21 July 2008

Shades of the 1930s

The government's efforts to keep Fannie and Freddie afloat have a lot in common with the New Deal.
Daniel Gross
Updated: 1:46 PM ET Jul 19, 2008

On Tuesday and Wednesday, Federal reserve chairman Ben Bernanke, a scholar of the epic financial meltdown of the Great Depression, and Treasury Secretary Henry Paulson, a survivor of more recent Wall Street crises, told Congress of their latest efforts to rescue the financial sector. If Fed chairman Alan Greenspan, Clinton Treasury Secretary Robert Rubin and his deputy Lawrence Summers were known as the Committee to Save the World during the financial crises of the 1990s, today's duo may go down as the Committee to Save Wall Street From Itself. For the past several months, the Fed and the Treasury Department have pulled all-nighters dealing with three-alarm fires, from the demise of Bear Stearns in March to the rising concerns over the mortgage giants Fannie Mae and Freddie Mac.

Fannie and Freddie play a huge role in the mortgage business by lending cash and guaranteeing loans made by others. But with the spread of the mortgage crises their stocks have plummeted in recent weeks, and questions have been raised as to whether the government would do what it implied it would all along when it established the two government sponsored organizations: stand behind their debt. Bernanke and Paulson gave an emphatic "yes," as they described to occasionally hostile Congress members their plans to allow Fannie and Freddie to borrow money from the Federal Reserve, and to empower the Treasury Department to buy (and buoy) the companies' stock and stand behind their $5.2 trillion in debt. The prospective moves, along with some slightly better-than-expected earnings reports from banks last week, calmed the markets. The price for this desperately needed action is likely to be more regulation and oversight. Will the crisis inspire a fundamental restructuring of the vital, symbiotic relationship between Washington and Wall Street, as happened during the New Deal? Or will these responses prove a temporary blip, as when the government bailed out the savings and loan industry in the late 1980s? In short, is this 1933 or 1989?

It certainly seems a bit more like 1933, and not just because CNN, the modern-day equivalent of newsreels, has been filled with pictures of people queuing outside failed banks. Rather, as happened 75 years ago, Wall Street—after two terms of a business-friendly Republican president—self-immolated on a pyre of greed, incompetence and excessive optimism. The troubles thought to be contained to a particular sector (stocks then, subprime mortgages now) spread throughout the entire financial system. And with confidence shattered, the federal government stepped in with unprecedented efforts. "This is a much broader extension of government assuming risk in the financial system than we saw in the 1980s," said Bill Seidman, the former chairman of the Resolution Trust Corp., the federally created liquidator of all those failed S&Ls.

The New Deal left behind plenty of important landmarks, from the Appalachian Trail to Hoover Dam. But its financial infrastructure has proved just as important. The Banking Act of 1933 created the Federal Deposit Insurance Corporation and forced member banks to submit to regulation. The Securities and Exchange Act (1934) brought forth a body to oversee the nation's stock exchanges. Later in the decade, Fannie Mae was established to revive the dormant mortgage market. "It was a wholesale restructuring of the financial system," said New York University historian Richard Sylla.

The efforts—strenuously opposed at the time by the supine financial sector—worked. "Only with the New Deal's rehabilitation of the financial system in 1933–1935 did the economy begin its slow emergence from the Great Depression," as Bernanke wrote in "Essays on the Great Depression." The art deco complex of backstops, insurance, oversight, disclosure and regulation proved to be remarkably durable: in 75 years, the FDIC hasn't lost a penny of depositors' money.

Of course, New Deal-era financial dams occasionally broke. In the 1980s, the Federal Savings and Loan Insurance Corporation (born 1934), which provided deposit insurance to S&Ls, was overwhelmed when the deregulated thrift industry imploded. The ensuing bailout—taxpayers made insured depositors whole—cost $120 billion. But while surviving thrifts entered the FDIC system, NYU's Sylla notes "there was no major reform." The Resolution Trust Corp. folded in 1995, a few years before the Depression-era prohibitions against investment banks owning commercial banks, known as the Glass-Steagall Act, were wiped away.

When the 1990s telecom/dotcom bubble burst, official Washington responded with a yawn. But the housing/subprime/ credit mess has inspired a different reaction for two important reasons: leverage and connectivity. Bear Stearns had more than $30 of debt for every dollar of capital. And U.S. banks are connected at the umbilical cord to institutions around the world. "The actions on Bear Stearns were necessary because Bear Stearns was extensively interconnected with the rest of the global financial system," says former Clinton Treasury secretary Robert Rubin. That holds doubly true for Fannie Mae and Freddie Mac, whose securities are bought in bulk by central banks around the world. The use of complex financial instruments like derivatives and credit default swaps have bound institutions the world over together in a contractual tower of cards that can easily collapse.

This time around—as was the case in the 1930s—the problems arose in unregulated or lightly regulated sectors. Subprime lenders (many of which were not part of the FDIC system) sold loans to Wall Street investment banks (which are not regulated by the Federal Reserve), which in turn traded them with unregulated hedge funds. As a result, there were few early warnings and no established protocols for dealing with a failing institution. The result: regulators have had to act like John Coltrane and Oscar Peterson. They're improvising.

The jam session started in March, when Paulson and Bernanke worked out a deal for JP Morgan Chase to take over ailing Bear Stearns. Paulson helped dictate the price, and Bernanke agreed to let JP Morgan present $30 billion in assets belonging to Bear at the so-called discount window—usually available only to banks in the system—in exchange for cash. In the ensuing weeks, as Wall Street firms were leery about lending money to one another, the Fed opened up the discount window to 19 investment banks—which, like Bear, aren't regulated by the Fed—thus putting more taxpayer funds at risk. As of last week, $13 billion in such loans were still outstanding.

Those sums pale in comparison to the potential exposure proposed last week, when Paulson and Bernanke gamely asked Congress to have the taxpayer explicitly back the $5.2 trillion in combined debt of Fannie Mae and Freddie Mac. "It's an unprecedented request for an open-ended amount," said Rep. Spencer Bachus, a House Finance Committee member and one of a group of skeptical GOP congressmen who met with Paulson after the hearing last Tuesday. Lawmakers said they want a quo for all the taxpayers' quid they're putting in.

One key difference between the current relationship between Washington and Wall Street and that of the early 1930s has to do with the political standing of the financial industry. Despite the recent disasters, the bipartisan revolving door from Wall Street to Washington—both the Clinton and the Bush administrations had Treasury secretaries who ran Goldman Sachs—is still whirling. Fannie and Freddie have a long history of hiring politically connected executives and lobbying intensely. Wall Street remains a vital source of campaign funds for Democrats and Republicans. "FDR talked about throwing the money changers out of the temple," says author Kevin Phillips, whose best-selling "Bad Money" describes the ascendance of finance in politics and the economy. "These guys [today] talk about keeping the money changers running the temple and charging 28 percent on credit-card interest." James Grant, proprietor of Grant's Interest Rate Observer, and one of the few on Wall Street to warn about the credit crisis, said that given Wall Street's failures, there should be a bipartisan hue and cry to insulate taxpayers from bankers' failures. "But I hear neither of the presidential candidates saying anything like that," he said. "The political dog that didn't bark is the one that is watching Wall Street, but it is fast asleep."

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