As a MBA student, I have the privilege of being exposed to knowledge and learning that helps make sense of the world we live in, but is somehow not common knowledge… It’s not exactly secret, but unless you actively seek it out, you’ll never be influenced to know. Lack of knowledge keeps us in a reactive state of fear and uncertainty, and we cannot act in a reasonable manner with incomplete information. This in and of itself invalidates most economic theory which is founded on the assumption of complete information to the consumer.
One such class full of priceless knowledge was my advanced finance class. Part of the assignments revolved around literature review of certain critical works related to finance in the new millennium. My favorite assignment was a synopsis of Joseph Stiglitz’s book Freefall. Stiglitz is Bernie Sanders’ economic advisor and I truly hope that regardless of who is the future president of the United States, they include Stiglitz in their council. The subject matter is the events and actions surrounding and leading to the Great Recession of 2008-2009. I strongly recommend that everyone read this book in order to understand how and why we got to the current state of affairs. Just like the lessons learned from the Holocaust – we cannot prevent another economic freefall if we cannot identify/define it.
Here is are my takeaways from a portion of Joseph Stiglitz’s book Freefall:
Summary of Ch. 5-8
After an in-depth look at the devolution of the financial sector in the earlier part of the book, Stiglitz makes a methodical breakdown of the inadequacies of the way the bank bailouts were designed, the struggles over regulation, and the lessons we need to learn from the crisis going forward.
Flawed Anatomy of Bailouts
According to Stiglitz, a key oversight in the Bush and Obama government’s actions to bail out big banks in 2008 and 2009 was the lack of though to corporate accountability and strategic planning about where the bail outs would lead the industry after the crisis, which left a system based on inappropriate risk/return distribution, poor incentive structure, and a dangerous precedent for future business practices. He mentions that inequality in capitalism serves the purpose of motivating people to be more competitive and produce a more efficient economy, giving rewards that correspond to one’s contributions. As he points out, the bail outs rewarded those who ultimately imposed huge costs on people all over the world, for the sake of short-term increases in bank profits which turned out to be a “mirage.” Leading up to the breaking of the crisis, neither bankers nor their regulators wanted to admit anything was fundamentally wrong, which means no though was given to the kind of financial system the country needed going forward.
The financial sector failed to innovate in a positive direction: towards products to more effectively help consumers (and themselves) manage financial risks in their own lives. As a matter of fact, they often hindered innovation that would reduce the cost of financial services, and focused on using their ingenuity for increasingly complex and unmanageable securities. Big banks who received the financial bail-outs were peripheral to any actual job creation (unlike some venture capital firms and community banks or credit unions), and the bailouts were based on what Stiglitz cites as examples of “intellectual incoherence.” He breaks down the failings of the financial system into five reasons behind the poor performance: first, Incentives matter, and the way incentives were structured created a mismatch between social and private returns. Second, too-big-to-fail institutions were “too complex, too unwieldy…too opaque” and very expensive to save. Third, big banks moved away from plain-vanilla banking to securitization, which also (fourth) led commercial banks to seek higher returns (and higher risks) for their deposits (commingling of consumer and investment banking sectors – “hedge fund envy”). Lastly, Stiglitz feels greed gripped many bankers into immoral activity, taking advantage of the poorest and most vulnerable.
Financial reorganization is a fact of life and key feature of capitalism for any industry facing bankruptcy. In a typical restructuring, shareholders lose everything, and bondholders become the new shareholders. Government’s role (in the way of bankruptcy courts)is to make sure all creditors are treated fairly and that management doesn’t steal or defraud any assets. Banks differ slightly because the government insures deposits, so changing of ownership differs slightly in a process called conservatorship, where the government essentially fills the hole in the balance sheet of the institution being taken over. Rather than taking this traditional approach and forcing a financial restructuring, the government took no action and allowed banks to take bigger, riskier bets in an effort to make back what they lost. According to Stiglitz, restructuring would have required almost no taxpayer funds and would potentially had the upside of increasing the value of the firm (due to decreased risk of bankruptcy) and bringing any undervalued assets to market value. This approach was discredited by the Obama administration because big banks were too big to be financially restructured or “too big to be resolved” (made solvent.) Here, Stiglitz also addresses the collapse of Lehman Brothers and the notion that the whole crisis could have been prevented if Lehman was also bailed out, stating that Lehman’s collapse was simply a consequence of the overall flawed lending practices and inadequate oversight by regulators, not a cause of the whole crisis, although it certainly accelerated the collapse. He further opposes the argument for Lehman’s rescue, in that the government has an obligation to save depositors, not use taxpayer money to save bond and shareholders. As an investment bank, Lehman had no depositors. It used commercial paper in money market funds to borrow money, functioning very similar to a bank, although fundamentally based in securities (this is called the shadow banking system because it circumvents traditional banking regulations.) Stiglitz cites that taking in this additional risk was only justified by the promise of above-average returns seen during the boom.
Initial rescue efforts were done largely through “hidden” bailouts, until September 2008, when it became clear that more assets than what was previously provided by the Fed would be needed. Under the Troubled Asset Relief Program (TARP), government would buy toxic assets, which would inject liquidity and clean up the bank’s balance sheets. This suited the banks because government would overpay for these assets (private sector or markets wouldn’t), in effect, a hidden recapitalization of the banks. This plan originally presented by Treasury Secretary Paulson was essentially a $700 billion “blank check”, creating a massive redistribution of assets from taxpayers to banks. According to Stiglitz, upbeat euphemisms calling the bailout a “recovery program” and transforming toxic assets into “troubled assets” or “legacy assets” was part of the denial problem that was plaguing the system at that time. Before being thoroughly discredited, this proposal went through the House of Representatives, where according to Stiglitz, “each of the opposing congressmen [was asked] how much they needed in gifts to their districts and constituents to change their vote.”
The second proposal for assisting the banks involved “equity injection,” in the hopes that this would stimulate banks to lend more, and also prevent bank undercapitalization (which proved to be a risk to the economy in the 1980’s). Stiglitz himself was admittedly among the supporters of this plan, although it was because he “had wrongly assumed it would be done right – taxpayers would receive fair value for the equity, and appropriate controls would be placed on the banks (p.125).” In Stiglitz’ opinion, the US taxpayer got shortchanged, even if simply compared with what Warren Buffett got at the same time, and even more so with each successive bailout. For example, ROI in the first set of bailouts was $0.66 per dollar, and in later bailouts for Citibank and AIG, it was only $0.41 per dollar. Another example of the “intellectual incoherence” in the matter was that banks and regulators wanted to pretend the crisis was solely due to unfounded low confidence and lack of liquidity – each bank believed in its own decision making and solvency were sound, but no one believed that about other banks, leading to a reluctance to lend to each other. According to Stiglitz, the reality was that years of non-transparent accounting and misleading, complex products meant that the banks now did not know their own balance sheets. Repeated announcements and speeches that the economy was on sound ground were muddied by concurrent bad news, further eroding the credibility of banks and regulators alike. According to Stiglitz, in October 2009, the IMF reported global banking losses to be around $3.6 trillion, while banks admitted to a much smaller amount, leaving the rest of the shortfall as a “kind of dark matter” in the system.
Finally, since equity injection had failed to restart lending and confidence, it was replaced by the Public-Private Investment Program (PPIP) in March 2009 under leadership of the Obama administration. As described by Stiglitz, the terms of the “partnership” were anything but normal, since up to 92% of the needed funds came from government, and only 50% of the profits would be returned – once again taxpayers would bear almost all of the losses. As Stiglitz provides a mathematical example, it is clear that this would work out as a bad deal in practice:
“Consider an asset that has a 50-50 chance of being worth either zero or $200 in a years time. The average value of the asset is $100. Without interest that is what the asset would sell for in a competitive market. It is what the asset is worth. Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That’s 50% more then it’s true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies there remaining 92% of the cost – $12 in “equity” plus $126 in the form of a guaranteed loan. If , in a years time ,it turns out that the true value of the asset is zero, the partner loses $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that’s left over after paying back the $126 loan. In that rosy scenario, the partner triples his $12 investment, but the tax payer having risked $138, gains a mere $37.”
To make matters worse, Stiglitz claims that there was ample opportunity for gaming (arbitrage) and adverse selection with the PPIP, transferring huge amounts of wealth from the government to financial markets in a way that was “clever, complex, and non-transparent.” Stiglitz concludes that these are actually long-term liabilities because “no one will know for years what it will do to the government balance sheet.” He goes on to say that the rescue plans were doomed to fail for a few elementary economic reasons:
- Conservation of matter – the loss from a toxic asset will not disappear when government buys it; following the environmental economics principle of polluter pays is a good guideline to figure out who pay for future toxic assets.
- There was no imposing taxes or dis-incentives on banks for “bad” externalities
- Moral hazard of bailouts
- Bad incentive structure leading bank officers to take government funds and pay out dividends and bonuses, rather than lending.
- Need to be forward looking – let bygones be bygones; give assets to healthy, functional, and efficient institutions rather than trying to save the failing ones.
Furthermore, Stiglitz asserts that some of the bailouts were made to institutions who do little or no lending, such as AIG, further sending a signal to the industry it would hold no liability for deals or guarantees made in bad lending. If anything, the bailout should have helped restructure the financial system to make it better at serving the function it is supposed to serve, rather than deepening institutionalizing bad practices. The result is what Stiglitz calls “ersatz capitalism,” a version of capitalism where losses are socialized and gains are privatized(2).
Regulation and Lack-thereof…
Further criticism is due to the Federal Reserve and it’s failures in forecasting and policy. According to Stiglitz, successive Fed chairmen Greenspan and Bernake irresponsibly advocated deregulatory philosophy, suggesting that investment bank risk did not pose any systemic effect. This was based on a series of fallacious arguments based on the belief that markets always work, and because they do, there is little need for regulation (it would reduce efficiency), and little to fear from bubbles. With lending from investment banks frozen, the Fed went from being a “banker’s banker” to being the “nation’s banker” and itself took on commercial paper from corporations without any regard to risk assessment for that paper. Given these actions, the Fed’s ability to manage inflation comes into question and presents a global issue due to a large amount of US debt held abroad. Stiglitz also argues that as long as unemployment remains high, deflation is a more serious risk because it could result in more defaults at the household level.
As discussed earlier in the book, financial market regulation has proven to be a historical necessity, however memories are short, and by the Reagan administration, financial deregulation began based on the promise of savvier science and technologies which enabled the invention of new risk management products, such as derivatives. Regulation of these new instruments was proposed, and resisted, as early as the 1990’s, despite endorsement from officials such as Brooksley Born, head of the Commodity Futures Trading Commission. On the topic of self-regulation, Stiglitz concludes that is “an oxymoron – doesn’t work” and further explains that even if a bank was managing it’s own risks well, without external regulation, there is nothing to control the systemic risks of all banks behaving similarly or ‘herd mentality’. This kind of correlations allows problems to compound as more banks try to sell more bad assets at the same time – oversupply drives market value down even further, leading to insolvency.
To answer the question of how unsound lending practices began in the first place, Stiglitz details the flawed and misaligned incentive structure used within to compensate banking executives. Most commonly, a large part of compensation and bonuses are paid out as stock options, related to income generated regardless of losses, resulting in high pay independent of good or bad performance. The accounting rules in effect actually leave shareholders unaware of the full cost of executive compensation in stock options Even at the producer level, focus was on quantity, not quality. Executives paid in stock options have a motive to drive stock price up by any means possible, including creative accounting, which was behind many of the scandals of the dot-com bubble. Bonuses based on long-term performance would encouraging executives to make more balanced investments, rather than investments with a small probability of disaster in the distant future. Shareholders should also have more say and clear information on compensation amount.
Transparency and availability of information are issues Stiglitz links back to the use of deception to control short-term outcomes. Without good information, markets can’t work well. The need for regulation here is two-fold : both in the quantity of information disclosed (it has to be comprehensive and universal), and the quality (allowing it to be interpreted in a meaningful way). Stiglitz indicates that this should start with creating good accounting systems by reversing the accounting standards loosened in April 2006, as well as re-introducing mark-to-market accounting, but with a clearer definition on it’s applications and use. Complexity is another feature of the financial sector that creates issues, which should be addressed by regulation. Financial derivatives are built using computer models with an agenda to maximize the fraction of a lousy subprime mortgage that could be packaged with other debt to get an AAA, AA, etc., rating. This is called “rating at the margin” and this complexity coupled with a lack of transparency allowed banks to change higher fees and be less competitive under the veil of targeted or one-of-a-kind products. Clearer standards for credit rating are needed. Stiglitz also suggests that to curtail excessive risk taking, 1) banks who do so should be restricted with higher reserves requirements and insurance fees 2) leverage needs to be more limited, and 3) a revision of the Glass-Steagall Act should be reinstated for any institution with the benefits of a commercial bank. Certain default swaps and other derivatives should be limited to exchange-traded transactions and subject to the principle of “insurable interest” requisite for other forms of insurance.
Other regulatory measures proposed by Stiglitz for “too big to fail” banking echoes the trust-busting policies of the past. Big banking should be broken up if they are inefficient and hinder innovation. They have no significant economies of scale or scope. Their competitive advantage comes from their monopoly power and the implicit government subsidies. Large government-insured banks should also be restricted from proprietary trading.
What to do next, and How to do it better?
After a full description and analysis of the crisis, as well as some short-term crsis recovery prescriptions, Stiglitz dives into prescriptive ideas for future prosperity. The financial crisis shows that financial markets don’t automatically work well, and markets are not self-correcting. A changed social construct and carefully defined regulation is needed to create a better balance between the role of government in the role of market. There is a need going forward to restructure the economy due to the changing dynamics of global imbalances – the US is borrowing as much as 6% of GDP from other countries and approximately 60% of its own, at a time when there’s a surge in retiring population. The G-20 summit has proposed a coordinated macroeconomic response so that these imbalances will be reduced in a way that keeps the global economy strong, which is a step in the right direction, although Stiglitz expresses some skepticism about the proposal’s ability to withstand conflicting domestic agendas. Further international cooperation is needed to manage climate change is a way that is sensitive to the economic needs and realities of developing regions. Furthermore, the gap between global supply and demand needs to be bridged by putting into use the world’s underutilized productive capacity. Innovations lead to the “manufacturing conundrum” during a particular stage of economic development, where employment falls even as a sector grows, so this has to be balanced with targeted growth in other sectors. Finally, inequality and stability will be challenged for the new economy.
Challenges specific to the US include employment, mobility, global warming, aging of the population, sectoral problems (specific to finance, energy, health care, education). There needs to be a focus on high-paying middle class job creation to strengthen the “backbone” of the country which took a hit with the weakening of the industrial base. The US needs consider what it’s long-term dynamic comparative advantage should be, and how to get there. Top priorities of the government going forward should be 1) full employment and a stable economy, targeting inflation, 2) promotion of knowledge and innovation, 3) to provide social protections and insurance and 4) to prevent exploitation and enforce usury laws.
- Freefall by Joseph Stiglitz