Savers shoulder the inevitable burden of bad loans
Britain’s new coalition government likes to remind voters we are all in this together. The phrase is rather glib. But in an important sense savers and borrowers around the world are finding the costs of reckless lending are falling on the innocent and guilty alike.
Few people this century will have experienced what it is like to turn up at their bank and be told they cannot withdraw deposited funds because the bank has “suspended” payments.
Suspension sounds harmless. But before the spread of deposit insurance, the word was enough to strike fear into the hearts of depositors, who risked losing much if not all their life savings, and being made to wait months or years for access to what remained.
Between 1930 and 1933, more than 9,000 banks across the United States were “suspended”, accounting for $6.9 billion or 15 percent of all deposits in the country, according to official figures. Behind those numbers are tales of misery for families, farmers and small businesses suddenly left without funds when their bank was suspended or collapsed forever.
So terrible was it, that even the threat of suspension could produce long lines of anxious depositors outside institutions trying to withdraw cash before the tellers closed their windows. In 1907, long lines marshaled by police formed outside the doors of the Knickerbocker Trust Company on New York’s Fifth Avenue as the depositors (“mostly small shopkeepers, mechanics and clerks”) tried to pre-empt suspension.
“Stacks of green currency, bound into thousand dollar lots, were piled on the counters beside the tellers. One by one these stacks were broached and they dwindled rapidly. Clerks went to the vaults from time to time with arms full of notes, piled up like bundles of kindling wood,” according to an account published by the Washington Post and reproduced in Robert Bruner and Sean Carr’s monograph “The Panic of 1907″.
“As the morning wore on many more depositors arrived carrying satchels, showing they were ready to carry off large amounts. One young man, with his hands trembling, stacked his trousers pockets full of one-hundred and twenty-dollar bills.”
Knickerbocker finally suspended that afternoon. Police turned away those who had not been fast enough to withdraw their money.
The creation of the Federal Deposit Insurance Corporation (FDIC) in 1934 lifted the threat of suspension over modern banks, at least federally regulated and insured institutions.
But state-regulated institutions without a federal guarantee continued to suffer runs and suspensions as late as the 1980s. In 1985, the governor of Ohio was forced to declare a three-day payment “holiday” at all saving and loan institutions in the state in response to the widespread formation of lines after the failure of the Home State Savings Bank and obvious inadequacy of the state’s deposit guarantee fund.
The panic soon spread to Maryland. “Depositors knew all too well what to do. They gathered up their lawn chairs, thermos bottles and portable radios and lined up outside the banks as if they were embarking on a familiar American outing. In a sense they were,” according to a report in Time magazine. Maryland eventually froze funds in more than 100,000 accounts at three thrifts.
The point of this long digression is not to provide a history lesson but to show what might very easily have occurred in 2008-2009 if the Federal Reserve and the U.S. government had not bailed out the banking system by slashing interest rates, swapping illiquid assets, and injecting new funds and equity.
LOSSES BY STEALTH
By now it should be clear that banks across the United States and much of Western Europe were not just illiquid but insolvent at the height of the crisis; their liabilities were worth far more than their assets could ever be sold for, even in the longer term, adjusting for interest costs and inflation.
The implied losses on those loans were (and remain) so large they would wipe out shareholders’ equity, leaving the remaining losses to fall on bond holders and depositors alike.
If market forces had been allowed to work freely, most of those businesses and households that had placed funds on deposit and in savings accounts with even the largest and most reputable commercial banks would have seen them frozen and perhaps never fully repaid.
But while intervention may have averted the threat of widespread suspensions and failures, the losses from imprudent lending and borrowing to acquire unproductive and permanently impaired assets remain. Someone somewhere has to shoulder them.
Like central banks around the world, the Federal Reserve has decided they should be borne by depositors, savers, pension funds and bond holders. Not in the form of suspensions, insolvencies and write-downs in the face value of accounts, but through the stealthy and gradual mechanism of negative real interest rates.
Depositors, savers and bondholders may rail against the unfairness of having their wealth confiscated via inflation, and clamor for a return to more “normal” interest rates. But the reality is that they have put their funds in institutions which have lent and lost them. By making the delinquencies and asset impairments more apparent, normal interest rates would simply accelerate those losses and make them more visible.
The money has gone. It is not only the banks and their shareholders that have lost money in the crisis. Through deposits and exposure to mortgage products, ordinary savers have lost money too. The only question is what form the losses take.
Economists remain divided about whether it is better for losses to be recognized and written down, or hidden and gradually worked off over time. But policymakers have shown an overwhelming preference for the hidden, gradual approach.
Writing in the Financial Times, economists and financial crisis experts Carmen and Vincent Reinhart argue for recognition and write-down: “Financial authorities have to end the charade that the problematic loans made as the real estate bubble inflated will be repaid. Those loans and the securities using them as collateral had dicey prospects when first made and have only gone further south.
“Unresolved legacy assets are dragging down household spirits, clogging intermediaries’ balance sheets, and impeding the clearing of the real estate market. The private sector will not borrow, banks will not lend, and the fiscal prospects of the U.S. government will be clouded”.
The Reinharts call for “ending the current counterproductive policy of denial”. They argue “acceding to the inevitable is never optional, only the timing has an element of discretion . . . the longer it takes to recognize, the larger they ultimately become”. Prompt loss recognition could avert the debacle of Japan’s lost decades.
Many politicians and commentators in the United States have also argued for a form of loss recognition by calling for home loan balances to be written down to remove or reduce the amount of negative equity.
The problem with such schemes is that every home loan was made by someone and is owned by someone — most often ordinary savers, depositors and pension fund beneficiaries. Writing off loan amounts would mean writing down deposits and benefits because there is not enough shareholder risk capital in the system to absorb all the losses.
Fed Chairman Ben Bernanke and other central bankers have concluded it is safer and less disruptive to trim their paper wealth through negative real rates than suspend their accounts or inflict direct haircuts.
But even avoiding suspensions and haircuts, the costs of the financial crisis are likely to be high. The Reinharts note “following severe financial crises the historical record suggests that economies tend to grow about 1.5 percentage points slower on average in the decade that follows”.
If true, real GDP will be around 15 percent lower in 2018 than it would have been in the absence of the crisis. Together with the extra millions of unemployed, that is the measure of the real cost of the financial crisis. The Fed’s intervention has ensured depositors will not suffer the risk of bank runs and suspensions. But they are set to pay a steep price for imprudent credit in other ways.