough, then I think we need a different attitude.
Posted by: Steve Kopits at June 10, 2009 01:30 PM
Steve: It sounds like you're using a different definition of "trough" than I am. Many of the series you refer to, such as the ADS, are quoted in rates of change. The rate of change of ADS and employment are both negative, just less negative than they were two months ago. That means things are still getting worse, only not as fast as they were before. I call it a trough when things actually start to get better.
On housing and autos, I read the current evidence as "flat" rather than "up".
You're right that consumer sentiment, equities, and interest rates all are bullish indicators. People are expecting better, that is clear, but what is the reality behind that?
As for oil and commodities, I would emphasize the possibility that it is developments in Asia rather than the U.S. that may be key to those markets at the moment.
Posted by: JDH at June 10, 2009 01:51 PM
Dick, just admit the free market screwed up. It isn't hard. We don't have to become monotheistic about it. That is when capitalism fails and why free market intellectualism by its nature fails just like Marxism.
The current financial crisis has several stories behind. Maybe if some things go different here and there, the crash doesn't happen the way it did. But some of those factors are out of our hands.
We all want a healthy banking system.
Posted by: Johnson at June 10, 2009 04:43 PM
Government does push and pull, sometimes in opposite directions.
However, the no doc, liar loans etc etc were exclusively the domain of private institutions. The GSE's never got into those markets.
Attempts by government to rein in things came too late. Horse already out of the barn kind of thing. Repubs tried to rein things in, Dems shot it down. Then the Dems under Frank tried, and Repubs shot that down.
The derivative securities debacle was all privately manufactured. If the government made any mistake, it made the mistake of relaxing its regulatory vigilance.
Government also hobbled itself by failing to fund needed infrastructure improvements and this created a lack of real credits for private investors and sovereign funds. So Wall Street made something up that looked like decent credits but were obviously nothing of the sort.
Posted by: beezer at June 10, 2009 05:51 PM
the no doc, liar loans etc etc were exclusively the domain of private institutions.
This crisis is caused 100% by government regulation, and the proof is that the government is trying to resuscitate a securitization market that died of its disastrous flaws and perverse incentives.
The private institutions were under extreme pressure to lend to people who were unsuitable to borrow, and subject to government incentives to make bad loans. Pushed by anti discrimination laws (the great majority of the dud housing loans were made to Mexicans and blacks)), and pulled by a government created securitization market, which the government created to prevent the banks from screaming too much about being forced to make dud loans.
Obviously securitization will lead to disaster if the originating institution has no continuing responsibility for dud loans, and today private enterprise refuses to buy such loans, while government today moves heaven and earth to try to get private enterprise to swallow such loans, tries to get private enterprise to continue practices that have led to disaster.
Obviously securitization will not work if the institution that makes the loan is able to entirely unload it on someone who has never met the borrower. Obviously securitization will not work if there is no one particular person who has the ability and incentive to determine that any one particular loan is good. The government created this system that nobody wanted, and is trying to keep it alive even though it is now wanted even less. Private institutions behaved badly because the government wanted them to behave badly, and continues to want them to behave badly. If it did not want this bad behavior, and did not want this bad behavior to continue today, it would allow securitization of mortgage loans to die a natural death.
Posted by: James A. Donald at June 14, 2009 07:35 PM