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Too Little, Too Late: Why?

Pete Souza/White House
President Obama taking questions from business leaders at the quarterly meeting of the Business Roundtable, Washington, D.C., December 5, 2012

Two years ago, Treasury Secretary Timothy Geithner praised the widely criticized $700 billion bank bailout of late 2008—known as the Troubled Asset Relief Program, or TARP—as “perhaps the most maligned yet most effective government program in recent memory.” By late 2010, losses to the government had turned out to be far lower than many feared. Since then, the Treasury has been repaid much of the capital it loaned to financial institutions and other firms, even making profits in some cases. The Treasury now reports that losses will finally be close to $50 billion when all is said and done.1

But the program came at an enormous political cost. Many Americans were infuriated by what they saw as a giveaway by the Bush administration to the very banks that caused the crisis in the first place. Reflecting that anger, Congress refused at first to pass the TARP bill, causing a plunge in stock prices. About a week later, with prodding from President Bush and congressional leaders, TARP passed on October 3.

The anti-bailout attitudes among Americans also made the Obama stimulus package of some $800 billion in early 2009 that much harder to pass. To get congressional approval, Obama believed he had to offer tax cuts to the Republicans. The result, many economists argued, was a less potent program than one composed almost entirely of government spending, such as aid to the states and infrastructure investment.

Similarly, the public distrust of government spending to address economic decline made it difficult to return to Congress for a second stimulus, which was badly needed by mid-2009 as the job market collapsed. Trying to fend off criticism of government spending, Obama rarely boasted of the good his stimulus did do, including the creation of at least two million jobs, or even the benefits of TARP and the other government rescue programs. Without a second stimulus, the economic recovery was slow, with an unemployment rate hovering around 8 percent, which so haunted Obama in his reelection bid.

The public’s angry reaction to the bailout of bankers seemed to extend to government intrusiveness of any kind, even the financial reregulation act known as Dodd-Frank, named for its sponsors, Senator Chris Dodd and Representative Barney Frank. Ironically, the TARP reaction may have made it harder to implement tough new regulations on the banks. The TARP bill left to the regulators themselves many difficult decisions that still haven’t been made. Higher capital requirements for financial firms are not yet set, for example. We still don’t have open exchanges for trade in the derivatives that were at the heart of the crisis. The regulation of those highly leveraged investment vehicles based on other securities has been watered down by intense Wall Street lobbying, as has the famed Volcker Rule, which would restrict trading by financial firms for their own profit. Speculative bubbles are already growing in some financial assets, such as low-rated corporate bonds and overseas debt, which stronger regulatory measures would have restrained.

Economic recovery began in mid-2009, and the unemployment rate has fallen from its high around 10 percent, but even today, most Americans believe that neither TARP nor the Obama stimulus helped revive the economy. The Obama administration kept the Bush bailout largely intact when it took over a few months later. Timothy Geithner was the Treasury man who bridged the two administrations. As president of the New York Fed, he was the codesigner of the original bailout with Henry Paulson, George Bush’s Treasury secretary, and, to a lesser degree, with Ben Bernanke, Bush’s appointee as chairman of the Federal Reserve. He continued to support the plan strongly as Obama’s new Treasury secretary, and undertook the early bargaining with Congress over avoiding the fiscal cliff.

Three new books discuss whether or not TARP was a success. Two are by insiders whose accounts are fascinating, although at times they seem designed to settle old scores. Neil Barofsky, the independent inspector general of TARP, appointed under Bush, has written Bailout, a harsh look at Geithner’s management of the program. Barofsky, a former prosecutor, was a zealous watchdog, even if his doggedness led to constant friction.

Sheila Bair, head of the Federal Deposit Insurance Corporation, created in the New Deal to insure savers’ deposits, has written Bull by the Horns. A strong-minded regulator, she was skeptical of government bailouts in general—on occasion, too much so—because they could create a “moral hazard,” supposedly making big financial institutions less cautious than they should have been, since they could count on the government to rescue them. Bair made her reputation earlier when, as a Treasury official, she began to warn about mortgage fraud in the early 2000s. She couldn’t get either the Federal Reserve or Congress to take action, even when she had an ally in Federal Reserve Governor Edward Gramlich, who also argued that federal preventive measures were necessary. Alan Greenspan and others paid no heed.

The third book, After the Music Stopped, is by Alan Blinder of Princeton, a former vice-chairman of the Federal Reserve and one of America’s leading economists. Blinder is an admirably clear writer and thinker and presents the history of the financial crisis and its rescue with more detachment than the other authors. His account is likely to become widely accepted, although he seems concerned to avoid confrontation with critics of the bailout.

In retrospect, the financial world started coming apart in late 2007, even though foreclosure rates on mortgages had begun rising rapidly by 2006, while home prices had begun falling. We can see now that far too many “subprime” and other innovative but risky mortgages were issued to people who would not be able to keep to their repayment schedules. The Federal Reserve started to cut interest rates rapidly in late 2007 and through 2008, but this wasn’t sufficient to generate more rapid growth in the Gross Domestic Product.

Indeed, the recent publication of the 2007 minutes of the Open Market Committee, which makes policy decisions at the Fed, showed embarrassingly that the members had no idea the subprime crisis could spread and thought it would have minor consequences at worst. In a new but unrevealing book of lectures by Bernanke, The Federal Reserve and the Financial Crisis,2 he doesn’t discuss at all why, even as the subprime market cracked all around them, the Fed failed so badly to anticipate the broader financial collapse and deep economic recession to come.

By 2008, major firms—AIG, Lehman Brothers, and Bear Stearns among them—were beginning to teeter as the mortgage securities they had issued fell in value and losses jeopardized their ability to meet their financial commitments. In March, the Treasury and the Fed arranged a purchase by JPMorgan Chase of Bear Stearns, the fifth-largest investment bank. In the summer, the Treasury essentially took over the quasi-public mortgage giants Fannie Mae and Freddie Mac. Markets calmed down for a couple of months, but Lehman Brothers, laden with mortgage debt and dubious real estate holdings, soon faced failure as well. This time, the Treasury and Fed decided not to intervene. When, on September 15, Lehman announced its bankruptcy, the biggest in history, the financial world faced the kind of crisis no one had experienced since the 1930s.

The giant insurance company AIG had sold guarantees on hundreds of billions of dollars of mortgage securities. Now it had to be bailed out or it would also collapse. Bernanke writes, “In our judgment, the failure of AIG would have been basically the end.” To avoid bankruptcy, Merrill Lynch sold itself to Bank of America. Supposedly safe money market funds, where savers thought their funds were as secure as in the bank, were losing value, having invested in the debt of firms like Lehman Brothers. Other banks like Washington Mutual had debts they could not pay.

Why hadn’t the crisis been foreseen by regulators, or by most economists, including the Fed’s Ben Bernanke? As Blinder points out, the linkages between Lehman Brothers and countless other financial firms were more intricate than most realized. If Lehman failed to pay its bills, so would others who had extended credit to Lehman. More important, the complex and widely sold mortgage securities known as collateralized debt obligations were more vulnerable to the failures of subprime mortgages than economists or federal officials had known.

Few outside the Fed were aware of the dangers, either. This lack of understanding is a black mark for the economics profession in general. The collapse was not just a matter of a burst housing bubble leading to reduced consumer spending. It was a collapsing house of cards, the failure of one risky security leading to the failure of another. Business lending virtually stopped. When Lehman collapsed, a moderate recession turned into a severe one. Bernanke offers the lame excuse that the Fed had no legal right to save Lehman because its collateral was not adequate, but many contest this claim, as Blinder points out.

In response to the consequences of the Lehman collapse, the Treasury, the Fed, and its New York branch, which oversaw the financial markets, acted in haste to create TARP, which would become the $700 billion plan to bail out the banks and other related companies (including, eventually, major auto companies), as well as to modify mortgages so that millions of home owners could rise out of foreclosure. The original idea was to buy the bad mortgage assets of the banks, a strategy Blinder had supported in testimony before Congress. Other economists disagreed and argued that the Treasury should nationalize the banks, buying them outright. Paulson originally wanted simply to buy the bad mortgages but changed his mind when he saw that the British were successfully making capital injections into their banks in return for a minority ownership, a partial nationalization of sorts.

Now Paulson, Bernanke, and Geithner agreed to make $125 billion available immediately to a handful of major banks, with another $125 billion in reserve. Much of this money was used to buy shares of the troubled banks, with the understanding that the banks could later buy them back. They were indeed ready to force the banks to take the money even if a few didn’t want it. Geithner was determined that no bank should look weaker than the others; if it did, then there could be a run on the seemingly weak bank’s resources and that would disrupt the interconnected markets still more. Fear of another bank run, like the one on Lehman, dominated Geithner’s thinking.

TARP clearly worked to stop the market panic, but it did so only when combined with other financial rescue programs. Lending began to flow again, and, though a deep recession was not forestalled, a Great Depression may well have been avoided. That the rescue worked in this broad sense was a victory for Geithner. But was this kind of victory sufficient when so much else was not accomplished? All these authors think not, and they are right. Could the bailout have been done more effectively? asks Blinder. He answers “yes.”

  1. 1

    Dylan Matthews, “The $48 Million TARP Puzzle,” Wonkblog, The Washington Post, July 27, 2012. 

  2. 2

    Princeton University Press, 2013. 

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