The nation is still struggling with the effects of the most serious financial crisis and economic downturn since the Great Depression. But Wall Street seems all too ready to return to the same untenable business practices that brought it to its knees less than three years ago.And some in government who claim to be representing Main Street seem all too ready to help.
Already we have heard rationalization of the subprime mortgage debacle and denigration of those of us who have advocated long-term, structural changes in the way we regulate the financial industry. Too many industry leaders, as well as some government officials, compare the crisis to a 100-year flood. “Who, us?” they say. “We didn’t do anything wrong. Nobody saw this coming.”
The truth is, some of us did see this coming. We tried to stop the excessive risk-taking that was fueling the housing bubble and turning our financial markets into gambling parlors. But we were impeded by the culture of short-termism that dominates our society. Our financial markets remain too focused on quick profits, and our political process is driven by a two-year election cycle and its relentless demands for fundraising.
I’ve had a unique vantage point during my five-year term as chairman of the Federal Deposit Insurance Corp., from the early failure of IndyMac Bankto the implementation of reforms designed to ensure that no conglomerate ever again is deemed “too big to fail.”
Now that I’m stepping down, I want to sound the alarm again. The common thread running through all the causes of our economic tumult is a pervasive and persistent insistence on favoring the short term over the long term, impulse over patience. We overvalue the quick return on investment and unduly discount the long-term consequences of that decision-making.
Our decades-long infatuation with financing our spending through ever-growing debt, in the private and public sector alike, is the ultimate manifestation of short-term thinking. And that thinking, particularly in business and in government, is actually getting worse, not better, as we look for solutions to put our economy on a sounder footing.
Today, some want to repeal or water down key financial reforms, fearing that strengthening the rules for firms will curtail our recovery. But the history of crises makes clear that reforms will make our economy stronger in the long run.
While short-termism on Wall Street and in Washington was a huge driver of the most recent financial crisis, we all fall prey to this tendency to some extent.
Households have failed to save enough money to carry them through hard times or to achieve long-term goals. It became old-fashioned to save up for the down payment on that first home. Taking out a mortgage shifted from the most serious financial decision a family would make to a speculative bet on how far home prices would rise. Homeownership went from being a source of stability in our economy to a source of instability.
Business executives squeeze expenses of all types to meet their quarterly earnings targets, even cutting research and development that could create a competitive advantage down the road. This market failure leads to under-investment in projects with long payoff periods. “Patient capital” has become almost quaint.
And policymakers do everything they can to avoid acknowledging a problem or policy mistake, even as it grows more difficult and expensive to fix with each passing day.
In our routine decision-making, research shows, we increasingly use the part of our brain attuned to greed, fear and instant gratification. This short-termism is reinforced when economic incentives are taken into account.
Performance-based compensation, for example, can have disastrous results when it fails to consider long-term consequences. This is particularly true in financial services, where the downsides of risk-taking may take years to materialize but can lead to failed banks, foreclosed homes, unemployed workers and a credit shortage for small businesses. This past week, the FDIC adopted a rule that allows the agency to claw back two years’ worth of compensation from senior executives and managers responsible for the collapse of a systemic, non-bank financial firm.
To date, the FDIC has authorized suits against 248 directors and officers of failed banks for shirking their fiduciary duties, seeking at least $6.8 billion in damages. The rationales the executives come up with to try to escape accountability for their actions never cease to amaze me. They blame the failure of their institutions on market forces, on “dead-beat borrowers,” on regulators, on space aliens. They will reach for any excuse to avoid responsibility.
Mortgage brokers and the issuers of mortgage-based securities were typically paid based on volume, and they responded to these incentives by making millions of risky loans, then moving on to new jobs long before defaults and foreclosures reached record levels.
Such arrangements gave rise to the acronym IBG-YBG(“I’ll be gone, you’ll be gone”), a watchword for short-termism in the mortgage industry during the boom.
When the housing bubble burst, home values started to fall and adjustable-rate loan payments ratcheted upward, and subprime borrowers began to default in record numbers. But the inherent short-termism of bankers and policymakers kept them from moving quickly to limit the damage as the financial crisis escalated in 2007 and 2008.
I was among the few at that time advocating for widespread loan modifications as an alternative to foreclosure, which was leading to more displaced families, larger declines in home prices and more devastating losses for investors. But mortgage servicers, also typically paid according to volume, had neither the financial incentive nor the willingness to devote resources to a change in strategy. Their under-investment in servicing has led to a huge inventory of foreclosed properties and mounting litigation that is likely to cost them far more than any savings they achieved by cutting corners.
Government efforts to promote modifications, meanwhile, have gradually moved in the right direction but have remained behind the curve. At the height of the crisis in the fall of 2008, when fear over where the bottom was ruled the markets, policymakers were supremely focused on the short-term priority of preventing the failure of the nation’s largest financial companies. Government assistance to financial institutions took a variety of forms, amounting to a total commitment of almost $14 trillion by the spring of 2009.
While those actions were necessary to prevent an even bigger economic catastrophe, we still have not addressed the No. 1 cause of both the crisis and the subpar recovery we are in: a stubborn refusal to deal head-on with past-due and underwater mortgages.
It’s time for banks and investors to write off uncollectible home equity loans and negotiate new terms with distressed mortgage borrowers that reflect today’s lower property values. It is true that this would force them to recognize billions in mortgage losses — losses they mostly stand to incur anyway over time. But it will eventually be necessary if we are to clear the backlog and end the cycle of defaults, foreclosures and falling home prices that continues to hold back the economic recovery on Main Street.
The media has also played a role in expanding our short-termism. The type of information that dominates cable news and the blogosphere is generally not designed to appeal to our more rational, long-term thought processes. Instead, it excites our emotions, inducing greed and fear, and more often stokes prejudice and cynicism than rationality and fortitude. The 24-hour news cycle bombards us with constant information that compels action, not patience. Sound logic is often trumped by the sound bite.
On financial reform, “bailouts as far as the eye can see” is how some have described our efforts. In fact, the whole point of the new law is to prevent bailouts, which now are expressly prohibited.
Responsible policies are promptly vilified if they involve the slightest hint of short-term sacrifice. For instance, common-sense efforts to raise large bank capital requirements and to require issuers of mortgage securitizations to bear some portion of the loss when securitized loans go bad are resisted by the industry, which claims that such measures will raise the cost of credit and could derail the economic expansion.
But credible research shows that these requirements will lead to only a modest increase in the cost of credit, accompanied by a large improvement in economic performance over the long run because of a lower frequency and severity of financial crises.
There are many other examples of short-termism beyond the financial sector. Too often, the response to subpar economic growth has been another tax credit or a cut in interest rates that feels good for a while but does nothing to enhance the long-term performance of our economy. Far-sighted investments in job training and modernizing our physical infrastructure would surely pay greater dividends over time.
And as currently structured, our Social Security and Medicare programs will prove financially unsustainable as the baby boomers retire and both longevity and medical costs continue to rise. The rational thinker in each of us can appreciate the logic that reform is absolutely necessary to keep these essential programs viable.Yet the political debate cannot move beyond whatever combination of short-term sacrifices are being proposed to balance the accounts.
The current impasse in addressing the unsustainable growth in the federal debt also goes beyond mere partisanship to a distorted sense of the long-term national interest. One could hardly envision a market development more injurious to our economic security than a technical default on U.S. government obligations, which would lower our national credit rating from AAA status. At the same time, raising the debt limit without progress toward reducing our structural deficit would be equally irresponsible and unsettling to the markets.
Yet those are exactly the scenarios looming in the budget debate.
An electorate and a news media properly focused on the long-term implications of our government policies would rightly condemn any political position that even contemplated such outcomes. They would also press for more far-reaching reforms.
Our loophole-ridden tax system — which favors spending over saving, debt financing over equity, and homebuilding over other long-term investments — is badly in need of an overhaul as well. Closing loopholes would result in a more efficient allocation of capital and would allow us to reduce marginal tax rates while raising more revenue to help pay down our national debt. But most of us would have to give up some of our deductions and tax credits in the short term.
There are signs that suggest the public is already moving toward embracing thrift, at least in terms of personal finances. Total household debt is down by as much as 10 percent from pre-crisis levels, while the personal savings rate has risen to its highest level in more than 15 years.
It’s true that consumers who save more and borrow less won’t contribute as much to economic growth in the short run. But surely we have learned by now that there are limits to what excessive spending and borrowing can do for long-term economic growth and stability.
Our financial system is still fragile and vulnerable to the same type of destructive behavior that led to the Great Recession. Unless all of us — households, financial leaders and politicians — are willing to make some short-term sacrifices for longer-term stability, we are at risk of another financial crisis that will be just as bad, if not worse, than the last one.
Sheila C. Bair was chairman of the FDIC from June 23, 2006, through July 8, 2011. During her tenure, she oversaw the takeover of more than 300 failed banks.