I reflected: “Given the scale of the crisis, that sounds more like sober gradualism than anything else and may only pause the carnage momentarily. Nor will stimulus be as simple as the CARES Act.”
Said Alice: “That’s why you’re here, dummy. Your white paper for Aamanzaihou’s been making the rounds on the Hill and in the policy shops.”
Rathbone nodded. “My expertise in the grounding line ice discharge of drainage basins in Antarctica is elementary. But I know financial panics, and we are on a clock here. This depression will not be great, greater, or greatest, it will be the fucking dark ages. You say this runs deeper, Ash. Well, we need to know how deep.”
Thus, I launched into my theory of the case, which I will summarize in abbreviated version below.
Homeowners in flood plains, Wall Street firms, and major insurers alike all rely on the predictability of risk. With developments like ARkSTORM, Cyclone Giri, and the sudden increase in the rate of sea level rise (among others), risk models were categorizing the confluence of these exogenous calamities as a 37-sigma event, or 37 standard deviations away from the norm. How likely is a 37-sigma event? A modest 8-sigma is supposed to happen less than once in the history of the universe. In this context, the large providers of financial products—mortgages, home insurance, pensions—simply could not shift risk away from their portfolios. In some cases, as with beach sand replenishment or ill-advised insurance markets, the government has subsidized climate risk, which has undermined everything from firm-level financial valuations to the value of vacation homes.
Dramatic events like the human and economic catastrophe of California gather headlines, but the more dire issue is sea level rise. If we look to where the crisis began in the low-lying areas of Florida, especially Miami, we see a simple chain of events. Home values collapsed as buyers began to realize that nuisance flooding (forget catastrophic hurricanes) would soon render their property worthless as groundwater regularly brings sewage into the streets. When Congress tried to increase rates for the National Flood Insurance Program to reflect its enormous indebtedness incurred by the Great Eastern Flood and ARkSTORM, the removal of even a sliver of this subsidy caused enormous pain. This priced out low- and middle-income homeowners but was not high enough to actually stop the buildup of risky and expensive properties. Borrowers faced the inability to repay mortgages and those who could sell were typically unable to recoup enough money to repay the mortgage principal, leading to a sharp spike in defaults. Meanwhile, banks were refusing to offer mortgages for flood-prone properties, and in the past fifteen years, this has decimated the tax base of numerous communities, leading to neighborhood blight and further collapse in property values. Municipal services were cut off, first in low-income and now middle-income areas, while rating agencies began downgrading the bonds of coastal municipalities to junk status. Facing enormous borrowing costs or having lost access to credit entirely, the communities have no money for infrastructure repairs—sewer pipes, water lines, and electrical lines being destroyed by intruding seawater—which further lowers property values in a vicious cycle. As homeowners saw the futility of making payments on doomed homes, they began to default in large numbers.
Financial crises are typically proceeded by credit bubbles, and the explosion of new housing added to the coasts between 1990 and 2030, both in the US and globally, perhaps represents one of the most ignominiously stupid bubbles in the history of capitalism. Driven largely by the signorial class and its appetite for staring pointlessly at water but indulged by anyone with access to the necessary credit, this will render quaint the subprime bubble of the aughts. The preposterous sight of beach homes crowding the shore while overflowing sewers and stormwater systems made roads regularly impassible, trapping residents during simple high tides, seems to have alerted homeowners too slowly. The bubble was also inflated by taxpayer subsidy, as federal flood insurance, dreadful zoning policy, and an absence of laws requiring risk disclosure allowed an unprecedented buildup across vulnerable coastline. In fact, the disastrous hurricanes of the last few decades have only served to fuel construction booms as federal disaster and insurance dollars arrive, no strings attached, and developers and speculators bid up the prices each time. The Pollution Reduction, Infrastructure, and Research Act of 2030 helped to fund a great deal of pointless coastal armament and beach replenishing for affluent communities that, of course, has mostly proved wasted effort. Paradoxically, even as sea levels have crept higher and storms have grown more intense, more people and more property have crowded the shoreline. Unfortunately, this coastal real estate bubble also coincided with another enormous consumer credit bubble that includes student loan debt, credit card debt, and auto loans. Beginning in the 1980s with liberalization and wage stagnation, credit essentially came to replace socioeconomic policy. Average workers and students have had to borrow more and more just to stay afloat and for the economy to sustain rising consumption. Now that mass layoffs have begun, those student loans, credit cards, and auto payments are going unserviced, and because those loans are also sliced and diced in securitization methods, it’s rendering toxic large portions of the assets moving between major financial institutions.
There’s been great hand-wringing and left-wing populist rhetoric that the bankers are again to blame, which I find a shallow and nonrigorous opinion. The Farooki piece in the New Yorker garnered widespread attention, but mostly missed the point. (And here I have to disclose my association with Tara Fund, one of the firms investigated in the piece, due to the fact that its manager is my brother-in-law.) As with many panics, any fraud is merely an addendum. All the activity described, from catastrophe bonds to the securitization and off-loading of coastal mortgage debt, was legal. CAT bonds, for example, driven by investors seeking higher yields following decades of low interest rates, were triggered by a few very expensive disasters, which has led to a panicked sell-off. It is not a Ponzi scheme described by leftist pundits, but a standard insurance bet gone wrong in an era of climatological extremes. Wall Street’s creation of financial products to insure against climate risk had the effect of spreading it to every part of the system.
The difference between 2037 and 2020 is that there is no vaccine on the way for the greenhouse effect. The difference between 2037 and 2008 is that this panic is largely justified due to sea level rise. While wild conspiracy theories have proliferated on the internet (for instance, that the government is trying to forcibly remove coastal homeowners to return it to the ancestors of the Seminole tribes), one can go to New Jersey beachfront communities and the homeowners will show you the water spilling through their front doors. Many of these mortgages are worthless because the physical infrastructure is destined to be inundated. Miami alone has over $500 billion in threatened assets. Pieces of the American coast have passed the geomorphic threshold where they will suffer significant and irreversible changes, by which I mean they cannot be defended. Looking out over the next forty years, roughly 2.5 to 2.8 million homes are under direct threat, which equates to over a trillion dollars in real estate. But not all these homes are doomed. As with the food crisis, climate panic is exacerbating the underlying trends. Florida’s tax base is collapsing as people panic-sell, but they are panic-selling even on high ground where water is unlikely to reach for decades, if not centuries. The collapse of prices is reaching deep inland as confusion and hysteria spread.
The panic in the US has been foreshadowed by what’s happening globally. One hundred and thirty port cities around the world are seeing similar effects on their economies. In India, flooding in the Bay of Bengal and the summer heat (at times breaching an unthinkable 135 degrees F) is dragging much of the middle class back into poverty, and this has served as the kindling for incredible violence against the Muslim minority and Bangladeshi refugees. China similarly has so much coastal investment that the panic will create even deeper social unrest as its once-booming middle class is forcibly relocated. More ominously, the German government has growing concerns about Munich RE, the world’s largest reinsurer. Stationarity is a bedrock principle of the insurance industry, but now several black swan events have cast doubt about the range of uncertainty created by climate risk, that weather phenomena might render insurance a virtually impossible business model. If the reinsurance giants begin to topple, the panic will turn to economic apocalypse. During the Great Depression, worldwide GDP fell 15 percent. This crisis, by my estimation, could shock global GDP by up to 35 to 40 percent. Standard countercyclical monetary policy is not of much use here, as most major central banks, including the Fed, the European Central Bank, and the Bank of England, have cut interest rates to zero since the economy began lagging. Aggregate demand continues to vanish. Stimulus will be key, but the Keynesian toolbox will not work until the roots of the crisis are addressed. At this point, I asked Secretary Rathbone what was at the root of all financial panics, to which he correctly replied: “Confidence.”