URL: http://www.newsweek.com/id/147759
Seeing Shades of the 1930s
The government's efforts to keep Fannie and Freddie afloat have a lot in
common with the New Deal.
Daniel Gross
NEWSWEEK
Updated: 1:46 PM ET Jul 19, 2008
On Tuesday and Wednesday, Federal reserve chairman Ben Bernanke, a
scholar of the epic financial meltdown of the Great Depression, and
Treasury Secretary Henry Paulson, a survivor of more recent Wall Street
crises, told Congress of their latest efforts to rescue the financial
sector. If Fed chairman Alan Greenspan, Clinton Treasury Secretary
Robert Rubin and his deputy Lawrence Summers were known as the Committee
to Save the World during the financial crises of the 1990s, today's duo
may go down as the Committee to Save Wall Street From Itself. For the
past several months, the Fed and the Treasury Department have pulled
all-nighters dealing with three-alarm fires, from the demise of Bear
Stearns in March to the rising concerns over the mortgage giants Fannie
Mae and Freddie Mac.
Fannie and Freddie play a huge role in the mortgage business by lending
cash and guaranteeing loans made by others. But with the spread of the
mortgage crises their stocks have plummeted in recent weeks, and
questions have been raised as to whether the government would do what it
implied it would all along when it established the two government
sponsored organizations: stand behind their debt. Bernanke and Paulson
gave an emphatic "yes," as they described to occasionally hostile
Congress members their plans to allow Fannie and Freddie to borrow money
from the Federal Reserve, and to empower the Treasury Department to buy
(and buoy) the companies' stock and stand behind their $5.2 trillion in
debt. The prospective moves, along with some slightly
better-than-expected earnings reports from banks last week, calmed the
markets. The price for this desperately needed action is likely to be
more regulation and oversight. Will the crisis inspire a fundamental
restructuring of the vital, symbiotic relationship between Washington
and Wall Street, as happened during the New Deal? Or will these
responses prove a temporary blip, as when the government bailed out the
savings and loan industry in the late 1980s? In short, is this 1933 or 1989?
It certainly seems a bit more like 1933, and not just because CNN, the
modern-day equivalent of newsreels, has been filled with pictures of
people queuing outside failed banks. Rather, as happened 75 years ago,
Wall Street—after two terms of a business-friendly Republican
president—self-immolated on a pyre of greed, incompetence and excessive
optimism. The troubles thought to be contained to a particular sector
(stocks then, subprime mortgages now) spread throughout the entire
financial system. And with confidence shattered, the federal government
stepped in with unprecedented efforts. "This is a much broader extension
of government assuming risk in the financial system than we saw in the
1980s," said Bill Seidman, the former chairman of the Resolution Trust
Corp., the federally created liquidator of all those failed S&Ls.
The New Deal left behind plenty of important landmarks, from the
Appalachian Trail to Hoover Dam. But its financial infrastructure has
proved just as important. The Banking Act of 1933 created the Federal
Deposit Insurance Corporation and forced member banks to submit to
regulation. The Securities and Exchange Act (1934) brought forth a body
to oversee the nation's stock exchanges. Later in the decade, Fannie Mae
was established to revive the dormant mortgage market. "It was a
wholesale restructuring of the financial system," said New York
University historian Richard Sylla.
The efforts—strenuously opposed at the time by the supine financial
sector—worked. "Only with the New Deal's rehabilitation of the financial
system in 1933–1935 did the economy begin its slow emergence from the
Great Depression," as Bernanke wrote in "Essays on the Great
Depression." The art deco complex of backstops, insurance, oversight,
disclosure and regulation proved to be remarkably durable: in 75 years,
the FDIC hasn't lost a penny of depositors' money.
Of course, New Deal-era financial dams occasionally broke. In the 1980s,
the Federal Savings and Loan Insurance Corporation (born 1934), which
provided deposit insurance to S&Ls, was overwhelmed when the deregulated
thrift industry imploded. The ensuing bailout—taxpayers made insured
depositors whole—cost $120 billion. But while surviving thrifts entered
the FDIC system, NYU's Sylla notes "there was no major reform." The
Resolution Trust Corp. folded in 1995, a few years before the
Depression-era prohibitions against investment banks owning commercial
banks, known as the Glass-Steagall Act, were wiped away.
When the 1990s telecom/dotcom bubble burst, official Washington
responded with a yawn. But the housing/subprime/ credit mess has
inspired a different reaction for two important reasons: leverage and
connectivity. Bear Stearns had more than $30 of debt for every dollar of
capital. And U.S. banks are connected at the umbilical cord to
institutions around the world. "The actions on Bear Stearns were
necessary because Bear Stearns was extensively interconnected with the
rest of the global financial system," says former Clinton Treasury
secretary Robert Rubin. That holds doubly true for Fannie Mae and
Freddie Mac, whose securities are bought in bulk by central banks around
the world. The use of complex financial instruments like derivatives and
credit default swaps have bound institutions the world over together in
a contractual tower of cards that can easily collapse.
This time around—as was the case in the 1930s—the problems arose in
unregulated or lightly regulated sectors. Subprime lenders (many of
which were not part of the FDIC system) sold loans to Wall Street
investment banks (which are not regulated by the Federal Reserve), which
in turn traded them with unregulated hedge funds. As a result, there
were few early warnings and no established protocols for dealing with a
failing institution. The result: regulators have had to act like John
Coltrane and Oscar Peterson. They're improvising.
The jam session started in March, when Paulson and Bernanke worked out a
deal for JP Morgan Chase to take over ailing Bear Stearns. Paulson
helped dictate the price, and Bernanke agreed to let JP Morgan present
$30 billion in assets belonging to Bear at the so-called discount
window—usually available only to banks in the system—in exchange for
cash. In the ensuing weeks, as Wall Street firms were leery about
lending money to one another, the Fed opened up the discount window to
19 investment banks—which, like Bear, aren't regulated by the Fed—thus
putting more taxpayer funds at risk. As of last week, $13 billion in
such loans were still outstanding.
Those sums pale in comparison to the potential exposure proposed last
week, when Paulson and Bernanke gamely asked Congress to have the
taxpayer explicitly back the $5.2 trillion in combined debt of Fannie
Mae and Freddie Mac. "It's an unprecedented request for an open-ended
amount," said Rep. Spencer Bachus, a House Finance Committee member and
one of a group of skeptical GOP congressmen who met with Paulson after
the hearing last Tuesday. Lawmakers said they want a quo for all the
taxpayers' quid they're putting in.
One key difference between the current relationship between Washington
and Wall Street and that of the early 1930s has to do with the political
standing of the financial industry. Despite the recent disasters, the
bipartisan revolving door from Wall Street to Washington—both the
Clinton and the Bush administrations had Treasury secretaries who ran
Goldman Sachs—is still whirling. Fannie and Freddie have a long history
of hiring politically connected executives and lobbying intensely. Wall
Street remains a vital source of campaign funds for Democrats and
Republicans. "FDR talked about throwing the money changers out of the
temple," says author Kevin Phillips, whose best-selling "Bad Money"
describes the ascendance of finance in politics and the economy. "These
guys [today] talk about keeping the money changers running the temple
and charging 28 percent on credit-card interest." James Grant,
proprietor of Grant's Interest Rate Observer, and one of the few on Wall
Street to warn about the credit crisis, said that given Wall Street's
failures, there should be a bipartisan hue and cry to insulate taxpayers
from bankers' failures. "But I hear neither of the presidential
candidates saying anything like that," he said. "The political dog that
didn't bark is the one that is watching Wall Street, but it is fast asleep."
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