Why do we need yet another discussion of the 2007-09 financial crisis and its aftermath? That question is asked and answered by Alan S. Blinder in his new book, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. Blinder provides new details about this harrowing chapter in our financial history and valuable insights about the effectiveness of potential regulatory policies.
“A comprehensive history of this episode is yet to be written,” writes Blinder, an economics professor at Princeton and former vice chairman of the Board of Governors of the Federal Reserve. “ The American people still don’t quite know what hit them, how and why it happened, or what the authorities did about it.”1
“One day,” he foresees, “some ambitious historian will put everything together in a two-thousand-page tome.”
Blinder’s goal is to be comprehensive but shorter. He succeeds rather well.
His book fills in many gaps, providing explanations of events and why they happened that are missing from other books about the crisis. A few surprising details emerge. Blinder takes definite positions about what he believes should have been done instead of what was done. These are positions he took publicly at the time. He also explains why others took opposite positions.
The pivotal events
The first pivotal events – which signaled subprime mortgage funds might not be worth what they were thought to be worth – occurred in July and August of 2007. Bear Stearns, the fifth-largest U.S. investment bank, admitted that July that one of its mortgage-related hedge funds might be worthless. Then on Aug. 9, the large French bank BNP Paribas suspended withdrawals from three of its subprime mortgage funds.
But it was not until over a year later, with the Lehman bankruptcy on Sept. 15, 2008, that the house of cards built on subprime mortgages abruptly fell.
Blinder explains why it was such a big deal when following that event, money-market funds “broke the buck,” meaning they were worth less than $1 per share. Several investment banks, to increase their leverage, had established off-balance-sheet structured investment vehicles (SIVs) to invest in collateralized debt obligations (CDOs). The banks funded these SIVs by issuing short-term commercial paper, implicitly backed by their sponsors – which included most notably Citigroup as well as Lehman and others. Their sponsors could, while still adhering to the capital requirements rules, leverage their capital in the SIVs by more than 50-to-1.
Meanwhile, money-market funds, searching for higher yield to compete with interest rates on ordinary bank account deposits, had begun investing in corporate commercial paper. Because of their higher yields, money funds had accumulated assets of $3.4 trillion in September 2008. When Lehman declared bankruptcy, the Reserve Primary Fund, the oldest money-market fund, had $785 million invested in Lehman commercial paper. Although this was only 1.2% of the fund, the Reserve Primary Fund could only redeem shares at 97 cents a share when investors came by the droves to redeem their funds.
This doesn’t seem like a very big deal – redemptions for three cents a share less than the one dollar expected – but it made investors in money funds realize suddenly that these weren’t insured like bank accounts were. That sent them scurrying to redeem their money fund investments – which required the money funds to liquidate some of their commercial paper investments.
But the commercial paper market was experiencing the shock of the Lehman bankruptcy. It became difficult not only to sell Lehman commercial paper, but also to sell commercial paper of other companies. The redemptions from the money funds drove the value of commercial paper down and made it more difficult for corporations to borrow on the commercial paper market.
But corporations were accustomed to funding their cash-flow needs this way, so a breakdown in the commercial paper market endangered their normal cash outlays. Blinder identifies the ultimate concern: “rumors that blue-chip companies like General Electric and IBM might be unable to meet payroll.”
This explains why the federal authorities felt the need to step in hurriedly and massively. Treasury secretary Hank Paulson made use of one of the sources of funds at his disposal, the Exchange Stabilization Fund (ESF – intended to prevent runs on the dollar), to insure money-market fund balances.
But in the rush of events, a terrible error was almost made. The initially planned policy was to insure all the deposits in money-market funds. But since bank deposits were insured by the Federal Deposit Insurance Corporation (FDIC) only up to $100,000 at the time, insuring money-market fund deposits up to an unlimited amount would cause a sudden and massive withdrawal of bank deposits. Blinder asks, “Why would anyone keep more than $100,000 in a bank deposit when they could get full insurance by moving the balance to a money fund?”
In the end, “well-justified howls of protest from bankers and their lobbyists” caused the Treasury to correct its error and reduce the amount insured. But the episode shows how when “hot money” starts to flow like a river of fast-moving lava, when something goes wrong it can have an instant and dramatic effect.
How did it happen?
Blinder recites the litany of errors that led up to the crisis. Though the errors and circumstances are now familiar, seeing them strung together in rapid succession reinvigorates the incredible disbelief that this could have been allowed to happen.
Total household debt exploded between 2000 and 2008 from 100% of GDP to 140%, most of it in mortgages. Blinder asks, “Did the regulators really believe that subprime mortgage lending could expand that rapidly without deterioration of quality?” Blinder is clearly a believer in more regulation and more diligent regulators. He argues that “One of the great tragedies of the financial crisis is that bank regulators could have slammed the door on some of the more outrageous underwriting practices but didn’t.”
As we know, mortgage underwriting practices badly deteriorated because mortgage lenders could realize a tidy commission from making a loan that could be on-sold quickly to investment bank packagers of asset-backed securities. The worst loans provided the best commissions because the lowest-quality loans tended to carry the highest interest rates and fees.
Then, the ratings agencies conferred on the upper tranches of the asset-backed debt securities the unusually high triple-A rating, even though “on the eve of the crisis, only six blue-chip American corporations – names like GE, Johnson & Johnson, and Exxon Mobil – and only six of the 50 states merited the coveted triple-A credit rating,” as Blinder points out.
The triple-A rating was justified by the fact that the default risks of the mortgage-backed securities (MBS) were supposedly well diversified in the securitized instruments. But as Blinder says, “many of the MBS were not nearly as well diversified geographically as had been claimed. In fact, it turned out that a distressingly large share of the bad mortgages came from a single state: California.”
Furthermore, in what is surely the paramount outrage perpetrated by the ratings agencies and their banker collaborators, lower-rated tranches of CDOs were repackaged and retranched into CDOs-squared. In the process, the benefits of diversification were redundantly claimed a second time, justifying yet another triple-A rating for the upper tranches of the CDOs-squared. This is perhaps the worst perversion – and there are many competitors – of mathematical modeling in the investment sphere that I have ever encountered.
“Precarious construction was based on asset-price bubbles, exaggerated by irresponsible leverage, encouraged by crazy compensation schemes and excessive complexity, and aided and abetted by embarrassingly bad underwriting standards, dismal performances by the statistical rating agencies, and lax financial regulation,” Blinder says.
Blinder makes a clear distinction between financial innovations that hedge and therefore reduce risk and those that create risk. For example, credit default swaps (CDSs), though nominally hedging instruments, create risk out of nothing when bought and sold “naked.” Unlike with other insurance (and CDSs are exactly that, insurance against the default of a bond), the buyer of a CDS is not required to own the bond against whose default the CDS insures. The analogy is that buying a naked CDS is like buying fire insurance on your neighbor’s house – a practice that is generally prohibited.
When one party buys a CDS without owning the bond it insures, and another party sells it, they both assume risk that would not have existed otherwise. This risk-creation would be each party’s private concern alone, if it weren’t for the fact that counterparty risk often becomes socialized – as it did for example, when AIG sold CDS contracts covering trillions of dollars that it could in no way back up with capital reserves. Thus, when AIG defaulted, the U.S. government made good on AIG’s insurance contracts. Whether the U.S. should have done this, and whether it should have paid others in full for AIG’s failed commitments, is still being debated.
How did the government deal with the problem?
Blinder describes at length the measures that were taken to stanch the bleeding and resolve the crisis, the actions that were then taken by the Federal Reserve – and are still being practiced – to contain the economic damage and the regulatory responses he believes should be made to prevent a recurrence.
Blinder’s discussion reveals several interesting insights. First – as many U.S. taxpayers don’t know – the government’s actions wound up yielding a profit for the U.S. Treasury and therefore for the taxpayer.
Second, it turned out that the subprime default rates were not as bad as expected for many subprime instruments, simply because interest rates hit almost unprecedented lows in the aftermath of the crisis. Floating rates on option adjustable-rate mortgages (option ARMs) with low initial “teaser” rates, for example, which were virtually expected to default when the rate was jacked up, in many cases did not default because the floating rate had declined so much.
One interesting set of incidents that Blinder recounts has to do with Treasury secretary Paulson’s concerns about “stigma.” On two occasions, Paulson insisted on implementing (or not implementing) certain policy details because he did not want to stigmatize a bank and cause a run on that bank. For example, if a condition for a bank receiving a bailout was that it agree to limit its executives’ compensations, then that might “stigmatize” the bank by advertising how desperate it was to receive the bailout. It seems a little appalling that this should have really been a concern – unless it was just a cover story for the maintenance of the good-old-boy network of overpaid executives. But according to Blinder, Paulson really seems to have believed that it posed a serious problem.
The issue of stigma arose again when on Oct. 12, 2008, Paulson dragooned the CEOs of nine of the largest American banks for a Sunday meeting at which he insisted that they all receive bailout funds, whether they wanted them or not (and some of these banks, like Wells Fargo, really didn’t need them). The idea was that if banks that claimed not to need the funds did not receive them but others did, then those who did would be stigmatized, which would pose a danger to their stability.
Blinder credibly counters this concern by arguing that according to the economic theory of stigma – which apparently is an economic theory, unbeknownst to me – the only stigma that would be of concern would be something that reveals an unobservable bank weakness. Since, Blinder says, it was quite observable to anyone that Goldman Sachs and JP Morgan Chase were sounder than, say, Citigroup, the concern about stigmatizing Citigroup was a misguided one.
Government policy in the aftermath
Blinder provides insights into the monetary measures implemented by the Fed in an effort to stabilize the economy after the crisis, particularly quantitative easing (QE). “Virtually all varieties of QE,” Blinder says, “are aimed at reducing spreads – either risk spreads of private securities over Treasuries, or maturity spreads (term premiums) of longer-dated Treasury securities over shorter ones.” Risk spreads are a measure of financial distress, so reducing them is thought to relieve that distress. In fact, the chapter in which Blinder discusses QE is titled “The Attack on the Spreads.”
The Fed purchases longer-term private debt instruments, driving their prices up and their yields down by increasing demand for them. The Fed also buys long-term Treasury bonds while shorting shorter-term ones in order to reduce maturity spreads.
This reminded me, uncomfortably, of the practice of “sterilized intervention” in currency markets that governments sometimes practice to control the values of their currencies. Investopedia defines sterilized intervention as the “purchase or sale of foreign currency by a central bank to influence the exchange value of the domestic currency, without changing the monetary base.” The trouble is that sterilized intervention often doesn’t work. Nevertheless, Blinder says QE is an alternative when conventional monetary policies are not an option because interest rates are already at rock bottom.
The original Troubled Assets Relief Program (TARP) was intended to provide relief for homeowners in danger of foreclosure as well as banks in danger of bankruptcy. But in the end, little relief for homeowners was actually provided. Blinder discusses the efforts to make good on this challenge, concluding that “the Obama administration did not exactly ignore the foreclosure problem” but that progress has been slow nonetheless.
Geithner did not allocate sufficient TARP money to preventing foreclosures, Blinder says, because “he, Summers, and others in the administration were not convinced that there was a foreclosure-mitigation plan that could work on a large scale, was legal, and would have a large economic impact at reasonable cost.”
Blinder does show what difficulties were encountered. For example, mortgage-backed securities “created legal structures that made it difficult to break out individual mortgages for modification – especially when several legal entities stood between the original borrower (say, John Doe in Phoenix) and the ultimate lender (say, an Italian pension fund).”
The lesson that Blinder does not immediately draw from this example but advocates elsewhere is that the complexity of the securities structures created not only a systemic danger but also a problem in their unwinding.
This brings us to Blinder’s recommendations for the prevention of further crises. Plainly, he believes one prerequisite is that regulators believe in regulating and are diligent about it – a condition that, according to Blinder, was not prevalent during the Bush administration years as the preconditions for the crisis accumulated.
Blinder’s general prescription is that financial reforms are needed, “including having simpler securities, requiring greater transparency, standardizing derivatives, trading them on organized exchanges, and requiring mortgage originators and securitizers to keep some ’skin in the game‘ by retaining ownership of some of the mortgages.”
One particular area of reform is worth dwelling on. Blinder argues that the too big to fail doctrine should probably be called “too big to fail messily.”
I’ll offer an analogy. Suppose a tall building is built in the midst of a highly populated area. If the building’s structure is unsound, it will be too big to fail because its collapse would affect the surrounding structures and population. But that is only if it fails messily. If the building is designed so that its failure would not affect its surroundings – if it collapses inward, for example – then its failure would not be a concern for the broader populace.
So, as Blinder states, “one logical approach would be to take the messiness out. Many ways to accomplish that objective fall under a wonkish heading called ‘resolution authority’ – a mechanism to orderly unwind a business in the event of a bankruptcy or catastrophic failure.”
Resolution authority raises a host of questions about the interrelationship of government and large systemically important financial institutions (SIFIs). The Dodd-Frank Act contains an Orderly Liquidation provision that provides a way to quickly and efficiently liquidate a large, complex financial company that is close to failing.
Resolution authority can also extend to requiring a SIFI to draw up and maintain its own liquidation plan, to make it easier for government to resolve the SIFI if it is close to failing and as a means to monitor its own counterparty risks and other entanglements.
The U.S. government, for example, has a Federal Emergency Management Agency (FEMA) with the authority to set up emergency supply chains for food and other requirements in the event of a natural disaster or other contingency. Why shouldn’t we also have a federal authority to set up or shore up emergency financial supply chains in the event of disaster striking financial institutions? This, essentially, is the end goal that resolution authority gestures toward. It may be beneficial to address this possibility directly in public discourse.
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, a partner and chief investment officer of Denver-based Fair Advisors, and a project consultant at the Fung Global Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri, and George Peacock, will be published by Berrett-Koehler in spring 2014.
Read more articles by Michael Edesess