How to Avoid Starting the Next Financial Crisis

I haven’t written in this blog for nearly a decade, and I start with a topic of gloom and doom.  I am naturally an optimist.  To me glasses are always half full.  But at the end of the day, I am also a realist, a financial economist, a finance professor and academic researcher. Therefore, I know that financial crises happen.  And the United States has gone longer than usual without an economic recession.  

Many financial institutions have leaders who have not experienced a financial crisis from the CEO’s office.  We may therefore be primed for making bad decisions that would lead not just to a recession.  And for some CEOs, they may even be primed to be the catalyst that stats the next financial crisis.  While most articles on financial crises are about how to survive them, this article is on how to avoid being the cause of one.  And by that - I mean you weren't even on the wrong team.  

The Root Cause of All Financial Crises

I have spent a decade (cumulative - off and on) teaching a course on the economics of financial markets.  The most recent incarnations of that course have focused on two connected issues.  First, the reasons financial institutions exist at all.  And second, the cause of crises.  I have found in studying historical financial crises, the crisis can be explained simply by showing that financial institutions have stopped performing a key economic function. 

Seldom do financial institutions seek to cause a crisis.  In nearly every instance, they honestly believe some other player has (or will) pick up the slack.  Financial markets are tricky in that they are always innovating new products and services.  Most crises occur when a financial institution believes that a new instrument is performing a function they used to.  They then cut costs by no longer performing that function.  Unfortunately, no one is then performing the function, and the market fails. 

Why Do Financial Institutions Exist?

To start down this train of thought you will have to think for a moment like a nerd.  Economic researchers ask questions that may not even occur to many people.  In thinking about the current financial market landscape, early finance researchers asked why banks existed in the first place.  It doesn’t seem all that efficient.  If some people have excess funds, why do they go to a bank to deposit them?  And for that matter, why would borrowers go to a bank?  Wouldn’t it be more efficient if you skipped the middleman (or financial intermediary) and had borrowers just go directly to the source of the funds?

Economists typically think that what we are observing has some rationale.  Therefore, they continue to propose reasons for what we see in the market until they are fairly certain they have the main reasons.  In this instance, there were two main answers to why depository institutions exist.  First, there was – what I call the accounting answer – the transactions cost explanation.  This answer considered most of the “practical reasons” why a rational borrower or depositor might prefer a bank to issue a loan directly.  Second, there was – what I call the theoretically abstract answer – the information asymmetry answer.  This answer is more abstract, but explains not only why banks exist, but more importantly why they fail.

Transactions Costs

The first reason given for the existence of “banks” is that they are more efficient.  It would be extremely expensive for individual investors/depositors to find their own borrowers.  And even if it were possible, banks bring expertise in underwriting, and economies of scale in writing loan contracts – as well as administering and monitoring the contract throughout the life of the loan.  Partly because of the banks experience or expertise, financial institutions can provide this intermediary role more efficiently than individual investor/depositors.

The problem with this explanation, is that it doesn’t tend to explain all financial institutions.  Therefore financial theorists had to work longer to provide further explanations for why “banks” existed.  The best explanation was made with the “information asymmetry” arguments proposed by George Akerlof[i], among others.    

Information Asymmetry

The basic concepts of information asymmetry propose that groups of people have different information sets.  As far as borrowers are concerned, the basic theory would suggest that the borrowers know whether they are good risks or not.  All loan applicants try to appear as though they are good risks so that they are offered loans, and that the interest rate is low.  As the potential borrower applies, the applicant knows more about their prospects to repay than does the bank.  Their information set is asymmetrical.

Asymmetric information can create two problems in financial markets.  The first is called adverse selection.  For lending institutions, adverse selection means that those who should not get a loan might be granted a loan.  In fact, the theory suggests that those with poor prospects are more likely to apply for loans. 

The second problem is called moral hazard.  Moral hazard refers to behaviors after the original deal is done that would compromise the value of the security that is generated.  For example in the case of a loan, a borrower may take on much more debt.  The increased financial leverage could compromise the borrower’s ability to repay.  That high default risk would adversely affect the value of the loan. 

The only way the lender can avoid either of these two problems is through overcoming the information asymmetry.  That just means that the financial institution must produce information on its own[ii].   But for the financial institution to continue as a viable part of the financial market, it must have a better means of producing this information than others operating in the financial markets. 

How Do These Principles Explain Credit Unions?

These principles have held for all depository institutions.  But since this blog is about credit unions, we will focus our attention on how these principles apply to them.  The first institution to call itself a credit union was a cooperative lending institution in Germany, started by Friedrich Wilhelm Raiffeisen.  The cooperative lending institutions that he piloted now bear his name (Raiffeisenbanken), but he called them Kreditvereine – or credit unions. 

Raiffeisen was a mayor in a village in 1850’s Germany.  The citizens of the village were primarily farmers.  They needed financial services so they could borrow money for planting in the spring, and would pay back the loan in the harvest.  However, the only financial institutions were large, money center banks.  They knew nothing about small farmers in back-water villages.  A significant information asymmetry existed.   There was also a major transactions cost problem.  These large banks were not in the habit of making loans as small as those demanded by individual farmers. 

Without understanding what we now understand about financial institutions and why they exist, Raiffeisen created a cooperative bank – a Kreditverein or credit union – that would allow the financial markets to overcome the transactions costs problem, as well as the information asymmetry problem.  The Kreditverein held a lien against all property owned by all members (whether or not they had loans outstanding with the institution).  The institution then borrowed large loans from money center banks, which were subsequently broken into smaller loans to their members.  This structure overcame the transactions cost barrier that existed in the market.

The information asymmetry was overcome by the members themselves.  They all knew the members of their community.  They could see their farms.  They knew how well their crops were growing, and they knew from personal experience about the integrity and work ethic of their neighbors.  What’s more, their own farm had a lien against it – so they were motivated to overcome the adverse selection and moral hazard problems.  Therefore only those with impeccable credit got a loan in the first place, and local farmers could oversee the loan’s repayment – knowing exactly when their neighbor harvested their fields, and when he got paid.  (Click on the image below to make it bigger.)

As credit unions arrived in the United States, they morphed into a consumer lending institution.  But the common bond maintained a similar advantage in information production.  The common bond became key to overcoming both main sources of information asymmetry – adverse selection and moral hazard.  Many early American credit unions had an employment or trade common bond.  The close association of members within the same company or trade allowed for a unique flow of information about potential borrowers.  The lender knew how much the borrower was paid, and the stability of their job.

If the common bond was that all members worked in the same company, the common bond could lead to information about job security, and possible promotions, that banks could not rival.  Even today, some credit unions have maintained unrivaled methods of maintaining information sources that are not available to banks, and some even have repayment methods that cannot easily be matched by banks (some of which might reduce the transactions costs as well).  As credit unions have grown larger and their common bonds have become diluted, some of these competitive advantages may also have become somewhat diluted.

What Was the Cause of the Last Recession?

Everyone knows that the last recession was caused by the “Global Financial Crisis” (or GFC).  But what caused the GFC?  Financial markets are set up to efficiently move funds from those who have excess funds to those who can productively use those funds.  A financial crisis occurs when the mechanism to move funds from those with an abundance to those with the need doesn’t work efficiently or effectively.  In short, was it because the markets were no longer providing a savings in transactions costs, or was it a case of the markets no longer producing the needed information to overcome the information asymmetry? 

The financial markets are both complex and innovative.  Innovation is generally a positive attribute in that it tends to reduce transactions costs over the long run.  However, whenever innovation occurs, there is a risk that components within the financial markets will cease to perform their current function, or that the function is no longer being performed at all.

During congressional hearings about the causes of the financial crisis, many acronyms were blamed for the crisis.  But these acronyms typically referred to instruments or innovated securities.  Some blamed MBSs (mortgage backed securities).  Others put the blame on CDOs (collateralized debt obligations).  And yet others blamed the CDS (credit default swap).  In short, congress thought innovation – in the form of a set of new financial securities – was to blame.  Their solution would be new regulation.  But focusing on regulating securities is always reactionary.  More importantly, it doesn’t focus on the root cause.  The real root cause was that the financial markets innovated in a way where a critical function was not being performed at all. 

Both MBSs and CDOs were seen as low risk because they were collateralized securities.  They were merely pools of collateralized debt instruments.  That technology had been around for a very long time.  Mortgages were already covered by many regulations.  If the borrower defaulted on the loan, you could sell the underlying property and be repaid.  But two instruments had been developed at roughly the same time to blindside the financial markets into thinking that due diligence had been done on some of the loans within those pools, when in fact it had not been. 

The first innovation was called a credit default swap (CDS).  The CDS was insurance that was issued by unsuspecting investors.  During a time of rapid loan growth, money center banks needed to free up some capital to make more loans.  They innovated a way to move money from reserves to loans by paying for insurance on that those loans would in fact be repaid.  They sold the investment as sharing the proceeds of their loan portfolio.  However, the investor was in fact guaranteeing that the loan would be repaid – or they were on the hood for both principal and interest. 

Many investors (including some school districts retirement funds) had little idea that they were putting their entire investment fund at risk with these instruments.  And the real problem was that banks did not have to do so much due diligence on those loans, because they were no longer on “the hook” for the loss, the credit default swap “investor” would have to make them good if the deal went bad.  In short, no one was motivated to produce the necessary information to overcome the adverse selection problem.  And monitoring loans is costly.  If you have a credit default swap, you could now downplay the risk of not monitoring the loan as closely also, introducing moral hazard. 

The CDOs and MBSs had a similar problem, but somewhat more nefarious.  They were pools of securities tied to individual mortgages.  Initially, MDSs and CDOs were pools of mortgages guaranteed by the Federal Housing Administration (FHA), or by people with high levels of equity in their own homes.  Their risks were low.  Much of the principal was covered by federal insurance.  And that not covered by insurance had for years been amply covered by the owners collateral.  This investment had become very popular for high return with little risk. 

As the demand for CDOs and MBSs increased, the market did anything it could be produce more of them.  But there are only so many people in the United States who can qualify for FHA or prime mortgages.  To meet ever higher demand for this investment product, mortgage writers began to dip into non-standard mortgages, and then into sub-prime mortgages.  A sub-prime mortgage is a mortgage with higher probability of default.  These loans were not well known to the CDO and MBS markets. 

Not knowing how to rate the risk of some of these securities, the rating agencies began making money in two contradictory ways.  First, by consulting fees to fund builders.  The fund builders and designers wanted to exact the highest profit they could from their pools of loans.  So they hired consultants with expertise in how those ratings were achieved.  The people most expert at making the ratings would be people who work for those agencies themselves. 

At the same time, the second way the rating agencies made money in this market was by rating the resulting offer.  Remember that the ultimate investor will use this rating to determine whether they are interested in the security or not – in essence the rating acts as the most important form of information production.  The rating agencies’ consulting revenue and rating revenue created a conflict of interest that was not lost on the regulator – but only became an issue after the financial crisis[iii].

The financial crisis was ultimately caused by the fact that the financial markets no longer produced their own information to overcome the information asymmetry.  But instead relied on the services to do their information production for them.  And the ratings agencies were making too much money helping the CDOs and MBSs marketers.  Their ultimate goal was to maintain the information asymmetry.  They were still selling lemons.  They needed buyers to believe that they were not lemons

Once the market realized that no one was effectively filling the role they were supposed to fill, the markets failed until they began to fill their original role, and until the lemons were removed from the market.

How did these principles apply to Credit Unions in the last recession?

Because of their unique organization (and objective function), American credit unions have not been as susceptible to financial crises as commercial banks.  During the Global Financial Crisis, fewer credit unions failed than commercial banks[iv].  However, they did not survive unscathed by it.  Some over invested in sub-prime mortgages, hoping to sell them to mortgage pools before their true value was discovered by the markets (just like many commercial banks and thrifts at that time). 

But their biggest Achilles heel was found in the wholesale credit union market – the corporate credit unions.  Corporate credit unions were financial institutions set up to serve retail corporate credit unions.  They served to address temporary liquidity among retail credit unions.  They could offer loans to credit unions with a temporary cash problem.  They took deposits from credit unions with more deposits, with too few quality loans.

The corporate credit union as an entity began in the 1960s.  They caught on because credit unions could deposit excess funds and earn a return on member deposits.  Over time, corporate credit unions began to compete on interest rates which meant they were always seeking higher returns on their assets.  And in the early 21^st century, there were not as many good loans to credit unions.  So they sought high quality investments with high rates of return (which any student of finance knows is contradictory).  The fastest growing corporate credit unions offered the highest returns.  As it turns out, many of the largest corporate credit unions (including US Central Credit Union) had invested a great deal of their capital into CDOs and MBSs that were backed by sub-prime mortgages that the rating services had rated as investment grade.  And the regulator was late in forcing them to adjust their value for reality.  

As a result, the crash of the corporate credit union to other corporate credit unions (US Central Credit Union) can be seen graphically below.  In this graph, the proportion of mortgage backed securities (MBSs) to total investments is what is really being graphed.  As a reference, I have also graphed the median, upper and lower quartiles for that same ratio.  The sharp drop was due to the fact that the NCUA "conserved" US Central, and slower liquidated it.  (Click on the image below to make it bigger.)

But US Central was not the only corporate credit union that thought it had found a way to beat the market.  The next four largest corporate credit unions were competing with one another on returns.  The only way to promise higher returns is to take on more risk - no matter what the rating agencies say.  These four corporate credit unions, together with US Central, represented 17.86% of the number of corporate credit unions at the beginning of 2008.  All five of them failed.  But to assume that that soaked up only 18% of the assets would be far understating the matter.  Of the assets reported on the monthy call reports of June 2008, 73.65% were held by these five corporate credit unions.  And in a report to congress, NCUA Chairman Deborah Matz reported that they collectively "served more than half of the entire credit union system."  The graph below shows the proportion of investments devoted to MBSs on the books of the top four corporate credit unions (click to make the images bigger.)

But the proverbial red flag was there.  As alluded to earlier, higher than normal returns are not consistent with investment grade investments (which should have conveyed more information than it obviously did).  And instead of spending time trying to understand why the markets were offering a security at higher than usual return while the rating services rated it so high, these corporate credit unions poured ever more money into those assets.  But all credit unions need to do their own due diligence. They need to produce information about their investments (including loans).  In this case they thought the rating service was doing it, but the market in pricing the security was telling them there was something wrong with the price.

By the time the NCUA started looking at the underlying assets, it was too late, and the cost to the retail credit union members of the corporate credit unions who invested without producing the information they should have was enormous. 

The Lessons That Should Have Been Learned (but probably weren’t)

A similar explanation could be made of virtually every financial crisis.  Eventually, financial institutions stop producing the information they need to vet the investments they make.  Because that is why that institution exists in the first place, the markets have to reassess their position relative to that institution, and how they interact with it.  That reassessment can be the root cause of a financial crisis.  

In many instances, an innovation has adjusted the system in such a way that components of the financial system believe that a critical function is being covered by another institution.  So in an attempt to save some money (to improve the efficiency of the market) they stop performing their critical function.  In the corporate credit union example, the corporate credit unions felt that they didn’t need to produce information as expensively since the rating services were doing that.  So they didn’t.  And the rest, as they say, is history.

Going forward, all financial service companies need to be careful of how they invest in loans (or other earning assets).  Credit unions must be certain that the due diligence that would have been done while generating loans or other earning assets are currently being done.  Cutting costs often also cuts the quality of information production.  And underwriting loans through sources that might have a conflict of interest should be avoided like a plague. 

In my next post, I would like to present statistics on a growing component of credit union industry lending portfolio that concerns me for the reasons discussed in this posting.  

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[i] George Akerlof was awarded a Nobel Prize in economics for his work in information asymmetry.  One of his easiest academic papers on this subject is also easy for many non-academics to grasp.  It is a seminal piece on the market for lemons (cars).  See Akerlof, George (1970); “’The Market for Lemons’: Quality, Uncertainty and the Market Mechanism”, Quarterly Journal of Economics (84), 488-500.

[ii] For one of the seminal pieces in this literature I would recommend Campbell, Tim S., Kracaw, William A. (1980); “Information Production, Market Signalling, and the Theory of Financial Intermediation”; Journal of Finance (35), 863-882.  It is far more difficult for non-academics to approach however.

[iii] For more information on this problem, interested readers are referred to a report produced by the Securities and Exchange Commission, entitled “Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies”. 

[iv] See evidence disclosed in Bauer, Keldon; “The corporate credit union crisis: Does it call for reform or re-engineering?”; Journal of Banking Regulation 16 (2), 89-105.