Phillip Swagel was the Assistant Secretary for Economic Policy at the Treasury from December 2006 to January 2009, the peak of the financial crisis. He has written a post-mortem of Treasury’s anticipation of, and response to, the financial crisis. This includes the decision to support the buyout of Bear Stearns, to allow Lehman Brothers to fail, to bail out AIG (the very next day) and the proposal and later abandonmnet of the use of TARP funds to buy toxic assets.
This is absolutely essential reading. Swagel has been very thorough and very honest. Here are the highlights of this 52 page retrospective. (Helmet Hoist: the Baseline Scenario.)
Anticipation of the Crisis Henry Paulson was organizing economists at the Treasury to prepare for stress to the financial system as early as Summer 2006 when he was appointed Treasury Secretary.
Secretary Paulson also talked regularly about the need for financial institutions to prepare for an end to abnormally loose financial conditions.
They recognized that recent financial innovation and increased international integration would pose novel challenges if there were a shock to the system. Nevertheless, Swagel acknowledges that they significantly underestimated the threat of the housing downturn as a potential shock. Here is an eye-opener.
What we missed was that the regressions did not use information on the quality of the underwriting of subprime mortgages in 2005, 2006, and 2007. This was something pointed out by staff from the Federal Deposit Insurance Corporation (FDIC), who had already (correctly) pointed out that the situation in housing was bad and getting worse and would have important implications for the banking system and the broader economy.
Initial Reactions to the Developing Crisis The first two major policy proposals emerged in August 2007. One was focused on increasing transparency of the quality of mortgages underlying asset-backed securities.
The paradox was that this database did not exist already—that investors in mortgage-backed securities had not demanded the information from the beginning.
The second was an early incarnation of what was eventually TARP. The MLEC was a kind of “bad bank” intended to hold toxic assets off bank balance-sheets while the market adjusted and re-priced them. This was the earliest expression of the Treasury stance that the assets are underpriced by the market and what was needed was patience for the turmoil in the markets to cool down. The banks didn’t go for it:
While banks dealt with the problem on their own, the MLEC episode looked to the world and to many within Treasury like a basketball player going up in the air to pass without an open teammate in mind—a rough and awkward situation.
Neither of these plans “came to fruition.” In the case of MLEC, the reason is implicit in the above quote, but Swagel is silent on what happened to the database idea.
Addressing the Housing Crisis Directly There is a long discussion in the article about various policies to intervene directly in the housing market. The general theme here is that Treasury, and especially White House Staff, were resistant to any policy that would appear to help out “irresponsible homeowners.” While Congress enacted some policies aimed at mortgage modifications, the White House would not go farther than removing red tape to streamline the modification process for mortgage servicers. The effects of all of these policies were limited:
As a practical matter, servicers told us that considerations of moral hazard meant that they did not write down principal on a loan when the borrower had the resources to pay—never. They would rather take the loss in foreclosure when an underwater borrower walked away than have to take multiple losses when entire neighborhoods of homeowners asked for similar write downs of loan principal.
(By the way, a game theorist would call this “reputation effects” rather than moral hazard, but that’s beside the point…)
Bear Stearns, Lehman, AIG There is not much explanation for why the Fed decided to make loans to JPMorgan to help them buy out Bear Stearns. Essentially, Swagel is saying they were caught off-guard, saw serious problems with a Bear-Stearns failure, and had to act quickly.
At Treasury, two additional lessons were learned: (1) we had better get to work on plans in case things got worse, and (2) many people in Washington, DC did not understand the implications of non-recourse lending from the Fed. This latter lesson was somewhat fortuitous, in that it took some time before the political class realized that the Fed had not just lent JP Morgan money to buy Bear Stearns, but in effect now owned the downside of a portfolio of $29 billion of possibly dodgy assets.
Why did they bail out AIG but not Lehman?
In sum, AIG was larger, more interconnected, and more “consumer facing” than Lehman. There was little time to prepare for anything but pumping in money—and at the time only the Fed had the ability to do so for AIG. Eventually the AIG deal was restructured with TARP funds being used to replace Fed lending in order to give AIG a more sustainable capital structure and avoid a rating agency downgrade that would have triggered collateral calls.
But there are regrets.
As time went on, it became clear that AIG was a black hole for taxpayer money and perhaps a retrospective analysis will demonstrate that the cost-benefit analysis of the action to save AIG came out on the other side. But this was not apparent at the time.
Fannie and Freddie Interestingly, the debate about whether to take ownership of the GSEs centered not around moral hazard, but whether making explicit the already implicit government guarantees of their debt would threaten to downgrade Treasuries.
putting the GSEs into conservatorship raised questions about whether their $5 trillion in liabilities would be added to the public balance sheet. This did not seem to Treasury economists to be a meaningful issue, since the liabilities had always been implicitly on the US government balance sheet—and in any case were matched by about the same amount of assets. But the prospect that rating agencies might downgrade U.S. sovereign debt was unappealing.
TARP and its Abandoment The econ-blogosphere’s favorite topic. What was Treasury’s rationale for proposing to use reverse auctions to buy “toxic assets.” Swagel vociferously denies that the intention was to inject capital by overpaying for assets. Instead, they had a multiple-equilibrium view. Committing to buy enough of the assets would restore confidence in their value and would unstick the markets. But he has a difficult time explaining this without it sounding like overpaying for assets.
if Treasury were to get the asset prices exactly right in the reverse auctions, those prices will be higher than the prices that would have obtained before the program was announced. That difference means that by paying the correct price, Treasury would be injecting capital relative to the situation ex-ante. And the taxpayer could still see gains—say if the announcement and enactment of the TARP removes some uncertainty about the economy and asset performance, but not all. Then prices could rise further over time. But the main point is that it is not necessary to overpay to add capital.
Surprisingly, Swagel says that Treasury had reverse auctions “ready to go” in October 2008. Why were they never started?
A concern of many at Treasury was that the reverse auctions would indicate prices for MBS that were so low they would make other companies appear to be insolvent if their balance sheets were revalued to the auction results.
Swagel suggests that their auction consultants (Ausubel and Cramton) had a way to deal with this but,
to some at Treasury the whole auction setup looked like a big science project.
Parting Shot He concludes with the following.
An honest appraisal is that the Treasury in 2007 and 2008 took important and difficult steps to stabilize the financial system but did not succeed in explaining them to a skeptical public. An alternative approach to this challenging necessity is to use populist rhetoric and symbolic actions to create the political space under which the implicit subsidies involved in resolving the uncertainty of legacy assets can be undertaken. It remains to be seen whether this approach will be successful in 2009.