Why Subprime Mortgage Losses Mattered in the 2008 Financial Crisis

“In 2007, many analysts dismissed the significance of subprime mortgage losses, which they compared to a bad day in the stock market. In a report that November, Hatzius called the analogy flawed. Citing research by the economists Tobias Adrian and Hyun Song Shin, he noted that stocks were mostly owned by ‘long-only’ investors such as pension funds who ‘passively accept a hit to their net worth.’

By contrast, mortgages are owned by leveraged institutions such as banks, investment dealers, hedge funds, Fannie Mae and Freddie Mac. For every dollar of losses, these investors would have to shrink their balance sheets to preserve their capital ratios. This was a key reason Hatzius projected weaker growth and a higher risk of recession in 2008 than the consensus.”
— Greg Ip

A Tweetstorm on Imperfect Information Processing

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Zombie Firms, Risk-Taking and Interest Rates

Link to the YouTube video shown above. h/t Torsten Slok

The video above is a nice discussion of zombie firms, with a bit of discussion of “cash” vs. risky assets toward the end. I was reminded of two passages I wrote in my post “Contra John Taylor,” in 2013:

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Low rates and zombie loans.

The low rates also make it possible for banks to roll over rather than write off bad loans, locking up unproductive assets. 

This is one of John’s best and most interesting points. It is a quirk of traditional loan contracts that the repayment rates expected by lenders are sometimes slower when nominal interest rates are low. This is a place where the free market should do its magic, with lenders making sure that the rates at which they are supposed to be repaid are adequate to help them identify badly-performing loans early on. The free market will get better at this the more experience businesses have with low nominal interest rate environments.

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Low interest rates as fuel for speculation. Here, he says

The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.

I can’t make sense of this statement without interpreting it as a behavioral economics statement about some combination of investor ignorance and irrationality and fraudulent schemes that prey on that ignorance and irrationality. The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality. (That is, I don’t see how the claim could hold in a model with rational agents and no fraud.) Whatever combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance an irrationality a successful model uses are likely to have much more powerful implications for financial regulation than for monetary policy. It is cherry-picking to point to implications of a not-fully-specified model for monetary policy and ignore the implications of that not-fully-specified model for financial regulation.