Treasury Continues to Fumble -- Will They Ever Get it Right?


There are few economists who would defend the decision to allow Lehman Brothers to go bankrupt last September. Its collapse induced a worldwide panic that sent stock markets plummeting and caused credit to freeze up. In the subsequent months, the downturn went into over-drive, with the United States losing almost three million jobs from October through February.

This set of events has led almost everyone to conclude that the trio who let Lehman go under -- Treasury secretary Henry Paulson, Federal Reserve chairman Ben Bernanke and the then-head of the New York Fed, Timothy Geithner -- erred badly in this decision. That seems a reasonable judgment.

However, the conventional wisdom includes a corollary that is much less obvious: because the Lehman bankruptcy was a disaster, U.S. taxpayers must honor in full all the debts of all the banks. This corollary could put U.S. taxpayers on the hook for trillions of dollars in commitments that the Wall Street boys apparently made on our behalf. Before we cough up the dough, we might want to consider whether Paulson, Bernanke and Geithner were not quite as stupid as the current conventional wisdom would imply.

The problems that followed from Lehman did not just stem from the fact that the government was not honoring Lehman's debts. This was an uncontrolled bankruptcy of a huge investment bank in a world where the official line was still that everything was under control. The Washington Post had even run a column the day before Lehman's collapse ridiculing those who were making negative comments about the state of the economy.

In this context, an uncontrolled bankruptcy of a major investment bank was sort of like a sledge hammer in the face: a rather rude and unexpected blow. The most immediate consequence was that Reserve Primary, one of the largest money-market mutual funds in the world, suddenly could not pay its shareholders in full, because it had tens of billions invested in Lehman. In the wake of Lehman's bankruptcy, Reserve Primary did not know how much, if any, of this investment it could recover. In the post-Lehman world banks could suddenly no longer trust each other, and the interbank lending rate went through the roof.

But now we have had six months to adjust. The Fed and Treasury are now guaranteeing deposits in money-market mutual funds. The Federal Deposit Insurance Corporation doubled the size of the bank accounts it guarantees, and non-interest-bearing accounts of any size are guaranteed. In addition, the Fed is now lending hundreds of billions of dollars directly to non-financial corporations, establishing a channel of funding that goes outside the banking system.

These and other measures have restored some measure of stability to the financial system. Now that we have these measures in place, is it still true that we can't subject Citigroup, Bank of America or Goldman Sachs to a managed bankruptcy (aka "nationalization") without the world coming to an end?

With a managed bankruptcy, all the insured deposits would be fully covered. However, the government would only repay bondholders a portion of their investment, depending on how severe the banks' losses are. By not compensating bondholders in full for their losses, the government could save taxpayers hundreds of billions, perhaps even trillions, of dollars.

In addition, a managed bankruptcy would also help to address the problem of moral hazard created by the bailouts thus far. Investors did not pay adequate attention to the health of banks and other large financial institutions like AIG because they assumed that the government would bail them out if things went badly. If the government makes these investors eat some of their losses, maybe they will put more thought into their investment strategies in the future. This could also let some big investors make some of the "sacrifices" for which fiscal conservatives -- including some big investors -- are so eager.

The silence of the fiscal conservatives on the vast sums going to the banks is hard to understand. After all, how can someone get so upset about the prospect of $200m being spent to re-sod the National Mall in Washington, but be unconcerned when $160 billion -- almost 1,000 times as much money -- goes out the door to AIG?

The sums of money going to bail out the financial industry dwarf the waste and pork that get John McCain and other budget hawks excited. Yet they are strangely calm about the bailout money. In fact, the amount we spent patching the financial system could well be large enough to make the Social Security system fully solvent over its 75-year planning horizon, yet we barely hear a peep from the Peter Peterson Foundation and its merry band of anti-Social Security crusaders.

The only answer we ever get in response is that we have no choice. But just six months ago, Henry Paulson, Ben Bernanke and Timothy Geithner thought we could make a much more extreme choice. They were wrong then, but they are not stupid. We should go back to the bankrupt Lehmans and see if we can do it right this time.

Understand the importance of honest news ?

So do we.

The past year has been the most arduous of our lives. The Covid-19 pandemic continues to be catastrophic not only to our health - mental and physical - but also to the stability of millions of people. For all of us independent news organizations, it’s no exception.

We’ve covered everything thrown at us this past year and will continue to do so with your support. We’ve always understood the importance of calling out corruption, regardless of political affiliation.

We need your support in this difficult time. Every reader contribution, no matter the amount, makes a difference in allowing our newsroom to bring you the stories that matter, at a time when being informed is more important than ever. Invest with us.

Make a one-time contribution to Alternet All Access, or click here to become a subscriber. Thank you.

Click to donate by check.

DonateDonate by credit card
Donate by Paypal
{{ }}
@2022 - AlterNet Media Inc. All Rights Reserved. - "Poynter" fonts provided by