One of the minor aspects of the econoblogger session with the Treasury on Monday (more on that shortly) is that several of the invitees said something along the lines of, “You guys did a great job in the crisis.”
What is disconcerting is how this view has now become conventional wisdom, despite the panicked Fed reaction (being way behind the curve, then overreacting and making 75 basis point cuts the new normal, with the result that short rates are now so low that the Fed is boxed in), denial and failure to investigate the seriousness of looming problems (for instance, Bear’s implosion should have led to a full bore investigation of the credit default swaps market, which would have led straight to AIG); the inconsistent bailout processes; the heinous language and process of the passage of porked-up TARP.
And now we have the aggressive selling of “how well it all worked.” For starters, consider the misleading “banks have paid back the TARP meme.” Yes, thanks to other back door, less visible bailouts, super cheap interest rates, regulatory forbearance (aka, extend and pretend, starting with bank second mortgages and HELOCs). This is simply a shell game, with the banks eager to pay back the TARP for the worse possible reason, so the top brass could escape restrictions on compensation.
An interesting proof of the success of the power-that-be’s PR campaign is the blogosphere silence on a Barry Ritholtz post of Monday, “2008 Bailout Counter-Factual.” I’m what would normally be late to it, but I can’t find another blog in my RSS reader having commented on it.
Barry makes an aggressive case, that none of the bailouts were necessary:
Imagine a nation in the midst of an economic crisis, circa September-December 2008. Only this time, there are key differences: 1) A President who understood Capitalism requires insolvent firms to suffer failure (as opposed to a lame duck running out the clock); 2) A Treasury Secretary who was not a former Goldman Sachs CEO, with a misguided sympathy for Wall Street firms at risk of failure (as opposed to overseeing the greatest wealth transfer in human history); 3) A Federal Reserve Chairman who understood the limits of the Federal Reserve (versus a massive expansion of its power and balance sheet).
In my counter factual, the bailouts did not occur. Instead of the Japanese model, the US government went the Swedish route of banking crises: They stepped in with temporary nationalizations, prepackaged bankruptcies, and financial reorganizations; banks write down all of their bad debt, they sell off the paper. Int he end, the goal is to spin out clean, well financed, toxic-asset-free banks into the public markets.
Thus, Bear Stearns is not bailed out by the Fed. Instead, the FOMC chair tells JP Morgan’s CEO “You have 9 trillion dollars in exposure to Bear derivatives. Instead of guaranteeing you $29 billion for a risk free takeover, we will start preparing a liquidation plan for Bear. And given your exposure to them, we best plan one for JPM too. (and if you don’t like that, you can kiss our ass).”
Tough talk, but the outcome would have been much better: JPM would likely have bought Bear anyway, if for no other reason than to prevent someone else from buying them, and forcing JPM into bankruptcy, to pick up their assets for pennies on the dollar. That would have set a much better tone for future bailout expectations, versus the massive moral hazard the Fed created with the Bear bailout.
Lehman? Prepackaged bankruptcy, less disruptive.
AIG ? There never was an implicit government guarantee that all counter-parties dealing with AIG-Financial Products — a giant leveraged structured finance hedge fund hiding under the skirt of the regulated insurer — would be made whole. But the Bush/Paulson/Bernanke bailout created one. Instead, AIG-FP should have been carved out for dissolution/wind down, while the insurer could have continued to exist on its own. AIG would have had the liability for the government’s costs, but the counter parties? They would have gotten zero. If you go to Vegas and shoot craps in the alley way behind the casino, don’t expect the gaming commission to collect your winnings. But that is what we did with AIG.
Fannie & Freddie: Two more crappy banks that should have been wound down. These were publicly traded companies that were guaranteed lower interest rates — not an infinite backing from taxpayers. They should have been wound down like all any insolvent bank. Today, they serve as the mechanism for backdoor bailouts of the rest of the wounded banking sector.
Yves here. Readers may take issue with many of Barry’s claims, but consider a few not well understood factoids. Re the Bear bailout, Bear had substantial unused credit lines from Japanese banks and the Japanese were astonished and relieved that they were not drawn down. I don’t have the exact amount, but it was unquestionably over $1 billion. There was no reason for the Fed to subsidize the JPM deal; Bear could have pulled down the credit lines pre closing. This would admittedly been senior credit rather than the junior funding that the Fed provided, but the point is there were ways to reduce the JPM commitment ex going to the central bank sugar daddy.
Similarly, Lehman was allowed to go into a disorderly collapse for poor reasons: namely, that it was politically unacceptable, after the Bear rescue, to bail out Lehman. But not bailing out does not mean “do nothing.” One tidbit from the Valukas report on Lehman (hat tip Economics of Contempt) is that Vice Chairman Don Kohn told Ben Bernanke in June 2008 that the view on the Street was that Lehman was as goner. If Kohn was hearing that, the New York Fed had to be hearing similar rumors.
Yet as Andrew Ross Sorkin’s Too Big to Fail makes clear, no one took the possibility of a Lehman bankruptcy serious. No one in the officialdom talked to a bankruptcy attorney.
This is a complete failure of planning. As a result, Lehman didn’t merely file for bankruptcy; it filed with a thin form, with no preparation of any kind. It collapsed in the most disruptive manner possible. And that was made even worse due to another, long-standing failure of oversight: the utter mess of Lehman’s derivatives book (how could anyone certify they had adequate financial controls?). So you had a legal train wreck compounded by an operational nightmare.
And it was the chaos unleashed by the Lehman failure that in turn led to the “No More Lehmans” policy, and the widespread view that extreme measures to prevent a big financial firm from failing were warranted. But this misses the fact that just as people can die violently or peacefully, so to do can company unwindings be more or less traumatic.
The biggest obstacle to Barry’s counterfactual is the fall 2008 timing. The sort of measure he described probably would have required a closure of trading markets (which September 11 showed did not bring the world to an end) and in a worst case, a full blown bank holiday. No one was willing to do anything that radical-looking; perversely, the course of least resistance was to tap the last reserve, the US taxpayer.