In response to the “Savings and Loans Crisis” of the late 1980s and early 1990s, and the 2008 recession/housing bubble pop, the US government bailed out financial institutions. This is an ordinary foremost financial crisis. But in both cases, part of the bailout was government-directed purchases of “toxic assets” (assets which caused financial distress by becoming worth less than they used to be all of a sudden). Since this approach was implemented in America during the two most recent financial crises, it might be implemented again. This is why, in the next crisis the government might decide to buy bitcoin. In sections 2 through 4 I’ll explain further why the financial system is setting itself up for another crash.
While I’m not sure when the next financial crisis will hit the US, the following sections will cover likely be significant contributing factors.
In section 1, I will cover the lax regulatory regime for systemically important financial institutions and why the government will have to spend money to cover their losses.
In section 2, I will cover how large financial institutions are setting themselves up to take losses in cryptocurrency.
In section 3, I will demonstrate the existence of a housing bubble.
In section 4, I will discuss how involved our financial institutions are getting in the housing market, feeding another bubble and setting themselves up for even more losses.
#1: Under-Regulated Systemically Important Institutions:
The reason that the government bails out financial institutions is that they can become systemically important to the economy in the sense that they have borrowed from a bunch of other financial institutions. If these systemically important institutions default on their debts, this can risk bankrupting their creditors. Those creditors can default on their debts and bankrupt some more creditors. Additionally, if enough firms start going bankrupt, nobody will want to take any risks by lending money or buying financial assets. This means even otherwise healthy firms will have trouble borrowing money or selling their assets at a fair price, forcing them into bankruptcy. Economists tend to point to the Great Depression as an example of what happens when you let this process go on for too long.
This is particularly an issue in recent financial crises in America when not all systemically important financial institutions are official banks. When an institution is officially a bank it is subject to some regulations, reporting standards which let the government see how much money its borrowing and when it’s borrowed more money than it can pay back, as well as legal means and precedent for the government to shut it down when it runs out of money. When non-bank financial institutions like hedge funds and investment banks become big parts of the financial system; this tends to make the purchase of toxic assets the least illegal way to bailout the financial system.
The dichotomy I introduced between official banks and other financial institutions is itself an oversimplification. The real state of financial institutions is more complicated and worse. Many companies have one foot on either side of the divide. For instance, Goldman Sachs is an unregulated financial institution, but it has a subsidiary, Marcus, which is a bank. (Technically, Marcus is a “brand of Goldman Sachs Bank USA and Goldman Sachs & Co. LLC (“GS&Co.”), which are subsidiaries of The Goldman Sachs Group,” according to the Marcus website). This part of Goldman Sachs can get various kinds of assistance from the federal government, including government insurance of checking accounts. However, it also has to follow some government regulations. I’m no financial legal expert (or financial crime expert) but my guess is that money deposited in the well-regulated safe part of Goldman will tend to make its way to the risky part of Goldman. Even if this is not the case, if the unsafe parts of Goldman Sachs start to go bankrupt it’s hard to imagine this not spilling over to the legit part. Bank of America, JP Morgan, Citigroup and many other institutions have both regular bank and investment bank appendages.
#2: Crypto Involvement by Major Financial Institutions
I will not bother to explain why crypto is a bubble. This would be like explaining why 1 plus 1 is 2. The following section gives a brief summary of some of the ways systemically important financial institutions have gotten involved in the shady world of crypto currency.
Goldman Sachs
Goldman Sachs currently has a division dedicated to cryptocurrency trading. According to Yahoo, their head of crypto trading, Andrei Kazantsev has recently advocated for the creation of a crypto options market. A crypto options market would be a mechanism to bet on the price of crypto going up or down while simultaneously betting that the people making the reverse bet have the money to pay if they lose. He also says a crypto options market will drive institutional investment in crypto. He may be right. The issue is he won’t be the one paying for it. In the previous housing bubble, another derivative betting market was created: the credit default swap market. People would use credit default swaps to bet that mortgage-borrowers wouldn’t be able to pay back their mortgages (this was what the Big Short was about). Eventually those default swap pessimists turned out to be right; but institutions on the other end, like AIG, didn’t have the money to pay their end of the bet and had to be bailed out.
Kazantsev also argues a crypto options market would be a good way for funds to hedge risk. However, buying options to lower risk is a bit like buying a security from Goldman Sachs to avoid being scammed: not possible.
Bank of America
According to Yahoo, Bank of America’s “Managing Director of Research” says that crypto currencies will be very useful in the metaverse. This is of course great news. Finally, we know what crypto is for. Now, all we need to know is what the metaverse is for! So far, there’s no public evidence that Bank of America is actively getting long on crypto. It is creating mechanisms for its users to buy crypto, but that might just be for it to charge fees. The best-case scenario is that Bank of America isn’t and won’t actually buy crypto but will pump up the market to scam its customers.
JP Morgan
JP Morgan has recently gotten involved in creating its own NFTs according to Yahoo. JP Morgan has also created new crypto-trading opportunities on its platforms, according to NASDAQ.
Wells Fargo
Wells Fargo has recently published a report which describes cryptocurrency as a viable asset. They too, it seems, want to cash in by getting their clients to invest in crypto and collecting fees.
Citigroup
Citigroup has also created new crypto-trading opportunities for its clients, according to NASDAQ.
#3: Housing Bubble
The US housing market is clearly in a bubble. Unlike “crypto” a housing market is not in itself a bubble. However, home prices are overvalued and growing at an unsustainable rate.
The chart below is the one-year change in inflation-adjusted home prices in log-%. Real home prices are essentially growing at the fastest pace on record. They are growing faster than they were during the 2008 bubble. This rapid increase started around the initial Covid outbreak, and it’s associated policy response. Often financial asset bubbles are attributed to the FED lowering interest rates, so the fact that a bubble would start during the crisis is not surprising. The FED lowered rates to keep the economy strong at the time.
The typical defense for such overvalued homes is a supply-side argument connected to supply chains. People make the argument that home prices are high because it is expensive to make new homes. However, the price to make new homes is determined by demand and supply forces. We cannot be sure it’s just supply-side forces driving home prices higher unless we look at the quantity of new home production. If the price of new homes were being held up by supply constraints alone and not demand for homes in excess of re-sale of existing homes, then production of houses would be declining. If demand for new homes (equal to quantity demanded for homes minus quantity of homes resold at existing prices) were increasing at the same time that supply of new homes was weakening, then prices could go up while new home production remains strong. The chart below matches the combined demand and supply effect scenario. It shows new home production going higher after the crisis, rather than lower. If supply side effects alone accounted for this price growth, then home production would be hit first due to supply constraints, and this would then feed into rising home prices. Because home production has not declined, we know this isn’t the case.
There are also many non-bubble arguments for high home demands. For instance, people argue that millennials all of a sudden decided to become homeowners. Others argue that people are leaving liberal states to escape public health regulations and pushing up home prices in conservative states. What all these arguments ignore is the question why anyone would buy rather than rent a house in any location given current conditions.
As home prices increase, the rent that one would pay to live in the typical urban primary residence (as measured by the CPI report) is falling in inflation adjusted terms. The graph below plots the inflation-adjusted growth in owner’s equivalent rent of primary residence, measured in log-% by year.
Taking the data together we know that home prices have been growing at an unsustainably high rate for over one year. We know that while supply-side factors seem to play a part, demand for new homes is also rising significantly. We furthermore know that there is no shortage in housing because rent prices aren’t growing in inflation adjusted terms. In fact, there seems to be an oversupply of housing (possibly because more people are too poor to afford their own housing). What there is a shortage of is ownership rights on housing. The fact that there aren’t enough houses to own as an asset is pushing up prices. Clearly, there has got to be some feedback where the out-of-control price growth is inducing more demand for home ownership. Likely people are putting off selling their houses that they would sell otherwise due to the capital returns they are currently earning. Likely, other people are trying to get into the market while they can still afford to.
#4: Financial Institution Involvement in Housing
Traditional banks are directly exposed to risks in the housing market in two ways. The first is through being mortgage issuers. The second is by lending to real-estate related corporations (like construction companies). Non-traditional investment banks like firms may find other ways to be directly exposed.
Wells Fargo
Many argue risky mortgage lending currently isn’t as big of an issue now as it was in the previous bubble. But that’s obviously not true. For instance, Wells Fargo has a special mortgage plan specifically aimed at poor people that requires only a 3% down payment, at least according to their website.
Goldman Sachs
Goldman Sachs was involved in a lot of shady activity during the last financial crisis. In October, at least, Goldman Sachs was publicly optimistic about home price appreciation. They predicted another 16% of home price growth by the end of next year, according to CNN. One wonders what kind of risky financial derivatives they're playing around with right now.
Citigroup
Citigroup offers a “Home Run Mortgage” package on their website. The package offers a down payment as low as 3% of the size of the purchase. The package is free from any pesky mortgage insurance requirements (why have an insurer get a government bailout when you can get bailed out directly). Furthermore, according to the website, one of the products of the “Home Run Mortgage” is “products offering the stability of a fixed rate.” This seems to imply that not only are the loans 3% down, but also have variable interest rates. So not only are the borrowers clearly incapable of paying back their debt, but additionally nobody actually knows how much debt they can’t afford to pay back.
JP Morgan
A “Senior Market Economist” published an article on JP Morgan’s website: The U.S. housing market is suddenly booming. In this article he was pretty reasonable, writing: “Home buyers: Proceed with care.” While of course, he pushed people to use JP Morgan as a mortgage lender he did concede there were risks in the housing market. However, on April 13th, when the market was more clearly in a bubble, he changed his tune (possibly he was ordered to). He wrote an article entitled “Do you want to jump into the U.S. housing market?” In this article he assured the reader that there was no housing bubble, that government support will keep the market strong and that buying a house will give you “Suburban Bliss.”
If he really wanted people to get mortgages, he should have mentioned JP Morgan Chase’s 3% down mortgage option. According to their website, it has “flexible credit guidelines and income limits.” According to the website, by applying for the loan and completing an educational course on the loans, you can actually be given $500 to help you with your down payment. In fact, if you are eligible for the “Chase Homebuyer Grant” you can be given an additional $5000 on top of the $500 from the educational course. Assuming JP Morgan gives you $5500 to cover your down payment, you can buy a house worth $183,333.33 or less on credit with $0 down.
Bank of America
Bank of America is involved in housing the traditional way, mortgages. They also offer 3% down mortgages with no insurance. Business Insider ran an article earlier this year on 4 housing-related stocks Bank of America officials were trying to pump.
Obviously, there are people in all of these big financial institutions that are smart enough to realize what they are doing. The reason these big institutions are buying into these bubbles is they expect to make profits while the bubbles grow and to be bailed out when the bubbles pop. This problem is not new. The solution is the same as it ever was: better, more stringent regulations.