Financial Moral Hazard

If we believe this Houdini act then we have only ourselves to blame.

How Many Bank Bailouts Can America Withstand?

The architects of the 2008 rescues pretend they’ve been vindicated.

Ten years after the financial crisis of 2008, the architects of the bailouts are still describing their taxpayer-backed rescues of certain financial firms as great products which were poorly marketed to the American people. The American people still aren’t buying.

A decade ago, federal regulators were in the midst of a series of unpredictable and inconsistent interventions in the financial marketplace. After rescuing creditors of the investment bank Bear Stearns and providing a partial rescue of its shareholders in March of 2008, the feds then shocked markets six months later by allowing the larger Lehman Brothers to declare bankruptcy. Then regulators immediately swerved again to take over insurer AIG and use it as a vehicle to rescue other financial firms.

Within days legislative drafts were circulating for a new bailout fund that would become the $700 billion Troubled Asset Relief Program. Throughout that fall of 2008 and into 2009, the government continued to roll out novel inventions to support particular players in the financial industry and beyond. Some firms received assistance on better terms than others and of course many firms, especially small ones outside of banking, received no help at all.

In the fall of 2008, Ben Bernanke chaired the Federal Reserve, Timothy Geithner ran the New York Fed and Hank Paulson served as U.S. Treasury secretary. Looking back now, the three bailout buddies have lately been congratulating themselves for doing a dirty but important job. They recently wrote in the New York Times:

Many of the actions necessary to stem the crisis, including the provision of loans and capital to financial institutions, were controversial and unpopular. To us, as to the public, the responses often seemed unjust, helping some of the very people and firms who had caused the damage. Those reactions are completely understandable, particularly since the economic pain from the panic was devastating for many.

The paradox of any financial crisis is that the policies necessary to stop it are always politically unpopular. But if that unpopularity delays or prevents a strong response, the costs to the economy become greater. We need to make sure that future generations of financial firefighters have the emergency powers they need to prevent the next fire from becoming a conflagration.

The authors say that their actions saved the United States and the world from catastrophe, but of course this claim cannot be tested. We’ll never get to run the alternative experiment in which investors and executives all have to live with the consequences of their investments. But Stanford economist John Taylor has made the case that massive ad hoc federal interventions were among the causes of the conflagration. On the fifth anniversary of the crisis he noted that in 2008 markets deteriorated as the government was taking a more active role in the financial economy, which may have contributed to a sense of panic:

…the S&P 500 was higher on September 19—following a week of trading after the Lehman Brothers bankruptcy—than it was on September 12, the Friday before the bankruptcy. This indicates that some policy steps taken after September 19 worsened the problem… Note that the stock market crash started at the time TARP was being rolled out… When former Treasury Secretary Hank Paulson appeared on CNBC on the fifth anniversary of the Lehman Brothers failure, he said that the markets tanked, and he came to the rescue; effectively, the TARP saved us. Appearing on the same show minutes later, former Wells Fargo chairman and CEO Dick Kovacevich—observing the same facts in the same time—said that the TARP… made things worse.

CNBC reported at the time on its Kovacevich interview:

TARP caused the crisis to get “much greater,” he added.

“Shortly after TARP, the stock market fell by 40 percent,” he continued. “And the banking industry stocks fell by 80 percent. How can anyone say that TARP increased the confidence level of an industry, when its stock market valuation fell by 80 percent.”

Perhaps the argument can never be resolved. What is known but is conveniently left out of the Times op-ed is an acknowledgment of the role that regulators played in creating the crisis by encouraging financial firms to invest in mortgage debt, to operate with high leverage and to expect help in a crisis. The Times piece includes no mention of Mr. Bernanke and his Fed colleagues holding interest rates too low for too long, or the massive risks at Citigroup overseen by Mr. Geithner’s New York Fed, or the mortgage bets at AIG approved by the Office of Thrift Supervision at Mr. Paulson’s Treasury Department.

Foolish regulators creating bad incentives was nothing new, though Beltway blunders had rarely if ever occurred on such a scale. What was of course most shocking for many Americans in 2008 was observing so many of their tax dollars flowing into the coffers of large financial institutions. For months both the financial economy and the real economy suffered as Washington continued its ad hoc experiments favoring one type of firm or another.

In 2009 markets began to recover and, thanks in no small part to years of monetary expansion by the Federal Reserve, stock investors enjoyed a long boom. But when it comes to economic growth and wages for the average worker there was no such boom, just an era of discouraged Americans leaving the labor force. And by keeping interest rates near zero for years, the Fed punished savers and enabled an historic binge of government borrowing.

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That federal borrowing binge was also enabled by the rescue programs. The basic problem was that once Washington said yes to bailing out large financial houses, politicians could hardly say no to anyone else. It was no coincidence that just months after enacting the $700 billion TARP, lawmakers enacted an $800 billion stimulus plan. So began the era of trillion-dollar annual deficits. Since the fall of 2008, federal debt has more than doubled and now stands at more than $21 trillion.

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The expansion of government also included record-setting levels of regulation, which limited economic growth. A financial economy heavily distorted by federal housing policy was cast as the free market that failed, and decision-making affecting every industry was further concentrated in Washington.

Messrs. Bernanke, Geithner and Paulson make the case that they saved the financial system but failed to sell the public on the value of their interventions. It’s a sale that can never be made. Even if the bailouts hadn’t led to an era of diminished opportunity and skyrocketing federal debt, Americans would have resisted the idea that our system requires occasional instant welfare programs for wealthy recipients chosen by un-elected wise men.

The bailout buddies are now urging the creation of more authorities for regulators to stage future bailouts. The Trump administration should do the opposite, so that bank investors finally understand they will get no help in a crisis.

This column isn’t sure how many bailouts of financiers the American political system can withstand but is certain that such efforts will never be welcomed by non-financiers.

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The Legacy of Timothy Geithner

I had to reprint this article as I was completely taken by surprise that the NY Times could actually be objective enough to publish such an expose.

The Legacy of Timothy Geithner

As the problems escalated, Mr. Geithner came to stand for providing large amounts of unconditional support for very big banks – including Citigroup, where Robert Rubin, his mentor, had overseen the dubious hiring of a chief executive and more general mismanagement of risk.

By SIMON JOHNSON

“Too big to fail is too big to continue. The megabanks have too much power in Washington and too much weight within the financial system.” Who said this and when?

The answer is Peggy Noonan, the prominent conservative commentator, writing recently in The Wall Street Journal.

As Timothy F. Geithner prepares to leave the Treasury Department, most assessments focus on how his policies affected the economy. But his lasting legacy may be more political, contributing to the creation of an issue that can now be seized either by the right or the left. What should be done about the too-big-to-fail category of financial institutions?

Mr. Geithner came to Treasury in the middle of a severe financial crisis, a set of problems that he helped to create and then worked hard to prevent from worsening. As president of the Federal Reserve Bank of New York, starting in 2003, he watched over – and failed to defuse – the buildup of systemic risk. In fact, the New York Fed was relatively on the side of allowing large, seemingly sophisticated financial institutions to fund themselves with more debt relative to their thin levels of equity.

This was a major conceptual mistake for which there still has not been a full accounting. In fact, blank denial continues to be the reaction from the relevant officials.

Mr. Geithner was also in the hot seat as more explicit government support for large financial institutions began in earnest in early 2008. The New York Fed brokered the sale of failing Bear Stearns to relatively healthy JPMorgan Chase, with the Fed providing substantial downside insurance to JPMorgan, against potential losses from assets they were acquiring.

Mr. Geithner also acquiesced to Jamie Dimon, the chief executive of JPMorgan Chase, allowing him to remain on the board of the New York Fed even as his bank was suddenly the recipient of very large additional subsidies (the insurance for his acquisition of Bear Stearns). This was the beginning of a deeper public realization that there had come to be too little distance between some parts of the Federal Reserve and the big banks.

For some senior officials within the Federal Reserve System, the appearance of this potential conflict of interest was a cause for grave concern. Unfortunately, their concerns were ignored by the New York Fed and by leadership at the Board of Governors in Washington. The result has been damage to the Fed’s reputation and an unnecessary slip toward undermining its political independence.

From March 2008, when Bear Stearns almost failed, through September 2008, very little was done to reduce the level of risk in the financial system. Again, Mr. Geithner must bear some responsibility.

In fall 2008, Mr. Geithner worked closely with Henry Paulson – Treasury secretary at the time – in an attempt to prevent the problems at Lehman Brothers from spreading. They were unsuccessful, in fairly spectacular fashion. The failure to anticipate the difficulties at American International Group must stand out as one of the biggest lapses ever of financial intelligence – again, a responsibility in part of the New York Fed (although surely other government officials share some blame).

As the problems escalated, Mr. Geithner came to stand for providing large amounts of unconditional support for very big banks – including Citigroup, where Robert Rubin, his mentor, had overseen the dubious hiring of a chief executive and more general mismanagement of risk. (While a director of Citigroup, Mr. Rubin denied responsibility for what went wrong.)

Rather than moving to change management, directors or anything about the big banks’ practices, Mr. Geithner favored more financial assistance – both from the budget (through various versions of the Troubled Asset Relief Program), from the Federal Reserve (through various kinds of cheap loans) and from all other available means, including insurance for private debt issues provided by the Federal Deposit Insurance Corporation.

In official discussions, Mr. Geithner consistently stood for more support with weaker (or no) conditions. (See “Bull by the Horns,” by Sheila Bair, former chairwoman of the F.D.I.C., for the most credible account of what happened.)

Mr. Geithner’s appointment as Treasury secretary in January 2009 allowed him to continue to scale up these efforts.

In retrospect, what helped stem the panic was the joint statement of Feb. 23, 2009, issued by the Treasury, the F.D.I.C., the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Reserve, that included this statement of principle:

The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses. The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth. Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.

Mr. Geithner is often given credit for pushing bank stress tests in spring 2009 as a way to back up this statement, so officials could assess the extent to which particular financial institutions needed more loss-absorbing equity. But such stress tests are standard practice in any financial crisis.

Much less standard is unconditional government support for troubled banks. Usually such banks are “cleaned up” as a condition of official assistance, either by being forced to make management changes or being forced to deal with their bad assets. (This was the approach favored by Ms. Bair when she was at the F.D.I.C.; her book lays out realistic alternatives that were on the table at critical moments. The idea that there was no alternative to Mr. Geithner’s approach simply does not hold water.)

Any fiscally solvent government can stand behind its banks, but providing such guarantees is a recipe for repeated trouble. When Mr. Geithner was at Treasury in the 1990s and Mr. Rubin was Treasury secretary, the advice conveyed to troubled Asian countries – both directly and through American influence at the International Monetary Fund – was quite different: clean up the banks and rein in the powerful people who overborrowed and brought the corporate sector to the brink of financial meltdown.

In Mr. Geithner’s view of the world, the 2010 Dodd-Frank financial reform legislation fixed the problem of too-big-to-fail banks. Outside of Treasury, it’s hard to find informed observers who share this position. Both Daniel Tarullo (the lead Fed governor for financial regulation) and William Dudley (the current president of the New York Fed) said in recent speeches that the problems of distorted incentives associated with too big to fail were unfortunately alive and well.

Ironically, despite the fact that the Obama administration failed to rein in the megabanks and allowed them to become larger and arguably more powerful, this has not helped the Republicans in electoral terms.

As Ms. Noonan puts it bluntly: “People think the G.O.P. is for the bankers. The G.O.P. should upend this assumption.”

This is a significant opportunity for anyone with clear thinking on the right – someone looking for a Teddy Roosevelt trustbusting or Nixon-goes-to-China moment. Again, Ms. Noonan gets it right: “In this case good policy is good politics. If you are a conservative you’re supposed to be for just treatment of the individual over the demands of concentrated elites.”

Recall that some grass roots conservatives are already there: House Republicans initially voted down TARP, the former presidential candidate Jon Huntsman’s plan to end too big to fail received widespread applause from many Republicans and a number of influential commentators, including George Will and Ms. Noonan, have advocated ending too big to fail.

This would play well in the Republican presidential primaries – and even better in the general election. Watch PBS “Frontline” on Jan. 22 for an articulate presentation of why serious potential financial crimes were not prosecuted during the first Obama administration, and think about how to turn these facts into political messages.

A smart candidate could even mobilize plenty of financial-sector support in favor of breaking up or otherwise restricting the too-big-to-fail financial entities. The megabanks have very few genuine friends.

The lasting legacy of Timothy Geithner is to create the perfect electoral issue for Republicans. Will they seize it?