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Bailing Out

CAS economist Simon Gilchrist on the Wall Street rescue


Simon Gilchrist, a CAS economics professor, says that even with a bailout, we will probably see a mild recession in the coming year, but without it, the ecomomic situation could turn out to be much worse.

The crafting of the $700 billion Wall Street rescue plan voted on in the House of Representatives yesterday was bipartisan. So was its defeat. Of the 228 votes that sunk the bill (versus 205 in favor) 133 were by Republicans, joined by 95 Democrats, who balked at the size of taxpayer commitment required by the plan.

The stock market didn’t take the defeat well. It plummeted 777 points, a record loss.

The compromise bailout plan was designed to unstick the nation’s flow of credit by buying up the now toxic mortgage-backed securities held by the nation’s banks. It came to the House after late-night negotiations over the weekend had added things like limits on executive pay within the bailed-out institutions, a promise that if the value of the mortgage-backed securities tanked, the president would attempt to recoup the losses from the financial industry through new fees or taxes, and two governmental oversight committees to watch over it all.

Proponents said it was a sound alternative to economic calamity, while opponents derided it as taxpayer-funded corporate welfare. The legislation’s backers hope to put it to another vote later this week, possibly after more negotiations of the plan’s details.

What now? Simon Gilchrist, a College of Arts and Sciences professor of economics, who specializes in macroeconomics, capital markets, and monetary policy, has much experience plotting the long-term future of markets and economies. In the 1980s, working with the current Federal Reserve chairman, Ben Bernanke, and New York University economist Mark Gertler, Gilchrist worked on a predictive economic model that has been pretty accurate in forecasting many crises in the intervening years, including, it turns out, the present one. We asked Gilchrist to help make sense of the bailout that almost was, and may yet be.

BU Today: Before we get to the details of any bailout, tell us who is to blame for this mess.
Gilchrist: There is plenty of blame to go around. The current financial crisis has its roots in the unsustainable growth in house prices that occurred between 2000 and 2005, along with the rapid expansion in use and securitization of subprime mortgages, including those no-doc mortgages, or “liars loans,” that should clearly never have been sold to begin with. In an environment of rapidly growing house prices, these instruments may have appeared to be relatively safe based on the current risk-models used by financial institutions and ratings agencies. Such risk assessments were naïve at best, however, and possibly willfully so, as were the beliefs by homeowners that housing prices could continue to expand at such a rapid rate. When combined with the deregulatory environment championed by both the Clinton and the George W. Bush administrations, the encouragement of Congress for Fannie Mae and Freddie Mac to purchase subprime mortgages to expand home ownership to disadvantaged groups, and the extreme risk-taking of financial institutions, we had a recipe for disaster.

It seems like a bipartisan majority of American people are just plain angry about forking over $700 billion, so what was Congress arguing about?
It’s obviously hard to keep everyone happy when cleaning up a mess that no one wants to touch. Nonetheless, underneath the political posturing are some real concerns about the need for oversight of the purchase and management of assets when using $700 billion of taxpayer money. Another obvious concern, which is perhaps more political than economic, is that executives of financial institutions seeking a bailout should not be allowed to walk away with substantial sums of money in their pockets.

In broad strokes, what were the terms of the deal struck over the weekend?
The deal authorizes the Treasury to use up to $700 billion to purchase mortgage-based assets and other related financial instruments from financial institutions operating in the United States. This would be subject to congressional oversight in various forms, not least of which is that the administration gets only $250 billion up front. It also includes provisions intended to limit the amount of executive pay that participating institutions can deduct as an expense against corporate taxes. This will presumably curb the large payouts such executives may otherwise receive. Finally, it also proposes a scheme to provide insurance for financial institutions against the losses incurred on mortgage-backed securities and other collateralized debt obligations.

The first try at passing the amended plan failed yesterday in the House. What are the chances of any rescue package assuaging the anger and convincing people that this is the right thing to do?
This plan is likely to remain politically unpopular no matter what happens. If a version of it succeeds, I suspect that the best we can hope for is that the American economy continues on its course towards a mild recession over the coming year. If it fails, the economic situation could turn out to be much worse. Either way, it will be very difficult for individuals to determine that this was the right thing to do, at least until the final bill is settled.

If you were in Congress, would you have voted for this plan?
Yes. Last weekend’s bailouts of European banks highlight the fragility of the global financial system and how far and how rapidly this problem can spread. A financial meltdown would severely impair the ability of households and firms to obtain the credit necessary to continue funding ongoing operations and spending plans.

Based on the “financial accelerator” economic model I developed in conjunction with Ben Bernanke and Mark Gertler in the 1980s, my recent research suggests that even prior to this September’s events, the financial crisis was creating a drag of about 2 percent on GDP growth. Since then, things have gotten worse, and I anticipate that even with the bailout, we will see a mild recession in the coming year. However, without a bailout, it would likely be a severe global contraction. While people can argue over the details of the plan, it does put in place a mechanism by which the government can intervene to alleviate the systemic risk associated with this financial crisis.

In the short run, the bailout will unfreeze the interbank lending market, the commercial paper market, and other key financial markets required to finance short-term lending. This will reduce the cost of credit to consumers and firms and allow them to obtain financing that would otherwise be unavailable. This, in turn, will alleviate pressure on the economy and reduce unemployment and increase growth. In the long run, however, taxes will be raised or spending cut to pay for this. Also, lending standards will be tighter, which ultimately is probably a good thing.

If the uncertainty about the value of these mortgage-backed securities is part of this crisis, how did the Treasury Department arrive at a price of $700 billion?
I don’t have any specific information on this. It’s useful to keep in mind that $700 billion is 5 percent of our gross domestic product. This is a ballpark number associated with the cost to governments of intervening during financial crises. I suspect it represents a figure that is large enough to convince the markets that the Treasury has the requisite firepower to resolve these issues. Ultimately, however, I hope that the true cost to the taxpayer is substantially lower as the Treasury eventually resells assets that were purchased under the plan.

Would this much new debt mean big changes in the agenda of the next president?
This undoubtedly puts a damper on any big spending initiatives in the next couple of years. It will also refocus the policy debate away from a discussion of whether we should regulate various financial services towards what type of financial regulation is best.

What kind of regulatory reform is needed to ensure this doesn’t happen again?
It seems clear that we can’t allow financial institutions that are ultimately too big to fail to operate with leverage ratios of 20- or 30-to-1. We’ve already seen voluntary reform of this kind as the last two investment banks, Goldman Sachs and Morgan Stanley, convert themselves into bank holding companies subject to the more stringent capital requirements of the commercial banking industry. We will also see various financial instruments that are currently unregulated as private contracts come under the umbrella of securities that are regulated by the Securities and Exchange Commission. Finally, we will see a push for more transparency in the system in terms of disclosing the holdings of various financial derivatives and who bears the risk. Hopefully, we won’t throw out the baby with the bathwater, however, so that we maintain an environment that encourages financial innovation and the development of financial instruments such as mortgage-backed securities and credit insurance contracts that are ultimately very useful for society.

Chris Berdik can be reached at cberdik@bu.edu.


14 Comments on Bailing Out

  • T.C. on 09.30.2008 at 10:41 am

    Free Market System

    My knowledge on how the free market system ultimately works is limited, but I truly have to wonder if interjecting the tax payer’s money into the system will work and will help us land softly into a mild recession.

    There are two points on that I wish to make:

    1. What if injecting the tax payer’s money doesn’t encourage banks to loosen their pockets, so to speak, and start lending amongst themselves, to companies, and to individuals again? We saw a similar behavior when folks received their $600 back from Uncle Sam. Some did spend the money and other folks just paid their bills or stashed the money in the bank.

    2. We’re already seeing signs that the banks are trying to self-correct, with larger, more stable banks snapping up other banks who weren’t able to handle the risks. A competitor goes out of business, you snap up their remaining business. (Although we as consumers may feel the painful pinch in the future when there are three major U.S. banks and we no longer get that free WaMu type checking account ;) ).

  • Anonymous on 09.30.2008 at 11:53 am

    I strongly disagree with the bail out of wall street. I would rather have my home devalued and my 403b depleted than to reward greed and irresponsibility. Bad behavior has consequences. It is time that “Wall Street” and the proponents of the free market/antireglatory polices take the heat for the mess that they have made.

    Why not divide the $700 billion up among all US citizens over 18. The people can bail themselves out. Pay off their homes, create small businesses, sent their kids to college, etc. Why does wall street get the welfare and the tax payers have to pay for it? It should be the other way around!

  • Anonymous on 09.30.2008 at 12:43 pm

    Our people, and our representatives think the financial system rescue plan is about protecting financial institutions from failure resulting from bad judgement about mortgage backed securities.

    It is actually about protecting the worldwide supply of money and credit from collapse. This collapse would follow “deleveraging” resulting from the vanishing value of highly leveraged collateralized debt obligations (CDO) and credit default swaps (CDS).

    These have become, under the market fundamentalist mandated financial deregulation regime, the source and underpinning of the money supply. If they collapse the money supply will collapse along with them. The money supply will then have to be re-created by central banks and governments. Doing that will require addressing enormously difficult political and distributional issues.

    The stock market is just a form of entertainment. A better indicator of economic conditions is the bonds market and the rates on commercial papers. If the cost of borrowing remains high for main street, 4th quarter earnings will be stagnant at best.

  • Jesse White on 09.30.2008 at 12:49 pm

    Ignorance or Deception?

    It is disheartening to hear “experts” and “analysts” repeat the same speech. “If these institutions are not bailed out,” they say, “there will be large scale economic recession.” However, I only rarely (Prof. Gilchrist not included) hear these pundits speak of the disastrous effects of allowing these institutions to be “bailed out”. Is no one aware of the massive deflation our currency will experience as a result of this bailout? If you do not allow a bail out, many institutions and people will suffer consequences, but if you DO allow the bailout we will all suffer. Continuously pumping money into the system only exacerbates these problems, and taking money from your left pocket and putting it into your right pocket doesn’t make you any richer. There needs to be economic reform, because this poor American system is based on DEBT, and it will continue to experience the same problems over and over again until the system is reformed. Stop looking for ways to allow an individual to use more credit to buy more “stuff” he/she doesn’t need. Teach people to live within their means. This exponential consumerism can only lead to one thing, destruction. I’m sad that a professor at my college can be so blind and misleading, but it is no surprise considering his relations with men like Bernanke. I hope that other professors at BU will help students to wake up and realize the true problems of this economy and allow the words of Gilchrist to bounce on deaf ears.

  • Aleks on 09.30.2008 at 1:02 pm

    Regulation, how about education?

    Is it possible if we re-allocated a small fraction of the federal funds that go toward finacial regulation on educating the public that we may have been able to avoid some of the fallout?

    Imagine there was an ad campaign aired during the superbowl that threw out some of the facts about the no docs and the huge comissions the brokers get for selling them. Add some facts like how much it costs to own a home on top of the mortgage payment, how much kids cost, new cars, etc. If prompted, is it possible some of the people who got in a money crunch and lost their home would have thought twice before signing?

    The media does a wonderful job telling you to ‘ask your doctor about this’ and ‘ don’t get caught driving last year’s car’. Based on their success I think it is possible to advertise knowledge and facts that will help citizens make rational financial decisions.

  • Maggie on 09.30.2008 at 4:12 pm

    Plenty of Blame to Go Around

    As someone at ground zero for this mess, I think it’s important to emphasize a few things:

    1. What’s proposed is not a “bail out” of financial institutions. In most cases, stockholders have been wiped out and along with them the CEOs (most of their compensation, by the way, is typically in restricted stock, which falls to zero beforehand). That’s also true for many employees, as restricted stock that cannot be sold is a common form of compensation.

    2. It’s important to emphasize that companies are actually owed by their investors and not the CEO. The real losers are pension plans and savings plans that hold shares in these firms. Yes, whenever a WaMu goes bankrupt, investments by a pension or savings plan in the company become worthless.

    3. The securities causing the problem are actually mortages that many people took out on speculation, or knew full well that they didn’t have the means to support. We bear responsibility for living beyond our means. The greed didn’t originate with the corporate CEOs. Of course, there were also shady purveyors of these mortgages and they deserve to be prosecuted (fraud has always been illegal). Nonetheless, each one of those mortgages has a willing signature on it. These securities are of questionable value because no one knows the value of the underlying home. Housing prices are down nearly 16% nationally and over 30% in some areas. The government plan essentially purchases these securities, and indirectly allows the government to stabilize the housing market. You can think of the rescue plan as a housing bail out.

    4. When private capital is no longer forthcoming, we must rely on public capital for economic stability. The lessons learned from financial panics around the world and throughout history suggest that the societal costs associated with a collapsing economy far outweigh the potential costs to taxpayers of stability programs. Free markets can and do fail — especially when there is uncertaintly and a wide bid-ask spread in asset prices, as we have here.

    5. I spent 4 years as a BU undergrad, 3 years getting a PhD and 30 years on Wall Street. I am now at the end of my working career and it’s a shame to see my entire life’s savings hanging on the outcome of an argument based on ideology and not an understanding of the underlying economics.

  • Marco Piede on 09.30.2008 at 4:44 pm

    Who Killed Glass-Steagall

    I would like to hear Prof. Gilchrist’s comments on the systematic destruction of the Glass-Steagall by Citicorp and JP Morgan’s lobbyists. For anyone interested, PBS has a summary from "Frontline." It appears that the source of our present financial woes began as our government supported the removal of the protections provided by Glass-Steagall. The blood evidence is everywhere, from the Fed, to the government, and all to support the financial sector’s greed.

  • Anonymous on 09.30.2008 at 8:54 pm

    Regulation and Moderate Economic Growth

    A well-regulated market is a market with good information. Since good information is a public good, government intervention is neccessary. Yes, free market works well when things are going well, but economists and market participants alike tend to forget that human nature never really changes. I am a big supporter of innvoation, but that should come with responsibility. I will support a strong regulatory framework that will sacrifice some market efficiency which will likely to achieve stability over the long term

    You don’t need PHDs in econoimcs or finance to know that human nature will always come back to hunt you.. When smart people screws up, everybody else have to suffer!!! Poor minimum wage workers who can’t afford medical care, well at least in Massachusetts, they get subsidized health care.

  • Ursula Bastiaan on 09.30.2008 at 9:10 pm

    The best for now is for the bail out to happen...

    I really think that the best plan for now is to have the bail out plan. I am no expert in economics, but I have been following the market and it seems like the financial sector has never ending troubles since bear stearns and lehman. It’s true that it’s too good to be true for the financial executives to just get fed by the government’s bail out money, when they are the ones who are responsible for whatever happens to their companies. But, if the government were not to intervene, what could happen in the future? I mean will the companies be able to survive? And how about consumers who are dependent on these companies? Maybe the government and the companies should have some kind of an exchange deal.. maybe they already have and if yes that’s great and just go with the bail out plan! It’s not as simple as it sounds I know. 700 billion dollars is a freakishly huge amount of money to be given out just like that, not knowing will these financial companies be able use this “opportunity” well. How about those mid-sized financial firms? I think the government should help them more, not the large, supposedly well-experienced companies.

  • Anonymous on 10.01.2008 at 5:43 pm

    Just because an economic

    Just because an economic model predicts something will work doesn’t mean its the only course of action. The role of government and how it affects the rights of people has to be considered, and in my opinion, is the reason why this plan is bad for our country. Whether a recession lasts for a few months or a decade, potentially avoiding/or lessening it doesn’t outweigh the major consequences this plan would have for the future of representative government in this country.

  • Anonymous on 10.03.2008 at 5:06 pm

    2% recession in GDP, more like 4 % probably, which is equivalent to 600 billions.

  • Tom in Texas on 10.09.2008 at 12:57 am

    Bail out the victims, not the looters

    The bailout should buy only first, variable-rate mortgages (no derivatives) at prices based on the initial interest rate frozen for the life of the mortgage. These are the sources of nearly all of the problem.

    The derivatives were essentially worthless at conception and are held primarily by big investors (like sovereign wealth funds) that can take the hit by selling off a yacht or two.

    The corporate criminals were betting the derivative ponies with their investors money and deserve no charity. Especially since they skimmed billions in corporate assets that belonged to their investors and may well have kept their institutions afloat.

    The corporate veil should be pierced by the courts and all those years of obscene unearned non-performance bonuses should be confiscated to mitigate the taxpayers losses. It is the only action that may restore some confidence on main street, especially in light of the miserable non-performance of the Congress and Executive Branch to date.

    The 800 page bill confirms all the worst impressions of the incompetence and moral weakness of our elected officials, many of whom probably don’t even know or understand much of the legislation they voted for.

  • Emma K. on 01.29.2009 at 4:03 pm

    So here we are, four months later, and we have another rescue plan of sorts, except this one is being called a stimulus plan. Regardless of the name difference, it’s the same thing…the economy is in danger of imploding, so the government is going to spend insane amounts of money to save us all.

    I’m not economist, but one thing I do know is that nothing ever goes up in a straight line, businesses and economies all have periods where they take one step back for every two steps forward. What really alarms me is that government and Americans refuse to acknowledge recession as a natural and healthy part of the economic cycle. So what we have is a continual series of government interventions which are putting off the inevitable and probably making it worse.

    Is the housing crash someone’s fault? No, because there’s nothing wrong with it. Housing got to a level where it was not affordable without taking out an irresponsible loan. Housing should, therefore, go down. And if America became so economically dependent on buying and trading toxic paper, maybe it’s a good thing that a recession forces us to actually make useful things for a living instead of shuffling around paper no one understands.
    Emma K.
    Portland personal injury lawyer

  • John on 02.20.2009 at 1:53 pm

    Great article, and definately

    I would like to hear Prof. Gilchrist’s comments on the systematic destruction of the Glass-Steagall by Citicorp and JP Morgan’s lobbyists. For anyone interested, PBS has a summary from "Frontline." It appears that the source of our present financial woes began as our government supported the removal of the protections provided by Glass-Steagall. 

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