A Stress Test for Capitalism
Last October, according to a report on Frontline, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke summoned the CEOs of the country’s nine largest banks to Washington. They were to come immediately, without aides, to listen and take notes.
Paulson told the group that the government was going to become a major shareholder in each bank after injecting them with $125 billion. He handed each CEO a term sheet explaining the rules. Each could make a phone call to consult staff, but all of them had to sign the deal that evening. Otherwise, feared the two officials, the banks would fail and take the financial system down with them.
Just like that, Washington had begun the costliest intervention in American economic history.
Anatomy of a Meltdown
The consequences of so much public debt will not be known for some time. Of more immediate interest, especially to academics, is how the financial system, despite an alphabet soup of regulatory agencies, suffered catastrophic losses once real estate values declined. To those who study economic behavior and the capital markets, the current crisis is a modern cautionary tale. Dean Paul Mahoney, a leading securities law expert, saw the meltdown unfold in three parts. First, excess leverage created a debt bubble. The Fed kept monetary policy too loose for too long. Cheap money and low returns on government debt sent investors looking for higher returns in real estate and equities. Meanwhile, homeowners saw their own equity soar and joined the party. Retail businesses saw record profits as those with “paper” wealth spent freely and copiously. As Chip MacDonald ’79, a partner in Jones Day’s Atlanta office, said at the Virginia Law & Business Symposium in February, “People were basically day-trading with their houses and refinancing periodically. They were using exotic instruments like option ARMs. There was all this cash to spend, and people spent it rapidly.”
Second, Mahoney points to the dramatic mispricing of the risk associated with securitized subprime mortgages. Faulty risk modeling and rating agency ignorance led the markets — and financial institutions — down a dangerous path. Bob Bruner, dean of the Darden Graduate School of Business, agrees, adding that “information asymmetries”— insiders purposely designing investments to be too complex for all but them to understand — contributed mightily to the subprime mortgage crisis. “Complexity obscures,” Bruner says. “By the time you get up to a sufficiently high level, no decision maker can have a clear idea of what is going on …. The lack of transparency is the core issue, and when you bundle that with the high degree of leverage, which reduces the flexibility that individuals, firms, and whole markets might enjoy, you have the tinder for an amazing bonfire.”
Third, underwriting standards loosened. Mahoney notes that in the 1990s, Congress passed legislation that required Fannie Mae and Freddie Mac, the two government-sponsored enterprises that purchase and securitize mortgages, to purchase a targeted amount of mortgage loans to low-income households. As a result, bank regulators began putting pressure on all lenders to make loans to high-risk borrowers, which ultimately led to a severe decline in underwriting standards in the mortgage market (and, not coincidentally, a booming market in the securitization of these instruments).
Enter the financial institutions bailout. “For many years the government seemed to be creating a free lunch with Fannie Mae and Freddie Mac,” says Mahoney. “They were saying, on the one hand, that these entities do not have an explicit guarantee from the federal government and that their investors were not backed by the full faith and credit of the U.S. government. Yet, at the same time, the government never explicitly and forcefully refuted or rejected the idea that there was an implicit guarantee of government backing. Market participants believed that if a huge problem ever materialized at Fannie Mae or Freddie Mac, the government would step in and make good on their obligations.”
And so it did. In September 2008, the government nationalized both institutions out of concern that their collapse would trigger an economic implosion (a redux of the considerations that prevailed in the government’s attempt to save Bear Stearns in March 2008). But it was also a monumental application by the government of the Good Samaritan rule. Investors could reasonably claim that the government had been deliberately ambiguous about its intentions, says Mahoney, which caused investors to rely on the government as a backstop. “Investors lent Freddie and Fannie money at something closer to government rates than commercial rates. It would have been unfair for the government to then walk away.” The government took over both entities and, predictably enough, they soon faced the next too-big-to-fail quandary: Lehman Brothers.
Paulson, however, drew the line with Lehman, signaling that moral hazard was a bigger threat than systemic failure. “The government said, ‘We need to stop this or else everyone is going to be too big to fail,’” says Mahoney. “The markets went absolutely haywire after the government did not step in to save Lehman Brothers. I think that reaction in the market after the Lehman Brothers failure is in some sense a measure of how much investors believed that the government would simply step in whenever a large important financial institution was about to go under.”
Instead, Mahoney believes the government should have made clear to the investment community that it would not rescue an entity in the absence of federal legislation guaranteeing its solvency. “The job ought to be left to that entity’s creditors and stockholders to figure out whether it is taking on too much risk rather than having in the back of their minds that it’s okay because the government will come in and clean up after the fact.” Whether investor complacency about the government-as-savior contributed to Lehman’s failure is anybody’s guess, but the result was a sudden freeze in the short-term credit markets.
Professor Albert Choi, who helped direct the Law School’s John M. Olin Program in Law and Economics, points out that the “shadow” banks — hedge funds and investment houses such as Lehman — offered their clients banking-like services such as commercial paper issues and interest rate swaps on very short turn-around. Money changed hands quickly and easily. When Lehman failed, that credit market froze, and the impact was far-reaching. “It didn’t just affect the investment banks and hedge funds,” says Choi. “It affected the bread-and-butter companies that rely on the short-term borrowing and lending market; huge healthy companies, like GE, that would routinely borrow and lend in the short term credit markets. Even state governments used these markets to meet their budget needs. Now the challenge is, who is going to fill that role?”
The Way Forward: Reform and (re)Regulation
Investors, having seen their 401(k)s shrink, want to see corporate America get back to business and make money again. But it would be a mistake to infer that all is forgiven. Lavish pay and feckless management are among the sins of this crisis, and the public — and an emboldened Congress and White House — want accountability and reform.
It’s not hard to see why. As losses mounted, fresh stories emerged about the large bonuses paid by the very companies that had received billions from U.S. taxpayers to save them. The relationship between results and rewards was broken, and it certainly looked like the social contract between Wall Street and Main Street was, too.
Professor Michal Barzuza, a corporate law scholar who joined the faculty in 2005, says that misdirected compensation incentives are what led to counterproductive behavior. “Companies rewarded people for taking risks in a way that was not efficient for the organization.” Employees were encouraged to innovate new securities that would make money for financial firms, spawning ever more esoteric financial products to sell to investors. “While it is important for compensation levels to be determined in the market, the compensation structure should be such that it rewards people for the right things,” Barzuza argues. “We need to find a way that is not too intrusive but still assures that we will not have these distortions.”
From excess leverage and relaxed underwriting standards to rating agency failures and improper incentives, hindsight tells us that a collapse was inevitable. Now that it has happened, is more government — more spending, more regulations — essential to recovery?
The cure might be worse than the disease. “Both the market and the government were involved in these failures,” says Mahoney. “Until we are at a point where we can do a very careful post-mortem and figure out exactly what went wrong, it makes no sense to say that this demonstrates that we need more regulation or more government involvement.”
At the outset, however, both the Bush and Obama administrations saw fit to step in and commandeer failing banks and insurers. For them, the stakes were too great for inaction, but that was as much a political calculation as an economic one. There was no single answer to what went wrong, but there was general agreement among many that re-capitalizing the banks and re-regulating lending and investment practices was the way forward.
But Bruner says he is “very skeptical that we can regulate away the chance of a financial crisis.” He is co-author of The Panic of 1907: Lessons Learned from the Market’s Perfect Storm and can identify more than a dozen financial crises in the last century that share the same fundamentals that caused the 1907 panic (e.g, buoyant growth, complexity, “adverse leadership,” a “consequential spark” that lights the fire, and others). His analysis shows that there are simply too many variables and too little control to anticipate and prevent these natural business cycles. “There is no single pill you can take,” he says. “No silver bullet of an explanation will explain everything that occurs in a crisis. It’s complex. The thoughtful practitioner in law or business or other fields needs to embrace that complexity” and understand the interrelatedness of factors in a crisis, which are difficult to untangle.
The real question, then, is whether we can make the financial market healthy enough to withstand inevitable crashes, says Choi. “Suppose you have a new earthquake-ready house in California, and an earthquake destroys it. The fact that your house collapsed tells you that there was something wrong with the house. Here, you can say the housing bubble collapse was the earthquake and the financial markets were the house.” The question is how to build a better house.
Some activities seem to cry out for re-regulation, or at least refined regulation. For example, when Lehman collapsed, “the Federal Reserve had to jump in and provide a huge amount of liquidity to shore up the ‘shadow’ banking system,” says Choi. “Of course, that can’t go on indefinitely. With investment banks gone, commercial banks likely will have to keep providing these services. But to do that, government regulations on capital reserve ratios and durational matching of assets and liabilities will have to be modified, even loosened, so that they can take on short term liabilities even though their long-term assets don’t match.”
But regulations can be a double-edged sword. For example, mark-to-market accounting, which requires carrying assets on your balance sheet at current market value, came into play after the savings and loan crisis in the late 1980s. It picked up steam after Enron. But when an economy is in crisis and the market is virtually disappearing, it can place undue stress on a company’s books. Many commercial banks failed because the market value of their assets suddenly plummeted. They could not raise enough capital to balance their decimated assets.
“A lot of people will say that mark-to-market accounting is a bad idea, can worsen the stress, worsen a crisis,” says Choi. “Even though these banks in the long run might be healthy, the mark-to-market accounting in conjunction with a financial crisis can create a short-term liquidity crisis. But the reason we had that accounting in the first place was to prevent the problems like the S&L and Enron crises. Now we are looking at the flip side of that problem. But if we go back to historical cost accounting, it will bring back the same issues that created the S&L and Enron debacles.”
De-regulation, too, can lead to imperfect results. Until 2000, most derivatives traded on formal markets using a central clearing house. Regulators designed the clearinghouse to be largely bankrupt-proof. This freed traders from worry about the individual credit risk of multiple counterparties because there was only one counterparty: the clearinghouse. But in recent years, in order to avoid the cost associated with this system and in response to changes in legislation, most derivatives transactions took place in the over-the-counter market. Traders again had to take into account the creditworthiness of their particular counterparty, causing asymmetries in the value of futures contracts. Given the parlous state of credit and the road that brought us here, does it make sense to return to a clearinghouse as the sole, and solid, counterparty? And if so, who is better at deciding these and other issues — the market or the government?
We’ll soon find out, but in a Financial Times op-ed in February 2009, Lloyd Blankfein, CEO of Goldman Sachs, offered cautionary words for policymakers and regulators. “It should be clear that self-regulation has its limits. [Investors] rationalized and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us — especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.” But, he warns, “there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm.”
Presently, multiple agencies regulate different activities: the SEC for securities; the Commodities Futures Trading Commission for commodities, futures, and derivatives markets; and the various banking regulators for commercial and consumer lending. Each has very different approaches in how it monitors the structure and solvency of the firms it oversees. Mahoney thinks “current proposals to have one regulator focus on capital adequacy and financial soundness across the full range of financial services firms makes some sense. But, like everything else, a lot of the value will depend on how it’s implemented and how sensibly it’s designed.”
Finally, to restore faith in the markets, Bruner would address the complexity with more transparency. “You help explain to people what is going on,” Bruner says. “You help to reinstitute the safety and soundness of balance sheets in the financial system. Then, you flood the market with liquidity …. And, to build confidence, you address the issues of investor fear with assurances, and with the intervention of tools of rescue.”
The Panic of 1907 brought us the FDIC and the Federal Reserve. The Great Depression gave us the New Deal and Social Security. We do not yet know what change this crisis will bring or what historians will call it, but it is safe to say its name will be spelled in capital letters.