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George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)rwEconomics.com

 

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It’s what you know for sure that just ain't so.
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A Primer on Economic Crises

Part II: The Nature of Financial Institutions

George H. Blackford © 2008/9

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Most financial institutions (commercial banks, investment banks, savings and loans, credit unions, insurance companies, hedge funds, pension funds, etc.) act as intermediaries between borrowers and lenders who have different objectives.  In general, most lenders wish to lend for a shorter period of time and in smaller amounts than borrowers wish to borrow.  You can see how this works by looking at a commercial bank. 

 

When you put money in a checking account you are in effect lending the bank a small amount of money for a short period of time—the amount of money you deposit and the time you leave it there until you write a check.  The bank takes the small amounts of money its depositors lend for this short period of time and makes larger loans to its borrowers for a longer period of time, say, tens or hundreds of thousands of dollars for 90 days or six months.  They can do this because in normal times depositors deposit money in their accounts at more or less the same rate they take money out so even though the balances of individual accounts change rapidly and dramatically the total amount of deposits available to the bank to lend is relatively stable.  When times are not normal, however, banks and other financial institutions can get into trouble.

 

Understanding Financial Institutions

There are two ways a financial institution (or any business or firm for that matter) can get into trouble.  One is if the value of its assets (those things that the institution owns) is less than the value of its liabilities (those things that the institution owes to others).  Even in normal times this is a serious problem for a financial institution because it means that the institution’s net worth (the difference between the value of what it owns, i.e., its assets, and what it owes, i.e., its liabilities; net worth is also referred to as net or owner's equity or capital) is negative.  In this situation the financial institution is insolvent, and even if it liquidates (sells) all of its assets it will not be able to pay all that it owes to others.  When a financial institution is insolvent it is in real trouble and is in danger of being forced to close its doors.

 

The other way a financial institution can get into trouble is if it has a liquidity or cash flow problem.  When there is a net cash flow out of a financial institution this generally means its financial obligations to others are coming due, and it must meet these obligations with cash.  If it doesn't have cash available to meet these obligations, for example to meet its payroll or make a payment on a loan it will default on its payments and, again, is in danger of being forced out of business.  When financial institutions do not have enough cash on hand to meet their obligations they must either borrow money (hence, keep their total liabilities from falling by creating a new liability) or, if necessary, they must sell off some of their assets to obtain the cash they need. 

 

Confidence and Financial Institutions

In normal times the financial system as a whole is able to handle the liquidity and solvency problems of individual institutions with relative ease, but there is a vulnerability that is inherent in the very nature of financial institutions (and to some extent in the nature of most businesses and firms) that arises from the fact that, in general, their assets have a longer term to maturity than do their liabilities.  You can see how this works in your bank. 

 

Your deposit is a short-term loan to your bank that it owes to you and hence is its liability.  The bank makes a loan with the money it gets from you for a specific period of time in the future, say 90 days, and this loan becomes its asset, something the bank owns.  The bank’s loan from you is on demand, that is, its term to maturity (period of time until the date your loan matures and your bank must pay it back to you) is zero since the bank must pay back your loan at your demand while the term to maturity of the loan the bank makes is 90 days.     

 

This means that the very existence of a financial institution depends on the confidence lenders have in the institution.  If lenders lose confidence in an institution, new lenders will refuse to lend to it, and old lenders will refuse to renew their loans when they come due.  In the case of your bank, new depositors will choose other banks, and old depositors will close their accounts.  In this situation your bank will be forced to pay out cash to pay off its depositors, and when it can’t get the cash from new depositors it will be forced to liquidate its assets by selling them off to meet the demands of its depositors.  It will be forced out of existence if it is insolvent in this situation, that is, if its net worth is negative.  What's more, even if it is solvent before depositors lose confidence in it, it can be made insolvent after depositors lose confidence if it is forced to sell off its assets  at fire-sale prices that are below what its assets  are actually worth. 

 

Confidence and the Financial System

This inherent vulnerability to the confidence of lenders not only applies to individual financial institutions; it extends to the financial system itself.  The reason is financial institutions are interconnected and interdependent in innumerable ways.  To a very large extent the assets  and liabilities of one financial institution are the liabilities and assets  of other financial institutions.  When you deposit money in your bank the bank agrees to pay you back the principal plus interest (if any) on the terms the bank sets for your account.  That deposit is your asset, something you own, and the bank’s liability, something it owes.  Your bank takes your money, combines it with the money of other depositors, loans the money to someone to buy a house and takes a mortgage on the house which becomes your bank’s asset and the homeowner's liability.  Your bank then sells the mortgage to an investment bank and it becomes the investment bank's asset and the money your bank gets from the investment bank becomes its asset which it can use to make more loans. 

 

The investment bank combines the mortgage it got from your bank with mortgages it got from other banks and uses these mortgages as collateral for Mortgage Backed Securities (MBSs).  These securities (mortgage bonds) are given a rating by a credit rating agency (such as Standard and Poor’s, Moody’s, or Fitch Ratings) and are then sold to other financial institutions such as pension funds and insurance company—perhaps, even to your pension fund or life insurance company or the pension fund or insurance company of the mortgagee who borrowed the money in the first place. 

 

At the same time the investment bank insures its mortgage assets against default by purchasing a Credit Default Swap (CDS) from a hedge fund or an insurance company.  This CDS becomes a kind of contingent asset for the investment bank, its value being contingent on the extent to which there is a default on one of the mortgages that it insures, and a contingent liability of the hedge fund or insurance company that sold the CDS where this liability is contingent on the same conditions as the investment bank's contingent asset.  At this point the investment bank holds your mortgage and the mortgages of others as assets  and the Mortgage Backed Securities (MBSs) that it sold are its liabilities.  The MBSs that are purchased by pension funds and insurance companies are their assets.  The investment bank also gained money, an asset, from its sale of MBSs, and this money can now be used to purchase more mortgages. 

 

This example should give you some idea how financial institutions are interconnected and interdependent, but even this example is highly simplified.  Banks, mortgage companies, hedge funds, and insurance companies all issue stock to finance themselves.  These institutions also borrow from banks, issue commercial paper, and sell bonds and interact with financial institutions via the markets for these financial instruments.  In addition, they borrow and lend directly from and to each other in order to meet their liquidity needs as their cash receipt and expenditure flows change on a day by day basis.  And we haven’t even touched on the role of the Federal Reserve and the US Treasury in the financial system. 

 

The financial system is like a huge spider web that folds back on itself in ways that are beyond imagination, and this simple example doesn't even come close to indicating its full complexity and interconnectedness.  What’s more, its complexity and interconnectedness not only includes domestic financial institutions, it is international in scope encompassing the financial institutions of foreign countries, their central banks and treasuries, the International Monetary Fund, the Bank for International Settlements, and the World Bank.  And all this system is dealing with is assets and liabilities that are nothing more than obligations to pay interests, principals, benefits, premiums, etc. at particular points in time. 

 

I can’t emphasize this enough:  All this system is dealing with is obligations, promises, contracts, or agreements that define the times and amounts that payments of money are to be made in the future. 

 

How we Benefit from the Financial System

When the system works properly, everyone benefits from this process.  In the simple example above, you benefit by having a convenient place to keep your cash to facilitate your expenditures, a higher yielding investment opportunity for your pension fund, and lower rates on your insurance policies.  The home owner benefits from the ability to get a mortgage at a lower rate than she would have been able to if the bank were forced to tie up its assets  with a long-term, illiquid mortgage that it couldn’t sell very easily if it needed cash.  The home owner also gains the same pension fund and insurance benefits you do.  The investment bank benefits because by securitizing the pool of mortgages it can issue an equivalent amount of mortgage bonds (MBSs) on which it pays a lower rate of interest than it receives from the pool of mortgages it has purchased. 

 

The hedge fund that insured this pool of mortgages by selling a CDS benefits because it can earn an income from the insurance it sells, and the investment bank benefits from this insurance by being insured against a loss on the mortgages it holds.  The pension funds and life insurance companies that purchase these Mortgage Backed Securities benefit because they are able to purchase long-term, high yielding assets  that are both ‘safe,’ because they are collateralized by real estate, and liquid because the market for Mortgage Backed Securities is much more liquid than is the market for individual mortgages.  And everyone benefits from the credit rating agencies that perform due diligence in investigating and reporting on the quality of the Mortgage Backed Securities that are sold in the markets, thus providing a valuable source of information to investors and making the market more efficient.

 

Everyone benefits from this process so long as it works properly.  When it doesn’t work properly, however, there is a chain reaction throughout the system that can shake the system to its core if it is allowed to get out of control. 

 

When Things go Wrong

Note that in the example above it is assumed that all of the future payments of money that the participants are obligating themselves to pay will be financed out of the payments made by the homeowner.  The homeowner makes interest and principle payments to the investment bank, out of which the investment bank pays interest payments to the pension fund and insurance premiums to the hedge fund, out of which the pension and hedge funds pay their pensioners and investors. 

 

What if the homeowner defaults on the mortgage?  If the homeowner defaults then the hedge fund that sold the CDS that insured the mortgage must pay.  If the hedge fund defaults on its CDS, then the investment bank that holds the mortgages must pay.  If the investment bank defaults on its Mortgage Backed Securities then the pension funds and insurance companies that purchased the Mortgage Backed Securities don’t get paid, and if the loss is sufficiently large they may default on their obligations to their pensioners and policy holders, and the pensioners and policy holders who are the ultimate lenders in this example must ultimately take the loss. 

 

But the disruption to the system does not stop here.  As was noted above, banks, hedge funds, mortgage companies, pension funds, and insurance companies all borrow from other financial institutions.  If one of these institutions defaults on its obligations it will be forced out of business.  All of the loans that are its liabilities are held as assets  by the institutions that lent to it.  Since these assets  are now at risk investors and lenders everywhere will begin to look at the liabilities of the failed institution to see what institutions hold its liabilities as assets  to see how the failure of the given institution will affect the viability of the institutions that lent to the failed institution. 

 

This is why lenders must have confidence the obligations, promises, contracts, and agreements that are the essence of the financial system will be honored.  If lenders lose confidence in the ability of a particular institution to meet its obligations lenders will stop lending to it, and that institution will be forced out of business.  This sets in motion a chain of events, often referred to as contagion, which brings into question other financial institutions in the system.  In normal times this process works itself out with very little difficulty, but we do not have normal times.  If the financial institution that fails is a major player in the system (‘too big to fail’) or if a large number of smaller institutions begin to fail (through a process referred to as contagion) the system itself is threatened, and once lenders lose confidence in the system itself the entire system simply grinds to a halt.   

 

This is no small matter because as the process of resolving this situation works itself out there are huge amounts of wealth that are at stake, and the economic wellbeing of everyone is at risk.

 

The Financial Crisis

As was noted above, the immediate cause of the financial crisis was the bursting of the housing bubble that had been building for the past seven years brought about by 1) deregulating the financial system, 2) what was either duplicity or stupidity on the part of securitizers and rating agencies, and 3) a failure to stop predatory lending practices on the part of mortgage originators.  (Andrews)  Now that we have examined the nature of financial institutions, we are in a position to understand why the bursting of the housing bubble caused so much turmoil even though only a small percentage of mortgages, 2% or 3%, were in default at the beginning of the crisis.

 

The defaulted mortgages had been securitized by including them in combined mortgages (MBSs), insured by Credit Default Swaps, and then spread throughout the financial system.  To make things worse, financial institutions have been allowed to speculate in unregulated markets on CDSs by allowing them to buy and sell CDSs for Mortgage Backed Securities, for Collateralized Debt Obligations (CDOs) (which are combinations of lesser rated  MBSs), and other Asset Backed Securities that the buyer of the CDSs doesn’t own. 

 

This practice had grown to the point where the value of the contingent liabilities created by these Credit Default Swap on the books of financial institutions are often five or ten times the value of the Asset Backed Securities they insure.  What’s more financial institutions have been allowed to treat ABSs in such a way that they can be hidden in their financial statements, and the way in which these securities have been put together it is difficult if not impossible to know what these financial assets  are made up of or to evaluate the degree of risk that should be associated with them to the effect that it is impossible to know what these assets  are actually worth. (Kroszner

 

The result was that no one knew at the time of the crash in 2008—and no one knows today—who owns the bad mortgages or the contingent liabilities and assets created when these mortgages were combined into Mortgage Backed Securities (MBSs) and other Asset Backed Securities and insured innumerable times with Credit Default Swap, let alone who owns the financial obligations of those institutions who own these toxic assets.  This lack of knowledge (often referred to as a lack of transparency) undermines the confidence of lenders in all financial institutions since no one knows which of these institutions are at risk and which are not. 

 

What’s more, as we head into a recession and housing prices fall further there is no guarantee the percentage of mortgages in default won’t go from 2% to 4% to 8% to 16% to 32% as this problem works itself out.  In fact, it is clear that this percentage is going to increase over time.  (Yang)  The only question is by how much.  As a result, CDSs, MBSs, CDOs, and other Asset Backed Securities have become known as ‘toxic assets’ and lenders are afraid to lend to any financial institution that might have an association, either directly or indirectly, with them.

 

Why Leverage Matters

This situation, combined with the wanton deregulation of the financial system that has taken place over the past 30 years (which accelerated dramatically under the Clinton Era and Republican Congress in the 1990s) (RiskGlossary) and the deplorable lack of enforcement of existing regulations under the Bush Administration for the past seven years, has led to a financial system that is a house of cards. 

 

Deregulation has allowed many of the major players in the financial markets to leverage  themselves (increase the ratio of their liabilities to their net worth) to the point that their net worth may be as little as 2% or 3% of their total assets.  (Gandel)  This means that a very small decrease in the value of their assets (2% or 3%) will make them insolvent, and there is a very serious possibility that these institutions will not be able to meet their financial obligations at some time in the near future. 

 

To see how central the increase in leverage is to the current financial crisis assume you have $1,000 and decide to become an investment banker:   

  1. If you lend your $1,000 out at 6% you can earn $60 a year.  ($1,000x.06=$60)  That gives you a 6% return on your $1,000 investment. 

  2. If instead of just lending your money you borrow $1,000 from a friend at 5% and lend out the $2,000 at 6% you can then take in $120 that cost you $50 in interest to your friend.  This leaves you $70 profit which is a return of 7% on your investment of $1,000 instead of 6%.  This extra 1% was obtained by leveraging you capital at a 1 to 1 ratio with your friend’s money. 

  3. Suppose you have enough friends to borrow $10,000 at 5% and are able to lend $11,000 out at 6%.  You have now leveraged your capital at 10 to 1 and can take in $660 that cost you $500.  This leaves you a $160 profit which is a return of 16% on your $1,000 investment.  But why stop here? 

  4. If you leverage your capital at 30 to 1 by borrowing $30,000 at 5% and lend the $31,000 out at 6% you take in $1,860 that costs you $1,500 which leaves you a $360 profit.  You end up with a return of 36% on your $1,000 worth of capital. 

This is what leverage is all about:  It increases the rate of return on the capital of financial institutions, and using this kind of reckless leverage and worse has allowed some of our largest financial institutions to make hundreds of billions of dollars over the last few years as the housing bubble grew. 

 

At the same time this leverage increased the instability of the financial system as a whole.  If, as in the above example, you are leveraged 30 to 1 all it takes is a 3.2% loss in your $31,000 worth of assets  and your net worth is zero.  That is, your $1,000 worth of capital that represents what you invested of your own money is completely wiped out.  What’s more, if all of the institutions in the financial sector are leveraged at a 30 to 1 ratio and the value of the total assets  held in this sector fall just 3.2% all of the net worth in the entire financial system will, in effect, be wipe out.  Some institutions may have a positive net worth that is offset by some that have a negative net worth, but the net worth in the financial system as a whole will be zero. 

 

Even though there is not necessarily a liquidity problem at this point (in the above example you have only lost $60 of the $1,860 income you were making before the default and are still only paying out $1,500 thus making a $300 annual profit) there soon will be because this is the kind of situation that makes lenders nervous.  The handwriting is on the wall so to speak. 

 

When a large number of financial institutions find themselves in this situation the entire system is at risk.  Since most financial institutions borrow short and lend long, as loans to them come due lenders will be less willing to renew their loans at current rates of interest.  Rates of interest that insolvent institutions must pay will begin to increase, and they will inevitably run out of cash at some point and be forced to sell off assets  to meet their cash flow needs.  The prices of these assets  will fall making the situation worse, and, in the end, lenders are going to stop lending and the entire system is going to collapse. 

 

This is, more or less, how we got to where we were in September of 2008.  Reasonable leverage is essential for the financial system to function efficiently.  Reckless leverage, however, is disastrous for the system. 

 

Why the System Ground to a Halt

Given the failure of Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, and AIG in September of 2008 we found that lenders had lost confidence in the financial system itself and had been driven into a panic.  As a result of this panic it was virtually impossible for financial institutions to borrow money or to sell their assets  at prices that would keep them from becoming insolvent because there were no lenders or investors out there who were willing to assume the risk of lending financial institutions money or of buying their assets  at prices that would not force them out of business.  This caused the financial system to grind to a halt. 

 

In the meantime, since most financial institutions lend for a longer term than they borrow the liabilities of financial institutions continue to mature at a faster rate than their assets, exacerbating their liquidity and solvency problems, and the entire system found itself in the process of collapsing.  It would have made no difference if the fundamentals of the economy were sound which, unfortunately, they were not.  All that mattered was that lenders no longer had confidence in the financial system and were refusing to lend to financial institutions. 

 

What’s more, since our financial system is interconnected with the financial systems of the rest of the world, many of the assets  and liabilities of our financial institutions are the liabilities and assets  of foreign financial institutions which put foreign financial institutions at risk as well.  As a result, we were faced with a worldwide financial crisis. (Kodres)  

 

The Coming Recession

Unfortunately, the story of the Crash of 2008 does not end with simply a crisis among our financial institutions because the financial sector of the economy is inextricably intertwined with the real sector of the economy.

 

The financial sector amounts to something like ten percent of the economy.  Ninety percent of the economy is in the nonfinancial or real sector.  This is the sector that produces nonfinancial, real goods and services:  real consumer goods that provide the food and clothing and shelter that are used to satisfy consumers’ wants and needs, and real investment goods that provide the tools, machines, and buildings that are used to produce economic goods.  It is the real sector of the economy that is the ultimate engine that produces the economic goods that are essential to our wellbeing and, indeed, to our very survival.  Without the real sector the financial sector has no reason to exist and, indeed, cannot exist.   At the same time, in a modern economy a functioning financial sector is essential to the efficient functioning of the real sector.

 

Income and the Circular Flow of Money

The real sector of the economy is made up of firms (businesses) and households (individuals and families):  Firms purchase labor from households and produce goods that are sold to households as well as to other firms.  Households sell their labor to firms and purchase goods from firms.  These purchases and sales are made possible by a circular flow of money through the economy from households to firms and back to households.  The money used by firms to purchase labor from households is also used by households to purchase goods from firms, and is, in turn, used by firms to purchase labor from households.  In the industrialized economies of the world this circular flow of money is the mechanism by which income payments are made by firms and received by households.  As a result, the financial sector of the economy is essential to the real sector of the economy in that the financial sector coordinates the circular flow of money from firms to households back to firms in such a way as to finance the purchases and sales of households and firms

 

Role of Financial Institutions

When individuals receive income payments from firms a portion of the money they receive is spent directly on products sold by firms and a portion is not spent on these products.  That portion that is generally lent to a financial institution in the form of a payment to an insurance company, a contribution to a pension fund, a deposit in an investment account or some other financial institution, or it is just left in the checking account where the check that represents the income payment is deposited.  When the money is lent to the financial system it is available to be lent to others, both firms and households alike, to balance out their income and expenditure flows. 

 

This makes it possible for a firm to make expenditures on payrolls, inventories, buildings, and equipment that exceed the amount of money it has on hand by going to the financial system to borrow the difference to finance its expenditures and then repay the loan from the income it expects to generate from its expenditures.  Similarly, this makes it possible for a household to make expenditures on food, clothing, washing machines, cars, and to purchase a home that exceed the amount of money it has on hand by going to the financial system to borrow the difference to finance its expenditures and then repay the loan from the income it expects to earn in the future. 

 

The circular flow of money from households to firms back to households is possible only if the financial sector of the economy is functioning properly, and a loss of confidence in the financial system that causes the financial sector to no longer function properly has a direct effect on the real sector.  As households and firms become less willing to lend to the financial system, the financial sector must contract.  As the financial sector contracts financial institutions become less willing to lend to households and firms, and households and firms find themselves more and more limited in their expenditures by the amount of money they have on hand. 

 

Non-financial firms have the same kinds of liquidity and solvency problems that financial institutions do.  In general, their assets are longer term and earn income over a longer period of time than their obligations to make payments to manage their liabilities.  As firms find it more difficult to borrow they also find it more difficult to meet their payrolls and fund their other expenditures.  As the situation gets worse they are forced to cut back their expenditures, reduce their levels of production, and lay people off.  In addition, if the inability to borrow gets bad enough, otherwise solvent firms can be forced to sell off their assets at fire-sale prices and can be forced out of business in the same way that otherwise solvent financial institutions can be forced to sell off their assets and go out of business.  

 

As firms lay people off and go out of business the incomes of households fall, and households, in turn, find themselves restricted in their ability to make expenditures.  Households are forced to cut back on their purchases of goods from firms, which has a feedback effect on firms that increases their liquidity problems and forces more firms to lay people off and go out of business, which has a feedback effect on households.   As employment and incomes fall there is tremendous pressure on wages and prices to fall as well.

 

Feedback Effects on the Financial Sector

A contraction in the real sector of the economy, in turn, has a feedback effect on the financial sector.  As employment and incomes fall, firms go out of business, and wages and prices fall in the real sector, not only does the willingness and, indeed, the ability of this sector to lend to the financial sector also fall, it becomes more and more difficult for households and firms to honor their existing obligations to the financial sector:  Firms find it more difficult to pay off their loans, make interest and principal payments on their bonds, (Kouwe) maintain the value of their stocks, or to make dividend payments to their stockholders.  Households find it more difficult to make payments on their loans, credit cards and other installment debts, and to make payments on their mortgages. 

 

These financial obligations of firms and households provide the very foundation of the financial sector of the economy, without which there is no reason for the financial system even to exist.  It is faith in the ability of firms and households in the real sector to meet their financial obligations to the financial sector that ultimately underlies the confidence in the financial sector itself because ultimately all of the income earned in the financial sector of the economy must come from the real sector of the economy. 

 

As this process unfolds we find ourselves in a vicious circle:  A lack of confidence in the financial sector causes a reduction in the willingness of this sector to lend to the real sector, which causes the real sector to contract and default on its obligations to the financial sector, which increases the lack of confidence in the financial sector which feeds back on the real sector.  The result is a downward spiral with more and more firms and financial institutions going out of business and more and more people losing their jobs, losing their homes, and going into bankruptcy.  This downward spiral must continue until either confidence in the financial sector is restored or the economy contracts to the point where virtually all expenditures by households and firms that survive in the real sector are made with the cash they have on hand.  At this point the financial sector will be more or less irrelevant except to the extent that banks—whose checking deposit are the primary form of money in use today—survive, since the real sector of the economy will be functioning on a cash only basis. 

 

Thus, if the financial crisis is allowed to get out of control, the end result will be the failure of innumerable firms in both the real and financial sectors and significant increases in the number of households, that is to say people who will lose their jobs, their cars, their homes, their businesses, and their life’s savings.  In addition, there will be massive transfers of wealth from those who are crushed in this downward spiral of the economic system to those who are able to survive, mostly by holding US Treasury obligations and watching the carnage unfold from the sidelines as they wait until they are ready to convert their assets to cash and buy up the real and financial assets of firms and households at fire-sale prices. 

Part III: Bailing out the Financial System

 

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