A wasted crisis
By propping up banks indiscriminately, the Obama administration's troubled asset relief program not only outraged voters but also magnified moral hazard in the financial system and made effective reform harder.
Barack Obama came to office with members of his administration quoting the adage of Paul Romer, the economist: "A crisis is a terrible thing to waste.” But it has wasted the financial crisis.
This week, the last two large banks to receive capital injections from the US government at the height of the crisis in October 2008 agreed their exit with the Treasury. Citigroup and Wells Fargo have chafed under the rules of the troubled asset relief program (TARP) and are returning $US45 billion in order to roam free.
Although it has been extended into next year, the TARP’s raison d’etre – preventing banks from collapsing – will soon be history. So now is a good time to recognise both its achievements and its failures.
In terms of its original aims, the TARP has succeeded – indeed it has worked better than expected. Tim Geithner, the US Treasury secretary, expects to make a profit on the capital investment element of TARP and the $US700 billion program will now add at most $140 billion to the federal deficit.
The US economy remains weak but, compared with the prospect of cataclysm that faced Hank Paulson, the former Treasury secretary, when TARP was devised, is stable. Signs of distress in markets have receded and confidence has returned.
Yet, as banks rush out of TARP to avoid second-guessing from Congress and restrictions on executive pay, little has changed on Wall Street. Bear Stearns and Lehman Brothers are gone but the banks that remain make money in the same old way.
As the FT reported on Wednesday, banks and hedge funds have made huge profits in distressed debt trading in the past year, aided by the Federal Reserve keeping short-term interest rates low. Meanwhile, the banks that turned out to be too big to be allowed to fail are bigger than ever.
TARP may have achieved its financial aims but, in terms of systemic risk, it has failed. By propping up banks indiscriminately, on soft terms, TARP not only outraged voters but also magnified moral hazard in the financial system and made effective reform harder.
"Given the severity of the crisis, the government had no choice but to intervene, but there were not enough strings attached and the moral hazard problem has worsened,” says Matthew Richardson, a professor at New York University.
The only hope of redressing this, now banks have wriggled out of TARP’s grip, is in reform legislation now making its way through Congress. It is likely to do some useful things, such as reforming derivatives trading and creating a "dissolution regime” for banks, but probably not enough.
The moral hazard problem – that banks have an incentive to grow and to take more risks with their capital, knowing the government will bail them out in any crisis – was exacerbated by the way in which last year’s rescues were executed.
In the week before the failure of Lehman, I among others urged Paulson, who had just bailed out Fannie Mae and Freddie Mac, not to keep on rescuing financial institutions. He held back but was forced into retreat by a collapse in market confidence.
By that time, the Treasury was improvising solutions and decided it had to treat all banks equally. TARP’s first incarnation as a plan to support prices of mortgage-backed securities was ditched in favour of investing capital (semi-forcibly) across the industry.
I had sympathy at the time with Paulson (and then Geithner) continually adjusting their position and justifications for intervention – or lack of it. They were, after all, facing a deluge of financial problems and a severe challenge in gaining approval from Congress.
Even so, they could have achieved the same ends without leaving such a residue of incentive problems. They did not need to improvise as much as they did, since they had historical examples to guide them.
As Charles Calomiris, a professor at Columbia University, has argued, Britain faced repeated financial crises in the first half of the 19th century because the Bank of England promised to buy bills if prices fell below a certain point, encouraging discount houses to inflate credit.
After it changed course in 1858, it established its authority by refusing to bail out Overend, Gurney in 1866. Sadly, Paulson’s attempt to pull an Overend, Gurney with Lehman backfired.
Even rescues can be structured to minimise bad incentives. In the 1930s, the US Resolution Trust Corporation allowed insolvent banks to collapse while investing preferred shares in healthier ones. By contrast, Paulson lumped Goldman Sachs and Citigroup together.
Moral hazard seemed like an academic problem at the time, but it is not academic now. By investing in all big banks, and bailing out bank bondholders and counterparties to AIG’s credit default swaps at par, he set powerful precedents.
The US dealt with that in the 1930s by passing the Glass-Steagall reforms but this time has, wrongly in my view, avoided structural changes. Instead, it is pinning its hopes on tightening regulations and a new mechanism to wind down failing investment banks.
But, unless banks are convinced they will be dissolved in any future crisis – and their bondholders and shareholders will lose money – bad incentives will become part of TARP’s historical legacy.
Last year, everyone worried about the consequences of TARP failing. In practice, it worked too well.