Mark Vaughan Washington University in St. Louis Federal Reserve Bank of Richmond

1. History Does not Repeat, But It Does Rhyme* Looking at the 2000s through a 1930s Lens *Mark Twain Mark Vaughan Washington University in St. LouisFederal Reserve Bank of Richmond FFIEC Community Financial Institutions Lending Forum William Siedman Center – Arlington, VA April 14, 2009

2. Disclaimer The views expressed are mine alone and do not represent official positions of the: • Federal Reserve Bank of Richmond • Board of Governors • Federal Reserve System

3. Outline • What caused the Great Contraction (1930-33)? • What caused the Great Recession (2007 - present)? • How do the Great Contraction/Great Recession differ? • How are the Great Contraction/Great Recession alike? • What are the public policy implications? • What does all this mean to community banks/examiners?

4. Great Recession December 2007 to Present (16 months): • Real output (GDP): ↓0.8% (December 2008) • Consumer prices: ↑0.6% (February 2009) • Unemployment: ↑4.9% to 8.5% (March 2009) • Bank failures: 39 (0.5% of U.S. banks, 2007) • Money supply (M2): ↑11.1% (February 2009) • Stock prices (DJIA): ↓42.0% (Peak to April 1, 2009) Shaping up to be worst since WWII!

5. Great Contraction August 1929 to March 1933 (43 months): • Real output (GNP): ↓30.5% • Consumer prices: ↓24.4% • Unemployment: ↑3.2% to 24.9% • Bank failures: 9,000 (30% of U.S. banks, 2007) • Money supply (M2): ↓35.2% • Stock prices (DJIA): ↓86.5% “Great Recession” still not close!

6. Great Recession vs. Great ContractionComparing Default Spreads to Gauge Intensity

7. What Caused the Great Contraction? Consensus of Economists • 1928: Fed tightened money to “pop” stock market bubble. • October 1929: Stock-market crash reduced wealth, increased uncertainty (reduced consumption/investment spending). • Fall 1930 - Spring 1933: Four panics led to massive currency withdrawals from banking system/massive hording of liquidity by banks (induced collapse of money supply). • “Amplifying” Policy Mistakes: • Fed did not inject liquidity necessary to stem panics. • Hoover “jawboned” businesses to maintain wages (late 1929). • Hoover championed Smoot-Hawley tariff (mid-1930). • Hoover raised income taxes (1932).

8. What Did Depression Linger? Consensus of Economists • New Deal policies were counterproductive. • NIRA, AAA, Wagner Act lowered output, raised prices/wages. • Tax increases (excise, income, corporate, Social Security) discouraged work, savings, and investment. • Attacks on “economic royalism” created regime uncertainty. • Federal Reserve doubled reserve requirements (1936-37) • Misunderstood high level of excess reserves in banking system. • Money supply (M2) dropped 3.7%. • Restarting banking/financial system took time. • Bankers horded liquidity. • Bankers avoided credit risk.

9. Bankers Have Long Memories (I)Took Years to Stop Hoarding Liquidity

10. Bankers Have Long Memories (II) Took Years to Get Comfortable with Credit Risk

11. What Caused the Great Recession? Possible Suspects • Tight money? • Raised Fed funds target from 1.0% (2004) to 5.25% (2006). • Collapse of housing/stock markets? • From December 2007 to December 2008, net worth of U.S. households/nonprofit organizations tumbled $11.2 trillion (17.9%). • Spike in oil prices? • Oil prices rose nearly 2.5 times from January 2007 to June 2008. • Collapse of credit flows? • Banks/other financial firms sold $152 billion in ABS in 2007, down from $906 billion in 2006. In 2009, only $16 billion sold so far. • Decline in labor supply? • Mortgage forgiveness, IRS leniency, etc. depend on income • Interesting, but probably much less important than other factor

12. Great Contraction and Great RecessionInteresting Similarities • Both preceded by robust economic times. • 1921-29: Annual real GNP growth = 5.2% (2 mild recessions) • 1982-2007: Annual real GDP growth = 3.2% (2 mild recessions) • Both preceded by innovations in consumer finance. • 1920s: Installment credit • 2000s: Mortgages/credit cards driven by credit-scoring/securitization • Both preceded by innovations in banking. • 1920s: Banks ramped up real-estate lending/investment banking. • 1990s-2000s: Banks ramped up real-estate lending/securitization. • Both preceded by era of banking consolidation. • 1921-29: Number of banks, ↓ 29,788 to 24,026 (-19.3%) • 1982-2007: Number of banks, ↓ 14,451 to 7,283 (-49.6%)

13. Great Contraction and Great Recession:Similarities? • Both started in U.S. and transmitted around the world. • 1930-33: via Gold standard • 2008: via Exposure to U.S. housing markets (toxic MBSs). • Both preceded by era in which Fed highly regarded. • Both preceded by housing boom. • Both preceded by stock market “bubble.” • Both featured high-profile failure perceived as “trigger.” • Bank of United States (December 1930) • Lehman Brothers (September 2008) • Both featured “scapegoating.” • 1930s: Andrew Mellon, Sam Insull, Pecora Commission • 2009: AIG bonuses

14. Great Contraction and Great RecessionKey Differences • “Troubled” banks different • 1930-33: Failures small, state-chartered, non-member, non-money center. • 2008: “Failures” large. • Presidential transition smooth, cooperative • 1929-33: 3+ years between onset of contraction and election • Election in November; inauguration in March (Hoover reached out; FDR rebuffed) • Federal government responded with ample stimulus • In real terms, total spending on financial crisis (to date + promised) is roughly 3 times the cost of World War II. • Federal Reserve provided ample liquidity

15. Fed Has Provided Ample Liquidity

16. Banking/Financial DifficultiesRoot Causes? Still too early to know, but candidates include: • Financial innovation? • U.S. obsession with owner-occupied housing? • Politicization of U.S. bank regulation? • Failure to “price” safety net correctly? • Poor monetary policy? In any event, plenty of “blame” to go around!

17. What Now?Policy Choices – A Personal View • Monetary/fiscal stimulus • Probably no more needed • Long-run effects of new federal policy responses • Pay more attention to incentives • Banker bashing • Enough already • Reworking of supervisory/regulatory framework • Probably makes sense, but… Full autopsy needed first. Mere reshuffling might not prevent “it” from happening again, soon.

18. What Does All this Mean for Community Banking? (and, by Extension, Community-Bank Supervision) “Report of my death was greatly exaggerated.” Mark Twain (1887) Gurus love to ruminate on death of community banking… Unlikely to happen. • Mid 1990s: Predictions of 2000 U.S. banks by 2000. • 1870-1990: Deposit split between state/national banks reverted to 50-50. • Suggests degree of heterogeneity in banking markets that provides community banks a continuing niche. • Recent problems suggest über banks do not have all the answers.

19. What Does All this Mean for Community Banking? (and, by Extension, Community-Bank Supervision) “Report of my death was greatly exaggerated.” Mark Twain (1887) What’s Next? • It will take a while for community banks to work through problems with real-estate backed assets. • Asset quality driven by business cycle, but lags. • Failures will continue (at less than alarming rate). • Recent evidence suggests rate of economic contraction might be slowing. • Another wave of mergers/consolidations likely follow. • When corner is turned, but not like 1990s.

20. What Does All this Mean for Community Banking? (and, by Extension, Community-Bank Supervision) “Report of my death was greatly exaggerated.” Mark Twain (1887) To survive/thrive, community banks will need: • Clear strategic vision (what is my niche?) • Innovative funding strategies (not just FHLB on speed-dial) • Strong risk-management infrastructure • Firm understanding of financial markets. • Keener grasp of correlations (among assets, among liabilities) • “Emperor has no clothes” approach to governance.

21. History Does not Repeat, But It Does Rhyme: Lessons from the 1930s for the 2000s? Questions over Mark Vaughan Washington University in St. LouisFederal Reserve Bank of Richmond Email: mark.vaughan@rich.frb.org FFIEC: Community Financial Institutions Lending Forum William Siedman Center – Arlington, VA April 14, 2009