“For whoever has, to him shall be given; and whoever has not, from him shall be taken even that which he seems to have” (Luke 8:18). In the parable of the lamp, Jesus was talking about knowledge but the message also applies to banking. Banks like to lend to people who already have lots of money. When banks lend to firms, for example, they typically will insist that the firm have some cash on hand, strong assets, and positive net worth (assets > debts). As a rule, banks are more concerned about downside risk than upside gain because if the firm does poorly, the bank could lose the entire value of its loan, but if the firm does incredibly well (like Google), the bank simply gets its loan back plus interest. Banks, therefore, don’t make a lot of investments in startups or firms with debts that exceed assets.

The bank’s incentives make sense for the bank, but for the economy as a whole this type of behavior amplifies booms and busts. Consider a firm that makes DVD players and that wants to expand into manufacturing LCD televisions. The market for LCD televisions is growing, the firm has expertise in electronics, and it has good contacts with retailers. The firm writes a business plan and applies to a bank for a loan. The firm is making lots of profits in its DVD division and, as a result, it has high net worth. The firm’s net worth acts like a kind of collateral for the bank—a cushion or guarantee that even if the LCD division fails, the firm will still have cash to pay back the loan. Satisfied that the loan is safe, the bank makes the loan.

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Now consider the same scenario during a recession. As before, we will assume that the market for LCDs is growing and the firm, of course, still has the same expertise in electronics and contacts with retailers. What differs now is not the potential profitability of the LCD division. What differs is that the firm’s DVD business is not going so well and, as a result, the firm has lower net worth and the bank has lost its safety cushion, a collateral shock. The bank now evaluates the loan as risky and says no. Moreover, now that the firm cannot expand into LCDs, it is left with a dying DVD division and it ends up going bankrupt and firing its workers. For whoever has, to him shall be given; and whoever has not, from him shall be taken.

More generally, during a boom, asset prices are increasing and firms have cash flow. As a result, banks are willing to approve more loans, which makes the boom even bigger. But as an economy enters the downward phase of business cycles, asset prices fall, cash flow is reduced, and firms have lower net worth. Lenders see loans as being riskier and they cut off or restrict credit. This process drives more firms under, thereby increasing joblessness and making the bust worse.1

This scenario is a good example of how real shocks and aggregate demand shocks can reinforce and amplify one another. In general, the real shock mechanisms in this chapter involve lower wealth, greater risk, and greater difficulties of adjustment, in various combinations. Those same economic problems will mean lower consumer spending, less business investment, and also less borrowing and lending, all factors that will feed into lower aggregate demand.

Collateral shocks also affect consumers. Say John bought a house near Orlando, Florida, one center of the recent real estate bubble, for $200,000. As was common practice at the time, suppose that John paid no money down, so he borrowed the entire purchase price, $200,000, from a bank. Once the real estate bubble burst and home prices fell, that same house suddenly was worth $120,000. Because the value of John’s house is now less than what he owes on it, John is said to be “underwater,”or, to use the term from Chapter 29, John has negative equity in the house. It’s difficult to get an exact estimate, but around 2010 nearly 20% of all American homes were underwater to some degree.

Now imagine that John receives a job offer in Houston, Texas, where the economy isn’t as depressed as in Orlando. It’s hard to rent out the Orlando house but it’s also hard to sell it. If John sells the house, he has to pay roughly $200,000 back to the bank (the exact sum depends on how long ago the loan was taken out and how many payments the buyer has made in the interim). Yet the sale yields only $120,000, or less if you take brokerage commissions into account. In other words, John has to come up with $80,000 or more in cold hard cash. For a lot of people, that’s extremely difficult to do, especially during a recession. The end result is that the move to Houston does not happen and John does not take the better job. “Underwater” positions make moving more difficult and the adjustment of the economy to business cycles is therefore slower.

An alternative scenario is that John takes the job in Houston and “mails in the keys.” In other words, John defaults on his mortgage. The home, as a financial asset, has a value of negative $80,000 to John so walking away makes financial sense. John is better off but the bank is worse off. That is a transfer of wealth, but the problem is worse than this.

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Few people make the choice to default right away. But if John is even thinking that he might default in the near future, does he take tender, loving care of the flowers and garden? Does he check carefully for cracks in the walls and ceilings and have them repaired promptly? Does he scout out a good real estate agent to sell? Or does he have lots of wild parties and trash the place?

We are sorry to say that a lot of trashing goes on (“Incentives Matter”). This is an extreme example, but one San Diego cop was “underwater” in his real estate position. He and his wife responded by tearing off doors, light fixtures, countertops, decorative beams, bathroom vanities, air conditioners, and appliances, either to take away or for the sheer pleasure of destruction. They also poured black dye on the carpets and spray painted all of the walls. The total damage to what was once a lovely six-bedroom house was estimated at over $200,000. One neighbor noted: “It didn’t hit me until they asked for the sledgehammer that they were going way beyond damage.”2

Very often, by the time default comes, the value of the home has declined sharply. It is common for instance that when banks have to foreclose, the bank loses 25% or even more of the value of that home.3 It’s also true that the value of other homes in the neighborhood declines when there are lot of foreclosures nearby. As of the summer of 2010, about one of 12 houses with mortgages below $1 million were in foreclosure, so that is a lot of wealth being dissipated.

The general lesson is that when the nominal owner of a property doesn’t have much equity in the property, very often he or she doesn’t do a good job taking care of the property. The lesson applies to more than just homes. We’ve already talked about how the bank loses on these deals, so what happens if a bank made too many bad loans to too many insolvent homeowners? Well, then it’s not just the home with low capital value—the bank itself has low capital value or sometimes it is said that the bank is thinly capitalized. And what do we know about individuals or organizations with low capital value? Return to the sentence earlier in this paragraph: “When the nominal owner of a property doesn’t have much equity in the property, very often he or she doesn’t do such a good job taking care of the property.”

In other words, when the bank itself is “underwater” or nearly so, the bank managers don’t do a very good job of taking care of the bank. No, they don’t usually take out a sledgehammer, but there are other ways of eroding the capital value of a bank. Bank employees won’t see the bank as a place for a career if it is tottering and, as a result, they won’t invest in their relationship with the bank or its customers. The managers will fail to build up new business opportunities and they will take dubious risks, all in the knowledge that since the bank is already on the verge of destruction, they don’t have to worry about the downside so much. It’s that same attitude of “nothing left to lose.” The banks with low capital values will not be run very well because there is little value to protect and the chance of “foreclosure” on the bank—in this case, called bankruptcy—is fairly high. The common expression is to refer to “zombie banks” when this situation arises, and indeed during 2009-2010 the number of bank failures reached an all-time high.

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The net result is this: When asset prices fall, there is a lot of collateral damage.