Zombie Banks and other reasons why Financial Intermediaries Fail

Here’s Four Reasons Financial Intermediaries Fail the latest video from our Principles of Macroeconomics class at Marginal Revolution University.

As always, these videos go great with our superb textbook, Modern Principles of Economics, but they can be used with any textbook. In fact, if you teach economics and want to incorporate video into any of your classes then check out our syllabus service. Just drop our instructional designer, Mary Clare Peate, an email and she will suggest some videos that map directly to your syllabus.

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Dear Alex,

Can we use your videos in our high school classes or is it only alloud for college courses?

thank you,
Miguel

Absolutely! Free to use for anyone!

Nothing on good old-fashioned credit losses? Or interest rate mismatch?

In the US since 1933 (FDIC established), approximately 99% (failures numbers and total assets) of bank failures were results of unsustainably large loan losses which caused insolvencies. The huge interest rate mismatches (long-term fixed loans funded with short-term adjustable deposits and 20% prime rates) of the late 1970's/early 1980's caused a crisis. The S&L regulator's (Federal Home Loan Bank Board) untoward reaction (deferred loss accounting, phoenix banks, appraised/noncash capital, additional lending authority - commercial RE, too rapid asset/loan growth, etc.) resulted in S&L's attempting to excessively grow and lend their way out of trouble. That exponentially increased the losses to taxpayers when in 1989 the FDIC and Resolution Trust Corporation were called upon to resolve.

Go easy on the prof. He's an intellectual. The video instructs on high-level theories and concepts mainly covering non-US economic and political pathologies, and seemed to have little to do with the US banking system, which isn't perfect but is not utterly dysfunctional.

For instance, US property rights/commercial law (contracts) are among its economic strengths. Since the 1970's, the US quietly embraced a number of the depicted pathologies. Sadly, when banking crises, like 2008, strike they blame the usual suspects markets, insufficient regulation, inadequate capital, etc.

.

It seems to me like MRU is conflating reasons what financial intermediation might not work well with reasons that specific financial intermediaries fail. The former is about institutions, the latter is about runs but also credit losses, trading losses, liquidity, etc.

"The former is about institutions, the latter is about runs but also credit losses, trading losses, liquidity, etc"

& fraud

http://www.peakprosperity.com/podcast/82001/bill-black-our-system-so-flawed-fraud-mathematically-guaranteed

In the adage, "Can't see the forest for the trees." I am the "trees" kind of guy.

"Fraud" may be an apt descriptor for much of what went on in the run-up to the recent banking crisis.

But, it was the type that likely couldn't be subject to criminal prosecution. One, it was too widespread. There aren't sufficient FBI agents, judges, juries or court rooms. Two, it would be difficult to prove the criteria for guilty verdicts.

An avenue of corrective/preventive actions and an explanation of causes would be systemic, unacceptable and unsatisfactory breakdowns/disregard for internal controls over financial reporting. See Federal statutes, e.g. FDICIA, and The Treadway Commission of Sponsoring Organizations' (COSO) Internal Control Framework literature. Among the five or six major titles is the first and most important "Control Environment" wherein ethics and excellence are set at the top (board of directors) levels and strictly enforced throughout the financial institutions' organizations.

I tend to favor subsidizing clean up crews to remove the remains from the sidewalk after they jump out the window.

Seriously, rules and laws are for the honest people. When the potential gains of fraud are high enough that only a fool would turn away, massive and widespread fraud is what you get. And regulators and politicians will get into the act.

Free markets correct by destruction. If destruction is not allowed to happen, you don't have a free market. And over time the market tends to resemble the planned economies that failed miserably last century.

"But, it was the type that likely couldn’t be subject to criminal prosecution. One, it was too widespread. There aren’t sufficient FBI agents, judges, juries or court rooms. Two, it would be difficult to prove the criteria for guilty verdicts" [SNIP]

Ahh, yes, the 'we didn't see it coming' excuse.*

From fraudulent conveyance of schite MBS to pension funds by the biggest banks to illegally repossessing homes of hapless homeowners http://www.nytimes.com/2016/05/15/books/review/chain-of-title-by-david-dayen.html.

And captured regulators and a fully fledged crime syndicate member as AG of the United States https://theintercept.com/2016/07/12/eric-holders-longtime-excuse-for-not-prosecuting-banks-just-crashed-and-burned/. who didn't even ARRAIGN a single bank executive over two terms in office.

Whocouldanode, right H?

UPSHOT: your argument is weak as piss.

* it would have helped if the bumbling Prez in 2004 hadn't 'reallocated' 1500 FBI agents from housing fraud [the FBI came to HIM] to the 'War on Terror'.

That's ignorant Bernie buffoonery. Under what specific federal legal authority could a decent case have been prosecuted? (And no, financial dealings with terrorist organizations and bank secrecy issues, which you wanted the president to spend fewer resources on, do not count).

carlospin:

You're still, ten years later, pretty upset, eh?

There were many causes, including fraud. But, solely fraud would not have caused such widespread damage.

Locking people up may be "sexy." But, it doesn't correct the damage or prevent future crimes. Deterrence goes only do far.

In the early 1980's, during the ag/oil patch crisis, many banks were closed and the FDIC was named receiver. At each closing, the FBI instituted investigations. But, the real work was paying the insured depositors and beginning the arduous work of collecting on bank assets to minimize the losses to the FDI fund.
Do you believe that Dodd-Frank will prevent a recurrence?

Not to worry. In 2006 I would have gotten a mortgage loan in two weeks. In 2013, I obtained a mortgage, home loan after having undergone a financial body-cavity search that took two months. FYI the loan-to-value was 56% - big down payment.

When everyone is making "big money," no one listens.

The "frauds" could not have been perpetrated without the excess liquidity and lax lending standards promoted by Fed, FDIC, FNMA, FHLMC, GNMA, HUD, FHA, CRA, etc.

The institutional buyers of them fraud MBS knew that they contained teaser-rate; low-doc, no-doc; negative amortization; Alt-A; NINJA, etc. features. Like every-irrational-body else, at the time, the "fraud" MBS buyers "believed" that RE prices always skyrocket and they needed to get in on the action.

Many of the loans comprising your fraud MBS were originated by others than the packagers of said fraud MBS.

One reason them MBS were "frauds" was because numerous applicants supplied fraudulent info, e.g., stating the RE was the borrower's primary residence when it was RE speculation: I know of a case in a pool wherein one speculator had six loans listed as primary RS.

H, mate we're in heated agreement regarding many of your points in your intelligent response, e.g. the hideous Frank 'n Dodd legislation & the fecklessness of Fannie/Freddie & Bush's program for boosting minority home ownership [leave Sheila Bair out of it]. But, may I remind you that the S&L disaster of the late eighties had @ its root an epidemic of control fraud [which Bill Black, linked to above, went after with singular tenacity. Remember the Lincoln S&L in AZ? Strangely enough, Black was kept on a v short choke chain following the mortgage origination catastrophe of the early 'oughts] https://www.amazon.com/Best-Way-Rob-Bank-Own/dp/0292754183

"The institutional buyers of them fraud MBS knew that they contained teaser-rate; low-doc, no-doc; negative amortization; Alt-A; NINJA, etc. features". Local councils in Norway & Australia [where I live] certainly didn't, nor did many pension funds, e.g. State Super, the NSW Gov't Employees Pension Fund [$38B in assets & in the top 100 globally]. Their investment mandates compelled them to purchase these assets precisely BECAUSE of their historical safety, investment performance & liquidity. To assume otherwise is glib and elides the fundamental problem of lying, fraud & deceit, aberrations of which you seem strangely comfortable.

"Deterrence only goes so far'. Mate, this weaker than piss. Although the Keating Five skated, https://en.wikipedia.org/wiki/Keating_Five Keating himself was convicted and sentenced to ten years imprisonment.
Allow me to connect the dots for you: deterrence works.

Last, to your shopworn trope of 'It was the loan applicants wot did it'. Tip for young players: its the financial institution that makes the credit decision. Outsourcing responsibility to shonky hairdressers turned loan originators doesn't absolve them of responsibility.

As to your recent cavity search, I am sorry for your humiliation and loss.

Perhaps if there WAS diligent investigation, arraignment, trials, convictions and robust sentencing of wholesale criminal behavior in the banking sector, your dignity would have remained intact.

Fantastic videos! I am going to watch all of them.

Kinda funny to see usury laws and negative interest rates on the same page .. but it is also a pretty pre-behavioral view, that usurious rates go to efficient allocation of capital.

Another fantastic video. Well done.

Kudos guys on producing excellent bite sized videos.

Another excellent video. A couple of points about Japan:

1) The graph in the video that shows GDP per capita starting from 1950 is a common representation of Japan's rapid growth period (usually considered to have been from around 1953 to 1973) , which shows the "economic miracle" but a graph in David Flath's text on Japan's economy shows available on "look - inside" at Amazon in chapter 3 shows that growth was strong before World War II put a screeching halt to that. Japan's GDP per capita would have probably been about the same today had there not been the Pacific War.

2) Japanese banks were cleaned up over time from the Koizumi era. Interestingly, Japan's GDP per capita growth from 2000 to 2015 has been the same as U.S. per capita growth yet economists (Summers, etc) and business journalists usually spoke of (and still speak of) Japan as the sluggish growth straggler.

3) Actually, Japan's U.S. GDP per capita growth has been the same as U.S. GDP per capita growth from 1991 with one important 5 year exception when the U.S. grew strongly from 1995 to 1999 while Japan struggled after the 1997 Asian financial crisis.

(edit: that should be: "Actually, Japan's GDP per capita growth has been the same as U.S. per capita growth..."

I always get excited when I see the word "zombie" no matter the issue being discussed :).

To me it seems that debt is only important for 2 purposes. To allow some businesses, with better ways of doing things, to grow faster and to move some consumption to earlier in life when you can enjoy it more. The first could be replaces with equity and latter is becomeing less neccessary due to smaller families.

So could an economy, after an adjustment period, have almost no debt but good growth?

I'm always put off by statements like "there are four ways that..." Did you prove from some set of axioms that there are exactly four? Or did you just think of four? (Whenever Haidt lectures on the five moral senses, I wish he would clarify whether the 5 came from a robust principal component analysis, or he just thought them up and then worked out questions sensitive to each.)

Also, your "insecure property rights" section only mentions the insecure rights of savers, but as de Soto has shown, insecure property rights of borrowers are an extremely important effect in the third world that hinders their ability to offer collateral and profit from capital improvements.

Whenever Haidt lectures on the five moral senses, I wish he would clarify whether the 5 came from a robust principal component analysis, or he just thought them up and then worked out questions sensitive to each.

Especially now that he has six moral foundations. Maybe there are 8, or 12, or...

The guy in the pic looks like Tyler. Is he actually a zombie?
:-)

Not much here about why some countries never get going for lack of credit and financial intermediation, which is suggested to be forthcoming at the beginning. Some suggestions which fall outside of the four issues discussed:
-excessive taxes on loan / debt security originations and excessive fees and taxes for security registrations and asset transfers
-restrictions or outright prohibitions on ability to provide security due to paternalism and lack of elite confidence in non-elites
-restrictions on fee simple title to realty
-poor security enforcement regimes and misguided bankruptcy laws which unduly preserve equity and unsecured positions

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