It is over a year now since the bankruptcy of Lehman Brothers. Why do you think Lehman Brothers was allowed to fail and what do you think was the impact of its collapse on the wider economy?It is hard to say why Lehman Brothers was allowed to fail by the US Treasury and Federal Reserve. After all, both government agencies had a long track record of bailing out financial institutions in distress, including:
• the 1984 bailout of Continental Illinois National Bank after the Penn Square lending excesses;
• the 1995 bailout of Wall Street investors in Mexican government securities following the peso devaluation of December 1994;
• the 1998 bailout of Long Term Capital Management and its counterparties;
• the Implicit so-called “Greenspan put” for the benefit of US capital markets understood to have been in effect since then;
• the March 2008 total bailout of creditors and partial bailout of shareholders in Bear Stearns, through a merger with JPMorgan Chase;
• the total bailout in Summer 2008, just before the Lehman bankruptcy, of creditors of Fannie Mae and Freddie Mac, both mortgage finance institutions sponsored by the federal government with an implicit guarantee;
• the September 2008 bailout, right after the Lehman bankruptcy, of insurance giant American International Group (AIG), thereby bailing out its counterparties, which included several international financial institutions;
• the Autumn 2008 Troubled Asset Relief Programme (TARP) investments in other brokerage firms such as Goldman Sachs and Morgan Stanley, as well as in commercial banks such as Citibank and Bank of America; and
• the December 2008 forced acquisition of Merrill Lynch by Bank of America, thereby indirectly bailing out the target’s investors.
Given this track record, Lehman’s bankruptcy stands out as an exception. As some Lehman executives were heard to murmur: “Dude, where’s my bailout?” As we discuss in the book, then Treasury Secretary Paulson claimed that he had no legal authority to provide a lifeline to Lehman, but it seems that the government could have been more creative with a solution if it had really wanted to save Lehman.
Although shortly after Lehman’s filing for bankruptcy protection people blamed its collapse for the wider deterioration of the economy, now that the dust has begun to settle it is likely that if the government had saved Lehman, some other institution would have failed sooner rather than later with even more disastrous consequences. Recall that only a day after Lehman’s bankruptcy, the government initiated the bailout of AIG. TARP allowed the government to bail out AIG, Fannie Mae and Freddie Mac, Citibank and Bank of America, among others.
In all, it seems that Lehman was not really a cause of the crisis, but rather the result of the government’s inconsistent treatment of like institutions in similar circumstances, which led to a loss of investor confidence and an increase in uncertainty that further contributed to the global crisis. During 2008, the US Treasury and Federal Reserve followed ad hoc, inconsistent policies, which added fuel to the crisis.
Furthermore, as a result of the panic caused by Lehman’s failure and it being considered a cause, as opposed to a consequence, of the global financial crisis, the Bush administration passed through Congress the TARP legislation in October 2008 and then the Obama administration passed the stimulus spending package in February 2009.
How effective do you think the US government measures will be in preventing a similar financial crisis?
The US government was the primary cause of the global financial crisis of 2008, through its policies during this decade, and specifically due to:
• easy money provided by historically low interest rates set for historically long periods by the US Federal Reserve - a policy which continues today;
• relaxed standards in the residential mortgage lending sector. After the demise of Fannie Mae and Freddie Mac, this policy has been continued in 2009 by the Federal Housing Administration and through mortgage modification programmes; and
• moral hazard, encouraging excessive risk-taking by financial institutions considered 'too big to fail'. The recent bankruptcy of CIT, a lender to medium and small-sized businesses, may signal a limit to this policy, but only after the US Treasury had invested over $2 billion of TARP funds in shares of this bankrupt financial institution. This bankruptcy is also not a good sign of the Treasury’s ability to spot systemic risk.
Accordingly, the US government may be setting the stage for the next financial crisis. For example, financial institutions can borrow from the US Federal Reserve at a rate of close to 0% and lend to the US Treasury at a rate of around 3%. This 'carry trade' does not seem sustainable for long. Proposed regulatory reforms in the financial industry will have mixed results, but they will certainly prove useless unless these core policies are corrected.
What do you think the regulatory response will be and what do you think would be an appropriate response?
In the past few months, we have seen more regulatory measures being considered to deal with the purported causes of the financial crisis. One of the problems with the new proposals, however, is that much of the regulation relies on broad discretion by the regulators, as opposed to reliance on rules that operate in a predictable manner during certain determined circumstances.
The financial reform plan includes a far-reaching proposal giving the US Federal Reserve authority to take over certain troubled financial institutions that create systemic risk (including insurance companies and hedge funds), and to inject money into them to facilitate their orderly unwinding. In any such case, the foreseen consequences for such institutions would be severe, including the loss of shareholder value, the dismissal of top management and the inability of creditors to recover their loans. Furthermore, the financial industry would have to cover part of the cost of any such bailout with the creation of a special fund paid by assessments on financial institutions of a certain size (right now, the proposal would cover those with more than $10 billion in assets). The proposed legislation would also allow the government to increase capital requirements on the largest institutions, with the purpose of discouraging banks from getting too big (since their profit margin would be reduced as a consequence), and would also allow them to have bigger cushions against unexpected losses in case of another crisis.
Other proposals include the regulation of derivatives, such as the credit default swaps that were involved in the US government’s bailout of AIG. This derivatives bill would bring these complex financial products under the authority of the US Commodities Futures Trading Commission and the US Securities and Exchange Commission. The latest draft of the proposed bill distinguishes between derivatives contracts made between financial institutions and contracts made by businesses to hedge fluctuations in their underlying business. In general, the former would go through central clearinghouses that guarantee the trades and would trade on exchanges, although exemptions may be available in uniquely complex cases. In turn, the latter would be exempted from having to go through clearinghouses or trade on exchanges, thanks to the lobbying efforts of businesses that have insisted that without such exemption, they would have much less capital to invest in their operations.
Another proposal includes the creation of an independent consumer protection agency that would tinker with how consumers use credit cards, mortgages and other loans. Some have also suggested that this agency should be coupled with lessons in debt management, in order to teach consumers to live within their means; but given the government's poor record in limiting its own spending, few take this proposal seriously.
One of the latest (and highly controversial) proposals has been to limit executive pay at some of the institutions that received TARP funds by cutting an average of 50% of their compensation, including about 90% of cash salaries, and tying compensation much more closely to the long-term financial health of such institutions. Specifically, the current proposal applies to the top five executives and the next 20 highest-paid employees at AIG, Fannie Mae, Freddie Mac, Citigroup, Bank of America, General Motors, GMAC, Chrysler and Chrysler Financial. This proposal seems to do nothing more than try to appease public anger towards Wall Street. However, this populist measure will likely do nothing more than make such employees more attractive to other firms that have not received or have since repaid TARP funds, which might result in companies that received government assistance losing their best employees to competitors at a time when their talent is most needed. The US Federal Reserve also seems keen to align employee and shareholder interests in the financial institutions under its authority, and may adopt similar limits to curb excessive incentive-based compensation.
It is important to underscore that the financial services industry has been lobbying Congress, and continues to do so, to limit the scope of the financial reform. That is why we see some of the noted exemptions and why the current proposals could be further watered down before and if they ever become legislation.
Imposing more stringent capital requirements on financial institutions, adopting related measures to assure that “too-big-to-fail” is the exception rather than the rule, and providing a legal framework to derivatives trading is a good initial approach to deal with the regulatory gaps that we have seen in past years. In addition, interest rates should also be increased as soon as practicable to avoid overleveraging. Overregulation and populist measures such as imposing selective executive pay limits should be avoided.
Are you concerned about the creeping nationalisation of the financial services sector?
Yes, and also in the auto manufacturing and healthcare sectors.
What do you think are the main challenges facing financial institutions now?
The main challenges to financial institutions include dealing with the wave of financial regulations that have been and will continue to be implemented as a result the current crisis while the economy undergoes a slow recovery. For banks, the remedial measures such as TARP have had mixed results: some banks have come back bigger and stronger than before and are again engaged in old trading practices, earning big profits and planning big bonuses (eg, JPMorgan Chase and Goldman Sachs), while others have required further financial assistance and continue to struggle to keep afloat (eg, Citigroup and Bank of America). In general, the US banking system is like a pyramid, with two or three firms that are profitable and doing well at the top, a few others that are doing okay but are still overinvested in risky assets, and a majority of smaller banks that are in trouble and may not be around for long.
The non-bank financial institutions (eg, AIG, Fannie and Freddie, General Motors and Chrysler, and their financial arms) have also required additional financial support and are in bad shape, to the point that it is likely that some of the government’s investments in those companies will not be recovered as suspected.
Do you think the economy is over the worst of it now?
It does seem that the worst part of the global recession has passed and that the economy is starting to recover, albeit slowly. In the United States, positive signs include the apparent stabilisation of the housing market, the slowing pace of job losses and the economic growth of 3.5% in the third quarter of this year. Retailers had been weathering the bad economy by tapping their inventories, but they will soon need to begin producing again, even though they are still hesitant to hire people until they can justify it in real terms.
Furthermore, the stimulus spending package approved in February of this year has not had its intended effect of creating many net new jobs (although the full effects of the stimulus are not expected until 2012). Stock markets have rallied in recent months, which may be a sign of optimism and confidence in a quick recovery, although this may also mean the beginning of yet another asset bubble.
However, a feature of this incipient recovery is that it is more stimulus led than consumer led. That is, part of the recent growth is the result of certain temporary government programmes that have encouraged spending, such as those providing benefits for purchasing new cars and homes; so this growth is somewhat inflated and may be hampered again once those programmes lapse. Any possible long-term recovery will take some time, largely because of high unemployment, which tends to lag behind economic growth after recessions. In addition, consumers and companies remain highly leveraged, and paying excess debt will mean weak spending for a time to come.
The main challenges to economic recovery include the following:
• Slow job creation - the policies pursued this year by the new administration and Congress (a stimulus spending package, government-run healthcare, cap-and-trade energy regulations and forced labour unionisation), discourage the creation of new jobs by entrepreneurs. Net new jobs are created not by governments or big businesses, but by new businesses and small or medium-sized businesses. The latter are not encouraged by current policies.
• Another financial crisis - the current easy money policy is likely to result in new asset bubbles, whether in the US stock market, in emerging markets or elsewhere, which will bring us back full circle. Inflation in the United States has been subdued, but the falling US dollar is a warning and the price of gold continues to skyrocket.
Accordingly, the Reserve Bank of India recently purchased 200 tons of gold bullion. That may be the clearest signal of all.