A combination of factors are producing huge loses to mortgage lenders that threatened the collapse of a large share of the financial sector. The Main Street consequences could have rivaled the Great Depression. Governments around the world intervened dramatically to save their banking systems with deposit and lending guarantees and the injection of tax payer funds to bolster banks’ capital in an effort to prevent the abrupt and damaging curtailment of normal bank lending. While these unusual steps may have been necessary to avoid still more catastrophic losses to Main Street, they carry significant risks of their own if not carefully designed to minimize moral hazard and explicitly limited in duration. While a collapse of the financial sector would dramatically worsen the recession that the U.S. and Europe are now in, the recession itself makes it more difficult to stabilize financial sectors. None the less, monetary and fiscal measures to moderate the severity and duration of the recession should not prevent macroeconomic adjustments and the healthy shakeout of inefficient firms that the economy needs.
Act I – How We Got Here
Scene 1 – The Housing Bubble Inflates, Then Deflates
Government policies to promote home ownership pressured lenders to lower underwriting standards and increase lending to previously unqualified borrowers. An abundance of world saving and easy monetary policy and the mortgage guarantees from Fanny Mae and Freddie Mac (government sponsored enterprises mandated with attracting funds to mortgage lending) channeled large amounts of low cost funds to home buyers. These factors along with poorly designed land use planning restrictions in some areas increased demand for housing more than supply and prices rose rapidly. The securitization and pooling of mortgages into Mortgage Banked Securities (MBSs) lowered the cost and spread the risk of mortgage lending world wide but also weakened the financial incentives of agents to monitor compliance with already low underwriting standards. With the repeal of the Glass Steagall Act in 1999, which separated investment from commercial banking, the short-term “performance” bonus practices and very high leverage (investing borrowed money) of many investment banks began to dominate the more conservative culture of commercial banks further eroding mortgage underwriting standards to levels no one believed could service beyond a few years (before which bonuses would already have been collected). Thus principle/agent weaknesses were greatly exacerbated. Irrational expectations of ever increasing housing prices attracted speculators on the investment side as well. Overly complex mortgage backed securities over relied on credit rating agencies with no experience with such instruments and conflicts of interest. Gaps in supervisory coverage between the Office of the Comptroller of the Currency (OCC), which supervises all National Banks, and the Federal Reserve, which supervises bank holding companies (among other financial entities), left excessive risk taking unsupervised. The widely held assumption that the government would back up the commitments of Fanny and Freddie, meant that private speculators could take their winnings and the tax payers the losses. Players in the mortgage markets may have acted recklessly but generally they were acting rationally within the policy/regulatory framework the government provided. Wide spread fraud (misrepresenting borrower qualifications), encouraged by the short-termism of investment banking also played a role.
Housing prices couldn’t and didn’t go on increasing at such rates. Demand slowed at such prices. Supply caught up and exceeded demand; the stock of unsold houses rose and the bubble burst. Borrower defaults began to rise above usual rates. The market value of MBSs fell and uncertainty over how much defaults would increase made it difficult to trade them even at steep discounts. By 2007 Wall Street began to realize that banks and other investors were going to absorb hug losses but the complexity and opacity of the structured financial instruments by which mortgages had been distributed made it difficult to evaluate who ultimately would pay them. These developments along with tightening monetary policy (rising interest rates) led the entire financial system to demand more liquidity to compensate for the reduced liquidity of MBSs and a loss of confidence in financial market counterparties. In mid 2007 hedge funds and other Wall Street firms began gradually to deleverage (reduce their reliance on borrowed funds to supplement investors’ funds and to fund investment banks, insurance companies and others). The cost of unsecured interbank lending sky rocketed. The TED spread (difference between the three month London Interbank Offer Rate—LIBOR—and the three month U.S. treasury bill rate) jumped from its usual 0.1% or so to over 4%. Hedge funds and others began to reduce their reliance of borrowed funds (deleveraging).
Housing price bubbles and their collapse even larger than in the U.S. are being experienced in many countries. The UK and Spain are particularly hard hit. These also reflect the world wide glut of saving and very low real interest rates over much of the last quarter century and especially 2002-3. Some of America’s mortgage losses are also being absorbed abroad because of foreign investments in U.S. MBSs.
Scene 2 – Federal Reserve Responds to Liquidity Demand
Whether to correct for the overly lax lending standards of previous years or because of the hording of liquidity by banks concerned by the loss of their normal sources of liquidity (or both), lending standards tightened. The Federal Reserve and the central banks of other affected economies responded in traditional fashion to provide the increased liquidity banks demanded in order to keep interest rates from rising and the money supply and credit growth from collapsing. The Federal Reserve responded quickly to supply the increased liquidity demanded by the market and even introduced new facilities that extended the terms, increased the list of eligible collateral (Federal Reserve Bank loans are collateralized), and broadened the range of institutions that could access these new facilities. Lenders were also encouraged to renegotiate the terms of nonperforming mortgages if foreclosure could be avoided and the lender’s losses reduced.
Central banks traditionally intervene to provide solvent banks with liquidity when depositors suddenly withdraw funds or secondary markets for bank assets become disorderly. Federal Reserve provision of liquidity to the market takes broadly two forms: collateralized lending to banks and purchases of assets from the market. Collateralized lending does not spare banks losses on their loans or the assets they invested in. The Federal Reserve would absorb losses from “toxic” collateral only if the banks it lends to fail. So called “open market operations” in which the Fed buys securities outright are a different matter. Hence such operations are generally limited to the highest quality assets—generally government securities. The Fed now accepts MBS as collateral in some of its lending facilities but does not buy them in open market operations. More recently it has taken the extraordinary step of buying corporate “commercial paper” in the open market because of the sudden difficultly companies have been having financing their operations in this customary way. In part, this reflects the fact that banks are no longer the dominant source of funds to the economy.
At the same time the Federal Reserve is lending huge amounts to banks and others on Wall Street, it has also been selling (previously purchased) government securities from its portfolio and attracting (now) interest baring deposits from banks in order to keep the federal funds rate at or near its policy target rate. At first glance this two way activity seems hard to understand but a closer look at the deleveraging process makes clear that the Federal Reserve is facilitating the markets rapid shift toward safety. If investors in hedge funds or money market funds (already relatively safe) withdraw funds in order to reduce the riskiness of their investments two questions arise: a) where will the funds get the money to pay for these withdrawals and b) where will the investors put the money they have withdrawn.
With regard to the first question, if funds try to borrow the money needed to repay investors, the leverage of the funds would increase. A larger share of the assets in the fund would be financed with borrowed money rather than with the deposits of investors. But leverage is now more expensive and harder to get. Thus funds will be forced to, or will chose to, sell assets in order to raise the money needed for the investor withdrawals. These sales add to downward pressure on the market price for these assets (every thing from GM stock to subprime MBSs) which might add to the demand by investors to withdraw their funds. Some of the stock markets incredible volatility probably comes from such forced sales. Furthermore, the market’s reduced preference for risk implies higher risk premiums for assets with unchanged expected returns. The fall in the market value of MBSs, for example, even without further deteriorations in their expected performance, reduces banks’ capital. Thus increased demand for liquidity (and safety) and bank capital are interrelated. Banks can use these assets as collateral to borrow the funds needed from the Federal Reserve to cover withdrawal, but this slows the pace of deleveraging.
With regard to what investors do with the money they have withdrawn, they will desire to invest it in something safer. The safest investment is in government securities and the yields on these have been driven to very low levels as the market has moved to safety. The Federal Reserve’s sales of government securities to keep their interest rates from falling too low is in effect helping the market shift from riskier investments to safer ones.
Banks, and “Wall Street” more broadly, received such special treatment because of their special character. Wall Street refers to so called “financial intermediaries” (banks, insurance companies, mutual funds, etc.), which facilitate and intermediate the flow of saving from households and firms to Main Street (manufacturing, agro, and service firms and households), which use these funds for investment and to smooth the uncoordinated flow of income and expenditures. Such market allocation of lendable funds has proven dramatically more efficient in directing them to more productive uses than the centrally controlled allocation of “planned” economies. Our higher standard of living reflects our more productive allocation and use of resources (for investment in physical and human capital). Secondary markets in which financial assets (stocks, bonds and now bank loans) can be traded have increased the “liquidity” of these assets and thus lowered the cost of financial intermediation by reducing the amount of cash banks and other Wall Street firms must keep on hand to bridge the mismatch of receipts and payments. Successful market allocation of resources depends critically on the incentives and discipline of profit and loss. Those taking risks in search of profits must act in the knowledge that they will pay the price of mistakes or bad luck. In addition, banks provide the payment services our modern economy critically depends on.
The American banking system is generally strong and sound because the profit and loss discipline of the market eliminates poorly run ones. Banks limit the risks they take with depositor and shareholder money because they do not expect the government to bail them out of their mistakes. This expectation reflects the willingness of banking supervisors to close insolvent banks. Closing a failing bank, rather than bailing it out, can be risky because of its potential spill over to other sound banks and the risk of wide spread deposit withdraws by depositors fearing the loss of their money, so called “bank runs”. But the U.S. has effective bank bankruptcy laws and tools, which largely overcome these risks. Thousands of banks have been taken over by the Federal Deposit Insurance Corporation (FDIC) and resolved (sold in whole or in pieces, or otherwise liquidated) without significant disruptions to the banking system. These laws give regulators powerful tools (basically the power to nationalize undercapitalized banks and to sell them in whole or in part and liquidate whatever is left) but limit their discretion in how these tools are used by the requirement that critically under capitalized banks must be taken away from their owners and resolved with the least cost to the insurance fund (FDIC) and other depositors.
These tools were applied to the growing but modest number of banks that failed over the past year (Countrywide, IndyMac, Washington Mutual, and Wachovia to name the bigger ones). These resolutions were handled smoothly with no disruption to the market. However, mortgage and related losses also fell heavily on investment banks and even insurance companies. When a few of them began to fail, the legal provisions for bank failures were not available. Thus the arranged buyout of Bear Stearns, an investment bank, earlier this year required the approval of its shareholder who demanded a somewhat higher prices than originally offered and the buyer (JPMorgan Chase) demanded and received from the Federal Reserve a guaranteed limit on its potential losses on Bears Stearns mortgage related assets. While the resolution of Bear Stearns was probably the best that could be achieved with the legal tools available and looked much like an FDIC resolution other than the modest price paid to shareholders, it was not guided by explicit legal rules. The later quasi (re)nationalization of Fannie Mae and Freddie Mac moved closer to the approach of an FDIC resolution but again without the same legal tools. These two Government Sponsored Enterprises (GSEs) where put into Chapter 11 bankruptcy, under the supervision of the newly created Federal Housing Finance Agency (FHFA) and with new managements and boards. However, all creditors were reassumed by the Treasury’s commitment of an unlimited line of credit and up to $100 billion capital if and as needed by each of the two. Shareholders on the other hand were deprived of any dividends and the prospect of surrendering their shares if Treasury capital was needed. On November 14 Freddie Mac reported $25 billion in losses for the third quarter, which activated the first of the promised tax payer capital injections of $13.8 billion to avoid insolvency. The future resolution (downsizing and reprivatization or orderly liquidation) of these two GSEs will be decided by the next congress. They should be liquidated.
As estimates of potential mortgage losses continued to rise, the viability of additional banks came into question. Lehman Brothers and Merrill Lynch (both investment banks) entered into discussions with potential buyers. When Dick Fuld, CEO of Lehman Brothers, refused the buyout offer from Barclays, the Federal Reserve refused to sweeten the deal with guarantees and allowed Lehman Brothers to enter Chapter XI bankruptcy, while Merrill Lynch accepted the buy out offer from Bank of America. America’s remaining two large investment banks, Goldman Sachs and Morgan Stanley, promptly requested and were granted permission to convert to commercial banks, thereby gaining access to Federal Reserve credit facilities in exchange for the significantly tighter regulation of commercial banks.
Act II – Financial Panic and Beyond
Scene 1—Addressing the Panic
The September 15th bankruptcy of Lehman Brothers, the sort of market discipline of excessive risk taking and failed gambles that I favor, triggered a genuine financial market panic. The TED spread rocketed from around 1.0% the first half of September to around 4.5% by early October. Treasury Secretary Paulson rushed to Congress with a two page proposal to authorize the Treasury to buy up to $700 billion of MBS “from any financial institution having its headquarters in the United States” under terms and conditions to be determined by the Treasury. Initially his proposal was to buy MBSs from banks under rules to be determined. After a false start in which the House rejected the proposal, the Emergency Economic Stabilization Act of 2008 was passed and signed into law on Oct 3rd, 2008. In what is now a 451 page law, which included a number of other unrelated or tangentially related measures, the Act essentially authorizes the Treasury to borrow up to $700 billion in order to aid the financial sector in almost any way it decided would help restore normal bank lending. As evidence mounted that lack of capital rather than liquidity was the primary cause of the claimed freeze up of bank lending and that it would be almost impossible for the Treasury to determine appropriate prices at which to buy “toxic” MBSs, the Treasury shifted the primary use of this authority to recapitalizing under capitalized but sound banks. The Act also more than doubled to level of deposit insurance coverage from $100,000 to $250,000.
On October 8, UK Prime Minister Gordon Brown announced that the British Treasury would inject capital (buy shares) in eight major British banks and guarantee interbank loans, the Bank of England would double the size of its “special liquidity scheme,” and the government would increase the size of guaranteed deposits. On October 13 most European government promised to follow suit. These measures taken together were meant to stop bank runs, increase bank capital, and remove the counterparty risk of interbank lending in order to restore normal lending and credit flows.
In addition, the Federal Reserve has taken unprecedented measures to unblock normal credit flows to Main Street firms and household outside of the traditional commercial bank channels, which have become less important in recent years. Following panic public withdraws (“runs’) on money market mutual funds, the government guaranteed their principle. Not only did most such funds stop purchasing most commercial paper, a very important source of trade and industry finance, but they were forced to sell some of the paper they already held to finance depositor withdrawals. The Federal Reserve then introduced an off balance sheet facility for buying commercial paper directly.
These were aggressive interventions into financial markets, which were bound to interfere with normal market discipline of the behavior of its participants. Were they justified? Can they be designed to minimize the moral hazard of encouraging risky behavior by bailing out mistakes? And why bail out Wall Street rather than Main Street?
Why Wall Street rather than Main Street is easy. Wall Street is “merely” the intermediary between savers and investors, between household/firm providers of funds and the Main Street users of these funds. The collapse of Wall Street would seriously impair or even bankrupt quite innocent Main Street firms or households by cutting off the credit they depend on for investment and day to day operations through no fault of their own. Saving Wall Street from collapse potentially saves the entire economy from unnecessary collapse. But were such sweeping interventions necessary to prevent the collapse of Wall Street and restore normal bank lending? That is hard to say for sure, but the risk of misjudgment was too great to take. Given the information in hand, governments were probably justified in taking these measures.
Scene 2 – Bailout Risks
Stopping the financial panic required steps to reassure depositors and investors that it was safe to leave or put their funds in banks and to increase bank capital to levels that would allow them to continue lending to credit worthy customers. Uncertainty about the soundness of banks needed to be removed. It was too late for carefully considered and finely tuned measures, thus broad brushed guarantees and capital injections were used. None the less, the cost to tax payers should be considered and damage to market discipline should be minimized where possible. The rules governing which financial institutions get tax payer funds to bolster their capital and the terms and conditions attached to such funds (e.g. matching private sector capital injections, cost to existing shareholders, tax payers’ share in upside profits, and duration of state funding) should be explicit and transparent to minimize market uncertainty and the risk of abuse.
Partial ownership of AIG and major banks and control of Fannie Mae and Freddie Mac are most certainly not a renewed interest in old socialist ideas of the superiority of state run enterprises, actual experience with which has been almost universally bad. None-the-less, government share ownership increases the risks of political interference significantly. The longer it holds these shares the higher the risks will be and examples can be found already. And broad lending guarantees carry considerable risks of reintroducing the excessive risk taking by Wall Street that started this crisis. Emergency financial market stabilization measures should be ended as quickly as possible.
Charles Dallara, Managing Director of the Institute of International Finance, reported that banks receiving government capital injections have been told not to use the funds to satisfy the liquidity needs of their foreign subsidiaries. The severity of the Great Depression is generally attributed to the failure of the Federal Reserve to provide liquidity to banks sufficient to prevent the collapse of the money supply, the ill conceived attempt to save American jobs with high tariffs embodied in the Smoot-Hawley Tariff Act of 1930, and the competitive devaluations around the world in self defeating efforts by each country to boost its exports. Fed Chairman Bernanke, a well versed student of the Great Depression, is determined not to repeat the Fed’s earlier mistake this time around and is thus providing hug amounts of liquidity to the financial system. All participants at the November 15, Washington Group of 20 (G-20) meeting on the financial crisis and international financial architecture have also confirmed the dangers of and their opposition to a new wave of protectionism. However, as Dallara, warns, the Treasury’s pressure on banks not to support their foreign subsidiaries with the Treasury’s capital injections could be the twenty first century’s version of misguided protectionism. It undermines the logic and premise of globalized banking organizations with a counterproductive effort to “keep capital at home.” Given that the U.S. government’s debt is largely financed by foreign capital inflows, this feature of the Treasury capital injection program (Troubled Asset Relief Program—TARP) is nothing short of shocking.
The purpose of the Wall Street “bailout” is to restore normal bank lending. However, too much pressure to lend runs the risk of recreating the conditions that produced the crisis in the first place (subprime loans to inappropriate borrowers). Banks should be left to exercise their best business judgment about how to use the new capital, and to whom to lend. Political interference in bank lending has almost always had a bad end around the world and the temptation and pressures on banks to favor districts or projects favored by their new government owners will increase with time. The positive contribution of recessions to our longer run economic health and productivity rests with the acceleration of sweeping away inefficient enterprises so that their capital and labor resources can be freed up to be used by more efficient firms. Some firms deserve to fail for the good of the rest of us and measures to “stabilize” the financial system should not interfere with that process more than necessary.
In addition to the nine large banks receiving $130 billion in capital under TARP, and additional 110 banks have asked for $170 billion under the governments bail out plan. The Treasury is now expanding the program to insurance companies and other Wall Street firms. But such larges is a slippery slope. Introducing the prospect of obtaining capital at more favorable terms than available in the market has brought a flood of lobbyists to Washington seeking funds for a wide variety of state and local governments and enterprises. The bankruptcy of a Main Street firm is quite different than of a financial intermediary and can be quite beneficial to the industry by reorganizing a firm or reallocating its assets to more productive hands. If the conditions for government money are made stringent enough (see Sweden’s experience with their bank bailouts in the early 1990s) those who can will find private money instead. Thus government bailout money generally goes to the weakest and least deserving firms, though TARP is designed to try to avoid this usual outcome.
The most controversial appeal for government bailout money has come from Main Street firms like General Motors, Chrysler, and Ford. Detroit auto bosses would like to keep their jobs, of course, but the market is registering its displeasure at their inadequate performance. Beyond them and Big Three shareholders, the overpaid United Auto Workers are the main lobbyists for this bailout. As we all know from the bankruptcies of Delta, United and other airlines, Chapter 11 reorganization does not necessarily mean the end of a firm. But it does void existing contracts (including labor contracts) and replace management in order to put together the good parts into a viable operation (if possible). American bankruptcy laws are well designed to guide the restructuring our Detroit auto firms (“old auto” rather than the more efficient and successful “new auto” manufacturing facilities for Toyota, VW and other foreign owned companies producing in the U.S.) Among other things without a renegotiation of their labor contracts to more competitive levels, they are unlikely to survive. America also needs to honor commitments to the WTO regarding state subsidies to companies that sell internationally as part of our general commitment to the benefits of free trade.
The temporary partial nationalization of selected banks runs other political risks as well especially in Europe where the French President continues to talk of state support of “national champions”. Government supports (capital and guarantees), even when explicitly meant to be temporary, can be hard to remove and failing to do so would be very damaging to market discipline of bank risk taking. They have invariably tempted politicians to interfere to favor pet projects, firms, or relatives, the bane of state owned banks wherever they have existed.
Bank failures (as opposed to temporary illiquidity) are different than the failures of Main Street firms and require a special insolvency regime. For two decades the FDIC has effectively used its authority to resolve failing banks efficiently at minimum cost to the insurance fund and to tax payers and with minimal disruption to the market. While many judgments are required in it’s exorcise of this authority, the criteria on which they are based are explicit in the law (minimum cost to the fund) and can be monitored. Secretary Paulson’s Treasury’s interventions have not had that benefit and have increasingly raised questions about the seeming arbitrariness of some decisions. For example, why was Lehman Brothers allowed to fail while Bear Stearns and Merrill Lynch where “saved”?
Many explanations have been offered. Lehman Brothers was smaller than the others and the markets had been given more time to adjust to and prepare for its bankruptcy and thus the market should be able to absorb it without systemic disruption. And it was time to restore market discipline. Another, not inconsistent, view is that Dick Fuld, CEO of Lehman Brothers, was an insider who overvalued his firm and arrogantly rejected the offers made by Barclays to buy it, while Merrill Lynch CEO, John Thain, come from the outside and had a more objective assessment of his firm’s real value and thus accepted the offer negotiated with Bank of America. But it is also impossible to escape the fact that Secretary Paulson was formerly the CEO of Goldman Sachs, a competitor of Bear Stearns, Lehman Brothers, and Merrill Lynch. A number of key Treasury officials also came from Goldman Sachs. His friend Warren Buffet bought $5 billion worth of Goldman’s perpetual preferred shares with a 10% dividend and an option to purchase $5B of common stock at $115 during the next five years. A cheaply priced capital injection by the Treasury should do nice things for Goldman’s share price. Poor Lehman Brothers, on the other hand has large investments from George Soros, not a friend of Mr. Paulson or the Bush administration. The Washington Post claims that Paulson’s deal to sell Lehman to Barclays was actually killed by British regulators.
The new program of assistance signed into law on October 3 and now focused on buying bank shares, is meant, in part, to replace this seemingly ad hoc approach to non bank financial institution resolution with a clearer set of rules and criteria. These rules seem still to be evolving. Both the U.S. approach and the UK/EU approaches dramatically reduce bank accountability for mistakes for the duration of partial government ownership. This period needs to be kept temporary. This is particularly important for guarantees of interbank loans. Normal dividend payments to other shareholders are suspended during the period of government share ownership.
The financial panic could have been ended overnight by a blanket government guarantee of all mortgage loans, however, the moral hazard would have been sever and public outrage over the gross unfairness of rewarding reckless speculators with the tax dollars of more prudent borrowers would surely have been pronounced. Bailing out such behavior would almost certainly bring on much more of it in the future. However, more carefully designed and targeted programs to help home owners able to make modestly reduced payments are already helping significant numbers avoid costly foreclosures. Bank of America, for example, reports that it has employed around 7,000 people to work full time on restructuring mortgages to help keep people in their homes (generally by lowering interest rates and thus monthly payments). They are willing to do so as long as the loss to them is less then would result from foreclosure. Lenders are accepting a modest loss in order to avoid still larger losses. More can be done in this area, which would reduce banks’ mortgage related losses and thus improve their capital, but careful consideration must be given to the unfairness of bailing out poor judgments and providing an incentive to default in order to benefit.
Koppell and Goetzmann recommend that the government “pay off all the delinquent mortgages” by offering “to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent.”  McCain introduced a similar plan during the Presidential debates October 7. These proposals are bold but fail on many of the fairness, moral hazard criteria above. McCain’s plan spares the lenders any cost of their misjudgments and fully bails out borrows who can’t or won’t pay. A better plan, proposed by Henry Sanborn, is for the Federal government to offer to pay a share, say 30%, of the existing contractual mortgage payment in exchange for which the lender must pay (write off) a share, say 10% and the mortgagee the rest. The government’s payments would be a loan to struggling homeowners with attractive terms that encourage early repayment. Replacing ARMs with Koppell and Goetzmann’s fixed rate mortgage could be usefully added to this plan. Actual and expected foreclosures should drop significantly to those levels that should not be prevented in any event and the market value of mortgages and mortgage backed securities would quickly increase, the associated losses to lenders decrease, and the capital of banks holding them increase.
To illustrate, a $200,000 30 year mortgage on a house valued at 220,000 with an initial teaser interest rate of 4% adjustable after two years, would require monthly principal and interest payments of $955 per month. After two years the remaining principle would be $192,812. If the interest rate on the adjustable rate mortgage (the category with the largest defaults) increased to 6% (most ARMs cap year to year adjustments at 2%), monthly payments would jump to $1,186 per month (or $1,440 per month at 8%), which might be more than the borrower could afford. Sanborn’s proposal is that if the lender can not agree on a voluntary restructuring satisfactory to the borrowing, the government would pay (as a loan) 30% of the monthly payments ($356) and the lender would eat (write off) 10% ($119) reducing the monthly payments for the borrower to $712. More likely that borrower would choose to borrow from the government the smaller amount needed to keep her payments at the affordable $955 per month. There is no firm data on the extent to which such measures would reduce mortgage defaults but it is likely to be considerable. Even if the market price of the house fell 20% to $180,000 (i.e. below the amount of the mortgage (serious home owners are not likely to walk away from their home as long as they can continue to make the monthly payments)
The case by case renegotiations now underway by Bank of America and others are the best targeted to individual situations but very labor and time intensive. Some what cruder standardized models for restructuring mortgages could be implemented much more cheaply and quickly though would probably cost lenders more. On November 13, Fannie Mae and Freddie Mac announced such a model they intend to use. FHFA Chairman James Lockhart expressed the hope that this model would provide a minimum standard for the industry. FDIC Chairman, Sheila Bair would like to go further by sharing half of the losses of lenders from loan restructuring that meet standard criteria with the government. By increasing the interest rate or principle reductions that would still save the lender money compared with foreclosure as a result of sharing the cost with the tax payer, Ms. Bair estimates that around 1.5 million home owners could be helped.
As the panic subsides, the current temporarily high demand for liquidity by banks subsides, and deleveraging in the rest of the financial sector runs its course, the Federal Reserve must be prepared to reabsorb the huge amount of base money it created as rapidly as it extended it. Doing so prematurely would risk deepening the recession much as the Fed did to cause the second wave of the Great Depression in the late 1930s. “Clear exit criteria for extraordinary interventions should be in place to help address moral hazard and limit the degree to which intervention substitutes for regular market functioning in the long term.”
Scene 3 – The Way Forward
On with the recession
With the financial panic now under control and lending and lending rates gradually returning to normal, monetary and fiscal policy must focus on moderating the recession without preventing it from correctly long standing macro imbalances. American consumers have long saved too little (consumed too much) to finance investments in American technology and productive capacity (and the government’s excess spending). Large balance of payments deficits filled the gap but are not sustainable. To sustain or increase investment with higher private sector saving the new macro mix requires lower external deficits (smaller balance of payments deficits) and lower fiscal deficits. The fall in the exchange rate of the dollar for the Euro and most other world currencies to more realistic and sustainable levels has already started the process of adjustment by making American exports more competitive and imports more expensive. This reduced consumer spending (increased household saving) is being offset by increased foreign spending on American goods (increased exports). These are very desirable adjustments.
However, the dramatic and very large fall in household wealth as a result of falling real estate and stock prices is beginning to reduce household consumption more rapidly than it can be replaced by increased net exports (which includes shifting some consumption from foreign to domestically produced goods and services). The spread of America’s financial crisis abroad and the bursting of Europe’s own real estate bubbles is undercutting the recent increases in American exports as is the appreciation of the dollar’s exchange over the last four months. In short, the adjustments needed within the American economy are not occurring as smoothly as they might have. Investment itself is retracting in the face of the credit crunch induced by financial turmoil and by falling demand. With falling consumption AND investment (rather than falling consumption with increased investment) and stalled growth in exports, only increased demand from fiscal policy (tax cuts or spending increases) can prevent a fall in aggregate demand from producing an increase in unemployment. In short, the American economy is in recession.
It is appropriate for monetary (lower interest rates) and fiscal policy (larger fiscal deficits) to attempt to moderate the recession in an effort to prevent overshooting. Automatic stabilizers, such as rising state and federal deficits as expenditures are maintained in the face of falling tax revenue and increased safety net expenditures for increased unemployment compensation, etc., are a first line of defense. But they might be usefully augmented by measures such as extending the period of eligibility for unemployment benefits and accelerating infrastructure expenditures that are needed in any event. Such fiscal measures, however, should not interfere with the broader macro economic adjustments needed (higher domestic saving and lower trade deficit) for long run sustainability. Nor should they thwart the healthy purging of inefficient firms and pruning of fat to keep viable firms efficient. The dynamism of the entry of new firms and the exit of unsuccessful (unprofitable) ones is a critical factor in our high and growing standard of living.
As noted about the Great Depression was caused by the failure of the Federal Reserve to provide sufficient liquidity to a distressed banking system and protectionist measures in the form of high import tariffs and competitive (and self defeating) currency devaluations around the world in what came to be called beggar they neighbor policies. These last elements call for policy coordination on a global basis and are discussed more fully in the next section in the context of future reforms of the system.
Reforming the system
It is still hard to believe that underwriters approved many of the loans now gone and going bad that have sparked the deleveraging frenzy driving the restructuring of the financial system and the current financial crisis. There are lessons to be learned that will surely involve additional or improved regulation. However, it is naive to say the least to think that government bureaucrats are generally better at spotting risks than those whose money is on the line.
Relevant industry groups are frantically at work seeking solutions that will reduce the prospects of such huge losses in the future. Regulatory bodies would do well to work with them, interfering only when industry self interest clearly conflicts with the broader public interest (easier said than done). Above all, adjustments and refinements to financial regulation should wait until we all have a better understanding of the existing weaknesses that can be fixed by regulation. It is too easy for new regulations to do more harm than good. The rush by the Securities and Exchange Commission (SEC) to ban short selling of traded stocks had among its unintended consequences a negative effect on corporate bond prices. This “reform” is widely believed to have been a mistake. Even Mr. Bad Guy Regulator, Eliot Spitzer, former state attorney general (and Governor) of New York, speaks nicely of the importance of short selling for market discipline.
It is a mistake to characterize the choice as between regulation or no regulation. Regulation comes in a wide variety of forms and degrees, some more aligned with requirement for market development and efficiency than others. Consider the exciting new technology and market for mobile phone payments. Using existing mobile phone accounts (unique phone number for each customer and arrangements for billing and paying for service), mobile payments add simple to use software to the instrument to sending payment instructions, a pass code for each number to authorize them, central deposit update and management software and registered points for receiving and paying out cash (in Kenya and Afghanistan the large preexisting network of air time salesmen are used though any merchant with a mobile phone can also be used). The combination of a unique phone number and pass code function in the same way as swiping a debit card and entering a pass code to pay a merchant from a customer’s bank account, but in the case of mobile payments payers and/or receivers do not need to have bank accounts.
The Vodafone system adopted in Kenya and Afghanistan and now being developed for Iraq is regulated, but not much beyond what the private providers of these services would demand of their customers to protect their operation. To satisfy Anti Money Laundering requirements, phone companies offering mobile phone payment services are required to “know their customers” (names and addresses) who are necessarily linked to their assigned phone numbers. This does not expand information requirements beyond what phone companies require to provide the phone service in the first place. The systems also set limits on maximum and minimum transfer amounts (per day, per transaction, per month), which again would surely be set even without regulation. The most intrusive regulation is that funds deposited in the system for transfer via mobile phones must be kept by the phone service operator in a trust account with a licensed bank and invested conservatively by that bank. Modern market friendly approaches to regulation have left entrepreneurs free to develop and implement this service, imposing only enough regulation to protect the safety of the system and prevent its use for money laundering. It reflects the kind of relationship between government and the market that provides a good model for regulation more generally.
Areas where reforms are being discussed range from extending the legal tools found in American bank insolvency laws to a broader range of financial institutions, improving the “pluming” (back office processing and accounting) for Credit Default Swaps—CDSs—and other derivatives); limiting CDSs to those with the actual credit exposure being insured (i.e. banning naked CDSs), strengthening capital charges for CDSs, reducing or eliminating tax incentives for leverage (including the mortgage interest deduction from personal income tax), refining the treatment of on and off balance sheet items for bank capital adequacy, making rating agencies liable for their work to the same standard as auditors, to strengthening rules on broker/dealer/bank use of collateral. More broadly solutions must be found for the break down of lending standards arising because private sector actors (brokers and agents) make decisions for fees with regard to other peoples money (should mortgage originators be required to keep some of the risk—to have some “skin in the game”—and should bonuses have to be structured to avoid rewording undue risk taking?). In addition, in the U.S. existing gaps in and poor coordination of financial sector supervision should be fixed by the reorganization of supervisory agencies and responsibilities. Morris Goldstein of the Peterson Institute of International Economics has outlined 10 points for reform "Making the G-20 Summit Work: The ‘Ten-Plus-Ten’ Plan" that provide a good basis for discussion of what might be needed.
The focus of the Washington Summit of the G-20 heads of state November 15 on broad principles rather than specific “fixes” is in this spirit and is to be welcomed.
“The Summit achieved five key objectives. The leaders:
- Reached a common understanding of the root causes of the global crisis;
- Reviewed actions countries have taken and will take to address the immediate crisis and strengthen growth;
- Agreed on common principles for reforming our financial markets;
- Launched an action plan to implement those principles and asked ministers to develop further specific recommendations that will be reviewed by leaders at a subsequent summit; and
- Reaffirmed their commitment to free market principles.”
They fulfilled Fred Bergsten’s advice to first “do no harm.” We can give a sigh of relief.
The G-20 Communiqué set out a work plan for reform that emphasized the importance of the coordination of monetary, fiscal and supervisory policies internationally and of the importance of the International Monetary Fund’s surveillance and financing roles and the need to ensure that it has sufficient resources. The Communiqué also stressed the need to better balance the voting strengths of member countries in the IMF and World Bank with their current economic importance in the world. This implies a reduction in European country quotas and increases in China, India, and Brazil among other emerging countries. The United States long ago gave up some of the quota it would be entitled to on the basis of its economic size.
The coordination of policies is important to avoid the competitive devaluations of the 1930s that were one of the contributing factors to the severity and duration of the Great Depression. It was precisely for such purpose that the IMF was created at Bretton Woods following World War II. Similarly its recent loans to Iceland, Ukraine and Hungary are classic uses of the IMF’s resources to supplement for the sudden drop in international capital flows that are part of the current crisis.
The G-20 has set out a sensible work plan for reviewing the lessons of the subprime crisis and developing reforms needed to strengthen the global trading system. It is hard to find fault with Communiqués statement that:
“12. We recognize that these reforms will only be successful if grounded in a commitment to free market principles, including the rule of law, respect for private property, open trade and investment, competitive markets, and efficient, effectively regulated financial systems. These principles are essential to economic growth and prosperity and have lifted millions out of poverty, and have significantly raised the global standard of living. Recognizing the necessity to improve financial sector regulation, we must avoid over-regulation that would hamper economic growth and exacerbate the contraction of capital flows, including to developing countries.”
“13. We underscore the critical importance of rejecting protectionism and not turning inward in times of financial uncertainty. In this regard, within the next 12 months, we will refrain from raising new barriers to investment or to trade in goods and services, imposing new export restrictions, or implementing World Trade Organization (WTO) inconsistent measures to stimulate exports.”
As always, the out come of these efforts will depend on the details developed over the coming months.
 Wall Street insiders I have discussed this with speak of a dramatic sea change in attitudes toward risk taking following adoption of the Gramm-Leach-Bliley Act in 1999, which repealed the Glass Steagall Act. The immediate performance bonus system found in investment banks and totally alien to commercial banks encouraged a hit and run attitude toward taking commissions and annual bonuses with little regard for the longer term viability of the exotic instruments being created.
 Any cost to the lender from reducing the interest rate or other terms of a mortgage to avoid foreclosure that was less than its loss from foreclosure (estimated currently at between 25 to 40% of the mortgage) potentially “saved” it money.
 On November 25, 2008 the Federal Reserve added a “Term Asset-Backed Securities Loan Facility” (TALF). The facility will lend to any U.S. person for one year against the collateral of Asset Backed Securities (ABS) that consist of “auto loans, student loans, credit card loans, or small business loans guaranteed by the U.S. Small Business Administration.”
 American International Group (AIG), for example, sustained large losses on Credit Default Swaps it had issued (insurance on the default of MBSs). It was taken over by the government to avoid bankruptcy.
 In early October the IMF estimated world wide losses from American mortgages and mortgage related securities would reach $1.4 billion of which about half have already been written off. Reported in The Economist, October 11, 2008 “A Special Report on the World Economy” p 4.
 Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets, Sec. 2.
 Virtually every category of American bank lending, including interbank loans, have increased over the past year through Oct 22 with a small decline in most categories on Oct 29, 2008 (See FRB H-8). Lending declined modestly and temporarily for several months last Spring. However, the composition of such lending changed away traditional business customers and the much larger and more important non bank credit market for corporate credit (e.g. commercial paper market) fell into great difficulty. Huge withdrawals from Money Market funds, a major buyer of commercial paper, were only slowed by a quick government guarantee of the principle deposited in such funds. The market dramatically accelerated the rearranging of the complex linkages through which regular credit flowed. While borrowers and lenders can ultimately adjust to new channels and linkages, the pace with which the (deleveraging) changes were happening could not be easily accommodated without serious disruptions to Main Street enterprises suddenly cut off from normal credit. A very useful discussion is presented in the IMF’s Global Financial Stability Report of October 2008 "Financial Stress and Deleveraging, Macrofinancial Implications and Policy"
 The ill conceived initial plan to buy toxic MBSs from certain banks has now given way to the use of Treasury’s new authority to inject capital into certain American banks. Peter Whoriskey, David Cho and Binyamin Appelbaum, "Treasury Redefiness Its Rescue Program" The Washington Post, Nov 13, 2008 P A01
 The Bretton Woods Committee meeting on the “New Global Financial Architecture”, November 12, 2008, Washington DC.
 The Washington Post Editorial, "No Free Lunch" November 14, 2008, P A14; Daniel J. Mitchell, "Say No to the Auto Bailout" CNN.com November 13, 2008; Thomas L. Friedman, "How to Fix a Flat", The New York Times, November 11, 2008; Martin Feldstein, "A Chapter for Detroit to Open", The Washington Post, November 18, 2008, Page A27; Kevin A. Hassett, "Recession will be less Damaging without Bailouts", AEI, November 17, 2008.
 As noted earlier this characterizations of what happened is an over simplification.
 U.S. Treasury, TARP Capital Purchase Program, Senior Preferred Stock and Warrants “The Senior Preferred will pay cumulative dividends at a rate of 5% per annum until the fifth anniversary of the date of this investment and thereafter at a rate of 9% per annum.”
 Similar questions have been raised about the role played by Robert Rubin in supporting the repeal of the Glass Steagall Act that made possible the merger of Citibank, Travelers Insurance and Salomon Smith Barney (a bank, an insurance company and an investment bank) to form Citigroup. When he left the Clinton administration Rubin accepted a highly paid position as a Director and Senior Counselor of Citigroup. Steven Pearlstein, "A Bailout Steeped in Irony", The Washington Post, November 25, 2008, Page D01.
 Gregory Baer, Deputy General Counsel at Bank of America, in a presentation at the New America Foundation November 13, 2008.
 Henry N. Sanborn, “A Different Solution to the Financial Mess” unpublished
 Patrick Rucker, "GSE Chief says Mortgage Aid Plan Should be Model" Reuters, November 13, 2008.
 FDIC, "FDIC Loss Sharing Proposal to Promote Affordable Loan Modifications"; Alan Zibel, "FDIC says plan could help 1.5 million keep homes", Associated Press November 14, 2008.
 IMF, “Global Financial Stability Report: Financial Stress and Deleveraging Macrofinancial Implications and Policy”, International Monetary Fund, October 2008
 The dollar peaked on July 6, 2001 when it exchanged for 1.19 Euros. Seven years later on July 16, 2008 it had fallen 47.5% to 0.63 Euros. Since then it as appreciated 22% (to 0.08 on October 29) but was still 33% below its 2001 peak.
 Aleeda Fazal, Task Force to Improve Business & Stability Operations in Iraq
 American organization of its supervision clearly needs to be restructured along the lines proposed by Secretary Paulson in March of this year.
 White House: "Fact Sheet: Summit on Financial Markets and the World Economy" November 15, 2008.