326: 200 Years of Financial Panics
Catch the full episode: https://www.wealthformula.com/podcast/326-200-years-of-financial-panics/
Buck: Welcome back to the show, everyone. Today. My guest on Wealth Formula Podcast is Thomas Vartanian. Thomas is the executive Director of the Financial Technology and Cybersecurity Center and author financial services Advisor, expert witness, academic and a board mentor. He is a former executive director of the Program on Financial Regulation and Technology at George Mason University’s Antonin Scalia Law School, where he was also a professor of law. Mr. Vartini also served in the Reagan administration during the SNL crisis as General Counsel of the Federal Home Loan Bank Board and the FSLIC. He’s also the author of 200 years of financial panics, Crashes and Recessions, Depressions and the Technology that Will Change at all. So, fantastic resume here. Mr. Vartinian, thank you for coming onto our show.
Thomas: Thanks for having me.
Buck: So I’m particularly interested in the fact that you were part of the Reagan administration during the Snow crisis, during presumably the Paul Volcker days. And I don’t know, maybe it was during hyperinflation or maybe part of the panacea for that. But what kinds of similarities are you seeing right now in our environment or not that are resulting in the higher inflation?
Thomas: Yeah, it’s a great question because the similarities are numerous. And let me just set this stage a little bit. So when I was sworn in as General Counsel of the Federal Home Loan Bank Board and the FSLIC, which are the two agencies that regulate all the savings and loans in the country, the then six month T bill rate was at 14.5%, inflation was at 12%. The 30 year T bill eventually went within the next year to 21%, which is the top point it reached, and inflation went to 15 or 16%. So we were in an enormously difficult financial environment. Over the next ten years, more than 3000 banks and savings and loans have failed. And when I was sworn in, I can remember this very vividly, I got a briefing from the head of Supervision of the Savings and Loans Division of Supervision at the agency and he came in and he told me that within 24 months, all 4500 savings and loans in the country would fail. Now, for a 31 year old lawyer, that’s a pretty tough pill to swallow because I thought this is going to be a great job. I didn’t realize it’s going to be combat pay. But you start thinking about that and you ask yourself the question I think you’re getting at, and that is how does the whole industry fail? At one time, the story that was circulating was fraud, criminality and negligence. Congress was after everybody because they were misusing their offices. But that’s not what caused the failure of the savings loan industry. That was the cover story. What caused the failure of the savings alone industry is what’s causing most of the financial distress we’re seeing today. And that was constant abuse of the economy by policymakers, particularly politicians. Constant spending, constant policy changes, trying to make the economy do things it didn’t want to do. And at that point, what became very clear to me after being in that job for a while is what happened was that 20 years of abuse of the economy caused the savings and loan crisis. So for example, you go back to 1966. Congress passed a law that said savings and loans could not pay more than five and a half percent to their depositors. Now, why would they do that? They did that because they wanted to subsidize home borrowers. If the institutions didn’t have to pay a high rate, they could lend it out at a lower rate and therefore subsidize housing in America.
Buck: And what year was that?
Thomas: That was 1966, when Congress passed that law. Okay. All right, look, that’s a good thing, right? It’s not ventil, it’s not something bad. We want to increase housing. But the fact of the matter is that it did it in a way that tried to force the economy into a position it couldn’t be in. Because when Jimmy Carter was ending his term of office, what happened is interest rates and inflation went through the sky. And so depositors said, well, why should I put my money with the savings alone at five and a half when I can get twelve from a money market fund, right? And the 30 year fixed rate interest rate mortgages that were on the books, of those savings alone at 7%, yielding 7%, were now worth fifty cents on the dollar in a 15% rate environment. Right. So you couldn’t sell those mortgages and you couldn’t get new liquidity. And that essentially was the reason why the savings and loan industry failed 15 or 20 years later. And it took that long for those boneheaded decisions to sort of ripen in the marketplace. And as market events changed, they effectively put an entire industry in a position where it could not survive. And so that was sort of the reason I wrote the book. And I’ve been sort of thinking about this for 45 years, because you have to ask yourself the following question if you’ve been involved in this and you’ve seen what happened, and that is, if that happened once, could it have happened other times, with all the financial crises that this country has had over its 200 year period?
Buck: Sure. So what do you see now as parallels of some of that? Limitations on low interest rates, obviously. But that’s more of a symptom more than anything else. That’s not something we had back in the 80s. But talk a little bit more about the similarities, what you’re seeing, and if we could drill down on that and just try to see if there’s I’m just trying to understand if there’s some things we can learn from that situation, other than the fact that a lot of it was just self inflicted congressional type of behavior.
Thomas: Yeah. So let me give you some examples of what I characterize as abuse of the economy. So the national debt is probably the most prominent evidence of what we’re doing to ourselves. National debt in 2010 was something about $6 trillion. It’s now $30 trillion, right. So we’re just spending money we don’t have, our children won’t have, and our grandchildren won’t have to be able to repay. So that’s the first thing. Second thing is let me give you an example of what happened with the Fed because the Fed has been the instrument that the government has been using to sort of drive this manipulated economy. In 2008, before the 2008 financial crisis began, the Fed’s balance sheet was $800 billion. Was it $800 billion balance sheet? That’s a pretty big balance sheet, right? Fed’s balance sheet today is $9 trillion. What does that mean? That means between 2008 and 2022, the Fed essentially printed $8 trillion of money. Now, you can’t print a trillion dollars of money, throw it into the economy and think we won’t have an inflation at some point down the line. But to make it even worse, what’s going on here is the Fed was printing the money to finance the United States government. So they were printing the money, buying treasury notes. They were then getting the interest on those treasury notes paid by the treasury and taking that interest and paying it back to the treasury. Now, that doesn’t look to me like a real economy functioning with real economic factors that’s a manipulated economy created to sort of deal with the problems we’re having in a circuitous way, we’re having a direct way. And so the combination of the 2008 crisis, the culvert crisis, has just put us in a position where it’s easier to print money and to ignore the problems and try to throw money at them. But eventually we know. Eventually we know that’s going to come back to bite us. And it’s now coming back to bitis because eventually what I say in my book, which is probably the greatest revelation I came to after reading about the last 200 years, is that every crisis is caused by a triggering event no one anticipated. That sucks the confidence out of the market. And once this confidence is gone, that’s it.
Buck: I’m curious when you’re talking about printing money, I feel like part of the reason that we ended up bringing up as much money as we did during Covid was in part because there was a tremendous amount of money printing and quantitative easing during the financial crisis that did not seem to trigger a lot of the inflationary activity that we’re seeing now. What do you think the difference? What’s the big difference? It’s not like there wasn’t a ton of new money then, but it didn’t create the kind of inflation that we’re seeing now. And as a corollary to that, the question is, should have Chairman Powell and Janet Yellen have seen this coming?
Thomas: So that’s when we get back to the analog with the savings and loan crisis, it’s always something you didn’t anticipate, which changes the dynamics and then destroys the best intentions that you had economically of manufacturing and managing the economy. So in this case, I think what was the breakpoint was Covid, because Covid changed the economic functioning of the country, changed the economic supply lines and global supply lines around the world. And once that started happening, the normal economics started to react differently, right? And we had shortages. We had people not working, we had people not being able to find work, and all kinds of different things. Those were the breakpoints that created differences in supply and demand that then started to expose all of these other abuses that have been thrown at the economy over the last 1020 years to basically come home to roost. And I think that’s the same sort of thing over and over again. There’s an unanticipated event that happens that causes the economic pain to bubble up to the top.
Buck: So I’m sure you don’t spend a lot of time on Twitter wasting your time here, but one of the quotes or one of the tweets that I thought was of interest was from a guy by the name Michael Berry. I guess he was made famous from the Big Short movie. He was the physician and shorted the economy and financial crisis. He tweeted something to the effect of
that. He felt like there is a potential for what’s called what he’s calling a bowl whip effect from a glut in supply and deflationary effects of retailers holding too much inventory. And therefore his thoughts, he’s conjecturing that there may be a change sooner rather than later in direction from the Fed. What do you think of that?
Thomas: I’ll tell you, I’ve represented hedge funds, investment banks and commercial banks for 40 years while I was in private practice after the government and I’ve worked with, I think, when many people would call some of the smartest financial minds in America. And the one thing I’ve learned is that nobody knows where we’re going, right? And once you try to predict where we’re going, you’re always going to be wrong. And the reason for that is we live in the most complex economic environment in the world with more interrelationships and more dynamics affecting each other, then it’s impossible to calculate where we’re going. So what I try to do is I try to keep my eye on the main trend lines, right? Where’s confidence going? Is it up or is it down? Where are interest rates going? Are they going up? Are they going down? Right? Where’s the money supply? Is it going up? Is it going down? What’s the Fed doing? That’s the kind of thing you can watch and you can sort of take some action off of. But I can’t really guess whether or not we’re heading towards stagflation greater inflation or whatever. All I know is the economy is in distress and it’s sort of spiraling.
Buck: Do you think we’re already in a recession right now?
Thomas: I don’t think we’re technically in a recession, but I think we’re in a confidence recession. I actually believe that it is a recession and confidence of the consumer and the people in general in the economy.
Buck: In terms of the other question I have for you is with regard to rates, how high can they go? I’ve read various articles, I’ve talked to various people about this, that there is sort of a ceiling, given the amount of debt, the national debt and paying debt. I’ve heard that there’s some people argue that there’s sort of a ceiling on that. Is that nonsense because you can just print as much money as you want and create as much, payback as much as you want? Or is there some truth to that?
Thomas: Yeah, well, you know, you’ve got the clash of a lot of different theories, your modern monetary theory and classic, classic vulcarism and things like that. But look, rates, left to their own purposes, can go as high as the economy and circumstances drive. As I say, I was general counsel of the Federal Home Loan Bank Board, and when interest rates hit 21% and I asked myself today why I didn’t buy 30 year T bills at 21%. And you know what the answer was, Buck. The answer was that interest rates were moving 100 to 200 basis points a day. So you never wanted to plunk down the money to make an investment because the market would move so dramatically in just 24 hours. You can’t imagine the market moving 200 basis points in one day in today’s environment. So interest rates can go to 20%, but I don’t think they will. But here’s the real issue I think you’re getting at, and that theory is getting at, and that is, as interest rates increase, so does the national debt. Because what’s happening is the treasury is rolling off its old financings at 0% or 1% and having to pay new investors and new venture buyers two or three or five or 6%. Now, if you triple the national debt, we’re talking about $90 trillion. And that could happen if rates triple, right. Over some period of time. The treasury has got to refinance its book of business and all of its debt and it’s got to do it at higher rates. So, yeah, there’s a sort of breakpoint there where you get to a point and you say, look, we’re talking about the collapse of the economy, not how high interest rates can go.
Buck: Right. I guess that’s ultimately sort of the question is like, how high could they go without complete destruction of the economy? And some reversal there. Do you think that the inflation that we’re seeing now, obviously it wasn’t transitory the way that Paulo called it before, the Fed called it before. But is there a reason to believe, just because of supply chain things notwithstanding what Barry had to say, that some of this organically should slow down on its own?
Thomas: Yeah, I think it’s a function of rebuilding confidence in the economy. I think the supply chain, I have no idea how long it’s going to take to work out the supply chain problems. And I think we’re all sort of caught short and surprised by the fact that we had those supplies rate problems. But that’s going to work itself out eventually. I think we understand that the Fed is going to raise rates gently over some period of time. I don’t think we’re going to get to 21%, but the Fed is going to raise rates and that’s going to have an impact. And I think then the question becomes are there other anticipated events that occur that sort of get in the way of the recovery? And let me give you an example going back to 2008 because 2008 is the most recent and vivid experiences that we’ve had. And I lived through that as a lawyer representing a lot of companies, a lot of large financial institutions from Merrill Lynch on down that were having all kinds of problems. And what happened there is pretty instructive in terms of understanding financial crisis. What happened was the default rate in subprime mortgages started to rise as the real estate market started to disintegrate. Right? And once those subprime mortgages started to default at a greater rate, the investors in the marketplace, the mortgage backed securities that had been created from those subprime mortgages didn’t see their investment return coming in. And so what happened is very interesting, there weren’t enough subprime mortgages made to cause the global economic crisis that resulted. So how did it happen? What happened is the market lost confidence in the balance sheet of financial institutions and for some period of time there wasn’t an asset on the balance sheet of a financial institution. It was worth anything. Right. So it wasn’t just subprime mortgages. It was the balance sheet now that was in question and until that confidence can be rebuilt and how was it rebuilt? It was rebuilt by the government saying two things. Number one, we’re raising capital requirements to protect the shareholders and the government. And number two, we’re going to require stress tests that will tell us how much capital these financial institutions need to offset their bad assets. And it was those kinds of actions and interventions by the government that built back the confidence in the system and therefore reestablished the value of those assets on the balance sheet. But it started with the deterioration of the subprime asset which by itself wasn’t large enough to cause the global economic crisis that we ended up with.
Buck: I know you’ve written a little bit and done interviews about when you were interviewed, I guess as a potential Vice Chair for the Fed. And the funny thing was that I think that your comment was effectively that as soon as they kind of knew what you would want to do with the rates, you wouldn’t get the job. Something to that effect.
Thomas: Well, you know, what I’ve said is I spent 90 minutes in the White House and March 15, 2017, interviewing with Gary Cohen and Steve Mnuchin, who I’d known from working on his deal, where he ended up buying a bank. And I laid out a pretty aggressive program to restructure financial regulation to make it more effective, more relevant to today’s economy and safer and sounder. And I got the impression that between that and my answer to Gary Cohn’s question about what I would do with interest rates in 2017 and that was to let them rise so that the Fed would have some tools to use in the next financial crisis, that there wouldn’t be any political will on part of the administration to undertake that agenda. And at this point in my life, having been in the government twice already and been in financial services 45 years, if I couldn’t make those changes to improve the financial system and make it safer for consumers and taxpayers in this country, I didn’t want to do the job. I don’t think they wanted me to do that job either. Right. So we sort of had a meeting of the minds at that point.
Buck: Does it make you look back, though, Thomas, on what it was like working in an administration in a time where you were dealing with the likes of Paul Volker? I’m just curious if you can contrast the time period and just what you are working with, what regulator’s working with it now? It just seems like there’s no real will on any side to stick to any principles of economic responsibility from any party, really. And is that different, you know?
Thomas: Buck I’ve been asked that question a lot, and I have a distinct answer to that. Based on my recollections in May of 1981. The chairman of my agency and I went over to see Paul Volker and his general counsel and with the specific request that Paul opened up the discount window to savings and loans because they were running out of liquidity and so they would have to borrow from the Fed to maintain their liquidity or they just fall off the edge of the table. And that would have been catastrophic to the housing industry, which would have been catastrophic to the economy because savings and loans were the principal lenders to the housing industry to House America. Commercial banks didn’t make mortgage loans at that time. And so we went over there to ask him to open the discount window. We had a series of meetings over at the Fed in his office and I was impressed by the fact that he was so troubled, so just involved in the issues. You could see the strain and the stress on his face. And he told us what he was going to do and he told us he was going to raise rates because the most important thing was to stop the inflation from annihilating the economy. But he was also telling us in his own way that it was going to be a tough ride for the savings and loan industry given that increase in the rates. And I’ve thought about that and I’ve thought about the impressions I gathered from that whole experience and I said to myself, you know, the problem has been that the financial services regulatory system, the oversight, the monetary control has become too politicized since then. I never heard a word of politics. I never smelled a whiff of political red or blue rules when I was in the government in the 1980s. And I never thought for a moment that people like Paul Volcker or my chairman Richard Pratt thought about anything other than what was the best thing for the country. And they decided what it was and they did it. The problem we have today, I think, is that financial regulation is getting politicized. And the problem with that is, frankly, that money is green. It’s not red or blue. And you can’t force it to be red and blue. And every time you try to force it to adhere to a red or blue policy, you’re forcing out of its natural habitat. You’re distorting the market. And every time the market gets distorted, it blows up at some point in time. And that’s the change. The main change I see that’s occurred.
Buck: Your book is called 200 Years of American Financial Panics: Crashes, Recessions, Depressions, and the Technology that Will Change it All. Now I’m curious, what’s the technology that will change at all?
Thomas: I’ve spent a lot of time in my career on financial technology. I constructed websites from a lot of the major banks in the late 90s when the internet explosion happened. And I worked on a lot of breaches of websites and things like that. And we were all captured at that time and I think we’re all captured today and mesmerized by technology. And what I mean by that is everybody looks at technology in terms of what it can do to make it more convenient, to make it more profitable, to make everything life more efficient and effective. And what we’re missing and what we’re being mesmerized about is the fact that we are creating vulnerabilities and insecurities in what we’re doing twice as fast as we’re creating the solutions. So you can’t look outside today and not be concerned about the solar winds problems and all those hacks and all that ransomware and electric grids going down and not think that we’ve got a real problem here. And so I’ve reached a few conclusions. Number one, that we’re not focusing on the security side of technology enough. Number two, that regulators aren’t using technology to regulate technology. So for example, let me give you an example because this is very clear in my mind from when I was a regulator. The oversight of the financial services business in America is done in the rear view mirror. We look at where they’ve been. We criticize what they’ve done, and we say, don’t do that again, or do it this way in the future. There is very little forward thinking, very little forward viewing, and very little predictive judgments going on about the economy or where financial institutions are going to be. And to do that, we could do it easily with technology, artificial intelligence. If I was sitting there as a regulator today, and I could run an algorithm that would give me the five most likely predictive financial scenarios that banks are going to have to deal with over the next five years, I think I could be a much more effective regulator than I was guessing. What I mean by that is the regulators have to use algorithms to regulate algorithms. You can’t be regulating the financial services business in the rear view mirror anymore. We live in a real time economy, right? We want to know what’s going on today and what’s going to go on tomorrow. But the regulatory system that was set up in the 1930s was set up to look at where we’ve been. And so that change has to occur in both the regulatory structure and the regulators have to be armed with the money to buy the kinds of intelligence and buy the kinds of technology that will make them more effective.
Buck: Is there any movement there? Are you seeing any promise of any additional technologies in that way?
Thomas: It is glacial. Buck absolutely. Gaze glacial. The best that I can say is as a result of the Dodd Frank Act in 2010, we ended up with stress testing, which runs models about the future and therefore requires banks to have certain amounts of capital to meet those models. But the models and the assumptions are the secret of the Fed. And who knows what technology they’re using to run those models and how they’re coming about. But that’s the best we’re doing in terms of technology. But, look, we all know we’re living in an enormously technologically enabled environment. Look what’s going on in the crypto market, right? Yeah. I mean, how can you regulate those kinds of elements without using the same kind of technology that’s being used by them? You can’t.
Buck: Absolutely. So the book again is 200 years of financial panics, crashes, recessions, depressions and the technologies that will change at all. Thomas bartinian Thomas. The book is available now.
Thomas: It’s available now. It’s on Amazon and all online booksellers. If you are interested in this kind of analysis of the history of where we’ve been only because it tells us where we’re going, pick up the book.
Buck: Fantastic. It sounds like a very good read for many of our listeners. Thank you so much for being on Wealth Formula podcast.
Thomas: Thanks for having me. I enjoyed it.
Buck: We’ll be right back.