On September 14, President Barack Obama gave a speech in New York to mark the anniversary of the Lehman Brothers failure. It was a year ago when — during the course of a single jaw-dropping week — the investment bank declared bankruptcy; Bank of America took over Merrill Lynch; and the U.S. federal government bailed out American International Group. How has Wall Street changed during the past year, and what will these changes mean for investors? What new financial regulations have been discussed, and what remains to be done? How much longer will it take the U.S. economy to emerge from the woods? Knowledge@Wharton spoke with finance professors Jeremy Siegel and Richard Herring to get their take on these questions and more.
An edited transcript of the conversation follows.
Knowledge@Wharton: Let’s start by talking about President Obama’s speech. What did you think of it?
Richard J. Herring: Like many of his speeches, it was strong on aspiration but short on detail. It was highly symbolic, to rattle the saber at Wall Street, the den of the problem. But at this point, it really depends on what Congress does with what he’s proposed. He’s proposed reform that is both timid and bold. It’s timid in that it really doesn’t do much to the regulatory structure. It’s bold in proposing some fairly radical attempts to control the non-bank financial institutions that have proved very troublesome in the current crisis.
Jeremy Siegel: It was fairly good. He’s restating his proposals that the Treasury put out quite a few months ago, some of which I support. There are some good points in those proposals, [although] a few trouble me. I am pleased that he said, “I’ve always been a strong believer in the power of the free market.” For someone who is accused of being a socialist or a communist, those are welcome words. He is not anti-Wall Street. There needs to be some reform and some of the proposals are good ones.
Knowledge@Wharton: We’ll come back to the reforms. But since you mentioned Wall Street — in the year since the collapse of Lehman Brothers, how has it changed? What will the changes mean for the stock markets and investors?
Siegel: We saw the whole concept of the investment bank totally changed. It killed itself as a standalone institution. It had to be absorbed by a commercial bank, as was the case with Bear Stearns, or in the case of Lehman, liquidated or take on a commercial-bank holding company status to get federal [funding] access. We saw institutions that got so big and when capital dried up, they panicked and said, “I have to have access to the Fed,” and became holding companies. Even Goldman Sachs, the most successful of the investment banks, [did that].
We can speculate on what’s going to happen. Maybe the hedge funds will be the new investment banks. The power of the Fed is enhanced as a result of the crisis and the ability to snap your fingers and get capital from the market is something that many firms are going to have to think two or three times about. It’s not going to be as easy in the future.
Herring: It’s changed surprisingly little, given the gravity of the situation and our near-death experience. Some very well-known and respected institutions have disappeared, but they have more or less morphed into larger institutions. While we had several institutions that were too big to fail, we now have fewer institutions that are emphatically too big to fail.
The approach started to go wrong with Bear Stearns. But it became most obvious with Lehman Brothers and American International Group (AIG), because we demonstrated in the space of two days that we had absolutely no capacity to resolve [problems at] large, insolvent non-bank institutions. We just didn’t have the right tools to do it. Now the Obama administration, without being very specific, has at least recognized that’s a problem. Unfortunately, the delays in implementing change may endanger the whole reform project because the financial institutions are lobbying very hard to not change anything.
Some institutions will be paying record bonuses again. In fact, the U.S. government has set up a situation where [bonus systems] can be very easily arbitraged by institutions getting essentially federal money [while] taking risky positions and making easy profits. In one sense, we’ve made the situation worse. There are green shoots of recovery all over the economy, but many of them are what [The New York Times columnist] Roger Cohen calls parachutes. You can say that with regards to the Cash for Clunkers program, because that’s why retail sales mainly went up. That’s not sustainable. You can see it in terms of the firms whose profits have increased because they are being supported in certain markets by the Fed’s intervention, which is now taking a view on not just the level but also the structure of interest rates. The credit structure of interest rates has always been something that we’ve let the market decide. You can no longer depend on that.
Knowledge@Wharton: A lot has been said in the past 12 months about financial reform. In his speech, President Obama called it, “The most ambitious overhaul of the financial regulatory system since the Great Depression.” What has been accomplished so far?
Herring: Almost literally, nothing except to encourage everyone to believe there are at least 19 institutions that are too big to fail. All that has been accomplished is to make the moral hazard problem even worse. That’s not fair to his reforms because [Obama's] proposal recognizes those problems and tries to pull back on them. It’s just not clear how he’s going to get them through Congress. It’s not like a parliamentary system; even though he’s a very popular president who controls strong majorities in both the House and the Senate, it’s still a very much a trilateral separation of powers. Congress has enormous power, to both move and obstruct in this case. And lobbyists have enormous power in Congress.
Some obvious combinations he didn’t even suggest because they were politically impossible. For example, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) both regulate derivatives, but the CFTC regulates them “on exchange”; the SEC “off exchange.” It makes no sense to have both of them. But historically, the CFTC has regulated commodities so it’s controlled by the Senate Agriculture Committee and the SEC is controlled by the Senate Finance Committee. [Members of] both committees depend heavily on contributions from lobbyists from those industries to be reelected. So they’re not at all eager to consider consolidation, even though it would make a lot of sense. That leads to a situation with a lot of regulatory arbitrage. And the only regulatory arbitrage Obama is dealing with directly is the Office of Thrift Supervision (OTS), which has thoroughly disgraced itself in the round, [being] responsible for the largest loss the Federal Deposit Insurance Corporation (FDIC) has ever sustained and even condoning back-dating of capital.
Finally, it looks like there’s a proposal to merge them with the Office of the Comptroller of the Currency (OCC), which is also a creature of the Treasury. It’s an independent creature presumably, but housed in the Treasury just like the OTS. They would be replaced with a consolidated office of bank supervision. But [Obama] hasn’t talked about an even more sweeping reform, which would put the other bank supervisory bodies in that same place because the Fed feels that, as a matter of theology, it has to have a hand in bank supervision. The FDIC — because it pays the bill when things go wrong — also feels it needs to be involved. So it’s not clear what’s going to come out of Congress. But it’s pretty clear it’s not going to come out quickly.
Siegel: Very little of the reform package has been put in place. The most important issues and actions that have been taken have been those of the Federal Reserve in terms of providing liquidity to the system and extending deposit insurance to more classes of deposits. The most important aspect of the Treasury’s reform package and is part of Obama’s proposals basically is that we’re going to identify a group a financial institutions that are “too big to fail.” They’re going to be called Class 1 financial institutions and have to have a lot of capital so the government doesn’t end up holding the bag. And it won’t only just apply to banks — we’ve had that for a long time — but to all financial institutions.
When we look back to before the crisis, we had a way to unwind banks in trouble. We had no way to unwind large non-bank financial institutions, especially AIG…. We need procedures to unwind those as well as what we already have for the banking system.
Knowledge@Wharton: What remains to be done as far as financial reforms go?
Siegel: That’s the most important one. But there’s a lot of debate about whether to have [financial institutions that are] too big to fail. To some extent, there’s no way around it. But [financial institutions shouldn't] think becoming too big to fail means it’s a free ride because the government will put a lot of capital and other requirements on them. In fact, once they see what happens what happens when they become “too big to fail”, many firms might choose to stay under the radar and we might end up with smaller firms. But once an institution becomes big enough, it gets one thing — protection from the government for senior bondholders. But it’s going to have to provide a lot of capital in terms of common, preferred or subordinated debentures. Institutions are going to have to take that hit to get protection on the basics…. That is the way to go. The realities are that there will be very big financial institutions and they will have to be under stringent capital requirements.
Herring: The most important thing that got only a paragraph in Obama’s proposal … is something that I’ve been pushing for a long time. I’ve been calling it a “winding down plan.” The British who have been speaking at length about this are a little harsher and call it a “funeral plan.” The only real solution to the too-big-to-fail problem is to have a clear plan to wind down or get rid of any institution if needed. If a bank cannot produce a plan that shows it can be wound down without intolerable spillovers, which would be passed by its board and checked by supervisors — or a college of supervisors in the case of international firms — it would be forced to restructure so it could be wound down, or might have to spin off divisions. But since we know regulation is never going to be perfect and prevent crises from happening and since we’ve set up incentives for institutions to take bigger risks by permitting them to be bigger and bigger and bailing them out whenever they go wrong — with the exception of Lehman — that in itself is a turning point.
You may recall when the G20 met soon after [Lehman's collapse], the newspaper headline was, “G20 Vows Never Another Lehman.” Even using bankruptcy in that situation made it clear that [the sector] will never go that way again, or at least, there’s a pretty good chance it won’t unless institutions can be controlled a little more ex ante.
There are few arguments for having very large institutions. There’s nothing in academic literature that suggests there are substantial economies of scale … nothing justifying having these $2 trillion institutions around. Yet regulators are facilitating the growth of these institutions by plastering them together in a panic and hoping they’ll work. But they get an advantage in the market that’s not fair to other players because they are implicitly too big to fail. They can borrow on better terms, or like AIG, they can offer guarantees without ever really having reserves to back them up. It distorts the whole system and leads it to riskier positions.
Knowledge@Wharton: It’s hard to talk about reform without talking about the reformers. Could you help us evaluate the policies of Treasury Secretary Tim Geithner and Federal Reserve Chairman Ben Bernanke?
Herring: On the positive side you could say they’ve been very innovative. Looked at another way, you could say they’ve been very panicky, because for a while last year, every weekend had yet another crisis that somehow had to be resolved. As a result, we have at least a dozen new Fed programs. The Fed has moved well beyond its original mandate of accepting only very high-class collateral and is accepting all kinds of collateral and making guarantees for assets on banks’ books. It’s supporting various markets that it wants to recover. The Troubled Asset Relief Program (TARP), which was completely incoherent in its first version, finally got passed. To everyone’s surprise, it became a program to recapitalize banks rather than restore liquidity to subprime debt, which was a fool’s errand anyhow. Unfortunately, banks will recapitalize without being asked for anything much in return.
We didn’t get greater transparency and we didn’t get a separation of good and bad assets. It was really kind of a forbearance [agreement]. And there’s been lots of actual forbearance going on because we know the FDIC has identified at least 400 banks that are on its “problem bank list.” But it only has the capacity to fail at most four, maybe five [at a time]. You have to have great sympathy with that approach because if it ever [manages] one badly, it could be a source of systemic risk. Its intention is always to move in over the weekend and open up on Monday mornings so insured depositors do not loose access to any service which is, you know, the best deposit insurance system in the world. But it’s overwhelmed by the breadth and depth of the problems, which could in fact become more serious. Problems are also probably problems in other sectors that have much more forgiving accounting.
We saw these problems in the investment banks first because they have always had a tradition of [valuing assets] using mark-to-market, or fair value, accounting…. But the commercial banks were really engaging in regulatory arbitrage because if a bank holds a risky asset in its banking, rather than trading, book, it has a much higher capital charge. The downside of holding the asset in its trading book is it has to use fair value accounting. Citibank in particular, but also UBS and other banks were taking massive writedowns … because they had made an arbitrage decision and lost essentially. So there’s great confusion about where the remaining losses reside. We know that Europe bought about 60% of the stuff and they’ve not really worked through the losses. They seem to have more discretion about when they reveal it.
Insurance companies operate with a very forgiving accounting system. That means it could be a long time before we see the losses that have been developing there. And the smaller and medium-sized banks tended to stay out of the collateralized stuff, but are heavily involved in commercial real estate, which is in some instances, the next shoe to drop. That’s mainly in their banking books, which means the markdowns take place only when management decides to do it or they’re compelled to do by regulators. It’s a very discretionary process and could drag on over a long period of time.
Siegel: Bernanke has done a stellar job. I strongly supported him for re-nomination, which he was. However, one weakness, of course, was he didn’t see the crisis coming. But almost no one in government did. His complicity with [then Treasury Secretary Henry] Paulson in presenting the TARP proposals was very poor. It wasn’t well prepared and as I indicated before, TARP wasn’t necessary. What was necessary was for the Fed to just say, “I’ve got an alternative way to protect these banks.” And they did take those measures with Citi and Bank of America, which put a fence around large classes of assets and gave those banks non-recourse loans. That is the heart of the new Public-Private Investment Program. PPIP is non-recourse loans. That’s what makes it go. That turned out to be the solution…. TARP became badly managed, political football and raised the hackles of millions of people. That could have been avoided.
But when you take the whole picture, we instituted measures that prevented a repeat of the Great Depression of the 1930s. The economy is well on its way to mending and I expect it to continue that way. There were some mistakes but the big picture is a success.
Knowledge@Wharton: And Tim Geithner?
Siegel: I don’t have strong feelings one way or the other. I thought Paulson made particular missteps, and Geithner has been at the front in terms of supporting what the Fed is doing and gave us the Treasury proposal. Something in the Treasury proposal I don’t like — and one of the aspects that is very dangerous — is that it includes an approval period by Congress for any loans made by the Federal Reserve. That can be very damaging. The Fed has to have maximum flexibility. To delay it [from providing] a loan could be fatal…. I believe that was put in as a nod to Congress to get them to pass the proposal, but I hope it is deleted in the final set of rules and regulations.
Knowledge@Wharton: Is there anything Geithner and Bernanke could have done differently during the past year?
Siegel: We could talk about Lehman Brothers, and whether they should have prevented Lehman from failing. You could probably say, “Yes.” But it would have rolled to another institution and then another. They probably should have come in stronger, saying “We’re going to protect these bondholders and contracts. The others, we won’t.” And be prepared for it. They were terribly unprepared for Lehman, particularly the fact that some of the big money funds held Lehman paper, which were forced to break down. That was a surprise, and threw them into a panic. That’s why they saved AIG on the following day.
Monday morning quarterbacking is always easy. Let me emphasize again that the liquidity measures taken by the Federal Reserve — the [reduction] of interest rates to near zero and the tremendous provision of reserves and lending facilities have been extraordinarily important and the key to preventing this crisis from becoming a Great Depression Number Two.
Knowledge@Wharton: Is there anything the regulators could have done differently?
Herring: The regulators could have done a lot of things differently. This is often talked of as a private-sector failure, and indeed it was. But it was equally a regulatory failure. That’s the reason I am put off by many of Obama’s proposals. Many of the suggestions are to just regulate more. We had hundreds of examiners in Citicorp looking at the same toxic debt that was on the books of other banks and they didn’t recognize it. It’s hard to imagine that without upgrading the talent and especially pay in the regulatory system that you’re going to get a much better result, unless you have some way of holding regulators accountable.
We thought what we had in place to prevent this sort of thing from happening was a prompt, corrective action system that would be triggered by a decline in capital. In almost every case when a bank has gone under over the last two years, the primary regulator has said a week before that the bank had more capital than the minimum required and there was no reason to worry. That simply means the capital standards are completely misleading and useless.
The market is focusing on, and rightly so, tangible equity and not the official definition of capital. But that too has problems. We don’t account for things necessarily in a way that reveals their true market value. But it’s a better measure certainly than Tier 1 and Tier 2 [capital ratio requirements defined by the Basel accords], which really are not [helpful in addressing] losses. Although Tier 1 includes tangible equity, it includes lots of other stuff that isn’t relevant to somebody who’s worried about what he’s going to get out of a bankruptcy.
Knowledge@Wharton: How are things with the U.S. economy?
Herring: I’d like to believe that all the green shoots are the real thing. But it seems that we’re on life support. Although it appears that things have turned around, most seem to be the result of government subsidies of one sort or another. I was quite surprised in Obama’s speech that he said didn’t think we were going to need another fiscal boost.
The problem is that the consumer sector, which has always been the engine of the U.S. economy, became terribly overleveraged. You can see it looking at long-term trends. In 2007, our debt-to-GDP ratio was the equivalent to what we had in 1929. Leverage in both cases got us into terrible trouble. What was different in the two cases is which sectors were leveraged. And in this case, it was the household sector that was enormously overleveraged, even more so the financial sector. This has really been a problem centered on financial institutions and consumers.
Now consumers are facing their retirement funding with $14 trillion less in assets that they once had. It’s got to be a priority for them to increase their savings. And with unemployment rising, there’s yet another reason that I’m a little skeptical about the numbers that we’ve seen. As for the Cash for Clunkers, we simply shifted around the spending pattern and moved forward what would have happened anyway. And I’m not sure the program was the wisest use of government funds when we have bridges falling down and a lack of mass transportation. Nonetheless, it did boost the figures, which Wall Street seems to be very happy about.
Siegel: We’re out of the recession. The recovery will be [in] July approximately…. We’re going to have about 3.5% GDP growth this quarter, which is quite good. We are definitely on the road to recovery, as is the rest of the world. It doesn’t mean it’s instantaneous. We dug ourselves a big hole. We need growth of 4% to 5% for quite a few quarters to take up the slack. It will happen, but it may take a number of years…. Going forward, I’m hoping growth in some quarters will be 4% to 5%.
Knowledge@Wharton: What about the rest of the world? Where are the areas of strength and weakness?
Siegel: Asia has shown particular strength. China has led the way in fiscal packages…. The recession in Asia was sharp because manufacturing contracted sharply in the forth quarter of last year and first quarter of this year. But [there will be] very big bounce backs. I’m even including Japan in that. Asia has been bouncing strongest, but it fell further. Europe is bouncing back also. The entire world is. It was the first coordinated world recession and we are getting a coordinated world recovery.
Herring: Europe has held up much better than I expected. I still don’t understand what’s happened in Germany, except that it had a successful Cash for Clunkers program too. Germany had a rotten first quarter, just as we did. I think it was down 7.5%. Yet, it seems to have rebounded, which is surprising because it is still a primarily an export-oriented economy. And it’s not clear who’s buying, except Asia.
It is more and more clear that if there is going to be an engine for the world economy, it’s not going to be the U.S. consumer this time. It’s going to be coming out of China. Which makes it a peculiar time to start picking trade wars with China. But not everything the government does is coherent.
Knowledge@Wharton: How about the Middle East?
Herring: It depends on the price of oil. If the world economy doesn’t pick up, the price of oil is not going to pick up and the Middle East hasn’t really made the transition from being a commodity producer to a more diversified economy. I don’t see it as being able to lead the world out of a recession. I see it as being very vulnerable to a world recession.
Knowledge@Wharton: With 20/20 hindsight, what are the main lessons we should be learning from the financial and economic crisis? Can it happen again?
Herring: Quite certainly it can happen again. It’s been happening with some regularity, but uncertain regularity. That’s what makes it difficult to deal with, ever since the beginning of capitalism. We can find bubbles in all sorts of markets. But bubbles in real estate tend to be the most punishing to an economy because the financial sector is so heavily involved in it. And usually the unemployment consequences are greater, there’s a greater fiscal cost and it takes longer to recover. It happens every 20 years or so, just about the time when a generation turns over and people have forgotten. But this [one] had many causes.
[This time] there was a macro policy that facilitated a run up on house prices and a complete breakdown in due diligence at every stage in the securitization process, which otherwise is probably one of the best financial innovations to have occurred in the post-World War II era. But it was just pushed too far, and for no good reason. [It wasn't helping] anybody but the investment bankers. It would be useful to put in place a reform to set best standards for securitization and discourage the complexity. It was striking that not only did the buyers of this product not understand it, but also those who manufactured it. They bore some of the biggest losses by holding what they thought were some of the safest tranches. Things really got out of hand. We were introducing products without having risk models to control them or really understanding how to value them. How do you deal with that? Regulation isn’t the answer because every time you get regulators who understand the models well, they [move to industry to earn more money]. That will [continue], unless we greatly change the relative salary of regulators, which is unlikely.
We will have to depend on market discipline. But to get market discipline, you’ve got to permit the possibility of failure. Most of the energy should be focused on how you can let institutions fail without bringing the system down with it. A lot of it has to do with what the government itself has done. The reason that Citicorp has 2,400 majority-owned subsidiaries is maybe partly because it wanted to be too complex to fail, but it’s mainly because of regulations and taxes….
Siegel: As long you have a free market, you can have a crisis. This was the first one of this magnitude in 70 years. If it will be 70 years until the next one, I’ll take that. That’s a pretty good job. Before we had the Federal Reserve, we used to have a crisis like this every 10 years. So the Fed, after failing dramatically in the 1930s, did the right thing to make sure the recession didn’t become a depression. When we look back, the Fed’s fast action — the rapid provision of liquidity and lending facilities — will be seen as the key that prevented us from going into the Great Depression Number Two.
When I was getting my education, there were always Friedman vs. Keynes debates. Both views [would be right today] in the sense that it was a shock that caused an aggregate caving in of demand, which was very Keynesian. But the solution was Friedmanite, in terms of protecting the banks and monetary institutions and providing liquidity. I knew Friedman well enough to know that he would have advocated Bernanke’s measures, which was to provide enough liquidity to prevent the financial system from collapsing the way it did in the 1930s. We can take some hope out of the fact that we used the lessons of the 1930s to prevent repeating the disaster that befell us 70 years ago.