CHAPTER 4

The Global Financial Crisis and Its Aftermath

“A Better Bailout Was Possible”

(Excerpt from The Crash of 2008 and What It Means, written almost contemporaneously and published in 2009.)

The Crash of 2008

The bankruptcy of Lehman Brothers on Monday, September 15, 2008, was a game-changing event. Until then, whenever the financial system came close to a breakdown, the authorities intervened. This time they did not. The consequences were disastrous. CDSs (credit default swaps) went through the roof, and American International Group (AIG), which carried a large short position in CDSs, was facing imminent default. By the next day, Tuesday, Treasury Secretary Henry Paulson had to reverse himself and come to the rescue of AIG, albeit on extremely punitive terms. But worse was to come. Lehman was one of the main market makers in commercial paper and a major issuer. An independent money market fund held Lehman paper, and since it had no deep pocket to turn to, it had to “break the buck”—stop redeeming its shares at par. This caused panic among depositors, and by Thursday, a run on money market funds was in full swing. The panic spread to the stock market. The Federal Reserve had to extend a guarantee to all money market funds, short selling of financial stocks was suspended, and the Treasury announced a $700 billion rescue package for the banking system. This provided some temporary relief to the stock market.

Paulson’s $700 billion rescue package was ill-conceived; more exactly, it was not conceived at all. Strange as it is, the Treasury secretary was simply not prepared for the consequences of his action when he allowed Lehman Brothers to fail. When the financial system collapsed, he had to rush to Congress without any clear idea of how he was going to use the money he was asking for and only a rudimentary concept of setting up something like the Resolution Trust Corporation, which acquired and eventually disposed of the assets of failing savings-and-loan institutions in the savings-and-loan crisis of the 1980s. So he asked for total discretion, including immunity from legal challenge. Unsurprisingly, Congress did not give it to him. Several voices, my own included, argued convincingly that the money would be better spent injecting equity into banks rather than taking toxic assets off their hands. Eventually, Secretary Paulson came around to the idea, but he did not execute it properly. I outlined how it should have been done in an article published in the Financial Times on September 24, 2008.

Conditions in the financial system continued to deteriorate. The commercial paper market ground to a halt, LIBOR (the London interbank offered rate) rose, swap spreads widened, CDSs blew out, and investment banks and other financial institutions without direct access to the Federal Reserve could not get overnight or short-term credit. The Fed had to extend one lifeline after another. It was in this atmosphere that the International Monetary Fund (IMF) held its annual meeting in Washington, starting on October 11, 2008. The European leaders left early and met in Paris on Sunday, October 12. At that meeting, they decided to, in effect, guarantee that no major European financial institution would be allowed to fail. They could not agree, however, to do it on an inclusive Europe-wide basis, so each country set up its own arrangements. The United States followed suit in short order.

These arrangements had an unintended adverse side effect all over the world: they brought additional pressure to bear on the countries that could not extend similarly credible guarantees to their financial institutions. Iceland was already in a state of collapse. The largest bank in Hungary was now subjected to a bear raid, and the currencies and government bond markets of Hungary and the other Eastern European countries fell precipitously. The same happened to Brazil, Mexico, the Asian tigers, and, to a lesser extent, Turkey, South Africa, China, India, Australia, and New Zealand. The euro tanked and the yen soared. The dollar strengthened on a trade-weighted basis. Trade credit in the periphery countries dried up. The precipitous currency moves claimed some victims. Leading exporters in Brazil had gotten into the habit of selling options against their appreciating currency and now became insolvent, precipitating a local mini-crash.

All these dislocations taken together had a tremendous impact on the behavior and attitudes of consumers, businesses, and financial institutions throughout the world. The financial system had been in crisis since August 2007, but the general public hardly noticed it and, with some exceptions, business carried on as usual. All this changed in the weeks following September 15, 2008. The global economy fell off a cliff, and this became evident as the statistics for October and November began to appear. The wealth effect was enormous. Pension funds, university endowments, and charitable institutions lost anywhere between 20 and 40 percent of their assets within a couple of months—and that was before the $50 billion Bernard Madoff scandal was exposed. The self-reinforcing recognition that we are facing a deep and long recession, possibly amounting to a depression, has become widespread.

The Federal Reserve responded forcefully, slashing the Fed fund rate to practically zero on December 16, 2008, and embarking on quantitative easing. The Obama administration is preparing a two-year fiscal stimulus package in the $850 billion range and other radical measures.

The international response has been more muted. The IMF has approved a new facility that allows periphery countries in sound financial condition to borrow up to five times their quota without conditionality, but the amounts are puny, and the possibility of a stigma continues to linger. As a result, the facility remains unused. The Fed opened swap lines with Mexico, Brazil, Korea, and Singapore. But European Central Bank president Jean-Claude Trichet inveighed against fiscal irresponsibility, and Germany remains adamantly opposed to excessive money creation that may lay the groundwork for inflationary pressures in the future. These divergent attitudes render concerted international action extremely difficult to achieve. They may also cause wide swings in exchange rates.

In retrospect, the bankruptcy of Lehman Brothers is comparable to the bank failures that occurred in the 1930s. How could it have been allowed to occur? The responsibility lies squarely with the financial authorities, notably the Treasury and the Federal Reserve. They claim that they lacked the necessary legal powers, but that is a lame excuse. In an emergency, they could and should have done whatever was necessary to prevent the system from collapsing. That is what they have done on other occasions. The fact is that they allowed it to happen. Why?

I would draw a distinction between Treasury Secretary Paulson and Federal Reserve Chairman Ben Bernanke. Paulson was in charge because Lehman Brothers, as an investment bank, was not under the aegis of the Federal Reserve. In my view, Paulson was reluctant to resort to the use of “taxpayers’ money” because he knew that it would entail increased government control. He was a true market fundamentalist. He believed that the same methods and instruments that got the markets into trouble could be used to get them out of it. This led to his abortive plan to create a super-SIV (special investment vehicle) to take over failing SIVs. He subscribed to the doctrine that markets have greater powers to adjust than any individual participant. Coming six months after the Bear Stearns crisis, he must have thought that markets had had enough notice to prepare for the failure of Lehman Brothers. That is why he had no Plan B when the markets broke down.

Ben Bernanke was less of an ideologue, but coming from an academic background, the bursting of the super-bubble found him unprepared. Originally, he asserted that the housing bubble was an isolated phenomenon that could cause losses up to $100 billion, which could be easily absorbed. He did not realize that equilibrium theory was fundamentally flawed; as a consequence, he could not anticipate that the various methods and instruments based on the false assumption that prices deviate from a theoretical equilibrium in a random manner would fail one after another in short order. But he was a fast learner. When he saw it happening, he responded by drastically lowering interest rates, first in January 2008 and again in December. Unfortunately, his learning process started too late and always lagged behind the actual course of events. That is how the situation spun out of control.

On a deeper level, the demise of Lehman Brothers conclusively falsifies the efficient market hypothesis. My argument is bound to be controversial, but it raises some very interesting questions. Each of its three steps will take the reader to unfamiliar grounds.

The first step is to acknowledge that there is an asymmetry between being long or short in the stock market. (Being long means owning a stock; being short means selling a stock one does not own.) Going long has unlimited potential on the upside but limited exposure on the downside, being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short selling of stocks.

The second step is to understand CDSs and to recognize that the CDS market offers a convenient way of shorting bonds. In that market the risk-reward asymmetry works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling CDSs offers limited profits but practically unlimited risks. The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDSs tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDSs to appreciate in case of adverse developments. No arbitrage can correct the mispricing. That can be clearly seen in the case of US and UK government bonds: the actual price of the bonds is much higher than the price implied by CDSs. These asymmetries are difficult to reconcile with the efficient market hypothesis.

The third step is to take into account reflexivity and recognize that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on confidence and trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating, which is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman Brothers, AIG, and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDSs mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two together made a lethal combination. That is what AIG, one of the most successful insurance companies in the world, failed to understand. Its business was selling insurance, and when it saw a seriously mispriced risk, it went to town insuring it in the belief that diversifying risk reduces it. It expected to make a fortune in the long run, but it was destroyed in the short run because it did not realize that it was selling not insurance but warrants for shorting bonds.

My argument lends itself to empirical research. The evidence shows that the CDS market is much larger than all the bond markets put together—having peaked at an amazing $62 trillion nominal amount outstanding. There is only anecdotal evidence that there was some collusion between the people who shorted stocks and bought CDSs, but the matter could be further investigated. The prima facie evidence favors the conclusion.

This raises some interesting questions: What would have happened if the uptick rule had been kept in effect and speculating in CDSs had been outlawed? The bankruptcy of Lehman Brothers might have been avoided, but what would have happened to the super-bubble? One can only conjecture. My guess is that the super-bubble would have been deflated more slowly, with less catastrophic results, but the aftereffects would have lingered longer. It would have resembled the Japanese experience more than what is happening now.

What is the proper role of short selling? Undoubtedly, it gives markets greater depth and continuity, making them more resilient, but it is not without dangers. Bear raids can be self-validating and ought to be kept under control. If the efficient market hypothesis were valid, there would be an a priori reason for not imposing any constraints. As it is, both the uptick rule and allowing short selling only when it is covered by actually borrowed stock are useful pragmatic measures that seem to work well without any clear-cut theoretical justification.

What about credit default swaps? Here I take a more radical view than most people. The prevailing view is that they ought to be traded on regulated exchanges. I believe they are toxic and should be used only by prescription. They could be allowed to be used to insure actual bonds but—in light of their asymmetric character—not to speculate against countries or companies.^* CDSs are not the only synthetic financial instruments that have proven toxic. The same applies to the slicing and dicing of CDOs (collateralized debt obligations) and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two instruments that have actually done a lot of damage. The issuance of stock is closely regulated by the SEC—why not the issuance of derivatives and other synthetic instruments? Most importantly, the role of reflexivity and the asymmetries I have identified ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.

Now that the bankruptcy of Lehman Brothers has had the same shock effect on the behavior of consumers and businesses as the bank failures of the 1930s, the problems facing the Obama administration are at least twice as great as those that confronted President Franklin Roosevelt. This can be seen from a simple calculation. Total credit outstanding was 160 percent of GDP in 1929, and it rose to 260 percent in 1932 due to the accumulation of debt and the decline of GDP. We entered into the crash of 2008 at 365 percent, which is bound to rise to 500 percent or more by the time the full effect is felt. And this calculation does not take into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation.

The nominal amount of CDS contracts outstanding is more than four times the GDP. On the positive side, we have the experience of the 1930s and the prescriptions of John Maynard Keynes to draw on. His General Theory of Employment, Interest, and Money was published only in 1936; we have it at our disposal from the outset.

Paulson Cannot Be Allowed a Blank Check

(Article published in the Financial Times on September 24, 2008.)

Hank Paulson’s $700 billion rescue package has run into difficulty on Capitol Hill. Rightly so: it was ill-conceived. Congress would be abdicating its responsibility if it gave the Treasury secretary a blank check. The bill submitted to Congress even had language in it that would exempt the secretary’s decisions from review by any court or administrative agency—the ultimate fulfillment of the Bush administration’s dream of a unitary executive.

Mr. Paulson’s record does not inspire the confidence necessary to give him discretion over $700 billion. His actions last week brought on the crisis that makes rescue necessary. On Monday, he allowed Lehman Brothers to fail and refused to make government funds available to save AIG. By Tuesday, he had to reverse himself and provide an $85 billion loan to AIG on punitive terms. The demise of Lehman disrupted the commercial paper market. A large money market fund “broke the buck,” and investment banks that relied on the commercial paper market had difficulty financing their operations. By Thursday, a run on money market funds was in full swing, and we came as close to a meltdown as at any time since the 1930s. Mr. Paulson reversed again and proposed a systemic rescue.

Mr. Paulson had gotten a blank check from Congress once before. That was to deal with Fannie Mae and Freddie Mac. His solution landed the housing market in the worst of all worlds: their managements knew that if the blank checks were filled out, they would lose their jobs, so they retrenched and made mortgages more expensive and less available. Within a few weeks, the market forced Mr. Paulson’s hand and he had to take them over.

Mr. Paulson’s proposal to purchase distressed mortgage-related securities poses a classic problem of asymmetric information. The securities are hard to value, but the sellers know more about them than the buyer: in any auction process, the Treasury would end up with the dregs. The proposal is also rife with latent conflict-of-interest issues. Unless the Treasury overpays for the securities, the scheme would not bring relief. But if the scheme is used to bail out insolvent banks, what will the taxpayers get in return?

Barack Obama has outlined four conditions that ought to be imposed: an upside for the taxpayers as well as a downside, a bipartisan board to oversee the process, help for the homeowners as well as the holders of the mortgages, and some limits on the compensation of those who benefit from taxpayers’ money. These are the right principles. They could be applied more effectively by capitalizing the institutions that are burdened by distressed securities directly rather than by relieving them of the distressed securities.

The injection of government funds would be much less problematic if it were applied to the equity rather than to the balance sheet. $700 billion in preferred stock with warrants may be sufficient to make up the hole created by the bursting of the housing bubble. By contrast, the addition of $700 billion on the demand side of an $11,000 billion market may not be sufficient to arrest the decline of housing prices.

Something also needs to be done on the supply side. To prevent housing prices from overshooting on the downside, the number of foreclosures has to be kept to a minimum. The terms of mortgages need to be adjusted to the homeowners’ ability to pay.

The rescue package leaves this task undone. Making the necessary modifications is a delicate task rendered more difficult by the fact that many mortgages have been sliced up and repackaged in the form of collateralized debt obligations. The holders of the various slices have conflicting interests. It would take too long to work out the conflicts to include a mortgage modification scheme in the rescue package. The package can, however, prepare the ground by modifying bankruptcy law as it relates to principal residences.

Now that the crisis has been unleashed, a large-scale rescue package is probably indispensable to bring it under control. Rebuilding the depleted balance sheets of the banking system is the right way to go. Not every bank deserves to be saved, but the experts at the Federal Reserve, with proper supervision, can be counted on to make the right judgments. Managements that are reluctant to accept the consequences of past mistakes could be penalized by depriving them of the Fed’s credit facilities. Making government funds available should also encourage the private sector to participate in recapitalizing the banking sector and bringing the financial crisis to a close.

A Better Bailout Was Possible

(Article cowritten with Rob Johnson, published on Project Syndicate on September 18, 2018.)

The recent exchange between Joe Stiglitz and Larry Summers about “secular stagnation” and its relation to the tepid economic recovery after the 2008–2009 financial crisis is an important one. Stiglitz and Summers appear to agree that policy was inadequate to address the structural challenges that the crisis revealed and intensified. Their debate addresses the size of the fiscal stimulus, the role of financial regulation, and the importance of income distribution. But additional issues need to be explored in depth.

We believe a critical opportunity was missed when the balance of the burden of adjustment was tilted heavily in favor of creditors relative to debtors in the response to the crisis and that this contributed to the prolonged stagnation that followed the crisis. The long-term social and political ramifications of this missed opportunity have been profound.

Back in September 2008, when then US Secretary of the Treasury Hank Paulson introduced the $700 billion Troubled Asset Relief Program (TARP), he proposed using the funds to bail out the banks but without acquiring any equity ownership in them. At that time, we and our colleague Robert Dugger argued that a much more effective and fair use of taxpayers’ money would be to reduce the value of mortgages held by ordinary Americans to reflect the decline in home prices and to inject capital into the financial institutions that would become undercapitalized. Because equity could support a balance sheet that would have been twenty times larger, $700 billion could have gone a long way toward restoring a healthy financial system.

The ability to use funds to inject equity into the banks was not part of the bill presented to the US House of Representatives. So we organized for Representative Jim Moran to ask House Financial Services chairman Barney Frank in a prearranged question whether it was in the spirit of the TARP legislation to allow the Treasury to use taxpayers’ money in the form of equity injections. Frank replied in the affirmative on the House floor.

This was in fact a tool that Paulson used in the closing days of George W. Bush’s administration. But Paulson did it the wrong way: he summoned the heads of major banks and forced them to take the money he allocated to them. But by doing so, he stigmatized the banks.

A few months later, when President Barack Obama’s administration arrived, one of us (Soros) repeatedly appealed to Summers to adopt a policy of equity injection into fragile financial institutions and to write down mortgages to a realistic market value in order to help the economy recover. Summers objected that this would be politically unacceptable because it would mean nationalizing banks. Such a policy reeked of socialism and America is not a socialist country, he asserted.

We found his argument unconvincing—both then and now. By relieving financial institutions of their overvalued assets, the Bush and Obama administrations had already chosen to socialize the downside. Only the upside of sharing in the possible stock gains in the event of a recovery was still at issue!

Had our policy recommendation been adopted, stockholders and debt holders (who have a higher propensity to save) would have experienced greater losses than they did, whereas lower- and middle-income households (which have a higher propensity to consume) would have experienced relief from their mortgage debt. This shift in the burden of adjustment would have imposed losses on the people who were responsible for the calamity, stimulated aggregate demand, and diminished the rising inequality that was demoralizing the vast majority of people.

We did recognize a problem with our proposal: providing relief to overindebted mortgage holders would have encountered resistance from the many homeowners who had not taken out a mortgage. We were exploring ways to overcome this problem until it became moot: the Obama administration refused to accept our advice.

The approach of the Bush and Obama administrations stands in stark contrast both to the policy followed by the British government and to earlier examples of successful financial bailouts in the United States.

In Great Britain, led by then Prime Minister Gordon Brown, undercapitalized banks were told to raise additional capital. They were given the opportunity to go to the market themselves, but they were warned that the UK Treasury would inject funds into them if they failed to do so. The Royal Bank of Scotland and Lloyds TSB did require government support. The equity injections were accompanied by restrictions on executive pay and dividends. In contrast to Paulson’s method of injecting funds, banks were not stigmatized if they could borrow from the markets.

Similarly, during the Great Depression of the 1930s, the United States took ownership and recapitalized banks via the Reconstruction Finance Corporation (RFC) and managed mortgage restructuring through the Home Owners’ Loan Corporation (HOLC).

No doubt the Obama administration helped to alleviate the crisis by reassuring the public and downplaying the depth of the problems, but there was a heavy political price to pay. The administration’s policies failed to deal with the underlying problems, and by protecting the banks rather than mortgage holders, they exacerbated the gap between America’s haves and have-nots.

The electorate blamed the Obama administration and the Democratic Congress for the results. The Tea Party was formed in early 2009 with large-scale financial support from the billionaire Koch brothers, Charles and David. In January 2010, Massachusetts held a special election for the late Ted Kennedy’s Senate seat, just after Wall Street paid extravagant bonuses, and elected the Republican Scott Brown. The Republicans subsequently took control of the House of Representatives in the 2010 midterm elections, gained control of the Senate in 2014, and nominated Donald Trump, who was elected in 2016.

It is essential that the Democratic Party recognize and correct its past mistakes. The 2018 midterm elections, which will set the stage for the 2020 presidential election, are an excellent opportunity to do so. The political and economic problems that confront the country are much deeper today than they were ten years ago, and the public knows it.

The Democrats must recognize these problems, not downplay them. This year’s midterm elections will be a plebiscite on Trump, but the Democratic presidential candidate in 2020 must have a program that many Americans find inspiring. The electorate has seen where the Republicans’ demagogic populism leads, and a majority should reject it in 2018.