The Banks Did It

The main thesis of this book is that it is impossible to understand what happened unless one studies what the banks themselves were doing. While this seems ob­vious now, in almost all of the accounts given by the Federal Reserve and the economic regulators, these financial institutions and their strategies to make money were not the focus of attention.

The goal was never to make sense of why the banks had given out so many subprime loans in the first place and what that meant about the way the system worked in order to assess the potential broader impacts of these foreclosures on the financial system. This meant the regulators never even tried to understand how connected the mortgage market had become to the financial markets and how mortgages were the raw material that was driving investments being made by banks in most of the developed world. While the story I told in the first two paragraphs of this chapter is now more or less accepted by regulators and econo­mists as an account of the crisis, it is still only a description of what happened. It is my assertion that until we drill down into what the banks were doing to make money and how they had come to do it, we will not really understand how the dominos were lined up in the first place, such that they were arranged to fall and produce the crisis.

But what are the elements of making sense of such a system? Any approach to understanding what banks were doing has to begin with the basic facts of Amer­ican banking. Finance has a long history of boom-and-bust in the United States stretching back into the nineteenth century. New products, new firms, and new markets are produced. But eventually, financial markets overreach, and chaos ensues. Usually, the economy is then plunged into a recession or depression. The government steps in and helps markets and banks reconstruct themselves so that lending and borrowing can resume. Usually the banks left standing play an important role in this reorganization. The cycle then begins anew.

To make sense of this kind of dynamic, one needs a set of concepts that rec­ognize three facets of the way that markets are organized in modern capitalism (Fligstein, 2001). First, one needs to understand that governments and markets are by definition co-constituted. That means that large-scale modern markets cannot exist without the extensive intervention and active engagement of gov­ernment. Government helps establish the rules of the road and gives firms the ability to build stable market structures. Governments frequently underwrite innovation and often provide the road map to new products and services. In the case of the mortgage market, the government innovated the conventional mortgage in the 1930s and mortgage securitization in the 1960s. Government regulation is not an alien invasion into the marketplace but rather a prerequisite for a market economy to function.

The alternative to government action is not a perfect market but rather re­al-world markets thoroughly sullied with collusion, fraud, imbalances of power, and production of substandard or dangerous products and prone to crises due to excessive risk taking.

The second facet is that the real-world political economy hinges on the rec­ognition that such market arrangements are not innocent but the outcome of power, both political and market power. They are the product of power struggles between firms, industries, workers, and government within particular markets and in the political arena. Stable markets can be characterized as containing in­cumbent-challenger structures whereby the largest firms set and use the rules of the game to reproduce their dominance while challengers figure out how to survive (Fligstein, 2001). In the United States, where firms have tended to have more market share and political power, this has generally meant that incumbent firms have been able to shape the political governance of their markets, thereby reinforcing their market power. In the case of financial markets since 1980, the largest and most politically connected banks have gotten the government to give them the kind of market rules they wanted.

Finally, the natural state of markets is dynamic. Emergence, stability, and moments of crisis and transformation are natural life-cycle events in markets. Governments may help to initially produce the conditions for the emergence of new markets, provide the architecture to stabilize existing ones, and manage cri­ses to limit damage and facilitate recovery. Government can innovate products, facilitate exchange, and provide investment in new technologies. But firms are ultimately the ones who influence how the market works and what is produced.

Making sense of the business models of financial institutions is at the core of understanding what caused the crisis. While the rules governing markets are per­tinent to an understanding of what happened, they do not explain how banks and markets were actually organized. This requires knowledge of the history of the mortgage market, the rise of securitization, and later the creation of the market for nonconventional mortgages (which include adjustable-rate, subprime, Alt-A, home equity, and jumbo loans). Without this knowledge, it is impossible to make sense of why the crisis was so large, so deep, and so unseen. Without tracing the history of the business models of financial institutions, we will fail to un­derstand why the banks were so vulnerable in 2007-2008. It was the banks who made loans to individuals. It was the banks who took those loans and created mortgage-backed securities (MBSs), sold those securities, and held on to many of those securities as investments And it was the banks who used the short-term credit markets (shadow banking) to borrow money to make all of this possible.

There are three important puzzles about the crisis that can be answered only by making sense of the system of mortgage securitization and the business mod­els of the banks. One puzzle involves two competing narratives that purport to explain what happened. The first narrative focuses on the idea that at the core of the financial crisis was the originate-to-distribute model of banking, which pushed banks to make riskier and riskier loans to people with bad credit. This idea implied that those who originated the loans did not care about the ability of the buyer to pay back the loan because the originator sold it to someone else, who was going to turn it into a security.

The problem with this narrative is that it directly contradicts the other main account of the crisis, with which I opened the chapter and which most analysts now agree fits the facts. In the fall of 2008, the largest banks held large amounts of mortgage-backed securities that they were funding by using the short-term credit markets (shadow banking). As they needed to put up more collateral to keep these loans, they found that the decreasing value of the securities meant that they rapid­ly experienced a liquidity crisis. When it turned out no one knew what the securi­ties were worth, this turned into the banks being insolvent (Brunnermeier, 2009). These two stories are obviously contradictory. Were financial institutions passing on the bad securities to unwitting buyers, or were they selling them to themselves? If they were buying these securities themselves, why was this happening?

A second puzzle is why financial institutions did not stop producing both mortgages and securities as the housing market slowed and foreclosures rose. One logical thing for the banks to have done as the mortgage market declined in 2006 was to shut down their origination businesses or their securitization businesses. They would have taken some losses, but they could have pivoted to businesses where they were making more money. In the case of commercial banks, they could have focused on their retail banking and credit card business­es. Investment banks could turn to their roles as traders of securities, advisers on mergers, and underwriters of corporate equity and debt.

Finally, the question of why the crisis was so deep and spread so quickly across the population of financial institutions in the United States and parts of Europe remains a mystery. The crisis spread almost instantaneously to Iceland, Great Britain, the Netherlands, Germany, France, Switzerland, and Luxembourg. Curiously, it failed to spread to Japan and the rest of Asia, and most of the devel­oping world was unaffected. Most financial crises in the postwar era have shown a flight away from risky settings, such as from developing countries to less risky ones, like the United States and Europe. But this crisis started in the United States and spread to a few European countries in a matter of months.

These puzzles can be resolved only by looking more closely at what the banks were doing and why they were doing it. The narrative I construct is more compli­cated than most of those out there. But it has the great advantage of helping make sense of the main dynamics of what happened and posing satisfying answers to these questions.