It’s hard to believe but it’s been five years 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 percent, 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.
So let’s set the record straight about a few misconceptions. Ready? Here we go.
1 The government should have done nothing.
There’s an idea gaining currency that everything the government did, from the Troubled Assets 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, Bank of America, AIG, GE Capital, Merrill Lynch, Morgan Stanley, Goldman Sachs 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 whether 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 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.
2The 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. Losses exceed 99 percent at Fannie Mae and Freddie Mac and are 97 percent at AIG and 85 percent or more for other stricken institutions taxpayers bailed out. The S&P 500, by contrast, is down only 13 percent. Yes, a 100 percent 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 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. 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.
3The 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 chairman of the FDIC. In a marvelous paper presented in May of last year — to my regret, I didn’t read it until this 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.
4Taxpayers 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 then 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 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.
5It’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.
Sloan is Fortune magazine’s senior editor at large. Additional reporting by Doris Burke.