Ten years ago today, the world financial system was in the grips of galloping panic. The investment bank Lehman Brothers had failed, and the world's largest insurer, AIG, had just been saved by the government buying it outright. Congress was debating a bill that would become the notorious TARP bank bailout.
But what's going to happen when the next financial crisis strikes? That question has been haunting political elites for years — especially ever since a reality show star assumed the presidency.
Three men who were at the very center of the 2008 crash — former Bush Treasury Secretary Hank Paulson, former Federal Reserve Chairman Ben Bernanke, and former head of the New York Fed and Obama Treasury Secretary Tim Geithner — have been arguing for months that America is ill-prepared for the next financial panic.
Back in June, they argued that regulators lacked enough discretion to tackle a really severe crisis. They filled out that argument in a New York Times article, complaining that post-crisis legislation has reduced the FDIC's ability to guarantee bank debt, the Federal Reserve's ability to extend emergency loans, and the Treasury Department's ability to guarantee money market funds. "These powers were critical in stopping the 2008 panic," and from thence another Great Depression. Neil Irwin, a business reporter for the Times, endorsed this argument in an article of his own, as did Catherine Rampell of The Washington Post.
This argument is severely mistaken, and in the case of the three former government officials, it is straight-up deceptive. What these men want for their successors is quiet authoritarian power to make sure financial elites like themselves do not pay for their misdeeds.
To understand what Paulson, Bernanke, and Geithner are arguing here, it's useful to bring out some material from Adam Tooze's new book Crashed. This is a magnificent history of the major players in the world economy — nations, politicians, and top bureaucrats — from the financial crisis to the beginning of the Trump presidency.
Tooze has a lucid explanation of what caused the financial meltdown and how the response was conducted. (One of the reasons his book is so great is that this is some of the most well-trodden ground in financial journalism of all time, but he still provides key new insights and unearths shocking new facts.)
Most everyone knows the crisis was centered on bad American subprime mortgages. The usual story goes something like this: Mortgage originators handed out garbage home loans to people who couldn't repay, they were packaged into securities, and the whole process inflated a huge bubble in the housing market. Eventually the bubble popped, the securities went bad, and many financial companies took huge losses. The government had to step in to prevent the whole financial system from collapsing.
That is a reasonably accurate gloss, but Tooze outlines important granular details about why the large losses happened. Companies like Bear Stearns, Lehman Brothers, and AIG were not directly killed by losses on subprime securities. Instead they were brought down by the fragility of the financial system, which was severely vulnerable to a crisis of confidence sparked by the subprime crisis.
AIG, for example, infamously wrote billions of credit default swaps (basically insurance contracts) on subprime securities. But its direct losses on these swaps only amounted to $11.5 billion (compared to its total assets of nearly $1 trillion), and those took months to process. What brought down AIG was margin calls. As its exposure to subprime became clear, people who had bought AIG insurance of any kind demanded additional collateral to hedge against the risk of it being unable to pay — meaning it had to scramble for tens of billions of dollars in cash over a period of weeks. Essentially, it was a kind of bank run (one which AIG obviously made much worse for itself by directly investing in subprime securities during the bubble).
Before the crisis, AIG would have gotten easy access to short-term wholesale funding (basically, funding that is not traditional bank deposits). But by September 2008, this funding system had completely seized up. For instance, one common wholesale funding mechanism is the repurchase agreement, or "repo." This is when a firm sells an asset to a buyer with an agreement to repurchase it later. It's basically a short-term loan secured with the asset as collateral. But in what's known as a haircut, this loan is typically less than the market value of the asset, to give the lender extra protection in case the firm doesn't repurchase.
Most of the big financial companies had come to rely very heavily on this kind of short-term funding for their daily operations. When the crisis began to take hold, first companies with large exposure to subprime, like Bear Stearns, were cut out of wholesale funding with stiff repo haircuts that ate up their liquidity and quickly drove them out of business. But panic spread, as nervous lenders demanded greater guarantees for all loans and funding costs skyrocketed across the entire financial system. Between April 2007 and August 2008, repo haircuts for U.S. Treasury bonds increased twelvefold, from 0.25 percent to 3 percent; for investment-grade bonds from 0-3 percent to 8-12 percent; and for asset-backed securities from 3-5 percent to 50-60 percent.
It was a self-perpetuating financial panic — a bank run internal to the financial system, instead of being driven by panicking depositors. Interest rates for commercial loans skyrocketed, up to 23 percent for high-risk corporate debt. Non-financial businesses were squeezed hard. By September, Lehman Brothers had bled out its liquidity and failed, while AIG was tottering on the brink of bankruptcy. If it had fallen, it likely would have taken out most of the remaining big Wall Street players at a stroke.
This brings us to the response to the crisis that Paulson, Bernanke, and Geithner (hereafter PBG) designed. Tooze demonstrates that their overwhelming priority was preventing the collapse of the financial system, returning it to health in pretty much the same state as before the crash, and doing so with as little public scrutiny as possible. The first major act was to take Fannie Mae and Freddie Mac into direct government ownership. These "government-sponsored entities" had traditionally produced most mortgage-backed securities. It was private companies who produced the vast majority of the subprime toxic waste, but Fannie and Freddie had gotten into the game as well and were teetering on the brink of collapse. Then AIG was nationalized by the Fed, which took a 79.9 percent equity stake.
The first attempt at explicit bailout legislation was basically a blank check for the government, but when that went down in Congress, PBG grudgingly accepted one with more controls and oversight. That was the Troubled Asset Relief Package, which passed in early October 2008.
As part of TARP, the nine biggest U.S. banks were forced to accept $125 billion of government capital — technically a partial temporary nationalization, but without any exercise of shareholder voting rights. (AIG also got billions more.) Though Wells Fargo was threatened with regulatory attack if it refused to accept the money, at bottom the deal was a sweetheart one. Citigroup in particular got funding fully 17 percentage points under the then-going rate for its bonds (5 percent versus 22 percent) — though its balance sheet was so bad it later required another $20 billion bailout and protection on $306 billion in toxic assets.
Outside of TARP, the Fed set up various lending programs to unfreeze the wholesale funding market. With the Term Auction Facility, the Term Securities Lending Facility, the Primary Dealer Credit Facility, and other programs, the Fed handed out trillions in loans and repo transactions. These were not publicized at all, but they did receive some public attention.
However, Tooze also points out an enormous part of the bailout that did go almost entirely unnoticed: the foreign portion. During the bubble years, regulators in rich countries allied with the U.S. had looked the other way as their banks invested heavily in toxic American mortgage securities — and Western European governments especially didn't bother to build up large dollar-denominated currency reserves, as developing nations like Russia and China had done.
When the initial crisis struck, many European leaders reacted smugly, viewing it as just deserts for decades of irresponsible American policy — a "dollar problem," not a euro one. However, they quickly learned that their banks had been just as irresponsible as the ones on Wall Street, if not more so, and had run up gargantuan dollar-denominated debts. Worse, without the dollar-printing press, those nations had no way of backstopping their system as the Fed had done. A severe shortage of dollar-denominated assets quickly developed in the European banking system, as well as in Japan, Australia, and developing countries without a dollar hoard.
In response, the Fed took the extraordinary step of extending its dollar-printing authority to selected central banks around the world. Bernanke revived "swap lines" from the Bretton Woods days — in essence, a currency exchange between central banks. The European Central Bank, for instance, would exchange some euros for dollars and agree to reverse the trade at some future date (and pay an interest premium). Eventually 14 banks would receive their own swap lines — and those of the ECB, the Bank of England, the Bank of Japan, and the Swiss National Bank were unlimited in size.
The scale of this program is mind-boggling. From December 2007 through August 2010, over $10 trillion in raw swaps were exchanged. Standardized to a 28-day swap (to account for differing term lengths), the amount was still $4.5 trillion. Those central banks, naturally, turned around and used the dollar funding to stabilize their domestic banking sectors.
The Fed had quietly acted as a lender of last resort not just for America, but for half the world economy. That is why there was no sterling-dollar or euro-dollar currency crisis, and why the entire European banking system didn't collapse for lack of dollar funding.
The selection of nations eligible for swap lines was an enormously consequential geopolitical decision. Countries left out could suffer shattering currency crises — while many well-connected banker elites in countries that were included were quietly shielded from the consequences of their terrible decisions. But there was absolutely no attempt to democratically legitimize the program. To this day there is almost no public understanding that it happened at all, either in the U.S. or elsewhere. (Indeed, I did not fully grasp the scale of the swap lines until I read Tooze's book.)
On the contrary, it "was shrouded in as much obscurity as possible," as Tooze writes, for fear of public backlash. Bernanke only revealed initial details after being hounded by Congress, and more comprehensive information only came out as a result of a lawsuit the Fed fought all the way to the Supreme Court. Two countries applied for swap lines and were denied — but we still don't know which ones.
This sort of quiet authoritarianism also characterized the final major component of the crisis response: foreclosure policy.
The main such program was the infamous Homeowner Assistance Mortgage Program, controlled by Geithner and authorized by TARP to help homeowners, which failed utterly in its supposed mission. As Carolyn Sissoko writes in an excellent explanation of the program, this failure was not the result of political fears of "helping troubled homeowners," as Irwin argues, but a deliberate policy choice. The government secretly helped the banks, still deeply threatened by huge piles of subprime loans even after the immediate panic was halted, by letting homeowners drown.
Here's how it worked. First, the Treasury Department and the Fed bought huge quantities of assets from Fannie and Freddie, allowing them to restart their issuance of non-subprime mortgage-backed securities. Then, Federal Housing Administration-issued mortgages exploded in number, increasing from 3 percent of mortgages before the crash to 30 percent by mid-2009 — effectively nationalizing a large part of the housing finance system.
All this supported housing prices and kept mortgage credit flowing, thus enabling the mass refinancing of subprime mortgages under the government umbrella. Because this meant new loans were used to pay off original garbage loans, banks were able to wind down their subprime portfolios. Losses were sometimes shunted onto the FHA, whose delinquency rates on insured mortgages from the first half of 2009 ran over 20 percent. But more often, it was individual homeowners who ate them.
The government used two strategies to ensure homeowners, not banks, bore the brunt of the pain. First, stop cramdown legislation. This would have allowed judges in a bankruptcy proceeding to reduce the value of primary mortgages down to the value of the home. This is already common practice for every other type of mortgaged asset, for obvious reasons. But cutting mortgage principal would have meant the banks taking losses. Obama had previously promised to press for this legislation, but under pressure from Geithner and treasury staff, he reneged.
Second, HAMP did not carry out any principal reductions (until 2012, after the crisis had passed), as was specifically authorized in the TARP legislation. Once again, the reason was to forestall the banks from taking losses. Instead, the program was deliberately designed to help almost no one.
Of course, this monstrous policy did create a lot of foreclosures (ultimately about nine million people would lose their homes), which also meant bank losses. But these came in relatively slowly, so that banks could absorb them. Geithner frankly admitted to Elizabeth Warren that he wanted HAMP to "foam the runway" for banks. On the other hand, the policy also kept people who didn't get foreclosed on paying inflated bubble-era mortgages, helping the banks and dragging out the negative economic effects of the crisis to this day.
This is why there was no attempt to explain bailout policy, even the arguably worthy parts like the swap lines to Europe. Contrary to Rampell's assertion that PBG "never convinced the public" of what they were doing, they knew perfectly well that if their activities came under detailed scrutiny, it would create entirely justified white-hot fury. The public might be convinced, as they were in FDR's time, of aggressive action to save the financial system if it were coupled to strong action to help the middle and working classes. But such action coupled to policy to make the public eat Wall Street's losses couldn't possibly be publicly acknowledged.
So we are finally in position to understand what the ideology of PBG means in practice. Over the past generation, the financial system has become deeply embedded in the rest of the economy. This gives it great power, due to the perception that if it destroys itself with speculative excess or criminal fraud, it will take everyone down with it. It's a sort of hostage situation — Geithner argues in his book that there is simply no option aside from stuffing limitless quantities of money into the financial system any time it starts to collapse.
In fact, it's an open question whether allowing Wall Street to collapse would have led to an economic downturn much worse than the Great Recession — which was already very, very severe. As Dean Baker argues, the government easily had enough power to keep the payment system operating and rescue bank depositors. Perhaps the recession itself would have been worse, but the major culprit behind the wretched recovery that followed was the inadequate stimulus and post-2010 turn to austerity. "There is no plausible story where a series of bank collapses in 2008-2009 would have prevented the federal government from spending the money needed to restore full employment," he writes.
Even if we grant the argument that it was necessary to spend billions in cash and credit to keep Wall Street from going belly-up, it was absolutely not necessary to conduct it the way PBG did. Their actions were rooted in their desire to keep the financial system inviolate, no matter the cost.
But in reality, while the government was handing out trillions in cash and loans to rescue Wall Street from its own mistakes, it could have restructured the financial system and forced banks to eat some of the losses — for example, by hiving off a lot of bad assets onto a separate bank which would be disconnected from the system and allowed to collapse. Indeed, in 2009 Citigroup's balance sheet was such a smoking crater that Barack Obama ordered Geithner to come up with a plan to do exactly that to the bank. But Geithner straight-up disobeyed the president, and eventually the various bailouts allowed it to survive.
It's certainly not a coincidence that Geithner and Bernanke are now comfortably ensconced in elite financial companies pulling down millions of dollars annually — Bernanke at PIMCO and Geithner at the hedge fund Warburg Pincus. (Ironically, only the Bush appointee Paulson is working outside Wall Street.)
But their wretched crisis-fighting record is not just corrupt, it is also a demonstration of why authoritarianism makes for poor policy decisions. PBG would prefer a system where well-credentialed elites like themselves make all the important decisions — while the people's elected representatives, and the public itself, are kept as far away as possible.
When such a system deals with a crisis, insider elites prosper, while outsiders — that is, 99 percent of the population — are left to drown. The result is economic catastrophe and rising political extremism.
But if policymakers were forced to announce and explain their actions publicly, they might not be so cavalier about forcing the public to pay for Wall Street's mistakes.