Too Little, Too Late: Why?

Two years ago, Treasury Secretary Timothy Geithner praised the widely criticized $700 billion bank bailout of late 2008—known as the Troubled Asset Relief Program, or TARP—as “perhaps the most maligned yet most effective government program in recent memory.” By late 2010, losses to the government had turned out to be far lower than many feared. Since then, the Treasury has been repaid much of the capital it loaned to financial institutions and other firms, even making profits in some cases. The Treasury now reports that losses will finally be close to $50 billion when all is said and done.¹

But the program came at an enormous political cost. Many Americans were infuriated by what they saw as a giveaway by the Bush administration to the very banks that caused the crisis in the first place. Reflecting that anger, Congress refused at first to pass the TARP bill, causing a plunge in stock prices. About a week later, with prodding from President Bush and congressional leaders, TARP passed on October 3.

The anti-bailout attitudes among Americans also made the Obama stimulus package of some $800 billion in early 2009 that much harder to pass. To get congressional approval, Obama believed he had to offer tax cuts to the Republicans. The result, many economists argued, was a less potent program than one composed almost entirely of government spending, such as aid to the states and infrastructure investment.

Similarly, the public distrust of government spending to address economic decline made it difficult to return to Congress for a second stimulus, which was badly needed by mid-2009 as the job market collapsed. Trying to fend off criticism of government spending, Obama rarely boasted of the good his stimulus did do, including the creation of at least two million jobs, or even the benefits of TARP and the other government rescue programs. Without a second stimulus, the economic recovery was slow, with an unemployment rate hovering around 8 percent, which so haunted Obama in his reelection bid.

The public’s angry reaction to the bailout of bankers seemed to extend to government intrusiveness of any kind, even the financial reregulation act known as Dodd-Frank, named for its sponsors, Senator Chris Dodd and Representative Barney Frank. Ironically, the TARP reaction may have made it harder to implement tough new regulations on the banks. The TARP bill left to the regulators themselves many difficult decisions that still haven’t been made. Higher capital requirements for financial firms are not yet set, for example. We still don’t have open exchanges for trade in the derivatives that were at the heart of the crisis. The regulation of those highly leveraged investment vehicles based on other securities has been watered down by intense Wall Street lobbying, as has the famed Volcker Rule, which would restrict trading by financial firms for their own profit. Speculative bubbles are already growing in some financial assets, such as low-rated corporate bonds and overseas debt, which stronger regulatory measures would have restrained.

Economic recovery began in mid-2009, and the unemployment rate has fallen from its high around 10 percent, but even today, most Americans believe that neither TARP nor the Obama stimulus helped revive the economy. The Obama administration kept the Bush bailout largely intact when it took over a few months later. Timothy Geithner was the Treasury man who bridged the two administrations. As president of the New York Fed, he was the codesigner of the original bailout with Henry Paulson, George Bush’s Treasury secretary, and, to a lesser degree, with Ben Bernanke, Bush’s appointee as chairman of the Federal Reserve. He continued to support the plan strongly as Obama’s new Treasury secretary, and undertook the early bargaining with Congress over avoiding the fiscal cliff.

Three new books discuss whether or not TARP was a success. Two are by insiders whose accounts are fascinating, although at times they seem designed to settle old scores. Neil Barofsky, the independent inspector general of TARP, appointed under Bush, has written Bailout, a harsh look at Geithner’s management of the program. Barofsky, a former prosecutor, was a zealous watchdog, even if his doggedness led to constant friction.

Sheila Bair, head of the Federal Deposit Insurance Corporation, created in the New Deal to insure savers’ deposits, has written Bull by the Horns. A strong-minded regulator, she was skeptical of government bailouts in general—on occasion, too much so—because they could create a “moral hazard,” supposedly making big financial institutions less cautious than they should have been, since they could count on the government to rescue them. Bair made her reputation earlier when, as a Treasury official, she began to warn about mortgage fraud in the early 2000s. She couldn’t get either the Federal Reserve or Congress to take action, even when she had an ally in Federal Reserve Governor Edward Gramlich, who also argued that federal preventive measures were necessary. Alan Greenspan and others paid no heed.

The third book, After the Music Stopped, is by Alan Blinder of Princeton, a former vice-chairman of the Federal Reserve and one of America’s leading economists. Blinder is an admirably clear writer and thinker and presents the history of the financial crisis and its rescue with more detachment than the other authors. His account is likely to become widely accepted, although he seems concerned to avoid confrontation with critics of the bailout.

In retrospect, the financial world started coming apart in late 2007, even though foreclosure rates on mortgages had begun rising rapidly by 2006, while home prices had begun falling. We can see now that far too many “subprime” and other innovative but risky mortgages were issued to people who would not be able to keep to their repayment schedules. The Federal Reserve started to cut interest rates rapidly in late 2007 and through 2008, but this wasn’t sufficient to generate more rapid growth in the Gross Domestic Product.

Indeed, the recent publication of the 2007 minutes of the Open Market Committee, which makes policy decisions at the Fed, showed embarrassingly that the members had no idea the subprime crisis could spread and thought it would have minor consequences at worst. In a new but unrevealing book of lectures by Bernanke, The Federal Reserve and the Financial Crisis,² he doesn’t discuss at all why, even as the subprime market cracked all around them, the Fed failed so badly to anticipate the broader financial collapse and deep economic recession to come.

By 2008, major firms—AIG, Lehman Brothers, and Bear Stearns among them—were beginning to teeter as the mortgage securities they had issued fell in value and losses jeopardized their ability to meet their financial commitments. In March, the Treasury and the Fed arranged a purchase by JPMorgan Chase of Bear Stearns, the fifth-largest investment bank. In the summer, the Treasury essentially took over the quasi-public mortgage giants Fannie Mae and Freddie Mac. Markets calmed down for a couple of months, but Lehman Brothers, laden with mortgage debt and dubious real estate holdings, soon faced failure as well. This time, the Treasury and Fed decided not to intervene. When, on September 15, Lehman announced its bankruptcy, the biggest in history, the financial world faced the kind of crisis no one had experienced since the 1930s.

The giant insurance company AIG had sold guarantees on hundreds of billions of dollars of mortgage securities. Now it had to be bailed out or it would also collapse. Bernanke writes, “In our judgment, the failure of AIG would have been basically the end.” To avoid bankruptcy, Merrill Lynch sold itself to Bank of America. Supposedly safe money market funds, where savers thought their funds were as secure as in the bank, were losing value, having invested in the debt of firms like Lehman Brothers. Other banks like Washington Mutual had debts they could not pay.

Why hadn’t the crisis been foreseen by regulators, or by most economists, including the Fed’s Ben Bernanke? As Blinder points out, the linkages between Lehman Brothers and countless other financial firms were more intricate than most realized. If Lehman failed to pay its bills, so would others who had extended credit to Lehman. More important, the complex and widely sold mortgage securities known as collateralized debt obligations were more vulnerable to the failures of subprime mortgages than economists or federal officials had known.

Few outside the Fed were aware of the dangers, either. This lack of understanding is a black mark for the economics profession in general. The collapse was not just a matter of a burst housing bubble leading to reduced consumer spending. It was a collapsing house of cards, the failure of one risky security leading to the failure of another. Business lending virtually stopped. When Lehman collapsed, a moderate recession turned into a severe one. Bernanke offers the lame excuse that the Fed had no legal right to save Lehman because its collateral was not adequate, but many contest this claim, as Blinder points out.

In response to the consequences of the Lehman collapse, the Treasury, the Fed, and its New York branch, which oversaw the financial markets, acted in haste to create TARP, which would become the $700 billion plan to bail out the banks and other related companies (including, eventually, major auto companies), as well as to modify mortgages so that millions of home owners could rise out of foreclosure. The original idea was to buy the bad mortgage assets of the banks, a strategy Blinder had supported in testimony before Congress. Other economists disagreed and argued that the Treasury should nationalize the banks, buying them outright. Paulson originally wanted simply to buy the bad mortgages but changed his mind when he saw that the British were successfully making capital injections into their banks in return for a minority ownership, a partial nationalization of sorts.

Now Paulson, Bernanke, and Geithner agreed to make $125 billion available immediately to a handful of major banks, with another $125 billion in reserve. Much of this money was used to buy shares of the troubled banks, with the understanding that the banks could later buy them back. They were indeed ready to force the banks to take the money even if a few didn’t want it. Geithner was determined that no bank should look weaker than the others; if it did, then there could be a run on the seemingly weak bank’s resources and that would disrupt the interconnected markets still more. Fear of another bank run, like the one on Lehman, dominated Geithner’s thinking.

TARP clearly worked to stop the market panic, but it did so only when combined with other financial rescue programs. Lending began to flow again, and, though a deep recession was not forestalled, a Great Depression may well have been avoided. That the rescue worked in this broad sense was a victory for Geithner. But was this kind of victory sufficient when so much else was not accomplished? All these authors think not, and they are right. Could the bailout have been done more effectively? asks Blinder. He answers “yes.”

First, he points out, the taxpayers could have participated in more of the profits. The dividends on the stock of distressed banks bought by the government, for example, were only 5 percent. By contrast, when Warren Buffett invested billions in Goldman Sachs a short while earlier, he received a 10 percent dividend on Goldman’s shares. “No private investors would have offered the terms the government did,” says Phil Angelides, the former head of the Financial Crisis Inquiry Commission.

Barofsky was especially disturbed, as he should have been, that there were no requirements for the banks to report how they spent the money provided by the taxpayers. Astonishingly, there were no demands by Paulson or Geithner that the banks lend any portion of their funds to businesses. Barofsky was in charge of preventing fraud. How could he do that if he did not know where the money was going? But Geithner argued that it was unreasonable to ask banks to tell the government what they were spending. Money, he argued, is “fungible”; if a bank spends $100 million on loans, acquisitions, or dividends, it is hard to tell what the particular source of that money was. Barofsky showed Geithner how it could be done, but to no avail.

This is one of many examples of how Geithner bent over backward to protect the banks. The New York Times published an article in early 2009 about Barofsky’s concerns, in which it reported that lending to business was not the highest priority of the rescued banks. They were using the money to pay down debt, make acquisitions, or build up their savings.³

What seemed to bother Sheila Bair most was that stockholders, bondholders, and other creditors of the banks were not asked to take any losses. They were bailed out whole. AIG’s creditors, including Goldman Sachs, were paid 100 cents on the dollar—a source of much public indignation.

But perhaps nothing rankled critics and the public as much as the government’s failure to limit the compensation of the rescued bankers. This created public resistance to further government rescue efforts—a resistance to which Obama seemed especially sensitive. It was Paulson who at first opposed any serious restrictions on compensation to the very executives who were responsible for the collapse. Wall Street professionals were paid enormous sums when all was going well, but they bore little loss when markets turned against them. The incentives to overspeculate were thus out of control.

President Obama asked for new restrictions on compensation when he inherited TARP, but he suffered further embarrassment. Once again, AIG was the focus of understandable public anger. The insurance company, which was essentially nationalized by the government with capital injections of more than $180 billion, had been allowed to pay its financial executives $165 million in bonuses. This news was kept secret even from Barofsky, the inspector general. Still, Bair writes, Geithner “had known about the bonuses and had not objected to them. He had also not given the president a heads-up.”

The furious Barofsky writes that executives at AIG got undeserved bonus payments of up to $6.4 million and twenty-two received at least $2 million each. The bonuses were given the “green light” because of an exemption written into the TARP legislation about fulfilling prior contracts. When the bonuses were made public in March 2009, Treasury officials claimed to be outraged, at least in public. But Barofsky writes that Treasury insiders still believed the bonuses were necessary to keep the best-qualified people at work—“No matter that the financial crisis had demonstrated just how unremarkable the work of those executives had turned out to be.” Bair is more blunt: “Who in the world would want to hire these yahoos…? I couldn’t believe they had anywhere else to go.”

Larry Summers, then Obama’s chief economic aide, went on TV to argue that he was outraged by the bonuses but he still insisted that contracts with the bankers must be honored. This was a farce, according to Barofsky. Contracts with mortgage holders and with employees were being broken all the time, he points out. Private and public pensions were being renegotiated across the country. Surely the federal government, which owned 80 percent of AIG, could have negotiated the bonuses down with the AIG employees.

Recent claims that reduced losses for TARP are proof of the program’s success are disingenuous. The financial rescue of America was a far broader effort. As part of the bailout, Bair’s FDIC guaranteed all the bank debt of major financial institutions and raised insurance coverage for deposits from $100,000 to $250,000. The Treasury guaranteed all the money market funds, some $3.4 trillion worth. The Federal Reserve essentially guaranteed several trillion dollars of commercial paper. And even before the Lehman bankruptcy, the Fed had engaged in many purchases of unconventional securities, such as Treasury bonds and mortgage securities themselves, as part of rescue programs that continue to this day.

At one point, according to Barofsky, the federal government overall had promised some $23 trillion to rescue financial institutions, a sum that created momentary alarm when Barofsky made it public. He should have made some qualifications, however. He could have pointed out that most of those guarantees were made against fairly reliable bonds held by the institutions, and other investments. But all these guarantees contributed to the sudden restored faith in the financial markets.

Thus, to use later financial returns in order to claim that TARP was one of the most effective government programs of all time is misleading and disturbing. One can understand Geithner’s defensiveness. He badly wanted the banks to take his deal for fear of panicking markets further, but it’s hard to justify his consistent sympathy for Wall Street’s opposition to restrictions on compensation or on requirements to lend the money and not sit on it. Geithner himself was not from Wall Street, but many of those running the programs in the Treasury were, including the powerful Neel Kashkari, formerly from Goldman Sachs. Geithner’s patron was Robert Rubin, Clinton’s Treasury secretary and former head of both Goldman Sachs and later Citigroup. Blinder says the Treasury’s policymakers were probably “too pro-Wall Street.” Bair is harsher. She writes that Geithner “had been elevated to the role for all of the wrong reasons, boosted by Bob Rubin, who no doubt had had every expectation that Tim would continue his Citigroup-friendly policies.”

One other decision by Geithner and his team is especially hard to understand. No member of top management was ever asked to leave his or her post in return for the bailout funds, even at Citigroup, the bank in arguably the worst condition. Bair accuses Geithner in particular of protecting Citigroup and its chairman, Vikram Pandit, who was also favored by Rubin, then still the titular head of Citi. Even when Citi needed another round of capital injection, Geithner refused to ask Pandit to step down or to force losses on bondholders or shareholders. As Bair writes, Pandit

had no commercial banking experience, yet he was running one of the world’s largest commercial banks. In addition, Citi management’s performance during the crisis had not been impressive. They had a very difficult time making decisions and then executing once the decisions were made.

Pandit was finally forced out by the Citigroup board last year.

The most egregious failure of TARP, however, was that both the Bush and Obama administrations never adequately used the funds to reduce mortgage debt for Americans, even though help for homeowners was a principal part of the TARP legislation. Nearly four million foreclosures were occurring each year. Only in 2012 did the number fall to less than three million.

Bair was determined to address foreclosures. She writes that the Treasury under Paulson proposed a modest and unworkable plan. But both Bair and Barofsky argue that the Obama administration was hardly better. Its principal new plan, the Home Affordable Mortgage Program (HAMP), set aside only $50 billion to reduce mortgage debt, and little of that was ever used. The White House had promised that HAMP would help three to four million home owners, but both Bair and Barofsky warned that the terms on which the government offered this money were not attractive enough to result in serious loan reductions. A recent report from the Government Accountability Office finds that only one million mortgages have been modified under the federal program. Asking why Summers and Geithner did not do better, Bair concludes, “I don’t think helping home owners was ever a priority for them.”

It should have been. High levels of debt, including much mortgage debt, have restrained consumers from spending, prolonging the economic recovery. Additionally, house prices have been held down with so many houses “underwater”—worth less than the amount of their mortgages. Had the Obama administration had the will, as Blinder points out, it could have used $100 billion or more from the TARP allocation to buy up mortgages from banks and reissue reduced and affordable mortgages to home owners.

Franklin D. Roosevelt did just this beginning in 1933 when he established the Home Owners’ Loan Corporation. In three years, it issued more than one million new mortgages. Several noted liberal economists, such as Paul Davidson, proposed such a plan early in the crisis. Similar plans were proposed by conservative economists like Glenn Hubbard, an adviser to Mitt Romney, and Martin Feldstein, formerly with the Reagan administration. “Had we done that,” Blinder writes, “the foreclosure problem would probably be over by now.”

Blinder could have added that, as a result, the economic recovery itself would surely have been stronger as well, the unemployment rate substantially lower, and the long-term budget deficit far more manageable. President Obama would then have had significant leverage over Congress to invest in education, infrastructure, and clean energy, and to maintain the nation’s needed social programs. This failure to modify mortgages is perhaps the most damaging domestic failure of the administration. Will it concentrate on mortgage relief in the second term?

In the books by Bair and Barofsky, Geithner is so heavily criticized that one hopes he writes his own book in rebuttal, though his view has been presented with little criticism in such best sellers as Too Big to Fail, by Andrew Ross Sorkin (2009). Mild-mannered in public appearance, Geithner can reportedly be harsh in private. Bair describes a meeting in which

he summoned all of the major agency heads to his conference room and proceeded to give us an expletive-laced tongue lashing about talking to people on the Hill.

Barofsky, who had many run-ins with Geithner, reports similar outbursts.

We shouldn’t take all these accounts at face value. Barofsky is a determined former prosecutor who, while mostly in the right, could at times be excessive, as his public announcement of the $23 trillion government liability suggests. Bair, in putting down Geithner, also writes that he was treated as more of a staffer by Paulson, Bernanke, and Summers than as an equal. If so, why does she blame him so often for the policy errors of both administrations?

As noted, Bair was generally skeptical about bailouts and fearful of moral hazard, a woman with flexible and smart conservative views in a tough job. She may have protested too much, but her accounts suggest that she was also not treated with the respect she deserved. Even her critics admit that Bair’s book is a thorough and able critique of policy in these years.

The nation is still undeniably living with TARP’s flaws. Bank lending even as late as the fall of 2012 had still not reached the levels of late 2008. Thirteen or fourteen million home owners are still underwater. Four million have already lost their homes. Many people remain angry about the failure to hold bankers responsible—no major banker has been criminally prosecuted for the financial fiasco. It will be hard to bail out the system again should a new crisis occur five or ten years from now.

Moreover, the financial community has not been reorganized and regulated in ways that give confidence that it will be a productive contributor to the American economy, rather than a danger zone, for decades to come. The crisis could have led to sweeping reform, but that opportunity was wasted.

What remains to be done? Blinder wants to make further reforms in the perverse compensation schemes that prevail on Wall Street; he would dock them for failure as well as pay them for success. He would make derivatives more transparent than Dodd-Frank does, insisting that many more of them be registered on open exchanges. He would reduce the leverage—the credit used to enhance speculative capacity—that banks are permitted to employ.

Bair provides a long list of suggestions. She is much less concerned with the size of banks than their individual activities, which makes sense to me. She’d rather see bank activities separated into distinct subsidiaries. FDIC-insured deposits should be used only for business loans and some other traditional banking activities. Operations involving both the financing of securities and derivatives should be walled off from insured deposits. She believes all these entities can operate under one bank holding company. I would like to see these activities completely split up into separate companies.

But there is still more to be done. As Bair notes, higher capital requirements on banks are still not in effect, and even initially tougher-minded international regulators have postponed demands for higher capital requirements. Both the Volcker Rule against proprietary trading by commercial banks and the regulation of derivatives are already watered down. Investors still rely on ratings agencies that are paid by the sellers of the securities being rated. There is no serious discussion of how to control the manipulation of markets by powerful traders; nor is there any attempt to reduce outsize fees to underwrite the latest securities marketed.

On Wall Street, moreover, there is virtually no competition over the prices charged for underwriting securities or managing large acquisitions. This failure of competition is almost never acknowledged, while the abstract virtues of competition are lauded. Although the recent nomination of the former federal prosecutor Mary Jo White has been called into question by her defense in private practice of Wall Street and other executives, her public record has raised the possibility, at least, that guilty business leaders may still be prosecuted and that Dodd-Frank rules will be enforced.

The fundamental danger to the economy that must be addressed is that the outsize profits to be made from unregulated and ultimately damaging trading and speculation attract money away from the forward-looking investments in American business that can strengthen the American economy and create more jobs. The question for the US today is not merely how to avoid another financial crash but also how to do much more to channel the nation’s precious savings into more productive uses.