THE DOCTORS' BILL
Sep 25th 2008
The chairman of the Federal Reserve and the treasury secretary give
Congress a gloomy prognosis for the economy, and propose a drastic
remedy
AMERICAN congressmen are used to hyperbole, but they were left
speechless by the dire scenario Ben Bernanke, the chairman of the
Federal Reserve, painted for them on the night of September 18th. He
"told us that our American economy's arteries, our financial system, is
clogged, and if we don't act, the patient will surely suffer a heart
attack, maybe next week, maybe in six months, but it will happen,"
according to Charles Schumer, a Democratic senator from New York. Mr
Schumer's interpretation: failure to act would cause "a depression".
Mr Bernanke and Hank Paulson, the treasury secretary, had met
congressional leaders to argue that ad hoc responses to the continuing
financial crisis like that week's bail-out of American International
Group (AIG), a huge insurer, were no longer sufficient. By the weekend
Mr Paulson had asked for authority to own up to $700 billion in
mortgage-related assets. By the time THE ECONOMIST went to press,
Congress and Mr Paulson appeared to have agreed on the broad outlines
of what is being called the Troubled Asset Relief Programme, or TARP.
However, passage was not assured as rank-and-file congressmen, in
particular Republicans, balked. Uncertainty over the outcome rattled
credit markets: three-month interbank rates jumped and Treasury yields
fell on September 24th. In a prime-time address that evening to rally
support, George Bush warned of bank failures, plummeting house values
and millions of lost jobs if Congress did not act.
Both the crisis and the authorities' response have been called the most
sweeping since the Depression. Yet the differences from that era are
more notable than the similarities to it. From the stockmarket crash of
1929 to the federally declared bank holiday that marked its bottom,
three and a half years elapsed, and unemployment reached 25%. This
crisis has been under way for a little over a year and unemployment is
just over 6%, lower even than in the wake of the last, mild recession.
More than 4% of mortgages are now seriously delinquent (see chart 1),
but the figure topped 40% in 1934.
The scale of the American authorities' response reflects both the
violence with which this crisis has spread, and the determination of
the American authorities, most importantly Mr Bernanke, to learn from
the mistakes that made the Depression so deep and long.
In responding with such speed and vigour, they run several risks. One
is that they overdo it, paying far too much for assets, sending the
deficit into the stratosphere and triggering a run on the dollar. The
risk of underdoing it may be even greater. Politicians, determined not
to be seen as doing favours for Wall Street, might blunt the
programme's effect in the name of protecting the taxpayer. Then there's
the logistical nightmare of fixing a market whose very complexity is
central to the crisis.
Experience, at home and abroad, is a poor guide. In past episodes
authorities have typically not committed public money to their
financial systems until bank failures and insolvency have become
widespread. The first wave of savings-and-loan failures came in the
early 1980s; the Resolution Trust Corporation was not created to
dispose of their assets until 1989. Japan's banks began to fail in
1991, but a mechanism for taking over large, insolvent banks was not
set up until 1998. Mr Paulson and Mr Bernanke are attempting to prevent
the crisis from reaching that stage. "The firms we're dealing with now
are not necessarily failing, but they are contracting, they are
deleveraging," Mr Bernanke told Congress. They are unable to raise
capital and are refusing to lend, and that, he said, is squeezing the
economy.
One risk with such a pre-emptive bail-out is that to congressmen the
benefits are hypothetical whereas the fiscal and political costs, five
weeks before an election, are all too real. In polls voters waver
between opposition and support depending on how the question is asked.
In spite of these risks, the odds seem to be in favour of both
political passage and success. America has owned up to its mistakes
with exceptional speed, and pulled out the stops to correct them.
After the crisis first broke in August last year, the Fed pursued a
two-pronged strategy. The first element was to lower interest rates to
cushion the economy. The second was to use its balance sheet to help
commercial and investment banks finance their holdings of hard-to-value
securities and avoid fire-sales of assets. Behind this approach lay the
belief that the economy and the financial system were basically solid.
Yes, too many houses had been built and prices were too high, but a
return to more normal levels would be manageable if stretched over a
few years. And banks in aggregate had entered the crisis in good shape,
with much more capital this June than in 1990. The Fed saw their
problem essentially as illiquidity, not insolvency. The Bush
administration broadly shared this diagnosis--and an aversion to using
public money to help overextended borrowers.
The intensification of the crisis came not from the banks but the
"shadow banking system": the finance companies, investment banks,
off-balance-sheet vehicles, government-sponsored enterprises and hedge
funds that fuelled the credit boom, aided by less regulation and more
leverage than commercial banks. As home prices fell and loan losses
mounted, more of the shadow system became insolvent.
Insolvency cannot be cured with more loans, no matter how easy the
terms. It requires more capital, which in deep crises only the
government can provide. Mr Bernanke's groundbreaking paper on the
Depression, published in 1983, noted that recovery began in 1933 with
large infusions of federal cash into institutions, through the
Reconstruction Finance Corporation, and households, through the Home
Owners' Loan Corporation. They were, he wrote, "the only major New Deal
programme which successfully promoted economic recovery."
A month ago Mr Bernanke and his closest aides began to think something
similar might now be needed. The Fed and the Treasury had already drawn
up contingency plans, thinking it would be months before a need arose.
Then the financial hurricane blew up over the weekend of September 13th
and 14th. That is when Mr Paulson, Mr Bernanke and Tim Geithner,
president of the Federal Reserve Bank of New York, decided not to
commit any public money to a bail-out of Lehman Brothers. They
reasoned, wrongly, that the financial system was adequately prepared.
The company's failure, coupled with the near-bankruptcy of AIG, threw
the safety of all financial institutions into doubt, causing their
stocks to plunge and borrowing costs to soar.
Several money-market funds that held Lehman debt reported negative
returns, sparking a flight of cash to the safety of Treasury bills that
briefly pushed their yields close to zero. On September 18th companies
could no longer issue commercial paper. Banks, anticipating huge
demands from companies seeking funds, began hoarding cash, sending the
federal funds rate as high as 6%. That week, no investment-grade bonds
were issued, for the first time (holidays aside) since 1981.
Conceivably, the Fed could have contained the damage by supplying lots
of cash. But that would have meant ever greater and more creative use
of its balance sheet. By September 17th it had grown to $1 trillion, up
by 10% in a fortnight, with most of it tied up in loans to banks,
investment banks, foreign central banks, AIG and Bear Stearns (see
chart 2). It was becoming the lender of first resort, not last.
Such steps were also courting political risk. After the rescue of AIG,
Nancy Pelosi, speaker of the House of Representatives, demanded, "Why
does one person have the right to grant $85 billion in a bail-out [to
AIG] without the scrutiny and transparency the American people
deserve?" Mr Bernanke later acknowledged that the Fed wanted to get out
of crisis management, for which it lacked authority and broad support.
"We prefer to get back to monetary policy, which is our function, our
key mission," he told Congress this week.
The Fed chairman told Mr Paulson on September 17th that the time had
come to call for a big injection of public money. By the next day Mr
Paulson was in agreement and the two men, after getting Mr Bush's
approval, approached Capitol Hill.
Mr Paulson's first proposal left Democrats cold: it would give the
Treasury virtually unchecked authority for two years to spend up to
$700 billion on mortgage assets or anything else necessary to stabilise
the system. It looked like a power-grab. Democrats countered with
several conditions: troubled mortgages would be modified where possible
to keep homeowners in their homes; an oversight board would watch over
the programme; taxpayers would share any gains for participating
companies via shares or warrants; and executives' compensation would be
capped. By September 24th, Mr Paulson seemed to be bending to all these
conditions. For its part, the finance industry is ready to yield to all
of these conditions in order to get something done. "It was a
gargantuan abyss that we faced last week," says Steve Bartlett,
chairman of the Financial Services Roundtable, which represents about
100 big financial firms.
Assuming it comes into existence, there are still numerous risks
surrounding the TARP. The first is that it does too much. At $700
billion, the amount allocated to it easily exceeds the Federal Deposit
Insurance Corporation's (FDIC) estimate of roughly $500 billion of
residential mortgages seriously delinquent in June, out of a total of
$10.6 trillion, though that figure will rise. The Treasury has sought
broad authority to buy not just mortgage securities but anything
related to them, such as credit derivatives, and if necessary equity in
companies weakened by their bad loans.
THE ARITHMETIC OF CRISIS
When the loans to AIG and Bear Stearns assets are added in, the gross
public backing so far approaches 6% of GDP, well above the 3.7% of the
savings-and-loan bail-out in the late 1980s and early 1990s (see chart
3). That would still be much less than the average cost of resolving
banking crises around the world in the past three decades, which a
study by Luc Laeven and Fabian Valencia, of the IMF, puts at 16%. One
reason why bail-outs, especially in emerging markets, have been so
costly is inadequate safeguards against abuse, says Gerard Caprio, an
economist at Williams College. "There was a lot of outright looting
going on."
The Congressional Budget Office had pegged next year's federal budget
deficit at more than $400 billion, or 3% of GDP. Private estimates top
$600 billion. Tack on $700 billion and various other crisis-related
outlays and the total could reach 10% of GDP, notes JPMorgan Chase, a
level last seen in the second world war. On September 22nd the euro
made its largest-ever advance against the dollar on worries that
America might one day inflate its way out of those debts. Such fears
are compounded by the expansion of the Fed's balance sheet. Some even
think that the burden of repairing a broken financial system could
place the dollar's status as the world's leading reserve currency in
jeopardy.
The consequences will probably not be so far-reaching. The true cost to
taxpayers is unlikely to be anywhere near $700 billion, because many of
the acquired mortgages will be repaid. The expansion of the Fed's
balance sheet reflects a fear-induced demand for cash, which drove the
federal funds rate above the 2% target.
It is more likely that the programme will not go far enough. Conscious
of the public's deep antipathy to anything that smacks of favours for
Wall Street, politicians from both parties have insisted that the
protection of the taxpayer be paramount. Yet the point of bail-outs is
to socialise losses that are clogging the financial system. If
taxpayers are completely insulated from losses, the bail-out will
probably be ineffective. "The ultimate taxpayer protection will be the
market stability provided," Mr Paulson argues.
This is especially critical in deciding how the government will set the
price for the assets it purchases. An impaired mortgage security might
yield 65 cents on the dollar if held to maturity. But because the
market is so illiquid and suspicion about mortgage values so high, it
might fetch just 35 cents in the market today. Recapitalising banks
would mean paying as close to 65 cents as possible. Those that valued
them at less on their books could mark them up, boosting their capital.
On the other hand, minimising taxpayer losses would dictate that the
government seek to pay only 35 cents. But this would provide little
benefit to the selling banks, and those that carried them at higher
values on their books could see their capital further impaired.
To some, that would be fine. "If they choose to fail rather than sell
their debt at its real market value and record the loss on the books,
they should be free to take that option," said Michael Enzi, a
Republican senator from Wyoming. The failure of smaller regional banks
may be tolerable. The FDIC offers a proven system for coping with
failed entities (although it too may need a loan from the taxpayer) and
other banks are keen to snap up their deposits. But the final result of
big-bank failures would be a deeper crisis and a bigger cost in lost
economic output.
Similarly, requiring participating banks to give the government
warrants or cap their executives' salaries might make them less willing
to take part. Veterans of the emerging-markets crises of the 1990s say
their effectiveness would have been crippled had their ability
instantly to deploy cash as they saw fit been compromised. "There is
far more risk that the authorities will have too little
flexibility...than there is risk that they will have too much
authority," says Lawrence Summers, a former treasury secretary.
A more serious criticism is that buying assets is an inefficient way to
recapitalise the banking system. Better, many argue, to inject cash
directly into weakened banks. A dollar of new equity could support $10
in assets, reducing the pressure to deleverage. Moreover, since the
price of banks' shares are less arbitrary and more homogeneous than
those of illiquid mortgage securities, the process would be far more
transparent, says Doug Elmendorf of the Brookings Institution. But
banks might not volunteer to sell equity to the government before they
reach death's door; and the prospect of share dilution could discourage
private investors. In any event, the Treasury plan could be flexible
enough to permit such capital injections.
BUT WILL IT WORK?
There have been several false dawns since the crisis began in August of
last year. This could be another. The TARP may address the root cause,
namely house prices and mortgage defaults, but the crisis has long
since mutated. "The same underlying phenomenon that we saw in housing
we're seeing in auto loans, in credit-card loans and student loans,"
says Eric Mindich, head of Eton Park Capital Management, a hedge fund.
The crisis could claim another institution before the TARP's effect is
felt.
The TARP could conceivably slow the resolution of the crisis by
stopping property prices and home ownership falling to sustainable
levels. Some homeowners who are up-to-date with payments but whose home
is worth less than their mortgage may stop paying, betting the federal
government will be a more forgiving creditor. The Treasury is
considering using the TARP to write down mortgages to levels that
squeezed homeowners can afford. But in the meantime, buyers might be
reluctant to step in while a big inventory of government-owned property
hangs over the market. That's one reason Japan's many efforts to bail
out its banks failed to revitalise its economy: the institutions that
took over the loans were hesitant to dispose of them for fear of
pushing insolvent borrowers into bankruptcy, says Takeo Hoshi of the
University of California at San Diego.
All the same, the TARP is likely to mark a turning-point. "It promises
to break the vicious circle of deleveraging in the mortgage market,"
predicts Jan Hatzius, an economist at Goldman Sachs. This does not mean
the economy will soon rebound, but it does suggest the worst scenarios
will be averted. If the TARP helps banks and investors establish
reliable prices for mortgage securities, it could restart lending and
help bring the housing crisis to an end.
This will not come without a price. The unprecedented intrusion of the
federal government into the capital markets seems certain to be
accompanied by a heavier regulatory hand, something on which both
Barack Obama and John McCain now agree.
Even without new rules, more of the system will be regulated because so
much of it has been absorbed by banks, which are closely overseen.
Sheila Bair, chairman of the FDIC, thinks this is a good thing. Banks
were relative pillars of stability because of their insured deposits
and the regulation that accompanied it. Although some banks have
failed, she notes that other banks, not taxpayers, will pay the
clean-up costs. Now that institutions like money-market funds are
caught by the federal safety net even though that was never intended,
they can expect to pay for it.
Yet predictions of a sea change towards more invasive government are
premature. The Depression witnessed a pervasive expansion of the
federal government into numerous walks of life, from trucking and
railways to farming, out of a broadly shared belief that capitalism had
failed utterly. If Mr Paulson and Mr Bernanke have prevented a
Depression-like collapse in economic output with their actions these
past two weeks, then they may also have prevented a Depression-like
backlash against the free market.
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