The 5
myths of the great financial meltdown
By Allan Sloan, senior editor-at-large
June 13, 2012
Five years after
the U.S. economy teetered on collapse, here are five reasons why we need to stop
pointing fingers and fix the problems that nearly sank us.
FORTUNE -- It's
hard to believe, but it's been five years and a day since the U.S. financial
system's problems surfaced, and we're still not even remotely close to being
able to feel good about the economy. My admittedly arbitrary start date is June
12, 2007, the day the Wall Street Journal reported that two Bear Stearns
hedge funds that owned mortgage securities were in big trouble. At the time,
things didn't seem all that grim -- in fact, U.S. stocks hit an all-time high
four months later. But in retrospect the travails of the funds, which collapsed
within weeks, were a tip-off that a crisis was afoot. Problems kept erupting,
efforts to restore calm failed, and we trembled on the brink of a financial
abyss in 2008-09. Things have gotten better since then, but still aren't close
to being right.
There's a long
way to go before the economy, and people, recover from wounds inflicted by the
financial meltdown. The value of homeowners' equity -- most Americans' biggest
single financial asset -- is down $4.7 trillion, about 41%, since June 2007,
according to the Federal Reserve. The U.S. stock market has lost $1.9 trillion
of value, by Wilshire Associates' count. Even worse, we've got fewer people working now --
142.3 million -- than then (146.1 million), even though the working-age
population has grown. So while plenty of folks are doing well and entire
industries have recovered, people on average are worse off than they were. Bad
stuff.
How should you
think about the past five years? What can we learn from them? And what can we
as a society do to minimize the chances of a recurrence?
I've been writing
about the financial meltdown and its aftermath almost continually since I
joined Fortune the month after the symptoms surfaced. Now, five years
into the problem, I find myself getting increasingly angry and frustrated
watching myth supplant reality about what happened, and seeing fantasy displace
common sense when it comes to fixing the problems that got us in this mess.
Ready? Okay, here
we go.
Myth No. 1: The government should have done nothing.
There's an idea
gaining currency that everything the government did, from the Troubled Asset
Relief Program (the now infamous TARP) to
the Federal Reserve's innovative lending programs and rate cutting, just made
the problem worse. And that we should have simply let markets do their thing.
Wrong! Wrong!
Wrong! During the dark days of 2008-09, when
giant institutions like Washington Mutual and Wachovia and Lehman Brothers
failed and the likes of Citigroup (C), Bank of America (BAC), AIG (AIG), GE Capital (GE), Merrill Lynch, Morgan Stanley (MS), Goldman Sachs (GS), and huge European banks were near collapse, letting
them all go under would have brought on the financial apocalypse. We could well
have ended up with a downturn worse than the Great Depression, which was the
previous time that failures in the financial system (rather than the Federal
Reserve raising rates) begat a U.S. economic slowdown.
You want to let
big institutions fail? Okay, look at what happened when Lehman was allowed to
go under in September 2008. (The Treasury and Fed insist there was no way to save the firm,
though I wonder if they would have devised one had they not gotten tons of
grief six months earlier for not letting Bear Stearns collapse.)
Lehman's collapse
froze short-term money markets, making normal finance impossible. A run on
money-market funds began when the Reserve Primary Fund, an industry pioneer,
said it was "breaking the buck"
because of losses on Lehman paper. Goldman Sachs and Morgan Stanley were about
to fail because hedge funds and other "prime brokerage" customers
began yanking their cash in response to prime brokerage assets at Lehman's
London branch being frozen.
The federal
government (including the Fed) had to front trillions of dollars and guarantee
trillions of obligations -- a total I calculated last year (see "Surprise! The Big Bad Bailout Is Paying Off") at more than $14 trillion -- to stop the panic.
Lehman was a beta
test for letting markets take care of problems themselves -- and it failed
miserably.
Myth No. 2: The government bailed out shareholders.
The real
beneficiaries of the government bailout of financial institutions weren't their
stockholders -- it was their lenders.
Shareholders of
troubled giant financial institutions that got TARP money and other goodies
have suffered severe pain since June 11, 2007, the day before the problem
surfaced (See the table at the bottom of the page). Losses exceed 99% at Fannie
Mae and Freddie Mac and are 97% at AIG and 85% or more for other stricken
institutions taxpayers bailed out. The S&P 500 (SPX), by contrast, is down only 13%. Yes, a 100% loss would be appropriate for
Citi, Bank of America, and AIG, which essentially failed. But their
shareholders sure haven't emerged as winners.
It's patently
unfair that lenders to these companies escaped unscathed, as did counterparties
to AIG, which were paid with taxpayer money. Why did the government do the right thing at GM (GM) and Chrysler, where it forced
creditors to take haircuts before financing the companies' reorganizations, and
the wrong thing by bailing out creditors at financial companies?
The Treasury
contends that whacking financial company creditors would have created more
problems than it solved. "In a severe financial crisis," said a very
senior Treasury official whom I agreed not to name, "the primary
obligation is to prevent panics and the severe economic damage they cause to
the innocent. In those crises, if you hair-cut the creditors of a systemically
important institution, it's like adding accelerant to a burning fire."
One of the
prominent dissenters from that approach is Sheila Bair, former chair of the
FDIC (and a current Fortune columnist). Bair
says that "there was not a market disruption" when bondholders of
Washington Mutual Savings Bank suffered serious losses as the Federal Deposit
Insurance Corp. seized WaMu in the biggest bank failure in history. My heart is with Bair. But I can totally understand why the Treasury and
Fed acted as they did.
The
bailing-out-creditors problem has supposedly been solved for future failures,
as we'll see in a bit. But I have my doubts.
Myth No. 3: The Volcker Rule will save us.
Let's get one
thing straight. Washington is unwilling to change the financial system
drastically, the way it was changed in the Great Depression's aftermath. Rather
than shrinking giant financial companies so that they're no longer too big to fail -- a process that Dick Fisher, head of the Dallas Fed, wonderfully likens to stomach-shrinking bariatric surgery -- we're trying
to legislate the problems away. Hence a whole raft of new, tough-seeming -- but
almost incomprehensible -- regulations.
The major one: the Volcker Rule, which
is supposed to let insured banks do securities transactions on behalf of their
customers but not speculate for their own accounts. That sounds great. But it
won't work. As I predicted, differentiating between market making and
speculating is proving impossible to define in a simple, enforceable way. The
first version of the proposed rule ran almost 300 pages. Good luck.
Instead of the
overhyped Volcker Rule, we need the severely underhyped Hoenig Rule. I've named
it for Tom Hoenig, former head of the Kansas City Fed and current acting vice chair of the FDIC.
In a marvelous paper
presented in May of last year -- to my regret, I didn't read it until this past
May -- Hoenig (pronounced ha-nig) proposes breaking up banks by
function, not size. It's so simple, it's brilliant. He would eliminate all
trading and hedging by banks. If a bank wants to hedge its loan portfolio, it
would have to buy a hedge, not make one. "You have to take those high-risk
activities out of insured banks, not try to regulate them more," he told
me.
He would allow
banks to engage in investment-banking activities such as underwriting bonds and
stocks -- so we're not talking about a return to the Depression-era Glass-Steagall
rules that Congress repealed in 1999. It's a smart separation of high-risk from
low-risk activities.
He would also
alter rules governing money-market funds and change the way
"repurchase" transactions are treated in bankruptcies. Money funds
would have to mark their assets to market rather than guarantee holders $1 a
share. That requirement, combined with the end of the implied federal support
of money fund accounts (which the government guaranteed at the crisis' peak),
would enforce serious discipline on fund managers.
The idea is to
improve financial transparency and severely limit the "shadow banking system"
that allowed the likes of Lehman, Bear Stearns, and Citi's "structured
investment vehicle" subsidiaries to pile up money-fund and repo
obligations that didn't show up on their parents' financial statements.
Hoenig is simple.
And workable. And would infuriate Wall Street and its fellow travelers. It's
too bad that Tom Hoenig's imprimatur is nowhere near as valuable in Washington
as Volcker's is. Hoenig would probably fix "too big to fail." With
Volcker, there's no hope.
Myth No. 4: Taxpayers are off the hook for future
failures.
Dodd-Frank reform
legislation passed in 2010 is being touted in Washington as a way to deal with future meltdowns of big financial institutions without risking taxpayer dollars or giving
creditors a free pass.
It would work
like this: The FDIC, using its new powers, would seize so-called systemically
important financial institutions -- SIFIs -- and wipe out their shareholders.
It would then convert the SIFIs' parent company debt to stock in a new SIFI at
a severe discount. The new SIFI could raise short-term cash to fund its
operations by borrowing from the Treasury or via Treasury-backed loans. The
Treasury would have first claim on everything the new SIFI owns. The Fed would
be out of the game.
"We want to
hold both shareholders and bondholders accountable," Martin Gruenberg,
acting head of the FDIC, told me. "We've got the authority we need. Can we
maintain stability and hold the company accountable to the marketplace? We've
tried to develop the capability to do that as an alternative to a
bailout."
They've tried --
but have they succeeded? I have my doubts. The FDIC's detailed proposals sound
great. But like the Volcker Rule, it will turn into a game of financial
Whac-A-Mole as SIFIs end-run the rules once they are made final. For instance,
it took me about three seconds to realize that SIFIs could borrow at the
operating-company level rather than at the parent company. ("It may be worthwhile
to consider requiring a certain level of debt at the holding company,"
Gruenberg said.) There will doubtless be dozens of other ways around the rules.
I'm rooting for
the FDIC. But my brain tells me that in this game, the financial moles won't stay
whacked.
Myth No. 5: It's the government's fault.
Yes, there were
plenty of reckless and immoral borrowers taking out mortgages they knew (or
should have known) they couldn't afford. And yes, you can make a case that the
federal government's zeal to increase homeownership levels was partly
responsible for lowering lending standards. But the idea that the government is
primarily to blame for this whole mess is delusional. It was the private market
-- not government programs -- that made, packaged, and sold most of these
wretched loans without regard to their quality. The packaging, combined with
credit default swaps and other esoteric derivatives, spread the contagion
throughout the world. That's why what initially seemed to be a large but
containable U.S. mortgage problem touched off a worldwide financial crisis.
We've had more
than enough shrieking and demonizing since this mess erupted in 2007. It's time
that we stopped trying to blame "the other" -- be it poor people or
rich people or Wall Street or community organizers -- for the problems that
almost sank the world financial system.
It's time --
after five years, it's well past time -- for us to stop pointing fingers at one
another, and to fix the excesses that almost sank us. The market sure didn't
work very well. The government regulation solutions, like the Volcker Rule and
Dodd-Frank "resolution rules," aren't going to work very well. We
need common sense, like the Hoenig Rule, and markets (as opposed to a zillion
regulators) that can enforce discipline on institutions that will not be too
big to be allowed to fail.
Those, my
friends, are the lessons of the past five years. Let's hope that at some point
we'll finally learn them.
Big bank shareholders' financial pain
--Additional reporting by Doris Burke
This story is from the July 12, 2012 issue of Fortune.