The evening of September 16, 2008, I met Randy Kroszner for dinner at Et Voila in the Palisades just outside of Georgetown. He arrived late explaining that the Fed’s monthly monetary policy meeting had lasted longer than expected. Randy is a Governor on the Board of Governors of the Federal Reserve. The attempt to rescue Lehman Brothers over the weekend had failed and it had declared bankruptcy the day before, so we had a lot of interesting things to talk about. Randy didn’t mention that the Fed had just agreed to lend up to $85 billion to AIG to cover its expected loses on its mortgage related Credit Default Swaps, thus giving the U.S. government a 79.9% equity stake in the insurer in the form of warrants called equity participation notes. When news of the AIG bailout was posted on my phone around 9:00pm during our meal, I asked Randy what in the world was going on. He was reluctant to discuss the topic uncertain whether the source of my news was a leak or an official Fed press release.
The housing bubble had started to deflate in 2007 and homeowners and their mortgage financiers were coming to grips with the reality of significant financial losses. “The DEFs of the Financial Markets Crisis” and “The Big Bailout–What Next?” While the Federal Reserve quickly reacted to inject liquidity into the banking system to compensate for the freezing up of the interbank credit market that followed the Lehman Brothers-AIG shockwaves, the key questions were who would bear these losses and how should they be contained to avoid spilling over to the financial system more broadly.
The Fed, with the help of $700 billion authorized by Congress in the Troubled Asset Relieve Program (TARP), bailed out Wall Street and contained the spread of potential bank failures. It was a scary time for all involved. Looking back from the relative calm of today with criticism of policy actions taken then is a bit unfair but how else are we to learn from experience?
The government actions in 2008 can be broadly stated as: a) providing all of the liquidity the financial sector needed following the Lehman Brothers collapse and financial panic; b) bailing out large banks and other financial institutions that might have been insolvent whether they were or not; and c) leaving underwater homeowners to drown. The first of these—providing liquidity—is universally accepted as a proper function of a central bank and one that the Fed executed well. The other two—bailing out banks but not homeowners—are the subjects of this note. I will review them from both an economic and a political perspective.
The economic rational for bailing out Wall Street was that there was a risk, with very uncertain probability, of the failure of large Wall Street institutions spilling over to and bankrupting other financial institutions holding assets in the failed Wall Street firms. Many of them were foreign (especially German Landesbanks) and no one knew for sure where the contagion might end. By saving Wall Street, the argument went, the government was saving Main Street as well (trickle down). Sheila Bair, then the Chairman of the Federal Deposit Insurance Corporation, among others urged the government to bail out homeowners who were defaulting on their mortgages as well. While different policies of homeowner relief were considered the one finally adopted, Home Affordable Refinance Program—HARP, was modest and left Ms. Bair quite unhappy: “Shortly after Fannie Mae and Freddie Mac announced their new plan, Ms. Bair declared that it was inadequate and pointedly said that the government had spent hundreds of billions of dollars to bail out financial institutions like American International Group, the giant insurer.” “White House scales back a Mortgage relief plan”
From economists’ perspective, bailing out anyone creates a moral hazard. If market players profit from risky bets when successful but expect that the government will pick up the tab when they are unsuccessful, they will take greater (excessive) risks. No one was eager to bail out property flippers (those who bought property with the intention of reselling it at a higher price rather than move in) from their failed gamble. But the same logic applies to those financial firms that lent the mortgage money in the first place or that kept the financing cheap by providing it from the derivatives market of Mortgage Backed Securities, etc. Government policy makers attempted to design their bailouts to minimize the moral hazard they were creating, especially after the foolish and panic driven bailout of Bear Stearns in March 2008. But policy was driven by government’s fear of financial contagion.
The political optics of bailing out mortgage lenders but not homeowners is not good. Why did politicians choose to support one but not the other? Moral hazard is a problem with both. The reality is that Washington politicians were (are) much closer to Wall Street than to Main Street and are thus more sensitive to Wall Street’s concerns. Growing recognition of this fact adds some understanding to the hostile attitudes toward Washington expressed by Trump supporters.
By far the better policy would have been, and in the future is, to stick by the existing rules for bearing losses (our bankruptcy and default laws), i.e. no government bailouts. Our bankruptcy laws and procedures are actually quite good. “Resolving Failed Banks” For starters Bear Stearns shareholders should have lost everything. On the underwater homeowner side, mortgage lenders have always sought to minimize their losses when borrowers are unable to repay according to the original terms of a loan. Often the least cost resolution is for the lender to agree to easier terms and to restructure the loan. Evicting the “owner” and selling the property, especially when it is under water (i.e. valued at less than the mortgage amount), is a costly undertaking and writing down and restructuring the loan is often the least cost approach. However, government driven programs can rarely match the lenders’ ability to restructure loans one by one that can be honored by the homeowner while minimizing the loss to the lender. “Changing direction on bank regulation”
Our government has increasingly attempted to micromanage the private sector, especially the financial sector. This is a mistake. It should establish clear and pragmatic rules for conducting business and for resolving failures (workable bankruptcy laws). “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” Within this broad legal framework, which to a large extent already exists, individual firms would be held accountable for the conduct of their business by their customers and their owners. If they fail, the first losses must fall on the owners (shareholders), who have a greater incentive to do well and have better market information on which to act than do government regulators. This requires a change in attitude and direction of government’s role in our lives.