No, it’s not centers of sub-prime madness like Arizona or Nevada. Nor is it big states like California or Florida. It’s Georgia. And Illinois is second. Check out the graph in this link:
There is a good reason why most bank failures in 2009 did not occur in the sub-prime states; sub-prime loans were not the main problem. Indeed mortgages of all types were not the main problem. What was? According to McNewspaper USA Today it was construction loans, often for commercial real estate:
The biggest bank killer around isn’t some exotic derivative investment concocted by Wall Street’s financial alchemists. It’s the plain old construction loan, Main Street banks’ bread and butter for decades.
Deutsche Bank has called them “without doubt, the riskiest commercial real estate loan product.” The Congressional Oversight Panel, a financial watchdog, has warned that construction loans have deteriorated faster and inflicted bigger losses on banks than any other real estate loans.
That’s right, everything we were told about the financial crisis in 2009 (and which I also believed for a while) is wrong. It’s a commercial RE crisis, not a mortgage crisis. You might argue that it was housing loans that triggered the liquidity crisis of late 2008. Yes, but the crash of late 2008 was caused by the Fed’s failure to do level targeting once rates hit zero. The main public policy issue with bank failures is the cost to taxpayers, not the impact on the business cycle.
In earlier posts I argued that the commercial real estate market does not appear to have been a bubble. It held up very well in late 2006 and 2007, even as residential housing was falling almost continuously. Only when NGDP growth slowed in 2008, did commercial real estate begin a significant decline. No big surprise there, commercial real estate is extremely sensitive to falls in NGDP produced by excessively tight money. The same problem hit commercial RE in the 1930s, when NGDP fell in half. There are stories of the Empire State Building being mostly empty after it opened in 1931.
Why were all those bad commercial real estate loans made? After all, shouldn’t banks take into account the risk of recession? Well nobody could have expected NGDP to suddenly fall 8% below trend. But even so, there clearly is a problem here. Indeed it appears that our current banking crisis, which was initially thought to be very different from the 1980s S&L fiasco, was almost an exact replay of that earlier crash. Initially we were told that the big banks were the problem this time–it was all about “Too-Big-to-Fail.” But they have been quietly repaying their TARP loans. Even the worst banking fiasco in nearly 80 years will not result in taxpayer money being permanently transferred to big banks. Even if you include the AIG bailout as an implicit bailout of the big banks, the small banks are still the main problem. Our government insurance company let’s smaller banks run wild, just as in the 1980s (i.e. before the so-called “regulatory reforms” that were supposed to fix the S&L problem.) The cost to FDIC of all these smaller bank failures in places like Georgia will be many times larger than the net cost of AIG plus the banking part of the TARP bailout. And let’s not even talk about the cost of bailing out the GSEs.
It’s not about big banks and it’s not about derivatives:
It did not end well. Construction loans started blowing up when the real estate market collapsed and the economy tumbled into recession. The 10 biggest banks, facing problems of their own with subprime mortgages, were largely immune to the deterioration in construction loans, which accounted for just 2% of their assets in 2007, according to the Federal Reserve. By contrast, construction loans accounted for more than 10% of assets at banks that didn’t rank in the top 1,000. “What’s causing the problem is Main Street America, the construction loan made by the bank down the street,” says Bill Bartmann, who owns a debt advisory firm. “They built, and nobody came.”
Making matters worse: Community banks never sold the construction loans to investors the way banks unload auto loans and residential mortgages. “Most construction loans are so unique, so different, so non-homogenous, that you can’t securitize them,” Bartmann says. “They were kept on the books of the banks that originated them.” And there, many of them started to turn rotten.
Here’s an example of what banks did in Georgia:
Rollo Ingram witnessed one spectacular flameout up close. He was chief financial officer at Atlanta’s RockBridge Commercial Bank, which opened in 2006, backed by other members of the city’s business elite.
RockBridge told banking regulators it planned to specialize in business lending. It didn’t, plunging instead into real estate and construction loans. The bank told regulators in 2006 that construction loans would account for 5% of its portfolio. By the end of 2007, they accounted for 42%. Business loans, which were supposed to make up 50% of RockBridge’s lending, came to just 28%, according to an after-the-fact autopsy by Federal Deposit Insurance Corp.’s inspector general.
Nor did RockBridge recruit veteran loan officers with enough experience to safely assemble its risky portfolio, the inspector general concluded. “They hired younger, less-experienced ones, and didn’t hire enough of them,” Ingram says. He says he was forced out in 2008 when he complained about the risky direction the bank was taking.
Those on the left complained the banking crisis resulted from “laissez-faire,” forgetting that the federal government effectively nationalized most of the liabilities of the banking system in 1934. That’s right; when you deposit $100 in your bank account you are actually lending the money to Uncle Sam, who re-lends it at the same rate to the bank. FDIC is effectively a government institution, and the fees on banks are effectively taxes, which of course are passed onto the public. The government didn’t seem to care that wildcat banks in Georgia colluded with property speculators and ran wild with government loans made at risk free rates.
But some on the right were arguably even worse, not paying enough attention to this problem and constantly harping on the need for “deregulation,” aka the doctrine of “business should be free of regulations that inhibit their ability to loot the Treasury.”
I’m amazed that after the S&L fiasco of the 1980s our government wasn’t able to figure out the problem. Or maybe they do understand the problem, but are in the pocket of property developers.
And of course now if someone proposed a crackdown, there’d be complaints about how it would “starve the economy of capital, and slow the recovery.” Just one more side-effect that results when hawks at the Fed prevent an adequate recovery in NGDP.
Update: I just saw an example of the “blame it all on laissez-faire” meme discussed in Arnold Kling’s blog. And Barry Eichengreen isn’t even very left wing.