A financial crisis redux?

 It's 7:30.  Do you know where your money is?  Kids, that's a very old reference, and my references are very dated.  No self-indulgence today.  This morning, we shall perform some good, old-fashioned social science.  In the real world, and the world of things that matter in the United States, the financial situation is getting scary.  Er.  Differently.  I suppose the tenuous economy with inflation perhaps just barely coming under control already consisted of "scary," but bank failures are never good.  Unless they are crypto banks.  Then they're awesome.  However, we appear to have a systemic problem with regional banks, with customers, investors, the FDIC and fellow banks looking at each other side-eye, and asking, is this thing going under?  At the extreme end of concern, there are rumblings of a new financial crisis.  With that in mind, let us review the history of the financial crisis, the "great recession," and perform a little compare-and-contrast.  How worried should you be?  That depends on your financial circumstances, your retirement time horizon, and many other factors.

The 2008 financial crisis occurred because of some combination of willful scamming and self-delusion.  People are remarkably proficient at moral rationalization, so picking apart any individual's moral culpability is challenging, but the whole thing started with a very bad idea.  Sub-prime mortgages.  The normal way to buy a house has been to put a downpayment on the house, and get a loan at a fixed interest rate for either 15 or 30 years.  However, there are some people who cannot put together a downpayment, and would struggle with initial payments.  Some mortgage lenders came up with the following thing, remarkably similar to a pyramid scheme.  When someone who does not meet the criteria for a conventional loan wants to buy a house, offer that person a sub-prime mortgage.  That loan required no downpayment, and for an initial period of time, the borrower would only pay interest, making no payments on the principal.  Say, five years.  During that period, the borrower gets to stay in the house for merely the cost of the interest accruing on the loan, and that would be lower than rent.  Great deal, right?  The problem is that after five years, the grace period ends, and the borrower then has to start making full payments.  Moreover, the interest rate would not be fixed.  It would adjust, and that meant the initial terms did not state the actual payments after the first five years.

But wait, the borrower asks?  What happens if I cannot afford those payments?

The lender responds, well, then you just sell the house and turn a profit because houses always increase in value.  You can't lose!

Which are the three words that always precede a no-win-situation.

As sub-prime mortgages proliferated, housing prices shot up because the availability of those loans brought so many people into the housing market.  Behold, the new tulip.  (Kids, go read about tulips.)  Since all of these borrowers got into the market at the same time, they all hit the rate adjustment and payment increase at the same time.  When they couldn't make their payments, they all put their houses on the market at the same time, and housing prices plummeted.  Behold, supply and demand.  No one could sell their houses, and sub-prime borrowers were stuck with the payments they couldn't make, having borrowed on the false belief that they could sell when the rates adjusted.  Oops.  This hit everyone who wanted to sell, sub-prime borrowers and everyone else alike, creating a big hit to the economy, but it was worse than that.

First, all of those loan payments that were due?  That was money that banks had on their balance sheets which vanished into the financial aether because the borrowers couldn't make their payments.  So if the Bank of Stupid and Vaguely Scammish Loans gives out a sub-prime loan to Dupe-Me Once, for five years, they count Dupe-Me Once's debt on their balance sheets, and then suddenly, Dupe-Me Once defaults, and the Bank of Stupid and Vaguely Scammish Loans doesn't have that money, even in the illusory sense.  Oops!

And it is worse, because the Bank of Stupid Loans wasn't actually stupid.  Once they loaned the money to Dupe-Me Once, they chopped up portions of the loan, along with every other similar sub-prime mortgage, and sold bundles of loans as "investments" to other banks.  Mortgage-backed derivatives!  So in fact, some other bank was on the line for some indeterminate portion of Dupe-Me Once's mortgage.  Or rather, lots of other banks were on the line for lots of small portions, and because it was all chopped up and portioned out, recombined with other loans, nobody knew who owned which debt.  The only thing that was known was that money wasn't coming in.

And it gets worse, because the banks and the investment firms took out insurance on the mortgage-backed derivatives, and as the derivatives collapsed, the insurance couldn't pay because there was so much bad debt in the system, so the insurance system was collapsing.

The housing market collapsed.  Banks lost liquidity, the insurance market was collapsing... this is what we call, "contagion."  It is easy to recognize contagion in retrospect, although the number of people blaring a warning klaxon at the time was rather small.  It was relatively clear that sub-prime mortgages were stupid, but what was not clear was just how far the contagion would spread.  Should we have known?  Well, one of the things I must regularly note is that this kind of prediction is just very difficult.  The regular cite here is Tetlock's Expert Political Judgment.  As Tetlock's experiments noted in every variant, specialists are no better than educated laypeople at making this kind of prediction, and the worst are those who rely on narrowly constructed models.  This is just about the hardest thing to do, and we suck at predicting this kind of thing.

So if you ask me, are we headed for another financial crisis/collapse/"great recession," take whatever I say with Tetlock's recommended salt dosage, checking with your cardiologist.  I'm just a Ph(ony) D(octor).

What we can do is ask about the empirical similarities and differences between 2008 and 2023.  The big question is whether or not there is a systemic catalyst for contagion?  Is there a systemic risk that is either being noted, or downplayed now?  That, I think, is the vital question.

Let's keep in mind a few things.  First, why is the housing market so important.  It is vital because it is the most valuable asset that most consumers own or try to purchase.  Hit the housing market, and you hit the 800 lb. gorilla of the consumer market.  Hit the liquidity of the housing market, and you hit the liquidity of consumers' financial assets.

As long as FDIC, combined with fellow banks, will back deposits, is anything hitting consumers' liquidity?  Not that I see.  The stock market has been in unpleasant territory with stomach-churning roller coasters, so there are wealth effects, but that isn't on the magnitude of what we saw in 2008 at the level of the nation's economy.

What about contagion within or across institutions?  Whether or not FDIC can cover every bank failure will depend on whether or not there is a run on regional banks.  That, I cannot predict.  A run on regional banks would be devastating.  Yet part of the reason they are covering above the FDIC-guaranteed deposit is to reduce any fears.  And keep in mind that there was no bank run in 2008.  If there was no bank run in 2008, would there be one now?  Unlikely.  Possible?  Sure, but unlikely.

What about across?  In 2008, we saw a rapid domino effect, as financial institutions collapsed through contagion.  Remember, American International Group was an insurance group that went ker-blooey because they couldn't cover the claims made on the losses from the sub-prime market.  If FDIC covers deposits, what's the contagion?  There could be some slowing of businesses who are reliant on regional banks, and that alone is bad, but without the kind of investment games that set off everything in 2008, the contagion just doesn't have a similar catalyst.

This is not good.  Make no mistake, this is not good, and the bank failures come at a time when the Fed is just getting inflation perhaps under control without a "hard landing."  The last thing the economy needs is additional pressure, but if you are going dimension by dimension, and rethinking the history of 2008, this does not look like the banking crisis in 2008.

How widespread will it turn out to be?  The trouble is that different banks seem to have different types of problems, which makes forecasting here especially difficult.  A collapse, though?  Only if there are bank runs, and if that didn't happen in 2008, why would one expect that now?

Then again, Tetlock says I'm useless here.  Of course, I'm invested for the long term.  I've lived through this before, I'll live through it again, and I'm too jaded to stress about this, or really much else beyond the few things in life that really matter.  Take a walk and think about what truly matters.

Tigran Hamasyan, "Pt. 1, The Collapse," from Shadow Theater.