HEAVY BURDEN
The Office of Financial Stability promises to lift us from our rocky economy and place us safely on even ground. But can it deliver on the promise?
By Carolyn Tang
OCTOBER 10, 2007. The Dow Industrial Average closed at 14,078.69. NASDAQ stood strong at 2,811.61. Analysts were, for the most part, optimistic as the domestic economy entered the fourth quarter.
OCTOBER 10, 2008. The Dow Industrial Average closed at 8,451.19, a drastic 40-percent drop in value compared to the previous year. Stalwart stock AIG was removed from the Index and replaced with Kraft. NASDAQ stood in tatters at 1,649.51, a 41-percent reduction in value. Analysts scrambled to keep up with the unraveling banking and finance sector.
You could see the first fissure back in August, if you knew where to look. The FDIC took over XYZ Bank, then, within months, the giants began to fall. When one fell, another was shaken. First, a government takeover of troubled siblings, Fannie Mae and Freddie Mac. Then, investors helplessly watched as prestigious Lehman Brothers’ frenzied calls for help went unanswered. Washington Mutual and AIG followed soon after, banking bastions no longer.
Such change in the span of a year. Could we have avoided this crisis? In hindsight, the temptation was too great. Interest rates were at such a record low that banks were almost incentivized to extend subprime loans to less-than-qualified borrowers. Many consumers, both at the personal and the commercial level, were sufficiently enticed by free-flowing credit that they underestimated their security and overextended their spending.
But as in every fairytale, doomsday finally came. Foreclosed homes, a rash of bankruptcies, and complicated derivatives that, when unraveled, yielded nothing. The castle in the clouds collapsed, and at the end of the day, there was nothing on the books but empty, extended capital. The economy grinded to a halt as credit froze and all forms of lending ceased.
“Imagine that you were driving down the road on a two-lane highway,” explains Gerry Sparrow, portfolio manager of Sparrow Growth Fund. “You trust that the other guy is going to stay in his lane, but that doesn’t always happen. And if you see an accident like that, you start driving a little bit better, keep your eyes open, and you’re more careful about speed and such. Right now, with the mortgages that went bad on the books of all the financial institutions, you can see why they’re a little reluctant to loan money.”
The US economy is reliant on the flow of credit. For the system to work, banks must lend to businesses, consumers, and even other banks. However, when there is no trust in the system, there is no lending.
“The credit freeze up was a terrible problem for financial institutions. They simply were unable to understand valuations on assets, and weren’t willing to lend to each other even. That was a huge, terrible problem for those institutions and for our economy as a whole,” says John Douglas, a partner with the law firm of Paul Hastings.
With banks fearful at the crossroads, consumers and businesses clamped down on spending even harder. “It is a vicious cycle,” says Dan Sondhelm, partner of SunStar, a finance industry consulting firm. “There is significant fear and lack of confidence in the marketplace. As a result, businesses and individuals are paralyzed in terms of earning and spending. It’s difficult for Americans to get the credit they need to pay bills, buy cars, renovate or buy homes. At the same time, it‘s difficult for businesses to get paid from these services and expand,” he explains.
And so, in October 2008, the US government passed the Emergency Economic Stabilization Act, which authorized the Treasury to establish a troubled asset relief program (TARP). Seven-hundred billion dollars was earmarked to lubricate the country’s economic gears: $250 billion was allocated upon enactment, with an additional $100 billion disbursed if the President certifies its need to Congress. A final $350 billion will be disbursed upon presidential request, unless Congress disapproves. To administer this kitty, the Act established a new Office of Financial Stability (OFS), headed by Interim Assistant Secretary for Financial Stability Neel Kashkari.
“The law gives the Treasury Secretary broad and flexible authority to purchase and insure mortgage assets, and to purchase any other financial instrument that the Secretary, in consultation with the Federal Reserve Chairman, deems necessary to stabilize our financial markets—including equity securities,” Kashkari stated in a speech to the Institute of International Bankers in Washington, D.C.
Indeed, such a statement gives the Treasury significant leeway in determining how to apply the funds. However, regardless of the vehicle, the OFS’ main charge is to provide the financial system with the resources necessary to jumpstart stalled markets.
“This $700 billion is really designed to get our financial markets working again. Otherwise, economic activity as we know it may slow down dramatically, with severe repercussions in the economy,” says Douglas.
Joseph Ament, professor of accounting and taxation at Roosevelt University, Chicago says the creation of the OFS is necessary in order to provide the financial system with the resources necessary to help alleviate the serious circumstances the domestic economy is facing in many of its basic and major sectors. “In recent past decades, there hasn’t been a perceived need for such an agency in the US government. With the international and national financial crisis, such a requirement has been determined by our Congress and our Treasury,” Ament comments.
In conjunction with the OFS, the Treasury also announced the appointment of several key interim TARP leaders, including Tom Bloom as interim CFO, Jonathan Fiechter as interim CRO, Donna Gambrell as interim chief of homeownership preservation, Don Hammond as interim CCO, and Reuben Jeffrey as interim CIO.
No doubt an experienced cohort. But will it be enough? “Does anyone have the experience and knowledge to deal with the catastrophic set of circumstances that is now being faced?” Ament asks.
Initially, the program was established to purchase troubled assets from financial institutions, in essence removing them from the system. However, this proved to be a difficult task. “It’s actually very hard, and very complicated,” Douglas explains. “It’s tough to figure out the pricing. Once you buy assets, you’ve got to figure out what to do with them. If you’re buying problem assets, you’ve got to figure out how to manage them. The government is not a particularly good manager of private-sector assets, so it would more likely try to sell them. Selling them might exacerbate losses.”
So instead the US government used the bailout funds to purchase preferred stock in some of the nation’s largest banks: Goldman Sachs, Morgan Stanley, JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Bank of New York Mellon and State Street Corp. The government is also expected to purchase additional equity from potentially thousands of other insured financial institutions; raise the FDIC cap on deposit insurance for certain types of bank accounts; and restrict executive compensation, bonuses, “golden parachutes” and other incentives at institutions participating in TARP.
“I think what happened is that the government decided that the best bang for the buck would be simply to take institutions that really are the lifeblood of our economy and strengthen those institutions through the capital program. Perhaps this approach would be easier, better and, in the long run, more effective. I hope they’re right,” says Douglas.
While many institutions have queued up for their share, there will be a small number of financially strong institutions that will choose not to apply for government funds. “Frost Bankshares down in Texas is one example,” Douglas explains.
“There also will be a number of institutions that won’t get the money because they are so financially weak that the Treasury is just not going to do it, and the regulators won’t support it. Those institutions will either have to find new capital, find a merger partner, or fail. That’s going to be pretty dramatic,” says Douglas. And with that, Douglas also notes the subtle irony of the bailout process. “This money was put in place to strengthen the financial system, and yet it will accelerate the failure or consolidation of a number of institutions.”
“This is an experimental process—an indicator of whether the business community is supportive of the steps that the Administration is taking in the financial markets,” Ament explains. “The volatility and volume of trading on the exchanges, and the deep drops and steep climbs in markets daily, sometimes several times up and down each day, are a continued indication of the great uncertainties prevalent in the economy.”
It’s not as though the government has been entirely hands off with the nation’s economy. In fact, the current level of involvement rivals that of the Great Depression. Additionally, with the purchase of equity, the government has in effect intertwined the fates of the banking sector with that of US taxpayers.
“The levers the government is using on the fiscal and monetary side are normal levers, but I think that the degree is different,” says Sparrow. “The magnitude is much larger than people expected, and bigger than anything in recent memory.”
The nature of the stimulus aside, the resulting impact is textbook economics. “Once credit begins to flow again, you get lending. That lending will spur job growth. And when there are more jobs, the economy will begin to grow. You’ll get housing starts again. Car sales go up. Consumer spending goes up. Then the stock market will respond. The stock market will go higher, people will feel more secure in their retirement and their spending, and it’ll loop around again,” says Sparrow.
He goes on to explain that by guaranteeing credit instruments, the OFS is essentially providing a safety net for the US economy. “For example, GE is getting guarantees on its commercial paper, so when institutions loan GE money, they know that GE is backed by the government and their fears are assuaged.”
And, in fact, the government may help to boost the economy with aid to the auto industry, a sector that employs a large percentage of the population, and whose failure would likely counteract any fiscal bailout activities.
“As the media headlines die down, people will spend more, and businesses will once again grow,” says Sondhelm. “There will be new winners in the business community, and it will be interesting to see who makes it to the top.”