The three people who were the most centrally involved in attempting to mitigate the fallout of the financial crisis of 2008, perhaps with the exception of Presidents George W. Bush and Barack Obama themselves, wrote this remarkable book. At the time, Dr. Ben Bernanke was the chairman of the Federal Reserve Bank (Fed), Mr. Timothy Geithner was the president of the New York Fed (and secretary of the treasury under President Obama), and Mr. Henry Paulson was the secretary of the treasury under President Bush.
The financial crisis of 2008 without doubt had huge negative consequences, not only for the US economy and its citizens but also worldwide. Millions lost their jobs, their homes, and their savings.
The authors make the simple conclusion that the best strategy is not to have a financial crisis. In their book, they detail insights and lessons they learned to prepare future policymakers from falling into the same disaster. Thus, a few central questions are as follows: Can the economy be managed in such a way that major crises might be avoided in the future? Do the central banks and the Fed have the necessary “firefighting tools” to be able to intervene in time? And do the necessary competences exist among the key actors who will have to shoulder the necessary actions? The latter is perhaps a particularly key question today, when we seem to see strong efforts coming from the sitting president to influence the Fed, evidently for his own short-term political gains.
But what are we talking about? First, what does a devastating financial crisis entail? According to the authors, the '07-'08 crisis came about because of “too much risky leverage, too much risk to shadow banks where regulation was inadequate 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 that turned to 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 Meanwhile, America’s regulatory bureaucracy was fragmented and outdated, with no one responsible for monitoring and addressing systems risks” (p. 112).
In the end, the crisis was contained, largely through the implementation of the so-called Troubled Assets Relief Program (TARP), which gave the Treasury the power to buy $700 billion worth of toxic securities. The US Congress gave the green light to do this in October 2008. Subsequently, new regulations, such as the Dodd-Frank Act and the so-called Basel III regulation, led to the setting of much higher capital requirements for financial institutions.
But let us go back to the chronology of the major steps of the crisis. Even before this, however, it is worthwhile to note that the then–decision-makers/authors were fully aware of Walter Byholt’s seminal thoughts on how to handle a financial crisis in the banking sector, based on the banks’ continuation of lending freely, so as to avoid a backlash from the borrowing public. The Central Bank would need to charge a significantly low interest rate on the loans it would provide to the banks to facilitate the necessary liquidity for this, and with realistic security. A major problem that the three decision-makers faced, however, was the excessive interdependence between the banks, which rendered the liquidity injection that the Fed or Treasury would call for too large for even them to handle and realistically be able to follow Byholt’s advice. They had no relevant theory to lean on!
It all started with a signal from BNP Paribas (on August 9th, 2007) that it would impose a withdrawal freeze on three US mortgage funds. At the time, no one could know, of course, that this was an important warning sign. Then, a relatively small financial institution focusing on financing the housing boom, Countrywide Financial, asked for direct help from the Fed to continue to handle its liquidities. In the end, Bank of America took over Countrywide.
The first major sign that the financial crisis was in “full swing” came from Bear Stearns, the fourth-largest New York City (NYC)-based investment bank. This bank had entered into a large number of questionable loans and was now having acute liquidity problems. To make things worse, it became clear that Bear Stearns was indeed very interconnected with many other players in the financial sector; it was perhaps “too big to fail”! In the end, this was “solved” when J.P. Morgan agreed to buy Bear Stearns, minus, of course, some of Bear Stearns’ weakest loans, which the Fed had to take over.
The next problem area came when two real estate mortgage companies, Fannie Mae and Freddie Mae, signaled that they were having severe liquidity problems. These two, representing a hybrid between private and government ownership, were jointly responsible for around 50% of all US real estate mortgages. Special legislation was ultimately passed in Congress (Housing and Economic Recovery Act) to allow the US Treasury to provide the necessary financial support. Mr. Paulson played a major role in this. For him and Republican President Bush, it must have been hard to swallow this type of strong governmental intervention!
Then came the Lehman Brothers crisis, which ultimately led to the bankruptcy of the third-largest NYC investment bank (on September 15th, 2008), the biggest bankruptcy in US history. It is interesting that although serious attempts were made to find other financial institutions the Lehman Brothers could merge with (Bank of America and Barclays showed interest), it all crumbled due to the Lehman Brothers’ immense amount of “bad debt.” And neither the US Treasury nor the Fed had been given the legislative power to bail out the Lehman Brothers. Hence, in the end, bankruptcy was inevitable.
Now came the last financial institution that found itself in a severe liquidity crisis—the insurance company AIG, a global leader in its industry, and indeed larger than any of the previously discussed financial entities. The Fed was able to provide AIG a liquidity injection of $185B, an almost unthinkable amount! The so-called TARP facility made this possible. The Fed took an 80% ownership in the firm. In the end, two years later, the US government was not only paid back in full but also gained a net profit of $35M for this transaction.
The passage of the TARP legislation represented a turning point. It allowed the US Treasury to directly purchase distressed assets, provide badly needed liquidity, and/or take an ownership stake in financial institutions that might have come into liquidity problems. Although the TARP was indeed a key ameliorating factor in getting the financial crisis under control, it was nevertheless seen as suspicious among many, especially Republicans. The then–presidential candidate, Senator John McCain, even interrupted his presidential campaign to involve himself in blocking the TARP!
In addition to the “rescue” of AIG, it was perhaps the Treasury’s loan to Citigroup, as well as to Bank of America, that was the biggest TARP-facilitated transaction. Here, too, the US government ended up receiving significant guarantee commissions.
The financial crisis of 2008 was now under control, and gradually its consequences faded away. Today, one must ask if such a severe crisis happen again? The authors provide a mixed answer. On the one hand, they recognize the importance of the additional capital requirements for financial institutions now being imposed, through the Barry Frank legislation, Basel III, and other means, as well as the establishment of the Federal Deposit Insurance Group (FDIC), a legislation that above all would safeguard better oversight.
On the other hand, the various US government entities charged with monitoring financial institutions seem to be, if at all possible, even more fragmented than before. And the increased polarization in Congress (between Republicans and Democrats) might make it hard to come up with bipartisan legislation, such as the TARP and FDIC, which turned out to be exceedingly effective in ameliorating the crisis. So, regrettably, a guarded optimism is all that these authors can conjure.
I am asking myself after having read this book: Why is this book's message important? What should I gain from it? The answers seem clear: First, irresponsible profit motives and executive greed were detrimental, especially in leading to heavily leveraged and technically intricate real estate loans and investments. Second, liquidity needs were even higher than we might initially have assumed, also due to today’s complex interrelationships among financial institutions. And third, exceptional competence among key governmental decision-makers seemed to be key!
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