On Wednesday, September 17, 2008, according to the New York Times, Fed Chairman Ben Bernanke used “a speaker phone from his ornate office” to tell Treasury Secretary Henry Paulson “that it was time to adopt a comprehensive strategy that Congress would have to approve” for dealing with the financial-market troubles. After a second call on Thursday morning, Paulson agreed. The next day he called publicly for what the Times described as “far-reaching emergency powers to buy hundreds of billions of dollars in distressed mortgages despite many unknowns about how the plan would work.”
Just one day later, September 20, the Bush administration announced a price tag: It would ask Congress for what the Times described as “unfettered authority for the Treasury Department to buy up to $700 billion in distressed mortgage-related assets from the private firms.” News reports noted that $700 billion amounts to more than $2,000 for every man, woman, and child in the United States. Secretary Paulson released a three-page draft of the legislation he wanted. It did not specify how the money would be spent, but did say that no court could review the Treasury’s decisions about spending the money. Paulson warned of dire consequences should Congress not approve the legislation quickly and as proposed.
In asking for huge sums and unrestrained power for government to intervene in financial markets, Bernanke and Paulson discarded any pretense of adhering to free-market principles. The Times reported that an attendee at a strategy meeting quoted Bernanke as justifying the abandonment of principles by declaring that, “There are no atheists in foxholes and no ideologues in financial crises.” The aim of avoiding a deeper crisis, in other words, rationalizes whatever seems expedient. We should flee from the threat of a “financial meltdown” even into the arms of a constitutional meltdown. Surprisingly, many “free-market” commentators and economists echoed this sentiment. Some of them pledged to reaffirm free-market principles in the future even while calling for their abandonment for the duration of the financial turmoil. Their questionable judgment seems to have been that more government intervention was needed to offset—and would offset rather than compound—the previous interventions that had created financial chaos.
Few in Congress questioned the figure of $700 billion. Some House Republicans proposed a nominally less-interventionist plan that would have had the federal government not purchase—“only” guarantee—home-mortgage assets. Instead of putting an explicit price tag on the taxpayers’ burden for the bailout, government guarantees of mortgages and mortgage-backed securities would have obliged taxpayers to pay lenders and bond holders whenever and wherever borrowers or security issuers defaulted, implying off-balance-sheet taxpayer exposure on an unspecified scale. A blank check rather than a $700 billion check—some improvement.
After congressional wrangling for nine days over what to add to the three-page Treasury proposal, a bill of 110 pages emerged. A deal had been struck. The Treasury’s authority to purchase had grown beyond mortgage-related assets to include “any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability.” In other words, whatever the two wanted.
Shock in the House
On Monday, September 29, the House of Representatives shocked political pundits by voting down the bailout bill 228–205. With constituent email and phone messages to Congress running heavily against the bailout (some estimates said 30–1), the majority that day disregarded dire warnings that Congress had “no time” to put any more careful thought into what it was doing.
Two days later, however, the U.S. Senate approved a further-revised bailout bill 74–25. Although they had not taken time to put a lot of additional thought into it, senators had nonetheless added a lot of text: The bill had now grown to 422 pages. The Emergency Economic Stabilization Act of 2008 now not only provided $700 billion for a Troubled Assets Relief Program, but also included sections and subsections on Renewable Energy Incentives, Carbon Mitigation and Coal Provisions, Transportation and Domestic Fuel Security Provisions, a grab-bag of tax-credit extensions, a subtitle for Mental Health Parity and Addiction Equity, another for Heartland and Hurricane Ike Disaster Relief, an increase in federal deposit insurance, and authority for securities regulators to relax accounting rules that financial firms facing mortgage-related losses were finding inconvenient. The height of special-interest absurdity was reached in Section 503 of the Act which, according to the official Library of Congress summary, “Exempts from the excise tax on bows and arrows certain shafts consisting of all natural wood that, after assembly, measure 5/16 of an inch or less in diameter and that are not suitable for use with bows that would otherwise be subject to such tax (having a peak draw weight of 30 pounds or more).”
Two days after the Senate vote, on Friday, October 3, the once-reluctant House approved the bailout bill 263–171. In the second House vote 33 Democrats and 25 Republicans switched from no to yes. One congresswoman unashamedly explained to National Public Radio that she had switched because the new bill included solar-energy tax credits. President Bush immediately signed the bill. Prices on the New York Stock Exchange, which had closed way down the day the first bill had failed to pass, closed down again on the day the revised bill passed and was signed into law.
The “plan” for how to spend the $700 billion bailout has always been extremely vague, from its inception in the Bernanke-Paulson phone call, through the case Paulson made before Congress, to the passage of the enabling legislation. Improvisation continued up to the date this account was written in late November. The Treasury originally announced an intention to buy troubled mortgage-related assets, and hence the bill refers to a Troubled Asset Relief Program, or TARP. But on what terms would they buy these assets? More than a month after passage, that had yet to be made clear. American Public Media’s Marketplace program reported on November 7 that, “A securities industry trade group just came out with a survey, and it found that financial players are so unclear about how TARP would work, they aren’t sure they want to participate.” The Treasury had to schedule a meeting with banking industry representatives on November 10 to fill them in on the evolving specifics of TARP.
The “troubled” assets to be purchased are mortgage loans, bundles of such loans (“mortgage-backed securities”), and apparently any other financial assets the Treasury wants to include. What makes them “troubled” is basically that financial institutions can’t sell them for what they paid for them. The basic reason is that an unexpectedly huge share of mortgages has gone bad: Mortgage-default rates have skyrocketed. Further, the secondary market for mortgage-backed securities has dried up. A firm trying to sell some of its holdings would fetch only fire-sale prices.
There is a basic problem with having the Treasury buy assets that the market won’t buy except at fire-sale prices. Either the Treasury outbids the market and overpays for the assets—which benefits financial institutions at taxpayer expense—or the government pays the current market price, which would compel banks to mark other assets down accordingly and book the losses they’ve been trying to avoid booking.
In arguing for the bailout, Bernanke proposed that an “auction” of troubled assets for taxpayer-provided dollars would enable accurate “price discovery,” even though the Treasury would be the only bidder, and thereby would restore an active market. How such an auction would work, how it could be designed to arrive at hoped-for prices—above current market prices but not above what the assets would supposedly be worth in a normal market—was never spelled out. In mid-November “Plan A” appeared to have been more or less officially shelved. Never mind that Paulson had told Congress that hundreds of billions for troubled-asset purchases were urgently and immediately needed to avoid financial Armageddon.
On November 25 the idea of troubled-asset purchases made a dramatic comeback under the auspices of the Federal Reserve, which is discussed below.
On October 13 the Treasury announced a new way to spend $250 billion of the $700 billion: It would inject equity capital into banks, buying newly issued preferred shares. It soon thereafter injected $125 billion into nine major banks: Citigroup, Bank of America, Wells Fargo, JPMorgan Chase, Bank of New York Mellon, State Street, Merrill Lynch, Morgan Stanley, and Goldman Sachs. The last-named is the former investment bank, recently converted into a commercial bank, previously headed by Paulson. From the group of nine banks the Treasury took “preferred shares” with fixed 5 percent dividends (increasing to 9 percent if the shares have not been repurchased in five years).
On November 23 the Treasury announced it would inject an additional $20 billion of equity into Citigroup. For this second injection it took preferred shares with an 8 percent dividend. The Treasury together with the FDIC also provided an off-balance-sheet guarantee against losses on about $300 billion of Citibank’s troubled real estate assets, in exchange for which the Treasury and FDIC took additional preferred shares.
The federal government is now part-owner of the nine banks. The banking system has been partially nationalized. The preferred shares are ownership claims of a type falling between debt obligations (bonds) and common stock shares. They are riskier than bonds because preferred shareholders must stand behind bondholders in the line to get paid in the event that the bank can’t pay everyone.
To compensate for its risk the Treasury also took stock warrants—contracts that give it the right to buy shares in the future at a specified price so that it can make a profit should the banks’ stock prices someday rise higher than that price. “Recapitalizing” a firm normally leads to lower share prices, however, because it means more shares dividing ownership of the same asset portfolio. The infusion dilutes existing shares. For this reason two of the nine banks reportedly objected to participating in the Treasury’s capital infusion with attached strings. The Treasury explained that it did not make participation voluntary because it did not want to stigmatize as weak the banks that chose to participate. A financial analyst’s report in late November named Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley, and Wells Fargo as the weakest institutions.
The other half of the Treasury’s $250 billion has been designated for assignment to smaller banks to be named later. Among other things, the Treasury reportedly hopes these capital injections will enable recipient banks to buy up other, weaker banks. An anonymous Treasury official told reporters: “One purpose of this plan is to drive consolidation.” Thus taxpayer money is being allocated to influence the shape of the banking market.
What will “Plan” C be? As the Treasury continues to improvise, everything and anything is possible. So says Neel Kashkari, the former Goldman Sachs employee under Paulson who is now the Treasury’s chief bailout administrator under Paulson. Asked whether funds might go to insurance companies, other financial firms, and even nonfinancial firms like automakers, one news story reported, “Kashkari indicated that everything was on the table. ‘We are looking at everything,’ he said. ‘We are trying to figure out what will provide the most benefit to the financial system.’”
House Speaker Nancy Pelosi, Senate majority leader Harry Reid, and other congressmen have urged the Treasury to use some of the $700 billion to inject capital into the leading U.S. automakers. These same lawmakers specified no such authority in the bailout bill. Some $1.5 billion of the $700 billion will go to local governments for reasons unrelated to the financial system.
Insurance executives have reportedly lobbied for the bailout to include troubled insurance company assets. There is now a precedent: The Treasury has given $67.5 billion of the bailout to AIG, the failed insurance giant brought down by its imprudently massive guarantees on mortgage-backed securities, in exchange for troubled assets and preferred shares. AIG was already on an $85 billion life-support loan from the Federal Reserve.
The Treasury’s $700 billion bailout is actually the second federal bailout program underway. The press has widely reported on the Treasury bailout bill and the post-bill spending improvisations. Columnists and the public have openly debated the dubious wisdom of that program. Congress has held hearings and has voted on the bailout bill, even if it has left it to the Treasury to decide how the $700 billion will be spent. But flying under the radar, attracting much less public attention and almost zero congressional scrutiny, have been the Federal Reserve’s ongoing efforts that in mid-November added up to a $1.7 trillion shadow bailout program for favored financial institutions, more than double the size of the Treasury’s bailout. On November 25 the Fed announced two new lending lines that will add another $800 billion, bringing the total to $2.5 trillion—more than triple the size of the Treasury’s bailout. (This section draws heavily on my paper for the November 2008 Cato Institute monetary conference, “Federal Reserve Policy and the Housing Bubble.”)
The Fed’s bailout efforts began back in March 2008 with the Fed putting up $29 billion to sweeten a deal in which the commercial bank JPMorgan Chase would take over the teetering investment bank Bear Stearns. A new Fed-owned subsidiary (“Maiden Lane LLC”) was set up to cleanse the Bear Stearns balance sheet by acquiring troubled mortgage-backed securities for the $29 billion. The transformation of the Federal Reserve’s balance sheet, which used to hold virtually nothing but safe Treasury securities, had begun. Between March and November, as the Fed improvised new interventions into financial markets, the dollar amounts of the Fed’s commitments grew and grew.
The interventions are visible among the assets on the Fed’s balance sheet for November 5, where many new entries appear that were absent one year ago. The list begins with “Term Auction Credit” at $301 billion, representing 28-day and 84-day loans to banks. Previously loans to commercial banks were limited to overnight loans for meeting reserve requirements. Banks were expected to attract longer-term funds from depositors or private institutional investors in the money market. Next on the list is “Primary Dealer and other Broker-Dealer Credit” of $72 billion—that is, loans to securities dealers. A year ago the Fed did not lend to securities dealers. Third is the “Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”—loans to banks or bank holding companies to allow them to purchase assets from money-market mutual funds. Previously money-market funds that needed to liquidate commercial paper holdings were expected to sell them in the money market. “Other credit extensions,” a catchall fourth new entry, amount to $81 billion.
The fifth new entry is “Net portfolio holdings of Commercial Paper Funding Facility LLC,” $243 billion. A memo to the Fed’s balance-sheet release explains: “On October 27, 2008, the Federal Reserve Bank of New York began extending loans . . . to Commercial Paper Funding Facility LLC. This LLC is a limited liability company that was formed to purchase three-month U.S. dollar-denominated commercial paper from eligible issuers and thereby foster liquidity in short-term funding markets and increase the availability of credit for businesses and households.” That is, the Fed has formed a new subsidiary for directly allocating funds to a particular segment of the financial system, the commercial paper market. Previously the Fed purchased only Treasury securities, and let private banking and financial markets allocate the funds it thus injected to their best uses.
Sixth is “Net portfolio holdings of Maiden Lane LLC,” $27 billion, representing the troubled assets acquired from Bear Stearns. Note that the assets have been marked down from their acquisition price of $29 billion: the Fed has suffered a loss of $2 billion. By holding the assets the Fed is speculating that the market for selling them will be better later on. Previously the Fed did not get involved in financial takeovers by absorbing troubled assets to sweeten the deal. The FDIC sometimes did, but only in mergers between two insured commercial banks. Bear Stearns was an investment bank, not an insured commercial bank.
Last September the Federal Reserve began buying federal agency notes—short-term IOUs of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks—from securities dealers. As of November 5 the Fed was holding $13 billion of such notes, where it held zero one year ago, though it has held small amounts of agency debt in the past. The Fed’s “primary” (overnight) loans to commercial banks are currently at $110 billion, up from only $1.4 billion a year ago. In total the Fed’s assets have more than doubled, from $889 billion a year ago to an astounding $2.08 trillion in mid-November. Further increases are on the way.
Two items make the Fed’s bailout loan program even larger than the $1.2 trillion increase in its total assets. First, the Fed has funded $303 billion of its new loans by selling off Treasury securities from its portfolio. Second, off its balance sheet (but recorded as a “memorandum item”), the Fed also runs a “Term Securities Lending Facility” that has lent $197 billion of its Treasury securities to broker-dealers, giving them something liquid to sell in exchange for IOUs collateralized by less liquid securities like mortgage-backed securities. As of November 5 the Fed’s new loans and purchases had extended $1.7 trillion in new credits to financial institutions over the past year.
On November 25 the Federal Reserve announced that in the following week it would begin purchasing up to $600 billion in securities issued or guaranteed by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. It would buy them from its primary securities dealers through “a series of competitive auctions.” It also announced the creation of a $200 billion Term Asset-Backed Securities Lending Facility to make new term loans to financial institutions, loans to be collateralized by nonmortgage pools of consumer and small-business loans. In both cases the Fed is engaged in price-setting, trying to drive interest spreads (the differential yields over Treasury bills required to attract purchasers) on riskier securities back into their historical ranges. Thus the Fed is second-guessing the risk premiums set in competitive financial markets. As of Thanksgiving, the new facilities had not yet appeared on the Fed’s balance sheet.
Unprecedented Credit Expansion
From $1.2 trillion of added bank reserves, the late-November lending programs (if not somehow offset) will push added bank reserves to $2 trillion. The Fed has no clear exit strategy from its unprecedented credit expansion. It has too few Treasury securities left to sell in order to pull the credits back in, the traditional method for contracting bank reserves. No doubt the Fed hopes that the new loans will be repaid (and not re-extended) as financial market conditions improve. But borrowing firms whose ability to repay depends on the prices of their mortgage-backed securities recovering may be unable to repay any time soon because the effects of overbuilding during the housing bubble will depress the price of real estate and thus of mortgage-backed securities for a long while. Moreover, they may be unwilling to repay. Nonbank financial firms that are now enjoying the Fed’s below-market lending rates will have no incentive to wean themselves and every reason to lobby for keeping the new bargain lending windows open indefinitely. “Temporary emergency” government subsidies have a way of living on and on. Just ask the recipients of federally subsidized farm loans.
The Fed’s new activities deserve to be called a bailout program because they seek to channel credit selectively at below-market interest rates, or purchase assets at above-market prices, in hopes of rescuing, or enhancing profits for, favored sets of financial institutions. The Fed’s new lending facilities are not parts of a central bank’s traditional “lender of last resort” role. A lender of last resort injects reserves into the commercial banking system to prevent the quantity of money from contracting—and thereby to protect the economy’s payment system—when there is an “internal drain” of reserves (bank runs and the hoarding of cash). There has been only one bank run (on IndyMac) and no contraction in the money stock. Investment banks do not issue checking deposits, are therefore not subject to depositor runs, and are not part of the payment system. Neither are securities dealers. Money-market mutual funds play a limited payment role, but because they do not issue demandable debt, they are not subject to runs. The Fed’s expansions of its own activities therefore had nothing to do with protecting the payment system or stabilizing the money supply.
The “lender” in “lender of last resort” has long been an anachronism. Central banks in sophisticated financial systems discovered decades ago that they can inject bank reserves without lending by purchasing government securities in the open market. By doing so, the central bank supports the money stock while avoiding the danger of favoritism associated with making loans to specific banks (or nonbanks) on noncompetitive terms. It also avoids the potential favoritism in purchasing other securities. The Fed’s new activities, by contrast, extend an array of loans to various financial institutions and purchase securities from nonbank issuers and holders. These activities pose the risk of favoritism—of substituting the Fed’s judgment for the market’s about what kinds of institutions and what particular firms should survive. They have nothing to do with replenishing the reserves of the banking system or preventing contraction in the stock of money. The Fed’s activities seem rather to aim at protecting financial institutions from the consequences of imprudent portfolio decisions.
The Federal Reserve’s new interventions into financial markets over the past year have proceeded at its own initiative and without precedent. They seem to be enjoying the complete freedom from oversight that Secretary Paulson unsuccessfully sought for the Treasury’s bailout program. The Fed’s program has attracted little attention mostly because it has not required a congressional appropriation. The Fed is “self-financing”: It can “print up” any funds it needs to make loans or purchase assets by simply expanding the quantity of unbacked claims on itself. This does not mean that Fed credit expansion provides a free lunch. When the Fed increases the stock of dollars, it levies an implicit tax on holders of existing dollar balances by creating an inflationary depreciation of the dollar.
An Evaluation of the Bailouts
The financial turmoil of 2008 was the result of what may be briefly described as a government-policy-induced cluster of entrepreneurial errors by financial-market participants. Paulson’s and Bernanke’s bailout programs are disabling the key market mechanisms for correcting entrepreneurial errors: price adjustments and bankruptcies. Delays in the correction of mortgage asset prices, and delays in the necessary resolution of insolvent financial institutions, do not promote but rather hinder a sound economic recovery. As ABC News commentator John Stossel has written: “We do need protection from reckless businessmen. But there is only one way to provide that: market discipline. That means no privileges and no bailouts.”
When government does not intervene with taxpayer-financed bailouts, private market participants will recapitalize banks (as Mitsubishi Bank recently did for Morgan Stanley) and buy distressed assets in genuinely price-discovering market transactions, to the extent that those risking their own money think warranted. The resolution (sale or liquidation) of firms that are not worth recapitalizing makes room in the market for better-run institutions to take their place. As the United States discovered in the savings-and-loan fiasco of the 1980s, and as Japan discovered in the 1990s, a government policy of keeping insolvent financial firms open beyond their expiration date makes survival more difficult for healthy firms.
Along these lines, the eminent monetary historian Anna J. Schwartz candidly criticized the bailout programs in an interview with the Wall Street Journal on October 18. To promote recovery the Fed and Treasury “should not be recapitalizing firms that should be shut down,” Schwartz said. Rather, “firms that made wrong decisions should fail. You shouldn’t rescue them. And once that’s established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich.”
Schwartz observed that “Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them.” Removing the uncertainty by enforcing the usual rules requiring insolvent firms to exit the market promptly would provide greater clarity to financial markets. The economist Pedro H. Albuquerque has drawn out the implications of this insight: bailout plans make “the information problem worse by keeping unhealthy banks afloat,” which “endangers the entire economy through planned obfuscation.” A hypothetical used-automobile market in which buyers are reluctant to buy because they fear that sellers are trying to palm off unreliable vehicles is known to economists as a “lemons” market. Albuquerque observes that “The government is artificially creating a lemon market when it does not allow discrimination between healthy and unhealthy banks to occur via bank failures.”
Some editorial and op-ed writers have claimed that many financial institutions have been “unregulated” too long and must now become regulated. But financial institutions have never been unregulated. They have been regulated by profit and loss. The failure of Lehman Brothers and the near-failure of Merrill Lynch raised the interest rate at which profit-seeking lenders were willing to lend to highly leveraged investment banks. The market thereby forced Goldman Sachs and Morgan Stanley to change their business models drastically and to convert to commercial banks. If that isn’t effective regulation, what is? Protecting firms from failure (Bear Stearns, AIG, Fannie Mae, Freddie Mac, Goldman Sachs, Citibank) and mitigating their losses with bailouts renders this most appropriate form of regulation much less effective.
The eagerness of Ben Bernanke and Hank Paulson to substitute their own judgment for the dispersed judgments of a freely competitive financial market may reflect simple intellectual error. Or, less innocently in the case of former Goldman Sachs CEO Paulson, it may be error compounded with partiality. In an open letter to Congress on the eve of the bailout bill’s passage, John A. Allison, CEO of the large and successful regional bank BB&T, pointed out that “There is no panic on Main Street and in sound financial institutions. The problems are in high-risk financial institutions and on Wall Street.” The bailout seemed designed, in his view, to benefit a select group of Wall Street firms: “The primary beneficiaries of the proposed rescue are Goldman Sachs and Morgan Stanley.. . . [T]his is primarily a bailout of poorly run financial institutions.” This design, Allison continued, was not an accident but the result of partiality in the designers’ interests and perspective: “Treasury is totally dominated by Wall Street investment bankers. They do not have knowledge of the commercial banking industry. Therefore they cannot be relied on to objectively assess all the implications of government policy on all financial intermediaries.”