MONEY Markets

Why Investors Are So Bad at Predicting Market Crashes

NYSE New York Stock Exchange
Stephen Chernin—Getty Images

After the market does well, no one expects a crash. After it crashes, everyone expects it to crash.

Stocks have boomed for nearly six years now. Are we due for a crash?

Yeah, probably. It’ll happen some day. Crashes happen.

But anytime I see people touting metrics that supposedly predict when a cash will occur, I shake my head. None of them work.

Yale School of Management publishes a “Crash Confidence Index.” It measures the percentage of individual and professional investors who think we won’t have a market crash in the next six months. The lower the index, the more investors think a crash is coming.

Yesterday came the headline: “More And More Investors Are Convinced A Stock Market Crash Is Coming.”

The Crash Confidence Index plunged in December to its lowest level in two years. “Less than a quarter of institutional investors and less than a third of individual investors believed that stocks wouldn’t crash,” Business Insider wrote.

Before you panic and liquidate your account, the most important line in Business Insider’s article is this: “On the bright side, this indicator may be a contrarian indicator.”

Bingo.

Plot the Crash Confidence Index (in blue) next to what the S&P 500 did during the following 12 months (in red), and you get this:

Investors were increasingly confident that stocks wouldn’t crash in 2007, and then a crash came. Then they were sure a crash would occur in 2009, just as a monster rally began. Same thing to a lesser degree in 2011.

If you plot the Crash Confidence Index next to what stocks did in the previous two months, you kind of see what’s going on here.

After the market does well — like in 2007 — no one expects a crash. After it crashes — like in 2009 — everyone expects it to crash:

This is similar to the consumer confidence index, which consistently peaks just before the economy is about to get ugly and bottoms when things are about to turn. (Although we only know the timing in hindsight.)

Stocks have done poorly during the last few weeks, so it’s not too surprising that expectations of a crash are growing. People like to extrapolate returns into the future.

We’ll have a crash some day. But more money has probably been lost trying to predict and hedge against a looming crash than has been lost by just expecting and enduring one when it comes.

For more on on this stuff:

More from The Motley Fool: Where Are The Customers’ Yachts?

TIME Morning Must Reads

Morning Must Reads: December 29

Capitol
The early morning sun rises behind the US Capitol Building in Washington, DC. Mark Wilson—Getty Images

Objects Spotted in Hunt for Jet

An Australian aircraft has detected objects that may be related to AirAsia Flight QZ 8501, which vanished Sunday en route from Indonesia to Singapore with 162 on board. The sightings were made near Nangka island, about 700 miles from where contact was lost

What We Know About QZ 8501

In the third Malaysia-linked aviation disaster this year, an AirAsia plane traveling from Indonesia to Singapore disappeared on Sunday over the Java Sea

U.S. Ends Afghan War

The U.S.-led coalition in Afghanistan ended its combat mission Sunday, marking the formal — if not real — end to the longest war in American history

Greece Fears New Financial Crisis

Greek financial markets reacted negatively on Monday to news that the country’s lawmakers refused to elect a new president, triggering snap elections that may bring to power the radical left-wing Syriza party, which has threatened to default

San Francisco 49ers, Jim Harbaugh Agree to Part Ways

The San Francisco 49ers and head coach Jim Harbaugh have “mutually agreed to part ways,” team CEO Jed York said in a statement on Sunday. York also said the 49ers have already started its search for the team’s next head coach

All Passengers Evacuated From Burning Ferry in Adriatic Sea

All passengers were evacuated off a burning Italian ferry adrift in the Adriatic Sea after the craft burst into flames on Sunday. More than 400 passengers have been safety removed from the vessel, and five passengers died

Box-Office Report: The Hobbit, Unbroken Beat Into the Woods

The two new films were neck and neck: Into the Woods made $15.1 million Christmas day, while Unbroken made $15.9 million. As it turns out, audiences were equally intrigued by the star-studded musical and the Oscar-ready drama

NYC Police Chief Defends Mayor

NYPD Commissioner Bill Bratton said it was wrong for police to turn their backs to a video monitor outside the church where New York City Mayor Bill de Blasio spoke at the funeral of officer Rafael Ramos. “I certainly don’t support that action,” said Bratton

ISIS Executes Nearly 2,000 People in 6 Months

ISIS executed 1,878 people in Syria over the past six months, including 120 of its own members, according to the U.K.-based Syrian Observatory for Human Rights. Most people killed by the Islamist group were civilians, among them 930 members of a single tribe

Ferguson Police Spokesperson Suspended

A spokesman for the Ferguson, Mo., police department has been suspended without pay after he admitted to calling a memorial for an unarmed black teenager shot to death by a white officer “a pile of trash,” the city said on Saturday

Spokesman: George H.W. Bush to Remain in Hospital

A spokesman for George H.W. Bush says the former President will remain in a Houston hospital for now but that news of a “possible discharge” could come soon. Bush was taken to the hospital on Tuesday for what was reported as a precaution

James Franco and Seth Rogen Live-Tweet The Interview

Twitter already went wild over The Interview when the controversial comedy was released online on Christmas Eve, and now, stars James Franco and Seth Rogen are joining the fray. The actors live-tweeted the film on Sunday

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TIME Greece

Greek Parliamentary Vote May Lead to Snap Elections and a Derailed Bailout

GREECE-POLITICS-ECONOMY-PARLIAMENT-VOTE
People walk past the Greek Parliament in Athens on Dec. 17, 2014. Greece is a step away from early elections that could repudiate its international bailout and rekindle a euro-zone crisis after lawmakers failed to elect a President Aris Messinis—AFP/Getty Images

Antiausterity left-wing party rides high in polls

The Greek Parliament is holding a vote Monday that will decide whether the country will go to snap elections, possibly bringing to power the left-wing Syriza party that has vowed to renegotiate the battered country’s international bailout.

The vote is the third and final round to elect a new President. Failure to do so will trigger polls by early February, reports Reuters.

Prime Minister Antonis Samaras’ nominee Stavros Dimas runs unopposed, but needs 12 more votes to secure the necessary supermajority.

Syriza is leading the opinion polls, buoyed by its objections to the present terms of the joint E.U.-IMF rescue package and a promise to review austerity measures taken in the country since the financial crisis of 2009.

“In Europe, sentiment is changing,” Syriza leader Alexis Tsipras wrote in his party newspaper Sunday. “Everyone is getting used to the idea that Syriza will be the government and that new negotiations will begin.”

[Reuters]

TIME Economy

We Still Haven’t Dealt With the Financial Crisis

Five Years After Start Of Financial Crisis, Wall Street Continues To Hum
A street sign for Wall Street hangs outside the New York Stock Exchange on September 16, 2013 in New York City. John Moore—Getty Images

It often takes years after a geopolitical or economic crisis to come up with the proper narrative for what happened. So it’s no surprised that six years on from the financial crisis of 2008, you are seeing a spate of new battles over what exactly happened. From the new information about whether the government could have, in fact, saved Lehman Brothers from collapse, to the lawsuit over whether AIG should have to pay hefty fees for its bailout (and whether the government should have penalized a wider range of firms), to the secret Fed tapes that show just how in bed with Wall Street regulators still are (the topic of my column this week), it seems every day brings a debate over what happened in 2008 and whether we’ve fix it.

My answer, of course, is that we haven’t. To hear more on that, check out my debate on the topic with New York Times’ columnist Joe Nocera, on this week’s episode of WNYC’s Money Talking:

TIME Asthma

Study: Fear of Job Loss Can Increase Asthma Risk

The report looked at German adults during the recent economic downturn

Fear of losing one’s job can cause a marked increase in the risk of developing asthma, according to a new study released Tuesday.

The study, published online in the Journal of Epidemiology and Community Health, found that for every 25% increase in job security that a worker felt, that worker’s likelihood of developing asthma increased by 24%. For people who told researchers it was more likely than not that they would lose their job, the risk of developing asthma climbed 60%.

Fear of losing one’s job has been linked to a number of negative health outcomes, but this is the first time it has been linked to the risk of developing asthma, the study’s authors said.

The study surveyed the records of more than 7,000 working German adults between 2009 and 2011, a time in which European economies were in downturn.

MONEY The Economy

China is Slowing. What If Its Housing Bubble Bursts?

Even if the real estate market in the world's second-biggest economy were to collapse, the repercussions may not be bad as you think.

While global investors covet China’s growth — as evidenced by the buzz surrounding Alibaba’s IPO — the Chinese economy is actually slowing down.

In 2013, the world’s second largest economy grew at an annual rate of 7.7%. By 2015, according to a recent report by the Organization for Economic Co-Operation and Development, that will drop to 7.3%. Meanwhile, the U.S. economy’s growth rate is projected to increase by almost one percentage point.

What’s going on? Well, China’s industrial production gains in August slowed to their lowest level since 2008 and retail sales growth declined by a few percentage points year-over-year.

Perhaps most important, the nation’s newly built home prices only grew by 2.5% in July, after surging by 10% at the beginning of the year.

The notion of a housing crisis in an economy more than three times the size of France brings back flashbacks of 2008 and probably a few chills down every investor’s spine.

“A property price crash in the world’s second largest economy would have global implications,” says Wells Fargo Securities economist Jay Bryson.

But those global implications wouldn’t be as worrisome as the U.S. housing collapse six years ago, per Bryson. Here’s why.

The Worst Case

To play out this thought experiment you have to assume that at some point in the near future China’s home prices will experience a decline on the order of what the U.S. experienced over the past decade. (Bryson played out this scenario in a recent report.)

Currently, residential investment makes up a pretty decent portion of the Chinese economy – about 10% of nominal GDP. To put that in context, that ratio was closer to 6% for the U.S. in 2006.

So housing is a big deal in China. If they experienced a value decline like we did, Bryson estimates that would lop off about one percentage point of growth. But the pain wouldn’t stop there.

A collapse in housing prices would result in fewer construction jobs – estimated at around 60 million people in urban China. Jobless workers would spend less, which means that those goods and services the now-unemployed construction workers would normally purchase would not get bought.

If out-of-work construction workers reduce their spending on food and entertainment, the businesses that produce that food and entertainment will make less money and then some of their workers may face unemployment too. Since my spending is your income, lower spending means people have less money in their paychecks, and the nation’s GDP suffers.

Moreover, if housing goes in the tank, banks will see losses, which means they’ll tighten credit, resulting in fewer loans for people to start businesses.

Let’s not forget the actual homeowners. If home prices fall, homeowners’ equity declines as well. (See: Sell, Short). And when people’s chief asset is suddenly worth a lot less, they’re not going to spend as much on other, discretionary items. “Although the lack of data makes it impossible to quantify the wealth effect in China, researchers have found that there is a statistically significant direct relationship in the United States between changes in wealth and changes in consumer spending,” per Bryson’s report.

Lower demand from China means that countries which sell goods to China (think Chile and Australia) will sell less stuff. As corporate profits are squeezed, a global bear market may result.

“Although China may not be as important to global economic growth as the United States, the global economy clearly would not be immune to a major property market downturn in China,” says Bryson.

The Not-So-Bad Case

Freaked out? Breathe deep and take solace in the fact that despite this potentially harrowing dénouement, the world probably wouldn’t endure another global financial crisis. And that’s thanks to responsible Chinese borrowers.

Chinese households usually have to put a lot more money down – 30% on their first home, up to 60% for an individual’s second – than Americans. So if prices were to decline substantially, Chinese homeowners would be in a much better position than Americans back in 2007 to deal with the crisis. For example, household debt-to-disposable income has grown substantially in China since 2007, but it’s still about one-third the size of U.S. households back in 2007.

The world will also feel less of a pinch. When mortgages started going bad in the U.S., foreign financial institutions lost close to $750 billion of the more than $2 trillion in write-downs resulting from the crash. That was because foreign banks owned a lot of U.S. mortgage-backed securities. Not so here. “Chinese mortgages are generally held by Chinese financial institutions in the form of whole mortgages.” So if prices were to drop, Chinese banks would suffer while U.S. one’s most likely wouldn’t.

Lastly, the Chinese government wouldn’t sit on its hands while its economy came crashing down. Beijing’s debt-to-GDP ratio is around 15%, so it has a lot of room to recapitalize its banks if needed.

So what’s an investor to do?

“I don’t lose sleep at night worrying about China, nor should other people,” says Bryson. “But they may want to keep an eye on it.”

TIME Regulation

The Fed Is Staying the Course, and That’s Great

Janet Yellen, chair of the U.S. Federal Reserve, listens to a question during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington on Sept. 17, 2014.
Janet Yellen, chair of the U.S. Federal Reserve, listens to a question during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington on Sept. 17, 2014. Bloomberg/Getty Images

Why boring monetary policy is good

The Federal Reserve’s monthly statement Wednesday was typically dull. Basically, the Fed is staying the course, because the economy is continuing a path of gradual improvement.

The Fed continued its “taper,” reducing the monetary stimulus it’s pumping into the economy by $10 billion for the 10th consecutive month, while announcing that this stimulus—known as “QE3”—should end on schedule next month. The Fed also continued to signal it won’t raise interest rates above zero “for a considerable time,” despite speculation it might soften that language. Fed Chair Janet Yellen then devoted most of her news conference to a mind-numbing discussion of procedural arcana involving “policy normalization principles” and “overnight RRP facilities.”

This is not exciting stuff. But boring monetary policy is an excellent thing to have, especially just six years after a spectacular financial crisis. At the time, the Fed took all kinds of unprecedented actions to save an economy that was contracting at an 8% annual rate and shedding 800,000 jobs a month. Some critics thought those actions would fail to prevent a depression. Others thought they would lead to hyperinflation, a devastating run on the dollar, or a double-dip recession. Instead, we’ve had 54 straight months of job growth. The jobless rate is down from 10% to just over 6% percent. The stock market is booming. Last year, the U.S. had its largest one-year drop in child poverty since 1966, and this year is looking even better. Two of the Fed’s inflation hawks actually dissented from the latest statement, arguing it “does not reflect the considerable economic progress that has been made.”

In other words, things are OK.

Things are not great; as Yellen pointed out, many American families are still dealing with aftershocks of the crisis, including tight credit, lingering debt, depressed wages and a shortage of jobs. Incomes for the non-rich have grown modestly since 2010 and not at all since before the crisis, although tax cuts for the middle class and the poor, tax increases for the rich, and expanded government benefits for the vulnerable have helped offset those trends. It’s true that our recovery from the Great Recession has been slower than previous recoveries from ordinary recessions. But it has been much stronger than previous recoveries in nations that endured major financial crises—and much stronger than Europe’s current recovery. The euro zone’s output has not yet reached pre-crisis levels; it’s still struggling with 12% unemployment and a risk of deflation.

We’re doing a lot better than that. We had more effective bank bailouts, more generous fiscal stimulus—until Republicans took over the House after the 2010 midterms and began demanding austerity—and much more accommodative monetary policy. It’s all worked remarkably well. We’ve faced some headwinds—the contagion from the near-collapse of Greece in 2010, the turmoil after we nearly defaulted on our debt in 2011—but the economy has continued its path of slow but steady growth. That’s why Yellen was able to discuss those mind-numbing “policy normalization principles,” the guidelines the Fed will follow as it starts raising rates and reining in its bloated balance sheet in 2015. We’re approaching normal. And the Fed’s forecast for the next few years also looks pretty decent.

It doesn’t look fantastic. But in 2008, the U.S. suffered a horrific financial shock, with a loss of household wealth five times worse than the shock that preceded the Depression. We’re still dealing with the aftershocks. Many Americans still don’t feel like the economy is working for them, an understandable reaction to persistent long-term unemployment, stagnant wages, and continuing foreclosures.

But as dull as it sounds, it’s working better every year. The lesson of our current plight is not that the system doesn’t work. It’s that financial crises really suck.

MONEY financial crisis

6 Years Later, 7 Lessons from Lehman’s Collapse

Lehman Brothers world headquarters is shown Monday, Sept. 15, 2008 in New York.
Lehman Brothers world headquarters is shown Monday, Sept. 15, 2008 in New York. Lehman Brothers, burdened by $60 billion in soured real-estate holdings, filed a Chapter 11 bankruptcy petition in U.S. Bankruptcy Court after attempts to rescue the 158-year-old firm failed. Mark Lennihan—Reuters

The venerable investment bank Lehman Brothers went under six years ago today. While Wall Street has recovered from the financial crisis that resulted, lessons endure for Main Street investors.

Exactly six years ago today, Wall Street came closer to imploding than at any other time since the Great Depression.

That was when the venerable investment bank Lehman Brothers filed for bankruptcy on Sept. 15, 2008, amid the global mortgage meltdown, triggering a cascade effect across Wall Street. Within days, the insurer AIG had to be bailed out by the federal government while other investment banks, including Morgan Stanley and Merrill Lynch, were pushed to the brink. Merrill, in fact, was eventually sold amid panic to Bank of America.

Six years later, the nation’s financial system seems to have largely healed. Banks are back to posting record profits. Over the past several years, financial stocks have been among the hottest areas of the market.

^DWCB Chart

^DWCB data by YCharts

And with the housing market recovering, even the dreaded mortgage-backed security — the type of bond that triggered the financial panic in the first place starting in 2007 — are back in fashion.

But even if it seems like it’s business as usual on Wall Street, for Main Street investors key lessons endure. Here are 7 of them.

Lesson #1: The price you pay for stocks matters. Really.

The media’s narrative is that the stock market plummeted into an historic bear market because of the global financial panic. That may be true, but equities may not have fallen that far — and for that long — if the circumstances weren’t ripe for a correction.

Remember that in October 2007, the price/earnings ratio for the stock market — based on 10 years of average profits — rose above 25, marking one of only a handful of times that market valuations rose so high. Not surprisingly, the stock market went on to lose 57% of its value from October 9, 2007, through March 9, 2009. (As an aside, the stock market’s so-called normalized P/E ratio is back above 25 again today.)

By March 2009, the P/E ratio for the S&P 500 had sunk to an historically low 13 (the historic average is closer to 16), which has been a signal of buying opportunities. Had you invested at that moment — listening to the Warren Buffett rule that says “be greedy when others are fearful and fearful when others are greedy” — you would have enjoyed total returns of 230% ever since.

Lesson #2: Don’t bank on any one group of stocks — even financials.

The turmoil after Lehman’s collapse was different and more frightening than the bursting of the Internet bubble in 2000. Why? This time the stocks that took the biggest hits weren’t shares of profitless startups that no one had ever heard of. In this crisis, the biggest losers were financial titans — some more than a century old — that produced a third of the market’s profits and dividends. No wonder these blue chips were fixtures in many retirement portfolios.

The love affair is clearly over … or is it? Financials have been among the market’s best performers since September 2011, having doubled in value in three short years. As a result, bank stocks, which made up less than 9% of the S&P 500 in 2009, based on total stock market value, now represent more than 16% of the broad market. That means they’re probably among the biggest holdings in your stock mutual funds and ETFs.

Lesson #3: Buy and hold works — eventually.

When the Dow fell to 6547 on March 9, 2009, stocks had already lost more than half their value. And equities wouldn’t fully recover until 2013. So it may seem that investors who pulled $25 billion out of stock funds in March and $240 billion over the next three years — plowing that money into bonds — were on the right track.

They weren’t. March 2009 marked the start of a bull market that saw stocks return 230% so far. Had you simply hung on to a basic 70% equity/30% bond strategy from Sept. 1, 2008, when things started to get scary, you’d have earned nearly the 9% historical annual return for this mix over five-year stretches since 1926. Of course, you’d have earned that only by staying the course.

Lesson #4: There is no such thing as a “conservative” or stable stock.

In past crashes, pundits always pointed out that the “safe” place to be is among giant, blue chip stocks that pay dividends and that are industry leaders. Well, Lehman Brothers, Citigroup, Merrill Lynch, and AIG all fell under those descriptions. Yet all of those stocks plunged more than the broad market.

This taught investors a huge lesson: Treat all stocks as the volatile, unpredictable creatures that they are. Even dividends, which are synonymous with financially stable, conservatively run companies, can’t be trusted, because during the crisis, the financial sector began slashing dividend payments to safeguard their finances.

Lesson #5: Reaching for yield can lead to a fall.

When stocks fall, the stability of cash can cushion the blow. Yet things don’t necessarily work out that way.

Just ask shareholders of Schwab YieldPlus. This so-called ultrashort bond fund — which was marketed as a cash alternative, though it really wasn’t one — fell 35% in 2008 when the mortgage securities that provided the “plus” in the fund’s name turned out to be riskier than thought. (In January 2011 Schwab settled the charges that it misled investors but did not admit wrongdoing.)

Before that, there was the Reserve Fund, the first money fund in 14 years to lose value in part because it tried to boost payouts by holding some Lehman debt.

It makes no sense to take risks with your rainy-day savings, a lesson that’s worth remembering today. Since early 2009, investors have poured billions of dollars into floating-rate bond funds, which buy short bank loans that offer higher payouts than basic cash, as well as ultrashort bond funds.

Lesson #6: Diversification works — but in diverse ways.

In 2008, only one type of diversification seemed to pan out: your basic mix of stocks and bonds. Among equities, everything pretty much fell in lockstep.

Fast-forward more than three years, when the financial crisis unfolded in a different guise — this time with the debt crisis in Europe. Fear of government defaults peaked in early 2012, with rates on Greek debt reaching 29%. Diversification worked here, too, but also in a different guise.

While conventional wisdom said investors should flee the continent, European shares wound up beating the world in 2012, returning 20.3%. The year before that, it was U.S. stocks that performed the best (despite Uncle Sam’s fiscal woes). And in 2013, Japan led the way, despite having experienced another recession.

Spreading your bets globally eventually pays off, especially given how mercurial equities can be. For investors who are hearing that the U.S. looks like the only promising market these days, this is a clear lesson to heed.

Lesson #7: Stocks always recover; people don’t.

The Dow closes at an all-time high, but that’s cold comfort to those who retired in the past five years. Big upfront losses can crack a nest egg, even if the market later improves. That’s because your portfolio has the most potential earning power in the first few years after you get the gold watch.

Historically, investors have been able to tap anywhere from 4% all the way up to 10% of their savings annually based on how markets fared in this all-important first decade of retirement.

Over the next 10 years, return expectations are extremely modest, so even a 4% withdrawal rate may seem optimistic. For boomers nearing retirement, the trick is not to make matters worse, as two out of five older workers did in 2008 by keeping 70% or more of their 401(k)s in equities.

It’s time to dial down the risks in your portfolio — before the next downturn.

MONEY financial crisis

A Simple Plan to Stop the Next Financial Crisis

Six years ago, Lehman Brothers went down and nearly took the global financial system with it. Could this one bold proposal make banks safer—without holding back the economy?

Here’s one thing every homeowner knows: The less equity you have in your house, the more likely you are to get in financial trouble.

This was easy to forget for a time in the mid-2000s, when house prices were climbing. But when real estate prices reversed, many borrowers who had put little or no money down quickly found themselves “underwater,” owing more on their houses than they could sell them for. People who had stuck to the old-fashioned 20% down-payment rule of thumb, on the other hand, had a cushion. Their house had to lose at least 20% of its value before they were stuck in a mortgage they couldn’t get out of.

Anat Admati, a professor at Stanford University’s graduate school of business, and German economist Martin Hellwig think the exact same lesson ought to be applied to banks.

Monday marks the sixth anniversary of the Lehman Brothers’ bankruptcy, the trigger event (if not necessarily the cause) of the worst of the global financial crisis. As part of an occasional series, I’ve been looking at different proposals to prevent the next panic. One obvious step is to regulate how banks lend out money, to crack down on predatory loans. Admati and Hellwig come at the problem from another direction — one that’s particularly apropos on the Lehman anniversary — by proposing tougher rules on how banks get their money in the first place.

They argue that banks should borrow less, relative to their assets. After all, what turned a bubble in real estate prices into a full-on financial panic was not just the toxic loans banks gambled on, but the fact that they too were playing with borrowed money.

In a nutshell, Admati and Hellwig say that 20% to 30% of the money a bank puts to work should be funded from shareholders’ pockets, instead of from debt. Currently, that number for big banks — their equity or “capital,” in bankers’ jargon — is more in the neighborhood of 5% to 6%. In other words, about 95% of banks’ assets (which includes the mortgages, business loans and other investments they hold) are matched on the other side of the balance sheet by money banks owe (to everyone from depositors to bondholders.) And that means, roughly, that if the value of a bank’s assets falls by more than 6%, it now owes more than it is worth.

Admati’s and Hellwig’s idea is getting attention. Admati has been the subject of a long profile by Binyamin Applebaum in the New York Times. Top Federal Reserve officials are citing her, and Applebaum says she’s lunched with Barack Obama at the White House. But the proposal has admirers on both sides of the ideological divide. Economist John Cochrane, no fan of Democratic banking reforms like Dodd-Frank, has praised Admati. And Republican Sen. David Vitter is co-sponsoring legislation requiring 15% capital with Democratic Sen. Sherrod Brown.

My Money colleague Kim Clark interviewed Admati at length back in 2013 about her book with Hellwig, The Bankers’ New Clothes. You can read the interview here.

I said in the headline that this plan is simple — and that’s true in the sense that it’s elegant. Instead of getting into the weeds of defining tricky concepts like “Too Big to Fail,” it puts a big, bright number on how much capital a bank has to hold to be considered safe. (Defining “capital” can in fact be contentious and complicated, but demanding a lot of it makes it harder to game.)

The tricky part is that it’s not so simple for people who don’t know banking to get why capital or equity is so important, or even what it is. As Admati frequently points out, banks have benefited from the misconception that higher capital requirements means banks would have to keep 20% or 30% of their money locked up in a vault, instead of lending it out to businesses or homeowners.

In fact, making banks “hold more capital” actually means they have to borrow less. In their book, Admati and Hellwig show that this is almost exactly like a homeowner making sure to build up equity in her house. This graphic published with Kim Clark’s Money interview with Admati shows how it works:

Screen Shot 2014-09-12 at 2.22.25 PM
SOURCES: Anat Admati, Money

To raise more capital, banks wouldn’t hold back lending. Rather, they’d tap their shareholders, either by issuing new stock or just by cutting the dividends they pay out of earnings, letting profits build up on the balance sheet. (They can still lend that money out if they choose — the point is, it wasn’t borrowed from someone else and won’t have to be paid back in a crisis.) This would be unwelcome news to many investors in banks, who often invest in large part to get those dividends.

Recently, I spoke with Brian Rogers, a fund manager at T. Rowe Price who invests a lot in banks, and he was satisfied that banks had already done enough to clean up their balance sheets and raise capital. Admati and Hellwig would doubtless say that investors’ confidence in banks now has a lot to do with the fact that the government bails the industry out when it gets in trouble.

Making banks less attractive to some stockholders, and limiting their ability to take advantage of debt when it’s attractive, could make them less eager to lend, raising interest rates.

In their book, Admati and Hellwig argue this isn’t necessarily the case — some investors might prefer to hold stock in less-risky banks. But even if there is a cost to safety, by now we have a pretty good idea of how expensive — for everyone — the alternative can be.

MONEY housing

How the Financial Crisis Put Up Two More Barriers to a Secure Retirement

Two new studies underline housing and income challenges facing older Americans.

Monday marks the sixth anniversary of the bankruptcy filing of Lehman Brothers, a key event in the Wall Street meltdown that led to the Great Recession. The recession wreaked havoc on the retirement plans of millions of Americans, and two studies released last week suggest that most of us haven’t recovered well.

To be more precise: Middle- and lower-income Americans haven’t recovered at all, while the wealthiest households have done fine.

The Joint Center for Housing Studies of Harvard University (JCHS) issued its findings on the challenges we face meeting the housing needs of an aging population in the years ahead. Meanwhile, the Federal Reserve Board released its triennial Survey of Consumer Finances (SCF), a highly regarded resource for understanding American households’ finances.

The Harvard study found that our existing housing stock is ill-suited to meet seniors’ needs, including affordability, accessibility, social connectivity and support services. And high housing costs are eating into the ability of low-income older adults to pay for necessities like food and healthcare.

Housing is the largest expenditure in most household budgets, and so is a linchpin of financial security and well-being. “It’s really at the nexus of your financial health, physical health and healthcare,” says Jennifer Molinsky, research associate at the JCHS and principal author of the study.

Harvard found that a third of adults over age 50 pay more than 30% of their income for housing—including 37% of people over age 80. Harvard defines that group as “housing cost burdened.” Another group of “severely burdened” older Americans spend more than 50% of income on housing. That group spends 43% less on food, and 59% less on healthcare, compared with households that can afford their housing.

Homeowners are much less likely to be cost-burdened than renters, the study found. But more homeowners are carrying mortgages well into retirement. More than 70% of homeowners aged 50 to 64 were still paying off mortgages in 2010.

The Federal Reserve findings on middle-class retirement prospects are equally troubling. Despite the economy’s gradual mending, the SCF found a widening gap in income and net worth. The top 10% of households was the only income band registering rising income (up 2% since 2010). Households between the 40th and 90th percentiles of income saw little change in average real incomes from 2010 to 2013. And the rate of homeownership was 65%, down from 69% in 2004 and 67% in 2010.

Ownership of retirement plan accounts also fell sharply. In the bottom half of income distribution, just 40% of households owned any type of account—IRA, 401(k) or traditional pension—in 2013, down from 48% in the 2007 survey. The Fed attributes the drop mainly to declining IRA and 401(k) coverage, since defined benefit coverage remained flat. Meanwhile, coverage in the top half of income distribution was much higher. In the top 10%, 95% of families are covered.

Overall, the average value of retirement accounts jumped a substantial 10% from 2010 to 2013, to $201,300. The Fed attributed that to the strong stock market and larger contributions. But for the lowest-income group that owned accounts, the average combined IRA and 401(k) value was just $39,100—and that is down more than 20% from 2007.

Considering the stock market’s strong performance in the intervening years, that suggests many of these households either sold while the market was depressed, drew down savings—or both. Meanwhile, upper-middle-income households saw a gain of 20% since 2007.

In Washington, lobbyists and policymakers have been debating about whether a retirement crisis really is looming. The various sides typically filter the data to support their viewpoints and agendas. But it’s difficult to think of two sources aligned than the Federal Reserve Board and Harvard. The SCF, in particular, is widely viewed as a gold standard survey that will be relied on for many economic reports in the months ahead. It includes information on the household balance sheets, pensions, income and demographic characteristics of about 6,500 families.

The JCHS study was funded by the AARP Foundation and The Hartford insurance company, so there’s a possible agenda there, if you doubt Harvard’s independence as researchers. (I don’t.)

Taken together, the studies paint the portrait of a widening divide in the retirement prospects of working Americans. No matter how the data is sliced, we’ve got problems that need to be addressed.

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