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Can They Stop the Great Recession?

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Charles Dharapak/AP Images
National Economic Council Director Lawrence Summers, Treasury Secretary Timothy Geithner, and Council of Economic Advisers Chair Christina Romer, Andrews Air Force Base, Maryland, January 12, 2010

Stiglitz is especially disappointed that the Obama economics team did not seriously change the course set by the Bush administration, led by Treasury Secretary Henry Paulson. But they were, after all, mostly the same people. Timothy Geithner was an integral member of the Bush team, assigned to rescue the financial system when he was president of the New York Federal Reserve Bank, as was Bernanke, whom Obama strongly recommended for a second term at the Fed. The third member of the triumvirate now running the rescue is Lawrence Summers, Clinton’s former Treasury secretary, who was a strong advocate of financial deregulation in the 1990s.

Stiglitz does not believe that saving Lehman Brothers would have prevented the crisis. He calls that “sheer nonsense,” and he is surely right. Wall Street was so overleveraged—i.e., its borrowings were so great in relation to its cash holdings—that far more radical action was ultimately required than keeping Lehman going on one cylinder. To his credit, Bernanke had been cutting interest rates sharply since August 2007, but the regulators were overconfident that that was sufficient. When markets did indeed fall apart after the Lehman announcement—bank lending dried up and the Dow Jones industrials fell five hundred points the next day—the regulators at last realized that they had to act more boldly. The next day, the Fed saved AIG with an $80 billion investment, and the Treasury guaranteed the liabilities of the $3.5 trillion money market industry. Later that week, Paulson, Geithner, and Bernanke put together the $700 billion request to Congress to set up TARP.

At first, the proposal did not pass Congress. But by October the Treasury was given authority to provide up to $250 billion to nine major banks (and later other banks) to shore up their capital in return for preferred shares paying a dividend of 5 percent a year and warrants, which are rights to buy common shares.

In retrospect, however, it is clear, as Stiglitz claims, that the government, in accepting these preferred shares and warrants, gave away the store. Earlier in 2009, the Congressional Oversight Panel boiled the numbers down: TARP, it concluded, overpaid for the package of securities by 34 cents for every dollar. Warren Buffett, as CEO of Berkshire Hathaway, and several Mideast investors got much better deals when they privately provided needed capital to firms like Goldman Sachs.

Although it was a bad deal, the TARP bailout, which was extended to General Motors and other such companies, and included still more injections of capital to especially troubled banks like Citigroup, stopped the extensive hemorrhaging, according to the Congressional Oversight Panel. Stiglitz does not give adequate credit to TARP. But he convincingly and clearly shows that the bailout and subsequent programs have not laid down a workable path to recovery. As the valuable Congressional Oversight Panel report, Taking Stock, makes clear, banks are still not lending adequately, and without an expansion of bank credit there will not be a strong economic recovery. If banks don’t lend when they get bailed out, Stiglitz wants to know, what is the purpose of the bailout? Moreover, the banks still have an enormous volume of bad mortgage assets on their books, which means that there are high financial hurdles ahead. Proposals to mitigate mortgage obligations in order to help homeowners to retain their houses are also far from adequate.

Stiglitz would have placed the most troubled of the banks under a federal conservatorship—a legal entity to take financial control of them—which could have forced the bondholders of the banks to trade their fixed-income investment for less certain shares in the company. The effect would have been to wipe out the existing shareholders. In his view, the shareholders—the owners—should have rightly borne the risk of bad management decisions.

Such a policy, however, may have had its own deficiencies. It risked causing a panic among bank bondholders who would have sold bonds of other companies abruptly and forced yet another and perhaps more severe financial collapse. Still, without establishing a conservatorship, the Treasury could have driven a much harder bargain for its capital injections, which would have reduced the cost of the bailouts and future federal budget deficits. It could have demanded guarantees that the recovering financial industry devote much of its rising revenue to relending to America, especially to small businesses and local communities. The failure to make such a demand has had particularly serious consequences. Banks and other beneficiaries of the taxpayers’ money have refused to make adequate credit available to small businesses that need it to survive. The Treasury could also have been tougher on executive compensation and removed some of the more incompetent managers of the banks.

There are several orthodox explanations why financial markets fail frequently, writes Stiglitz. One of the major reasons for market failures that economists are generally aware of is known as agency risk. The financial incentives that motivate the executives who run the firms (the agents) differ from the interests of the longer-term investors, the shareholders (the principals). On Wall Street, executives, research analysts, and traders were allowed to maximize their own short-term earnings, with little responsibility for future losses to the shareholders. This inevitably encouraged risk-taking, not risk management.

Another inherent market problem for Wall Street was the prevalence of “asymmetric information,” a theoretical idea for which Stiglitz and several others won the Nobel Prize. In this case, those who invested in mortgage-backed securities knew far less about the creditworthiness of the mortgage holders than those who wrote the mortgages, or the homeowners themselves. But in the new Wall Street, mortgage brokers immediately sold the mortgages to Wall Street packagers, and no one carefully examined the books to see if the mortgage payments were likely to be made.

Investors bought the securities on the basis of Wall Street recommendations and high ratings provided by private credit-rating agencies like Moody’s and Standard & Poor’s. These agencies themselves had conflicts of interest. They were paid by the institutions that wanted high ratings from them and they readily overlooked flaws in the computer models they used, which, they assured investors, compensated for lack of information about individual mortgage holders.

As Stiglitz makes clear, trading in derivatives—in particular, the credit default swaps sold as insurance against mortgage securities collapses—was not conducted openly. The same is true for the collateralized debt obligations, the securities backed by mortgages that were often falsely sold as almost riskless. Transparency and adequate information—two staples of free markets according to economists of every political stripe—were rarities in the mortgage markets.

Finally, Stiglitz writes, the fact that systemic risk itself is allowed to develop should be seen as a market failure. As the financial community became larger and more intertwined, further propelled by deregulation, it created risks for the entire system. Rather than dealing with market failures, as economic theory suggests they should, the regulators, including Greenspan and, until recently, Bernanke, took comfort in “efficient markets theory,” which argues that markets usually set prices accurately. If so, the prices of mortgage-backed securities reflected the true risk. There was therefore no need to investigate much further, and they did not.

The crisis was not something that just happened to the financial markets; it was man-made,” Stiglitz writes. “It was something Wall Street did to itself and to the rest of our society.” To him, the bankers were the chief cause of the catastrophe, pursuing self-interest to an irresponsible extreme and claiming that the market was rewarding them justly with millions of dollars in bonuses, while many of them claimed that securities based on shaky mortgages were virtually riskless. But regulators were surely equally to blame; I would argue, given their explicit responsibility, even more so.

Recent reports by journalists on how decisions were actually made on Wall Street shed needed light on these economic abstractions. The most comprehensive anecdotal account to date of the crisis is The Sellout, by Charles Gasparino, an enterprising former reporter for The Wall Street Journal who recently left the financial cable network CNBC to work for the Fox Business Network. Gasparino cuts his way through Wall Street rhetoric and in the process uncovers in considerable detail how blind profit-making ambition led to the destruction of the markets. He interviewed the men and women who were involved in the fall of Bear Stearns, which was sold for almost nothing by the pot-smoking and incompetent Jimmy Cayne, and the collapse of Lehman under the autocratic and absurdly aloof Richard Fuld.

Bear Stearns and Lehman had been at the forefront of the mortgage-writing business since the 1990s. Citigroup and Merrill Lynch, however, were the relative latecomers who pushed Wall Street over the edge. At Citigroup, CEO Sandy Weill, with the encouragement of Clinton’s former Treasury Secretary Robert Rubin, according to Gasparino’s account, authorized aggressive traders like Thomas Maheras to expand unimpeded into the mortgage-backed securities markets. With the Glass-Steagall Act repealed in 1999—the law had separated commercial and investment banks—Citigroup’s ratio of debt-to-equity soared. After Weill retired in 2003, his chief lawyer, Charles Prince, succeeded him, but with Rubin’s encouragement, let Maheras have his way. “Are you sure that’s what Rubin said?” one incredulous high-level Citigroup executive told Gasparino when he heard how Rubin encouraged Maheras and others to take risks.

At Merrill Lynch, the star investment banker Stan O’Neal, named CEO in 2002, was determined to turn his staid company into a financial powerhouse comparable to Goldman Sachs. He saw the mortgage business as a vein of gold. He borrowed lavishly to support the new aggressive mortgage bond traders he hired and refused to listen to warnings from his underlings about the thin foundation of the mortgage-backed securities market. His personal glory was at stake. In only a few years, Citigroup and Merrill became the two largest underwriters of collateralized debt obligations on Wall Street, much of it comprised of subprime mortgages. Their financing contributed significantly to the final years of the housing price bubble. Both generated enormous losses. Merrill Lynch has now been sold to Bank of America and Citigroup is barely surviving after receiving more bailout money than any other bank.

No one could argue, after reading Gasparino’s book, that compensation practices and regulatory neglect did not drive bad decisions. Cayne, Fuld, Prince, and O’Neal barely understood the mortgage securities market at all—nor did they try. But they each made a fortune despite their ignorance.4 Less well known to the public is that all these companies were aggressive participants in every stage of the market. Citigroup, through subsidiaries, sold almost as many subprime mortgages to unaware homeowners as did Countrywide Financial, the largest residential mortgage writer. At the same time, Countrywide built a securitization operation that sold as many collateralized debt obligations to pension funds and others as almost any Wall Street bank. These companies were rife with conflicts of interest.

Now the nation faces a spring in which Congress will debate how to reregulate a financial community with hundreds of millions of dollars to spend on lobbying and political campaigns. Stiglitz believes that risky banking activities should be separated from basic business lending and savers’ deposits. President Obama took a step in this direction by supporting a suggestion of former Federal Reserve chairman Paul Volcker to restrain banks from engaging in some forms of speculative behavior. But even under the so-called “Volcker rule,” a great deal of speculation will continue to be done on the banks’ trading desks. At the time of this writing, some members of the Senate Banking Committee already opposed the Volcker rule. Among central questions are whether Congress and the administration will demand that large financial institutions come under rigorous regulation, including strong requirements for maintaining adequate capital, for transparency, and for control of derivatives. It is not too late to demand that institutions bailed out by the government should be obliged to extend loans to creditworthy homeowners.

Meanwhilte, Stiglitz, in his recent journalistic writing, is appropriately worried that fears of growing deficits will prevent the nation from developing another stimulus package that is necessary to avoid a second recession. The responsibility for ongoing economic recovery and adequate financial reregulation lies squarely with the President. It is not an easy task, given the size of the federal deficit Obama inherited from the Bush administration and the depth of the financial crisis he faced—and the wealth and vehemence of the political opposition. Regulatory reform was not passed in America until four years after the 1929 crash, when Franklin D. Roosevelt finally took office. But Roosevelt never took his eye off the need for regulation, a lesson that Obama, one hopes, is learning.

—March 10, 2010

  1. 4

    Cayne and Fuld did lose a lot of money when their companies collapsed, but according to a Harvard Law study, “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman, 2000–2008,” they had earned tens of millions of dollars in previous years.

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