The Great American Bank Robbery, Part II
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The following is Part II of a two-part excerpt from Freefall: America, Free Markets, and the Sinking of the World Economy by Joseph Stiglitz (W.W. Norton & Co., 2010). Click here for part I.
The U.S. government should have played by the rules and "restructured" the banks that needed rescuing, rather than providing them with unwarranted handouts. This is so, whether or not in the end some of the banks manage to pay back the money that was given to them. But both the Bush and the Obama administrations decided otherwise.
As the crisis broke out in late 2007 and early 2008, the Bush administration and the Fed first veered from bailout to bailout with no discernible plan or principles. This added political uncertainty to the economic uncertainty. In some of the bailouts (Bear Stearns), shareholders got something, and bondholders were fully protected. In others (Fannie Mae), shareholders lost everything, and bondholders were fully protected. In still others (Washington Mutual), shareholders and bondholders lost nearly everything. In the case of Fannie Mae, political considerations (worrying about earning the disfavor of China--as a significant owner of Fannie Mae bonds) seemed to predominate; no other good economic rationale was ever presented. Though there was often some reference to "systemic risk" in explaining why some institutions got bailed out and others didn't, it was clear that the Fed and the Treasury had insufficient appreciation of what systemic risk meant before the crisis, and their understanding remained limited even as the crisis evolved.
Some of the early bailouts were done through the Federal Reserve, leading that body to take actions that were totally unimaginable just a few months before. The Fed's responsibility is mainly to commercial banks. It regulates them, and the government provides deposit insurance. Before the crisis, it was argued that investment banks didn't need either access to funds from the Fed or the same kind of tight regulation, since they didn't pose any systemic risk. They handled rich people's money, and they could protect themselves. But all of a sudden, in the most munificent act in the history of corporate welfare, the government's safety net was extended to investment banks. Then, it was extended even farther, to AIG, an insurance firm.
Eventually, by late September 2008, it became clear that more than these "hidden" bailouts through the Fed would be required, and President Bush had to go to Congress. Treasury Secretary Paulson's original idea for getting money into the banks was referred to by its critics as "cash for trash." The government would buy the toxic assets, under the Troubled Asset Relief Program (TARP), injecting liquidity and cleaning up the banks' balance sheets at the same time. Of course, the bankers didn't really believe that the government had a comparative advantage in garbage disposal. The reason they wanted to dump the toxic assets on the government was that they hoped the government would overpay--a hidden recapitalization of the banks.
The real tip-off that something was awry came when Paulson went to Congress and presented a three-page TARP bill giving him a blank check for $700 billion, with no congressional oversight or judicial review. As chief economist of the World Bank, I had seen gambits of this kind. If this had happened in a Third World banana republic, we would know what was about to happen--a massive redistribution from the taxpayers to the banks and their friends. The World Bank would have threatened cutting off all assistance. We could not condone public money being used in this way, without the normal checks and balances. Indeed, many conservative commentators argued that what Paulson was proposing was unconstitutional. Congress, they believed, could not walk away so easily from its responsibilities in allocating these funds.
Some Wall Streeters complained that the media was souring the mood by calling it a bailout. They preferred more upbeat euphemisms, a "recovery program" rather than a "bailout." Paulson transformed the toxic assets into the gentler-sounding "troubled assets." His successor, Tim Geithner, would later convert them into "legacy assets."
On the initial vote, on September 29, 2008, the TARP bill was defeated by twenty-three votes in the House of Representatives. After the defeat, the Bush administration held an auction. It asked, in effect, each of the opposing congressmen how much they needed in gifts to their districts and constituents to change their vote. Thirty-two Democrats and twenty-six Republicans who voted no on the original bill switched sides to support TARP in the revised bill, passed on October 3, 2008. The congressmen's change of vote was prompted in part by fears of a global economic meltdown and by provisions ensuring better oversight, but, for at least many of the congressmen who had changed their votes, there was a clear quid pro quo: the revised bill contained $150 billion in special tax provisions for their constituents. No one said that members of Congress could be bought cheaply.
Naturally, Wall Street was delighted with the program to buy the bad assets. Who wouldn't want to offload their junk to the government at inflated prices? The banks could have sold many of these assets on the open market at the time but not at prices they would have liked. There were, of course, other assets that the private sector wouldn't touch. Some of the so-called assets were actually liabilities that could explode, eating up government funds like Pacman. For example, on September 15, 2008, AIG said that it was short $20 billion. The next day, its losses had grown to some $89 billion. A little later, when no one was looking, there was a further handout, bringing the total to $150 billion. Still later, the handout was increased to $180 billion. When the government took over AIG (it took just short of an 80 percent share), it may have gotten some assets, but amidst these assets were even bigger liabilities.
Ultimately, Paulson's original proposal was thoroughly discredited, as the difficulties of pricing and buying thousands of individual assets became apparent. Pressure from those not wanting to overpay the banks was, moreover, brought to bear to set prices for the toxic assets through a transparent auction mechanism. It soon became apparent, however, that auctioning off thousands of separate categories of assets would be a nightmare. Time was of the essence, and it couldn't be done quickly. Besides, if the auction was fair, the prices might not be so high, leaving the banks with a big hole in their balance sheet. After vigorously defending the proposal as the best way forward for weeks, Paulson suddenly dropped it in mid-October 2008 and moved on to his next plan.
The next proposal was an "equity injection." There were several reasons why it was thought to be important to give more equity to banks, to recapitalize them. One was the hope that by doing so they would lend more. The other was a lesson from the 1980s: undercapitalized banks are a risk to the economy.
Three decades ago, savings and loan associations faced a problem similar to that confronting the banks today. When interest rates were suddenly raised to fight inflation in the late 1970s and early 1980s, the value of the mortgages held by the savings and loan banks plummeted. But the banks had financed these mortgages with deposits. With what they owed depositors remaining the same and the value of their assets much diminished, the savings and loans were, in any real sense, bankrupt.
Accounting rules, however, allowed them to forestall the day of reckoning. They didn't have to write down the value of the mortgages to reflect the new realities. They did, however, have to pay higher interest rates to their depositors than they were getting from their mortgages, so many had a serious cash-flow problem. Some tried to solve the cash-flow problem by continuing to grow--a kind of Ponzi scheme in which new deposits helped pay what was owed on old deposits. So long as no one blew the whistle, everything was fine. President Reagan helped them along by softening accounting standards even more, allowing them to count as an asset their "goodwill," the mere prospect of their future profits, and by loosening regulations.
The savings and loans were zombies--dead banks that remained among the living. They had an incentive to engage in what Boston College professor Ed Kane called "gambling on resurrection." If they behaved prudently, there was no way they could crawl out of the hole they had dug, but if they took big risks and the gambles paid off, they might finally become solvent. If the gambles didn't work out, it didn't matter. They couldn't be more dead than they already were. Allowing the zombie banks to continue to operate and loosening regulations so they could take bigger risks increased the eventual cost of cleaning up the mess.
(There is a fine line between "gambling," or excessive risk-taking, and fraud, so it is no accident that the 1980s was marked by one banking scandal after another. It is, perhaps, no surprise that in the current crisis we have again seen so much of both.)
The advocates of the proposal for equity injections (including myself) had wrongly assumed that it would be done right--taxpayers would receive fair value for the equity, and appropriate controls would be placed on the banks. Cash was poured in to protect them, and when they needed more money, more cash was poured in. In return taxpayers got preferred shares and a few warrants (rights to purchase the shares), but they were cheated in the deal. If we contrast the terms that the American taxpayers got with what Warren Buffett got, at almost the same time, in a deal with Goldman Sachs, or if we compare it with the terms that the British government got when it provided funds to its banks, it was clear that U.S. taxpayers got shortchanged. If those negotiating supposedly on behalf of Americans had been working on a similar deal on Wall Street, they would have demanded far better terms.
Worse still, even as taxpayers became the principal "owner" of some banks, the Bush (and later Obama) Treasuries refused to exercise any control. The U.S. taxpayer put out hundreds of billions of dollars and didn't even get the right to know what the money was being spent on, let alone have any say in what the banks did with it. This too was markedly different from the contemporaneous U.K. bank bailouts, where there was at least a semblance of accountability: old management was thrown out, restrictions on dividends and compensation were imposed, and systems designed to encourage lending were put into place.
In contrast, U.S. banks carried on paying out dividends and bonuses and didn't even pretend to resume lending. "Make more loans?" John C. Hope III, the chairman of Whitney National Bank in New Orleans, told a room full of Wall Street analysts in early 2009. "We're not going to change our business model or our credit policies to accommodate the needs of the public sector as they see it to have us make more loans."
Wall Street kept pushing for better and better terms--making it less and less likely that taxpayers would be adequately compensated for the risk they were bearing, even if some of the banks did manage to pay back what they received. One of the benefits to come out of Paulson's initial brazen demand that there be no oversight or judicial review of his $700 billion blank check to Wall Street was that Congress established an independent oversight panel, and it showed how bad the bailout deals were for the American taxpayers. In the first set of bailouts, at the time, taxpayers got back only sixty-six cents in securities for every dollar they gave the banks. But in the later deals, and especially the deals with Citibank and AIG, the terms were even worse, with forty-one cents for every dollar given.
In March 2009, the Congressional Budget Office (CBO), the nonpartisan office that is supposed to give independent cost evaluations of government programs, estimated that the net cost of using the TARP's full $700 billion will total $356 billion. The government would get paid back less than 50 cents on the dollar. There was no hope for being compensated for the risk borne. In June 2009, in a closer look at the initial $369 billion of TARP spending, the CBO put the estimated loss at over $159 billion.
There was a high level of disingenuousness in the whole bank bailout gambit. The banks (and the regulators who had allowed the whole problem to arise) wanted to pretend that the crisis was just a matter of confidence and a lack of liquidity. A lack of liquidity meant that no one was willing to lend to them. The banks wanted to believe that they had not made bad decisions, that they were really solvent, and that the "true" value of their assets exceeded the value of what they owed (their liabilities). But while each believed that about themselves, they didn't believe it about the other banks, as can be seen from their reluctance to lend to each other.
The problem with America's banks was not just a lack of liquidity. Years of reckless behavior, including bad lending and gambling with derivatives, had left some, perhaps many, effectively bankrupt. Years of non-transparent accounting and complex products designed to deceive regulators and investors had taken their toll: now not even the banks knew their own balance sheet. If they didn't know whether they were really solvent, how could they know the solvency of anybody to whom they might lend?
Unfortunately, confidence can't be restored just by giving speeches expressing confidence in the American economy. Repeated pronouncements, for instance, by the Bush administration and the banks that the economy was on solid ground, with strong fundamentals, were belied by recurrent bad news. What they said was simply not credible. Actions are what matters, and the actions of the Fed and Treasury undermined confidence.
By October 2009, the International Monetary Fund (IMF) reported that global losses in the banking sector were $3.6 trillion. The banks had admitted to losses of a much smaller amount. The rest was a kind of dark matter. Everyone knew it was in the system, but no one knew where it was.
When Paulson's plan failed either to rekindle lending or to restore confidence in the banks, the Obama administration floundered over what to replace it with. After flailing around for weeks, in March 2009 the Obama administration announced a new program, the Public--Private Investment Program (PPIP), which would use $75 to $100 billion in TARP capital, plus capital from private investors, to buy toxic assets from banks. The words used were deceptive: it was described as a partnership, but it was not a normal partnership. The government would put in up to 92 percent of the money but get only half the profits and bear almost all of the losses. The government would lend the private sector (hedge funds, investment funds, or even, ironically, banks--which might buy up the assets from each other) most of the money it had to put up, with nonrecourse loans, secured only by what was purchased. If the security or mortgage turns out to be worth less than the amount borrowed, the borrower defaults, leaving the government, not the private investors, to absorb the brunt of any losses.
In effect, the Obama team had finally settled on a slight variation of the original cash-for-trash idea. It was as if it had decided to use a private garbage-hauling service, which would buy the garbage in bulk, sort through it, pick out anything of value, and dump the remaining junk on the taxpayer. And the program was designed to give the garbage collectors hefty profits--only certain members of the Wall Street club would be allowed to "compete," after having been carefully selected by the Treasury. One could be sure that these financiers who had been so successful in squeezing money out of the economy would not be performing these duties out of civic-mindedness, gratis.
The administration tried to claim that the PPIP was necessary to provide liquidity to the market. Lack of liquidity, it argued, was depressing prices and artificially hurting banks' balance sheets. The main problem, however, was not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They had lost their capital, and this capital had to be replaced.
The administration tried to pretend that its plan was based on letting the market determine the prices of the banks' "toxic assets"--including outstanding house loans and securities based on those loans--as the "Partnership" bought up the assets. The magic of the market was being used to accomplish "price discovery." The reality, though, was that the market was not pricing the toxic assets themselves, but options on those assets, basically a one-sided bet. The two have little to do with each other. The private partnerships gained a great deal on the "good" mortgages, but essentially handed the losses on the bad mortgages over to the government.
Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year's time. The average "value" of the asset is $100. Without interest, this is what the asset would sell for in a competitive market. It is what the asset is "worth." Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That's 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the remaining 92 percent of the cost--$12 in "equity" plus $126 in the form of a guaranteed loan.
If, in a year's time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that's left over after paying back the $126 loan. In that rosy scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37.
Making matters worse, there is ample opportunity for "gaming." Assume the bank buys its own asset for $300 (the administration didn't preclude the partnerships from including the banks), putting up $24. In the bad state, the bank "loses" $24 on its "partnership" investment, but still keeps the $300. In the good state, the asset is still worth only $200, so again the government swallows the loss, except for the $24. The bank has miraculously parlayed a risky asset whose true value is $100 into a safe asset--to it--worth a net $276. The government losses make up the difference--a whopping $176 on average. With so much money being thrown around, there is plenty of room for a deal; one can give a share to the hedge funds. One doesn't have to be greedy.
But Americans may lose even more than these calculations suggest because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets and especially the assets that they think the market overestimates (and thus is willing to pay too much for). But the market is likely to recognize this, which will drive down the price that it is willing to pay. Only the government's picking up enough of the losses overcomes this "adverse selection" effect. With the government absorbing the losses, the market doesn't care if the banks are "cheating" them by selling their lousiest assets.
At first, the bankers and the potential partners (hedge funds and other financial companies) loved this idea. The banks only sell the assets that they want to sell--they can't lose. The private partners would make a wad of money, especially if the government charged little enough for the guarantees. Politicians loved the idea too: there was a chance they would be out of Washington before all the bills came due. But that's precisely the problem with this approach: no one will know for years what it will do to the government's balance sheet.
Eventually, many of the banks and private partners became disillusioned. They worried that if they made too much money, the bureaucrats and the public wouldn't let them get away with it and would find some way of recouping the profits. At the very least, the participants knew they would be subject to intense congressional scrutiny--in the way that those that received TARP money had been. When accounting regulations were changed to allow banks not to write down their impaired assets--to pretend that the toxic mortgages were as good as gold--the attractiveness diminished still further: even if they got more than the asset was worth, they would have to recognize a loss, which would require finding more capital. They would prefer to postpone the day of reckoning.
The proposal was described by some in the financial markets as a win-win-win proposal. Actually, it was a win-win-lose proposal: the banks win, investors win--and, if the program works for the banks, taxpayers lose. As one hedge fund manager wrote to me, "This is a terrible deal for the taxpayer, but I'm going to make sure that my clients get the full benefit."
So, given all these flaws, what was the appeal of the administration's strategy? The PPIP was the kind of Rube Goldberg device that Wall Street loves--clever, complex, and non-transparent, allowing huge transfers of wealth to the financial markets. It might allow the administration to avoid going back to Congress to ask for more money to fix the banks, and it provided a way to avoid conservatorship.
In the many months since the proposal was rolled out, it has not worked as the administration had hoped. Within a few months, this program for taking over "legacy" loans, like so many of the other programs, was abandoned, and the program for legacy securities was vastly downsized. The most likely outcome was that whatever limited benefits the remaining PPIP for securities would bring would come with a high price. Money that might better have gone to the banks would go to the private "partners"--a high price to pay for a private garbage-removal service.