Lessons Learned From The Current Crisis
By Shawkat M Hammoudeh and Mark A Thompson
Shawkat Hammoudeh is Professor of Economics and International Business at Drexel University, and Mark Thompson is Cree-Walker Chair of Business Administration at Augusta State University. The authors can be reached at hammousm@drexel.edu and mthompson@aug.edu, respectively.
Who should get bailed out? Who should not? In the piecemeal approach that the government followed prior to the comprehensive $700bn rescue plan, the chance for an ailing institution to be bailed out in this financial crisis depends on several factors including size, connectedness and sophistication of investors. If you have the size, like Bear Stearns, Fannie Mae, or Freddie Mac, then you will get support from the government to dodge the crisis. What if you are the fourth largest investment bank (ie, Lehman Brothers)? You will be let go to bankruptcy! But if you are Merrill Lynch, you will be rushed to fire-sell yourself to a very large commercial bank. If you are well connected with other giant enterprises and you are also the world’s largest insurer like AIG, you will be bailed out. Letting AIG go is likely to have a ripple effect on the world’s corporate debt and money markets. If your investors are foreign entities and are not relatively sophisticated, such as the sovereign wealth funds (SWFs), you will have a greater opportunity to be supported as foreign pressure mounts.
The last few months have given us a financial mosaic of events on Wall Street, with far-reaching impacts on the US and the world economies. What lessons have we learned from the worst financial crisis since the Great Depression? The piecemeal approach does not work and a comprehensive plan that rises to the gravity of the crisis and has the support of both the executive and legislative branches is by far the better solution. The crisis shows that the government and the financial institutions should be proactive and act in a timely manner. Timing is important in this crisis. Lehman Brothers had the opportunity to borrow in the discount window, but it squandered this opportunity. Two weeks may have made a difference for the survival of this investment bank. In contrast, AIG sought and received help and it is still with us. If the government had embarked promptly on a more comprehensive solution, the financial landscape would have been different now.
Financial World Transformed
A financial world of giant institutions such as Bear Stearns, Lehman Brothers, Washington Mutual (WaMu) and AIG has been transformed into a world of supergiants such as Bank of America and JP Morgan, as Merrill Lynch was rushed into the arms of Bank of America to avoid the fate of Lehman Brothers and WaMu failed and was acquired by JP Morgan. This new world will be characterized by greater thrift and less leverage. The dwarf institutions will always feel vulnerable and find it risky to stay on their own feet. Investment banks will find it safer to link up with commercial banks to survive the current crisis and to succeed in the new financial world. Commercial banks have more stable loans and less cyclical balance sheets than investment banks. Some supergiant investment banks will transform themselves into banking holdings to be able to establish banking subsidiaries. In this world, the government will also cast a strong shadow over Wall Street.
Under the piecemeal approach, the Federal Reserve’s balance sheet can run out of ammunition, hindering its ability to put out new financial fires. The Fed had $800bn on its balance sheet last year. Now it has about $450bn, which will be less than $200bn if we account for the $200bn pledged to the new lending facility created earlier this year to loan money to investment banks. Recent events may have been favorable to auctioning off government debt to enlarge the Fed’s dwindling balance sheet. However, although the Fed is well equipped to provide short-term money to banks, it is ill equipped to provide long-term capital to fix investment banks’ balance sheets. This will also undermine its credibility regarding the dollar.
Lessons From History
History has taught us that the Fed will need to work with an emergency government agency as part of a comprehensive rescue plan to quarantine the investment banks’ toxic assets and oversee the troubled institutions. Such an entity was created during the Great Depression, the 1980s saving and loan crisis, and the 1997 Asian crisis. The current crisis is no different. In the Great Depression era, this entity was the Reconstruction Finance Corporation (RFC), and in the saving and loan crisis it was the Resolution Trust Corporation (RTC). In both situations, the government agency’s mandate entailed ownership of failed institutions. RFC was also charged with creating jobs. In the current situation, the major task of this proposed entity is to articulate a price-setting process for troubled assets. In contrast, RTC acquired the assets of already failed institutions and did not face this task. Are open auctions in which the government and the private sector bid securities prices a good process for the current crisis? We think so. This process should create a market for those securities. The auction should start with a price that is higher than the fire-sale price and hopefully end up at a price near the value on an institution’s book. The agency can also learn few lessons from the experience of RTC. The implementation process will not be easy and will create controversies. Bill Seidman, the former RTC chairman, can testify to that.
There are other questions that the government should figure out in implementing a comprehensive solution to the crisis. Should the government just buy the troubled assets or should it have equity interests in the institutions? The Democrats are pushing for the equity stake as a supplementary option, while bankers and their lobbyists are opposing it, describing it as a black mark on their financial statements, which may restrict the banks’ ability to lend. This should be a restricted option and the focus should be on buying the assets. Should the plan cover troubled and untroubled assets domestically and overseas? Should homeowners be helped in order to stabilize housing prices which are at the root cause of the crisis? Should the institutions be given the option to buy insurance from the government to insure some of their bad home loans rather than buy them as demanded by the Republicans? This option would limit the amount of federal funds used in the rescue. These questions should be open and be addressed over time, depending on the progress of the plan. Since Congress will share oversight, fine-tuning may be required down the road to keep the plan on track.
Taxpayers should get used to the fact that politicians will use a big chunk of their money to nationalize de facto ailing private institution during major crises such as the current one. The stakes and challenges are tremendous. The taxpayers should also not expect quick fixes regardless of the amount of the money used, even if it is as large as $700bn. The socialization of a private giant such as AIG is startling but it is needed to prevent further collapse in the system, although it did not produce immediate results. However, the taxpayers should be cognizant of the fact that rescue plans that entail buying assets do not add all the value of the plan as an expense to the government budget deficit. Budget rules allow the government to treat asset purchases as a means of financing. Only the interest cost on the Treasuries that will be issued to finance the plan and the investment losses that will be realized from reselling the assets are considered as an expense to the budget deficit. Moreover, taxpayers should have the right to question the wisdom of making them bear the losses of solvent institutions on behalf of those institutions’ stakeholders. How much the government will recover, how much it will lose and when those expenses will appear in the budget is not clear now. However, the deficit should not increase by $700bn and a $1 trillion budget deficit (or 7% of GDP) in 2009, as some say, is unlikely.
The Role Of Regulators
How would the regulators act on those hard-learned lessons? Regulators do not fully understand the rapidly changing instruments floating in the system. The regulators who will deal with the current crisis should be very familiar with the various risk management instruments and their interconnectedness. Today’s debt assets are complex securities. They are strands of instruments several steps away from the actual collateral, which makes it difficult for regulators to unravel those strands to reach the actual collateral. Regulators should be able to make a firm decision on regulating the infamous credit-default swaps (CDS) on loans and corporate bonds. As much as $1 trillion of contracts need to be settled in the new and unregulated CDS market. The New York Insurance Department has moved to regulate CDS. These supposedly risk-hedging instruments have been identified as one of the culprits that generated stress in the markets. CDS played a role in the collapse of Lehman Brothers and pushed AIG into government custody.
Not all the existing instruments or rules are needed or desirable now. Regulators should also examine the mark-to–market accounting rule that contributed to sharp downspins in asset prices. But we should also keep in mind that abolishing this rule now will not make the distressed assets go away. However, with sound supervision, it should help asset prices recover as they do not have to face the downward spinning that was generated by the rule. This rule and the CDS reinforce risk and vicious downward spirals in asset prices. Regulators should prohibit naked shorting for good and favor short selling at uptick. The uptick rule, which was abolished recently by SEC, is akin to ‘circuit breaker’ rules. It calms the markets by halting trading during highly volatile times and abates some of the relentless downward pressure on stocks. There will be new regulations to deal with the crisis and a new financial system will finally emerge.
The $700bn rescue plan is necessary but may not be sufficient. It should help Wall Street and hopefully Main Street. However, the White House and Congress should be flexible and timely. Further economic measures such as monetary easing and fiscal stimulus may be needed down the road to connect Wall Street with Main Street in order to avoid another Great Depression.
Copyright MEES 2008.
