Why the US Banking System Remains Fragile

“Fannie and Freddie remain two of the world’s largest financial institutions, but most Americans understand very little about the two mortgage giants”.

-John Griffith, Center for American Progress.

This topic about bank system fragility is inspired by the book by conservative economists Charles W. Calomiris and Stephen H. Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, These authors wondered why The United States has had twelve systemic banking crises since 1840, while Canada has had none.

Compare that with US bank failures:

• A 2023 CNN report found that in 2008, 25 banks failed immediately according to the Federal Deposit Insurance Corporation’s database.

• Over the three years that followed, nearly 400 banks failed.

• In 2023, the FDIC noted four bank failures:The Heartland Tri-State Bank; Silvergate bank; SVB Bank, and First Republic Bank.

Some 800 books have been written about the cause of the 2008 financial crisis. Calomoris and Haber criticize the popularly accepted theories that the failure was principally caused by:

* bankers’ risky behavior

* regulators’ incompetence

* market failure

Rather the authors say, it was, and remains, the design of the system- the result of political decisions.

The Difference in Defaults

In a simple chart, Calomoris and Haber give us a stark comparison of the mortgage default rates in Canada and the US in the period most relevant to our discussion.

The authors introduce the graph with this terse comment:

“Canadian banks have historically also been much more efficient in managing risk than U.S. banks. In particular, they have been able to achieve lower risk of default on their debts”.

Skin in the Game

Let’s look at the source of that “efficiency”. Canadian banks keep the risk of mortgage defaults entirely on their own books:

* Canadian banks do not securitize their mortgages and sell them to investors

* There is no equivalent of Fannie and Freddie in the Canadian banking system

* There is no implied government guarantee to investors who bought mortgages from the banks.

Canadian banking regulations only require:

* That if a borrower had less than a 20% down payment, the bank must take out mortgage default insurance as a hedge against the possible default.

* There is a government insurance agency but there are also private insurance companies.

* The borrower pays the premiums. There is no extra cost to the bank.

No Skin in the Game

As Commercial banks in both countries can create money out of nothing, they could do that to make up for any losses from bad loans without limitation. However, that would result in reckless lending and wild inflation. There are regulations to restrict how much money commercial banks can create by making loans.

* This would allow the banks to make more mortgage loans and help more average homeowners to buy a home.

* The banks would get their profit upfront.

* Investors would get an investment as secure as US bonds with a higher interest rate.

* The government wpould guarantee the investors would not lose any money.

The US government then created two agencies: Fannie Mae (Federal National Mortgage Association (FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation (FHLMC) to purchase the mortgages from the bank and create the residential mortgage back securities (RMBS) for sale to the investors.

The creation of these two government sponsored enterprises (hence called GSEs) is based on the false assumption that they were necessary to achieve a better percentage of homeownership.

Both Canada and the US achieved the same percentage of home ownership that peaked at 69% in 2011 .

The government guarantee of the Fannie and Freddie RMBSs packages violated the essential principle of capitalism: a person must take the consequences of bad decisions. Instead:

• The Government bailed out Fannie and Freddie in the amount of $187.5 billion.

* That money went to investors who had purchased F&F residential mortgage-backed securities (RMBSs).

After Fanny and Freddy were put into conservatorship, they became exceptionally profitable.

Next, we will look at why and how the predatory wealthy will claim that profit and the American taxpayers will not notice.

Originally published at https://jandweir.substack.com.