Firefighting - The Financial Crisis - Bernanke, Geithner & Paulson

Bernanke, Geithner and Paulson - Firefighting

Remembering the deep financial abyss

How do you remember the financial firestorm that swept through 2007-08? For Warren Buffett, the Oracle of Omaha, it was like staring “into the abyss”. I’m sure it’s left indelible scars on former US Federal Reserve chairman Ben Bernanke, former Secretary of Treasury Hank Paulson and former President of the New York Federal Reserve Tim Geithner as well – Three individuals, amongst others, at the helm of the United States’ response to the Great Financial Crisis (GFC).

Bernanke, Geithner and Paulson (BG&P) came together ten years later to reflect in Firefighting: The Financial Crisis and its Lessons. One motivation for their book, the authors say, is fear “that the enemy is forgetting” again. That is, we will one day recreate the vulnerabilities that led to the GFC. This message is all the more pressing as a new generation of young bankers, policymakers, and investors join the fray.

Firefighting, in my opinion, is essential reading for Wall Street, financial historians, politicians and business students. As the crisis fades into distant memory, we have to remember not to repeat history’s mistakes. With that in mind, this post will summarise the key lessons that I took from Firefighting.

The spark: Mistaken beliefs

The 2007-08 Global Financial Crisis was a “classic financial panic” — a crisis of confidence in the mortgages market that led to a run on the entire financial system. Like many other crises in financial history, excess credit, leverage and risk taking had fuelled the boom and bust.

Countrywide’s failure was case in point. They had an “overreliance on lower-quality mortgages, regulatory arbitrage, and especially runnable short-term financing”. Lehman’s collapse, likewise, was not at all dissimilar: “loosely regulated, heavily over-leveraged, deeply interconnected non-bank, with too much exposure to the real estate market and too much dangerously runnable short-term financing”.

But bad lending practices in American subprime mortgages was only “the spark”. Indeed, much of the calamity was the result of a l olla palooza effect. Many psychological, structural and political forces of misjudgement acted in tandem, amplifying each other until the system gave way. BG&P highlight several behavioural factors that contributed to the crisis:

House prices never fall

Initially, people held complete faith in the housing market. It was “conventional wisdom” that you could buy real estate with minimal or zero risk. If any repayment troubles arose, you could just “refinance or sell at a profit”. (Speaking from firsthand experience, I’ve seen my own family, friends, and neighbours fall prey to this reasoning. And it’s difficult to convince them of otherwise when history over the last decade gives you no evidence of the alternative.)

“They were like drug dealers who got high on their own supply, genuinely believing that stratospheric housing prices would defy gravity indefinitely”.
Bernanke, Ben., Geithner, Timothy., & Paulson, Henry. (2019). Firefighting: The Financial Crisis and Its Lessons.

Get up and dance!

An originate-to-distribute model grew to meet burgeoning demand for mortgages. This in turn led to a deterioration in underwriting standards. Loan originators didn’t care about their customers’ credit history because they didn’t bare the risk of default. Their executives knew this, but couldn’t cut back either. There was reputation and career risk for individuals that went against the grain. Asking for prudence is hard when profits are soaring. As Citigroup CEO Chuck Prince noted in 2007, “as long as the music is playing, you’ve got to get up and dance”.

It’s all triple A anyway

Mortgages were then sliced and diced in many ways. And credit ratings agencies would give these instruments triple-A ratings, regardless of underlying risk. Like the banks and homeowners, they wrongly assumed that housing prices couldn’t decline simultaneously across the United States.

This time is different

But collateralised debt obligations, derivatives and other related securities were “complex, opaque, and embedded with hidden leverage”. With millions of contracts floating around, it was “nearly impossible” to understand the totality of exposures and risk in the market overall. Finance hadn’t solved the problem of risk, “it was just hidden and diluted and spread around the world”.

Even then, people believed the financial system could handle a collapse in the subprime mortgages market. After all, subprime accounted for less than 15 percent of all U.S. mortgages at the time. What we all missed, the authors emphasise, is how panic can spread from one locality to the rest of the system.

In Radical Uncertainty, John Kay and Mervyn King believe that people’s inability to distinguish between knowable and unknowable risk was a leading cause of the catastrophe. Personally, I believe it was more of an unwillingness than an inability. These investment products were very profitable, and the personal cost of failure or wrongdoing was terribly low. The peddlers didn’t care about the consequences. People will pretend it’s smart and safe if it makes them money.

Kindling: Institutional weaknesses

Something that appears profitable in isolation is not always so in the aggregate. This is the problem of twin strategies. So, why didn’t policymakers and regulators intervene earlier? Here, the authors offer a few reasons:

Complacency

During the credit boom, the financial system’s weaknesses “did not seem pressing”. Economic activity on Wall Street and Main Street seemed stable. But this “long period of calm lead to complacency”. In BG&P’s opinion, U.S. capital rules were too narrow. Regulators neglected the leverage and risk embedded in “complex derivatives and off-balance-sheet vehicles” and allowed banks to use “poor-quality capital” to meet mandated ratios.

As Friedrich Hayek observed more than six decades prior, statistical aggregates may exhibit “greater stability than the movements of the detail”. The system might show a face of calm while its underbelly wrenches. Humans find uncanny ways to breed instability from stability.

The American Dream

Homeownership was central to the American dream. Many citizens, businesses, and politicians defended the mortgage boom, credit boom, subprime lending and securitization for this very reason. Yes, early reforms were necessary. But reform is often a difficult ask “without a crisis to make the case for it”.

Fragmentation and dysfunction

Similarly, the “failure of institutional organisation” had weakened the U.S. government’s capacity to combat financial risk. Oversight of non-banking institutions was fragmented and dysfunctional. And no agency had responsibility for the overall health of the entire financial system itself. Some banks, for example, switched legal forms to “choose” favourable regulators.

Risk migration

Additionally, many of the large, highly leveraged and interconnected financial institutions that partook in the mortgage frenzy were not traditional banks. They didn’t have “the security of insured deposits… [, ] regulatory constraints on their leverage… [and] the ability to turn to the Fed if their financing evaporated”. Given the house of cards, creditors fled at “the first hint of trouble”. As history has shown, problems arise when everybody wants their money returned immediately.

“The basic problems were too much risky leverage, too much runnable short-term financing, and the migration of too much risk to shadow banks where regulation was negligible and the Fed’s emergency safety net was inaccessible. There were also too many major firms that were too big and interconnected to fail without threatening the stability of the system, and the explosion of opaque mortgage-backed derivatives had turned the health of the housing market into a potential vector for panic. Meanwhile, America’s regulatory bureaucracy was fragmented and outdated, with no one responsible for monitoring and addressing systemic risks.”
Bernanke, Ben., Geithner, Tim., & Paulson, Henry. (2019). Firefighting: The Financial Crisis and Its Lessons

Accelerant: Financial epidemics

Financial markets are complex adaptive systems that depend mightily on the trust, beliefs and expectations of its participants. These systems are “inherently fragile”, often subject to periods of mass delusion or hysteria. And they are fragile because people, by their nature, are fickle, social creatures.

“Unlike other businesses whose success depends primarily on the cost and quality of their goods and services, [financial institutions] are dependent on confidence… Perception and reality both matter… Fear is hardwired into the human psyche, and the herd mentality is powerful”.
Bernanke, Ben., Geithner, Timothy., & Paulson, Henry. (2019). Firefighting: The Financial Crisis and Its Lessons.

E. coli effect

Bank runs are not a thing of the past. They happen today with “a click of a mouse”. When the housing bubble faltered, people sought to unwind their exposures. Fire sales led to margin calls, and margin calls led to fire sales. The feedback loop heightened the panic. It “paralysed credit and shattered confidence”. Foreclosures and job losses abound.

“Financial crises will never be a thing of the past. Long periods of stability can create overconfidence that breeds instability… It is during those boom times, when liquidity seems limitless and asset values seem destined to keep rising, that risk taking tends to get excessive, posing dangers that can extend well beyond the risk takers.”
Bernanke, Ben., Geithner, Timothy., & Paulson, Henry. (2019). Firefighting: The Financial Crisis and Its Lessons.

The vicious cycle was a product of what the authors call the E. coli effect. News of food poisoning, for example, can frighten customers. Make it visceral enough, and buyers might abandon an entire food category or food chain altogether. As panic swept the nation, all financial securities, good and bad, looked “even more toxic”. Bear Stearns, for example, fell into “a crisis of confidence”. Creditors wouldn’t roll over their short-term debt, and clients were terminating their accounts with the company.

Fighting the financial firestorm

With the financial firestorm raging across the United States, governments found their tools for firefighting were, at least initially, limited. Treasury often needed congressional approval, while the Fed’s powers were constrained to the collateral they could lend against. Both institutions found it difficult to “guarantee obligations, invest capital or buy illiquid assets” — Actions necessary to stabilise the system and ameliorate the panic.

Troubled relief

With turmoil spreading into Main Street, the government launched several initiatives: stabilisation funds and liquidity facilities; temporary bans on short selling against financial firms; and getting ailing institutions to raise private capital. Paulson also went to Congress for the $700B Trouble Assets Relief Program (TARP) to remove “toxic” securities from the system.

Initially, Paulson believed that asset purchases was a better choice relative to capital investments. The former, in theory, would improve prices, balance sheets and investor confidence. The latter, Paulson believed, might stoke the market’s flight-to-safety if they perceived capital investments as nationalisation.

Unfortunately, designing a “fair and effective [asset purchasing] program” under their duress was too difficult. So, Treasury used TARP to purchase nonvoting preferred stock in major financial institutions. This would inject capital into the system, avoid fears of nationalisation and improve market confidence. In parallel, the FDIC looked into bank debt guarantees, while the Fed worked with other central banks across the world to coordinate interest rate cuts.

Treasury also used TARP to rescue General Motors and Chrysler. Although restructures or liquidations are common bankruptcies — BG&P believed that major bankruptcies in Main Street, while the financial system was still broken, may have decimated entire supply chains. More on this later.

Geithner’s stress test

Unfortunately, all of this still wasn’t enough to stop the vicious cycle. So, Geithner proposed “the stress test” (Supervisory Capital Assessment Program). The idea was simple: transparency. The Fed and bank regulators would assess the capital adequacy of major banks. They would make the results public and have the inadequate banks raise capital, take TARP capital and/or face nationalisation.

While transparency was risky, Geithner didn’t believe they could restore confidence until uncertainty was brought under control. While they weren’t sure the stress test would bring about calm, markets were already anticipating the worse. So, any effort to improve the banking system’s health could only help.

Ultimately, of the nineteen biggest financial firms, the stress test found nine to be well capitalised for a Great Depression-like scenario. The remaining ten required $75 billion in new capital injections combined. This happened alongside additional liquidity programs, fiscal stimulus, monetary stimulus. At enormous cost to millions of folks, the GFC did eventually subside.

Preventing market wildfires

What can we learn from all this? While governments cannot eliminate financial crises altogether, they can reduce systemic vulnerabilities and its scope for destruction. According to the authors, the U.S. response in 2008 would have been more effective if: (1) regulatory systems were less fragmented and myopic; (2) crisis managers could respond with “overwhelming force” from the get-go; and (3) mechanisms existed that required Wall Street to “pay for its own rescue”.

The response

Since then, post-crisis work on Dodd-Frank, Consumer Protection Act and Basel III have helped to improve and broaden capital and liquidity standards of financial institutions. Dodd-Frank, for example, imposed greater margin requirements on derivatives; banned mergers that “concentrate more than 10 percent of the system’s liabilities in a single bank”; introduced the Consumer Financial Protection Bureau and Financial Stability Oversight Council; and requires the Fed to stress test the biggest banks annually.

Big or small?

While some critics have called for the breakup of big banks, the authors don’t believe that size is necessarily a detriment to the system. The Great Financial Crisis happened because institutions took on too much risk. The situation might have been even worse if the likes of JP Morgan and Wells Fargo were too small to “swallow” their failing peers in Wachovia, Countrywide and so on. Looking back further, cascading failures amongst smaller banks had contributed to the Great Depression.

Fading memories

As the authors put it, “financial crises recur in part because memories fade”. It’s tempting to loosen restraints on leverage, liquidity and capital buffers when the economy is humming, and when crises are a thing of a distant memory. Future governments may one day “recreate the vulnerabilities” that produced the GFC. Financial institutions, likewise, may someday find themselves drunk on credit in a never-ending arms race for market share and risk taking.

“Markets have short memories, and as history has demonstrated, long periods of confidence and stability can produce overconfidence and instability. Rules that seem necessary in the aftermath of a disaster start to feel onerous in calmer times.”
Bernanke, Ben., Geithner, Tim., & Paulson, Henry. (2019). Firefighting: The Financial Crisis and Its Lessons

Darwinian correction

Many have criticised the bailout of Wall Street. Indeed, they have a strong case for it. The fallout has created generational consequences for many families and small businesses. And the bailout may create even greater moral hazards in the future. For many, the Great Financial Crises was an exercise of Wall Street injustice.

The authors empathise with this view. Unfortunately, financial markets and economic systems are not always “self-correcting”. Yes, government intervention was “distasteful”, but it was “preferable to a financial implosion”. Inaction would’ve left the system catatonic. In the authors’ own words:

“We are all reluctant to rescue reckless bankers … [But] if your neighbour sets his house on fire …, you want the fire department to put it out before it spreads to your house and your entire town, even though letting it burn would punish the perpetrator… Capital is the shock absorber that can help an institution withstand losses, retain confidence, and remain solvent during a crisis. … The invisible hand of capitalism can’t stop a full-blow financial collapse. … The politics of financial rescues are terrible, but economic depressions are worse.”.
Bernanke, Ben., Geithner, Tim., & Paulson, Henry. (2019). Firefighting: The Financial Crisis and Its Lessons

A depleted arsenal

The authors say that governments today have even less tools to fight future financial fires. Dodd-Frank, for example, has constrained the Fed’s discretion to take on risky assets during emergencies and “weakened” their lender-of-last-resort programs. And many major economies today don’t have the same monetary and fiscal “ammunition” as they once did. What’s more, public hostility towards bailouts during the GFC may discourage similar approaches in the future. The authors worry that the political climate might become so untenable that governments are unable to respond with force and swiftness.

A message to Washington

Bernanke, Geithner and Paulson’s message to Washington is clear: “fix [your] economic roof before the next hard rain”. Washington, the authors say, will have “to restock [its] emergency arsenal”. They’ll need to retain some authority to inject capital, buy assets and guarantee liabilities — the “most powerful” tools for “quelling panics”. This, in turn, requires a renewed “commitment to fiscal responsibility”. Governments must also “address long-standing structural problems”, from growing polarisation in politics to widening disparities in economic participation. People know what needs to be done. The real question, I think, is whether they can.

Firefighting : The Financial Crisis and its Lessons – Bernanke, Geithner and Paulson