Subprime mortgage crisis solutions debate
Encyclopedia
The Subprime mortgage crisis solutions debate discusses various actions and proposals by economists, government officials, journalists, and business leaders to address the subprime mortgage crisis
and broader economic crisis of 2007-2010.
, as well as long-term reforms to the global financial system. During 2008-2009, solutions focused on support for ailing financial institutions and economies. During 2010, debate continues regarding the nature of reform. Key points include: the split-up of large banks; whether depository banks and investment banks should be separated; whether banks should be able to make risky trades on their own accounts; how to wind-down large investment banks and other non-depository financial institutions without taxpayer impact; the extent of financial cushions that each institution should maintain (leverage restrictions); the creation of a consumer protection agency for financial products; and how to regulate derivatives
.
Critics have argued that governments treated this crisis as one of investor confidence
rather than deeply indebted institutions
unable to lend, delaying the appropriate remedies. Others have argued that this crisis represents a reset of economic activity, rather than a recession or cyclical downturn.
In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis. To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending. For a summary of U.S. government financial commitments and investments related to the crisis, see CNN - Bailout Scorecard.
In the U.S. during late 2008 and early 2009, President Bush's $700 billion Troubled Asset Relief Program (TARP) was used to re-capitalize ailing banks through the investment of taxpayer funds. The U.S. response in 2009, orchestrated by U.S. Treasury Secretary Timothy Geithner and supported by President Barack Obama
, focused on obtaining private sector money to recapitalize the banks, as opposed to bank nationalization or further taxpayer-funded capital injections. In an April 2010 interview, Geithner said: "The distinction in strategy that we adopted when we came in was to try and maximize the chance that capital needs could be met privately, not publicly." Geithner used "stress tests" or analysis of bank capital requirements to encourage private investors to re-capitalize the banks to the tune of $140 billion. Geithner has strenuously opposed actions that might interfere with private recapitalization, such as stringent pay caps, taxes on financial transactions, and the removal of key bank leaders. Geithner acknowledges this strategy is not popular with the public, which wants more draconian reforms and the punishment of bank leaders.
President Obama and key advisors introduced a series of longer-term regulatory proposals in June 2009. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system
and derivatives
, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions, among others.
Mr. Geithner testified before Congress on October 29, 2009. His testimony included five elements he stated as critical to effective reform:
The U.S. Senate passed a regulatory reform bill in May 2010, following the House which passed a bill in December 2009. These bills must now be reconciled. The New York Times has provided a comparative summary of the features of the two bills, which address to varying extent the principles enumerated by Secretary Geithner. The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010.
Solutions may be organized in these categories:
refers to this ability to borrow funds in the credit markets or pay immediate obligations with available cash. Prior to the crisis, many companies borrowed short-term in liquid markets to purchase long-term, illiquid assets like mortgage-backed securities (MBS), profiting on the difference between lower short-term rates and higher long-term rates. Some have been unable to "rollover" this short-term debt
due to disruptions in the credit markets, forcing them to sell long-term, illiquid assets at fire-sale prices and suffering huge losses.
The central bank of the USA, the Federal Reserve or Fed, in partnership with central bank
s around the world, has taken several steps to increase liquidity, essentially stepping in to provide short-term funding to various institutional borrowers through various programs such as the Term Asset-Backed Securities Loan Facility
(TALF). Fed Chairman Ben Bernanke
stated in early 2008: "Broadly, the Federal Reserve's response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." The Fed, a quasi-public institution, has a mandate to support liquidity as the "lender of last resort" but not solvency
, which resides with government regulators and bankruptcy courts.
from 5.25% to a target range of 0-0.25% since 18 September 2007. Central banks around the world have also lowered interest rates.
Lower interest rates may also help banks "earn their way out" of financial difficulties, because banks can borrow at very low interest rates from depositors and lend at higher rates for mortgages or credit cards. In other words, the "spread" between bank borrowing costs and revenues from lending increases. For example, a large U.S. bank reported in February 2009 that its average cost to borrow from depositors was 0.91%, with a net interest margin (spread) of 4.83%. Profits help banks build back equity or capital lost during the crisis.
is a means of encouraging banks to lend, thereby stimulating the economy. The Fed can expand the money supply by purchasing Treasury securities through a process called open market operations which provides cash to member banks for lending. The Fed can also provide loans against various types of collateral to enhance liquidity in markets, a process called credit easing. This is also called "expanding the Fed's balance sheet" as additional assets and liabilities represented by these loans appear there. A helpful overview of credit easing is available at: Cleveland Federal Reserve Bank-Credit Easing
The Fed has been active in its role as "lender of last resort" to offset declines in lending by both depository banks and the shadow banking system
. The Fed has implemented a variety of programs to expand the types of collateral against which it is willing to lend. The programs have various names such as the Term Auction Facility
and Term Asset-Backed Securities Loan Facility
. A total of $1.6 trillion in loans to banks were made for various types of collateral by November 2008. In March 2009, the Federal Open Market Committee
(FOMC) decided to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency (Government-sponsored enterprise
) mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt
this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities during 2009. The Fed also announced that it was expanding the scope of the TALF program to allow loans against additional types of collateral.
, expansion of the Fed balance sheet means the Fed is electronically creating money, necessary "...because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation."
, affecting the ability of the U.S. government to finance budget deficits. The Fed is lending against increasingly risky collateral and in great amounts. The challenge to reduce the money supply at the right cadence and amount will be unprecedented once the economy is on firmer footing. Further, reducing the money supply as the economy begins to recover may place downward pressure against economic growth. In other words, raising the money supply to cushion a downturn will have a dampening effect on the subsequent upturn. There is also risk of inflation and devaluation of the currency. Critics have argued that worthy borrowers can still get credit and that credit easing (and government intervention more generally) is really an attempt to maintain a debt-driven standard of living that was unsustainable.
A bit of accounting theory is helpful to understanding this debate. It is an accounting identity
(i.e., a rule that must hold true by definition) that assets equals the sum of liabilities and equity
. Equity is primarily the common
or preferred stock
and the retained earnings
of the company and is also referred to as capital
. The financial statement
that reflects these amounts is called the balance sheet
. If a firm is forced into a negative equity scenario, it is technically insolvent from a balance sheet perspective. However, the firm may have sufficient cash to pay its short-term obligations and continue operating. Bankruptcy
occurs when a firm is unable to pay its immediate obligations and seeks legal protection to enable it to either re-negotiate its arrangements with creditors or liquidate its assets. Pertinent forms of the accounting equation for this discussion are shown below:
If assets equal liabilities, then equity must be zero. While asset values on the balance sheet are marked down to reflect expected losses, these institutions still owe the creditors the full amount of liabilities. To use a simplistic example, Company X used a $10 equity or capital base to borrow another $290 and invest the $300 amount in various assets, which then fall 10% in value to $270. This firm was "leveraged" 30:1 ($300 assets / $10 equity = 30) and now has assets worth $270, liabilities of $290 and equity of negative $20. Such leverage ratios were typical of the larger investment banks during 2007. At 30:1 leverage, it only takes a 3.33% loss to reduce equity to zero.
Banks use various regulatory measures to describe their financial strength, such as tier 1 capital
. Such measures typically start with equity and then add or subtract other measures. Banks and regulators have been criticized for including relatively "weaker" or less tangible amounts in regulatory capital measures. For example, deferred tax assets (which represent future tax savings if a company makes a profit) and intangible assets (e.g., non-cash amounts like goodwill or trademarks) have been included in tier 1 capital calculations by some financial institutions. In other cases, banks were legally able to move liabilities off their balance sheets via structured investment vehicles, which improved their ratios. Critics suggest using the "tangible common equity" measure, which removes non-cash assets from these measures. Generally, the ratio of tangible common equity to assets is lower (i.e., more conservative) than the tier 1 ratio.
typically involves the assumption of either full or partial control over a financial institution as part of a bailout. The board and senior management is replaced. Full nationalization means current equity shareholders are entirely wiped out and bondholders may or may not receive a "haircut," meaning a write-down on the value of the debt owed to them. Suppliers are generally paid fully by the government. Once the bank is again healthy, it is sold to the public and taxpayers get some or all of their initial investment back.
Banks that are insolvent from a balance sheet perspective (i.e., liabilities exceed assets, meaning equity is negative) may restrict their lending. Further, they are at increased risk of making risky financial bets due to moral hazard
(i.e., either they make money if the bets work out or will be bailed out by the government, a dangerous position from society's point of view). An unstable banking system also undermines economic confidence.
These factors (among others) are why insolvent financial institutions have historically been taken over by regulators. Further, loans to a struggling bank increase assets and liabilities, not equity. Capital is therefore "tied up" on the insolvent bank's balance sheet and cannot be used as productively as it could be at a healthier financial institution. Banks have taken significant steps to obtain additional capital from private sources. Further, the U.S. and other countries have injected capital (willingly or unwillingly) into larger financial institutions.
Economist Paul Krugman
has argued for bank nationalization: "A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners." He advocates an "explicit, though temporary government takeover" of insolvent banks.
Economist Nouriel Roubini
stated: "I'm worried that many banks [are] zombies, they should be shut down, the sooner the better... otherwise they will take deposits and make other risky loans." He also wrote: "Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume." He recommended four steps:
Harvard professor Niall Ferguson
argued: "Worst of all [indebted] are the banks. The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt... banks that are de facto insolvent need to be restructured – a word that is preferable to the old-fashioned “nationalisation”. Existing shareholders will have to face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalisation after losses have meaningfully been written down."
Alan Greenspan
estimated in March 2009 that U.S. banks will require another $850 billion of capital, representing a 3-4 percentage point increase in equity capital to asset ratios.
The U.S. government authorized the injection of up to $350 billion in equity in the form of preferred stock
or asset purchases as part of the $700 billion Emergency Economic Stabilization Act of 2008
, also called the Troubled Asset Relief Program (TARP).
Steven Pearlstein
has advocated government guarantees for new preferred stock, to encourage investors to provide private capital to the banks.
For a summary of U.S. government financial commitments and investments related to the crisis, see CNN - Bailout Scorecard.
For a summary of TARP funds provided to U.S. banks as of December 2008, see Reuters-TARP Funds.
Government intervention may not always be fair or transparent. Who gets a bailout and how much? A Congressional Oversight Panel (COP) chaired by Harvard Professor Elizabeth Warren was created to monitor the implementation of the TARP program. COP issued its first report on 10 December 2008. In related interviews, Professor Warren indicated it was difficult to obtain clear answers to her panel's questions.
U.S. Treasury Secretary Timothy Geithner announced a plan during March 2009 to purchase "legacy" or "toxic" assets from banks. The Public-Private Partnership Investment Program involves government loans and guarantees to encourage private investors to provide funds to purchase toxic assets from banks. The press release states: "This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases – along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets."
Economist Joseph Stiglitz criticized the plan proposed by U.S. Treasury Secretary Timothy Geithner to purchase toxic assets: "Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time." He stated that toxic asset purchases represents "ersatz capitalism," meaning gains are privatized while losses are socialized.
The government's initial Troubled Asset Relief Program (TARP) proposal was derailed because of these questions and because of the timeline involved in successfully valuing, purchasing, and administering such a program was too long with an imminent crisis faced in September–October 2008.
Martin Wolf
has argued that the purchase of toxic assets may distract the U.S. Congress from the urgent need to recapitalize banks and may make it more politically difficult to take necessary action.
Research by JP Morgan and Wachovia indicates that the value of toxic assets (technically CDO's of ABS
) issued during late 2005 to mid-2007 are worth between 5 cents and 32 cents on the dollar. Approximately $305 billion of the $450 billion of such assets created during the period are in default. By another indicator (the ABX
), toxic assets are worth about 40 cents on the dollar, depending on the precise vintage (period of origin).
A key aspect of the AIG scandal is that over $100 billion in taxpayer funds have been channeled through AIG to major global financial institutions (its counterparties) that have already received separate, significant bailout funds in many cases. The amounts paid to counterparties were at 100 cents on the dollar. In other words, funds are provided to AIG by the U.S. government so that it can pay other companies, in effect making it a "bailout clearinghouse." Members of the U.S. Congress demanded that AIG indicate to whom it is distributing taxpayer bailout funds and to what extent these trading partners are sharing in losses. Key institutions receiving additional bailout funds channeled through AIG included a "who's who" of major global institutions. This included $12.9 billion paid to Goldman Sachs
, which reported a profit of $2.3 billion for 2008.
A list of the amounts by country and counterparty is here: Business Week - List of Counterparties and Payouts
Economist Joseph Stiglitz testified that bank bailouts "...are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this." He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.
Fed Chairman Ben Bernanke
argued in March 2009: "If a federal agency had had such tools on September 16 [2008], they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now."
Harvard professor Niall Ferguson
has argued for bondholder haircuts at insolvent banks: "Bondholders may have to accept either a debt-for-equity swap or a 20 per cent “haircut” (a reduction in the value of their bonds) – a disappointment, no doubt, but nothing compared with the losses when Lehman went under."
Economist Jeffrey Sachs
has also argued for bondholder haircuts: "The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices."
Dr. John Hussman
has argued for significant bondholder haircuts: "Stabilize insolvent financial institutions through receivership if the bondholders of the institution are unwilling to swap debt for equity. In virtually all cases, the liabilities of these companies to their own bondholders are capable of fully absorbing all losses without the need for public funds to defend those bondholders...The sum total of the policy responses to this crisis has been to defend the bondholders of distressed financial institutions at public expense."
Professor and author Nassim Nicholas Taleb argued during July 2009 that deleveraging through forcible conversion of debt to equity swaps for both banks and homeowners is "the only solution." He advocates much more aggressive and system-wide action. He emphasized the complexity and fragility of the current system due to excessive debt levels and stated that the system is in the process of crashing. He believes any "green shoots" (i.e., signs of recovery) should not distract from this response.
The fear of losing one's investments which is contributing to the recession would increase with each expropriation.
On 13 February 2008, former President George W. Bush
signed into law a $168 billion economic stimulus package, mainly taking the form of income tax
rebate checks mailed directly to taxpayers. Checks were mailed starting the week of 28 April 2008.
On 17 February 2009, U.S. President Barack Obama
signed the American Recovery and Reinvestment Act of 2009
(ARRA), an $800 billion stimulus package with a broad spectrum of spending and tax cuts.
Keynesian economics
suggests deficit spending by governments to offset declines in consumer spending and business investment can help increase economic activity. Economist Paul Krugman
has argued that the U.S. stimulus should be approximately $1.3 trillion over 3 years, even larger than the $800 billion enacted into law by President Barack Obama
, or roughly 4% of GDP annually for 2–3 years. Krugman has argued for a strong stimulus to address the risk of another depression and deflation, in which prices, wages, and economic growth spiral downward in a self-reinforcing cycle.
President Obama argued his rationale for ARRA and his spending priorities in his speech of February 25, 2009 to a joint session of Congress. He argued that energy independence, healthcare reform, and education merit significant investment or spending increases.
Economists Alan Blinder
and Alan Auerbach both advocated short-term stimulus spending in June 2009 to help ensure the economy does not slip into a deeper recession, but then reinstating fiscal discipline in the medium- to long-term.
Economists debate the relative merit of tax cuts vs. spending increases as economic stimulus. Economists in President Obama's administration have argued that spending on infrastructure such as roads and bridges has a higher impact on GDP and jobs than tax cuts.
Economist Joseph Stiglitz explained that stimulus can be seen as an investment and not just as spending, if used properly: "Wise government investments yield returns far higher than the interest rate the government pays on its debt; in the long run, investments help reduce deficits."
wrote: "The reality being repressed is that the western world is suffering a crisis of excessive indebtedness. Many governments are too highly leveraged, as are many corporations. More importantly, households are groaning under unprecedented debt burdens. Worst of all are the banks. The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt."
Many economists recognize that the U.S. is facing a series of long-term funding challenges
related to Social security
and healthcare
. Fed Chairman Ben Bernanke
said on October 4, 2006: "Reform of our unsustainable entitlement programs should be a priority." He added, "the imperative to undertake reform earlier rather than later is great." He discussed how borrowing to enable deficit spending increases the national debt, which poses questions of inter-generational equity, meaning the right of current generations to increase the burden on future generations.
Economist Peter Schiff
has argued that the U.S. economy is resetting at a lower level and stimulus spending will not be effective and only raise debt levels: "America's GDP is composed of more than 70% consumer spending. For many years, much of that spending has been a function of voracious consumer borrowing through home equity extractions (averaging more than $850 billion annually in 2005 and 2006, according to the Federal Reserve) and rapid expansion of credit card and other consumer debt. Now that credit is scarce, it is inevitable that GDP will fall. Neither the left nor the right of the American political spectrum has shown any willingness to tolerate such a contraction." He argues further that U.S. budgetary assumptions mean certain wealthy nations must continue to fund annual trillion dollar deficits indefinitely, for a 2-3% Treasury bond return, without significant net redemption to fund domestic programs, which he considers highly unlikely.
While commenting on the G20 summit, economist John B. Taylor
said "This financial crisis was caused and prolonged largely by government excesses in the fiscal and monetary policy areas, and continued excess as far as the eye can see will neither end the crisis nor prevent further ones.".
Prominent Republicans have strongly criticized President Obama's 2010 budget, which includes $900 billion or larger annual increases in the national debt through 2019 (Schedule S-9).
A large amount of real wealth was destroyed during the boom (the realization of which fact constitutes the bust). Consequently, the private sector needs to rebuild what is missing. Spending by the government during this period diverts resources from that rebuilding and prolongs the recession. Conservatives argue it would be better to cut government spending. This would reduce the cost of inputs used by businesses which would allow them to expand and hire more workers.
economists argue that the best stimulus would be to lower marginal tax rates. This would allow businesses to expand those investments which are truly productive and heal the economy. They note that this worked when presidents Kennedy and Reagan cut taxes.
Various economic studies place the fiscal multiplier from stimulus between zero and 2.5. In testimony before the Financial Crisis Inquiry Commission
, economist Mark Zandi
reported that infrastructure investment provided a high multiplier as part of the American Recovery and Reinvestment Act, while spending provided a moderate to high multiplier and tax cuts had the lowest multiplier. His conclusions by category were:
During May 2009 the Whitehouse Council of Economic Advisors estimated that the American Recovery and Reinvestment Act spending elements would have multipliers between 1.0 and 1.5, while tax cuts would have multipliers between 0 and 1. The report states that these conclusions "...are broadly similar to those implied by the Federal Reserve’s FRB/US model and the models of leading private forecasters, such as Macroeconomic Advisers."
Supply side economists have argued that tax rate cuts have a multiplier sufficient to actually raise government revenues (i.e., greater than 5.5). However, this is disputed by research from the Congressional Budget Office
, Harvard University, and the U.S. Treasury Department. The Center on Budget and Policy Priorities
(CBPP) summarized a variety of studies done by economists across the political spectrum that indicated tax cuts do not pay for themselves and increase deficits.
To summarize the above studies, infrastructure investment and spending are more effective stimulus measures than tax cuts, due to their higher multipliers. However, any type of stimulus spending increases the deficit.
, meaning large stock market declines or disruption in the availability of credit to worthy borrowers.
In a dramatic meeting on September 18, 2008 Treasury Secretary Henry Paulson
and Fed Chairman Ben Bernanke
met with key legislators to propose a $700 billion emergency bailout of the banking system. Bernanke reportedly told them: "If we don't do this, we may not have an economy on Monday." The Emergency Economic Stabilization Act also called the Troubled Asset Relief Program (TARP) was signed into law on October 3, 2008.
Ben Bernanke also described his rationale for the AIG
bailout as a "difficult but necessary step to protect our economy and stabilize our financial system." AIG had $952 billion in liabilities according to its 2007 annual report; its bankruptcy would have made the payment of these liabilities uncertain. Banks, municipalities, and insurers could have suffered significant financial losses, with unpredictable and potentially significant consequences. In the context of the dramatic business failures and takeovers of September 2008, he was unwilling to allow another large bankruptcy such as Lehman Brothers
, which had caused a run on money-market funds and caused a crisis of confidence that brought interbank lending to a standstill.
On November 24, 2008, Republican
Congressman Ron Paul
(R-TX) wrote, "In bailing out failing companies, they are confiscating money from productive members of the economy and giving it to failing ones. By sustaining companies with obsolete or unsustainable business models, the government prevents their resources from being liquidated and made available to other companies that can put them to better, more productive use. An essential element of a healthy free market, is that both success and failure must be permitted to happen when they are earned. But instead with a bailout, the rewards are reversed – the proceeds from successful entities are given to failing ones. How this is supposed to be good for our economy is beyond me.... It won’t work. It can’t work... It is obvious to most Americans that we need to reject corporate cronyism, and allow the natural regulations and incentives of the free market to pick the winners and losers in our economy, not the whims of bureaucrats and politicians."
Journalist Nicole Gelinas wrote in March 2009: "In place of a wrenching but consistent and well-tested process [bankruptcy] of winding down a failed company, what have we chosen? A world of investors who can never be sure, in the future, that if they put their money into a company that fails, they can depend on a reliable process to recoup some of their funds. Instead, they may find themselves at the mercy of a government veering from whim to whim as it reads the mood of a volatile public...In saving the remnants of failed companies from free-market failures, Washington may be sacrificing the public’s confidence that the government can ensure that free markets are reasonably fair and impartial. One year into an era of exhausting and arbitrary bailouts, it’s not clear that our policy of destroying the system in order to save it is going to work."
Bailouts are extremely costly for taxpayers. In 2002, World Bank
reported that country bailouts cost an average of 13% of GDP. Based on U.S. GDP of $14 trillion in 2008, this would be approximately $1.8 trillion.
, Hope Now Alliance
, and Homeowners Affordability and Stability Plan
. These all operate under the paradigm of "one-at-a-time" or "case-by-case" loan modification, as opposed to automated or systemic loan modification. They typically offer incentives to various parties involved to help homeowners stay in their homes.
There are four primary variables that can be adjusted to lower monthly payments and help homeowners: 1) Reduce the interest rate; 2) Reduce the loan principal amount; 3) Extend the mortgage term, such as from 30 to 40 years; and 4) Convert variable-rate ARM mortgages to fixed-rate.
described the issue this way: "No part of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America. Government programmes have been ineffectual, and private efforts not much better." Up to 9 million homes may enter foreclosure over the 2009-2011 period, versus one million in a typical year.
Critics have argued that the case-by-case loan modification method is ineffective, with too few homeowners assisted relative to the number of foreclosures and with nearly 40% of those assisted homeowners again becoming delinquent within 8 months.
On 18 February 2009, economists Nouriel Roubini
and Mark Zandi
recommended an "across the board" (systemic) reduction of mortgage principal balances by as much as 20-30%. Lowering the mortgage balance would help lower monthly payments and also address an estimated 20 million homeowners that may have a financial incentive to enter voluntary foreclosure because they are "underwater" (i.e., the mortgage balance is larger than the home value).
Roubini has further argued that mortgage balances could be reduced in exchange for the lender receiving a warrant that entitles them to some of the future home appreciation, in effect swapping mortgage debt for equity. This is analogous to the bondholder haircut concept discussed above.
Harvard professor Niall Ferguson
wrote: "...we need...a generalised conversion of American mortgages to lower interest rates and longer maturities. The idea of modifying mortgages appals legal purists as a violation of the sanctity of contract. But there are times when the public interest requires us to honour the rule of law in the breach. Repeatedly during the course of the 19th century governments changed the terms of bonds that they issued through a process known as “conversion”. A bond with a 5 per cent coupon would simply be exchanged for one with a 3 per cent coupon, to take account of falling market rates and prices. Such procedures were seldom stigmatised as default. Today, in the same way, we need an orderly conversion of adjustable rate mortgages to take account of the fundamentally altered financial environment."
The State Foreclosure Prevention Working Group, a coalition of state attorney general
s and bank regulators from 11 states, reported in April 2008 that loan servicers could not keep up with the rising number of foreclosures. 70% of subprime mortgage holders are not getting the help they need. Nearly two-thirds of loan workouts require more than six weeks to complete under the current "case-by-case" method of review. In order to slow the growth of foreclosures, the Group has recommended a more automated method of loan modification that can be applied to large blocks of struggling borrowers.
In December 2008, the U.S. FDIC reported that more than half of mortgages modified during the first half of 2008 were delinquent again, in many cases because payments were not reduced or mortgage debt was not forgiven. This is further evidence that case-by-case loan modification is not effective as a policy tool.
A report released in April 2009 by the Office of the Comptroller of the Currency
and Office of Thrift Supervision
indicated that fewer than half of loan modifications during 2008 reduced homeowner payments by more than 10%. Nearly one in four loan modifications during the fourth quarter of 2008 actually increased monthly payments. Nine months after modification, 26% of loans where monthly payments were reduced by 10% or more were again delinquent, versus 50% where payment amounts were unchanged. The U.S. Comptroller stated: "...modification strategies that result in unchanged or increased monthly payments run the risk of unacceptably high re-default rates."
It is the inability of homeowners to pay their mortgages that causes mortgage-backed securities to become "toxic" on the banks balance sheets. To use an analogy, it is the "upstream" problem of homeowners defaulting that creates toxic assets and banking insolvency "downstream." By assisting homeowners "upstream" at the core of the problem, banks would be assisted "downstream," helping both parties with the same set of funds. However, the government's primary assistance through April 2009 has been to the banks, helping only the "downstream" party rather than both.
Economist Dean Baker
has argued for systematically converting mortgages to rental arrangements for homeowners at risk of foreclosure, at considerably reduced monthly payment amounts. Homeowners would be allowed to remain in the home for a substantial period time (e.g., 5–10 years). Rents would be at 50-70% of the current mortgage amount. Homeowners would be given this option, indirectly forcing banks to be more aggressive in their refinancing decisions.
Breaking contracts would potentially lead to higher interest rates, as investors demand higher compensation for taking the risk that their contracts may be subject to homeowner bailouts or relief mandated by the government.
As with other government interventions, homeowner relief would create moral hazard — why should a potential homeowner make a down payment or limit himself to a house he can afford, if government is going to bail him out when he gets in trouble?
were argued as contributing to this crisis:
A precedent is the Sarbanes-Oxley Act of 2002, which implemented a "cooling-off period" between auditors and the firms they audit. The law prohibits auditors from auditing a publicly-traded firm if the CEO or top financial management worked for the audit firm during the past year.
(IMF) writing independently of that organization. The study concluded that: "the prevention of future crises might require weakening political influence of the financial industry or closer monitoring of lobbying activities to understand better the incentives behind it."
The Boston Globe reported during that during January–June 2009, the largest four U.S. banks spent these amounts ($ millions) on lobbying, despite receiving taxpayer bailouts: Citigroup $3.1; JP Morgan Chase $3.1; Bank of America $1.5; and Wells Fargo $1.4.
and key advisors introduced a series of regulatory proposals in June 2009. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system
and derivatives
, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions, among others.
and AIG
more effectively.
stated there is a need for "well-defined procedures and authorities for dealing with the potential failure of a systemically important non-bank financial institution." He also argued in March 2009: "...I would note that AIG
offers two clear lessons for the upcoming discussion in the Congress and elsewhere on regulatory reform. First, AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now. Second, the AIG situation highlights the need for strong, effective consolidated supervision of all systemically important financial firms. AIG built up its concentrated exposure to the subprime mortgage market largely out of the sight of its functional regulators. More-effective supervision might have identified and blocked the extraordinarily reckless risk-taking at AIG-FP. These two changes could measurably reduce the likelihood of future episodes of systemic risk like the one we faced at AIG."
Economists Nouriel Roubini
and Lasse Pederson recommended in January 2009 that capital requirements for financial institutions be proportional to the systemic risk
they pose, based on an assessment by regulators. Further, each financial institution would pay an insurance premium to the government based on its systemic risk.
British Prime Minister Gordon Brown
and Nobel laureate A. Michael Spence have argued for an "early warning system" to help detect a confluence of events leading to systemic risk
.
Former Federal Reserve Chairman Paul Volcker
testified in September 2009 regarding how to deal with a systemically important non-bank that might get into trouble:
Volcker argued that none of the above involves injection of government or taxpayer money but involves an organized procedure for winding down a systemically-important non-banking institutions. He advocated that this authority should reside with the Federal Reserve rather than a council of regulators.
play a critical role in the credit markets. In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking system. He described the significance of this unregulated banking system: "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion." He stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."
The FDIC has the authority to takeover a struggling depository bank and liquidate it in an orderly way; it lacks this authority for non-bank financial institutions that have become an increasingly important part of the credit markets.
Nobel laureate Paul Krugman
described the run on the shadow banking system
as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."
Krugman wrote in April 2010: "What we need now are two things: (a) regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and (b) there have to be prudential limits on shadow banks, above all limits on their leverage."
The crisis surrounding the failure of Long-term Capital Management
in 1998 was an example of an unregulated shadow banking institution that many believed posed a systemic risk.
Economist Nouriel Roubini
has argued that market discipline
, or free market incentives for depositors and investors to monitor banks to prevent excessive risk taking, breaks down when there is mania or bubble psychology inflating asset prices. People take excessive risks and ignore risk managers during these periods. Without proper regulation, the "law of the jungle" rules. Excessive financial innovation that is not controlled is "very risky." He stated: "Self-regulation is meaningless; it means no regulation."
Former Chairman and CEO of Citigroup Chuck Prince said in July 2007: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing." Market pressures to grow profits by taking increasing risks were significant throughout the boom period. The largest five investment banks (such as Bear Stearns
and Lehman Brothers
), were either taken over, liquidated, or converted to depository banks. These institutions had increased their leverage ratios, a measure of risk defined as the ratio of assets or debt to capital, significantly from 2003-2007 (see diagram).
of the American Enterprise Institute
,"...the federal government had to commit several hundred billion dollars for a guarantee of Citigroup's assets, despite the fact that examiners from the Office of the Comptroller of the Currency (OCC) have been inside the bank full-time for years, supervising the operations of this giant institution under the broad powers granted by FDICIA to bank supervisors." He questions whether regulation is better than market discipline at preventing the failure of financial institutions, as follows:
Market bubbles are not caused by failure of a free market to control manias — the market mechanism has been short-circuited by the Central Bank using its legal monopoly to create excessive amounts of new money. People seek to avoid the effects of inflation on their savings by investing in assets whose prices are being artificially increased. This aggravates the price rises, but this vicious cycle of phony capital gains eventually becomes unsustainable.
) are not subject to the same capital requirements (or leverage restrictions) as depository bank
s. For example, the largest five investment banks were leveraged approximately 30:1 based on their 2007 financial statements, meaning that only a 3.33% decline in the value of their assets could make them insolvent as explained above. Many investment banks had limited capital to offset declines in their holdings of MBSs, or to support their side of credit default insurance contracts. Insurance companies such as AIG did not have sufficient capital to support the amounts they were insuring and were unable to post the required collateral as the crisis deepened.
Alan Greenspan
has called for banks to have a 14% capital ratio, rather than the historical 8-10%. Major U.S. banks had capital ratios of around 12% in December 2008 after the initial round of bailout funds. The minimum capital ratio is regulated.
Greenspan also wrote in March 2009: "New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage." He estimated that another $850 billion will be required to properly capitalize major banks.
Economist Raghuram Rajan
has argued for regulations requiring "contingent capital." For example, financial institutions would be required to pay insurance premiums to the government during boom periods, in exchange for payments during a downturn. Alternatively, they would issue debt that converts to equity during downturns or when certain capital thresholds are met, both reducing their interest burden and expanding their capital base to enable lending.
Economist Paul McCulley
advocated "counter-cyclical regulatory policy to help modulate human nature." He cited the work of economist Hyman Minsky
, who believed that human behavior is pro-cyclical, meaning it amplifies the extent of booms and busts. In other words, humans are momentum investors rather than value investors. Counter-cyclical policies would include increasing capital requirements during boom periods and reducing them during busts.
JP Morgan Chase CEO Jamie Dimon
also supported increased capital requirements: "Also welcome in the administration's new proposals is the focus on strong capital and liquidity requirements -- not just for traditional banks but for a broad range of financial institutions. We now know that "once-in-a-generation" swings in the business cycle are anything but. All financial institutions, wherever they're regulated, must stand ready with strong capital reserves to serve as a cushion during times of unexpected market and economic difficulties. This must be combined with adequate loan loss reserves, to cover the expected losses from the growing number of borrowers who likely will default, and necessary liquidity, in case credit markets freeze up as they did last fall."
During a boom (before the corresponding bust begins), even most economists are unable to distinguish the boom from a period of normal (but rapid) growth. Thus officials will be unwilling or politically unable to impose counter-cyclical policies during a boom. No one wants to take away the punch bowl just when the party is warming up.
have argued that institutions that are "too big to fail" should be broken up, perhaps by splitting them into smaller regional institutions. Dr. Stiglitz argued that big banks are more prone to taking excessive risks due to the availability of support by the federal government should their bets go bad.
Various Wall Street special interests would likely be weakened if major financial institutions are broken-up or no longer allowed to make campaign contributions. Further, restrictions could be placed more easily on the "revolving door" of executives between investment banks and various government agencies or departments. Similar rules regarding conflicts of interest were placed on accounting firms and the corporations they audit as part of the Sarbanes-Oxley Act
of 2002.
The Glass-Steagall Act
was enacted after the Great Depression
. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of key provisions of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries...spearheaded in Congress by Senator Phil Gramm
." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.
Martin Wolf
wrote in June 2009: "A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that."
Niall Ferguson
wrote in September 2009: "What's needed is a serious application of antitrust law to the financial-services sector and a speedy end to institutions that are 'too big to fail.' In particular, the government needs to clarify that federal insurance applies only to bank deposits and that bank bondholders will no longer protected, as they have been in this crisis. In other words, when a bank goes bankrupt, the creditors should take the hit, not the taxpayers."
The New York Times editorial board wrote in December 2009: "If we have learned anything over the last couple of years, it is that banks that are too big to fail pose too much of a risk to the economy. Any serious effort to reform the financial system must ensure that no such banks exist."
President Barack Obama
argued in January 2010 that depository banks should not be able to trade on their own accounts, which effectively brings back Glass-Steagall Act
rules separating depository and investment banking. This is because taxpayers guarantee the deposits of depository banks and high-risk bets with that money would be inappropriate.
s or deliberate attempts to reduce the value of stocks caused the downfall of certain firms, such as Bear Stearns
. Hedge funds or large investors with significant short positions allegedly began a rumor campaign, creating a crisis of confidence regarding the firm. Since it was financed by short-term loans that frequently required replenishment and was highly leveraged (i.e., vulnerable), such rumors may have contributed to bankrupting the firm as lenders refused to extend financing and investors pulled funds from the company.
On 18 September 2008, UK regulators announced a temporary ban on short-selling the stock of financial firms.
Bear raids (like bank runs) are only a danger to firms which are over-extended and thus deserve to fail.
Author Michael Lewis
wrote that CDS enabled speculators to stack bets on the same mortgage bonds and CDO's. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG
) bet they would not.
famously referred to derivatives as "financial weapons of mass destruction" in early 2003.
Former President Bill Clinton
and former Federal Reserve Chairman Alan Greenspan
indicated they did not properly regulate
derivatives, including credit default swaps (CDS). A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.
Economist Joseph Stiglitz summarized how CDS contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."
NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems.... In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations.
Financier George Soros
has recommended that credit default swaps no longer be traded, calling them "instruments of destruction that ought to be outlawed."
U.S. Treasury Secretary Timothy Geithner proposed a framework for legislation to regulate derivatives during May 2009, stating that "...derivatives are largely excluded or exempted from regulation." Key elements of the framework include:
stated in February 2009: "The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10 percent and monthly payments that can be comfortably handled by the borrower's income. That income should be carefully verified."
China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.
Economist Stan Leibowitz argued that the most important factor in foreclosures was the extent to which the homeowner has positive equity. Although only 12% of homes had negative equity, they constituted 47% of all foreclosures during the second half of 2008. He advocated "relatively high" minimum down payments and stronger underwriting standards. "If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can't just walk away."
A 2009 Republican
congressional staff report cited government pressure as a cause of the crisis: "Washington must reexamine its politically expedient but irresponsible approach to encouraging higher levels of home ownership based on imprudently small down payments and too little emphasis on borrowers’ creditworthiness and ability to repay their loans."
The Fed implemented new rules for mortgage lenders in July 2008.
The ratio of average CEO total direct compensation relative to that of the average worker increased from 29 times (1969) to 126 times (1992) and 275 times in 2007.
Bank CEO Jamie Dimon
argued: "Rewards have to track real, sustained, risk-adjusted performance. Golden parachutes, special contracts, and unreasonable perks must disappear. There must be a relentless focus on risk management that starts at the top of the organization and permeates down to the entire firm. This should be business-as-usual, but at too many places, it wasn't."
President Obama has assigned Kenneth Feinberg as "Special Master" on executive pay, for firms that received government assistance, including several major banks and General Motors. He will review the pay packages proposed by these firms for their top executives.
Some say the opposition to such high compensation is largely based on envy — many people do not want to acknowledge that the work of another person could be worth hundreds of times more than their own work. Perhaps they resent the success of others. Critics say that if government regulates executive compensation, then it will be removing the main tool by which the owners of the business control their company - such controls would amount to defacto nationalization. Capable executives may move to unregulated or foreign companies.
reviews new drugs. Products would be reviewed to ensure the risks could be "safe for consumption" and effectively communicated to investors or homeowners, depending on the product. Related legislation has been proposed in Congress.
If people want U.S. government guaranteed safety, they can put their money in: cash, an FDIC insured account, or in U.S. Treasury securities. The whole point of other securities is to allow people to make their own judgment on risk instead of accepting the opinion of a financial dictator such as FPSC.
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
and broader economic crisis of 2007-2010.
Overview
The debate concerns both immediate responses to the ongoing subprime mortgage crisisSubprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
, as well as long-term reforms to the global financial system. During 2008-2009, solutions focused on support for ailing financial institutions and economies. During 2010, debate continues regarding the nature of reform. Key points include: the split-up of large banks; whether depository banks and investment banks should be separated; whether banks should be able to make risky trades on their own accounts; how to wind-down large investment banks and other non-depository financial institutions without taxpayer impact; the extent of financial cushions that each institution should maintain (leverage restrictions); the creation of a consumer protection agency for financial products; and how to regulate derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
.
Critics have argued that governments treated this crisis as one of investor confidence
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
rather than deeply indebted institutions
Insolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
unable to lend, delaying the appropriate remedies. Others have argued that this crisis represents a reset of economic activity, rather than a recession or cyclical downturn.
In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis. To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending. For a summary of U.S. government financial commitments and investments related to the crisis, see CNN - Bailout Scorecard.
In the U.S. during late 2008 and early 2009, President Bush's $700 billion Troubled Asset Relief Program (TARP) was used to re-capitalize ailing banks through the investment of taxpayer funds. The U.S. response in 2009, orchestrated by U.S. Treasury Secretary Timothy Geithner and supported by President Barack Obama
Barack Obama
Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...
, focused on obtaining private sector money to recapitalize the banks, as opposed to bank nationalization or further taxpayer-funded capital injections. In an April 2010 interview, Geithner said: "The distinction in strategy that we adopted when we came in was to try and maximize the chance that capital needs could be met privately, not publicly." Geithner used "stress tests" or analysis of bank capital requirements to encourage private investors to re-capitalize the banks to the tune of $140 billion. Geithner has strenuously opposed actions that might interfere with private recapitalization, such as stringent pay caps, taxes on financial transactions, and the removal of key bank leaders. Geithner acknowledges this strategy is not popular with the public, which wants more draconian reforms and the punishment of bank leaders.
President Obama and key advisors introduced a series of longer-term regulatory proposals in June 2009. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system
Shadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
and derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions, among others.
Mr. Geithner testified before Congress on October 29, 2009. His testimony included five elements he stated as critical to effective reform:
- Expand the Federal Deposit Insurance CorporationFederal Deposit Insurance CorporationThe Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
(FDIC) bank resolution mechanism to include non-bank financial institutionsShadow banking systemThe shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
; - Ensure that a firm is allowed to fail in an orderly way and not be "rescued";
- Ensure taxpayers are not on the hook for any losses, by applying losses to the firm's investors and creating a monetary pool funded by the largest financial institutions;
- Apply appropriate checks and balances to the FDIC and Federal Reserve in this resolution process;
- Require stronger capital and liquidity positions for financial firms and related regulatory authority.
The U.S. Senate passed a regulatory reform bill in May 2010, following the House which passed a bill in December 2009. These bills must now be reconciled. The New York Times has provided a comparative summary of the features of the two bills, which address to varying extent the principles enumerated by Secretary Geithner. The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010.
Solutions may be organized in these categories:
- Investor confidence or liquidity: Central banks have expanded their lending and money supplies, to offset the decline in lending by private institutions and investors.
- Deeply indebted institutions or solvency: Some financial institutions are facing risks regarding their solvencySolvencySolvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...
, or ability to pay their obligations. Alternatives involve restructuring through bankruptcy, bondholder haircuts, or government bailouts (i.e., nationalization, receivership or asset purchases). - Economic stimulus: Governments have increased spending or cut taxes to offset declines in consumer spending and business investment.
- Homeowner assistance: Banks are adjusting the terms of mortgage loans to avoid foreclosure, with the goal of maximizing cash payments. Governments are offering financial incentives for lenders to assist borrowers. Other alternatives include systematic refinancing of large numbers of mortgages and allowing mortgage debt to be "crammed down" (reduced) in homeowner bankruptcies.
- Regulatory: New or reinstated rules designed help stabilize the financial system over the long-run to mitigate or prevent future crises.
Liquidity
All major corporations, even highly profitable ones, borrow money to finance their operations. In theory, the lower interest rate paid to the lender is offset by the higher return obtained from the investments made using the borrowed funds. Corporations regularly borrow for a period of time and periodically "rollover" or pay back the borrowed amounts and obtain new loans in the credit markets, a generic term for places where investors can provide funds through financial institutions to these corporations. The term liquidityMarket liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
refers to this ability to borrow funds in the credit markets or pay immediate obligations with available cash. Prior to the crisis, many companies borrowed short-term in liquid markets to purchase long-term, illiquid assets like mortgage-backed securities (MBS), profiting on the difference between lower short-term rates and higher long-term rates. Some have been unable to "rollover" this short-term debt
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
due to disruptions in the credit markets, forcing them to sell long-term, illiquid assets at fire-sale prices and suffering huge losses.
The central bank of the USA, the Federal Reserve or Fed, in partnership with central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
s around the world, has taken several steps to increase liquidity, essentially stepping in to provide short-term funding to various institutional borrowers through various programs such as the Term Asset-Backed Securities Loan Facility
Term Asset-Backed Securities Loan Facility
The Term Asset-Backed Securities Loan Facility is a program created by the U.S. Federal Reserve to spur consumer credit lending. The program was announced on November 25, 2008 and was to support the issuance of asset-backed securities collateralized by student loans, auto loans, credit card...
(TALF). Fed Chairman Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
stated in early 2008: "Broadly, the Federal Reserve's response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." The Fed, a quasi-public institution, has a mandate to support liquidity as the "lender of last resort" but not solvency
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...
, which resides with government regulators and bankruptcy courts.
Arguments for lower interest rates
Lower interest rates stimulate the economy by making borrowing less expensive. The Fed lowered the target for the Federal funds rateFederal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
from 5.25% to a target range of 0-0.25% since 18 September 2007. Central banks around the world have also lowered interest rates.
Lower interest rates may also help banks "earn their way out" of financial difficulties, because banks can borrow at very low interest rates from depositors and lend at higher rates for mortgages or credit cards. In other words, the "spread" between bank borrowing costs and revenues from lending increases. For example, a large U.S. bank reported in February 2009 that its average cost to borrow from depositors was 0.91%, with a net interest margin (spread) of 4.83%. Profits help banks build back equity or capital lost during the crisis.
Arguments against lower interest rates
Other things being equal, economic theory suggests that lowering interest rates relative to other countries weakens the domestic currency. This is because capital flows to nations with higher interest rates (after subtracting inflation and the political risk premium), causing the domestic currency to be sold in favor of foreign currencies, a variation of which is called the carry trade. Further, there is risk that the stimulus provided by lower interest rates can lead to demand-driven inflation once the economy is growing again. Maintaining interest rates at a low level also discourages saving, while encouraging spending.Monetary policy and "credit easing"
Expanding the money supplyMoney supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
is a means of encouraging banks to lend, thereby stimulating the economy. The Fed can expand the money supply by purchasing Treasury securities through a process called open market operations which provides cash to member banks for lending. The Fed can also provide loans against various types of collateral to enhance liquidity in markets, a process called credit easing. This is also called "expanding the Fed's balance sheet" as additional assets and liabilities represented by these loans appear there. A helpful overview of credit easing is available at: Cleveland Federal Reserve Bank-Credit Easing
The Fed has been active in its role as "lender of last resort" to offset declines in lending by both depository banks and the shadow banking system
Shadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
. The Fed has implemented a variety of programs to expand the types of collateral against which it is willing to lend. The programs have various names such as the Term Auction Facility
Term auction facility
The Term Auction Facility is a temporary program managed by the United States Federal Reserve designed to "address elevated pressures in short-term funding markets." Under the program the Fed auctions collateralized loans with terms of 28 and 84 days to depository institutions that are "in...
and Term Asset-Backed Securities Loan Facility
Term Asset-Backed Securities Loan Facility
The Term Asset-Backed Securities Loan Facility is a program created by the U.S. Federal Reserve to spur consumer credit lending. The program was announced on November 25, 2008 and was to support the issuance of asset-backed securities collateralized by student loans, auto loans, credit card...
. A total of $1.6 trillion in loans to banks were made for various types of collateral by November 2008. In March 2009, the Federal Open Market Committee
Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...
(FOMC) decided to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency (Government-sponsored enterprise
Government-sponsored enterprise
A government-sponsored enterprise is a financial services corporation created by the United States Congress. Their function is to enhance the flow of credit to targeted sectors of the economy and to make those segments of the capital market more efficient and transparent...
) mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt
Agency debt
Agency debt is a security, usually a bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the government, but not guaranteed by the government since the agencies are private entities. Such agencies have been set up in order to allow certain groups of...
this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities during 2009. The Fed also announced that it was expanding the scope of the TALF program to allow loans against additional types of collateral.
Arguments for credit easing
According to Ben BernankeBen Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
, expansion of the Fed balance sheet means the Fed is electronically creating money, necessary "...because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation."
Arguments against credit easing
Credit easing involves increasing the money supply, which presents inflationary risks that could weaken the dollar and make it less desirable as a reserve currencyReserve currency
A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves...
, affecting the ability of the U.S. government to finance budget deficits. The Fed is lending against increasingly risky collateral and in great amounts. The challenge to reduce the money supply at the right cadence and amount will be unprecedented once the economy is on firmer footing. Further, reducing the money supply as the economy begins to recover may place downward pressure against economic growth. In other words, raising the money supply to cushion a downturn will have a dampening effect on the subsequent upturn. There is also risk of inflation and devaluation of the currency. Critics have argued that worthy borrowers can still get credit and that credit easing (and government intervention more generally) is really an attempt to maintain a debt-driven standard of living that was unsustainable.
Solvency
Critics have argued that due to the combination of high leverage and losses, the U.S. banking system is effectively insolvent (i.e., equity is negative or will be as the crisis progresses), while the banks counter that they have the cash required to continue operating or are "well-capitalized." As the crisis progressed into mid-2008, it became apparent that growing losses on mortgage-backed securities at large, systemically-important institutions were reducing the total value of assets held by particular firms to a critical point roughly equal to the value of their liabilities.A bit of accounting theory is helpful to understanding this debate. It is an accounting identity
Identity (mathematics)
In mathematics, the term identity has several different important meanings:*An identity is a relation which is tautologically true. This means that whatever the number or value may be, the answer stays the same. For example, algebraically, this occurs if an equation is satisfied for all values of...
(i.e., a rule that must hold true by definition) that assets equals the sum of liabilities and equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
. Equity is primarily the common
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
or preferred stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
and the retained earnings
Retained earnings
In accounting, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or...
of the company and is also referred to as capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
. The financial statement
Financial statement
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
that reflects these amounts is called the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
. If a firm is forced into a negative equity scenario, it is technically insolvent from a balance sheet perspective. However, the firm may have sufficient cash to pay its short-term obligations and continue operating. Bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
occurs when a firm is unable to pay its immediate obligations and seeks legal protection to enable it to either re-negotiate its arrangements with creditors or liquidate its assets. Pertinent forms of the accounting equation for this discussion are shown below:
- Assets = Liabilities + Equity
- Equity = Assets - Liabilities = Net worth or capital
- Financial leverage ratio = Assets / Equity
If assets equal liabilities, then equity must be zero. While asset values on the balance sheet are marked down to reflect expected losses, these institutions still owe the creditors the full amount of liabilities. To use a simplistic example, Company X used a $10 equity or capital base to borrow another $290 and invest the $300 amount in various assets, which then fall 10% in value to $270. This firm was "leveraged" 30:1 ($300 assets / $10 equity = 30) and now has assets worth $270, liabilities of $290 and equity of negative $20. Such leverage ratios were typical of the larger investment banks during 2007. At 30:1 leverage, it only takes a 3.33% loss to reduce equity to zero.
Banks use various regulatory measures to describe their financial strength, such as tier 1 capital
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...
. Such measures typically start with equity and then add or subtract other measures. Banks and regulators have been criticized for including relatively "weaker" or less tangible amounts in regulatory capital measures. For example, deferred tax assets (which represent future tax savings if a company makes a profit) and intangible assets (e.g., non-cash amounts like goodwill or trademarks) have been included in tier 1 capital calculations by some financial institutions. In other cases, banks were legally able to move liabilities off their balance sheets via structured investment vehicles, which improved their ratios. Critics suggest using the "tangible common equity" measure, which removes non-cash assets from these measures. Generally, the ratio of tangible common equity to assets is lower (i.e., more conservative) than the tier 1 ratio.
Nationalization
NationalizationNationalization
Nationalisation, also spelled nationalization, is the process of taking an industry or assets into government ownership by a national government or state. Nationalization usually refers to private assets, but may also mean assets owned by lower levels of government, such as municipalities, being...
typically involves the assumption of either full or partial control over a financial institution as part of a bailout. The board and senior management is replaced. Full nationalization means current equity shareholders are entirely wiped out and bondholders may or may not receive a "haircut," meaning a write-down on the value of the debt owed to them. Suppliers are generally paid fully by the government. Once the bank is again healthy, it is sold to the public and taxpayers get some or all of their initial investment back.
Arguments for nationalization or recapitalization
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
(i.e., either they make money if the bets work out or will be bailed out by the government, a dangerous position from society's point of view). An unstable banking system also undermines economic confidence.
These factors (among others) are why insolvent financial institutions have historically been taken over by regulators. Further, loans to a struggling bank increase assets and liabilities, not equity. Capital is therefore "tied up" on the insolvent bank's balance sheet and cannot be used as productively as it could be at a healthier financial institution. Banks have taken significant steps to obtain additional capital from private sources. Further, the U.S. and other countries have injected capital (willingly or unwillingly) into larger financial institutions.
Economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
has argued for bank nationalization: "A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners." He advocates an "explicit, though temporary government takeover" of insolvent banks.
Economist Nouriel Roubini
Nouriel Roubini
Nouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...
stated: "I'm worried that many banks [are] zombies, they should be shut down, the sooner the better... otherwise they will take deposits and make other risky loans." He also wrote: "Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume." He recommended four steps:
- Determine which banks are insolvent.
- Immediately nationalize insolvent institutions or place them into receivership. The equity holders will be wiped out, and long-term debt holders will have claims only after the depositors and other short-term creditors are paid off.
- Separate nationalized bank assets into good and bad pools. Banks carrying only the good assets would then be privatized.
- Bad assets would be merged into one enterprise. The assets could be held to maturity or eventually sold off with the gains and risks accruing to the taxpayers.
Harvard professor Niall Ferguson
Niall Ferguson
Niall Campbell Douglas Ferguson is a British historian. His specialty is financial and economic history, particularly hyperinflation and the bond markets, as well as the history of colonialism.....
argued: "Worst of all [indebted] are the banks. The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt... banks that are de facto insolvent need to be restructured – a word that is preferable to the old-fashioned “nationalisation”. Existing shareholders will have to face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalisation after losses have meaningfully been written down."
Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
estimated in March 2009 that U.S. banks will require another $850 billion of capital, representing a 3-4 percentage point increase in equity capital to asset ratios.
The U.S. government authorized the injection of up to $350 billion in equity in the form of preferred stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
or asset purchases as part of the $700 billion Emergency Economic Stabilization Act of 2008
Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act of 2008 The Emergency Economic Stabilization Act of 2008 The Emergency Economic Stabilization Act of 2008 (Division A of , commonly referred to as a bailout of the U.S. financial system, is a law enacted in response to the subprime mortgage crisis...
, also called the Troubled Asset Relief Program (TARP).
Steven Pearlstein
Steven Pearlstein
Steven Pearlstein is an American columnist. He writes a column on business and the economy that is published twice weekly in The Washington Post...
has advocated government guarantees for new preferred stock, to encourage investors to provide private capital to the banks.
For a summary of U.S. government financial commitments and investments related to the crisis, see CNN - Bailout Scorecard.
For a summary of TARP funds provided to U.S. banks as of December 2008, see Reuters-TARP Funds.
Arguments against nationalization or recapitalization
Nationalization wipes out current shareholders and may impact bondholders, raising constitutional issues — seizure of private property without due process and without just compensation. It is initially very costly to taxpayers, who may or may not recoup their investment when the nationalized bank is later sold to the public. The government probably will not be able to manage the institution better than the current management. The threat of nationalization also makes it challenging for banks to obtain funding from private sources.Government intervention may not always be fair or transparent. Who gets a bailout and how much? A Congressional Oversight Panel (COP) chaired by Harvard Professor Elizabeth Warren was created to monitor the implementation of the TARP program. COP issued its first report on 10 December 2008. In related interviews, Professor Warren indicated it was difficult to obtain clear answers to her panel's questions.
"Toxic" or "Legacy" asset purchases
Another method of recapitalizing institutions is for the government or private investors to purchase assets that are significantly reduced in value due to payment delinquency, whether related to mortgages, credit cards, auto loans, etc. A summary of the pro- and con- arguments is included at: Brookings - The Administrations New Financial Rescue Plan and Brookings - Choosing Among the OptionsArguments for toxic asset purchases
Removing complex and difficult to value assets from banks' balance sheets across the system in exchange for cash is a major win for the banks, provided they can command an appropriate price for the assets. Further, transparency of financial institution health is improved across the system, improving confidence, as investors can be more assured of the valuation of these firms. Financially healthy firms are more likely to lend.U.S. Treasury Secretary Timothy Geithner announced a plan during March 2009 to purchase "legacy" or "toxic" assets from banks. The Public-Private Partnership Investment Program involves government loans and guarantees to encourage private investors to provide funds to purchase toxic assets from banks. The press release states: "This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases – along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets."
Arguments against toxic asset purchases
A key question is what to pay for the assets. For example, a bank may believe an asset, such as a mortgage-backed security with a claim on cash from the underlying mortgages, is worth 50 cents on the dollar, while it may only be able to find a buyer on the open market for 30 cents. The bank has no incentive to sell the assets at the 30 cent price. But if taxpayers pay 50 cents, they are paying more than market value, an unpopular choice for taxpayers and politicians in a bailout. To truly be helping the banks, the taxpayers would have to pay more than the value at which the bank is carrying the asset on its books, or more than the 50 cent price. Further, who will determine the price and how will ownership of the assets be administered? Does the government entity setup to make these purchases have the expertise?Economist Joseph Stiglitz criticized the plan proposed by U.S. Treasury Secretary Timothy Geithner to purchase toxic assets: "Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time." He stated that toxic asset purchases represents "ersatz capitalism," meaning gains are privatized while losses are socialized.
The government's initial Troubled Asset Relief Program (TARP) proposal was derailed because of these questions and because of the timeline involved in successfully valuing, purchasing, and administering such a program was too long with an imminent crisis faced in September–October 2008.
Martin Wolf
Martin Wolf
Martin Wolf, CBE is a British journalist, widely considered to be one of the world's most influential writers on economics. He is associate editor and chief economics commentator at the Financial Times.-Early life:...
has argued that the purchase of toxic assets may distract the U.S. Congress from the urgent need to recapitalize banks and may make it more politically difficult to take necessary action.
Research by JP Morgan and Wachovia indicates that the value of toxic assets (technically CDO's of ABS
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
) issued during late 2005 to mid-2007 are worth between 5 cents and 32 cents on the dollar. Approximately $305 billion of the $450 billion of such assets created during the period are in default. By another indicator (the ABX
Asset-backed securities index
The ABX is a credit derivative swap contract that pools lists of exposures to mortgage backed securities.In January 2006, CDS Indexco and Markit launched ABX.HE, a subprime mortgage backed credit derivative index, with plans to extend the index to underlying asset types other than home equity loans...
), toxic assets are worth about 40 cents on the dollar, depending on the precise vintage (period of origin).
Bondholder and counterparty haircuts
As of March 2009, bondholders at financial institutions that received government bailout funds have not been forced to take a "haircut" or reduction in the principal amount and interest payments on their bonds. A partial conversion of debt to equity is fairly common in Chapter 11 bankruptcy proceedings, as the common stock shareholders are wiped out and the bondholders effectively become the new owners. This is another way to increase equity capital in the bank, as the liability amount on the balance sheet is reduced. For example, assume a bank has assets and liabilities of $100 and therefore equity is zero. In a bankruptcy proceeding or nationalization, bondholders may have the value of their bonds reduced to $80. This creates equity of $20 immediately ($100–80=$20).A key aspect of the AIG scandal is that over $100 billion in taxpayer funds have been channeled through AIG to major global financial institutions (its counterparties) that have already received separate, significant bailout funds in many cases. The amounts paid to counterparties were at 100 cents on the dollar. In other words, funds are provided to AIG by the U.S. government so that it can pay other companies, in effect making it a "bailout clearinghouse." Members of the U.S. Congress demanded that AIG indicate to whom it is distributing taxpayer bailout funds and to what extent these trading partners are sharing in losses. Key institutions receiving additional bailout funds channeled through AIG included a "who's who" of major global institutions. This included $12.9 billion paid to Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, which reported a profit of $2.3 billion for 2008.
A list of the amounts by country and counterparty is here: Business Week - List of Counterparties and Payouts
Arguments for bondholder and counterparty haircuts
If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute money and the government may be able to just provide guarantees in the short-term to further support confidence in the recapitalized institution.Economist Joseph Stiglitz testified that bank bailouts "...are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this." He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.
Fed Chairman Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
argued in March 2009: "If a federal agency had had such tools on September 16 [2008], they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now."
Harvard professor Niall Ferguson
Niall Ferguson
Niall Campbell Douglas Ferguson is a British historian. His specialty is financial and economic history, particularly hyperinflation and the bond markets, as well as the history of colonialism.....
has argued for bondholder haircuts at insolvent banks: "Bondholders may have to accept either a debt-for-equity swap or a 20 per cent “haircut” (a reduction in the value of their bonds) – a disappointment, no doubt, but nothing compared with the losses when Lehman went under."
Economist Jeffrey Sachs
Jeffrey Sachs
Jeffrey David Sachs is an American economist and Director of The Earth Institute at Columbia University. One of the youngest economics professors in the history of Harvard University, Sachs became known for his role as an adviser to Eastern European and developing country governments in the...
has also argued for bondholder haircuts: "The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices."
Dr. John Hussman
John Hussman
John Hussman is a stock market analyst and mutual fund owner. He is known for his criticism of the US Treasury and the Federal Reserve and for predicting the 2008-2009 US Recession...
has argued for significant bondholder haircuts: "Stabilize insolvent financial institutions through receivership if the bondholders of the institution are unwilling to swap debt for equity. In virtually all cases, the liabilities of these companies to their own bondholders are capable of fully absorbing all losses without the need for public funds to defend those bondholders...The sum total of the policy responses to this crisis has been to defend the bondholders of distressed financial institutions at public expense."
Professor and author Nassim Nicholas Taleb argued during July 2009 that deleveraging through forcible conversion of debt to equity swaps for both banks and homeowners is "the only solution." He advocates much more aggressive and system-wide action. He emphasized the complexity and fragility of the current system due to excessive debt levels and stated that the system is in the process of crashing. He believes any "green shoots" (i.e., signs of recovery) should not distract from this response.
Arguments against bondholder and counterparty haircuts
Investors may balk at providing funding to U.S. institutions if bonds become subject to arbitrary haircuts due to nationalization. Insurance companies and other investors that own many of the bonds issued by major financial institutions may suffer large losses if they must accept debt for equity swaps or other forms of haircuts.The fear of losing one's investments which is contributing to the recession would increase with each expropriation.
Economic stimulus and fiscal policy
Between June 2007 and November 2008, Americans lost a total of $8.3 trillion in wealth between housing and stock market losses, contributing to a decline in consumer spending and business investment. The crisis has caused unemployment to rise and GDP to decline at a significant annual rate during Q4 2008.On 13 February 2008, former President George W. Bush
George W. Bush
George Walker Bush is an American politician who served as the 43rd President of the United States, from 2001 to 2009. Before that, he was the 46th Governor of Texas, having served from 1995 to 2000....
signed into law a $168 billion economic stimulus package, mainly taking the form of income tax
Income tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
rebate checks mailed directly to taxpayers. Checks were mailed starting the week of 28 April 2008.
On 17 February 2009, U.S. President Barack Obama
Barack Obama
Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...
signed the American Recovery and Reinvestment Act of 2009
American Recovery and Reinvestment Act of 2009
The American Recovery and Reinvestment Act of 2009, abbreviated ARRA and commonly referred to as the Stimulus or The Recovery Act, is an economic stimulus package enacted by the 111th United States Congress in February 2009 and signed into law on February 17, 2009, by President Barack Obama.To...
(ARRA), an $800 billion stimulus package with a broad spectrum of spending and tax cuts.
Arguments for stimulus by spending
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
suggests deficit spending by governments to offset declines in consumer spending and business investment can help increase economic activity. Economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
has argued that the U.S. stimulus should be approximately $1.3 trillion over 3 years, even larger than the $800 billion enacted into law by President Barack Obama
Barack Obama
Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...
, or roughly 4% of GDP annually for 2–3 years. Krugman has argued for a strong stimulus to address the risk of another depression and deflation, in which prices, wages, and economic growth spiral downward in a self-reinforcing cycle.
President Obama argued his rationale for ARRA and his spending priorities in his speech of February 25, 2009 to a joint session of Congress. He argued that energy independence, healthcare reform, and education merit significant investment or spending increases.
Economists Alan Blinder
Alan Blinder
Alan Stuart Blinder is an American economist. He serves at Princeton University as the Gordon S. Rentschler Memorial Professor of Economics and Public Affairs in the Economics Department, Vice Chairman of The Observatory Group, and as co-director of Princeton’s Center for Economic Policy Studies,...
and Alan Auerbach both advocated short-term stimulus spending in June 2009 to help ensure the economy does not slip into a deeper recession, but then reinstating fiscal discipline in the medium- to long-term.
Economists debate the relative merit of tax cuts vs. spending increases as economic stimulus. Economists in President Obama's administration have argued that spending on infrastructure such as roads and bridges has a higher impact on GDP and jobs than tax cuts.
Economist Joseph Stiglitz explained that stimulus can be seen as an investment and not just as spending, if used properly: "Wise government investments yield returns far higher than the interest rate the government pays on its debt; in the long run, investments help reduce deficits."
Arguments against stimulus by spending
Harvard professor Niall FergusonNiall Ferguson
Niall Campbell Douglas Ferguson is a British historian. His specialty is financial and economic history, particularly hyperinflation and the bond markets, as well as the history of colonialism.....
wrote: "The reality being repressed is that the western world is suffering a crisis of excessive indebtedness. Many governments are too highly leveraged, as are many corporations. More importantly, households are groaning under unprecedented debt burdens. Worst of all are the banks. The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt."
Many economists recognize that the U.S. is facing a series of long-term funding challenges
United States federal budget
The Budget of the United States Government is the President's proposal to the U.S. Congress which recommends funding levels for the next fiscal year, beginning October 1. Congressional decisions are governed by rules and legislation regarding the federal budget process...
related to Social security
Social Security debate (United States)
This article concerns proposals to change the Social Security system in the United States. Social Security is a social insurance program officially called "Old-Age, Survivors, and Disability Insurance" , in reference to its three components. It is primarily funded through a dedicated payroll tax...
and healthcare
Health care reform in the United States
Health care reform in the United States has a long history, of which the most recent results were two federal statutes enacted in 2010: the Patient Protection and Affordable Care Act , signed March 23, 2010, and the Health Care and Education Reconciliation Act of 2010 , which amended the PPACA and...
. Fed Chairman Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
said on October 4, 2006: "Reform of our unsustainable entitlement programs should be a priority." He added, "the imperative to undertake reform earlier rather than later is great." He discussed how borrowing to enable deficit spending increases the national debt, which poses questions of inter-generational equity, meaning the right of current generations to increase the burden on future generations.
Economist Peter Schiff
Peter Schiff
Peter David Schiff is an American investment broker, author and financial commentator. Schiff is CEO and chief global strategist of Euro Pacific Capital Inc., a broker-dealer based in Westport, Connecticut and CEO of Euro Pacific Precious Metals, LLC, a gold and silver dealer based in New York...
has argued that the U.S. economy is resetting at a lower level and stimulus spending will not be effective and only raise debt levels: "America's GDP is composed of more than 70% consumer spending. For many years, much of that spending has been a function of voracious consumer borrowing through home equity extractions (averaging more than $850 billion annually in 2005 and 2006, according to the Federal Reserve) and rapid expansion of credit card and other consumer debt. Now that credit is scarce, it is inevitable that GDP will fall. Neither the left nor the right of the American political spectrum has shown any willingness to tolerate such a contraction." He argues further that U.S. budgetary assumptions mean certain wealthy nations must continue to fund annual trillion dollar deficits indefinitely, for a 2-3% Treasury bond return, without significant net redemption to fund domestic programs, which he considers highly unlikely.
While commenting on the G20 summit, economist John B. Taylor
John B. Taylor
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution....
said "This financial crisis was caused and prolonged largely by government excesses in the fiscal and monetary policy areas, and continued excess as far as the eye can see will neither end the crisis nor prevent further ones.".
Prominent Republicans have strongly criticized President Obama's 2010 budget, which includes $900 billion or larger annual increases in the national debt through 2019 (Schedule S-9).
A large amount of real wealth was destroyed during the boom (the realization of which fact constitutes the bust). Consequently, the private sector needs to rebuild what is missing. Spending by the government during this period diverts resources from that rebuilding and prolongs the recession. Conservatives argue it would be better to cut government spending. This would reduce the cost of inputs used by businesses which would allow them to expand and hire more workers.
Arguments for stimulus by tax cuts
Conservatives and supply-sideSupply-side economics
Supply-side economics is a school of macroeconomic thought that argues that economic growth can be most effectively created by lowering barriers for people to produce goods and services, such as lowering income tax and capital gains tax rates, and by allowing greater flexibility by reducing...
economists argue that the best stimulus would be to lower marginal tax rates. This would allow businesses to expand those investments which are truly productive and heal the economy. They note that this worked when presidents Kennedy and Reagan cut taxes.
Arguments against stimulus by tax cuts
There is significant debate among economists regarding which type of fiscal stimulus (e.g., spending, investment, or tax cuts) generates the largest "bang for the buck," which is technically called a fiscal multiplier. For example, a stimulus of $100 billion dollars that generates $150 billion of incremental economic growth (GDP) would have a multiplier of 1.5. Since the U.S. Federal government has historically collected about 18% of GDP in tax revenue, a multiplier of approximately 5.56 (1 divided by 18%) would be required to prevent a deficit increase from any type of stimulus. Technically, the larger the multiplier, the less the impact on the deficit because the incremental economic activity is taxed.Various economic studies place the fiscal multiplier from stimulus between zero and 2.5. In testimony before the Financial Crisis Inquiry Commission
Financial Crisis Inquiry Commission
The Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the...
, economist Mark Zandi
Mark Zandi
Mark Zandi is an Iranian American economist and co-founder of Moody's Economy.com, a widely-cited source of economic analysis.. Moody's Economy.com is part of Moody's Analytics. Prior to founding Economy.com, Zandi was a regional economist at Chase Econometrics.He was born in Atlanta, Georgia of...
reported that infrastructure investment provided a high multiplier as part of the American Recovery and Reinvestment Act, while spending provided a moderate to high multiplier and tax cuts had the lowest multiplier. His conclusions by category were:
- Tax cuts: 0.32-1.30
- Spending: 1.13-1.74
- Investment: 1.57
During May 2009 the Whitehouse Council of Economic Advisors estimated that the American Recovery and Reinvestment Act spending elements would have multipliers between 1.0 and 1.5, while tax cuts would have multipliers between 0 and 1. The report states that these conclusions "...are broadly similar to those implied by the Federal Reserve’s FRB/US model and the models of leading private forecasters, such as Macroeconomic Advisers."
Supply side economists have argued that tax rate cuts have a multiplier sufficient to actually raise government revenues (i.e., greater than 5.5). However, this is disputed by research from the Congressional Budget Office
Congressional Budget Office
The Congressional Budget Office is a federal agency within the legislative branch of the United States government that provides economic data to Congress....
, Harvard University, and the U.S. Treasury Department. The Center on Budget and Policy Priorities
Center on Budget and Policy Priorities
The Center on Budget and Policy Priorities is a non-profit think tank that describes itself as a "policy organization ... working at the federal and state levels on fiscal policy and public programs that affect low- and moderate-income families and individuals."The Center examines the short- and...
(CBPP) summarized a variety of studies done by economists across the political spectrum that indicated tax cuts do not pay for themselves and increase deficits.
To summarize the above studies, infrastructure investment and spending are more effective stimulus measures than tax cuts, due to their higher multipliers. However, any type of stimulus spending increases the deficit.
Arguments for bailouts
Governments may intervene because of the belief that that an institution is "too big to fail" or "too interconnected to fail," meaning that allowing them to enter bankruptcy would create or increase systemic riskSystemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
, meaning large stock market declines or disruption in the availability of credit to worthy borrowers.
In a dramatic meeting on September 18, 2008 Treasury Secretary Henry Paulson
Henry Paulson
Henry Merritt "Hank" Paulson, Jr. is an American banker who served as the 74th United States Secretary of the Treasury. He previously served as the Chairman and Chief Executive Officer of Goldman Sachs.-Early life and family:...
and Fed Chairman Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
met with key legislators to propose a $700 billion emergency bailout of the banking system. Bernanke reportedly told them: "If we don't do this, we may not have an economy on Monday." The Emergency Economic Stabilization Act also called the Troubled Asset Relief Program (TARP) was signed into law on October 3, 2008.
Ben Bernanke also described his rationale for the AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
bailout as a "difficult but necessary step to protect our economy and stabilize our financial system." AIG had $952 billion in liabilities according to its 2007 annual report; its bankruptcy would have made the payment of these liabilities uncertain. Banks, municipalities, and insurers could have suffered significant financial losses, with unpredictable and potentially significant consequences. In the context of the dramatic business failures and takeovers of September 2008, he was unwilling to allow another large bankruptcy such as Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
, which had caused a run on money-market funds and caused a crisis of confidence that brought interbank lending to a standstill.
Arguments against bailouts
- Signals lower business standards for giant companies by incentivizing risk
- Creates moral hazardMoral hazardIn economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
through the assurance of safety nets - Promotes centralized bureaucracyBureaucracyA bureaucracy is an organization of non-elected officials of a governmental or organization who implement the rules, laws, and functions of their institution, and are occasionally characterized by officialism and red tape.-Weberian bureaucracy:...
by allowing government powers to choose the terms of the bailout - Instills a socialistic style of government in which government creates and maintains control over businesses.
- Instills a corporatistCorporatismCorporatism, also known as corporativism, is a system of economic, political, or social organization that involves association of the people of society into corporate groups, such as agricultural, business, ethnic, labor, military, patronage, or scientific affiliations, on the basis of common...
style of government in which businesses use the state's power to forcibly extract money from taxpayers.
On November 24, 2008, Republican
Republican Party (United States)
The Republican Party is one of the two major contemporary political parties in the United States, along with the Democratic Party. Founded by anti-slavery expansion activists in 1854, it is often called the GOP . The party's platform generally reflects American conservatism in the U.S...
Congressman Ron Paul
Ron Paul
Ronald Ernest "Ron" Paul is an American physician, author and United States Congressman who is seeking to be the Republican Party candidate in the 2012 presidential election. Paul represents Texas's 14th congressional district, which covers an area south and southwest of Houston that includes...
(R-TX) wrote, "In bailing out failing companies, they are confiscating money from productive members of the economy and giving it to failing ones. By sustaining companies with obsolete or unsustainable business models, the government prevents their resources from being liquidated and made available to other companies that can put them to better, more productive use. An essential element of a healthy free market, is that both success and failure must be permitted to happen when they are earned. But instead with a bailout, the rewards are reversed – the proceeds from successful entities are given to failing ones. How this is supposed to be good for our economy is beyond me.... It won’t work. It can’t work... It is obvious to most Americans that we need to reject corporate cronyism, and allow the natural regulations and incentives of the free market to pick the winners and losers in our economy, not the whims of bureaucrats and politicians."
Journalist Nicole Gelinas wrote in March 2009: "In place of a wrenching but consistent and well-tested process [bankruptcy] of winding down a failed company, what have we chosen? A world of investors who can never be sure, in the future, that if they put their money into a company that fails, they can depend on a reliable process to recoup some of their funds. Instead, they may find themselves at the mercy of a government veering from whim to whim as it reads the mood of a volatile public...In saving the remnants of failed companies from free-market failures, Washington may be sacrificing the public’s confidence that the government can ensure that free markets are reasonably fair and impartial. One year into an era of exhausting and arbitrary bailouts, it’s not clear that our policy of destroying the system in order to save it is going to work."
Bailouts are extremely costly for taxpayers. In 2002, World Bank
World Bank
The World Bank is an international financial institution that provides loans to developing countries for capital programmes.The World Bank's official goal is the reduction of poverty...
reported that country bailouts cost an average of 13% of GDP. Based on U.S. GDP of $14 trillion in 2008, this would be approximately $1.8 trillion.
Homeowner assistance
A variety of voluntary private and government-administered or supported programs were implemented during 2007-2009 to assist homeowners with case-by-case mortgage assistance, to mitigate the foreclosure crisis engulfing the U.S. Examples include the Housing and Economic Recovery Act of 2008Housing and Economic Recovery Act of 2008
The Housing and Economic Recovery Act of 2008 designed primarily to address the subprime mortgage crisis. It authorized the Federal Housing Administration to guarantee up to $300 billion in new 30-year fixed rate mortgages for subprime borrowers if lenders write-down principal loan balances to 90...
, Hope Now Alliance
Hope Now Alliance
The Hope Now Alliance is a cooperative effort between the US government, counselors, investors, and lenders to help homeowners who may not be able to pay their mortgages. Created in 2007 in response to the subprime mortgage crisis, the alliance claims to have helped over 1 million homeowners avoid...
, and Homeowners Affordability and Stability Plan
Homeowners Affordability and Stability Plan
The Homeowners Affordability and Stability Plan is a U.S. program announced on February 18, 2009 by U.S. President Barack Obama. According to the US Treasury Department, it is a $75 billion program to help up to nine million homeowners avoid foreclosure, which was supplemented by $200 billion in...
. These all operate under the paradigm of "one-at-a-time" or "case-by-case" loan modification, as opposed to automated or systemic loan modification. They typically offer incentives to various parties involved to help homeowners stay in their homes.
There are four primary variables that can be adjusted to lower monthly payments and help homeowners: 1) Reduce the interest rate; 2) Reduce the loan principal amount; 3) Extend the mortgage term, such as from 30 to 40 years; and 4) Convert variable-rate ARM mortgages to fixed-rate.
Arguments for systematic refinancing
The EconomistThe Economist
The Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
described the issue this way: "No part of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America. Government programmes have been ineffectual, and private efforts not much better." Up to 9 million homes may enter foreclosure over the 2009-2011 period, versus one million in a typical year.
Critics have argued that the case-by-case loan modification method is ineffective, with too few homeowners assisted relative to the number of foreclosures and with nearly 40% of those assisted homeowners again becoming delinquent within 8 months.
On 18 February 2009, economists Nouriel Roubini
Nouriel Roubini
Nouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...
and Mark Zandi
Mark Zandi
Mark Zandi is an Iranian American economist and co-founder of Moody's Economy.com, a widely-cited source of economic analysis.. Moody's Economy.com is part of Moody's Analytics. Prior to founding Economy.com, Zandi was a regional economist at Chase Econometrics.He was born in Atlanta, Georgia of...
recommended an "across the board" (systemic) reduction of mortgage principal balances by as much as 20-30%. Lowering the mortgage balance would help lower monthly payments and also address an estimated 20 million homeowners that may have a financial incentive to enter voluntary foreclosure because they are "underwater" (i.e., the mortgage balance is larger than the home value).
Roubini has further argued that mortgage balances could be reduced in exchange for the lender receiving a warrant that entitles them to some of the future home appreciation, in effect swapping mortgage debt for equity. This is analogous to the bondholder haircut concept discussed above.
Harvard professor Niall Ferguson
Niall Ferguson
Niall Campbell Douglas Ferguson is a British historian. His specialty is financial and economic history, particularly hyperinflation and the bond markets, as well as the history of colonialism.....
wrote: "...we need...a generalised conversion of American mortgages to lower interest rates and longer maturities. The idea of modifying mortgages appals legal purists as a violation of the sanctity of contract. But there are times when the public interest requires us to honour the rule of law in the breach. Repeatedly during the course of the 19th century governments changed the terms of bonds that they issued through a process known as “conversion”. A bond with a 5 per cent coupon would simply be exchanged for one with a 3 per cent coupon, to take account of falling market rates and prices. Such procedures were seldom stigmatised as default. Today, in the same way, we need an orderly conversion of adjustable rate mortgages to take account of the fundamentally altered financial environment."
The State Foreclosure Prevention Working Group, a coalition of state attorney general
Attorney General
In most common law jurisdictions, the attorney general, or attorney-general, is the main legal advisor to the government, and in some jurisdictions he or she may also have executive responsibility for law enforcement or responsibility for public prosecutions.The term is used to refer to any person...
s and bank regulators from 11 states, reported in April 2008 that loan servicers could not keep up with the rising number of foreclosures. 70% of subprime mortgage holders are not getting the help they need. Nearly two-thirds of loan workouts require more than six weeks to complete under the current "case-by-case" method of review. In order to slow the growth of foreclosures, the Group has recommended a more automated method of loan modification that can be applied to large blocks of struggling borrowers.
In December 2008, the U.S. FDIC reported that more than half of mortgages modified during the first half of 2008 were delinquent again, in many cases because payments were not reduced or mortgage debt was not forgiven. This is further evidence that case-by-case loan modification is not effective as a policy tool.
A report released in April 2009 by the Office of the Comptroller of the Currency
Office of the Comptroller of the Currency
The Office of the Comptroller of the Currency is a US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States...
and Office of Thrift Supervision
Office of Thrift Supervision
The Office of Thrift Supervision was a United States federal agency under the Department of the Treasury that charters, supervises, and regulates all federally- and state-chartered savings banks and savings and loans associations. It was created in 1989 as a renamed version of another federal agency...
indicated that fewer than half of loan modifications during 2008 reduced homeowner payments by more than 10%. Nearly one in four loan modifications during the fourth quarter of 2008 actually increased monthly payments. Nine months after modification, 26% of loans where monthly payments were reduced by 10% or more were again delinquent, versus 50% where payment amounts were unchanged. The U.S. Comptroller stated: "...modification strategies that result in unchanged or increased monthly payments run the risk of unacceptably high re-default rates."
It is the inability of homeowners to pay their mortgages that causes mortgage-backed securities to become "toxic" on the banks balance sheets. To use an analogy, it is the "upstream" problem of homeowners defaulting that creates toxic assets and banking insolvency "downstream." By assisting homeowners "upstream" at the core of the problem, banks would be assisted "downstream," helping both parties with the same set of funds. However, the government's primary assistance through April 2009 has been to the banks, helping only the "downstream" party rather than both.
Economist Dean Baker
Dean Baker
Dean Baker is an American macroeconomist and co-founder of the Center for Economic and Policy Research, with Mark Weisbrot. He previously was a senior economist at the Economic Policy Institute and an assistant professor of economics at Bucknell University. He has a Ph.D...
has argued for systematically converting mortgages to rental arrangements for homeowners at risk of foreclosure, at considerably reduced monthly payment amounts. Homeowners would be allowed to remain in the home for a substantial period time (e.g., 5–10 years). Rents would be at 50-70% of the current mortgage amount. Homeowners would be given this option, indirectly forcing banks to be more aggressive in their refinancing decisions.
Arguments against systematic refinancing
Historically, loans were originated by banks and held by them. However, mortgages originated over the past few years have increasingly been packaged and sold to investors via complex instruments called mortgage-backed securities (MBS) or collateralized debt obligations(CDO's). The contracts involved between the banks and investors may not allow systematic refinancing, as each loan must be individually approved by the investor or their delegates. Banks are concerned that they may face lawsuits if they unilaterally and systematically convert a large number of mortgages to more affordable terms. Such assistance may also further damage the financial condition of banks, although many have already written down MBS asset values and much of the impact would be absorbed by investors outside the banking system.Breaking contracts would potentially lead to higher interest rates, as investors demand higher compensation for taking the risk that their contracts may be subject to homeowner bailouts or relief mandated by the government.
As with other government interventions, homeowner relief would create moral hazard — why should a potential homeowner make a down payment or limit himself to a house he can afford, if government is going to bail him out when he gets in trouble?
Conflicts of interest
A variety of conflicts of interestConflicts of Interest
"Conflicts of Interest" is an episode from the fourth season of the science fiction television series Babylon 5.-Arc significance:* Garibaldi begins to work for William Edgars. In the process Garibaldi is reintroduced to his ex-girlfriend, Lise, who is currently married to Edgars.* The "Voice of...
were argued as contributing to this crisis:
- Private credit rating agencies are compensated for rating debt securities by those issuing the securities, who have an interest in seeing the most positive ratings applied. Critics argued for alternative funding mechanisms.
- There is a "revolving door" between major financial institutions, the Treasury Department, and Treasury bailout programs. For example, the former CEO of Goldman SachsGoldman SachsThe Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
was Henry PaulsonHenry PaulsonHenry Merritt "Hank" Paulson, Jr. is an American banker who served as the 74th United States Secretary of the Treasury. He previously served as the Chairman and Chief Executive Officer of Goldman Sachs.-Early life and family:...
, who became President George W. Bush's Treasury Secretary. - There is a "revolving door" between major financial institutions and the Securities and Exchange Commission (SEC), which is supposed to monitor them.
A precedent is the Sarbanes-Oxley Act of 2002, which implemented a "cooling-off period" between auditors and the firms they audit. The law prohibits auditors from auditing a publicly-traded firm if the CEO or top financial management worked for the audit firm during the past year.
Lobbying
Banks in the U.S. lobby politicians extensively, based on a November 2009 report from employees of the International Monetary FundInternational Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
(IMF) writing independently of that organization. The study concluded that: "the prevention of future crises might require weakening political influence of the financial industry or closer monitoring of lobbying activities to understand better the incentives behind it."
The Boston Globe reported during that during January–June 2009, the largest four U.S. banks spent these amounts ($ millions) on lobbying, despite receiving taxpayer bailouts: Citigroup $3.1; JP Morgan Chase $3.1; Bank of America $1.5; and Wells Fargo $1.4.
Regulation
President Barack ObamaBarack Obama
Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...
and key advisors introduced a series of regulatory proposals in June 2009. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system
Shadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
and derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions, among others.
Systemic risk regulator
The purpose of a systemic risk regulator would be to address the failure of any entity of sufficient scale that a disorderly failure would threaten the financial system. Such a regulator would be designed to address failures of entities such as Lehman BrothersLehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
and AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
more effectively.
Arguments for a systemic risk regulator
Fed Chairman Ben BernankeBen Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
stated there is a need for "well-defined procedures and authorities for dealing with the potential failure of a systemically important non-bank financial institution." He also argued in March 2009: "...I would note that AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
offers two clear lessons for the upcoming discussion in the Congress and elsewhere on regulatory reform. First, AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now. Second, the AIG situation highlights the need for strong, effective consolidated supervision of all systemically important financial firms. AIG built up its concentrated exposure to the subprime mortgage market largely out of the sight of its functional regulators. More-effective supervision might have identified and blocked the extraordinarily reckless risk-taking at AIG-FP. These two changes could measurably reduce the likelihood of future episodes of systemic risk like the one we faced at AIG."
Economists Nouriel Roubini
Nouriel Roubini
Nouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...
and Lasse Pederson recommended in January 2009 that capital requirements for financial institutions be proportional to the systemic risk
Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
they pose, based on an assessment by regulators. Further, each financial institution would pay an insurance premium to the government based on its systemic risk.
British Prime Minister Gordon Brown
Gordon Brown
James Gordon Brown is a British Labour Party politician who was the Prime Minister of the United Kingdom and Leader of the Labour Party from 2007 until 2010. He previously served as Chancellor of the Exchequer in the Labour Government from 1997 to 2007...
and Nobel laureate A. Michael Spence have argued for an "early warning system" to help detect a confluence of events leading to systemic risk
Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
.
Former Federal Reserve Chairman Paul Volcker
Paul Volcker
Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...
testified in September 2009 regarding how to deal with a systemically important non-bank that might get into trouble:
- A government entity should have the authority to take over a failed or failing non-bank institution and manage that institution.
- The regulator should attempt to find a merger partner. If no partner can be found, the entity should ask debtholders to exchange debt for equity to make the company solvent again.
- If none of the above works, the regulator should arrange an orderly liquidation.
Volcker argued that none of the above involves injection of government or taxpayer money but involves an organized procedure for winding down a systemically-important non-banking institutions. He advocated that this authority should reside with the Federal Reserve rather than a council of regulators.
Arguments against a systemic risk regulator
Libertarians and conservatives argue for minimal or no regulation, preferring to let markets regulate themselves. They argue that it was government intervention, such as requiring Fannie Mae and Freddie Mac to lower lending standards, that caused the crisis in the first place and that extensive regulation of banks was ineffective.Regulating the shadow banking system
Unregulated financial institutions called the shadow banking systemShadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
play a critical role in the credit markets. In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking system. He described the significance of this unregulated banking system: "In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion." He stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."
The FDIC has the authority to takeover a struggling depository bank and liquidate it in an orderly way; it lacks this authority for non-bank financial institutions that have become an increasingly important part of the credit markets.
Arguments for regulating the shadow banking system
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
described the run on the shadow banking system
Shadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."
Krugman wrote in April 2010: "What we need now are two things: (a) regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and (b) there have to be prudential limits on shadow banks, above all limits on their leverage."
The crisis surrounding the failure of Long-term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
in 1998 was an example of an unregulated shadow banking institution that many believed posed a systemic risk.
Economist Nouriel Roubini
Nouriel Roubini
Nouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...
has argued that market discipline
Market discipline
Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy...
, or free market incentives for depositors and investors to monitor banks to prevent excessive risk taking, breaks down when there is mania or bubble psychology inflating asset prices. People take excessive risks and ignore risk managers during these periods. Without proper regulation, the "law of the jungle" rules. Excessive financial innovation that is not controlled is "very risky." He stated: "Self-regulation is meaningless; it means no regulation."
Former Chairman and CEO of Citigroup Chuck Prince said in July 2007: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing." Market pressures to grow profits by taking increasing risks were significant throughout the boom period. The largest five investment banks (such as Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
and Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
), were either taken over, liquidated, or converted to depository banks. These institutions had increased their leverage ratios, a measure of risk defined as the ratio of assets or debt to capital, significantly from 2003-2007 (see diagram).
Arguments against regulating the shadow banking system
Banking regulations, some of the most restrictive of any industry, did not prevent banks from taking on significant risks, assuming high levels of leverage, or hiding certain obligations in off-balance sheet entities. Why then, should similar regulations that proved ineffective be extended to non-bank financial institutions? According to Peter J. WallisonPeter J. Wallison
Peter J. Wallison is a lawyer and the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He specializes in financial markets deregulation. He was White House Counsel during the Tower Commission's inquiry into the Iran Contra Affair...
of the American Enterprise Institute
American Enterprise Institute
The American Enterprise Institute for Public Policy Research is a conservative think tank founded in 1943. Its stated mission is "to defend the principles and improve the institutions of American freedom and democratic capitalism—limited government, private enterprise, individual liberty and...
,"...the federal government had to commit several hundred billion dollars for a guarantee of Citigroup's assets, despite the fact that examiners from the Office of the Comptroller of the Currency (OCC) have been inside the bank full-time for years, supervising the operations of this giant institution under the broad powers granted by FDICIA to bank supervisors." He questions whether regulation is better than market discipline at preventing the failure of financial institutions, as follows:
- "The very existence of regulation—especially safety-and-soundness regulation—creates moral hazard and reduces market discipline. Market participants believe that if the government is looking over the shoulder of the regulated industry, it is able to control risk-taking, and lenders are thus less wary that regulated entities are assuming unusual or excessive risks.
- Regulation creates anticompetitive economies of scale. The costs of regulation are more easily borne by large companies than by small ones. Moreover, large companies have the ability to influence regulators to adopt regulations that favor their operations over those of smaller competitors, particularly when regulations add costs that smaller companies cannot bear.
- Regulation impairs innovation. Regulatory approvals necessary for new products or services delay implementation, give competitors an opportunity to imitate, and add costs to the process of developing new ways of doing business or new services.
- Regulation adds costs to consumer products. These costs are frequently not worth the additional amount that consumers are required to pay.
- Safety-and-soundness regulation in particular preserves weak managements and outdated business models, imposing long-term costs on society."
Market bubbles are not caused by failure of a free market to control manias — the market mechanism has been short-circuited by the Central Bank using its legal monopoly to create excessive amounts of new money. People seek to avoid the effects of inflation on their savings by investing in assets whose prices are being artificially increased. This aggravates the price rises, but this vicious cycle of phony capital gains eventually becomes unsustainable.
Bank capital requirements & leverage restrictions
Nondepository banks (e.g., investment banks and mortgage companiesMortgage bank
A Mortgage bank specializes in originating and/or servicing mortgage loans.A mortgage bank is a state-licensed banking entity that makes mortgage loans directly to consumers...
) are not subject to the same capital requirements (or leverage restrictions) as depository bank
Depository bank
A depository bank is a bank organized in the United States which provides all the stock transfer and agency services in connection with a depository receipt program...
s. For example, the largest five investment banks were leveraged approximately 30:1 based on their 2007 financial statements, meaning that only a 3.33% decline in the value of their assets could make them insolvent as explained above. Many investment banks had limited capital to offset declines in their holdings of MBSs, or to support their side of credit default insurance contracts. Insurance companies such as AIG did not have sufficient capital to support the amounts they were insuring and were unable to post the required collateral as the crisis deepened.
Arguments for stronger bank capital requirements / leverage restriction
Nobel prize winner Joseph Stiglitz has recommended that the USA adopt regulations restricting leverage, and preventing companies from becoming "too big to fail."Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
has called for banks to have a 14% capital ratio, rather than the historical 8-10%. Major U.S. banks had capital ratios of around 12% in December 2008 after the initial round of bailout funds. The minimum capital ratio is regulated.
Greenspan also wrote in March 2009: "New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage." He estimated that another $850 billion will be required to properly capitalize major banks.
Economist Raghuram Rajan
Raghuram Rajan
Raghuram Govind Rajan is currently the Eric J. Gleacher Distinguished Service Professor of Finance at the Booth School of Business at the University of Chicago. He is also an honorary economic adviser to Prime Minister of India Manmohan Singh and the current President of the American Finance...
has argued for regulations requiring "contingent capital." For example, financial institutions would be required to pay insurance premiums to the government during boom periods, in exchange for payments during a downturn. Alternatively, they would issue debt that converts to equity during downturns or when certain capital thresholds are met, both reducing their interest burden and expanding their capital base to enable lending.
Economist Paul McCulley
Paul McCulley
Paul Allen McCulley is a former managing director at PIMCO. He coined the terms Minsky moment and Shadow banking system which became famous during the Financial crisis of 2007-2009....
advocated "counter-cyclical regulatory policy to help modulate human nature." He cited the work of economist Hyman Minsky
Hyman Minsky
Hyman Philip Minsky was an American economist and professor of economics at Washington University in St. Louis. His research attempted to provide an understanding and explanation of the characteristics of financial crises...
, who believed that human behavior is pro-cyclical, meaning it amplifies the extent of booms and busts. In other words, humans are momentum investors rather than value investors. Counter-cyclical policies would include increasing capital requirements during boom periods and reducing them during busts.
JP Morgan Chase CEO Jamie Dimon
Jamie Dimon
James "Jamie" Dimon is a business executive. He is the current chairman, president and chief executive of JPMorgan Chase, and previously served as a Class A director of the Board of Directors of the New York Federal Reserve, a three year term which started January 2007...
also supported increased capital requirements: "Also welcome in the administration's new proposals is the focus on strong capital and liquidity requirements -- not just for traditional banks but for a broad range of financial institutions. We now know that "once-in-a-generation" swings in the business cycle are anything but. All financial institutions, wherever they're regulated, must stand ready with strong capital reserves to serve as a cushion during times of unexpected market and economic difficulties. This must be combined with adequate loan loss reserves, to cover the expected losses from the growing number of borrowers who likely will default, and necessary liquidity, in case credit markets freeze up as they did last fall."
Arguments against bank capital requirements / leverage restriction
Higher capital ratios or requirements mean banks cannot lend as much of their capital base, which increases interest rates and theoretically places downward pressure on economic growth relative to freer lending regulations.During a boom (before the corresponding bust begins), even most economists are unable to distinguish the boom from a period of normal (but rapid) growth. Thus officials will be unwilling or politically unable to impose counter-cyclical policies during a boom. No one wants to take away the punch bowl just when the party is warming up.
Breaking up financial institutions that are "too big to fail"
Regulators and central bankers have argued that certain systemically-important institutions not be allowed to fail, due to concerns regarding widespread disruption of credit markets.Arguments for breaking-up large financial institutions
Economists Joseph Stiglitz and Simon JohnsonSimon Johnson (economist)
Simon Johnson is a British American economist. He is the 'Ronald A. Kurtz Professor of Entrepreneurship at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. He has held a wide variety of academic and policy-related positions, including...
have argued that institutions that are "too big to fail" should be broken up, perhaps by splitting them into smaller regional institutions. Dr. Stiglitz argued that big banks are more prone to taking excessive risks due to the availability of support by the federal government should their bets go bad.
Various Wall Street special interests would likely be weakened if major financial institutions are broken-up or no longer allowed to make campaign contributions. Further, restrictions could be placed more easily on the "revolving door" of executives between investment banks and various government agencies or departments. Similar rules regarding conflicts of interest were placed on accounting firms and the corporations they audit as part of the Sarbanes-Oxley Act
Sarbanes-Oxley Act
The Sarbanes–Oxley Act of 2002 , also known as the 'Public Company Accounting Reform and Investor Protection Act' and 'Corporate and Auditing Accountability and Responsibility Act' and commonly called Sarbanes–Oxley, Sarbox or SOX, is a United States federal law enacted on July 30, 2002, which...
of 2002.
The Glass-Steagall Act
Glass-Steagall Act
The Banking Act of 1933, , was a law that established the Federal Deposit Insurance Corporation in the United States and introduced banking reforms, some of which were designed to control speculation. It is most commonly known as the Glass–Steagall Act, after its legislative sponsors, Senator...
was enacted after the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of key provisions of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries...spearheaded in Congress by Senator Phil Gramm
Phil Gramm
William Philip "Phil" Gramm is an American economist and politician, who has served as a Democratic Congressman , a Republican Congressman and a Republican Senator from Texas...
." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.
Martin Wolf
Martin Wolf
Martin Wolf, CBE is a British journalist, widely considered to be one of the world's most influential writers on economics. He is associate editor and chief economics commentator at the Financial Times.-Early life:...
wrote in June 2009: "A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that."
Niall Ferguson
Niall Ferguson
Niall Campbell Douglas Ferguson is a British historian. His specialty is financial and economic history, particularly hyperinflation and the bond markets, as well as the history of colonialism.....
wrote in September 2009: "What's needed is a serious application of antitrust law to the financial-services sector and a speedy end to institutions that are 'too big to fail.' In particular, the government needs to clarify that federal insurance applies only to bank deposits and that bank bondholders will no longer protected, as they have been in this crisis. In other words, when a bank goes bankrupt, the creditors should take the hit, not the taxpayers."
The New York Times editorial board wrote in December 2009: "If we have learned anything over the last couple of years, it is that banks that are too big to fail pose too much of a risk to the economy. Any serious effort to reform the financial system must ensure that no such banks exist."
President Barack Obama
Barack Obama
Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...
argued in January 2010 that depository banks should not be able to trade on their own accounts, which effectively brings back Glass-Steagall Act
Glass-Steagall Act
The Banking Act of 1933, , was a law that established the Federal Deposit Insurance Corporation in the United States and introduced banking reforms, some of which were designed to control speculation. It is most commonly known as the Glass–Steagall Act, after its legislative sponsors, Senator...
rules separating depository and investment banking. This is because taxpayers guarantee the deposits of depository banks and high-risk bets with that money would be inappropriate.
Arguments against breaking-up large financial institutions
Some corporate customers may be inconvenienced by having to work with separate depository and investment banks, through the re-enactment of a law such as the Glass-Steagal Act.Short-selling restrictions
Short-selling enables investors to make money when a stock or investment goes down in value. Short-sellers made enormous profits throughout the financial crisis.Arguments for restricting short-selling
Some believe that bear raidBear raid
A bear raid is a type of stock market strategy, where a trader attempts to force down the price of a stock to cover a short position...
s or deliberate attempts to reduce the value of stocks caused the downfall of certain firms, such as Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
. Hedge funds or large investors with significant short positions allegedly began a rumor campaign, creating a crisis of confidence regarding the firm. Since it was financed by short-term loans that frequently required replenishment and was highly leveraged (i.e., vulnerable), such rumors may have contributed to bankrupting the firm as lenders refused to extend financing and investors pulled funds from the company.
On 18 September 2008, UK regulators announced a temporary ban on short-selling the stock of financial firms.
Arguments against restricting short-selling
The ratio of those "long" (i.e., those who are betting the stock will go up) or "short" (i.e., those who are betting the stock will go down) sends important signals regarding the future direction of the stock or expectations of future performance. Short selling is only harmful if it reduces the price of the investment below what its value should be. However, if that occurs, then the short seller would suffer a loss since the price would tend to go back up to its appropriate value; and too many such losses would put him out of business. Thus no regulation is needed. Short selling helps bring prices down to their appropriate level more quickly.Bear raids (like bank runs) are only a danger to firms which are over-extended and thus deserve to fail.
Derivatives regulation
Credit derivatives such as credit default swaps (CDS) can be thought of as insurance policies that protect a lender from the risk of default by the borrower. Party A pays a premium to Party B, who agrees to pay Party A in the event Party C defaults on its obligations, such as bonds. CDS can be used to hedge or can be used speculatively. Derivatives usage grew dramatically in the years preceding the crisis. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008.Author Michael Lewis
Michael Lewis (author)
Michael Lewis is an American non-fiction author and financial journalist. His bestselling books include The Big Short: Inside the Doomsday Machine, Liar's Poker, The New New Thing, Moneyball: The Art of Winning an Unfair Game, The Blind Side: Evolution of a Game, Panic and Home Game: An...
wrote that CDS enabled speculators to stack bets on the same mortgage bonds and CDO's. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG
AIG
AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...
) bet they would not.
Arguments for regulating credit derivatives
Warren BuffettWarren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
famously referred to derivatives as "financial weapons of mass destruction" in early 2003.
Former President Bill Clinton
Bill Clinton
William Jefferson "Bill" Clinton is an American politician who served as the 42nd President of the United States from 1993 to 2001. Inaugurated at age 46, he was the third-youngest president. He took office at the end of the Cold War, and was the first president of the baby boomer generation...
and former Federal Reserve Chairman Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
indicated they did not properly regulate
derivatives, including credit default swaps (CDS). A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.
Economist Joseph Stiglitz summarized how CDS contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."
NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems.... In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations.
Financier George Soros
George Soros
George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...
has recommended that credit default swaps no longer be traded, calling them "instruments of destruction that ought to be outlawed."
U.S. Treasury Secretary Timothy Geithner proposed a framework for legislation to regulate derivatives during May 2009, stating that "...derivatives are largely excluded or exempted from regulation." Key elements of the framework include:
- Require clearing of all standardized over-the-counter (OTC) derivatives through regulated central counterparties (CCPs);
- Robust margin and capital requirements for key market participants;
- Financial reporting and disclosure requirements;
- Clarify regulatory enforcement authorities of the U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading CommissionCommodity Futures Trading CommissionThe U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
(CFTC); and - Limiting the types of counterparties that can participate in derivative transactions.
Arguments against regulating credit derivatives
Credit derivatives provide market signals regarding the risk of particular investments. For example, the cost of providing CDS protection for particular bonds is a signal regarding the risk of those bonds. CDS also allow particular credit risks to be hedged, as an entity can purchase protection from many sources of credit risk, much like an insurance policy. While total notional value related to CDS are enormous (estimated between $25–$50 trillion), the true exposure related to that notional value is approximately $2.5-$3.0 trillion. This amount would only be lost if the underlying assets lost their entire value (i.e., akin to all the cars insured by car insurance companies being totaled simultaneously; CDS insure bonds instead of cars), which is outside any reasonable scenario. Since many of these CDS provide protection against defaults of bonds in quality companies, true risk of loss related to CDS is considerably less.Mortgage lending regulations
Mortgage lending standards declined during the boom and complex, risky mortgage offerings were made to consumers that arguably did not understand them. At the height of the bubble in 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. An estimated one-third of adjustable rate mortgages originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.Arguments for establishing minimum down payments and lending standards
Warren BuffettWarren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
stated in February 2009: "The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10 percent and monthly payments that can be comfortably handled by the borrower's income. That income should be carefully verified."
China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.
Economist Stan Leibowitz argued that the most important factor in foreclosures was the extent to which the homeowner has positive equity. Although only 12% of homes had negative equity, they constituted 47% of all foreclosures during the second half of 2008. He advocated "relatively high" minimum down payments and stronger underwriting standards. "If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can't just walk away."
A 2009 Republican
Republican Party (United States)
The Republican Party is one of the two major contemporary political parties in the United States, along with the Democratic Party. Founded by anti-slavery expansion activists in 1854, it is often called the GOP . The party's platform generally reflects American conservatism in the U.S...
congressional staff report cited government pressure as a cause of the crisis: "Washington must reexamine its politically expedient but irresponsible approach to encouraging higher levels of home ownership based on imprudently small down payments and too little emphasis on borrowers’ creditworthiness and ability to repay their loans."
The Fed implemented new rules for mortgage lenders in July 2008.
Arguments against establishing minimum down payments and lending standards
Higher lending standards may place downward pressure on economic growth and prevents those of lesser economic means from owning their own home.Arguments for regulating executive compensation
Economist Joseph Stiglitz argued: "We need first to correct incentives for executives, reducing the scope for conflicts of interest and improving shareholder information about dilution in share value as a result of stock options. We should mitigate the incentives for excessive risk-taking and the short-term focus that has so long prevailed, for instance, by requiring bonuses to be paid on the basis of, say, five-year returns, rather than annual returns."The ratio of average CEO total direct compensation relative to that of the average worker increased from 29 times (1969) to 126 times (1992) and 275 times in 2007.
Bank CEO Jamie Dimon
Jamie Dimon
James "Jamie" Dimon is a business executive. He is the current chairman, president and chief executive of JPMorgan Chase, and previously served as a Class A director of the Board of Directors of the New York Federal Reserve, a three year term which started January 2007...
argued: "Rewards have to track real, sustained, risk-adjusted performance. Golden parachutes, special contracts, and unreasonable perks must disappear. There must be a relentless focus on risk management that starts at the top of the organization and permeates down to the entire firm. This should be business-as-usual, but at too many places, it wasn't."
President Obama has assigned Kenneth Feinberg as "Special Master" on executive pay, for firms that received government assistance, including several major banks and General Motors. He will review the pay packages proposed by these firms for their top executives.
Arguments against regulating executive compensation
The top executives of a business are primarily responsible for ensuring that the business is conducted in a profitable manner; this can make the difference between a viable business and a failure which must be liquidated. Very few people are willing and able to perform that kind of task. Thus it is reasonable for boards of directors of large corporations to pay very high salaries to top executives who can perform. To ensure performance, it is usual to link the compensation to measures of the business's success, e.g. by paying the executive mostly in stock or call options which are deferred (to give the stock market a chance to evaluate the executive's performance before he can cash in on it). When especially successful, the executive can expect to receive compensation exceeding the average of other executives in comparable positions.Some say the opposition to such high compensation is largely based on envy — many people do not want to acknowledge that the work of another person could be worth hundreds of times more than their own work. Perhaps they resent the success of others. Critics say that if government regulates executive compensation, then it will be removing the main tool by which the owners of the business control their company - such controls would amount to defacto nationalization. Capable executives may move to unregulated or foreign companies.
Financial Products Safety Commission (FPSC)
The concept is that a government agency or commission would review new financial products, similar to how the U.S. Food and Drug AdministrationFood and Drug Administration
The Food and Drug Administration is an agency of the United States Department of Health and Human Services, one of the United States federal executive departments...
reviews new drugs. Products would be reviewed to ensure the risks could be "safe for consumption" and effectively communicated to investors or homeowners, depending on the product. Related legislation has been proposed in Congress.
Arguments for a FPSC
Economist Joseph Stiglitz has argued that a government agency should review new financial products. A financial products safety commission concept was included in the plan outlined by President Obama and his financial team.Arguments against a FPSC
Critics may argue that such a commission would slow financial innovation, adversely impact Wall Street profit, or reduce credit availability if popular products (such as adjustable rate mortgages) are deemed inappropriate for consumers.If people want U.S. government guaranteed safety, they can put their money in: cash, an FDIC insured account, or in U.S. Treasury securities. The whole point of other securities is to allow people to make their own judgment on risk instead of accepting the opinion of a financial dictator such as FPSC.
See also
- Bailout
- Long-term Capital ManagementLong-Term Capital ManagementLong-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
- Panic of 1907Panic of 1907The Panic of 1907, also known as the 1907 Bankers' Panic, was a financial crisis that occurred in the United States when the New York Stock Exchange fell almost 50% from its peak the previous year. Panic occurred, as this was during a time of economic recession, and there were numerous runs on...
- Shadow banking systemShadow banking systemThe shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
- Stiglitz Testimony
- Subprime mortgage crisisSubprime mortgage crisisThe U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
- United States federal budgetUnited States federal budgetThe Budget of the United States Government is the President's proposal to the U.S. Congress which recommends funding levels for the next fiscal year, beginning October 1. Congressional decisions are governed by rules and legislation regarding the federal budget process...
External links
- Brookings Institution - Bad Bank, Nationalization, Guarantees
- Brookings Institution - The Administrations New Financial Rescue Plan
- AEI - Regulation without Reason
- Charlie Rose - March Interview with NYT: Krugman, Nocera, Sorkin
- President Obama-Remarks on Financial Rescue and Reform-September 14, 2009
- NYT-Freakonomics Blog-How Would You Simplify the Financial Reform Bill? August, 2010