The Obama Administration’s policy response to the financial crisis has helped to cultivate a sense that “Wall Street” plays by a different set of rules than the rest of the American economy. The inability to diagnose and solve the very specific problems that became evident after Lehman has triggered more widespread dissatisfaction and unfocused anger, as evidenced by the “Occupy Wall Street” protests. Unfortunately, even at this late date, the President appears to prefer to attack profit motives more generally rather than confront the ways large banks are sheltered from market forces.
President Obama has said the “Occupy Wall Street” protests reflect “broad-based frustration about how our financial system works.” He has gone on to suggest that the Administration would respond to this discontent by continuing to fight for consumer rights. Evidently, in President Obama’s view, the protestors are animated by disgust over the fine print in credit card agreements and the “hidden fees” banks charge when consumers open checking accounts. This interpretation of the protestors’ motives comes in the immediate wake of his direct criticism of Bank of America’s decision to institute a $5 fee to cover the cost of debit card transactions. The President objected to the ability of Bank of America’s management and Board of Directors to decide unilaterally to charge fees to cover the cost of the service they provide. The bank, in his words, don’t have “some inherent right just to – you know, get a certain amount of profit.” The President would prefer if decisions about the legitimacy of cost recovery would, presumably, be made by the new Consumer Financial Protection Bureau (CFPB).
Professor Douglas Cummings has analogized the policy response to the financial crisis to a bar brawl. When a fight breaks out in a bar, you don’t hit the person who started it; you hit the person you don’t like. The same was true in the financial crisis. The problem was too-big-to-fail banks, an overreliance on non-bank, short-term liabilities like repurchase agreements (repos) and commercial paper, and insufficient equity capital in banks’ capital structures. Instead of directly addressing these pressing problems and the risk they pose to financial and economic stability, President Obama and his political allies decided to focus on things like mortgage documentation and debit card fees. On a related front, many consumer advocacy groups saw the financial crisis as their chance to finally enact reforms of credit card issuers’ adjustable interest rate policies. This sort of opportunism could be excused, or justified, as the reality of politics, if reform actually addressed all the other big systemic issues. But financial reform didn’t do that; the Dodd-Frank bill, more or less, formalized the legal framework for bailouts.
The Troubled Asset Relief Program (TARP) was launched by the Bush Administration to avert financial collapse. But the Obama Administration didn’t just inherit it; it embraced the program and made it its own. After all, there is no greater defender of TARP than current Treasury Secretary Tim Geithner. His Treasury Department launched a full-throttled defense of the program and he personally described it as “the most effective government program in recent memory.” The problem with TARP was not so much the rescue itself, but its aftermath. As TARP inspector general Neil Barofsky explained, many people believed the implicit bargain of the TARP bailout was financial regulatory reform that addressed the risk large financial institutions pose to the economy. Instead, the Obama Administration allowed these banks to exit the program with no final resolution on the issue.
The aftermath of the Lehman bankruptcy taught us that a class of financial firms had grown too large, too interconnected, and too dependent on short-term external finance to meet obligations. But it also taught us that these firms are so important to global finance that the failure of any one could trigger cascading losses at similar firms and bring down much of the financial system. The evidence that we needed TARP to avoid financial collapse was the same evidence that we needed wholesale reform of too big to fail institutions. No segment of the economy is so important that it should require periodic transfers of $350 billion to stay afloat. Put another way, the problem was not the bailout per se – the problem was that the bailout was necessary.
At the very least, government aid should not have come until senior management and common shareholders were wiped out completely and unsecured bond holders accepted some haircut. Senior executives at some banks earned large bonuses for reaching revenue targets that came from imprudent risk taking. If there were no legal remedy to clawback these bonuses, any future payments should have been suspended. After all, it’s the shareholders that received large dividends and imputed capital gains in the 2003-2007 period. Allowing them to retain the “option value” of their depressed shares essentially excused them for the poor governance of the Board of Directors they elected. Unsecured creditors similarly failed to evaluate the credit risk present at these institutions in the event of a systemic shock. They hardly deserved full repayment given that similar misjudgment would result in huge losses if the loans were made to firms in a different industry.
As Phillip Swagel explains in a Brookings paper, legal limitations and the need for fast action meant that bank management had to agree to participate in the capital purchase program, which constrained the government’s ability to enforce a more equitable distribution of costs at the program’s outset. However, as long as the Treasury was a part owner of these banks, it could have taken action to combat compensation excesses, solve the second lien problem that has plagued mortgage renegotiation, and addressed underwater mortgages and related refinancing obstacles.
Instead of seeking resolution to these issues, the Obama Administration rushed banks to exit the program through a stress test that was, on balance, tough but only because it overestimated potential losses from commercial loans while underestimating losses on second liens, like home equity loans. More significantly, banks were allowed to leave the program even as they remain vulnerable to illiquidity in overnight funding markets. Large U.S. banks have been under extreme pressure as of late due to the problems in Europe even without much direct exposure to bad assets because they remain dependent on short-term, wholesale borrowing.
The bank portion of TARP did return the taxpayer commitment, but this ex post thinking is almost irrelevant. What if a household bet its mortgage on black at the roulette table? Do we need the results of that spin of the wheel to decide if this was a good decision? TARP asked taxpayers to take huge risks by committing hundreds of billions of risk capital to institutions at below market prices. The money provided to these institutions came with extremely modest (if any) dilution to existing common equity holders and was subordinated to all unsecured debt. Yet, the returns offered to taxpayers were extremely modest – a 5% dividend rate for assuming risks that private sector participants would have demanded at least five times as much to take. Put another way - would you accept a 5% return for investing in a friend’s technology start-up that had a 1-in-100 chance of succeeding? Would the decision to invest be validated after the company turned into, say the next Facebook, and you received your 5% dividend?
The use of profitability as the measure of programmatic success is problematic because it ignores the conditions that gave rise to the investment in the first place. Should the government provide below-cost capital to every business in America that’s likely to fail? Or should reforms be instituted so that any business can fail without destabilizing the rest of the economy?