Five long and eventual years have passed since the demise of the once venerable firm of Lehman Brothers. To mark the occasion, Wall Street, the United States Treasury Department, the White House, and their several political proxies and spokespersons have taken to the mass media to instruct the public in the "lessons" to be drawn from the financial crisis of 2007-09. Regrettably, what we are witnessing is the propagation of several self-serving falsehoods in the hope that the public can be induced to embrace them now that the immediacy of the events in question are in the past. Some of the lessons are so flagrantly false that they demand immediate correction.
(1) No One Saw It Coming.
Of all the falsehoods being promulgated, this one is in many ways the most egregious and damaging. The reason is that it systemically denies the attribution of credit and thereby voice (and political power) to those who in fact did see "it" coming even as it simultaneously provides blanket exoneration to those whose ignorance or, more likely, cowardice combined with self-interest, prevented them from perceiving or acting upon the increasingly unmistakable evidence of a dangerously inflated bubble and overly leveraged and fragile financial system.
Those making this claim can, more correctly, observe that "no one in our close-knit circle of elites saw it coming." Stated in this latter form, the statement suggests a most interesting question. Why, we might ask, was their circle exclusively made up of individuals who did not, would not, or could not, see the crisis coming? Why is it, in a nation with the diversity and talent of the United States, that all of the senior managers of our largest financial firms, and those charged with regulating them, could come to be exclusively made up of individuals sharing the same perspective -- a perspective that, I might add, was and remains so singularly and disastrously dysfunctional for the economy upon which the rest of us depend?
These are compelling questions because, as a matter of fact, many highly-informed people "did see it coming." Indeed, by 2007 the American landscape was littered with risk managers, senior analysts, and even a few economists who "did see it coming" and who had the temerity to speak up about it. We also know that these several persons were invariably pressured to remain silent. Refusing to do so, they found themselves marginalized and their careers stalled. Not a few of them were dismissed from their positions for speaking up. Remarkably, five years after the failure of Lehman, not a single one of the many persons with an accurate assessment of what was going on has been elevated to a position of responsibility in the administration of a president who repeatedly promised the American people that he would bring about "change." By contrast, the persons in authority who not only failed, but failed catastrophically, in their appointed roles have been retained or promoted by this administration. Am I the only one who thinks that this is a perverse outcome worthy of mention?
(2) The Crisis Was Almost Exclusively About Liquidity
Just to review, a firm is illiquid when the sum total of its assets are greater than its liabilities but, for some reason, it can neither sell nor borrow against these assets in a timely manner, that is to say in time to meet its previously contracted financial obligations. By contrast, a firm is said to be insolvent when the sum total of all its assets is less than its liabilities.
Wall Street, Treasury, the White House, and the Congressional leadership of both major political parties (who came together to support the infamous bailout legislation that created TARP), desperately want you to believe that in the Fall of 2008 America's largest and most prominent financial firms were illiquid as opposed to insolvent (for the record, insolvent financial firms have made this claim since the beginning of time). From the beginning, the story peddled by Wall Street, Treasury, and the White House is that a momentary, irrational, and essentially groundless "panic" had gripped financial markets, causing a passing, albeit catastrophic, decline in the price of otherwise good and worthy assets. As a consequence, those assets could no longer serve as collateral for the short-term lending that had become lifeblood of Wall Street financing. This perspective, one that remains unquestioned across Manhattan and Northwest Washington, was enshrined in the name given to the bailout legislation -- the Troubled Asset Relief Program. Notice, these assets were described as "troubled," not "failed," not "garbage," not "riddled with fraud and misrepresentation." No, they were merely "troubled."
To affirm their contention that the problem was one of liquidity rather than insolvency, Wall Street, Treasury, and the White House have never passed on any opportunity to tell us that taxpayers actually "made money" on the bailout. This claim, as with so much else that they have told us, is a whopping falsehood. To maintain this illusion requires a great deal of "creative accounting," as a colleague and I demonstrated in our re-estimation of the true costs of the AIG bailout.
(3) TARP Was the Only "Responsible" Choice in 2008
Besides being self-serving, this falsehood is usually rendered even more audacious when Congress' vote for TARP is described as a "difficult choice" that required "courage." Apparently we are to believe that voting for a federal program that lends money at below market rates to major campaign supporters with effectively no accountability is "courageous." Amazing.
Understanding the indefensibility of the program, our economic and political elites have made a substantially and touchingly bi-partisan effort to get the public to believe that "TARP was the only choice." This initiative is now doubly important as the ostentatious and open-handed bailout of Wall Street makes a less-than-appetizing contrast with the now undeniable absence of economic recovery experienced by the overwhelming majority of Americans (according to the latest figures from the Census Bureau, the annual income of the median household remains more than 8% below where it was in 2007). But no matter what is said, the public was, and remains, correct in its belief that good options other than the bailout that occurred existed.
In reality, by the mid-2000s several decades of ideologically-driven deregulation, de-supervision, and willy-nilly mergers that transformed large Too Big To Fail (TBTF) financial firms into even larger TBTF financial firms had come to be exacerbated by systemic opacity and historically high degrees of leverage, much of which was supported by short-term borrowing. Any adult looking at this system would have been alarmed, but by that time few were present.
Ultimately, the entire house of cards was dependent upon real estate values rising at 12-15 percent a year when, at best, American household incomes were rising at 2-3 percent a year. Everyone, except perhaps Wall Street executives, knows that mortgages are ultimately paid out of household incomes. Since the system had come to depend upon property values and the ensuing mortgage debt rising substantially faster than household incomes, it was certain to fail. What no one could know and did not know was the exact date that failure would occur. But that it would fail was a certainty. Toward the end of his book The Big Short, Michael Lewis correctly noted that the mistake made was not that Lehman Brothers was allowed to fail, rather the mistake was that it was allowed to succeed in the first place.
When the system did implode, there was some good news -- the United States has an extensive experience with resolving failed banks. Since the 1980s, the Federal Deposition Insurance Corporation (FDIC) has taken over literally hundreds of them (and it has taken over almost 500 more since the crisis began). However, in the Fall of 2008 there was one difference, but it turned out to be crucial -- some of the banks that were being rendered insolvent in the crisis were exceptionally large and they were even more connected politically.
But what a difference! The correct choice in 2008, which was well understood at the time, was to stay with tried and true strategies. FDIC could and should have taken over the most insolvent banks independently of their size or political connections.
Now, at this point some history will be useful. When Continental Illinois Bank failed in 1984 (at the time it was the nation's 7th largest bank), it was recognized that it was simply TBTF. As a matter of fact, that was the first time that TBTF was used to describe any financial institution. What, exactly, does it mean? It means that the firm in question is deemed to be so central to the system by which payments are made and contracted financial commitments are cleared that the disruption caused by its failure would in all likelihood jeopardize the health and even existence of many otherwise safe and sound banks and even non-bank business enterprises.
However, the difference between the 1980s and today is that no one said, "Hey, I have a solution to TBTF. Lets just give these demonstratively failed firms and their failed executives oodles of unbelievably cheap money with essentially no strings attached so that they can continue to pursue their failed and/or fraudulent business plans while showering favored insiders with undeserved but astonishingly lavish bonuses." No, that was not how people thought about the TBTF problem as recently as the 1980s.
Understanding the centrality of Continental Illinois Bank to the financial system of the United States, FDIC did not immediately shut it down when they took it over. Instead, shareholders were zeroed out, senior management was sacked, and the bank continued to operate with a team made up of FDIC employees supplemented by a number of outside consultants (many of them retired bankers).
Let us note that while the systemically critical functions of TBTF firms continue to function under both approaches, the "old school" 1980s-style FDIC approach had several distinct advantages over the bi-partisan policy devised in the Fall of 2008 and maintained in the Spring of 2009 by Hank Paulson, Timothy Geithner, Ben Bernanke, and Lawrence Summers. First, with FDIC in full control and the bank's failed managers on the sidewalk, the bank's lobbyists and publicists could be immediately fired. This meant that there would be little interference with the work that had to be done going forward (had we followed this blueprint in 2008, financial reregulation would have been greatly facilitated). Second, with FDIC in full ownership of the firm, the FBI had unfettered access to all of the firm's files so that a full and complete forensic audit could be conducted without obstruction or even prior authorization from a judge. Third, the riskiest and most insolvent (or fraudulent) segments of the firm could be closed without delay. Fourth, FDIC could wind up the affairs of the firm and sell off its several businesses piecemeal at good prices (It took about seven years to fully resolve Continental Illinois).
Now, it is true that in the case of non-bank financial firms the takeover legalities would have been a little more tricky, but in the end they could have been taken over by the Federal Reserve through its Section 13(3) authority which, by the Fall of 2008, had become something akin to a magician's wand that enabled the Fed to do almost anything it wished. This, probably, would have resulted in the Fed effectively buying these firms for a pittance moments before they filed for bankruptcy (let us recall that the Fed took over AIG in something like this manner only a few days after Lehman failed). Creditors would have been delighted and shareholders would have had few good alternatives. Yes, the Fed would have been responsible for the liabilities of these firms, but as the government was going to be on the hook for these debts one way or the other, why not claim some authority to go along with the responsibility?
I could go on, as many other falsehoods about the fateful autumn of 2008 are being trotted about today, although they do not seem to be getting much traction with the public. An example is the often-heard assertion that the Dodd-Frank Act ended TBTF and that Americans will never again be asked to bail out Wall Street. To my knowledge, the only people who say they believe it are on payroll of Wall Street, the Treasury, or the White House. Moreover, the low interest rates that America's largest banks pay to get buyers to purchase their bonds suggests that sophisticated players believe that the guarantee remains very much in place.
Unfortunately, the pretence that TBTF is no longer operative is more than just an amusing vanity held by our political classes and their sponsors among our nation's largest financial firms. This is a pretense that can and does have pernicious consequences. The guarantee means, in effect, that the executives of America's TBTF banks are overpaid civil servants who have the authority to create financial obligations fully backed by the United States government. But the pretense that there is no guarantee means that they can do this without any oversight. I don't know about you, but given what we have seen of the judgment and ethics of these individuals, I am less than comfortable with this arrangement.