Saturday, July 9, 2011

The Women Who Saved America from a Second Great Depression

To name names of those who should be remembered for their heroism in trying to save the United States from itself...

First, Brooksley Born tried hard, but was up against the "old boys" who were so smug in their anti-regulation jihad that they had her fired. She failed, but she was a heroine of the struggle. Hopefully history will let her name shine while we all learn to hate and villify Alan Greenspan, Robert Rubin, Ben Bernanke, Larry Summers, Timothy Geithner, and their ilk.

Second, Sheila Bair at the FDIC did heroic action in preventing the deregulators from completely gutting the banking system just before the 2008 Financial Crisis struck and nearly destroyed the country. Here is a bit from a retrospective of her work by Joe Nocera in an article in the NY Times:
Curbing subprime-lending abuses should have been the job of the Federal Reserve, which has a consumer division. But the Fed chairman, Alan Greenspan, with his profound distaste for regulation, could not have been less interested. The other bank regulators, the Office of the Comptroller of the Currency, which oversees national banks, and the Office of Thrift Supervision, which regulates the savings-and-loan industry, should have cared, too. But their responses to the growing problem were at best tepid and at worst hostile. (The O.C.C. actually used its federal powers to block efforts by states to curb subprime abuses.) By the time Bair got to Washington, the O.C.C. had spent a year devising “voluntary subprime guidance” for the banks it regulated, but it had not yet gotten around to issuing that guidance.

The F.D.I.C. jumped into the breach. Bair knew the issue well, because during her time at Treasury, when the industry was much smaller, she tried, unsuccessfully, to get the subprime lenders to agree to halt their worst practices. Now she was hearing that things had become much worse. Bair instructed the F.D.I.C. to buy an expensive database that listed all the subprime loans in the mortgage-backed bonds that Wall Street was selling to investors. She was shocked by what she saw. “All the practices that we looked at back in 2001 and 2002, which we thought were predatory — things like steep payment resets and abusive prepayment penalties — had gone mainstream,” she said.

By the spring of 2007, she was holding meetings with industry executives, pushing them to raise their lending standards and to restructure — that is, modify — abusive mortgages so homeowners wouldn’t lose their homes when the housing bubble burst and large numbers of loans were bound to default. “There is nothing unusual about this,” she told me. “Restructuring is one of the tools the banking industry has at its disposal.”

One thing she learned from those meetings was that the mortgage servicers, generally divisions of the big banks, had the legal right in most cases to modify mortgages they managed for the investors who owned mortgage bonds. They just didn’t have the will. After doing some arm-twisting, Bair felt she had extracted a commitment that the mortgage servicers would do so.

She also pushed the O.C.C. to issue its voluntary guidance, even though it would help only marginally. The vast majority of subprime loans were issued by institutions outside the regulated banking system, out of the reach of the O.C.C. or the F.D.I.C. But those nonbanks depended on the regulated banks for their own financing. As a way to get at the unregulated lenders, Bair came up with the idea of applying the government’s subprime guidance to any company that was financed by a regulated bank. The banks, she says, “fought us tooth and nail.” She lost.

At the same time, she was fighting a rear-guard battle on another critical banking issue — so-called capital requirements, the amount of capital banks must hold as a cushion against losses. Banks always want their capital requirements to be as low as possible, so they can take more risks, which can enable them to make more money — and reap bigger bonuses for executives. In 2004, an international group called the Basel Committee on Banking Supervision proposed rules that would allow banks to hold capital on a “risk-weighted” basis, meaning that assets with lower risk would require less capital. (As it turned out, triple-A-rated mortgage bonds stuffed with bad subprime mortgages were considered very low risk under the Basel proposal. That is why so many banks loaded up on them in the years leading up to the crisis.) To make matters worse, the Basel II accords, as they were called, permitted banks to evaluate their assets with their own internal risk models.

Most European countries quickly adopted Basel II. In the United States, the Federal Reserve was strongly in favor of doing so, too, as was the O.C.C. But the F.D.I.C., fearing that lower capital requirements and the self-selection of risk models would increase the risk of bank failures, opposed Basel II. This meshed perfectly with Bair’s own instincts, and once she arrived at the F.D.I.C., she became the standard-bearer in opposing the new rules. The Fed, in particular, pushed her to sign on; it didn’t need the F.D.I.C.’s approval, but it is politically important for all the regulators to be aligned when instituting such an important change. Instead, Bair conceded, “we dragged it out and dragged it out.” She dragged it out so long, in fact, that the financial crisis arrived before Basel II was ever implemented in the United States.

Foot-dragging is not the sort of bureaucratic tactic that draws praise or even much notice. But I’ve long believed that her opposition to Basel II has been a hugely underappreciated factor in helping to save the financial system when the crisis came. The European banks, lacking adequate capital, were crushed by the financial crisis. Big banks in places like Ireland and Iceland collapsed. Germany doled out hundreds of billions of dollars to shore up its banks. Even today, banks in Europe are in far worse shape than they are in the U.S. American banks didn’t have enough capital, either, but they had a lot more than their European counterparts, and for all their ongoing problems, they are much healthier institutions today.

By the summer of 2007, the subprime bubble had burst. Just as Bair expected, the default rate on subprime mortgages was rising quickly. Looking ahead, it wasn’t hard to see that all those adjustable-rate mortgages written in 2006 and early 2007 were going to reset in a year or two. During the bubble, when housing prices were rising, homeowners avoided the higher rates by refinancing. Now that was no longer possible. Disaster loomed, as millions of Americans would no longer be able to make their mortgage payments. Yet only the F.D.I.C. seemed to take this possibility seriously — and to fear the consequences. Paulson and Bernanke, for their parts, maintained that the damage from the bursting of the subprime bubble would be “contained,” as they liked to put it.
She was odd man out in the struggle to save America at the height of the crisis and she is underappreciated for what she did and especially for what she refused to do which was critical in containing the use of taxpayer dollars to save the ultra-rich:
Too often, she felt, their requests were excessive, putting taxpayers at risk while bailing out undeserving debt holders. For instance, during the peak of the crisis, with credit markets largely frozen, banks found themselves unable to roll over their short-term debt. This made it virtually impossible for them to function. Geithner wanted the F.D.I.C. to guarantee literally all debt issued by the big bank-holding companies — an eye-popping request.

Bair said no. Besides the risk it would have entailed, it would have also meant a windfall for bondholders, because much of the existing debt was trading at a steep discount. “It was unnecessary,” she said. Instead, Bair and Paulson worked out a deal in which the F.D.I.C. guaranteed only new debt issued by the bank-holding companies. It was still a huge risk for the F.D.I.C. to take; Paulson says today that it was one of the most important, if underrated, actions taken by the federal government during the crisis. “It was an extraordinary thing for us to do,” Bair acknowledged.


As she thinks back on it, Bair views her disagreements with her fellow regulators as a kind of high-stakes philosophical debate about the role of bondholders. Her perspective is that bondholders should take losses when an institution fails. When the F.D.I.C. shuts down a failing bank, the unsecured bondholders always absorb some of the losses. That is the essence of market discipline: if shareholders and bondholders know they are on the hook, they are far more likely to keep a close watch on management’s risk-taking.

During the crisis, however, Treasury and the Fed were adamant about protecting debt holders, fearing that if they had to absorb losses, the markets would be destabilized and a bad situation would get even worse. “What was it James Carville used to say?” Bair said. “‘When I die I want to come back as the bond market.’”
She tried mightily to fix the mortgage foreclosure problem but she was up against the rest of Washington, even Obama, because she wanted to do something effective and the rest were interested only in window dressing:
Without question, it is difficult to get mortgage modifications right. But many Democrats originally voted for TARP because it contained a provision mandating that $50 billion of the $700 billion in bailout money go to mortgage modification. The Paulson Treasury ignored that part of the law — and the Geithner Treasury has barely touched that $50 billion.

Still, a Democratic administration had to do something. Bair offered up the F.D.I.C.’s ideas, which involved, among other things, some government insurance protection for redefaults that took place after three months. She was sure her plan had better economic incentives for servicers than anything else under consideration. But the Obama administration went with a plan that didn’t fundamentally change the incentives, and that was not much different from what the Treasury under Bush did after the financial crisis.

When Bair was shown the plan, literally hours before it was announced by the president, she told them, “That’s fine; I’m not going to speak out against this, but don’t expect me to marry up to it either, because I don’t think it will work.” She told me: “They wanted my name and reputation on it.”


“I think the president’s heart is in the right place,” Bair told me. “I absolutely do. But the dichotomy between who he selected to run his economic team and what he personally would like them to be doing — I think those are two very different things.” What particularly galls her is that Treasury under both Paulson and Geithner has been willing to take all sorts of criticism to help the banks. But it has been utterly unwilling to take any political heat to help homeowners.

The second key issue for Bair has been dealing with the too-big-to-fail banks. Her distaste for the idea that the systemically important banks can never be allowed to fail is visceral. “I don’t think regulators can adequately regulate these big banks,” she told me. “We need market discipline. And if we don’t have that, they’re going to get us in trouble again.”
History will smile upon Brooksley Born and Sheila Bair. Hopefully the long arm of history will ensure that the names of George W. Bush, Alan Greenspan, Robert Rubin, Ben Bernanke, Larry Summers, Phil Gramm, Timothy Geithner, etc. If you need a summary of the misdeeds, read the post by Barry Ritholtz.

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