The precedent for the Great Financial Crisis was set only three decades ago in the 1980s with the Savings & Loan Debacle. In the early 1980s, the S&L’s or “thrifts” saw their business model undermined by high interest rates. The thrifts borrowed short, chiefly by taking deposits, and lent long, chiefly for mortgages. When interest rates ballooned from the Fed’s war on inflation under Paul Volcker, the thrift’s borrowing rate ran up well above the rate of its lending.
The answer under Ronald Reagan was not to admit insolvency and deal with the crisis in its infancy, but instead was to deregulate the thrifts in an effort to let them “grow” out of their problems. Instead it was the problem that would grow. Deregulated thrifts offered high rates and attracted massive amounts of capital, which they were then compelled to lend at even higher rates to make their profits. With the lax regulation they enjoyed, the environment was set for fraud and irrational, or at least rash, lending, and within a few years the spectacular collapse of the industry.
By 1995, half the thrifts had gone out of business. The Federal Savings & Loan Insurance Corporation (FSLIC) was abolished and replaced by the Office of Thrift Supervision (OTS). A massive takeover and rationalization of the industry took place, with the determination, “This will never happen again.” Twenty years later the OTS was abolished in the wake of a second and far greater financial sector collapse. Deregulation had returned within a decade, in even more complete form, with the repeal of New Deal banking laws (Glass-Steagal) and the rise of the anti-regulators of the George W. Bush administration.
The housing boom of the 2000’s depended on mortgage originators and mortgage lenders who were virtually unregulated, but it also depended on the banks and Wall Street. Originators found takers for fraudulent, onerous and undocumented mortgages and sold them to mortgage lenders. The banks provided the short-term “warehouse” loans to bridge the deal on into the Wall Street securitization market. Here the individual mortgages were combined to form securities that were sold as solid investments around the world. At the same time, banks themselves originated their own somewhat better, but still suspect, subprime and non-traditional mortgages to turn into securities.
When the inherent weakness of the mortgages came to the top and the securities found their true value, the Great Financial Crisis was triggered.
In the S&L debacle it was high interest rates instigated by the Fed’s war on inflation that led to a Wild West of fraud and excess. In the Great Financial Crisis, it was low interest rates forced by the Fed in fear of deflation that created another Wild West, as massive amounts of capital searching for yield flooded into the “safe” mortgage market.
Regulators who saw each crisis forming and who advocated strong action at the outset or strict rules governing lending activities were muted and frustrated by other, “captured” regulators and pressured directly by elected politicians acting on behalf of big donors. The “Keating Five” was a memorable example from the S&L debacle. Five Senators were censured for their efforts to protect Charles Keating, an S&L billionaire. When the S&aL debacle was over, more than 3,000 bankers and thrift officers went to jail.
That number is about 3,000 more than the Great Financial Crisis. Many banks have failed, but a certain class is still with us – the too big to fail. (These now include JP Morgan Chase, Wells Fargo, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup.) These institutions continue to receive special concessions, but more than anything else, it is the too big to fail insurance they enjoy that gives these enormous companies lower cost capital and an advantage over their smaller rivals. (Banking is not an industry with economies of scale.)
That favoritism arises in part from the efforts of Fed Chairman Ben Bernanke, one of the economists who has failed. Bernanke himself, or the Fed itself, took over the original mandate of TARP, or one of them, and bought one and quarter trillion dollars of mortgage backed securities. This year the Fed is ready to take another trillion dollars on to its balance sheet. Thus we see incredible efforts to expand credit to the private sector at the same time we are determined that the public sector do nothing of the sort.
The recent turn in the housing market, in terms of price and volume, is thought of as a recovery. Indeed, it is. As in going up. The upturn is a blip with respect to the long term, and the foregoing shows that every effort has been made to do this without recognizing it in the lives of the underwater homeowners. What that means is that as prices recover, at each step, shadow inventory will come back on line.
So credit and banking, success or failure?
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