One year ago, the failure of giant investment bank Lehman Brothers helped trigger a financial meltdown unlike anything since the Great Depression. After a series of interventions by the federal government, including Treasury and Federal Reserve programs aimed at financial institutions and a massive stimulus bill aimed at the economy, the stock market has recovered much of the ground it lost, and some are pronouncing the "Great Recession" over.
Robert Bliss, F.M. Kirby Chair in Business Excellence in the Schools of Business and a former economist with the Federal Reserve Bank of Chicago, has done extensive research on how bank insolvencies are resolved. He warned about "systemic risk" in a 2003 paper, long before the term would be explained to average readers in a daily newspaper.
Q. Looking back over the past year, what do you consider the main lessons of the financial crisis?
A. Before the crisis began, regulators had been focusing primarily on credit risk in loan portfolios. The crisis has taught us that we should also focus regulatory attention on off-balance sheet activities, on nonbank players in the financial markets — the so-called "shadow banking system" — and on liquidity. Shadow banking refers to the use of securitizations, the bundling of mortgages for instance, and to nonbank financial players, such as Fannie Mae, Freddie Mac.
When the crisis began, what we found out was that banks were holding a lot of assets, but when it came time to sell them there was no market. The assets were not liquid enough to sell in time to pay off creditors, who were declining to renew their loans because they had doubts about the value of the assets and because the banks were highly leveraged. This fragility of funding sources for financial institutions had been under the radar for regulators before the crisis.
Banks have become conduits for loans. In the years before the crisis, banks moved from a model of making and holding loans to one of making loans and selling them as securitizations. In doing so, they generated funds to make more loans. What's been happening in the last few months is banks have become stronger and more able to lend. There has been some pickup in the demand for loans, but the securitization market has not improved and the market for corporate loans is still extremely weak. Therefore, banks are unwilling to make loans because they are unable to sell the loans to investors.
The government has basically ignored that part of the problem except for the mortgage market. The federal government has aggressively used Fannie Mae and Freddie Mac to buy mortgages to support the housing market since it took them over. The government is guaranteeing those mortgage securitizations, so investors are willing to buy them, but Fannie and Freddie are lowering their credit standards and that poses an increasing the risk to taxpayers.
Q. The media have focused on the stock market recovery and indicators such as home sales and consumer spending. What problems have the media overlooked?
A. What the media haven't focused on are the credit markets, which are still very weak. We went through a period where things were falling apart. That has been stemmed, but with the exception of housing, we're not seeing much of a pickup in investor confidence in buying credit products, and this has become essential to the functioning of the credit markets. We still have a large number of banks failing, mostly very small ones. The FDIC is taking on a lot of risk, and its reserve fund is down, way below the statutory requirement. It is also using guarantees instead of cash, which pushes its losses and risks into the future. When the crisis passes, the FDIC will have to raise its fees to banks to restore the fund.
Q. Is the banking system in better shape today, or are we at risk for another crisis in the near future?
A. I think the likelihood has receded that we could have a panic and lockup of the financial markets like we saw last year. The financial markets have stabilized. The question is, when will we get back to running smoothly again? We don't want to go back to the easy money that we had in 2005, and loose credit standards, but we would like to go back to where the entire system is channeling funds from savers to firms and households that need to borrow and can use the money for constructive purposes. That flow through the system is not re-established yet, but I think the sense of panic is gone. This is in large part due to government intervention that has transferred a great deal of the risks to the taxpayers through massive injections of money, and more particularly through guarantees, which people aren't paying a whole lot of attention to.
Q. As someone who has tracked the banking industry for many years, what troubles you most today?
A. The risks that the government is undertaking in the way it's handling bank closures, in the way it's handling Fannie and Freddie, I'm afraid, are going to be very costly. The Fed has put an enormous amount of money into the system that they are going to have to take back out to avoid inflation. To do that while keeping the economy growing at an acceptable rate will be a very delicate balance. We're going to be on a tightrope between slow growth and inflation for several years to come.
And then the other thing I see is the Treasury and the regulators are gathering to themselves an enormous amount of power to intervene in private markets, and this should be a concern. It's one thing to come in and help stabilize the markets in a crisis. It's another to build regulatory and legal systems that presume that the government will do so and that make it easier for the government to do so, and that alter the way in which financial systems and financial contracts function in the economy and in the courts.
We have to remember that the government was no better at anticipating the crisis than the markets were. In running the firms that government officials have control over, such as Fannie Mae and Freddie Mac, they've tended to pursue political rather than economic objectives. They're not prescient, and they're not good economic stewards. These firms were too big to fail only because the government said they were too big to fail. You can't remove the presumption that the government will bail out firms by creating laws that make it easy for government to take over firms. It's just a contradiction. Plus, there is a presumption that the government can run the financial system better than markets.
Under (treasury secretaries) Paulson and Geithner, there's been an urge to punish. This comes out of frustration and blame shifting. Should the Executive branch set as an objective assessing blame and extracting penalties? That probably belongs in the courts. The market should punish bad decisions, but there is a difference between bad decisions and illegal behavior. There is this arrogation of power to decide where to assess blame that is troubling.
Finally, you can't divorce the financial markets from the economic side. The huge budget deficit and the impact that's going to have on our economy is something we need think very seriously about. It will affect the value of the dollar. We have a government deficit — more than 10 percent of GDP — and the federal debt is approaching 100 percent of GDP. That's a huge risk to the economy.