Five years since the great collapse, the U.S. financial system looks healthier — but problems persist.
Fear gripped the USA five years ago. As Americans awoke on Monday, Sept. 15, 2008, they learned that Lehman Bros. had collapsed in bankruptcy, inflicting billions of new losses on a financial system already rocked by a cratering housing market and a tightening credit crunch.
Upending Wall Street’s weekend hopes that the nation’s fourth-largest investment bank would be saved, the punch landed amid a barrage. Merrill Lynch, one of the world’s largest brokerages, had been forced into a shotgun marriage with Bank of America. Insurance giant AIG was teetering. The U.S. auto industry was imploding. And investors were starting an electronic run on their retirement accounts.
Aftershocks of the worst financial crisis since the Great Depression still reverberate in today’s fragile recovery. The national psyche remains uneasy, worrying: Could it happen again?
“The next crisis is going to involve not just Europe and the United States, but India and Brazil and China,” said former senator Chris Dodd, speaking generally about serious threats that can spring from anywhere in an increasingly global financial system. “What happens in one corner of the world, particularly in significant economies, affects everybody.”
Dennis Kelleher, president of financial industry watchdog group Better Markets, offered an even darker forecast as he complained that giant banks at the vortex of the 2008 crisis have mounted Washington lobbying campaigns “to fight financial reform that would prevent them from doing it all over again.”
There was no time for financial and government leaders to think five years ahead during the dark days of 2008. Often they were forced to battle on multiple fronts — the threatened failure of Wachovia, the fourth-largest U.S. bank, the meltdown of Washington Mutual, the biggest failure in U.S. banking history — that in ordinary times would require weeks or months of full-time rescue intervention.
It was the financial version of around-the-clock triage, with trillions of dollars at risk, and the future of the national and global financial system in the balance, said former Treasury secretary Henry Paulson. The former Goldman Sachs chief helped quarterback the U.S. rescue effort, leading Bush administration teams as he brainstormed and executed bailout plans with Federal Reserve Chairman Ben Bernanke, Timothy Geithner, then head of the Federal Reserve Bank of New York, federal regulators and Congress.
The quickening drumbeat of failures shook even some rescue leaders.
“What if the system collapses?” Paulson asked his wife, Wendy, in a phone call as efforts to save Lehman failed. “Everybody is looking to me, and I don’t have the answer. I am really scared.”
“None of us knew how bad it would be, but we knew it would be very bad,” Paulson added in a USA TODAY interview, recalling how, after months of non-stop containment efforts “there just was a moment there when I was seized with fear.”
Among the many emergency measures used by rescue leaders, Paulson said three proved most crucial in quelling the near-panic and restoring financial stability:
• Executing a federal takeover of Fannie Mae and Freddie Mac, the government-sponsored housing finance giants that collectively owned or guaranteed more than $5 trillion in residential mortgages and mortgage-backed securities. The action kept the housing market alive in 2008 by calming fears that the undercapitalized entities could default on their bonds.
• Guaranteeing money market mutual funds, the then-$3.5 trillion industry many Americans rely on for retirement and businesses use for short-term funding. Halting the investor run took an unprecedented federal guarantee of the industry. It came after the Reserve Primary Fund, one of the nation’s largest funds, couldn’t meet a stampede of requests from worried investors who raced to withdraw their money because the fund held hundreds of millions of dollars in Lehman debt that became worthless when the investment bank collapsed.
• Establishing the Troubled Asset Relief Program, which enabled Treasury to move quickly in restoring confidence in the nation’s banks by purchasing equity securities in hundreds of banks and recapitalizing the financial system. Originally budgeted at $700 billion, the lifeline commonly known as TARP was later extended to insurance and auto companies. About $421 billion was spent, and $357 billion has been repaid.
Noting that the government’s takeovers of Fannie and Freddie and TARP were controversial and required congressional approval, Paulson said, “Nothing could be worse than going up there and saying, ‘Hey, we need it, we’re powerless without it,’ and then not getting it.”
Bernanke stunned Capitol Hill leaders when he warned in a pivotal September 2008 meeting that a meltdown of the global financial system loomed unless they acted quickly on TARP funding authorization. “The oxygen left the room,” recalled Dodd, a Connecticut Democrat who then chaired the Senate banking committee.
Ultimately, the approvals emerged from two weeks of high-stress Capitol Hill negotiations as financial conditions continued deteriorating. “As I look back on it now, and look at all the dysfunction in Washington … rather than say, boy, was this a terrible two weeks, I look at it and say, ‘Isn’t it amazing that in two weeks, Democrats and Republicans came together to give us these extraordinary authorities?’ ” Paulson said.
LONG-TERM FINANCIAL CURE?
In the view of David Hirschmann, president and CEO of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness, the business industry would give rescue leaders “high marks for the speed and effectiveness with which they made very difficult decisions that were not popular to step in and make sure our financial markets continued to work while the patient was bleeding on the table.”
But in the five years since, as President George W. Bush was succeeded by President Obama and the new White House administration and Congress enacted the sweeping but still-unfinalized Dodd-Frank financial reform package, questions and criticism surround efforts to ensure a long-term cure and prepare for new financial threats.
While predicting that a crisis as major as the 2008 implosion was “far less likely, Hirschmann warned, “That doesn’t mean there won’t be failures.”
“The question is, have we created a better system to detect problems early, to look at the risks in the broader system? I think the jury’s still out on that,” he said.
Paulson, too, has pointed to potential threats, including the as-yet-unchanged structures of Fannie and Freddie. He said placing them under government control was a temporary “timeout” that provided breathing space to replace the current system in which the two housing-finance giants dominate the home mortgage market and leave taxpayers shouldering the cost of failures and shareholders reaping the benefits of success.
Permanent change is crucial, said Paulson, because “today the government basically is backstopping, one way or the other, about 90% of all new mortgages. I look at it and say we’re sowing the seeds of another major problem” because government subsidies to Fannie and Freddie are setting the terms of home loans, rather than “the private market and the discipline that it brings.”
President Obama last month outlined a proposed overhaul of the decades-old U.S. housing finance-system that would essentially phase out Fannie and Freddie. In his Phoenix announcement, Obama endorsed the ideas behind a proposal developed by a bipartisan Senate group.
Paulson also urged broad reform of the money market industry. The Securities and Exchange Commission moved toward that process with a June proposal that would let the net asset value of some funds “float” instead of being fixed at $1 per share. Having the funds act more like bonds would make investors aware that the investments are not insured like bank accounts, and that they could lose their money.
Sheila Bair, chairwoman of the FDIC during the 2008 financial crisis, warned that the U.S. stock and bond markets have grown overvalued in response to low interest rates and the Federal Reserve Board’s policy of quantitative easing — buying Treasury bonds and other government securities from financial markets in a bid to promote more lending and liquidity. The Fed has signaled it could start tapering the program as early as this month.
“There are a lot of uncertainties. We’ve never tried this before,” said Bair, who now chairs the Systemic Risk Council, a non-partisan group urging strict Wall Street oversight. “Though I’m very eager for the Fed to stop this … they need to go very slowly, because the longer you’re in, the harder it is to get out, and we don’t know what all the ramifications will be.”
Bair and Paulson also warned of continued reliance on short-term funding such as repurchase agreements, a system in which banks sell securities to buyers for cash and agree to repurchase them later at the same price, plus interest. The bulk of those funds are lent overnight and can be pulled on short notice — as happened during the financial crisis — potentially endangering banks’ balance sheets.
While calling the Dodd-Frank Wall Street Reform and Consumer Act “a huge step forward,” Paulson urged an overhaul of federal financial regulatory agencies and their sometimes overlapping responsibilities. The existing structure leads to some dysfunctional competition and lack of clarity for businesses, he said.
“We need a financial system that extends credit, that makes sure that there’s confidence, that small businesses can get loans … that people can get mortgages,” Hirschmann said. “The problem with having this alphabet soup of regulators is nobody’s in charge of looking at all the pieces and making sure they work together.”
Echoing concerns raised by Paulson, Dodd and others, Hirschmann also cited a relative absence of coordination with efforts to improve financial regulation in other countries. “Some of the solutions require a global approach. And that’s proving much harder” to achieve, he said.
Raising the prospect of international financial threats, Bair said some emerging markets have grown quickly because they had higher interest rates that drew U.S. investment. Now that domestic interest rates are more favorable, “the money comes back,” she said, raising potential challenges both abroad and at home.
“We don’t really know where the tentacles of this have gone,” Bair said.
Additionally, some financial experts argue regulators have become too lenient as memories of the financial crisis fade and efforts to spur business and job growth increase in response to what Mohamed El-Erian, CEO of global investment firm PIMCO, called the “exhausted and outdated growth engines” of the U.S. and other Western nations. Their mature economies are growing slower than those of emerging nations such as China.
Bair criticized an August decision in which federal regulators proposed easing a Dodd-Frank provision that would require lenders to maintain a financial stake in mortgages they securitize. The provision was aimed at blocking some subprime and other risky mortgage loans that worsened the financial crisis.
“The intellectual pendulum or the regulatory pendulum has swung way over toward promoting growth,” said James Kwak, an associate professor at the University of Connecticut’s law school and a co-founder of The Baseline Scenario, an influential economics blog. “But I think the thing people are forgetting we got into this economic mess in the first place because of decades of policies that prioritized the housing market over prudent risk management in the financial sector.”
The largest U.S. banks more generally have been the focus of renewed calls for reform from government watchdogs and others who say the institutions are so complex and interconnected they pose a continuing financial system risk.
Dodd-Frank hasn’t changed that too-big-to-fail situation, said Richard Fisher, president of the Federal Reserve Bank of Dallas. He has urged Congress to limit the federal safety net to the giants’ traditional commercial banking function. The proposal would also require creditors and trading partners to sign acknowledgements that activities of non-bank affiliates and holding companies aren’t insured. The plan would require restructuring so each of a given bank’s internal affiliates is subject “to a speedy bankruptcy process.”
Anat Admati, a finance and economics professor at Stanford University’s business school, warned that Americans are no safer from destabilizing bank risk today than in 2008 because “flawed regulations and ineffective enforcement” allow deeply interconnected financial institutions to continue making risky financial investments with too much borrowed money.
“Why are we allowing these institutions to be so indebted?” asked Admati, co-author of The Bankers’ New Clothes. “Why, if we could put speed limits, wouldn’t we put speed limits? Why don’t we prevent the distress and the default?”