Guest Post: Looking Back To the Late '80s For 'Contagion' Guidance
Submitted by Jeffrey Snider via Real Clear Markets
Looking Back To the Late '80s For 'Contagion' Guidance
The clock has been turned back to 1989 and the stock market briefly cheered the temporal transformation, although credit markets have remained far less sanguine. With Europe on everyone's collective mind, rumors of an expanded European Financial Stability Fund (EFSF) acting akin to the early version of U.S. TARP had many hoping that a true resolution had finally been found. Of course, the first plan (the one sold to Congress) for TARP was to act as a resurrected Resolution Trust Corporation (RTC), so the markets are reaching back to the late 1980's for guidance on how to "successfully" contain banking contagion.
The RTC was created in response to the widening savings and loan crisis of the mid-1980's. By the time it opened its doors on August 9, 1989, 296 thrift banks had already failed, with approximately $125 billion in combined assets. Policymakers at the time were desperate to avoid what many believed was another forming Great Depression.
The plan for the RTC was simple and straightforward: buy up the assets of the failed banks, fund and warehouse them over time so that the inevitable firesales that typically accompany bank failures could be avoided and not hinder any expected recovery or, worse, drag even healthy institutions down. All that required funding, of course, but, more importantly, it meant absorbing losses since the pool of assets the RTC would gather would largely consist of non- or sub-performing (by 2008 they called this kind of asset "toxic").
The FDIC notes contemporary loss estimates at the outset:
"For example, most loss projections for RTC resolutions during the year leading up to passage of FIRREA in 1989 were in the range of $30 billion to $50 billion, but some reached as high as $100 billion at that time. Over the next few years, as a greater-than-expected number of thrifts failed and the resolution costs per failure soared, loss projections escalated. Reflecting the increased number of failures and costs per failure, the official Treasury and RTC projections of the cost of the RTC resolutions rose from $50 billion in August 1989 to a range of $100 billion to $160 billion at the height of the crisis peak in June 1991; a range two to three times as high as the original $50 billion."
As is usually the case in these circumstances, staring into the beginning of an abysmal crisis, estimates are never really accurate since no one ever wants to face up to the scale of the problem, or at least do not want the public to know what the ultimate tab will be when all is said and done. This is page one in the handbook for government intervention - underestimate the scale. Underestimating is also helped by an over-adherence to mathematical models and simulations that are entirely based on static assumptions derived from "good" times and periods, providing enough seemingly solid rationalizations for why it won't be so bad.
Again, the FDIC quotes the former RTC chairman L. William Seidman's summation of that time:
"Only three months after the cleanup started it was already evident that the problem was far worse than anyone in government had envisioned, including me, and it was getting worse every day. The economy was beginning to slide into recession. Real estate was in real depression in some parts of the country, particularly in Texas, where the savings and loan problem was the largest . . . we would also need billions more to pay off depositors and carry weak assets of the institutions until they were sold and we could recover the funds we had invested . . . we were faced with taking the most politically unacceptable action of all, having to admit that we made a big mistake."
Ultimately the FDIC estimates that the RTC cost taxpayers $123.8 billion, including the interest costs of floating bonds to fund all these activities. Given that the RTC ultimately shepherded 747 thrifts with a combined $393 billion in assets into oblivion, what might an EFSF be looking at when the big banks in Europe each have assets totaling several trillion? That is just the first warning and should serve as a lucid reminder of what may be in store for Europe (notwithstanding additional potential collateral damage all over the globe).
A second warning comes from Mr. Siedman. He admits, perhaps unwittingly, that the RTC did nothing to prevent the coming housing depression of that time (in parts of the U.S.), nor did it prevent the wider economic recession in 1991. Instead, what posterity regards as the significant success of the RTC episode is that the 1991 recession was far milder than those initial expectations (though former President George H.W. Bush may disagree), and fears of a second Great Depression. The banking panic and collapse of the S&L's was thus safely "contained", or so it goes.
I think, however, in the light of the history of the next two decades another cost has to be added to the tab of the RTC bill. Though it will be impossible to measure accurately, there has to be an account for what happened in finance after the final destruction of the savings and loan industry - which is exactly what the RTC accomplished. From the early 1990's on, marginal credit production ceased to be a function of deposit multiplication of central bank "money". The age of securitization and equity balance sheet capacity was born, intentionally to offset the lost credit capacity of all those failed S&L's.
The overall credit market slowed to its weakest point since the 1930's during the year 1992. The overall share of total financial credit owned by the S&L industry had fallen to 8.5% by that time from 20% in 1970, and 16.2% as late as 1988. In 1988, GSE's and their sponsored mortgage pools accounted for a combined 12.7% of financial credit, growing their share to 15.7% by 1992 and a total of 20% by the year 2000. Even ABS issuers had surpassed S&L's by the turn of the millennium, accounting for 6.5% of intermediary credit compared to an irrelevant 5.3% for thrifts.
As much as this might be proclaimed a successful transition from the anachronistic notion of deposit/credit relationship of the traditional money multiplier, to the "modern" wholesale money investment bank system of balance sheet equity governance, the seeds of the credit bubbles were planted by the RTC's S&L unwind.
These changes have had unintended consequences through the years, including, but not in any way limited to, the dramatic housing bubble that has defined the precursory need to bail out the global banking system again. There is a large cost here that may never be fully known, but is all too real. Had the private sector borne more of the actual losses back then (the FDIC estimates private losses at only $29 billion) then the history of banking might have been different, though we will never know. A chastened banking system might not have so easily expanded during the 1990's, especially if that chastening had led to the correct pricing of systemic and asset risks.
In the current case, an EFSF that mimics the RTC may never get as far as another few credit bubbles, no matter how hard monetary and fiscal authorities try to create them. Where the "success" of the RTC and likely failure of the EFSF intersect is in the available conduit(s) of credit production. The monetarists' implants within the new and "improved" credit and banking system of the 1990's were fruitful only because of the ripe conditions of that age.
First of all, the household balance sheets of the American public, even in the most affected areas, were in as good a shape as they had ever been. At the beginning of 1991, U.S. households held $1.5 trillion more in deposit accounts and fixed income assets than they owed in credit market debt. Americans could borrow over the next few decades because of this starting position of relatively stable, less risky net worth (that transitioned to price net worth from that point on). American and European households today are not in a similarly less risky position.
Even if they were, there is no credit market mechanism left to transmit credit money throughout the global economic system. In the early 1990's, as the S&L's collapsed into near oblivion, the GSE's took over the mortgage market and commercial banks took over the rest (eventually moving to off-balance sheet arrangements that may never have worked in an environment where depository credit was still viable and sizable). Both classes of intermediaries were largely unscathed from that period and stood awaiting the opportunity to essentially grab market share. Once that was accomplished, leverage of equity capital (thanks in large part to the stock bubble) was the primary marginal source of credit for the next fifteen years. I doubt any of that would have been possible had the traditional link of deposits not been severed by the S&L failures and the monetary incentives to "influence" household savings into price assets.
Today, the entire global system is imperiled, not just a single subset. The largest banks in the world are exactly the ones where all the trouble is centered. We are not talking about quietly dissolving 747 small banks; we are really talking about keeping a few dozen of the biggest banks afloat by allowing them to offload embedded losses of a still unknown scale. If marginal credit production since 1992 has been done on the back of securitizations and balance sheet capacity, it cannot overcome the roadblocks of no balance sheet capacity (since it has become concentrated in these largest banks) and a now-extinct securitization pipeline. The ultimate irony will be if somehow a depository system reappeared and re-established marginal credit supremacy, but that would take a confirmed commitment to stability and the correct pricing of risks.
In reality, the entire hope of the EFSF effort is to simply get rid of the persistent crisis of the banking system - another psychological ploy to enact or reboot rational expectations of a recovery. Even if the EFSF were to relieve these suffering institutions of their Greek debt, it does not solve the problem of their Portuguese or Italian debt exposures. Nor does it solve the problem of Portugal and Italy.
What is really happening across the world is the peeling back of the façade of the last few decades of monetarism. The banking system, per se, is not the problem. The problem is that the world has too many existing claims on its created productive assets and the perceptions of the world's ability to create additional productive assets. And in many cases, quite sadly, those productive assets have been neglected in the sorry chase for paper profits, often financed by overly cheap and abundant credit. Short-term thinking about stock buybacks and dollar devaluation has trimmed the amount of resources devoted to actual, productive innovation.
I don't think it is any coincidence that the last decade was noticeably lacking of revolutionary innovations, the kind of innovations that changed the very nature of business and commerce (even how we live our lives). Over the same time, the amount of debt accumulated on the backs of the neglected productive economy multiplied exponentially. Is it any wonder that we now routinely question the ability of large nations to repay said claims?
So much human capital and innovation has been devoted to the realm of finance that, in admittedly perfect hindsight, it is easy to see a crowding out of true potential wealth (we might be better off if math geniuses were presented with a different regime of incentives that valued the solutions to more real world problems over the pursuit of a "perfect" algorithm for high frequency trading, at the same time real innovation that is done in the laboratory of trial and error does not fit into the sclerotic notion of risk represented in the mathematical paper chase).
The larger panic about banks is simply a realization that the music has been playing an awfully long time without interruption, and the game of musical chairs is nearly at its end. What is surprising to many is the sheer number of players (debt claims) and the disastrous deficiency of chairs (productive assets). The mad scramble for those remaining chairs will be impolite and unfortunately violent (both metaphorically and literally speaking).
The hopes of the entire age of monetarism now rest on a global economy that is visibly weakening, and likely already contracting (though the confirmation will not come until government revisions to initial estimates are published many months from now). Credit is not an answer to the problem of too much credit. In one respect this is a positive development. So many parts of the world are now impervious to monetary policy's disastrous ends, especially the suicidal trend of households to move out of par assets and into price assets (both stocks and real estate).
The massive undertaking of risk over the last few decades has been completed solely because it was so badly mispriced by monetary policies all over the world. A systemic reset to risk pricing would disable all these short-term incentives to chase and pile paper.
Without hope of a monetary or fiscal solution, and with the process of sovereign loss transfers finally at its logical end, the economic backdrop looms as a scary contrast to the QE-inspired run in risk price assets of last autumn. Perhaps that also serves as a warning that this idea of easy money will be a hard habit to break, translating into an elongated period of substandard conditions and agonizing mistakes. This matches the historical pattern of ratcheting crises that bookend fleeting solutions.
Clearing out these last vestiges of the monetary structure would be a welcome end to the neglect of the productive economy. Not only would an end to wanton dollar destruction close the incentive to send productive investment overseas, but coupled to a diminished incentive to devote an obscene proportion of corporate profits to stock price enhancements might just get businesses to invest locally - spurring small businesses in the process.
As much as the Fed decries "slack" in the economy, expanding manufacturing production is not the only measure of productive capacity and wealth (there is much potential in investing in the human capital and capacity where future innovation resides). R&D is not the end all, be all of business growth, but when the past leaders in innovation willingly spend twice as much on stock repurchases as R&D (Microsoft and Cisco, for example) some rebalancing might just be in order.
The real economic recovery lies not in the credit and accounting schemes that shuffle paper from one perception to another, whether it be an RTC, EFSF, or Eurobonds, or even IMF bonds. The economic recovery we all want is waiting for a return to universal acceptance of the idea of wealth itself. Once the system shifts from this insipid idea of wealth being piles of money to wealth being productive ability, then the economic incentives of all businesses and intermediaries can be re-aligned with the long-term potential for real, solid growth.
In the meantime, the death of the old system will be hard to watch. The desperate flailing and floundering of the old guard of monetarism can still be dangerous. And volatile.