WASHINGTON – In an op-ed to be published in the March 2, 2012 edition of the Wall Street Journal, Treasury Secretary Tim Geithner (pictured) discusses the perils of financial crisis amnesia, contrasting the terrible costs of crisis with the complaints of those attempting to weaken or repeal crucial Wall Street reforms.
The full text of the piece follows.
Financial Crisis Amnesia
By Tim Geithner
My wife looks up from the newspaper with bewilderment at another story about people in the financial world or their lobbyists complaining about Wall Street reform.
Four years ago, on an evening in March 2008, I received a call from the CEO of Bear Stearns informing me that they planned to file for bankruptcy in the morning.
Bear Stearns was the smallest of the major Wall Street institutions, but it was deeply entwined in financial markets and had the perfect mix of vulnerabilities. It took on too much risk. It relied on billions of dollars of risky short-term financing. And it held thousands of derivative contracts with thousands of companies.
These weaknesses made Bear Stearns the most important initial casualty in what would become the worst financial crisis since the Great Depression. But as we saw in the summer and fall of 2008, these weaknesses were not unique to that firm.
In the spring of 2008, more Americans were starting to face higher mortgage payments as teaser interest rates reset and they could no longer refinance out of them because the value of their homes stopped rising—the leading edge of a wave of foreclosures and a terrible fall in house prices. By the time Bear Stearns failed, the recession was then already several months old, but it would of course get much worse in coming months.
These problems were partly the result of amnesia. There was no memory of extreme crisis, no memory of what can happen when a nation allows huge amounts of risk to build up outside of the safeguards all economies require.
When the CEO of Bear Stearns called that night, it was not because I was his firm’s supervisor or regulator, but because I was then the head of the Federal Reserve Bank of New York, which serves as the fire department for the financial system.
The financial safeguards in the law at that moment were tragically antiquated and weak. Neither the Fed, nor any other federal agency, had the necessary comprehensive authority over investment firms like Bear Stearns, insurance companies like AIG, or the government-sponsored mortgage giants Fannie Mae and Freddie Mac.
Regulators did not have the authority they needed to oversee and impose prudent limits on overall risk and leverage on large nonbank financial institutions. And they had no authority to put these firms, or bank holding companies, through a managed bankruptcy that wound them down in an orderly way or to otherwise adequately contain the damage caused by their failure. The safeguards on banks were much tougher than those applied to any other part of the financial system, but even those provisions were not conservative enough.
A large shadow banking system had developed without meaningful regulation, using trillions of dollars in short-term debt to fund inherently risky financial activity. The derivatives markets grew to more than $600 trillion, with little transparency or oversight. Household debt rose to an alarming 130% of income, with a huge portion of those loans originated with little to no supervision and poor consumer protections.
The failure to modernize the financial oversight system sooner is the most important reason why this crisis was more severe than any since the Great Depression, and why it was so hard to put out the fires of the crisis. The failure to reform sooner is why the crisis caused gross domestic product to fall at an annual rate of 9% in the last quarter of 2008; why millions of Americans lost their jobs, homes, businesses and savings; why the housing market is still so far from recovery; and why our national debt has grown so significantly.
For all these reasons, President Obama asked Congress to pass tough reforms quickly, before the memory of the crisis faded. The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by the president on July 21, 2010, put in place safer and more modern rules of the road for the financial industry. Yet only four years after the financial crisis began to unfold, some people seem to be suffering from amnesia about how close America came to complete financial collapse under the outdated regulatory system we had before Wall Street reform.
Remember the crisis when you hear complaints about financial reform—complaints about limits on risk-taking or requirements for transparency and disclosure. Remember the crisis when you read about the hundreds of millions of dollars now being spent on lobbyists trying to weaken or repeal financial reform. Remember the crisis when you recall the dozens of editorials and columns against reform published on the opinion pages of this newspaper over the past three years.
Are the costs of reform too high? Certainly not relative to the costs of another financial crisis. Credit is relatively inexpensive and growing across most of the U.S. financial system, although it is still tight for some borrowers. If the costs of reform were a material drag on credit growth, then loans to businesses would not have grown faster than the overall economy since the law passed and its implementation began.
Are these reforms complex? No more complex than the problems they are designed to solve. And, it should be noted, most of the length and complexity in the rules is the result of the care required to target safeguards where they are needed, not where they would have a damaging effect.
Is there some risk that these reforms will go too far with unintended consequences? That depends on the quality of judgment of regulators in the coming months as they flesh out the remaining reforms. But our system provides considerable protection against that risk, with the rules subject to long periods of public comment and analysis and with room in the law to get the balance right. The greater error would be for Congress or the regulators, under tremendous pressure from lobbyists, to once again exempt large swaths of the financial industry from rules against abuse.
These reforms are not perfect, and they will not prevent all future financial crises. But if these reforms had been in place a decade ago, then the rise in debt and leverage would have been less dangerous, consumers would not have been nearly as vulnerable to predation and abuse, and the government would have been able to limit the damage that a financial crisis could have on the broader economy. President Obama, along with Sen. Chris Dodd and Rep. Barney Frank, deserves enormous credit for pushing for tough reforms quickly.
My wife occasionally looks up from the newspaper with bewilderment while reading another story about people in the financial world or their lobbyists complaining about Wall Street reform or claiming they didn’t need the Troubled Asset Relief Program. She reminds me of the panicked calls she answered for me at home late at night or early in the morning in 2008 from the then-giants of our financial system.
We cannot afford to forget the lessons of the crisis and the damage it caused to millions of Americans. Amnesia is what causes financial crises. These reforms are worth fighting to preserve.
Mr. Geithner is secretary of the U.S. Treasury.
I was taught in business school that the 3 C’s of credit were Character, Capacity, and Collateral. If character wasn’t there, don’t make the loan. Then in 1977, Acorn came along and a law was passed that banks had to make loans to everyone on an equal basis. Character no longer mattered. Banks could not redline neighborhoods. (Not that we had any in our town.) You had to define your banking area. If you made a signature loan to a long-time customer in an upper class neighborhood in a neighboring city, you had to do the same for someone in a poor neighborhood in your own town. Our bank had customers all over the nation who continued to bank with us after they moved away. But we couldn’t make them single-payment unsecured loans unless we did that for any person in our defined banking area. And we had to keep records of every loan request we declined. What happened was that we were no longer able to service our long-time non-business customers with single payment loans. Everyone had to get a loan with installments, even if s/he intended to repay it in 2 weeks. It made for a lot of extra paperwork, a lot of frustration for our customers, and difficulty explaining the new law.
We also had to keep detailed records about our banking area, every community organization that we had lent money to within that area, contributed to, yadda. There had to be a notice about this on display in our lobby, and the record book had to be available for immediate inspection by the public, upon request. No one ever asked. No acorns in our area.
I left banking during the farm crisis, but I saw the writing on the wall with the changes that happened when I bought a house and the mortgage was going to be sold on the secondary market. The bank where I got my mortgage decided to keep my loan in house because it was “a good one”. The rate at the time was 12.5%. I remember wondering if they were selling some bad ones.
The 3 C’s of credit have changed considerably over the years. Character, Capacity, and Collateral went by the wayside years ago in the housing market. When bank examiners don’t like the quality of a loan, they “classify” it. The new 3 C’s of credit in the mortgage market are Classification, Collection, and Charge Off. This lack of intelligent lending practices in the housing market became a pervasive cancer that brought our economy down, along with Acorn continually pushing for laws for loans to people who had no capacity to repay. There are way more people to blame, but the bankers should have kept them from making stupid decisions.
John – I wouldn’t go so far as a conspiracy, but I would say we have legislators whose elections are tied to the $ they raise, so they are susceptible to creating legislation “suggested” by large donors.
These donors, which include the substantial firms in the financial sector, pursued the changes noted in my previous post with the intent to make more money.
They were successful in both the legislation and money making. The problem is they do not want to face the music when things go awry (they say they’re now too big to fail) so they turn to the taxpayers to make good.
I think the fix would include reinstating a Glass/Stegall type act (forcing those “too large to fail” to split up), allowing state insurance commissioners to require reserves (since the “swaps” are essentially insurance), reinstating a savings and loan type lender (who are much closer to the markets they serve) and term limits/campaign finance reform (or combination thereof) on elected officials.
As voters, we need to get real in that we cannot berate a legislator for trying to reign in Federal government overspending which includes “entitlement” spending. Under the entitlement label I would include Medicare, social security and the unfunded portions public employee retirement systems.
I would also put state governments on notice that they have to work out their budget problems without Federal assistance. Simply put, just because in Iowa we require our legislature to balance the budget, I do not want to have my tax dollars go towards the legislative dipsticks in Illinois or California.
It is simply wrong to saddle our children and grandchildren with all these costs going forward.
4ever49, that was a great post. I remember the days of Federal Savings and Loans and I hate to admit it but never realized that they were not around anymore. I will say though, in my opinion, thats big governments way of taking over the banking system so they can screw it up to. They do it a little at a time so people don’t notice it. There are people in government that want to be in charge of everything and have world domination. Conspiracy theory, you bet…
I find it very curious that while Geithner describes a “large shadow banking system” that had developed without adequate regulation was at the core of the problem, and that new regulations and over sight of this “shadow system” are needed to make things right. Also, that existing regulations were “antiquated and weak”.
A little perspective is needed.
Back in the ‘80’s and before, there existed the FSLIC (Federal Savings and Loan Insurance Corporation) that insured deposits in Savings and Loans, who at that time did the majority of home lending. Because Congress is accepting of campaign donations, regulations of S&L’s were weakened and in short time S&L’s were in trouble and eventually run out of business. Home lending then shifted to commercial banks, and created the huge mortgage brokerage business that made, packaged and sold the same to investors. Important in all this is the fact that the link between the lender and the local community were severed.
In the late ‘90’s, Congress saw fit to repeal the Glass/Stegall Act. This law prevented entities in traditional banking (i.e. debt) owning stock brokerage firms (i.e. equity). We then saw large banks buying out (or merging) with large stock brokerage firms. Further, legislation was passed allowing issuance of derivatives (credit default swaps (CDS), etc.) and blocking state insurance regulators from requiring those who deal in these swaps from establishing reserves to back up the sale of these products.
The mortgage brokerage business, and particularly CDS’s ballooned into astronomical amounts. A reversal in the economy quickly translated into a rise in mortgage defaults, which then led to calls on the default swaps purchased to cover defaults – which did not have any reserves to make them good. The crises ensued.
Rather than more regulation, it seems to me that someone needs to recognize that the structure of the system we now have is fundamentally flawed and that more regulation simply is putting lipstick on a pig.
Written by an upstanding man that works for the US Treasury and cheats on his tax’s.