The 2008 Financial Crisis: Causes, Response, and Consequences
Causes and Consequences of the Financial Crisis of 2007 to 2009
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8/3/2019 Causes and Consequences of the Financial Crisis of 2007 to 2009
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CAUSESANDCONSEQUENCESOFTHEFINANCIALCRISISOF20072009
WILLIAMPOOLE*
Bytheearlyfallof2009,thebusinesscontractionthatbeganinDecember2007appearedtobeending,1buttheoutlook,remainedhazy.Despiteanumberofgreenshoots,asFederalReserveChairmanBenBernankelikedtoputit,2thedatawerenotdecisiveenoughtodeclaretheendofthecontraction.Employmentwasstill falling throughSeptember2009.3Although
inOctober
2009
it
certainly
seemed
that
the
economy
was
near
thebottom, itwasnot safe to say that thecrisiswashistory.4Nevertheless,much isalreadyknownabout thecausesof thefinancial crisis and government responses to it, permitting amuch more than speculative review. David Wessel has providedasuperbblowbyblowaccountofeventsduringthecrisis;5 there is no point in repeating that account here.Nevertheless,abriefchronologyof thephasesof the financialcrisisshouldhelptoorganizethediscussion.
*Senior
Fellow,
Cato
Institute;
Distinguished
Scholar
in
Residence,
University
of
Delaware.Attitudestowardthecrisisare, inevitably,shapedby theperspectiveoftheobserver.MyownperspectiveisthatofaChicagoschooleconomistwithstronglibertarianleanings.Myperspectiveisalsoshapedbymytenyears(March1998toMarch2008)aspresidentandCEOoftheFederalReserveBankofSt.Louis.
1.NATL BUREAU OF ECON. RESEARCH, DETERMINATION OF THE DECEMBER 2007PEAK INECONOMICACTIVITY(2008);BD.OFGOVERNORSOFTHEFED.RESERVESYS.,SUMMARY OF COMMENTARY ON CURRENT ECONOMIC CONDITIONS BY FEDERALRESERVEDISTRICT,OCTOBER2009,ativi(2009)[hereinafterCURRENTCONDITIONS].
2.ShobhanaChandra&MatthewBenjamin,BernankeGreenShootsMaySignalFalseSpringAmidJobLosses, BLOOMBERG.COM, Apr. 6, 2009, http://www.bloomberg.com/apps/news?pid=20601103&sid=aJa8WNMvKaxg.
3.SeePressRelease,BureauofLaborStatistics,U.S.DeptofLabor,TheEmploymentSituationFebruary2010,at1(Mar.5,2010),availableathttp://www.bls.gov/news.release/pdf/empsit.pdf.
4.
See
CURRENT
CONDITIONS,
supra
note
1,
at
i.
5.DAVID WESSEL, IN FED WE TRUST: BEN BERNANKES WAR ON THE GREATPANIC(2009).
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I. CHRONOLOGYOFTHEFINANCIALCRISISThecrisisbrokeinmidAugust2007,whenthemarketsuddenly
cutoff
funding
to
several
financial
entities.
6
The
Federal
Reserves
initial response inAugustwas to reduce thediscount ratetheinterestratetheFedchargesonloanstobanksinthehopethatbankscouldprovidefundstofirmscutoffbythemarket.7
InmidSeptember2007,theFedbegantocutitsmainpolicyinterestrate,thefederalfundsrate.Theratehadstoodat5.25%fromJune2006throughAugust2007.8AlthoughtheFedordinarilychanges its fed fundsratetarget instepsoftwentyfivebasispoints,thefirstreductioninSeptemberwasbyfiftybasispoints.9As financial strainsgrew and the economygraduallyweakened, the Fed continued to reduce its fed funds targetrate,reaching3%inlateJanuary2008.10
Inmid
March
2008,
financial
strains
intensified
as
the
market
cutoff funding toBearStearns,a largeNewYork investmentbank.11 To prevent Bear Stearns from failing, the Federal Reserveprovidedanemergencyloanandassumedthecreditriskon some Bear Stearns assets, which persuaded JP MorganChase tobuyBearStearns.12A fewdays later,theFederalReserve cut its federal funds rate target by seventyfive basispoints,down to2.25%.13TheBearStearnsbailoutmarked theendofthefirstphaseofthefinancialcrisis.
6.CONG. RESEARCH SERV., FINANCIAL CRISIS? THE LIQUIDITY CRUNCH OFAUGUST2007,at9(2007).
7.PressRelease,Bd.ofGovernorsoftheFed.ReserveSys.,FederalReserveBoardDiscount Rate Action (Aug. 17, 2007), available at http://www.federalreserve.gov/newsevents/press/monetary/20070817a.htm.
8.Fed.ReserveBankofN.Y.,HistoricalChangesof theTargetFederalFundsandDiscount Rates, http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html(lastvisitedMar.24,2010).
9.Id.10.Id.11.TurmoilinU.S.CreditMarkets:ExaminingtheRecentActionsofFederalFinancial
Regulators:HearingBefore theS.Comm. onBanking,Hous.&UrbanAffairs, 110thCong. (2008) (statementofBenS.Bernanke,Chairman,Bd.ofGovernorsof theFed.ReserveSys.).
12.
Minutes
of
the
Bd.
of
Governors
of
the
Fed.
Reserve
Sys.
(Mar.
16,
2008),
avail
ableathttp://www.federalreserve.gov/newsevents/press/other/other20080627a2.pdf.13.Fed.ReserveBankofN.Y.,supranote8.
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InApril,theFedlowereditsfundsratetargetanothernotchto2%,whichithelduntilSeptember.14Duringthissecondphaseofthe crisis, the economy was drifting downward,but not at an
alarmingpace.
This
phase
ended
with
the
Lehman
crisis.
The
FeddidnotbailoutLehmanBrothers,aninvestmentbanktwicethe size of Bear Stearns, and Lehman declaredbankruptcy onSeptember 15.15 Lehmans collapse marked the beginning ofphasethreeofthecrisis,whenmarketstrainswentfromserioustocalamitous.TheFedbailedoutAmericanInternationalGroup(AIG),ahugeinsurancecompany,thedayafterLehmanfailed.16InOctober2008,theFedcutitstargetfundsrateintwostepsto1%andfurthertonearzeroinDecember.17
TheflighttosafetywassointensethatinNovemberandDecember2008themarketbidtheyieldonTreasurybillsliterallyto zero on some days.18 Credit strains were severe and eco
nomicactivity
declined
sharply.
There
is
no
particular
date
or
event to mark the end of phase three of the crisis; marketsgradually improved and the economy transitioned to phasefour,inwhichcreditconditionsbecamemoresettledandcreditbegantoflowagain.
The financial crisis was worldwide, with EuropeanbanksandmarketsasseverelyaffectedasthoseintheUnitedStates.19AsianbankswerestrongerthanU.S.andEuropeanbanks,butAsiacouldnotescapetheeffectsofthecrisis.20Outputandemploymentfellaroundtheworld.
14.Id.
15.PressRelease,LehmanBrothers,LehmanBrothersHoldingsInc.AnnouncesIt Intends to File Chapter 11 Bankruptcy Petition (Sept. 15, 2008), available athttp://www.lehman.com/press/pdf_2008/091508_lbhi_chapter11_announce.pdf.
16.Press Release, Bd. of Governors of the Fed. Reserve Sys., Federal ReserveBoard,withfullsupportof theTreasuryDepartment,authorizes theFederalReserve Bank ofNew York to lend up to $85billion to the American InternationalGroup(AIG)(Sept.16,2008),availableathttp://www.federalreserve.gov/newsevents/press/other/20080916a.htm.
17.Fed.ReserveBankofN.Y.,supranote8.
18.JohnWaggoner,Investorsrushtoearnnothing:4weekTbillssell likehotcakesat0%interest,USATODAY,Dec.10,2008,at1B.
19.OutputSlumpsAcrossEurope,EURONEWS,Oct.12,2008,http://www.euronews.net/ 2008/12/10/outputslumpsacrosseurope/.
20.BenS.Bernanke,Chairman,Bd.ofGovernorsof theFed.ReserveSys.,Ad
dressat
the
Federal
Reserve
Bank
of
San
Franciscos
Conference
on
Asia
and
the
GlobalFinancialCrisis:AsiaandtheGlobalFinancialCrisis(Oct.19,2009),availableathttp://www.federalreserve.gov/newsevents/speech/bernanke20091019a.htm.
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II. CONDITIONSLEADINGTOTHECRISIS21Afterthestockmarketpeakin2000andtoresistthe2001re
cession,the
Fed
reduced
its
target
federal
funds
rate
in
steps,
eventually reaching 1% in 2003.22With interest rates low andmemoriesofthedotcomstockcrashfresh, investorssearchedfor higher yielding investments. They thought that they hadfound the perfect vehicle in collateralized debt obligations(CDOs)backedbysubprimemortgages.TheCDOswerestructuredobligations,withseveraltranchesofdifferingriskcharacteristics. The senior tranche had first claim on the mortgageinterestandprincipalpaidby the subprimemortgages in themortgage poolbacking each CDO issue. The senior trancheswereratedtripleAbytheratingagencies.23
As the decade proceeded, underwriting standards for sub
primemortgages
deteriorated.
Mortgage
brokers,
who
origi
nated the subprime mortgages, lent to households withoutadequate incomeorassets to service the mortgages.24 Incomeand assetdocumentationwas weak or nonexistent.25 Some ofthe mortgageborrowerswere investors anticipating quick resaleofthepropertiestheypurchasedtheflippers.26Nevertheless, the market was so hungry for yield that investmentbanks found that they could easily package subprime mortgages intoCDOsandpeddle them to investors.Toomany investors, unfortunately, took the tripleA ratings at face valueandloadedtheirportfolioswiththeCDOs.
Citigroupisagood,butbynomeansunique,example.Citihad
formed
structured
investment
vehicles
(SIVs)
as
off
balance
sheet
entities to hold CDOs.27 Because mortgages return principalgradually over a period of years, these CDOs were inherentlylongtermassets for theSIVs.TheSIVs financed theirpurchases
21.Foramorecompletetreatment,seeWilliamPoole,TheCreditCrunchof200708:LessonsPrivateandPublic,44BUS.ECON.38(2009).
22.Fed.ReserveBankofN.Y.,supranote8.
23.RogerLowenstein,TripleAFailure,N.Y.TIMES,Apr.27,2008(Magazine),at36.24.KurtEggert,TheGreatCollapse:HowSecuritizationCausedtheSubprimeMelt
down,41CONN.L.REV.1257,1276(2009).
25.Id.at128182.
26.
Id.
at
128889.
27.ArthurE.Wilmarth,Jr.,TheDarkSideofUniversalBanking:FinancialConglomeratesandtheOriginsoftheSubprimeFinancialCrisis,41CONN.L.REV.963,1033(2009).
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mostly withborrowed funds, not equity.28 Moreover, theborrowed funds were often in the form of shortmaturity, assetbackedcommercialpaper.29Commercialpaperissimplyacorpo
rateIOU,
and
the
asset
backing
for
each
commercial
paper
issue
wasapackageofCDOs.Thecommercialpaperwasshort term,withmaturitiesofthirtydays,sixtydays,orevenovernight.
When the financialcrisisbroke inAugust2007,commercialpaper investors no longer rolled over their maturing paper.30Theydemanded tobepaid incash instead. In thecaseof theCitigroupSIVs,CiticouldhavelettheSIVsdefault,butinsteadbrought the assets onto itsownbalance sheetand repaid thematuring commercial paper.31 Doing so put great strain onCitigroupitself.
Thefederalgovernmentencouragedgrowthofthesubprimemortgage market in an attempt to increase the percentage of
familiesowning
their
own
homes.32
Congress
and
the
Bush
Administration pushed the giant mortgage intermediaries,Fannie Mae and Freddie Mac, to accumulate subprime mortgages.33Previously,FannieandFreddiehaddealtonlyinprimemortgageswithamaximum loantovalue ratioofeightypercent.34 The mainbusiness of these governmentsponsored enterprises (GSEs) was to securitize prime mortgages intomortgagebacked securities, someofwhich they sold into themarket and some ofwhich theyheld in their ownportfolios.Other federal policies also encouraged home ownership andgrowthofthemortgagemarket.
House construction led the way to faster economic growth
afterthe
2001
recession.35
Federal
policies
that
encouraged
28.Id.
29.Id.30.Id.31.Id.; see also INTL MONETARY FUND, GLOBAL FINANCIAL STABILITY REPORT:
CONTAINING SYSTEMIC RISKS AND RESTORING FINANCIAL SOUNDNESS 72 (2008)(explaininghowconsolidationofSIVsimpactsacompanysbalancesheet).
32.RussellRoberts,HowGovernmentStokedtheMania,WALLST.J.,Oct.3,2008,atA21.33.Id.34.U.S. GOVT ACCOUNTABILITY OFFICE, FANNIE MAE AND FREDDIE MAC:
ANALYSIS OF OPTIONS FOR REVISING THE HOUSING ENTERPRISES LONGTERM
STRUCTURES
2
n.7
(2009).
35.LawrenceH.White,FederalReservePolicyandtheHousingBubble,29CATOJ.115,119(2009).
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housingandanincreaseinhousepricesfedtheboom.36Mortgages,bothprimeandsubprime,appearedtobereasonablysafeinvestmentsbecause aborrower in distress could refinance or
sellthe
property
for
enough
to
repay
the
mortgage.
As
house
prices leveledoff in2006,andadjustableratemortgages takenoutinthelowinterestrateenvironmentof20032004begantoadjustup, themusic stopped.37Defaultsbegan to rise,and inmid2007,somefirmshadtroublefinancingtheirpositions.38
Analystscontinuetoargueabouthowmuchresponsibilityforthefinancialcrisisbelongstothefederalgovernment.Myviewis that the federalgovernment was a supporting actorbut theresponsibility rests primarily with theprivate sector. The governmentdidnotmakeorevendirectlyencourageBearStearnsto sponsor hedge funds investing in subprime CDOshedgefundsthatcollapsed inJuly2007.Citigroupwasnotcompelled
toform
its
SIVs
holding
subprime
assets.
It
did
so
in
part
to
take
assetsoffitsbalancesheettoescapebankcapitalrequirements.NordoIfaultlaxregulation.Thefundamentalproblemwas
a failure of economic analysis inboth the private sector andamongregulatoryagencies.Neithermarketparticipantsnorfederal agencies thought that a significant decline in the nationalaverageofhousepricescouldoccur.The failure tounderstandfullytherisksofsubprimemortgagesandtoforeseethedeclineinhousepricesmightbeanhonestmistakeofportfoliomanagersand federalauthoritiesalike.Buildingportfolioswith riskylongmaturityassetsfinancedwithlittleequitycapitalandshortmaturityliabilities,however,isaninexcusablemistake.Thefed
eralgovernment
pursued
policies
to
encourage
home
owner
ship, but that fact cannot justify the portfolio policies thatcrashed. The privatesector managers of firms thatbuilt suchportfoliosbeartheresponsibilityforbuildinghousesofcards.
36.Roberts,supranote32.37.SeePressRelease,S&PIndices,HomePricesContinuetoSendMixedMessages
as2009ComestoaCloseAccordingtotheS&P/CaseShillerHomePriceIndices(Feb.23,2010)(showingagraphdepictingthefallinhousingpricesin2006).
38.RandallS.Kroszner,Governor,Bd.ofGovernorsof theFed.ReserveSys.,
Addressat
the
Consumer
Bankers
Association
2007
Fair
Lending
Conference:
The
Challenges Facing Subprime Mortgage Borrowers (Nov. 5, 2007), available athttp://www.federalreserve.gov/newsevents/speech/kroszner20071105a.htm.
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III. THEFEDERALGOVERNMENTSMANAGEMENTOFTHECRISIS
Althoughthe
National
Bureau
of
Economic
Research
did
not
of
ficiallyidentifythecyclepeakinDecember2007untilayearlater,39afterAugust2007thefinancialstresswasobvious,asweresignsofaweakeninginthegeneraleconomy.TheFederalReservewasthefirstrespondertothecrisis;fiscalpolicyresponsescamelater.
Tounderstand theFedsmanagementof thecrisis, it is importanttodistinguishmonetarypolicyfromcreditpolicy.Monetarypolicyinvolvescentralbankcontroloverinterestratesandtheaggregatequantityofcentralbankfundsinthesystem.TheFedsmainmonetarypolicy instrument is the federal funds interestrate,whichistherateonovernightloansbetweenbanks.Traditionally,theFedcontrolsthisratethroughpurchasesand
salesof
government
securities
in
the
open
market.
Credit policy refers to the centralbanks efforts to providefunds toparticularborrowersorborrowing sectors.From thebeginning,theFedhadacreditorientedviewastohowtorespondtothecrisis.ItsfirstpolicyactioninAugust2007,asthecrisisbegan,wasnot toreduce its fed funds targetratebut instead to lower the discount rate, which is the rate the Fedchargeson its loans tobanks.40Thediscountratehad forsomeyearsbeenonehundredbasispointsabovethefedfundstargetrate,buttheFedcutthemargintofiftybasispointsonAugust17,2007.41Predictably,thatactionhad littleeffectbecausemostbankswerestillabletoborrowreadily inthemarketatthefed
funds
rate,
which
was
fifty
basis
points
cheaper.
ManyintheFedthoughtthatstigmaexplainedwhybanksusedthediscountwindowsosparingly.42Banks,theythought,wereunwilling toborrow from thewindowbecausedoingsowould be a sign to the market of financial weakness, eventhough theFedmaintained the confidentialityof theborrow
39.SeeNATLBUREAUOFECON.RESEARCH,supranote1.40.SeePressRelease,Bd.ofGovernorsoftheFed.ReserveSys.,supranote7.41.Fed.ReserveBankofN.Y.,supranote8.
42.Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys.,
Addressat
the
Federal
Reserve
Bank
of
Richmond
2009
Credit
Markets
Sympo
sium: The Federal Reserves Balance Sheet (Apr. 3, 2009), available at http://www.federalreserve.gov/newsevents/speech/bernanke20090403a.htm.
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428 HarvardJournalofLaw&PublicPolicy [Vol.33
ing.43TheFedsearched foranothermechanism to injectmorefundsintothebankingsystemandinDecember2007launchedtheTermAuctionFacility,orTAF.44TheTAFwasatypeofdis
countwindow
borrowing
in
which
the
Fed
auctioned
off
blocksoffundstothehighestbidders.45TheTAFdidnot,however,solvethebasicproblemthatthe
banks andbank credit markets faced. As the crisis deepened,mostbankswerereportinglargelosses;discountwindowlending,includingthatthroughtheTAF,wascollateralized.46Banksretainedthecreditriskonthecollateral.AtthetimeoftheLehmanfailureinmidSeptember2008,TAFcreditoutstandingwas$150billion,butavailabilityofTAFfundsdidnothingtomakebanks more willing to lend to Lehman or other riskyborrowers.47Thus,theTAFdidlittletoimprovebankcreditavailability.
NordidtheTAFdomuchtobringdownbanklendingratesto
creditworthyborrowers.
A
bank
borrowing
from
the
Fed,
even
at
theattractiveTAFauctionrate,couldchooseeithertomakenewloanswith the fundsor to let itsother liabilities,suchascertificatesofdeposit(CDs),runoff.Thus,themarginalcostofmakinganewcommercialloanwasstilltheCDrateandnottheTAFauction rate. Essentially, TAF provided a modest increase inbankearningsbecausetheTAFborrowingratewasbelowabankscostoffundsfromothersources,suchasfromissuingCDs.TheTAFdidnotsolvetheassetliabilitydurationmismatchproblembanksfaced. Banks held substantial longerterm loans financed withshorterterm funds.Even theninetydayTAF fundsdidnotaddressthisproblem.Atbest,theTAFwasastopgapmeasurethat
didnot
address
the
fundamentals
of
the
financial
crisis.
As TAF funds outstanding grew, and as the Fed inventedotherspecialfacilitiestoeasecreditstrainsinparticularsectorsof themarket, theFeddidnot increase the total funds itmade
43.Id.44.PressRelease,Bd.ofGovernorsoftheFed.ReserveSys.,FederalReserveand
other centralbanks announce measures designed to address elevated pressures inshorttermfundingmarkets(Dec.12,2007),availableathttp://www.federalreserve.gov/newsevents/press/monetary/20071212a.htm.
45.Id.46.Id.
47.Press Release, Bd. of Governors of the Fed. Reserve Sys., Federal Reserve
andother
central
banks
announce
further
coordinated
actions
to
expand
signifi
cantly the capacity to provide U.S. dollar liquidity (Sept. 29, 2008), available athttp://www.federalreserve.gov/newsevents/press/monetary/20080929a.htm.
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availabletothemarket.JustbeforetheLehmanfailure,totalreservebankcreditwasonly3.6%abovethefigureayearearlier,whichdidnotevidenceanexpansionarymonetarypolicy.48The
Fedhad
reduced
its
fed
funds
target
rate,
but
the
reductions
hadbarelykeptpacewiththedeclineinthedemandforfundsinthemarket.Althoughtotalreservebankcredithadgrownby$30billion over the fiftytwo weeks prior to midSeptember2008,theFedsholdingsofgovernmentsecuritieshaddeclinedby$300billion.49Duringthisphaseofthecrisis,theFed ineffectfinancedtheBearStearnsbailout,theTAF,andotherspecial credit facilities by selling government securities from itsportfolio.50Theeasiercreditpolicywasnotreinforcedbyanincreaseintheaggregatesupplyoffundstothemarket.
WhethertheFedshouldhavepursuedamoreexpansionarymonetary policybefore Lehmans collapse is not clear. In the
summerof
2008,
employment
was
not
in
afreefall
and
the
enormousincreaseinenergypricestoapeakinJulyraisedvalidinflationconcerns.51FedmonetarypolicychangeddramaticallyaftertheLehmanfailureandthebailoutofAIG.AfterLehman,theFedfinancednewcreditextensionsbyprintingnewmoney.The Fed held its government securities portfolio roughly constantandallowedtotalreservebankcredittoexplodefrom$888billionjustbeforeLehmanto$2.25trillion52attheendof2008.53Termauctioncreditroseto$450billion,andseveralothercreditprogramswereexpandedornewlyinvented.54
48.See BD. OF GOVERNORS OF THE FED. RESERVE SYS., FEDERAL RESERVE
STATISTICALRELEASE
H.4.1FACTORSAFFECTINGRESERVEBALANCESOFDEPOSITORYINSTITUTIONSANDCONDITIONSTATEMENTOFFEDERALRESERVEBANKS,SEPTEMBER11,2008(2008).
49.Id.50.Seeid.51.SeePressRelease,BureauofLaborStatistics, supranote3;seealsoTheSemi
annualMonetary Policy Report to the Congress:Hearing Before the S. Comm. onBanking,Hous.&UrbanAffairs, 110th Cong. (2008) (statement of Ben S. Bernanke,Chairman,Bd.ofGovernorsoftheFed.ReserveSys.).
52.ThisfigureisbasedontheweeklyaveragefortheweekendingDecember31.53.BD. OF GOVERNORS OF THE FED. RESERVE SYS., FEDERAL RESERVE STATISTICAL
RELEASEH.4.1FACTORSAFFECTINGRESERVEBALANCESOFDEPOSITORY INSTITUTIONSANDCONDITIONSTATEMENTOFFEDERALRESERVEBANKS,DECEMBER29,2008(2008);BD.OFGOVERNORSOFTHEFED.RESERVESYS.,FEDERALRESERVESTATISTICALRELEASEH.4.1 FACTORS AFFECTING RESERVE BALANCES OF DEPOSITORY INSTITUTIONS AND
CONDITION
STATEMENT
OF
FEDERAL
RESERVE
BANKS,
SEPTEMBER
4,
2008
(2008).
54.FED.RESERVEBANKOFN.Y.,DOMESTICOPENMARKETOPERATIONSDURING2008,at24(2009).
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430 HarvardJournalofLaw&PublicPolicy [Vol.33
The initial fiscal policy response to the crisis was the EconomicStimulusActof2008,55enactedinFebruary,whichprovided tax rebates andbusiness tax deductions to counter the
recessionthat
many
thought
might
have
begun.56
The
Congres
sional Budget Office (CBO) estimated that the legislationwouldincreasethefederaldeficitby$152billionin2008.57Thedeficit is an imperfect measure of the impact of fiscal policy,butforpresentpurposeswillserveasausefulmeasureofthesizeofthefiscalresponse.TheCBOconcludedthatthelegislationmadeamodestcontribution,raisingconsumptionin2008,but that the impact on overall economic activity disappearedbytheendofthatyear.58Thus,thisstimulusbillmadenolastingcontributiontoeconomicstability.
InFebruary2009,thenewObamaAdministrationpassedtheAmericanRecoveryandReinvestmentActof2009.59Thisfiscal
packagewas
much
larger
than
the
one
passed
ayear
earlier.
TheCBOestimated the impacton thebudgetdeficit tobeanincrease of $185billion in fiscal 2009, of $399billion in fiscal2010,andatotalof$787billionoverthetenyearbudgethorizon of 2009 to 2019.60 Economists will argue about the effectivenessofthislegislationforyearstocome.
Boththe2008and2009stimulusbillswereattemptstotemper thegeneraleconomicdownturn.Other fiscalactionsweremoredirectlyaimedat the financialcrisis. InJuly2008,at theurgingofTreasurySecretaryHenryPaulson,CongressgrantedtheTreasuryauthoritytoprovidefinancialassistancetoFannieMaeandFreddieMac.61Atthetime, thesetwonominallypri
vatefirms
had
more
total
obligations,
on
and
off
balance
sheet,
thanthepublicallyheldTreasurydebt.Theywerebroughtinto
55.Pub.L.No.110185,122Stat.613.56.Id.101103.57.CONG.BUDGETOFFICE,COSTESTIMATE:H.R.5140,ECONOMICSTIMULUSACT
OF2008,at12(2008).58.CONG.BUDGETOFFICE,DIDTHE2008TAXREBATESSTIMULATESHORTTERM
GROWTH?1(2009).59.Pub.L.No.1115,123Stat.115.60.SeeLetterfromDouglasW.Elmendorf,Dir.,Cong.BudgetOffice,toCharles
E.
Grassley,
Ranking
Member,
Comm.
on
Fin.,
U.S.
Senate
(Mar.
2,
2009).
61.JeanneSahadi,SenatePassesLandmarkHousingBill,CNNMONEY.COM,July26,2008,http://money.cnn.com/2008/07/26/news/economy/housing_bill_Senate/index.htm.
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federal conservatorship uneventfully in early September,beforearunonthemcouldcreateapanicinthemarkets.62
The Troubled Asset Relief Program63 (TARP) was designed
todeal
directly
with
the
so
called
toxic
subprime
mortgage
assets on banks books. The turmoil following the LehmanbankruptcywassogreatthattheTreasuryandtheFederalReserveagreedthatitwasnecessarytoattackthetoxicassetproblemdirectly.64Afterconsiderablepoliticalwrangling,Congresspassedthe$700billionTARPbill.TheoriginalTreasuryobjectivewithTARPwas tobuy toxicassets frombanks.The ideawassubjecttoafatalflawthatshouldhavebeenobvioustotheTreasuryfromthestart:WhatpricewouldtheTreasurypayfortoxic assets? If the Treasury paid what the assets were trulyworth, the program would not serve to assist thebanks; ifTreasuryoverpaid, the resultwouldbea taxpayergift to the
banks.After
batting
around
several
ideas,
the
Treasury
aban
donedtheideaofbuyingtoxicassets.65Instead, theTreasury usedTARP funds to strengthenbank
capital through purchases of senior preferred stock in thebanks.66 Inessence, theTreasury tooka semiownershipposition inbankswithoutdiluting common shareholders.Bybolstering bank capital, the Treasury enabled banks to resumelending to the private sector, or at least reduced pressure onbankstocontracttheirlending.ByJune2009,Treasurycapitalpurchases totaled $199billion, of which $70billion hadbeenrepaid.A totalof 591 institutions were involved. Inaddition,TARP fundswereused foravarietyofother loans, including
$55billion
in
assistance
to
automobile
firms.
67
62.CONG.RESEARCHSERV.,FANNIEMAEANDFREDDIEMACINCONSERVATORSHIP1(2008),availableathttp://fpc.state.gov/documents/organization/110097.pdf.
63.EmergencyEconomicStabilizationActof2009,Pub.L.No.110343,122Stat.3765.64.Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys.,
AddressattheNationalAssociationforBusinessEconomics50thAnnualMeeting:CurrentEconomicandFinancialConditions(Oct.7,2008),availableathttp://www.federalreserve.gov/newsevents/speech/bernanke20081007a.htm.
65.HenryM.Paulson,Jr.,Secretary,U.S.DeptoftheTreasury,RemarksonFinancial Rescue Package and Economic Update (Nov. 12, 2008), available athttp://www.financialstability.gov/latest/hp1265.html.
66.
CONG.
BUDGET
OFFICE,
THE
TROUBLED
ASSET
RELIEF
PROGRAM:
REPORT
ON
TRANSACTIONSTHROUGHJUNE17,2009,at2(2009).67.Id.
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IV. EVALUATIONOFTHEGOVERNMENTSRESPONSETOTHEFINANCIALCRISIS
TheTreasury
and
the
Federal
Reserve
were
slow
to
recog
nizethat theproblemwasmuchmorethan liquidity.Marketswerecuttingofffundingtobanksandotherfinancialfirmsbecauseinvestorsfearedthatthefirmsmightbeinsolvent.Thosefears werejustified. Two Bear Stearns hedge funds had collapsed inJuly2007,andanumberofotherentitieswereobviouslyandvisibly in shaky financialcondition.68There shouldhavebeenanearlierrecognition thathousepricesweregoingtodecline,becausepriceswereoutof linewithfundamentals.Thus, not only would subprime mortgages become increasingly troubledbut soalsowouldprimemortgages.Failure torecognizetheimplicationsofdeclininghousepriceswasnota
regulatory
failure
but
a
basic
failure
of
economic
analysis.69
Regulatorscouldenforcecapitalstandardsonbanksandcouldmonitor bank risk management policies. As ordinarily conceived, the economic analysis of house prices went beyondwhatbanksupervisorsandexaminerswereexpectedtodo.
TheTreasuryandtheFederalReservecanalsobefaultedforfailing to engage in adequate contingency planning after theBear Stearnsbailout. It is hard to read Wessels account anyother way.70 The Treasury and the Fed did not seek fundingfromCongressbecausetheyassumedthatCongresswouldnotberesponsive.71Theydidnottrytomakethepubliccase,however. After Lehman failed, they had no choice, and Congress
did
respond
with
prompt
passage
of
the
TARP
legislation.
In
contrast, the risks of failing to deal with Fannie Mae andFreddie Mac were well understood and the two firms weretakenintoconservatorshipwithoutincident.72
68.WESSEL,supranote5,at93.69.Seeid.(notingthattheFedsmainpolicyconcernasofJuly2007wastherisk
ofrisinginflationandnotthehousingbubble).70.Seeid.at17880.71.Id.at179(PaulsonandBernankeconcludedthattherewasntanypointin
asking
Congressunless
the
crisis
intensified
to
the
point
where
there
were
no
otheroptions.).72.Id.at18687.
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TheTreasuryandtheFederalReservehavenotmadeastrongcaseforfinancialreform.73Largebankshavebecomelarger;theproblemof toobig to fail (TBTF) ismuchmore serious. Baker
andMcArthur
estimate
that
the
public
subsidy
to
the
big
banks,
becauseofthemarketsassumptionthatanylargebankintroublewillbebailedout, runssomewherebetween$6billionand$34billionperyear.74Theissueisnotprimarilythesubsidyarisingfromthefactthatbigbankscanborrowmorecheaplythancansmallbanks.75Instead,thesubsidypermitsthebigbankstogrowevenbigger,increasingtherisktothefinancialsectorif(orwhen) they get into trouble again. Moreover, cheap financingencouragesthebigbankstotakeriskstheymightnototherwisetake;withimpliedfederalbacking,banksneednotfearthatthemarketwillcutofffinancing.
More than eighteen months after the Bear Stearnsbailout,
thereseems
to
be
no
sense
of
urgency
in
addressing
the
TBTF
problemand in instituting reforms tomake the financial system more robust. This situation reflects a failure of politicalleadershipinWashington.Althoughbanksarecurrentlymorecautious thantheywerebefore thefinancialcrisis,underlyingconditionsand incentiveshavenotchanged.As theeconomyimprovesandmemoriesofthefinancialcrisisfade,thereisrealdangerthatanewfinancialcrisiswillbetakingshape.
V. LEGALANDGOVERNANCEISSUESDavidWesselisgenerallyverycomplimentaryofthepolicies
pursued
by
the
Federal
Reserve.
His
introductory
chapter
to
In
FedWeTrustistitledWhateverItTakes,76andherepeatsthatphrase frequently in his commentary on Fed creativity in inventingnewcreditfacilitiestodealwiththecrisis.Itwilltake
73.TheSenateisnowconsideringareformbill,andtheHousepassedabillinDecember2009.SewellChan,ReformBillAddsLayersofOversight,N.Y.TIMES,Mar.16,2010,atB1.
74.SeeDEANBAKER&TRAVISMCARTHUR,CTR.FORECON.&POLYRESEARCH,THEVALUEOFTHETOOBIGTOFAILBIGBANKSUBSIDY2(2009).
75.Id. (arguing that thementioned subsidyarisesprecisely from the fact that
banks
enjoying
protection
under
the
too
big
to
fail
concept
are
able
to
borrow
morecheaply).76.WESSEL,supranote5,at1.
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someyears toaccumulate research findingsas tojusthoweffectivetheFedscreditfacilitieswere.77
Alegalissue,orgovernanceissue,surroundstheFederalRe
servesuse
of
Section
13(3)78
of
the
Federal
Reserve
Act.79
This
Section came into theAct as an amendment in 1932.80 UndertheFederalReserveAct,thebasicpoweroftheFedistomakeloanstobanksandtoconductopenmarketoperationsinobligations issuedorguaranteedby the federalgovernment.Section 13(3) provides emergency authority for the FederalReserve to lend to nonbanks when such lending is deemednecessaryinunusualandexigentcircumstances.81
TheFederalReserveinvokedSection13(3)asitslegaljustificationforseveraldifferentactions.TheFedappealedtoSection13(3)asthelegalbasisfortheemergencyfundstobailoutBearStearnsandAIG.Thesamejustificationwasoffered,however,
forsome
other
special
credit
facilities,
including
the
commer
cialpaper funding facility, illustrating the issues surroundingsuchjustificationsingeneral.Theamendmentwasinsertedlatein the legislativeprocessandwasnotsubject tocommitteeorfloordebate.Thereiscaselaw,however,indicatingwhatun
77.SeeWilliamPoole,TheBernankeQuestion,CATO.ORG,July28,2009,http://www.cato.org/pub_display.php?pub_id=10388.
78.DavidFettigprovidesusefulbackground informationonSection13(3).SeeDavidFettig,TheHistoryofaPowerfulParagraph:Section13(3)enactedFedbusinessloans76yearsago,REGION,June2008,at33;seealsoDavidFettig,LenderofMoreThanLastResort:RecallingSection13(b)andtheyearswhentheFederalReserveopeneditsdiscountwindowtobusiness,REGION,Dec.2002,at14.
79.The
Federal
Reserve
Act
of
1913,
Pub
L.
No.
63
43,
ch.
6,
13,
38
Stat.
251,
263(codifiedasamendedat12U.S.C.343(2006)).80.Pub.L.No.72302,ch.520,210,47Stat.709,715(codifiedat12U.S.C.
343(2006)).81.12U.S.C.343(2006)(Inunusualandexigentcircumstances,theBoardof
GovernorsoftheFederalReserveSystem,bytheaffirmativevoteofnotlessthanfivemembers,mayauthorizeanyFederalReservebank,duringsuchperiodsasthesaidboardmaydetermine,atratesestablishedinaccordancewiththeprovisions of section 357of this title, to discount for any individual,partnership, orcorporation,notes,drafts,andbillsofexchangewhensuchnotes,drafts,andbillsofexchangeare indorsedorotherwise secured to the satisfactionof theFederalreservebank: Provided, Thatbefore discounting any such note, draft, orbill ofexchange for an individual or a partnership or corporation the Federal reservebank shall obtain evidence that such individual, partnership, or corporation isunable to secure adequate credit accommodations from otherbanking institu
tions.All
such
discounts
for
individuals,
partnerships,
or
corporations
shall
be
subjecttosuchlimitations,restrictions,andregulationsastheBoardofGovernorsoftheFederalReserveSystemmayprescribe.).
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usual and exigent circumstances most likely meant in 1932.Contemporaneouscourtsinterpretingsimilarlanguageinotherstatutesfocusedonthesuddennessandunexpectednessofca
lamitousevents
and
whether
immediate
action
was
required
to
avoiddisaster toacorporation.82 In thecontextof theFederalReserveAct,therefore,thetermunusualandexigentcircumstances likely contemplates unforeseen financial circumstances that require immediateaction or remedy, particularlywhennecessarytoensurethesurvivalofabusinessentity.
Furthermore, although the third edition ofBlacks LawDictionary, published in 1933, did not have a definition of unusual and exigent circumstances, it did have a definition ofexigencythatcorroboratesthecaselawsfocuson imminence:[d]emand,want,need,imperativeness;emergency,somethingarisingsuddenlyoutofthecurrentofevents;anyeventoroc
casionalcombination
of
circumstances,
calling
for
immediate
action or remedy; a pressing necessity; a sudden and unexpectedhappeningoranunforeseenoccurrenceorcondition.83
Finally,onerelevantpieceoflegislativehistoryconcernsSection11(r)oftheFederalReserveAct,84whichpermitstheBoardtoutilize its13(3)powers in situationswhere thereare fewerthanfivememberspresent.85Thisprovisionwaspartofalargerbill aimed at providing insurance in the event of terrorist attacks. One can thus assume the reason for it was so that theBoard could take immediate action in response to a financialcrisisasexigentasonebroughtonbya terroristattack.Congressclearlyhadsuchanextremeexigencyinmindbecauseit
providedthat
even
adelay
to
contact
other
Board
members
by
phoneorotherelectronicmeanswouldbetoolong.86
82.SeeGoodRoadsMach.Co.ofNewEng.v.UnitedStates,19F.Supp.652,653(D.Mass.1937);Carsonv.AlleganyWindowGlassCo.,189F.791,796(D.Del.1911).
83.BLACKSLAWDICTIONARY721(3rded.1933).
84.Pub.L.No.107297, tit.III,301,116Stat.2322,2340(2002)(codifiedat12U.S.C.248(r)(2006)).
85.12U.S.C.248(r).86.12U.S.C.248(r)(2)(A)(ii)(III)(requiringbeforetheBoardexercisesits13(3)
powers that itdeterminethatexigentcircumstancesexisted,thattheborrower isunable tosecurecredit throughothermeans, thataction isnecessary toprevent
seriousharm
to
the
economy
or
the
stability
of
the
U.S.
financial
system,
that
theyhavebeenunable tocontact theotherboardmembersbyanymeansavailable,andthatwaitinganyfurthertodosowouldbeimpossible).
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The Feds reliance on Section 13(3) is fullyjustified in thecontextofdecisionstobailoutBearStearnsandAIG,whateverthe merits of thosebailouts, for those situations were clearly
emergencies.The
case
for
relying
on
Section
13(3)
to
justify
the
programtobuycommercialpaper,however,ismuchlessclear.The Fed announced its Commercial Paper Funding Facility(CPFF)onOctober7,2008.87The first loansweremadeaboutthreeweekslater,onOctober27.Byyearend,thisprogramhadanoutstandingbalanceof$332billion.Theprogramreachedapeakof$350billioninmidJanuary2009.88
The launch of CPFF did not reflect a weekend emergency.Thefinancialcrisiscalledforquickanddecisiveaction,butnotimmediateactiondecidedinamatterofhours.Iftherewasanemergencyatall,itwasbecauseofcongressionalunwillingnesstoact,notbecauseCongressdidnothave time toact. IfCon
gresswas
unwilling
to
act
because
of
its
concern
about
the
poli
tics of a program to provide credit to large corporations, afederal agency should not make its own decision on what isnecessary, committing hundreds ofbillions of dollars in taxpayerresources.
OnepossibleviewisthattheFedfounditselfinanunfortunateposition,butthatitdidwhatithadtodogivenOctobersfinancialturmoil.ThatseemstobeWesselsview:whateverittakes.89TheFed shouldhavemadea strongpubliccase thatCongresshadtoacttoprovidetheneededcredit.Therewouldhavebeenapublicdebateabout thewisdomof theproposedprogram.Weknownothingof the internaldebates in theFed
aboutthe
CPFF.
Essentially,
the
Fed
simply
asserted
that
the
program was necessary to reduce financial turmoil. The Federal Reserve has never explained, either in October 2008 orsince,whyassistancetotheparticularborrowerseligiblefortheCPFFwasessentialtodealingwiththefinancialcrisis,whereasassistancetootherpotentialborrowerswasnotessential.
IfCongresshadacted, theCPFFwouldhavebeenadministeredby theTreasury, insteadofby theFed,and financedbynewTreasurydebt,insteadofbymonetaryexpansion.Aswithother federal credit programs, eligibility, reporting require
87.PressRelease,Bd.ofGovernorsoftheFed.ReserveSys.(Oct.7,2008),avail
able
at
http://www.federalreserve.gov/newsevents/press/monetary/20081007c.htm.
88.WESSEL,supranote5,at22829.89.Id.at229.
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ments, disclosure requirements, the interest rate, and othercredit terms would havebeen determinedby legislation, ordelegatedtotheTreasury.Governmentprogramprovisionsare
inherentlypolitical
decisions.
The
Fed
should
not
have
been
making these decisions, because doing so would inevitablydrawitintopoliticaldisputes,suchasthoseoverdisclosure.
TheFederalReservesprogram tobuymortgagebackedsecurities (MBSs) raises similar governance issues. The Fedsprogramistobuyatotalof$1.25trillionofMBSsbytheendofthefirstquarterof2010.90LiketheCPFF,thisprogramwasnota weekend emergency effort, but rather one that Congresscould have authorized. The Fed initially announced this program inapress releaseonNovember25,2008.91The firstappearanceofMBSsontheFedsbalancesheetwasnotuntiltheH.4.1releaseforJanuary15,2009.92
Thetime
between
announcement
and
execution
of
the
Feds
MBSpurchaseprogramiscomparabletothegapbetweenpassage of the TARP legislation in 2008 and the stimulusbill inFebruary2009.CongresscouldhavedebatedanMBSpurchaseprogramanddecidedwhetherthebenefitsoftheprogramoutweighedtheadditionalgovernmentdebtrequiredtofinance it,ratherthanlettinganunelectedagencyinitiatetheprogram.
Oneelementofsuchacongressionaldebatemight logicallyhavebeen whether it wouldbe a good idea to expand theamount of Treasury debt outstandingby $1.25 trillion to finance this program. Given the enormous scale of thebudgetdeficit, thatwouldhavebeenavalid issue todebate. Instead,
theFederal
Reserve
is
financing
the
program
by
creating
new
money. Another item that might havebeen debated in Congresswouldhavebeenwhethera totaloutlayof$1.25 trillionshouldallgo forpurchasingMBSs.Somemighthavearguedthat someof the funds should instead havebeen used to expandloanstosmallbusinesses.Or,perhapssomeshouldhave
90.Id.at269.
91.PressRelease,Bd.ofGovernorsoftheFed.ReserveSys.(Nov.25,2008),availableathttp://www.federalreserve.gov/newsevents/press/monetary/20081125b.htm.
92.BD.OFGOVERNORSOFTHEFED.RESERVESYS.,FEDERALRESERVESTATISTICAL
RELEASE H.4.1 FACTORS AFFECTING RESERVE BALANCES OF DEPOSITORYINSTITUTIONSANDCONDITIONSTATEMENTOFFEDERALRESERVEBANKS,JANUARY
15,2009,tbl.1(2009).
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beenusedtobuybondsfromhardpressedstategovernments,ortoexpandmortgagereliefforborrowersnearforeclosure.
Thepointisnottoargueherethemeritsofalternativeusesof
$1.25trillion
but
to
emphasize
that
decisions
on
credit
pro
gramshavehistoricallybeen left toCongress.Once the financialcrisisisfullyresolved,Congressshouldtakeupthisissue.Whatare theappropriate constraintson theFederalReserve?The issue may wellbe on the congressional agenda at somepoint.Wesselflagstheissueinhisfirstchapter:
BarneyFrank,thesharptonguedsharpmindwhochairedtheHouseFinancialServicesCommittee,capturedtheissueclearly. Labeling Bernanke the loan arranger with hissidekick, Paulson, Frank said, I think highly of Mr. Bernanke and Mr. Paulson. I think they are doing well, although I think itsbeen inappropriate in a democracy to
have
them
in
this
position
where
they
were
sort
of
doing
this
stuffunilaterally.Theyhadnochoice.And itsnot to theirdiscredit,but...thisnotionthatyouwaituntiltheresaterrible situation and youjust hope that the chairman of theFederal Reserve would pop up with the secretary of theTreasury and rescue you. Its not the way in a democracy...youshouldbedoingthis....
Nooneinademocracy,unelected,shouldhave$800billiontospendasheseesfit,hesaid.93
Economistsalmostuniversallybelievethat thereshouldnotbepolitical interferencewith thecentralbanksmonetarypolicy decisions. A legacy of the Federal Reserves expansive
creditprograms
may
be
that
Congress
will
enact
constraints
on
theFederalReservethataffectitsmonetarypolicydecisionsaswellasitscreditpolicies.ManywillfindthepositionstatedbyBarneyFrankpersuasive;whethertheywillbeabletoseparatemonetaryfromcreditpoliciesislessclear.
VI. REFORMSTOENHANCEFINANCIALSTABILITYAdistressingfeatureofthefinancialcrisisisthatsuchevents
havehappenedsooftenbefore.CharlesKindlebergersclassicbook,Manias,Panics andCrashes:AHistory ofFinancialCrises,went through four editions and hasbeen updated since his
93.WESSEL,supranote5,at7.
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death to a fifth edition.94 A more recentbookby Carmen M.Reinhart and Kenneth S. Rogoff, This Time IsDifferent: EightCenturies of Financial Folly,95 adds a great deal of data to the
Kindlebergerhistory.
The cost of the financial crisis is immense. One number issufficienttoindicatethescaleofthecostsintheUnitedStates:Thecrisisisresponsibleforreducingemploymentbyeightmillionjobsandperhapsmoredependingonexactlywhentherecoverybegins.96Largebanks thatget into financial troublenotonlyaffecttheirownshareholdersandemployees,butalsofirmsandemploymentacrossthecountryandaroundtheworld.
Themostfundamentalreformistoforcebankslargeenoughtocreateasystemicrisktotheeconomytoholdmorecapitalasa cushion toprotect thedeposit insurance fundand to createmoremarketdisciplineintheirmanagement.Economistshave
studiedthis
issue
for
years;
the
most
promising
approach
is
thatbanks shouldbe required to issue a substantialblock oflongtermsubordinateddebt.97
To illustrate the proposal, suppose every firm with abankcharterwas required tomaintainablockof tenyear subordinated notes equal to ten percent of its total liabilities. Everyyear, thebankwouldhave to rollover thematuringnotes; ifthemarketwereunreceptive,thebankwouldhavetoshrinkitstotalassetsbytenpercenttolivewithinitsremainingblockofoutstanding subordinated notes. Stability of thebanking systemandmarketdisciplinemightbe furtherenhancedbyproviding thatabankcouldconservecash thatwouldotherwise
beused
to
redeem
maturing
sub
debt
by
converting
the
sub
debttoequityatapredeterminedratio.Marketdisciplinerequiresthatsomecreditorsbeatrisk.Fi
nancial stability, however, requires that creditors who fear alossmustnotbeabletorun.Akeyfunctionofabankistooffer
94.CHARLES P. KINDLEBERGER & ROBERT Z. ALIBER, MANIAS, PANICS, ANDCRASHES:AHISTORYOFFINANCIALCRISES(5thed.2005).
95.CARMEN M. REINHART & KENNETH S. ROGOFF, THIS TIME IS DIFFERENT:EIGHTCENTURIESOFFINANCIALFOLLY(2009).
96.FloydNorris,TheJobsNewsGetWorse,N.Y.TIMES,Oct.4,2009,atWK3.
97.See BD. OF GOVERNORS OF THE FED. RESERVE SYS. STUDY GROUP ON
SUBORDINATED NOTES & DEBENTURES, USING SUBORDINATED DEBT AS ANINSTRUMENTOFMARKETDISCIPLINE172 (1999) (analyzing thoroughly thesubordinateddebtproposal).
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demand deposits and other shortdated time deposits or depositlikeobligations.Theonlywaytoassurefinancialstabilityand toassurethatsomecreditorsbeatrisk istorequire long
termdebt
in
the
capital
structure.
The
proposal
also
has
the
advantage that, when abank is forced to contractbecause itcannotrollovermaturingsubdebt,thebankitselfmanagestherestructuring.ItisbesttoavoidregulatorydiscretionbecauseabankintroublemaybeabletoappealtoCongresstooverrideregulatorsdecisions.
Another useful reform wouldbe to encourage a less leveraged economy.Oneway todo sowouldbe tophaseout thedeductibilityof interestonall income tax returns.Atpresent,the deductibility of interest encourages debt over equity. Aquickcalculationindicatesthatphasingoutthedeductibilityofinterestoncorporatereturnsandreducingthestatutorycorpo
ratetax
rate
from
its
current
thirty
five
percent
to
fifteen
per
centwouldberoughlyrevenueneutral.
VII. REFLECTIONSONFREEMARKETSThe financial crisis is a sobering experience for a Chicago
schooladvocateofthemarket.Thefederalgovernmentwasnotwithoutblameforthecrisis,butthebasicproblemwasthatfartoo many financial firms pursued shortsighted portfolio policies.Banking101saysthatitisdangeroustodesignaportfoliowith longduration risky assets financed with shortdurationliabilitiesandthincapital.Thatiswhatonefinancialfirmafter
another
did,
and
the
government
is
not
to
blame
for
those
mis
guidedprivatesectorpolicies.Throughout history, financial crises occur when liquidity
driesup,usuallybecause solvency concernsarisewhen riskyassetsdeclineinvalue.Whyisitthatthemarketseemstomakethesamebasicmistakerepeatedly?Itisterriblyimportantthatwe figure out the answer to this question,because we alsoknowthatmarketsandnotgovernmentruneconomiesgenerateeconomicgrowth.Thisfinancialcrisiswascostly;ifwecannotfigureouthowtomakemarketeconomiesmorestable,weriskgrowing government involvement,whichwe canbe certainwillmakeeconomiesgrowmoreslowly.
My
tentative
conclusion
is
that
market
participants
system
aticallyunderestimate theprobabilityofextremeevents.Theyrelyon instincts describedby the normal distributionandby
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formalmodelsbasedonnormality.Yet, there isanenormousamountofevidencethattheprobabilityofextremeeventsoutinthe tailsof theprobabilitydistribution ismuchhigher than
indicatedby
the
normal
distributionthe
fat
tails
problem.98
Ifthisobservationiscorrect,thenanappropriatefunctionofgovernment is tocreate incentivesthatoffsetthemarketsunderestimate of tail probabilities. For largebanks, the issue isoneof externalities.A largebank failurehas costly effectsonmanythirdparties.Eliminatingthedeductibilityofinterestontax returns would help to control the externality as would astiffsubordinateddebtrequirementforbanks.
Inreflectingonthecausesandconsequencesofthisfinancialcrisis, it isamistaketothinkofthesubprimemortgage fiascoasauniquecausethatwillnotrecur.Itisindeedunlikelythatthe subprime mortgage market itself will again create a sys
temicrisk,
but
some
other
new
and
creative
market
probably
will.Theessenceofadynamiccapitalmarketisthatitsearchesfornewopportunitiesandfeedscapitaltonewventures.Someofthenewventuresturnouttobebusts.Whatoughtnothappenisthatthebustsshaketheentireeconomybecausetheyarefinancedbybanksintooriskyafashion.Federalpolicyshouldrequirethatbanksholdalargercapitalcushionagainsttheinevitablebusts.Itismostunfortunatethatfinancialreformisnotyetaconsequenceofthisfinancialcrisis.
98.SeeBenoitMandelbrot,TheVariationofCertainSpeculativePrices,36J.BUS.394(1963).