We Weren't Punked -- There is a Severe Financial Crisis

A recent paper by the Minneapolis Federal Reserve has gotten a lot of attention. The paper is titled Facts and Myths About the Financial Crisis of 2008 and it argues there was in fact no credit crisis. Several people have used this paper to argue that Wall Street overstated the severity of the credit crisis in order to get a bail-out they didn't need. What these commentators have failed to heed is this paper was widely criticized within the financial community, even drawing a rare rebuke from a sister Federal Reserve Bank. In short, to argue there was no credit crisis -- to say we were "punked by Wall Street" -- flies in the face of every available fact on the crisis.

First, let's provide some background for this debate. As of this writing 311 lenders have "imploded." The XLFs -- the ETF that tracks the financial sector - is down almost 70% from a high in the summer of 2007. Total credit losses at the world's financial institutions have totaled 1 trillion dollars:

The gauge is down 46 percent in 2008 as credit losses and writedowns at the world's largest banks surpassed $1 trillion and the U.S., Europe and Japan entered the first simultaneous recessions since World War II.

In other words, the financial sector's economic position is terrible at best.

But the evidence runs deeper. About every six weeks the Federal Reserve issues a paper titled "The Beige Book." This is a book complied from anecdotal evidence from the Federal Reserve Districts on the general economic environment. Every Beige book issued in 2008 has indicated credit conditions were tightening and loan demand was decreasing.

January 16, 2008:

Reports from banks and other financial institutions noted further declines in residential real estate lending, and lending to the commercial real estate sector was generally described as mixed. Some Districts reported lower consumer loan volumes, whereas the volume of commercial and industrial lending varied. Most Districts cited tighter credit standards.

March 4, 2008:

Most Districts reporting on banking cite tight or tightening credit standards and stable or weaker loan demand.

April 16, 2008:

Financial institutions in many Districts indicated some deceleration in consumer loan demand, tightening in lending standards, and deterioration in asset quality

June 11, 2008:

Lending activity also varied across Districts and market segments, though tighter credit standards were reported for most loan categories.

July 23, 2008

In banking, loan growth was generally reported to be restrained, with residential real estate lending and consumer lending showing more weakness than commercial lending.

September 3, 2008

Most Districts reported easing loan demand, especially for residential mortgages and consumer loans; lending to businesses was mixed.

October 15, 2008:

Credit conditions were characterized as being tight across the twelve Districts, with several reporting reduced credit availability for both financial and nonfinancial institutions

December 3, 2008:

Lending contracted, with many Districts reporting reductions in residential, commercial and industrial lending and tightening lending standards.

In addition to the Beige Book, the Federal Reserve issues a Senior Loan Officer Survey every three months. These reports stated the following:

January 2008:

In the January survey, domestic and foreign institutions reported having tightened their lending standards and terms for a broad range of loan types over the past three months. Demand for bank loans reportedly had weakened, on net, for both businesses and households over the same period.

April 2008:

Compared with the January survey, the net fractions of banks that tightened lending standards increased significantly for consumer and commercial and industrial (C&I) loans. Demand for bank loans from both businesses and households reportedly weakened further, on net, over the past three months, although by less than had been the case over the previous survey period.

July 2008:

In the current survey, large net fractions of domestic institutions reported having tightened their lending standards and terms on all major loan categories over the previous three months. In particular, the net fractions of banks that had tightened credit standards on consumer loans increased notably relative to the April survey.

October 2008:

In the current survey, large net fractions of domestic institutions reported having continued to tighten their lending standards and terms on all major loan categories over the previous three months. The net percentages of respondents that reported tightening standards increased relative to the July survey for both C&I and commercial real estate loans, as did the fractions reporting tightening for all price and nonprice terms on C&I loans.

Finally, there is the quarterly banking profile from the FDIC. Here is the summary from the most recent report:

Troubled assets continued to mount at insured commercial banks and savings institutions in the third quarter of 2008, placing a growing burden on industry earnings. Expenses for credit losses topped $50 billion for a second consecutive quarter, absorbing one-third of the industry's net operating revenue (net interest income plus total noninterest income). Third quarter net income totaled $1.7 billion, a decline of $27.0 billion (94.0 percent) from the third quarter of 2007. The industry's quarterly return on assets (ROA) fell to 0.05 percent, compared to 0.92 percent a year earlier. This is the second-lowest quarterly ROA reported by the industry in the past 18 years. Evidence of a deteriorating operating environment was widespread. A majority of institutions (58.4 percent) reported year-over-year declines in quarterly net income, and an even larger proportion (64.0 percent) had lower quarterly ROAs. The erosion in profitability has thus far been greater for larger institutions. The median ROA at institutions with assets greater than $1 billion has fallen from 1.03 percent to 0.56 percent since the third quarter of 2007, while at community banks (institutions with assets less than $1 billion) the median ROA has declined from 0.97 percent to 0.72 percent. Almost one in every four institutions (24.1 percent) reported a net loss for the quarter, the highest percentage in any quarter since the fourth quarter of 1990, and the highest percentage in a third quarter in the 24 years that all insured institutions have reported quarterly earnings.

Before we even get to the Minneapolis Federal Reserve Report we've clearly established the following.

1.) There have been over 300 failures of various lenders
2.) The financial industry has taken over $1 trillion in losses since the start of this crisis
3.) Financial stocks are down almost 70% since the summer of 2007 making it nearly impossible for institutions to raise additional capital in the equity market.
4.) Each Beige Book issued in 2008 indicated a troubled credit market
5.) Every loan officer survey issued in 2008 indicated tightening credit standards and decreasing loan demands
6.) The FDIC's latest Quarterly banking profile showed massive losses for the US banking industry along wither serious deterioration in asset quality.

In the face of the preceding facts the Minneapolis Fed argues "here we examine three claims about the way the financial crisis is affecting the economy as a while and argue that all three claims are a myth." Their first claim is because there was no decrease in outstanding credit the claims of a credit crunch are overblown: "These figures show that their claim, that banks have essentially stopped lending to non-bank entities is false, at least as of October 15." Unfortunately this argument runs in the face of economic history. Here is a chart of total US bank credit outstanding:

What does this chart tell us? There are two important facts.

1.) The latest recession is the only recession where total credit outstanding has leveled off for an extended period. (The first recession in the 1980s saw a contraction but only after total credit increased). While it didn't decrease it also didn't increase. Compare this to the previous 6 recessions when lending increased at least slightly throughout the recession. In other words, the leveling off of credit creation is a story in and of itself.

2.) In order for the US economy to grow it must have a continual supply of new credit. A leveling off is just as hazardous as a decline.

And that is what happened during most of 2008. The graphs contained within the Minneapolis Federal Reserve report show a clear leveling off of total outstanding credit for most of 2008. Again - this is the only recession in the last 40 years where this has happened.

And Professor Mark Thoma who runs the blog Economists View offers this rebuttal:

Here is every loan series the Federal Reserve Band of St. Louis finds it worthwhile to report in FRED (the title of the section is "Banking: Loans"). These are all percentage changes in quantities (expressed in billions of dollars) from a year earlier, not prices:

Professor Thoma concludes:

I realize that growth rates are still positive and relatively high in some cases -- even real estate loan growth remains above previous troughs -- and that can be interpreted as lack of evidence of a big problem. But I thought the claim was there is no evidence of a fall off in loan activity. The graphs above show there has been an impact, it's not negative yet, but there has been a sharp downturn. It also suggests that if the downturn follows previous patterns - and hopefully Fed intervention or private sector adjustment will prevent that (see the hopeful signs at the end of some of the series above) - but if it does repeat the pattern, we still have a long way to go before things turn around.

And then there is this rebuttal from Tyler Cowan:

First of all, some of the conclusions drawn are simply false. While rates on the highest quality non-financial commercial paper have behaved fairly well in recent weeks, rates for lower quality stuff have soared. The spread between the two, actually, is one of Calculated Risk's credit market indicators.

The failure to distinguish between the two types of paper is indicative of the broader, unwarranted credulity of the authors. For instance, many of the series they present actually show an unusual spike in bank lending during the crisis period. Are we to understand that for most banks, conditions actually improved, suddenly, sharply, and atypically while the rest of the financial world went to hell? Well, we might do that. Or we might suspect that the increase in bank lending was itself a product of tight credit conditions elsewhere--that borrowers were falling back onto lines of credit they normally wouldn't use thanks to the severity of lending conditions.

And all of this occurs before we get to a rare rebuttal from a sister Federal Reserve Bank. The Bank of Boston issued a paper titled Looking Behind the Aggregates, a Reply to Facts and Myths About the Financial Crisis of 2008. This paper notes the large spikes in several key short-term rates:

And then there is the large drop-off in non-investment grade commercial paper issuance:

Finally, there is the Treasury market. On Friday I wrote the following on my blog:

What the Minneapolis Fed report fails to take into account is inflation in one reason for investors to purchase Treasury bonds. Another is safety. Because US Treasury bonds are considered the safest in the world people are buying them at a high rate meaning Treasuries are yielding an incredibly low rate right now. Some T-Bills have recently been issued at 0% interest! That in and of itself tells us the level of concern is abnormally high and a credit crunch is indeed going on - people don't' want any return; they simply want their money bank!

In short, inflation expectations are one reason why people buy Treasury bonds. But another very important reason is safety. And investors are clearly concerned mostly with safety right now if they don't even want a return on their investment.

In short - we were not "hoodwinked" by Wall Street. There was and is a serious problem with the financial system that needed fixing in a serious and immediate way. To argue differently flies in the face of all available facts.

Comments

[Clayton]

Even though I have a masters I do not understand "basis points" and other economic jargon/. I do understand that 50,000,000 American have as eight individual credit cards at their limits. In the last ten years working people lost up to $2,000 due to devaluation of the dollar. Incomes did not increase during the Bu$h years. The wage earners made up the difference by put more expenditures on their credit cards. Remember when the interest rates on credit cards was 6%? Many have exceeded their credit card limits. Therefore credit interest rates have be increased, in come cases, as high as 38%. If you wonder WHY the consumers haven't bee purchasing at previously set levels, they don't have cash, and their 8 credit cards are full. You want a real stimulus? Have the Fed Reserve pay off all credit cards! By the way, my credit card, my only one, is empty, so I do not have skin in this game.

I can't wait until the credit card bubble pops!

[ThePeacemakers]

No, we were punked.
The crisis: "Oh, no the world is falling in, the banks aren't lending"
Bailout: Still no lending.
The world not fallen in.

[NoPCZone]

One Question:
When do the crooks and enablers of Wall Street go to jail?

Some kid in the hood gets popped selling a joint and goes to jail.

Some Wall Street thief steals billions and does minimal time in a minimum security prison. Sometime they only say 'I assume the responsibility for this' and no justice is ever served.

[flatus]

I saw the terror in Bernanke's eyes as he struggled to maintain the Bush "all is rosy" talking point while sitting before Congress over a year ago. So, by that alone, I know this is the real deal.

[TJCole]

Americans were "punked" with all the Republicans and so called "conservatives" Deregulation and "government is the problem" talk of Ronald Reagan that's when America got, "Punked"....."Dudes..!"

[dobberdoss]

Lets not forget another REAL reason for the "bailouts" either. To make the poor & middle class responsible for the debts of the rich therfore keeping the so-called "elite" at the top of the s*** pile

[research]

I'm surprised at you Hale.

This is blatant Distraction and Straw man stuff.

Ignore the banks.

Invest in America's people, it's infrastructure, it's energy independence via solar wind an efficiency.

It's Hoover failure versus FDR success all over again.

http://www.huffingtonpost.com/users/profile/research

[DuganS1]

Banks (or investment banks, insurance co's, etc) are the institutions that lend the money for investment in infrastructure, alternative energy, and other enterprises, unless the federal gov temporarily takes over that function (and history has shown the govt to be very inefficient in doing so). The Hoover vs FDR comparison is not a good one. While Hoover made the crisis worse by mis-steps, FDR prolonged the recovery by being extremely intransigeant towards business. Private investment didn't reach 1929 levels until 1940-1941 and didn't exceed them until 1946-47. A medium or long term business recovery didn't happen until FDR cut lose the New Dealers nearing the end of his second term, brought in business leaders to run the economy, had govt give large loans at extremely favorable terms to build the industrial base, and allowed for large depreciation allowances and favorable cost-plus contracting to bring back profitability back to business and allowing business to thrive after war end. The infrastructure spending may have lifted the economy from the depths of late 1932, but it certainly didn't bring a full recovery, far from.

[research]

We've had this argument and you lost.

FDR was right.

Hoover was wrong
http://www.huffingtonpost.com/users/profile/research

Size of private investment is irrelevant. Since the economy was being supported by massive government spending this is a "Duh".

Intransigent? FDR came down on bankers like a ton of bricks, what you call business tried to KILL FDR to bring a fascist government into effect.

All measure of economic activity, went to maximum in 1939 1940 as we spent on the war preparations. Employment soared to record levels. GDP also. production per person, EVERY measure. Except Peace, which is why public works of the same 5T$ magnitude as WWI is infinitely preferable.

Why can't you understand that SPENDING on production/public works is what rescued the economy?

You keep repeating: Infrastructure didn't do enough, but the war did.

Duh. The war was 10 times the spending.

JOBS create the economy.

[WASanford]

Dugan you seem to have a propensity to make off the cuff statements without backing them up. If history, for instance, has shown our government to be very inefficient in making loans, what history are you referencing? When did that occur and in what circumstances? Where can I find the history you refer to concerning the end of FDR's second term?

I have a little habit that comes into play whenever someone mentions "the government." I always substitute the words "We the people" for it. Try it, I think you'll find it gives you a different perspective into what's actually happening. We are the ones who form our communities and governments and approved our constitution. When they don't work, it's not some unnamed monolith that's at fault, it's us.

[cylindar]

This is not news. It is obvious that the current meltdown is a result of several industries in the US and essentially individual greed. I hope anyone involved even down to the homeowner who thought they could scam others gets burned to hell and sideways. I want to see the system go down baby! The reason: It is wrong and does not contain a shred of decent ethics.

[dobberdoss]

Amen, burn baby burn

[William1950]

We have been punked.. which does not mean there is no real problem... there is. But we have been punked by private interests and business taking over our representative government for their own purposes over the interests of the people. And when the scheme got too big to support itself then suddenly we are in a crisis.. surprise! What we need now is a viable soultion to this whole mess, which to me means a new and different economic model... In the meantime we could always start a huge war... The alternative to that is a completely welfare based society, or base net worth on social worth... What bothers me is that all the analysis and blame that is going around is not addressing a SOLUTION ... We need something NOW.

[PATina]

BINGO !!!!!!

[zizyphus]

All the polite analysis overlooks the fact that our various federal agencies are operating as if they controlled by organized crime. And the new AP report said the execs got over a billion in bonuses, after deliberately defrauding investors around the world.

From the crooked mortgage brokers, to the crooked banks who processed the loans, from the ratings agencies who marked the frauds as AAA, to the hedge funds and banks that launder all the black market money, all should be in jail, but instead are looking forward to their offshore accounts.

[DeepsyRascal]

The seed was the corrupt mortgage brokers selling ninja loans but this could have been nipped in the bud (pardon the pun). It could only grow with the banks' involvement and the idea of sharing the risk to the global community.
A lot of this 'crookedness' is on account of corporates and consumers wanting (and getting) cheap credit, or wanting a decent retirement or savings income. This fuels the investment community to construct and invest in ever more complex investments to generate extra income, which leads to ever more 'innovative' complex investments being structured by banks so they can sell them on for huge fees.
We aspire to a lot of things but living within our means has not been one of them.The financial services industry has a duty to protect consumers and this whole debacle shows that it cannot be trusted to run its own house by self regulation. When bank CEOs ask for or even get a bonus, defies logic. Are they that apathetic, do they really understand what is going on? Or do they just see this is as another downturn in the market, there have been bad ones in the past, undoubtedly more to follow, but at the end of the day, banks will always be there.

[research]

It's the CDS and CDO's. Look it up, or check my profile for links.

Blaming homeowners is like blaming a sick horse for millions lost betting on the horse

off track.

[Erdgeist]

This is the part that for me becomes fuzzy:

"2.) In order for the US economy to grow it must have a continual supply of new credit. A leveling off is just as hazardous as a decline."

I guess what this means is that countries which buy a lot of U.S. debt like Japan, China, and the UK need to buy more because we want to spend & import more than we save & export leading to a burgeoning trade deficit, not to mention a huge national debt which we have to service.

It seems to me that the logical way out of this is to up tariffs on various kinds of imported goods until we begin to manufacture and export more than we import. This would have the added benefit of creating *real jobs* and not just service sector jobs like being a janitor or a pizza delivery boy. In addition, I think we need to bring back the 90% tax bracket on all incomes over what the POTUS makes and cut military spending in half.

[DuganS1]

Initiating tariffs would bring a much larger global meltdown then we've experienced already. The policy of the Bush administration has been to devalue the dollar to correct the trade balance. This created the recent export boom which ran from early 2005 to August 2008. I think we need to devalue more among other things. As for the 90% tax bracket on income over POTUS, the problem is that the salary of POTUS in many metro areas makes you only upper-middle class. I do agree that a new tax bracket should be created for ultra-high earnings, probably over a million at a rate of say 50%. The 90% rate for those over $400,000 would dry up investment and sink us right into a depression.

[William1950]

the export boom??? our largest export has been DEBT. How can one make money selling DEBT? that is what has happened and it gets reported as GDP ... Debt.
And as far as taxes go... We need to have a flat tax. 10% with ZERO deductions and ZERO exemptions, and the first $25,000 free...

[leftLibertarian]

While there is a crisis, it is not up to the taxpayers to bail out financial institutions that were poorly run.

Let Them Fail.

[hey0there]

and eat cake!

[dobberdoss]

Amen again. see reason above for why that did not happen

[Robert59]

Hale,

Methinks you're advancing an argument, but muddying it by not breaking out demand for loans and credit available to lend. Each day I receive two to three letters from various institutions asking me to refinance my house, asking me to open up a home equity line of credit, asking me to sign up for a credit card. And it's not just me, but all my friends, neighbors, and coworkers. It's difficult for me to believe there is a credit crunch.

I don't doubt there's been a drop off in demand for loans as my same bubble relay the same thing; they aren't making purchases requiring financing.

Where is the proof the credit lines were about to freeze? We've heard about it, but have we seen it?
I tend to believe we were punked. The Fed stepped in when it became clear banks didn't trust other banks. The LIBOR rate went way up and now it's come way down. The reason it's come down is because we are using tax dollars given to banks (either in direct infusions under TARP or through the Fed when it loans money) who are now able to pay their debts whenever there is a call,

The Minneapolis Fed is right. The bigger question is why Bush and company aren't advocating the same medicine for the finance sector they are demanding of the Big 3? Could it be because one industry is viewed as the friend of the Repubican Party and the other isn't?

[DuganS1]

Receiving letters/advertisements in the mail and actually getting a loan from the bank are two entirely different things. There is plenty of anecdotal evidence in the Beige book of consumers and businesses having difficulty getting financing - car dealerships, in particular, have had trouble getting consumers financed.

[Robert59]

I'm well aware they are two separate things, but everyone I know who is still employed and making their payments is being inundated with mailers asking them to take on more debt.

With regards to anecdotal evidence in the Beige Book, of course car dealerships are going to have a hard time accessing credit; it's not because credit is tight, but because they are poor credit risks (30 to 50 percent reduction in car sales this year). I suspect homebuilders would be having the same problem accessing credit.

The only hiccup I experienced was getting a parent loan for one of my college age children. That had nothing to do with credit being clogged, but banks wanting a better return on the loan. The government caps the interest rate. Fortunately enough pressure was put on them they started loaning money again.

Car dealerships having trouble getting consumers financed? I haven't seen it. Now GMAC might be reluctant to finance, but that's because they made so many bad investments in the housing industry.

[rlugbill]

Yes, there is a crisis. The root of the problem was that the government was bought out by large financial interests and the government let the banks operate without proper regulation. So, the solution is not to continue this government in bed with banks thing we've got going, but to do the opposite. Get the government back to its business of regulating banks and financial institutions, not enabling them.

All that has happened is that the banks are being bailed out instead of the people who live in the houses. All they would have to do is for the government to guarantee the loans if the bank agreed not to foreclose, and keep the people in their homes with the interest piling up, the way student loans do when someone is in financial difficulty. The people could pay what they could and when they sold the house, the mortgage would still be a lien on the house and the bank would eventually get their money back.

Instead, they waste lots of money on lawyers, remodeling, realtors, etc. by forcing people out of their homes and end up with homes that are very low in value. The banks go for the lose-lose solution when they foreclose. And the government encourages this practice.

[Thermodynamics]

Hale Stewart is saying that yes, we really do have our paw in the bear trap. The problem is that there should not be any bear trap. We are bailing out organizations that made enormous profits and then got into deep debt using leveraged trading. If we do not bail them out they will sink us by draining all available credit. Your credit card won't even work.

I really do think there are other ways to handle this problem, but not while Bush is in office. It would require some extraordinary legal actions like the moratoriums on mortgages in the 30s. The objective would be to isolate the bad securities from the credit markets. Paulson has not even asked to have this done. In that sense we have been punked.

Also see David Dana
http://www.huffingtonpost.com/david-dana/the-feudal-mistake_b_149377.html

[Robert59]

What Mr. Dana wrote I've been saying for months. Glad to hear I'm not alone.