Banking Panic 2007-2009 (1)
Mankind hasn't learned how to control sudden wealth, whether in families, third-world countries, or the richest nation in history. The world banking crisis of 2007 is the biggest example yet.
New topic 699 2020-09-15 17:51:02 TITLE Federal Reserve :
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Much has been made of risks for giant creditors in the 2007 credit crunch. What about the little creditors, the depositors with their savings at stake?
An old friend, than over ninety years old, once growled that Paul Volcker, the esteemed even heroic Chairman of the Federal Reserve, was only interested in saving "the banks". It's certainly true that many members of that board are elected by banks in the different regions, but it isn't easy to see how the Chairman could help banks if he wanted to, or why he would want to. It takes only a moment of reflection to realize, however, that all banks would naturally want to charge the highest possible interest for their loans and pay the lowest possible interest to depositors. Essentially, everybody is their adversary.
Except the Federal Reserve, which needs its regulatory power over banks to control the amount of money in circulation, in order to stabilize the currency both at home and abroad. In another place, we discuss the remarkable ingenuity and the worrisome weaknesses of this arrangement, but for now, let it suffice that it's the arrangement we have.
The difference between the prevailing return on deposits and the return on loans is called the yield curve, because short term rates, which the Federal Reserve controls, normally slope upward toward higher long term rates, which the Federal Reserve does not control. Essentially, the Fed controls what depositors are paid, but has no direct control over what borrowers are charged. Depositors are savers, and it is widely agreed that Americans do not save enough. To some degree, that must be the fault of the Federal Reserve. And when market conditions force a decline in the rates charged borrowers, the Federal Reserve must allow the banks to squeeze the depositors' rate of return, or banks will go bust. That's all my old friend was trying to say when he criticized a national hero. Luckily for Volcker's reputational legacy, he needed to boost interest rates dramatically in order to stop inflation, and that put plenty of interest in the pockets of old folks with money in bank deposits, while unfortunately, it throttled borrowers unable to obtain loans except at very high prices. He stopped inflation in its tracks, but at the price of hurting business.
For over a year before the 2007 credit crunch, short-term rates (and depositors' interest return) were higher than long term rates (and borrowers' interest cost), an infrequent occurrence called an inverted yield curve. The difference between the Bernanke problem and the Volcker problem was that this time long rates were stuck at historically low levels, probably because of international situations. Depositors were protected and banks were made to suffer, although their reserves were invisibly eroding. One has to suspect the housing bubble was allowed to go on, to some degree to rescue the banks. With inflation starting to appear, interest rates needed to be raised, and with a national election approaching, deposit returns needed to rise to placate elderly savers. Furthermore, banks had a relatively new competitor for deposits, the money market funds.
The inverted yield curve put savers in a strange position. Normally, they had to balance in their minds the higher interest rates obtainable by investing in bonds, against the inflexibility of locking up the money for long periods. With an inverted curve, however, bonds looked like the dumbest possible investment when they paid less interest than money market funds. Bonds were thus under pressure to raise rates, but they didn't rise. Greenspan's conundrum still persisted, but the situation highlighted one of the unpleasant consequences of correcting it. If interest rates rise, the price of existing bonds must go down; somebody's going to lose money. That's what was soon going to happen, once the credit collapse got started. Bond prices might dip and return if you didn't actually sell, but if you urgently needed cash in the meantime, you had to call on your money market savings. The spreading of the problem from one asset class to another was likened to the spread of a contagion.
In a sense, that's isn't quite accurate, because the similarity of bank deposits and money market funds is to some extent an illusion. Money market funds are minibonds. These bundles share the characteristic with bonds that rising interest payments result in falling prices for the principal involved. To preserve the appearance of interest-bearing cash they have a par value of a dollar a share, and the interest they pay is really a dividend. To preserve the appearance further, when interest rates must rise, fund owners make strenuous efforts to avoid "breaking the buck", or lowering the principal value, even to the extent of investing their own money to support the price. Rising interest rates are hard on money market funds, and most funds are owned by banks. The banks are under pressure by other factors in the credit squeeze, so it would not be inconceivable that they would be forced to break the buck. Elderly savers would not like that development and in an election year could make their displeasure felt. A great many people might wish to shift their savings from money market funds back to bank deposits, which are largely insured. A commotion of this sort would bring more attention to a comparison of different funds, leading to the wide-spread discovery that the money market funds, which stock brokerage accounts employ as "sweep" funds for dividends and spare cash, have long paid substandard interest rates because of ignorance and inertia by the clients. And so, the contagion threatens to spread further.
Originally published: Tuesday, February 12, 2008; most-recently modified: Wednesday, May 22, 2019