Guest Post: Rationality of Banks
Note: This post originally appeared, in slightly different form, at the author’s personal blog, Diogenes of Brooklyn. It appears here with that blogger’s kind permission.
He does talk in the third person sometimes.
Like most Americans, Diogenes knows nothing of economics and finance. But quite a lot about the ways that banks work, or don’t work, has become public knowledge.
Remember when we were taught that economics was about rational markets. Milton Friedman, patron saint of Republican economists, used to say on TV that everything is rational. Keynes thought markets were more or less rational, except when they went nuts, the government had to step in. Mr. Romney still says it in public: Just a little private enterprise competency in the White House and everything will be hunky-dory, or however they say that in the language of the Harvard Business School. It will get to be as good as it was the lasts time we had a President with a Harvard MBA (irony alert).
Nowadays there is not so much rationality. Especially about the toxic assets. The whole economy is in pretty bad shape, but the colossal failure started with the Real Estate Bubble. A little of it was about Fannie and Freddie and the very powerful and very evil Barney Frank, but over 80 per cent of the problem was The Banks and Wall Street and good old private capital. Wall Street had access to billions and billions of dollars that were not usefully employed. Most of the stock market in the doldrums, and the owners of the biggest chuck of money, the Chinese Government, could not invest the money at home for fear of distorting their very productive but fragile economy. That enormous pile of money was invested in MBS’s and CDO’s and all the rest. And that money in the mortgage market allowed the most enormous bubble in USA real estate. You know the stories, whole towns in California where nobody lives, and nobody will ever live. People who bought houses at inflated prices. Standard and Poors said when they rated the derivatives, that Real Estate prices had always gone up, they could not go down. A lot of people lost their jobs in the Great Republican Recession, and could not sell their houses at any amount, let alone an amount that would cover the mortgage, even if they had put up 20%. It was a mess, and it remains a mess.
For a while Diogenes was associated with a company who told the world they had $10 billion from overseas investors, and that these investors wanted to buy the toxic assets of US Banks, at 26 cents on the dollar.
Seemed like a pretty straightforward assignment, just call some large number of banks, talk to the people responsible for unloading the things, and arrange a deal. Not one bank that wanted to do a deal. For a while people said this was because we let them know the price in advance. It really was no secret how they came to the price of 26%: When Merrill Lynch had to unload a ton of these assets in order for Bank of America to take them over, the assets sold in a hurry at that price.
It was not about price. It turns out that all of the banks preferred to let the assets get picked up by FDIC for 16%, instead of selling them privately for 26%. HSBC turned over the assets that my associates wanted to buy at 26 cents, and gave them them up to the government at a lower price, 16%.
Seemed pretty stupid to me. And some of the banks lied to me. The VP at IndyMac told Diogenes they were selling these assets (actual foreclosed houses) one by one at 90 cents on the dollar, and would not entertain any bulk sales of any kind. And that they were working the portfolio down at a rate that was acceptable to the regulators. Turned out not to be true. David Letterman should someday be as funny as the guy from IndyMac.
In order to actually make a deal with investors, someone at the bank would have to take responsibility for de-valuing assets, in writing. That is, the bank officer would have to make a decision to sell assets that were on the books for a billion dollars, and make the bank lose 740 million dollars, before the sale could take place at 260 million. That guy would immediately lose his job and he would never be able to work in the banking business again. Let it go to FDIC, nobody has to sign off on it. As we say here in Brooklyn, Poi-fict.
The whole banking fiasco was based on an interlocking network of stupid rules and irrational markets. It is no wonder that if failed in a spectacular way. It’s a good thing the Republicans have decided to end the Dodd-Frank bill, and get Big Government out of the way of the bankers who really know how to operate the money markets. The collapse of the world economy has been so much fun, that we really ought to give them another go at it (irony alert).
paragraphs!
“A little of it was about Fannie and Freddie and the very powerful and very evil Barney Frank, but over 80 per cent of the problem was The Banks and Wall Street and good old private capital.”
Fannie and Freddie had nothing to do with the bubble of 2003-2007.
Just last night I discovered Mara Der Hovanesian’s 2006 cover-story piece on the bubble.
http://www.businessweek.com/magazine/toc/06_37/B4000magazine.htm
And she just utterly nailed it.
“and the owners of the biggest chuck of money, the Chinese Government, could not invest the money at home for fear of distorting their very productive but fragile economy. “
This is an odd take on the situation. China has dollar holdings thanks to their rising trade surplus with us — $33B in 1995, $83B in 2000, $202B in 2005, $270B in 2010.
The Chinese economy runs on yuan not dollars, so these holdings are only good for external investment and trade (eg. buying raw materials). Chinese corporations acquiring USD turn them into the central bank for yuan (which can be printed at will). This is very mercantilist and clever, as it inflates their economy and protects the yuan’s weakness.
“And that money in the mortgage market allowed the most enormous bubble in USA real estate.”
It wasn’t just the available funding, it was the collapse of lending standards and sound underwriting. Suicide loans became commonplace, 40% of the market or more.
But this was a virtuous cycle for several years of the bubble, say 2004-2006, in that rising home prices allowed households to liberate trillions of dollars of cold hard cash by borrowing against their houses.
These trillions inflated salaries and created immense demand all throughout the economy. It was very much a stealth stimulus on the order of Bernanke’s “Helicopter Money” speech.
The debt bubble is very visible in the statistics:
http://research.stlouisfed.org/fred2/graph/?g=6MF
shows how consumer borrowing rose to 2.2X incomes at the height of the bubble.
Looking at Y-O-Y debt growth:
http://research.stlouisfed.org/fred2/graph/?g=6MG
we can see it exceed 20% of wages during the Bush Boom. We were simply borrowing our way to prosperity, 2004-2007.
Here’s what the annual debt take-on looked like in plain dollar terms:
http://research.stlouisfed.org/fred2/graph/?g=6MH
Households were borrowing $500B/yr in 2000, but that more than doubled to $1.2T/yr in 2006.
That’s around $1000/household per month!
“A little of it was about Fannie and Freddie and the very powerful and very evil Barney Frank, but over 80 per cent of the problem was The Banks and Wall Street and good old private capital.” Fannie and Freddie had nothing to do with the bubble of 2003-2007. Just last night I discovered Mara Der Hovanesian’s 2006 cover-story piece on the bubble. http://www.businessweek.com/magazine/toc/06_37/B4000magazine.htm And she just utterly nailed it. “and the owners of the biggest chuck of money, the Chinese Government, could not invest the money at home for fear of distorting their very productive but fragile economy. ” This is an odd take on the situation. China has dollar holdings thanks to their rising trade surplus with us — $33B in 1995, $83B in 2000, $202B in 2005, $270B in 2010. The Chinese economy runs on yuan not dollars, so these holdings are only good for external investment and trade (eg. buying raw materials). Chinese corporations acquiring USD turn them into the central bank for yuan (which can be printed at will). This is very mercantilist and clever, as it inflates their economy and protects the yuan’s weakness. “And that money in the mortgage market allowed the most enormous bubble in USA real estate.” It wasn’t just the available funding, it was the collapse of lending standards and sound underwriting. Suicide loans became commonplace, 40% of the market or more.
But this was a virtuous cycle for several years of the bubble, say 2004-2006, in that rising home prices allowed households to liberate trillions of dollars of cold hard cash by borrowing against their houses. These trillions inflated salaries and created immense demand all throughout the economy. It was very much a stealth stimulus on the order of Bernanke’s “Helicopter Money” speech. The debt bubble is very visible in the statistics: http://research.stlouisfed.org/fred2/graph/?g=6MF shows how consumer borrowing rose to 2.2X incomes at the height of the bubble. Looking at Y-O-Y debt growth: http://research.stlouisfed.org/fred2/graph/?g=6MG we can see it exceed 20% of wages during the Bush Boom. We were simply borrowing our way to prosperity, 2004-2007. Here’s what the annual debt take-on looked like in plain dollar terms: http://research.stlouisfed.org/fred2/graph/?g=6MH Households were borrowing $500B/yr in 2000, but that more than doubled to $1.2T/yr in 2006. That’s around $1000/household per month!
“A little of it was about Fannie and Freddie and the very powerful and very evil Barney Frank, but over 80 per cent of the problem was The Banks and Wall Street and good old private capital.”
Fannie and Freddie had nothing to do with the bubble of 2003-2007.
Just last night I discovered Mara Der Hovanesian’s 2006 cover-story piece on the bubble.
http://www.businessweek.com/magazine/toc/06_37/B4000magazine.htm
And she just utterly nailed it.
“and the owners of the biggest chuck of money, the Chinese Government, could not invest the money at home for fear of distorting their very productive but fragile economy. “
This is an odd take on the situation. China has dollar holdings thanks to their rising trade surplus with us — $33B in 1995, $83B in 2000, $202B in 2005, $270B in 2010.
The Chinese economy runs on yuan not dollars, so these holdings are only good for external investment and trade (eg. buying raw materials). Chinese corporations acquiring USD turn them into the central bank for yuan (which can be printed at will). This is very mercantilist and clever, as it inflates their economy and protects the yuan’s weakness.
“And that money in the mortgage market allowed the most enormous bubble in USA real estate.”
It wasn’t just the available funding, it was the collapse of lending standards and sound underwriting. Suicide loans became commonplace, 40% of the market or more.
But this was a virtuous cycle for several years of the bubble, say 2004-2006, in that rising home prices allowed households to liberate trillions of dollars of cold hard cash by borrowing against their houses.
These trillions inflated salaries and created immense demand all throughout the economy. It was very much a stealth stimulus on the order of Bernanke’s “Helicopter Money” speech.
The debt bubble is very visible in the statistics:
http://research.stlouisfed.org/fred2/graph/?g=6MF
shows how consumer borrowing rose to 2.2X incomes at the height of the bubble.
Looking at Y-O-Y debt growth:
http://research.stlouisfed.org/fred2/graph/?g=6MG
we can see it exceed 20% of wages during the Bush Boom. We were simply borrowing our way to prosperity, 2004-2007.
Here’s what the annual debt take-on looked like in plain dollar terms:
http://research.stlouisfed.org/fred2/graph/?g=6MH
Households were borrowing $500B/yr in 2000, but that more than doubled to $1.2T/yr in 2006.
That’s around $1000/household per month!
“A little of it was about Fannie and Freddie and the very powerful and very evil Barney Frank, but over 80 per cent of the problem was The Banks and Wall Street and good old private capital.”
Fannie and Freddie had nothing to do with the bubble of 2003-2007.
Just last night I discovered Mara Der Hovanesian’s 2006 cover-story piece on the bubble:
http://www.businessweek.com/magazine/toc/06_37/B4000magazine.htm
And she just utterly nailed it.
“and the owners of the biggest chuck of money, the Chinese Government, could not invest the money at home for fear of distorting their very productive but fragile economy. “
This is an odd take on the situation. China has dollar holdings thanks to their rising trade surplus with us — $33B/yr in 1995, $83B/yr in 2000, $202B/yr in 2005, $270B/yr in 2010.
The Chinese economy runs on yuan not dollars, so these holdings are only good for external investment and trade (eg. buying raw materials). Chinese corporations acquiring USD turn them into the central bank for yuan (which can be printed at will). This is very mercantilist and clever, as it inflates their economy and protects the yuan’s weakness.
“And that money in the mortgage market allowed the most enormous bubble in USA real estate.”
It wasn’t just the available funding, it was the collapse of lending standards and sound underwriting. Suicide loans became commonplace, 40% of the market or more.
But this was a virtuous cycle for several years of the bubble, say 2004-2006, in that rising home prices allowed households to liberate trillions of dollars of cold hard cash by borrowing against their houses.
These trillions inflated salaries and created immense demand all throughout the economy. It was very much a stealth stimulus on the order of Bernanke’s “Helicopter Money” speech.
The debt bubble is very visible in the statistics:
http://research.stlouisfed.org/fred2/graph/?g=6MF
shows how consumer borrowing rose to 2.2X incomes at the height of the bubble.
Looking at Y-O-Y debt growth:
http://research.stlouisfed.org/fred2/graph/?g=6MG
we can see it exceed 20% of wages during the Bush Boom. We were simply borrowing our way to prosperity, 2004-2007.
Here’s what the annual debt take-on looked like in plain dollar terms:
http://research.stlouisfed.org/fred2/graph/?g=6MH
Households were borrowing $500B/yr in 2000, but that more than doubled to $1.2T/yr in 2006.
That was around $1000 per household per month!
Troy;
Let me add to this:
There is nothing wrong with a typical ARM. They were developed for first time homeowners or those expecting salary increases. Banks performed their due diligence on each borrower to make sure they were credit worthy. The typical ARM was 1, 3, or 5 years in length before allowing an increase which might typically be 1-2% maximum cap per period and also have a designated cap over the lifetime. The ARM was calculated to pay interest and principal and some were calculated at lower payments early and then increased over a period of years (less than 5). I had a 1 year ARM (3.5%) with a yearly cap of 1% per year and a lifetime cap to 10%. I also had a balloon mortgage at 5% with a guaranteed refinancing for $500 and 1/2% on top of the 5%. All were done by a private and honest originator who I knew for a decade in business. Typically these loans were based on the rise and fall of treasuries or some index.
There are some things you are missing or have overlooked in your story. The mad rush to mortgage investments was a second choice by the Chinese and other foreign investors looking for safe haven for the excess of trade dollars (currency of the world) in their hands. Most came to the US to buy treasuries which was the safest global investment. http://mises.org/daily/3382/The-Fed-Did-It-and-Greenspan-Should-Admit-It By no means is this a defense of Greenspan as he twarted any attempt to regulate the derivatives http://www.stanfordalumni.org/news/magazine/2009/marapr/features/born.html market which set the stage for the free market wild west show on Wall Street and with TBTF.
Secondly, there were many homeowners who now had access to their built-up home equity throough legislation passed during the Clinton era. To extract equity prior to then was near impossible unless on took a second mortgage and passed the review of the bank. To get at it, they simply refinanced their old mortgage. Alt-A mortgages were the way to go.
After all of this, Greenspan reversed course and statrted an increase in Fed Rates from the 1-3/4% (and 1% in 2003) he held them at since 2001. The stage was set for the biggest crash since the Depression on Main Street.
The biggest global mecroeconomic crash and debt default is yet to come. The transitional period will be breathtaking.
The Euro and European experinment will break down within the next few weeks. Even the best German banks have leveraged their reserves greater than Lehman’s did in 2008.
The difference between the Euro and the dollar is that the dollar has 200 years of history and central government and a central taxation and entitlement program – with so many many multinational holders of US debt and 100 dollar bills.
The debt-money-asset system is a global macroeconomic construct. Its countervailing debt and composite asset prices proceed in a cyclical predictable time dependent quantum pattern.
The collapse of the Euro experiment will absent trillion of Euros and Euro debt from the denominator of system resulting in the greatest nonlinear asset valuation collapse in the history of mandkind.
Even the 1720 SouthSea Bubble will pale.