Like the Roosevelt administration before it, the Obama administration’s response to the crisis entailed much more than just the use of fiscal and monetary tools. It included an impressive array of initiatives targeted at specific sectors, from housing and motor vehicles to financial services. Few if any of these, however, began to approach, in ambition or achievement, the initiatives launched under the New Deal.
In particular, the Obama administration’s attempts to provide distressed homeowners with mortgage relief were a pale imitation of what was achieved by the Home Owners’ Loan Corporation of the 1930s. Changes in the nature of housing finance in the intervening period made it more difficult to restructure mortgages without imposing large losses on either the banks or taxpayers, something that was both a political and an economic nonstarter. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 did not begin to rise to the ambition of the Glass-Steagall Act of 1933 or the Securities Exchange Act of 1934. By more successfully deploying their monetary and fiscal tools, policy makers this time prevented the worst. And by preventing the worst, they allowed the vested interests that benefited from the prevailing financial system to regroup. They relieved the pressure for root-and-branch reform.
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Residential construction had accounted for 6 percent of U.S. GDP at the peak in 2005; its share now fell to barely 2 percent. Construction activity always falls sharply in a recession, to be sure. But what was worrisome now was how weak residential construction continued to act as a drag once the economy began to recover.
To explain the failure of construction to recover, observers pointed to the outsized building boom prior to 2006 and the exceptional severity of the recession, which drained the pool of potential homebuyers. Problems in the banking system and securitization markets made it hard to finance construction of new subdivisions and apartment buildings. Mortgage underwriters, having embraced lax standards before, swung now to the other extreme. Regulators tightened their scrutiny of lending practices.
Above all, as many as four million of the sixty million American homeowners with mortgages had fallen behind on their payments by early 2009 and were at risk of foreclosure. It took a home builder of unusually sunny disposition to invest in a new subdivision with this massive shadow inventory hanging over the market. A further ten to fifteen million households were encumbered with mortgage debts that now exceeded the value of their homes. For the moment, they were still current on their mortgages, but there was always the risk that they might walk away, adding their homes to the list of bank-owned properties. In addition to the drag on the construction sector, there were the losses for the banks. There was the deterioration of neighborhoods blighted by untended properties. Above all, there were the dislocation and suffering of families losing their homes.
In the 1930s the Home Owners’ Loan Corporation helped to mitigate these problems. But there was no HOLC this time. Instead the Obama administration responded with a set of limited initiatives that failed to deliver even on their own modest ambitions. The Home Affordable Modification Program (HAMP) was designed to provide financial incentives for banks and mortgage servicers to reduce interest rates for four million homeowners unable to make their monthly payments. Servicers satisfying program provisions received an up-front fee of $1,000 and further modest payments if the borrower remained current. But as of late 2013, just 1.3 million mortgages had been modified under the program. The government had spent barely a quarter of TARP funds earmarked for the purpose.
The Home Affordable Refinance Program (HARP) was designed to permit an additional five million homeowners not immediately at risk of foreclosure to refinance at lower rates. To qualify, a mortgage must have been acquired by Freddie Mac or Fannie Mae. Conveniently from this point of view, Fannie and Freddie now owned or guaranteed a majority of US home loans. Less conveniently, Freddie and Fannie’s independent administrator, Ed DeMarco, who was charged with rehabilitating the GSEs, resisted enlisting them in the cause. By mid-2011 barely a million homeowners had been helped, and by the end of 2013, six full years into the crisis, fewer than 3 million homeowners had availed themselves of this program. There were also initiatives for lending money to unemployed homeowners and transfers to the states for anti-foreclosure programs. But fewer than one in thirty homeowners were helped by these government programs, compared to one in ten in the 1930s.
Policy makers struggled with both ethical and budgetary dilemmas. A program narrowly targeted at delinquent homeowners would reward those who had stopped paying, using the tax dollars of others whose homes were also underwater but who nonetheless continued to make their payments. A program addressing the problems of all twenty million homeowners whose mortgages exceeded the value of their homes would, however, quickly become so expensive as to be politically toxic.
Alternatively, the foreclosure problem could have been addressed through changes in statute. Judges could have been empowered to restructure mortgages in personal bankruptcy proceedings, just as they restructured other debts. Senator Obama had sponsored legislation to this effect, and Candidate Obama endorsed the concept. But for President Obama, this would have meant losses for the banks, which preferred to extend and pretend—to hope that their problem loans would be repaid once the housing market recovered. Some loans might have to be written down, but the banks preferred to realize these losses later, when their condition was stronger.
And, despite the bailouts, the banks remained a powerful lobby. Community banks lobbied against legislation to allow bankruptcy judges to meddle with their mortgage portfolios, just as they had lobbied against deposit insurance in the 1930s. This created doubts that legislation empowering judges to restructure mortgages could attract the necessary supermajority of votes in the Senate. In any case, a policy that implied large losses for the lenders would have undermined Treasury’s strategy for rehabilitating the financial system, which was based on the banks’ earning their way back to health. Secretary Geithner opposed any form of intervention that meant losses for the banks. The Senate was quietly told that bankruptcy reform was not a priority of Treasury, and legislation aimed at revising the statute died a quick death.
It has been argued that the difference in the 1930s was decisive action to resolve the banking crisis. By declaring a bank holiday, closing down bad banks, and allowing only well-capitalized depository institutions to open, it is said, FDR strengthened the banking system sufficiently so that it could absorb losses from a more ambitious mortgage restructuring initiative. This, as we have seen, is inaccurate. The main thing FDR did was to provide a cooling-off period, some soothing words, and the capacity for the Federal Reserve to act as a lender of last resort through the Emergency Banking Act of 1933. Then as now, the banks were too weak for the government to force them to absorb large losses. The Home Owners’ Loan Corporation, recall, bought only mortgages that financial institutions willingly sold.
In fact, the HOLC could help as many as one in ten homeowners without massive budgetary costs and without imposing large losses on banks and other mortgage lenders because its help was limited to interest-rate relief. This was all many homeowners needed, since, given down payments of as much as 50 percent, few of them were underwater even with the sharp fall in house prices. The fact that more homeowners were underwater in 2009 as a result of having made smaller down payments made resolving the foreclosure crisis harder.
Finally, the greater complexity of mortgage finance made restructuring more difficult. Having purchased a mortgage, investors might lose as much as 40 percent if a home was repossessed; such were the costs of evicting the occupant, sprucing up the property, and putting it on the market. They therefore had an incentive to agree to at least some reduction of principal to keep the borrower in his or her residence. Homeowners, however, dealt not with investors but with mortgage servicers, who were set up to collect monthly payments if they were made and to foreclose if they were not. Servicers were not competent to restructure mortgages, as subsequent tales of lost paperwork and serial miscommunication made clear. Nor did the prospect of a $1,000 HAMP payment give them much incentive to acquire the capacity.
In principle, this was a problem that the public sector could solve. The federal government hired twenty thousand specialists to administer the HOLC and oversee mortgage restructuring in the 1930s. This time, in light of the greater complexity of mortgage finance, the commitment of manpower would have had to be greater still. But given pervasive distrust of big government, there was resistance now to doing anything similar.
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The Great Depression and the banking crisis prompted passage of the Glass-Steagall Act, creation of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation, and measures strengthening the power of the Federal Reserve to act as a lender of last resort. These reforms did not eradicate every trace of the earlier banking and financial system. The United States still had a large number of banks, matched now by a large number of regulators. The shadow of history was too long for it to be otherwise. Still, by creating deposit insurance, establishing a proper lender of last resort, and subjecting banks and securities markets to stricter regulation, policy makers drew the right lessons. By strengthening confidence in the banking and financial system and limiting risk taking, they inaugurated what was, in retrospect, a singular half-century of financial stability.
Financial reform this time was more limited. The most important explanation, alluded to above, was the very success of policy makers in preventing the worst. Building on the lessons of the 1930s, they averted an economic calamity on the scale of the Great Depression. The Depression discredited inherited financial arrangements. The implosion was so complete that there was little left to risk by radical reform. Unquestionably, the rescues of Bear Stearns, AIG, Citigroup, and Bank of America and the failure of Lehman Brothers were a shock. But this shock paled in comparison with the catastrophe that was 1933, when the banking and financial system was shut, the basis for the monetary standard was suspended, and economic activity ground to a halt. With things so bad, it was hard for the opponents to argue that root-and-branch reform would make them worse.
The other factor standing in the way of more fundamental 1930s-style reform was the size and complexity of the financial system. The complexity of megabanks like Citigroup, Bank of America, and Wells Fargo made breaking them up more easily said than done, however much the proponents of breakup asserted otherwise. Not only were the big banks still in business but, as a result of the shotgun marriages presided over by the authorities, they had grown even bigger. There was a wider range of financial institutions and instruments to be brought into the regulatory net, including hedge funds, insurance companies, and money market mutual funds. Because the cogs of the financial system were interlocking, radical reform of the rules governing one might have unintended consequences for others. If money market funds were obliged to hold costly capital, for example, they would have to reduce their returns. Investors would shun them, forcing the money funds to curtail their purchases of commercial paper. Hence reform of the rules governing money market funds might have a negative impact on the commercial paper market and impair the operation of the financial system as a whole.
Similarly, the existence of a wide variety of derivative instruments complicated efforts to drive their trading into clearinghouses and onto exchanges. Although easily standardized securities would survive such requirements, others might not. It was not clear which were which, or whether those that survived would mainly be the instruments used by farmers for hedging risk or speculators for manipulating it.
And derivative securities were traded not just in the United States but internationally. In the 1930s world of controls on capital flows, it was possible for national authorities to proceed unilaterally. But if other countries now failed to follow the United States in tightening regulation, transactions and the institutions undertaking them might simply move offshore, much as AIG Financial Products had moved offshore before the crisis. The $6.2 billion of trading losses incurred by JPMorgan’s Chief Investment Office in 2012 similarly occurred offshore. As former Senator Ted Kaufman, onetime chief of staff to Joe Biden and no friend of the financial services industry, put it, Bruno Iksil, the JPMorgan trader immediately responsible, wasn’t called the “London Whale” because he worked in Philadelphia.
The regulatory apparatus was similarly more complex. The United States had as many as seven separate bank regulators, each with its turf. Lobbying by regulators as well as the regulated made radical reform such as creation of a single consolidated bank supervisor impossible to achieve. Moreover, there now existed international standards for capital and liquidity, the Basel Accord, with which the United States had to comply. Compared to 1933, there were simply more facts on the ground. Incremental reform was still possible, but radical reform was hemmed in on all sides.
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There were two estimable congressional leaders in 1933, Carter Glass and Henry Steagall, but there were now two equally effective leaders in Congressman Barney Frank and Senator Christopher Dodd. Frank, the chair of the House Financial Services Committee, had an outsized ego even by congressional standards. Prone to strong statements and bad jokes, and conscious of his reputation as the quickest mind in the House, he did not shy away from denigrating his opponents. But he was able to master complex technical issues and had a knack for shepherding controversial legislation through committee. Dodd, chair of the Senate Banking Committee, ran a disastrous presidential campaign in 2008, and as a “friend of Angelo” he received mortgage loans on his houses in Washington, D.C., and Connecticut from Countrywide Financial. But he was committed to forging a bipartisan consensus, and as a lame-duck senator who announced his decision not to run for reelection in January 2010, he saw successful financial reform legislation as his legacy.
The result was the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which sought to strengthen the system rather than overturn it. At its center were measures to raise capital and liquidity requirements, create a regulatory entity responsible for systemic stability, and protect consumers. Dodd-Frank applied capital requirements at the level of the bank holding company, and not just its commercial banking subsidiary, in order to limit holding-company smoke and mirrors. It specified more demanding capital requirements for banks holding financial derivatives. It required more capital in general.
Following a lengthy comment period, the regulators issued rules implementing these directives. Banks were required to hold equity capital in the amount of 7 percent of their risk-weighted assets. To limit their ability to manipulate their risk weights and shift assets off balance sheet, large internationally active banks were made subject to a simple leverage ratio of 5 percent, including off-balance-sheet exposures (and an even higher 6 percent for the eight largest banking organizations). Large banks were put on notice that, reflecting their systemic importance, they would be subject to capital surcharges to be specified later.
If a step in the right direction, this was still less capital and more leverage than many thought prudent. But in raising capital requirements, the Fed, the FDIC, and the Comptroller of the Currency were limited by the opposition of community banks, which warned that much higher capital requirements could put them out of business. In applying higher capital and liquidity requirements to the largest banks, they were influenced by warnings that heavier requirements would damage the ability of US banks to compete internationally. These questions were all mind-numbingly complex, making it hard for the public to counter the lobbyists.
Creating a regulator responsible for not just the health of individual financial institutions but the stability of the system was similarly more easily said than done. Although the Fed was the obvious entity to assume this function, it was not the most popular agency in town. The issue was taken up in March 2009, just when it was learned that the recently bailed out AIG Financial Products was paying retention bonuses of up to $6.4 million to seventy-three key employees. The Fed had provided the money to bail out AIG. It had known about the bonus payments but had no power to prevent them, or so it claimed. Later it emerged that AIG had been permitted to use the bailout funds to pay off obligations to Goldman Sachs at 100 cents on the dollar. Not only was the Fed aware of the fact, but it instructed AIG’s lawyers not to disclose to the SEC internal memos authorizing the payments.
Whatever the merits of the decision, rewarding the Fed with additional power was a political nonstarter under the circumstances. Not that bestowing those powers on the Treasury Department would have been more popular. With encouragement from Sheila Bair, Frank opted for a committee as the path of least resistance. The Financial Stability Oversight Council, as the committee came to be known, included the Fed and eight other regulators, along with the Treasury secretary in the chair.
Committees move slowly and can find it hard to take decisive action. The Oversight Council took nearly three years to designate two nonbank financial companies, AIG and General Electric Capital, as systemically important and therefore subject to consolidated supervision. Opting for a committee rather than a single systemic stability regulator was unfortunate from this point of view. This outcome again illustrated how chance events like the timing of AIG’s bonus payments could have long-term consequences.
Chris Dodd was quick to embrace the idea of a consumer financial products safety commission as a political winner. Frank and the White House similarly saw it as a way of doing something, at least symbolically, for Main Street. The creation of what came to be known as the Consumer Financial Protection Bureau was championed by Elizabeth Warren, the tireless Oklahoma-born Harvard law professor specializing in personal bankruptcy law. Warren’s campaign was sufficiently effective that her appointment to head the new bureau was blocked by deregulation-minded Republicans. Events took an ironic turn when that denial led Warren to run, successfully, for the Senate as a progressive Democrat in 2012.
The new bureau was charged with rooting out predatory and abusive practices like impenetrable mortgage documentation and up-front fees for debt-relief services that failed to materialize. Again the community banks resisted, on the grounds that they had not engaged in such practices and that the intrusion of a consumer protection bureau would complicate their lives. But the groundswell of support was irresistible. That the financial-services lobby was quick to complain of the bureau’s use of enforcement lawyers on examination teams and policy requiring regulated entities to turn over all internal compliance documents, including those protected by attorney-client privilege, is an indication that it got off to a fast start.
Derivatives regulation was the other major item on the agenda. The government was compelled to bail out AIG because of its $446 billion of bilaterally settled credit default swaps, default on which might have caused its counterparties to collapse. Reformers now proposed moving transactions in such instruments onto exchanges where they could be netted and cleared electronically, limiting the open positions of traders. Prominent among the advocates was Gary Gensler. This was the same Gary Gensler who was once the youngest person ever to be made partner at Goldman Sachs and who shepherded the Commodity Futures Trading Act, which deregulated trading in credit default swaps, while serving as undersecretary for domestic finance in the Clinton Treasury. But the crisis had opened his eyes, and as chair of Obama’s Commodity Futures Trading Commission he now pushed for moving derivatives trading onto electronic exchanges.
But exchange-based trading would have meant lower fees for the banks. It would have required standardizing derivative instruments and eliminating made-to-order business. The less-than-satisfactory compromise was to move settlement of derivatives transactions not onto exchanges but into clearinghouses. Self-organizing clearinghouses run by financial institutions were the main way banks cleared payments and dealt with failures prior to the advent of the Federal Reserve. Following that model, all institutions buying or selling a derivative security through a clearinghouse could be required to put up a margin payment. Those margin payments could then be used to make other counterparties whole in the event of the failure of one of their number.
The problem was that clearinghouses, by sharing risk in this way, also concentrate it. If several members fail simultaneously, the clearinghouse itself may be rendered insolvent and have to be bailed out. This reform, such as it is, may end up only creating yet more too-big-to-fail institutions. Whether this is a step forward only time will tell.
* * *
The remaining changes focused on filling the regulatory gaps revealed by the crisis. Dodd-Frank created a Federal Insurance Office in the Treasury to monitor the insurance industry and hopefully head off future AIGs. It created an Office of Credit Ratings in the SEC to oversee the rating agencies. It required the Federal Reserve to conduct annual stress tests of bank holding companies with $50 billion or more of total assets. It expanded the regulatory perimeter by requiring hedge funds to register with the SEC and revoking the exemption enjoyed by investment advisors with fewer than fifteen clients. Though these were useful steps, they were far from revolutionary.
Then there is what Dodd-Frank failed to do. It did not eliminate too-big-to-fail, either by breaking up the banks or by prohibiting them, Glass-Steagall style, from making risky investments. Instead, the six biggest banks—JPMorgan, Goldman Sachs, Bank of America, Citigroup, Wells Fargo, and Morgan Stanley—were allowed to grow 37 percent larger by the end of 2013 than in 2008–09, at the height of the crisis. Although Dodd-Frank gave the FDIC orderly liquidation authority—that is, the power to impose losses on a failed institution’s shareholders and creditors—simply bestowing that power doesn’t mean that the agency will be prepared to use it, especially if the result will be market disruptions and contagion to other financial institutions. The fact of large financial institutions operating across borders means that orderly resolution will require close cooperation between courts and regulators in a number of countries, in order to avoid a disorderly scramble for assets like what followed the failure of Lehman Brothers. Simply bestowing orderly resolution authority on a U.S. agency does nothing to advance this.
A related provision of Dodd-Frank requires more than one hundred large financial institutions to provide the regulators with “living wills” describing how their affairs will be wound up in the event of failure. In the first such wills submitted in 2012, the banks described hopefully how their various divisions might be smoothly sold off to competitors. But those plans said nothing about who might buy the operations of a failed megabank in a crisis. They gave few grounds for confidence that regulators would be willing to euthanize a big bank given uncertainty about the consequences. Officials talked a good game about ending too big to fail. The reality was different.
The alternative to too-big-to-fail would have been too-safe-to-fail. Deposit-taking banks could have been turned into “narrow banks” permitted to make only safe and liquid investments. A strict version of Glass-Steagall, as advocated by Warren, could have been resurrected. But, again, radical reform was a bridge too far. Instead, the Obama administration settled for what came to be known as the Volcker Rule, championed by former Fed chairman Paul Volcker, which merely sought to ban trading for the bank’s own book rather than on behalf of its clients or as a way of hedging risks. This was a way for the administration to look as if it was taking tough action. Scott Brown’s surprise victory in the special election to replace Senator Edward Kennedy in January 2010, making him the first Republican to represent the Commonwealth of Massachusetts in the Senate in four decades, was enough for the president to stake out a more populist, antibank position. The Volcker Rule was a means to this end.
But its efficacy, like that of orderly resolution authority and living wills, was doubtful. The Volcker Rule was watered down to meet the objections of the financial services industry and obtain a sixtieth filibuster-proof vote from none other than Senator Brown. Rather than banning proprietary trading, banks were still permitted to invest up to 3 percent of their equity in such trades. In any case, it was unclear where to draw the line between legitimate hedging and market-making trades on the one hand and speculative trading for the bank’s own book on the other. The $6.2 billion of losses suffered by JPMorgan from bets placed by the London Whale highlighted the iffy nature of the distinction. JPMorgan described these as “legitimate portfolio hedging operations” compatible with the Volcker Rule, whereas an inspector for its embarrassed regulator, the Comptroller of the Currency, dismissed them as a “make believe voodoo magic ‘composite hedge.’”
The experience of the 1930s suggests that radical reform is possible only in the wake of an exceptional crisis. Absent that crisis, business as usual remains the order of the day, and radical reform that threatens to disrupt such business is ruled out. An exceptional crisis halts such business for a time. The problem starting in 2009, if it can be called a problem, was that policy makers managed, just barely, to prevent a 1930s-style crisis. There was still business as usual to conduct. Radical reform that interfered with customary banking practices could be criticized as jeopardizing the recovery then slowly getting underway. This left only strengthening the existing system, as opposed to replacing it. And the incremental nature of the reform process, which unfolded slowly as new rules implementing Dodd-Frank directives were proposed by the regulators, allowed concentrated interests, notably the bank lobby, to re-form and mobilize in opposition.
Radical reform, 1930s style, may have appealed in principle, but it proved impossible in practice.
Excerpted from "Hall of Mirrors: The Great Depression, the Great Recession, and the Uses -- and Misuses -- of History" by Barry Eichengreen. Published by Oxford University Press. Copyright 2015 by Barry Eichengreen. Reprinted by permission of the publisher. All rights reserved.
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