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Sometimes government programs that seem flawed at their launch turn out to succeed against all expectations. No, this is not a post about the Affordable Care Act — I still think that will prove to be an unsustainable fiscal train wreck. I have in mind the Obama administration’s Financial Stability Plan to continue the bank rescue, kicked off in a speech by Timothy F. Geithner as Treasury secretary just over five years ago, on Feb. 10, 2009.
Mr. Geithner sought to explain how the new administration would carry on with the job of stabilizing still-fragile financial markets. The Bush Treasury, at which I was a senior official, had intervened to support money market funds, banks, General Motors and Chrysler, and the American International Group insurance company (for which TARP money was used to restructure the Federal Reserve’s loan). The Federal Reserve and Federal Deposit Insurance Corporation had taken a range of vital and innovative actions to stanch the crisis, and staff members from the Treasury and Fed were developing a program to address credit market strains that were hindering business and consumer lending.
Even though Mr. Geithner had made key contributions to the financial rescue programs while in charge of the Federal Reserve Bank of New York, it was natural to expect the recently inaugurated President Obama to put his own stamp on the program, especially when many Americans were understandably discomfited at the idea of the bank rescue in the first place. Indeed, the president himself had built up expectations just a few days earlier that his Treasury chief would provide “a new strategy to get credit moving again.”
The Geithner plan aimed to assure investors of bank stability, to cleanse bank balance sheets of remaining illiquid assets such as subprime mortgage-backed securities, and to encourage new lending to businesses and consumers. In broad strokes, this had the makings of an appropriate response to the problems facing the financial system, in large part by continuing and building on the efforts already under way that had succeeded in arresting the panic of September 2008.
Americans have long come to expect the Obama administration to overpromise and underdeliver. But the introduction of the financial stability plan took place before this pattern became clear, and market participants were dismayed that the secretary’s speech had little information on how the worthwhile goals it set out would be achieved.
Trust in the stability of banks gradually had been rebuilt after the October 2008 announcement of TARP capital injections. The improvement reversed following the speech, as can be seen in Figure 15 of a report issued by the Treasury in September 2009, which shows an increased cost to buy insurance against bond defaults by major banks. (It is admirable that the Geithner Treasury marked the timing of the secretary’s speech on charts in its report even while knowing that this would highlight the self-inflicted wound.)
I remember the feeling of dismay at the seemingly half-baked plan while watching the speech with others at a New York City asset management firm where I was talking about the economy. The reaction of equity markets mirrored the unhappiness in that room, with stocks down more than 5 percent that day.
It turns out, however, that the program sketched out by Mr. Geithner both came to pass and made a difference. Five years later, the United States financial sector is in much better condition. Banks have absorbed losses from loans made during the bubble and rebuilt their capital, and investor confidence has returned. Mr. Geithner’s proposals did not all work right away or in the scale initially envisioned. In the end, however, Secretary Geithner deserves credit for making good on what he promised.
By far the most important component of Mr. Geithner’s proposal was a stress test to assess whether banks had “sufficient financial strength to absorb losses and to remain strongly capitalized” in the event of another severe downturn. Led by the Federal Reserve, the stress test involved coming up with forecasts of banks’ financial positions in the event of a hypothetical renewed recession and housing price collapse. Banks that could not make it through this very negative economic scenario would be given six months to raise capital from private investors, after which regulators would have pressed them to accept more TARP capital.
It is hard to remember, but back in the spring of 2009 many people believed that the United States government would nationalize large banks, starting with Citigroup and then moving on to Bank of America and perhaps others. Indeed, according to the New Yorker writer Ryan Lizza, this was a well-founded concern in the sense that nationalization was discussed as a policy option by the Obama administration amid a swell of sentiment for this action among economists and columnists.
In reality, nationalization was unlikely from the start for both legal reasons and political ones, the latter including that administration officials did not trust the F.D.I.C. to handle a seized megabank, as would have been required by law. But investors did not realize this, and thought that new equity investments in banks would be at risk of being wiped out by a government takeover.
Concern over the possibility of force majeure was heightened by the Obama administration’s erratic response in March 2009 to the political furor involving bonuses to A.I.G. executives, with President Obama ordering officials to find ways to block the bonuses even after his staff had already declared that this was not possible under the law. Together, these factors led to a halt to capital raising by banks in the first quarter of 2009 (as can be seen in Figure 1 on Page 7 of the September 2009 Treasury report). Just when financial stability and economic recovery depended on a stronger banking system, investor fears — some reflecting the administration’s own missteps — stood in the way.
The stress test results announced in May 2009 dispelled these concerns. Ten of the 19 banks examined were required to raise $75 billion of additional capital between them, but the needed amounts were widely seen as attainable for all but GMAC Bank (since renamed as Ally Bank and still having problems with the Fed’s stress tests). On the whole, the first stress test was seen as a credible indication that major American banks would not fail — and thus were not at risk of being taken over by the government. Citigroup in the end converted government preferred shares from TARP into common stock, substantially diluting the holdings of many pre-crisis investors. But the company remained afloat.
For market participants, the stress test results were the equivalent of an “all clear” flag at the beach after a storm — it was safe to go back into the water of banking industry investments (and they did, as noted a year later by then Fed chairman, Ben S. Bernanke). A straight line can be drawn between the 2009 stress tests and today’s stronger American banking system — not at all what was expected given the initial reaction to Secretary Geithner’s speech.
The initiative to support new consumer and business lending announced by Secretary Geithner was the Term Asset-Backed Securities Lending Facility (TALF) under development since the fall of 2008 — Steven Shafran, the brilliant Treasury official who had come up with the idea, stayed on into the new administration to get the program up and running. The TALF was designed to restore the flow of securitized lending for auto purchases, student loans, business equipment, and other activities in which individual loans were packaged together into securities that were then sold to investors. This lending had fallen off sharply since the crisis manifested in August 2007. TALF was a complement to the Federal Reserve’s quantitative easing program in the sense that the Fed purchases of Treasury bonds and mortgage-backed securities were meant to push down overall long-term interest rates while TALF was aimed at specific market strains.
The program had a clever design: it was attractive to use during times of market stress, when funding to make loans was expensive, but it became relatively costly and thus less desirable once markets returned to normal. New lending was closed in June 2010 with $43 billion in loans outstanding. A full discussion of TALF is a topic for a different post (though still relevant in that there are proposals even within the Fed for what amounts to a permanent TALF). But an evaluation of TALF lending found that the program resulted in lower interest rates for the target activities while not favoring any particular security. In other words, TALF worked effectively to address a problem that hindered particular types of household and business spending.
The last piece of the Geithner plan was for a Public-Private Investment Program (PPIP) in which the Treasury put government money alongside private investors to buy up the so-called legacy bad assets — the illiquid mortgage-backed securities that had figured so prominently in the crisis. It turned out that the additional capital raised after the stress tests was more important for restoring confidence in the financial system than government assistance in cleaning up the old bad assets. In the end, PPIP was a modest program (though with a positive financial return for taxpayers), but the problem at which it was aimed was largely addressed elsewhere.
As Mr. Geithner put it in May 2009 after the release of the stress tests, he was looking for banks “to get back to the business of banking.” This is what has happened. To see the alternative, consider the situation in euro zone countries, where multiple rounds of stress tests have not convinced investors that banks are sound, and weak credit growth remains a problem for economic growth.
Mr. Geithner is writing a book and can eventually give his account of these and other initiatives while he was Treasury secretary, including those on housing, where the results are still widely seen as not living up to the administration’s promises. On the bank rescue, however, the passage of time casts a considerably more favorable light than could possibly have been imagined back when his financial stability plan was announced.
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