Government Bailouts and the Stimulus Package - Causes and Cures
Discovery@Olin caught up with Olin Business School finance professor, senior associate dean and banking expert Anjan Thakor to get his latest thoughts on the financial crisis.News of economic doom and gloom keeps piling up almost daily. The news outlets provide round-the-clock reports of additional government bailouts of companies. The bailout of the financial sector and the auto companies represents an outlay unlike any we have witnessed in the past for such a purpose. The economic stimulus package, just passed, represents the largest government expenditure in history.
Is all this going to help rescue the economy and end the recession?
To address this question, we first need to understand how we got here. In my opinion, there were three main reasons for the current economic crisis.
First, there was plentiful liquidity after the economy came out of the shallow recession induced by the tech bubble in 2001. During that time, the Federal Reserve Board kept interest rates low and the economy awash in liquidity. Moreover, wealth in emerging markets such as China coupled with high personal savings rates due to the absence of extensive Western-style social safety nets, meant that there was a lot of liquidity available in those markets as well. Much of that liquidity found its way into the U.S. through the purchases of Treasury bills and bonds as well as corporate debt and equity securities and mortgage-backed securities by foreign investors. So there was a lot of money chasing assets that originated in the U.S.
Second, the idea that the American dream of owning a house should be within the reach of every person in the U.S. was pursued to what many economists now believe was an economically unwise extreme. Written by Anjan Thakor, senior associate dean and John E. Simon professor of finance This political obsession led to housing subsidies that substantially increased incentives to be highly leveraged, at both the individual and bank levels. High leverage always leads to high financial fragility. Moreover, there was political intervention to spur homeownership, even at the expense of prudent risk management by leaders. There was political pressure on Fannie Mae and Freddie Mac to make affordable housing more accessible via initiatives in mortgage securitization, as well as pressure on banks to be more aggressive in low-income loan origination and less aggressive in foreclosures after delinquency in repayments. For example, in 1996 the probability of foreclosure on a home conditional on 90-day delinquency was about 70 percent. By 2003, this had fallen to 25 percent. Why? Because mortgage lenders were now operating in an environment of lax credit, with pressure to ease up on foreclosures. To add to this, Congress passed legislation in 2006 to induce Moody’s and Standard & Poor’s to accept Fitch’s more lenient ratings of mortgages that went into collateralized debt obligations. As an overall consequence of these and related developments, risk management became substantially weaker in the whole financial system as the subprime mortgage market exploded. This led to a surge in the demand for liquidity to finance these assets. Given the fact that the supply of liquidity was high because of U.S. monetary policy and the actions of foreign investors, a perfect storm of high-demand-meets-high-supply began to brew!
Third, one cannot overlook the role of hubris. Part of the reason why investors found it attractive to buy securitized claims against pools of subprime mortgages is that they were earning high returns, and many investors believed the risk was not commensurately high because the mortgage pool against which the securitized claims had been issued was diversified. So if house prices fell in one area - say, California - the losses would be offset by an increase in house prices in another area - say, New York. As long as house prices did not decline nationally, investors would be fine. Similarly, lenders made mortgage loans under the assumption that house prices would always keep going up. And since we had not had a national housing price decline since the 1930s, it seemed like a safe bet that we were not going to see a national housing price decline anytime soon. Subsequent events have exposed the obvious fallacy in this reasoning – house prices nationally have declined about 6 percent in the past 1 1/2 to two years. Thus, many securitized assets had risks that were improperly managed by many financial institutions.
These factors led to the current crisis, which began when defaults began to pile up and banks subsequently began to get into trouble. In ordinary times, the government would have allowed banks such as Bear Stearns (which had no insured deposits) to fail. But with the increasing intertwining of banks and markets (see my forthcoming essay with Arnoud Boot, “The Accelerating Integration of Banks and Markets and Its Implications for Regulation,” in the Oxford Handbook of Banking*), Bear Stearns was considered too interconnected to fail in the sense that, because its failure could cause others to fail as well, the government would not allow it to fail. In any case, the interconnectedness of various players in the financial market caused the crisis to spread quickly like a virus through the whole system. As the surviving institutions witnessed this, they recognized that their own continued survival depended on “hunkering down” and preserving liquidity. Consequently, the interbank liquidity market dried up and credit extension came virtually to a grinding halt. The crisis was in full swing.
Now, let us examine the proposed cures to get us out of this crisis.
First, the government initially thought that since liquidity had dried up, the solution would lie in lowering interest rates and flooding the economy with money. Unfortunately, this is one of the reasons why we are in this mess. This initiative didn’t work, and it’s easy to see why.
Next, Treasury Secretary Henry Paulson and the Bush administration said that the government would buy all the toxic assets that were dragging down banks’ balance sheets. This would leave them with healthier balance sheets, and they could go about their business of borrowing and lending again. The problem with this was fundamental – how does one value these toxic assets, especially when there is virtually no trading going on? And even if one could value them correctly, they were likely to be worth so little that banks would be left with highly depleted equity positions when the asset sales were recorded on their balance sheets.
The third initiative involved the government addressing the “equity hole” problem on banks’ balance sheets directly by injecting equity via purchases of preferred stock in these institutions. Surprisingly, two simple rules for taking equity positions were not followed by the government: (1) If you buy preferred stock, you have to put restrictions on the ability of banks to pay common stock dividends. (2) In exchange for providing capital, you have to have corporate governance representation via government representatives on the boards of directors of these banks. So what happened? As the government injected billions of dollars into these banks, the banks took the money and paid dividends to their common stockholders, paid out handsome executive bonuses, and purchased other banks. The crisis did not abate.
What does the government need to do now?
The first step should be the establishment of something akin to the Resolution Trust Corp., which was created during the Savings & Loan crisis. Such an organization can attend to the orderly acquisition and disposal of troubled assets from banks, in contrast to the spasmodic reactions that we have witnessed.
Second, we could establish bridge banks. These are created when the government acquires troubled institutions for a short time, say, 18 months to two years. During this time the government has the right to change management, the time to examine the banks’ books carefully, and determine appropriate asset values. Also, with government ownership, the incentives of managers in the bank are realigned with the social optimum, troubled assets are segregated (perhaps into a separate organization called “the bad bank”) and the bank is slowly brought back to health. Eventually, the bank is sold off through a re-privatization program that enables taxpayers to gain from the upside associated with selling the bank in a healthier market.
Let me close by remarking briefly on the stimulus package of over $800 billion. While some components of this package have merit, it rests on two troubling premises: (1) that government spending is the solution to the problem and (2) that without this stimulus, the crisis will prolong. I am not entirely convinced about either premise. In particular, providing incentives to individuals to borrow more to buy more stuff – such as tax breaks for buying new cars – only adds to the factors that contribute to greater personal leverage and financial fragility, which is not what we need right now. And while there are elements in the stimulus package that can help revitalize the economy, there is far too great an allocation of resources to items that will do little to stimulate the economy.
Ultimately, we will get out of the crisis because we will get the banking system to start lending again and because of two traditional strengths of the U.S. economy – private entrepreneurship (including risk taking) and innovation. Encouraging these should be the focus of government intervention. A simple way to do this is by to provide tax breaks and other subsidies for these activities. In this regard, providing additional resources to the National Institute of Health was a good idea, but reducing money initially allocated in the stimulus package to the National Science Foundation was not a great idea. A more ambitious way is to invest more in the infrastructures related to these activities. Places such as Silicon Valley, companies such as Google and Microsoft, and our fine research universities are the envy of the rest of the world. Let us invest in strengthening those institutions rather than simply assuming that throwing enough money at a problem is bound to produce some good results.
Written by Anjan Thakor, senior associate dean and John E. Simon professor of finance
*Oxford Handbook of Banking, Edited by Allen N. Berger, Phillip Molyneux and John Wilson, September 2009, Oxford University Press
