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WEALTH OF NATIONS
Treasury And The Fed: Beyond Crisis Management
Now that the brute facts are being confronted, Paulson and Bernanke deserve good marks.
Explaining his decision to let Lehman Brothers, one of the world's leading investment banks, collapse, Treasury Secretary Henry Paulson Jr. assured the country on Monday that the financial system was intact and secure. He warned, however, that more bumps might lie ahead.
Such foresight: The next day, Paulson and Ben Bernanke, chairman of the Federal Reserve Board, announced an $85 billion initiative that amounted to the nationalization of American International Group, a giant insurance company that otherwise would also have gone bust.
The taxpayers' portfolio of shattered financial behemoths is growing apace. Even once-mighty AIG is small beer, however, compared with last week's government takeover of Fannie Mae and Freddie Mac, the pseudo-private agencies that bought or guaranteed mortgage-backed securities and have on their books more than $5 trillion of assets (a figure equivalent to 40 percent of the nation's annual output). All of these transactions, together with the funds that backed the sale of Bear Stearns (another big investment bank); plus the Fed's previous "enhanced" facilities for providing extra liquidity to the markets; plus the enlarged mandates of the Federal Housing Administration and other programs, expose the public purse to costs that will run into the tens, and more likely hundreds, of billions of dollars. And this crisis is not even close to being over.
This side of the Great Depression, such circumstances are unprecedented, and so it is not really a criticism of Paulson and his colleagues to say that they are making this up as they go along. When Treasury first announced its contingency plan for Fannie and Freddie -- in effect, pledging unlimited taxpayer support should it be necessary -- officials were hoping that they would not need to keep their promise, that making it would be enough to calm the markets. For a while it looked as though they might get away with it. But the bluff was called, the government took over Fannie and Freddie, and since then it has been capitulation to reality all the way.
It is good to face facts, finally, but is Treasury behaving consistently? It put up nearly $30 billion of public money to facilitate the sale of Bear Stearns; refused help to Lehman (which then folded) and Merrill Lynch (which was snapped up by the Bank of America); yet dug deep to rescue Fannie and Freddie, and now AIG. It all seems to make no sense.
But I think it does make sense, after a fashion. The key factors are the systemic implications of each collapse. How big were the ripples going to be? How much damage would they cause elsewhere? These are far from clear-cut questions. The answers take into account the size of the failing institution, its interconnectedness with other parts of the financial system, the complexity of those interconnections, and the abruptness of its plight.
The most questionable rescue (though its shareholders, who lost most of their investment, might not call it a rescue) was Bear Stearns. If Lehman could be allowed to fail, why not Bear? Treasury says that the markets had weeks to prepare for the Lehman failure -- the firm was known to be in deep trouble. Bear was much more of a shock, and its collapse liable to do more damage. Maybe so.
Fannie and Freddie simply had to be supported. Had they disappeared, the prospects for any recovery in the housing market -- the key to a wider economic upturn -- would have been destroyed. AIG was a closer call, but I don't hear many economists saying that the government should have let it fold and merely watched what happened. The dumping of AIG's enormous security holdings on the market at forced-sale prices, driving down asset values everywhere, would have risked a worsening crisis. Added to this was the fact that the company has insured vast quantities of debt securities. If those policies had become void, the value of many of the contracts, held by other firms, would have collapsed--another channel of contagion (and an especially opaque one) to the broader market.
Letting AIG go under would have been a much bigger gamble than letting Lehman fail -- and, on balance, not a good bet. Treasury and the Fed, having decided to step in, deserve credit for structuring the deal as a de facto nationalization so that taxpayers will end up with any value that can be salvaged. This is not a case of riding to the rescue of AIG's shareholders or managers.
Now that the brute facts of the matter are being confronted, I think both Treasury and the Fed deserve good marks for crisis management. As I say, they are getting little criticism so far on this score. If Democratic presidential nominee Barack Obama thought he had a better short-term way of shoring up the financial system, his campaign would no doubt be telling us.
There is controversy, all right, but it is not about these emergency maneuvers so much as about what got us into this mess in the first place, and what lessons we should draw for the future. The simplest and most popular narrative, of course, is that the whole episode proves the folly of financial deregulation. See what happens when you let markets regulate themselves? Those people on Wall Street go crazy with greed and the rest of us end up paying the price.
This story leans Democratic, so to speak. Democrats love regulation, Republicans do not, so the Democrats win. Also, the crisis moves broader economic issues higher up on the electoral agenda, again favoring Obama.
To be sure, the whole sorry mess is a consequence of regulatory failure. Former Fed Chairman Alan Greenspan is, I think, the only serious observer of the issue who denies this -- as he would, since he regarded the dual explosions of subprime mortgages and mortgage securitization (the packaging and reselling of those loans) as unambiguously good things when they happened on his watch. GOP presidential nominee John McCain is not denying the failure. Even Treasury is not denying it. The department's recently published blueprint for regulatory reform acknowledges by its very existence that defective regulation played a key role in this sorry tale.
Where I quibble with the standard story is over the idea that financial regulation is an easy thing to get right; and that more regulation, as opposed to smarter regulation, must be better. History shows that things are not so simple.
We did not start with a pre-existing, intelligently regulated housing finance system, working to everyone's satisfaction, which free-market vandals then chose to destroy in an act of ideological hubris. The traditional bank-financed mortgage -- offered long term at a fixed and regulated rate -- was fatally assaulted as far back as the 1960s and '70s, not by deregulation but by inflation. The rules forced lenders to lend long term and borrow short; inflation rendered this mismatch unsustainable. It was during President Johnson's administration that Fannie Mae (as it came to be known) was established in its modern form and assigned the explicit goal of creating a secondary market in mortgage-backed securities to overcome the mismatch and keep the supply of mortgage loans flowing.
Some years later, the next great milestone in the evolution of the modern mortgage market was the Depository Institutions Deregulation and Monetary Control Act. Again the system's widely perceived failures led to demands for reform: The measure was not, as it were, an unprovoked assault.
In signing the law, the president said, "As you know, under existing law, which this bill will change, our banks and savings institutions are hampered by a wide range of outdated, unfair, and unworkable regulations. Especially unfair are interest-rate ceilings that prohibit small savers from receiving a fair-market return on their deposits. It's a serious inequity that favors rich investors over the average savers. Today's legislation will gradually eliminate these ceilings and allow, through competition, higher rates for savers. It provides an orderly transition for institutions to develop new investment powers." This was 1980: The right-wing, market-fetishising ideologue in the White House was Jimmy Carter.
The idea that all one has to do is vote for more financial regulation -- never mind the details -- and all will be well is infantile.
Regulating finance in ways that do not have perverse unintended consequences and that are robust to innovation, avoidance, and ever-changing circumstances is no small feat. By all means, a crackdown on irresponsible mortgage lending ought to be uncontroversial. More broadly, I favor a regime that discourages excess leverage by imposing more-onerous capital requirements on a much wider range of financial firms, such as hedge funds, "special investment vehicles," money-market funds, insurance companies, and the rest of the so-called shadow financial system. The system's capacity to absorb losses needs to be bolstered. This avenue needs exploring, although it's not without drawbacks. I could name other re-regulatory strategies that would do more harm than good.
Letting financial firms that placed huge losing bets go under is a start. The most poisonous combination of all is light or no regulation combined with a taxpayer-financed escape clause. The fate of Lehman, and others to follow, is part of the antidote.