I don’t know why I called this a “simple guide to the banking crisis.” Really, it’s the longest post I’ve written here. But here it is:
Why is the banking crisis so hard to solve? We stood and watched while Hank Paulson and Ben Bernanke fumbled with their response in the fall. Now we are being treated to the distressing spectacle of Tim Geithner struggling as well to articulate a clear policy for dealing with zombie banks. How come these smart and powerful men can’t get a handle on the problem?
I want to lay out 5 simple propositions which will help you understand why the banking crisis is so intractable. Then I will explain what happens next.
Proposition 1: The boom in the U.S. was funded almost totally by foreign money.
This is absolutely the key point for understanding the current banking crisis. Historically, households have been the major source of capital for the U.S. economy. That’s certainly what I was taught in economics graduate school.
But that quietly changed in 1999, when American households flipped from being net lenders to being net borrowers. Foreign money became basically the only source of capital for the U.S.
Take a look at the chart below, which charts net financial investment (adjusted for inflation). Net financial investment for households (the blue line) includes additions to savings and checking accounts, purchases of stocks and mutual funds, and additions to corporate and government pension funds, while subtracting the growth in household mortgages and consumer credit.
Net financial investment for households turned negative in 1999, and stayed that way through 2007 before turning positive in 2008.
To put it another way: In the decade 1988-97, net financial investment for households totalled $2.6 trillion, as households accumulated more financial assets than liabilities. In the decade 1998-2007, net financial investment for households totalled negative $3 trillion.
This was an enormously significant shift. This was the first decade on record where households took more money out of the financial system than they put in.
Who took the place of households as net investors? It was foreign money, pouring into the country in the trillions of dollars (see the light purple line). Foreign investors were buying everything from subprime mortgage-backed securities to hedge funds to purchases of shares.
Proposition 2: Foreign investors preferred to put their money into investments that were perceived as having low risk.
Here’s the story. Suppose you are investing in a different part of the world. You are likely a bit skittish about putting your money so far from home, so you are likely to choose relatively safe investments.
In the same way, foreign investors in the U.S. flocked to investments which offered decent returns and high (perceived) safety. This demand for safety showed up in the Fed statistics. Between 1998 and 2007, foreign investors poured roughly $10 trillion into acquiring financial assets in this country. Out of that total, only about $3 trillion went into supposedly-risky equities, mutual funds, and direct investment in U.S. businesses. The rest went into perceived less-risky investments, such as Treasuries and mortgage-backed securities (after all, housing never goes down!).
But there’s more. Wall Street catered to this foreign demand for safety. Many hedge funds, for example, promised “positive absolute returns”, meaning that they would do well even in down markets (see here). That’s one important reason why hedge funds boomed in this decade—they promised safety to foreign money, which were willing to pay big fees to get it. Many hedge funds were pitched directly to foreign investors. When John Paulson testified before Congress in November, he said that 80% of his $36 billion in assets came from foreign investors.
And when there wasn’t enough “safe assets” to sell to willing foreigners, the intrepid investment bankers created more. Consider, for example, credit default swaps, which pay off if a bond defaults—in effect, insurance on debt. Wall Street saw this as a ‘two-fer.’ They would sell corporate bonds to foreign investors, and at the same time collect fees on credit default swaps on the bonds in order to reassure those apparently too-nervous investors from another part of the world.
But the joke in the end was on Wall Street. The foreign investors bought the bonds, but they also bought the protection—which much to everyone’s surprise was needed. And the U.S. banks and investment banks were left with piles of ‘toxic assets’—the obligation to pay off all sorts of bonds and derivatives.
Proposition 3: Today, after everything has gone bad, many of the counterparties on the other side of the toxic assets are foreign investors, directly or indirectly.
This proposition is based on both arithmetic and circumstantial evidence. The arithmetic is simple. Foreign investors were the main source of funds during the boom years, when these mortgage-backed securities and credit default swaps were being issued in droves. Since not many of these securities are being sold these days, it’s likely that foreign investors are still on the other side of these securities.
Moreover, as companies struggle, more details are revealed of their problem. When Lehman went bust, its bankruptcy filing showed that Lehman’s biggest bank loans came from foreign banks such as Japan’s Mizuho Corporate Bank and Aozora Bank
Bloomberg reported on March 11 that "most U.S. bank debt is held by insurers and foreign investors."
More recently the WSJ had a very good article uncovering the names of the some of the banks who were owed money by AIG. These banks received $50 billion in government funds because they were the counterparties to AIG’s toxic trades. While Goldman Sachs was first on the list, there were also a large number of foreign financial institutions, including Deutsche Bank (German), Société Générale (French), Rabobank Neitherlands), Dankse (Denmark), and Banco Santander (Spain)
One additional point: Goldman Sachs tops the list of companies that received funds from the government via AIG, but that may be misleading. If Goldman marketed its investment funds to foreign investors, these foreign investors are the ultimate beneficiaries of the payments from the government via AIG. There is absolutely no transparency.
Proposition 4: It’s a lot harder for the Federal Reserve and Treasury to resolve a banking crisis where the main counterparties are not American.
The international angle is very important. Geithner and Bernanke keep saying that the problem is that no one knows how much the toxic assets are worth. But that’s not the full story. If the counterparties and beneficiaries of the toxic assets held by American banks are also American, it would be relatively easy for Geithner and Bernanke to gather them in a room and make them come to a ‘reasonable’ agreement about how much these securities were worth. After all, even the most powerful hedge funds must ultimately bow to the power of the Fed and Treasury, especially in a crisis.
But with most of the counterparties in other countries, the job becomes much more difficult. There’s no way for Bernanke and Geithner to force European banks, for example, to accept any particular valuation of derivatives or bank bonds—not without the cooperation of the foreign regulators.
In fact, right now we have the worst of both worlds. U.S. banks own securities which may or may not obligate them to pay a large amount of money to foreign investors. And foreign banks have assets on their books which no one trusts are worth what they say. The uncertainty is killing both the borrowers and lenders.
Proposition 5: The fact that the counterparties are overseas means that out of the three options: bailout, bankruptcy, or nationalization—none are satisfactory.
A bailout means that the government makes good on the value of the securities, including the derivatives which are tied to the collapse of the U.S. economy. That means the worse things get, the more money flows out of the country. Not politically acceptable.
Letting insolvent banks go bankrupt is the option being pushed by some politicians, including John McCain. In some ways it would be the cleanest solution, allowing the bankruptcy courts and the FDIC to do the tough job of allocating the losses from the toxic securities.
The problem, though, is that they tried the bankruptcy option with Lehman, and they nearly broke the global financial system in the process. The Lehman bankruptcy backfired, creating new panic around the world. This reflects how much money many foreign investors had put into the U.S., and how many worried about losing it when Lehman went under.
Nationalization creates a political problem. Once the government buys a company, it is financially and morally resonsible for its debts. It puts the U.S. government in the position of either using taxpayer money to bailout foreign investors, or telling foreign investors, no, the richest country in the world is not going to pay its debts.
What’s the solution?
Conclusion: Sometime later this year we will have a massive global conference aimed at simultaneously resolving the banking crises in the major developed countries. The goal will be a political negotiation of the value of the toxic assets, and a clearing of the books.
If the conference succeeds, then it will be possible to fix the financial system relatively easily. But if it fails, then things get dicey.
Addition: Tyler Cowen makes a related point here:
The best actual marker of the progress of the financial crisis is not stock or real estate prices, but rather how well international cooperation holds up.