Bailing Out
CAS economist Simon Gilchrist on the Wall Street rescue
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.
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