Notes on the Financial Crisis, #1

By Tom Weisskopf | October 1st, 2008

This is the first in a series of notes on the financial crisis that Tom Weisskopf, professor of economics at the University of Michigan, started writing up soon after the crisis began. We are posting the first three installments, and we'll continue to post his notes as he sends them along. —Eds.

1. The current financial crisis is broadly attributable to the system of (relatively) deregulated and globalized capitalism into which the U.S. economy is now thoroughly integrated. The origins of the globalization go back 60 years; the origins of the deregulation go back to the late 1970s, when the Carter administration began to cut back on regulation and free up markets—a process accelerated by each subsequent administration.

2. This system has contributed to overall economic growth (in the U.S. and in the world), but it has also generated greater inequality and greater insecurity almost everywhere.

3. Early signs of the problems caused by inadequate regulation of financial markets were the Savings & Loan crisis of the late 1980s, the Long-Term Capital Management Fund meltdown of the late 1990s, and the Enron scandal of 2001.

4. The timing and nature of the current financial crisis is due to the sub-prime mortgage mess, in which massive global funds looking for quick profits stimulated deceptive and fraudulent mortgage lending practices in the United States—in a context of deregulated home finance and an overheated housing boom in the first part of this decade.

5. Some economists—notably the late Ned Gramlich (former professor in the UM Economics Department and later member of the Federal Reserve Board Governor)—warned about the looming subprime mortgage disaster, but his warnings were ignored, most unforgivably by Fed Chairman Alan Greenspan.

6. An integral part of the problem was the way in which Wall Street institutions packaged and securitized risky mortgages into derivatives and other fancy and largely unregulated financial instruments, obscuring the risks and leading right into over-valuation of those instruments.

7. Now we’re seeing the inevitable bust following the housing and mortgage lending boom, which has led to enormous difficulties in people’s ability to make mortgage payments (often at sharply-upward-adjusted interest rates). People who were promised that they could borrow off of ever-rising home equity see their home values dropping by 10-20-30%, can’t keep up with their mortgage payments, and face foreclosure on their home. Experts believe that prices are likely to fall still further, and that there will be mounting foreclosures for another year or two.

8. The result is that many banks and other financial institutions around the world are now carrying a lot of “toxic” assets, worth much less than they were acquired for because they include so many loans that can’t be repaid. This means that they have to write down their asset base, forcing them to look for new sources of capital to avoid being vastly over-leveraged (too many loans out relative to their assets) and making it very hard for them to meet short-term obligations (loans that they themselves have to pay back in the short run).

9. With many financial institutions facing the same kinds of problems, and all of them highly inter-connected, most are looking for short-term credit (loans) and hardly any are ready to provide it—except at an exorbitant cost—because they fear, rightly, that they may not be paid back. Thus the most vulnerable financial institutions have already failed (Lehman Brothers) or have had to be bailed out by the U.S. Treasury (Bear-Sterns, Fannie Mae, Freddie Mac).

10. These failures—and the likelihood of more to come—have destroyed financial market confidence (in debtors’ ability to pay) and have accelerated what amounts to a freeze-up of credit—the “blood” of the economic system, without which businesses large and small—not to mention purchasers of consumer durables like autos—simply cannot do business.

11. So financial institutions have all these toxic assets (which they originally created), none of them trust anyone else’s estimate of the value of these assets, and hardly any of them are willing to lend to anyone else. And because the U.S. financial system is so thoroughly integrated into a financial network that is now truly global (no more iron curtains walling off capitalist finance), few financial institutions or countries around the world can escape being adversely affected by the loss of confidence and the lack (or high cost) of credit originating in the United States.

12. All of the above means that something must be done to restore confidence and credit, or the whole system will plunge into a serious global recession—quite possibly a depression on the scale of the 1930s. The unfortunate fact is that you can’t save the average person (“Main St.”) without saving the financial institutions (“Wall St”).

13. Does this mean that the Paulson/Bernanke $700 billion bailout plan is the answer? YES and NO.

14. YES: something really big—of this order—must indeed be done. The government has to take responsibility for clearing out most of the toxic assets that are poisoning the system, and this means buying them at a discount from the financial institutions holding them. Otherwise the economy tanks, and everyone loses. But NO, it doesn’t have to be done the way PB have proposed to do it.

15. What’s wrong with the PB proposal, as originally presented?

• (a) it has far too little transparency or accountability (Paulson gets far too much power);
• (b) it does not give the U.S. Treasury a plausible way to recoup a significant portion of the bailout money if/when the system reboots, so as to spare taxpayers the full cost of the bailout;
• (c) it does not punish the people whose short-run self-interested actions led to the crisis;
• (d) it does not give any help to all of the bad-mortgage borrowers who have suffered from foreclosures or are vulnerable to doing so in the future;
• (e) it does nothing to change the under-regulated financial environment that made the crash possible.

16. A good bailout bill needs to address all of the above—except perhaps for (c), which simply can’t be adequately accomplished because it’s too late to catch and punish most of the culprits, who have taken their money and run. Here are some reasonable suggestions that have been made to address the above concerns:

• (a) set up an accountable review board to monitor the whole bailout process and provide full information to all parties concerned;
• (b) insist that the U.S. Government get a significant equity claim on the future profits of any institution that it bails out by buying up its toxic assets (e.g., by getting preferred shares in the firm, reducing taxpayers’ downside risk and insuring that they participate in some of the upside potential);
• (c) limit compensation (and end golden parachutes) for executive officers of rescued firms;
• (d) allow mortgage-stressed borrowers to declare personal bankruptcy when they simply cannot meet their payments and enable courts to restructure their mortgages, and/or set up a new Home Owners Loan Corporation—as during the New Deal—that can buy mortgages from people who are in danger of losing their houses and convert them into obligations they can afford to repay;
• (e) develop new and effective regulations to keep financial institutions within reasonable bounds, making their operations much more transparent and limiting the extent to which they can leverage their capital and trade in complex and risky instruments. A related idea is to apply a tax on financial transactions, which would reduce speculation-based market volatility; the proceeds could be used to help defray the costs of bailouts already implemented by the U.S. Treasury.

17. But given current political realities, is there any chance that a better plan can actually be enacted? Here is the current state of play in Congress:

• (a) the bill that was defeated in the House on Monday was somewhat better than the original PB plan—thanks largely to Democrats like Chris Dodd and Barney Frank—who insisted on improvements addressing concerns 15a and 15b above;
• (b) House Democrats on the Left—the 100-odd who voted against the Monday bill—would probably be prepared to support a plan that looks much more like what I have outlined under point 16 above;
• (c) House Republicans on the Right—the more than 100 who voted against the Monday bill—want no bailout bill at all; they still believe that problems can best be solved by private enterprise operating in lightly regulated markets with minimal government intervention, and that people and institutions will be best off just having to sink or swim on their own;
• (d) “moderate” Democrats and Republicans, who support the Monday bill, proved to be 12 votes short of a majority in the House; but they have a large majority in the Senate. So the issue is really what it will take to get a House majority behind a bailout plan.

18. The moderates are trying to design a plan that will attract more votes in the House. If they move the plan to the Left or to the Right, they will probably scare away as many votes on one side as they would pick up on the other. So they are looking for “sweeteners” that could persuade some marginal Congresspeople on each side to join them—such as higher limits on FDIC deposit insurance, some effort to limit executive compensation in bailed-out firms, and some tax cuts (which would in effect raise the cost of the bailout). Because they have now gotten fairly strong support from both Barack Obama and John McCain, they are likely to succeed when the House gets around to voting once again on a bailout plan.

19. Which means that the worst scenario—no bailout, a further collapse of confidence and credit, and a likely depression—will most probably be averted. But the U.S. public will be stuck with a very costly bailout plan that will greatly cramp the economic programs of the next President, and which fails do much for those who have suffered the most from the crisis (except to protect them, and the rest of us, from a worse fate). Apparently Barack Obama has said that he would try to deal with the myriad economic problems neglected by the bailout plan he supports—see in particular concerns 15d and 15e above—once he becomes President. For that he would need, at the very least, a large swing to the Left in the coming Congressional elections.

Tom Weisskopf is a professor of economics at the University of Michigan.