This Isn’t And Never Has Been A Sub Prime Crisis

Back in 2008, when the Great Recession was just beginning, I told my staff not to label the financial problems facing the US and Europe as a “sub-prime” crisis. The default levels in the sub-prime mortgage market in the US weren’t actually much higher than they were in the previous US recession of 2000-2001. The big difference between then and now was the degree of securitisation – the problems arose because of structured derivatives built on sub-prime mortgage loans that were mispriced relative to their risk factors, not the sub-prime mortgage loans themselves. Calling it a “sub-prime” crisis risked causing people to misunderstand what the crisis was about, and what had to be done about it.

But two years on, the financial problems have spread far beyond asset-based securities as Scott Sumner discusses:

Which state had the most bank failures during 2008-10?

No, it’s not centers of sub-prime madness like Arizona or Nevada. Nor is it big states like California or Florida. It’s Georgia. And Illinois is second. Check out the graph in this link:

There is a good reason why most bank failures in 2009 did not occur in the sub-prime states; sub-prime loans were not the main problem. Indeed mortgages of all types were not the main problem. What was? According to McNewspaper USA Today it was construction loans, often for commercial real estate:

The biggest bank killer around isn’t some exotic derivative investment concocted by Wall Street’s financial alchemists. It’s the plain old construction loan, Main Street banks’ bread and butter for decades.

Deutsche Bank has called them “without doubt, the riskiest commercial real estate loan product.” The Congressional Oversight Panel, a financial watchdog, has warned that construction loans have deteriorated faster and inflicted bigger losses on banks than any other real estate loans.

That’s right, everything we were told about the financial crisis in 2009 (and which I also believed for a while) is wrong. It’s a commercial RE crisis, not a mortgage crisis. You might argue that it was housing loans that triggered the liquidity crisis of late 2008. Yes, but the crash of late 2008 was caused by the Fed’s failure to do level targeting once rates hit zero. The main public policy issue with bank failures is the cost to taxpayers, not the impact on the business cycle.

You can check the number of failed banks in the US through this link (from Oct 2000) – about 80% of that list are for bank failures from 2008 onwards. If you’re wondering about the big Wall Street banks like Citi, they had the benefit of TARP money from the Federal Reserve (mostly repaid now), and their investment banking arms in any case operated in the wholesale markets rather than retail (hence not FDIC insured).