By Roy C. Smith
The 2008 Financial Crisis is best remembered for the
dramatic weekend of Sept. 13-14, after which Lehman crashed, AIG was rescued, and
Merrill merged. But, it began much earlier, in late 2006, and still raged
through the first quarter of 2009. Substantial and unprecedented actions were
taken by the Treasury and the Federal Reserve to stem the tide, and afterward,
many regulatory changes were made to prevent or moderate the next global
financial crisis. These regulatory changes include the Dodd Frank Wall Street
Reform Act, Basel III, the Financial Stability Board of the G20, and the
creation of several new financial regulatory entities in Europe.
The crisis spawned the “Great Recession” in the US, and
despite great efforts to stimulate the economy, a decade of growth rates
averaging 2%, well below the long-term average of 3.5%. The crisis led to
similar growth-killing results around the world, tested the strength of the European
Union and the euro and the future of Emerging Market economies, and sparked
tensions with Russia and China.
It was a nasty event we don’t want to see repeated.
Ten years and a great deal of study by economists and others
leave us still lacking a consensus on (a) what caused the crisis, (b) whether
the reforms it generated will be enough to prevent another systemic collapse of
the financial system, and (c) whether the reforms are worth their cost in
enforcement and compliance expense and lost economic growth due to constraints
on lending.
Here are some of my observations and conclusions:
Causes of the Crisis:
The collapse was mainly the result of a massive liquidity
squeeze that began slowly in 2007 in the relatively small but riskier,
sub-prime end of a line of mortgage-backed investment products. Sub-prime was a
relatively small part of the US fixed income market with $600 billion
outstanding in 2006, but it was the fastest growing - it represented only 8% of
new mortgage-backed issues in 2003 but 24% in 2005. In Jan. 2007 all
mortgage-backed securities amounted to $5.5 trillion (another $6.4 trillion of
debt secured by assets other than mortgages was also outstanding), out of some
$177 trillion of tradable debt outstanding globally. The liquidity squeeze steadily
accelerated, however, spreading first to other mortgage and fixed income
instruments, then, after the unexpected bankruptcy of Lehman Brothers, it rolled
into an avalanche that carried everything away.
The liquidity squeeze was enhanced by new technology that
enabled large quantities of complex, non-transparent, securitized mortgage debt
to be issued, hedged with credit-default insurance, and leveraged by
derivatives and in other ways. These apparently safe and relatively high
yielding securities, for which demand was enormous after three years of low
interest rates and negative stock market returns (2000-2002), were sold into a
globally integrated capital market that had become huge: on the eve of the
Lehman bankruptcy, the market capitalization of all tradeable stocks, bonds and
bank loans in the world was $242 trillion, 3.5 times world GDP. Investors from Europe, China, Japan and other
countries had acquired substantial US and European mortgage-backed positions. But,
rising fears of mortgage defaults, contamination of opaque prime mortgage pools
by added pieces of sub-prime, and reports of write-offs in the industry triggered
a run on all mortgage-backed securities. Falling prices would send trillions of
dollars of sell orders into the market that virtually destroyed buy-side
liquidity and began a vicious cycle of margin calls and mark-to-market write-downs
that caused further write-offs that wiped out the capital of the banking
system. This was the biggest market collapse in financial history, for which
neither industry participants nor regulators were prepared.
Though major banks clearly turbo-charged their activities in
all parts of the mortgage-securitization business, they believed they were
simply (and lawfully) taking advantage of opportunities in a bull market that
was driven by demand from informed institutional investors. Doing so, however, required a willingness to
hold very large trading positions. Most banks were no greedier or more reckless
than usual, but their top managers were notably clueless about what was coming
and they were unprepared for the market run when it came. These banks were in
an industry that is more highly regulated and supervised than almost any other,
because of the consequences of their collective mistakes. The largest banks were
considered too big for the government to allow to fail, so some moral hazard affected
the banks’ actions. But the banks’ watchers and minders were equally unaware of
what was coming, and did nothing to constrain the aggressive risk taking of
some of the banks during the run up to the crisis.
Indeed, the watchers had been asleep all through the Alan Greenspan
years as Fed Chairman (1987-2006) when all of government was enjoying the “Great
Moderation” economy (1985-2007) of low inflation, disappearing business cycles
and rising security prices brought on by the widespread and large-scale adoption
of free-market economic principles that linked the global economy and financial
system as never before. Greenspan’s view was that markets could regulate the
behavior of banks and other financial institutions by adjusting prices of their
shares and bonds more effectively than the controls of regulators could. This
view, applying the “efficient market hypothesis,” proved to be completely
wrong. Markets were cheerleaders in the run up to the crisis, not restrainers.
The Great Moderation also brought about a time of great
deregulation, which many economists believed would increase competition and force
companies to lower prices and be more efficient. This was the main thought
(encouraged by substantial Wall Street lobbying and political contributions for
a decade) behind the repeal in 1999 (with full the support of the Clinton
Administration and the Fed) of the 1933 Glass Steagall Act that separated banking
from the securities business. I was among the few critics of this action at the
time because I thought the banks would rapidly increase their exposure to
securities dealing (in which they had little training or experience) to take
market share away from the investment banks.
This would increase risks to banks and their depositors who were insured
by the US government through the FDIC. As the FDIC guaranteed the deposits of
banks, it ought to have a say in the risk levels associated with them. But,
neither the FDIC, the Fed nor the Treasury ever attempted to assess, limit or
manage the increased risks that repeal of Glass Steagall brought about.
After repeal there were several large bank mergers that
increased the size of the largest banks considerably and enabled some of them,
particularly Citigroup with assets of $2.2 trillion after its gun-jumping merger
with Travelers in 1998, to expand aggressively into the securities underwriting,
trading and brokerage businesses. This expansion encouraged the investment
banks, now all publicly traded companies, to further leverage their balance
sheets to remain competitive with the banks. The new competition did bring down
fees and trading spreads, but the loss in revenues was made up by more
aggressive proprietary trading (relatively easy in a falling interest rate
environment), servicing of hedge funds and sovereign wealth funds, and
innovative “structuring” of bespoke investment products for sophisticated
investors. In short, the risks inherent
in the securities business increased with leverage and the complexity of traded
instruments, without commensurate increases in risk management capabilities.
Probably in no other financial crisis in world history has
the role of a few key government officials (particularly Treasury Secretary Henry
Paulson and Fed Chairman Ben Bernanke) been so important in managing through
the uncertainties and the politics of the crisis and enabling a reasonably
quick return to normal economic activity.
These individuals deserve high marks for their energy and determination,
despite some serious miscalculations and mistakes that are clearer in
retrospect than they were at the time. Both
claim that if they hadn’t done what they did, the impact of the crisis would
have been worse, and lasted longer than it did. This is probably true but
unproveable.
Paulson was the captain of the ship in extremis, and he
provided the leadership that enabled confidence that the ship would escape the
shoals. He ignored his Republic Party’s deep-set notions of the sanctity of the
free market and sought to find interventionist actions, including bailouts,
that would quell the panic in the markets. He did not hesitate to try different
things, and to move on if they did not work as intended. He signaled that the government was deeply involved
and would get it right eventually. But what really saved the day was the
tide-shift that allowed the ship to float over the shoals altogether – i.e.,
the massive and totally unprecedented infusion of liquidity into the markets by
the Fed that amounted to about $5 trillion (14x the size of Treasury’s “Troubled
Assets Relief Program”), according to a Bloomberg news report.
Bernanke understood the essential importance of restoring
liquidity at whatever cost, and, though he deferred to Paulson on Lehman
Brothers, he was unhesitating in committing it from the Fed’s own resources. Politics
severely limited what the Treasury could do, but the Fed was independent of the
government and had more leeway. The Fed’s infusions were not bailouts per se,
but they stabilized market prices in commercial paper, money market funds, bank
deposits and term loans, and other financial instruments and included major
foreign banks in its assistance efforts. It quadruped its own balance sheet –
printing money as necessary to expand its resources, without having to ask
permission of Congress or, after Lehman, worry too much about the quality of
the collateral it was taking on. The Fed just did it. And what it did was
essential to the financial turnaround of the US, which came out of the crisis
just as the European Sovereign Debt crisis of 2010 was beginning. These efforts
by the Fed preceded its later, more questionable, commitment to “quantitative easing”
purchases of securities to lower long-term interest rates.
Post-Crisis Actions and Reforms
Though the banking system was secure by mid 2009, the future
of banks was not. Banks were widely blamed for the crash and the severe effects
that followed, and loathed for having been bailed out by the TARP at very low
cost to them while many other Americans were losing their jobs and their homes
to the crisis. President Obama called the banks greedy and reckless, and
politicians and media commentators were calling for their leaders to be jailed. The Fed’s intervention in markets was not widely
known or opposed, even though it was an indirect form of bailout for some. The
Fed’s provision of liquidity, however, was only a different form of acting in
its traditional role as a “lender of last resort” to assist “solvent” banks facing
a run on deposits (or their inability to roll them over in the institutional market)
to protect the whole financial system from failing.
“Insolvent” banks, however, are supposed to be taken over by
the FDIC, which replaces management and boards and funds a restructuring of the
bank until it can be broken up, sold or refloated. This is what happened (without
disturbing markets) to the Continental Illinois Bank, the seventh largest, in
1984, and to Washington Mutual, the largest US savings bank with assets of $330
billion, the largest bank ever taken over by the FDIC, in 2008. There were many
questions about the solvency of Citigroup and Bank of America (after its
acquisitions of Countrywide and Merrill Lynch) during the crisis, but there
were also fears that each was many times larger than Washington Mutual and “too
big to fail” (especially after Lehman) and therefore had to be bailed out by
the TARP or the Fed to avoid further contagion and continuation of the crisis.
The public anger over bailouts provoked two responses – the
Justice Department sued the shareholders of all the major banks for fraud (mismanagement,
really) and collected nearly $200 billion in settlement payments from them
(though no officer or director of a major bank was charged with a civil or
criminal offense), and the passage of the Dodd Frank bill in 2010. Both were
shots fired in anger that weakened, rather than strengthened, the banking
system.
The preamble to Dodd Frank says it is to end "too big to fail," to
protect the American taxpayer by “ending bank bailouts,” and …other
purposes. Only one of sixteen sections addresses
“financial stability,” so there is a lot of extraneous stuff in it. But the
bill prevents the Treasury from organizing another TARP in the future, and
limits the Fed’s crucial role as a lender of last resort. The Fed is restricted
to assisting only solvent banks in a liquidity crisis. Insolvent banks (whatever
their size) will have to be taken over by the FDIC. Overall, the law is
cumbersome and burdens banks with redundant regulations and high compliance
costs. Whether its terms reduce the risk of systemic failure in the future is
debatable; I believe it may do so indirectly, but its cost to the banks is a
serious burden to their ability to provide credit in a growing economy, but
time will tell.
Dodd Frank increases some of the regulatory powers of the
Fed, especially regarding “systemically important financial institutions” that are
now subject to “stress tests” to determine the capital adequacy and risk
management capability of large banks under different economic scenarios. These
tests are powerful because failure can result in the curtailment of dividends
or stock buyback programs, and so far, have reduced some of the risk-taking
activities banks might otherwise have wished to continue. The Fed, however,
probably had the power to conduct stress tests before Dodd Frank, but did not elect
to do so. Now that they are in place, however, they will probably continue
indefinitely.
A more important regulatory change was the agreement to
Basel III (a third revision of the Basel Accord, a voluntary agreement between
28 countries to maintain common standards of risk-adjusted capital adequacy of
banks, first adopted in 1987). This agreement tightened standards considerably
– it doubled the amount of capital banks had to have, halved their permitted
leverage and imposed new liquidity measures. These measures have considerably
reduced the flexibility and risk-taking abilities of banks and limited their
earnings potential.
Because of Basel III and other regulatory changes, the
world’s top ten capital market banks have averaged returns on equity less than
their cost of equity capital in every year since 2010. This has severely
affected the banks’ business models and required many of them to reduce
commitments to capital market activity significantly. The 2017 corporate tax cuts, however, have
improved after-tax returns to the banks.
Will the Reforms Do the Job?
Based on all the regulatory actions since 2010, large banks
that were seen to be free-wheeling traders and aggressive enablers of client financial
transactions have been transformed into regulated public utilities with growth
potential not much different from the economy as a whole. This is probably not
what was intended in the effort to reregulate finance, and is certainly not
what the banks wanted, but it may be an acceptable outcome for the public. The
system is less exposed to sudden market write-offs that destroyed capital and
extended the crisis in 2008. “Shadow banking” players (i.e., hedge funds,
private equity funds and some other non-bank financial institutions – of which
only one remains as a systemically important financial institution as
determined by Dodd Frank) -- are filling in where banks used to operate, but
these are not thought to increase systemic risk very much because of the widely
diversified nature of their holdings.
Meanwhile, global market capitalization is today over $300
trillion, up 40% since 2007, so capital markets are continuing to function and
few enterprises qualified to raise capital are unable to do so. Debt buildups continue to occur, particularly
in government sectors, where some point to dangers of future crises, though any
that may occur are likely to be local rather than global, and more easily
sustained.
One thing we can say about the ten years prior to and since
2008, is that they demonstrate that governments are imperfect regulatory organizations
at best. Politics confuse policy debates
and almost always result in programs that have weaknesses in design and in
execution. Responses to crises must be
energetic and purposeful, even if they are sometimes ineffective. The most
serious risks in the future lie in accumulations of financial risk that can suddenly
trigger an avalanche that causes much damage before it runs its course. Global
market runs can only be halted with massive liquidity assistance that can only
come from governments, and Ben Bernanke set a durable precedent on how to provide
it. Though the regulatory actions since 2008 contain contradictions, they
should be enough to temper the accumulation of such high levels of market risk
in the hands of a small number of banks required to mark-to-market -- at least
for a while.
Meanwhile, several other important issues remain unresolved
after ten years. Are we satisfied that the best way to assess credit quality of
marketable instruments is through a small number of rating agencies paid by
those they rate? What is to be the future of the federal housing entities, FNMA
and FMAC? How is the government to unwind its position in AIG? Is the FDIC to
be fortified and prepared to intervene in very large bank failures? And perhaps
most important, has the curtailment of risk taking in the broad global banking
sector affected the private sector’s ability to finance new entrepreneurial
activity, innovation and growth? In an age when the “new normal” levels of
economic growth are said to be in the 2.5% area (as compared to a long-term
average US growth rate of 3.5%) are the marginal benefits of additional
financial safety worth the cost of reduced growth due to increased financial
conservatism by banks forced to function as regulated public utilities?
During his presidential campaign, Mr. Trump promised to
repeal or revise Dodd Frank, but has not done so, nor does there seem to be
much energy behind doing so in the future. The other issues have not been
addressed. Most likely, the next few years will not involve important new regulatory
changes. Few observers, however, believe that the regulatory composition we
have now will end financial crises in the future. As hard as these are to predict,
it is even harder to predict where they will come from and how they will impact
the structures we have in place to absorb them. Finance has always been like
this, but we do learn from what we go through.
