I enjoy the topic of debt but the more time I spend staring at it the more frustrating the framing around it seems.
Modern loans don't work the way a classic model of lending would suggest. That has implications - loans represent a redistribution of real-world resources away from people who have worked for them and towards people who the banks like.
This is a very concerning dynamic given that the 2007-2008 era financial crisis revealed that the bankers are incompetent at assessing risk. They should not be the ones choosing who gets a home or who gets to succeed in business. There is an ongoing trend where people in credit exposed markets (housing, other assets) are raking in unreasonable returns at a lower-than-advertised risk as more and more easy credit is created. It isn't fair or clever.
> the 2007-2008 era financial crisis revealed that the bankers are incompetent at assessing risk
I think we need the inverse of Hanlon's razor[0] to be a thing. "Never attribute to stupidity that which can be adequately explained by systemic incentives promoting malice." A Hanlon's handgun, if you like.
What I remember from reading about the 2008 financial crisis isn't that bankers were incompetent. It's that various parties started packaging up financial instruments to make them look like less risky instruments, so that they could be sold to suckers. Then they insured themselves against those instruments blowing up. This suggests they knew well what they were doing.
In fact, banks aren't in the business of assessing risk. They're in the business of making money, which they often do through assessing risk. The important point is that assessing risk (or giving loans, or mortgages, etc.) isn't their raison d'etre, but a way to make money they've specialized in. If there's a way to make easy money by doing something else entirely, or by compromising their core competence, there are strong economic incentives to do that.
This applies to all other companies doing anything else as well. There's few organizations that consider doing things they do well as a terminal value; usually, it's only instrumental in getting money. That's something IMO we have to keep in mind if we're trying to make accurate predictions of future behavior of a company.
The loan packaging and insurance was a symptom of the underlying problem that drove the 2008 crisis: transatlantic transactions that worked to evade regulations to control systematic risk.
This process started, if you had to pick a place, with a US bank issuing a mortgage. The cash part eventually wound its way to various short-term "risk-free" assets, one of which being short-term asset-backed loans to European financial institutions. The mortgage asset got packaged up and sold on to the broader capital markets, of which European financial institutions participated. So, the US banking system basically created a market in which European financial institutions could buy mortgage-backed paper, financing the purchase at good short-term rates generated by the cash created by issuing the backing mortgages.
Of course, banking regulators know that just letting banks go hog-wild creating asset-liability pairs is going to end up badly, so this is where the regulatory arbitrage comes in. Under US banking regulations, banks had limits to the assets on their books. There's a strong incentive to offload them into the capital markets - the banks realize an immediate profit, and clear out valuable space on their balance sheet. European banks, on the other hand, had a more complex leverage limits that took into account the perceived riskiness of various assets that they owned, with AAA-rated assets giving the highest leverage limits.
So that, in a nutshell, is what happened in the run-up to 2008. Banks generate more profits when they create more risk, so there's regulatory limits on risks. US banks evaded those risk limits by selling the risk on to the capital markets, and US regulators assumed that this process was systematically safe. EU banks evaded those risk limits by blindly levering up to buy whatever AAA-rated dollar-denominated assets the US capital markets handed to them, and EU regulators assumed that high leverage on AAA-rated assets was systematically safe. Neither regulatory regime had a good holistic view of the financial asset vortex brewing in the Atlantic.
Anyhow, my overall point is "so that they could be sold to suckers" doesn't really tell the entire story. The asset packaging was done in order to take as much risk as possible under US and EU banking regulations, taking advantage of transatlantic differences in regulatory regimes.
Thanks for a much more detailed account of the crisis. Yes, I simplified in my post, but your more complex story still doesn't read to me as "people were being incompetent"; I see in it a tale of a complex system getting exploited in several different places at the same time, and shaking itself apart in the process.
Entirely tangential: the first time I saw your handle here several years ago, I initially misread it as "trust vectoring" (don't know why, I knew of the term "thrust vectoring" before). Ever since, this phrase stuck with me, and I feel it applies to the 2008 crisis.
I think that still is more or less a polite way of saying that American banks found suckers in Düsseldorf and Frankfurt to sell to. Sometimes in multiple steps: First sell to Deutsche Bank, they sell to suckers in Düsseldorf.
There was also plenty of domestic mortgage over-expansion; Anglo-Irish blew up by lending to far too many speculative property projects. The book on this is excellent.
I remember talking to people involved in those kind of projects at the time and even they noted that Anglo-Irish never seemed to turn down an opportunity to lend money.
Don't forget the part where the ratings agencies systematically failed to accurately assess the riskiness of the MBSs because they didn't want to piss off their customers (the banks / their mortgage issuance wings).
All financial crises have a common trait: A few smart people exploiting the market.
The smart people in the 2008 crisis were those who had been bundling CDOs to hide the bad debt in the decades before, as well as those who insured themselves against the blowup _knowing that it would blow up_.
They _depended_ upon the majority of financial institutions believing the lie that the property market would never crash.
That's the stupidity in Hanlon's Razor for the 2008 crisis, exploited by the few smart ones.
I was just a few of years out of school,I think it was 2006. Walked into a local bank branch to get some stuff sorted out.The women tried to sell me some private pension scheme,which was popular at the time.I asked her what would happen if the bank would fail,to which she responded with uncontrollable laughter and finally managed to say: banks don't fail. Well,I thought, I'm sure as hell I won't be buying products from this bank..We all know what happened 2 years later.
While this person obviously didn't empathize with your concerns, it should be mentioned that bank tellers are often under pressure from higher ups to sell products to walk-in customers, regardless of whether they need them or not. And the easiest way to sell is to basically tell the customers that their concerns aren't valid.
The most egregious example of this is the Wells Fargo scandal, where new accounts were created for customers without their knowledge [1]. Similar complaints can be found with pretty much all major banks. It's a natural consequence of a culture where employees are ordered to upsell customers on lines of credit, new credit cards, and other financial products.
>It's that various parties started packaging up financial instruments to make them look like less risky instruments, so that they could be sold to suckers.
This was enabled by fraud. At the root of it were the people fraudulently stating borrowers had incomes higher than they really were.
I would say that was a symptom rather than a cause - once people stopped caring about the quality of mortgages (because they would be sold off and packaged up and sold on) it was pretty much inevitable that this would happen.
They can’t be sold off if they never passed the underwriting tests in the first place. Intentionally not verifying incomes and/or fraudulently staying higher incomes is what allowed for plausible deniability to rate them higher than they should have been.
>What I remember from reading about the 2008 financial crisis isn't that bankers were incompetent. It's that various parties started packaging up financial instruments to make them look like less risky instruments, so that they could be sold to suckers.
First of all, I disagree: I think risk mispricing ("House prices can't fall across the country"), or incompetence, was the big problem.
But suckers get suckered every day. If big money-runners can't be bothered to understand what they are buying, I don't feel sorry for them.
>Then they insured themselves against those instruments blowing up.
This is standard financial practice. Why would they hold a huge, one-sided bet on the housing market on their books?
Didn't AIG end up on the wrong end of a vast quantity of that "insurance" - which turned out well (it certainly turned out splendidly well for the AIG employees selling the stuff).
Incompetence played a large role. I knew a couple of people who were interning at investment banks at the start of the financial crisis. The banks had absolutely no idea who owned each piece of the synthetic instruments - including the underlying collateral - that were on their books. Keep in mind that the insurance wasn't there to protect themselves - it was there to ensure that the product would receive an AAA credit rating - which made it palpitate to institutional investors who were restricted from purchasing or otherwise stayed away from riskier assets. It turns out that you can't accurately insure (or price) instruments when you don't have some knowledge of the thing that secures the instrument.
Seems to me if the banks piled up a bunch of junk, didn't track who owned what, took advantage of the lack of bad information to make crap insurance look just good enough to fool the ratings agencies, and sold the resulting AAA-rated instruments for AAA prices, then the banks did a perfectly competent job making money for themselves.
The ratings agencies did a bad job, but that doesn't mean they weren't able to do better. They make more money doing a bad job so that's what they did.
The real incompetents were the investors, but the whole system was telling them they didn't need to be competent, that's what the ratings agencies were for.
The real incompetents are the developers of the system. It's clearly optimised to create the illusion of useful business activity out of bad-faith value manipulation and outright market fraud.
Of course they're not considered incompetent if they personally do well out of it. So perhaps the real problem is more systemic.
The behaviour of ratings agencies is very well depicted in 'Big Short', which essentially says that if one company won't do it, other will always agree to issue AAA rates.
The underlying individual assets didn't really turn out to be poorly rated. The problem was they assumed a low-level of correlation between the risk of individual assets. Basically, they believed default risk for a house in Milwaukee essentially an independent variable compared to default risk in South Carolina. They made that assumption because there had never been a nationwide (or global really) housing crash.
That assumption actually drove nationwide demand for mortgages, which lowered rates, thereby creating the correlation they assumed didn't exist.
Corporate debt is a very different animal from consumer debt. In the current environment of very low rates, it is often cheaper/prudent for a corporation to take on debt rather than use its cash. See Apple, who has ~100B in corporate debt outstanding. For them it was cheaper to pay dividends and do share buybacks using debt than to take a hit repatriating cash at that time.
Corporate debt is so cheap now, that it is also often better to issue more bonds than to do any public offering. Giving away ownership is probably the most expensive form of financing long term.
Finally, as a percentage of GDP 10T just isn't very interesting. It's akin to the 500 point market swing headlines, and uses large numbers to make it sound more exciting.
This comment gets it. I think it's disingenuous and borderline immoral to use a big number to drum up sensationalist panic without explaining how it even behaves or contextualizing what it exists inside of. People are reflexively going to complain about how it seems like 2008 all over again even though the beast is, as you say, entirely different.
10T is a huge number, but that's not the issue -- the issue is that as a percentage of GDB that's also at an all times high value.
It is like 2008 in the sense that a bubble popping (corporate debt this time) is forcing the FED to bailout irresponsible corporations yet again (see the recent balance sheet increase).
That's just a bit like saying when drug prices are so low it's ok to have a lot of overdoses, because, hey, people are taking advantage of those low drug prices.
If we entered a new era where such low interest rates are necessary for the "econony", great let's all accept this new fact.
However the interest rates were cut in 2008 so that elites could be bailed out, lest they default and drag everybody else and they were supposed to be brought back where they used to be; the central banks balance sheets were supposed to be brought back to where they were historically -- none of this has happened.
Nah, the interest rates being so low serve mostly the elites while propping up massive bubbles in financial markets, real-estate and big corporations too big to fail.
The central banks/states get to pick who is saved, involve themselves more and more in the economy and replace what should be regular market mechanisms and create huge systemic problems.
What's so wrong with savers receiving decent yields for their bank deposits?
Why should everybody all of a sudden use their savings to buy houses that they let?
Just so they can fuel the vicious bubble cycle of the de jour investment vehicle the elites have picked?
Why should central banks exchange money printed out of thin air with negative interest rates for ill performing bonds, locking in the profits of bond-holders?
The only answer is "because otherwise it will lead to cascading series of defaults that will bring down the economy" -- then the problem is the financialization of the economy and no actionable way of removing the bad apples from the basket, in which case we're allready in for a catastrophic failure of the current financial system when all the apples will go bad.
Yes, an all time high of ~47% which is ~1% over the last all time high. Not as big of a doomsday headline though. It also doesn't take into account that corporate profits are also at highs.
I'm not saying that continuing to increase corporate debt is necessarily good. But, the fear mongering of 10T alone without looking at the whole picture is disingenuous. A much better article with more of the picture is here.
Rates have been very low for a very long time, you would expect to all time high debt with current interest rates. It would be more concerning if people were not taking advantage of the essentially free money.
I'd be concerned if the idiots taking decisions and crashing the financial system when interest rates were at 5% were not severly punished and let loose when interest rates were at 0%, almost like an arsonist being put in charge of a gas station.
Oh wait, they weren't....
This is just like consumer debt. It's better to get a 3% mortgage and put all your cash in the stock market then to payoff your house. Not only do you get a higher return, but you save on taxes.
I think the difference is in the types. Mortgage debt can make sense assuming you're borrowing within your means to pay, but consumer debt also includes credit cards, auto loans, personal loans, and student loans that often have questionable financial logic behind them.
> loans represent a redistribution of real-world resources away from people who have worked for them and towards people who the banks like.
This is simple, appealing, and extremely misleading; loans are more a temporal redistribution of resources. You get something that you will have worked for before you do the work, but that doesn't really absolve you from getting the income to pay the loan back.
> They should not be the ones choosing who gets a home or who gets to succeed in business
Who should?
> There is an ongoing trend where people in credit exposed markets (housing, other assets) are raking in unreasonable returns at a lower-than-advertised risk as more and more easy credit is created.
It's not that the risk is lower, but it has become horribly correlated. All the homeowners win or lose together. Globalisation of the housing market as a "safe asset" makes the problem worse. Perhaps we need a crackdown on owner-non-occupiers like the Vancouver foreign purchasor tax.
Actually they do; banks can create new money. It is practically impossible to compete with an institution that can create new money when providing capital. It is called Fractional Reserve Banking and only licensed institutions can do it as far as I recall.
I'm not intimately familiar with US markets, being Australian, but the M2 suggests that half the money currently in existence was created since 2007. If whoever is creating that money doesn't have a stranglehold on providing capital they are going to, at a minimum, have massive influence. It is worth focusing in on, it may only be half the money in the system but that is actually a big deal.
I think you're talking about the ability of the federal reserve to print money and buy US treasures, thus increasing the money supply.
The thing is, US currency is global commodity and as such is subject to supply and demand forces. The Fed targets a 2% inflation rate, which strikes a nice balance.
If the currency appreciates, people will hord it and a currency bubble will cause major economic problems.
Just look at bit coin. It currently worth $20,000, no wait $10,000, no wait $17,000, no wait...
Now try to base a functioning economy on a commodity that has wild swings. It can't be done well.
To the extent this is true, anyone can create new money by extending credit - such as when issuing an invoice with delayed payment terms. There's a not-inconsiderable amount of money floating about in trade credit.
I dunno. Not politicians, not the people who were in the system around the last financial crisis and not their proteges. A local Plumber's Union for all I care, although I'm sure a market could find better alternatives if it were left alone to function. I suppose my assumption is that we should try a new community of people every time the current community causes a trillion dollars in damage. If my plumber caused a trillion dollars in damages I would consider going with a different plumber next time. The current crop of managers who get to decide what the financial system does are the only community of people (apart from politicians, maybe) where there is noncontroversial proof that they are likely to cause a trillion dollars of losses through poor decision making and bad models. When companies muck up that badly people should lose money, not get to drink from a money hose as in '08.
From Wikipedia [0]:
September 29, 2008: The House of Representatives rejected the Emergency Economic Stabilization Act of 2008 instituting the $700 billion Troubled Asset Relief Program. In response the Dow Jones dropped 777.68 points, its largest single-day decline.
^ That sort of thing is beyond stupid. That inhibits the capitalist system from properly bankrupting owners and purging incompetent managers. A 700 point market rises for the owners because taxpayers will fix things and all the managers will eventually get a bonus from having a positive impact on stock prices. This is the opposite of free market capitalism, and the fact that it happened over a short timeframe doesn't change its importance to the long term incentive structure of the system.
I'm going to draw an analogy with mortgages. Superficially someone who wants to own a home has the option of taking out a mortgage or not. However the 'no debt' option means you must find a home in a market where nobody else has access to a lender. The choices in any competitive market are basically to take on debt or bow out and rent. In a competitive market, the person who lends the money tips the scales and decides who gets resources - in this case a house.
So back to corporate debt; yes on the one hand investors choose to take on the debt. On the other hand, if they aren't willing to take on debt then the rational choice is more to bow out of the market than to put in long hours and compete. The alternative to debt is competitors that simply have more resources without having to work particularly hard for them. Much like taxi companies v. Uber - how do you compete with a company that from a profit perspective pays passengers to ride with them? Why do you compete? The short term answers to those questions are challenging. Only people who are willing to take on excessive debt for some other reason will be left after a few years. Or companies with a tolerance for pain.
I wouldn't have a problem with this dynamic except for the fact that the banks clearly have government backing and are only surviving because of it - if investors had control and had to bear the consequences of the bankers action there would have been profound changes after the last financial crisis instead of Quantitative Easing and a return to business as usual. There is substantial evidence that the people who control the money are very bad at what they do. They should be replaced with people who are, at a minimum, are an unknown quantity rather than legitimately incompetent.
I know technically all this debt is probably being purchased by retirement funds. But the major contributing reason the retirement funds are willing to buy such low quality trash is because the banks (and central banks) have been pumping money into the system to compete for anything that could possibly return a yield. Competition is usually a good thing, but competition by people who can literally print money is not helpful.
It's not a material amount vs overall outstanding market and a majority of the holdings are in higher quality, short-dated bonds that will likely be paid at maturity long before any credit stress is seen. Corporate treasurers are not in the risk taking business. They are squeezing out incremental yield from cash on hand.
The people that control the money is not bad what at what they do. It’s just that the incentives are wrong when the system is rigged so that either they win, or we lose.
> However the 'no debt' option means you must find a home in a market where nobody else has access to a lender.
Or you can have a lot more money to start with than the average home buyer; you only need equal access to financing if you also have equal access to cash.
No kidding. Pretty much anyone selling a property will pick a cash offer over a financed one, if nothing else to eliminate a long wait period for underwriting.
I think he means that given 2 people with the same amount of wealth, the one that borrows money can either buy a nicer house than you, or outbid you if you want the same house.
They assessed risk then sold their mortgages to third parties. How accurate do you figure their assessments were if they knew they wouldn’t hold that debt? Then the financial instruments created from that debt were valued by models trained on RE prices that grew for something like 8 years then tanked. So those same instruments grew then tanked. Nobody called them out on it because they hid the functioning behind models no one could really understand at the Fed.
> 2007-2008 era financial crisis revealed that the bankers are incompetent at assessing risk.
They are not incompetent at assessing risk. That is entirely their job.
It was that the government intervened in the housing market and to do so, assumed risk from the 1993 Clinton initiative to offer minorities access to mortgages and purchase their own homes.
Then how do you explain that at that time in Europe asset based finance (for things like car leases, trucks, boats etc.) changed from fairly rigid due diligence on the borrower to almost auto granting the loans?
Modern loans don't work the way a classic model of lending would suggest. That has implications - loans represent a redistribution of real-world resources away from people who have worked for them and towards people who the banks like.
This is a very concerning dynamic given that the 2007-2008 era financial crisis revealed that the bankers are incompetent at assessing risk. They should not be the ones choosing who gets a home or who gets to succeed in business. There is an ongoing trend where people in credit exposed markets (housing, other assets) are raking in unreasonable returns at a lower-than-advertised risk as more and more easy credit is created. It isn't fair or clever.