These are troubling times for both the public health and the economy. In terms of a downturn, however, we’re not quite where we were during the 2008 financial crisis, according to a University of Virginia School of Law professor who wrote a book about that time period and its related bailout.  

Professor Paul Mahoney, a business law expert and author of “Wasting a Crisis: Why Securities Regulation Fails,” shared his thoughts this week about whether the current government spending strategy will alleviate the looming problem, and whether he still thinks that no bank is too big to fail, among other topics. 

Mahoney is a David and Mary Harrison Distinguished Professor at UVA Law and serves on the SEC Investor Advisory Committee. He was dean from 2008-16, when he helped shepherd the Law School through the earlier financial downturn.  

Can you compare where we are now to the 2008 financial crisis? 

It is still early days for the potential financial consequences of COVID-19 and the social and governmental responses to it. We’re only a few weeks into significant social distancing restrictions. These have been sufficient to create an unprecedently quick jump in unemployment, but not yet to create a financial crisis. The big question is whether the restrictions can be loosened in time to prevent a great wave of business failures and defaults on home mortgages. If not, the banking system might come under the type of stress we saw in late 2008. 

We’ve seen the beginnings of concern about bank health in the last two weeks. The spread between the interest rates at which banks lend to one another and the rates on Treasury securities, which is a simple measure of perceived credit risk, has risen substantially. It’s nowhere near where it was in late 2008, but banks are clearly worried. They aren’t yet in crisis. 

What is your take on the stimulus check plan? Will it work? 

The current economic downturn is quite unusual. In a normal recession, unemployment and falling asset values make consumers less willing to spend, leading to a fall in household expenditure and therefore in GDP. Because they see the underlying problem as a lack of demand, economists tend to favor fiscal stimulus — the government spending borrowed money — even if the stimulus is not carefully targeted at distressed households. The idea is that more money in circulation equals more spending, which revives businesses, which helps alleviate the recession. 

Our current situation is unique. What are people going to spend money on? Travel? Dining out at a restaurant? Going to a baseball game or concert? Those things are all off the table in the short run. There are only so many rolls of toilet paper and bags of frozen vegetables you can buy. 

So even a committed Keynesian might have some doubts about whether sending checks to most households is the wisest use of government funds at the moment. Focusing on maintaining employment and housing is more important. 

Are stimulus checks, at least for individuals, inevitable in a pandemic?  

Financial assistance to households seems politically inevitable in the current situation, and rightly so. The single best thing we can do is keep people employed. The Paycheck Protection Program in the CARES Act is targeted at the right problem, in my opinion. 

Not every business will be able to avoid layoffs. Mortgage and rental relief for workers who are sick or laid off is therefore another important need. The legislation includes provisions for mortgage forbearance. That has to be coordinated with provisions targeted at banks and other mortgage servicers so that we avoid the collapse of the secondary market for mortgage-related assets that we saw from 2007 to 2009, which was the precipitating event for the financial crisis. 

The reason government assistance is often controversial and called a “bailout” is that the affected businesses or households had engaged in overtly risky behavior, like operating with excessive leverage or building a house in a hurricane zone. Government assistance can create moral hazard by protecting against downside risk while allowing the business or household to capture the upside. That’s not an issue here. The reason people are out of work is that the government has told us to stay at home. It’s not a consequence of workers or their employers taking excessive risks from which they now wish to be saved. 

Would calls to suspend trading do any good? 

I think the equity markets have performed their task pretty well during the past few weeks. The steps taken to slow the spread of the virus will have an adverse impact on the economy and on stock values. But keeping markets functioning so that investors have a realistic idea of where they stand and can reallocate capital if they wish — assuming that the markets can continue to provide liquidity as they have been — is better than the alternative of keeping people in the dark. The market is sending useful signals about which businesses are affected more or less by the slowdown. 

Does this current situation affect your work on the SEC Investor Advisory Committee in any way you can discuss? 

Obviously, we can’t meet in person. SEC Chair Jay Clayton convened an online public meeting of the IAC last Thursday to discuss COVID-19 issues for the markets and the SEC. I think there was broad consensus that it is beneficial to keep the markets and their regulators functioning as best we can during this period. 

Has your opinion changed that no financial institution is too big to fail?  

The traditional argument for differential government assistance to the largest banks during a crisis is that those banks are interconnected — in short, if Big Bank A fails, and it owes money to other banks, those banks might fail as well. That is not the same thing as arguing that we need to save banks because lending is essential to economic recovery. It’s an argument that the biggest banks are different and their failure is more harmful than that of a smaller bank. 

I’m simply not convinced that this is true in practice. Indeed, I don’t think there is much evidence that interconnectedness caused significant problems during the global financial crisis. The problem was that as housing prices fell and defaults rose, many banks sustained large losses on mortgage-related assets. They were too highly leveraged to sustain those losses. That’s not an interconnectedness issue or a size issue per se. 

If I’m right about that, then there’s no greater urgency to save one $1 trillion bank than to save ten $100 billion banks. When it comes to operating companies, interconnectedness is even less an issue. But because larger companies will generally have more political clout, they will often get a better deal when the government writes checks. There is a structural bias in favor of larger companies in these emergency assistance programs. 

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