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Can They Stop the Great Recession?

Taking Stock: What Has the Troubled Asset Relief Program Achieved?

by the Congressional Oversight Panel
181 pp. (December 9, 2009)
Brendan Hoffman/Getty Images
Joseph Stiglitz with House Democrats Barney Frank and Steny Hoyer at a news conference on the economy, Capitol Hill, October 13, 2008

A year and a half after the bankruptcy of Lehman Brothers and the near collapse of the global financial system that followed, the US Congress still has adopted no new rules to reregulate financial institutions. Well over three years have passed since the housing market began to unravel after an unprecedented boom fed by Wall Street speculation. Some financial firms borrowed more than forty times their capital at the height of speculation in 2006 and 2007 to invest in mortgage and other securities. Yet today, there are still no significantly higher capital requirements for them. There are no restraints on multimillion-dollar banker compensation, except on the executives of companies that took and have not yet paid back bailout funds from the Bush administration’s $700 billion Troubled Asset Relief Program (TARP). Most of the major firms, including Goldman Sachs and even struggling Citigroup, already have.

There are no adequate new restrictions on the private credit-rating agencies such as Moody’s, which doled out AAA ratings in increasing numbers even as mortgage securities became far more risky in 2006 and mortgage defaults started to rise. There are no new requirements to trade derivatives openly and transparently, and they are still being traded in obscurity. The value of these highly leveraged and typically volatile instruments was based on other more stable securities, such as treasury bonds, which enabled investment firms to take on more risky investments while avoiding regulatory restrictions. And there are no new regulations to protect consumers from credit card or mortgage fraud, despite rampant deception and abuse of homeowners.

Meantime, financial institutions are thriving again. After many posted large losses in 2008, the banking firms earned record profits in 2009, and are set to pay as much as $145 billion in bonuses to their employees. The rest of the American economy is largely suffering. A congressional oversight panel headed by Harvard Law School professor Elizabeth Warren reported in December that lending to businesses and consumers by major banks was down from the previous year, especially by the twenty banks that received the biggest bailouts. The unemployment rate hovers around 10 percent. When those who have given up looking for jobs or are taking temporary jobs are included, about one in six Americans who want to work full-time cannot do so. Household incomes are suffering in general and because of high levels of debt, few experts see a strong economic recovery in the making. Three years after housing prices fell by an average of one third, they are still not rising. As a result of the recession the federal deficit keeps increasing as tax receipts flounder, preventing the federal government from introducing programs to rebuild infrastructure, improve education, and provide health care for all Americans.

Joseph Stiglitz, the Nobel Prize– winning economist who also served in the Clinton administration, cannot suppress his dismay in a new book, Freefall, over how poorly Congress and the Obama administration, not to mention the Bush administration before it, have reacted to the nation’s greatest modern economic test. His anger sometimes leads to inappropriately bold criticism. After all, Obama inherited from his predecessor some of the worst economic circumstances of any first-term president. But Stiglitz, a leading economic theoretician, with considerable public policy experience as well (he was the World Bank’s chief economist), presents a substantial and disheartening case that the US is losing a battle to right the nation’s course—and the world’s. He has managed to clarify deftly and intelligently almost all the relevant and perplexing issues that have arisen from the crisis, and he proposes a comprehensive and sensible, if politically difficult, way forward as well.

For Stiglitz, the most important conclusion to be drawn is that the deep recession and financial collapse made hash of the long-standing claims of former Federal Reserve Chairman Alan Greenspan and the leading economist of the political right, the late Milton Friedman, and their countless disciples that unfettered competitive markets will lead to more stable economies and long-term prosperity. Competition itself, they alleged, checks excessive risks and minimizes market manipulation.

To the contrary, Stiglitz replies, markets very often fail, especially financial markets. Without large-scale government intervention, the financial system would have stopped working entirely. For a few days—after the demise of Lehman Brothers in September 2008—it essentially did. A depression, with soaring unemployment, shuttered factories and stores, and growing hunger and starvation around the world, would have very likely been the result. But Washington, Stiglitz fears, may not yet have learned from its errors.

Last December, the House of Representatives passed what I would consider a minimally acceptable financial reregulation plan, which was based on a Treasury Department white paper issued in the early summer that was hardly an example of rigorous analysis or adequate reform. But even its moderately strong proposals have been watered down in the House bill, while a Senate bill is now taking shape and is likely to be weaker. In particular demands to make trading of derivatives open and above board—the derivatives that would have brought down the giant insurance company AIG without a federal bailout—are now compromised. The House has exempted up to 30 percent, according to some analysts, of all such trading from having to go through an exchange or clearinghouse, opening loopholes that still more traders will probably learn how to exploit. Yet the exemptions were explicitly endorsed by Treasury Secretary Timothy Geithner last August in a sad retreat from his original proposal.

The other strong proposal of the Treasury white paper was the creation of a Consumer Finance Protection Agency (CFPA), to monitor and approve consumer products like credit cards, auto loans, payday loans, and mortgages. The deception of homeowners by mortgage brokers since the 1990s, especially with the surge in subprime mortgages in the 2000s, is one of the most deplorable examples of regulatory failure in modern American history. Hundreds of billions of dollars’ worth of low-rate and no-down-payment mortgages were made to Americans with poor credit who believed their brokers when they told them not to worry about the fine print.

It turned out that many of these brokers, who were regulated by no one (and still aren’t), told the homeowners just about anything they wanted to hear. For many of these subprime mortgages—usually with an “adjustable rate”—interest payments would go up significantly in two years. The only way many mortgage holders could avoid default was if home prices kept rising, which would allow them to refinance into another temporarily cheap mortgage or sell their house. Some $650 billion worth of these mortgages were written in 2006. By 2007, defaults on subprime mortgages reached 15 to 20 percent and at the nation’s largest mortgage broker, Countrywide Financial Services, nearly 30 percent.1

A well-managed independent Consumer Finance Protection Agency could have prevented this. The House bill provides for only a watered-down version of it. There will be no outright requirements to offer very simple, understandable credit card or mortgage products, for example. But it is increasingly unlikely that the Senate Banking Committee under Christopher Dodd will send even a mild version of it to the full Senate. Currently Dodd is proposing that oversight of consumer finance be given to a new bureau in the Treasury Department or be housed in the Federal Reserve. And though the Obama administration announced that it strongly backs an independent agency, it has not been able to mobilize support for it.

The financial lobbyists, according to law professor Michael Greenberger of the University of Maryland, have made killing this agency their primary goal. Those mortgages and other consumer debt products fed one of the largest sources of profit in Wall Street history, and they do not want it seriously tampered with. The Wall Street firms turned the mortgage, credit card, and auto debt into complex securities bought—for trillions of dollars—by pension funds, trust funds, hedge funds, mutual funds, and insurance companies in the US and around the world, funneling trillions of dollars into these markets, particularly housing. The Wall Street firms made substantial fees every step of the way from selling these asset-backed securities. There were $5.5 trillion worth of mortgages outstanding in America in 2001. By 2007, there were $11 trillion, made possible not by lending by the old-fashioned thrift institutions but through the conversion of good and bad debt into salable securities.

To control excessive lending and risk-taking, the Obama administration proposals and the House bill both largely depend instead on raising capital requirements on financial institutions, particularly those deemed so large that their failure can bring down the entire financial system, posing what is often called a “systemic risk.” The Obama administration proposes that the Federal Reserve be the new “systemic risk regulator” with authority to set capital requirements (and also to set liquidity requirements, meaning that a sufficient volume of assets is held that can readily be sold), not only for commercial banks, which they now regulate, but for any and all financial institutions, including investment banks, whose excesses may jeopardize the financial system. The House endorses this proposal.

But Stiglitz is appalled that the administration and Congress are so eager to confer such ultimate power on the Fed after its recent performance. Federal Reserve Chairman Ben Bernanke, who took over from Alan Greenspan in 2006, asserted in a major speech in May 2007 that the growing mortgage defaults would not spread to the rest of the financial system. At the time, house prices had already been falling for a year, major mortgage brokers were going broke, and two Bear Stearns hedge funds, which invested aggressively in mortgage-backed securities, were near collapse. Well before Bernanke’s inexplicable statement, according to journalistic accounts, prominent Wall Street traders and analysts were warning their bosses about the broad dangers of the system. The head of fixed-income trading at Bear Stearns, which the federal government essentially pushed into acquisition by JPMorgan Chase at a distressed price in March 2008, pleaded with his CEO and other executives that they stop investing in mortgage-backed securities back in 2005. Raking in huge sums, they chose to ignore him.2

Similarly, the head of mortgage research at Deutsche Bank, Karen Weaver, warned in 2005 that the value of mortgage securities was highly vulnerable to a downturn in housing prices. In 2006, heeding her advice, Deutsche Bank sharply shifted its policy and started selling the securities. So did Goldman Sachs. Lewis Ranieri, who founded mortgage securitization back at Salomon Brothers in the late 1970s, issued stern warnings about the vulnerability of the market by late 2006. And respected economists at the Bank for International Settlements in Basel warned a few weeks after Bernanke’s remarks about the possibility of a depression-size collapse because of excessive securitizing of mortgage and other debt.3

Stiglitz points out that the Fed under both Greenspan and Bernanke had refused to try to mitigate the housing bubble, despite the unprecedentedly rapid run-up in prices in the 2000s. They could, for example, have raised down-payment requirements on mortgages or raised margin requirements on bank lending for securities. The Fed did not, as it is entitled to do, investigate the rampant mortgage deceptions or probable frauds committed by the mortgage brokers. Even the Federal Bureau of Investigation was issuing warnings about such fraud and deception by 2004. Stiglitz and others believe that any institution capable of creating systemic risk should, at the least, be subject to more rigorous regulation not just from the Fed but from other agencies as well. Originally Senator Dodd wanted to remove such oversight powers from the Fed but he has since backed off.

  1. 1

    See The People of the State of California v. Countrywide Financial Corporation, available at ag.ca.gov/cms_attachments /press/pdfs/n1582_draft_cwide_com plaint2.pdf.

  2. 2

    Lawrence G. McDonald, A Colossal Failure of Common Sense (Crow Business, 2009), pp. 135–138.

  3. 3

    On Weaver and Ranieri, see among others, Paul Muolo and Mathew Padilla, Chain of Blame (Wiley, 2008), pp. 223 and 216–225. On the BIS, see BIS Slams Central Banks, Warns of Worse Crunch to Come,” The Daily Telegraph, June 30, 2008.

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