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The Great Recession: Ten Years Later

Irwin M. Stelzer

Ten years ago, almost to the day, something went wrong with the American banking system. So horribly wrong that it almost brought down the entire system of international finance and caused what is now known as the Great Recession.

It seems that bankers got the idea that if they lent money to people who could not possibly repay the loans, but lent to a lot of those people, and then bundled those mortgages into securities, then these bundles of papers would turn out to be good investments.

Rating agencies agreed, and awarded the coveted triple-A rating to those packages of mortgages. (Of course this had nothing to do with the fact that the rating agencies earned fees only for deals that went through—scupper a deal by giving it a poor credit rating, and no fee.) So attractive were the returns to be earned, that European and other banks around the world the clamored for a piece of the action, and bought gobs of these securities, which in the end proved more or less worthless. Europeans, who have been slow to clean up the mess at their banks, still blame the American banks, although the precise mechanism by which financial institutions here forced European banks to buy this worthless paper remains unclear.

The mortgages in these packages became known as NINJA mortgages, as the recipients of the loans often had No Income No Job or Assets. And in the end they could not meet the required monthly payments. The results of the massive losses that imperiled the global economy were three:

Taxpayers had to bail out the banks lest they go down, drying up lending and bringing the “real economy” to a grinding halt;

Bank shareholders—not the CEOs of the big banks—paid $150 billion in fines, some of these payments justified, some because the Obama administration saw the banks as honey pots they could dip into to fund favored political groups, no unpopular taxation necessary;

Reform legislation was passed, most notably the Dodd-Frank law, which included the so-called Volcker Rule, aimed at limiting the investment risk banks could take.

A decade later all is more or less calm on the banking front, the efforts of Wall Street-hating politicians notwithstanding. For the most recent of its “stress tests” on 34 major banks, the Fed posited a circumstance in which we have a severe global recession: the unemployment rate, now at 4.3 percent, rises to 10 percent, and corporate loan and real estate markets are under “heightened stress.” Which is about as bad as things can get. The Fed concluded: “This year’s results show that, even during a severe recession, our large banks would remain well capitalized. This would allow them to lend throughout the economic cycle, and support households and businesses when times are tough.”

Which cheery finding creates its own problem. An elaborate empirical study by Anjan Thakor, professor of finance at the Olin School of Business at Washington University in St. Louis, concludes that a long sequence of “good outcomes … lead[s] to an excessive upward revision in beliefs about bankers’ skills.” Regulators, investors and the bankers themselves come to “believe that banks are highly capable of managing risk. . . . [and] underestimate the true risk in high-risk products.”

President Trump has always opposed Dodd-Frank, not because he is fond of bankers, but because he is fond of easy credit, as are most property developers. Anything that impedes bank lending, even to borrowers of as uncertain credit reliability as his companies proved to be when he was in the private sector, is anathema to Trump. Dodd-Frank and related regulations are specifically designed to make banks hold more capital, the flip side of which is curtailed lending capacity. And the Volcker rule is preventing banks from once again using their capital to engage in risky investing. Those regulatory ties that bind banks make lending more difficult than Trump deems necessary. And stifle growth. He wants them gone. Bank lobbyists are pressing Congress hard to oblige the president.

For the moment, the debate about the future shape of the U.S. banking industry is being shared by three broad groups. The Fed seems more or less satisfied with the status quo, with a bit of relaxation of some excessively onerous regulation. The industry and the administration want a major roll-back in regulations. And a small group, led by Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis, wants Congress to discuss breaking-up the largest banks. I would add to their argument, which is based on the idea that reforms have not removed the too-big-to fail threat, another: the big banks might not just be too-big, but too-complicated-to-manage. Recall the “London Whale,” the scandal in which traders at JP Morgan lost $6.2 billion dollars under the unseeing eyes of their executive supervisors. And the current scandal engulfing Wells Fargo, which saw commission-hungry salesmen, operating under a meet-your-quota or find-work-elsewhere system, open accounts for customers without notification, charge 800,000 customers for auto insurance they didn’t need, throw 274,000 into delinquency by charging them for services they didn’t order, and repossess 25,000 cars the owners of which fell behind because of charges loaded onto their accounts without their knowledge. As of late last week the chairman of the bank’s board seemed likely to follow Wells’ president into unsought retirement. Although this is a separate matter from bank solvency, politicians are a bit nervous to call for “deregulation” in the face of such perfidy.

At the moment, bank regulators have their minds on other matters. They are preparing for the annual conclave of central bankers at Jackson Hole two weeks hence. With the crisis behind them, they will discuss “Fostering a Dynamic Global Economy”, a topic broad enough to give the two-most watched players an opportunity to unburden themselves of important hints at future policy.

Janet Yellen, chair of the U.S. Fed, will be attending her last such meeting in that capacity if the president succeeds in finding a successor more agreeable to him. She is expected to confirm her faith in the acceleration of the U.S. economic recovery, which allows the Fed to tighten monetary policy, slowly but steadily, raising interest rates and reducing the pressure on investors to hunt for riskier assets such as shares.

And, other things being equal,higher interest rates would strengthen the dollar, which would slow growth, making the president more than a little cross. His plan had been to offset the upward pressure on the dollar by loosening fiscal policy with deep cuts in taxes and an infrastructure spending program. Hopes for major tax cuts and increased spending are fading fast as Trump’s ability to bend congress to his will has been shown to be less than complete. Some 74 percent of businessmen and tax professionals surveyed by Deloitte say they are doubtful or not very confident that the tax code will be overhauled this year. And few in Washington or on Wall Street believe that the spending that would result from passage of an infrastructure will be a factor this year (or ever).

Higher interest rates and no loosening of fiscal policy should drive the dollar up—unless enough traders still believe Trump will get his cuts and his spending, in which case they won’t. Such is the certainty economists can provide.

Mario Draghi, president of the European Central Bank, is the other banker of interest. If he hints that the strengthening Eurozone economy might warrant a retreat from quantitative easing—printing money, to use a term eschewed because of its easy understandability—then traders will likely expect the euro (up about 11 percent against the dollar this year) to continue its rise.

Ten years ago all eyes were on then-Fed chairman Ben Bernanke as he discussed what he later described as the “financial storm that reached gale proportions” just weeks before the Jackson Hole meeting. That storm has been weathered, but at very high cost to taxpayers, workers, and some homeowners. Whether the ensuing “upward revision in belief about bankers’ skills” is “excessive”, as professor Thakor claims, we won’t know until we see whether the deregulation debate results in excessive removal of the safeguards that helped the financial sector weather that storm.

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