Unintended Consequences, Part III: The Great Financial Crisis
More to come next week.
Barely a decade after LTCM imploded, the U.S. was in the midst of the worst financial crisis since the Great Depression. (I discuss the causes of the 2008-09 crisis in my book “Bailout Nation”). Unlike the massive fiscal response which alleviated the worst effects of the Great Depression, the response to the GFC was light on fiscal stimulus – and heavy on monetary policy.
Each era responded to their respective crises in different ways. In response to the huge fiscal stimulus of the 1930s, millions of jobs were created; the unemployment rate, which had peaked at 24.9%, fell back towards normal levels. But the size and scope of the federal government expanded dramatically, as did the national debt.
The reliance of monetary over fiscal policy post-financial crisis resulted in a different set of unintended consequences. After billions were spent rescuing the banking sector, the Federal Reserve worked to prevent new insolvencies. The banks still held millions of mortgages in danger of defaulting; many had teaser rates that automatically reset as rates rose.1 What the banks needed were low and steady rates – and some time to let the real estate mortgage recover. So the Fed took rates down to zero, a policy decision that helped banks manage all of those risky real estate loans on their books
The Fed’s Zero Interest Rate Policy (ZIRP) made for very low mortgage rates. As real estate prices gradually recovered, so too did the banks’ assets slowly recover, helping to improve their balance sheets.
But the rest of the financial world benefitted also. Owners of prime real estate, both commercial and residential, watched the value of their properties recover. By 2016, the Case-Shiller U.S. National Home Price Index passed its pre-crisis peak. Former homeowners 2 whose credit scores were damaged became renters. Multi-family property owners, including many private equity funds, flourished in this environment.
So too, did equity holders. If you held through the March 2009 market lows, or better yet, put fresh capital to work, you were richly rewarded. From those lows, the S&P 500 index tripled over the next 5 years. Even after the 35% crash in 2020, the index is still worth 4X what is was during the worst of 2009. This disproportionately benefited people with riosk capital. According to research by New York University professor of economics Edward Wolff – he is a research associate at the National Bureau of Economic Research3 – the wealthiest 10% of U.S. households own 84% of all stocks. A rescue plan that benefitted the stock market disproportionately accrued to the investor class – the wealthiest members of society.
Perhaps the greatest unearned rewards fell to senior executives holding large grants of company stock options. From October 2007 to March 2009, stock market fell about 56%. Numerous companies used this collapse as an opportunity to reprice those stock grants. As the market and the economy recovered, these options became deep in the money – meaning they could be exercised cheaply, minting countless millionaires.
As the monetary response engineered by the Federal Reserve was saving the financial sector and benefiting those with capital, what was going on in Congress? They were neglecting the traditional role they play in responding to an economic crisis.
The playbook devised by Lord John Maynard Keynes’ had served governments well for generations. When household and private sector demand dropped precipitously due to some crisis or another, the government stepped in to replace it. That meant temporarily ramping up spending and cutting taxes. It was a well understood and effective policy.
For reasons people still debate, the fiscal response in 2009 was lacking. People who found jobs after the crisis often discovered they were much worse than the jobs they lost during the crisis. They earned less, had worse benefits, and were more stressed. The lack of a large fiscal response meant that the good middle-class jobs usually associated with government projects or employment never materialized. Gains from the economic recovery did not “trickle down” to the labor class.
Sometimes, the unanticipated, unintended consequences can kill. You can draw a straight line from other seemingly unrelated events, from the Great Financial Crisis to the current pandemic. Not just the rise of popularism and the election of President Trump – although he surely was a beneficiary of the backlash to the bailouts. The lack of a strong fiscal response, and overly generous bailouts terms for banks and other companies led to other resentments.
Consider the Homeowners Affordability and Stability Plan,4 a plan announced February 18, 2009. It was a mortgage-modification program designed to help homeowners whose houses were worth less than their mortgages. (Anything that reduced mortgage defaults helped the banks). The very next day, television news commentator Rick Santelli went off on what CNBC called “the rant heard round the world.” That was but one of many factors that leading to the rise of the Tea Party, which itself was instrumental in creating a historic shift of power in the 2010 congressional elections. Sweeping into the House of Representatives with a new majority, this new deficit obsessed class imposed widespread fiscal restraints on Congress. They opposed all of the costly legislation President Obama supported. As Pro Publica reported, even efforts to bulk up the National Emergency Medical Stockpile “fell apart in tense standoffs between the Obama White House and congressional Republicans.”
The result: “dire shortages of vital medical equipment in the Strategic National Stockpile,” including N95 respirator masks and personal protective equipment. Today, the U.S. is far less prepared to respond to a pandemic than we otherwise would been. In part because some people were offended by the 2009 rescue plan that included aid to people behind in their mortgage payments.
What would have occurred had we not bailed out banks? What might America look like today if instead of a finance rescuing monetary stimulus, there was a more traditional fiscal stimulus?
Start with a run of bankruptcies for large finance firms. Perhaps the most illustrative would be a chapter 11 reorganization of Bank America. In the reorg, the company shareholders get wiped out, and the firm’s creditors – namely the holders of its bonds – become the owners. To satisfy the prior debts, the piece get unwound: Bank America gets spun out as a clean debt-free banking entity. Merrill Lynch similarly is spun out as an Investment Bank/Broker, free from its heavy liabilities. Countrywide, one of the largest underwriters of subprime mortgages, is also spun out. Then all of the bad assets are put up for sale, where they generate a return of about 20-30 cents on the dollar (I like to say there are no such things as toxic assets – only toxic prices).
We could do this with all of the major financial institutions that were in trouble, from Citigroup on downwards. What you end up with – after the immediate pain – is a healthier, better capitalized, less concentrated banking sector. But the immediate result is that the market keeps falling, with the S&P500 working towards a low near $500 and the Dow Industrials falling to just under 5000. The reorganization of so much of the banking sector finally spurs congress into a fiscal stimulus. A giant infrastructure plan is passed, along with new funding for subsiding community colleges and creating a new peace corps. Out of this comes some decent middle-class jobs.
Beyond the healthier banks, the Fed no longer has a need for its ZIRP policy. This huge driver of inequality would not have generated a massive wealth gap working for capital owners, with labor left behind.
We experience the world as a series of probabilistic outcomes, most of which could have come out very differently. Investors should be cautious about explaining what happens by only looking at results. Instead, always consider the counterfactual. It often tells more than the facts themselves.
1. “Jingle mail” described the practice of mailing your house keys to the bank instead of a mortgage payment. These voluntary defaults were becoming increasingly common once people figured out their houses were worth a fraction of the mortgage. They could rent the same house down the street for half the monthly cost.
2. Housing and bank analyst Josh Rosner described these homeowners as “renters with an option to default.”
3. Household Wealth Trends in the United States, 1962 to 2016: Has Middle Class Wealth Recovered? By Edward N. Wolff NBER Working Paper No. 24085 November 2017 https://www.nber.org/papers/w24085
4. This later became part of the Home Affordable Refinance Program (HARP).