My chat on financial reform with Nicole Gelinas, part two
This is the second edition of my chat with the fabulous Nicole Gelinas, author of the phenomenal must-read, must-own After the Fall: Saving Capitalism from Wall Street and Washington. (Part one is here.)
What was a reasonable alternative to TARP?
We were never going to escape this debacle without pumping massive amounts of taxpayer money into the financial system. By 2008, the erosion of market discipline and prudent regulations (which go together) had left the economy vulnerable to a historic financial disaster. The proverbial black swan would have been if we not gotten the crisis.
Washington could have deployed TARP funds better than it did, though. Bush-era Treasury Secretary Henry Paulson’s first mistake was in thinking that he could use TARP finds to hide financial-industry losses. That is, he wanted TARP to buy up bad securities from banks at higher-than-market prices. As the S&L crisis proved nearly two decades ago, the economy can’t recover until bad assets find their real market price. Yet more government distortion just delayed that process.
What Paulson and, later, Geithner eventually did was better: pumping capital into banks so that they could withstand at least some of their losses on mortgage-related securities and other investments. Still, though, Washington used TARP to shield bondholders to the TARP banks from their losses – meaning that “too big to fail” lives another day.
How would a conservatorship of a TBTF firm work?
No firm should be “too big to fail – so it really would be a conservatorship for failed financial firms.
We learned in the Great Depression that some firms cannot fail through the normal bankruptcy process. Bank failures caused unacceptable economic panic and social harm. The FDIC was the elegant solution. It protected small depositors from losses and from service interruption, muting financial panic in a crisis. But it also allowed markets to discipline bad banks, because uninsured lenders still took their losses.
The task of a conservatorship for failed financial firms should be the same: to enforce market discipline of failed financial firms in an orderly manner – with creditors taking their losses – while protecting the economy from the disordered panic that we saw after Lehman.
A conservatorship could carry on operations at a failed financial firm, just as the FDIC does with failed banks when it cannot find a buyer. But lawmakers must make clear that the conservator’s goal is liquidation: to spin off good assets into more competent hands, with creditors responsible for any shortfall, just as they are in bankruptcy.
With AIG, the government has never made clear whether it’s trying to save AIG or wind it down. So we have the bizarre situation of AIG executives saying that the company stock is worthless even as it trades on public markets in the double digits. Meanwhile, private-sector insurance companies must compete against a government-guaranteed behemoth.
A conservatorship won’t work, though, unless lawmakers and regulators enact other rules to make the economy better able to withstand financial-industry failure. I talked about some of this in my answers to your other questions. The main goal is to insulate the economy somewhat from the natural excesses of financial-industry optimism and pessimism, without micromanaging finance. Borrowing limits mute optimism, because they prevent investors from bidding assets up with no money down (think housing in 2005, stocks in 1928).
Other regulations can mute pessimism. When the old uptick rule governed “short sales,” stock sellers couldn’t sell a stock down to zero. Pushing financial instruments onto exchanges, too, can mute panic — again, look at AIG.