On the Brink (59 page)

By early 2009, it was clear that our actions had prevented a meltdown. Coupled with initiatives from the Federal Reserve and the Federal Deposit Insurance Corporation, the programs we designed and implemented at Treasury—along with those advanced by the Obama administration, which were largely continuations or logical extensions of ours—had stabilized the financial system, restarted credit markets, and helped to limit the housing collapse. Even before I left office in January 2009, the major banks were gaining strength, and many would soon have access once again to the equity and debt markets.

Among these actions, an innovative guarantee staved off a meltdown of money market funds. The Term Asset-Backed Securities Loan Facility, which Treasury conceived and designed jointly with the Fed, has been successful in reestablishing the securitization marketplace for consumer finance in areas such as credit card and auto receivables. And our decision to put Fannie and Freddie into conservatorship ensured the availability of affordable loans for new homebuyers and for those refinancing their mortgages. This was by far the single most important step taken to counter the price declines in housing, a sector critical to our recovery.

We also had a significant impact on foreclosure mitigations by mobilizing and coordinating the private sector to adopt common loan modification plans. We encouraged fierce competitors to cooperate with one another and to work closely with financial counselors to get troubled homeowners to pick up the phone to contact their mortgage servicers. Overall, we ramped up the pace of loan modifications and spared hundreds of thousands of families from the hardship of losing their homes. (The counseling group we supported, known for its 888-995-HOPE toll-free line, was integrated by the Obama administration into its own program.)

And, of course, our decision to take preferred-equity stakes in financial institutions through the capital purchase program—paired with debt guarantees from the FDIC—succeeded in stabilizing the reeling banking industry. Altogether nearly 700 healthy banks, big and small, took advantage of the program, which invested $205 billion in these institutions. I believe the taxpayer will make money on these bank investments. We had originally estimated that up to 3,000 banks might participate, bolstering their capacity to lend. Unfortunately, the political backlash that erupted against institutions’ taking TARP money led many banks to withdraw their applications and discouraged others from submitting theirs.

I came to Washington as an advocate of free markets, and I remain one. The interventions we undertook I would have found abhorrent at any other time. I make no apology for them, however. As first responders to an unprecedented crisis that threatened the destruction of the modern financial system, we had little choice. We were forced to use the often inadequate tools we had on hand—or, as I often remarked to my team at Treasury, the duct tape and baling wire of an outdated regulatory regime with limited powers and authorities.

Our actions were intended to be temporary. If we don’t get the government out as soon as is practical, we will do grave harm to our economy. Yes, our first priority has to be recovery. But it is equally important that we exit these programs. This is critical to our own continued economic success.

The history of capitalism in America has been one of striking the right balance between profit-driven market forces and the array of regulations and laws necessary to harness these forces for the common good. In recent years, regulation failed to keep pace with rapid innovations in the markets—from the proliferation of increasingly complex and opaque products to the accelerating globalization of finance—with disastrous consequences.

In my time in Washington, I learned that, unfortunately, it takes a crisis to get difficult and important things done. Many had warned for years of impending calamity at Fannie Mae and Freddie Mac, but only when those institutions faced outright collapse did lawmakers enact reforms. Only after Lehman Brothers failed did we get the authorities from Congress to inject capital into financial institutions. Even then, despite the horrific conditions in the markets, TARP was rejected the first time it came up for a vote in the U.S. House of Representatives. And, amazingly enough, as I write this, more than one year after Lehman’s fall, U.S. government regulators still lack the power to wind down a nonbank financial institution outside of bankruptcy.

I am not sure what the solution is for this ever more troubling political dysfunction, but it is certain that we must find a way to improve the collective decision-making process in Washington. The stakes are simply too high not to. Indeed, we are fortunate that in 2008 Congress did act before the financial system collapsed. This took strong leadership in both the House and the Senate, because all who voted for TARP or to give us the emergency authorities to deal with Fannie and Freddie knew they were casting an unpopular vote.

Since I’ve left Treasury I’m often approached by people eager to hear about my experiences. Most often they have two basic questions for me: What was it like to live through the crisis? And what lessons did I learn that could help us avoid a similar calamity in the future?

I hope the book you’ve been reading answers the first question. The answer to the second question is obviously complex, but as I have thought about this over the last year or so, I would narrow down the many lessons into four crucial ones:

1.
The structural economic imbalances among the major economies of the world that led to massive cross-border capital flows are an important source of the justly criticized excesses in our financial system.
These imbalances lay at the root of the crisis. Simply put, in the U.S. we save much less than we consume. This forces us to borrow large amounts of money from oil-exporting countries or from Asian nations, like China and Japan, with high savings rates and low shares of domestic consumption. The crisis has abated, but these imbalances persist and must be addressed.

2.
Our regulatory system remains a hopelessly outmoded patchwork quilt built for another day and age
. It is rife with duplication, gaping holes, and counterproductive competition among regulators. The system hasn’t kept pace with financial innovation and needs to be fixed so that we have the capacity and the authority to respond to constantly evolving global capital markets.

3.
The financial system contained far too much leverage, as evidenced by inadequate cushions of both capital and liquidity
.
Much of the leverage was embedded in largely opaque and highly complex financial products
. Today it is generally understood that banks and investment banks in the U.S., Europe, and the rest of the world did not have enough capital. Less well understood is the important role that liquidity needs to play in bolstering the safety and stability of banks. The credit crisis exposed widespread reliance on poor liquidity practices, notably a dependence on unstable short-term funding. Financial institutions that rely heavily on short-term borrowings need to have plenty of cash on hand for bad times. And many didn’t. Inadequate liquidity cushions, I believe, were a bigger problem than inadequate capital levels.

4.
The largest financial institutions are so big and complex that they pose a dangerously large risk
. Today the top 10 financial institutions in the U.S. hold close to 60 percent of financial assets, up from 10 percent in 1990. This dramatic concentration, coupled with much greater interconnectedness, means that the failure of any of a few very large institutions can take down a big part of the system, and, in domino fashion, topple the rest. The concept of “too big to fail” has moved from the academic literature to reality and must be addressed.

There are a number of steps we should take to deal with these issues. To start, we should adjust U.S. policies to reduce the global imbalances that have been decried for years by many prominent economists. If, as a consequence of our current economic problems, American citizens begin to save more and spend less, we ought to welcome and encourage this change. We should go further and remove the bias in our tax code against saving—in effect moving toward a tax code based on consumption rather than income. The system we have today taxes the return on savings, giving incentives to spend rather than to save. Moving to a consumption tax would remove the bias against saving and help boost investment and job creation while reducing our dependence on foreign capital.

Our government needs to tackle its number one economic challenge, which is reducing its fiscal deficit. Our ability to meet this challenge will to a large extent determine our future economic success. We are now on a path where deficits will rise to a point at which we may simply be unable to raise the necessary revenues even if significant tax increases are imposed on the middle class. Dealing with this problem requires moving quickly to reform our major entitlement programs: Medicare, Medicaid, and Social Security. Any such reform needs to be done in a manner that recognizes and addresses the $43 trillion of built-in deficits that the GAO is projecting over the next 75 years. These will only become more difficult to deal with as time goes by. The longer we wait, the greater will be the burden on the next generation.

Striking the right balance to achieve both effective regulation and market discipline is another huge challenge we face. The recent crisis demonstrated that our financial markets had outgrown the ability of our current system to regulate them. Regulatory reforms alone would not have prevented all of the problems that emerged. However, a better framework that featured less duplication and that restricted the ability of financial firms to pick and choose their own, generally less-strict, regulators—a practice known as regulatory arbitrage—would have worked much better. And there is no doubt in my mind that the lack of a regulator to identify and manage systemic risks contributed greatly to the problems we faced.

We need a system that can adapt as financial institutions, financial products, and markets continue to evolve. Before the crisis forced us to shift from making long-range recommendations to fighting fires, Treasury conducted a thorough analysis of the proper objectives of financial services regulation, and this exercise led us to sweeping proposals for fundamental reforms. These recommendations were controversial when they were issued in March 2008, but in retrospect seem quite prophetic.

Among other things, we proposed a system that created a government responsibility for systemic risk identification and oversight. We recommended strengthening and consolidating safety and soundness regulation to eliminate redundancy and counterproductive regulatory arbitrage. Acknowledging the proliferation of financial products—and the abuses that have accompanied them—we also proposed a separate and distinct business conduct regulator to protect consumers and investors.

There is a well-recognized need for a global accord requiring banks to have higher levels of better-quality capital. This will be more difficult to achieve for some of the more highly leveraged European banks, but consistency here is important, and a stronger capital position will allow the banks to lend more in a downturn, when credit is most needed. Regulators must also require bigger liquidity cushions, and these, too, must be harmonized globally. A simplistic one-size-fits-all model will not work for liquidity. Bank managements and regulators need to have a better understanding of the potential liquidity demands, which will vary bank by bank, under adverse conditions.

With a $60 trillion global economy and a $14 trillion U.S. economy, it is inevitable that we will have a number of very large financial institutions whose increasing size and complexity are driven by customer demands in a global marketplace. Inside the U.S., which still has 8,000 relatively small banks along with its many big institutions, competitive pressures will also force the industry to continue to consolidate. Just as many people shop at Wal-Mart while mourning the disappearance of their local retailers, so, too, will they find their way to bigger commercial banks offering a wider range of lower-cost services and products than smaller banks do. The institutions that are emerging to satisfy all of these needs are complex, difficult to manage and regulate, and pose real risks that must be confronted.

There is no question that tighter, and one trusts better, regulation is coming. I hope and expect that big institutions will be regulated in a way that considers the risks resulting from their size and from acquisitions or new business lines that make them riskier and further complicate the already difficult task of managing them effectively.

However, regulation alone cannot eliminate instability, and we will inevitably be confronted with the failure of another large, complex institution. The challenge is to strengthen market discipline as a tool to force institutions to address problems before they become impossible to solve and to design a means of absorbing a large failure without the entire financial system’s being threatened. As I have said repeatedly, we need more authority to deal with, and wind down, failing institutions that are not banks. The current bankruptcy process is clearly inadequate for large, complex organizations, as the failure of Lehman Brothers demonstrated.

I shudder at the thought of any future administration’s having to cope with another crisis hobbled by the constraints that we faced. For this reason, I favor broad authorities to deal with the failure of a systemically important institution—including the power to inject capital and to make emergency loans. Some critics may say that such powers would only increase the risk of moral hazard, but I am confident that procedural safeguards can be put in place to help manage such concerns and to mitigate market distortions.

Wind-down authority must be constructed to impose real costs on creditors, investors, and the financial franchises themselves so that market discipline can continue to be a constructive force in the regulation of large, complex firms. However wind-down authority is devised, it will affect market practices and credit decisions. To minimize uncertainty in the market, the government should provide clear guidance as to how it would use this enhanced authority. And a very high bar should be set before it is used, similar to the constraints that are placed on the FDIC before it liquidates—or, in technical terms, “resolves”—commercial banks.