This is part III of our Unintended Consequences/Counter-factual series; part one on Chrysler is here; part II on Long Term Capital Management is here.
Coming soon to BusinessWeek: Recalling a better way to rescue economies in crisis…
Barely a decade after LTCM imploded, the U.S. was in the midst of the worst financial crisis since the Great Depression. (I discuss the causes of the 2008-09 crisis in my book “Bailout Nation”). Unlike the massive fiscal response which alleviated the worst effects of the Great Depression, the response to the GFC was light on fiscal stimulus – and heavy on monetary policy.
Each era responds to crises in their own and different ways. These all eventually lead to differing unintended consequences.
In response to the Great Depression, a huge fiscal stimulus aka the New Deal of the 1930s was introduced: New institutions were created, new regulations were put into place, and new public works programs were enacted. The government created millions of new jobs, but there was a massive increase in the size and scope of the national bureaucracy and policy apparatus. The national debt scaled up with these increases as well. The SEC, FDIC, BLS were just some of the federal agencies to come out of that era.
In response to the Great Recession, we saw a very different set of programs, primarily monetary based, versus fiscal. Post-financial crisis, these policies resulted in a different set of unintended consequences. After billions were spent rescuing the banking sector, the Federal Reserve wanted to avoid insolvencies to ensure those billions were not wasted. (A little “sunk cost fallacy” perhaps?) The banks still held millions of mortgages in danger of defaulting; many had teaser rates that automatically reset as rates rose.1 What the banks needed were low and steady rates – and some time to let the real estate market recover, and for people to stop defaulting on their mortgages. So the Fed took rates down to zero (aka Zero Interest Rate Policy or ZIRP), a policy decision that helped banks manage all of those crappy real estate loans on their books
ZIRP made for very low mortgage rates. As real estate prices gradually recovered, so too did the banks’ assets slowly recover, helping to improve their balance sheets. One of the Unintended Consequences of this mostly monetary rescue was that it greatly benefitted the wealth of capital holders; this widened both wealth and income inequality. Owners of prime real estate, both commercial and residential, watched the value of their properties recover. By 2016, the Case-Shiller U.S. National Home Price Index passed its pre-crisis peak. Former homeowners 2 whose credit scores were damaged became renters. With many fewer home buyers in the market, Multi-family property units soared in price, as did rents.
Same with equity investors: From the March 2009 lows of 666 on the S&P 500 Index, the market tripled over the next 5 years. Even post-Covid Crash, the index is still worth 4X what is was during 2009. (For more details on the topic, see prior discussions here, here, here, and here; for graphics see this, this, this, this, this, and this).
Bottom line: The Fed disproportionately benefited people with risk capital.3
Sometimes, the unintended consequences lead to very unanticipated places. The rise of popularism here and around the world, but we see it in the reaction to the weak fiscal response, and the overly generous bailouts terms for banks and other companies. Some analysts even claim the Great Financial Crisis is is impacting our response to the current pandemic.
Consider the counterfactual: What would have occurred had we not bailed out banks? What might America look like today if instead of a finance rescuing monetary stimulus, there was a more traditional fiscal stimulus?
Start with a run of bankruptcies for large finance firms. Perhaps the most illustrative would be a chapter 11 reorganization of Bank America. In the reorg, the company shareholders get wiped out, and the firm’s creditors – namely the holders of its bonds – become the owners. To satisfy the prior debts, the piece get unwound: Bank America gets spun out as a clean debt-free banking entity. Merrill Lynch similarly is spun out as an Investment Bank/Broker, free from its heavy liabilities. Countrywide, one of the largest underwriters of subprime mortgages, is also spun out. Then all of the bad assets are put up for sale, where they generate a return of about 20-30 cents on the dollar (I like to say there are no such things as toxic assets – only toxic prices).
We could have done this with all of the major financial institutions that were in trouble in 2008, from Citigroup on downwards. What you end up with – after a lot of pain – is a healthier, better capitalized, less concentrated banking sector. But the immediate result likely would have been a market that fell even further — maybe S&P500 towards a low near 500 and Dow Industrials towards ~5,000. The reorganization of so much of the banking sector finally spurs congress into a fiscal stimulus. A giant infrastructure plan is passed, along with new funding for subsiding community colleges and creating a new peace corps. Out of this comes some decent middle-class jobs.
Beyond the healthier banks, the Fed no longer has a need for its ZIRP policy. This huge driver of inequality would not have generated a massive wealth gap working for capital owners, with labor left behind.
We experience the world as a series of probabilistic outcomes, most of which could have come out very differently. Investors should be cautious about explaining what happens by only looking at results. Instead, always consider the counterfactual. It often tells more than the facts themselves.
American-Style Capitalism is a Joint Venture (March 11, 2020)
Wealth Distribution Analysis (July 18, 2019)
History of the Wealth Gap in Europe and America (November 17, 2014)
1. “Jingle mail” described the practice of mailing your house keys to the bank instead of a mortgage payment. These voluntary defaults were becoming increasingly common once people figured out their houses were worth a fraction of the mortgage. They could rent the same house down the street for half the monthly cost.
2. Housing and bank analyst Josh Rosner described these homeowners as “renters with an option to default.”
3. Household Wealth Trends in the United States, 1962 to 2016: Has Middle Class Wealth Recovered? By Edward N. Wolff NBER Working Paper No. 24085 November 2017 https://www.nber.org/papers/w24085